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

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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.

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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.

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Savings Incentive Match Plan for Employees

A Savings Incentive Match Plan for Employees (SIMPLE Plan) is a written salary-reduction arrangement that allows small businesses that meet certain requirements to make retirement contributions on behalf of eligible employees. A SIMPLE Plan "is ideally suited as a start-up retirement savings plan for small employers not currently sponsoring a retirement plan." A SIMPLE Plan is established by a written agreement and setting up Individual Retirement Accounts for employees.

In order to be eligible to establish and maintain a SIMPLE Plan, a business can not maintain or sponsor another retirement plan and must have 100 or fewer employees who earned $5,000 or more in the prior year. All of the employees in this category are eligible to participate in the plan and the employer may not impose more restrictive eligibility requirements. The employer is required to make either a non-elective contribution of 2% of each eligible employee’s compensation or a match of the employee’s elective salary reduction of up to 3% of the employee’s compensation.

Employees can make salary reduction contributions up to $12,000 in 2013, plus catch-up contributions of $2,500 for individuals 50 or older. Elective deferrals of an employee’s wages are included in Form W-2 wages for social security and Medicare purposes only. Employer contributions to a SIMPLE Plan are excluded from the gross income of the employee and deductible by the employer.

While the contribution limits of a SIMPLE Plan are lower than some other small employer retirement plan options, SIMPLE IRA Plans do not have the start-up and operating costs of other plans, nor is there any filing requirement for the employer. Furthermore, because SIMPLE Plan contributions can reduce salary, they can be used to reduce payroll or self-employment tax when compared to some other retirement plans.

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Excel's Sumproduct Function

Excel's SUMPRODUCT function is more useful than it appears.  On its surface, SUMPRODUCT simply "returns the sum of the products of corresponding ranges or arrays." The easiest way to demonstrate this is to use the following table:

	A	B
1	5	3
2	2	6
3	0	10
4	1	8

The formula =SUMPRODUCT(A1:A4,B1:B4) yields 35, which is the sum of the products of columns A and B, calculated as follows: (5*3)+(2*6)+(0*10)+(1*8).

While this functionality alone can be useful in some contexts, the real power of SUMPRODUCT comes from utilizing criteria. The values in any column can be logically tested as TRUE or FALSE in Excel. The logical value TRUE is represented by the number one and the logical value FALSE is represented by zero.

With that in mind, we can analyze a larger table that lists a client's name, the business entities associated with that client, and the due date and fee amount of the annual renewal filing required by the state the entity is formed in:

	A	B	C	D	E	F
1	Client	Entity Name	Entity Type	State	Month Due	Amount
2	John Doe	ABC Corporation	Corp	UT	Apr	15
3	John Doe	Doe Family Partnership	LP	UT	Dec	15
4	John Doe	Doe Rental Property, LLC	LLC	DE	Jun	250
5	John Doe	Doe Equipment, LLC	LLC	DE	Jun	250
6	Bill Smith	Bill Smith, DDS, Inc.	Corp	NV	Jan	325
7	Bill Smith	Smith Family Partnership	LP	WY	Dec	50
8	Bill Smith	Smith Equipment, LLC	LLC	DE	Jun	250
9	Bill Smith	Smith Business Property, LLC	LLC	NV	Oct	325
10	Bill Smith	Smith Rental Property, LLC	LLC	NV	Oct	325
11	Bill Smith	Smith Vacation Home, LLC	LLC	WY	Feb	50

Suppose that Bill Smith is wondering what he will be paying each year for all his annual state renewal filings. This can be easily calculated with the following formula: =SUMPRODUCT(--(A2:A11="Bill Smith"),F2:F11). The result is 1,325.

The array in column A must equal "Bill Smith" in order for the figure in column F to be included in the total. The first four rows do not equal Bill Smith so they return FALSE, and the remaining rows do equal Bill Smith so they return TRUE. The "--" turns the Boolean values TRUE and FALSE into the integer value 1 and 0 respectively. The products of the values from column A and the values in column F added together equal 1,325.

Of course, the above result is also possible with the following SUMIF formula: =SUMIF(A2:A11,"Bill Smith",F2:F11). However, SUMIF does a poor job of handling multiple criteria, while SUMPRODUCT can. Following are some additional examples of SUMPRODUCT formulas and the information they return.

To find the total fees due for Bill Smith's LLCs, use this formula: =SUMPRODUCT(--(A2:A11="Bill Smith"),--(C2:C11="LLC"),F2:F11), which results in 950.

To find the total fees due for Bill Smith's Nevada LLCs, use this formula: =SUMPRODUCT(--(A2:A11="Bill Smith"),--(C2:C11="LLC"),--(D2:D11="NV"),F2:F11), which results in 650.

To find what all clients will be paying for LLC fees in the month of June, use this formula: =SUMPRODUCT(--(C2:C11="LLC"),--(E2:E11="Jun"),F2:F11), which results in 750.

In summary, SUMPRODUCT simply returns the sum of the products of corresponding ranges or arrays. However, if multiple arrays are used as filters, its usefulness increases dramatically.

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Charging Order Remedies

A charging order is a statutory provision of law that allows a creditor of a company’s owner to take distributions made to the owner by the company. It is a limited remedy designed to protect innocent owners by preventing a creditor from disrupting business activities by seizing or controlling company interests. Because the creditors cannot control the entity, they cannot control when distributions are made, meaning that the creditors get nothing if the business never makes a distribution. Limited partnerships and limited liability company statutes, but not corporation statutes, generally limit a creditor to a charging order.

As an example of how charging order protection works, assume that Jane forms a new Corporation and contributes $10,000. Jane is the Corporation’s 51% owner, and her husband John owns 49%. The Corporation prospers and is worth $10 million some years later. At that time, Jane is driving her personal car negligently and runs over and kills a doctor; she incurs a $10 million judgment. Because her business is formed as a corporation, the estate of the doctor can levy on Jane’s stock, thereby gaining control of the Corporation, and sell its assets in satisfaction of the judgment. This will result in Jane’s loss of employment and in the liquidation of the corporation at a substantially discounted price, with her husband receiving 49% of the discounted proceeds.

However, if Jane had initially organized her business as a limited liability company, the exclusive remedy for the estate of the doctor in most jurisdictions is a charging order. As such, the estate would be entitled to distributions that the LLC makes, but nothing more; it cannot levy on Jane’s LLC interest, fire her, or liquidate her company.

Because limiting a creditor to a charging order is designed to protect the innocent members in a business entity, this limitation may not apply where a limited liability company has only a single member. In fact, a number of courts have held that creditors of the sole member of an LLC are not limited to the charging order remedy and that they may seize the debtor’s LLC interest. Accordingly, a single member LLC by itself cannot be relied upon to provide meaningful asset protection.

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File 1120S instead of Schedule C

Schedule C is part of Form 1040 and is used to report income or loss from a business. “Business” means any continuous activity engaged in for income or profit. Schedule C is also used to report statutory employee wages and expenses, income and deductions of certain qualified joint ventures, and certain income shown on Form 1099-K and Form 1099-MISC. There are two important reasons why reporting business income on Form 1120S is better than reporting business income on Schedule C.

First, is audit risk. The IRS continually tracks the “tax gap,” or the amount of tax liability faced by taxpayers that is not paid on time. A huge portion of the tax gap is attributable to Schedule C under-reporting; this is the reason why the IRS audit efforts focus so heavily on Schedule C. Additionally, claiming several years of losses in a row on Schedule C will increase audit risk with the IRS arguing that the “business” is really a “hobby” and that the losses should be disallowed.

Not only does filing Schedule C cause an audit risk, it also results in paying more self-employment taxes than necessary. On Schedule C, all of the net income from the business is subject to self-employment tax, which is normally around 15 percent. Self-employment tax is in addition to income tax.

By forming a business entity and electing to have that business entity taxed under Subchapter S of the Internal Revenue Code, self-employment tax liability can be reduced. A Subchapter S Corporation (S-Corp) is created when an eligible entity, such as a corporation or limited liability company, elects to be treated according to the rules of Subchapter S of the Code and its regulations.

S-Corp net income is reported on form 1120S and flows through to the personal tax return of its owners, avoiding Schedule C and self-employment tax all together. However, S-Corps must pay a reasonable salary to its owners. Salary is subject to payroll taxes, and payroll taxes are virtually identical in amount to self-employment taxes. However, S-Corps do not need to pay all net income as salary, and any net income not paid as salary avoids both self-employment tax and payroll tax.

In order to form an S-Corp and file Form 1120S, advance planning must be undertaken since a business entity should be formed and Form 2553 should be filed to make the S-Election near the beginning of the tax year. Doing so, however, is likely to result in a smaller overall tax liability at year end.

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