Tax, Trusts & Estates Law Monitor : Estate Planning Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Gift Tax & Trust Issues

For those people who thought there would be a lull in proposed estate/gift tax legislation as a result of the sweeping 2010 tax law, that is not the case. President Obama’s 2012 budget proposal released last week contains numerous important estate and gift tax proposals, which are as follows:

1. Returning the estate/gift tax to 2009 levels, meaning a $3.5 million estate tax exemption amount, a 45% estate/gift tax rate and a $1 million lifetime gift tax exemption.
2. Making permanent the new portability rules with respect to enabling the surviving spouse to use the deceased spouse’s unused exclusion amount.
3. Adding another category of restrictions for family controlled entities that would be required to be disregarded for valuation purposes. A key component of planning involves the use of leverage and valuation discounts to reduce (i) the value of lifetime gifts if assets are transferred during life and (ii) the value of a decedent’s assets at death. This proposal potentially could limit the utility of family owned investment partnerships and limited liability companies.
4. Limiting the use of GRATs to a minimum term of 10 years and requiring the remainder interest to have a value greater than zero. This proposal has been floating around for some time now, and is another attempt to have the usefulness of GRATs minimized.
5. Limiting the duration of generation-skipping transfers in trust to ninety (90) years from the creation of the trust. With many states eliminating rules related to the duration of trusts, this proposal is aimed at recapturing revenue lost with the permitted perpetuity of trusts.

As these proposals are debated, we will keep you apprised of any developments.
 

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New Jersey’s gross income tax system is unique because (1) it allows few deductions (that’s what they mean by “gross income”) and (2) income is separated into different categories or baskets (such as partnership income, interest income, etc.). Allowable deductions in one basket cannot offset income in another basket. This system can create mismatches with a taxpayer’s federal income tax liability and traps for the unwary.

Danny “Tiger” Schulmann is a successful karate practitioner, instructor and franchiser of karate schools, with over 40 schools in the New York metropolitan area, but he was recently KO’d by New Jersey’s Division of Taxation due to such a mismatch between his income and deductions.

Schulmann created an S corporation management company which provided management services to each karate school. Each karate school in turn was structured as a separate corporation co-owned between Schulmann and the instructor who would run the school. Each instructor also could receive up to 20% commissions when one of his or her students opened a new school.

Schulmann paid the 20% commission from a personal account rather than a business account. He testified that he did this to guarantee the instructors that there would be cash available for the payments, which totaled $863,000 - $1.025 million for the years in question. This was a mistake, however, for New Jersey gross income tax purposes.

The Division of Taxation denied the deductions, taking the position that the commission payments were personal expenses, not S corporation expenses (even though they were obligations of the business). In a January, 2011 opinion, the New Jersey Tax Court agreed, holding fast to the concept that expenses in one category cannot offset income in another category. Having chosen to make the commission payments personally rather than through the business, Schulmann could not avoid the structure when it resulted in unfavorable tax consequences.

Tax advisors, as senseis to their clients, should guide them with care through the challenging tests of New Jersey’s income tax system.

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We were alerted by one of our blog readers last week to a Wall Street Journal editorial published on February 8 stating that, from an estate tax perspective, New Jersey is the worst state in which to die. The article explains that up to 54% of a New Jersey decedent’s wealth could be lost to estate taxes in 2011 (New York decedents would lose 45.4%). While we disagree with some of the factual assertions set forth in the article (including that the state death tax deduction is new in 2011 – it is not and has been in place since 2005), we agree with the larger point that state estate taxes should be a significant concern for New Jersey (and New York) taxpayers.

With the federal estate tax exemption at $5 million per person in 2011 and 2012, the margin between the New Jersey exemption ($675,000) and the New York exemption ($1 million) has widened appreciably. The consequence is that for married taxpayers who want to take advantage of the first spouse to die’s full federal exemption and pass $5 million to their beneficiaries (for example, to an exemption trust for the benefit of the surviving spouse and/or children), then without special planning, a New Jersey/New York estate tax of approximately $391,600 would be due. Parties must consider whether it is worthwhile to pay some state level estate tax in the first spouse to die’s estate, especially in light of the fact that beginning in 2011, a married decedent’s federal estate tax exemption is portable, meaning the surviving spouse can use the first spouse to die’s unused estate tax exemption amount.

A number of variables factor into the decision, including: (1) the size of the surviving spouse’s estate; (2) all appreciation of the assets owned in the exemption trust will pass free of federal and state estate taxes in the future; (3) the current law is in place for two years, and as a result, the federal exemption amount could be reduced and estate tax rates (currently 35%) could be increased; (4) the age of surviving spouse; and (5) future plans of the surviving spouse, who possibly could move to a state with no estate tax (ie, Florida).

All of these decisions lead to another point. Estate plans need to be drafted in a very flexible manner to enable different decisions to be made depending on each taxpayer’s individual circumstances. It is not appropriate in this tax environment to have an inflexible plan.
 

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Under the Tax Relief Act of 2010, an individual has a lifetime exemption equal to $5 million for 2011 and 2012.  This exemption can be used to not pay estate and gift taxes or both.  In 2013, this exemption is scheduled to go back to $1 million unless there is further legislation enacted to have the exemption be different.  There is a legitimate concern that it will be important to utilize this exemption over the next 2 years to avoid the potential risk that it may go down to a lesser amount in the future.  There needs to be careful analysis as to whether one should gift.  A key concern is the income tax basis that the recipient will receive. If one inherits an asset, the basis is the date of death value.  Alternatively, if one receives a gift, the basis is the lesser of the grantor's basis and the fair market value of the property at the time of gift.  This can have a great impact on a subsequent sale of the asset and/or depreciation deductions available for a depreciable asset.  For example, assume that dad bought a rental property for $100,000 and it is now worth $5 million.  Dad wants to transfer the property to his child. If dad gifts the property, then the child's basis will be $100,000. If the child then sells the property for $5 million, he/she will have a capital gain of $4.9 million which at an approximate combined federal and state income tax rate of 25% would result in taxes of $1,225,000.  Alternatively, if Dad died owning the property, the child's basis would be $5 million and a subsequent sale would result in no capital gain.  If the child did not sell the inherited property, he/she would be able to take much higher depreciation deductions based on the substantially increased basis to reduce taxable rent payments thereby substantially reducing income taxes.  Therefore, any gift plan analysis must take into account the benefits to be derived by gifting such as federal and New Jersey/New York estate tax savings versus any potential lost income tax benefits.

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As estate planners, we routinely prepare health care directives. But how many of us have detailed discussions with clients about their burial wishes? Perhaps we should.

A recent New Jersey Appellate Division case involving a conflict over a decedent’s remains highlights the importance of clearly expressed burial wishes. The case – In the Matter of Peggy Z. Puder (unpublished opinion, decided 1/14/2011) – involved Peggy Puder, of Greek Orthodox descent, who married Arthur Puder in a Jewish wedding ceremony in 1982. In 1989, Peggy and Arthur executed reciprocal Wills. Peggy’s Will left everything to Arthur and named him as executor. Peggy also specifically excluded her mother and twin brother from her Will.

In 2006, Peggy was diagnosed with terminal cancer and she died in May, 2007. Her remains were interred in a mausoleum in the Greek Orthodox section of a Paramus, New Jersey cemetery, with the apparent consent of her husband and brother. However, in September, 2007, shortly after being named executor of Peggy’s estate, Arthur authorized the disinterment of the remains and their reinterment in a marital burial plot in the Jewish section of the cemetery.

Peggy’s mother filed suit, seeking to prevent Arthur’s action. The trial court thus had to interpret the provisions of New Jersey’s disinterment statute. The court found that the husband/executor had the sole authority over the handling of his wife’s remains and the decedent’s mother had no standing. The Appellate Division affirmed.

The situation in the Puder case is an unfortunate example of how bad blood among family members may turn into a court battle. It clearly could have been avoided if the decedent had expressed her burial wishes in a writing such as an advance directive.

If a client wishes to be an organ donor, be cremated, have a “green burial” (ie, a burial with minimal environmental impact, for example, by not using embalming fluid or metal), if available, or have some other unique treatment or disposition of his or her remains, then these wishes should be included in the client’s health care directive. These wishes should not be included in a Will which may not be found or read in time. Such planning will not be captured in ordinary health care directive forms, but can be handled by a competent estate planning attorney, and may very well prevent a post-mortem family feud.
 

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With many taxpayers receiving their W-2s in the past 2 weeks, 2011 income tax returns are now squarely on the radar screen. With that in mind, we wanted to note the following:

• For those early filers, due to the late enactment of the 2010 tax law (December 17), the IRS has not been able to process all of the law changes into its computers. As a result, the IRS announced it will begin to process tax returns with itemized deductions no earlier than February 14.
• Taxpayers have additional time to file their returns this year. Tax returns are due April 18th due to an April 16th holiday in the District of Columbia (Emancipation Day, observed on April 15th). Because the IRS follows the District of Columbia holiday calendar, the due date is Monday, April 18th. This includes the due date for gift tax returns.
• As a result of The Emergency Economic Stabilization Act of 2008, new cost basis reporting rules are in effect as of January 1, 2011. The new law requires brokerage firms and mutual fund companies to report a taxpayer’s adjusted cost basis for specified securities to the IRS on Form 1099-B and whether the holding periods for the securities are short term or long term. The rules are phased in over a three-year period. Stocks acquired after January 1, 2011 will be required to be tracked, mutual funds acquired after January 1, 2012 will be required to be tracked, and bonds and options acquired after January 1, 2013 will be required to be tracked.

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One of the benefits of an S corporation ownership structure is a payroll tax advantage. An S corporation owner will pay payroll tax on his or her salary, but not on the entire amount of corporate profit. For example, if a corporation’s profit would be $500,000 without factoring in the owner’s salary, and the owner takes $200,000 as compensation and shows $300,000 in profit, only the salary amount is subject to payroll tax. This is one of the benefits S corporations have over LLCs, where all company profit is considered self-employment income and subject to payroll tax. (A legislative proposal to change this treatment recently failed to pass.)

This advantage may encourage S corporation owners to take less in salary and more in profit so as to save payroll taxes, but a recent case [David E. Watson, P.C. v US, 107 AFTR 2d ¶2011-305 (S D IA, December 23, 2010)] shows that salary still must be reasonable.

David Watson, a CPA in Des Moines, Iowa, set up an S corporation which was a principal in a four member accounting firm. In 2002 and 2003, the accounting firm made profit distributions to Watson’s S corporation of approximately $204,000 and $175,000 respectively. In those years, Watson reported a mere $24,000 of salary and the rest as S corporation profit, saving over $20,000 in payroll taxes.

The IRS disagreed with this reporting position, arguing that recent accounting graduates with no experience had average salaries at the time of approximately $40,000 per year, and that Watson’s reasonable salary was approximately $91,000. The District Court for the Southern District of Iowa agreed, ordering Watson to pay back taxes, interest and penalties.

This case may be viewed as an IRS victory, and it demonstrates that S corporation owners must take a reasonable salary. Nonetheless, the case also demonstrates the benefit of the S corporation structure. Had Watson organized as an LLC, all of the profits distributed would have been subject to payroll tax.
 

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