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Black Friday Sale on 2017 Tax Planning Tips
(c) 2017
by Joseph B. Darby III, Esq.
Sullivan & Worcester LLP
One Post Office Square,
Boston, MA 02109
(617) 338-2985 (office)
(617) 719-1534 (cell)
SW Tax Briefings
One Post Office Square
Boston MA 02109
December 6, 2017
4:00 - 5:45 pm
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Joseph B. Darby III, Esq.
Joseph B. Darby III, Esq. is a senior partner in the Boston office of Sullivan & Worcester, LLP, and
has been admitted to the practice of law in Massachusetts since 1979. He concentrates his legal
practice on tax and business law, and advises individuals and business entities on a wide variety of
tax-related matters, including income-tax planning for business and real estate transactions, estate
planning, wealth preservation, and represents taxpayers in tax controversies with the IRS and state
tax authorities. He is recognized as one of the Best Lawyers in America in the area of tax practice
by Best Lawyers®, the oldest and most respected peer-review publication in the American legal
profession
Mr. Darby is the author of the highly regarded Practical Guide to Mergers, Acquisitions and
Business Sales, the Second Edition of which was published in 2017 by The National Underwriter
Company, a Division of ALM Media, LLC, and he is a recognized authority in the structuring of
mergers, acquisitions, business sales, and related business transactions. He teaches a course entitled
Tax Aspects of Buying and Selling a Business at the Boston University School of Law Graduate
Tax Program (GTP).
Mr. Darby is also a recognized authority on the taxation of intellectual property, including tax issues
related to the development, licensing and exploitation of intellectual property rights, and the
migration of valuable intellectual property to offshore jurisdictions. He teaches two courses on
taxation of intellectual property at the GTP, the first entitled Taxation of Intellectual Property, and
the second entitled Structuring Intellectual Property Transactions.
Mr. Darby has been the recipient of numerous journalism and writing awards, including recognition
as “Tax Writer of the Year” in 2007 and 2011 by Practical International Tax Strategies, a Thomson
Reuters publication. He has authored 2 books and more than 1,000 articles for such diverse
publications as The Tax Lawyer, Worth Magazine, Venture Capital Magazine, Banker &
Tradesman, Mass High Tech, Hemispheres Magazine, Contract Professional, Trusts & Estates
Magazine, The Boston Globe, The Boston Herald, The Boston Business Journal and The Boston
Phoenix.
Mr. Darby was a sports writer in an earlier life, and wrote sports columns for numerous publications
including The Boston Herald, The Boston Phoenix, Hemispheres Magazine and Worcester
Magazine. The New England Press Association honored him with the First Place award in the
category of Sports Columns in 1990, beating out all other competitors that year.
Mr. Darby is the editor of an entertaining and informative tax blog entitled “Tax and Sports Update,” a
fun and readable tax blog that is billed, tongue in cheek, as “The ONLY tax newsletter with an
award-winning sports column.” The blog is at www.taxandsportsupdate.com.
Mr. Darby has served as pro bono legal counsel to a variety of Boston-area charitable organizations.
He is currently the President and a Board Member of the Watertown Police Foundation, an
organization formed to support the Watertown Police Department and the Watertown community at
large to cope with the challenges faced in the aftermath of the events of April 19, 2013. He is a
former President of the Boston Police Foundation (2008-2012), and served in a similar capacity for
that organization.
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Mr. Darby received his B.S. degree in Mathematics and Political Science, from the University of
Illinois in 1974, with Departmental Honors in Mathematics, Magna Cum Laude, Phi Beta Kappa
and Bronze Plaque (top 1% of graduating class). He graduated with honors from Harvard Law
School in 1978.
Additional biographical information, including copies of numerous articles written by Mr. Darby, is
available at his firm website www.sandw.com.
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Black Friday Sale on 2017 Tax Planning Tips
(c) 2017
By: Joseph B. Darby III, Esq.
Sullivan & Worcester, LLP One Post Office Square
Boston, MA 02109
(617) 338-2985 (work)
(617) 719-1534 (cell)
I. STATE OF THE UNION.
A. The State of the Union.
1. The United States in 2017 continues to be a politically divided country, with
ongoing acrimony and splenetic debates across a spectrum of issues, many of which directly or
indirectly implicate federal tax policy and the Internal Revenue Code.
2. The Republican Party holds the office of President and both houses of
Congress, and is trying mightily to enact tax reform. At this moment there are two competing bills
that have been passed, by the House of Representatives and by the Senate, respectively, and these
two bills will go through the Congressional reconciliation process and will eventually pass – or not.
It is hard to assume that ANYTHING is a sure thing in Congress these days, but at the moment the
expectation is that the Congress will in fact deliver a major piece of tax legislation before the end of
this year.
3. This Outline is supplemented by Exhibit A, which contains a special handout
that compares key provisions of the Senate and Congressional tax bills, and offers some thoughts on
where the legislative process may end up – and some thoughts on year-end 2017 tax strategies.
B. The Current State of the Internal Revenue Code…and the Public Fisc.
1. There is a very good chance that the Internal Revenue Code (the “Code”) will
continue to have the same legal characteristics as in recent years – namely, a massively complicated
statute that literally NO ONE fully understands, rife with political compromises and general
financial chicanery, offering expensive tax indulgences to favored constituencies, all while coming
no where close to actually paying for the current federal budget expenses.
2. Fact: The United States is $20.6 trillion in debt on the date of this seminar.
See the chart on the top of the next page.
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3. The U.S. federal budget deficit for fiscal year (FY) 2018 (October 1, 2017
through September 30, 2018) is currently projected to be $440 billion. U.S. government spending
for FY 2018 is projected to be $4.094 trillion compared to projected revenue of $3.654 trillion.1 The
Treasury Department reported that the deficit for FY 2017 was $666 billion.
4. Revenue for FY 2017 was a record $3.3 trillion, but spending was also a
record at almost $4 trillion. The deficit was 14% higher than the prior year.
C. Four Reasons for the Budget Deficits.
1. These enormous federal budget deficits are the result of four factors.
2. First, the attacks that occurred on 9/11/2001 led to the War on Terror. U.S.
military spending rose from $437.4 billion in 2003 to a peak of $855.1 billion in 2011.
3. Second, mandatory spending, notably on Social Security and Medicare
benefits, has continually and inexorably increased (we have known about this for decades), and has
exceeded $2 trillion per year since FY 2011. These payments already comprise a large (and
growing) majority of the federal budget each year. Only an Act of Congress reducing these benefits
can change that inexorable calculus. It would, in other words, require an Act of Courage.2 How
likely is that to happen?
4. Third, the $787 billion economic stimulus package added to the 2009 deficit
by cutting taxes, extending unemployment benefits, and funding lots of miscellaneous federal
spending, much of it not particularly productive. This expansionary fiscal policy was intended to
1 Source: "2018 Budget. Table 2," Office of Management and Budget, March 16, 2017. “Mid-Session Review Fiscal
Year 2017. Table S-5,” OMB, July 15, 2016. 2 It would require a majority vote in both houses and a signature by the president. It is unlikely to happen until the
budget becomes an absolute crisis. A meaningful reduction in benefits would necessarily take a lot of money away from
current and future beneficiaries. The current political assumption – whether correct or not – is that enraged seniors
would vote lawmakers out of office. It has been called the “third rail” of U.S. politics.
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push the economy out of recession. In fact, the Great Recession ended in the second quarter of
2009, but the huge deficits (in excess of $1 trillion per year) continued for many years thereafter.
5. Fourth, the Great Recession reduced federal revenue and taxes. Government
revenue fell from its pre-recession record of $2.57 trillion in FY 2007 to $2.1 trillion in FY 2009,
and did not fully recover until FY 2013 when it reached $2.78 trillion.
D. Why Does the Government Always Overspend?
1. The argument can be made that the more the government spends, the more it
stimulates the economy. That's because government spending is itself a component of gross
domestic product. An economically valid criticism is that government purchases “political” goods
and services, and that the expenditures are often wasteful, unproductive, politically expedient, and
crowd out private sector spending that would be much more efficient and productive. Debating the
benefits and drawbacks of governmental deficit spending can be the basis of a lively conversation,
not to mention a fist fight. They will not be addressed, or solved, in this Outline.
2. Let us all instead consider the famous and chilling admonitions of Alexander
Fraser Tytler3:
“A democracy cannot exist as a permanent form of government. It can only exist
until the voters discover that they can vote themselves largesse from the public
treasury. From that moment on, the majority always votes for the candidates
promising the most benefits from the public treasury with the result that a democracy
always collapses over loose fiscal policy, always followed by a dictatorship. The
average age of the world's greatest civilizations has been 200 years. These nations
have progressed through this sequence: From bondage to spiritual faith; From
spiritual faith to great courage; From courage to liberty; From liberty to abundance;
From abundance to selfishness; From selfishness to apathy; From apathy to
dependence; From dependence back into bondage.”
II. A LOOK-BACK AT THE AMERICAN TAXPAYER RELIEF ACT OF 2012: TAXES
ARE NOW A LOT HIGHER!
NOTE: Throughout this Outline, various tax thresholds are triggered by
different income measurements, including taxable income (“TI”), adjusted gross
income (“AGI”), modified adjusted gross income (“MAGI”) and just plain “wages,”
depending on the tax changes involved. Pay attention to this odd mish-mash of trigger
levels as you review this Outline. Also, see Appendix A, which ambitiously attempts to
“chart” all the different inflection points and tax rates.
3 Alexander Fraser Tytler, Lord Woodhouselee FRSE (15 October 1747 – 5 January 1813) was a Scottish advocate,
judge, writer and historian who served as Professor of Universal History, and Greek and Roman Antiquities at the
University of Edinburgh.
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A. Summary of the Major Provisions in ATRA-2012.
1. Income Tax Rate Increases. ATRA-2012 imposed steep tax increases on a
relatively narrow band of higher-earning taxpayers, increasing tax rates from the 2012 maximum
marginal tax rate of 35% to a new (nominal) maximum marginal tax rate in 2013 of 39.6%. The
maximum rates are applicable in 2017 for single taxpayers with TI over $418,400 ($426,700 for
2018) and for married taxpayers filing jointly with combined TI over $470,700 ($480,050 for 2018).
Moreover, with all the phase-outs now built into the tax law, the maximum federal income tax rate
is probably closer to 45% at its peak maximum marginal effective rate, and, with the addition of the
3.8% ObamaCare Medicare Tax, reaches an effective federal income tax rate of almost 50% at
some points in the federal tax brackets. In high-tax states such as California and New York, the
combined effective marginal income tax rate on income may now be at or above 60%.
2. Higher Tax Rates for Long Term Capital Gains (“LTCG”) and Qualified
Dividends of Certain Taxpayers. ATRA-2012 increases the maximum tax rate on long-term capital
gains and on “qualified dividends” from 15% in 2012 to 20% in 2013 and later years, and is
applicable in 2017 for unmarried taxpayers with TI of over $418,400, and for married taxpayers
filing jointly with combined TI over $470,700. These thresholds will continue to be indexed
annually for inflation. In addition, capital gains and qualified dividends are also potentially subject
to the Net Investment Income Tax (“NIIT”), as described more fully below.
3. AMT Relief. ATRA-2012 allegedly tried to deal with the run amok
alternative minimum tax (“AMT”) by providing for a permanent indexing for inflation of key AMT
elements, including the AMT exemption amount, the threshold for applying the 26% versus 28%
brackets to individual taxpayers, and the AMT phase-out levels. ATRA-2012 also modified the
AMT calculation so as to allow non-refundable personal credits to be taken against AMT tax
liability. The changes were projected to reduce the number of taxpayers paying the AMT in 2013
from about 28 million (absent the fix) down to “only” about 4 million. However, the AMT
continues to affect almost any person with significant income. The exemption amount, for example,
reaches the full phase out at relatively low thresholds. Meanwhile, all kinds of tax items are
add-backs to the AMT, including interest on private activity bonds, interest paid on mortgages on
second homes, state income taxes paid, tax preference items from flow through investments, etc.
One can pretty reasonably argue that for upper middle class taxpayers and wealthy taxpayers – i.e.,
our clients – the AMT is more often than not the “real” federal income tax.
4. Two Phase-Outs Reintroduced for Higher-Income Taxpayers.
a. ATRA-2012 reinstated the personal exemption phase-out (“PEP”),
and also reinstated the so-called “Pease Limitation” on Schedule A itemized deductions.
Both the PEP and the Pease Limitation apply to single taxpayers with AGI over $261,500 in
2017, and married taxpayers filing jointly with AGI over $313,800 in 2017. These
thresholds are indexed annually for inflation.
b. The PEP causes a taxpayer to lose 2% of the otherwise allowable
personal and dependency exemptions for each $2,500 that the taxpayer’s AGI exceeds the
applicable threshold (i.e., 2% for each $2,500 over $261,500 in 2017 of AGI for a single
taxpayer and over $313,800 in 2017 of AGI for joint filers).
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c. At the same AGI levels, the Pease Limitation causes Schedule A
itemized deductions to be reduced at a rate of 3% of a taxpayer’s AGI over the specified
threshold amount, up to a maximum disallowance of 80% of the itemized deductions
claimed. For purposes of the 80% cap on disallowance, the itemized deductions taken into
account (i.e., multiplied by 80%) will not include the deductions for medical expenses,
investment interest expense, casualty or theft losses, or allowable wagering losses. A
taxpayer calculates that 3% phase-out and the 80% cap, and the reduction is the lesser of the
two amounts.
5. Medicare Taxes Increased.
a. Although not part of ATRA-2012, there were two additional new or
increased taxes enacted by the Patient Protection and Affordable Care Act of 2010, known
popularly as ObamaCare, that also went into effect on January 1, 2013, and these taxes are
referred to in this Outline collectively as the “Medicare Taxes.”
b. First, there is the Net Investment Income Tax that imposes a 3.8% tax
on the “net investment income” or “NII” of taxpayers with MAGI in excess of $200,000 for
single taxpayers and $250,000 for married taxpayers filing jointly. [NOTE: These
thresholds are NOT indexed.]
c. Second, there is a corresponding increase to the Medicare Hospital
Insurance Tax or “HI” tax of 0.9%, imposed on taxpayers with wages that exceed certain
threshold amounts ($200,000 of wages for single taxpayers, $250,000 of combined wages
for married taxpayers filing jointly), thereby increasing the HI component of FICA tax
withholding from 2.9% (1.45% paid by each of employee and employer) to 3.8% (2.35%
paid by the higher-compensated employee and 1.45% paid by the employer). Similar
increases apply for self-employed taxpayers under the Self-Employment Contributions Act
(“SECA”) system. NOTE: An employer is required to withhold from wages it pays to an
individual in excess of $200,000 in a calendar year, without regard to the individual’s filing
status or wages paid by another employer.
d. Significantly, the Medicare Taxes take effect at significantly lower
income thresholds than the increase in income tax rates, and in fact are imposed at
approximately the same levels as the AGI thresholds at which the PEP and Pease Limitation
take effect, which is AGI of over $250,000 for single taxpayers and AGI over $300,000 for
married couples filing jointly.
III. ESTATE AND GIFT TAX CHANGES INTRODUCED BY 2012 ACT
A. Overview of ATRA-2012 Estate and Gift Tax Changes.
1. ATRA-2012 produced a surprisingly pro-taxpayer compromise with respect
to gift and estate taxation. Under the 2012 Fiscal Cliff, the lifetime unified gift and estate tax credit
was supposed to drop back to the level of just $1 million, and the top gift and estate tax rates were
supposed to jump back to 55%. Under ATRA, the top estate tax rate increased to 40% (from 35%
in 2012), but the lifetime unified gift and estate tax credit and the lifetime generation-skipping
transfer (“GST”) exemption remain at the $5 million level, indexed for inflation from 2010 onward.
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For 2017, the lifetime unified credit-equivalent amount was $5,490,000, increasing to $5,600,000 in
2018.
2. State death taxes continue to be deductible under Code Section 2058 in
calculating the federal taxable estate.
3. The applicable exclusion amount (credit-equivalent exclusion amount)
remains portable for estate and gift tax purposes, but note that portability does not apply for the
GST exemption.
4. While it is hard to consider any tax law “permanent” these days, the estate
and gift tax changes are no longer subject to the sunset provisions contained in the 2001 and 2010
Tax Acts, thereby making permanent the additional tax relief contained in the prior legislation, i.e.,
there is no longer a built-in ticking time bomb to return the credit-equivalent amount back to
$1 million and the estate tax rates back up to 55%. As a result, the large majority of American
citizens, including those in the middle class, upper-middle class, and “poor rich” class, are no longer
forced to engage in heavy-duty estate and gift tax planning – at least not for the moment.
IV. NET INVESTMENT INCOME TAX (“NIIT”)
A. Overview of the Net Investment Income Tax.
1. The Net Investment Income Tax is imposed by Section 1411 of the Internal
Revenue Code (“IRC”). The NIIT applies at a rate of 3.8% to certain net investment income of
individuals, estates and trusts that have income above the statutory threshold amounts.
2. In general, “Net Investment Income” includes, but is not limited to: interest,
dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses
involved in trading of financial instruments or commodities, and businesses that are passive
activities to the taxpayer (within the meaning of Code Section 469).
3. Individuals will owe the tax if they have “Net Investment Income” and also
have modified adjusted gross income over the following thresholds:
Filing Status Threshold Amount
Married filing jointly $250,000
Married filing separately $125,000
Single $200,000
Head of household (with qualifying person) $200,000
Qualifying widow(er) with dependent child $250,000
NOTE: These threshold amounts are not indexed for inflation.
4. Estates and trusts are subject to the NIIT if they have undistributed NII and
also have adjusted gross income over the dollar amount at which the highest tax bracket for an
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estate or trust begins for such taxable year. For tax year 2017, this threshold amount is $12,500.
There are special computational rules for certain trusts, including ESB Trusts. As a practical
matter, the NIIT becomes applicable to a trust at a very low income level ($12,500) compared to a
single individual ($200,000) or a married individual ($250,000 on a joint return).
B. Character of Trust Income as Active or Passive for NIIT Purposes.
1. Net Investment Income includes income from a taxpayer’s passive activities,
but does not include “active” income from businesses in which the taxpayer materially participates.
2. The IRS has never provided any useful guidance on what constitutes
“material participation” in an activity by either a trust or an estate, e.g., whether income from an
S corporation held by a trust or estate is active or passive (and, in turn, whether such income is
subject to the NIIT). For example, Regulations Section 1.469-5T(g), entitled “Material
participation of estates and trusts,” is and has been “[Reserved]” for a period of more than twenty
years.
3. The IRS currently takes the audit and litigation position that a trust (and
presumably an estate) can never materially participate in a real estate rental activity, i.e., that the
trust can never qualify as a “real estate professional” and thereby be eligible to treat the real estate
rental activity as an active business. With respect to a business operated through an S corporation,
or through an LLC, that is other than a real estate rental activity, the IRS has generally taken a
relatively narrow interpretation of the circumstances under which a trustee can satisfy the material
participation rules, and thus leans strongly toward characterizing such income as “passive” income
subject to the NIIT.
4. To date, only a brief reference in legislative history4 and two published cases,
Frank Aragona Trust v. Commissioner5 and Mattie Carter Trust v. United States,
6 provide any
guidance on material participation by a fiduciary for purposes of Section 469 (and, in turn, for
purposes of the NIIT). Fortunately, the two published cases, Aragona Trust and Carter Trust, were
huge victories for the trust/taxpayers, and in each case the court found that the activity was active
rather than passive. NOTE: Both cases were passive activity loss cases, not NIIT cases, but the
legal principles are identical, namely, whether the income (or loss) of the trust is active or passive
for purposes of Code Section 469.
5. On January 20, 2015, the Tax Section of the American Bar Association sent a
lengthy and thoughtful letter to the Commissioner of the Internal Revenue Service, expounding on
the question of how the NIIT should apply to estates and trusts. The letter discusses how
S corporation stock or other business interests should be treated in the hands of a trust or an estate
and generally argues that the income should be “active” rather than “passive” under a variety of
common factual circumstances. The letter is divided on whether, if a “true” trust distributes income
to a beneficiary, the “active” status should be measured by the participation of the trustee or the
beneficiary.
4 Senate Finance Committee, Tax Reform Act of 1986, S. Rep. No. 99-313, at 730 (1986) (“Senate Report”).
5 142 T.C. No. 9 (Mar. 27, 2014) (“Aragona Trust”).
6 256 F. Supp. 2d 536 (N.D. Tex. 2003) (“Carter Trust”).
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C. NIIT Tax Planning Strategies.
1. Try to Stay under the Threshold Amount. The NIIT takes effect on MAGI
(essentially AGI) of $250,000 for married filing jointly, $200,000 for filing under single status. For
trusts, the 2017 threshold is $12,500 – VERY LOW. One of the strategies that may be useful in
staying under the applicable threshold is to use installment sales.
2. Invest through Tax-Deferred or Tax-Exempt Retirement Plans. Distributions
from IRAs, Roth IRAs, qualified pension plans (including 401(k) plans), or qualified annuity plans
are not subject to the NIIT, so investment build-up inside the plans avoids the NIIT. Likewise,
investments in tax-exempt bonds or similar tax-exempt investments are excluded from the NIIT.
3. Establish a Non-Grantor Charitable Lead Trust (“CLT”). There are other
reasons to consider a CLT besides the NIIT, but this is an added bonus. A taxpayer who is strongly
charitably inclined may want to contribute investment assets to a CLT. That way investment
income is taxed to the CLT rather than the taxpayer. By contrast, if the taxpayer keeps the
investment assets and makes a charitable contribution of the income, the charitable contribution can
offset the income tax (up to the 50% limit) but DOES NOT OFFSET THE NIIT. “Net income” is
net of charitable contributions deductions, but NIIT is not.
4. Sell Appreciated Assets Using a Charitable Remainder Trust. This strategy
defers recognition of a large amount of capital gain (which would ALL be subject to the NIIT if
recognized in a single year) and spreads it over a period of, say, 20 years. Assume Mr. and
Mrs. Entrepreneur want to sell their business for $5 million, and they have essentially zero tax basis
in the stock. The stock sale would generate $5 million of LTCG, taxed at 20%, plus the 3.8% NIIT.
Contribute the stock instead to a CRT, sell the stock, and then pay a 5% annuity for 20 years. The
Entrepreneurs receive $250,000 per year ($5 million X 5%), they get a current charitable
contribution deduction up from the transaction (a rough estimate is the contribution would be about
$500,000, and could be used in the current year plus the next five years to reduce taxable income),
and the NIIT is deferred, probably reduced substantially, and possibly eliminated entirely (if the
Entrepreneurs have no other income – not likely, but the NIIT is very likely to be reduced
substantially).
5. Consider Investing in Rental Real Estate – But You MUST Qualify as a Real
Estate Professional. Income from an active business under the passive activity loss rules (Code
Section 469) is not subject to the NIIT, and this includes rental income from real estate, but only if
the income is “active” which requires that the taxpayer meet the criteria of a real estate professional.
This means the taxpayer must spend more than 750 hours per year on real estate rental activities.
6. Capital Loss Harvesting. The NIIT is a tax on net investment income, and so
it makes sense to minimize gain in the current year by recognizing capital losses to offset current
capital gains.
7. Don’t Forget Investment Expenses. In addition to capital losses, remember
that certain expenses can be deducted in computing NII. These potential deductions include:
a. Deductions allocable to gross income from rents or royalties;
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b. Deductions allocable to passive trades or businesses;
c. Penalties on early withdrawal from a CD or other savings account;
d. Net operating losses, subject to special rules;
e. Investment interest expenses (Code Section 163(d)(3) expenses);
f. Investment expenses defined in Code Section 163(d)(4)(C) (e.g., investment
advisory fees or other costs directly related to investment income); and
g. State income taxes related to the investment income.
V. INDIVIDUAL INCOME TAX PLANNING IDEAS IN 2017 AND BEYOND
A. Basic Strategies.
1. The “classic” income tax planning strategy is to defer income recognition and
accelerate deductions. However, even with “classic” tax planning, because of the stepping up of
brackets, phase-outs and other floors, ceilings and thresholds, the simple, intuitive strategy is no
longer necessarily the right way to go. It takes thoughtful planning over a timeline of a couple of
years to do it well.
2. But be aware that moving tax items may be counterproductive, especially if
the taxpayer is in the AMT, e.g., you may want to move income earlier in time and deductions later
in time!
3. Income-tax planning and gift and estate tax planning must be integrated in a
new and unprecedented way, particularly planning for the increase in tax basis.
4. Gifts of appreciated property can “transfer” income to younger family
members in lower tax brackets. But be aware of the Kiddie Tax issues.
5. Kiddie Tax planning is an interesting corner of the tax planning world. Give
children income producing assets early in life, and take advantage of the stepping up of the Kiddie
Tax. The first $2100 of income each year is taxed at preferential rates – the first $1050 is tax free
and the next $1050 is taxed at 10%. Moreover, Massachusetts tax does not kick in until $8000, so
even income taxed at the parents’ tax bracket saves Massachusetts tax. Consider, for example, a
gift of $100,000 of blue-chip growth stocks with a combined 2% annual dividend and anticipated
4% annual growth rate.
6. Also think about WHICH assets to use for gifting. It makes a difference.
7. Transferring high-basis assets (e.g., cash) to reduce the estate and keep it
below the lifetime credit equivalent amount ($5,490,000 in 2017) means that all income tax
liabilities are eliminated on death under Code Section 1014 step-up in tax basis. Realize that the
income tax rates and the estate tax rate are often pretty close to equal, and income tax is sometimes
even higher than estate tax. Therefore, retaining appreciated assets in the estate is often the winning
strategy.
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8. Remember the Massachusetts estate tax kicks in above $1 million in estate
assets and goes as high as 16%. See the attached Exhibit B, discussing the strange calculation
formulas for Massachusetts Estate Taxes.
9. The Roth IRA, with permanent elimination of future income taxes on all
investment gains, is the way to go – if the federal government keeps its promises. Not everyone
trusts the U.S. government to keep its promises.
10. Think about making Roth IRA contributions for an amount equal to your
child’s earnings at the summer job. There is a cap of $5500 per year, but give the FULL amount of
the summer earnings each year.
11. Backdoor IRA. There are AGI limitations on the ability to make a
non-deductible annual contribution to a Roth IRA ($186,000 to $196,000 is phase out range in 2017
for married filers – $118,000 to $133,000 for single – and above those levels no contribution is
allowed) but there is no AGI limitation on a non-deductible contribution to a traditional IRA, even
if you already contributed the maximum to 401(k) or other qualified plans. You may be able to
make a non-deductible contribution to a traditional IRA and then later roll it over into a Roth IRA,
since there is no AGI limitation on the rollover transaction. Be aware that this works best if you
have no other existing IRA accounts; otherwise, income may be recognized on a prorated basis over
all the IRA accounts.
12. Interest rates are extremely low, so this continues to be a great time to do a
“freeze.”
13. GRATs are GREAT! Very low interest rates means enhanced transfers to
beneficiaries through a Grantor Retained Annuity Trust (“GRAT”).
14. Family loans for long periods at low applicable federal rates (“AFR rates”)
make a lot of sense as a very simple device to transfer wealth.
15. Installment sales to defective grantor trusts are a huge and leveraged play on
time value of money and freezing values at today’s value for estate and gift tax purposes.
16. Split-dollar loans can be used to finance large life insurance policies at the
abnormally low AFR rates.
17. But low interest rates take the juice out of Qualified Personal Residence
Trusts (“QPRTs”), unless the property can claim a huge discount and/or has great potential for
appreciation. This is an interesting topic to discuss further, because rental of the property by
parents after the QPRT period has expired becomes a de facto “gifting” strategy taxed at income tax
rates (to the kids). Furthermore, the discount is not only based on interest rates, but also on actual
life expectancy and even very elderly people can benefit from a QPRT if they survive the term. A
QPRT is often described as either “a win or a tie.” It may occupy or distract from other planning
opportunities, but it is never an outright loser. QPRT has potential asset protection benefits, the
wealth is tied up so kids can’t monetize the asset and spend or waste it, and the kids, if they die,
have fractional interest discounts.
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18. Recognize that higher taxes means more wealth transfer if one uses a grantor
trust – parent pays the higher taxes for benefit of children and other heirs. Even if the parents are in
the maximum bracket, it’s no worse than a non-grantor trust.
19. Give Away Taxes. Charitable gifts transfer the taxes as well as making a
philanthropic act or statement. Sophisticated choices include private foundations, donor advised
funds, and charitable lead annuity trusts (“CLATs”).
20. But think about how BEST to make charitable transfers, and evaluate
carefully the 30% limitation versus the 50% limitation. Sometimes it actually makes sense to sell
stocks, pay the LTCG (and if necessary the NIIT) and then make gifts of cash at the 50% deduction
limitation rather than the 30% limitation.
21. On the investment side, increase portfolio emphasis on life insurance,
annuities and similar tax-deferred investments. Retirement plans are good, but Roths Rock!
B. Gifts of Appreciated Securities to Donees in Lower Tax Brackets, and
Income-Shifting in General – The “Kiddie Tax.”
1. Consider making transfers of appreciated securities in certain situations and
keeping your cash, which has full tax basis. For example, contributions to a charity may not
produce a full or substantial charitable deduction after taking account of the Pease Limitation and
the AMT impact on a taxpayer’s return, but to the extent that the taxpayer chooses to make
charitable contributions, low-basis stock will produce a charitable deduction equal to the fair market
value of the stock without having to pay the capital gains taxes.
2. Similarly, gifts of appreciated stock to an adult child (e.g., a child that is not
subject to the kiddie tax restrictions described below) will transfer the built-in gains to the child,
which is not optimal estate tax planning, but is very good income tax planning, especially if the
child is in the 15% tax bracket or lower, and therefore pays significantly lower capital gains tax on
the sale.
3. NOTE: Historically, wealthy taxpayers typically chose to transfer cash rather
than highly appreciated stock in order to maximize after-tax wealth transfer to the children.
However with the estate tax applicable only above $10,980,000 ($5,490,000 X 2) of assets for a
married couple in 2017 (subject to inflation indexing in future years), and with income tax rates
considerably more “progressive,” transfers of highly appreciated property that taxpayers plan to sell
anyhow may be more viable as an overall strategy, since children are likely to be in lower tax
brackets. Likewise, transfers of dividend-paying stocks will produce more after-tax wealth to
taxpayers in a lower tax bracket. On the other hand, if parents plan to hold assets until death, it is
better to hold highly appreciated property (because of the step-up in tax basis under Code Section
1014(a)). In general, income-shifting, especially through gifting of property, should be very much
in vogue in 2017 and beyond.
4. Kiddie Tax. The following two rules often affect the tax and reporting of the
investment income following gifts of securities to children:
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a. If the child's interest, dividends and other unearned income total more
than $2100, part of that income may be subject to tax at the parent's tax rate instead of the
child's tax rate. See Form 8615 Instructions, Tax for Certain Children Who Have Unearned
Income.
b. If the child’s interest and dividend income (including capital gain
distributions) total less than $10,500, the child’s parent may be able to elect to include that
income on the parent's return rather than file a return for the child. See Form 8814, Parents’
Election To Report Child’s Interest and Dividends.
NOTE: For either of the foregoing rules to apply, the child must be required to file a return.
For filing requirement information, see Publication 929, Tax Rules for Children and Dependents,
and Do I Need to File a Tax Return? on IRS.gov.
5. Calculate the child's tax on Form 8615 and attach it to the child's tax return
when:
a. The child's unearned income was more than $2100,
b. The child meets one of the following age requirements:
i. The child was under age 18 at the end of the tax year
ii. The child was age 18 at the end of the tax year and the child’s
earned income did not exceed one-half of the child’s own
support for the year, or
iii. The child was a full-time student who was under age 24 at the
end of the tax year and the child’s earned income did not
exceed one half of the child’s own support for the year
(excluding scholarships),
c. At least one of the child's parents was alive at the end of the tax year,
d. The child is required to file a tax return for the tax year, and
e. The child does not file a joint return for the tax year.
6. A parent may be able to avoid having to file a tax return for the child by
including the child’s income on the parent’s tax return. To make this election, the parent should
attach Form 8814 to the parents from Form 1040 (PDF) when:
a. At the end of the tax year the child was under age 19 or under age 24,
if a full-time student,
b. The child’s interest and dividend income was less than $10,500 for
the tax year,
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c. The child had income only from interest and dividends, which
includes Alaska Permanent Fund dividends and capital gain distributions,
d. No estimated tax payments were made for the tax year, and no prior
tax year’s tax overpayment was applied to the current tax year, under the child’s name and
Social Security number,
e. No federal income tax was withheld from the child’s income under
backup withholding,
f. The child is required to file a return unless the parent makes this
election,
g. The child does not file a joint return for the tax year,
h. The parent is the parent qualified to make the election or files a joint
return with the child’s other parent.
7. A child required to file Form 8615 may also be subject to the Net Investment
Income Tax (NIIT).
8. Examples of the Kiddie Tax.
a. Example 1. Ike has a 23 year old son, Junior, who earned $12,000 of
compensation income this year as a struggling law student. Ike gives Junior a family
heirloom, that is categorized as a collectible, valued at $100,000 with $0 basis. Junior sells
the family heirloom for his personal support. As a student under age 24, the kiddie tax
applies to Junior and he recognizes $2100 of gain at the kiddie tax rate and $97,900 of gain
at his parent’s rate. (NOTE: The parent’s tax rate is 28% on the collectibles gain, plus (very
likely) 3.8% for the NIIT, plus state capital gains tax.)
b. Example 2. Tina has a 19 year old son, Raymond, who has $150,000
of earned income as a popular lead guitarist of a local band after dropping out of school.
Tina gives Raymond a thoroughbred stallion that she has held for more than two years (the
long-term holding period for race horses), which stallion is valued at $100,000 with $0 tax
basis. Raymond, who receives a carryover tax basis and a tacking of the holding period,
then sells the stallion and uses the proceeds to buy a new convertible. As an non-student
over age 18 and because Raymond provides for more than 50% of his own support out of his
earned income, the kiddie tax does not apply to Raymond and he recognizes the $100,000 of
gain at his own rate.
c. Example 3. James has a 19 year old son, J. J., who has $30,000 of
earned income as a local artist. James gives J. J. a substantial stock portfolio as his
“inheritance” and the portfolio generates $100,000 annually in qualified dividends.
Raymond uses the dividends to support himself while he pursues his artistic career. As a
non-student over age 18, the kiddie tax does not apply to Raymond and he recognizes the
$100,000 of dividend income at his own federal income tax rate. NOTE: Since his earned
income is relatively low, he will be taxed on the qualified dividend income at the marginal
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tax brackets for long-term capital gains, which in 2017 starts at 0% up to taxable income of
$91,900 and then at the 15% rate above $91,900. Since J. J. will have at the very least the
right to claim his personal exemption and standard deduction, most of his dividend income
should be tax free and only a modest portion taxed at the 15% tax rate. J. J. is also below
the $200,000 threshold for the NIIT. His parents, assuming they are in the maximum tax
bracket, would likely pay the maximum tax on the qualified dividend income of 20%, plus
3.8% for the NIIT.
C. S Corporation 10-Year Recognition Period Under Code Section 1374 Was
Shortened to Five Years Permanently in 2016.
1. When a C corporation converts to S corporation status, the corporation must
track its Net Unrealized Built-In Gains (“NUBIG”) and must pay a special corporate level tax at the
maximum corporate tax rate (currently 35%) if NUBIG is recognized by the corporation at any time
during the five-year recognition period following conversion to S status.
2. Congress shortened the recognition period on a permanent basis from ten
years to five years in 2015.
3. The 5-year rule is highly important for anyone with a former C corporation
that has converted to S corporation status and is currently counting down the years under Code
Section 1374.
D. The Rise of Roth IRAs. Roth retirement accounts are very intriguing, but often
misunderstood, as tax-advantaged investment vehicles. First of all, if income tax rates remain
exactly the same, and if no “outside” funds are used to pay income tax liabilities upon the
conversion of regular IRA to a Roth IRA, then the net after-tax benefits of a regular IRA versus a
Roth IRA are arguably identical.
2. Example: Assume a regular IRA account has exactly $1 million in assets,
and further assume that the investment strategy will produce exactly a 100% investment return over
the next 10 years. Assume that the Taxpayer will be subject to a 40% tax rate both in the current
year and in the tax year 10 years from now, and that the funds in the IRA will be used to pay the tax
liabilities that arise upon the conversion to a Roth IRA. Converting the regular IRA to a Roth IRA
results in $400,000 of tax liability in the current year, reducing the funds in the Roth IRA account to
$600,000. Over the next 10 years this amount doubles, to $1.2 million, which at that time can be
distributed tax-free (assuming the requirements of a qualified Roth distribution are met). By
contrast, if the taxpayer leaves the $1 million in the regular IRA account, and it doubles $2 million
over the next 10 years, and then the $2 million is distributed to the Taxpayer, subject to a 40% tax
rate, the Taxpayer will owe $800,000 of taxes at that time, and will be left with a net after-tax return
of $1.2 million. Thus, under this scenario, the regular IRA and the Roth IRA produce the same
after-tax return in the tenth year.
3. However, if one makes certain (seemingly practical) assumptions, one can
argue that a Roth conversion at this time may make a lot of sense.
a. First, given the current, rather steep stepping up of income tax
brackets, even if there is no further increase in tax rates, it would probably cost less to pay
17 {B2223037; 16}
tax on $1 million in 2017 (or especially if the conversion is spread out over this year and the
next few years) rather than try to distribute twice as much taxable income, namely $2
million or more, ten or more years from now. The point is that spreading recognition of $1
million of taxable income now is probably going to have a lower tax cost than distributing
the $1 million plus investment growth (e.g., $2 million) later in time. NOTE: It is possible
that the stepping up of tax brackets will somewhat offset or reduce this “back end bulge”
problem, but hopefully one’s investment portfolio performs better than the inflation rate.
b. Second, if marginal tax rates increase substantially further in future
years, then paying taxes at today’s rates may appear reasonable or even cheap in retrospect.
c. Third, and most compelling, the Taxpayer can convert the entire
$1 million held in the regular IRA account to a Roth IRA, and then pay the $400,000 tax bill
with non-IRA funds. This has the effect of allowing the taxpayer to contribute an extra
$400,000 to the Roth IRA. If this $1 million then doubles to $2 million over the next
10 years, the entire amount can be distributed thereafter without any further tax cost. This
ability to leverage the amount of funds contributed to the Roth IRA is clearly more
advantageous than continuing to hold the investment in a regular IRA for many taxpayers.
d. Converting to a Roth IRA is not so beneficial if the taxpayer believes
that the federal income tax rates applicable to him or her are likely to decline in future years.
Realistically, taxpayers and their advisors have to project the future direction of U.S. income
taxation, which is impossible, the future direction of the taxpayer’s income, which may be
somewhat possible, and then make educated guesses from there.
E. Booming Business in 1031 Like-Kind Exchange Transactions Threatened by
Pending Tax Legislation in December 2017.
1. In light of the significantly increased income tax rates starting in 2013 – and
especially the increase on long-term capital gains taxes – there has been a booming business in
using like-kind exchanges (“LKEs”) to defer recognition of taxable gain.
2. Real estate is an industry that is heavily dependent on LKEs, but there has
been an increased interest in the use of like-kind exchanges for classes of assets beyond or in
addition to real estate. For example, like-kind exchanges have been regularly used to exchange
assets such as motor vehicles, airplanes, radio and television spectrum licenses, farm animals, major
league baseball contracts, gold investments, and even various categories of intellectual property. If
you are interested, you may obtain a copy of the Author’s Outline entitled “Like Kind and Loving
It: 1031 Exchanges of Art, Airplanes, Automobiles and Wine Collections.”
3. Determining when and under what circumstances investment or business
property is “like-kind” is beyond the scope of this Outline, but see Chapter 19 of Joseph B.
Darby III, Practical Guide to Mergers, Acquisitions and Business Sales, Second Edition, published
by National Underwriter Company, a division of ALM Media, LLC, for a more complete discussion
of the business opportunities to utilize Code Section 1031.
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4. The pending House and Senate Bills in December 2017 would both restrict
like-kind exchanges to real property and essentially eliminate art, airplanes, automobiles and wine
collections (and everything else).
F. Using the Principal Residence as Your Principal Tax Shelter.
1. A principal residence is eligible for an exclusion of gain on sale of up to
$250,000 for single individuals and $500,000 for married couples.
2. Generally speaking, the requirements for claiming an exclusion of gain from the
sale of a principal residence are relatively straightforward. In order to be eligible for the exclusion, the
taxpayer must have owned and used the home as a principal residence for at least two years during the
five years prior to disposition.
3. Whether or not a home is a principal residence is a question of fact for which
no bright line test exists. While physical presence by the taxpayer is generally the controlling factor,
all facts and circumstances are considered in the analysis.
4. To the extent that a taxpayer is able to exclude the gain for regular income
tax purposes, it will also excluded from the NIIT (unlike gain from the sale of a second home) and
so tax-smart investing in 2017 and beyond literally begins at home
5. The pending tax bills would both rather dramatically restrict this popular
exclusion provision. The bills both require ownership and use as a principal residence for five of
eight prior years, among other limitations.
G. Why Real Estate Works So Well as a Tax Shelter.
1. Real estate embodies many smart tax-planning strategies.
2. You can offset losses from one real estate rental activity (a “passive activity
loss,” or “PAL”) against income or gain from another investment (a “passive income generator” or
“PIG”). Moreover, you can control whether you are creating PALs or PIGs by how much debt you
put on the property.
3. Example 1. X buys a building for $1 million that produces $100,000 of net
rental income (a PIG). X then buys a second building with enough interest-only debt so that it
produces a net rental loss of -$100,000 (a PAL). X can offset the income from the PIG with the
PAL, to produce zero taxable income. Meanwhile, the properties will throw off significant cash
flow because of the depreciation. Note that it is often possible in to obtain interest-only debt on the
property, and also qualified non-recourse debt, and X can therefore configure his debt arrangements
to minimize risk, minimize income taxes, and maximize current cash flow.
4. Example 2. After a few years, both real estate rental properties do well, the
annual rents increase, and property 1, the PIG, becomes a bigger PIG while property 2, the PAL,
becomes a skinnier PAL and eventually turns into a small PIG (perhaps called a PIGlet?). The
dreaded specter of taxable income looms. Fortunately, X decides to refinance properties 1 and 2
and use the loan proceeds to buy property 3. Under the interest tracing rules the interest on the
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refinancing loans is deductible with respect to the purchase of property 3, which will turn property 3
into a PAL, and the losses from property 3 can be used to offset the taxable income generated by
properties 1 and 2. All three properties continue to generate cash flow thanks to depreciation.
5. You can eventually exit from real estate investments using either of two
strategies:
a. Code Section 1031 allows you to rollover the sale proceeds into a new
“real estate” property if you want to shift market, location, or other strategic redeployment
of capital.
b. Even the “worst case” is pretty good: You recognize all the
accumulated depreciation over many years later as “unrecaptured Section 1250 gain,” pay a
special federal-level capital gains tax rate of 25% on such gain in the year of sale (after you
have claimed depreciation deductions worth as much as 39.6% in tax benefits many years
earlier), and you pay LTCG tax rates on the appreciation in value above the original
purchase price thanks to Code Section 1231.
c. If you qualify as a real estate professional and meet the material
participation requirements, then there no NIIT on you “investment” gains.
H. Life Insurance Products.
1. The Author of this Outline has never been a particularly strong fan of life
insurance products as investment assets per se. Instead, the most clear-cut situations in which life
insurance made sense included the following:
a. Purchasing what might be called “death insurance”, pursuant to which
a young working couple with young children could insure against premature death of the
breadwinners by having term insurance at fairly low premiums and with a high death
benefit, to hedge against the risk that either or both of the parents might die prematurely
before entering their high income earning years. For example, a 35-year old husband with a
wife and two young children might buy several million dollars of term life insurance, at a
relatively low annual premium, to insure that his family will have the money to raise the
children and send them through college, in the case he were killed in an auto accident the
next week.
b. The other common use was for what might be called “estate tax
insurance,” pursuant to which a married couple would purchase a second-to-die policy,
expecting to pay a lengthy but relatively low fixed premium, and which insurance would pay
a very substantial cash death benefit (e.g., millions of dollars) which could then be used to
pay the estate tax of the second-to-die spouse. This strategy was especially beneficial for a
married couple with substantial illiquid assets, such as real estate, a family business, or any
other similar assets where the value of the assets in the estate of the latter-to-die spouse
(absent an effective and aggressive estate tax planning) would result in a substantial estate
tax liability and the estate would lack the liquidity to pay the estate tax.
20 {B2223037; 16}
2. Because of the significant increase in income tax rates and the opportunity
for a life insurance product to accumulate tax-free build up within the policy and then make tax-free
loans (but subject to interest) to the policyholder, there is now a greater potential to create an
investment vehicle that produces strong economic returns coupled with low or even zero income tax
consequences and very minimal adverse estate tax consequences, all wrapped up into one
sophisticated package.
3. The illustration provided separately by the Author shows how this might
work. NOTE: This is not an endorsement of any company or any product, and merely illustrates a
possible strategy that treats the life insurance product primarily as a tax-deferred investment
vehicle.
a. A 55-year old professional earning a good income decides to invest
$50,000 per year for 12 years into a whole life insurance product, beginning at age 56 and
with the final payment contributed at age 68, when the individual anticipates retirement.
b. Over 12 years, the cumulative premium is $600,000. Some portion or
all of this $600,000 represents the “tax basis” of the owner in the insurance policy.7
c. Starting at age 69, the policy owner begins making annual
distributions to himself, starting with $21,382, and building up at a rate of 5% per year over
the ensuing years. The initial distribution will be a tax-free return of tax basis in the life
insurance policy, if the policy is in fact properly classified as an insurance policy. This is a
critical element because if it fails to meet financial guidelines at the onset as set forth in the
definition of life insurance, the arrangement may be treated as a modified endowment
contract, and treated therefore as an annuity, meaning that some or all of the initial
distributions will be treated as a taxable income. Partial taxability is not the end of the
world, but it does change the after-tax net benefit of the investment structure. The goal is to
make sure the product qualifies as a life insurance product and enjoys the advantages of tax-
free distribution of tax basis first, and the ability to make loans that are characterized as
loans, and not distributions.
d. At some point, the tax basis in the investment is depleted and brought
down to zero, and thereafter the cash advances are treated as loans rather than as
distributions.
e. There are two ways the insurance industry can account for loans, and
in the illustration shown, the loan is treated as a separate and distinct financial transaction,
not as a reduction in the cash surrender value of the policy. This means that the cash
surrender value, unreduced by the loan amounts outstanding, continues to earn a dividend
return. The dividend return is significant because it offsets in part the interest that will be
charged on the loans. Moreover, since the dividends and the loan interest rate are likely to
be somewhat correlated both if inflation kicks in or, in all events, as investment returns and
an interest rate returns vary up and down over time, and this correlation will help make sure
7There is a fairly significant debate as to what the proper calculation is for the tax basis in a life insurance product. The
IRS is currently arguing that the tax basis needs to be reduced by the value of the annual death benefit enjoyed by the
insured individual, but the issue is the subject of on-going dispute.
21 {B2223037; 16}
that there is probably a relatively modest spread over time between interest costs and
dividend distributions. For example, the spread between the dividend return and the interest
rate cost might be 2% or 3%, rather than the full amount of the interest rate charged on the
loan. This is pretty important, because it hedges the risk that rising interest rates could
completely devastate the economic value of the investment. It is not a complete investment
hedge, but it does provide some element of protection.8
f. The tax advantages of this structure should be familiar to accountants
and other tax planners because it is almost identical to the manner in which a private
company, e.g., an S corporation, returns value to its shareholders. Obviously, shareholders
in an S corporation can make distributions to themselves that are first a return of outside tax
basis, and, if the tax basis is brought down to zero, it is pretty common to make loans from
the company to the shareholders that would provide tax-free access to corporate cash. The
difference is that, unlike an S corporation or an LLC, the life insurance policy is able to do
an internal tax-free build up initially (tax-free to the owner of the policy) and then can lend
the money out, thereby providing both a tax-free internal building up of wealth and then
tax-free access to that internal wealth build up. An S corporation offers the second
opportunity, but not the first.
g. This is not an endorsement of any company or product, but simply
raises the issue of looking more closely at the investment benefits of life insurance policies
because of their unique tax attributes. Note that in the projected calculations the policy is
assumed to be owned by the insured and is includible in his estate. The death benefit is
initially set at $1 million, and the value does not significantly increase above that amount
over the many years of the projected ownership of the policy. Rather, beginning around age
90, the cash surrender value starts to decrease rapidly and goes down to a comparatively
modest amount of $210,000 at age 100. The point is that this offers a way to have an
investment asset that has a lot of value, but does not result in a substantial estate tax liability
at the end of the ownership period, because the death benefit is actuarially diminished by the
accumulation of the outstanding loans over time. In effect, the death benefit is being used to
pay off the accrued loan balance and accrued interest of the policy, so that in effect it
becomes a self-created and self-funded viatical arrangement.
h. The Author of this Outline has always noted with candor that life
insurance companies and other insurance companies tend to be quite profitable, and that
profit is earned through the use of your money. If you could invest the money as they do,
and cut out the middleman, you would get a better economic return on your investment than
life insurance offers. However, your investments in the stock market are depleted each year
by the taxes imposed on interest, dividends and capital gains, and these tax costs rose
dramatically for higher earning individuals under ATRA-2012. It is not a level investment
playing field, and so insurance deserves to be considered in the investment mix going
forward. A taxpayer should evaluate an insurance purchase with good advisors and open
eyes, but clearly the higher the tax rates on interest, dividends and capital gains, the more
8It is important to understand what internal accounting mechanism is used by a particular insurance provider. Make
sure that they show the tax consequences of making the loans and how it affects their anticipated internal build up once
the outside tax basis has been depleted and the policy is providing loans to the owners.
22 {B2223037; 16}
advantageous one is likely to find life insurance as an investment asset, in addition to the
other two prominent uses noted above.
I. Liquidating an Existing Charitable Remainder Trust.
1. The idea is that an existing charitable remainder trust (“CRT”) structure can
be liquidated “early” on a win-win basis. The taxpayer with the lead annuity has an asset that can
be characterized as a capital asset, and therefore sold at capital gains rates, even though it would
otherwise produce a long schedule of ordinary income paid over a significant period of time.
2. The charity that is the remainder beneficiary has a strong interest in such a
termination because, by liquidating the lead interest, it can accelerate its access to the economic
benefits of the remainder interest. The concept is to sell the lead interest to the charity for a
promissory note, so the charity immediately thereafter owns the entire beneficial interest in the
underlying property.
3. The trust then sells the underlying property, enjoying a non-taxable
recognition of gain, and uses the sale proceeds to pay off the promissory note, which in turn
produces long-term capital gain to the taxpayer selling the lead annuity interest.
NOTE: It would not be appropriate to set this up as a step transaction, but it is a viable
strategy for an existing “old and cold” CRT.
J. Set up a New CRT in Order to Produce an Up-Front Income Tax Deduction.
1. This is really an income tax strategy where the goal is to manufacture and
create tax deductions at a point in time when, for example, the taxpayer recognizes a very large
amount of income, e.g., from the exercise of non-qualified stock options or other similar ordinary
income transactions.
2. The reason that a CRT makes more sense than a charitable lead annuity trust
or other similar device is that the charitable lead trust deduction is subject to a 30% limitation on
deductibility, whereas the CRT will produce a deduction eligible for the 50% limitation on
deductibility and is therefore more usable and efficient. Moreover, after a few years, it may lead
into the other strategy noted above.
K. Combining of Income Tax and Estate Tax Planning.
1. Income tax planning and estate tax planning have clearly merged into a
larger, more integrated planning environment in recent years.
2. The single biggest factor is the step-up in tax basis under Code
Section 1014(a), which, in this era of very high unified estate and gift tax credits, makes it possible
to retain highly appreciated assets in an estate, avoid federal income taxation (but possibly not state
taxation) and also avoid paying federal income tax on the appreciation of investment assets.
3. Integrated tax planning for the wealthy will involve strategies for making
money, keeping money and then passing it on to heirs, charities and other favored persons. All
23 {B2223037; 16}
three steps need to be implemented effectively, and they are interactive in most cases, calling on
both early wealth-planning strategies and early income tax planning strategies.
L. Taxpayers Will Need to Reconsider Their Investment Strategies.
1. Taxpayers have modified investment decisions based on the fact that federal
income taxes on capital gains and qualified dividends for high-income taxpayers increased by 8.8%
compared to 2012.
2. These tax rates are still well below the maximum rates imposed on interest
income, royalty income, and other forms of ordinary income, but taxpayers may consider more
carefully the possibility of investing in growth stocks that pay low dividends and in effect reinvest
profits within the company, allowing for a deferral of tax.
3. Other intriguing possibilities include investing in tax-exempt obligations of
state and local government (though with a strong caveat to consider risks, since state and local
government finances are increasingly shaky) and also the use of tax-free build up through life
insurance products and Roth IRA accounts, as discussed elsewhere in this Outline.
M. Monitor and Plan for Recognition of Capital Gains.
1. The increase in the capital gains tax rate above certain AGI thresholds
($418,400 for single and $470,700 for married, in 2017), and the imposition of the NIIT on NII at
significantly lower AGI thresholds (frozen at $200,000/$250,000 for single/married) suggests that
taxpayers should carefully evaluate the years in which they will recognize capital gains, recognize
offsetting capital losses, and manage recognition of passive income and passive losses, all in order
to make sure these transactions are timed and coordinated in order to maximize the offsetting
positions and minimize the net taxable income or gain.
2. This is easier to say than to do. That said, moving losses forward and
deferring gain recognition is always a standard strategy in capital gains management. The NIIT is a
bigger and more complicated issue because the thresholds are low and essentially sinking (by virtue
of not being indexed), but this also suggests repositioning family gain recognition to lower brackets
(e.g., gifts of highly appreciated property to children and grandchildren who are at lower tax
brackets).
VI. FOR BUSINESSES, INCOME TAX PLANNING IDEAS IN 2017 AND BEYOND
A. Converting to S Corporation Status to Avoid Medicare Taxes.
1. Taxpayers for years used S Corporation status to avoid the 2.9% HI tax on
net earnings from self employment, by paying a low level of “reasonable” compensation subject to
the HI tax, and then distributing the rest of the profits through the K-1.
2. This strategy has continued to work for active shareholders in an
S Corporation, who are able to treat K-1 distributions as active income not subject to the HI tax (the
same strategy works for the new 3.8% HI tax) and also works to avoid the new NIIT tax on passive
income, which do not tax active income distributed by an S corporation trade or business.
24 {B2223037; 16}
3. By contrast, owners of a single member LLC will likely be subject to the full
3.8% tax on all income derived from the LLC. NOTE: Income allocated to shareholders in an
S Corporation are subject to NIIT.9
4. The proposed tax bills both have complicated new provisions on
pass-through entities that are designed to lower tax rates (based on invested capital) but also modify
the ability to play games with the amount of income subject to either FICA or NIIT taxation. The
bills also seem to eliminate distinctions between S corporations and LLCs. There is a distinct
possibility that these rules could lead to a return in some cases to C corporation status as the
preferred operating vehicle for at least some businesses.
5. Note that even in recent years some smaller businesses have operated as
C corporations in order to take advantage of the lower tax rates on the first $50,000 or $75,000 of
income. Similar opportunities may arise, especially if the C corporation rate is reduced to 20%
while individual (and pass-through) rates remain at 35% or above.
B. Taxation of C Corporations.
1. The corporate tax rate would drop from 35% (and higher at some levels due
to phase-outs) to a maximum of 20%, and (in the House Bill but not the Senate Bill) 25% for
personal service corporations.
2. This rate reduction is both termendously beneficial to U.S.-based
corporations and also should end the embarassing “expatriation” problem that has afflicted the U.S.
business community over the past ten years. See the Author’s article, “Building the New Berlin
Wall,” which excoriates the current U.S. policy of trying to prevent U.S. corporations from
“inverting” in order to escape the highest corporate tax rates of any major country.
VII. STRATEGIES FOR ESTATE AND GIFT TAX PLANNING FOR 2017 AND
BEYOND
A. Income Tax Strategies.
1. Estate planning in 2017, like all prior years, consists of three basic principles:
(1) use all your deductions, exemptions and exclusions available under the Internal Revenue Code,
(2) use the deductions, exemptions and exclusions as early in time as possible, so that the
subsequent income and subsequent growth from those transferred assets inures to the benefit of the
next generation rather than the present generation, and (3) take appropriate steps to reduce the
valuation placed on transferred assets, such as through the use of GRATs, installment sales of
partnership interests to defective grantor trusts, and a variety of other strategies.
2. The estate tax provisions for the moment are comparatively favorable
compared to historic standards, because the $5,490,000 exemption per person, which is doubled to
almost $11 million for married couples, and thanks to the enactment on a permanent basis of
“portability,” means that married couples that have less than $11 million of assets (and this will
9 See Treas. Reg. §§ 1.1411-1(f)(1), 1.1411-6(a).
25 {B2223037; 16}
continue to be indexed for inflation going forward) will generally not be subject to estate and gift
tax liabilities.
3. That said, any taxpayers with substantially more assets than the $11 million
threshold may also be in for an early Christmas present, if the lifetime exemption amount is
approximately doubled to $10 million per person ($20 million for a married couple).
4. The number of people in the estate tax regime each year is already very
small. The Joint Committee on Taxation estimates that 99.8% of decedents each year will pay zero
estate tax, and only 0.2% – 2 out of every 1000 decedents – will play ANY federal estate tax.
B. Portability Is Complicated and Valuable.
1. Tax advisors and accountants will need to focus on utilization of portability.
Basically, if a married spouse dies without using the full $5 million unified estate and gift tax credit
($5.49 million in 2017, as adjusted for inflation), the surviving spouse can use it. However, there
are various rules that affect when the surviving spouse can use it, especially if the surviving spouse
subsequently remarries. Using this to maximum effect will be an important issue.
2. Note that the lifetime exclusion amount is “frozen” (i.e., ceases to be indexed
for inflation) on the death of the first spouse, and meanwhile the GST exemption is not portable at
all. Therefore, using these tax attributes early and effectively will continue to be an important part
of estate-planning for wealthy individuals. However, note that the onerous impact of the NIIT rules
on trusts in particular will complicate the structuring of “dynasty” trusts going forward. See the
further discussion on Trust Income Taxation, below.
3. Complicating this exercise is the increased benefit derived from a step-up in
tax basis under Code Section 1014, which may in some cases militate in favor of using portability to
delay the “step up” event until the death of the second-to-die spouse, assuming assets generally
appreciate in value over longer periods of time.
C. Pay Attention to MA Estate Tax.
1. Here in Massachusetts, while the federal threshold of $10 million pushes an
awful lot of people out of the estate planning arena for federal purposes, Massachusetts continues to
have a decoupled Massachusetts estate tax that takes effect upon $1 million of assets.
2. The “simple” solution to Massachusetts estate tax planning is simple and
glib: Move! In particular, many MA residents later in life choose to change residency to a state
such as Florida without an estate tax. However, the Massachusetts Department of Revenue is very
aggressive about auditing residency issues, especially where a taxpayer retains a residence in
Massachusetts, and where that residence is the former principal residence. Massachusetts usually
audits residency issues in connection with income tax returns, but will probably pay increasing
attention to residency in connection with estate tax audits as well.
3. With all these factors, for a large portion of the client base of a typical law or
accounting firm, estate planning will probably be more focused on Massachusetts estate tax
planning rather than federal tax planning.
26 {B2223037; 16}
D. Trust Income Taxation is Complicated and Brutal.
1. The secret hidden bomb in the ATRA-2012 was the imposition of the NIIT
on trusts. The NIIT tax kicks in for individuals at $200,000 of MAGI for single filers and $250,000
for married filing jointly, but, for trusts, it kicks in at the threshold at which the maximum tax rate
takes effect, e.g., $12,500 for 2017. The major stunner here is that while trusts can typically
distribute out their distributable net income (“DNI”) to beneficiaries and thereby pass the income
from the trust out to the beneficiaries, so that the NIIT applies, if at all, at the beneficiary level,
trusts typically do not pass out capital gains. This means that if a trust sells substantial capital
assets, ranging from real estate to stock to bonds to whatever, and the trust instrument does not
provide for the distribution of capital gains as part of the trust income (that is certainly the situation
for a large majority of trusts), then the effect is that capital gains at the trust level will be subject not
only to a 20% capital gains tax rate, but also a 3.8% health care tax.
2. Although it is pretty unusual in most circumstances, a trust can elect to treat
capital gains as part of the trust income, and thus as part of distributable net income, and potentially
LTCG recognized at the trust level could then be distributed and taxed at the capital gains rates of
the beneficiaries, just like the distribution of trust income from interest, dividends, royalties and
similar investments. However, the trust instrument needs to provide for this, or at least provide for
the trustee to make a reasonable determination of the allocations between principal and income
under The Massachusetts Principal and Income Act (MGL Section 203D). These distribution
decisions are probably locked in place for the vast majority of existing trusts, and so the capital
gains for these trusts will be subject to the 20% capital gains tax plus the 3.8% NIIT. A new trust
will have the opportunity to determine how best to treat capital gains under these circumstances.
3. Unitrusts may be a potentially useful concept in this context because you can
set the return rate at a specified percentage, usually in the range of 3% to 6%, and you can distribute
income each year at the specified rate, and this may allow you to pull some significant portion of
the capital gain out as trust income (but the distribution is taxed to the beneficiary-distributee as
capital gain at the favorable LTCG tax rates).
4. NOTE: This tax-driven tension that encourages distributions of capital gain
to individual beneficiaries comes with the complicated question of fiduciary duties to the current
income beneficiaries versus the remaindermen (or, if you prefer, the remainder persons).
5. Trust income tax planning goes well beyond “year end tax planning” but it is
certainly an interesting and provocative topic. Issues worth considering include:
a. Spousal Lifetime Access Trusts (“SLATs”);
b. Delaware Incomplete Non-Grantor Trusts (“DINGs”) ;
c. Simple decanting of trust assets from one jurisdiction to another
(usually necessary for older trusts), or exercising a power to change the governing law and
jurisdiction of the trust (increasingly permitted by modern trusts). NOTE: This is
sometimes considered the trust equivalent of an “F” reorganization, and in some cases can
materially reduce or eliminate the STATE income taxation of the trust’s income.
27 {B2223037; 16}
E. Investment Partnerships and Mixing Bowl Transactions.
1. Taxpayers who have large built-in capital gains, but who do not want to
recognize the gain currently can sometimes instead contribute appreciated property to a so-called
“investment partnership” specifically set up to act as a kind of “homemade” mutual fund. For
example, 100 taxpayers each owning highly appreciated stock of one specific corporation can form
a partnership contribute those 100 respective stocks into the partnership, and effectively exchange
their ownership in one highly appreciated stock for ownership in a partnership with 100 stocks.
2. In order to avoid taxation under Code Section 721(b), the partnership must
also have more than 20% of non-diversifying assets, e.g., real estate or gold, but for many years
various banks and investment companies have provided these kinds of “investment partnerships” as
investment tools. The Author anticipates that trusts, in particular, may wish to avoid the capital
gains tax plus the health insurance tax, and may choose to consider participating in investment
partnerships rather than recognize current gain at a 23.8% federal rate plus the applicable state
capital gains tax. This is especially true if the investment partnership provides a regular stream of
qualified dividends, which could be distributed out to trust beneficiaries.
F. Focus on Tax Basis Planning.
In the estate planning arena, one of the most important strategies going forward will be to
“create” tax basis for federal income tax purposes under Code Section 1014, by retaining low-basis
assets in the estate of the decedent, which can then be stepped-up on death – ideally, without
triggering any estate tax. The very large lifetime unified credit will take many people out of the
estate tax, but these taxpayers will now have the opportunity to step-up tax basis in low-basis assets,
e.g., the stock in the family-owned corporation, highly appreciated real estate that has been in the
family for years, and so forth. With LTCG rates up and the NIIT tax on top of it, creating tax basis
in assets through Code Section 1014 will continue to be one of the central purposes of an estate plan
in 2017 and going forward.
VIII. AMT PLANNING STRATEGIES – LET’S HOPE CONGRESS REPEALS THE
AMT!
A. Brief Explanation of the AMT.
1. The AMT is a parallel income tax to the ordinary income tax system –
kicking in for any taxpayer for whom the ordinary income tax falls below what they would owe
under the AMT. Introduced in 1969, it was conceived as a tax on the wealthy, intended to ensure a
minimum effective tax rate on those with high incomes. However, the pool of taxpayers subject to
the AMT has grown exponentially over the past 40 years. Until ATRA-2012, the AMT was not
indexed for inflation, and because it had been adjusted only a handful of times over its history it has
sucked in more and more taxpayers each year – from less than 20,000 taxpayers at its inception to
nearly 4,000,000 taxpayers in 2013. Notwithstanding the permanent indexing introduced by
ATRA-2012, that figure is expected to continue to grow at an annual rate of 4% to 6% over the next
decade, further encroaching on the middle class.10
10
http://www.taxpolicycenter.org/taxtopics/quick_amt.cfm#2
28 {B2223037; 16}
2. The AMT sets a tax rate of 26% to 28%, well below the maximum ordinary
tax rate of 39.6%. Its bite comes not from the tax rate itself, but rather from the lack of exemptions
for the taxpayer and dependents and the limitation on deductions. For instance, state, local, and
property taxes are non-deductible under the AMT, as are several itemized deductions. On the
flipside, the AMT provides its own special (and sizable) exemption to shelter lower-income
taxpayers. In 2017, the exemption is $54,300 for single taxpayers and $84,500 for married. Thus,
the AMT tends to only be an issue of concern for taxpayers with gross incomes above $100,000 or
those with large numbers of personal exemptions or itemized deductions. Note that since there is no
clear and simple test to determine if the AMT applies, those at risk of triggering of it must either
work through the entire AMT to ensure that they paying the proper tax, or else risk penalties and
interest if the IRS determines that the AMT applies.
B. Basic Strategies for the AMT.
1. Do AMT planning over two years.
2. Tax-exempt bond investments generally do not help solve the AMT problem,
and in the case of private activity bonds, make it worse, so taxable bond investments may be better
since the yield is higher.
3. Lots of capital gains can be a serious problem under the AMT. The capital
gains themselves are taxed at the capped rate equal to the “regular” 20% rate on LTCG. However,
LTCG pushes up the alternative minimum taxable income (AMTI) and in essence can use up the
exemption and force all the other income into the higher 26% or 28% brackets. Therefore it is
arguable as important – and maybe even more important – to time recognition of capital gains for
AMT purposes as well as for regular tax and NIIT purposes.
4. Time your deductible expenses for AMT as well as regular tax. Many
deductions for regular tax are added back for AMT purposes, including state taxes paid and
mortgage interest on second homes, and using up these expenses in an AMT year effectively throws
them away. The key is to do dual tax planning – regular tax AND AMT tax at the same time.
5. Incentive stock options (“ISOs”) are out of vogue these days, primarily
because of the awful AMT consequences, which cause the “spread” between exercise price and fair
market value of the stock to be treated as a preference item for AMT purposes even though it is
excluded from income for regular tax purposes. If you have ISOs you must have a clear exercise
strategy. One GOOD strategy is to cut a deal with the company whereby you exercise and
disqualify the ISOs to make them NSOs, and then have the company pay you its windfall tax
savings. (An NSO exercise provides a cashless tax deduction for the company equal to the taxable
income recognized by the option holder on exercise, and a profitable corporation can pass that
benefit to the option holder as cash compensation.)
6. Minimize PALs. Passive activity losses are not deductible for AMT
purposes, but may be deductible under some circumstances for regular tax purposes, so watch the
PALs and manage them carefully. Note that PALs are calculated differently for AMT than for
regular tax because AMT generally requires a less favorable depreciation schedule of business
assets.
29 {B2223037; 16}
7. A taxpayer can deduct the interest on up to $100,000 of home-equity loans
for regular tax purposes, but for AMT purposes can only deduct interest on loan balances of up to
$100,000 that are used to acquire or improve a first or second residence.
8. Miscellaneous itemized deductions (such as investment expenses, fees for tax
advice and preparation, and unreimbursed employee business expenses) are allowed for regular tax
purposes but are disallowed under the AMT.
C. Proposed Tax Changes.
1. The House Bill proposes to repeal the corporate AMT. The Senate Bill
retains the corporate AMT.
2. The House Bill would permanently repeal the individual AMT. The Senate
Bill would retain the individual AMT with higher exemption amounts and phase-out thresholds.
IX. CHARITABLE GIVING IDEAS; MISCELLANEOUS OBSERVATIONS
A. Charitable Gifting Rules.
1. Most taxpayers who regularly engage in charitable giving tend to think about
it during the holiday season at the end of each calendar year. Often, that is the best time because of
the ability to fine tune the gifting strategy to the income for that tax year.
2. You may deduct charitable contributions of money or property made to
qualified organizations if you itemize your deductions. Generally, you may deduct up to 50% of
your contribution base (generally adjusted gross income but disregarding NOL carrybacks) to
so-called “50 percent charities,” but 20% and 30% limitations apply in some cases.
3. Charitable contribution deductions are generally available so long as you
itemize deductions. Charitable contributions of capital gain property held for more than one year are
usually deductible at fair market value, subject to a limitation on gifts of appreciated property equal
to 30% of contribution base in any given year. Deductions for capital gain property held for one
year or less are usually limited to cost basis, again subject to the limitations noted above. Amounts
that cannot be used in the current year due to limitations can be carried forward for up to five
additional years.
4. Qualified Organization. The gift must be to a “qualified organization.” This
includes the usual and familiar organizations such as churches, schools, mainstream charities
exempt under Code Section 501(c)(3), branches of government, and so forth.
5. Timing. Contributions must actually be paid in cash or other property before
the close of your tax year to be deductible, whether you use the cash or accrual method.
6. Valuation. If you donate property other than cash to a qualified organization,
you may generally deduct the fair market value of the property. If the property has appreciated in
value, however, some adjustments may be required.
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7. Deduction Limitations. In general, contributions to major charitable
organizations may be deducted up to 50% of adjusted gross income computed without regard to net
operating loss carrybacks. Other contributions are subject to 30% and 20% limitations, depending
on the nature of the property contributed and the specific organization.
8. An interesting question is whether you should sell stock and give cash,
subject to a 50% limitation, versus give the appreciated stock subject to the 30% limitation. For
example, if you commit to give $5 million over next five years, do you sell stock and give cash, or
give stock, in which case you can only deduct 30% of AGI? Note that selling stock results in gain
that increases the AGI, and so the “sell and give” strategy may create more gifting capacity without
too much additional tax.
B. Miscellaneous Observations.
1. Be aware of when you are required to take mandatory IRA distributions. The
70- ½ year rule gets screwed up all the time.
2. Related to that, consider making gifts from IRAs.
APPENDIX
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A-1
“Building the New Berlin Wall,” by Joseph B. Darby III, Business Entities Magazine, a Warren,
Gorham and Lamont publication, May/June 2016 issue.