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- Written by: Martin M. Shenkman
Estate planning is often viewed as independent of income tax compliance, and vice versa. The reality is that properly crafted estate planning will have to be reflected in many ways on the client’s income tax return for that planning to succeed. Practitioners who are alert to the income tax reflections of estate planning techniques will be in a better position to assure that those techniques are properly carried through from both an estate planning as well as an income tax compliance perspective. The following are some of the many income tax ramifications of a client’s estate planning that practitioners should consider:
√ Family Loans
With continued historically low interest rates, intra-family loans remain a popular wealth-shifting device. A parent, for example, can loan a large sum to a child, who can invest the money to grow his or her estate. The parent can charge the minimum current interest rate under IRC Sec. 7872 and avoid any of the interest imputation, gift and other consequences.
Family loans are also common as parents and other benefactors endeavor to help future heirs cope with economic challenges. For these common family loans to be respected a number of criteria should be met:
There should be a written loan document (e.g., a signed promissory note). Practitioners should hold a copy in the client’s permanent file.
The parent/lender should charge interest and the child/borrower should make payments as required under the loan documents. The interest income should be reflected on the parent’s tax return you prepare. If you also prepare the child’s income tax return the interest expense should be reflected if deductible. If the loan was to help the child purchase a home, be certain to obtain a copy of the mortgage that was recorded corroborating that the interest expense qualifies as home mortgage interest.
Confirm that the interest income/ expenses are consistent with terms of the note. If not it might indicate that a payment was missed, some of the loan forgiven, or other issues that you need to address to assure that the loan is respected for tax purposes.
√ Reasonable Compensation Issues
Practitioners are commonly aware of the issues relating to “reasonable” compensation when preparing an S corporation return considering David E. Watson, P.C., 714 F. Supp. 2d 954 (S.D. Iowa 2010). Some clients try to push the envelope of unreasonably low compensation to save on payroll taxes:
IRC Sec. 1402(a). The flip side of the S corporation tax coin is the compensation reporting on the shareholders’ personal Form 1040. But S corporation distributions to save payroll taxes is only the tip of the reasonable compensation iceberg. There are a host of critical estate planning issues that might be affected (in many cases undermined entirely) if the individual client’s compensation is not reasonable. Much like the story of the porridge and the three bears, if it is too large or too small, estate tax problems could result. The temperature of the porridge, and the amount of the compensation, has to be just right.
If an individual client is reporting compensation that is unreasonably high, that might imply that the client has retained an interest in the family limited partnership, S corporation or other entity, part of which was given by gift to heirs. A common estate planning technique was and remains to gift stock in the family business entity to heirs using the annual gift exclusion, presently $13,000. But over the years as the percentage interest owned by the heirs increases, if the parent continues to take all or the lion’s share of the earnings as compensation, the IRS may well argue that the parent has retained an income interest in the corporation. The net result is the IRS arguing that the entire value of the corporation is included in the parent’s estate: IRS Sec. 2036.
Even if the client is not concerned about estate tax, the potential for a reversion to a much lower federal estate tax exemption, and the creditor protection of the completed gifts, could all prove problematic.
If the client has made prior gifts to grantor retained annuity trusts (“GRATs”) of interests in the business, taking an unreasonably low compensation could be tantamount to the client making an additional gift to the GRATs. That is impermissible and could unravel the entire estate plan.
Reasonable compensation can raise issues that affect any estate or asset protection plan a client may have. Practitioners reviewing personal returns need to consider the broad implications of the compensation issue, not just the unreasonably low compensation in an S corporation context.
√ Grantor Trusts
Grantor trusts have become one of the most popular asset protection and estate planning techniques. When a client transfers assets to an irrevocable trust, it is common to include in the trust provisions that characterize it as a grantor trust, the income of which is taxable to the client. The payment of income tax on income that remains inside an irrevocable trust is a powerful method of reducing remaining assets that would otherwise be exposed to creditors or estate taxes.
Another common grantor trust is the ubiquitous revocable living trust. While often used to avoid probate, living trusts are often used to segregate inherited or gift assets that may be immune from equitable distribution in a divorce proceeding. How these grantor trusts are handled on the client’s Form 1040 could be critical to the success of vital client planning.
If the client’s parent or other benefactor established the trust and the trust included an annual demand or Crummey power for the child/ beneficiary, the trust might be a grantor trust as to the child, not the parent. This technique, known as a Beneficiary Defective Irrevocable Trust (BDIT), has to be handled quite differently than the more traditional grantor trust (e.g., a domestic asset protection trust or dynasty trust) a client establishes with the client as the settlor (setting up the trust) and taxed as the grantor. Reporting the income on the wrong client Form 1040 could undermine the planning.
In the case of a revocable living trust that was intended to preserve the immunity of assets the client received as a gift or inheritance, if the income tax attributable to that trust’s assets are paid out of marital funds, the integrity of those assets as immune in a future divorce could be compromised. A number of variations of grantor trusts, each with its own unique nuances, and improper treatment for tax reporting could undermine a much more significant plan.
√ Insurance Transfer for Value Rules
Clients universally assume life insurance proceeds are income tax free. While this might often be true, there is a significant exception to this generalization. If an insurance transfer runs afoul of the transfer for value rules the proceeds might be subject to income tax. IRC Sec.101(a)(2).
The rules are not logical and caution is always in order. If a corporation distributes insurance to a shareholder, the transfer for value rules might be triggered. However, a transfer from a partnership to a partner does not trigger the transfer for value rules. Any transfer of life insurance that appears on any return should be investigated to assure that the transfer for value rules are not triggered.
√ Entity Distributions
While quite simplistic, distributions from entities too often don’t match the underlying legal documentation. For example, a parent has given annual gifts of stock in a closely held family S corporation or FLP for three years to four children. The distributions should be in proportion to the equity interests held by each equity owner. Far too often the ownership percentages on the Forms K-1 are not consistent with the ownership interests reflected in the underlying legal documents (e.g., stock certificates for a corporation, operating agreement for an LLC, etc.).
Practitioners should be certain to confirm K-1 percentages to governing documents in their permanent file for the entity. If the documents are current, copies have not been provided, or the percentages differ, the client should be advised to follow up with his or her attorney. If practitioners file income tax returns corroborating disproportionate distributions those returns could be the support cited by a creditor or IRS auditor looking to pierce the entity or undermine a client planning transaction.
√ Schedule C Disregarded LLCs
Clients often favor the use of single member disregarded LLCs so that the cost and administrative burdens of a partnership return Form 1065 can be avoided. The downside to this is that in the event of a lawsuit the client’s personal Form 1040 may be open to investigation since that is the return on which the income is reported. It could be far preferable to have a multimember entity and file a Form 1065. In the event of a lawsuit or other challenge, only the entity’s Form 1065, not the client’s personal return, may be discoverable.
√ Schedule B and Title to Assets
In spite of the 2010 Tax Act’s enactment of portability, which supposedly permits the surviving spouse to utilize the unused estate tax exemption of the first to die, most estate planning practitioners still generally prefer to use the more traditional estate planning technique of funding a bypass trust on the death of the first spouse. There are simply too many risks and unknowns to rely on portability of a bypass trust.
For many clients dividing nonretirement investment assets (e.g. brokerage accounts) so that each spouse has adequate assets to fund a bypass trust on death (and for many clients it is not the federal exemption amount that will need to be funded but the lesser state estate tax exemption amount in a decoupled state.
When preparing Schedule B, practitioners should be alert to how asset ownership is divided and if the 1099s indicate that a predominance of assets are in the name of one spouse, the issue should be raised.
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- Written by: Martin M. Shenkman
Succession planning almost invariably focuses on planning for the death of a partner or other equity holder. But the greater risk for many business owners and their businesses is the risk of disability. The statistics are unexpected to most. Estimates are that 15% to 25% of people between the ages of around 25 to 65 will be disabled. There is more than a 25% likelihood that a 20-year-old will be disabled prior to their retirement. Practitioners need to focus clients on succession planning for disability and guide them to taking proactive steps to mitigate against what could otherwise be a disruptive event at best; calamitous at worse. Comprehensive disability planning includes preparing a plan for how the business can be transitioned during the disability of an equity owner, especially a key person. In addition to such management consulting type considerations, the governing document for the business (shareholders’, partnership or operating agreement) should address disability in a comprehensive manner that is tailored to the particular business, each equity owner’s role and importance to that business, and the financial realities involved. Consider the following:
√ Valuation:
If a long term or permanent disability is to trigger a buy out, what pricing should be involved in the re-purchase of the disabled equity owner’s interests? The value to be used must be determined simultaneously with consideration of the funding options so that whatever is agreed to will not create undue financial hardship on the remaining equity holders.
√ Funding:
Should disability buy out insurance be used? Is it affordable? While it is often advisable to encourage clients to price disability buyout insurance, in many instances they will object to the cost. Even if the cost is agreeable, often the payouts that are affordable to purchase will be less than most clients anticipate or believe appropriate. Weigh further saddling the business with additional payment requirements.
√ Senior/founder provisions:
If the patriarch of a family business or founding partner of a professional practice is disabled, should the same general disability provisions applicable to a new or much more recently admitted equity owner apply? Too many agreements provide for uniform disability definitions and provisions. The founding or senior owner may be an integral and valuable component of the goodwill and identity of the business and the business itself will benefit from continued association. That does not mean that compensation cannot be adjusted, but perhaps the relationship should not be terminated, or if terminated after a longer time frame. From the founding equity owner’s perspective it would seem rather unfair to be terminated in the same 90-day disability period as a newly minted owner. Importantly, senior members are often older and more likely to suffer a more significant health issue then younger members. A fixed time period does not account for that reality.
√ Prevent Gaming the Provision:
A common issue with disability clauses is preventing an equity owner from unfairly manipulating the formulas in the governing document. For example, if a shareholders’ agreement provides that an owner who is out disabled for more than 60 days must be bought out, the owner might return to work every 59th day. One solution to minimizing the risk of this type of abuse is to also include a band around this primary disability clause, e.g., in addition to being out for 60 days, if a shareholder is disabled and unable to provide services for 90 days in any 280 day period, that shareholder shall be deemed disabled. This would catch such a game.
√ Different Degrees of Disability:
Too many agreements assume that “disability” is a single point in time clearly definable condition. It is rarely so black and white. If an equity owner suffers an acute medical condition it might well be that after a period of hospitalization and recuperation that owner can return to full time regular work with the company. However, many medical conditions are chronic and will continue for the equity owner’s lifetime. If for example the equity owner is diagnosed with an autoimmune disease whose symptoms include severe fatigue. The equity owner may be able to continue working almost indefinitely, but with a reduced work schedule. The generic nature of most disability clauses does not generally facilitate this level of distinction, but it can be valuable to both the business and the key-person/owner. Give careful consideration to defining temporary versus permanent disability. If an equity owner has an acute medical condition and will require two months to recuperate, most businesses would not wish to force someone out for two months. But what if the recuperation period might be a year? What parameters make sense? In some instances there may be no need to differentiate; in others there might be. Permanent disability may trigger buy out of equity or removal of the persons name from the firm. Temporary disability may have less severe consequences.
√ Compensation and Benefits:
Merely addressing when a disabled shareholder should be required to sell equity to the entity or other owners is not sufficient. How should the salary and perquisites of that equity owner be reduced? Should the adjustments change over time? Many businesses will provide for the payment of a partial salary for a period of time then reduce the compensation to zero and sometime thereafter eliminate perquisites. What is affordable to the business? What degree of safety net do the business owners wish to provide each other in advance of knowing which of them may be affected? What changes should take place at what trigger points? Should equity owners be required under the governing document to purchase private disability income replacement insurance to lessen the financial burden on the business (and guilt burden on the other owners)? Should the payments by the business be tailored to mesh with the actual policies or the mandated coverage? What if the coverage changes or lapses?
√ Which Provision Governs:
Any comprehensive governing document may have a multitude of buyout provisions. Practitioners should review the trigger points and economic consequences of each of the provisions. For example, in a two partner corporation the shareholders agreement might include what is sometimes referred to as a “Dutch auction” or “reciprocal buy/sell.” This type of provision is designed to provide an exit strategy if the owners don’t get along and without the cost and complexity of a battle of the appraisers. This mechanism might work as follows: If partner A wants partner C out, partner A can trigger a reciprocal buy sell by setting a purchase price. Partner C then can either buy out partner A or if not done within some specified time period, then partner A must buy out partner C who must in turn sell. The same agreement might provide an optional retirement provision that permits a shareholder over age 52, for example, to “retire” and receive a payout of some percentage of gross over the next four years, and an additional payout of “capital” however defined. With these three provisions, if a shareholder aged 53 suffers a heart attack and will be out for some period of time, which provisions govern? Can the well shareholder force the application of the Dutch auction before the ill shareholder triggers the disability buyout? Can the ill partner choose to “retire” if that appears based on the economics of the business to provide a greater payment? All provisions must be coordinated to prevent a rush by one or the other partner to manipulate the terms of the agreement.
√ Multiple Events:
One of the most commonly overlooked issues in a business buyout agreement is the risk of multiple trigger events being operative at one time. One partner may die, another may retire six months later, and a third may become disabled. This might all occur within the same approximate time period. Can the entity afford to make the aggregate payments to each? The financial strain of multiple payments, if not properly planned for, could devastate the business. In some cases a ceiling on aggregate payments may be included in the agreement to avoid hardship to the entity (e.g., aggregate payments shall not exceed 20% of gross revenues in any year). Should ordering provisions be provided? For example, should whichever payment is triggered first govern priorities of payments? So that if a shareholder died, and then two months later another shareholder is disabled, the payments the corporation can make under the agreement are devoted to the deceased shareholder whose buyout was triggered first, and only what is left is then applied to the disabled shareholder’s buyout? Alternatively, payments can be prorated. The critical point is to address the issue of multiple events. During the period that buyout payments are made (i.e., those other than insurance funded payments) should existing partners have caps on salary or perquisites? If this is not done, the payments to the deceased, disabled or other terminated partners could be unfairly deferred.
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- Written by: Martin M. Shenkman
With all the hoopla given to the 2010 Tax Act increase in the exemption amount of $5 million many practitioners have written off estate tax planning as something that only applies to a very wealthy few that is not pertinent to their practices. But, there remains a host of post-death tax elections and decisions that practitioners should continue to address in serving client’s estates. There are many income tax elections that may affect even smaller estates. A $5 million exemption doesn’t obviate all planning by any stretch. Consider the following:
Meeting a Pecuniary Bequest
When an estate satisfies a pecuniary (dollar) bequest with property in kind, the transaction is deemed the equivalent of a sale or exchange of the property by the estate, and the use of the proceeds to satisfy the pecuniary bequest. For example, if a will provides for a $100,000 payment to a cousin, and the estate uses stock with a tax basis of $60,000 after death (since there is a step up on death) that has appreciated to $100,000, $40,000 gain will be triggered. Practitioners need to guide clients on selecting which assets to use to satisfy which bequests. This income tax hit can apply regardless of the size of the estate. An estate may be entitled to a deduction for a loss on funding a pecuniary bequest in spite of the rules limiting loss deductions on related party transactions. IRC Sec. 267(b)(13).
Tax Losses Flow Through on Estate Termination
In the final year of an estate unused capital losses and net operating losses pass out to the beneficiaries. IRC Sec. 642(h); Treas. Reg. Sec. 1.642(h). This may present a planning opportunity to plan the year end of the estate with the year in which the beneficiaries receiving the residuary estate can benefit from the estate’s losses. Practitioners should endeavor to coordinate the tax status of all involved.
Where to Deduct Certain Expenses
The executor can elect to deduct the expenses of estate administration on the estate tax return or the estate’s income tax return, Form 1041. The administrative expenses involved may include: expenses deductible under IRC Sec. 2053 and 2054 such as executor commissions, accounting and legal fees, appraisal fees, probate costs, expenses incurred in selling estate assets to pay debts and expenses, etc. Note that funeral expenses can only be deducted on the estate tax return, not on the estate income tax return. Medical expenses can be deducted on either the estate tax return or income tax return. IRC Sec. 213(c). For some decedents this figure can be substantial. With so few estates subject to federal estate tax in light of the $5 million exemption, the election to deduct estate expenses on Form 1041 that can be deducted will be common. Practitioners may have to weigh the income tax benefits against state estate tax benefits in some instances in order to reach the optimal decision.
Estimated Tax Payments Can be Credited to Beneficiary
A trustee can elect to have a portion or all of the trust’s estimated tax payments treated as if paid by (credited to) a beneficiary. IRC Sec. 643(g). An executor can elect to have a portion or all of the estate’s estimated tax payments (note that none are required during the first two years post-death) treated as if paid by (credited to) a beneficiary for the final tax year of the estate only. Any amount of estimated taxes allocated to a particular beneficiary are treated as a distribution to that beneficiary on the last date of the tax year. The election is made on Form 1041-T, “Allocation of Estimated Tax Payments to Beneficiaries.” If the estate (or trust) has made tax payments and the beneficiary has not, this can provide a valuable method to avoid underpayment of estimated tax penalties for a beneficiary.
Election for Estate or Trust to Recognize Gain
An election can be made by an estate (or trust) to recognize gain for income tax purposes. IRC Sec. 643(e)(3). Gain or loss shall be recognized by the estate or trust in the same manner as if the property had been sold to the distributee at its fair market value IRC Sections 661(a)(2) and 662(a)(2). An election under this provision applies to all distributions made by the estate (or trust) during a taxable year, and shall be made on the return of such estate (or trust) for such taxable year.
Election to Treat Trust as Estate
- The executor and the trustee of a qualified revocable living trust may elect to treat the trust as part of the estate for income tax purposes. This election may prove advantageous, because it may permit the trust to benefit from several income tax benefits that but for making this election the estate could choose, but the trust could not do so:
- Choosing a non-calendar fiscal year for income tax purposes.
- Avoiding estimated income tax requirements for two years after the date of death.
- Obtaining a deduction for funds set aside for charity that are not yet paid to charity under IRC Sec. 642(c)(2).
- Automatic eligibility, without making any election, as an S corporation shareholder for the duration of the period of estate administration. IRC Sec. 13651(c)(2)(A).
- Utilizing the $25,000 active real estate exception to the passive loss limitation rules for two years post-death. IRC Sec. 469(i)(4).
- Recognition of a loss on satisfaction of a pecuniary bequest. IRC Sec. 267(b)(13).
Treat Amounts Paid After Year End as Paid in Prior Year
An amount paid or credited to a beneficiary within the first 65 days of a tax year can be treated, if the election is made, as if paid or credited during the prior fiscal year. IRC Sec. 663(b).
Bypass, Portability, Disclaimer
Many wills, especially those for mid-wealth clients, use a disclaimer approach to funding a bypass trust. All assets are bequeathed outright to the surviving spouse who is given the option to disclaim in which event those assets are then bequeathed into a bypass trust. Practitioners must guide clients as to whether to fund a bypass trust by disclaimer or to instead have portability apply. If portability is to apply, then the appropriate estate tax filing must be made (not yet issued as of this writing). If the bypass trust is to be funded, which may save on state estate tax, provide asset protection, etc., then the necessary legal documents have to be filed with the local surrogate or probate court within the requisite time period. So, even for smaller estates, decisions and actions are necessary.
Extension of Time to Pay
Estate tax payment can be delayed for reasonable cause for a reasonable period of time, not to exceed 12 months, if approved by the IRS. To qualify the executor must make a request for the extension and demonstrate that the request is based upon reasonable cause. Treas. Reg. Sec. 1.6161-1(a)
Estate Tax Deferral
In certain cases, estate taxes may be paid in from two to ten installments, and can be deferred for up to four years after the date the tax is due, providing up to a 14 year deferral. In order to qualify for the deferral numerous requirements have to be met, including that the value of interests in closely held businesses included in determining the gross estate exceeds 35 percent of the adjusted gross estate, and the executor must file an election. IRC §6166. As part of the election, the executor must file an agreement as described in Section 6324A(c).
Actions Effecting Valuations
While not a formal tax election, an executor making a decision to sell an asset should be mindful of the fact that post-death sales may establish the value of an asset for estate tax purposes. One court held that a post-death sale of a closely held stock position was determinative of the value of the stock on the decedent’s estate tax return. Estate of Helen H. Noble. 89 TCM 649.
Alternate Valuation Date (“AVD”)
Estates may value estate assets, in very simplistic terms, six months from the date of death. The election must apply to all estate assets, no partial application is permitted. Treas. Reg. Sec. 20.2032-1(b)(2). So, practitioners need to help executors determine the impact on all beneficiaries in order to make an optimal decision.
Graegin Loan
A Graegin loan technique may provide a mechanism to fund some portion or all of the estate tax cost for an illiquid estate while simultaneously reducing the value of the taxable estate. For example, if an insurance trust holds liquid proceeds of an insurance policy, it can loan money to the estate and thereby enhance the estate tax deduction for future interest payments. The tax law has permitted a deduction on the estate tax return of all future interest payments required to be paid under a non-cancellable note. If there is no estate tax due, estate needs might better be met by the insurance trust buying assets from the estate. Estate of Cecil Graegin, 56 TCM 387 (1988).
754 Basis Adjustment
The basis of partnership property (or property of a limited liability company taxed as a partnership) may be adjusted as the result of a transfer of an interest in the partnership by sale or exchange or on the death of a partner if the election provided by IRC §754 is in effect with respect to such partnership.
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- Written by: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD
By: Martin M. Shenkman, CPA, MBA, PFS, AEP, JD | Every CPA can and should be a proactive to help clients with estate planning matters. In the past, many CPAs shied away from this vital role, to their client’s detriment, and to theirs. Of all the members of a client’s estate planning team, more often than not it is the CPA, not the attorney or investment adviser, that has a long term relationship. The knowledge and position of trust that this relationship can provide, makes the CPA the preferred adviser to broach tough estate planning topics with clients. The tough topic is not saving estate taxes, which for all but 3,000 or so estates a year is academic. The toughest topic for clients to focus on is not only the most important for the client, but also one squarely within the expertise of the local CPA practitioner. The “hot topic” is later life planning. CPAs can guide clients to use Quicken, or any personal checkbook program to address many of the critical and practical issues of later life planning that otherwise are ignored. In coming years this will represent a growing practice opportunity for the local practitioner. It will fill a planning void many clients need addressed.
What Is Later Life Planning and How Can the Local Practitioner Help?
Later life planning is the future of estate planning for the aging client not subject to a federal estate tax. Consider how each of the issues or steps below creates a practice development opportunity:
- What steps can the client take to assure that he or she will remain in control over his or her assets for as long as possible?
- While the prior generation of estate planning clients was focused on saving estate taxes on the wealth they spent a lifetime accumulating, the Boomer clients who are the next vanguard of estate planning clients are focused on assuring they will have adequate cash flow for the duration of their lives. This is not only a result of the demise of the estate tax but more so a result of increasing longevity. These clients need realistic budgets that are monitored as part of an integrated financial and investment plan to assure that clients stay on course over this long time period.
- As a client ages, and everyone knows the population is aging, what can be done to minimize the risks of elder financial abuse. Whatever the statistics on financial abuse indicate, this author’s belief is that most elder financial abuse is undetected, and of those situations that are identified, most are unreported because either family is involved, or there is no one adversely affected that has knowledge of the situation.
- Most if not every estate plan includes the preparation and execution of a durable power of attorney to name an agent to handle financial matters in the event of the client’s disability. Yet it is rare that anything is done to address the practicalities of an agent actually using a power of attorney.
The “I Don’t Use a Computer” Smoke Screen
How can the practitioner harness the power of Quicken to accomplish all of these and other goals? Today’s retiree is likely comfortable using a computer and Quicken, more or less. For those “less” more assistance can be rendered. For older clients that are not as computer comfortable, a CPA can maintain computer records for the client and in many cases the children or agents will be computer savvy and appreciate the security and other benefits. Many older clients have a child or other person handling their finances, if the CPA can fill part of the role by maintaining detailed records, that “helper” will be incredibly appreciative. So don’t dismiss this role and opportunity because some clients are not tech savvy, that deficiency only makes the CPAs assistance more important.
Checklist: Harnessing Quicken – A Cornucopia of Services
√ Reminders
Reminders can easily be set in Quicken so that clients don’t overlook important bills. If the client is uncomfortable setting these up, the practitioner can easily help do so. But the benefits of this feature go well beyond paying a monthly mortgage. The more important items to schedule reminders are for those non-monthly items that are more readily overlooked. Further, the reminders should include a wide range of vital financial and estate planning steps, not simply bill paying. A carefully thought out reminder list, updated perhaps every few years, can be invaluable. Also, as clients age it is more difficult to remember important items. If a child or other loved one helps a client with their medical care, finances or other matters, this reminder list might serve as a checklist for a semi-annual “check-up” when they meet with mom or dad. Consider the following as possible reminders to discuss with a client to assure that the list is comprehensive. Obviously, each client will have his or her own unique nuances:
1. Mortgage payment.
2. Property tax payments quarterly (on the town’s fiscal year basis).
3. Colonoscopy every five years.
4. Annual physical.
5. Order one free credit report every four months during the year from each of the three credit reporting agencies.
6. Annual mammography.
7. Dental and other appointments.
8. Meet with investment adviser semi-annually.
9. Meet with estate planner every three years.
10. Annual renewal of local town license for dog or other pet.
11. Quarterly tax estimates.
12. Change smoke detector batteries annually.
13. Change oil in emergency generator.
14. Expiration dates for term life insurance conversion features.
15. Start date for a deferred annuity.
16. Reminder to have CPA and investment adviser review gain/loss harvesting before year-end.
17. Distributions from investment limited partnerships.
18. Capital calls on private equity investments.
19. Review property and casualty insurance coverage limits every other year.
There is no rule that Quicken reminders cannot be used to assure a client does not forget any important life event. The listing of reminders is a great tool for the client to review with anyone helping advise him or her to assure that all key events are listed.
√ Budgeting
As every practitioner and client knows a financial plan requires a realistic budget and an investment plan built on financial targets (e.g., a grandchild’s wedding) and that budget. Too often, however, budgets are based on computer assumptions or wild guesstimates since the client does not provide any hard data. When a client has no computerized records, culling actual expense data from a manual check book (assuming the client even keeps that, as many do little recordkeeping) and non-existent receipts for ATM withdrawals and cash expenses, will be difficult or impossible. Once a client’s checkbook and other financial transactions are computerized, it becomes a simple task to generate current and prior year expenditures by category. These can then be reviewed and adjusted for unusual items, or to reflect future expense matters. But the key is that the figures used as the foundation of the budget and financial projections will be grounded in reality, not in some “Clever-esque” fiction of what some American family supposedly spends.
Once the plan is completed, the details of an actual budget will give the client the data to identify expenses that are the least painful to cut if that is what is required.
Once the process is completed, it can be templated so that the budget and financial projections, paired with a Monte Carlo simulation of financial outcomes, can be updated and repeated every year or two so that changes can be incorporated and the plan fine-tuned to stay on track.
While this is all simple and obvious far too few clients engage in these fundamentals of planning. While there is no statistical data to support this, it seems to this author that the wealthier the client often the less likely this process is pursued, as if one of the luxuries of wealth is not to have to worry over budget nuances. The reality is that many very wealthy clients spend at a rate that will likely undermine their financial security over their actual lives (in contrast to mere life expectancy). So practitioners that can facilitate clients pursuing this planning may well be the key to the participating client’s financial security.
While these more traditional and obvious applications of budgeting and planning, based on Quicken data, can be incredibly useful, there are many significant non-traditional uses of Quicken financial data as described in the planning tips following.
√ Automation
Estate planning doesn’t have to only focus on depressing scenarios of death and disability. Many clients, especially Boomers, plan active post “retirement” years. The term “retirement” is in quotes because many Boomers plan to continue working in some manner after the traditional retirement age of 65. So if an active Boomer is off on safari, how will bills be paid? When a Boomer is hiking the Appalachian Trail, how will her property taxes be paid? The more obvious planning scenarios must then be addressed. The fact that they might be obvious to practitioner and client alike doesn’t suggest that many clients actually address them. In the event of disability, who will handle payments? How, if a client faces physical challenges, will they make bank deposits? The solution to all of these scenarios is to automate as many financial transactions as possible. Consider:
1. Every recurring bill that can be automatically charged to a credit card, should be set up to be so charged.
2. Every recurring bill that cannot be charged to a credit card should be set up to be automatically deducted from the client’s checking account.
3. Every credit card that can be automatically paid from the client’s checking account should be set up for automatic payment.
4. The client should establish overdraft protection on the checking account used to avoid any insufficient funds.
5. All deposits that can be made automatically to the client’s checking account should be set up for automatic deposit.
This type of planning accomplishes a wide array of benefits. Consider:
1. If the client develops cognitive issues, there are far fewer transactions a month to process. It is easier to monitor routine automatic transactions then to process the entire transaction.
2. Automatic payments and deposits reduce the mail, bills, and other documents and transfers that create opportunities for identity theft or elder financial abuse.
3. If the client is disabled, the transition from the client handing his or her affairs to the point of an agent stepping in to handle the client’s financial and other affairs is rarely clean or simple. The more automated transactions are the fewer dropped balls will occur during that period.
4. The agent taking over these matters will have a far easier time understanding his or her responsibilities if many transactions are automatic, so that there is a clear paper trail of what is happening.
5. Automation will also minimize the time the agent will have to devote to assisting. Most estate planners as well as clients give little attention to the time demands serving as a fiduciary will require. When a client names an adult child to serve in this capacity, that child may have significant work, family and other responsibilities. So no matter how honest and financially astute, whatever can be done to minimize the time demands of serving as an agent under a parent’s power of attorney is likely to be appreciated and enable the child to do a better overall job. In the more extreme situations of a parent with a long term disabling disease, such as Alzheimer’s disease, which might result in a child serving as an agent for a decade or even decades, the simplicity that automation creates may be vitally important for the family.
Automation of a client’s routine finances is one of the most important steps to safeguard a client in his or her later years. Yet this vital guidance is often lacking as each professional adviser assumes that this is too mundane or simple to address, or that another adviser of the client’s has addressed it.
√ Reports to Monitor Client
Once a client’s finances have been automated periodic monitoring of Quicken records can provide incredible protection for the client. Frequently estate plans presume that a client will be well, and then either become incompetent or die. The reality for many is a myriad of shades of gray in terms of the client’s cognitive and physical abilities, shades that change often significantly. Disability is rarely a clearly demarcated event. As such, monitoring a client to identify the declines leading to disability, or the troughs in what might be a rollercoaster of health fluctuations from relative wellbeing to significant disability during an attack or flare up of a chronic disease and back to relative wellbeing. Consider the following:
1. Analyze living expenses and compare on a year-to-year basis and generate budgets and observe the variations from budget to actual. This may reveal a mere innocuous change in spending patterns, or something much more significant, perhaps even sinister.
2. A detailed print out of medical expenses from Quicken can readily help a care manager or family member assisting in the care of an aging client identify if the client has forgone semi-annual dental visits or other care. It may also identify whether the client has relied on out-of-network health care providers at excessive cost. The payees may provide a valuable listing of medical providers to which a care manager may wish to seek reports in order to properly assess the client’s health care and to create a care plan. While this information might be gleaned from paperwork the client has retained, the Quicken records, especially in light of the ubiquitous co-payments, may prove a good test of the completeness of those records.
3. What has the client’s expenditures on food been and where have they been made? Such simple sounding data could be incredibly important for a family member endeavoring to monitor the client’s wellbeing at a distance. If the food expenditures decline precipitously it might indicate that an elderly client is not eating enough. This could indicate depression or apathy, common symptoms of many chronic diseases that affect the elderly. It could indicate cognitive or physical decline that makes securing adequate food difficult. Perhaps a home aid that is supposed to be purchasing food is stealing the money or simply not performing services as needed. Even the composition of the payees may indicate an important change.
4. Investment abuse is a common component of elder financial abuse. If the Quicken records indicate a deposit on a land purchase or private equity investment is that really appropriate and intended or is it a sign of an insidious turn of events? Does the sudden appearance of large annuities or life insurance policies indicate an appropriate change in investment planning or is it a sign of a financial adviser taking advantage of the client?
Practitioners can use www.gotomypc.com or other services to patch in remotely to the client’s laptop to review these matters. If the client’s excuse is that he or she does not have Internet access, then the client is also not taking advantage of a host of other inexpensive and practical steps to safeguard themselves. Alarm systems, video cameras and other security devices are cost-effective and practical, even essential for aging clients, especially those with health challenges. Age or illness may impede the client’s sense of smell, hearing and other sensory abilities. A smoke detector, glass breakage detector and other monitoring devices connected to a central alarm system may be essential. The panic buttons for a client to call for help in the event of a fall (think of those infamous TV advertisements “Help, I’ve fallen and I can’t get up”) may all work best with an Internet connection. The point is simple; the objections clients might raise to any of this assistance are usually signs of other, perhaps more significant, issues that should be addressed. While a practitioner might view a discussion of Internet connections and alarm and security devices outside of his or her purview, who is addressing these essential later-life planning issues? Often no one is addressing them.
√ Road Map for Agents
So a client is disabled and his daughter, a corporate attorney, is named as agent under the client’s durable power of attorney. The daughter has more than adequate sophistication to address any of the financial and legal issue that might arise.
1. But where does she begin?
2. What expenses does she have to pay for her now incapacitated father?
3. Where can she find out?
4. In most cases there are manual checkbooks of questionable completeness, random cash receipts, perhaps a year old tax return that is far too broad in scope to address the specifics involved.
5. Certainly the daughter can cull the mail to identify bills to pay and deposits to make, but that is not a simple task.
6. If the father has been subject of elder financial abuse as his cognitive abilities have declined, the mail may have been compromised.
7. What bills was the father receiving by mail?
8. Which by email?
The simple and practical solution would be for the father, when relative well, to have automated his checkbook and related records. If that had been done a simple Quicken report of activities by category could reveal exactly what types of expenses should be paid. Simply put the best road map to facilitate anyone serving as a fiduciary, whether as agent under a durable power of attorney, successor trustee under a revocable living trust, or in many other capacities, are the Quicken reports any accounting practitioner can readily assist the parent in setting up.
√ Reports of Agent’s Activities
Much has been written in the professional literature about planning and drafting durable powers of attorney, but comparatively little about their actual use. As the population ages, elder financial abuse grows, and families continue to be less unified, the likelihood of lawsuits against agents for their actions under powers of attorney is likely to grow. Practitioners can be of incredible assistance to minimize these risks faced by those serving as agents, and thereby help the families and others effected. Consider:
1. Encourage (insist if possible) that agents meet with an estate-planning attorney to review the power of attorney. Certainly the client (the “principal” or “grantor” under the power of attorney) reviewed the legal document with his or her estate-planning attorney when the document was planned and signed. However, the person serving as agent is generally not involved in any of those meetings. Just as significant, the focus of the discussion in those meetings is quite different. When a client is well and discusses a power of attorney, often attention is given to who the agent is, whether a gift power should be used, how many documents to sign, where they should be kept and other concerns. When an agent steps in to act in a fiduciary capacity the focus should be on what expenditures to make, what assets should the agent marshal, and so forth.
2. What are the circumstances under which the agent is acting under the power of attorney? The agent might be one child (sibling, niece/nephew) among many. The expenses will likely reduce the future inheritances of those other persons not serving as agent. That creates a real (not theoretical) conflict of interests between the agents and the others that may be affected. This conflict can be dramatically heightened if the durable power of attorney has a gift provision. Who can or should the agent make gifts to?
3. If the agent expends significant money on an experimental medical treatment will the other heirs have a claim for misuse of funds? What if the agent under the financial power of attorney is a different person than the person serving as health proxy? If the person serving as health proxy does not authorize the experimental medical treatments should that change the appropriateness of the agent’s expenditure?
4. The reality is that few agents formally report what they do to anyone. In some instances it might actually be advantageous for the agent to have an attorney petition a court for agent to be appointed as a guardian of the client’s property so that there is court supervision over the expenditures.
5. Whatever is done, what role can an accounting practitioner have in all of this? A tremendous role. Regardless of the circumstances, if the agent retains an independent accountant to record and report the income and expenses to all those who may be affected, it might significantly change the perception of the other heirs and deflect later challenges. This author’s experience has been that one of the common triggers for disgruntled family members (or other heirs) is lack of information. When someone has no idea what is going on, has received no formal communication, they will often assume the worst. And why shouldn’t they if no relevant information has been provided? Siblings often resent that another sibling was named agent before them, or even more so, instead of them. Starting with that feeling, and then compounding it by the sibling serving as agent not informing them, the resentment, frustration and eventually anger, often foment. If instead an independent accountant provides a professional periodic summary of all financial transactions that the agent has made to all affected parties, several results might occur. First, the resentment and suspicions that often drive later family feuds or legal action, may be avoided altogether. Since often these issues never arise formally until after many years have passed, the affected heir complaining will be in a much different position. It will be difficult to argue non-disclosure or inappropriate expenditures when they have received detailed reports prepared by an independent accounting for all intervening years. Perhaps most important, if an accounting practitioner is involved in the process, professional guidance as to expenditures, proper recordkeeping, contemporaneous records, appropriate tax reporting and more, are all likely to be addressed. These are items that while simple and obvious to all accountants, are likely to be overlooked by a non-professional.
6. If the agent is charged with investing the client’s funds, which many if not most are, what investment plan will be pursued and how will it be documented. The CPA practitioner can guide the client to either retain appropriate professional investment counsel and/or create an investment plan and memorialize it in an investment policy statement
7. Much of the above can be based on using data from the client’s Quicken records and guiding the agent to maintain those records while serving in a fiduciary capacity.
Proper recordkeeping and reporting by fiduciaries for our aging population is a practice opportunity that will grow significantly in the future. But the first step to this work is educating clients that those serving as their agents had best retain professional accounting guidance.
√ Gifts Historically Made
A common provision in many powers of attorney is to permit the agents to make gifts. Many standard forms as well as attorney prepared documents have language that in some form permits the agent to make gifts to individuals or charities that the client has historically made gifts to. How can one determine to whom gifts were historically made? While a Form 1040 might be useful for purposes of charitable gifts, Quicken reports should provide a comprehensive listing of all gifts to all people that can support the actions of an agent.
Conclusion
A local practitioner with a modicum of effort reviewing a client’s expenditures can often identify a range of significant life changing events before anyone else is aware of them. Expanding estate planning services into the arena of later life planning to help safeguard and secure a client’s future can be a great practice development opportunity for the practitioner, and literally a lifesaver for the client. In most cases clients will be reticent to address this type of planning. They will believe they are not in need of these services, that the cost is too great, and more. The range of excuses proffered will likely be creative and even amusing. The reality is that no one knows when and to what extent their cognitive or physical skills will begin to decline, or when that decline; will expose them to abuse or other problems. Identity theft and elder financial abuse are not burgeoning because the American public has taken every prudent and practical step to protect themselves. They are exploding in occurrence precisely because most people don’t act until it is too late.
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
- Details
- Written by: Martin M. Shenkman
Form 709 for 2010 will be the most complex gift tax return you will complete during your career as a result of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Act). Gift tax returns are considered by some practitioners to be rather simple, when they are anything but.
You have to understand which gift transfers have to be reported. This is often not obvious.
The requirements to ensure “adequate disclosure” are onerous, and it is easy to overlook something that might be necessary. Some of the documents that should be disclosed are often prepared by the client’s attorney or held by the client’s financial planner and may not be readily available in the practitioner’s file.
Reporting generation skipping transfers (GST) is extraordinarily complex in “normal” years. Determining whether or not a particular transfer is subject to the GST tax can be daunting. Ascertaining whether or not the GST automatic allocation rules apply to automatically allocate GST exemption creates yet another layer of complexity.
The following checklist will focus on the changes and how they may affect this year’s Form 709:
Filing Due Date Complexity
April 18, 2011 is the actual due date for 2010 individual income tax returns and gift tax returns reporting 2010 gifts or GST. However, the 2010 Act granted a nine-month extension for certain items. So, September 19, 2011 is the extended deadline for the 2010 Act filing and payment leniency. This is confusing since the 2010 Act extension provision does not provide an extension for gift tax returns, although there is an extension for reporting transfers that have a GST tax impact. It appears that the allocation of GST exemption (or a decision not to allocate GST exemption or to expressly choose not to have the automatic GST exemption allocation rules apply) is extended. These decisions are generally reported on the same gift tax return, Form 709 that transfers subject to the gift tax are reported on.
It is possible that the gift tax return for 2010 could have two separate filing requirements; one for reporting gifts, which does not benefit from the special extension rules and one for reporting the GST implications of the same gifts, which is afforded the leniency of the extension. If so, then those filing these returns will have to determine how to address potentially different filings and different deadlines for the same gifts.
The safe answer is to file without regard to the extension period and only use that grace period if a change must be made to the original filing. An individual taxpayer who extends his or her income tax return can defer filing until October 17, which would extend the due date for the gift tax return. Given the complexity of these returns it is perhaps advisable to extend the due date for the filing of the decedent’s personal income tax return until October and thereby extend the filing of the gift tax return.
GST Automatic Allocation Opt-Out
GST transfers made in 2010 qualify for a zero percent GST tax rate so that there may be no advantage to also allocating GST exemption to those transfers. However, if the automatic allocation of GST exemption rules would apply, affirmatively opting out of that automatic allocation may be important to avoid wasting GST exemption. The opt out must be made on timely filed gift tax return. A client who might not otherwise have had to file a return might have to file merely to opt out.
The decision to opt out will not be obvious. If a client set up a trust in 2010 only for grandchildren (skip persons), the trust itself should be characterized as a skip person. The GST tax on a transfer to such a trust in 2010 was zero. If the trust will distribute out all trust assets to grandchildren a GST tax will never be assessed. For these types of trusts opting out of automatic GST allocation is probably advisable.
However, practitioners must understand the intent for the trust to determine the appropriate gift tax return reporting. If the intent for the trust is to continue in perpetuity beyond the grandchildren’s generation, GST tax may apply on distributions beyond the grandchildren’s generation and perhaps then GST exemption should be allowed to be automatically allocated. Without further analysis, including the possible impact of a disclaimer filed even in 2011, it may be impossible to ascertain the status of the trust. Extra precautions, coordination with the attorney who drafted the trust, and clear communication with the client are essential to make this determination.
Evaluating 2010 GST Trusts
While a trust might look like a typical “grandchild” trust, more in depth analysis is required to know how to file a 2010 gift tax return. For the special 2010 zero GST tax trust planning to succeed, only “skip persons” should have been beneficiaries of the trust. An important issue is confirming that the trust itself is in fact a skip person for GST purpose. This requires that all interests in the trust be held by skip persons (IRC 2613(a)). If no person holds an “interest” in the trust and at no time may a distribution be made to a non-skip person then the trust would qualify. This requires practitioners to carefully review the “interests” in the trusts involved to confirm that only skip people had interests.
Disclaimers
Generally, disclaimers must be filed within nine months of creating an interest or the transferor’s death. The 2010 Act extended the time period for disclaimers for decedent’s dying prior to the December 17, 2010 enactment date for nine months. For decedent’s dying after enactment, the nine-month un-extended deadline will end between September 17-30, 2011, as there are no extensions for decedents dying December 17-31 2010. Clients may wish to disclaim gifts or bequests made in 2010 so that the family unit can take advantage of the zero GST tax rate that applied in 2010. Practitioners will have to confirm before filing a gift tax return whether any later disclaimers affected the transactions being reported.
Undesired Gifts
For much of 2010 the 35% gift tax rate looked like a bargain in contrast to the 55%. Some taxpayers, especially wealthy elderly taxpayers, may have made substantial taxable gifts in 2010 to lock in what had thought would be a 20% lower rate. With the unexpected enactment of a 35% rate and $5 million gift exemption most of these taxpayers would have been better off not making those gifts, or at least delaying them until January 1, 2011.
Some advisors have endeavored to undue these gifts in light of the unfairness that the tax law uncertainty created. Some of these prior gifts might be renounced or other steps taken to “unwind” them. Some advisors have speculated that it might be feasible to make a rescission of the gift. Other practitioners have speculated that such gifts might be unwound based on a mistake of fact. Practitioners need to be alert to these transactions and how they are reported. Careful consideration should be given to fully disclosing the initial gifts and any positions taken as to how they were unwound or rescinded.
In the case, Breakiron v. Gudonis, 2010-2 USTC ¶ 60,597 (D. Mass. 2010), the parents created a qualified personal residence trust (“QPRT”). A remainder beneficiary was advised by his tax professional that he could disclaim the interests within nine months after the end of the parent’s retained interests. The disclaimer was valid under state law, but violated the time requirements under IRC Sec. 2518. The IRS assessed gift tax on the untimely disclaimer. To salvage the situation, the beneficiary went to district court and the court held that he could rescind the disclaimer voiding the taxable gift.
Qualified Severances
The unique 2010 GST tax rules provided another planning opportunity that practitioners need to be alert for. If a client created a trust that had a GST inclusion ratio greater than zero but less than one, this undesirable GST status could have been resolved by dividing the trust into two.
Assume, for example, that the inclusion ratio was .7. In 2010 it was possible because of the special 2010 Tax Act GST provisions to make distributions to skip persons when the GST tax rate was zero. The practitioner may have recommended that the above trust be divided in a “qualified severance.” The objective would have been to divide the trust into two parts. One part would be 30% of the whole, have a GST inclusion ratio of zero, and therefore be entirely GST exempt. The other part would be 70% of the whole with a GST inclusion ratio of 1 and be fully non-GST exempt.
If this severance were completed in 2010 the trustee could have (assuming the governing instrument so permitted) distributed the property out of the larger non-GST-exempt trust to skip persons when the GST tax rate applicable to the transfer was zero. The only trust left would be the fully GST-exempt trust. It will not be sufficient in 2010 to merely assume the clients are working with the same trusts that practitioners reported transfers to in prior years.
REVIEW QUESTION
True or False? A charity may be a beneficiary of a special 2010 zero GST.
Answer: False
For the special 2010 zero GST tax trust planning to succeed, only “skip-persons” should have been beneficiaries of the trust.
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