Hello from the Chair Scott M. Nelson
As I write this update, the legislature has convened for 2014 and is seriously discussing repeal of the gift tax and simplification of the estate tax. The Probate and Trust Section is working closely with the Tax Committees and the Minnesota Department of Revenue to draft technical corrections to the existing law and draft proposed legislation, which responds to the policy proposals being considered by the House, Senate and Governor’s office. An interesting dynamic this year is that the House and Governor are up for re-election in November, while the Senate is not (until 2016). While the transfer tax issues are a high priority for our Section, we also will be watching other legislation which may impact our practices, including a proposal to adopt a transfer on death system for vehicle titles, our proposals carried over from last year of allowing an agent to be appointed on financial accounts and fixing state estate tax apportionment issues for QTIPs, and legislative responses to recent case law addressing residency issues.
By the time you read this, the Department of Revenue should have released its estate tax study, which you can find on-line here: http://www.revenue.state.mn.us/research_stats/Pages/Whats-New.aspx. With final work being completed on the Minnesota version of the Uniform Trust Code, the Section will be looking at forming a new subcommittee that will analyze changes to the Uniform Probate Code that will provide coordination and consistency between the two statutes. If you have any interest in participating in this subcommittee, you can contact Michael Sampson or Andrew Baese to let them know of your interest.
A CLE luncheon has been scheduled for Tuesday, May 6 at the Dorsey Whitney conference room, featuring a panel discussion with Dr. John Vuchetich, Michael Sampson and Matthew Frerichs regarding working with clients who have diminished capacity, with the focus on diminished capacity caused by mental illnesses and other co-occurring conditions. Additionally, another CLE luncheon is being put together for Thursday, March 27 on elder abuse. This section is continuing to work on other CLEs, and you can watch for further announcements yet this Spring.
For many of our clients, the significance of income tax planning will become more apparent as they receive their 2013 returns. Because of the recent income tax changes, this will be an issue for all income levels and have some impact on our work with our clients. Income tax might be much more important for our clients than the transfer taxes.
Finally, in my last newsletter I mentioned a February 21 seminar sponsored by the Elder Law and Health Law Sections entitled “Who Calls The Shots? Exploring the Authority of the Principal, Agent and Provider Under a Health Care Directive.” Because of the weather, that presentation has been rescheduled for Friday, April 18. If interested you can find more information here: http://msba.mnbar.org/Meetings/Meeting?ID=328.
Wills for Heroes
The following clinics are still in need of volunteers:
- Monday, March 17, 2014 - Forest Lake Police Department
- 2 attorney openings
- 1 data entry openings
- Tuesday, April 8, 2014 - Forest Lake Fire Department
- Monday, April 28, 2014 – Hanover Fire Department
For those interested in volunteering, to sign up for any of those clinics or for more information on Wills For Heroes, please contact Andrea Bischoff (email@example.com) or Susan Link (firstname.lastname@example.org) or visit http://www2.mnbar.org/willsforheroes/index.asp.
Upcoming Events and CLE Programs
- Greater MN Probate & Trust Study Group Conference Call
- Wednesday, March 19, 2014 at 9 a.m.
- Call-in Number: (800) 406-9170 passcode: 1491722
- Contact either Bradley Hanson (320-251-1414 ext. 1119) or JoEllen Doebbert (320-763-7838) with any questions or to join the group.
- MSBA Probate & Trust Law Section Monthly Meeting
- Thursday, March 20, 2014 at 3:30 p.m.
- Location: MSBA Offices
- Call-in Number: (800) 406-9170 passcode: 1491722
Federal & Minnesota State Tax Update
Estate of Helen P. Richmond, et al. v. Commissioner, (2014) TC Memo 2014-26 – Valuation of Closely Held Entities
In Estate of Helen P. Richmond, the Tax Court re-determined the estate tax value of decedent’s 23.44% interest in family-owned investment holding company, whose portfolio consisted primarily of publicly traded stock. The decedent’s estate tax return reported the fair market value of the decedent’s interest in the holding company using a capitalization-of-dividends method to value the asset. The IRS used a net asset value method and determined a deficiency in decedent’s estate, as well as an accuracy-related penalty under Section 6662.
The Tax Court held that the fair market of decedent’s 23.44% interest in the holding company was better determined by using the net asset value method in light of the fact that the holding company’s assets were easily valued (publicly traded securities) and the market value of the assets inherently reflected the holding company’s future income stream. Furthermore, the Tax Court found that the estate expert’s use of a 100% discount for built-in-capital gain tax was unreasonable because it “illogically treats a potential liability that is susceptible of indefinite postponement as if it were the same as an accrued liability due immediately.”
The Tax Court further held that the estate was liable for a 20% accuracy-related penalty under Section 6662 because the estate failed to show that it acted with reasonable cause and in good faith. The Court’s holding with respect to the 20% accuracy-related penalty was supported by the fact that the estate had relied on an unsigned draft valuation report prepared by an accountant, who was not a certified appraiser.
GST Tax - Modification of Trust. In PLR 201407008, the trustee and beneficiaries of an irrevocable trust exempt from generation-skipping transfer (GST) tax proposed to modify a provision in the trust related to the appointment of successor trustees. The powers exercisable by the trustees under the terms of the trust did not include any discretionary powers over either income or principal, and the trustees were prohibited from prematurely terminating or accelerating any beneficial interest in the trust. Therefore, the IRS privately ruled that the proposed modification which would permit individuals who may also be beneficiaries of the trust to appoint, and be appointed as, additional or successor trustees, would not have the affect of creating a general power of appointment in any such individual for purposes of Section 2041 or 2514. In addition, based upon the facts submitted, the IRS concluded that the proposed modification would not cause the trust to lose its exempt status from GST tax.
March 7520 Rate. The Section 7520 applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest increased from 2.4% to 2.2% for March 2014.
Joe Higgins is an associate at Briggs and Morgan, P.A. Joe is based in the firm’s St. Paul office and is a member of the Estate Planning and Administration Section where he focuses his practice in estate planning, trust and estate administration, and nonprofit law. Joe is admitted to practice before Minnesota, Wisconsin and Florida state courts.
Planning For The 3.8% Medicare Surtax
By: Douglas Wolgamot
Winthrop & Weinstine
This article does not constitute legal or tax advice.
First effective in 2013, a new 3.8% surtax (the “Surtax”) applies to certain unearned/investment income. The Surtax was enacted as part of the Health Care and Education Reconciliation Act of 2010, which amended the Patient Protection and Affordable Care Act (a/k/a Obamacare). The Surtax is considered a revenue-raiser and is often referred to as the “Medicare” tax, even though it is not tied to the Medicare system. The Surtax is applied in addition to all other income taxes, including the alternative minimum tax. The IRS recently published final Regulations on the Surtax, and it also issued proposed Regulations intended to address certain issues that the final Regulations failed to address. The Surtax will impact many taxpayers, and professional advisors will need to have a working knowledge of the Surtax to effectively serve their clients.
Who does the Surtax apply to? The Surtax impacts taxpayers with unearned income and modified adjusted gross income (“MAGI”) that exceeds certain thresholds. The MAGI threshold is: $250,000 for married taxpayers filing jointly; $200,000 for single taxpayers; and $125,000 for married taxpayers filing separately. The individual MAGI thresholds are not adjusted for inflation. Therefore, unless current law is changed, the Surtax is expected to impact more and more taxpayers over time. The threshold for trusts and estates is only $11,950 of income for 2013, and it is indexed for inflation.
What is the Surtax imposed upon? For individual taxpayers, the Surtax is imposed upon the lesser of net investment income (“NII”) or the excess of MAGI over the applicable threshold. For trusts and estates, the Surtax is imposed upon the lesser of undistributed NII or the excess of adjusted gross income over the $11,950 threshold. NII includes the following three categories of income: (i) gross income from interest, dividends, annuities, royalties and rents; (ii) gross income from passive activities or a trade or business of trading in financial instruments or commodities; and (iii) net gain to the extent taken into account in computing taxable income.
Example. A married couple filing jointly has NII of $50,000 and other income of $200,000. The taxpayers’ MAGI does not exceed the $250,000 threshold, so the Surtax does not apply to any of the NII. However, if the couple’s other income increases from $200,000 to $240,000, then $40,000 of their $50,000 of NII will be subject to the Surtax, for a total Surtax of $1,520.
What exclusions to the Surtax exist? There are several exclusions to the Surtax. Some specific exclusions include the following: gain on the sale of a principal residence under Code Section 121; gain on the sale of Qualified Small Business Stock that is excluded from income; gain on like-kind exchanges; the internal build-up of cash value inside life insurance policies; and retirement plan distributions. Although an oversimplification, these exclusions generally mean that if gain is excluded from the regular income tax, it is not subject to the Surtax.
Material Participation for Individuals. Certain unearned income from a trade or business where the taxpayer materially participates is also not subject to the Surtax. Material participation has the same meaning used in the passive loss rules, which generally requires that a taxpayer be involved in the operation on a regular, continuous, and substantial basis. While there are several ways a taxpayer can meet this standard, a taxpayer who participates in the trade or business for more than 500 hours during the year will qualify as materially participating. Where a taxpayer materially participates in a trade or business, gain on the sale of assets used in the trade or business is not subject to the Surtax. A portion of the gain on the sale of an interest in an S-corporation, LLC, or partnership in which the taxpayer materially participates is also not subject to the Surtax. The difficulty is determining the portion that is not subject to the Surtax. The final Regulations withdrew complicated rules that were originally intended to address this issue. The proposed Regulations suggest that new rules be implemented in order to simplify this calculation.
Material Participation for Trusts and Estates. Determining whether a taxpayer materially participates becomes more complicated when the taxpayer is a trust or estate. The difficulty arises from understanding whose participation matters. Although the IRS “reserves” this issue in the current regulations, generally, a trust or estate materially participates if the fiduciary participates. The IRS has noted that the enactment of the Surtax has created the need for additional clarification on how to determine if an estate or trust materially participates in a trade or business. The seminal tax court case on this issue held that the activities of the trust’s or estate’s fiduciaries, employees, and agents should be considered to determine whether the trust’s participation is regular, continuous, and substantial. Matti K. Carter Trust v. U.S., 256 F.Supp.2d 536. However, in a clear attempt to significantly limit the material participation exception for trusts and estates, the IRS took the position, in a 2013 technical advice memorandum, that a trust or estate materially participates if the fiduciary (and not the fiduciary’s agents or employees) participates and does so in the capacity as a fiduciary. I.R.S. Tech. Adv. Mem. 201317010 (April 26, 2013). The position the IRS takes in the future on this issue will have far reaching consequences with respect to application of the Surtax to trust and estate income.
Planning Opportunities. With thoughtful planning, new trusts can be structured and existing trusts and estates can be administered so as to avoid the imposition of the Surtax. For trusts or estates that will hold interests in closely held businesses, understanding the nuances of the material participation rules is of vital importance.
Grantor Trusts. Grantor trusts look to the participation of the grantor (rather than the trustee) when determining whether a trust materially participates in a trade or business, and the threshold used for individual taxpayers is then applied to the grantor.
Example. A client who materially participates in an S-corporation transfers shares of the corporation to an irrevocable grantor trust for the benefit of her children. She names her sister, who does not materially participate in the business, as sole trustee. The unearned income on the shares held in the trust avoids the imposition of the Surtax because of the grantor’s material participation in the business. It does not matter that the trustee does not materially participate.
Qualified Subchapter S Trusts (“QSST”). There is some disagreement among practitioners about the most reasonable method of determining material participation as it relates to a QSST. The proposed Regulations recognize this disagreement but treat S-corporation operating income differently than gain from a disposition of the S-corporation stock itself. With respect to operating income, the proposed Regulations look to the material participation of the QSST beneficiary. With respect to the sale of S-corporation stock, the proposed Regulations look to the material participation of the trust itself, through its trustee.
Example. A client transfers S-corporation shares to a QSST for the benefit of his sister, who materially participates in the business. He names his brother, who does not materially participate in the business, as sole trustee. The operating income on the shares held by the QSST is not subject to the Surtax because the beneficiary materially participates. On the other hand, if the QSST sells its shares of S-corporation stock, the gain on the sale is subject to the Surtax because the trustee does not materially participate in the business.
Non-Grantor Trusts. Non-grantor trusts, such as an Electing Small Business Trust (“ESBT”), look to the activities of the trustee when determining if a trust materially participates in a trade or business.
Example. A client transfers S-corporation shares to an irrevocable non-grantor trust (an ESBT) for the benefit of his children. He names the company’s CFO as sole trustee. The unearned income on the S-corporation shares avoids the imposition of the Surtax because of the material participation of the trustee. It does not matter if the grantor materially participates in the business.
Estates. Like non-grantor trusts, the personal representative’s activities are used to determine whether the estate materially participates in a business.
Example. An estate holds units in a partnership in which the personal representative does not materially participate. The estate is subject to the Surtax with respect to undistributed unearned partnership income.
Fiduciary Selection Planning. As the examples above demonstrate, the material participation of a grantor or fiduciary in a business can mean the difference between paying or avoiding the Surtax. Trust documents should be drafted flexibly to allow for necessary changes in fiduciaries. Adding a co-fiduciary who materially participates in a trade or business may be an effective method to avoid the Surtax. Existing fiduciaries should be carefully examined in order to determine if a change in fiduciaries is necessary or advisable to avoid the Surtax. The risk that the IRS will limit a fiduciary’s material participation to include only those activities performed by the fiduciary in his or her capacity as trustee or personal representative must be considered when structuring a transaction. Under the right circumstances, planning may involve creating a role for the fiduciary in the operation of the company in order to satisfy the material participation standard.
Managing Trust and Estate Distributions. The Surtax only applies to the undistributed net income of a trust or estate in excess of the threshold. Income distributed to a beneficiary is generally deductible by the trust or estate and taxable to the beneficiary. Since the individual taxpayer MAGI thresholds are much higher than the threshold for trusts and estates, a trust or estate may be able to minimize or eliminate the Surtax by making distributions to the beneficiaries. Internal Revenue Code Section 663(b) permits distributions to be made within the first sixty-five (65) days of any taxable year to be considered made in the previous taxable year. This gives trustees some additional time to assess whether distributions could reduce the Surtax payable, if such distributions are permitted by the trust document and are consistent with the intent of the trust.
Managing Investments. Fiduciaries can manage investments to reduce NII and therefore reduce the Surtax by investing in tax exempt, tax deferred, or capital appreciating assets. Of course, the investments must be consistent with the terms of the trust and the trustee’s fiduciary duty.
With the recent changes to the Federal estate tax laws, income tax planning is becoming an increasingly important part of the estate planning conversation. The Surtax will impact many taxpayers, and clients will look to their professional advisors to navigate these complicated rules. Understanding the nuances of the Surtax will be an essential part of a successful estate planning practice.
Doug Wolgamot is an attorney with Winthrop & Weinstine, P.A., in the Tax, Trusts & Estates practice group. Doug advises high net worth individuals and families on estate, tax and charitable planning, trust and estate administration, probate administration, and estate and trust controversies. Prior to practicing law, Doug worked as a CERTIFIED FINANCIAL PLANNER™, giving him a unique ability to tailor his clients’ estate plans to help accomplish their financial planning objectives.
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