Tax Planning

Friday, September 13, 2013

Do You Still Need Estate Planning?

The exemption from federal estate and gift taxes is now $5,250,000.00 (and is being indexed for inflation). As a result, many people think that they no longer need estate planning because their estate does not exceed this amount.  

This is a classic case of the tax tail wagging the business dog. After all, in any type of planning (whether business planning or estate planning), the non-tax, business objectives should always come first.  Once the non-tax, business objectives have been determined, tax planning (whether income tax planning or estate and gift tax planning) should be used to accomplish those non-tax, business objectives in the manner that is the most beneficial from a tax perspective.

The primary non-tax or business purpose of estate planning is dividing and distributing your assets according your wishes upon your death, and the proper estate planning documents need to be executed to accomplish this non-tax objective, regardless of the size of your estate.  Therefore, it is always important to have the necessary estate planning documents in place to divide and distribute your estate according your wishes.

Why You Need a Will?

A last will and testament is the most important estate planning document.  Settling your estate is much simpler when you have will. Texas law provides for a streamlined probate process known as independent administration when you have a will. On the other hand, if no will exists, court supervised dependent administration will probably be required, which is much more time-consuming and expensive. 

By executing a will, you can select the person who will handle the affairs and assets of your estate. Without a will, the court will appoint the person who will handle the affairs and assets of the estate.

Do You Need a New Will?

You may need a new will (or at least prepare a codicil or amendment to your existing will) if:

  1. You want to divide your estate differently than what is set forth in your current will. This might happen if you have additional children after signing the will. It also might happen if gifts are being made to grandchildren and you now have additional grandchildren.
  2. You want to change the executor (or successor executor) or the trustee(s) (or successor trustee(s)) named in your will. This may be a matter of choice.  Alternatively, the persons named in your will may have predeceased you or may be unable to serve as your executor or as trustee, and you need to name someone else.
  3. You left specific property (usually real estate) to someone and subsequently sold that property. This may require a change to your will. For example, your will provides that a gift of real estate tract 1 is made to child A. Real estate tract 1 is then sold. If you want child A to receive something of equivalent value to real estate tract 1, your will needs to be changed.
  4. You left specific property to someone who predeceased you. Wills usually cover these types of situations, and these provisions should be discussed with you before you sign the will. Nevertheless, if this type of event occurs, you need to review your will and make sure that the division of property in the will is consistent with your current wishes.
  5. Changes in the tax laws may have altered the division and distribution of property under the will. This is most likely to occur when the will provides for the creation of a bypass trust and a marital deduction trust.  Most wills provide that the bypass trust will be funded with assets equal to the amount of the estate tax exemption, and the remainder of the assets will be placed in the marital deduction trust. Assume, for example, that your will was drafted in 2001 and that your assets in 2001 were worth $4,000,000.  Further assume that your assets are currently worth $5,000,000. In 2001, $675,000 would have been placed in the bypass trust, and the remaining $3,325,000 would have been placed in the marital deduction trust. Today, all of the assets would be placed in the bypass trust. Depending upon the terms of the bypass trust, this could leave the surviving spouse without a sufficient amount of income.
  6. Use of the bypass and marital deduction trusts is no longer necessary to prevent stacking of assets in the estate of the surviving spouse. Now, the surviving spouse is entitled to use the unused portion of the estate tax exemption of first spouse to die even if a bypass or credit shelter trust is not formed. This is known as portability. However, to take advantage of portability, an estate tax return for the first spouse to die must be filed even if no estate taxes are due.

Do You Need Other Documents Dividing Your Assets?

While the will is the most important estate planning document, it is important to understand that the will often does not control the division and distribution of all assets.  In fact, it is not unusual for the the will to control the division and distribution of less than half of the assets of the person who passed away.  Due to these circumstances, it is extremely important to pay close attention to the assets that do not pass according to the terms of the will (non-probate assets).

Some of the most common non-probate assets include:

  1. Bank accounts or brokerage accounts held as joint tenants with rights of survivorship; 
  2. Defined pension plan benefits (whether from defined contribution plans or defined benefit plans);
  3. 401(k) plan benefits;
  4. IRA's; and
  5. Life insurance benefits. 

Account Agreements

In the case of bank accounts and brokerage accounts, if those accounts are held as joint tenants with rights of survivorship, the agreement opening the account is, in essence, an estate planning document because upon the death of one of the account holders, the assets will pass to the surviving joint account holders.

When a husband and wife establish accounts as joint tenants with rights of survivorship, this normally does not create a problem because the surviving spouse (who is also the surviving joint tenant) becomes the sole owner of the assets in the account.  Nevertheless, it is important to determine whether these accounts held by spouses as joint tenants with rights of survivorship create tax or trust funding problems.

On the other hand, accounts set up as joint tenants with rights of surviivorship frequently create major problems and unintended consequences whenever a parent with more than one child establishes an account with only one of those children as joint tenants with rights of survivorships.  Parents often do this so that one child has signature authority on the account and can assist the parent with paying the parent's regular monthly expenses.  However, the parent usually does not understand that in this instance, the will not control the division or ownership of the account opened as joint tenants with rights of survivorship upon the parent's death.  The child who is the joint tenant on the account will own all of the assets in the account upon the parent's death.  If the parent had wanted all of his or her assets to be divided equally, the parent's objective of splitting the assets equally will not be achieved.

Beneficiary designations

Defined pension plan benefits are paid in the form of a qualified joint and survivor annuity (QJSA), and properly naming the person who will receive the survivor annuity is a critical part of estate planinng. In the case of a married plan participant, the person who will receive the survivor annuity must be the surviving spouse unless he or she has properly waived his or her right to the survivor annuity.

The division and distribution of 401(k) benefits, IRA benefits and life insurance benefits are not determined by the will, but, instead, are determined by the beneficiary designations.

Income Tax Issues

It is extremely important for the non-participant joint survivor of qualified pension plans and the beneficiary of 401(k) plans and IRA's to do the necessary income tax planning.  The assets are not entitled to a basis step-up upon the death of the participant, and the income is taxable (unless attributable to participant contributions) as income in respect of a decedent.

Income from a ROTH IRA is not income in respect of a decedent because no deduction was taken at the time of the contribution.

What if You become Incapacitated? 

As people live longer, it becomes increasingly important to address issues relating to incapacity.  For example:

  1. Who will handle your affairs if you are unable to do so?  Without proper planning, it will be necessary for a guardian to be appointed to handle your affairs.  Once again, this is a time-consuming and expensive process.  It can also cause ill will between the various family members because children are often required to file suit against a parent to establish a guardianship.  To avoid these problems, it is advisable to execute a durable power of attorney, whereby power is granted to one of the children (preferably the one who is either the closest or has the most experience with financial matters) to handle the financial affairs of the person granting the power (the principal). 
  2. Who will make medical decisions for you if you are unable to do so?  Again, without proper planning, it will be necessary for a guardian to be appointed, which, again, is a time-consuming and expensive process.  If guardianship proceedings are initiated, the guardian appointed to care for your finances may or may not be the same person appointed to care for you, personally.  If a guardian is appointed for you, will the person appointed be the person you wanted and will he or she make the medical decisions you would have wanted?  To avoid these problems to the fullest extent possible, you should name someone as your agent to make medical decisions for you in the event you are unable to do so.  The person appointed should be the person you believe will follow your wishes when making these decisions.
  3. If you do not want to be placed on life support if you are diagnosed as terminally ill, you should execute a directive to physicians (living will) wherein you so state.  You should provide a copy of the living will (as well as your medical power of attorney) to doctors and hospitals that regularly provide services to you.

Does Your Estate Need to File an Estate Tax Return?

Your estate will need to file an estate return if the taxable estate exceeds the the estate tax exemption amount (currently $5,250,000). However, there are other situations in which an estate tax return either must be or should be filed.

FIrst, your estate must file a return if your surviving spouse wants to take advantage of your unused estate tax exemption under the portability provisions.

Second, it is advisable for your estate to file an estate tax return, even if not required, to establish the fair market values as of the date of death if trusts are being funded under the terms of the will.  This makes it much easier to establish basis whenever these trusts are terminated years later.

Friday, July 19, 2013

Fighting the IRS

You're fighting the IRS, but you are uneasy and don't know what to do. This all depends upon the type of tax and how long you have waited.

In general, fighting the IRS about income taxes and estate taxes is much easier than fighting the IRS about employment taxes.

In the case of income and estate taxes, the IRS will conduct an audit and then send you a letter asking you to agree to the results of the audit. If you do not agree to the results of the audit, you will have a chance to file an appeal (with the IRS) contesting the audit. You think that filing an appeal with the IRS sounds somewhat ridiculous, but it is actually quite useful. The IRS employee handling the appeal has much authority not to pursue the various proposed changes to your income and deductions (usually detrimental to you) than the IRS employee who conducted the audit.

You move forward with the appeal ,and the IRS completes the appeals process and asks you to agree or disagree to the results of the appeal.  If you do not agree to the results of the appeal, a notice of deficiency (more commonly known as a 90 day letter) will be sent to you. The 90 day letter gives you 90 days from its date to file a petition with the U. S. Tax Court in Washington, D.C. to contest the results of the appeal (or, if you did not file an appeal, the results of the audit).  The good thing about filng a petition with the U. S. Tax Court is that  you do not have to pay the tax before filing your petition.

Unfortunately, you are not diligent and allow the 90 days to pass without filing a petition with the U. S. Tax Court. Upon the expiration of the 90 day period, the amount, as determined by the appeals office (or, in the audit, if you did not file an appeal) becomes a liability payable to the IRS.

You are not out of options, however.  You can pay the tax and file a claim for refund.  If your claim for refund is denied, you can file suit in federal district court for the district in which you reside, or in the United  States Court of Federal Claims.  It is important to remember, however, that if you litigate in the federal district court for the district in which you reside or in the United States Court of Federal Claims, you must pay the tax and sue for a refund.  On the other  hand, if  you had been diligent and filed a petition with the U.S. Tax Court within the 90 day period, you would not have been required to pay the amount of the tax before litigating.

You are not sure, but you think you also have some potential liabilities for employment taxes.  You were an officer of a corporation that is no longer in business, and it had a substantial amount of unpaid employment taxes at the time that it ceased operations.  You were an officer of the corporation from the time of its inception until it ceased business operations. Your control of corporate disbursements by the corporation varied while the corporation was in business.

You have always heard about corporations providing limited liability and you wonder if it applies in this situation. While limited liability continues to apply, in this situation, federal tax law preempts state law. Under the Internal Revenue Code, control persons can be held personally liable for taxes withheld from the salaries of employees of corporations and other types of entities. This is commonly known as the 100 percent penalty even though it is not a penalty and this is not an accurate description of the provision. 

You want to know whether this makes you personally liable for all of the unpaid taxes of your corporation.  It does not. You can be held liable for the taxes withheld during the period that you were a control person, but you are not personally liable for the employer's share of social security and medicare taxes.  Furthermore, you are not personally liable for any penalties and interest owed by the corporation.

You mention that the IRS has not yet sought to recover any of these taxes from you, and  you want to know the procedures the IRS must follow to recover these taxes.  The IRS will send you a letter claiming that you are a control person and will seek to impose liability upon you for the amount of any withheld taxes, including income tax withholding, social security tax withholding and medicare tax withholding.  You will then have an opportunity to file an appeal to contest the claims of the IRS.  If you do not file an appeal or if the appeal is unsuccessful, the amount of liability asserted by the IRS becomes a liability payable to the IRS.

Even after there is a liability payable to the IRS, you still have an opportunity to contest your liability by paying the tax and suing for refund in federal district court in the district in which you reside or in the United States Court of Federal Claims.

Friday, July 19, 2013

So You're Starting Your Own Business: Now What?

You've been thinking for some time about starting your own business and you have now finally decided to do so. NOW WHAT?

You asked about operating as a sole proprietorship, a corporation or a limited liability company (LLC). Specifically, you wanted to know what is necessary to begin operating in any of these forms. You were also concerned about liability exposure and wanted information about the tax implications.

To operate as a corporation or LLC, you must form the entity by filing the necessary documents with the Texas Secretary of State. You will also need to obtain an employer's identification number from the IRS. If you had previously operated the business, it may be necessary to sign documents transferring business assets to the corporation or LLC. If you have any business loans, it will be important to make sure that the transfers do not trigger due on sale clauses in your loan documents.

To operate as a sole proprietor, you will need to file documents in the county in which you will operate your business to advise the public of the name under which you are conducting business. This is frequently referred to as a dba. Assuming you are using a name other than your personal name, you will also need to obtain an employer's identification number from the IRS.

You then asked about exposure to liability. Operating as a sole proprietor provides no protection from liability. By forming a corporation or LLC, you will be protected from liabilities as long as you observe the necessary formalities.

Due to the lack of liability protection, you decide that you are not interested in operating as a sole proprietor and begin inquiring about the tax implications of forming a corporation or LLC.

You have heard about subchapter C corporations and subchapter S corporations, but do not understand the difference.

There is no difference between a subchapter C corporation and a subchapter S corporation under state law. It is strictly a matter of treatment under the federal income tax laws.

A subchapter C corporation is subject to double taxation. The corporation is taxed on its own income, and if it pays a dividend, the shareholders of the C corporation will be taxed on any dividends received. You have heard that this double taxation may be avoided by paying yourself a salary (or some other form of payments deductible by corporation).  This is generally true, provided that the amount of the payments to you are not unreasonably high.

This sounds quite complicated to you so you ask about the taxation of S corporations. An S corporation files a corporate tax return, but generally does not pay any tax on its income. Instead, the income and losses flow through to the shareholders who report such income and losses (subject to certain limitations) on their personal returns. Upon subsequent payment of dividends, there is generally no additional tax. You have heard that this can be used to avoid employment taxes. This is generally true, provided that the salary paid to you is not unreasonably low. You find this difficult to understand because this rule is the opposite of the rule for C corporations.

You were not aware of the various restrictions that apply to S corporations. For example, S corporations can have only one class of stock, cannot have more than 100 shareholders, and (with certain limited exceptions) can only have individuals as shareholders. To become an S corporation, the corporation must file Form 2553 with the IRS, and all shareholders of the corporation must sign Form 2553, thereby agreeing to the S election.

You then asked about the taxation of LLC's. A LLC is treated as a partnership for federal income tax purposes as long as it has two or more members. However, as in your case, if the LLC has only member, it will be treated as a sole proprietorship for federal income tax purposes. In other words, it would be treated as if the entity did not exist for federal income tax purposes and you would report the income (and loss) on a Schedule C on your personal income tax return. This treatment for federal income tax purposes is the same as if you were operating as a sole proprietor. I remind you that, even though the single member LLC and a sole proprietor, are treated the same for income tax purposes, the two are not the same. The single member LLC provides liability protection, but the sole proprietorship does not. Furthermore, the LLC, unlike the sole proprietorship, will be treated as a separate entity for federal employment tax purposes and Texas franchise tax purposes. You find it difficult to understand how the LLC can be treated as existing as a separate entity for one purpose and as not existing for another purpose. 

Due to these inconsistencies in the treatment of single member LLC's, you once again ask if the result would be different if the LLC had more than one member. Whenever a LLC has more than one member, it is treated as a partnership for federal income tax purposes. The partnership files its own return, and its income and losses flow through to the partners who report such income (and losses subject to certain limitations) on their personal income tax returns.

You then ask whether it is necessary for the entity to maintain its own bank account. To preserve limited liability, all formalities must be observed. This includes maintaining a separate bank account for the entity, signing documents as a representative of the entity, having regular meetings and having special meetings to authorize extraordinary transactions.

N. Dean Hawkins & Associates, Inc. assists clients throughout the Dallas metropolitan area, including Dallas, Collin, Denton, Kaufman and Rockwall counties.

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