The Wealth Counsellor - December 2010

Merry Christmas and Happy New Year from the attorneys at The Greening Law Firm, P.C.! Between decorating the house, putting up lights, cooking, buying gifts, more cooking, taking family photos to put in the Christmas card you were supposed to have finished in September, and finishing all those little projects that have to be done before the end of the year that you really didn't mean to put off for so long--whew!--the holiday season can be busy. Frantic. Downright hectic. Make sure you take a moment to catch your breath, smile, and remember that all this hustle and bustle is a side effect of living a rich, full life and sharing it with your loved ones.

Here at the firm, we're still dedicated believers in the American Heart Association and its mission. Second only to the Federal government, the AHA provides an enormous amount of funding for heart health and treatment research¹. You can learn more about how you can help the AHA fight heart disease and stroke through volunteering here, or through planned giving here.

In this month's newsletter, we're talking taxes. First, we look at taxes that weren't in 2010, the estate tax and the GST tax, and then we turn to a new tax attached to the health care bill.

¹http://americanheart.org/presenter.jhtml?identifier=4464

Season's greetings,

Ronald G. Greening

The Greening Law Firm, P.C.

The State of the Federal Estate Tax

Since 2001, when President George W. Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) into law, we have known that the federal estate tax and generation-skipping transfer tax (GSTT) was scheduled for a one-year suspension beginning January 1, 2010, with the twist that basis adjustment at death would be limited for 2010 decedents. But even though that's what the law said, few, if any, of us thought Congress would actually allow it to happen. Nor did we think that the "sunset" would play out on December 31, 2010 and that those taxes would revert to their 2001-level exemptions rates.

How Did We Get Here?
EGTRRA was designed to provide significant tax relief, including "permanent" relief from the federal estate tax. Under EGTRRA, the maximum estate tax and GST tax rate steadily lowered to 45%, while the tax exemption amounts increased to $3.5 million. Under EGTRRA, in 2010, the federal estate and GST taxes went away completely, but with a twist and only for that one year. Because of the Senate rule that would have required an unattainable 60 votes for permanent repeal, EGTRRA was enacted with a "sunset" provision. Thus, on January 1, 2011, unless the Congress acts, the federal estate and GST tax laws will revert back to their pre-EGTRRA levels. The federal estate and gift tax exemptions will be unified at $1 million and the GST tax exemption will be $1 million, adjusted for inflation and the maximum rate will be increased from 45% to 55%.

What Will Congress Do Now?
The picture is finally becoming clearer. The Senate passed a plan yesterday that will set the estate tax exemption at $5 million. The bill will next move to the House, where it will be debated this week. The bill received overwhelming bipartisan support in the Senate and has President Obama's endorsement.

Planning Tip: No matter what happens, retroactive reinstatement of the federal estate tax seems highly unlikely. Several American billionaires have died since January 1, 2010, including Houston pipeline tycoon Dan L. Duncan and New York Yankees owner George Steinbrenner. With such vast estate values in the balance, heirs would certainly challenge the constitutionality of a retroactive estate or GST tax law. The Congress is well aware that a retroactive estate or GST tax law would be in legal limbo for however many years it took to get a U.S. Supreme Court decision.

One option under consideration by Congress is giving the estates of those who died in 2010 the choice of using the 2009 law (i.e., $3.5 million federal estate tax exemption and maximum 45% rate) or the 2010 law (i.e., no estate or GST tax, but modified carryover basis).

Planning Tip: A choice between the 2009 and the 2010 law would require the planning team's careful analysis of the 2010 decedent's asset mix, historic gains, tax rates, and the timing and likelihood of sale of those assets in the future.

Modified Carryover Basis for 2010 Only
Before January 1, 2010, subject to some exceptions, inherited assets came with a new basis - fair market value at date of death. Thus if a client died owning publicly-traded securities bought many years ago, the beneficiaries could sell the stock shortly after the client's death and pay little or no income tax. The only tax the beneficiaries would have to pay would be on the difference between the sale price and the fair market value on the date of death. (Of course, the stock would also be included in the client's gross estate for estate tax purposes.)

Under EGTRRA, however, in 2010 alone the rules are different: A 2010 decedent's estate would have $1.3 million in basis adjustment to allocate (plus in some cases an additional $3 million for assets going to a surviving spouse). For other assets, the new basis would be the the lesser of the decedent's basis or the asset's fair market value on the decedent's date of death. Thus, EGTRRA eliminated the automatic 100% "step-up" to the date-of-death value but retained a "step-down" for depreciated assets. Significantly, that modified carryover basis system could impact far more people than the estate tax ever would!

Adding insult to injury, because of the EGTRRA "sunset" provisions, what the basis will be for an asset inherited in 2010 but not disposed of until after 2010 is uncertain. It may have the limited basis adjustment of the 2010 modified carryover basis rules or it may have the full step-up in basis. It will be up to the courts to decide.

Problems with Pre-2010 Planning and 2010 Deaths
The elimination of the estate and GST tax for 2010 can have unintended consequences. Some plans fill up the family trust and some use up the remaining estate tax exemption. For a 2010 death, in the first case, the marital trust will go unfunded and in the latter, the marital trust will be overfunded at the expense of an unfunded credit-shelter trust. If the clients are in a second marriage with his and her children, neither result is likely to be what they had in mind. Life estates and some QTIP trusts also can have unintended results with a 2010 death.

That being said, the odds that a client will want to make estate plan changes now in case of a 2010 death are extremely low unless death becomes imminent. All planning team members have made our clients aware of the need to look at their plans because of the 2010 anomaly and if they haven't done so yet, they probably aren't going to now. However, we could remind them one more time while advising them of the need to look at year-end actions to consider taking if it looks like the Congress will remain in stalemate on income and estate tax issues. And, if you hear of a client who is seriously ill, do not hesitate to raise the 2010 anomaly issues just in case.

Planning Tip: Where the family and marital trusts have identical beneficiaries and dispositive provisions, as is typical in nuclear families, a 2010 death will have no non-tax significance. However, if the family and marital trusts contain different beneficiaries or different dispositive provisions (such as in second marriage situations with his and her children), a 2010 death may cause dire consequences to the beneficiaries of the family trust or to the surviving spouse, depending on the division language used.

Planning Tip: If the clients' A-B trust division is based on using up the estate tax exemption, a 2010 death could mean not using the available credit-shelter trust planning, thereby exposing all of their assets to estate tax when the surviving spouse dies.

What Should Clients Do Now?
Clients should be reminded that a 2010 death can have unintended estate and tax consequences so that, if serious illness strikes before the end of the year, the team can be consulted.

For all clients, the key in today's uncertain environment is flexibility. Their plans can and should have sufficient flexibility to accomplish their goals no matter what - whether the "what" is a 2010 death or Congressional action or inaction.

With the deficits projected for the next few years at least, clients would be well advised to anticipate higher tax rates and lower exemptions for both estate and income taxes. That means that many clients who had assumed that they would not have taxable estates need to reexamine their assumption. There are also 2010-only opportunities for clients who will have taxable estates as long as there is an estate tax. Some of the planning opportunities that may now be of interest to clients are:

Moving client-owned life insurance into an Irrevocable Life Insurance Trust (ILIT);
Buying life insurance in an ILIT to provide liquidity to pay estate taxes;
Doing charitable planning, including Charitable Remainder Trusts (CRTs) for highly appreciated property; and
Using Testamentary Charitable Lead Trusts (TCLATs) to "zero out" the estate tax.

Other advanced estate tax avoidance strategies, such as Grantor Retained Annuity Trusts (GRATs), tax-burn trusts, installment sales to "defective" grantor trusts, and Qualified Personal Residence Trusts (QPRTs) will be attractive to more clients if we go back to a $1 million estate tax exemption.

For 2010 year-end planning, clients with taxable estates should consider making:

Taxable gifts (to take advantage of the 2010-only 35% gift tax rate);
Outright gifts to grandchildren while there is no GST tax (consider gifts of LLC interests, rather than outright gifts, for purposes of control); and
Loans to family members to take advantage of historically low interest rates.

Clients with 401(k), 403(b) or IRA accounts should assess whether they would benefit from 2010 Roth conversions if it looks like the Congress will not extend the "Bush Era" income tax cuts applicable to them.

Conclusion
We strongly encourage all clients to review their estate plans to ensure that their plans continue to meet their objectives while minimizing all taxes, including state and federal estate tax as well as income tax. Now is the time for the planning team to encourage clients to move forward with planning to ensure that the clients meet their goals and objectives in retirement and upon disability or death.

Commentary for advisers: It is looking more and more like the exemption will be $5 million in 2011. It is recommended that you start assessing your clients now to see which ones will be over the exemption and start their planning now.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer's particular circumstances.

Current Planning to Avoid the Health Care 3.8% Surtax

A new 3.8% surtax on certain investment income starts January 1, 2013, as part of the health care reform act. While that's a couple of years away, it is not too early to start planning for it, because there are steps clients can take this year that will help reduce or even eliminate it.

In this issue of The Wealth Counselor, we present an overview of this surtax, explore what taxpayers it will affect, and give some planning ideas you can use now with your clients.

Understanding the Tax
The 3.8% investment income surtax, also called the health care surtax or the Medicare tax, applies to tax years ending after December 31, 2012. The surtax is:

For individuals, 3.8% of the lesser of:

net investment income for such taxable year, or
the excess, if any, of

the modified adjusted gross income for the year, over
the threshold amount.

For trusts and estates, 3.8% of the lesser of:

the undistributed net investment income for the year, or
the excess, if any, of

the adjusted gross income (as defined in Code Section 67(e)) for the year, over
the dollar amount at which the highest tax bracket in Code Section 1(e) begins for the year ($11,200 in 2010).

Three Key Numbers
There are three numbers that determine how this surtax will affect a client.

1. Net Investment Income
This is the sum of gross investment income over allocable investment expenses. For purposes of this surtax, investment income includes interest, dividends, capital gains, annuities, rents, royalties and passive activity income.

Investment income does not include active trade and/or business income; any of the income sources listed above (e.g., interest, dividends, capital gains, etc.) to the extent it is derived in active trade and/or business; distributions from IRAs and other qualified retirement plans; or any income taken into account for self-employment tax purposes.

For the sale of an active interest in a partnership or S-corporation, gain is included as investment income only to the extent net gain that would be recognized if all of the partnership/S-corporation interests were at fair market value.

2. Modified Adjusted Gross Income (MAGI)
Here, MAGI is the sum of adjusted gross income (the number from the last line on page 1 of Form 1040) plus the net foreign income exclusion amount.

3. Threshold Amount
Married taxpayers filing jointly . . . $250,000
Married taxpayers filing separately . . . $125,000
All other individual taxpayers . . . $200,000
Trusts and estates . . . Beginning of the top bracket ($11,200 for 2010)

Who Will Pay the New Surtax?
Here's a quick formula to determine if the 3.8% surtax will apply:

MAGI less than or equal to threshold amount = No tax
MAGI greater than threshold amount = Tax is 3.8% of the lesser of

investment income or
MAGI - threshold amount

Note that the surtax liability is determined on income BEFORE any tax deductions (page 2 of Form 1040) are considered. As a consequence, a client with lots of deductions could be in the lowest tax bracket and yet have investment income that is subject to the surtax!

Also, because the capital gain rate will increase for high-income taxpayers to 20% in 2011, with the 3.8% surtax the total tax on capital gains can be 23.8% in 2013 and beyond.

Let's look at some examples:

Individuals
Example: Evan, single, has $100,000 of salary and $50,000 of net investment income.
Result: The 3.8% surtax would not apply because MAGI is less than $200,000.

Example: Jill, single, has $225,000 of net investment income and no other income.
Result: The 3.8% surtax would apply to $25,000 of income (excess of $225,000 MAGI over $200,000 threshold amount).

Example: George and Eve, married filing jointly, have $300,000 of salaries and no other income.
Result: The 3.8% surtax would not apply (no investment income).

Example: Frank and Lily, married filing jointly, have $400,000 of salaries and $50,000 of net investment income.
Result: The 3.8% surtax would apply to $50,000 of net investment income (lesser of rule).

Estates and Trusts
Example: The Pat Jones Trust has investment income of $51,000 and no distributions.
Result: $39,800 of income ($51,000 - $11,200 top bracket amount) will be subject to the 3.8% surtax.

Example: The Estate of Sue Jones earned $111,200 of dividends and made no distributions.
Result: $100,000 ($111,200 - $11,200 top bracket amount) will be subject to the 3.8% surtax.

Example: The Estate of Jim Jones earned $111,200 of interest and distributes 100% of income.
Result: The income will be reported by the heirs. That income will go into their individual surtax determinations, but the Jim Jones Estate will pay no 3.8% surtax.

Planning Tip: Start adjusting trust and estate investments now to reduce income in 2013 and beyond.

Planning Considerations
For taxpayers who could be hit by the surtax, look for ways to reduce investment income and MAGI:

* The 3.8% surtax does not directly apply to distributions from IRAs and other qualified retirement plans, and contributions to these plans provide tax-deferred growth. Therefore, taxpayers may wish to increase contributions to IRAs and 401(k), 403(b) and 457 plans. However, required minimum distributions will increase MAGI as they are considered ordinary income.

* The 3.8% surtax does not apply to distributions from Roth IRAs, but Roth conversion income will count toward MAGI. Thus 2010-2012 Roth conversions can help to avoid the surtax by reducing post-2012 MAGI from required minimum and other plan distributions in 2013 and beyond.

* Because income from tax-exempt and tax-deferred vehicles like municipal bonds, tax-deferred nonqualified annuities, life insurance and nonqualified deferred compensation are not included in investment income, investments in these vehicles should become more favorable.

* Charitable remainder trusts should become more appealing because they permit taxpayers to defer income over a period of time, enabling them to stay under the threshold amount.

* Charitable lead trusts will become more popular to shift investment income to a CLT which in turn will be offset by the "above the line" charitable deduction.

* Installment sales will be popular to smooth income.

* Oil and gas (with up to 95% initial investment deduction, 15% depletion allowance and IDC deduction on passive oil and gas) will continue to be attractive investments.

* For eligible estates and electing trusts, select the proper year to reduce the surtax.
Example: Frieda dies in January 2012. Her estate elects a November 30, 2012 year end.
Result: The surtax will not apply to her estate until the year beginning December 1, 2013, providing 11 additional months without the surtax.

Roth IRA Conversions Today Reduce Future MAGI
As stated earlier, required minimum distributions from Traditional IRAs are exempt from the surtax but they increase MAGI. This can effectively create a 43.4% effective tax on IRA distributions (39.6% income tax plus 3.8% surtax on investment income made surtaxable by the IRA distribution).

Planning Tip: Converting to a Roth prior to 2013 can reduce MAGI in 2013 and beyond and thereby reduce or eliminate surtax exposure.

Example: Robert and Anna, age 69, have pension income of $130,000 and net investment income of $115,000 for a total MAGI of $245,000, just below the threshold amount. In 2013, their RMDs from their IRAs will be $50,000, which will bring their MAGI to $295,000.
Result: MAGI is $45,000 above the threshold amount ($295,000 less $250,000) so the surtax will be imposed on $45,000 of their net investment income. Making Roth conversions in 2010, 2011 and 2012 to eliminate the RMD in 2013 would eliminate the surtax.

Planning Tip: Using outside/taxable funds to pay the income tax on a Roth conversion can be advantageous in lowering future MAGI.

Example: In 2010, Paul converts a $1 million IRA to a Roth IRA, incurring $450,000 of state and federal income tax. Paul pays the income taxes from his outside/taxable investment funds.
Result: Future investment income from the outside funds will no longer exist and will avoid the 3.8% surtax. Distributions from the Roth IRA are neither investment income nor included in MAGI.

Planning Tip: Anyone can now convert to a Roth IRA, regardless of income. If the conversion occurs in 2010, half of the conversion amount can be claimed as income in 2011 and half in 2012. After 2010, conversions must be claimed as income for the year in which the conversion is made.

Conclusion
Even though the 3.8% health care surtax will not go into effect until 2013, taxpayers who will be exposed to it should begin planning in 2010, especially if a Roth conversion is desirable. Now is the time to get organized and run the projections so you will be able to incorporate any changes in year-end planning for your clients.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer's particular circumstances.

Practice Limited to Estate Planning, Estate Administration, Probate, and Elder Law

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For professionals' use only. Not for use with the general public.
You have received this newsletter because I believe you will find its content valuable, and I hope that it will help you to provide better service to your clients. Please feel free to contact me if you have any questions about this or any matters relating to estate or wealth planning.

The hiring of an attorney is an important decision. The items discussed in this newsletter are of a general nature and not intended to provide legal advice. Please consult with a qualified estate planning/elder law attorney to determine the best options for your personal circumstances.

In accordance with IRS Circular 230, the content of this newsletter is not to be relied upon for the preparation of a tax return or to avoid tax penalties imposed by the Internal Revenue Code. If you desire a formal opinion on a particular tax matter for the purpose of filing a return or avoiding the imposition of any penalties, please contact us to discuss the further Treasury requirements that must be met and whether it is possible to meet those requirements under the circumstances, as well as the anticipated time and fees involved.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer's particular circumstances.