Tax Reform "Framework"

     Following in the footsteps of the recently released estimates of the 2018 inflation adjusted exemptions for the Estate and Gift Taxes, yesterday the President unveiled what the White House refers to as a "framework" for tax reform. This framework contains a number of significant proposals, many of which are similar to ideas put forward during the President's campaign including:

• reducing the number of individual income tax brackets from 7 to 3,

• nearly doubling the current standard deduction,

• increasing the child tax credit to an unspecified higher level, 

• significantly reducing the corporate income tax rate, and

• reducing the tax rate on income received from "pass-through" companies (such as LLC's, partnerships, and S-corps).

Also significant in the framework is a renewed effort to reduce individual and corporate tax deductions and repeal the Estate and Gift Tax.

     Economists, pundits, and reporters will have much to say about this effort to reform the tax code, but for our purposes it is important to remember that this framework is essentially a “wish list’ and not a well-defined bill Congress can discuss and pass. The framework omits significant details, including basic, but integral, information such as where the individual bracket thresholds start and stop. While this is clearly a statement of intent regarding how the administration would like to move forward on tax reform, the lack of specifics make it little more than a compilation of common Republican talking points on the subject of tax reform from the last 10 years.

     From our point of view, any discussion of tax reform is an important issue to stay abreast of in order to understand how it will impact our clients planning. The potential repeal of Estate and Gift Taxes reinforces this belief, as any change of that magnitude is likely to create a ripple effect reaching other aspects of the tax code, including whether inheritors receive a step up in basis and the rules regarding the distribution of inherited IRAs. That said, it is our philosophy to keep track of tax proposals but not to spend a significant amount of time gazing into our crystal ball to determine how proposed legislation that may never come to pass will affect our clients.

     Rest assured we will continue to stay abreast of tax proposals and their impact on the planning landscape so that if and when a tax reform proposal becomes law we will be prepared to provide our clients with the expertise necessary to adapt their planning to the changed landscape and ensure that it continues to achieve their goals moving forward.

Alan and Matt

The Ripple Effect of US v. Windsor on Planning

     Today marks a milestone for Plainly Legal. This is our 100th post, and we would like to thank everyone who has supported this venture and visited our Blog. That said, let's move on to today's topic, as recent weeks have produced significant news that affects our practice and those of our associated professionals.

     As we discussed in July, the Supreme Court's decision in the case of US v. Windsor, holding Section 3 of the Defense of Marriage Act (DOMA) unconstitutional, impacts planning for married same-sex clients. Since that decision, other departments of the Federal government have announced responses to this holding.

     On August 29th the US Department of Treasury and the Internal Revenue Service ruled that same-sex couples, legally married in states that recognize their marriages, would be treated as married for federal tax purposes. This ruling applies to all married same-sex couples regardless of whether their state of residence recognizes same-sex marriage. This ruling applies to all forms of federal taxation including income, gift, and estate tax. Because of this ruling, legally married same-sex couples may file their 2013 federal income tax return using either the married filing jointly or married filing separately filing status. These couples may, but are not required to, file amended returns for the tax years 2010, 2011, and 2012, choosing to be treated as married for those years. However, Michigan has yet to weigh in on whether legally married same-sex couples may file joint returns. 

     While the IRS has readily complied with the Supreme Court's decision, other departments of the Federal government are not as quick to change their policies. The Department of Veterans Affairs Secretary Eric Shinseki announced that the Supreme Court ruling did not specifically strike down a federal regulation defining a spouse as someone of the opposite sex, and therefore the Department of Veterans Affairs would continue to limit VA benefits to opposite sex spouses. This decision was almost immediately challenged, and on August 30th US District Judge Consuelo Marshall of Los Angeles ruled that based on the Supreme Court's decision in US v. Windsor, the regulation in question was unconstitutional and approved an injunction permanently barring the VA from applying that regulation.

     In contrast to the Department of Veterans Affairs, the Pentagon has announced that as of September 3rd same-sex spouses of military members will now be eligible for the same health care, housing, and other benefits enjoyed by opposite sex spouses. This decision has been met with some resistance, especially from the State of Texas, where the Texas National Guard currently refuses to process requests from same-sex couples.

As events unfold and the scope of the Supreme Court's decision becomes clearer, we at Plainly Legal will continue to provide you with commentary that may assist you in new planning for clients covered by the decision. 

     Again, thanks to all of our readers for their regular visits to the site, and we look forward to continuing to provide you with useful and insightful information regarding estate, tax, and business planning.

Matt Ferrara

Income Recognition from Cancellation of an Insurance Contract

The general rule is that that the proceeds of a life insurance contract, payable on the death of the insured, does not create taxable income. Consequently, even though the beneficiaries of a life insurance policy may realize a substantial economic gain by the receipt of the proceeds, this gain will not generally be taxable. However, one should be careful in dealing with an insurance policy during the lifetime of the insured. Some policy owners will borrow the cash surrender value prior to death to pay premiums, which may create a tax problem, as illustrated by a recent Tax Court decision.

In that case, a taxpayer purchased a life insurance policy and made premium payments for the first 13 years of the policy. The taxpayer elected an automatic loan premium provision in the event that the owner stopped making premium payments. Eventually, the taxpayer stopped making premium payments and the insurance company used the automatic loan premium provision to borrow the cash surrender value prior to death to pay the premiums. The policy provided it would lapse if its cash value could no longer cover the premium payments. This would occur if the outstanding loan balance and interest exceeded the policy's cash value.  The insurance company notified the taxpayer that the policy had lapsed because the outstanding loan balance and interest exceeded the policy's cash value.

To understand the consequences of this action it is important to understand that Internal Revenue Code Section 61(a) defines gross income as “all income from whatever source derived,” unless otherwise provided. Generally, any amount that is received under a life insurance contract prior to death is included in gross income to the extent it exceeds the investment in the contract. The phrase “investment in the contract” is defined generally as the aggregate amount of premiums or other consideration paid for the contract less the aggregate amount previously received under the contract, to the extent it was excludible from gross income. In the case at hand, the difference between the outstanding loan balance and the investment in the contract was $37,981, and the insurance company issued a Form 1099-R showing this taxable amount.

The taxpayer timely filed his personal income tax return but did not report the taxable amount shown on the Form 1099-R. The IRS eventually sent the taxpayer a notice of deficiency showing an adjustment to income of $37,981 for pensions and annuities. The taxpayer argued the amount was not income for purposes of income taxation.

The Tax Court determined that for Federal income tax purposes, loans against the cash value of a life insurance contract are true loans from the insurance company to the policyholder with the policy serving as collateral and thus not taxable distributions when received. When the insurance company terminated the policy, it charged the amounts of policy loans and capitalized interest against the proceeds from termination made available at that time. This constructive distribution in satisfaction of the loans had the effect of a payment of the policy proceeds to the taxpayer constituting income to the taxpayer to the extent it exceeded his investment in the policy.  In this case, of the Tax Court agreed with the IRS in charging penalties as well as interest because the taxpayer had knowledge of the income because he received the Form 1099-R.

When clients have financial difficulties, they will often use premium policy loans to carry the policy in difficult times, or may cancel the policy altogether. Due to the potential for unintended tax consequences clients considering these actions should seek professional help to determine policy parameters and tax consequences. 

Alan Ferrara

Leveraging IRA Accounts using Life Insurance

One interesting item in President Obama's latest budget proposal is limiting IRA accounts to $3 million, or some number calculated to purchase a maximum benefit of $205,000 at retirement. In addition to limiting the amounts that can be tax-deferred under IRAs, this would probably have the effect of minimizing the benefit of "stretch IRAs". While this idea may never be a part of the final budget it does bring to mind a planning option I have used with IRAs in the right circumstances.

Because IRAs eventually are generally fully taxable, a $3 million IRA, or even a smaller IRA, will be subject to significant income taxation. If the taxpayer's estate is above the $5 million lifetime exemption, the total tax burden on the IRA only gets worse.

If a client desires to maximize the amount going to their heirs, they may want to consider leveraging their IRA using life insurance. The strategy works as follows:

1. Presuming the client does not need IRA distributions to support their lifestyle, Instead of delaying IRA distributions until age 70 1/2, a client begins taking distributions after 59 1/2 when there are no longer penalties for early distributions.
2. After paying the income tax on the IRA distribution, the client gifts the remainder of the distribution to an Irrevocable Trust benefiting family members.
3. The Irrevocable Trust Trustee purchases a life insurance policy on the life of the client. After satisfying some legal requirements (Crummey Notices), the Trustee uses the funds to pay the annual premium of the life insurance policy.
4. At the death of the client, the Trustee collects the insurance proceeds, income tax-free, and uses them for the benefit of the client's family.

The client has succeeded in turning a heavily income (and possibly estate) taxed IRA account into a tax-free account, of significantly greater value, depending on the size of the insurance policy.

If the beneficiaries are minors or adults without a good record of handling money, the Irrevocable Trust can protect them from themselves and their creditors. If all of the beneficiaries are adults and the client is comfortable with their maturity, the client can simply make gifts to the family members who will then use it to purchase a life insurance policy on the client. Either way, the proceeds are income tax-free and, if properly structured, are not part of the client's estate.

The client can go a step further if he/she does not like the idea that the IRA benefits are going to be income and possibly estate taxable after death. The client and the client’s spouse can have full use of the IRA account during their lifetimes, and then provide that at the second death the IRA account be distributed directly to a charity, tax-free. The family members get their benefit, the charity gets its benefit, and the only entity that loses is the Internal Revenue Service.

Most of my clients are not inclined towards making significant charitable gifts, but with the right strategy, they love the idea that their loved ones are protected, they can satisfy any charitable inclinations, and the IRS is essentially paying for it. With proper planning and the help of qualified professionals, family members are better protected.

Alan Ferrara