Tax Planning for Businesses: What You Need to Know for 2020
BY: Salvatore Schibell, Lawson, Rescinio, Schibell & Associates
The Current Tax Climate
After the passing of the Tax Cuts and Jobs Act in December 2017 (TCJA), which was the most significant set of changes to the U.S. tax code in 30 years, 2019 is a relatively stable year for tax changes. The large majority of the TCJA changes went into effect for the 2018 tax year. As a recap, the TCJA legislation cut the top corporate tax rate to 21%, lowered the top marginal rate for individual taxpayers to 37%, eliminated or scaled back several deductions, reduced taxes on business income earned by pass-through businesses, doubled the estate tax exemption and enhanced immediate expensing of capital investments. Apart from these changes introduced in 2018, here are some 2019 highlights:
There continue to be seven tax brackets in 2019, a change from five was made in 2018. For individuals the top tax rate of 37% applies to those with taxable income of $510,301 in 2019, up from $500,001 in 2018, and $612,351 in 2019, up from $600,001 in 2018. The standard deduction for heads of household will increase $350 to $18,350 in 2019. Estates will have an exemption of $11,400,000 in 2019, up $220,000 from 2018.
In 2019, the maximum amount of workers can contribute to their 401(k) rose $500 from 2018. The amount is $19,000 ($25,000 for workers over age 50 in 2019). IRA amounts rose $500 to $6,000 ($7,000 for those over age 50). Given the changing nature of tax law and the complexity of our tax rules, planning is essential.
The purpose of this article is to provide the reader with a broad overview of important tax issues affecting business in a manner not too overburdened with the detail in the law.
Choosing a Business Structure
As your business grows or your personal financial situation changes, the business form in which you operate may need to change, as well. Keep in mind that the business structure you choose impacts your personal liability, as well as the amount of tax owed by you and your company. Choosing the right structure at the onset is important. Changing the business structure later could have tax consequences. Each business structure has its advantages and disadvantages.
C corporations are taxed as entities separate from their shareholders, and you pay taxes as an investor on dividends received—the so-called “double taxation.” The taxes incurred in liquidating a C corporation will be much higher than those of an S corporation or partnership because tax gets paid on gains at the corporate level at 21% and upon liquidation, tax will be paid on the liquidating gain at individual rates. Salary paid to you and other shareholders must be reasonable, or a portion of it may be reclassified as a nondeductible dividend payment, meaning double taxation on the income earned by the C corporation and dividends paid to shareholders. If earnings are accumulated beyond the corporation’s reasonable needs, an additional tax of 21% may be imposed on these earnings. Federal marginal tax rates are a flat 21%. Distributions are be taxed again as dividends. Shareholders pay tax on dividends. Losses do not pass through to shareholders.
S corporations generally pay no tax, and income and losses are passed through to shareholders. The permissible number of shareholders is 100, and eligible members of the same family may be treated as a single shareholder. Estates, certain trusts, and tax-exempt organizations may also be shareholders. S corporations avoid the double taxation inherent in C corporations, but they must follow strict rules. S corporations that were previously C corporations can trigger corporate-level tax in certain situations. The amount of time that an S corporation that has converted from a C corporation must hold onto its assets to avoid taxes on any built-in gains at the time of the conversion was shortened from ten years to seven years. Under the Small Business Jobs Act of 2010, this holding period was further shortened to five years, and under the Protecting Americans from Tax Hikes (PATH) Act of 2015, this change to five years was made permanent. S corporations may own any percentage of the stock of other corporations. Fully owned subsidiaries may also elect “S” status, but the qualified subsidiary is a disregarded entity for tax purposes. Generally, no Federal tax is imposed on the business entity. Income and expenses are allocated among shareholders. Taxable income is subject to individual rates from 10% to 37%, whether profits are distributed or not. Losses pass through to shareholders. Restrictions on loss deductibility apply. State treatment of S corporations may vary.
Partnerships avoid corporate double taxation and usually allow more flexibility in distributions and allocations of tax items than either a C or S corporation. Family limited partnerships (FLPs) offer a number of benefits: you can split income with your children, realize estate tax savings, and continue to control assets transferred to the partnership. However, family limited partnerships must be carefully structured, as they are closely monitored by the IRS. No Federal tax is imposed on the business entity. Income and expenses are allocated among partners, and each pays tax of 10% to 37% (plus self-employment tax, if applicable) on their share of partnership profits, whether distributed or not. Losses pass through to partners. Restrictions on loss deductibility apply. Personal liability generally rests with the partners in a general partnership.
LLCs & LLPs*
Limited liability companies (LLCs) and limited liability partnerships (LLPs) generally offer limited liability and flow-through taxation. They have a flexible structure, which allows any entity, including a corporation, to be an owner. Special allocations of income and losses, as well as investments in other entities, are not limited. No Federal tax is imposed on the business entity. Income and expenses are allocated to members or partners, and each pays tax of 10% to 37% (plus self-employment tax, if applicable) on their share of LLC or LLP profit, whether distributed or not. Losses pass through to members or partners. Restrictions on loss deductibility apply.
If you are a sole proprietor, your personal return is your business return. If you risk substantial business liability, consider some form of incorporation, LLC, or LLP to protect your personal assets. Reported on Schedule C of Form 1040, income is subject to individual rates of 10% to 37%, plus self-employment tax. Shareholders are shielded from personal liability for business debts. Only their investment is at risk.
* Owners of business entities, which are not taxed as “C” corporations, are eligible for a 20% Qualified Business Income (QBI) deduction. The deduction for QBI may be limited and/or subject to phase-out, depending on the taxable income of the individual, as well as such factors as the type of business, amount of wages paid by the business, and amount of capital assets owned by the business. For income above $321,400, the legislation phases in limits on what otherwise would be an effective marginal rate of not more than 29.6%.
Qualified and Nonqualified Retirement Plans
One of the most effective benefits for attracting and retaining employees is a company-sponsored retirement plan. Many pension and profit-sharing plans are “qualified” retirement plans. In other words, each employee’s share and earnings are held until the employee either leaves the company or retires. The employee pays taxes upon receiving the money, and the employer receives an immediate deduction when making contributions. Pension plans usually base eventual benefits on wages and length of service. Profit-sharing plans typically define the employer’s annual contribution. Benefits are determined by the size of the contributions and their earnings.
Two types of qualified retirement plans—Simples and 401(k) plans—can be offered at little cost to a business. Contribution limits for these plans have increased over the years, so there is no better time to sponsor one. Each of these plans has certain pre-qualification requirements that must be met before implementation. Because qualified retirement plans often restrict the amount of benefits a higher-paid employee can receive, nonqualified plans can be attractive. Nonqualified plans do not have to cover every employee. There are no compensation, benefit, or contribution limits other than an overall reasonableness test. The bookkeeping and reporting requirements are minimal. Nonqualified plans do have some disadvantages. The main drawback is that the benefits are unsecured—they are merely “promises to pay.” A company cannot formally set aside funds as future benefits. Assets intended for these benefits must remain general company assets and therefore may be subject to a creditor’s claims. Another disadvantage is that payroll taxes are generally due when services are performed, not when compensation is paid. Finally, the employer does not receive a tax deduction until the benefits are actually paid to the covered employees, at which time the employee is taxed on the benefits received.
Health insurance is another important benefit that can distinguish one employer from another when it comes to attracting and retaining employees. Over the last several years, rules regarding employer-sponsored health insurance have changed, as a result of health care reform passed in 2010. Small businesses with fewer than 25 employees that pay at least 50% of the health care premiums for their employees qualify for a tax credit of up to 50% of their premiums if insurance is purchased through an exchange. The amount of the credit for a specific business is based on the number of its employees and the average wage. While employers are not required to offer health insurance plans under current law, in 2019 a business with 50 or more full-time employees (defined as working 30 or more hours per week) will be required to provide health insurance to at least 95% of their full-time equivalent employees (FTE) and dependents to age 26 or pay a penalty. The business must provide health insurance plans that meet “minimum value” standards, or ones that cover at least 60% of the total cost of medical services. If the employer’s plan fails to meet the minimum value requirement or costs more than 9.86% of an employee’s annual income, then the company will have to pay penalties.
Section 199A Business Deduction
The new Section 199A permits individuals, trusts, and estates to deduct up to 20% of their “qualified business income” from a partnership, S corporation or sole proprietorship (including a disregarded entity) as well as some other pass-through entities. For each qualified trade or business, the 20% deduction cannot exceed the greater of (a) 50% of the W2 wages paid by the qualified business, or (b) 25% of wages paid and 2.5% of the unadjusted basis immediately after acquisition of the qualified property of the business. Qualified property is generally depreciable tangible property held by a qualified trade or business or used in the production of qualified business income and for which the depreciation period has not expired, (or in the case of short-lived property, before the 10-year anniversary of its being first placed in service by the taxpayer). Further, the deduction is limited for any “specified service business” or any trade or business of performing services as an employee. A specified service business generally is any business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services or where the principal asset of such trade or business is the reputation or skill of one or more employees or owners.
Only income that is considered effectively connected with the conduct of a trade or business within the United States is eligible to be treated as qualified business income. Capital gain or loss items, dividends, interest, and certain other investment type items are also excluded from the definition of qualified business income. For service businesses, the determination for the 20% deduction is made by taking into consideration the taxable income limits of the individual owner.
New Limitation on Excess Business Losses
Noncorporate Taxpayers and Individuals
For tax years beginning after December 31, 2017 and before January 1, 2025, the Act provides that a noncorporate taxpayer’s “excess business loss” is disallowed. Under the new rule, excess business losses are not allowed for the tax year but are instead carried forward and treated as part of the taxpayer’s net operating loss (NOL) carryforward in subsequent tax years. An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to the taxpayer’s trades and businesses over a threshold amount. The threshold amount for a tax year is $510,000 for married individuals filing jointly, and $255,000 for other individuals, with both amounts indexed for inflation; e.g. if the combined business losses for a year exceed $510,000 relating to married individual filings, the excess will be carried forward to future tax years and applied against business income. In the case of a partnership or S corporation, the provision applies at the partner or shareholder level.
Benefiting from Business Losses
If your business has suffered losses, make sure you take advantage of every allowable deduction. Net operating losses (NOLs) are generated when a company’s deductions for the tax year are more than its income. Under old law, NOLs could be carried back two years to obtain a refund and then carried forward for up to 20 years, or you could elect out of the carryback. Under the Tax Cuts and Jobs Act of 2017, carrybacks of NOLs are no longer allowed, but an indefinite carryforward of NOLs is allowed. The new tax law also sets a limit on the amount of NOLs that a company can deduct in a year equal to the lesser of the available NOL carryover or 80% of a taxpayers’ pre-NOL deduction taxable income. Corporate capital losses (C Corp) are also currently deductible, but only to the extent of capital gains. A three-year carryback and a five-year carryforward period apply. If your business operates as a partnership, S corporation, or LLC, you may deduct business losses on your personal tax return. Losses may be limited because of the at-risk or passive activity loss rules. Keep in mind that you can only deduct your share of losses to the extent that you have sufficient income tax basis for your investment. Also, take advantage of other possible loss deductions. You may deduct all or some bad business debts as ordinary losses when your good-faith collection efforts are unsuccessful. Inventory losses, casualty and theft losses (to the extent they are not covered by insurance), and losses from a sale of business assets may also be deductible.
Enhanced Business Asset Expensing Rules
Increased Code Section 179 (Expensing business acquisition write-off)
For property placed in service in tax years beginning after December 31, 2017, the maximum amount a taxpayer may expense under (Code Sec. 179) is increased to $1.2 million for 2019, and the investment phase out threshold amount is increased to $2.55 million for assets acquired in excess of this amount. For tax years beginning after 2019, these amounts (as well as the $25,000 sport utility vehicle limitation) are indexed for inflation.
Qualified Real Property The definition of (Code Sec. 179) property is expanded to include certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. The definition of qualified real property eligible for (Code Sec. 179) expensing is also expanded to include the following improvements to nonresidential real property after the date such property was first placed in service: roofs, heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems and including, as in prior law, leasehold improvements. Section 179 property generally is new or used tangible personal property plus qualified real property.
100% Cost Recovery of Qualifying Business Assets (Bonus Depreciation)
Under the new law, 100% first-year deduction for the adjusted basis is allowed for qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023. The additional first-year depreciation deduction is allowed for new and used property. Note prior to the law change Bonus Depreciation was only applied to new property acquisitions. Qualified property is basically defined the same as Code Section 179 property as explained above. Bonus depreciation may be used for assets that are not considered used in a trade or business, (i.e., real estate), as opposed to Section 179 assets that must be used in a trade or business to qualify for the write-off. Bonus depreciation phases down commencing after December 31, 2022 and sunsetting after 2026.
Bonus depreciation, as prior law allowed, may not be used to expense qualified nonresidential real property formerly defined as qualified lease hold improvement property, qualified restaurant property, and qualified retail improvement property.
Luxury Automobile Depreciation Limits Increased
For passenger automobiles placed in service after December 31, 2017, in tax years ending after that date, for which the additional first-year depreciation deduction is not claimed, the maximum amount of allowable depreciation is increased to $10,100 for the year in which the vehicle is placed in service, $16,100 for the second year, $9,700 for the third year, and $5,760 for the fourth and later years in the recovery period. For passenger automobiles placed in service after 2019, these dollar limits are indexed for inflation. For passenger autos eligible for bonus first-year depreciation, the maximum first-year depreciation allowance relating to the Bonus depreciation element remains at $8,000, resulting in an increase from $10,100 to $18,100 for first-year depreciation. In addition, computer or peripheral equipment is removed from the definition of listed property, and so isn’t subject to the heightened substantiation requirements that apply to listed property.
Limits on Deduction of Business Interest
For tax years beginning after December 31, 2017, every business, regardless of its form, is generally subject to a disallowance of a deduction for net interest expense in excess of 30% of the business’s adjusted taxable income. The net interest expense disallowance is determined at the tax filer level. However, a special rule applies to pass-through entitles, which requires the determination to be made at the entity level, for example, at the partnership level instead of the partner level.
For tax years beginning after December 31, 2017 and before January 1, 2022, adjusted taxable income is computed without regard to deductions allowable for depreciation, amortization, or depletion and without the former Code Sec. 199 deduction (which is repealed effective December 31, 2017).
An exemption from these rules applies for taxpayers (other than tax shelters) with average annual gross receipts for the three-tax year period ending with the prior taxable year that do not exceed $25 million. Real property trades or businesses can elect out of the provision if they use the ADS depreciation convention to depreciate applicable real property used in a trade or business. An exception from the limitation on the business interest deduction is also provided for floor plan financing (i.e., financing for the acquisition of motor vehicles, boats, or farm machinery for sale or lease and secured by such inventory).
Generally effective for transfers after December 31, 2017, the rule allowing the deferral of gain on like-kind exchanges is modified to allow for like-kind exchanges only with respect to real property that is not held primarily for sale. For tax year 2018 and subsequent years, trade in of vehicles and other personal property has been eliminated resulting in applying the sale or exchange rules to this type of transaction.
Tax Accounting Issues
Taxable Year of Inclusion
Generally, for tax years beginning after December 31, 2017, a taxpayer is required to recognize income no later than the tax year in which such income is considered as income on an applicable financial statement (AFS) or another financial statement under rules specified by the IRS (subject to an exception for long-term contract income under (Code Sec. 460)).
The Act also codifies the current deferral method of accounting for advance payments for goods and services to allow taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income is also deferred for financial statement purposes.
Cash Method of Accounting
For tax years beginning after December 31, the cash method may be used by taxpayers (other than tax shelters) that satisfy a $25 million gross receipts test, regardless of whether the purchase, production, or sale of merchandise is an income-producing factor. Under the gross receipts test, taxpayers with annual average gross receipts that do not exceed $25 million (indexed for inflation for tax years beginning after Dec. 31, 2018) for the three prior tax years can use the cash method.
Qualified personal service corporations, partnerships without C corporation partners, S corporations, and other pass-through entities can use the cash method without regard to whether they meet the $25 million gross receipts test, so long as the use of the method clearly reflects income.
Accounting for Inventories
For tax years beginning after December 31, 2017, taxpayers that meet the $25 million gross receipts can account for inventories by either (1) treating inventories as non-incidental materials and supplies, or (2) conforming to the taxpayer’s financial accounting treatment of inventories. Treating inventories as non-incidental materials requires capitalizing the inventory items, materials, and expensing the costs when the items are used or sold.
Capitalization and Inclusion of Certain Expenses in Inventory
For tax years beginning after December 31, 2017, any producer or re-seller that meets the $25 million gross receipts test is exempted from the application of Uniform Capitalization rules (UNCAP), capitalizing general and administrative expenses into inventory. The exemptions from the UNCAP rules that are not based on a taxpayer’s gross receipts are retained.
Accounting for Long-Term Contracts
For contracts entered into after December 31, 2017, in tax years ending after that date, the exception for small construction contracts from the requirement to use the Percentage of Completion Method of revenue recognition (PCM) is expanded to apply to contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer that (for the tax year in which the contract was entered into) meets the $25 million gross receipts test.
Cost Segregation Studies
Capital cost segregation is a comprehensive study of real property to maximize allowable tax depreciation through faster cost recovery. Generally, real estate improvements must be depreciated over 27.5 or 39 years using a straight-line method. A cost segregation analysis identifies property components and related costs that Federal tax law allows to be depreciated over five or seven years using 200% of the straight-line rate, or over fifteen years using 150% of the straight-line rate. Under these rules, it is possible to increase your allowable first-year depreciation tenfold. The Tax Cuts and Jobs Act of 2017 expanded the ability to expense qualifying property immediately. Qualifying assets placed in service between September 27, 2017 and December 31, 2022 are eligible for immediate expensing. After 2022, the deduction phases out by 20% each year. Examples of assets that may need proper classification include landscaping, site fencing, parking lots, decorative fixtures, cabinets, and security equipment.
NOTE: The rules differ for certain property types, and not all states follow Federal depreciation rules. Businesses subject to the Alternative Minimum Tax (AMT) may derive less benefit from cost segregation.
Deductions for Meals, Entertainment, and Transportation Costs
The Tax Cuts and Jobs Act of 2017 has changed the way businesses handle meals, entertainment and transportation expenses from a tax perspective.
Meal expenses associated with operating a business, including meals during employee travel, remain deductible subject to the 50 percent limitation. The cost of a client dinner, as long as it is not extravagant, is still allowed under the 50 percent deduction rule. Documentation of the business purpose of the meal is necessary for deductibility. The recently changed tax law extends the 50 percent deduction limit to employer-operated eating facilities through 2025. After 2025, employer-operated eating facilities become non-deductible.
The law eliminates deductions for entertainment even if it is directly related to the conduct of business.
The recent tax law changes also eliminated deductions for qualified transportation fringe benefits and certain expenses to provide commuting transportation to employees. The cost of providing employee’s transit passes or parking is no longer allowed as a deduction to the employer. In addition, the costs associated with providing transportation for an employee’s commute to work are not deductible unless necessary to ensure an employee’s safety. Business-related travel expenses are still deductible under the new law. This includes business travel between job sites, travel to a temporary assignment (generally one year or less) that is outside your general area of residence, travel between primary and secondary jobs, and all other cab, bus, train, airline, and automobile expenses. Any regular commuting expenses to your primary job cannot be deducted. The Tax Cuts and Jobs Act changed the deductibility of unreimbursed employee expenses. Previously, if a taxpayer incurred business travel expenses that the company did not reimburse, they could deduct these on their individual income tax return (subject to limitations), but under the recent law changes, this is no longer allowed.
To support business travel deductions, keep supporting documents for expenses. Document the following: date, place, amount, and business purpose of expenditures; name and business affiliation or business purpose of trip; and in the case of meals, all of the above must directly precede or follow a substantial business discussion associated with your business. Be sure to keep personal expenses separate from business expenses.
Expense reimbursement plans
Companies may institute “accountable” or “nonaccountable” expense reimbursement plans. Generally, accountable plans better serve both the employer and employee. Under accountable plans, employees submit mileage logs or actual expense receipts for which they are reimbursed at the standard mileage rate or for actual expenses. The company deducts the reimbursements in full, and employees do not report them as income or deduct related expenses.
Employing Your Children
There are tax advantages to putting your teenage son or daughter to work in your business. Wages paid to your child are fully deductible as a business expense. If you are a sole proprietor or a partner in a partnership in which only you and your spouse are partners, you do not have to pay FICA on those wages if the child is under age 18, nor do you have to pay unemployment insurance if the child is under age 21. The child’s wages may be subject to a lower tax rate than if you were to retain the same money as business earnings. Children will have to pay tax on the salary you pay him/her to the extent it exceeds the standard deduction. Children, who are likely in lower tax brackets, pay a 10% rate on earned income up to $9,700, and 12% on the next $29,775. A child with earned income receives a standard deduction of up to $12,200 for 2019 and may qualify for an IRA deduction of $6,000, which can total $18,200 free from Federal income tax. Children may also be partners in partnerships or shareholders in S corporations, which can reduce the overall family tax burden in certain situations.
Employee or Independent Contractor?
Your business may have already discovered the advantages of outsourcing projects or certain business functions, including payroll taxes, insurance, and benefit cost savings. Be aware, however, that the IRS continues to scrutinize whether a worker has been properly classified as an employee or an independent contractor. If an audit reveals a worker’s status has been misclassified, the business may face penalties and additional employment taxes.
In determining whether a worker is an employee under common law, a business is advised to consider all the factors that might indicate its control or the worker’s independence. According to the IRS, factors that provide evidence of control and independence fall into three categories: behavioral control, financial control, and type of relationship. Give us a call if you would like to discuss these factors.
Business Succession Planning
On average, only one closely held business in three successfully passes on to the next generation. A lack of proper transition planning is often why businesses fail after their founders retire, sustain a disability, or die. By implementing a business succession plan, you can help protect your company’s future. At a minimum, a sound plan may help you accomplish the following:
- Transfer control according to your wishes.
- Carry out the succession of your business in an orderly fashion.
- Minimize tax liability for you and your heirs.
- Provide financial security for you and your family after you step down.
To succeed, you need to examine the immediate, intermediate, and long-term goals of your family and your business. With a timeline in place, it is possible to fine-tune your plan based on the involvement you wish to have in the company and the future you envision for your business. As you develop the appropriate tax and financial strategies, two important steps are valuing your business and deciding how to transfer ownership. There are many valuation methods. Depending on your situation, one technique may be more appropriate than another. The common goal for business owners selling their businesses is to reach a valuation that fairly compensates the owner for his or her interest, while making the price attractive to the potential buyer. Profit may be less of a concern for owners who are passing a business to children. Owners have a variety of options for transferring ownership, and the most appropriate strategy depends on your specific situation, considering your personal financial and tax situation, your current form of business ownership (sole proprietorship, partnership, corporation, etc.), and the future owners (family, employees, third party, etc.). One or more of the following tax minimization strategies can play a key role in your planning process:
- Gift stock to family members. Begin now so ownership can be transferred while avoiding unnecessary transfer taxes.
- Employ a buy-sell agreement that fixes the estate tax value of your business. An effective agreement provides estate tax liquidity and provides your successors with the means to acquire your stock.
- Create an Employee Stock Ownership Plan (ESOP) and sell your stock to the plan. Special rules allow you to sell your stock to the ESOP and defer the capital gains tax if you reinvest in qualified securities. Ownership can be transferred to your employees over time, and your business can obtain income tax deductions for plan contributions.
- Plan to qualify for the estate tax installment payment option. It allows you to pay the portion of your estate tax attributable to your closely held business interest over a period of up to 14 years. Artificially low interest rates apply during the tax-deferral period. Other special rules apply.
For most people, transferring wealth to loved ones or a favorite charity is a long-term goal. Appropriate tax planning for your personal situation may help ensure you leave a legacy. Estate planning involves many strategies generally designed to preserve assets, minimize taxes, and distribute property according to your wishes. If it has been awhile since you reviewed your estate plan, consider doing so, as the landscape of estate and gift planning is changing. It is also important to note that State estate tax laws may differ from Federal estate tax laws, and state estate tax laws may differ from state to state.
Federal regulations concerning the taxation of property owned at death contain a catch-all definition stating that the “gross estate of a decedent who was a citizen or resident of the United States at the time of his death includes the value of all property—whether real or personal, tangible or intangible, and wherever situated—beneficially owned by the decedent at the time of his death.” The first step in understanding the potential implications of the Federal estate tax is to know what major assets comprise your estate. Consider the following:
Personal assets, such as personal property, savings, real estate, retirement plans, and proceeds from your life insurance policies.
Rights to future income, such as payments under a deferred compensation agreement or partnership income continuation plan. These rights are commonly referred to as “Income in Respect of a Decedent (IRD)” and may be includable at their present cash value.
Business interests, whether as a proprietor, a partner, or a corporate shareholder.
It is important to note, however, that the value of Social Security survivor benefits, received as either a lump sum or a monthly annuity, is not includable in your gross estate. Determining what may be included in your gross estate may require professional, in-depth analysis. It is also important to re-evaluate your estate plan periodically to help protect your beneficiaries and heirs from having to choose between fulfilling your wishes and meeting estate tax requirements. Failure to plan your estate not only has the potential to increase your heirs’ potential tax liability, but it also leaves responsibility to the state courts to divide your assets, assign guardians for your children, and dictate all other details in handling your estate. Your involvement now can help you prepare for your loved ones’ future.
Estate Tax Law Changes
The estate planning landscape has been marked by change and uncertainty over the years. Under 2001 tax law, the Federal estate tax became progressively generous in the run-up to 2010, when it was phased out completely for a single year. Under the 2010 Tax Relief Act, the Federal estate tax was reinstated. The Tax Cuts and Jobs Act of 2017 doubled the exemption amounts from 2018 to 2025. In 2019, there is a top tax rate of 40% and an exemption amount of $11.4 million, or $22.8 million for married couples.
Early preparation is key to developing appropriate strategies to minimize potential estate taxes and ultimately maximize the amount transferred to your heirs. With the reinstatement of estate taxes, the exemption allows you to transfer $11.4 million to your children or other heirs tax free at death. (Bear in mind that an unlimited amount may be passed tax free to a spouse.) If you are married and your combined assets (including life insurance) surpasses $22.8 million, consider implementing advanced planning tools, such as trusts, to help minimize taxes.
The Portability Provisions
The 2010 Tax Relief Act included a provision allowing the estate tax exemption to be transferred between spouses in 2011 or 2012, so that if one spouse dies and does not use the full exemption amount, the remainder can be used by the surviving husband or wife. This provision was made permanent for 2013 and beyond by the American Taxpayer Relief Act of 2012. To make use of this so-called “portability” option, the executor of the first spouse must actively elect it on the estate tax return, even if no liability is owed. Then, when the remaining spouse dies, the heirs will owe estate tax only on any amount above the combined exemption. This means that husbands and wives do not have to split assets between them or be concerned about who holds the title on various assets. Yet, these changes to the estate tax do not eliminate the need for planning. Wealthy taxpayers who currently fall within the exemption limits may still want to consider setting up a bypass trust in anticipation of future changes in the rules. In addition, couples with different sets of final beneficiaries, such as children from previous marriages, may wish to set up a bypass trust in order to clarify the beneficiaries of their separate assets.
Gifts to Family and/or Friends
One way to gradually transfer your estate tax-free is to use the annual exclusion and “gift” up to $15,000 per person, per year, to an unlimited number of recipients. If you and your spouse choose to “split” gifts, then $30,000 per year can be given away without you or the recipients paying transfer tax. (Gift-splitting is not necessary in community property states.)
You may also want to take advantage of the lifetime gift tax exemption. Under the 2010 Tax Relief Act, the Federal lifetime gift tax was reunified with the estate tax. In 2019 the top tax rate is 40% and the exemption is $11.4 million. If you would like to make a gift to a grandchild (or anyone else) and not be limited by the annual exclusion amount, make a direct payment to the providers for education (tuition only) and medical expenses. Gifts of this nature do not count toward the annual limit. You can also exclude gifts of tuition or medical payments made now for future services. If you transfer realty to a relative for little or no consideration, make certain you report the gift. The IRS is searching property records to uncover unreported gifts.
Gifts may be made directly to the donee or deposited in a trust for the donee’s benefit. Many estates can be completely transferred to others in this way over time. There are special requirements when the trust beneficiary does not have a present interest in (does not enjoy current benefits from) the trust property. Gifts to such trusts do not qualify for the $15,000/$30,000 annual exclusions. In the case of trusts set up for minors, annual exclusion gifts are allowed, but beneficiaries must have full access to the trust assets at age 21.
One possible solution to the “present interest” problem is to create a “Crummey” trust for greater flexibility and control. This requires that you give each trust beneficiary a right of withdrawal when funds are transferred to the trust. Transfers subject to Crummey powers will qualify for the annual exclusions.
To enhance your gifting strategy, you may want to consider creating a Family Limited Partnership (FLP), to which you can transfer property (such as rental property) and then gift interests to family members without relinquishing full control.
Generation-Skipping Transfer Tax
Transfers to your grandchildren may be subject to the Generation-Skipping Transfer (GST) tax. Under the 2010 Tax Relief Act, the GST tax is equal to the highest estate and gift tax rate in effect for the year (40% for 2019). The GST tax may be avoided by making gifts that qualify for the annual exclusion directly to your grandchildren. (Crummey power trusts will not work for this purpose.)
Given the complicated schedule and brief windows of opportunity, planning your tax and financial future is important in order to take full advantage of the potential savings.
About the Author
Salvatore Schibell, CPA, CFP®, MS Taxation, MBA, CGMA is the tax partner at Lawson, Rescinio, Schibell & Associates, P.C.
One of his specialties is working with contractors to maximize profitability utilizing his vast experience and educational skills.
Sal may be contacted at 732-539-7328.