2012 FEDERAL TAX UPDATE FOR INDIVIDUALS

Transcription

1 2012 FEDERAL TAX UPDATE FOR INDIVIDUALS I. TAX RATE STRUCTURE FOR 2012 AND Michael J. Reilly, CPA/ABV, CVA, CFF, CDA Partner Dannible & McKee, LLP Financial Plaza 221 South Warren Street Syracuse, NY & Individuals Regular Income Tax Rates 15%, 28% 10%, 15% 31%, 36% 25%, 28% and 39.6% 33%, and 35% Individuals Long-term Capital Gain Tax Rate 2 Individuals in 10% and 15% Regular Tax Brackets 10% 0% Individuals in Higher Regular Income Tax Brackets 20% 15% Individuals - Qualified Dividend Tax Rate Individuals in 10% and 15% Regular Tax Brackets 15%-39.6% 0% Individuals in Higher Regular Income Tax Brackets 15%-39.6% 15% Gain Attributable to Depreciation on 1250 Real Property (Not Subject to Ordinary Income Recapture) Held 12 months or less 15%-39.6% 10%-35% Held more than 12 months 15%-25% 10%-25% Health Care Legislative Changes Additional Medicare Tax on Earned Income 0.9% 3 N/A Medicare Contribution Tax on Net Investment Income 3.8% 4 N/A Corporations Regular Income Tax Rates 15%-35% 15%-35% Qualified Personal Service Corporation Tax Rate 35% 35% Accumulated Earnings Tax Rate 39.6% 15% Personal Holding Company Tax Rate 39.6% 15% Gift and Estate Taxes Estate Tax Exclusion Amount $ 1,000,000 $ 5,120,000 Gift Tax Exemption Amount 1,000,000 5,120,000 Maximum Tax Rate 55% 35% 1 Assuming the Bush Tax cuts are allowed to expire and the 2010 Health Care Legislation does not get repealed. 2 An 18% maximum rate will apply to most long-term capital gains from selling assets that are (1) acquired after December 31, 2000 and (2) held for more than five years. 3 The additional Medicare tax applies to wages and self-employment income over the applicable threshold - $200,000 for unmarried individuals, $250,000 for married filing joint, and $125,000 for married filing separate. 4 The Medicare contribution tax applies to the lesser of (1) net investment income or (2) MAGI over the applicable threshold - $200,000 for unmarried individuals, $250,000 for married filing joint, and $125,000 for married filing separate. 5 For 2013 and beyond, the phase-out rules for personal and dependent exemption deductions and itemized deductions are scheduled to return (i.e., disguised tax increases).

2 - 2 - II. HEALTH CARE ACT TAX CHANGES AFFECTING INDIVIDUALS IN A. New $2,500 Cap on Health Care FSA Contributions. 1. Before the Health Care Act, there was no tax-law limit on the amount you could contribute each year to your employer s health care Flexible Spending Account (FSA) plan. a. However, many plans have always imposed their own annual limits. b. Amounts that you are allowed to contribute to the FSA plan are subtracted from your taxable salary. c. The FSA funds may then be used to reimburse yourself tax-free to cover qualified medical expenses. d. Starting in 2013, the maximum annual FSA contribution for each employee will be capped at $2, Tax Planning Implications. a. If you have an FSA plan, your employer will ask you near the end of the year to decide how much you want to contribute to your health care FSA for b. At that point, the new $2,500 contribution limit may affect you. c. Need to make sure you use up your 2012 contribution before the deadline for doing so (may be as late as March 15, 2013). B. New Higher Threshold for Itemized Medical Expense Deductions. 1. Before the Health Care Act, the allowable itemized deduction for unreimbursed medical expenses paid for you, your spouse, and your dependents equaled the excess of your qualified medical expenses over 7.5% of your adjusted gross income (AGI). 2. Starting in 2013, the deduction threshold will be raised to 10% of AGI for most individuals. 3. However, if either you or your spouse will be age 65 or older as of December 31, 2013, the new 10%-of-AGI threshold will not take effect until a. Also, if you or your spouse turns age 65 in any year , the long-standing 7.5%-of-AGI threshold will apply for that year through b. Starting in 2017, the 10%-of-AGI threshold will apply to everyone.

3 Tax Planning Implications. a. If you will be affected by the new 10%-of-AGI threshold next year, consider accelerating elective qualifying unreimbursed medical expenses into 2012 so that your allowable medical expense deduction for this year will be based on the more taxpayer-friendly 7.5%-of-AGI threshold. C. New 0.9% Medicare Tax on Compensation and/or Self-Employment Income. 1. For 2012, the Medicare tax on employee compensation and/or net selfemployment (SE) income is 2.9%. a. If you are an employee, 1.45% is withheld from your paychecks, and the other 1.45% is paid by your employer. b. If you are self-employed, you pay the whole 2.9% yourself. 2. Starting in 2013, an extra 0.9% Medicare tax will be charged on employee compensation and/or net SE income above: a. $200,000 if you are unmarried, b. $125,000 if you use married filing separate status, or c. $250,000 of you and your spouse s combined compensation and/or net SE income if you are married filing jointly. 3. These thresholds will not be adjusted for inflation in post-2013 years. 4. If you are self-employed, the additional 0.9% Medicare tax hit will come in the form of a higher SE tax bill. 5. Note, the additional Medicare tax will not qualify for the deduction for 50% of SE tax that you are allowed to claim against AGI. 6. If you owe the 0.9% Medicare tax, it should be taken into account in determining if you need to make quarterly estimated tax payments starting in Tax Planning Implications. a. If you have the ability to shift some employee compensation and/or net SE income from 2013 into this year, the new 0.9% Medicare tax will not apply to that amount. b. However the income shift might have negative effects on your 2012 tax situation. D. New 3.8% Medicare Contribution Tax on Investment Income (See Section III below).

4 - 4 - III. NEW 3.8% MEDICARE CONTRIBUTION TAX ON INVESTMENT INCOME. A. Overview. 1. Through 2012, the maximum Federal income tax rate on long-term capital gains and dividends is only 15%. 2. Starting in 2013, the maximum rate on long-term gains is scheduled to rise to 20% and the maximum rate on dividends is scheduled to rise to 39.6% as the so-called Bush tax cuts expire. 3. Starting in 2013, all or part of the net investment income, including longterm capital gains and dividends, earned by higher-income individuals can be hit with an additional 3.8% Medicare contribution tax. 4. As a result, the maximum Federal rate on long-term gains for 2013 and beyond will actually be 23.8% (versus the current 15%) and the maximum rate on dividends will be 43.4% (versus the current 15%). 5. The additional 3.8% Medicare contribution tax will not apply unless your modified adjusted gross income (MAGI) exceeds: a. $200,000 if you are unmarried, b. $250,000 if you are a married joint-filer, or c. $125,000 if you use married filing separate status. 6. The additional 3.8% Medicare contribution tax will only apply to the lesser of : a. Your net investment income, or b. The amount of MAGI in excess of the applicable threshold. 7. MAGI means regular AGI plus the excess of the amount excluded from gross income under the foreign earned income exclusion over any deductions or exclusions that are disallowed with respect to such excluded foreign earned income. 8. These MAGI thresholds are not adjusted for inflation. 9. If you owe the additional 3.8% Medicare contribution tax, it should be taken into account in determining if you need to make quarterly estimated tax payments starting in B. Net Investment Income Defined. 1. Net investment income for purposes of the additional 3.8% Medicare contribution tax is gross investment income less properly allocable deductions.

5 Gross investment income equals the sum of: a. Net taxable gains from assets held for investment, including gains from selling stocks and mutual fund shares and the taxable portion of gains from selling personal residences. (i) Gains from property held in a trade or business in which you actively participate (other than the business of trading in financial instruments or commodities) are not included. b. Gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a business in which you actively participate (other than the business of trading in financial instruments or commodities). (i) However, interest from tax-exempt bond interest is not included. c. Gross income from passive business activities and the business of trading in financial instruments or commodities. 3. Net investment income generally includes the gain on certain real estate transactions. a. However, it does not include gain on the sale of real property held in your active business. 4. Net investment income does not include the gain on the sale of your principal personal residence to the extent the gain is not taxable because of the $250,000 ($500,000 for married, filing jointly) home gain exclusion. a. But any gain exceeding the exclusion amount is included in net investment income. b. If you sell a second home (e.g., vacation home), the entire gain is included in net investment income. 5. Dividend distributions from an S corporation in which you materially participate are not included in net investment income, nor are gains on the sale of a partnership or S corporation in which you materially participate. 6. Net investment income does not include distributions from tax-favored retirement plans and accounts such as pension plans, 401(k) plans, SEP IRAs, SIMPLE IRAs, traditional IRAs, and Roth IRAs. 7. Social Security benefits are also not included.

6 - 6 - Bill and Sharon, a married joint-filing couple, have 2013 MAGI of $265,000 and $60,000 of net investment income. They will owe the 3.8% additional Medicare contribution tax on $15,000 ($265,000 MAGI less the $250,000 threshold). The $570 ($15, %) Medicare contribution tax should be included in their 2013 estimated tax payments. Jim and Cheryl, a married joint-filing couple, have 2013 MAGI of $350,000 and $60,000 of net investment income. They will owe the 3.8% Medicare contribution tax on $60,000 (the entire amount of their net investment income). This $2,280 ($60, %) tax should be included in their 2013 estimated tax payments. Fred, an unmarried individual, has 2013 MAGI of $180,000 and $100,000 of net investment income. He will not owe the 3.8% Medicare because his MAGI is below the $200,000 threshold for unmarried taxpayers. Kate, a well-off widow, sells her principal residence for a $700,000 gain in Due to the $250,000 Federal home sale gain exclusion break for unmarried individuals, her taxable gain is only $450,000 ($700,000 $250,000). In 2013, Kate also has $290,000 of income from other sources including $65,000 of net investment income from capital gains, dividends, interest, etc. Kate s 2013 MAGI is $740,000 ($450,000 from the home sale gain plus $290,000 from other sources). She will owe the 3.8% Medicare contribution tax on the entire amount of her net investment income of $515,000 ($450,000 from the home sale gain plus $65,000 from other sources) because $515,000 is the lesser of Kate s excess MAGI of $540,000 ($740,000 MAGI less her $200,000 threshold) or her net investment income of $515,000.

7 - 7 - C. Trust Income Can Also Be Affected. 1. For a trust, the additional 3.8% Medicare contribution tax will apply to the lesser of: a. Undistributed net investment income, or b. The amount of AGI in excess of the threshold for the top trust Federal income tax bracket. 2. For 2012, that threshold is only $11,650. D. Tax Rate Impact. 1. The additional 3.8% Medicare contribution tax in conjunction with other scheduled rate increases, the following maximum federal rates will apply in 2013: a. 23.8% (20% + 3.8%) on net long-term gains in excess of net short-term capital losses (versus 15% for 2012). b. 23.8% (20% + 3.8%) on net 1231 gains from passive business activities (versus 15% for 2012). c. 43.4% (39.6% + 3.8%) on net short-term gains in excess of net long-term capital losses (versus 35% for 2012). d. 43.4% (39.6% + 3.8%) on net dividend income (versus 15% for 2012). e. 43.4% (39.6% + 3.8%) on net interest, royalty, annuity, and rental income (versus 35% for 2012). f. 43.4% (39.6% + 3.8%) on net ordinary income from passive business activities and net ordinary income from the business of trading in financial instruments or commodities (versus 35% for 2012). E. Planning to Mitigate Higher Taxes on Investment Income. 1. Investment gains that would be subject to higher tax rates if they are recognized in 2013 won t be hit with those higher rates if the gains are recognized in Taxpayers should consider triggering gains by selling affected appreciated assets by December 31, a. Taxpayers should only sell assets that they are thinking about selling anyway. 3. On the other hand, holding onto depreciated investment assets (i.e., rental real estate properties that were acquired at the top of the market) until after this year could be beneficial because losses from selling them in

8 and beyond could shelter taxpayers from higher future tax rates on net investment income. 4. Losses would reduce: a. Taxable income for regular tax rate purposes, b. AGI for purposes of various phase-out rules, and c. MAGI and net investment income for purposes of the additional 3.8% Medicare contribution tax. IV. YEAR-END TAX PLANNING. A. Consider Deferring Income or Doing the Opposite. 1. It may pay to defer some taxable income from this year into next year, especially if you expect to be in a lower tax bracket in a. For example, if you have a business on the cash-method, you can postpone taxable income by waiting until late in the year to send out some customer invoices (i.e., you won t receive payment for them until early 2013). 2. You can also postpone taxable income by accelerating some deductible business expenditures into this year. 3. Deferring income may also be helpful if you re affected by unfavorable phase-out rules that reduce or eliminate various tax breaks (child tax credit, education tax credits, etc.). 4. By deferring income every other year, you may be able to take more advantage of these breaks every other year. 5. However, if the Bush tax cuts are allowed to expire at the end of 2012, the income deferral strategy may not be advisable. a. Pushing income from 2012 into 2013 could expose you to higher marginal tax rates next year. b. Therefore, consider taking the opposite of the traditional approach by accelerating income into this year and deferring deductions until next year so more income will be taxed at this year s lower rates. B. Leverage Standard Deduction by Bunching Deductible Expenditures. 1. If your 2012 itemized deductions likely to be just under, or just over, the standard deduction amount, consider the strategy of bunching together expenditures for itemized deduction items every other year, while claiming the standard deduction in the intervening years.

9 The 2012 standard deduction is $11,900 for married joint filers, $5,950 for single and married filing separate filers, and $8,700 for heads of households. EXAMPLE Bob and Mary are joint filers whose only itemized deductions are $4,000 of annual property taxes and $8,000 of home mortgage interest. If they prepay their 2013 property taxes by December 31, 2012, they could claim $16,000 of itemized deductions on their 2012 return ($4,000 of 2012 property taxes, plus another $4,000 for the 2013 property tax bill, plus the $8,000 of mortgage interest). Next year, they would only have the $8,000 of interest, but could claim the standard deduction (which will probably around $12,500 for 2013). Following this strategy will cut their taxable income by a meaningful amount over the two-year period (this year and next). 3. Examples of other deductible items that can be bunched together every other year to lower your taxes include charitable donations and state income tax payments. 4. Taxpayers that think they will pay a higher tax rate next year, may want to claim the standard deduction this year and bunch their itemized deductions into 2013 where they can offset the higher taxed income. a. This will boost their overall tax savings for the two years combined. C. Take Advantage of 0% Rate on Investment Income. 1. For 2012, the Federal income tax rate on long-term capital gains and qualified dividends is 0% when they fall within the 10% or 15% Federal income tax rate brackets. 2. This will be the case to the extent your taxable income (including longterm capital gains and qualified dividends) does not exceed $70,700 if you are married and file jointly ($35,350 if you are single). 3. While your income may be too high to benefit from the 0% rate, you may have children, grandchildren, or other family members who will be in one of the bottom two brackets.

10 a. If so, consider giving them some appreciated stock or mutual fund shares that they can then sell and pay 0% tax on the resulting long-term gains. b. Gains will be long-term as long as your ownership period plus the gift recipient s ownership period (before he or she sells) equals at least a year and a day. 4. Giving away stocks that pay dividends is another possible idea. a. As long as the dividends fall within the gift recipient s 10% or 15% rate bracket, they will be Federal-income-tax-free. 5. If the Bush tax cuts are allowed to expire at year-end, the minimum tax rate on 2013 long-term gains for these taxpayers will be 10% (or 8% for gains from certain investments held for over five years), while the minimum rate on 2013 dividends will be 15%. OBSERVATION If you give securities to someone who is under age 24, the Kiddie Tax rules could potentially cause some of the resulting capital gains and dividends to be taxed at the parent s higher rates instead of at the gift recipient s lower rates, which would defeat the purpose. OBSERVATION Be aware that if you give away assets worth over $13,000 during 2012 to an individual gift recipient, it will generally reduce your $5.12 million unified federal gift and estate tax exemption. However, you and your spouse can together give away up to $26,000 without reducing your exemptions. D. Time Investment Gains and Losses. 1. As you evaluate investments held in your taxable accounts, consider the impact of selling appreciated securities this year. a. The maximum Federal income tax rate on long-term capital gains from 2012 sales is only 15%. b. Therefore, it often makes sense to hold appreciated securities for at least a year and a day before selling. c. Now may be a good time to sell some long-term winners to benefit from today s historically low capital gains tax rates. 2. Also consider selling some loser securities (currently worth less than you paid for them) before year-end.

11 a. The resulting capital losses will offset capital gains from other sales this year, including short-term gains from securities owned for one year or less that would otherwise be taxed at ordinary income tax rates. b. As a result, you don t have to worry about paying a higher tax rate on short-term gains if you have enough capital losses to shelter those short-term gains. c. If capital losses for 2012 exceed capital gains, you will have a net capital loss for d. You can use that net capital loss to shelter up to $3,000 of your 2012 high-taxed ordinary income from salaries, bonuses, selfemployment, etc. ($1,500 if you re married and file separately). e. Any excess net capital loss is carried forward to E. Gifts to Relatives and Charities. 1. Gifts to Relatives. PLANNING POINT Selling enough loser securities to create a bigger net capital loss that exceeds what you can use in 2012 might make sense. You can carry forward the excess net capital loss to 2013 and later years and use it to shelter both short-term gains and long-term gains recognized in those years. That will give you extra investing flexibility in 2013 and beyond because you won t have to hold appreciated securities for over a year to get better tax results. Remember: The maximum Federal income tax rate on long-term capital gains is scheduled to increase to 20% starting in 2013 (up from the current 15%) while the maximum rate on short-term gains is scheduled to increase to 39.6% (up from the current 35%). a. Do not give away loser shares (currently worth less than what you paid for them). (i) (ii) Instead sell the shares, and take advantage of the resulting capital losses. Then, give the cash sales proceeds to the relative. b. Do give away winner shares to relatives. (i) Most likely, they will pay lower tax rates than you would pay if you sold the same shares.

12 (ii) (iii) (iv) Relatives who are in the 10% or 15% Federal income tax brackets will generally pay a 0% Federal tax rate on longterm gains from shares that were held for over a year before being sold in Even if the shares are held for one year or less before being sold, your relative will probably pay a lower tax rate than you would (typically only 10% or 15%). However, gains recognized by a relative who is under age 24 may be taxed at his or her parent s higher rates under the so-called Kiddie Tax rules. 2. Gifts to Charities. a. Sell loser shares and claim the resulting tax-saving capital loss on your return. (i) (ii) Then, give the cash sales proceeds to the charity and claim the resulting charitable write-off (assuming you itemize deductions). This strategy results in a double tax benefit (tax-saving capital loss plus tax-saving charitable contribution deduction). b. Give away winner shares to charity instead of giving cash. (i) (ii) (iii) F. Convert Traditional IRA into Roth IRA. For publicly traded shares that you ve owned over a year, your charitable deduction equals the full current market value at the time of the gift. When you give winner shares away, you escape from the related capital gains tax. This also results in a another double tax-benefit since you avoid capital gains tax on the winner shares, and you get a tax-saving charitable contribution write-off. EXAMPLE If your traditional IRA has still not fully recovered from the losses realized during the 2008/2009 stock market meltdown, your account may now be worth less than it once was. Correspondingly, the tax hit from converting your traditional IRA into a Roth IRA right now would also be less than it would have been at the market peak. This is because a Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth IRA. While even the reduced tax cost from converting is unwelcome, it may be a small price to pay for future tax savings.

13 After the conversion, all the income and gains that accumulate in your Roth IRA, and all withdrawals, will be totally free of any Federal income taxes assuming you meet the tax-free withdrawal rules. In contrast, future withdrawals from a traditional IRA could be hit with tax rates that are higher than today s rates. Proper IRA conversion planning can be tricky. You have to be satisfied that paying the up-front conversion tax bill makes sense in your circumstances. In particular, converting a big account all at once could push you into higher 2012 tax brackets. You must also make assumptions about future tax rates, how long you will leave the account untouched, the rate of return earned on your Roth IRA investments, etc. V. C-CORPORATION STRATEGY - PAYING CORPORATE DIVIDENDS THIS YEAR BEFORE RATES GO UP. A. Overview. 1. Normally, dividend treatment is something to avoid because of the double taxation issue. 2. In effect, dividends are subject to double taxation. Your corporation pays income taxes on the earnings that generate the dividends, then you have to pay income taxes too when the earnings are paid out to you. 3. This harsh effect has been softened somewhat for the last several years because the maximum dividend tax rate was only 15%. 4. However, in 2013, barring any tax legislation, this favorable maximum rate is scheduled to skyrocket to 43.4% after B. Planning. 1. If your corporation has built up substantial earnings and profits over the years, sometime before the end of 2012 is an ideal time to consider paying some dividends. 2. Although, double taxation is assured, a 15% tax rate may be quite manageable especially if you were expecting to pay a dividend in the future anyway. 3. In addition to getting cash into your hands at historically low tax rates, paying dividends this year may have additional benefits for your corporation: a. Reduce Future Exposure to Accumulated Earnings Penalty Tax. A profitable corporation becomes exposed to the accumulated earnings penalty tax when it accumulates earnings in excess of reasonable business needs and does not pay dividends. Right

14 now, the accumulated earnings tax rate is only 15%. Absent a law change, after 2012, the accumulated earnings tax rate will return to the maximum individual Federal rate on ordinary income 39.6% for Therefore, now is a great time to pay out dividends and reduce your corporation s exposure to this penalty tax. b. Better Tax Treatment for Distributions in Future Years. To the extent 2012 cash distributions reduce the corporation s earnings and profits, there s a greater likelihood that distributions in future years will be treated as tax-free returns of capital or as long-term capital gains (which may once again be taxed at lower rates than dividends). c. Establish a Dividend Paying Record. A history of paying dividends will make it more difficult for the IRS to characterize compensation paid to business owners (which is deducible by the corporation) as disguised dividends (which aren t deductible). In other words, future compensation amounts will be easier to defend as reasonable if at least some dividends have been paid in the past. VI IS A CRITICAL YEAR FOR BENEFICIAL ESTATE PLANNING OPPORTUNTIES. A. Background. 1. The 2010 Tax Relief Act provided a host of estate and gift tax planning opportunities to save significant amounts of taxes, but if you don t act now, it may soon be too late. 2. The applicable exclusion amount (often referred to as the exemption ) in 2012 is at an all-time historical high of $5.12 million (possibly even more for certain surviving spouses if the portability election is made). a. From 2001 through 2009, this amount gradually increased from $675,000 to $3.5 million. b. The $5.12 applicable exclusion amount applies to transfers at life or death, which means assets up to that amount can be given away now or at death without triggering gift or estate tax. 3. The top estate, gift, and GST tax rate (it s a unified tax system) is only 35% on transfers exceeding the applicable exclusion amount. a. Compare that to the top rate of 45% in 2009 and 60% in The 2010 Tax Relief Act added an additional benefit by allowing a special portability provision for estates of married individuals who die in 2011 or 2012.

15 a. The estate of a married individual who didn t use the decedent s full exclusion amount can pass the unused amount to the decedent s surviving spouse, who can then add this to his or her basic $5.12 million exclusion amount for transfers during life or at death. (Note that portability doesn t apply to the decedent s unused exclusion for GST tax purposes, however). b. To make the election, a complete Federal estate tax return (Form 706) must be timely filed (but the IRS has recently offered at least some relief in the reporting requirements as explained below.) 5. The provisions of the 2010 Tax Relief Act are scheduled to come to an end on December 31, 2012, after which the top transfer tax rate is scheduled to jump to 55% (60% for certain estates valued over $10 million) unless new law is enacted. 6. The applicable exclusion amount of $5.12 million in 2012 is scheduled to drop to $1 million in a. Many believe Congress will step in and change the applicable exclusion amount to a more moderate level possibly to $3.5 million, which was the amount available in b. Given the current Federal budget deficit, it seems unlikely that the level will remain at $5.12 million; let alone increase. 7. Unless extended by Congress, the portability election will not be available after 2012 even if the surviving spouse hasn't used up the amount passed to him or her by the decedent. a. Although many commentators believe this election will be extended beyond 2012, (in fact, it was included in President Obama's 2013 budget proposal) it's anyone's best guess what will happen. B. Gifting Appreciating Property before Gifts made during life can provide significant tax benefits. 2. Closely-held businesses, real estate, and stock portfolios may increase in value dramatically over time. 3. By transferring those assets during lifetime, the appreciation and income earned after the date of the gift is effectively removed from the donor's future estate. 4. Unfortunately, the appreciation earned up to the date of the gift isn't removed from the future estate value because of the way the unified estate and gift tax system adds adjusted taxable gifts back to an individual's estate at death.

16 But making lifetime gifts of property that are likely to appreciate in the future can significantly reduce the amount of transfer tax that would otherwise be due if the property were held until death. 6. If such gifts are made in 2012 before the applicable exclusion amount drops, even greater estate tax savings can be achieved. Lifetime Gifts Can Remove Future Appreciation From Donor's Estate Claire transferred undeveloped land valued at $1 million to her daughter, using her annual exclusion ($10,000 at that time) several years ago and her applicable exclusion amount of $990,000 ($1 million - $10,000 annual exclusion) to shelter the gift from gift tax. Claire died in late 2012 when the land was valued at $7.5 million. Her gross estate (excluding the land) was valued at $3.2 million. Although the property is not included in Claire s gross estate, the $990,000 adjusted taxable gift is added back to her adjusted taxable estate. Since Claire's gross estate of $4.19 million ($3.2 million + $990,000 adjusted taxable gifts) is sheltered by her $5.12 applicable exclusion, no estate tax is due. If instead, Claire had kept the property until her death, the property will be included in her estate at the $7.5 million appreciated value. Assuming there were no estate expenses or deductions, her adjusted taxable estate would be $10.7 million ($3.2 million + $7.5 million), resulting in estate tax of nearly $2 million. Thus, by gifting the property during her lifetime, Claire saves nearly $2 million in Federal estate taxes, and if state death taxes applied, there would be even greater estate tax savings. Delaying Transfers Until After 2013 Results In Higher Estate Taxes Upon The Donor's Death Assume the same facts as in Example 1 except that Claire didn't make the transfer until her death, which occurred in early If the applicable exclusion amount falls to $1 million, as scheduled, Claire's estate tax would be about $5.2 million.

17 By not making the gift during her life and waiting until 2013 to transfer the property, Claire's estate tax is about $3.6 million higher than it would otherwise have been if she had gifted to property years ago. (In which case, her gross taxable estate would have been $4.19 million ($3.2 million + $990,000) and the estate tax would be around $1.6 million). 7. Of course, making large gifts isn t appropriate for all taxpayers (for example, those with less than $1 million of net worth or those who may have difficulty maintaining their standard of living during retirement years). a. But for many taxpayers, making lifetime gifts should be encouraged, particularly while the current applicable exclusion amount is high enough to cover up to $5.12 million in transferred value. 8. Some have expressed concern about the "clawback" potential of subjecting the excess of gifts made in 2012 when the applicable exclusion amount is $5.12 million over the $1 million applicable exclusion amount for 2013 recaptured as an estate tax upon the donor's death. a. However, most commentators do not believe this will be an issue. b. But even if there is such a clawback, the future appreciation on the gift will escape estate tax, as well as any income earned on the gifted property. C. Gifts of Interests in FLPs and LLCs. 1. This gifting strategy can result in even more transfer tax savings for taxpayers with business or investment property likely to appreciate over the years. 2. By transferring the property to a Family Limited Partnership (FLP) or LLC and gifting interests in the FLP or LLC to family members (or others), transfer taxes can be reduced by both the increased applicable exclusion amount and appropriate valuation discounts, such as the minority discount. 3. Because the window of opportunity for such discounts may be closing soon, taxpayers who could benefit from this planning should be encouraged to act sooner, rather than later. a. President Obama's budget proposal for 2013 included provisions to restrict discounts on valuing an interest in a family-controlled entity transferred to a family member. b. Although, his budget wasn't approved, this provision has come up in previous proposals.

18 D. Annual Exclusion Gifts and Medical and Education Exclusion Gifts. 1. Annual exclusion gifts (up to $13,000 per donee in 2012) and medical and education exclusion gifts (no maximum amount) should be considered before making other gifts since these will not cause any of the donor's applicable exclusion amount to be used (at the time of the gift or upon the donor's death), and yet the donor's future taxable estate is reduced while the donee benefits from the gift. 2. Payments for medical and educational purposes must be direct transfers on behalf of an individual for medical expenses to a health care provider or to a qualifying educational organization for tuition. E. Grantor Retained Annuity Trusts. 1. A Grantor Retained Annuity Trust (GRAT) is an excellent planning tool, particularly when interest rates are low and the taxpayer's assets are likely to significantly appreciate. 2. A GRAT, which is an irrevocable trust, allows the grantor (creator) of the trust to retain the right to periodic payments of a fixed amount of principal and interest for a fixed period of years. In other words, the grantor retains the right to a fixed annuity from the trust. 3. It's important to make sure, given this economy, that the trust assets can earn a sufficient amount of income to make the annuity payment. 4. At the end of the trust term, which is specified by the grantor when the trust is created, the trust assets pass to the beneficiaries named by the grantor (usually his or her children or grandchildren). 5. When a GRAT is funded, the gift tax value of the transferred assets is based on the actuarial value of the remainder interest in the GRAT, which can be substantially less than the FMV of the trust's assets, especially given today's low interest rates. a. The value of the remainder interest is the entire FMV of the property transferred into trust reduced by the value of any interest retained by the grantor. b. No annual gift tax exclusion is allowed for such a gift since it's not considered a present interest. 6. Because the amount of the taxable gift is limited to the value of remainder interest, the grantor can transfer significant amounts of wealth at a gift tax discount. a. Then, if the grantor survives the term of the trust, the value of the assets in the trust is removed from the grantor's estate. b. In addition, by paying the income taxes on the taxable income of the trust, the grantor continues to reduce his or her future estate.

19 If a taxpayer wants to make a lifetime transfer of property to a family member, such as an interest in a business, a GRAT can be used to transfer more value (with reduced gift tax impact) than an outright gift of the property. a. However, to avoid gift taxes, the trust should be structured so that the value of the remainder interest does not exceed the grantor's $5.12 million basic exclusion (for 2012). b. Furthermore, by "zeroing-out" GRATs (i.e., retaining enough annuity interests to reduce the gift tax value of the remainder interest to zero) and by reducing the GRAT term (to reduce the risk of the grantor's death during the term, which would cause the trust to be included in the grantor's estate), taxpayers can maximize the benefits of GRATs. 8. There is a possibility that this opportunity may be going away soon. a. The Obama Administration's 2013 proposed budget included a provision that would require GRATs to have a minimum term of 10 years or a maximum term of the life expectancy of the annuitant plus 10 years. b. Additionally, the GRAT would be required to have a remainder interest valued at greater than zero when the interest was created. c. Although, his budget wasn't approved, this provision has come up in previous proposals. F. Electing Portability for a Married Decedent. 1. The 2010 Tax Relief Act provides a unique opportunity for married couples who die in 2011 or 2012 to pass their unused exclusion amount to a surviving spouse, who can then add this amount to his or her own $5.12 million basic exclusion amount for transfers during life or at death. 2. The major benefit of making the election is simplicity, especially for the moderately wealthy married couple. 3. But for many estates not otherwise required to file an estate tax return (because they are below the $5.12 million filing threshold for 2012), executors (or the beneficiaries they serve) have been reluctant to incur the preparation fees of filing a complete Form 706, which is necessary to make the election. 4. The good news is that the IRS has recently provided relief for estates not otherwise required to file. a. Executors of such estates will generally not have to report the value of property qualifying for the marital or charitable deduction (Temp. Reg T(a)(7)).

20 b. However, in certain situations, such as when the value of property relates to, affects, or is needed to determine, the value passing from the decedent to another recipient (such as when a fraction of the decedent's estate passes to a surviving spouse and the other fraction to a trust for a surviving spouse and the decedent's children), this relief isn't available. G. Surviving Spouse's Gifts of Deceased Spouse's Unused Exclusion Amount. 1. A surviving spouse who has received an unused exclusion amount from a pre-deceased spouse (referred to as the "deceased spousal unused exclusion amount" or DSUEA) should consider using the DSUEA to shelter taxable lifetime gifts (those in excess of the annual exclusion amount). a. This allows even more wealth to pass free of estate tax. 2. In newly released guidance on the portability rules, the IRS says the surviving spouse doesn't have to use any of his or her own basic exclusion before using the DSUEA (Temp. Reg T(b)). VII. TRAPS TO AVOID IN A LIFETIME GIVING PROGRAM. A. Background. 1. There are many ways to transfer property during an individual's lifetime in a manner designed to avoid or minimize Federal estate and gift tax. 2. However, many of these opportunities can backfire if the transfer is not properly structured. 3. With 2012's favorable estate and gift tax regime possibly going away in 2013, we expect, there will be a lot of gift giving over the remainder of B. Lifetime Giving Traps and How to Avoid Them. 1. Avoid gifts of future interests in property if the annual gift tax exclusion (currently $13,000) is vital to the planning objective. If the donee's enjoyment of the property is postponed, the property interest is a future interest, not a present interest. For the annual exclusion to apply, the property transferred generally must be a present interest (IRC 2503(b)). 2. Don't overlook gift-splitting with a spouse. For 2012, gift-splitting allows a spouse to shelter $26,000 of gifts to anyone individual with the annual gift tax exclusion if the donor's spouse consents to treat half of the gifts as made by him or her (IRC 2513). 3. Make payments for tuition or medical care directly to the educational institution or medical care provider and not to the individual who is to receive the education or medical care, or to any other person. Direct

21 payments of tuition or medical expenses qualify for an unlimited gift tax exclusion and don't reduce the $13,000 annual exclusion (IRC 2503(e)). 4. Avoid gifting highly appreciated property shortly before the donor's death, as this will cause the donee to lose the benefits of the basis step-up that would otherwise occur at the donor's death (IRC 1014). Instead, the donor's basis in the property will carry over to the donee, and the subsequent sale of the property at the appreciated price will generate a large capital gain to the donee. 5. Avoid transferring property that is likely to depreciate in value after the transfer. Adjusted taxable gifts, valued at the date of the gift, are added back to the taxable estate to determine the estate tax base. If the property's value declines after the gift transfer, the higher value (at the date of the gift) will be added back to the donor's estate. 6. Be aware of the kiddie tax rules when transferring income-producing property to a child (a) under age 18 or (b) age 18 (or if a full-time student) whose earned income does not exceed one-half of the amount of his or her support. Unearned income is taxed at the parents' marginal tax rates for these children. Therefore, assets for transfer should be selected carefully, and alternatives to direct gifts to the child should be considered. 7. Avoid gifts of mortgaged property when the mortgage balance exceeds the adjusted tax basis. The excess will be taxable income to the donor. 8. If the donee isn't expected to live for more than a year, and the donor is to receive the property back when the donee dies, do not make gifts of appreciated property to that individual. Such property will not receive the step-up in basis, and the donor will have needlessly depleted his or her applicable credit amount (IRC 1014(e)). 9. Don't delay making lifetime transfers on the assumption that lifetime and testamentary transfers of the same amount have the same tax effect under the unified transfer tax system. The gift tax is tax exclusive, while the estate tax is tax inclusive, meaning that the funds used to pay the tax are included in the estate tax base but not in the gift tax base. As a result, lifetime giving, even when gift tax is incurred, can result in significant overall tax savings because the amount of gift tax is removed from the taxable estate, unless the gift is made within three years of the decedent's death (IRC 2035(c)). In addition, valuation discounts may apply to lifetime transfers of property that would not be available for testamentary transfers.

22 When structuring a Crummey trust (in which beneficiaries are given the right to withdraw contributions to the trust for a period of time in order to make the contributions present interest gifts eligible for the annual gift tax exclusion), be aware that the lapse of the donee's withdrawal powers may trigger a deemed gift if the current income beneficiary and remainder beneficiary are different individuals. The gift may be a future interest and will not qualify for the annual gift tax exclusion. 11. Also for Crummey trusts, observe the formalities of giving notice to donees of their withdrawal rights, or the annual gift tax exclusion may be lost. Do not assume a waiver of notification of future gifts will be sufficient. 12. Be aware of the Generation-skipping Transfer (GST) tax when grandchildren or other skip persons are donees of direct gifts or beneficiaries of trusts. For transfers in trust, the annual gift tax exclusion does not apply for GST tax purposes unless each grandchild or other skip person is the sole beneficiary of his or her trust (IRC 2642(c)). 13. Watch out for transfers with retained interests or powers by the donor. Generally, gifts made during the donor's life are not included in the gross estate. As long as the individual transfers his or her entire interest in the property (excluding life insurance, discussed in item 15), it will not be included in the gross estate no matter when the individual dies. However, if an individual made a transfer of property and retained a power or interest described in IRC , the transferred property will be included in that individual's gross estate if he or she owned the power or interest at death, or disposed of the retained power or interest within three years of death (IRC 2035(a)). Powers that would cause estate inclusion are as follows: a. 2036: retained right to income, possession, or enjoyment of the property, or the right to designate who receives the income, possession or enjoyment. b. 2037: retained reversionary interest (meaning the donor retains the right to receive property back under certain conditions). c. 2038: retained power to alter, amend, revoke, or terminate the beneficial enjoyment of the property. 14. Do not allow the donor to name himself or herself the trustee if he or she possesses powers that could cause the trust property to be included in the estate (at date-of-death values). (Powers that would cause estate inclusion were listed in item 13 above.) In addition, trust property will be included in the donor's estate if he or she reserved the power to discharge a trustee and appoint himself or herself trustee (Regs (b)(3) and (a)(3)). Also, if a donor names himself or herself custodian of a Uniform Gifts (or Transfers) to Minors Act account, the property in the account at the donor's death will be includable in the estate.

23 Don't delay transfers of ownership or incidents of ownership in life insurance. If the insured transfers ownership (or incidents of ownership) in a life insurance policy within three years of death, the proceeds will be included in the insured's gross estate (IRC 2035(a)). This includes transfers to irrevocable life insurance trusts. [Note that if the insured held any incidents of ownership in the policy at the time of death, it doesn't matter how many years have passed since the policy was transferred to a donee-the proceeds will be included in the insured's gross estate under IRC 2042(2).] 16. Avoid delaying lifetime transfers of certain assets that could help the estate qualify for various postmortem estate planning opportunities. If transferred within three years of the donor's death, corporate stock that may be eligible for a 303 stock redemption and real estate that may be eligible for the 2032A special use valuation are included in the donor's gross estate for determining whether the percentage tests are met (not for actual gross estate inclusion) (IRC 2035(c)). In addition, the estate may qualify to make installment payments of estate tax under IRC Consider the income tax consequences of making gifts in trust due to the compressed income tax rate structure for trusts-for 2012 the maximum tax rate (35%) for trusts kicks in once taxable income exceeds $11,650; it doesn't kick in for individuals until taxable income exceeds $388,350. Possible solutions for gifts in trust include making the trust a grantor trust (for income tax purposes) or arranging for the trust to invest in nonincome-producing assets, such as growth stocks or assets that generate tax exempt incomes, such as municipal bonds. 18. If the taxpayer creates a power of attorney and intends to allow the attorney-in-fact to make gifts, do not fail to specifically authorize this gifting power. The power can be limited (e.g., up to the annual gift tax exclusion). Other powers to consider authorizing in the power of attorney are the power to: a. Consent to gift-splitting with the grantor's spouse, b. Allocate the GST tax exemption, and c. Sign gift tax returns and pay any gift tax owed by the grantor. 19. Don't forget that all transfers for less than FMV are subject to the Medicaid lookback period of 60 months. 20. While gifts often are a great way to reduce the donor's potential taxable estate, watch out for unintended consequences to the donee. Where the donee is disabled, gifts outright or into a support trust may disqualify the donee for valuable government aid. Similarly, granting Crummey withdrawal rights may disqualify a disabled person for government aid. In addition, gifts to or in certain kinds of trusts for an individual who may attend college can reduce his or her eligibility for financial aid. Gifts that

24 satisfy an individual's duty of support can also trigger unexpected income tax. 21. Avoid gifts of installment notes to someone other than the spouse. A disposition of an installment obligation at other than its face value to a nonspouse donee will result in immediate gain recognition for the difference between the fair market value and the basis of the installment obligation at the time of the gift (IRC 453B(a) and (g)). 22. Be aware of the income tax consequences of transferring an interest in qualified retirement plan benefits, a traditional IRA, or Roth IRA. Lifetime gifting or assigning the rights to another is treated as a distribution to the owner/participant. As such, the owner would be required to recognize current income (for a qualified plan or traditional IRA) and perhaps be subject to the 10% premature penalty tax if the owner is under age 59 ½. 23. Avoid gifts of IRC 1244 stock that would otherwise be eligible for ordinary (instead of capital) loss treatment for the sale or worthlessness of qualifying closely held stock if certain conditions are met. Because ordinary loss treatment is available only to original shareholders, a loss incurred by a done wouldn't be eligible for 1244 treatment. Thus, the loss would be a capital loss, subject to the usual capital loss limitations. VIII. IRS ISSUES FAVORABLE RULES ON TAX TREATMENT OF LOCAL LODGING EXPENSES (P. A. Background. 1. The IRS has issued long-awaited regulations that permit certain notaway-from-home lodging expenses to be: a. Deducted by workers, or b. If paid for by employers, treated as tax-free working condition fringe benefits (WCFBs) or tax-free accountable-plan reimbursements. 2. The new regulations come in the form of proposed reliance regulations, which means taxpayers can rely on them even though they are only proposed rules. 3. The new rules are retroactive so some taxpayers may be able to file refund claims for open tax years. B. Working Condition Fringe Benefits Existing Rules (IRC 132(a)(3) and Reg (a)). 1. The value of an employer-provided working condition fringe benefit (WCFB) is excluded from the recipient employee's gross income for Federal income and employment tax purposes.