All posts in Taxes

08 Apr

What Can You Do To Avoid Transfer Tax Audits?

In Taxes by admin / April 8, 2013 / 0 Comments

Estate Planner Mar-Apr 2000

In recent years, the IRS has frowned on several widely used estate planning techniques. But if you always strictly follow the IRS’s approved path, you could end up paying more transfer tax than you should — not all positions taken by the IRS are upheld in court. If you anticipate that some of your transfers will receive heightened scrutiny, you may take additional steps to prevent an audit or reduce the controversy surrounding an audit.

Valuation Discounts

One area under IRS scrutiny is valuation of family entities where discounts for minority interest and lack of marketability are claimed on transfers of business interests to family members. The IRS has focused on examining valuation discounts for these entities. Gifts of interests in closely held businesses are notoriously hard to value because no ready market exists in which interests in them are bought and sold. So, the value of such a business as a whole is often a matter of opinion. In addition, when family members give business interests, they often take discounts that further depress the gifts’ value. These discounts can arouse the IRS’s interest.

Similarly, gifts of interests in family limited partnerships (FLPs) that include fractional interest and marketability discounts are also commonly audited. FLPs reduce estate tax by transferring limited partnership interests to a younger generation. The value of these interests is discounted when the gifts are made to reflect their lack of marketability. The idea is that willing buyers would pay less for these interests because the owner is not easily able to sell the interests to someone else. Generally, limited partnership interests are not traded in any public market and lack a reasonable prospect of being registered for trading in a public market. A discount is also taken to adjust for interests being minority interests that the buyer is not able to exert control over.

Donors of interests in family businesses often limit the gifts to the donor’s $10,000 annual exclusion from gift tax ($20,000 for a married donor whose spouse agrees to split the gift). Even though the donor will not owe gift tax, filing a proper gift tax return is important. Though it may seem counterintuitive, one way to lessen an audit risk is by fully disclosing all relevant facts when filing a gift tax return. Adequate disclosure of the gift prevents the IRS from extending gift tax statute of limitations. Inadequate disclosure allows the IRS to revalue the gifts and assess additional tax. The donor is obliged to file a complete return and report the value of the gifts. While the IRS does not require an appraisal, it can be helpful to have an expert opinion to support your valuation.

Crummey Powers

The use of Crummey powers commonly used in irrevocable insurance trusts is another example of IRS hostility. The IRS has refused to issue rulings on these powers and has repeatedly challenged them in tax court. But despite these attacks, people still use them.

Crummey powers in trusts allow a donor to apply the $10,000 annual gift tax exclusion that is available only for current gifts to transfer to the trust. Without Crummey powers, if you establish a trust for the benefit of your children and your children lack control over the trust assets, gifts of cash to the trust might not be considered to be of a present interest and would thus fail to qualify for the exclusion. Crummey powers give beneficiaries the right to withdraw cash for 30 days after the deposit so that the gift becomes a present interest. The best way to protect against a challenge to Crummey powers is to comply with all rules and to use them reasonably. It is safer to provide Crummey powers only to those beneficiaries who have a real interest in the trust. Adding remote relatives just to obtain additional annual exclusions will draw IRS attention. And follow all technical rules regarding Crummey powers and IRS-required notices.


Help Us Help You

As you will always want to stay within the law when reducing tax, you should seek the assistance of a professional. Be sure to contact us for help in these often complicated matters so you can minimize the likelihood of an IRS audit or adverse audit findings.

08 Apr

Get Your Exercise Tax Planning With Nonqualified Stock Options

In Taxes by admin / April 8, 2013 / 0 Comments

Estate Planner Jul-Aug 2000

Nonqualified stock options, whether in a “dot com” company or in an “old economy” company, can be valuable assets. But to make sure you don’t lose too much of that value to Uncle Sam, you need to understand the tax ramifications and plan accordingly.

You normally receive nonqualified stock options for the performance or future performance of services. Section 83 of the Internal Revenue Code governs the income tax consequence of property you receive in connection with services. But for these purposes, the receipt of a stock option is not considered receipt of property if the option doesn’t have a readily ascertainable fair market value at its grant. (If it does, a taxable event may result from the grant.)

But when you exercise the stock option and receive the stock, a transfer of property occurs and Section 83 may apply. Generally, when the option is exercised, the difference between the share value at the date of exercise and the exercise price will be taxed to the option holder as compensation income (unless there are restrictions on the property received).

Once the option is exercised, the compensation portion of the transaction is complete and the employee then holds the property as investment property (assuming it is a capital asset in his or her hands.) The option holder’s basis in the option will be the cost of the option, consisting of the sum of the exercise price plus the amount of compensation income recognized by the employee under Section 83.

Let’s take a closer look at how Section 83 affects nonqualified stock options.

Determining Ascertainable Fair Market Value

Four conditions must be met for your option (which is not actively traded on an established market) to have a readily ascertainable fair market value:

1. The option is transferable by you as the option holder.

2. The option is exercisable immediately in full by you.

3. Neither the option nor the underlying property is subject to any restrictions that have a significant effect on the option value.

4. The fair market value of the option privilege is readily ascertainable.

Even if the option’s value becomes readily ascertainable between the date of the grant and the exercise date, you still do not recognize income until you exercise the option. Under Section 83, the difference between the share value at the date of exercise and the exercise price generally will be taxed to you as compensation income (unless there are restrictions on the property received).

This closes out the compensation aspect of the transaction and you then hold the stock as investment property (assuming it is a capital asset in your hands). Your basis will be the cost of the option (the sum of the exercise price plus the amount of compensation income you recognized).

Determining Risk of Forfeiture

As part of your tax planning, you may defer income recognition on the exercise of stock options until the actual sale if the stock received is subject to substantial risk of forfeiture and transferability restrictions. Two questions are helpful in determining whether your stock meets these conditions:

1. Are the required services “substantial?”

2. Are the forfeiture conditions likely to be enforced against you, as the employee?
Services may be considered substantial if you have to perform them to keep the shares of stock. If you have the right to decline to perform such services without forfeiting the stock, then they may be considered insubstantial.

What if your employer transfers stock in connection with your performance of services as an employee? Under the terms of the transfer, you are subject to a binding commitment to resell the stock to the corporation if you terminate your employment for any reason before the expiration of a two-year period from the date of the transfer.

In this example, your rights in the stock would be subject to a substantial risk of forfeiture during the two-year period. The compensation element of the stock received under the options remains open until the restrictions on transferability lapse and the forfeiture provisions no longer apply.

Making a Section 83(b) Election

You can elect under Section 83(b) to close the compensation element of the transaction at the time you receive the shares of stock from your employer. When you make the election, you will recognize income on the difference between the value of the shares and the option price. If there is no difference, then you will not recognize compensation income. Any appreciation — from the time of the election until the time of the later sale — is potential capital gain. You must make the election within 30 days after the property transfer. If there is a chance the value of the property will appreciate, making a Section 83(b) election is generally advantageous. After you make the election, any increase in the value of the shares received under a nonqualified stock option will be taxed at the lower capital gains rates, rather than as ordinary income. If no election is made, when the restriction lapses, the full value of the property (less any amount paid for the property) will be taxed as ordinary income.

Receiving the Most From Your Nonqualified Stock Options

If you receive nonqualified stock options from your employer, be aware of the tax ramifications of Section 83 when you exercise the option. With a clear understanding of how Section 83 affects nonqualified stock options, you can realize a greater return.

08 Apr

Minimize Income Tax Issues With Proper Estate Planning

In Taxes by admin / April 8, 2013 / 0 Comments

Estate Planner Sept-Oct 2000

To assure that your estate plan will work as you intend, don’t overlook income tax issues your loved ones may face after you are gone. A problematic issue to consider is that some assets you own at death may constitute deferred income — also known as income in respect of a decedent (IRD). The most obvious examples of IRD are regular individual retirement accounts (IRAs) and retirement plans. If you are a doctor, lawyer, accountant or own an unincorporated business, you may have significant IRD in the form of uncollected fees or accounts receivables. These types of assets will remain subject to income tax after your death, either by your estate or your beneficiary.

Allocating assets among your beneficiaries to reduce income tax is a key part of a smart estate plan. You may already be familiar with the advantages of deferring income tax during your lifetime with assets such as traditional IRAs. An important goal of estate planning is to allow your family to continue that deferral after you are gone. Let’s take a closer look at how IRD can affect your estate planning.

Not All Assets Are Treated Equally 

When deciding how to distribute your assets upon your death, keep in mind that not all assets are treated equally.

For example, suppose you leave your house to your son and leave your interest in a deferred compensation plan to your daughter. Even if both assets have the same market value at your death, your daughter may receive much less because the assets received are subject to income tax. Your son will receive a step-up in basis on the house as of the date of your death. When he sells the house, he will not owe capital gains tax. IRD assets are not entitled to a step-up in basis.

If you have sufficient assets in your estate, you’ll want to fund the trust that qualifies for the marital deduction with IRD assets rather than with your credit shelter trust. Doing so doesn’t waste credit shelter funds on income tax. Use other assets for the credit shelter trust. In addition, paying income tax with the marital share may reduce the estate tax ultimately paid by the surviving spouse at death.

Benefits under a deferred compensation plan that you have not yet paid income tax on is another type of IRD. Roth IRAs are not IRD because you fund them with after-tax dollars and they continue to grow income tax free.

Another example of assets that are not treated equally are IRAs. For example, if you leave a regular IRA to one child and a Roth IRA with the same value to another child, whoever receives the Roth IRA will realize a larger payoff. Why? Because a regular IRA has a built-in income tax liability and the Roth IRA is income tax free. In addition, if your child continues to hold the Roth IRA, the growth in its value will also be income tax free.

In contrast, income tax can be deferred on a regular IRA if it continues to be held, but any increase in the IRA’s value will also be subject to income tax. (An additional advantage of receiving a Roth IRA is that distributions are not required to begin at age 701/2, unlike a regular IRA.)

The disadvantages of receiving IRD assets are offset somewhat because your beneficiaries can receive an income-tax deduction based on the amount of federal estate tax paid on the IRD asset. Be careful to fairly apportion this deduction among your beneficiaries. For example, if you leave $1 million of IRD assets to your daughter through a beneficiary designation and $2 million of non-IRD assets to your son through your will, your son may receive a $1 million estate tax bill, while your daughter may be able to shelter the income and receive the deduction.

Play by the Rules

An important part of planning for IRD assets is to ensure that your beneficiaries can defer payment of income tax as long as possible. When planning your estate, keep in mind these general rules regarding IRD:

When giving a specific amount, be sure enough non-IRD assets are available to fund it. Otherwise, income tax may be triggered. For example, if your will provides that you leave $10,000 to your friend and the bequest is satisfied with an IRD asset, your estate could owe income tax.

Many estate plans use a formula to provide that your applicable exclusion amount (currently $675,000) will pass to one trust and the balance will pass to a marital trust for your spouse. The use of these formulas can sometimes trigger IRD on the funding of the trust. To avoid triggering IRD, provide that a specific fraction of your assets be used to fund the trusts rather than a specific amount.

Avoid naming your estate — rather than specific persons — as beneficiary of IRD. If your estate receives the asset first and it passes to a beneficiary, then income tax may become due immediately.

Lessen the Impact of Income Tax On Your Beneficiaries

Planning for estate tax can be difficult enough. Factoring in income tax significantly increases planning complexity. By learning how to allocate IRD affected assets, you can greatly lessen the impact of income tax on your beneficiaries.