Techniques to Generate Tax Savings for Your Clients

1. Techniques to Generate Tax Savings for Your Clients Leif G. Novie, CPA, JD Morrison Brown Argiz & Farra 1001 Brickell Bay Drive Miami, Fl 33131 305-373-5500 Internal Revenue Service Circular 230 DisclosurePursuant to Internal Revenue Service Circular 230, we hereby inform you that any tax advice set forth herein with respect to U.S. federal tax issues was not intended or written by to be used, and cannot be used, by you or any taxpayer, for the purpose of avoiding any penalties that may be imposed on you or any other person under the Internal Revenue Code.

2. Notice 2008-16 • Permits bundled fiduciary fees to be fully deductible for 2008 • Notice applies to tax years beginning prior to 1/1/09 • Extends interim guidance previously issued in Notice 2008-32 • Final regulations will eventually be issued consistent with the Knight decision rendered by the Supreme Court. • It is anticipated that final regulations will require fees unique to trusts to be separately allocated in order to not be subject to 2% floor. • Supreme Court did not actually mention unbundling

3. Distributions by estate/complex trust • In some cases it may make tax sense tax delay making distributions • Is the estate/ complex trust and beneficiary in same tax bracket? • Is the estate/ complex trust in a jurisdiction without a state income tax? • If an estate, consider a fiscal year end in order to delay recognition of income.

4. Example- Decedent died February 3, 2008. By choosing a tax year end of January 31, the initial return of the estate will have a year end of January 31, 2009. Assuming all income of the estate will be passed out to the beneficiary (assuming distributions made), the beneficiary will report the income on her 2009 tax return. As such, the payment of tax on the income is delayed by almost one year. • Note that this may not be a good plan if income tax rates are expected to rise in the future.

5. Will estate/ complex trust be subject to AMT but not the individual or vice versa? • Can do late planning by use of the 65 day rule.

6. IRC Section 643(g) • Allows a fiduciary to shift estimated tax payments to beneficiaries • This may help reduce or eliminate a beneficiary’s underpayment • Consider doing if there is no tax due on the fiduciary income tax return

7. Indirect administrative expenses • May be allocated to any income category of income as long as a pro-rata portion is allocated amongst tax-exempt income • If there is income with state tax consequences, consider allocating general administrative expenses against this income category. • See regulation 1.652(b)-(3)

8. U.S. Savings Bonds • Consider electing to pick up accrued interest on decedent’s final income tax return • Usually beneficial if decedent in a low income tax bracket • Any tax owed on decedent’s final return will be a deduction on estate tax return (form 706) • Need to also consider how bonds will be taxable to estate or beneficiaries and the loss of the IRD deduction

9. Value on form 706 is typically the basis IT may be rebutted by clear and convincing evidence. See Revenue Ruling 54-97 Basis of assets received from decedent

10. IRD • Should it be recognized by estate or distributed to beneficiaries? • IRD item must be distributed before the income is received by the estate to avoid being allocated to the beneficiaries • IRD (estate tax deduction) is deductible by estate without any limitations. Although not subject to the 2% floor, beneficiary must itemize to obtain benefit of IRD deduction.

11. Final year estate return • Excess deduction lost in any year except final year • Delay paying large expense items until final year if no tax benefit for expenses • May be beneficial to accelerate final year and terminate estate in order to pass out loss attributes to beneficiaries

12. Example Estate has capital loss carryforward of $500,000 and NOL carryforward of $300,000 in 2008. Beneficiary, who has a very good investment advisor, has $1 million of capital gains and $500,000 of interest income. If the estate’s final year return is 2008, the capital loss carryforward and the NOL can be passed out and used by the beneficiary against 2008 income.

13. Net Operating Losses • Net operating losses of decedent can not be carried over to estate. Make sure it is carried back on decedent’s final return. • NOL’s may be deducted by beneficiaries in year of termination. Beneficiaries can not carry back these NOL’s.

14. Grantor trusts • Many contain a clause allowing the grantor the ability to relinquish the power making the trust a grantor trust. • Is grantor in a higher tax bracket than beneficiaries? • Has grantor moved to a state that has an income tax while beneficiaries remain in Florida? • Is estate tax no longer an issue for grantor. • Need to consider potential estate tax savings of grantor paying tax on the income.

15. Capital gains • If beneficiary has capital loss carry-forward, consider distributing asset instead of having trust or estate sell the asset. • If the trust has excess deductions, consider recognizing gain so that deductions are not wasted. Securities sold at gain can be re-purchased with increased basis. Example- An trust typically distributes all income to its sole beneficiary. Beneficiary has a capital loss carry-forward. Trust has an asset it is about to recognize a significant gain. Instead of recognizing the gain and paying the tax, the trust distributes the asset to the beneficiary. Beneficiary can then sell the asset and have the loss carry-forward offset the gain.

16. Alternative Minimum Tax Issues • Estates and trusts may be subject to AMT if significant miscellaneous itemized deductions • This may become more prevalent after 2008 in light of the Knight decision • By making distributions to beneficiaries, it may be possible to avoid AMT, depending upon beneficiaries tax situation

17. For individuals with NOL’s, be aware of amount of AMT NOL when doing tax planning. AMT NOL needs to be computed in order that AMT does not incorrectly occur. • Be aware of differences in other AMT carryovers such as passive activity losses and investment interest carryover • May be beneficial when doing year end planning to determine how much taxes and/or miscellaneous itemized deductions can be taken before hitting AMT. • Individuals with substantial income, most of which consissts of qualified dividends and long term capital gains will usually be subject to AMT • Individuals subject to AMT should typically not invest in municipal bonds subject to AMT

18. U.S. beneficiaries and foreign trusts • Need to be wary of throwback rules • All income should be distributed to avoid throwback rules • Beneficiaries need to make sure adequate information regarding income is received from the foreign trust in order to properly report income on their income tax returns

19. Section 642(c) • Permits charitable contributions paid in following tax year to be deducted in current tax year • Election needs to be made EXAMPLE- A non-grantor charitable lead annuity trust (CLAT) is established with $1million and pays $60,000 annually to charities. In year 1 the CLAThas $100,000 of income and paid the $60,000 to charity. As such, tax is due on $40,000 of net income. The election can be made to treat charitable contributions paid in the following as paid in the current year in order to reduce net income to zero to eliminate the current year’s tax.

20. Basis adjustment due to gift tax • Increase basis of gifted assets when gift tax paid • Basis of assets gifted must be lower than gifted assets’ fair market value • Basis in cash can not be increased • Amount of basis increase is the amount of gift tax attributable to the net appreciation in value of the gift

21. If more than one gift of a present interest is made to the same donee in a given year, the annual exclusion applies to the earlier of gifts made • Reducing the gift is beneficial since a greater portion of gift tax is allocated to the gift’s basis • If annual exclusion cash gifts are to be made in addition to the gifted property, it is beneficial that the cash gifts are made after the gift of property

22. Example 1 Donor makes a gift of $100,000 to donee Gifted property has a basis of $30,000 Gift tax paid is $40,000 The gift tax paid of $40,000 is multiplied by the net appreciation of $70,000 over the fair market value of the the gift less the annual exclusion. This results in an increase of basis of $31,818 to $61,818 100,000 less 30,000 40,000 X --------------------------- = 31,818 100,000 less 12,000

23. Example 2 Same facts except $12,000 annual cash exclusion gift was made earlier in the year 100,000 less 30,000 40,000 x ---------------------------= 28,000 100,000 As such, the basis adjustment is 3,818 less when the annual cash gift precedes the gift of property

24. State Tax issues • Be aware of how various states tax fiduciaries • Typically taxed based on location of assets, location of grantor/ decedent, location of fiduciary or a combination • Choice of fiduciary may be important to avoid state tax. For instance, California can tax a trust with a California trustee

25. Trader vs. Investor • Investor Expenses • 2% misc deduction limitation • 3% limitation on phase-out of itemized deductions • Miscellaneous 2% expenses subject to AM

26. Trader expenses are generally deducted “above the line” and not subject to limitations • Interest from a trade or business is deductible on Schedule C or Schedule E. Investment interest is deductible on Schedule A • From a tax perspective it is better to invest in a hedge fund classified as a trader as opposed to an investor • Courts generally look at all facts and circumstances to determine if activity is at the level of trader status • Generally trading must be substantial and taxpayer must seek to profit from short term profits • In Leonard F. Fuld 139 F2d 465 there were 665 sales transactions during the year which was substantial enough for trader status • In William G. Holsiger TC Memo 2008-191, the Court noted that a significant amount of investments were held more than 31 days in its ruling that the taxpayer did not demonstrate he was attempting to profit from short term market swings. • A trader without a mark to market election still reports capital gains as short or long term capital gains.

27. Casualty losses • IRC section 165(c)(3) provides for losses not connected with a trade or business or transaction entered into for profit if such loss arises from fire, storm, shipwreck, theft or other casualty • IRC section 165(c)(2) allows losses incurred in any transaction entered into for profit, even though not connected with a trade or business

28. Losses under IRC section 165 (c)(3) are subject to 10% limitation of adjusted gross income • Casualty losses may be carried back three years instead of two • Loss is generally deductible in the year loss is discovered • Authority is unclear whether deduction is allowed to be claimed in a year when the amount of recovery on a portion of the loss is uncertain • Special rules apply for losses in Federal declared siaster areas including election to take loss in preceding year

29. Worthless securities • If any capital asset becomes worthless during the taxable year, the loss should be treated a a sale on the last day of the year • For a decedent, consider if worthless securities or investments exist and whether the loss can be claimed on the decedent’s final income tax return. Keep in mind, basis is adjusted to zero at death so that loss can not be recognized by the estate. • IRC section 6511(c)- 7 year statute of limitations for worthless securities

30. It has been held that the suspension of stock trading alone does not establish that a security is wortless since the suspension can be lifted and there may be a private market for the stock • A security may be worthless even though a company has not filed bankruptcy. The security may be deemed worthless when it no longer has value in liquidation and there is no reasonable expectation for future profit.

31. Section 1244 Small Business Stock • Treated as an ordinary loss • General qualifications (I say “generally” because there are a few exceptions beyond the scope of this discussion) • Must be stock in a domestic corporation • At the time stock was issued, corporation must be deemed a small business corporation • Stock was issued for money or other property • During past 5 taxable years more than 50% of aggregate gross receipts were derived from sources generally other than passive

32. Section 1244 • Loss is limited to $50,000 or $100,000 if filing jointly • A corporation is generally considered a small business corporation if the aggregate amount of money and property received for stock does not exceed $1 million

33. Section 1045 Capital gain rollover • Stock must be held for over 6 months as a capital asset • Gain is not recognized if replacement stock is purchased during 60 day period beginning on date of sale • Replacement stock must be “qualified small business stock” • If amount realized on sale exceeds the replacement stock cost, gain is recognized. However, 50% of gains can be excluded if the stock meets requirements under IRC 1202 relating to exclusion of gain from certain small business stock.

34. Section 1202 • Allows for partial exclusion for gain from small business stock • 50% of gain from small business stock is excluded from income • Qualified small business stock means any domestic C corporation qualifying under the rules of IRC section 1202(d) • Active business requirement- at least 80% of assets must be used in the active conduct of a qualified business

35. Qualified business • Any business EXCEPT: - service business - banking, finance or insurance - farming - natural resource extraction/production - hotel/restaurant • 7% of amount excluded is an AMT preference amount