NEW JERSEY SOCIETY OF ENROLLED AGENTS

Transcription

1 NEW JERSEY SOCIETY OF ENROLLED AGENTS January 8, 2014 RECENT TAX LEGISLATION INCLUDING THE AFFORDABLE CARE ACT Presented by: Brian D. Reynolds, Esq. MANTELL, PRINCE & REYNOLDS, P.C. Mountain Heights Center at Berkeley Heights 430 Mountain Avenue Murray Hill, New Jersey FAX:

2 RECENT LEGISLATION I. The American Taxpayer Relief Act of 2012 II. The Patient Protection and Affordable Care Act of 2010 III. The Health Care and Education Reconciliation Act of 2010 IV. The Defense of Marriage Act A. United States v. Windsor B. Hollingsworth v. Perry THE AMERICAN TAXPAYER RELIEF ACT OF 2012 A. The American Taxpayer Relief Act of On January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 (the Act ), and the President signed the Act on January 2, The Act permanently extends the Bush era tax rates for many taxpayers while increasing tax rates for individuals with taxable income above statutory thresholds. The Act increases the tax rate for ordinary income for affected individuals and increases the tax rate for net long-term capital gains and qualified dividend income for these taxpayers. In addition, the Act makes changes to estate and gift tax rules and extends a number of popular tax provisions that otherwise would have expired. 2. The Act puts in place numerous provisions, including: a. enacting a top income tax rate at 39.6% on ordinary income for taxpayers with taxable income over $400,000 for individuals, $425,000 for heads of households and $450,000 for married couples filing jointly, while permanently extending rates on other tax brackets at 2012 levels; b. enacting a top long-term capital gains rate at 20% for taxpayers with taxable income in excess of $400,000, $425,000 for heads of households and $450,000 for married couples filing jointly, with rates on other tax brackets permanently extended at 2012 levels; c. extending the taxation of qualified dividend income at the preferential rates applicable to long-term capital gains; -2-

3 d. permanently establishing the top estate and gift tax rate at 40% and the lifetime per person estate and gift exemption amount at $5,000,000, indexed for inflation from 2010; e. permanently enacting portability of the estate tax exemption (by allowing the executor of a deceased spouse s estate to transfer any unused estate tax exemption amount to the surviving spouse); f. permanently unifying the estate and gift taxes, with a single graduated rate schedule and a single lifetime exemption amount; and g. permanently establishing the generation-skipping transfer ( GST ) tax rate at 40% and the GST exemption at $5,000,000, indexed for inflation from Limits on Deductions and Exemptions a. PEP Limitations to Apply to High Earners. The Act reinstates the Personal Exemption Phaseout (PEP) for tax years beginning after The PEP had previously been suspended. The PEP threshold begins for those making $300,000 for joint filers and a surviving spouse; $275,000 for heads of household; $250,000 for single filers; and $150,000 (one-half of the otherwise applicable amounts for joint filers) for married taxpayers filing separately. Under the phaseout, the total amount of exemptions that can be claimed by a taxpayer subject to the limitation is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer s AGI exceeds the applicable threshold. The deduction is completely phased out for single filers whose AGI exceeds $372,500 and married couples whose AGI exceeds $422,500. These dollar amounts are inflation-adjusted for tax years after The personal exemption amount for 2013 is $3,900 b. Pease Limitations to Apply to High Earners The Act reinstates the Pease limitation on itemized deductions for tax years beginning after The Pease limitation had previously been suspended. Taxpayers subject to the Pease limitation must reduce the total amount of their itemized deductions by 3% of the amount by which the taxpayer s adjusted gross income (AGI) exceeds the applicable threshold amount up to 80% of otherwise allowable itemized deductions. The starting threshold is $300,000 for joint filers and a surviving spouse; $275,000 for heads of household; $250,000 for single filers; and -3-

4 $150,000 for married taxpayers filing separately. These dollar amounts are inflation-adjusted for tax years after For affected taxpayers, the Pease limitation adds approximately 1% to the marginal tax rate on income above the Pease thresholds 4. The Act does not address issues related to the debt ceiling and other spending issues which are expected to be addressed by Congress later this year. As part of this process, there may be additional tax changes. B. Federal Gift Tax 1. The annual exclusion is $14,000 per beneficiary for $28,000 if married couple agrees to split gifts 2. The lifetime gift tax exemption is now $5,340, NOTE: For individuals who have previously used all of their lifetime exemption, the inflation adjustment allows them to make additional taxable gifts. C. Federal Estate Tax 1. The Act establishes a top estate and gift tax rate of 40% for estates of decedents dying after December 31, 2012 and gifts made after that date. The $5,000,000 estate and gift exemption, indexed for inflation from 2010, is made permanent by the Act. -4-

5 2. The following chart illustrates the federal gift, estate and generationskipping transfer tax changes over the past several years: & Estate Tax Exemption $3,500,000 All Exempt $5,000,000 1 $5,250,000 $5,340,000 Estate Tax Rate 45% 0% 35% 40% 40% Gift Tax Exemption $1,000,000 $1,000,000 $5,000,000 2 $5,250,000 $5,340,000 Gift Tax Rate 45% 35% 35% 40% 40% GST Exemption $3,500,000 $3,500,000 $5,000,000 3 $5,250,000 $5,340,000 GST Rate 45% 0% 55% 40% 40% 3. NOTE: The federal estate and gift tax exemption is unified so that use of the gift tax exemption during life reduces the amount available at death. D. Portability 1. The Act also continues (and makes permanent ) the concept of portability. By way of background, under prior law, if an individual died and failed to utilize all of his/her gift and estate tax exemption, this exemption was forever lost. Under portability, a surviving spouse is able to utilize the unused exemption of his/her deceased spouse if the deceased spouse died after This means that, with respect to a typical husband and wife, if the husband dies and does not fully use his estate tax exemption, the unused exemption can be attributed to the wife, so that when she dies, her estate can use both her federal estate tax exemption and her late husband s unused exemption. EXAMPLE: If, in 2014, the first spouse to die has a $5,000,000 estate and utilizes only $1,500,000 of exemption at death, by electing portability, the estate of the surviving spouse will have a $9,180,000 ($5,340,000 + $3,840,000) exemption available at his or her subsequent death. 1 $5,120,000 in $5,120,000 in $5,120,000 in

6 2. In order to elect portability, a complete Form 706 (Unites States Estate Tax Return) must be filed. The portability election portion of Form 706 is attached hereto as EXHIBIT A. 3. NOTE: Portability does not apply to the GST Tax or to New Jersey Estate Tax. 4. Sample Will Provision. Although not required for portability, it may be beneficial to include the following (or similar) language in a Last Will and Testament: I direct that the personal representative of my estate do all things necessary to make a valid election to allow my surviving spouse to have the benefit of my deceased spousal unused exclusion amount, to the greatest extent permitted under applicable federal estate tax law. My surviving spouse shall have no obligation to make any payment to my estate or to the other beneficiaries of my estate in order for the personal representative of my estate to make or because the personal representative of my estate has made this election, nor shall any equitable adjustment be made with respect to the dispositions under my estate because the personal representative of my estate has made this election. QUERY: Is it worth the cost of filing a Form 706 for a moderately wealthy individual for the sole purpose of electing portability? 1. Does computer software automatically generate the Form 706? 2. For estates valued at less than the applicable exclusion amount ($5,340,000 in 2014), estimates can be used in certain circumstances (See portion of Instructions to Form 706 attached hereto as EXHIBIT B). 3. As we will discuss, filing a Form 706 for portability purposes could actually increase an Estate s New Jersey tax liability. E. Last Deceased Spouse Rule. A surviving spouse can only use the unused exemption of his/her last deceased spouse. 1. EXAMPLE: Assume that Husband 1 dies in 2014, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1 s estate tax return to permit Wife to use Husband 1 s unused exclusion amount. As of Husband 1 s death, Wife has made no taxable gifts. Thereafter, Wife s applicable exclusion amount is $7.68 million (her $5.34 million basic exclusion amount plus the $2.34 million unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death. -6-

7 2. EXAMPLE: Assume the same facts as above except that Wife subsequently marries Husband 2. Husband 2 also predeceases Wife, having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2 s estate tax return to permit Wife to use Husband 2 s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3.68 million ($2.34 million for Husband 1 and $1.34 million for Husband 2), only Husband 2 s $1.34 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5.34 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband 2 s $1.34 million unused exclusion). Thereafter, Wife s applicable exclusion amount is $6.68 million (her $5.34 million basic exclusion amount plus $1.34 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death. 3. NOTE: Remarriage in and of itself will not remove right to the unused exemption, but if the new spouse predeceases, then only that spouse s unused exemption can be used. 4. Because a predeceased spouse s unused exemption applies for gift tax purposes also, perhaps it is better to make gifts to use exemption to make sure it is not lost by remarriage and death of new spouse or by a law change. Query: does surviving spouse have to use his or her own gift exemption first? 5. In the author s opinion, portability should be considered a safety net and not relied upon for proper estate planning. EXAMPLE: Suppose H dies with assets worth $10.5 million and a Will that bequeaths all assets to W, his wife. W, who has no assets in her name, elects portability and therefore has a $10.5 million federal estate tax exemption. If W dies, her estate will be sheltered from federal estate tax since her exemption will be $10,680,000. If, however, prior to her death, W s assets grow to $15.68 million in value, W will have a taxable estate of $5,000,000 ($15,500,000 - $10,680,000). If instead, H had fully funded a credit shelter trust upon his death, and the $5.34 million in the trust grew to $7.84 million, W s taxable estate would only be $2.5 million. -7-

8 NEW JERSEY INHERITANCE AND ESTATE TAX I. New Jersey Inheritance and Estate Tax A. New Jersey Inheritance Tax 1. In calculating the amount of transfer inheritance tax due, the key factor is the nature of the relationship between the decedent-transferor and the beneficiary (rate of tax varies based on the classification of the beneficiary) 2. For New Jersey resident decedents, the inheritance tax is imposed on the transfer of intangible property wherever situated and personal and real property located in New Jersey 3. Deductions: Reasonable and ordinary expenses of estate administration 4. New Jersey Inheritance Tax Rates: Beneficiary Exemption Tax Rate Spouse, parents, children, stepchildren, domestic partner, civil union partner (Class A) 100% None Siblings, children-in-law (Class C) $25,000 11%-16% Others (Class D) $500 15%-16% Charities (Class E) 100% None B. New Jersey Estate Tax 1. An estate tax is imposed on the estates of New Jersey resident decedents when the inheritance and death taxes paid to New Jersey and other states is less than the maximum credit allowed to the estate under the Internal Revenue Code as it existed on December 31, Imposed on estates greater than $675,000 with a maximum rate of 16% a. December 31, 2001 law applies b. In light of the new federal estate tax laws, a Credit Shelter Trust may receive all assets passing under a will resulting in unnecessary New Jersey Estate Tax being due. -8-

9 3. EXAMPLE: Husband dies with assets valued at $5,000,000. His will, which was drafted in 1999 (when the federal estate tax exemption was $650,000), provides that the maximum amount possible without creating a federal estate tax should pass to a credit shelter trust for the benefit of his spouse. Accordingly the trust is funded with $5,000,000 and approximately $400,000 in New Jersey Estate Tax is due. If Husband s Will had instead provided that only the maximum amount possible that could pass free of New Jersey Estate Tax should fund the credit shelter trust and that the balance of his estate should pass outright to his spouse, no tax would be due. 4. PLANNING POINT: In planning for New Jersey residents, the key is to strike a balance between taking full advantage of the federal estate tax exemption and the payment of New Jersey Estate Tax. As we will see, it is critical to consider both estate and income tax implications. II. PLANNING OPPORTUNITIES REGARDING NEW JERSEY ESTATE TAX A. In light of the difference between the New Jersey estate tax exemption ($675,000) and the federal estate tax exemption ($5,340,000 for 2014), the Executor of an Estate, with the counsel of their advisors, often must decide whether and to what extent a credit shelter trust is funded and whether New Jersey Estate Tax should (or has to) be paid. EXAMPLE: Assume H died in 2013 with assets valued at $10,000,000. H s Will provides for a traditional Credit Shelter Trust. At the time of H s death, W is 83 years old, in poor health and with assets of her own of $5,000,000. It is likely that the benefit of sheltering $5,250,000 from federal estate tax on the death of W outweighs the imposition of the approximately $400,000 of New Jersey Estate Tax as of the death of H. Accordingly, the Credit Shelter Trust should probably be fully funded. QUERY: Would the answer be the same if W was 42 and in good health? 1. With the increase in the federal estate tax exemption and the new concept of portability, the question is how much tax should be paid to New Jersey, if any. 2. Consideration must also be given to the benefits of a second step-up in basis at the surviving spouse s death since assets in a credit shelter trust will not be included in the surviving spouse s estate and will therefore not receive a step-up in basis. -9-

10 2. Is it possible for the traditional Non-Marital Credit Shelter Trust to be partially Q-tipped? It depends primarily upon the terms of the Credit Shelter Trust. a. All income must be payable to the surviving spouse. b. There can be no other beneficiaries of the trust while the surviving spouse is alive. 3. On October 1, 2007, changes to the New Jersey Administrative Code were published by the New Jersey Division of Taxation concerning the New Jersey Estate Tax. (See 39 N.J.R. 4106(c), N.J.A.C. 18:26-3A.3). 4. It is now clear that the New Jersey Inheritance and Estate Tax Branch will allow an estate to make a New Jersey-only QTIP Election if the estate is not required to file a federal Form 706. a. This means that those estates with more than $675,000 in value can make a New Jersey QTIP Election with respect to a portion of what would be the Non-Marital Trust for federal estate tax purposes to defer New Jersey Estate Tax. b. Presumably, therefore, upon the death of the surviving spouse, the value of the Non-Marital Trust would not be included in the estate of the surviving spouse for federal estate tax purposes, but would be included in the estate of the surviving spouse for New Jersey Estate Tax purposes. EXAMPLE. At the death of the first spouse, a New Jersey QTIP Election is made to the extent of $1,325,000 with respect to a $2,000,000 Non-Marital Trust. Assume that at the death of the surviving spouse, the Non-Marital Trust has grown in value to $4,000,000. The $4,000,000 in the Non-Marital Trust is excluded from the surviving spouse s estate for federal estate tax purposes. For New Jersey estate tax purposes, however, $2,650,000 ($4,000,000 x $1,325,000/$2,000,000) is included in the surviving spouse s estate. 5. QUERY: Will the assets in the NJ-only QTIP trust receive a step-up in basis for New Jersey Gross Income Tax purposes? The State of New Jersey has not publicly commented on the issue and the issue has not yet been litigated. In private discussions, the Division of Taxation has taken the position that federal income tax basis will control (i.e. no stepup for New Jersey Gross Income Tax Purposes). 6. If a Form 706 is required to be filed, positions taken on the Form 706 and Form IT-Estate must be consistent. -10-

11 7. Does the Will specifically address planning to avoid the New Jersey Estate Tax? New Jersey practitioners have developed a number of approaches to effectively plan around the New Jersey estate tax: a. Disclaimer Will b. Bifurcated Credit Shelter Trust c. Clayton QTIP Trust 8. EXAMPLE: Assume H dies in 2013 with assets valued at $2,000,000. H s Will was structured as a traditional Disclaimer Will. At the time of his death, W is 44 years old, in perfect health and has $1,000,000 of her own. The New Jersey Estate Tax should probably be avoided because the $99,600 New Jersey Estate Tax cost may be too high a price to pay since there is a significant likelihood that W s estate will pay no federal estate tax at her death. At most, W should disclaim $675,000 of her inheritance to shelter it from both federal and New Jersey estate tax at her death since a disclaimer of $675,000 will not result in any New Jersey Estate Tax being due at H s death. 7. One looming loophole strategy for saving state estate taxes is for the client to make gifts (even deathbed gifts) rather than owning the assets at death. Only two states (Connecticut and Minnesota) have a gift tax, and a few more have contemplation of death provisions for transfers within a certain period of time prior to death. If there is no state gift tax, lifetime gifts covered by the $5 million indexed federal gift exemption could be made totally free of federal or state gift or estate taxes. However, an offsetting factor is that gifts of low basis assets would prevent the gifted from receiving a basis adjustment at the donor s death (because the assets would not be included in the donor s gross estate). III. POTENTIAL DISASTERS CAUSED BY THE INCREASE IN THE FEDERAL ESTATE TAX EXEMPTION A. Reliance on a formula to allocate your estate between children and spouse EXAMPLE: Husband dies with assets valued at $5 million. His will, which was drafted in 2006 when the federal estate tax exemption was only $1.5 million, provides (via formula) that the maximum amount possible without creating a federal estate tax should pass to his children from a prior marriage and the balance of his estate should pass to his spouse. In light of the increased federal estate tax exemption, Husband s children will receive his entire estate and nothing will pass to his spouse. B. Reliance on a formula to allocate amount a spouse or other beneficiary receives -11-

12 outright versus in a trust EXAMPLE: Husband dies with assets valued at $5 million. His will, which was drafted in 2008, provides that the maximum amount possible without creating a federal estate tax should pass to a trust for the benefit of his spouse and the balance of his estate should pass outright to his spouse. In light of the significant increase in the federal estate tax exemption, the Wife will receive her entire inheritance in trust and approximately $400,000 of New Jersey Estate Tax will be due. Depending upon the terms of the trust for the spouse, it may be possible to eliminate the New Jersey estate tax liability. ESTATE TAX RETURN FILING REQUIREMENTS I. Estate Tax Return Filing Requirements. A. Gross Estate Less Than $675,000 (including adjusted taxable gifts) 1. No Form 706 is required to be filed with the Internal Revenue Service. However, if the Executor wants to preserve the unused exclusion amount for use by the decedent s spouse (under Portability), a complete Form 706 must be filed. In some cases estimates of the value of assets may be used. 2. No Form IT-Estate needs to be filed with the New Jersey Estate Tax Branch because the gross estate is less than $675, NOTE: A Form IT-R (New Jersey Inheritance Tax Return) may need to be filed if there are beneficiaries who are not so-called CLASS A beneficiaries. B. THE SWEET SPOT: Gross Estate Between $675,000 and $5,250,000 (for 2013 deaths) or $5,340,000 (for 2014 deaths) 1. No Form 706 is required to be filed unless the Executor wants to preserve the unused exclusion amount for use by the decedent s spouse (under Portability) 2. Form IT-Estate (New Jersey Estate Tax Return) must be filed 3. Estates have option to complete the simplified Form IT-Estate which also requires a Form IT-R to be filed or file a deemed December 31, 2001 Form 706 (U.S. Estate Tax Return) with Form IT-Estate. -12-

13 4. Because no Form 706 is required to be filed with the IRS, the estate can make any election which will reduce New Jersey Estate Tax, even though no such election is made for federal estate tax purposes since inconsistent positions are not taken. 5. The Alternative Valuation Date election pursuant to IRC Section 2032 can be made for New Jersey Estate Tax purposes. Such election will have no impact upon tax basis determination for federal income tax purposes. Will the Alternate Valuation Date election have impact upon tax basis of assets for New Jersey Gross Income Tax purposes? 6. Because no Form 706 is required to be filed, administrative expenses can be deducted pursuant to IRC Section 2053 on Form 1041 (U.S. Fiduciary Income Tax Return) pursuant to Section 642(g) even though such expenses are taken on Form IT-Estate. See sample 642(g) election attached hereto as EXHIBIT C. 7. NOTE: If a Form 706 is filed for Portability purposes, consistent positions must be taken on both the Form 706 and the Form IT-Estate. See January 31, 2011 letter from the New Jersey Division of Taxation attached hereto as EXHIBIT D. C. Gross Estate in Excess of $5,250,000 (for 2013 deaths) or $5,340,000 (for 2014 deaths) 1. Both a Form 706 and a Form IT-Estate are required to be filed 2. The New Jersey Estate Tax Branch has announced that tax elections on the Form 706 and the deemed December 31, 2001 Form 706 must be consistent. If both federal and New Jersey estate tax is due and owing, a reduction in valuation, or administrative expense deduction will reduce both death taxes 3. The New Jersey Estate Tax Branch will not allow inconsistent positions with respect to the deduction of administrative expenses. Accordingly, if administrative expenses are deducted on Form 1041 (U.S. Fiduciary Income Tax Return) pursuant to IRC Section 642 (g) for federal income tax purposes, those expenses cannot be deducted on Form IT-Estate. THE 3.8% TAX ON NET INVESTMENT INCOME A. Basic Statutory Structure; Regulations. -13-

14 1. The tax on net investment income was technically part of the Health Care and Education Reconciliation Act of 2010, which was passed one week after the Patient Protection and Affordable Care Act, but the two statutes are collectively called the Affordable Care Act. 2. Section 1411 imposes a surtax (in addition to federal income taxes) of 3.8% on the unearned income of individuals, estates, and trusts for taxable years beginning after December 31, 2012 (which is commonly referred to as the Medicare tax ). For individuals, the tax is 3.8% of the lesser of a. the individual s modified adjusted gross income in excess of a threshold amount ($200,000 for individuals and $250,000 for couples), or b. the individual s net investment income for the year. 3. For estates and trusts, 1411(a)(2) imposes a tax equal to 3.8% times the lesser of a. the estate s or trust s adjusted gross income (as defined in 67(e)) in excess of the highest income tax bracket threshold ($11,950 for 2013, $12,150 for 2014), or b. the estate s or trust s undistributed net investment income. 4. The threshold for individuals is not indexed. The threshold for estates and trusts is the dollar value for the highest income tax bracket for estates and trusts, which is indexed, but which is a very low number. Multiple estates and trusts cannot be used to avoid the 1411 tax B. AGI of Individuals. 1. Tax applies to lesser of (i) net investment income or (ii) excess of modified AGI over threshold amount 2. Threshold Amount is $250,000 for joint returns; $200,000 for single returns; $125,000 for married filing separate returns 3. Modified AGI is defined as AGI increased by amount excluded from gross income as foreign earned income under IRC Section 911(a)(1), net of related deductions and exclusions disallowed under IRC Section 911(d)(6) 4. Nonresident aliens are not subject to the 3.8% tax -14-

15 5. Net investment income a. Misleading term since certain types of trade or business income of taxpayer who does not materially participate are subject to the 3.8% tax (in addition to portfolio income) b. Statutory drafting approach under IRC Section 1411(c)(1): net investment income defined as excess (if any) of: i. Specified categories of gross income or net gain; over ii. Deductions allowed by this subtitle which are properly allocable to such gross income or net gain 6. Gross income or net gain taken into account in calculating net investment income oversimplified view of statutory language: a. Gross income from interest, dividends, annuities, royalties and rents, other than such income derived in the ordinary course of a business activity not subject to IRC Section 1411(c)(1)(A) b. Gross income derived from IRC Section 469 passive activity c. Gross income derived from trade or business of trading financial instruments or commodities (whether or not taxpayer is passive) d. Net gain from disposition of portfolio assets or other investment property (e.g., raw land held as capital asset; stocks or securities held as capital assets) e. Net gain from property held in IRC Section 469 passive activity f. Net gain from property held in trade or business of trading financial instruments or commodities (whether or not taxpayer is passive) 7. Net gains from dispositions of property are included in net investment income only to the extent taken into account in computing taxable income. IRC Section 1411 (c)(1)(a)(iii) a. Therefore, all non-recognition provisions should apply, including i. Like-kind exchanges ii. iii. Tax-free reorganizations IRC Section 721 capital contributions -15-

16 8. Offset for capital losses and capital loss carryforwards a. Presumably capital losses for the current year, as well as capital loss carryforwards from prior years, should be completely netted against capital gains otherwise treated as net investment income b. But does it matter if capital loss or capital loss carryforward arises from sale of capital asset held in an active business? c. Can IRC Section 1231 capital losses from active business exempt from the 3.8% tax offset capital gains otherwise subject to the 3.8% tax? 9. Although statute not clear, Joint Committee report (J.C.T. Rep. No. JCX ) provides that net investment income does not include items which are excluded from gross income under the income tax, providing the following specific examples: a. Interest from tax-exempt bonds accordingly, municipal bonds could become more attractive investments b. Veterans benefits c. Gain from sale of principal residence excluded under IRC Section 121 d. Net investment income excludes distributions from IRAs (whether traditional or Roth) and certain qualified plans. IRC Section 1411(c)(5) e. But such amounts (if otherwise included in AGI) are taken into account in determining if taxpayer is above the threshold amount f. Thus, individual with net investment income from other sources but with modified AGI less than threshold amount could be pushed into 3.8% tax if IRA or qualified plan distribution causes modified AGI to exceed the threshold amount C. AGI of Estate or Trust. 1. The AGI of an estate or trust is determined under 67(e). AGI is computed the same as for an individual except that deductions are -16-

17 allowed for charitable contributions, the personal deduction, distributions to beneficiaries, and costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if property were not held in such trust or estate. 2. As a general rule, most of the income of estates and trusts will be net investment income. D. Capital Gains. 1. Capital gains are an item of net investment income. While distributions reduce both AGI and net investment income, capital gains cannot be distributed without authority in the trust instrument or state law for doing so. Trust instruments can either mandate how distributions are allocated against various types of taxable income, or can give the trustee discretion to allocate capital gains to income that is distributed. 2. Capital gains ordinarily are excluded from DNI. Reg (a)-3(a). However, the regulations provide the capital gains will be included in DNI if they are, (1) pursuant to the terms of the governing instrument and applicable law or (2) pursuant to a reasonable and impartial exercise of discretion by the fiduciary (in accordance with a power granted to the fiduciary by applicable local law or by the governing instrument if not prohibited by applicable local law). E. Distributions. 1. Distributions from an estate or trust may reduce the income subject to the top 39.6%/20% rates on ordinary and capital gains income, respectively, as well as reducing the income subject to the 3.8% tax on net investment income. Thus, distributions to beneficiaries can save tax, if the individual beneficiary is not in the top tax bracket ($450,000/$400,000 in 2013, 457,600/$406,750 in 2014). In addition, distributions can save the 3.8% tax on net investment income if the beneficiary does not have AGI exceeding the $250,000/$200,000 threshold. 2. This may present additional pressure on fiduciaries to make distributions. Of course, the fiduciary must look to the distribution standards in the trust agreement to determine the extent to which these tax considerations come into play. If the distribution is based solely on the health, education, support, and maintenance of the beneficiary, the trustee may not have the authority to take into consideration tax effects of distributions. Drafting Tip: Giving a non-beneficiary trustee the authority -17-

18 to consider tax implications may broaden the ability of the fiduciary to consider these tax implications of distributions. Even so, the fiduciary would generally treat taxes as merely one factor to be considered in the overall factors that the fiduciary considers in determining the appropriateness of distributions Day Rule. Under IRC Section 663(b), the fiduciary may elect to treat distributions made during the first 65 days following the close of the taxable year as if they had been made on the last day of the prior year. An estate s or trust s taxable income may not be determined by the end of the taxable year, and the 65 day rule can be helpful in planning distributions to carry out income to multiple beneficiaries, each of whom have higher thresholds, than subjecting income to taxation at the trust or estate level (with its very low $11,950 taxable income threshold in 2013, $12,150 for 2014). F. Minimizing Income Taxation of Trusts. 1. The combination of the new top rate bracket that applies to trusts with only $11,950 in 2013, $12,150 for 2014, of taxable income and the 3.8% tax on undistributed net investment income of trusts results in a dramatic percentage increase in the federal income tax rate that applies to trusts. 2. Passive income is included in both AGI and net investment income. The material participation requirements under the 469 passive loss rules are used for this purpose. Section 469(h)(1) defines material participation as an activity in which the taxpayer participates on a regular, continuous, and substantial basis. 3. Individuals can use one of seven tests (one of them being the 500 hour rule) to establish material participation to avoid passive income treatment. 4. The rules are not as clear regarding material participation by trusts or estates. Regulations addressing passive activity rules for trusts and estates have never been written. The IRS position is that trusts and estates are not treated as individuals for this purpose (so, for example, the 500 hour rule does not apply). The IRS position is that the trustee must be involved directly in the operations of the business on a regular, continuous, and substantial basis. 5. If a trust owns an interest in an active trade or business operation, a planning consideration will be whether to name some individual who is actively involved in the business as a co-trustee. -18-

19 6. The Net Investment Income Tax for Individuals, Estates and Trusts will be determined pursuant to Form See draft of Form 8960 attached hereto as EXHIBIT E. 7. See Excerpts from Internal Revenue Service Q&A on the Net Investment Income Tax attached hereto as EXHIBIT F. THE ADDITIONAL 0.9 PERCENT MEDICARE TAX A. Effective January 1, 2013, The Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively the Act ) impose an additional 0.9-percent Medicare tax on the employee only (not the employer) of the gross wages in excess of $200,000 for unmarried taxpayers ($250,000 for married taxpayers filing a joint return on the combined gross wages or self-employment income). B. Accordingly, pursuant to the Act, an employee s Medicare tax now has two parts. 1. The first $200,000 is taxed at 1.45% ($200,000 x 1.45% = $2,900) 2. The excess is taxed at 2.35% (1.45% + 0.9%) 3. The employer s Medicare tax remains at a flat rate of 1.45% on the entire amount of gross wages C. The Additional Medicare Tax will be determined pursuant to Form See draft of Form 8959 attached hereto as EXHIBIT G. D. NOTE: Withholding of the additional 0.9% Medicare tax begins at $200,000 without regard to the individual s filing status. Accordingly, a married taxpayer who earns more than $200,000 but less than $250,000 will be entitled to a refund of the additional Medicare Tax (assuming his or her spouse does not have any income). E. Differing Thresholds. 1. Observe that there are three different thresholds (with respect to both categories of income and amounts) under the American Taxpayer Relief Act and the Affordable Care and Patient Protection Act. 2. The thresholds for the new maximum 39.6% ordinary income tax and 20% capital gains tax rate are $450,000/$400,000 of taxable income in 2013 ($457,600 and $406,750 in 2014). -19-

20 3. The thresholds for the PEP/Pease limitations are $300,000/$250,000 of adjusted gross income in 2013 ($305,050/$254,200 in 2014). 4. The thresholds for the 3.8% Medicare tax are $250,000/$200,000 of adjusted gross income (these thresholds are not indexed). 5. The effect of these varying thresholds will create some strange tax rates. For example, the 3.8% net investment income tax (based on AGI) will apply in many cases where the top income tax bracket (based on taxable income) will not, so a large number of taxpayers will be paying 18.8% on dividends and capital gains. 6. See Excerpts from Internal Revenue Service Q&A on the Additional Medicare Tax attached hereto as EXHIBIT H. PLANNING OPPORTUNITIES FOR SAME-SEX COUPLES I. On Wednesday, June 26, 2013, a divided U.S. Supreme Court rendered its highly anticipated decision in United States v. Windsor, 133 S. Ct (2013), and declared that Section 3 of the Defense of Marriage Act is unconstitutional. The Court s decision, while it leaves open questions, will create estate planning opportunities and have other important implications for same-sex married couples. Clients in same-sex relationships should talk with their lawyers, accountants and Bessemer advisors about how to take advantage of the planning opportunities following the Windsor decision. (This summary is based on a discussion prepared by Jaclyn Feffer and Dana Fitzsimons, with Bessemer Trust.) A. Background - The Defense of Marriage Act. The Defense of Marriage Act ( DOMA ) was passed in For the purpose of over 1,000 federal laws and numerous federal regulations, Section 3 of DOMA defines marriage as the legal union between one man and one woman as husband and wife, and the word spouse as a person of the opposite sex who is a husband or a wife. Section 3 of DOMA prevented same-sex married couples from being recognized for purposes of government employee benefits, Social Security benefits, tax benefits and filing status, and other aspects of federal law. B. State Laws. Fifteen states and the District of Columbia have passed laws or have court cases recognizing same-sex marriages. (California, Connecticut, Delaware, Iowa, Maine, Maryland, Massachusetts, Minnesota, New Hampshire, New Jersey, New Mexico, New York, Rhode Island, Vermont, and Washington.) C. Windsor Case. 1. In 1993, Edie Windsor and Thea Spyer registered as domestic partners under New York law. They were married in Canada in 2007 and New -20-

21 York deemed their marriage to be valid. Thea died in 2009, naming Edie as her executor and leaving her estate to Edie. Edie filed the estate tax return for Thea s estate and claimed the marital deduction. The IRS denied the deduction on the basis of Section 3 of DOMA. Edie paid the estate tax and sued for a refund in New York federal court. 2. A five member majority of the Supreme Court, under an opinion by Justice Kennedy, affirmed the Second Circuit decision and declared Section 3 of DOMA to be unconstitutional. D. Revenue Ruling The day after Windsor was decided, the Internal Revenue Service announced that it is working with the Department of Treasury and Department of Justice and will move swiftly to provide revised guidance in the near future regarding how federal tax laws will be applied in light of the Windsor case. That guidance was published on August 29, 2013 in Rev. Rul Rev. Rul has three holdings and a clarification regarding its prospective application. a. Terms Relating to Marriage Include Same-Sex Couples. For Federal tax purposes, the terms spouse, husband and wife, husband, and wife include an individual married to a person of the same sex if the individuals are lawfully married under state law, and the term marriage includes such a marriage between individuals of the same sex. There is nothing surprising about this holding, and it was fully expected following the Windsor decision. b. Place of Celebration Standard. For Federal tax purposes, the Service adopts a general rule recognizing a marriage of same-sex individuals that was validly entered into in a jurisdiction (whether a state, district, territory or foreign country) whose laws authorize the marriage of two individuals of the same sex even if the married couple is domiciled in a place that does not recognize the validity of same-sex marriages. This holding, adopting a place of celebration test rather than a place of domicile test, was anticipated but by no means certain. c. Domestic Partnerships and Civil Unions Not Included. For federal tax purposes, the interpretation of terms to include same-sex couples does not include individuals (whether of the opposite sex or the same sex) who have entered into a registered domestic partnership, civil union, or other similar formal relationship recognized under state law that is not denominated as a marriage under the laws of that state -21-

22 3. Prospective Application. The holdings are applied prospectively as of September 16, 2013 (the date that the Ruling will be published in IRS ). Affected taxpayers may rely on the ruling for the purpose of filing original returns, amended returns, adjusted returns, or claims for credit or refund for any overpayment of tax..., provided the applicable limitations period for filing such claim under section 6511 has not expired. All items on such return or claim that are affected by the marital status must be reported consistently. Similarly, taxpayers may rely retroactively on the ruling with respect to overpayment of employment tax and income tax with respect to tax-exempt employer-provided health coverage benefits or fringe benefits that are based on an individual s marital status. 4. Notice IR expands on the discussion of the prospective application, and makes crystal clear that same-sex married couples must file 2013 federal income tax using either married filing jointly or married filing separately filing status. For prior tax years, however, the taxpayer can choose whichever is the better result regarding the individual s marital status: a. Individuals who were in same-sex marriages may, but are not required to, file original or amended returns choosing to be treated as married for federal tax purposes for one or more prior tax years still open unset the statute of limitations. b. The Notice points out that refund claims can still be filed for tax years 2010, 2011, and The Notice does not point out that refunds also can be filed for 2009 income tax returns until October 15, 2013 if the due date for filing the return was extended to October 15, Rev. Rul states that the IRS will give further guidance in the future regarding the retroactive application of Windsor to employee benefits and employee benefit plans and arrangements. (For example, what if the surviving party of a same-sex marriage did not previously receive the benefits of a spouse rollover or other benefits available to spouses under the minimum distribution rules?) E. Tax Planning Opportunities for Same-Sex Spouses after Windsor. 1. The Windsor decision presents planning opportunities and will have significant consequences concerning federal benefits for same-sex spouses (some of which may ultimately be available only for spouses living in states that allow same-sex marriage), such as Social Security benefits, retirement benefits, health insurance, disability benefits, taxes, and more. A few of the tax planning opportunities are mentioned briefly below. -22-

23 a. Marital Deduction. One of the most significant benefits to samesex spouses after Windsor is the availability of the unlimited federal estate and gift tax marital deduction. Property passing from one spouse to another (either during life or after death) is free from estate and gift tax. The deduction applies to both outright gifts and certain trusts, such as qualified terminable interest property (or QTIP ) trusts. Same-sex spouses will be able to pass assets to one another with no federal transfer tax cost. Same-sex spouses who previously paid estate or gift taxes on transfers may want to talk with their advisors about whether they can file amended returns and seek refunds for taxes paid. Pursuing such claims may involve seeking judicial approval to reopen statutes of limitations that have expired. b. Portability. Same-sex spouses will be able to take advantage of the new portability rules made permanent earlier this year under the American Taxpayer Relief Act. 2010(c). The current estate tax exemption amount for each individual is $5.25 million (indexed for inflation). This exemption is portable between spouses. That is, if the first spouse dies without utilizing his or her full exemption, the surviving spouse may elect to utilize the remaining deceased spouse s unused exemption in addition to the spouse s own exemption. c. Disclaimers. An individual cannot generally disclaim (i.e., relinquish rights to) property, if the disclaimer would result in the property passing for the individual s benefit. There is an exception to this general rule for disclaimers by a surviving spouse. 2518(b)(4). This may be useful for same-sex spouses who desire the flexibility of allowing the surviving spouse to determine the extent to which a credit shelter trust is funded after the first spouse s death. d. Gift-Splitting. Same-sex spouses will be able to split gifts whereby one spouse makes a gift to a third party (but the other spouse does not join in that gift), and both spouses elect to treat the gift as if it came one-half from each e. Review Existing Estate Plan. Clients should review existing planning documents, such as irrevocable trusts, to determine if they are impacted by the decision (for example, whether samesex spouses are now considered permissible beneficiaries). Clients should also consider whether they need to revisit their current life insurance plan or beneficiary designations. f. Joint Income Tax Returns. After Windsor, same-sex spouses will -23-

24 no longer be treated as separate individuals for federal income tax purposes and will be allowed to file joint income tax returns. Same-sex spouses may wish to talk with their advisors about whether they can amend prior separately-filed federal income tax returns as joint returns, which may also involve statute of limitations concerns. Additionally, with respect to same-sex spouses who move to a state that does not permit same-sex marriages, income tax filings may be more complex and cumbersome and separate individual returns may be prudent in some cases. A further complication is that the couple may be treated as spouses for federal income tax purposes but not for state income tax purposes. g. Non-Recognition of Gain for Interspousal Transfers. Same-sex married couples may take advantage of the special rule providing that there is no gain recognition for transfers between spouses h. S Corporation Shareholder. Spouses are treated as one person for purposes of determining the number of shareholders of an S corporation (and that the maximum number of 75 is not exceeded). 1361(b)(1)(A), 1361(c)(1). i. Grantor Trusts. There are a number of special rules for spouses in applying the grantor trust rules of , 679. (This may result in either an advantage or disadvantage for same-sex married couples, depending on whether or not they prefer that a trust be treated as a grantor trust.) Same-sex couples who have previously created irrevocable trusts should review the trust situation in light of Windsor to determine if the decision has changed the grantor trust status of the trust. j. Qualified Retirement Accounts. Same-sex spouses will be able to elect a spousal roll-over for a qualified retirement account, thereby potentially extending the ultimate payout of the account. k. Jointly Owned Property. The basis and contribution rules with respect to jointly owned property should now be simplified for same-sex spouses (but if they own property in a state that does not recognize same-sex marriage this may not apply). 2040(b). l. Marriage Settlement Agreement and Divorce. The favorable tax rules for transfer of property pursuant to a marriage settlement agreement will apply to same-sex spouses. Alimony payments to a same-sex spouse may be deductible (and income to the recipient ex-spouse), or may not produce deductions or taxable income, at the election of the divorcing parties. Qualified Domestic -24-

25 Relations Orders (QDROs), which divide qualified retirement benefits at divorce, will be available to same-sex divorcing spouses. 2. Additional, Less Favorable Implications. Same-sex spouses need to be aware that federal recognition of their marriages may also subject them to less desirable aspects of federal law. a. Marriage Penalty. Same-sex spouses with two incomes who previously filed income tax returns as separate individuals will now be required to file either joint or married filing separate returns, in either case being subject to the marriage penalty. (For example, each party could have taxable income of $400,000 before being in the top 39.6% bracket if single, but both spouses together can have only up to $ without being subject to the top bracket. (These top brackets for individuals are adjusted upward to $406,750 and $457,600 and in 2014.) Another example is that the exemption from the 3.8% Medicare tax on net investment income is $200,000 for unmarried individuals but only $250,000 for married individuals, 1411(b).) b. Mortgage Interest Deduction. Unmarried taxpayers may each benefit by being able to deduct mortgage interest with respect to $1.1 million of debt, whereas married couples may only deduct the interest on a combined maximum of $1.1 million. Thus, same-sex spouses may lose a portion of their mortgage interest deduction. c. Employee Benefit Plans. Participants in certain employee benefit plans subject to ERISA will be required to obtain the spouse s written consent before designating anyone other than the spouse (such as a trust) as beneficiary of certain benefit plans. d. Regulatory Requirements. Same-sex spouses may be subject to certain regulatory requirements imposed on married couples, such as financial or other disclosures required of federal government employees and their spouses. e. Losses. Losses are generally not allowed for transfers between spouses Conclusion and Caution. It is clear that the Windsor decision will provide numerous planning opportunities and benefits to same-sex spouses that were not previously available. There will, however, also be costs, the uncertainty of major unresolved constitutional questions, and complications arising from state legislative reactions to Windsor and the seemingly inevitable future litigation. Differences between federal and state law in this respect may add some complexity to planning, but the -25-

26 federal benefits are almost certain to justify dealing with that complexity. -26-

27 RECENT TAX LEGISLATION INCLUDING THE AFFORDABLE CARE ACT INDEX OF EXHIBITS EXHIBIT A: Portability Election of Form 706 EXHIBIT B: Excerpt from Instructions to Form 706 EXHIBIT C: EXHIBIT D: EXHIBIT E: EXHIBIT F: EXHIBIT G: EXHIBIT H: Sample IRC Section 642(g) election January 31, 2011 Letter from New Jersey Division of Taxation Form 8960 (Net Investment Income Tax Individuals, Estates & Trusts) Excerpt from Internal Revenue Service Q&A on Net Investment Income Tax Form 8959 (Additional Medicare Tax) Excerpt from Internal Revenue Service Q&A on Additional Medicare Tax -27-

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