Welcome to CPA at Law, helping individuals and small businesses plan for the future and keep what they have.

This is the personal blog of Sterling Olander, Certified Public Accountant and Attorney at Law. For over five years, I have worked as a tax professional helping clients with tax mitigation strategies, tax controversies, business transactions, wealth preservation structures, tax-exempt organiations, and estate plans.

I write about any legal, tax, or technological information that I find interesting or useful in serving my clients. All ideas expressed herein are my own and don't constitute legal or tax advice.

Paying Gift Tax Now vs. Estate Tax Later

In addition to the annual exclusion, which allows individuals to make annual gifts of up to $14,000 per donee without implicating any taxes, there is another way to utilize gifting to family members to minimize estate taxes upon death.

This strategy applies to estates with a value in excess of the federal estate and gift tax exemption. In 2014, this exemption will be $5,340,000, up from $5,250,000 in 2013. Spouses can generally combine their credit amounts, resulting in the passing of estates worth two times the individual estate and gift tax exemption upon the death of the second spouse. Any estates that are worth less will not be subject to any estate or gift tax.

For estates with a fair market value in excess of the exemption amounts, a tax will apply. The estate tax and gift tax statutes are designed so that the estate tax cannot be avoided by gifting assets before death. If assets in the estate in excess of the exemption amount are gifted during the lifetime of the donor, a gift tax will need to be paid at the same rate as the estate tax.

However, paying gift tax is less expensive than paying the estate tax because paying the gift tax permanently removes the tax paid from the donor's taxable estate. If the taxable gift were not made, the amount that would have been paid in gift tax remains in the taxable estate and is itself subject to the estate tax.

For example, assume the current gift and estate tax rate of 40% and a donor who has previously gifted his or her entire exemption amount. In order to gift $1 million to a donee, the donor will make the gift of $1 million and pay a $400,000 gift tax for a total of $1,400,000.

If the donor had not made the gift before he or she passed away, the estate would include the $1,400,000 and be subject to the 40% tax rate. The donee would only receive $840,000 after the estate tax of $560,000 is paid ($1,400,000 * 40%). In other words, the estate would save and the beneficiary would receive $160,000 more simply because the donor made a gift before death instead of waiting to pass his or her estate afterwards.

Timing is key to the success of this planning technique. Under IRC 2035(b), the taxable estate of the donor includes any gift tax paid on transfers made within three years before the donor's death; accordingly, if the donor dies less than three years after making the taxable gift, the strategy fails. On the other hand, the donor is choosing to accelerate the payment of taxes and give up the use of the money paid as tax. "The donor must survive for three years to avoid the §2035 gross up, but must not survive for so long that the value of the loss of use of the money paid as gift taxes exceeds the value of the estate tax savings." Lischer, 846-2nd T.M., Gifts to Minors

The Net Investment Income Tax

A new tax on investment income is in effect as of the start of the year. This "Net Investment Income Tax," or NIIT, is equal to 3.8% multiplied by the lesser of (1) the taxpayer's net investment income and (2) the amount that the taxpayer's modified adjusted gross income exceeds a certain threshold. The threshold amounts are $200,000 for single filers and heads of households, $250,000 for joint filers, and $125,000 for married individuals filing separate returns.

Investment income generally includes interest, dividends, capital gains, rental and royalty income, nonqualified annuities, and passive activity income. Expenses attributable to the investment income are subtracted to arrive at net investment income. The NIIT does not apply to wages, unemployment compensation, nonpassive business income, social security benefits, tax exempt interest, self-employment income, and distributions from qualified retirement plans. However, such amounts are included in the calculation of the modified AGI threshold amount.

For example, if a married taxpayer filing a joint return receives a $25,000 royalty with $5,000 worth of costs attributable to that royalty and has an AGI of $260,000, $10,000 will be subject to the NIIT. This is the lesser of the taxpayers net investment income and the amount the taxpayer's modified AGI of $260,000 exceeds the applicable threshold of $250,000. The taxpayer will owe a NIIT of $380.

One planning mechanism that can ameliorate the NIIT is for taxpayers to increase their participation in business activities that would otherwise be considered passive activities so that the income is not subject to the NIIT. Material participation generally means that the taxpayer be involved in the business operations on a regular, continuous, and substantial basis.

Another planning opportunity arises in the context of trusts for the benefit of a taxpayer's beneficiaries in lower income brackets. The NIIT applies to trusts at a much lower income threshold than it does for individuals. Accordingly, trusts that have the option of passing their income to the beneficiaries to be taxed on the individual level or retaining the income and paying any resulting tax at the trust level should opt for the former.

Other planning strategies focus not on reducing net investment income but on reducing adjusted gross income. For example, taxpayers should maximize contributions to retirement accounts such as 401(k)s, IRAs, and SEP accounts. As with any tax planning strategy, early implementation is key.

Examples of Self-Directed IRA Prohibited Transactions

In a previous post, I described the basics of self-directed IRAs; in this post, I provide some examples of prohibited transactions with disqualified people. The following are the transactions that are specifically prohibited by the Internal Revenue Code and an example of each:

Selling, Exchanging, or Leasing Property

The owner of an IRA intends to invest in real property with his IRA, but before the self-directed IRA account is properly funded, the owner learns of an opportunity that he needs to act on quickly. He purchases a property from an unrelated party with his own funds and the next day transfers the property to his IRA at the same price. This is a prohibited transaction between the IRA and the IRA owner even if the IRA would have been allowed to make the exact same purchase directly from the unrelated party.

Lending Money or Extending Credit

The owner of an IRA wishes to invest her IRA in an asset but does not have enough cash in the IRA for an outright purchase. The bank agrees to a loan but only if the IRA owner agrees to personally guarantee the debt. This is treated as an extension of credit from the IRA owner to the IRA and as such is a prohibited transaction.

Furnishing Goods or Services

The owner of an IRA that leases a piece of rental property hires her son to repair a broken window on the property and the son does so for a fair market price. This is a prohibited furnishing of services by a disqualified person (the son) to his mother's IRA.

Use of IRA Assets by a Disqualified Person

An IRA owner decides to purchase a vacation home and have a management company lease it to third parties throughout the year. If the vacation home is owned by the IRA and the IRA owner allows his in-laws to stay in the home for a weekend, this is a prohibited transaction even if fair market rent is paid to the IRA.

Fiduciary Self-Dealing with the IRA

An IRA owner loans IRA funds to a corporation in which the IRA owner is a 35% shareholder. This is likely to result in a prohibited transaction even though the corporation is owned less than 50% by the IRA owner and is technically not a disqualified person. This is because the IRA owner is a fiduciary of the IRA and will likely be deemed to be dealing in his or her own interest.

Receipt of Consideration by a Fiduciary from Transacting with the IRA

An IRA owner, who is a licensed real estate agent, purchases real estate for his IRA from an unrelated party and receives a commission from the sale. Because the IRA owner is a fiduciary of the IRA and received consideration from transacting with the IRA, this is a prohibited transaction.

For further discussion and examples of prohibited transactions, please see Warren L. Baker's article on WealthCounsel's blog and this article by Strategic Property Exchanges, LLC.