Techniques to Generate Tax Savings for Your Clients

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Techniques to Generate Tax Savings for Your
Clients
 

• Leif G. Novie, CPA, JD
• Morrison Brown Argiz Farra
• 1001 Brickell Bay Drive
• Miami, Fl 33131
• Internal Revenue Service Circular 230
  DisclosurePursuant to Internal Revenue Service
  Circular 230, we hereby inform you that any tax
  advice set forth herein with respect to U.S.
  federal tax issues was not intended or written by
  to be used, and cannot be used, by you or any
  taxpayer, for the purpose of avoiding any
  penalties that may be imposed on you or any other
  person under the Internal Revenue Code.

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Notice 2008-16

• Permits bundled fiduciary fees to be fully
  deductible for 2008
• Notice applies to tax years beginning prior to
  1/1/09
• Extends interim guidance previously issued in
  Notice 2008-32
• Final regulations will eventually be issued
  consistent with the Knight decision rendered by
  the Supreme Court.
• It is anticipated that final regulations will
  require fees unique to trusts to be separately
  allocated in order to not be subject to 2 floor.
• Supreme Court did not actually mention unbundling

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Distributions by estate/complex trust

• In some cases it may make tax sense tax delay
  making distributions
• Is the estate/ complex trust and beneficiary in
  same tax bracket?
• Is the estate/ complex trust in a jurisdiction
  without a state income tax?
• If an estate, consider a fiscal year end in order
  to delay recognition of income.

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• Example- Decedent died February 3, 2008. By
  choosing a tax year end of January 31, the
  initial return of the estate will have a year end
  of January 31, 2009. Assuming all income of the
  estate will be passed out to the beneficiary
  (assuming distributions made), the beneficiary
  will report the income on her 2009 tax return. As
  such, the payment of tax on the income is delayed
  by almost one year.
• Note that this may not be a good plan if income
  tax rates are expected to rise in the future.

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• Will estate/ complex trust be subject to AMT but
  not the individual or vice versa?
• Can do late planning by use of the 65 day rule.

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IRC Section 643(g)

• Allows a fiduciary to shift estimated tax
  payments to beneficiaries
• This may help reduce or eliminate a beneficiarys
  underpayment
• Consider doing if there is no tax due on the
  fiduciary income tax return

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Indirect administrative expenses

• May be allocated to any income category of income
  as long as a pro-rata portion is allocated
  amongst tax-exempt income
• If there is income with state tax consequences,
  consider allocating general administrative
  expenses against this income category.
• See regulation 1.652(b)-(3)

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U.S. Savings Bonds

• Consider electing to pick up accrued interest on
  decedents final income tax return
• Usually beneficial if decedent in a low income
  tax bracket
• Any tax owed on decedents final return will be a
  deduction on estate tax return (form 706)
• Need to also consider how bonds will be taxable
  to estate or beneficiaries and the loss of the
  IRD deduction

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Basis of assets received from decedent

• Value on form 706 is typically the basis
• IT may be rebutted by clear and convincing
  evidence. See Revenue Ruling 54-97

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IRD

• Should it be recognized by estate or distributed
  to beneficiaries?
• IRD item must be distributed before the income is
  received by the estate to avoid being allocated
  to estate
• IRD (estate tax deduction) is deductible by
  estate without any limitations. Although not
  subject to the 2 floor, beneficiary must itemize
  to obtain benefit of IRD deduction.

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Final year estate return

• Excess deduction lost in any year except final
  year
• Delay paying large expense items until final year
  if no tax benefit for expenses
• May be beneficial to accelerate final year and
  terminate estate in order to pass out loss
  attributes to beneficiaries

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Example

• Estate has capital loss carryforward of
  500,000 and NOL carryforward of 300,000 in
  2008. Beneficiary, who has a very good investment
  advisor, has 1 million of capital gains and
  500,000 of interest income. If the estates
  final year return is 2008, the capital loss
  carryforward and the NOL can be passed out and
  used by the beneficiary against 2008 income.

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Net Operating Losses

• Net operating losses of decedent can not be
  carried over to estate. Make sure it is carried
  back on decedents final return.
• NOLs may be deducted by beneficiaries in year of
  termination. Beneficiaries can not carry back
  these NOLs.

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Grantor trusts

• Many contain a clause allowing the grantor the
  ability to relinquish the power making the trust
  a grantor trust.
• Is grantor in a higher tax bracket than
  beneficiaries?
• Has grantor moved to a state that has an income
  tax while beneficiaries remain in Florida?
• Is estate tax no longer an issue for grantor.
• Need to consider potential estate tax savings of
  grantor paying tax on the income.

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Capital gains

• If beneficiary has capital loss carry-forward,
  consider distributing asset instead of having
  trust or estate sell the asset.
• If the trust has excess deductions, consider
  recognizing gain so that deductions are not
  wasted. Securities sold at gain can be
  re-purchased with increased basis.
• Example- An trust typically distributes all
  income to its sole beneficiary. Beneficiary has a
  capital loss carry-forward. Trust has an asset it
  is about to recognize a significant gain. Instead
  of recognizing the gain and paying the tax, the
  trust distributes the asset to the beneficiary.
  Beneficiary can then sell the asset and have the
  loss carry-forward offset the gain.

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Alternative Minimum Tax Issues

• Estates and trusts may be subject to AMT if
  significant miscellaneous itemized deductions
• This may become more prevalent after 2008 in
  light of the Knight decision
• By making distributions to beneficiaries, it may
  be possible to avoid AMT, depending upon
  beneficiaries tax situation

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• For individuals with NOLs, be aware of amount of
  AMT NOL when doing tax planning. AMT NOL needs to
  be computed in order that AMT does not
  incorrectly occur.
• Be aware of differences in other AMT carryovers
  such as passive activity losses and investment
  interest carryover
• May be beneficial when doing year end planning to
  determine how much taxes and/or miscellaneous
  itemized deductions can be taken before hitting
  AMT.
• Individuals with substantial income, most of
  which consissts of qualified dividends and long
  term capital gains will usually be subject to AMT
• Individuals subject to AMT should typically not
  invest in municipal bonds subject to AMT

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U.S. beneficiaries and foreign trusts

• Need to be wary of throwback rules
• All income should be distributed to avoid
  throwback rules
• Beneficiaries need to make sure adequate
  information regarding income is received from the
  foreign trust in order to properly report income
  on their income tax returns

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Section 642(c)

• Permits charitable contributions paid in
  following tax year to be deducted in current tax
  year
• Election needs to be made
• EXAMPLE- A non-grantor charitable lead annuity
  trust (CLAT) is established with 1million and
  pays 60,000 annually to charities. In year 1 the
  CLAThas 100,000 of income and paid the 60,000
  to charity. As such, tax is due on 40,000 of net
  income.
• The election can be made to treat charitable
  contributions paid in the following as paid in
  the current year in order to reduce net income to
  zero to eliminate the current years tax.

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Basis adjustment due to gift tax

• Increase basis of gifted assets when gift tax
  paid
• Basis of assets gifted must be lower than gifted
  assets fair market value
• Basis in cash can not be increased
• Amount of basis increase is the amount of gift
  tax attributable to the net appreciation in value
  of the gift

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• If more than one gift of a present interest is
  made to the same donee in a given year, the
  annual exclusion applies to the earlier of gifts
  made
• Reducing the gift is beneficial since a greater
  portion of gift tax is allocated to the gifts
  basis
• If annual exclusion cash gifts are to be made in
  addition to the gifted property, it is beneficial
  that the cash gifts are made after the gift of
  property

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Example 1

• Donor makes a gift of 100,000 to donee
• Gifted property has a basis of 30,000
• Gift tax paid is 40,000
• The gift tax paid of 40,000 is multiplied by the
  net appreciation of 70,000 over the fair market
  value of the the gift less the annual exclusion.
  This results in an increase of basis of 31,818
  to 61,818
• 100,000 less 30,000
• 40,000 X ---------------------------
  31,818
• 100,000 less 12,000

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Example 2

• Same facts except 12,000 annual cash exclusion
  gift was made earlier in the year
• 100,000 less 30,000
  
• 40,000 x --------------------------- 28,000
• 100,000
• As such, the basis adjustment is 3,818 less when
  the annual cash gift precedes the gift of
  property

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State Tax issues

• Be aware of how various states tax fiduciaries
• Typically taxed based on location of assets,
  location of grantor/ decedent, location of
  fiduciary or a combination
• Choice of fiduciary may be important to avoid
  state tax. For instance, California can tax a
  trust with a California trustee

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Trader vs. Investor

• Investor Expenses
• 2 misc deduction limitation
• 3 limitation on phase-out of itemized deductions
• Miscellaneous 2 expenses subject to AM

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• Trader expenses are generally deducted above the
  line and not subject to limitations
• Interest from a trade or business is deductible
  on Schedule C or Schedule E. Investment interest
  is deductible on Schedule A
• From a tax perspective it is better to invest in
  a hedge fund classified as a trader as opposed to
  an investor
• Courts generally look at all facts and
  circumstances to determine if activity is at the
  level of trader status
• Generally trading must be substantial and
  taxpayer must seek to profit from short term
  profits
• In Leonard F. Fuld 139 F2d 465 there were 665
  sales transactions during the year which was
  substantial enough for trader status
• In William G. Holsiger TC Memo 2008-191, the
  Court noted that a significant amount of
  investments were held more than 31 days in its
  ruling that the taxpayer did not demonstrate he
  was attempting to profit from short term market
  swings.
• A trader without a mark to market election still
  reports capital gains as short or long term
  capital gains.

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Casualty losses

• IRC section 165(c)(3) provides for losses not
  connected with a trade or business or transaction
  entered into for profit if such loss arises from
  fire, storm, shipwreck, theft or other casualty
• IRC section 165(c)(2) allows losses incurred in
  any transaction entered into for profit, even
  though not connected with a trade or business

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• Losses under IRC section 165 (c)(3) are subject
  to 10 limitation of adjusted gross income
• Casualty losses may be carried back three years
  instead of two
• Loss is generally deductible in the year loss is
  discovered
• Authority is unclear whether deduction is allowed
  to be claimed in a year when the amount of
  recovery on a portion of the loss is uncertain
• Special rules apply for losses in Federal
  declared siaster areas including election to take
  loss in preceding year

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Worthless securities

• If any capital asset becomes worthless during the
  taxable year, the loss should be treated a a sale
  on the last day of the year
• For a decedent, consider if worthless securities
  or investments exist and whether the loss can be
  claimed on the decedents final income tax
  return. Keep in mind, basis is adjusted to zero
  at death so that loss can not be recognized by
  the estate.
• IRC section 6511(c)- 7 year statute of
  limitations for worthless securities

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• It has been held that the suspension of stock
  trading alone does not establish that a security
  is wortless since the suspension can be lifted
  and there may be a private market for the stock
• A security may be worthless even though a company
  has not filed bankruptcy. The security may be
  deemed worthless when it no longer has value in
  liquidation and there is no reasonable
  expectation for future profit.

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Section 1244 Small Business Stock

• Treated as an ordinary loss
• General qualifications (I say generally because
  there are a few exceptions beyond the scope of
  this discussion)
• Must be stock in a domestic corporation
• At the time stock was issued, corporation must be
  deemed a small business corporation
• Stock was issued for money or other property
• During past 5 taxable years more than 50 of
  aggregate gross receipts were derived from
  sources generally other than passive

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Section 1244

• Loss is limited to 50,000 or 100,000 if filing
  jointly
• A corporation is generally considered a small
  business corporation if the aggregate amount of
  money and property received for stock does not
  exceed
• 1 million

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Section 1045 Capital gain rollover

• Stock must be held for over 6 months as a capital
  asset
• Gain is not recognized if replacement stock is
  purchased during 60 day period beginning on date
  of sale
• Replacement stock must be qualified small
  business stock
• If amount realized on sale exceeds the
  replacement stock cost, gain is recognized.
  However, 50 of gains can be excluded if the
  stock meets requirements under IRC 1202 relating
  to exclusion of gain from certain small business
  stock.

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Section 1202

• Allows for partial exclusion for gain from small
  business stock
• 50 of gain from small business stock is excluded
  from income
• Qualified small business stock means any domestic
  C corporation qualifying under the rules of IRC
  section 1202(d)
• Active business requirement- at least 80 of
  assets must be used in the active conduct of a
  qualified business

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Qualified business

• Any business EXCEPT
• - service business
• - banking, finance or insurance
• - farming
• - natural resource extraction/production
• - hotel/restaurant
• 7 of amount excluded is an AMT preference amount