2017 year-end tax planning – a year of uncertainty

President Trump and the Republicans Congress are working to pass a new tax law. However, not all details are known. Furthermore, the current House and Senate bills differ on many significant provisions. Also, more revisions are expected as the two bills are reconciled and brought to the floor for votes. Finally, the Republicans failed to repeal the Affordable Care Act, so many provisions could change, if any changes are ever enacted.

With all the uncertainty, how do you plan? Very carefully – you need to augment your traditional year-end planning by anticipating likely changes.

Practical planning steps

First, be practical:

  • Determine what income and deductions you can move from 2017 to 2018 or vice versa.

Second, review the impact:

  • What happens if you shift any of these amounts of income and deductions to the other year?

Finally, watch for the impact of the Alternative Minimum Tax (“AMT”):

  • If the AMT is repealed next year, how does that change your analysis? Deductions lost to the AMT this year could have value in 2018.

Income

Both the House and Senate bills lower the tax brackets, so income should be subject to less tax in 2018. Furthermore, if the Medicare tax is eliminated, pushing income into 2018 could save significantly.

Conclusion: You probably want to move income to next year if you can.

One possible exception is the sale of your home: both bills move the residency requirement from two of the last five years to five of the last eight years. So, if you are selling to sell a home you lived in less than five years, try to close in 2017.

Exemptions and standard deduction

Both bills raise the standard deductions to $12,000 single/$24,000 married. This may offset deductions that you lose, as discussed below.

Conclusion: You probably want to move deductions to 2017.

Itemized Deductions and Credits

The deduction for state income taxes would be eliminated and deduction of property taxes either eliminated or capped at $10,000 (the current amount).

Mortgage interest on new home purchases would be deductible only on loans of up to $500,000 on the primary residence only.

And these deductions could be eliminated: student loan interest, moving expenses, tax preparation fees, casualty losses, medical expenses. Also, the deduction of alimony could be eliminated for divorces occurring after 2017 and electric car credits and bike to work exclusions could end.

Conclusion: If these deductions are capped or eliminated, you will want to move these amounts into 2017.

Pass-through businesses

Income from an LLC, partnership or S Corporation could see a top tax rate of 17.4 to 25%. However, to avoid abuse (as seen with a similar law in Kansas), rules would be applied so that taxpayers will not simply create entities to have all of their income tax at the lower rate.

Conclusion: wait and see, read the fine print, then see if there are any opportunities to exploit.

Estate taxes

Either the tax on estates would be eliminated or the credit doubled.

Conclusion: you may want to postpone your year-end gift planning.

 

Summary

Carefully review any income and deductions that you can still affect to see if moving will lessen the total taxes you pay for 2017 and 2018.

Good luck and best wishes for the holidays!

If you have any questions, please contact me.

Holiday Planning Series with the Squash Brothers, part I, tax planning

Watch our Holiday Planning Series, Part I, as Steven and the Squash Brothers discuss taxes, “starting backwards with tax planning now so you pay less next April.”

Next time, they discuss cash management.

Estate Planning – Techniques for Reducing Taxes in Large Estates

The change in the tax law from the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 gives us a two year window for significant estate tax planning, ending December 31, 2012.

Instead of a $1 million lifetime cap, you can now gift up to $5 million. When your spouse joins in, a major amount of wealth can be transferred. This makes it important to act now, because the law could change in for 2013.

Leveraged Gifting – you can use a defective irrevocable trust (the defective grantor trust is discussed below) to fund an installment purchase of assets from you to the trust over time. The trust is “defective” so that there is no taxable transaction and no gain; it is as if you are selling to yourself. With the installment sale, a note is used and has to bear interest at the IRS mandated rates, the lowest rate of interest allowed. The goal is to repay the note using appreciated assets, where the transfer back to you is also not taxed, and complete the repayment before you die. If it is not completed, the note is an asset taxable in your estate.

Dynasty Trust – you can use the increased generation skipping transfer tax (GST) to pass more to grandchildren and future generations. Again, the new limits allow you to pass far more on to future generations.

Life Insurance Trust – an irrevocable trust that holds insurance for whatever purpose you design, while be excluded from your taxable estate. Your trustee would purchase insurance on your life. The risks of this alternative are that it is irrevocable and that the cost of the permanent insurance is very high.

Second-to-die Life Insurance – a trust that purchases second-to-die life insurance crates a source to pay estate taxes while not increasing the taxable estate.

GRAT – Another alternative is the grantor retained annuity trust (“GRAT”), which uses some portion of your unified credit as a window through which to pass assets at a discount created by the IRS tables that tell us what the asset gifted will be worth at the end of the term of the trust. You receive annuity payments during the term and the principal passes to your children at the end of the term. (This is why it must be funded with “excess” wealth – if you give the trust a term of 20 years but live many years thereafter, there will be many years during which you have foregone the benefit of the assets gifted). The expectation is that the principal will actually be worth more than the amount you gift to the trust, with such increased value escaping estate taxes. Under the new law, there are no GRAT or value limitations.

Cautions: First, the securities laws will treat you as the owner of trust assets for any restrictions on dealing with publicly traded stock. Second, if you die before the end of the term, assets revert to your estate and the structure collapses to look as if nothing was done. Last, a twist: if you stipulate that the trust will not terminate at your death, you substantially reduce the amount that gets thrown back to your estate, reducing the risk of not living through the term of the trust.

Tax inclusive and exclusive – the Sam Walton strategy can used when you want to transfer more than your unified credit alone will allow. If you make a taxable gift, it is tax exclusive (the tax comes from other assets). Thus, the tax is calculated as a percent of the gift. If you die owning the asset and it then passes to your children, it is tax inclusive as the tax is calculated as the total amount, so less of the assets pass to your children. QPRT – The qualified personal residence trust (“QPRT”) uses the unified credit and discount of a future value like the GRAT but applies it to your residence. Thus, both the benefits and risks are similar; it is the asset that differs.

“Defective” grantor trust – The “defective” grantor trust is effective for gift tax purposes and “defective” for income tax purposes so that assets are not included in your estate and yet you pay the tax on their appreciation. Paying the income taxes without any gift tax cost effectively gives away additional wealth. Again, you can leverage this with an installment sale.

Family Limited Partnership – the family limited partnership (“FLP”) is a partnership that you form, acting as the general partners and the limited partners. You transfer assets into the FLP such as any commercial real estate or your shares in your company. When this is complete, you can gift limited partnership interests to your children. Because only the general partners have any say in the management of the FLP, the IRS allows for a discount to the value of the limited partners interest. This discount is 35 to 40%, so more is passed to children without using up your unified credit. Unlike the other alternatives delineated below, when you transfer limited partner interests, your children receive the benefit now. In addition, you have the burden of tax returns for the FLP, as well as tax liability for children who may not receive distributions from the FLP to cover the taxes.

Charitable Remainder Trust – This charitable remainder trust (“CRT”) is a trust that pays a fixed annuity to you and then distributes the remaining principal to charities. You get a gift charitable deduction for the net present value of the future distribution to charities.

Charitable Lead Annuity Trust – This reverses the CRT, where a trust that pays a fixed annuity to charities selected by its trustees and then returns the remaining principal to you or to your estate. You get a gift tax deduction for the actuarial value of the annuity payments to charities or an estate tax charitable deduction.

Caution – you have an investment risk in each vehicle, where failing to generate the larger principal value in the future that you count on to use the strategy will frustrate its purposes. This is the risk of selecting assets that are expected to soar in value but instead collapse. Therefore, none of these alternatives should be considered until you are comfortable that you have “excess” wealth to pass to your children or to a charity and comfortable that you can make a commitment to do so that cannot be reversed. If you say “no” out of lack of comfort or confidence in any strategy, then you will want to stick to a basic plan for now.

What about the Future? Most observers expect the $5 million exemption to stay, along with the 35% estate tax rate. The exemption could be lower, or the rate increased. All of this is reason to review the ideas below and then update your estate plan.

Please see Estate Planning.

Tax Trap: risk of double taxation on contributions to Qualified Plans by certain states.

If you contribute to a Keogh, SEP-IRA, Money-Purchase or Profit-Sharing Plan as a self-employed taxpayer, or if you have made deductible contributions to an IRA, then you may have a tax issue on distributions from that plan or IRA. (Obviously, this does not apply to Roth IRAs but it can apply to roll-over IRAs.)

Many states follow the federal tax rules, allowing a deduction to these plans. However, Commonwealth of Massachusetts, among others, does not.

That is, in the case of contributions to all of these Plans and even a traditional IRA, Massachusetts gives you no deduction on the contribution. Therefore, you have to take a deduction for that contribution against later distributions. Otherwise, you have paid tax twice on that amount.

To say it differently, because Massachusetts does not allow a deduction at the time of the contribution, i.e., it was “after-tax” money when contributed, you must offset those amounts against withdrawals, amortizing over time, so that you are not taxed on the after-tax contribution when it comes back out as a part of the distributions.

Therefore, you will want to track the contributions made, so that the total can offset the amount taxed by Massachusetts when you withdraw.

We are addressing this issue in an appeal to the Massachusetts DOR Appellate Court, as certain plans face double taxation.