Law News and Tips
Fred Vilbig © 2019
A REAL ESTATE DILEMMA
Some time ago a client with a real estate dilemma called. He had a big tract of land, and now someone wanted to buy it – for a lot of money – for duck hunting. What?
The problem, though, was that his father had given it to him; and his father had given it to him; and his father had…. Well you get the idea. And if he sold it now, he was going to get hit with a million-dollar tax liability – literally. Here’s why, in fairly simple terms.
When you sell something you’ve owned for over a year, you have to pay a 20% tax on your capital gains. Your capital gain is the difference between (i) what you sell your property for and (ii) what is called your “basis.” Your basis is (a) what you paid for the asset (less any depreciation or amortization – never mind about that for now); (b) the date of death value if you inherited the property; or (c) the donor’s basis if it was a gift.
In our situation, all of my client’s ancestors had given the property to children, so his basis was the original 1905 purchase price for the land. Land was cheap back then, so he had a huge capital gain. So what to do?
In meeting with my client, I discovered that he really didn’t need the principal from the sale; he was just looking for retirement income. He didn’t have any children, so he wasn’t concerned about leaving an inheritance to anyone. He was a fairly religious person and was actively involved in his church. So I recommended a charitable remainder unitrust. A what?
A charitable remainder unitrust (a “CRUT”) is an irrevocable trust that is tax-exempt. If a CRUT sells an asset, there is no tax on the sale. With a CRUT, the donor can reserve a kind of an “income” interest over his or her lifetime or for a period of years not to exceed 20. The “income” interest is a fixed percentage of the annually recalculated fair market value of the trust principal. The percentage (called a “unitrust percentage”) must be at least 5% and is capped out based on a math formula. During the donor’s lifetime, he or she receives payments from the unitrust (which are taxable). The principal, though, continues to grow on a tax-free basis like an IRA. On the donor’s death, the principal goes to the designated charity. Pretty nifty under the right circumstances.
The CRUT was just the right vehicle for my client. He was able to transfer the land into a unitrust while retaining the “income” right for his lifetime. Yes, he was taxed on the income, but the principal grew tax-free. When he dies, his church is going to receive a significant gift. Because of that, on creating the CRUT, my client was entitled to a charitable contribution deduction. It isn’t a deduction for 100% of the value of the donated asset. Rather, it is a deduction for what is called the present value of the lifetime stream-of-income. Warning: calculating all of these things can result in headaches. You’ll want to talk to an attorney or an accountant knowledgeable in this area.
I think this was a good outcome. The client was happy. The church was happy. The only losers in this scenario were the ducks. Call if you have any questions.
Fred L. Vilbig © 2019
529 Plans are sometimes referred to as “education IRAs.” And that’s a good way to look at them. Parents and grandparents can put money into a plan for the benefit of a child or grandchild, and the money grows tax-free. Even when the beneficiary takes the money out of the Plan, as long as he or she uses the money for education, all of the growth avoids taxes. If they use it for something else, then the growth is taxable as ordinary income.
Before saying more, I need to make a disclosure. I don’t set up 529 Plans for clients. I had to ask a financial planning friend of mine, John Fischer, about the rules to set them up. And wouldn’t you know it? The rules vary from company to company and from state to state. I don’t want to get too complicated on this part, but here goes.
When you are funding a 529 Plan, you are actually making a gift to the beneficiary. In 2019, gifts of up to $15,000 ($30,000 in the case of a married couple who splits the gift) are exempt from the federal gift tax. If you put more than that into a 529 Plan and the beneficiary is a family member, you can actually spread the gift out over 5 years, but you can’t exclude more than $10,000 per year in that case. Anything over that is technically “subject to” the gift tax. Unless the plan has a limit to it, you can give more, but it creates a gift tax issue.
But there’s a funny thing about the gift tax: all it does is it eats into your federal estate tax exemption. No taxes are actually due until you have given away the maximum estate tax exemption which is currently $11,500,000. That’s a really big number. Only 0.1% of Americans who die in any year will owe any estate tax. For the rest of us, this is not a real issue. So practically speaking, for most people, there are no tax limits to what you can put into a 529 Plan. And don’t worry about filing a gift tax return. The penalty for failing to file is a percentage of the taxes due. No taxes due, then no penalty. But I digress.
When I have a client come to me with a 529 Plan, we have to decide how to plan for it. So long as they are alive, they can always change the beneficiary. But if they die with money still in the plan, what happens to those assets? It turns out that you can name a successor owner of the account. And that successor can be your trust. That way if the beneficiary dies before everything is withdrawn, if you are not able to change the beneficiary due to your death or incapacity, the successor owner can make the change. Without planning properly, the Plan assets could end up in probate. And that’s what we want to avoid.
So my advice is that if the plan permits it, name your revocable trust as the successor account owner. That way, if the primary beneficiary dies and you can’t or don’t change the Plan, so long as you’ve named your trust as the successor owner, the trustee can take care of those assets. The problem, though, is that I don’t know if all 529 Plans allow for a trust to be a successor owner. You’ll have to talk to your financial advisor about that.
Having said all of that, it is important to note that helping a child or grandchild with college or graduate school or a vocational or trade school is always appreciated.
Call if you have questions.
RESOLUTIONS AND TAXES
Every year when the New Year rolls around, we all talk about making resolutions. We make resolutions to improve our appearance and physical health. We make resolutions to become better people. We make resolutions to improve our finances. I saw one study that says that people achieve less than 10% of their New Year’s resolutions. I wonder if it’s even that high.
I would like to propose a resolution for the New Year (I know this will be published in late January, but we had the new tax law to deal with). I want people to resolve to update their estate plans, and the new tax law provides an incentive. Here’s why.
The federal estate tax exemption used to be $600,000. With homes and life insurance and retirement benefits, a lot of people got caught by this tax. We wrote a lot of estate plans with tax planning included, which was the right thing to do at the time.
A typical plan for a married couple involved two separate trusts. We used two trusts to make administration simpler on the death of the first spouse to die. The trusts were generally equal in value. Every year or so we wanted to look at the assets in the separate trusts to make sure they were still generally equal, and the clients were supposed to periodically rebalance the trusts by shifting assets from one to the other where possible.
On the death of the first spouse to die, the assets in his or her trust would be distributed first to a tax-sheltered trust up to the amount of the exemption. The trustee of that trust (typically the surviving spouse) was required to distribute all of the income to the beneficiary. The surviving spouse was almost always entitled annually to demand a distribution of 5% of the trust for no reason at all. In addition, the trustee could use the principal for the health, education, maintenance, and support of the spouse in the trustee’s discretion. The amounts in the tax-sheltered trust would avoid estate taxes even on the death of the second of the spouses to die, provided that the trust was properly administered. Clients generally felt that these restrictions were reasonable enough to avoid estate taxes. Any amounts in excess of the exemption would be distributable to a marital trust that could be subject to estate taxes on the death of the second spouse to die.
The problem with this plan is that the tax-sheltered trust was an irrevocable trust. Irrevocable trusts are taxable. They have to file tax returns. Failure to file the return can result in penalties and interest. And these trusts can generate taxes on trapped capital gains. Taxes on trust income are particularly bad because although the rates are comparable to individual rates, they kick in very quickly. For instance, any trust income over $11,950 will be taxed at 39.6%.
With the new tax law, the exemption amount is around $11 million. A married couple can avoid taxes on approximately $22 million. It is estimated that only two in every 100,000 people will be subject to federal estate tax. What that means is that for most married couples, an estate plan with tax planning is not only unnecessary, but it can also end up costing money.
Another problem with these old plans is that the separate assets of spouses can be liable for the debts of the individual spouse.Jointly held marital assets are protected from the claims of the creditors of either individual spouse. In 2011, the Missouri legislature passed a law allowing joint, marital trusts to be protected from the claims of individual spouses as well. Separate trusts could be liable for the debts of an individual spouse.
I would like to propose a resolution with couples with old estate plans: update your plan. Don’t leave the surviving spouse with a headache.When one of you dies, it probably is not a good time to deal with this sort of thing.
It’s the right thing to do. I’ll wait for your call.
LLCs AND TAXES
When I first started practicing law, we formed a lot of corporations.That was because corporations offered limited liability, and generally partnerships would not.The problem with a corporation, though, is that they are taxable entities (exclusive of S-corporations); they have to file annual reports with the state; and they have to have annual director and shareholder meetings (which, of course, most small businesses don’t do).It was kind of a pain.
In order to at least reduce the tax burden on small businesses, Congress (followed by the states) allowed smaller corporations to be taxed as partnerships under Subchapter S, the S-corporation.There wasn’t a corporate tax, but the paperwork remained.
In 1977, the State of Wyoming (of all places) did something very unusual. Their legislature came up with a new form of business entity that had limited liability like a corporation but otherwise acted like a partnership: no paperwork; no required meetings; and no company level taxation.The limited liability company was born!The idea caught on big time. When Hawaii adopted a similar law in 1996, all 50 states had some form of LLC law.Company profits generally flow through the business to the LLC members according to their percentage interest.
Now it is pretty rare for us to see incorporated small businesses.Almost all small businesses are now formed as LLCs.In order to form an LLC, you first need to file Articles of Organization. The problem is that a lot of people just stop there.As I’ve written about before, the law requires an operating agreement.It doesn’t say what has to be in the operating agreement, but just that you must have one. A single member LLC operating agreement can be very basic. A multi-member LLC operating agreement is going to be more complex.
Under current law, a single member LLC doesn’t even have to file a separate tax return.Instead, the company income just flows through to Schedule C of the owner’s Form 1040.With multi-member LLCs, they have to file a partnership tax return (a Form 1065)( unless they opt to be taxed as an S-corporation, in which case they file a Form 1120-S), and each member’s share of the profits and losses are reported on a Schedule K-1 and flow through to the individual owner’s return.
The new tax law, the Tax Cuts and Jobs Act, includes a new deduction for LLC owners (actually it’s for any non-corporate business owner).Basically it’s a 20% deduction for “qualified business income,” subject to numerous calculations, including wage limitations.To me, along with the reduction in the corporate income tax, this seems the heart of the jobs and pro-business purpose of the new law.The problem is that the devil is in the details.It will be interesting to see how this plays out for small business owners.The limitations are designed to cut down on abuses, but there are a lot of wily characters out there.We’ll have to see how things work out.
In any event, this new deduction should help small business owners, and given the competitive world we live in, they can use all of the help they can get.
The first consultation is free. Or call him now at (314) 241-3963
We finally have the much ballyhooed and vilified 2017 tax act, the “Tax Cuts and Jobs Act” (the “2017 Act”) – don’t you just love these names. The 2017 Act changes a lot of fairly obscure provisions of the tax code that will affect a relatively small number of people, but some of the changes will impact a lot of people. How they affect individual taxpayers will have to be seen. It should be noted that a number of provisions under the old law have not been repealed, but they have only been suspended through 2025. This is probably due to budgetary requirements.
For purposes of this post, I want to provide a very brief summary of some of the provisions that I think will affect the most people. I can assure you that much more will be written on it in the future.
New Income Tax Rates and Brackets: The 2017 Act reduces most of the tax rates for individuals by 2 or 3 %. The 2017 Act also creates new tax brackets for trusts and estates. Under the old law, trust and estate rates were the same as those for individuals, but they were telescoped down so that you hit the maximum tax rate at about $12,500. This will change.
Increase in the Standard Deduction: Under current law, the standard deduction for 2018 would have been $13,000 for married couples; $9,550 for heads-of-households; and $6,500 for individuals who were either single or married but filing separately. Under the 2017 Act, the standard deduction is increased to $24,000 for married couples; $18,000 for heads-of-households; and $12,000 for individuals who are single or are married but filing separately. That’s the good news.
Personal Exemptions Suspended: Now for the bad news. In exchange for the increase in the standard deduction amounts, the deduction for personal exemptions is reduced to zero until 2026. It appears that these two changes in conjunction with one another mean that prior non-itemizers may come out ahead while prior itemizers may come up short.
New Inflation Adjustment Factor: Beginning in 2018, several inflation adjusted amounts will use a “chained” consumer price index (“CPI”) formula. Reportedly the chained CPI grows faster than the unchained rate. This is an obscure point, but it might work in the favor of taxpayers.
Kiddie Tax: Since this applies to kids up to 18 (or 22 if full-time students), this is probably a bad name. Perhaps a better name would be “dependent’s tax.” However, the 2017 Act changes the tax charged on a child’s income. Earned income will be taxed at single individual rates. Net unearned income (interest, dividends, rent, and royalties) will be taxed according to the new brackets for trusts and estates.
Capital Gains: The 2017 Act retains the present provisions on capital gains, but the breakpoints will be indexed for inflation using the new chained CPI.
A number of deduction provisions are also modified under the 2017 Act.
State and Local Tax Deductions: Non-business payments for state and local property taxes and income taxes are deductible, but only up to $10,000. This will be a bitter pill to swallow for residents of high income tax states.
Mortgage and Home Equity Loan Interest Deductions: The deduction for interest paid on home equity loans is suspended through 2025. For mortgages created after December 15, 2017, the deduction or mortgage interest is limited to interest paid on mortgages up to $750,000 for married couples (down from $1,000,000), and $375,000 (down from $500,000) for married taxpayers filing separately. This new lower limit does not apply to pre-December 15, 2017, mortgages, but it would apply to any refinancing of old mortgages.
Charitable Contribution Rules: The limitation on the deduction for cash contributions to public charities (generally schools and universities, churches, museums, etc.) is increased from 50% of the donor’s AGI to 60% of his or her AGI. There is no increase in the deductibility of non-cash contributions to public charities or any contributions to what are called private foundations.
Miscellaneous Itemized Deductions: Under current law, a taxpayer can deduct certain expenses (such as the cost of preparing tax returns) to the extent that they exceeded 2% of the taxpayer’s AGI. This deduction has been suspended through 2025.
Individual Mandate: The individual mandate under the Affordable Care Act which imposed a penalty for not maintaining a mandated health insurance policy has been repealed.
Alternative Minimum Tax: The tax code imposes an additional tax on certain “tax preference” items and on excess children. Income is exempt up to a certain amount. For taxpayers who are hit by this tax, the 2017 Act almost doubles the exemption.
529 Accounts: Under current law, 529 plans could be used to pay for qualified higher education expenses. Under the 2017 Act, these plans can be used for tuition at elementary and secondary public, private, or religious schools, and even for certain home school expenses, up to a $10,000 annual maximum.
Estate and Gift Taxes: The 2017 Act doubles the estate tax exemption amount, indexed for inflation. It is expected that the 2018 exemption amount will be $11.2 million ($22.4 million for married couples). I’ll write more on that in the future. This increase also increases the generation skipping tax exclusion amount.
Qualified Business Deduction: The 2017 Act added a new deduction for non-corporate taxpayers engaged in a business activity other than certain service businesses, including law and accounting. The deduction is allowed for S-corporation shareholders. The math is complicated, but it’s basically connected to a business’ W-2 wages. In promoting the 2017 Act, the Republicans said that it would promote the creation of jobs. It seems that this deduction does that, but time will tell.
There has been a lot of spin put on the 2017 Act by both the left and the right. Time will tell how it plays out nationally, but to see how it will affect your taxes personally, you will probably need to see your tax advisor.
They say that making sausage isn’t pretty. I like sausage, but I’ve never made it, and I probably don’t want to know much about it. With all the government
regulation of food now, this probably isn’t as bad as it once was. However, when families used to process their own meat, they were very efficient.
Everything was used. As the saying goes, the only thing they didn’t use was the moo. And all the spare parts went into the sausage. You probably just
don’t want to know.
I look at politics much the same way. Having served on my city government, I can say it was ugly and frustrating to say the least.
To understand what’s going on, it’s probably good to keep the process in mind. Bear with me while we return to Civics 101 with an ugly dose of reality.
All revenue legislation is supposed to start in the House of Representatives. It starts in the House Budget Committee. This is where the special interest pressure starts, at least in Congress. There is public debate. Amendments are voted up or down. Then the bill is voted on according to party lines basically without regard to the merits of the bill.
If approved by the committee, the bill is then sent to the full House. Moderate horse-trading ensues, and amendments are proposed. Noble sounding speeches are made, but only for the benefit of the constituents at home. Some amendments pass while some are voted down. If the party in control likes the bill, it passes the House and is sent to the Senate.
The Senate will refer it to their Ways and Means Committee. More horse-trading ensues. Nice speeches are made. Amendments are voted up or down. Some version of the bill makes it out of that committee and goes before the Senate. Again if the party in control likes the bill, it gets approved.
The problem is the versions of the bills approved by the Senate and the House are never the same. The two versions then have to go to a Conference Committee to “reconcile” the two bills. Amendments can be inserted at that time too after all public debate is over. It’s here were some of the most controversial provisions are added, such as the HHS Mandate and the Johnson Amendments. Do you hear the meat grinder going?
What emerges from the Conference Committee many times bears striking differences from what went in. And the House and Senate then have to vote the reconciled bill straight up or straight down, without any further amendments.
In my mind the problem with this process is that you and I have no real input into what comes out of the Conference Committee. Special interest groups and very powerful constituents put pressure on the committee members. Individual congressmen propose amendments that favor one of their particular constituents. If his or her vote is needed for passage, that provision passes. Sometimes you’ll see tax code provisions that referred to a business located on a lake that operates a sandwich shop between the hours of ten and five in the state of Alabama. The name of the particular beneficiary of that law is not mentioned, but it was written so narrowly that it could only apply to one organization. But nice speeches were made.
The tax bill being proposed at best has only slim margins for passage. Concessions to individual congressmen will be necessary to get the votes they need. It will be interesting to see what special interest provisions end up in it. I guess this is all part of the democratic process, but it sure seems like sausage making to me. Is that any way to run our government?