United States: Tax Insights: Protecting your Wealth as Estate and Income Taxes Change

The 2001 and 2003 tax cuts are set to expire at the end of 2010 — threatening to alter drastically both transfer tax and income tax rules. High net worth taxpayers face the prospect of income tax increases and new estate tax rules, but also opportunity. You may have begun considering whether 2010 is the year to reverse your income tax strategy and accelerate income and defer deductions, and whether it's time to put transfer tax strategies into play while asset values are depressed and transfer tax rates are low.

Because there will be no finished legislation until after the November elections at the earliest, preparation will be key. There are opportunities to accelerate income taxes into 2010 while rates are low, but they will take time to implement. Prepare now so you can be ready to act once the legislative outlook becomes clearer. Transfer tax strategies that take advantage of the current repeal of the generation-skipping transfer (GST) tax and 35 percent gift tax rate likely will need to be completed before year-end.

Remember there are many reasons taxpayers should NOT accelerate income taxes, and many situations will not call for any acceleration strategies. The time value of money still makes deferral a powerful strategy, and it is not certain that the income tax rate increases will occur as scheduled. Transfer tax strategies during legislative uncertainty also carry risks. You must be comfortable with your own economic and political analysis and understand the risk. Your analysis should start with a look at what's actually happening with rates.

Expiration of Bush tax cuts

The 2001 and 2003 tax cuts are scheduled to expire at the end of 2010. This means the end of current income tax rates and estate tax reform and related benefits:

• Top capital gains rate increase from 15% to 20% (18% for assets held over five years)
• Dividends rate increase from 15% to ordinary income treatment (top rate of 39.6%)
• Top marginal income tax rate increase from 35% to 39.6%
• Reinstatement of personal exemption phaseout and "Pease" phaseout of itemized deductions
• Estate tax reinstatement at a 55% top rate and just a $1 million exemption

In addition, the health care reform legislation added further tax increases effective in 2013:

• A new 3.8% Medicare tax on unearned income — such as capital gains, dividends and interest — to the extent AGI exceeds $200,000 (single) or $250,000 (joint)
• An increase from 1.45% to 2.35% in the employee share of Medicare tax on earned income above $200,000 (single) or $250,000 (joint)

This means capital gains are scheduled to go from a 15 percent top rate in 2010 to a top rate of 23.8 percent by 2013. Dividends and interest, which would be taxed at ordinary income rates, would have a 43.4 percent top rate by 2013.

On the transfer tax side, we've reached the bottom of a yo-yo in estate, gift and GST tax rules. The 2001 tax cuts lowered transfer tax rates gradually and increased exemptions until the estate and GST tax were fully repealed in 2010. But in 2011, the transfer taxes revert to a top rate of 55 percent and an exemption of just $1 million. There are a number of other changes to transfer tax rules that would be reversed in 2011:

• Reinstatement of the deduction for qualified family owned businesses
• Reinstatement of the state death tax deduction
• Repeal of a number of technical modifications to GST tax rules — the most notable being relief for missed allocations of GST exemption

Legislative scenarios

Income taxes

• Nothing is extended in 2010. If Congress fails to reach an agreement in the lame duck session after the November elections, it is likely that lawmakers will try to reinstate the tax cuts retroactively for some or all taxpayers in 2011. Planning will be very difficult if 2010 ends before we know what will happen to rates in 2011.

• Extensions below $200,000 and $250,000. Congress could follow the president's campaign promise and extend the 2001 and 2003 tax cuts for income under $200,000 (single) or $250,000 (joint). Under this plan, the top capital gains and dividend rate would go to 20 percent (18 percent for assets held at least five years). Congress would still need to determine how the income thresholds would operate and for how long to extend the tax cuts.

• Temporary extension for everyone. The tax cuts could be extended temporarily for everyone if enough lawmakers agree that it's a bad idea to raise taxes on anyone during a recovery. This would make acceleration into 2010 pointless.

Transfer taxes

The retroactive reinstatement of the GST or estate tax for 2010 appears extremely unlikely. However, lawmakers have discussed allowing the estates of decedents who die in 2010 the choice of using the 2009 estate tax law in order to provide relief for current carryover basis rules.

In 2010, taxpayers no longer receive a step up in the basis of inherited assets for income tax purposes (an estate can allocate an additional $1.3 million in basis). For taxpayers with estates over $1.3 million, but not significantly greater than $3.5 million, the step up in basis and estate tax exemption of 2009 may provide a better tax result.

There is widespread interest in reforming transfer tax rules permanently, but there has been no legislative progress. The president and many Democrats support extending the 2009 estate tax exemption level of $3.5 million and 45 percent top rate permanently. Republicans generally favor an even larger exemption and lower rate. Congress does not appear close to an agreement, and action during a lame duck session on this issue could be very difficult. Unless a surprise compromise emerges, it appears likely at this point that lawmakers will not be addressing this issue until 2011.

Reasons not to accelerate tax

Under any of legislative scenarios, there are many reasons NOT to entertain strategies to accelerate tax into 2010. You need to do the following:

• Analyze whether tax increases apply. Taxpayers under the $200,000 (single) or $250,000 (joint) threshold are unlikely to see any increase under current legislative proposals, and an extension of the tax cuts for everyone is still very possible.

• Determine if you will be subject to the AMT. If you're subject to the alternative minimum tax (AMT) under both the new and old rates, you may not benefit from any acceleration of income or capital gains.

• Consider the time value of money. Before recognizing any gain ahead of schedule, consider when you otherwise would have had to pay tax. Even with a rate increase, the time value of money still makes deferral a powerful strategy. You probably do not want to trigger gain on property you would have held onto for years just to avoid a capital gains rate increase from 15 percent to 18 percent. Economic considerations should always come before considering any tax-motivated sale.

• Consider your future situation. You need to consider your future tax situation, i.e., when income without acceleration would otherwise have been realized. Strategies such as converting from a traditional IRA to a Roth IRA may not make sense if you will be in a lower tax bracket in retirement.

• Remember estate tax consequences. Remember to consider estate and income tax implications together. Triggering gain on assets may not make sense if it would be more beneficial to allow your heirs to receive a step up in basis at death.

• Collateral damage. Many of the available strategies can have broader consequences that limit their usefulness.

Income tax strategies

Accelerate income and defer deductions – If you do determine it is prudent to prepare to accelerate tax, it is possible to control the timing of many types of ordinary income, including self-employment income, bonuses, consulting income and retirement plan distributions. As cash basis taxpayers, individuals often have the ability to control in what year a deduction may be taken by when they make a payment.

Trigger capital gain – There are many options for triggering capital gain, but consider the time value of money and when the gain would otherwise be recognized:

• Securities. It is possible to trigger gain and pay tax on stock and other securities without changing position. There is no wash sale rule on capital gains, so stock can be sold and bought back immediately to recognize the gain. But it may make more sense to take advantage of today's low rates to diversify a concentrated position. If the lion's share of your portfolio is tied up in one stock or asset because you're deferring the tax bill on a large gain, keep in mind that rates are not going lower. This might be a good time to reallocate that equity and protect your assets from risk.

• Other assets. Turning over other types of assets in a similar manner may involve higher costs and more complications. Strategies that seek to recognize gain but allow a taxpayer to retain some control or use of the assets must satisfy rules that determine whether ownership has indeed been transferred effectively

• Installment sales – Individuals can consider electing out of the deferral of gain recognition available for an installment sale. Deferred income on most installment sales made after 1987 can be accelerated by pledging the installment note for a loan.

Exercise options – You can consider exercising nonqualified stock options (NSOs) before rates increase because the spread between the exercise price and the fair market value of the stock on the exercise date is treated as ordinary income. You also start the holding period for long-term capital gains treatment earlier. If you do not plan to hold incentive stock options (ISOs) long enough to qualify for capital gains treatment, you can sell them before rates increase.

Convert to a Roth account – You can consider a conversion from a 401(k) or traditional IRA to a Roth IRA now while tax rates are low. Tax will be owed on the amount of the conversion now in exchange for no tax on future distributions if the conversion is made properly.

Accelerate tax through a privately held business – Pass-though vehicles such as limited liability companies, partnerships and S corporations are taxed at the individual level, so entity-level decisions can accelerate income and defer deductions for partners, members and shareholders.

Accelerate dividends – The easiest way to allow shareholders to recognize income while the dividend rate is 15 percent is simply to distribute them now. It may be simple to push 2011 dividends into 2010, but your corporation may not be interested in distributing dividends yet. Instead have your corporation consider distributing dividends to shareholders with shareholders immediately re-contributing the dividend back to the corporation — or issuing a note to shareholders. Mere bookkeeping entries may not be sufficient to accomplish the actual distribution and trigger the tax. Care should be exercised to ensure the dividend will be respected for tax purposes.

Converted S corporations – Special opportunities exist for S corporations that used to be C corporations. Normally, distributions from a profitable S corporation are considered to come first from the income passed through to the shareholder and taxed at their levelIn order to prevent double taxation, these distributions are considered nontaxable to the extent they do not exceed the amount in the S corporation's accumulated adjustment account. However, an S corporation may elect to treat the distribution as first coming out of accumulated E&P, and thus taxable. If insufficient cash is on hand, an election to make a "deemed" distribution is available under the S corporation regulations.

Transfer tax strategies

Leverage 2010 GST tax repeal

There may be opportunities to take advantage of current transfer tax rules. While you can't control when you die, you can control the timing of your gifts. The current 35 percent gift tax and the absence of the GST tax in 2010 may present an opportunity to remove significant assets from your estate at steep transfer tax discounts. You can exhaust your gift tax exemption to pass assets down several generations essentially tax-free, or you can pay the reduced gift tax rate and remove the assets free of estate and GST taxes.

Consider a dynasty trust, which allows assets to skip several generations of taxation. You can fund the trust by making gifts now while the gift tax is low and there is no GST tax. The trust remains in existence from generation to generation. Because the heirs have restrictions on their access to the trust funds, the trust is excluded from their estates. Special planning is required if you live in a state that hasn't abolished the rule against perpetuities.

Use gift tax exemptions

The annual exclusion is indexed for inflation in $1,000 increments and is $13,000 per beneficiary in 2010. You can double the exclusion by electing to split a gift with your spouse. So you and your spouse can remove $26,000 per beneficiary from your estate with no gift or estate tax consequences.

You can also consider using the $1 million exemption to give away assets now. This not only removes the gift from your estate, but also lowers future estate tax by removing future appreciation and any annual earnings. The economic downturn may make this a timely strategy. You want to give property with the greatest potential to appreciate, and you may have assets with values that are artificially depressed due to the current economic conditions. There are many gifting vehicles that could be valuable when asset values are down, including the following:

• Grantor retained annuity trusts (GRATs)

• Sales to intentionally defective grantor trusts (ILITs)

• Transfers to a family limited partnership (FLPs)

• Transfers to a charitable lead trust (CLTs)

Review and update your estate plan

Regardless of where exactly the exemption amounts and rates end up in the future, there are strategies that can help you mitigate your transfer taxes. You should review your plan regularly to ensure it fits in with any changes in tax law or your circumstances.

Family changes like marriages, divorces, births, adoptions, disabilities and deaths can all lead to the need for estate plan modifications. Geographic moves also matter. Different states have different estate planning laws and regulations. Any time you move from one state to another, you should review your estate plan. It's especially important if you are married and move into or out of a community property state.

Consider increases in income and net worth. What may have been an appropriate estate plan when your income and net worth were much lower may no longer be effective today. Remember that estate planning is about more than just reducing taxes. It's about ensuring that your family is provided for and that you leave the legacy you desire

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.