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By Editor, August 15, 2010

Background

As you know, the Bush tax cuts (from legislation enacted in 2001 and 2003) are scheduled to expire at the end of this year. But, you may not understand the full extent of what is in store if Congress allows the expirations to occur without making any changes.

Higher Income Tax Rates for All

Some clients may believe that only individuals in the top two federal income tax brackets will face higher rates when the Bush cuts expire. Not true! Unless Congress takes action and President Obama goes along, rates will automatically go up for everyone who pays taxes—not just “the rich.”

Specifically, the existing 10% bracket will go away, and the lowest “new” bracket will be 15%. The existing 25% bracket will be replaced by the “new” 28% bracket; the existing 28% bracket will be replaced by the “new” 31% bracket; the existing 33% bracket will be replaced by the “new” 36% bracket; and the existing 35% bracket will be replaced by the “new” 39.6% bracket. [See IRC Sec. 1(i) .] Appendix 1 shows income levels in each of these brackets for 2010 and 2011 assuming that there are no inflation adjustments between 2010 and 2011.

Outlook: The Administration has pledged to keep the three lowest brackets (the 10%, 15%, and 25% brackets) in place. The 28% bracket would be expanded to accommodate unmarried taxpayers with income (whatever that is determined to mean) below $200,000 and joint filers with income below $250,000. Only taxpayers with income above those levels would be affected by the new 36% and 39.6% rates. As stated above, however, Congress must make changes, and the president must go along for these things to happen. Right now, that is looking more problematic than a few months ago, and it now appears that Congress will not even bring up the subject until sometime after returning from its summer recess in August. To sum up, the only thing we know for sure is that tax rates will go up for everyone if Congress sits on its hands.

Marriage Penalty Will Get Worse

Right now, the 10% and 15% rate brackets for married joint-filing couples are 200% as wide as the 10% and 15% brackets for singles. Similarly, the standard deduction for joint-filing couples is 200% of the amount for singles. Right now, the 10% and 15% rate brackets for those who use married filing separate status are the same as the 10% and 15% brackets for singles. Similarly, the standard deduction for those who use married filing separate status is the same as the standard deduction for singles.

The Bush tax cuts put this relatively favorable framework for married individuals in place to reduce the so-called marriage penalty, which can cause a married couple to pay more federal income tax than if they were single. Note that the marriage penalty still exists for many married couples, but it’s not as harsh as before the Bush tax cuts. [See IRC Secs. 1(f) and 63(c) .] However, unless Congress makes changes and the president goes along, the marriage penalty will automatically get worse when the Bush tax cuts expire.

Starting next year, the new lowest bracket of 15% for Married Filing Joint (MFJ) couples will be only 167% as wide as the 15% bracket for singles—for Married Filing Separate (MFS) couples, it’ll be 83.5% as wide as the 15% bracket for singles. Similarly, the new standard deduction for joint-filers will be only 167% of the standard deduction for singles. For MFS status, it’ll be only 83.5% of the amount for singles.

Outlook: Presumably, the Administration’s pledge to keep things the same for lower and middle-income taxpayers includes extending the Bush tax cut elements that reduce the impact of the marriage penalty. However, extending those elements would require Congress to make changes and the president to go along. Will it happen? We don’t know, and neither does anyone else.

Itemized Deduction Phase-out Rule Will Return with a Vengeance

Before the Bush tax cuts, a nasty phase-out rule could eliminate up to 80% of affected itemized deductions for higher-income individuals. The phase-out rule covered the big-ticket deductions for mortgage interest, state and local taxes, and charitable donations. Deductions for medical expenses, investment interest expense, casualty and theft losses, and gambling losses were not affected. Thanks to the Bush tax cuts, the phase-out rule was gradually eased and finally eliminated this year. Next year, however, it will automatically return with a vengeance, unless Congress takes action and the president goes along.

If nothing changes, clients will lose $1 of affected deductions for every $3 of AGI in excess of the applicable AGI threshold (subject to the 80% disallowance limitation), starting next year. The threshold for 2011 is estimated to be $171,100 (or $85,550 for those who use MFS status). (See IRC Sec. 68 .)

Outlook: The Administration has said it wants the phase-out rule back, but at higher AGI thresholds of $250,000 for married joint-filing couples and $200,000 for other taxpayers. However, raising the AGI thresholds would require Congress to take action and the president to go along. Don’t bet the house on it.

Personal Exemption Phase-out Rule Will Return with a Vengeance

Before the Bush tax cuts, another nasty phase-out rule could eliminate some or all of a higher-income individual’s personal exemption deductions. Thanks to the Bush tax cuts, this phase-out rule was gradually eased and finally eliminated this year. Starting next year, it will automatically return with a vengeance, unless Congress takes action and the president goes along. [See IRC Sec. 151(d)(3) .]

If nothing changes, taxpayers need to be ready for yet another bite out of their wallets if their 2011 AGI exceeds the applicable threshold. The phase-out thresholds for 2011 are estimated to be $256,700 for MFJ; $171,100 for singles; $213,900 for heads of households; and $128,350 for MFS.

Outlook: The Administration has said it wants the phase-out rule back, but at different AGI thresholds: $250,000 for married joint-filing couples, $200,000 for unmarried individuals, and $125,000 for those who use married filing separate status. Since this is pretty close to what will happen without any making changes, it would not be surprising if Congress chooses to do nothing.

Higher Capital Gains and Dividends Taxes for All

Right now, the maximum federal rate on garden-variety long-term capital gains and qualified dividends is 15%. (As you know, a 25% maximum rate applies to unrecaptured Section 1250 gains, and a 28% maximum rate applies to long-term gains from collectibles.) Starting next year, the maximum rate on garden-variety long-term capital gains will increase to 20% (or 18% on gains from assets held for over five years). Starting next year, dividends will once again be taxed at ordinary income rates. So, the maximum rate on dividends will balloon to a whopping 39.6%.

Right now, a 0% federal rate applies to garden-variety long-term capital gains and qualified dividends collected by folks in lowest two rate brackets of 10% and 15%. Starting next year, folks in the “new” lowest bracket of 15% will have to pay 10% on long-term gains (or 8% on gains from assets held for over five years) and 15% on dividends (since dividends will be taxed at ordinary income rates). Again—these things will happen automatically, unless Congress takes action and the president goes along. [See IRC Sec. 1(h) .]

Outlook: The Administration has repeatedly said the current 0% and 15% rates on long-term capital gains and qualified dividends will be left in place except for married couples with income above $250,000 and unmarried individuals with income above $200,000. For this to happen, however, Congress must take action and the president must go along. A few months ago that looked likely, but now it looks more problematic. In particular, we think the odds are rising that dividends will once again be taxed at ordinary rates (of up to 39.6%), starting next year. We hope we are wrong.

Some Bush Tax Cuts Are Likely to Be Continued

Some elements of the Bush tax cuts have gained bipartisan support and become “extenders.” They will probably be continued, despite the scheduled demise of the Bush tax cuts. Examples include inflation-indexed AMT exemption amounts, the ability to use nonrefundable personal tax credits to offset individual AMT liabilities, the above-the-line deduction for qualified higher education tuition and fees, and the increased Section 179 deduction. We also think the current versions of the child tax credit, earned income credit, dependent care credit, and adoption credit are also likely to be continued, despite the scheduled demise of other elements of the Bush tax cuts. (The Bush tax cut legislation liberalized these credits, and later legislation liberalized them even more).

Conclusions

Despite what some people think, the Bush tax cuts don’t just help “the rich.” They help just about anyone who pays federal income taxes, including people who only file returns to collect free money from the government thanks to refundable tax credits. The scheduled demise of the Bush tax cuts next year will hurt lots of people, unless Congress makes changes and the president jumps on board.

Our Washington politicians don’t seem to be in a big hurry to resolve the many tax uncertainties that we have summarized here. Even worse, it appears the odds are increasing that we may not see resolution until after the November election.

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By Editor, August 3, 2010

It is a common misconception that trusts are only for the wealthy.  If you have children, particularly minor children, a trust is one of the best ways you can provide for them if something were to happen to you…no matter the size of your estate.

Trusts are effective tools that can put you in control of who will manage the assets (including life insurance) for the benefit of your children and when your children will receive their inheritance.

Here are a few examples of how a trust can be beneficial:

Blended Families:  A bypass trust can be used to provide for children from a prior marriage.

Jeff and Jane are married and each has a child from a previous marriage.  Jane inherited the farm from her family and wants to pass it on to her daughter.  A bypass trust can be used to make sure that Jeff could still enjoy the income from and use of the farm if Jane dies first, but then upon Jeff’s death, the trustee would distribute the assets to Jane’s daughter. If the farm was left to Jane’s daughter directly in the will, it would leave Jeff in the uncomfortable position to ask if he could remain there or he could not stop her if she decided to sell the property.  Or, if Jane left the property directly to Jeff in the will, his son could ultimately end up with all or part of it.

Special Needs: A Special Needs Trust can provide for disabled children

Stephen and Sarah have a 7 year old daughter with Down syndrome.  They want to provide for her needs if they were to pass away or become disabled, but don’t want to disqualify her from receiving Social Security disability benefits.  She cannot have more than $2,000 in her own name without losing the benefits.  Using whole life insurance policies, they fund a special needs trust, where the trust is the owner of the policy.  Additionally, Sarah’s mother wants to name the grandchild as beneficiary of assets in her will, but will name the trust instead.

Asset Protection: A Spendthrift trust can provide for children who might not be able to manage money

Ryan and Rachel don’t have any children, but want to leave their assets to their only relative, a 20 year old nephew.  They create a spendthrift trust to provide asset protection for him.  As beneficiary, he receives the benefit of the trust, but cannot demand benefits from the trust.  The trustee has the power to provide for the beneficiary by paying his living and educational expenses directly to the provider and the nephew doesn’t have control over the benefits.  Provisions can be drafted so that control can change as he gets older, or can never have control if he cannot be trusted with the money.

Motivation:  An Incentive trust can provide motivation for children to make worthwhile decisions

George and Gale have three teenage children.  They worry their children will do nothing with their lives because they are anticipating a large inheritance.  They also want their children to understand the value of work and believe that earning your way through life is better than living off an inheritance.  They set up an incentive trust for each of their children with provisions to address these concerns.  The trustee is given guidance to reward each child for graduating from college then matching each child’s personally earned income in every calendar year not to exceed $100,000.  When the child reaches age 30, other incentives are specified. 

Life Insurance: A life insurance trust can ensure the money is used to benefit your children

Dean and Dianne name Dianne’s sister guardian of their two minor children if something were to happen to both of them.  Since the children are minors, they cannot be named directly as beneficiaries of their life insurance policies.  Dianne’s sister is great with children, but they are worried about her managing the life insurance proceeds.  They set up a life insurance trust and name the trust as the owner and beneficiary of the policy.  They then name the children as beneficiaries of the trust.  They name Dean’s brother, as trustee of the trust.  Trusts must be followed as they are written. If the money is ever abused, family members will have more legal leverage to get the situation corrected with a judge than if the proceeds were left out of trust. 

Trusts can be designed to fit any family’s particular situation or needs. Some trusts may provide for broad, liberal distributions over a short number of years, where others may provide strict requirements, assuring that the trust will last for the child’s lifetime and beyond.  Parents should be involved in the design of the trust to ensure the right fit.  If thoughtfully structured, you can have the peace of mind that you have provided for your children financially and how you see best fits them individually.

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By Editor, August 3, 2010

As your parents age, pay close attention to their mental health, as well as their physical health. Advanced age or illness can impair their intellectual ability to manage day-to-day activities, making the need for an incapacity determination a possibility.

The issue of incapacity can bring about gut-wrenching decisions that are worthy of some advanced planning and thought.

If you observe a parent’s declining mental condition, you may have to make the difficult decision to have him declared incompetent. A guardian or conservator will then be appointed by a judge to manage his affairs.

What is “capacity?”

“Capacity,” generally means the mental ability to adequately function and live in the manner to which one is accustomed, but the legal definition can vary from state to state. If a person is unable to adequately care for their own health or financial needs, an adjudication process to determine their competency may be necessary.

What is a guardian or conservator?

If incapacity has been determined by a judge and a guardian or conservator has been appointed, the guardianship or conservatorship will specify the extent of duties.  They may be responsible for managing all aspects of your parent’s life or a narrower scope, such as financial matters.  They will owe a duty of care to your parents and will be held accountable by the court to demonstrate appropriate actions. The guardian or conservator is often a child or adult grandchild, but doesn’t have to be a family member.

Asking for assistance

Ideally, an elderly parent knows he needs assistance and asks for help.  In this circumstance, the expense and emotional charge of a guardianship proceeding can be avoided. There are various ways to assist your parents, such as:

Power of attorney

Your parents may still be legally competent to make decisions, but consent to give you or another trusted individual the legal right to act on his behalf for financial and health care matters.  This is similar to a guardianship or conservatorship.

Paying bills

If you are unable to write checks and pay your parent’s bills, you can hire a professional firm to provide the service.  Delegating the work could free up time and energy for you to focus on other things, while still maintaining a sense of control.

If you face decisions involving the capacity of your parents, understanding the roles of a guardian or conservator makes it somewhat easier.  Advance communication with your parents and family members is also key.

Contact Wilson Price Family Office  for more information about how to plan for a parent’s incapacity, guardianship or conservatorship.

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By Editor, August 3, 2010

You can typically name beneficiaries for a variety of assets, including retirement plans, annuities and life insurance policies.  But naming a beneficiary is not as simple as putting a name on a form; it should involve careful consideration, as the repercussions for your loved ones could be significant.

Out-of-date

If you haven’t reviewed your beneficiary designations recently, it’s possible the designations are no longer appropriate.  Review your designations on a regular basis, ideally annually, and when major life events occur, such as marriage, divorce, birth or death.  The assets are passed outside of legal proceedings and the designation is absolutely binding.  The assignment of assets cannot be superseded, not even by a Will. 

Be Specific

Most beneficiary designation forms allow you to name more than one primary and contingent beneficiary with specified percentage of assets.  Be specific and name each versus naming one trusted relative or friend to distribute the assets for you.  If no beneficiary is named, the assets will be distributed through the probate process, which in the case of a retirement plan, can create adverse tax consequences.

Tax Consequences

With life insurance, the goal is to keep the proceeds out of your estate.  If your spouse doesn’t need the money after you are gone, policies (existing or new) can be structured in various ways to keep life insurance from increasing the value of your estate.  This will be even more apparent next year if the estate tax exemption falls to $1 million.  Life insurance may play a major role in creating taxable estates for those who wouldn’t normally have the issue. This estate tax issue can be avoided in many cases if structured properly. 

Regardless of the beneficiary designation, retirement plans, however, will be includable in the value of the estate.  It is important, though, to make sure the designation is not left blank or that “the estate” is not named as the beneficiary.  In these cases, the retirement assets must be distributed within 5 years or at least as fast as the decedent was receiving required minimum distributions (RMDs), thus triggering a quicker income taxability of the assets in addition to the estate taxability. If your family does not need the funds for living expenses, the goal here is to defer distributions as long as possible, “stretching” the assets over longer life expectancies.  This can be accomplished by naming an individual as beneficiary.

Other considerations

To avoid taxable distributions altogether, you could donate your retirement plan to a charity if other assets are available to provide for your family.  Not only will the organization receive the assets tax-free, but your estate will also be eligible for a charitable deduction.

You can name almost anyone as your beneficiary, including individuals, charities and trusts, but minor children, however, cannot be named beneficiaries of life insurance policies, retirement plans or annuities. Additionally, if you are considering designating a special-needs person as your beneficiary, it may hinder the individual’s eligibility for government provided benefits.

There are various ways to still provide for those you want to benefit after you are gone, but with careful planning with an accredited estate planner.

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By Editor, August 3, 2010

As we all face five more months of 2010 with our hands still in the air on the issue of estate tax repeal, you might be wondering, “What’s the deal?”

Though we don’t profess to have all the answers, we do have some insight on where things currently stand. 

Both the House and Senate will adjourn this Friday, August 6, for a five week recess, reconvening on September 13, 2010.  The first estate tax return (Form 706) for a 2010 decedent would potentially be due October 1, 2010 if retroactive legislation were to reinstate the estate tax this year. However, “there is no agreement on the estate tax either in substance or process. None whatsoever,” said Max Baucus (D-MT), Senate Finance Committee Chairman, in May 2010. 

Baucus abandoned efforts to temporarily extend the estate tax in December 2009 due to republican opposition despite the successful passing of H.R. 4154 in the House a week earlier, permanently extending 2009 estate tax levels.  The House bill was read for a second time on January 20, 2010, making it available for consideration by the Senate at any time.

A few new bills have been introduced this year addressing the repeal. Most notably, S. 3533, introduced on June 24, 2010, a bill sponsored by Vermont Independent, Bernard Sanders, retroactively reinstating the estate and GST taxes for 2010 with exemptions starting at $750,000 to $3.5 million and ranging rates from 39% to 45%.  The bill also introduces additional bracket levels of $10 million, $50 million and $500 million taxed at 50%, 55% and 65%, respectively.  California Representative, Linda Sanchez (D-CA) introduced an identical bill in the House on July 15, 2010, H.R. 5764: The Responsible Estate Tax Act.

Republicans, however, have taken a different approach and attempted to attach an amendment to the Small business lending bill or Jobs bill, setting the exemption at $5 million and 35%. There would be an option for each estate to choose whether to apply retroactively or not.  The bill passed the House in June 2010, but without the amendment so far. The Senate has their own version of this bill and there has been some commentary that the issue of the estate tax could be used to gain republican support of the bill.  Yet, on July 29, 2010, all 41 Senate Republicans filibustered the bill, wanting the opportunity to add a few amendments (the estate tax being one of them). 

Though permanent repeal of the estate tax is an unlikely option, Senator DeMint (R-SC) made such a motion on July 22, 2010, but was defeated by a 39-59 roll call vote. 

As we approach a mid-term election in November, it seems politically impractical to grant the wealthy an estate tax break by increasing the exemption to $5 million or higher with a lower rate of 35%.  However, if Congress doesn’t take action, the exemption will fall to $1 million with a top rate of 55% come January 1, 2011.  Perhaps this is Congress’ desire, as these levels could generate revenue of over $400 billion over the next 10 years. Additionally, revenue will be seen from the sale of assets inherited this year, potentially more revenue than would have been collected if we were at $3.5 million this year instead of repeal. The new surge of gift tax revenue this year (because of the lower 35% gift tax rate) is estimated to generate more than $14 billion.

Lack of consensus on reform in 2010 has left estate planning analogous to strategies in a chess game – only everyone is keeping their hands on the pieces.