Income Tax Issues with New Tax Act

Before we get into the tax provisions of the Tax Relief Act, we should mention that, as this article was written, about 50 million taxpayers faced an IRS-imposed delay in filing their 2010 personal income tax returns. The delay is due to late Congressional action in passing the Tax Relief Act, causing many taxpayers to wait until mid- to late February to file their 1040 personal income tax returns so that the IRS can re-do many of their forms to deal with the new tax laws.


Those who may need to wait to file include taxpayers claiming:

· itemized deductions on Schedule A of their 1040 (mortgage interest deductions, charitable deductions, medical and dental expense deductions, etc.);

· the higher education tuition and fees deduction (this deduction covers up to $4,000 of tuition and fees paid to post-secondary institutions and is claimed on form 8917); and

· the educator expense deduction (for K-12 educators with out-of-pocket classroom expenses of up to $250).

It is worth noting that the IRS has extended the filing deadline for personal income tax returns from Friday, April 15, to Monday, April 18.

Now, for some of the changes:

Income and Capital Gains Tax Rates. The current federal income tax rates will be retained for two years (2011 and 2012), with a top rate of 35% on ordinary income and 15% on qualified dividends and long-term capital gains.

Social Security Tax Break. In 2011, employees and self-employed workers will receive a reduction of two percentage points in Social Security payroll tax, bringing the rate down from 6.2% to 4.2% for employees and from 12.4% to 10.4% for the self-employed on a maximum earned income of $106,800.

The Medicare tax rate remains the same: 1.45% for employees and 2.9% for the self-employed on all earned income. The income-tax deduction for the self-employed will be increased to 59.6% of the Social Security tax, and 50% of the Medicare tax.

Alternative Minimum Tax. A two-year Alternative Minimum Tax (AMT) “patch” for 2010 and 2011 will keep the AMT exemption near current levels and allow personal credits to offset AMT. Without the patch, an estimated 21 million additional taxpayers would have owed AMT for 2010.

Tax Credits. Key tax credits that benefitted working families and that were enacted or expanded in the American Recovery and Reinvestment Act of 2009 were retained by the Tax Relief Act. Specifically, the new law extends, for two years, the $1,000 child tax credit and maintains its expanded refundability. The refundable credit equals 15% of earned income in excess of $3,000.

The Tax Relief Act also extended rules expanding the earned-income credit for larger families and married couples and extended for two years the higher education tax credit (the “American Opportunity” credit) and its partial refundability.

Depreciation. Businesses can write off 100% of their equipment and machinery purchases, effective for property placed in service from September 9, 2010, through December 31, 2011. For property placed in service in 2012, the new law provides for 50% additional first-year depreciation.

Tax Deductions. Many of the “traditional” tax extenders are extended for two years, retroactively to 2010 and through the end of 2011. Among many other provisions, the Tax Relief Act extends (a) the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes; (b) the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers; and (c) the above-the-line deduction for higher education expenses.

The Tax Relief Act also retroactively reinstates, for 2010 and 2011, the exclusion from gross income of up to $100,000 of qualified charitable distributions directly from a regular IRA or Roth IRA, provided the taxpayer is at least 70½ years old. A qualified distribution made in January 2011 can be treated as made in 2010 for purposes of the $100,000 limitation and the required minimum distribution (RMD) for 2010.

A FEW TIPS

Give to Charity. You don’t have to meet a threshold to deduct your charitable donations. As long as you give to an IRS-qualified organization within the tax year, you usually can claim it as an itemized deduction for the full amount that you give.

Adjust Your Withholding Rate. Make sure you are having only the amount you need withheld from your paycheck. If you over-withhold federal taxes, you’ll get a big refund, but you’ve given up your hard-earned dollars for the other 364 days of the year. On the other hand, do not under-withhold, or you’ll end up owing the IRS at filing time.

Evaluate Educational Accounts for Kids. College costs increase every year, but tax-advantaged savings accounts can help. The key is determining which plan best suits your needs. For example, every state offers a 529 plan, and, although plan contributions are not tax-deductible, the earnings are not taxed. In addition, when you take out funds to pay for eligible expenses, the distributions are also tax-free.

Start a Business. Whether you operate your own business as your main source of income or as a sideline venture, tax laws offer several ways to save. As described above, the tax deduction for equipment and other business-related tools and machinery has been increased. Other popular business tax breaks, such as writing off new business startup costs, and many home office expense deductions also still apply.

New Tax Laws Impact Planning

On December 17, 2010, Congress and the President finally acted to extend the Bush era tax cuts that would have otherwise expired on December 31. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Tax Relief Act”) includes many taxpayer-friendly provisions for both individuals and businesses.

In this article we focus on how the new law impacts estate and gift tax planning.  Bear in mind, though, that these changes are good only through 2012.  At that point, we’ll either be back to square one, or Congress will again need to act.

$5 Million Estate Tax Exemption and 35% Rate.  The new law includes favorable estate tax provisions for individuals who died in 2010, as well as those who die in 2011 and 2012.  First, for individuals who die in 2011 or 2012, there is now a $5 million estate tax exemption and a 35% tax rate that applies to amounts over that. For estates of individuals who died in 2010, taxpayers can choose between (a) the new rules contained in the Tax Relief Act or (b) the rules that were otherwise in effect in 2010, which provided for no estate tax but modified the step-up in basis rules.

Portability of Unused Exemption.  Significantly, under the new rules, married individuals who don’t use up their estate tax exemption will be able to pass along the unused amount to a surviving spouse. In other words, unused exemptions of individuals who die in 2011 or 2012 (but not 2010) will be “portable.”

The ability to pass along unused estate tax exemptions to a surviving spouse is a very favorable development. It allows both spouses’ exemptions to be utilized without having to set up a credit shelter trust or engage in other tax planning maneuvers – as long as they both die in 2011 or 2012. Unfortunately, the new portability rules sunset after 2012, so it won’t help decedents who die after 2012. Also, the portability rules do not apply to the generation-skipping transfer tax exemption (gifts to grandchildren or to individuals who are more than 37½ years younger than the person making the gift).

Unlimited Basis Step-ups for Inherited Assets.  For heirs of decedents who die in 2011 and beyond, the Tax Relief Act reinstates the familiar rule that allows the federal income tax basis of inherited capital-gain assets (such as real estate and stock) to be stepped up to reflect fair market value on the date of death. This favorable rule is also reinstated for decedents who died in 2010, unless the estate elects to instead use the modified carryover basis rules that were otherwise in effect in 2010.  With the restoration of the unlimited basis step-up rules, heirs won’t owe any federal capital gains taxes on appreciation that occurs through the date of death.

Estate and Gift Tax Exemptions and Rates Are Equalized.  The Tax Relief Act also sets the lifetime federal gift tax exemption for 2011 and 2012 at $5 million, with the 2012 amount indexed for inflation (ditto for the generation-skipping transfer tax exemption). Thus, the gift and estate tax exemptions are again equalized for 2011 and 2012.

This is a huge improvement over the previous $1 million cap on the lifetime gift tax exemption (which continues to apply for 2010). An unmarried person can now give away up to $5 million while alive without paying any gift tax, and a married couple can give away up to $10 million.

However, keep in mind that, to the extent you dip into your gift tax exemption, your estate tax exemption is reduced on a dollar-for-dollar basis. The tax rate on 2011 and 2012 gifts in excess of the $5 million exemption is 35%, the same as the estate tax rate. Again, due to sunset provisions, the gift tax exclusion reverts to $1 million after 2012.

Clarity for Estates of 2010 Decedents and 2010 Generation-Skipping Transfers.  The Tax Relief Act clarifies the estate tax treatment of estates of individuals who died in 2010, and the generation-skipping transfer (GST) tax treatment of generation-skipping gifts made in 2010, but it does so in a weird way.  The new law reinstates both taxes for 2010 with $5 million exemptions for each.  But, executors have the option of electing out of the estate tax for 2010 in accordance with the 2010 repeal.

If executors elect out of estate tax, the aforementioned modified carryover basis rules apply to heirs for income tax basis purposes.  So, heirs of large estates can wind up owing capital gains taxes on appreciation that occurs through the decedent’s date of death, but there won’t be any federal estate tax. If the election out is not made for an estate, the $5 million exemption applies for 2010, and the income tax basis of inherited assets equals fair market value as of the date of death.

For 2010, the GST exemption is also $5 million.  However, the 2010 GST rate is deemed to be 0%, so there’s no actual GST liability for 2010. Therefore, large generation-skipping gifts could have been made in 2010, and only the gift tax will be owed (2010 gifts in excess of the $1 million gift tax exemption for that year are taxed at a flat 35% rate).  Unlike the estate tax exemption, though, the GST tax exemption is not subject to any portability.  As a result, gifts to grandchildren or younger generations must continue to be carefully planned.

Estate Tax Relief Maybe in the Offing

During the year 2010, there has so far been no federal or Arizona State estate tax. However, barring action by Congress before the end of the year, the estate tax is scheduled to return on Jan. 1, with an exemption of only $1 million per person and a maximum rate of 55 percent.

I have good news to share with you. The long wait for action to address the unknown status of the federal estate tax may be approaching an end. President Obama has announced a tentative deal with Congressional Republicans earlier this week, which, if finalized, will result in a number of tax benefits, including addressing the estate tax.

In the deal, President Obama made substantial concessions to Republicans. In addition to dropping his opposition to any extension of the current income tax rates on incomes above $250,000 for couples and $200,000 for individuals, he agreed to a deal on the federal estate tax that infuriated many Democrats. The deal would ultimately set an exemption of $5 million per person, and a maximum rate of 35 percent — a higher exemption and far lower rate than many Democrats wanted.

A New York Times article cautioned, however, that the deal is not supported by all parties, and many key Democrats have vowed to fight it. So, resolution may be within sight, but it is not yet a finalized deal.
“The House Democrats have not signed off on any deal,” Representative Chris Van Hollen of Maryland, who has been representing House Democrats in formal negotiations on the tax issue, said Monday night. “We will thoroughly review and discuss the proposed package in the caucus.” Some senior Democrats said an agreement by President Obama to accede to Republican demands on the estate tax could lead to a revolt among lawmakers.

With this positive news in the air, it may be time to schedule a meeting to adjust your estate plans to maximize the impact of this likely change in the federal estate tax law.

Planning Challenges: Marriage, Divorce and Remmariage

Although this case is unusual, it shows how life changes can destroy the best of plans or intentions. This case highlights the importance of updating those plans after a life event, such as birth, death, marriage, divorce and remarriage. You should especially heed these lessons if you:

A. are divorced and have reconciled or might reconcile with your former spouse;

B. are single and want to solidify control over your assets in preparation of a future marriage;
or

C. are cohabitating with a significant other.

When Howard Herpich and Svetlana Ozerova married in February 2003, they signed a prenuptial agreement in which each waived his or her rights to property that the other brought into the marriage. This agreement also directed that, "in the event of a separation and reconciliation," the document would remain binding. One month after the wedding, the couple separated. Their divorce was finalized in early 2005. In executing the prenuptial agreement, the couple divided up marital assets accordingly and settled their joint financial affairs. Six months later, the Herpiches reconciled and remarried. When Mr. Herpich died two years later, Mrs. Herpich was appointed personal representative over his estate. Mr. Herpich’s two adult children from his prior marriage sought to prevent their stepmother from controlling any part of his estate, claiming that the prenuptial agreement remained in effect. The trial judge sided with Mr. Herpich’s children, determining that the prenuptial agreement remained valid despite the divorce the separated the couple's first and second marriages.

The judge ruled that the terms "separation and reconciliation" encompassed divorce and remarriage and essentially denied Mrs. Herpich any control to her late husband's estate. Mrs. Herpich appealed, and the appellate court reversed the trial judge's ruling, finding that the “separation and reconciliation" wording in the agreement cannot be considered the same as "divorce and remarriage.” The appellate court ruled that the prenuptial agreement had been effectively terminated by the 2005 divorce and was no longer binding, since the original agreement's language had anticipated only one marriage between the Herpiches, not a divorce and a remarriage.

Creditor Proof IRAs

The combination of tax deferral and asset protection is a potent, long-term legal and financial strategy. Whether IRAs and other retirement plans are exempt from the claims of creditors of the IRA's owner varies from state to state. In Arizona, for example, IRAs are generally exempt from such claims. But does the same protection apply to IRAs that are inherited? If an original owner dies, and the IRA is not liquidated but instead is inherited by the beneficiary, will the IRA be protected from the claims of the beneficiary's creditors? Again, In Arizona, the answer is “yes.” However, what if the beneficiary lives in a state other than Arizona when the inheritance occurs? This can be a significant concern for an owner of an IRA – such as a parent or grandparent who wants to leave the IRA to a beneficiary but is worried that it may be seized by a creditor. The key variable: How do the laws of the state where the beneficiary lives at the time he or she inherits the IRA address this issue?

In a Florida case, Robertson v. Deeb, the court decided that inherited IRAs are not protected from creditor claims. The court reasoned that the IRA exemption applied only to the original owner and did not extend to the beneficiary. Texas bankruptcy courts reached the same conclusion in In re Jarboe. In that case, Mom died leaving her IRA to Son. Several years later, Son filed for bankruptcy and claimed that the IRA was exempt under the state property code. The bankruptcy trustee argued that the inherited IRA was not exempt, and the court agreed. Conversely, in a recent Minnesota case (In re: Nessa), the bankruptcy court ruled that an inherited IRA was protected. The key difference in this decision is that Minnesota adopted the federal property exemptions from bankruptcy law, whereas Florida and Texas used state exemptions. So, even though Arizona protects the beneficiary of an inherited IRA, your children or grandchildren might one day move to a state (such as Texas or Florida) that does not.

Solution: an IRA Trust. Don't take chances with your hard-earned retirement money. My general recommendation is to leave IRAs to beneficiaries in a stand-alone IRA trust to ensure maximum protection from creditors. Why use a stand-alone trust and not your living trust? For a trust to be a “designated beneficiary” for IRA and retirement plan purposes, very complex rules must be strictly followed. Failure to follow those rules can result in disastrous unintended consequences. Most living trusts simply are not set up correctly to meet the “designated beneficiary” definition. Make sure your living trust is carefully reviewed, and amended if necessary, if you are thinking of naming it as a beneficiary of an IRA or other retirement plan.

If you die without establishing a stand-alone IRA trust, there may still be other options available. For example, a beneficiary who receives an IRA from anyone other than a spouse and is concerned about the IRA’s exposure to creditors may wish to reinvest the proceeds in exempt assets such as homestead property or life insurance. However, whether a particular kind of asset is exempt from the claims of creditors is determined, again, on a state-by-state basis. As a result, the stand-alone IRA trust is the only sure bet when it comes to protecting inherited IRAs.

Avoid Confusion in Crisis

More and more Baby Boomers are finding themselves making medical and financial decisions for their aging parents. These decisions often fall to one child, with other siblings out of the loop for reasons of distance, conflicting responsibilities, etc. But some families have a lot of leaders – or at least they have a lot of strong-willed adult children who have opinions on what a parent needs or doesn’t need in terms of long-term care.

Key Question: Who Is in Charge? For example, Dad enters a hospital in need of immediate hip surgery. Unfortunately, he has an allergic reaction to medications. He is hallucinating and incoherent. The doctors need to change his treatment, but they aren’t sure who in his family to turn to for a final decision. Dad’s four adult children disagree as to his treatment, and long-simmering sibling rivalries surface just at the time when Dad most needs his family to unify.

Remember, a family is not a democracy. In most families, managing by consensus just doesn’t work. There’s a reason why Dad or Mom was initially in charge. In a crisis, it often takes too long to get a consensus. Relatives that need to be present can’t be there or can’t be reached on the phone. Or worse, while the majority of adult children are in agreement, they allow a lone dissenter to hold veto power over their decision. Whether the issue is health or money, consensus-building usually won’t work in a time of crisis.

What are the types of tools that are critical? The most powerful assets in crisis situations are Dad’s or Mom’s written instructions and choice of leadership. I recommend that every adult has in place at least these two valuable tools: First, every adult should have a Durable Power of Attorney. This provides financial authority to allow a chosen family member to make financial decisions for Dad if he is incapacitated. Second, every adult should have a Health Care Power of Attorney and Living Will. The laws governing these documents vary somewhat from state to state, but the concept is the same: Someone is charged with making all health care decisions for Dad, including whether to withdraw artificial life support. These written instructions are critical for families. The clearer the instructions, the less speculation, controversy and anxiety await adult children in stepping into their parent’s decision-making position.

Could the Estate Tax Repeal Cost Your Family More?

Due to Congress's failure last year to pass a revised version of the 2001 estate tax bill or to extend 2009's rules of a $3.5 million exemption and 45% estate tax, the estate tax law expired on January 1. Thus, with the repeal (for now) of the federal estate tax for 2010, it is widely assumed that the estates of high net worth Americans who die this year will be exempt from estate taxation.

Not so fast. While that might be true for some, it is also true that beneficiaries who inherit appreciated assets this year may now face a capital gains tax.

Here’s why. When the estate tax law expired, so did a provision that allowed assets to be "stepped up" to their date-of-death value at the passing of the owner, thus avoiding the levying of a capital gains tax on the appreciation of those assets. Therefore, while the current law has no estate tax, it does tax assets that have appreciated above a $1.3 million exemption when sold by heirs.

This peculiar situation poses some challenges with respect to estate planning. While the demise of the 45% estate tax certainly would help some families more than a 15% capital gains tax would hurt them, for many other families the opposite is true.

According to the Tax Policy Center, this change will negatively affect the families of at least 50,000 taxpayers who die this year. In contrast, the old law affected only about 15,000 estates per year.

This fiendishly complex issue is discussed in a February 13, 2010, Wall Street Journal article, "Why No Estate Tax Could Be a Killer," that includes estimates showing who would be better off under last year's law versus this year's system. The author determined that heirs of estates with assets totaling between $1.3 and $4.3 million would have been better off last year, while those with larger estates will fare better this year.

This is a very interesting argument that is causing a lot of discussion. If your estate includes any low-basis assets, such as stocks, real estate or a family business, you should review your asset situation with your estate planning attorney to gain a clearer notion of how the current law will affect you. While this situation remains unresolved, you should avoid taking any irrevocable actions, such as distributing or selling major assets.

Selecting the Guardian for a Minor Child

Who would you like to be the guardians of your young children if you pass away?

Nothing will stop a good financial, estate, or life insurance plan dead in its tracks quicker than the following question: “Who would you like to be the guardians of your young children if you pass away?”

Squealing brakes. Usually, the parents just look at each other with terror and confusion. In many ways, it's an overwhelming thought and the ultimate conversation stopper. This is where parents really need help from their advisors. Few couples can think through this alone and if they try, they simply stop planning. As a result, they leave their children — the most important thing in the world to them — at risk. No judge in the world wants to appoint a guardian for a minor child; they would rather have the decision made before the case gets before them.

The “least evil” guardian. Parents usually procrastinate choosing a guardian because they're looking for the best one. Considering that parenting is usually a mix of elation, love, guilt, and self-loathing, all at the same time, it's hard to find someone who would be ideal to replace you. Where will you find someone who'll love your children like Mother Theresa would, while investing like Warren Buffett? The answer, of course, is that you never will.

The first thing we suggest is to divide the responsibilities. First, choose someone to raise the children (the guardian). Then, select someone else to invest the money (the trustee). The guardian's job is to raise the children until they reach 18. Once they reach this age, the children, in theory, are adult enough to make their own decisions.

But how do you choose among all the different candidates? The best guardian is the “least evil” one. This is the person among all your client's family and friends, who would never live up to the ideal standards of Mother Theresa and Warren Buffet, but would raise young children better than anyone else.

Benefits of a trust. The trustee can be a family member, or an independent third party like a trust company. Its job is to manage the investments for the children. It's important to remember that, while the children are adults at age 18, a trust can be structured to last longer than the children's lifetimes. This provides a tremendous amount of flexibility to parents when considering how to leave money to their offspring. They don't need to give a lump sum distribution at age 18. A trust, therefore, is the preferred estate planning tool in many cases.

But it also begs the question, “Who should be the trustee - the “Warren Buffett” - for the kids?” Who is that special person who can profitably invest money for your heirs with a long-term perspective? It's a crucial decision.

Naming a Guardian for Your Children: Six Common Mistakes

If you have named guardians for their kids, you may have made one of these six common mistakes:

You may have named a couple to act as guardians, but you have not indicated what should happen if the couple broke up or one of the spouses died. This means your kids could end up in the care of someone you did not choose.

You may not have named enough alternates to serve if your first choice cannot serve.

You may have considered financial resources of potential guardians when deciding who should raise your children. Your guardians do not have to also be financial decision-makers for your kids; your guardians are the people who will be in charge of your kids' emotional, spiritual and physical well-being – not necessarily their money. It's your responsibility to leave enough money behind to take care of your kids, either through savings or life insurance. You can name someone other than your guardians to take care of that money if the best-choice guardians are not good with money.

You may have not provided for someone to take care of the money you are leaving behind. That means your money could go outright to your kids at 18 – unprotected.

You probably named only long-term care guardians and did not make any arrangements for the short-term care of your kids if you were in an accident. This means your kids could be taken out of your home and into the care of strangers until the authorities could figure out what to do.

You probably did not exclude anyone who might challenge your decisions or who you know you would never want raising your kids.

The good news: Avoiding these mistakes is easy when you have the right guidance.