For many people today, income tax planning offers far greater tax-saving opportunities than gift and estate tax planning. A record-high gift and estate tax exemption — currently $5.49 million ($10.98 million for married couples) — means that fewer people are subject to those taxes.
If gift and estate taxes aren’t a concern for your family, it can pay to focus your planning efforts on income taxes — in particular, on basis planning.
Benefits of a “stepped-up” basis
Generally, your basis in an asset is its purchase price, reduced by accumulated depreciation deductions and increased to reflect certain investment costs or capital expenditures. Basis is critical because it’s used to calculate the gain or loss when you or a loved one sells an asset.
Under current law, the manner in which you transfer assets to your children or other beneficiaries has a big impact on basis. If you transfer an asset by gift, the recipient takes a “carryover” basis in the asset — that is, he or she inherits your basis. If the asset has appreciated in value, a sale by the recipient could trigger significant capital gains taxes.
On the other hand, if you hold an asset for life and leave it to a beneficiary in your will or revocable trust, the recipient will take a “stepped-up” basis equal to the asset’s date-of-death fair market value. That means the recipient can turn around and sell the asset tax-free.
Undoing previous gifts
What if you transferred assets to an irrevocable trust years or decades ago — when the exemption was low — to shield future appreciation from estate taxes? If estate taxes are no longer a concern, there may be a way to help your beneficiaries avoid a big capital gains tax hit.
Depending on the structure and language of the trust, you may be able to exchange low-basis trust assets for high-basis assets of equal value, or to purchase low-basis assets from the trust using cash or a promissory note. This allows you to bring highly appreciated assets back into your estate, where they’ll enjoy a stepped-up basis when you die. Keep in mind that, for this strategy to work, the trust must be a “grantor trust.” Otherwise, transactions between you and the trust are taxable.
Is your basis covered?
Before making any changes to your estate plan, be aware that, if an estate tax repeal is signed into law, it’s possible the step-up in basis at death could go away, too. We can keep you apprised of the latest developments and help you determine whether your family would benefit from basis planning.
When you purchase a life insurance policy, the amount you’ll pay in premiums is determined by factors you control.A life insurance policy is a contract between you and a life insurance company. The insurer agrees to pay your beneficiaries a benefit if you die. The rate you pay is determined by health factors and the type of policy you choose, either term or permanent. A term policy is good for a limited time and is less expensive; a permanent policy costs more, but provides lifetime coverage.
Naturally, there are some factors you can’t control: your age and your family health history. The older you are, the higher your rates. Evidence that a close relative has a chronic disease, such as cancer, may lead to higher rates. Women usually live longer than men, so men will see a higher premium.
Fortunately, there are number of actions you can take to lower your life insurance premiums.
Being overweight is costly. Studies show that if you are 25 percent overweight, you have a 25 percent greater chance of dying at a younger age than someone who isn’t overweight. Excess weight can lead to a variety of health issues, such as high blood pressure, heart or digestive problems, high blood pressure, or diabetes.
Not only can being overweight affect the quality of your life, but life insurance companies often decline coverage or charge higher rates when someone is obese. Losing weight right before applying for insurance won’t help because the insurance company takes your weight average over 12 months. So, plan ahead!
Watch Your Sodium Intake
Insurance carriers want to know if you have high blood pressure, a condition that adds stress to your arteries and can lead to serious problems, such as heart disease and strokes.
One way to lower blood pressure is by limiting foods that are high in salt. The American Heart Association recommends no more than 2,300 milligrams of sodium per day. Choose carefully. High levels of sodium can be found in many of foods we consume daily. Three ounces of deli turkey can have 1,050 milligrams of sodium, while a whole a cheeseburger can have up to 1,690 milligrams of sodium.
Limit Alcohol Consumption
An occasional drink won’t affect your rates, but more than two drinks a day will knock you out of preferred, lower rates. Three or more daily drinks will take you out of standard rates. Insurers take this into consideration because alcohol abuse can lead to cardiovascular problems, dementia, stroke, depression, liver disease and gastrointestinal problems.
Choose a Less Dangerous Occupation
If your job has a higher than normal chance of leading to premature death, you could be denied coverage or may have to pay higher premiums. An insurance company might charge $2 more for every $1,000 of coverage. If you have a $200,000 policy, it would cost you an extra $400 annually.
Occupations falling into that category include logging and fishing. Other occupations that can lead to higher premiums are truck driving and on-the-road sales, because they expose the worker to hazardous conditions, such as falling asleep behind the wheel.
If you want to know whether your job is considered a risk, review the Bureau of Labor Statistics list of dangerous occupations. It’s the list many insurance companies use to determine risk.
Stop High-Risk Recreational Activities
Do you like to live on the edge, participating in activities like skydiving, skiing, hang gliding, rock climbing, hot air ballooning or scuba diving? Participation in risky activities could mean you will be denied coverage or be charged higher rates. Remember, not all insurers use the same list, so it pays to talk to your advisor for options.
Smoker in their 30s can expect to pay two to three times more for a policy than nonsmokers. Smokers in their 40s can expect to pay three to four times more.
Don’t omit this information on your application. Providing false information can be considered insurance fraud. Many insurance companies require a medical exam. Evidence you’re a smoker will show up on the blood and urine tests. If you manage to hide this fact, but die during the first two years of the policy, and it’s discovered you smoked, your beneficiaries could be denied the benefits.
The good news is that if you quit smoking, you can qualify for lower rates within a year. And, if you smoke cigars occasionally or chew tobacco, let your insurance company representative know. These forms of tobacco will show up on your blood test, but some insurance companies may be more lenient with these tobacco uses and may give you a non-smoker rating.
For more information on life insurance or a quote, please contact us.
These trends affect both public and private companies:
• Regulatory enforcement. The Department of Labor, Federal Trade Commission and other agencies have stepped up enforcement in recent years, which have resulted in claims of mismanagement against directors and officers who fail to prepare for this increased enforcement. However, a new report by Marsh has predicted that the impact of these and other regulations including under Sarbanes-Oakley and Dodd-Frank may be diminished as a result of actions taken by the Trump administration.
• Emerging risks. These include cyber liability, environmental liability, breach of privacy, reputation risks and more. Failure to take action to protect the company against these risks could result in claims of negligence against directors and officers. As more specific insurance for some of these risks, such as cyber and environmental liability, have been developed, some pressure on D&O policies and premiums have been reduced.
• Changing policies. Insurers have been adding exclusionary language to insurance policies the past few years, limiting coverage and leaving officers and directors personally responsible for claims not covered by those policies. The Marsh report has speculated, however, that reduced D&O claims and a better outlook for D&O insurance may result in companies offering to “sell back” some exclusionary terms and even offer reduced premiums.
Source: Marsh’s full report is “The U.S. Financial and Professional Market in 2017: Our Top 10 List.”
DSG's Tony Yu, Attorney & CPA, to Speak at Annual Community Seminar for Business Owners and New Immigrant Families
If a substantial portion of your wealth is tied up in a family or closely held business, you may be concerned that your estate will lack sufficient liquid assets to pay federal estate taxes. If that’s the case, your heirs may be forced to borrow funds or, in a worst-case scenario, sell the business in order to pay the tax.
For many eligible business owners, Internal Revenue Code Section 6166 provides welcome relief. It permits qualifying estates to defer a portion of their estate tax liability for up to 14 years from the date the tax is due (not the date of death). During the first four years of the deferment period, the estate pays interest only, set at only 2%, followed by 10 annual installments of principal and interest.
A deferral isn’t available for the total estate tax liability, unless a qualifying closely held business interest is the only asset in your estate. The benefit is limited to the portion of estate taxes that’s attributable to a closely held business.
Estate tax deferral is available if the value of an “interest in a closely-held business” exceeds 35% of your adjusted gross estate. To determine whether you meet the 35% test, you may only include assets actually used in conducting a trade or business — passive investments don’t count.
Active vs. passive ownership
To qualify for an estate tax deferral, a closely held business must conduct an active trade or business, rather than merely manage investment assets. Unfortunately, it’s not always easy to distinguish between the two, particularly when real estate is involved.
The IRS provided welcome guidance on this subject in a 2006 Revenue Ruling. The ruling confirms that a “passive” owner may qualify for an estate tax deferral, so long as the entity conducts an active trade or business. The ruling also clarifies that using property management companies or other independent contractors to conduct real estate activities doesn’t disqualify a business from “active” status, so long as its activities go beyond merely holding investment assets.
In determining whether a real estate entity is conducting an active trade or business, the IRS considers such factors as the amount of time owners, employees or agents devote to the business, whether the business maintains an office with regular business hours, and the extent to which owners, employees or agents are actively involved in finding tenants and negotiating leases.
Weigh your options
As you plan your estate, consider whether your family will be eligible to defer estate taxes. If you own an interest in a real estate business, you may have an opportunity to qualify it for an estate tax deferral simply by adjusting your level of activity or increasing your ownership in an entity that manages the property. Contact us for additional details.
Generally, trusts must have one or more human beneficiaries, but there’s an exception for certain “purpose” trusts. One type of purpose trust that you may be familiar with is the charitable trust. But don’t overlook the noncharitable purpose (NCP) trust as a potential tool for achieving your estate planning goals.
What is an NCP trust?
Historically, trusts were required to have human beneficiaries. Why? Because, for a trust to be valid, there must be someone to enforce it. Charitable trusts were the exception: The attorney general of the relevant jurisdiction was authorized to enforce the trust in the public interest.
Over the years, however, many U.S. states and a number of foreign jurisdictions have enacted legislation that authorizes NCP trusts. These trusts may be used to achieve a variety of purposes, such as maintaining family residences, personal property and gravesites and funding a family business.
A trust may be an NCP trust even if the grantor’s children or other heirs will ultimately receive trust property as “remaindermen.” Suppose, for example, that you create an NCP trust to maintain and exhibit your art collection. After a specified time period, the trust terminates and the collection is distributed to your children. The fact that your children will receive the art once the trust has fulfilled its purpose doesn’t change its character as an NCP trust. Nor does it render the trust valid or enforceable absent an applicable NCP trust statute.
To be valid, an NCP must meet certain requirements. Most important, it must 1) have a purpose that’s certain, reasonable and attainable, 2) not violate public policy, and 3) be capable of enforcement. Typically, an NCP trust is enforced by a designated “enforcer” — someone whose job is to ensure that the trust’s purpose is fulfilled and who has the authority to bring a court action — and/or a “trust protector,” who’s empowered to modify the trust when its purpose has been achieved or is no longer relevant.
Which jurisdiction should you choose?
Choosing the right jurisdiction for an NCP trust is critical. The permitted uses of NCP trusts, as well as their duration, vary significantly from state to state, as do the powers of a trust protector or enforcer. Most states limit an NCP trust’s duration to a term of 21 years, although some permit longer terms or even “dynasty” NCP trusts of unlimited duration.
Of course, 21 years may not be sufficient for certain purposes, such as supporting a family business or caring for horses or other animals whose life expectancies exceed 21 years. If your state doesn’t have an NCP trust statute, or if its requirements fail to meet your needs, you may be able to set up a trust under the laws of another state or even a foreign country. To do so, you must establish a connection with that jurisdiction, such as appointing a trustee who resides in the jurisdiction or moving trust assets there.
Seek professional help
Be aware that NCP trusts raise a variety of income, estate, gift and generation-skipping transfer tax issues. We can assess your situation to determine if an NCP trust is right for your estate plan.
If you expect your estate to have a significant estate tax liability at your death, be sure to include a well-thought-out tax apportionment clause in your will or revocable trust. An apportionment clause specifies how the estate tax burden will be allocated among your beneficiaries. Omission of this clause, or failure to word it carefully, may result in unintended consequences.
There are many ways to apportion estate taxes. One option is to have all of the taxes paid out of assets passing through your will. Beneficiaries receiving assets outside your will — such as IRAs, retirement plans or life insurance proceeds — won’t bear any of the tax burden.
Another option is to allocate taxes among all beneficiaries, including those who receive assets outside your will. Yet another is to provide for the tax to be paid from your residuary estate — that is, the portion of your estate that remains after all specific gifts or bequests have been made and all expenses and liabilities have been paid.
There’s no one right way to apportion estate taxes. But it’s important to understand how an apportionment clause operates to ensure that your clause is worded in a way that your wealth will be distributed in the manner you intend.
Suppose, for example, that your will leaves real estate valued at $5 million to your son, with your residuary estate — consisting of $5 million in stock and other liquid assets — passing to your daughter. Your intent is to treat your children equally, but your will’s apportionment clause provides for estate taxes to be paid out of the residuary estate. Thus, the entire estate tax burden — including taxes attributable to the real estate — will be borne by your daughter.
One way to avoid this result is to apportion the taxes to both your son and your daughter. But that approach could cause problems for your son, who may lack the funds to pay the tax without selling the property. To avoid this situation while treating your children equally, you might apportion the taxes to your residuary estate but provide life insurance to cover your daughter’s tax liability.
Omission of apportionment clause
What if your will doesn’t have an apportionment clause? In that case, apportionment will be governed by applicable state law (although federal law covers certain situations).
Most states have some form of an “equitable apportionment” scheme. Essentially, this approach requires each beneficiary to pay the estate tax generated by the assets he or she receives. Some states provide for equitable apportionment among all beneficiaries while others limit apportionment to assets that pass through the will or to the residuary estate.
Often, state apportionment laws produce satisfactory results, but in some cases they may be inconsistent with your wishes.
If you ignore tax apportionment when planning your estate, your wealth may not be distributed in the manner you intend. We can answer your questions about taxes and estate planning.
The stretch IRA: A simple yet powerful estate planning toolThe IRA’s value as a retirement planning tool is well known: IRA assets compound on a tax-deferred (or, in the case of a Roth IRA, tax-free) basis, which can help build a more substantial nest egg. But if you don’t need an IRA to fund your retirement, you can use it as an estate planning tool to benefit your children or other beneficiaries on a tax-advantaged basis by turning it into a “stretch” IRA.
Stretching the benefits
Turning an IRA into a stretch IRA is simply a matter of designating a beneficiary who’s significantly younger than you. This could be, for example, your spouse (if there’s a substantial age difference between the two of you), a child or a grandchild.
If you name your spouse as beneficiary, he or she can elect to roll the funds over into his or her own IRA after you die, enabling the funds to continue growing tax-deferred or tax-free until your spouse chooses to begin withdrawing the funds in retirement or must take required minimum distributions (RMDs) starting after age 70½. (Note that RMDs don’t apply to Roth IRAs while the participant is alive.)
If you name someone other than your spouse as beneficiary, he or she generally will have several options:
Usually the inherited IRA is the best choice because it maximizes the benefits of tax-deferred or tax-free growth.
Naming a trust as beneficiary
A disadvantage of naming your child or grandchild as beneficiary of your IRA is that there’s nothing to prevent him or her from taking a lump-sum distribution, erasing any potential stretch IRA benefits.
To ensure that this doesn’t happen, you can name a trust as beneficiary. In order for a trust to qualify for stretch treatment, it will need to meet certain requirements, such as distributing RMDs received from the IRA to the trust beneficiaries.
Contact us for additional details.
A life insurance policy can be an important part of an estate plan. The tax benefits are twofold: The policy can provide a source of wealth for your family income-tax-free, and it can supply funds to pay estate taxes and other expenses.
However, if you own your policy, rather than having, for example, an irrevocable life insurance trust (ILIT) own it, you’ll have to take extra steps to keep the policy’s proceeds out of your taxable estate.
3-year rule explained
If you already own an insurance policy on your life, you can remove it from your taxable estate by transferring it to a family member or to an ILIT. However, there’s a caveat.
If you transfer a life insurance policy and don’t survive for at least three years, the tax code requires the proceeds to be pulled back into your estate. Thus, they may be subject to estate taxes.
Fortunately, there’s an exception to the three-year rule for life insurance (or other property) you transfer as part of a “bona fide sale for adequate consideration.” For example, let’s say you wanted to transfer your policy to your daughter. You could do so without triggering the three-year rule as long as your daughter paid adequate consideration for the policy.
Determining adequate consideration isn’t an exact science. One definition is fair market value, which is essentially the price on which a willing seller and a willing buyer would agree.
Triggering the transfer-for-value rule
The problem with the bona fide sale exception is that, when life insurance is involved, it may trigger another, equally devastating, rule: the transfer-for-value rule. Under this rule, a transferee who gives valuable consideration for a life insurance policy will be subject to ordinary income taxes on the amount by which the proceeds exceed the consideration and premiums the transferee paid.
So, in the previous example, even if your daughter purchased the policy for the appropriate amount to avoid the three-year rule, she could be subject to some income tax when she receives the proceeds.
Recipe for success: Selling to a trust
It may be possible to avoid the three-year rule — without running afoul of the transfer-for-value rule — by selling an existing life insurance policy for adequate consideration to an irrevocable grantor trust. A grantor trust is a trust structured so that you, the grantor, are the owner for income tax purposes but not for estate tax purposes.
While there’s been talk of an estate tax repeal, it’s still uncertain if and when that will happen. So if your estate is large enough that estate taxes could be an issue, it’s best to continue to factor that into your planning. Please contact us if you have questions about how you should address your life insurance policy in your estate plan.