MELISSA J. WILLMS DAVIS & WILLMS, PLLC HOUSTON, TEXAS JULY 9, 2018 Unified transfer tax system $10,000,000 exclusion/exemption for gift, estate and GST tax for years 2018 2025 Indexed for inflation: $11.18 million for 2018 For years 2011 2017 (and after 2025), $5 million adjusted for inflation $5.49 million for 2017 40% Rate on Excess For many clients, tax planning now means planning for basis adjustment (vs. estate tax minimization) 1
Taxpayers include: Individuals Trusts and estates Corporations Partnerships* Categories of Taxes Taxable income Capital gains (and losses) Net investment income 3 Tax rates Highest tax rate on taxable income = 37% Highest capital gains tax rate = 20% Capital gains tax is tied to tax on taxable income, sort of Net investment income = 3.8% Reaching the 37% bracket in 2018 Individuals: $500,000 single $600,000 married, filing jointly Trusts and Estates: $12,500 4 2
Gifts Future income taxes shift to donee Property subject to non recourse debt Installment obligations Gifts and inheritances are not income taxable Loans Avoid below market loans Applicable Federal Rate ("AFR") 5 What/Who is a Related Party? Section 1031 Exchanges Losses Disallowed Installment Sales Transactions Between Spouses 6 3
Incur capital losses to offset capital gains Capital losses don t carry forward to estate Transfer low basis assets to terminal person Swap high basis assets for low basis assets in grantor trust Partition or transmute community property Pay outstanding medical expenses 7 Prior income tax returns Form 4506 T Form 4506 Final income tax return Due dates and estimated taxes "Executor" is responsible and liable for tax Fiduciary liability 31 USC 3713 Personal liability Exceptions Transferee liability State law influence 8 4
Claims for refund Form 1310 Statute of limitations Time periods Request for prompt assessment Form 4810 Request for discharge from personal liability Form 5495 Joint return with surviving spouse Apportioning the tax Is it worth the risk? Planning with the final return Use expireable NOLs and capital losses Accelerate new installment gain 9 "Benchmark" against which to measure proceeds of sale for determining gain or loss Gain or loss = Amount realized Basis General rule: Basis = cost of asset Special rules for property acquired from a decedent Generally, basis is fair market value at date of death Alternate valuation date value Special use valuation value In essence, estate tax value Applies regardless of whether estate tax is due Basis may step up OR down, i.e. basis adjustment Original cost basis is simply ignored Holding period automatically becomes long term 10 5
Basis consistency and value reporting New IRC 1014(f) and 6035 Estate tax returns filed after 07/31/15 IRC 1014(f) = Basis consistency Applies to beneficiaries of estates required to file an estate tax return Initial basis cannot exceed final estate tax value Property that generates estate tax Not marital or charitable deduction property Not certain tangible personal property Zero basis rule: after acquired or omitted property 11 IRC 6035 = Value (not basis) reporting Applies to executors or other persons required to file an estate tax return Applies to all property (including marital or charitable deduction), EXCEPT: Cash, IRD, certain tangible personal property, property disposed of where CG/CL recognized Form 8971 to IRS and Schedules A to beneficiaries Earlier of 30 days after estate tax return due or filed Supplemental reporting Subsequent transfers 12 6
1. Property acquired by will or intestacy 2. Revocable trust property 3. Property decedent transferred with retained right to control 4. Property subject to a general power of appointment 5. Both halves of community property 6. Other property included in gross estate 7. Former QTIP property 13 Income in Respect of a Decedent ("IRD") Income "earned" by the decedent but not properly reported by him or her Decedent entered into legally significant transaction Decedent performed substantive tasks required No economically significant contingencies Decedent would have received property but for death Property "re inherited" within one year of gift 14 7
More important in recent years Generally, carry over basis For losses, basis limited to FMV on date of gift Does not apply for gifts between spouses Basis increased by any gift and GST tax paid Gifting asset gets appreciation out of estate BUT loss of basis adjustment at death 15 Estates are taxpaying entities (not legal entities) Obtaining an EIN Form SS 4 Notifying IRS of fiduciary relationship Form 56 Termination of relationship Death of grantor of revocable trust New taxpayer Contrast estate vs. revocable trust reporting issues Tax year Fiduciary liability Estimated taxes Medical expenses Charitable income tax deduction Holding S corporation stock 16 8
Revocable Trust treated as Estate IRC 645 election Form 8855 Why unify? Fiscal year end Delay of estimated tax payment requirement Holding S corporation stock Increased personal exemption Defer first income tax return 17 Taxable Income vs. Fiduciary Accounting Income (there is a difference!) For general tax rules, "income" means what s taxable BUT, for trusts and estates, "income" contrasts with "principal" IRC 643 FAI determines which beneficiary is entitled to a receipt 18 9
Fiduciary Accounting Income Read the Trust Agreement! UPIA (Uniform Principal and Income Act) Necessary step to get to DNI Does UPIA apply to executors? 19 Allocating Income Need a receipt Is the receipt principal or is it income? Trust Agreement vs. State Law/UPIA Receipts from entities (corps., partnerships, LLCs, etc.) Receipts from mutual funds Allocating Expenses Trust Agreement vs. State Law/UPIA Who bears the expense income or principal? 20 10
Power to Adjust Not the same as allocating principal and income Allows re allocation IF: Prudent investor rule applies Amount distributed referenced as income (vs. principal) Prescribed allocation is not "fair and reasonable to all" Does it apply to executors? Equitable Adjustments To adjust economic or tax effects between income and remainder beneficiaries resulting from fiduciary actions 21 Individuals: 3.8% tax on net investment income over threshold MAGI > $200,000 for single; >$250,000 for joint filers Estates and trusts: 3.8% tax on lesser of Undistributed Net Investment Income (UNII) or Excess of AGI over threshold >$12,500 in 2018 for estates and trusts For taxable years beginning after 12/31/12 22 11
NII is sum of gross income from the following, reduced by properly allocable deductions: Interest Annuities Dividends Rents and royalties Passive trade or business activities and trading partnerships Net gains taken into account to determine taxable income (includes capital gains) Unless income derived in the ordinary course of a nonpassive trade or business other than trading in financial instruments or commodities IRC 1411(c)(2) Retirement Plans can cause NII tax to apply (p. 38) 23 All estates and trusts subject to Subch. J unless exempt per 1411 Regs. Trusts include: Pooled Income Funds Qualified Funeral Trusts QSSTs and ESBTs subject to special rules 24 12
Qualified Subchapter S Trusts ("QSSTs") Beneficiary must elect Only one income beneficiary allowed All FAI to beneficiary at least annually Form 2553 Elect by 2 months, 15 days after stock transferred Income tax to beneficiary unless stock sold Electing Small Business Trusts ("ESBTs") Trustee makes election Multiple trust beneficiaries allowed Election made by letter request Elect by 2 months, 15 days after stock transferred or after end of 2 year holding period for stock transferred by death Income always taxed to trust at highest rate 25 Excluded trusts and estates Grantor Trusts 170(c)(2)(B) Charitable Trusts or Estates or 501 Trusts CRTs, subject to special rules for distributions Any trust exempt from tax per Subtitle A Cemetery Perpetual Care Funds Electing Alaska Native Settlement Trusts (IRC 646) Foreign trusts and estates, except distribs. to US beneficiaries of estates 26 13
"Undistributed" Net Investment Income Total NII less (i) Distributed NII and (ii) 642(c) deductions Distributed NII = lesser of DNI distribution deduction or NII DNI carries out Net Investment Income If income is distributed as part of DNI and is NII, it s also distributed for NII purposes Capital Gains are generally NII but NOT generally included in DNI 27 Passive Income Gives Rise to NII Advisors Need to Understand Application of Passive Activity Rules to Trusts and Estates Rules under IRC 469 Deal With: Material participation Rental activities Definition of "activity" (including the grouping of activities) 28 14
Regular, continuous, substantial involvement Work in an activity done by an individual (or spouse) who owns an interest in the activity Exceptions: Work not customarily done by owners if principal purpose is avoidance of IRC 469 Work done as investor unless involved in daily operations 29 Individuals Must Meet at least ONE of these: More than 500 hours Substantially all Not less than anyone else (and > 100 hours) Significant participation activities exceed 500 hours Nickel and dime test (5 of previous 10 years) Personal service activity (any 3 years) Facts and circumstances (and > 100 hours) (Note: For limited partners, only underlined tests are available) No Objective Test for Trusts and Estates 30 15
Mattie K. Carter Trust In determining whether trust materially participates, consider participation of those who run business on trust s behalf, rather than just participation of trustee TAM 201317010 Sole means is to find that activities of fiduciaries, in their capacities as fiduciaries, are conducted on a regular, continuous, and substantial basis Frank Aragona Trust (Mar. 27, 2014) Tax Court held activities of individual trustees can count so that trust materially participates in business 31 Advise Clients Which Investments Cause NII Importance of "Team" Approach: Attorney, Accountant, Financial Planner, Exec/Trustee More Record Keeping Requirements for Executors and Trustees More Communication Between Fiduciaries and Beneficiaries Speed Up Administration of Estates Consider Investment Mix, Management Style Consider "Buy and Hold" Investment Approach 32 16