Navigating the 2013 Capital Gain Tax Maze

Before the new 2013 capital gains rates went into effect taxpayers had a relatively simple way of understanding their capital gains taxes as there was only two rates for long term capital gains: zero percent for low income earners and 15% for middle and upper income earners. The fiscal cliff tax bill, the affordable care act, and numerous expiring tax cuts have all created a new and confusing system for long-term capital gains. The bottom line is that everyone will be paying more under the rules so careful planning is only that much more important as you have much more to lose by failing to plan.

Here’s a breakdown of the changes for 2013 forward.

1. CAPITAL GAINS TAXES. There are now three rates for long-term capital gains taxes. The applicable rate depends on your taxable income. Taxable income, not to be confused with adjusted gross income, is your taxable income after retirement plans and HSA deductions as well as your itemized deductions of mortgage interest, charitable deductions, etc. The rates and income brackets break down as follows.

I.         0% Rate- Single filers with taxable income of $36,250 or below and joint filers at $72,500 or under.

II.         15% Rate- Single filers with taxable income of $36,251 to $400,000, or joint filers with $72,500 or $450,000 of income.

III.         20% Rate- Single filers with taxable income of $400,001 and above and joint filers with $450,001 and above.

2. 3.8% NET INVESTMENT INCOME TAX. This tax was a result of the affordable care act and adds an additional tax to capital gains of 3.8%. The rate applies after a taxpayer reaches $200,000 of adjusted gross income for single tax filers or $250,000 adjusted gross income for those filing joint. Keep in mind that these income limits are based on adjusted gross income, which takes into account retirement plan contribution deductions but does not take into account itemized deductions such as mortgage interest or charitable deductions.

Because the new tax rules and the new higher rates are based on income levels it provides for a number of planning opportunities for families and others wishing to minimize taxes. Here are a few things to keep in mind when planning for these new rates.

Older High Income Earners- They may want to hold onto assets until death rather than sell. Now that the rates are significantly higher older high-income earners not in need of the capital from the sales of stocks, real estate, or other assets that would generate a capital gain may want to hold onto their assets and allow their heirs to inherit them. One of the key benefits to inheriting property is that the heir inherits the property at the value of the decedent’s death and all of the gains in the asset are wiped out so that if the heir sold the property then the heir would avoid capital gains taxes entirely.

Real Estate Investors Looking to Re-Invest. Real estate investors looking to re-invest in another property should strongly consider selling their property and repurchasing a replacement property using a 1031 exchange. A 1031 exchange can be used to defer capital gains taxes by effectively rolling them into a new property such that when you sell the new replacement property you would pay the taxes due. The idea here is that delaying and deferring payment of taxes is always better than paying taxes now. There are some procedures and timelines that need to be followed here to properly complete a 1031 exchange but this is a great strategy for real estate investors who plan to buy more real estate when selling a property.

The Sale Of Home Exemption Is Still Alive. The sale of home exemption is still in place and joint filers who have owned and lived in their home for 2 out of the last 5 years can sell their home and avoid paying taxes on up to $500,000 of capital gains ($250,000 if single filer).

Gift Appreciated Assets for Your Charitable Contributions. High income earners facing the higher capital gains rate and the new net investment income tax may want to consider gifting their appreciated assets to charity as opposed to selling the asset, paying the capital gains and net investment income tax and then gifting the proceeds from the sale of the asset. This could result in as much as a 35% tax savings depending on the taxpayer’s income and state of residence (20% federal capital gains rate, 3.8% net investment income tax, plus state taxes from 5% to 10% on average, depending on your state). Under current law, a taxpayer may gift a certain level of assets to charity and can take the fair market value of the asset as a charitable deduction and then the charity sells the asset and avoids paying any taxes too. The net result is the asset transfers to the church or charity you intend and the capital gain (and net investment income tax) ends up disappearing. Many large charities, universities, and churches have departments set up to receive these assets and  to assist and encourage contributors.

The bottom line is that rates have gone up so planning for the sale of an asset has only become that much more important in order to minimize your tax burden. Please contact us at the office at 435-586-9366 to speak with one of the attorneys or CPAs about your specific tax situation and planning needs.

Raising Money Under the New Rule 506(c) Offering: Advertising Now Allowed

The JOBS Act of 2012 amended the rules for private placement offerings (aka “PPMs”) to allow people to advertise and solicit their offerings to prospective investors. Under prior law, a PPM could not be marketed or solicited to people whom the offeror did not have an existing relationship with.  Hence, the use of the word “private” offering in the current labeling of these types of investments.

This new type of offering that will allow advertising and general solicitation will be known as a Rule 506 (c) Offering. Under this new law, the person raising money could create a website soliciting the funds, or they could hold seminars or meetings with potential investors and could solicit the investment of funds from those in attendance. This is a significant change to the current rules that clearly prohibit such activities.

Under the new Rule 506 (c) Offering there is one hitch: the person raising funds may only accept funds from accredited investors. An accredited investor is someone who has $200K in annual income ($300K if married) or $1M in net worth (excluding equity in home). The accredited investor status must be documented by the investor or certified by a third party such as an accountant or financial planner. This verification rule is a new requirement for Rule 506 (c) Offerings.

The SEC has proposed regulations on the new rule and it should be implemented in the next month or two. A new Rule 506 (c) Offering requires the same documents and SEC filings as the current PPMs. These documents include a Regulation D filing to the SEC, an offering memorandum, accredited investor questionnaires, and numerous other company documents.

All other prior offering rules are still available under law including those rules that allow an issuer to raise money from up to 35 unaccredited investors per offering but that offering must remain private and the new advertising rules would not apply. So, moving forward, those seeking to raise large amounts of money under Regulation D approved offerings have two options. First, raise money under the current rule and you can accept up to 35 unaccredited investors but are restricted from advertising. Or, second, only accept money from accredited investors but be allowed to advertise the offering. You don’t get both options in one (advertising and unaccredited investors) but at least you now have another option in being allowed to advertise and solicit under the new rules.

S-Corp Salary/Dividend Split and Reasonable Compensation

One of the most common tax minimization strategies used by operational small business owners is known as the salary/dividend or salary/net income split. This strategy can only be properly executed in an s-corporation where a business owner can pay themselves a portion of income in salary and a portion of income in dividend or net profit. The ultimate goal is to pay as little salary as possible (and therefore as much net income as possible) so as to minimize the amount of self employment taxes that are due.

This strategy cannot be utilized in a c-corporation nor can it be utilized in an LLC or sole proprietorship. It is only possible in an s-corporation as similar income running through a sole proprietorship or an LLC is entirely subject to self employment tax as income cannot be split between salary and net income in an LLC or sole proprietorship. Also, keep in mind that such a strategy is not utilized in passive business structures such as real estate businesses as rental income, interest income, and other passive income is exempt from self employment tax and therefore it is not necessary to implement the income splitting technique of the s-corporation.

In short, the strategy is implemented by “splitting” the income that is payable to the s-corporation owner into two categories: salary and net income (aka dividend). The reason this splitting of income is advantageous is that net income received by the s-corporation owner is not subject to the 15.3% self employment tax that is otherwise due and payable on salary. For every $10,000 of income an s-corporation owner can classify as net income as opposed to salary the business owner will save $1,530. Keep in mind that after about $100,000 of salary the savings of pushing additional income to net income is reduced as the self employment tax rate drops to 2.9%. It is still certainly worth implementing at higher income but the savings are then made at the 2.9% rate.

Watson v. Commissioner

When this strategy was first utilized many years ago, some taxpayers decided to just pay all of their income out as net income and elected to take no salary or wages and therefore pay no self employment tax. This was quickly challenged by the IRS and Revenue Ruling 59-221 was issued which stated that a business owner who renders services to their business must take “reasonable compensation” for the services rendered.  Over the years, the Courts have ruled on many cases of what is reasonable compensation but in 2012 the Courts made a significant ruling where they adjusted a business owners allocation between salary and net income in a case known as Watson v. Commissioner, 668 F.3d 1008 (8th Cir, 2012).

In Watson, the owner/employee Watson was a CPA and took $24,000 of salary a year and about $190,000 of annual net income. The IRS challenged the allocation of $24,000 of salary as being unreasonably too low. Watson lost in the District Court and appealed to the 8th Circuit Court of Appeals who re-characterized Watson’s income to $93,000 of salary and about $120,000 of net income. The case is an important one for properly understanding the factors that should be considered in all businesses when determining how much income a business owner can claim as net income instead of salary.  Here are some of those factors.

Factors Determining Net Income

  • Professional services businesses should take a larger portion of salary to net income than those in non-professional services: If the business is a professional services business (e.g. physician, dentist, lawyer, consultant, real estate broker, contractor, etc.) the IRS will more carefully scrutinize the services provided by business owners because the business provides a personal service.
  • Full-time working business owners should take a larger portion of salary to net income than part-time working business owners: If the business owner is involved full time in the business, more salary will be required. If the business owner’s involvement is part time or if they are involved in other businesses, a much lower salary can be justified.
  • Don’t take a salary that is below the salary paid to lower level employees in the business: In the Watson case the Court determined that a salary for Watson of $24,000 was not reasonable as new accountants salaries at his office were more than this.
  • Take a salary that is around the industry average for a person of similar experience in your industry: In the Watson case the Court scrutinized the experience and training of Watson and determined that a salary of $24,000 was not reasonable as accountants with similar experience and training in the industry were paid at least $70,000.

In summary, the salary/net income split is a legitimate tax planning technique for business owners but it is not one in which a business owner making over $200,000 a year can justify taking about 10% of income as salary (as was the case in Watson).  The Court disallowed the 10% salary level but did allow him to take about 43% of his income as salary (and almost 60% as net income). This still resulted in some excellent tax savings.

As a general rule, we recommend that business owners take at least 1/3 of their income as salary and pay self employment tax on those amounts. Many other factors should be considered, such as those outlined above, and every business has a unique situation. The good news is that taking a large portion of income from a business as net income as opposed to salary is alive and valid and there are plenty of taxes to be saved each year by using this strategy. A business owner just can’t get too aggressive and take salary levels that are grossly below what people with similar experience in the industry are paid.

2013 Retirement Plan Contribution Limit Increases

By: Mathew Sorensen, Partner KKOS Lawyers

Good news. The IRS has announced increases into the amount of money individuals may contribute into their retirement plans in 2013. The IRS increased the amounts that may be contributed to Traditional and Roth IRAs. The IRS also increased the total amount that may be contributed as employee contributions into 401(k) plans. Here’s how the increased annual limits broke down.

Traditional and Roth IRAs- Increased from $5,000 to $5,500 a year. Those over 50 can still make an additional catch-up contribution of $1,000. Also, the income qualification limit for Roth IRA contributions increased from $183,000 to $188,000 for married couples and from $125,000 to $127,000 for those filing single.

401(k) Plans- The annual employee contribution amount that may be contributed into a 401(k) increased from $17,000 to $17,500. The catch up contribution from employee plans is still $5,500 per year for those who are 50 or older.

SIMPLE IRA- The amount that may be contributed to SIMPLE IRAs annually is increased from $11,500 to $12,000. Catch-up contributions for those over 50 stays at $2,500.

SEP IRA- The total amount that may be contributed annually increased from 25% of compensation or $50,000 to 25% of compensation or $51,000, whichever is less.

With increased tax rates on the horizon the tax benefits of making retirement plan contributions are only that more valuable. There are also tax credits for employers adopting new plans as well as savers credits for low income workers contributing to retirement plans. Please contact us at the law firm for assistance in determining which retirement plan is right for you.

 

 

 

2012 Estate Planning Opportunities & Year End Considerations

By: Mathew Sorensen, Partner KKOS Lawyers

The 2012 estate and gift tax exemption is $5,120,000. This means that the first $5,120,000 of an individual’s estate may be inherited (at death) or gifted (during life) in 2012 before any estate or gift tax is due. This exemption amount will be reduced to $1,000,000 in 2013 unless the Congress and President act on a compromise plan to fix the current reduction in the exemption. As a result of the significant reduction in the exemption, many individuals are contemplating a transfer of assets by gifts to their children/heirs now as a way to reduce their estate and to utilize the large exemption amounts while they can.

If you are an individual with a large estate (over $2M) you should consider whether to gift certain assets to family members while the exemption remains high. There are certain items to consider when analyzing your estate and determining whether to make a gift now as a result of estate and gift tax laws.

GIFT PROPERTY WITH HIGH TAX BASIS

First, when you gift during your lifetime the tax basis in the asset transfers to the person who receives the gift. In other words, if you have a property you bought for $100,000 that is now worth $300,000, the person receiving the gift would receive your $100,000 tax basis such that when they sell the property they pay capital gains taxes on anything above $100,000. When someone inherits property upon death, however, they receive tax basis in the property at the fair market value of the property at the date of death.  So, if the basis to the owner was $100,000 but the fair market value was $300,000 at their death the heir would get the property at a $300,000 tax basis and when they sell the property they would only pay taxes on any gain above $300,000 (as opposed to $100,000 with a gift during the lifetime of the donor). As a result of the tax basis rule difference between receiving property at death or by gift during life, we recommend clients retain highly appreciated assets that may be subject to capital gains and instead pass those on following their death.  Contrastingly, assets with high tax basis where there would be no large capital gains are excellent assets to gift since there is no tax benefit to retain until death.

UTILIZE THE EXEMPTION OF ONLY ONE SPOUSE

A second planning item to consider for married couples is using the gift tax exemption of only one spouse when gifting. Under current tax law, each spouse has their own separate exemption and you can utilize one spouse’s gift tax exemption (or a portion) now during their lifetime while leaving the other spouse’s exemption totally un-used and available to the other spouse. Special planning and tax reporting needs to be taken into account in this situation but the benefit of having one spouse use up a large part of their exemption and to take advantage of a very large gift tax exemption – while we know one is there – is a significant benefit and we leave the other spouses exemption totally un-used and available for future years (whatever those limits may be).

ASSETS THAT ARE GOOD CANDIDATES TO TRANSFER BY GIFT & FLLCs/FLPs

The last item to consider is what types of assets may be transferred by gift now. There are a few assets that are very good assets to transfer by gift now. First, if there are any large loans to family members that may be forgiven as part of your estate you may want to consider forgiving those loans now as a way to lock in the large gift tax exemption.

High basis stocks or investment properties are also excellent assets to consider gifting now while the exemption is relatively large. Since these assets don’t have a high tax basis there is not an incentive to keep them and to let them transfer upon death.

Lastly, clients with very large estates who are making significant transfers may want to consider forming a Family Limited Liability Company (“FLLC”) or Family Limited Partnership (“FLP”) which own the assets and gifting portions of those company’s interests to their family members. These companies are used by many families to hold real estate, family businesses, or stock and are used to transfer value to family members over time in a tax advantageous way. Because of certain IRS rules regarding ownership in a family company the actual value of these ownership interests may be reduced and thereby a larger portion of value may be transferred in a FLLC or FLP during the lifetime of the owners than can be done in transferring the property or stock directly to heirs. The outcome of this is you can squeeze more value and gifting into the tax exemption with zero taxes in a FLLC or FLP than you can in transferring the asset outright.

Careful planning and tax reporting needs to be done when making large gifts and we can help develop a plan for your family and estate. In most situations, a gift tax return claiming the exemption (IRS Form 709) needs to be filed with the IRS (and in some states with state gift tax laws) and estate planning documents may need to be modified or amended.

Asset Protection for Self-Directed IRAs

When analyzing asset protection for self directed IRAs we must consider two types of potential threats. First, we must analyze how a creditor can collect against an IRA when the creditor has a judgment or claim against the IRA owner personally. Secondly, and most importantly for self directed IRA owners, we must analyze how a creditor can collect against an IRA or its owner when the IRAs investment incurs a claim or judgment.

There has been much written on the protections to retirement plans that prevents a creditor of the IRA owner from collecting against the IRA to satisfy their judgment.  Various federal and state laws provide this protection which prohibits a creditor of an IRA owner from collecting or seizing the assets of an IRA or other retirement plan.  For example, if an individual personally defaults on a loan in his or her personal name and then gets a judgment against them the creditor may collect against the individual’s personal bank accounts, non retirement plan investment accounts, wages, and other non-exempt assets but is prohibited from collecting against the IRA or other retirement plans of the individual. Even in the case of bankruptcy a retirement plan is considered an exempt asset from the reaches of the creditors being wiped out. U.S. Bankruptcy Code, 11 U.S.C. §522. Because of these asset protection benefits retirement plans are excellent places to hold assets outside the reach or creditors.

The second asset protection issue and the focus of this article is to consider how an is IRA protected from claims arising from the IRA’s investments and activities? This issue is one that is particularly important to self directed IRA accounts since some self directed IRA investments are made into assets that can create liability to the IRA and the protections preventing a creditor of the IRA owner against the IRA assets does not apply to liabilities arising from the IRAs investments. In other words, if the IRA has a liability the IRA is subject to the claims of creditors. For example, if a self directed IRA owns a rental property and the tenant in that property slips and falls the tenant can sue the self directed IRA who owned and leased the property to the tenant. Consequently, the IRAs assets are subject to the collection of the creditor including the property the IRA owned and leased to the tenant as well as the other assets of the IRA. But what about the IRA owner and their personal assets, are their personal assets also at risk?

Let’s analyze this issue further and look at whether a creditor/plaintiff against the IRA can also sue the IRA owner personally if the IRA’s assets are not sufficient to satisfy the judgment against the IRA. IRC § 408 states that an IRA is a trust created when an individual establishes an IRA by signing IRS form 5305 (this form is completed, with some variations, with every IRA) with a bank or qualified custodian. Courts have analyzed what an IRA is under law and have stated that they are a trust or special deposit of the individual for the benefit of the IRA owner. First Nat’l Bank v. Estate of Thomas Philip, 436 N.E. 2d 15 (1992). In other words, the IRA is not a separate entity or trust which would be exempt from creditor protection of its underlying owner. Since the IRA is a trust that is revocable and terminated at the discretion of the IRA owner, each investment in fact is truly controlled by the IRA owner as he or she could terminate the IRA at any time and take ownership in their personal name. As a result, the IRA is akin to a revocable living trust used for estate planning which trust is commonly understood by lawyers and courts to provide no asset protection and prevention of creditors from pursuing the trust creator and owner from liabilities and judgments that arise in the trust. Following this same rationale, a self directed IRA would likely be subjected to a similar downfall in the event of a large liability which is not satisfied by the assets of the IRA. As a consequence, the personal assets of the IRA owner may be at risk.

As a result of the asset protection liabilities for self directed IRAs, we recommend that self directed IRA owners consider an IRA/LLC for the asset protection reasons that many individuals use LLC’s in their personal investment and business activities. Simply put, an LLC prevents the creditor of the LLC from being able to pursue the owner of the LLC (in this case the IRA). An IRA/LLC is an LLC owned typically 100% by the IRA and the LLC would operate and take ownership of the investments and the liabilities similar to an LLC used by an individual. For example, instead of the IRA taking ownership of a rental property directly and leasing it to a tenant the IRA/LLC would instead take title to the property and would lease the property to the tenant. When the IRA/LLC owns and leases the property any claims or liabilities that arise are contained in the LLC and as a result of the LLC laws a creditor is prevented from going after the LLC owner (in this case the IRA, or the IRA owner).

There are certain types of self directed IRA investments that benefit greatly from the asset protection offered by an IRA/LLC. Rental real estate owned by an IRA achieves significant asset protection benefits from an IRA/LLC since rental real estate can create liabilities to their owner. Other self directed IRA investments such as promissory note loans, precious metals, or land investments do not have the same asset protection issues and potential to create liability for the IRA and as a result an IRA/LLC isn’t as beneficial from an asset protection perspective for these types of investments.