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The 2010 Federal Estate Tax Choice

To pay or not to pay, that is the question

On December 17, 2010, President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act (the Act) into law. The Act reinstated the federal estate tax for persons who died in 2010, retroactively applying a 35% maximum estate tax rate and a $5 million estate tax exemption. The Act also allows those estates to opt out of the tax. For some estate executors, a choice must be made between paying the tax or not paying the tax. Why would an executor choose to pay the estate tax? There's a good reason.

No estate tax, no step-up in basis


If an executor chooses to elect out of the estate tax, estate property will receive a modified carryover income tax basis, and not a step-up (or step-down) in basis. Step-up (or step-down) generally means that the tax basis of the estate’s assets increases (or decreases) to fair market value (FMV) at the date of death. This is important for two types of assets--assets that have greatly appreciated in value and assets that have a cost basis that is difficult to prove. The modified carryover basis regime allows the decedent's cost basis to be increased by $1.3 million, with an additional $3 million increase for assets received by surviving spouses.

Comparing tax results


Executors will need to evaluate which tax system will be more beneficial to the estate: estate tax or capital gains tax. Estates valued at less than $5 million may want to choose the estate tax system in order to get an income-tax-free step-up in basis on appreciated assets. Certain larger estates might choose the estate tax if the estates calculate that the reduction in capital gains tax on any sale of inherited assets with a stepped-up basis will more than offset the increase in estate tax. Other larger estates might choose no estate tax if the estates calculate that the estate and its beneficiaries will pay less in capital gains tax on any sale of inherited assets than the estate tax that would otherwise be due.

Deadlines


The Act extends the estate tax return filing and payment deadline to September 17, 2011, for the estates of persons who died between January 1 and December 17, 2010. This is also the deadline for filing IRS Form 8939 if the estate elects out of the estate tax in favor of the modified carryover basis regime. September 17, 2011 is also the deadline for making qualified disclaimers from these estates. Estates should also check state law for the applicable state deadlines for making a qualified disclaimer. The estates of decedents dying after December 17, 2010 must follow the usual nine-month deadlines for filing tax returns and making tax payments and disclaimers.

This article was provided by Forefield and distributed by Lawrence Sprung.

Estate Tax Exemption Is Portable (For Now)

Introduction

Recent legislation introduced a new, but perhaps temporary, estate planning concept--exemption "portability." In short, the estate of a deceased spouse can transfer to the surviving spouse any portion of the federal estate tax exemption that it does not use. The surviving spouse's estate can then add that amount to the exemption it is entitled to, increasing the total amount that can be passed on to heirs tax free. This new feature makes it easier for married couples to minimize the potential impact of estate taxes.

The federal estate tax exemption defined

The federal government imposes a tax on the value of your property when you pass it along to your descendants at your death. Any amount that is passed to a surviving spouse is generally fully deductible. The estate is also allowed to exclude a certain amount that passes on to nonspouse beneficiaries. That amount is called the "basic exclusion amount," which is $5 million in 2011.

How the exemption works for married couples

Prior to the new tax law, if a spouse died without having planned for his or her exemption, the deceased spouse's estate would have passed tax free to the surviving spouse under the unlimited marital deduction (assuming all assets passed to the surviving spouse), and the deceased spouse's exemption was lost or "wasted." The surviving spouse's estate could then only transfer an amount equal to his or her own exemption free from federal estate tax. To solve this dilemma, married couples typically set up what is commonly referred to as a credit shelter trust (aka "bypass" or family trust) that sheltered or preserved the exemption of the first spouse to die.

The following example illustrates how portability can achieve a similar result without the use of a credit shelter trust.

Example: Result without portability

Assume Henry and Wilma are married, have all of their assets jointly titled, and have a net worth of $10 million. Henry dies first, when the federal estate tax exemption is $5 million and there is no portability. Henry's estate passes to Wilma free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption. Assume that at the time of Wilma's death, the exemption is still $5 million, the federal estate tax rate is 35%, and Wilma's estate is still worth $10 million. With Henry's exemption completely wasted, Wilma can pass on only $5 million free from federal estate tax. Assuming no other variables, Wilma's estate will owe about $1,750,000 in federal estate tax: $10 million estate - $5 million exemption = $5 million taxable estate x 35% estate tax rate = $1,750,000.

Example: Result with portability

Assume Henry and Wilma are married, have all of their assets jointly titled, and have a net worth of $10 million. Henry dies first, when the federal estate tax exemption is $5 million and there is portability. As above, Henry's estate passes to Wilma free from federal estate tax under the unlimited marital deduction and does not use any of his $5 million exemption. Even though Henry's estate owes no tax, Henry's executor files a timely return on which he elects to transfer Henry's unused exemption to Wilma. Assume that at the time of Wilma's subsequent death the exemption is still $5 million, the federal estate tax rate is 35%, and Wilma's estate is still worth $10 million. Since Wilma has "inherited" Henry's unused exemption, she can pass on the entire $10 million estate free from federal estate tax. Portability of the estate tax exemption saves Henry and Wilma's heirs $1,750,000 in estate tax.

Portability does not eliminate the benefits of credit shelter trusts

Even with portability, there are still tax and nontax considerations that may lead you to use a credit shelter trust, such as:

The portability feature is in effect for only two years and will expire after 2012, unless Congress enacts further legislation.
The trust can help protect assets against creditors of the surviving spouse or future beneficiaries (typically children and grandchildren).
The trust gives the first spouse to die control over the ultimate distribution of his or her assets. For example, in a second marriage situation, one spouse may wish to ensure that any assets remaining after his or her spouse's death pass to his or her children from a previous marriage.
Appreciation of assets placed in the trust will escape estate taxation in the survivor’s estate.
The portability feature applies only to estate tax; it does not apply to the generation-skipping transfer (GST) tax. Without a trust, any unused GST tax exemption of the first spouse to die will be lost.

Some technical information

To use the exemption portability, the first spouse to die must elect to use portability on his or her estate tax return. An estate tax return must be filed by the first spouse to die to use portability even if the return is not otherwise required to be filed.

Many states have state estate tax exemptions that are less than the federal estate tax exemption. So, while your surviving spouse might not be subject to federal estate tax upon your passing, your surviving spouse may have to pay state estate tax if you rely solely on the federal exemption portability.

Exemption portability is available only from the last deceased spouse. It will be lost if the surviving spouse remarries and is widowed again. In other words, if the surviving spouse survives spouse 1, the surviving spouse can use spouse 1's unused exemption even if the surviving spouse marries spouse 2. However, if spouse 2 also predeceases the surviving spouse, the exemption of spouse 1 can no longer be used. However, the surviving spouse can then use the unused exemption of spouse 2.

This article was provided by Forefield and distributed by Lawrence Sprung.

New Rules Offer Easier Cost Basis Reporting

Brokers must track and report cost basis

If you're contemplating selling stock in 2011 and beyond, you should be aware of new federal regulations that give you more flexibility in managing the tax impact of your investment decisions. The new regulations, which went into effect January 1, 2011, require brokers to track your cost basis. Even better, they allow you to determine how your brokerage firm reports the cost basis of a sale. That can be helpful if you want to minimize the amount of gain on which you'll owe federal income tax or maximize a capital loss.

Your cost basis represents the original purchase price of a security plus any commissions or other fees; your adjusted cost basis is that cost basis adjusted for a variety of factors such as stock splits, corporate acquisitions or spinoffs, and reinvested dividends. Until now, reporting the gain or loss from your investments has been your responsibility, and could be very challenging for the average investor. The new regulations should make it easier to record your capital losses or gains accurately on your federal income tax form.

The Emergency Economic Stabilization Act of 2008 requires that, as of January 1, 2011, U.S. broker-dealers and other financial intermediaries must not only track the adjusted cost basis of their investors' accounts, but also report that basis to investor clients on their 1099 forms and to the Internal Revenue Service. The rules will be implemented over time. They'll apply to shares of individual stocks you buy after January 1, 2011, to investments in mutual funds and dividend reinvestment plans after January 1, 2012, and to bonds, options and other securities bought after January 1, 2013. Shares acquired before January 1, 2011 are exempt from the new rules, as are securities held in retirement accounts.

You can tailor your reporting method to suit your tax situation

The new regulations allow you to determine in advance what accounting method you wish to use for each sale of stock after January 1, 2011. Most broker-dealers will designate a default option to use if you do not specify a method. That default will typically be the so-called FIFO method (an acronym for "first in, first out"), which means that the first shares of a security purchased are considered the first shares sold. However, your broker might also allow you to specify LIFO ("last in, first out") or designate specific shares as the ones sold. In some cases, such as shares bought through a direct reinvestment program, using an average cost basis for all shares may be most convenient (most mutual fund companies already employ this method of calculating cost basis).

You may be able to put in a standing order specifying the method you want to use for all trades, or choose on a case-by-case basis; you may also authorize your financial professional to make that decision for you. The rules permit investors to change the designated method for a given trade until the settlement date (the date on which money actually changes hands, which for a typical stock sale is three days after execution of the trade). After the trade settles, you cannot change your mind about the method used. Brokers also will be required to report losses that are disallowed as a result of a wash sale (which occurs when shares are sold and then repurchased within 30 days).

Because the new regulations don't apply to investments purchased before January 1, 2011, you'll still need to do your own calculations on those transactions. The cost basis information will be included on the 1099 form you receive from your broker for tax year 2011.

This article was provided by Forefield and distributed by Lawrence Sprung.

Tax-Free Charitable Contributions from IRAs Extended Once Again

Background

The Pension Protection Act of 2006 first allowed taxpayers age 70½ or older to exclude from gross income otherwise taxable distributions ("qualified charitable distributions," or QCDs) from their IRA that were paid directly to a qualified charity. Taxpayers were able to exclude up to $100,000 in both 2006 and 2007. The law was extended through 2009 by the Emergency Economic Stabilization Act of 2008, and has just been extended again, through 2011, by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the Tax Relief Act).

How QCDs work for 2011

You must be 70½ or older in order to make QCDs. You direct your IRA trustee to make a distribution directly from your IRA (other than SEP and SIMPLE IRAs) to a qualified charity. The distribution must be one that would otherwise be taxable to you. You can exclude up to $100,000 of QCDs from your gross income in 2011. If you file a joint return, your spouse can exclude an additional $100,000 of QCDs in 2011. Note: You don't get to deduct QCDs as a charitable contribution on your federal income tax return--that would be double dipping.

QCDs count toward satisfying any required minimum distributions (RMDs) that you would otherwise have to receive from your IRA in 2011, just as if you had received an actual distribution from the plan. However, distributions that you actually receive from your IRA (including RMDs) that you subsequently transfer to a charity cannot qualify as QCDs.

Example: Assume that your RMD for 2011, which you're required to take no later than December 31, 2011, is $25,000. You receive a $5,000 cash distribution in February 2011, which you then contribute to Charity A. In June 2011, you also make a $15,000 QCD to Charity A. You must include the $5,000 cash distribution in your 2011 gross income (but you may be entitled to a charitable deduction if you itemize your deductions). You exclude the $15,000 of QCDs from your 2011 gross income. Your $5,000 cash distribution plus your $15,000 QCD satisfy $20,000 of your $25,000 RMD. You'll need to withdraw another $5,000 no later than December 31, 2011, to avoid a penalty.

Example: Assume you turned 70½ in 2010. You must take your first RMD (for 2010) no later than April 1, 2011. You must take your second RMD (for 2011) no later than December 31, 2011. Assume each RMD is $25,000. You don't take any actual distributions from your IRA in 2011. Prior to April 1 you make a $25,000 QCD to Charity B. Because the QCD is made prior to April 1, it satisfies your $25,000 RMD for 2010. Prior to December 31 you make a $75,000 QCD to Charity C. Because the QCD is made prior to December 31, it satisfies your $25,000 RMD for 2011. You can exclude the $100,000 of QCDs from your 2011 gross income.

As indicated above, a QCD must be an otherwise taxable distribution from your IRA. If you've made nondeductible contributions, then normally each distribution carries with it a pro-rata amount of taxable and nontaxable dollars. However, a special rule applies to QCDs--the pro-rata rule is ignored and your taxable dollars are treated as distributed first. (If you have multiple IRAs, they are aggregated when calculating the taxable and nontaxable portion of a distribution from any one IRA. RMDs are calculated separately for each IRA you own, but may be taken from any of your IRAs.)

Why are QCDs important?

Without this special rule, taking a distribution from your IRA and donating the proceeds to a charity would be a bit more cumbersome, and possibly more expensive. You would need to request a distribution from the IRA, and then make the contribution to the charity. You'd receive a corresponding income tax deduction for the charitable contribution. But the additional tax from the distribution may be more than the charitable deduction, due to the limits that apply to charitable contributions under Internal Revenue Code Section 170. QCDs avoid all this, by providing an exclusion from income for the amount paid directly from your IRA to the charity--you don't report the IRS distribution in your gross income, and you don't take a deduction for the QCD. The exclusion from gross income for QCDs also provides a tax-effective way for taxpayers who don't itemize deductions to make charitable contributions.

QCDs in 2010

As indicated earlier, the Tax Relief Act also allowed QCDs to be made for 2010, but the deadline for making 2010 QCDs (January 31, 2011) has passed. If you made QCDs in 2011 that you elected to apply to 2010, you must subtract those QCDs from your December 31, 2010, IRA balance when calculating your RMD for 2011.

This article was provided by Forefield and distributed by Lawrence Sprung.

IRS Releases 2011 Inflation Adjustments

On December 23, 2010, the IRS released inflation adjustments for 2011 (Rev. Proc. 2011-12). This revenue procedure applies to taxable years beginning in 2011, and transactions or events occurring in calendar year 2011, where applicable. The following is a list of affected areas:

-Tax Rate Tables
-Child Tax Credit
-Hope Scholarship and Lifetime Learning Credits
-Earned Income Credit
-Standard Deduction
-Qualified Transportation Fringe
-Personal Exemption
-Interest on Education Loans

The full text of these changes can be found in IRS Rev. Proc. 2011-12.

Previously, on October 28, 2010, the IRS had released a partial list of inflation adjustments for 2011 (Rev. Proc. 2010-40). The full text of these changes can be found in IRS Rev. Proc. 2010-40.

This article was provided by Forefield and distributed by Lawrence Sprung.

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