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AMERICAN
JOBS CREATION ACT OF 2004
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Day of reckoning: a summary of applicable provisions -
On
October 22, 2004, President Bush signed the “American Jobs Creation
Act of 2004.” The legislation creates 274 amendments to the Internal
Revenue Code and will likely affect every taxpayer. The Conference
Report alone is 600 pages. This is likely to be the last tax legislation
in this decade where tax cuts are funded with deficit spending.
By the time of your receipt of this Client Update, a new presidential
term will have started. No matter who is in office, tax legislation
through the end of the decade will only involve tax cuts that
are fully funded with tax increases. The pressure on taxes will
be substantial. Why?
As
one of the architects of the 2001 Act put it, "[we have] put a
10-pound bag of sugar into a 5-pound bag." Bill Thomas (R-Ca.)
Our story properly begins in 2001, when a projected $5.6 trillion
surplus existed: $2.6 trillion represented a Social Security surplus
and $3 trillion represented extra dollars that were available
for tax relief, spending, and paying down the debt. The 2001 Act
had a $1.35 trillion price tag over the then 10-year budget window
(2001-2010). In order to squeeze all of the tax cuts it wanted
at that time into this number, Congress made liberal use of sunrise
and sunset provisions. Congress phased in cuts or phased them
out in order to shoehorn them into the budget figure. Similar
legislation was passed in 2003.
When
Congress confronts expiring provisions that phaseout throughout
the decade, finding ways to pay for extending them will present
a continuing challenge. Two major ones, curtailing the ever-increasing
reach of the alternative minimum tax (“AMT”) and avoiding the
sunset of the estate tax to pre-2001 exemptions and rates, are
projected to cost hundreds of billions of dollars. One should
recognize that the AMT affects voters and will continue to affect
them more and more, quite substantially. Many believe that the
estate tax affects fewer people and at least some of those affected
will not longer be able to vote. As one writer recently put it,
"The AMT will force everyone's hand."
2004
Act Summary of applicable provisions:
-Sales
Tax Deduction. On election of the taxpayer, an itemized deduction
may be taken for State and local sales taxes in lieu of the itemized
deduction under present law for State and local income taxes.
Florida wins!
-Sale of Principal Residence. The $250,000 exclusion ($500,000
if married filing a joint return) of gain realized on sale of
a principal residence will not apply if the home was acquired
in a like-kind exchange where any gain was deferred within the
prior 5 years.
-Expensing
Property Purchases; SUVs. The ACT extends the $100,000 expensing
rule for asset purchases, but eliminates the ability to use it
fully toward the purchase of an SUV.
-S
Corporations. The ACT provides 10 provisions to simplify S corporation
rules and to extend their use.
-Sale of Horses. The holding period is reduced from 24 months
to 12 months for capital gains treatment on sales of investment
horses.
-Kiddie Tax. Increasing the child's age from 14 to 18 years has
expanded the Kiddie tax provisions, where unearned income of a
child is taxed as if realized by his or her parents.
-Personal
Use of Company Owned Aircraft. The Act clarifies deduction rules
associated with an officer’s, director’s, or owner’s personal
use of company- owned aircraft.
-Transfers
of Partnership Interests. Rules have been clarified on the consequences
of having built-in gains and losses on transfers of partnership
interests.
-Leasehold
and Restaurant Improvements. The Act reduces the recovery period
for certain leasehold-improvement or restaurant-improvement costs
incurred before January 1, 2006 from 39 years to 15 years.
LONG
AWAITED POWELL DECISION ON HOMESTEAD
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Florida Supreme Court Decides Important Homestead Case-
On
September 15, 2004, the Florida Supreme Court issued a decision
in Zingale v. Powell. The Supreme Court held that the homestead
cap on assessed value increases for property taxes is tied to
the application and grant of the homestead tax exemption and not
just entitlement. Accordingly, it overturned the contrary decision
of the Fourth District Court of Appeal. The Powells had purchased
their Fort Lauderdale home in 1990 and since then, it was their
primary residence. It was not until receiving notice of an increase
in the assessed value of their home in 2001 that the Powells first
applied for the homestead exemption. Their homestead exemption
application was approved for tax year 2001.
The
Powells sought application of the assessment cap to their year
2000 taxes, but the Broward County Property Appraiser denied the
relief on the basis that the homestead exemption application was
received after the deadline for entitlement in 2000. The lower
court held that homeowners are entitled to the constitutional
assessment cap on increases in the assessed value of their home,
even though they have not actually applied for and been granted
a homestead exemption.
The
Supreme Court disagreed, finding the cap on increases in valuation
and the right to an exemption of part of a property's value from
taxation to both be part of a coordinated constitutional scheme
that must be read and applied together. Thus, a successful application
for homestead is necessary both to obtain the exemption and qualify
for the cap.
BIG
FAMILY PATERNSHIP VICTORY
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Circuit Court of Appeals Provides Significant Blow to the IRS
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The
5th Circuit Court of Appeals has shut down a threat to family
partnerships that would have curtailed their use in estate planning.
Essentially, the IRS argument would have caused all assets contributed
to a family partnership to be taxed in the estate of a deceased
family member without realizing any estate tax reduction. The
IRS argument, however, was found by the court to be illogical,
and to ignore common business practice and valuation. An American
Bar Association amicus brief supported this position. The court
therefore approved the taxpayer's considerable tax savings.
There
were two primary reasons for the taxpayer's victory in Kimbell.
First, non-tax motivated reasons for forming the partnership were
found to exist. Additionally, the family respected the operational
formality of their partnership.
Family
partnerships offer many benefits and there are many reasons to
form them. For example, research supports their use in creation
and fulfillment of family mission statements and investment policies.
In Kimbell, the court found the following additional non-tax reasons
for forming the Kimbell family's partnership: protection against
creditors and divorce interference; annual gifts without fractionalization
of assets; a means of increasing family wealth; support planning
not available through a trust; family knowledge of family business;
and promotion of family ownership. We believe this may be an opportune
time to create family partnerships. The benefits can be quite
substantial, which we routinely prove to many families. The last
time Congress intervened to pass tax legislation aimed at family
partnerships was in 1989 and that legislation grandfathered preexisting
partnerships. As of this writing, there exists no legislation
on the horizon and none is expected. However, we have no crystal
ball and can only suggest that now is an optimum time.
Note:
We have recommended that our clients update their family partnership
documentation to further thwart some of the IRS arguments and
potential grounds for attack. Family partnerships that we have
created for our clients contemplated many of the IRS arguments
in Kimbell, but can be improved by amendment. Nevertheless, we
have had many clients in the last several years die having created
family partnerships. Many have had their estates and family partnerships
reviewed on IRS audit, while some have altogether escaped IRS
audit. Notwithstanding audit, millions of dollars of estate tax
savings have been realized for these clients, and we and their
families are quite gratified!
FLORIDA INTANGIBLE TAX UPDATE
- In Excess of 18 New Bills Introduced and Audits Increase -
The
Florida intangible tax remains a relatively easy tax to avoid,
but the Department of Revenue (the "DOR") has increased audits
and is taking narrow views on the issues. Nevertheless, properly
drawn trusts that avoid the tax are still being approved by the
DOR. Few people that have material intangible tax should, therefore,
be paying it because of the ease in which the tax can be avoided.
Perhaps for this reason the Florida legislature introduced in
excess of 18 bills during 2004 to either increase, decrease, eliminate,
or modify the intangible tax laws of Florida. Notwithstanding
an absence of legislative change, the DOR's new audit policies
and views on the issues encourage a review of intangible tax avoidance
trusts (commonly known as "FLINT Trusts") and modification to
better thwart potential DOR arguments. Therefore, our recommendation
is to have your FLINT Trusts reviewed and modified to curtail
DOR debate over their viability. In this regard, the current DOR
position requires that either an independent trustee must serve
or that the trust creator and at least one other person must serve
as co-trustees over discretionary matters. FLINT Trusts can still
be drafted to allow one trustee to handle investment decisions
and certain other matters, but care must be given in the drafting
of these provisions.
IRS
CONCEDES BENEFICIAL USE OF GRATS
-New Proposed IRS Regulations Influenced by Sam Walton Decision-
Grantor
retained annuity trusts (GRATs) are beneficial estate planning
tools for senior family members who desire to leverage growth
on assets above a given rate out of their taxable estates. It
permits a specified retained cash flow to be kept by the senior
family member for a term of years, and growth above a specified
rate to shift to junior family members in a tax efficient manner
that reduces estate taxes. Two recent cases (Schott and Walton)
provided favorable taxpayer victories and blows to the IRS's interpretation
of GRAT rules. The IRS is now acquiescing and revising regulations
in a manner that concedes certain taxpayer interpretations, providing
more certainty when planning using GRATs. The result should be
greater use of GRATs.
IRS
PERMITS TRUST REIMBURSEMENT OF GRANTOR'S TAX
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Overcomes a Disadvantage in Use of Defective Trusts-
The
estate tax advantages of sales to defective trusts can be quite
substantial. A defective trust is not one that was improperly
drawn, but rather one that is structured to have the income taxes
paid by the grantor rather than the trust. Using a defective trust
permits the grantor senior family member to gift growth assets
out of his or her estate while retaining a cash flow stream for
life. Often these trusts are used as the purchaser of growth assets
that are sold by a senior family member in exchange for a note
or private annuity. The advantages were recently reported in the
Wall Street Journal. See Installment Sales and Trusts Play Well
Together, Wall Street Journal, Page B6, July 14, 2004. No capital
gains taxes on the sale are incurred because of the trust's status
as a an income tax defective trust. In some circumstances the
senior family member may want the trust to reimburse him or her
for the income taxes that must be paid, even though for estate
tax purposes it would be best for this not to happen. This is
because money that would pass gift and estate tax free to junior
family members is returned to the senior family member in order
to reimburse him or her for income taxes that the grantor must
pay. In Revenue Ruling 2004-64, the IRS conceded that a grantor
senior family member could be reimbursed for income taxes without
jeopardizing the estate tax advantages of the strategy. The ruling
provides examples of how to structure reimbursement provisions
of the trust. Often we use this strategy in conjunction with family
partnerships. For example, after a family has successfully formed
a family partnership and it has been operated for some time, we
may be asked to recommend estate tax reduction strategies to reduce
current estate tax exposure. Selling all or a portion of a senior
family member's interest in a family partnership to a family trust
structured to be defective for income tax purposes can achieve
substantial estate tax advantages. Typically, it is structured
to provide an amount of income to the selling senior family member
that conservatively satisfies any cash flow needs or desires.
NEW
15% DIVIDEND TAX RATE
- Much More Complicated in Planning and Practice -
The
new dividend tax rules hold various traps for the unwary and are
more complex than most advisors originally believed. For example,
not all items of income that clients view as dividends qualify
for the reduced rate and in some cases dividends that would otherwise
qualify won't because of how their accounts are held in institutions.
Dividends held in margin accounts or held in street name with
brokerage firms, where stock may be lent to other customers, may
find that what they thought was dividend income, taxed at 15%
rates, is really interest income taxable at normal ordinary income
rates. Furthermore, stocks subject to hedging transactions, such
as puts, collars, short sales, or other techniques designed to
protect against downside movement in a security, may not qualify
for the 15% rate due to technical holding period rules. Also,
sometimes it may be better to elect to have "qualified dividend
income" treated as investment income, foregoing a lower 15% rate
but permitting the dividend income to be offset by investment
interest expense. Some taxpayers will also want to avoid dividend
income, which is taxed at lower rates, because it may increase
the likelihood that a person will be subject to the alternate
minimum tax ("AMT"), even though the 15% rate applies to both
the regular and alternate tax. This is because a high income taxpayer,
taxed in the highest tax bracket on considerable dividend income,
could be expected to avoid application of the AMT when now the
15% rate may lower this expectation.
CARE
MUST BE TAKEN WITH IRA'S AFTER DEATH
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New Rules Help But Important Decisions Remain -
IRA
distribution rules have become simpler but there still remain
traps and complexity. There are also important rules that can
be used to benefit you and your family, but affirmative action
is required. For example, often it is advantageous to integrate
retirement accounts with trusts. This strategy has now existed
since the late 80's and the process has become simpler. Nevertheless,
if proper actions are not taken after death, the benefits of the
process of integrating with trusts can be lost.
In
the year of death, it is important to determine whether a mandatory
required distribution is required. If it has not been paid by
the time of death, the 50% penalty for failure to make the distribution
may be avoided with proper actions by the beneficiaries. Furthermore,
it may be desirable to divide the IRA into shares representing
separate beneficiaries. Doing so will permit mandatory distributions
to be made over the life of each beneficiary, rather than the
oldest of a group of beneficiaries. This planning must take place
by September 30 of the year after the year of death. If one or
more trusts are the beneficiaries, the trust instrument must be
provided to the plan administrator by October 31 of the year after
the year of death. Last, in order to avoid a second 50% penalty
exposure, the mandatory required distribution for the year after
death must be made by December 31 to the beneficiary fixed as
of September 30.
IRA
and retirement plan distribution rules have become simpler, but
they remain complex. Hundreds of pages of regulations exist, which
have evolved in a manner that provides substantial opportunity.
Nevertheless, traps remain and the penalties or cost of error
can be quite substantial.
DAILY
MORTGAGE RATE MONITOR
STATE
DEATH TAX TRAPS
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Decoupling From Federal System Continues to Create Obstacles -
As
was reported in our last several Client Updates, the District
of Columbia and 17 states have decoupled their death tax systems
from the federal estate tax system to avoid significant revenue
loss. Individuals residing in states that have decoupled face
a significantly greater estate tax exposure than if they perfected
Florida or certain other states that have not decoupled as their
tax home. An increased exposure also exists on the estates of
individuals who have perfected their tax homes in states that
remain coupled, but own real property of substantial value in
states that have decoupled. For example, a person domiciled in
Florida who dies owning $3 million of real property in New York,
Massachusetts, or certain other states will experience an increase
in estate tax over a person who held all of their property in
Florida or other coupled states. Depending on the particular states
involved, there may be ways of avoiding this increased exposure
by using certain trusts and other entities.
If
either or both of a married couple are nonresidents and the nonresident
spouse survives, decoupling produces more complexity since taxes
that may be deferred on the estate of the first spouse to die
requires an election that causes the assets passing to be taxed
on the surviving spouse's death as if they were part of the first
spouse's estate. When that tax is determined, it is imposed on
the estate of the surviving spouse, but certain credits that are
applied against the taxes on the surviving spouse's estate may
be artificially reduced. This reduction can cause a tax rate of
as high as 60% to be imposed.
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