New Legislation Overrides Draconian IRS Penalties on Small Employers that Reimburse or Pay for Employee Health Insurance Premiums

On December 13, 2016, Pres. Obama signed into law the “21^st Century Cares Act.”  Part of that legislation allows small employers to provide qualified health reimbursement arrangements (HRAs) for employees.  When the Affordable Care Act (ACA) was enacted, the long-time practice of allowing employers to pay for a limited amount of employee medical expenses, including health insurance premiums, on a tax-free basis was rendered non-compliant.  The ACA required these HRAs to be integrated with a group health insurance plan meeting the ACA mandate, such as no annual limit on the amount of benefits provided.  Large employers, meaning those with 50 or more full-time equivalent employees, are required by the ACA to offer minimum essential and affordable group health insurance to their full-time employees.  Small employers are not required to offer group health insurance, but many want to provide some financial assistance to their employees who want to select their own individual health insurance plans.  The financial assistance was provided under so-called “stand alone” HRAs which the ACA rendered non-compliant.  Small businesses that continued these stand-alone HRAs were threatened by the IRS with $100 per day per employee penalties ($36,500 a year per employee) under IRS Notice 2015-17.  Under the Notice, such small businesses had to stop the practice by June 30, 2015 (with a special rule for one-employee S corporations).  Thus, even though small employers aren’t subject to the mandate to offer group health insurance, they could be put out of business by the government for offering to help pay for the individual health insurance plans of their employees!  The penalty was a way of strong-arming small employers to enroll employees in the government run Small Business Health Options Program (SHOP) marketplace exchange.

This government nonsense is finally dealt with by the 21^st Century Cares Act which is applicable to HRA plan years beginning after 2016.  To avoid the $100 per day per employee penalty after 2016, small employers must now render any financial assistance through a qualified small employer HRA which meets these requirements:

1.      The employer must have less than 50 full-time equivalent employees.

2.      The employer must not offer group health insurance to any employee.

3.      All eligible employees must receive the same terms under the HRA, although variances based upon age or the number of family members is permitted (much like the pricing of a health insurance policy).  Excluded employees are those who haven’t completed 90 days of service, who haven’t attained age 25, who are part-time or seasonal workers, or who are part of a union.

4.      Only employer funds may be used to fund the HRA and no employee salary reduction contributions are permitted.

5.      The HRA either pays or reimburses the employee’s eligible medical expenses, and if health insurance premiums are paid or reimbursed, the employee must first submit proof of insurance coverage.  If the HRA permits, employee family member expenses can also be reimbursed.

6.      The maximum HRA benefit is limited to $4,950 for self-only plans, or to $10,000 for HRAs that also provide reimbursement for family members of the employee.  These amounts are adjusted for inflation after 2016.  If an employee isn’t covered for the full year, then these amounts must be prorated by the number of months covered.

7.      The amount of the benefit must be reported as information on the employee’s W-2.  Under a new provision, if the employee does not have minimum essential health insurance for the month in which the medical care is provided, then the HRA reimbursement is taxable compensation and is not tax-free.

8.      A written notice must be given to employees not later than 90 days before the beginning of the HRA plan year or else there is a $50 per employee per failure penalty (not to exceed a maximum $2,500 for a calendar year).  For the first HRA year beginning in 2017, the notice isn’t treated as late if given no later than 90 days after enactment, which is March 13, 2017.  The notice must state the amount of the employee’s permitted benefit, that the employee must inform any health insurance exchange to which the employee applies for advance payment of the premium assistance tax credit of the amount of HRA benefit, and that the employee may be subject to penalty if he or she does not comply with the mandate to purchase minimum essential health insurance coverage.
UPDATE:  IRS Notice 2017-20 suspends the March 13th notification date for 2017 plans until 90 days after further guidance has been issued by the IRS.

The new law removes the penalty for HRA plan years beginning before 2017 for any small employer that failed to stop providing the old style HRA as of June 30, 2015.  It appears that the penalty will apply after 2016 if small employers don’t follow the new qualified HRA rules.

A change is also made for purposes of the premium assistance tax credit for employees purchasing health insurance on an exchange when they also participate in a qualified HRA.  The premium assistance credit is reduced by the amount of HRA benefit.  This provision prevents double dipping where the employee receives both a government subsidy and an employer subsidy for purchasing health insurance on the government exchange.

Interesting 2016 Tax Return Due Dates

While we wait for our elected national leaders to do something responsible with our tax laws, let's look ahead to some interesting 2016 tax return due dates.

·        The tax filing season will officially begin on January 23, 2017.  That is when the IRS will officially begin accepting electronic and paper tax returns.

·        A new tax law requires the IRS to hold tax refunds arising from the earned income tax credit or from the additional child tax credit until at least February 15, 2017, in an attempt to cut down on tax fraud.  Practically, the tax refunds will not be available until the week of February 27th.

·        The April 15, 2017 due date falls on Saturday this year.  Normally, the due date would be the Monday following, but that Monday is a Federal holiday for the District of Columbia (Emancipation Day) so the actual due date is Tuesday, April 18, 2017 for filing 2016 federal individual, trust, and C corporation income tax returns.  The various states will have their own due dates.  Utah’s due date will follow the federal due date.  The April 18th due date is also effective for filing Form 4868 for an automatic six-month extension.  The extended due date is October 16, 2017, because October 15th falls on Sunday.

·        As noted above, the C corporation 2016 tax return due date has been changed to April 18, 2017 from the normal March 15, 2017 due date.  However, the six-month extension period has been shortened to five months, leaving the normal extended due date at September 15, 2017.  UPDATE:  For 2016 C corporation tax returns, the IRS has used its regulatory authority to grant a 6-month filing extension period despite the statute's 5-month limit.  S corporation tax returns are still due March 15, 2017 and the S corporation extension period remains six months.

·        A very important change affects 2016 partnership tax returns.  The due date is now March 15, 2017 instead of April 18, 2017.  In addition, the normal five-month extension period has been lengthened to six months.  But with the shortened original due date, the extended partnership due date remains September 15, 2017.  The Utah 2016 partnership tax return due date stays on April 18, 2017 under HB39.

·        Another change affects the federal trust tax return extension period.  The extension period for 2016 trust income tax returns is lengthened to five and a half months from five months, making the extended due date October 2, 2017 (since September 30^th falls on a Saturday) instead of September 15, 2017.

·        Still another very important change affects the Foreign Bank Account Report (FBAR, FinCen 114) 2016 due date.  The FBAR is now due at the same time the individual income tax return is due.  In a news release dated December 16, 2016, FINCEN announced that the 2016 FBAR is due April 18, 2017 instead of June 30th.  In addition, unlike past years, the FBAR may now be extended to the individual income tax return extended due date.  In the announcement, FINCEN stated that automatic extensions to October 15th would be granted for those failing to meet the April deadline without the filing of any forms or extension requests.  The announcement indicated that the extended due date is October 15, 2017.  Since the FBAR due date is tracking the individual income tax return due date, it is possible that the automatic extended due date will actually be October 16, 2017, and indeed the IRS confirms the October 16th extension date on its website.

·        Forms 1099 and W-2 have typically been due to payees by January 31^st and remain so for the 2016 forms.  However, the due date for submitting the forms to the government has changed to January 31, 2017 from the normal due date of February 28^th (for paper-filed forms) or March 31^st (for electronically-filed forms).

Planning for Possible Tax Law Changes After 2016

Pres.-Elect Trump has stated that a major tax bill lowering taxes is one of his top three priorities.  In addition, House Republicans have readied major tax reform proposals.  It seems clear that changes will happen as soon as 2017.  Although we don’t know the specific details of what will be enacted, we do know many of the proposals, and taxpayers should act in the remaining days of 2016 to garner tax savings.  Some of the more significant possible changes, and relevant ways to reduce your taxes, are listed below.  The planning ideas below are general in nature.  Your specific tax situation might call for different action.  Actual tax changes may differ from proposals.  You should work with your tax preparer to project your 2016 and 2017 income taxes so that the proper actions for your circumstances can be taken.

1.      Reduction of the top ordinary individual income rate to 33.0% from 39.6% (long-term capital gain and qualified dividend rates are proposed to remain the same).

a.      Defer income to 2017 when it will be taxed less at the lower rate.

                                                              i.      Defer a December bonus to January.

                                                            ii.      Exercise non-qualified stock options after 2016.

                                                          iii.      Cash basis businesses whose profits are taxed in your personal tax return can delay billings until late December so that collections are received in January.

                                                          iv.      Those attaining age 70 ½ in 2016 can defer their first required minimum distribution from IRAs or other retirement accounts until as late as April 1, 2017, although that means two RMDs will be received in 2017.

                                                            v.      Defer taxable Roth IRA conversions to 2017.

b.     Accelerate deductions to 2016 when more taxes will be saved at the higher rate.

                                                              i.      See discussion below for ideas on prepaying itemized deductions.

                                                            ii.      See discussion below for business deduction strategies.

c.      Note that because of the differences in rate bracket amounts between current law and proposed law, those in certain lower brackets of taxable income may experience a tax rate increase from 2016 to 2017.

2.      Repeal of the Affordable Care Act (Obamacare) net investment income tax (NIIT) of 3.8%.

a.      Defer the recognition of 2016 investment gains until 2017.

b.     Harvest capital losses to offset any recognized 2016 capital gains.

                                                              i.      Be careful to avoid the wash-sale rule when reinvesting proceeds.

c.      Defer cashing in U.S. savings bonds.

3.      Increase in the standard deduction to $30,000 for joint filers and $15,000 for singles, up from $12,600 and $6,300 respectively.

a.      If your total itemized deductions are not much more than the new limits, prepay some of your 2017 itemized deductions in 2016 to avoid losing tax benefits.

                                                              i.      Prepay several years of charitable contributions.  Establish a donor-advised fund to receive your donation if you are not prepared to give the funds to specific charities now.  Donating long-term appreciated capital assets doubles the tax benefits by eliminating the tax on the unrealized gain.

                                                            ii.      Prepay any 2016 state income taxes that would be due with your tax return in April 2017 (assuming you are not subject to the AMT).

4.      Cap the total amount of itemized deductions to $200,000 (joint)/$100,000 (single).

a.      If your total itemized deductions exceed these limits, prepay your 2017 itemized deductions in 2016 as discussed above.

b.     Furthermore, if you have considered making a substantial charitable contribution sometime in the near future, 2016 may be the year to do so to avoid losing the tax deduction if the cap is indeed imposed on charitable donations.

5.      Repeal of the alternative minimum tax (AMT).

a.      Defer to 2017 items that typically cause AMT.

                                                              i.      Payment of state and local tax.

                                                            ii.      Exercise of incentive stock options (ISO).

b.     If you are subject to the AMT and the AMT exemption has been fully phased-out, your marginal tax rate on ordinary income would increase from 28% in 2016 to 33% in 2017.

                                                              i.      Accelerating 2017 non-investment income (because of the NIIT) into 2016 will save tax.  Examples are exercising a non-qualified stock option or making a Roth IRA conversion.

c.      If you are subject to the AMT and the AMT exemption is in the process of being phased-out, your marginal tax rate on ordinary income would decrease from 35% to 33%.

                                                              i.      Prepaying charitable deductions or other deductions permitted under the AMT would save taxes at a slightly higher rate within the AMT exemption phase-out range of income.

6.      Repeal of the 40% tax on estates over $5.45 million (per individual).  Imposition of a capital gain tax at death for estates valued over $10 million (it is unclear whether this limit is per individual or per married couple, and whether it is an actual tax at death or if it is simply the loss of tax basis step-up to the value at death).

a.      This proposal is a difficult area to plan for because a person’s life expectancy will most likely extend beyond the president-elect’s term in office, and a future administration/Congress could reenact the estate tax.

b.     It is also difficult to plan for because we don’t know whether the current rules allowing a step-up in tax basis to fair market value at death will be continued.

c.      Taxpayers currently planning to make gifts to beat the effective date of proposed regulations that substantially eliminate valuation discounts are in a tough position, as the regulations may not be finalized.

d.     It seems that a “wait and see” approach may be best before undertaking irrevocable planning strategies before we know what the rules will be.  You should discuss your individual circumstances with your estate planner to decide upon the most prudent course of action (or non-action).

7.      Reduction of the C corporation top tax rate from 35% to 15% (Trump) or 20% (House)

a.      Deferring taxable income to 2017 will result in permanent tax savings.

b.     Accelerating deductions to 2016 will likewise result in tax savings.

                                                              i.      Electing to expense certain asset acquisitions placed in service in 2016 under Section 179 may be advisable.

                                                            ii.      Review the purchase of low-cost assets to be sure they are expensed under your capitalization policy rather than recorded as depreciable assets.

                                                          iii.      Consider whether the “partial disposition” rules might apply to a significant improvement made during the year, such as the replacement of a roof.

Proposed Tax Regulations to End or Restrict Valuation Discounts for Family Gifts

UPDATE:  On October 2, 2017, the Treasury Department informed Pres. Trump that, as part of its review to eliminate burdensome tax regulations, the proposed regulations discussed below will be withdrawn in their entirety.  It is expected that the withdrawal will occur in 60 days by publication in the Federal Register.
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On August 4, 2016, the Treasury Department issued long anticipated “proposed” tax regulations restricting the use of valuation discounts for gifts to family members.  The effective date is expected to be sometime in 2017 when final regulations are issued.  A public hearing on the proposed regulations is scheduled for December 1, 2016.  Already legislation has been proposed in Congress to nullify these controversial regulations.  However, it was Congress that gave Treasury the power to write these regulations in the first place.  When Code Section 2704 was enacted back in 1990, it was intended to eliminate the ability of taxpayers to use artificial means to depress the value of ownership interests in corporations or partnerships gifted to family members when the family retained control of the entity (and therefore the full economic value of the entity).  Congress left the details of how to implement the statute to the Treasury Department.

Valuation discounts are an important part of gift and estate tax reduction strategies.  Valuation discounts are allowed both for minority interests (lack of control) and for lack of marketability.  Over the years, creative advisors and friendly state legislatures have devised strategies and enacted local laws that have allowed taxpayers to get around the intent and reach of Section 2704.  Many court cases have sustained these strategies.  Taxpayers have for many years enjoyed making gifts at values discounted to true fair market value.  After years of trying to get Congress to amend the law to prevent avoidance of Section 2704, the IRS has taken matters into its own hands.  The pendulum now swings back in favor of the government because these regulations make the valuation for gift tax purposes greater than the true fair market value of the gifted interest.  Experts have said that gifts made within a family unit will be valued at a higher gift tax value than what the value of the interest would be if it were sold to an unrelated third party!  The regulations also have application to the estate tax value of retained interests held at death.

The regulations are quite complex and will have unintended consequences.  They are also not fully understood.  Some assumptions and commentary made by leading experts and practitioners may, in the end, not be totally consistent with the intent of the regulations.  Without getting into the technical weeds, some of the highlights include:

·         A transfer (gift) of a minority interest to a family member, where family members remain in control of the business on an aggregate ownership basis, will not qualify for valuation discounts.

o   Control is defined as ownership of at least 50% of capital or profits interests, or any equity interest that can cause the entity to liquidate in whole or in part, or any general partnership interest.

o   Family members, for this purpose, are broadly defined to include the individual's spouse, any ancestor or lineal descendant of the individual or the individual's spouse, any brother or sister of the individual, and any spouse of the foregoing.  This definition does not include nieces and nephews.

·         A new 3-year lookback period is proposed to prevent minority discounts created by transfers made before death.  For example, if father owned 55% of his business entity and made a gift of 6% to his children, his remaining 49% ownership would qualify for a lack of control minority valuation discount at his death.  But if the gift of the 6% occurred within the 3-year period ending on his date of death, his 49% ownership would be valued as if he still owned 55% (meaning no minority interest discount for the 49% he retained).

·         The introduction of “disregarded restrictions” where control remains within the family after the transfer that expand beyond the existing so-called “applicable restrictions” that have been ignored by taxpayers.  Restrictions targeted by these rules include those that:  1) limit the owner’s ability to liquidate his/her ownership interest for cash or property, 2) delay the timing of the liquidation payment for more than six months, 3) allow the liquidation payment to be anything other than cash or property, and 4) limit the liquidation price to an amount below minimum value.  These restrictions will be ignored for purposes of valuing the property that was transferred because they can “lapse” or be removed after the transfer by family members still in control of the entity.

o   Minimum value is defined as the fair market value of assets reduced by liabilities of the entity.

·         An exception to the elimination of the minority interest discount applies if, immediately before the transfer, a nonfamily member owns at least 10% of the entity and the sum of all nonfamily interests total at least 20%, the nonfamily member can redeem its interest for cash or assets with notice of no longer than 6 months, and the nonfamily members have owned their interests for at least 3 years.

·         An exception to the elimination of the minority interest discount also applies if each owner has an enforceable right to liquidate his/her ownership interest within 6 months either in cash or property at minimum value.

What should taxpayers do now?  If you are contemplating making gifts and engaging in estate tax planning strategies, you should do so soon, before publication of the final regulations which is expected sometime in 2017.  But, a gift made to a family member before the effective date to create a minority interest for the decedent will not be effective to create an estate valuation discount if the gift was made within 3 years of death and death occurs after the effective date.  The gift would have received the traditional discounts because it was made before the effective date, but the estate value of the retained interest would not be discounted because death occurred after the effective date and within three years of the gift.

Gifting and estate freezing strategies will still be very effective in reducing estate tax even after publication of the final regulations.  The final regulations will reduce part of the financial benefit of such strategies, but it is the post-gift appreciation outside of the taxpayer’s estate that brings the most financial benefit, and this benefit remains.  For smaller estates that will not incur estate tax, these valuation regulations may represent good news in that the value of retained business interests at death will have a higher value permitting a higher income tax basis under the so-called “step-up in basis” rules.  However, some commentators believe that a higher tax basis step-up because of these regulations is not assured.

Changes to Overtime Pay Rules Effective December 1, 2016

As directed by Pres. Obama, the U.S. Department of Labor published new regulations in May regarding overtime pay under the Fair Labor Standards Act (FLSA) to be effective December 1, 2016.  The FLSA requires employers to pay most employees at least the Federal minimum wage and to pay for overtime, which is the number of hours worked in excess of 40 in a workweek, paid at a rate of 1 ½ times the regular hourly rate.  Federal and Utah minimum wage is currently $7.25 per hour and Utah follows the FLSA overtime rules.  Exemptions from overtime pay is permitted for employees who work in certain administrative, professional, or executive jobs.  An exemption is also provided for highly compensated employees not working in one of these areas.

A minimum “salary-level” test must be met for employees working in executive, administrative, or professional positions to be considered exempt from overtime pay.  On December 1, 2016, the minimum increases to $913 per week ($22.825/hour or $47,476/year) up from the current $455 per week ($11.375/hour or $23,660/year).  The regulations provide for automatic increases to these amounts every three years, the first increase beginning January 1, 2020.

For the highly compensated person not working in one of the three areas, the current compensation level of $100,000 per year is increased on December 1, 2016 to the 90^th percentile of earnings for all full-time salaried employees which is $134,004.  This amount will also be adjusted every three years.

Employers should review their employee classifications to ensure that exempt employees are properly classified.  Be sure that job descriptions accurately reflect the employees’ duties.  Exempt employees earning less than the new annual compensation of $47,476 will need to receive overtime pay starting December 1, 2016.  The regulations permit nondiscretionary bonuses, incentives, and commissions to satisfy up to 10% of the new standard salary level, but these payments must be made quarterly.  If an exempt employee works overtime, and earns close to the new salary level, it may be less expensive to give the employee a raise to meet the new exemption standard instead of making overtime payments, or else prohibit the working of overtime.  Adjusting an employee’s compensation to meet the new standard introduces several other complications to be considered, such as considering whether raises must be given other employees to treat them fairly, and being cognizant of any equal pay issues between men and women having similar duties.

More information can be found on the DOL website here.

Update 

On November 22, 2016, a federal judge in Texas blocked implementation of the new overtime rules pending a court decision on the legal challenge against the rules.  Several business groups and 21 states challenged the legality of the rules issued by the DOL.  While welcome news to employers, it comes very late and employers may have already discussed pay increases with employees which will be very difficult to take back.  More information can be found here.

Revenue Procedure 2016-42 Helps Charitable Remainder Annuity Trusts Qualify in a Low Interest Rate Environment

One of the many consequences of the government’s manipulation of interest rates is the impact on the qualification of charitable remainder annuity trusts (CRATs).  A CRAT is a split-interest trust where the person transferring property to the trust typically retains a fixed annuity payment for life (or a term of years not exceeding 20) with the balance (called the remainder) of the trust passing to a designated charity at the end of the annuity payment term.  Because the CRAT is tax-exempt, it is typically used in tax planning for the sale of appreciated property. 

There are several rules that a CRAT must meet, one of which is the 5% exhaustion test of Revenue Ruling 77-374.  This ruling requires that the probability of the annuity payment depleting the assets of the CRAT, so that nothing remains for the charity, cannot be greater than 5%.  The probability of exhaustion is computed by considering the annuity as a percentage of the initial value of the property transferred to the trust (the amount of the annuity must be at least 5% of the initial value), the IRS valuation interest rate under IRC §7520 (use the highest of the current month (1.40% for August 2016) or of the two preceding months (1.80% each for June and July)) which is used to discount the annuity stream to present value, and the life expectancy of the annuitant over which the annuity will be paid.  In August 2016, it is clear that the CRAT minimum annuity payout percentage of 5% is greater than the IRS valuation rate of 1.80%; therefore, if the time period over which the annuity is paid is too long, the 5% depletion test will be failed.  For a single life annuitant at the 1.80% IRS valuation rate, only a 72-year-old or older person can establish a CRAT.  For a joint life expectancy of a husband and wife, the spouse of a 72-year-old must be at least age 77!  Contrast this to August 2008 when the §7520 rate was 4.20%.  Then a 52-year-old could establish a CRAT without failing the exhaustion test. 

Because the low interest rate environment has rendered CRATs unusable except for the oldest of taxpayers, the IRS published Revenue Procedure 2016-42.  It provides a provision which, if adopted, enables the CRAT to disregard the exhaustion test upon creation.  The provision requires the CRAT to terminate early if the future value of the CRAT, when discounted back to the CRAT formation, drops below 10% of the initial CRAT value.  The formula could cause an early termination and end of the annuity payment if the CRAT were to suffer a decline in value, even if temporary due to market fluctuations.  The provision will require annual monitoring before each year’s annuity payment is made.  If the 10% test is failed, then no annuity is paid for that year and the CRAT pays all of its assets over to the charity and terminates.  While this revenue procedure opens the door for CRATs to be used by younger taxpayers, younger taxpayers may find that a charitable remainder unitrust (CRUT) or charitable gift annuity may be preferable to the CRAT which bears the risk of early termination.  However, in the right situation, this new provision can enable the CRAT to be used.

The New “Death Tax”

The lifetime exemption from Federal estate tax (sometimes called the death tax) was permanently increased to $5.00 million plus inflation adjustments (measured from 2010) as part of the American Taxpayer Relief Act of 2012.  It had been scheduled to drop from $5.12 million to $1.00 million in 2013.  For 2016, the exemption stands at $5.45 million.  Because each spouse has this limit, a married couple effectively has a $10.90 million combined exemption.  The government also permanently enacted “portability” enabling the surviving spouse to elect to “port” or add to her or his own lifetime exemption any unused exemption of the deceased spouse.  The large exemption amounts in effect make the estate tax applicable only to a tiny percentage of taxpayers, estimated to be 0.6% of all taxpayers.  Given that almost no one pays the estate tax, what then is the new death tax?  Answer:  it is the income tax.  The income tax is the tax that most people should plan for in their estate planning documents.  Unique income tax benefits and detriments associated with trusts and estates require careful planning. 

When a person dies, the income tax basis of the assets that are included in the gross estate of the decedent changes to be equal to the fair market value (FMV) as of the date of death (or the “alternate valuation date” if that election is made for a tax-paying estate).  An exception applies to assets that are considered “income in respect of a decedent” (IRD).  IRD assets are typically tax-deferred retirement accounts such as 401(k)s, traditional IRAs, and also accrued income items such as accrued interest and dividend income, and unreported income from installment sale contracts.  These IRD assets do not receive a new income tax basis at death.  In addition, if the new basis conformity reporting isn’t complied with when required (see my blog post here), the tax basis of unreported inherited assets becomes zero.  In most instances the FMV will exceed the tax basis of the assets.  Therefore, changing the tax basis to FMV eliminates the inherent capital gains tax.  The new reality of the high estate tax exemption amount should change the emphasis in estate planning from reducing the estate tax (that most likely won’t be owed) to reducing the income tax (that will be owed). 

Putting the emphasis on income tax reduction when structuring estate plans requires looking at both lives for a married couple.  If the surviving spouse continues to live for a number of years, the FMV of the assets owned by the decedent spouse should continue to increase.  If such assets could be included in the gross estate upon the death of the surviving spouse, the assets in effect receive a “second step-up” in income tax basis.  Below are some planning suggestions.  A variety of factors must be considered before adopting any of these suggestions. 

1.      Consider changing your existing estate plan from using the traditional A-B trust structure to simply leaving all assets of the first spouse to die to the surviving spouse, whether directly or in a qualifying trust, and electing portability.  The traditional structure allocates the first spouse’s assets to the B trust (sometimes called the credit shelter, bypass, or family trust) in an amount equal to the unused estate exemption amount.  The balance of the assets (if any) are left to the A trust for the surviving spouse.  The traditional A-B structure is an attempt to use the deceased spouse’s estate exemption that would be lost if not used.  But now, with the availability of the portability election, any unused exemption will be preserved.  The tax problem with the B trust is that the income tax basis of the trust assets will be frozen at the FMV at the time of the first death.  The B trust is designed not to be included in the gross estate of the surviving spouse; therefore, there is no second step-up upon the death of the second spouse.  Leaving the first spouse’s assets to the surviving spouse, whether directly or in a qualifying trust, enables those assets to receive a second step-up in basis.  Before changing your A-B trust structure, other reasons for the structure, such as asset protection or multi-generational trust purposes must be considered.

2.      If the older/sicker spouse owns an irrevocable grantor trust from prior gifting or estate planning strategies, there will likely be a provision in the trust document that permits the spouse-grantor to substitute or replace assets in the grantor trust with assets of like FMV.  Substituting high basis assets for low basis assets in the trust will bring the low basis trust assets into the spouse’s gross estate for a basis step-up.

3.      If the A-B trusts already exist, or if there are other gifting or estate irrevocable trusts that are nongrantor trusts, then the income tax burden of these trusts can be quite high.  For example, in 2016, the top 39.6% ordinary and 20.0% capital gain tax rates begin at only $12,400 of trust taxable income, whereas for a married couple, such rates don’t begin until $466,950 ($415,050 for single taxpayers).  Distributions of trust taxable income to beneficiaries can often result in less overall tax.  Distributions just for income tax reasons should, however, be consistent with the trustor’s purposes for the trust.

4.      When drafting a trust document, the distribution language should give discretion to the trustee to make distributions from income and principal, and should give the trustee authority to define trust accounting income, such as including capital gains in the definition.

5.      Give the older/sicker spouse ownership of appreciated, low-basis property so that it might receive a basis step-up.  However, a special rule prevents a basis step-up if the deceased spouse received the property within 12 months of death from the person inheriting the property.

6.      Have the older/sicker spouse gift high-basis property having an unrealized loss so that the high basis might be preserved instead of being “stepped down” to FMV upon death.  While there are limitations on how much loss can be triggered on the sale of gifted high-basis property, the preserved basis will be available to reduce the capital gain if the property’s value recovers.

7.      Avoid fractionalizing ownership interests to obtain large valuation discounts.  If you don’t have estate tax, you want high valuations to obtain higher tax basis for the property to be inherited by your heirs.

8.      Elect portability where it makes sense.  Electing portability to preserve the unused lifetime estate tax exemption requires the filing of a timely estate tax return for the deceased spouse.  Preparing an estate tax return is expensive, costing thousands of dollars, so it must fit the family’s circumstances to be worthwhile.

Partners Cannot Be Employees

Temporary tax regulations were issued on May 4, 2016, to halt a perceived abuse where wholly owned limited liability companies (LLCs) were used to enable partners to be treated as employees for purposes of participating in tax-favored employee benefit plans.  Under Revenue Ruling 69-184, partners are not considered employees and therefore should not receive Form W-2 and should not participate as regular employees in employee benefit plans.  However, that ruling was published in 1969, and since that time LLCs have been created and the concept of disregarded entities introduced.  Some taxpayers have used the new developments to plan around the ruling.

Wholly owned or single member LLCs are generally “disregarded” as an entity separate from its owner for both income tax and self-employment tax purposes.  For employee employment tax purposes, prior regulations held that a disregarded entity is treated as a corporation, meaning that the LLC rather than the LLC owner is treated as the employer of its employees.  The prior regulations gave an example of an individual owning 100% of an LLC and stated that the individual was not an employee of the LLC.  But since the regulations did not provide an example of a partnership owning 100% of an LLC, some taxpayers interpreted the regulations as permitting the partnership’s partners to be treated as employees of the LLC and therefore eligible to participate in certain tax-favored employee benefit plans not otherwise available to self-employed individuals.

The temporary regulations require partnerships owning a business in a wholly owned LLC to treat the partners as self-employed individuals rather than as employees of the LLC beginning the later of August 1, 2016, or the first day of the next employee benefit plan year beginning after May 4, 2016.

The publication of these temporary regulations is a good reminder of the IRS’ position that partners should not be part of the payroll system.  Partner compensation is considered to be a “guaranteed payment” that is disclosed on Schedule K-1 rather than reported on Form W-2.  Guaranteed payments are self-employment income not subject to payroll tax withholding.  Therefore, partners will need to make timely estimated tax payments of their income and self-employment taxes in order to avoid a penalty for underpaying estimated tax.

Tax Proposals of the Three Presidential Candidates

Thomson Reuters RIA Checkpoint this week issued a summary of the tax proposals of the three remaining presidential candidates.  The summary is based largely on information provided on the candidate's websites as of May 17, 2016.  Excerpts from their article:

Hillary Clinton 

Individual tax reform: 

1.     Impose the "Buffett rule" requiring taxpayers earning more than $1 million per year to pay at least 30% in taxes, and "broadening the base of income subject to the rule."

2.     Enact the "Fair Share Surcharge"—i.e., an extra 4% surtax on taxpayers who make more than $5 million per year.

3.     Modify the treatment of capital gains for taxpayers in the highest bracket by implementing a graduated holding period where the rate decreases, from 39.6% to 20%, over a 6-year period, to promote long-term investment.

4.     Limit the tax value of certain tax breaks to 28%. 

Business tax reform:  

1.     Restrict corporate inversions by increasing, from 20% to 50%, the post-merger threshold of foreign shareholder ownership for an American company to be considered foreign.

2.     Impose an "exit tax" on companies that undergo an inversion to ensure that U.S. taxes are paid on unrepatriated earnings held overseas.

3.     Create a $1,500 "apprenticeship tax credit" for every new worker that a business trains and hires.

4.     Provide for a new 15% tax credit for employers that share profits with their workers.

5.     End "wasteful tax subsidies" for oil and gas companies. 

Estate tax reform: 

1.     Exempt the first $3.5 million of an individual's estate from estate tax ($7 million for married couples), without adjustment for inflation.

2.     Increase the top rate to 45%.

3.     Cap the lifetime gift tax exemption at $1 million. 

Miscellaneous tax reforms: 

1.     End the "carried interest" loophole (under which private equity and hedge fund managers are taxed at capital gains rather than ordinary income rates on fund income).

2.     Close the loophole under which taxpayers essentially avoid IRA contribution limits by undervaluing contributed assets, and preventing taxpayers with "mega IRAs" from contributing further.

3.     "Ask the wealthiest to contribute more" to Social Security, including "options to tax some of their income above the current Social Security cap, and taxing some of their income not currently taken into account by the Social Security system."  

Bernie Sanders 

Individual tax reform. 

1.     Leave the existing rates in place for married couples with income below $250,000 and single filers with incomes below $200,000. However, he would replace the existing top three rates (of 33%, 35%, and 39.6%) as follows:

a.     37% on income between $250,000 and $500,000;

b.     43% on income between $500,000 and $2 million;

c.      48% on income between $2 million and $10 million; and

d.     52% on income of $10 million and above.

2.     Replace the alternative minimum tax (AMT), personal exemption phase-out (PEP), and "Pease" limitation on itemized deductions with a provision limiting the tax savings for each dollar of deductions to 28¢ for "high-income households."

3.     Repeal the favorable rates on capital gains and dividends for married couples with incomes over $250,000 (which would instead be subject to the otherwise applicable income tax rate), while retaining the existing favorable treatment for taxpayers who fall under that threshold.  Increase the 3.8% surtax [established by the Affordable Care Act] on net investment income to 10%. 

Business tax reform: 

1.     End deferral of foreign-source income, instead requiring corporations to pay U.S. taxes on offshore profits as they are earned.

2.     Not allow a corporation to "claim to be from another country" if its management and control operations are primarily located in the U.S.

3.     Eliminate loopholes and subsidies that benefit oil, natural gas, and coal interests. 

Estate tax reform: 

1.     Exempt the first $3.5 million of an individual's estate from the estate tax.

2.     Establish a new progressive estate tax rate structure: 45% on the value of an estate between $3.5 million and $10 million; 50% for the value of an estate between $10 million and $50 million; and 55% for the value of an estate in excess of $50 million, with an "additional billionaire's surtax" of 10%.

3.     Strengthen the generation-skipping tax by applying it with no exclusion to any trust set up to last more than 50 years.

4.     Limit the annual exclusion from gift tax for gifts made to trusts. 

Miscellaneous tax reforms: 

1.     Enact a "Wall Street" or "financial transaction" tax on trades of stock (0.5%), bonds (0.1%), and derivatives (0.005%).

2.     Eliminate the Social Security wage base (for 2016, $118,500) so that everyone pays the same percentage of their income.

3.     End the "carried interest loophole."

4.     Enact a new payroll tax to fund paid family and medical leave.

5.     Create a 6.2% income-based health care payroll tax paid by employers, and a 2.2% income-based tax paid by households (both referred to as "premiums"), to help fund Medicare for all.  

Donald Trump

Individual tax reform: 

1.     Lower income tax rates as follows:

a.     0% for single filers earning up to $25,000, married filers earning up to $50,000, and heads of household earning up to $37,500;

b.     10% for single filers earning $25,001 to $50,000, married filers earning $50,001 to $100,000, and heads of household earning $37,501 to $75,000;

c.      20% for single earners earning $50,001 to $150,000, married filers earning $100,001 to $300,000, and heads of household earning $75,001 to $225,000; and

d.     25% for single filers earning $150,000 and up, married filers earning $300,001 and up, and heads of household earning $225,001 and up.

2.     Change the long-term capital gains and dividends rates to be:

a.     0% for taxpayers in the 0% and 10% income tax rate brackets;

b.     15% for taxpayers in the 15% income tax rate bracket; and

c.      20% for taxpayers in the 25% income tax rate bracket.

3.     Reduce personal exemptions and deductions.

a.     Taxpayers in the 10% brackets will keep "all or most" of their current deductions,

b.     Those in the 20% bracket will keep "more than half" of their current deductions, and

c.      Those in the 25% bracket will keep "fewer" deductions.

d.     Charitable giving and mortgage interest deductions, will remain unchanged for everyone.

e.     Individuals would also be allowed to fully deduct health insurance premium payments. 

Business tax reform: 

1.     Cut the corporate tax rate to 15% and also create a new "business income tax rate" within the "personal tax code" that would match the 15% corporate tax rate for pass-through businesses.

2.     Provide a one-time deemed repatriation of corporate cash held overseas at a 10% rate.

3.     End deferral of taxes on corporate income earned abroad.

4.     Reduce or eliminate corporate loopholes that "cater to special interests," as well as "deductions made unnecessary or redundant" by the new lower rates, and phasing in a "reasonable cap" on the deductibility of business interest expenses.  

Estate tax reform: 

1.     Eliminate the estate tax. 

Miscellaneous tax reforms:  

1.     End the current tax treatment of carried interest.

2.     Repeal the Affordable Care Act.