The Lobb Report, Volume 5 | Mark Lobb

Mark Lobb is an attorney with Lobb and Cliff, a law firm specializing in tax and estate planning who is also a part of the Inland Empire Business Doctors, a group which we are a member of. The Lobb Report has been so informative, we got permission to reprint it here. Enjoy. – Ed.

The Lobb Report

Lobb & Cliff, LLP

Volume 5, January 3, 2011

Happy 2011!  As you know, a lot happened in Washington D.C. during the last three weeks of last year.  Below is a brief analysis of laws and extended laws which concern you and your business.

President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (referred to in this e-mail as the “Band-Aid”) into law on December 17. The Band-Aid includes the all important extension of the 2001/2003 Bush administration tax cuts for two years.  Our government gave Band-Aids to everyone in every tax bracket.  We also have a new two year Band-Aid as it concerns estate tax provisions.  The Band-Aid includes not only an extension of some current laws, but also contains some new laws, so don’t look at the Band-Aid as business as usual.

If my math is correct, there will be an election in November of 2012.  The timing may cause more Band-Aid legislation and last minute deals.  However, I predict the Band-Aid legislation will lapse and we will revert back to the 2001 rates going into 2013.  I say this because I do not see Congress and the President coming to terms in order to ink a new deal in the next election year.   If the Democrats believe they will be able to take back the House and hold onto the Senate and the Executive office as 2012 comes to a close, they will have no incentive to negotiate with the Republican controlled House.  If the Republicans believe they will take the Senate and Executive office, they will have no incentive to deal with the Democrats in 2012.  It may be that early in 2013, a new tax bill is negotiated and signed into law with an effective date retroactive to January 1, 2013.   This gives us a lot to think about in regards to selling capital assets, estate planning, succession planning, etc. as we move through the next two years.

For the next two years, we will have the following rate provisions:

Individual Tax Rates: The individual income tax rate brackets will be at 10%, 25%, 28%, 33% and 35%.  The threatened highest rate approaching 40% has been avoided.

Capital Gains Rates: The capital gains rates will remain at 0% for taxpayers below the 25% bracket and 15% for those in the 25% rate and above.  As you may recall, the rates were to revert back to 10% for those under the 25% bracket and 20% for those above the 25% bracket… bullet dodged again!

Dividend Rates: Dividend rates will track capital gains rates with a 0% rate for persons below the 25% bracket and 15% for everyone else.  Without the Band-Aid, dividends were to be taxed at the ordinary income rates.

The Band-Aid as it concerns tax is extensive and I am not going to discuss it entirely in this e-mail.  However, I will review some of what I deem to be the provisions relevant to my clients and their businesses.

Employee Payroll Tax Cut. Are you ready for a holiday?  For 2011 only, the Band-Aid reduces the Social Security tax rate on employees from 6.2% to 4.2%.  It also reduces the self-employment tax (SECA) rate from 12.4% to 10.4%.

The Band-Aid does not reduce the Social Security contribution base, which is $106,800 for 2011. Thus, the maximum Social Security (not Medicare) tax in 2011 for employees is $4,485.60. The self-employment tax deduction, which is normally one-half the self-employment tax, is updated so the full “employer-side” 7.65% tax is still deductible.

Exclusion of 100 Percent of Gain on Certain Small Business Stock. You may want to start a new “C” corporation in 2011.  I had many clients start “C” corporations at the end of 2010 as a result of the potential sunset of this law. The Band-Aid extends the 100% exclusion of the gain from the sale of qualifying small business stock acquired before 2012, and held for more than five years. In addition, the alternative minimum tax preference item attributable for the sale remains eliminated. Qualifying small business stock is stock from a C corporation whose (1) gross assets do not exceed $50 million (including the proceeds received from the issuance of the stock), and (2) meets a specific active business requirement. The amount of gain eligible for the exclusion from tax is limited to the greater of 10 times the taxpayer’s basis in the stock or $10 million of gain from the sale of the stock of the “C” corporation.

Alternative Minimum Tax Exemption Amount and Credit Relief. The Band-Aid puts in place a 2-year patch for the AMT. The Band-Aid increases the AMT exemption amount to $72,450 for tax years beginning in 2010, and $74,450 for tax years beginning in 2011. For an individual who is not married and is not a surviving spouse, the exemption amount is $47,450 for tax years beginning in 2010, and $48,450 for tax years beginning in 2011. For married taxpayers filing separate returns, the exemption amount is half of the married filing jointly amount. In addition, both the personal credits and nonrefundable credits can offset AMT through 2011.

Repeal of Phase-out for Personal Exemptions. The phase out of the personal exemption (referred to as PEP) for higher income individuals had been gradually decreasing, so that by 2010, the phase-out was entirely repealed. The Band-Aid extends the repeal of PEP for an additional two years, through 2012. Personal exemption amounts will continue to be allowed regardless of the taxpayer’s income.

Phase-out of Overall Limitation on Itemized Deductions. Similar to the PEP, the phase-out of the overall limitation on deductions for higher income taxpayers had gradually decreased until its 2010 complete repeal. The Band-Aid extends this repeal for an additional two years, through 2012.

Contributions of Capital Gain Real Property Made for Conservation Purposes. The Band-Aid extends, from 2009, the increased contribution limitations and carryover period for charitable contributions of certain conservation property for contributions made through December 31, 2011.

Tax-free Distributions from Individual Retirement Plans for Charitable Purposes. Through 2011, the Band-Aid allows taxpayers age 70 1/2 or older to make tax-free distributions to charities from their traditional individual retirement accounts (IRAs) and Roth IRAs up to $100,000 per taxpayer, per taxable year. Although this provision expired at the end of 2009, the Band-Aid permits individuals to make charitable transfers during January of 2011 as if they were made during 2010.

Deduction for Mortgage Insurance Premiums. The Band-Aid extends for one year, through 2011, the itemized deduction for the cost of mortgage insurance on a qualified personal residence. The deduction is phased-out ratably by 10% for each $1,000 by which the taxpayer’s adjusted gross income (AGI) exceeds $100,000, so that the deduction is unavailable for a taxpayer with an AGI in excess of $110,000.

Above-the-line Deduction for Qualified Tuition and Related Expenses. The Band-Aid extends, from 2009, the above-the-line deduction for qualified tuition and related expenses through 2011. The maximum deduction is $4,000 for taxpayers with adjusted gross incomes not exceeding $65,000 ($130,000 for joint returns) and $2,000 for taxpayers with adjusted gross incomes not exceeding $80,000 ($160,000 for joint returns).  This provision does not help those receiving this e-mail, but I included it because its application is brought up in meetings from time-to-time.

Coverdell Education Savings Accounts. These are tax-exempt savings accounts used to pay the higher education expenses of a designated beneficiary. The $2,000 annual contribution amount and expanded definition of education expenses to include elementary and secondary school expenses are extended by the Band-Aid for an additional two years, through 2012.

Exclusion for Employer-provided Educational Assistance. An employee may exclude from gross income up to $5,250 for income and employment tax purposes per year of employer-provided education assistance. Earlier legislation expanded this provision to include graduate as well as undergraduate education through the end of 2010. The Band-Aid extends this expansion of the exclusion for an additional two years, through 2012.

Extension of Grants for Specified Energy Property in Lieu of Tax Credits. The Band-Aid extends through 2011 the 2009 American Recovery and Reinvestment Act provision that allows taxpayers to apply for grants for specified energy property in lieu of tax credits.

Credit for Non-business Energy Property. The Band-Aid extends, from 2010, the non-business energy property credit to property placed in service on or before December 31, 2011, but utilizes the credit structure and rates that existed before the 2009 American Recovery and Reinvestment Act. Thus, for property installed after December 31, 2010, the credit is 10%, with a maximum of $500, with $200 of that for windows. The Band-Aid prohibits taxpayers from taking the credit for expenditures for qualified energy efficiency improvements made from subsidized energy financing.

Estate and Gift Tax:

Estate Tax: For decedents dying in 2011 and 2012, the Band-Aid greatly reduces the reach of the estate tax by granting estates a $5.0 million exemption for the value of the estate subject to the tax. In 2009, the last year in which there was an estate tax, the exemption was $3.5 million, so this is a significant increase. In addition, the Band-Aid introduces the concept of exemption “portability” between spouses — if one spouse does not use all of his or her $5.0 million exemption, it may be used by the estate of the surviving spouse, effectively creating a $10.0 million exemption for married couples. The estates that exceed this $5.0/$10.0 million threshold will be subject to a new 35% tax rate, considerably lower than the 45% rate that prevailed before 2010.

Gift Tax: Gift Taxes are also lighter. Since 2001, taxpayers have had only a $1.0 million lifetime exemption for gift tax purposes. That exemption is increased to $5.0 million for gifts made in 2011 and 2012, and the tax rate on 2011 and 2012 gifts in excess of that amount is 35%.Estates of Decedents Dying in 2010: The estates of those who died in 2010 faced considerable uncertainty prior to the passage of this legislation. A 2001 law repealed the estate tax for persons dying in 2010, but also imposed a carryover basis regime that required heirs use the decedent’s tax basis for inherited property. Before 2010, inherited property received a basis step-up at death. For some heirs, this 2010 requirement was a greater tax burden than would have been imposed by the estate tax. In addition, there was a risk that the estate tax would be retroactively reinstated for 2010, so many executors did not know what to do.

Congress has now eliminated that uncertainty for 2010 estates. It has repealed carryover basis and reinstated the estate tax for 2010, but with the $5.0 million exemption and a 35% tax rate.  The new law also provides that estates of persons dying in 2010 can elect out of the estate tax, provided that they accept the carryover basis regime.  The estate tax return is normally due nine months after the date of death. In light of the special circumstances in 2010, the Band-Aid extends that filing date as well as the payment date for the tax for 2010 decedents to September 17, 2011.

Generation-Skipping Transfer Tax: The Band-Aid makes a number of changes to the generation-skipping transfer (GST) tax which is an additional tax imposed on gifts and bequests to grandchildren and great-grandchildren. The 2001 legislation repealed the GST tax for 2010 only, but there was a lack of clarity as to the effect of that repeal. The Band-Aid should eliminate that uncertainty, because it provides that the GST tax was in effect in 2010, but with a 0% tax rate. This means that any generation-skipping transfers that occurred in 2010 were tax-free, but that taxpayers could still take advantage of the various GST tax exemptions that could reduce or eliminate the tax in future years.  Going forward, the Band-Aid aligns the GST tax with the reformed estate and gift taxes. In 2011 and 2012, the GST exemption is increased to $5.0 million and the tax rate is 35%. In 2013, the GST tax, like the estate and gift taxes, will revert to a $1.0 million exemption and a 55% tax rate.

Planning Opportunities: With the changes made by the Band-Aid, there are many planning opportunities and additional time to take advantage of last year’s favorable tax laws.

Estates of decedents who died in 2010 now have certainty as to the tax law, but still must decide whether accept the new default regime of a $5.0 million exemption with a 35% tax rate, or to elect the prior 2010 law of no estate tax, but with a carryover basis. If the estate is less than $5.0 million, in most cases it will be best to accept the application of the estate tax and thereby acquire a basis step-up in the assets. But an analysis should still be done to determine whether the heirs are better off with a stepped-up basis or the carryover regime. The Band-Aid also created “portability” of the estate tax exemption, which enables surviving spouses to use the exemption of the predeceased spouse if it was not fully used.  It is worth noting that, if the estate of a married decedent accepts the application of the estate tax in 2010, the portability provisions do not apply to the unused portion of the $5.0 million exemption. Portability applies only to decedents dying in 2011 and 2012.

If an individual is likely to die in 2011 or 2012, his or her estate plan must be reviewed to determine whether it takes full advantage of the $5.0 million exemption and, if applicable, the portability of that exemption. For the great majority of our clients, who intend to live well beyond 2012, the temporary nature of the estate and gift tax changes means that they cannot be relied upon for planning purposes. Congress will revisit the estate, gift and GST taxes in late 2012, and we cannot predict what action it will take at that time.  As stated above, I don’t think we will have the answer until 2013.  Many of you have been reluctant to do any estate planning in light of the legislative uncertainty and the possibility of estate tax repeal.  As I have said many times, always plan as though estate tax will be applied at a 55% rate for estates over $1,000,000.   Estate tax laws as we know them today will change many more times between now and when you or your spouse die.

Asset Protection:

Many of you have your homes titled in a revocable living trust.  A revocable living trust provides no asset protection.  So, the concern is “what do you do with your home to protect it?”

Homestead Exemptions: In California, we have homestead exemptions ranging from $75,000 to $175,000 depending upon circumstances such as whether you are married and living in the same home, 65 years old or older, physically or mentally disabled, etc.   For a homeowner, a judgment creditor can lien your home and once you sell your home, the judgment creditor will be allowed to take any equity in your home above the amount of the homestead exemption.  In addition, if you have equity in your home, the judgment creditor can force a sale of your home to get to the equity.  If the judgment creditor forces a sale of your home, you actually receive your share of the homestead exemption and the judgment creditor gets any remaining amounts.  Obviously, if you have a mortgage on your home, the mortgage holder gets paid before either you or your judgment creditor.

You do not have to file a homestead declaration to receive the exemption unless you voluntarily sell your home after the lien attaches or if the house is foreclosed on by your mortgage holder.  Also, if you own multiple homes, you should file the homestead declaration before the lien attaches to create a presumption that the home in which you want the exemption to apply is your actual dwelling.  There are a lot of rules surrounding “homestead exemptions” so don’t rely entirely on this quick blurb to fully understand “homestead exemptions.”

When you own a home with a mortgage, if your mortgage along with your homestead exemption meets or exceeds the amount of a certain liability or judgment, you do not have an immediate concern of losing your home.  I say immediate because if values come back and suddenly you have equity in your home above the amount of your applicable homestead exemption, if there is a lien on your home, the judgment creditor may be able to foreclose on that lien at a later date.

Installment Sales: If you have no equity or little equity in your home today, you may wish to sell your home to an irrevocable trust.  If you do this, you may continue to live in your home for an extended period, even if you eventually have substantial equity in your home at a later date.  If the trust is properly set  up and the sale follows certain rules, this may be a consideration to protect the home from a current creditor.  We often use grantor defective or beneficiary defective trusts as the buyer of the home.  This is not only a very good asset protection plan, but it also is a fully integrated estate plan.

Qualified Personal Residence Trusts: Many people have asked me about qualified personal residence trusts (“QPRT”).  A QPRT offers some asset protection for your home under certain circumstances but probably not if you fund the trust with your home after a lawsuit has been filed against you our your spouse and certainly not if a judgment has been entered against you or your spouse.

A typical QPRT is a trust created by someone (the “Settlor”) who desires to leave their home to family members at some point in the future. Those family members are usually children of the Settlor.   So, if mom and dad decide to fund their home into a QPRT for their kids, mom and dad will specify in the trust a term which dictates when the kids get the home.  Mom and dad will live in the home until the term expires and then the home becomes the property of the kids.

The core idea is to create an estate plan for the family home which has the benefit of reducing estate and gift taxes.   A QPRT is a better estate planning mechanism than a revocable living trust for the home because the home is funded into the trust at a discounted value and may end up outside the estate of the Settlor when the Settlor dies.  Since I am discussing a QPRT in the context of asset protection, I am not going to fully discuss the estate planning issues, but will do so in another “Lobb Report” later this year.

If you proceed with a QPRT, you must remember it is an irrevocable trust.  This means you cannot change it.  However, if your kids still like you after the stipulated term of years in the trust has expired, they may rent the home to you at favorable rates.  Thus, you may get to live in the home until you die.  Also, the QPRT does not trigger a reassessment of taxes under Proposition 13 as long as the Settlor retains the right to use and occupy the residence.

For asset protection, once you fund the trust, it is no longer your home.  Thus, if you properly and timely fund the QPRT with your home, the home may not be an asset available to a judgment creditor.  The key is a “timely” funding.  Also, you can do fractional interest funding into the trust.  Thus, if you do not want to place your entire home into an irrevocable trust, you can fund less than 100%.  This may be prudent in situations whereby you have equity in your home and you wish to bleed out the equity through gifting into a QPRT to deter any future creditor from trying to execute a judgment on your home.

Most people have their homes in revocable living trusts and although there is no asset protection in such trusts, there is nothing “wrong” in holding title in such a manner.  If you think you will have asset protection needs in the future let me know and we will put it on the agenda for your next quarterly planning meeting.

________________________________________________Mark Lobb

Managing Partner
Lobb & Cliff, LLP
1325 Spruce Street, Suite 300
Riverside, CA  92507
951.788.9410 (Phone)
951.788.0766 (Fax)

IRS Circular 230 Disclosure: Pursuant to Internal Revenue Service Circular 230, only formal opinions satisfying specific requirements may be relied on for the purpose of avoiding certain penalties under the Internal Revenue Code. Any tax advice contained in this communication (including attachments) does not constitute a formal opinion satisfying such requirements. Accordingly, we must advise you that any such tax advice was not intended or written to be used, and cannot be used, by you or any other person as such an opinion for the purpose of (i) avoiding penalties imposed under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.

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