From Washington & Albany — Income & Estate Tax Planning in 2015

Tax News & Comment -- March 2015 View or Print

Tax News & Comment — March 2015 View or Print

I.    From Washington

Income tax planning in 2015 will seek to reduce the effect of high federal and New York tax rates. Avoidance of unnecessary capital gain realization through basis increases or nonrecognition transactions will remain important. Estate tax planning is simplified by portability at the federal level. The top federal income tax rate is now 39.6 percent, its highest since 2000. Capital gains are taxed at 23.8 percent, which includes the 3.8 percent net investment income tax. The top New York rate levels off at 8.82 percent, while New York City adds another three and a half percent for most residents. Wage earners must pay social security and Medicare tax. All told, ordinary income tax rates in New York for wage earners now top out at 52.26 percent; long-term capital gains rates reach 37.69 percent.

The cost of living in New York is higher than in other states not only because of high tax rates, but also because of high living costs. However, many people who leave New York to avoid northeast winters seem to come back when the weather moderates. The Department of Taxation is well aware of this and keeps a vigil over those persons who seek to enjoy the benefits of New York without paying tax here. Residency audits continue to spark litigation. Income tax planning is now prominent in estate planning, not so much for reasons of the federal estate tax, which has whimpered out, but because of the importance of basis; more particularly, the basis step up at death. While placing assets in a credit shelter trust will remove those assets from the estate of both spouses forever, the cost will be a second basis step up at the death of the surviving spouse. In contrast, if assets are gifted to the surviving spouse in a QTIP, a second basis step up is possible with no loss of the federal estate tax exemption, due to portability.

Trusts other than grantor trusts are taxed at 39.6 percent when fiduciary income reaches only $12,150. This means that trusts should distribute income to beneficiaries in lower tax brackets whenever feasible. Trust losses in excess of income benefit no one until the final year of the trust. Accordingly, it may be prudent to defer the timing of trust operating losses until the final year of the trust when the losses may be taken as itemized deductions by beneficiaries. Grantors who sold assets to grantor trusts to save estate taxes may no longer wish to report the tax of the trust they created, since the income tax liability may exceed 50 percent on the personal level, and reducing estate tax planning may no longer be necessary. One solution to these “burned out” trusts may be to “turn off” grantor trust status. Many trusts will contain language expressly permitting such “toggling.” If the trust does not so expressly provide, the grantor may consider amending the trust or decanting the trust into another trust that does contain express language permitting toggling.

While the IRS has not issued regulations concerning the tax implications of turning off grantor trust status, the situation is somewhat muddled, and Revenue Ruling 85-13 — whose tenets are consistent with permitting such a switch — has assumed such prominence, that the tax risk of turning off grantor trust status may be one well worth assuming. The government may be uninterested in challenging these transactions, since at best the taxpayer achieves small or moderate rate bracket benefit. Someone is going to continue to pay the tax; if not the grantor, then the trust or the trust beneficiaries. However, once grantor trust status is turned off, it may be risky to attempt to turn grantor trust status back on at a later date. This “toggling” might present an opportunity for the IRS to argue that the device was being used for tax-avoidance. Somehow it seems inappropriate for a trust to toggle between being a grantor trust or nongrantor trust at the whim of the grantor on a yearly basis.

Especially with the advent of portability, marriage itself is an extremely effective estate tax plan for more affluent taxpayers with accumulations of wealth. Gifts between spouses occasion no income and except in rare occasions no gift tax. Gifts of low basis property to an ailing spouse who lives one year can accomplish a valuable basis step up if the property is willed back to the donor spouse. If the ailing spouse cannot be expected to live a year, giving property to the ailing spouse and having the ailing spouse will the property to children will also lock in the basis step up with no tax risk. (Although in the latter case the children, rather than the surviving spouse, will end up with the property.)

Predicting which spouse may die first is an unseemly proposition, yet the life expectancy of men is statistically shorter than women. As a general rule it may make sense to title lower basis assets (which would benefit most from a basis step up) in the name of the husband. The basis of assets may also be stepped down at death if the asset has declined in value. Avoiding a step down in basis can best be achieved by selling the asset before death. Familiar nonrecognition transactions, which taxpayers take for granted, such as 1031 exchanges, or 121 exclusions, are gem-like tax provisions that can save vast amounts of capital gains tax when highly appreciated residences or business property is disposed of. If the taxpayer is willing to wait seven years, these twin Code provisions can also be used together, magnifying tax benefits.

For those inclined to retire in sunny locations without income tax, moving to Texas, Arizona, or Florida may preserve retirement capital by eliminating the burden of New York income tax. Again, those making the decision to leave will risk being subject to a residency audit if they return too frequently. Much tax planning over the past fifteen years has focused on reducing the size of one’s estate for estate tax purposes. Ironically, some of that planning may turn out to have been counterproductive, since it may be preferable to have property previously transferred out of the estate brought back into the gross estate to benefit from the basis step up at death. Various strategies can be employed to attempt to reverse tax planning that has now become a liability.

The taxpayer whose earlier estate-planning entities are now a liability may attempt to liquidate the entity or undo discounts that no longer provide any tax benefit. This may be achieved by amending or restating the operating or partnership agreement. Alternatively, the taxpayer may utilize a “swap” power in a grantor trust to substitute a higher basis asset — perhaps even cash — for a lower basis asset, in order to take title to low basis property that can most benefit from a basis step up at death. It is not clear to this writer whether the “swap” power which so many have espoused for so long, actually works. See, Tax News & Comment, February 2014, “Rev. Rul. 85-13: Is There a Limit to Disregarding Disregarded Entities.” If the taxpayer is willing to take the risk and it does work, great.

The taxpayer may be tempted to argue that poorly maintained vehicles previously established with the intention of transfer assets — and the appreciation thereon — out of the grantor or donor’’s estate should be pulled back into the estate by virtue of IRC §2036. However, the IRS — quite understandably — does not like to be “whipsawed,” and one would expect the IRS to fiercely challenge such strategies. In essence, it is possible that the arguments previously made by the IRS may not be made by the taxpayer. The taxpayer might attempt to make these arguments due to the attenuation of the estate tax and the invigoration of the income tax. In the end, the difference between capital gains rates and estate tax rates, which only recently were significant, have now narrowed to the extent that complicated analyses may be required to determine whether or not to rely on portability or whether to use a credit shelter trust. Even such analyses are subject to the vagaries of the market and the economy, but may be probative of the best course of action. When presented with a clean slate, and everything else being equal, most agree that portability and the second basis step up it carries with it, is the best estate planning option in most cases.

To reduce the value of assets in the decedent’s estate that will be entitled to a basis step up, but whose inclusion in the estate would no longer produce estate tax revenue, the IRS may now accept questionable valuation discounts claimed by the taxpayer that the Service might previously have challenged for a multitude of reasons. One reason might have been that the basis for the discount was not adequately disclosed. The doctrine of substance over form, first enunciated by the Supreme Court in 1935 in Gregory v. Helvering, 293 U.S. 465, provides that for federal tax purposes, a taxpayer is bound by the economic substance of a transaction where the economic substance differs from its legal form. However, the taxpayer, once having chosen a form, may not later assert that the form chosen should be ignored.

In seeking to ignore a questionable valuation which would now benefit the government, the IRS might argue that the taxpayer, having chosen the form, must be bound by that form, and that the IRS may accept even a valuation that appears questionable, since it was reported by the taxpayer. However, this would seem to be a distorted view of the doctrine of substance over form. In practice, the IRS might achieve its goal anyway since there appears to be no way that the taxpayer could effectively argue that earlier valuation was incorrect, without inviting other, more serious problems. Moreover, the taxpayer would be placed in the peculiar and unenviable position of essentially requesting that the IRS to audit a previous gift tax return.

Proving basis at death is not generally necessary due to the basis step up occasioned upon death by virtue of IRC §1014, but at times the determination of historical basis may be necessary when capital gains must be calculated with respect to property held for many years. While an old saw provides that if the taxpayer cannot prove basis, basis is zero, this is simply not true. Just as the courts have consistently held that difficulty in valuing property or services will not prevent the calculation of realized gain, the taxpayer may establish basis by the best available means. It is true that the taxpayer may have the initial burden of proof when establishing basis, but under IRC §7491 that burden can change “if the taxpayer comes forward with credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer.”
Portability is now a permanent fixture on the estate tax landscape, and levels the playing field for taxpayers who have been lax in their estate planning. As Howard Zaritsky noted at the University of Miami conference in Orlando, portability is the default means of ensuring best use of the large federal estate exemption. In advising a client to implement estate plans not utilizing portability, Mr. Zaritsky aptly observed that the advisor should be sure that what he or she is counsels, if portability is foregone, will not be worse. Of course in New York some additional estate tax planning is necessary to utilize the increasing New York estate exemption, since New York — like almost all other states — has not adopted the concept portability.

New York has also prevented an obvious end-run around its own estate tax by residents making large gifts before death. Now, gifts made within three years of death will be included in the taxable estate of New Yorkers for state estate tax purposes, and will attract estate tax at rates of between 10 and 16 percent. The “cliff” rule will penalize those estates which dare to exceed the New York exemption amount by between 0 and 5 percent. In fact, once the estate exemption amount is exceeded by 5 percent, New York will grant the estate no exemption; the entire taxable estate will be subject to estate tax.

The use of QTIP trusts in devising property to surviving spouses will continue to ensure a basis step up while accomplishing portability of the federal exemption. QTIP trusts and portability elections are now the magic elixir of most moderate to high net worth individuals who seek to implement an effective estate plan. Portability, still new, does have some issues which need to be resolved by Congress. For example, basing the unused exclusion amount on the last-to-die spouse may produce inequitable results. Some have called upon Treasury to fix this problem. In the interim, especially in second marriage situations, a provision in a prenuptial agreement regarding portability may be a good idea. This will protect the heirs of both spouses against uncertainties in the portability statute.

Asset protection using trusts established in Nevada, Delaware, North Dakota or Alaska have proved to be only marginally superior to asset protection trusts created in, for example, the Cayman Islands. Those trusts have generally been ineffective when challenged in state court. However, implementing trusts in those tax-friendly jurisdictions may be quite effective in saving tax.

New York has implemented new rules which seek to restrict tax benefits to New Yorkers who implement trusts in these jurisdictions. There may still be some benefit to be availed of by a New York grantor who establishes such a trust for beneficiaries who do not reside in New York.

In planning for a possible IRS audit, taxpayers should keep in mind that email exchanges to non-attorneys are not privileged, and the privilege extending to exchanges with attorneys may be lost if other persons are copied. Memoranda of law espousing a particular tax-saving strategy may become discoverable in litigation, and even if marked “confidential,” may find its way into the hands of the IRS. It is best not to explicitly detail the merits of a particular tax-saving strategy even in confidential memoranda.

When implementing a tax planning strategy, courts have been particularly impressed with arguments made by taxpayers which emphasize non-tax motivations for a tax-saving transaction. Where valuations are required for returns, taxpayers should be aware that drafts of appraisals can be used against the taxpayer. The IRS has immense information-gathering power and the taxpayer should assume that at audit the IRS will possess more information than the taxpayer might otherwise assume.

Fiduciaries determining trust distributions may now be required to be more mindful of IRS scrutiny. The trust may provide for a discretionary distribution standard based upon the “health, education, maintenance and support (“HEMS”) of the beneficiary.” The trustee may be inclined to make larger distributions to lower-bracket beneficiaries to reduce the incidence of taxation to the trust which is in a higher tax bracket. However, in the event of a large distribution to a beneficiary which appears unjustified, the IRS may argue that the distribution violated the HEMS standard, and that the trust should pay tax at higher rates on amounts distributed in excess of what is required to satisfy the HEMS standard.

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