Tax Lawyers Minneapolis

Gift and Estate Tax Impact of the American Taxpayer Relief Act of 2012

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One of the most dramatic effects of the American Taxpayer Relief Act of 2012 (ATRA) was felt in the area of gift and estate taxes.

Pre-ATRA Situation

In 2012, the estate and gift tax exemptions, indexed for inflation, were set at $5,120,000 each (up from $5,000,000 in 2011). Moreover, in 2012, the surviving spouse could use the unused exemption of a deceased spouse (this is called “portability”). Finally, the gift tax exemption was the same as the estate tax exemption, so taxpayers could make lifetime gifts that fully utilized their exemptions. In some situations, these gifts would shift the gifted assets’ future appreciation and income out of the donors’ taxable estates. The maximum tax rate for transfers in excess of the exemption was 35 percent.

All of these provisions expired on January 1, 2013. The $5,120,000 exemption was reduced to a $1,000,000 and the maximum tax rate was increased to 55 percent; the portability provision also expired. There was also a problem of the infamous “clawback” with respect to taxpayers who gifted their property using the higher exemption limits in 2012.

ATRA Changes

ATRA corrected the negative impact of the expiration of the 2012 gift and estate tax provisions. It set the permanent exemptions at $5,000,000 with one unexpected surprise – the exemption amount was indexed for inflation. This means that, for 2013, the exemption amount is $5,250,000. The higher exemption amount also renders the clawback provision harmless at this point.

Furthermore, ATRA reinstated the portability provision so that a surviving spouse can still use a deceased spouse’s unused exemption (provided that an estate tax return is filed and the portability election is properly made). However, it should be remembered that the portability is not available for a deceased spouse’s unused generation-skipping transfer tax exemption.

On the more negative side, ATRA raised the maximum tax rate from the 2012 levels to 40 percent. On the other hand, it is still a lot lower than the 55-percent tax that would have been applicable without ATRA.

With respect to charitable contributions, ATRA reinstated the exclusion from gross income for qualified charitable contributions by taxpayers over age 70 ½ of up to $100,000 distributed from an IRA through December 31, 2013. See this article for more details.

Annual Exclusion and Form 3520 Threshold Amount

For the tax year 2013, the gift tax annual exclusion increased from $13,000 to $14,000 per donee and from $139,000 to $143,000 for gifts made to a non-citizen spouse. The threshold at which gifts receivable from foreign partnerships and corporations become reportable to the IRS also increased from $13,258 to $15,102. The threshold amount for Form 3520 (with respect to value of gifts from foreign individuals and estates) remains at $100,000.

Contact Sherayzen Law Office for Help with Your Estate and Tax Planning

If you are in the process of creating your estate and/or tax plan, contact Sherayzen Law Office for help. Our experienced estate planning tax firm will thoroughly review your case, identify available options and prepare all of the required legal and tax documents to implement your plan.

Family Partnerships and Income-Splitting

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Family partnerships can offer an advantageous method for splitting business income between family members who may be taxed at lower income rate brackets. This can result in substantial tax savings. However, because of the potential for widespread abuse of this device by shifting income to close relatives who may perform little or no actual work for a partnership, the Internal Revenue Code Section 704(e) (with related regulations and case law) place certain limitations upon family partnerships.

Under these limitations, the IRS can determine that the family partnership arrangement is invalid for tax purposes and disallow income-splitting. This article introduces the reader to the concept of a “family partnership” and outlines some of the general rules for determining whether family members will be recognized as valid partners.

Who is a Family Member for Purposes of IRC Section 704(e)?

Under IRC Section 704(e), “family members” include spouses, ancestors, lineal descendants, and any trusts for the primary benefit of such persons. It is important to note that brothers and sisters are not listed in this classification.

How Will a Family Member be Recognized as a Valid Partner?

In general, a family member may only be recognized as a partner of a family partnership if either of two conditions is met.

Under the first condition, if capital is a “material income-producing factor” and the partnership interest (allowing for full ownership and control) was acquired in a bona fide transaction, regardless of whether it was obtained by purchase or gift from another family member, a family member may be treated as a valid partner. Typically, capital will be considered a material income-producing factor if the partnership receives a significant portion of its gross income from utilizing capital resources (such as from investments in plant and equipment, or inventories). However, capital will usually not be treated as material income-producing factor if the partnership receives much of its gross income from service-oriented elements (such as commissions or fees). Additionally, the family member/partner must have a legitimate capital interest in the assets of the firm – a profits interest alone will not be sufficient.

Alternatively, pursuant to various cases interpreting IRC Section 704(e), if capital is not a material income-producing factor, but a family member contributes vital services to the partnership, the family member may be recognized as a legitimate partner of a family partnershp.

Transfer of a Partnership Interest to Children

One of the most common traps associated with income-splitting in family partnerships is the transfer of a partnership interest to the partner’s children. In such cases, the general rule is: where the capital is a material income-producing factor and a partnership interest is transferred, whether by gift or purchase, to children under the age of eighteen, a large portion of a dependent child’s income distribution received from the partnership may be subject to the “Kiddie tax” rules. Thus, unless the child’s income constituted earned income, it may be taxed at his parents’ tax rate. If a child performs legitimate services for the partnership, however, the Kiddie tax rules may be inapplicable.

Contact Sherayzen Law Office for Tax Planning with respect to Family Partnerships

The information contained in this article is general in nature, and does not constitute legal advice. In order to avoid making costly tax mistakes, you may wish to seek the advice of legal counsel.

If you currently have an interest in a family partnership or you would like to create one, contact Sherayzen Law Office, Ltd. Our experienced business tax firm will thoroughly analyze your case, create a customized ethical tax plan that fits your needs and implement this plan (including preparation of any legal and tax documents).

IRS FY 2012 Performance Results

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The IRS released the statement describing its performance in the Fiscal Year 2012. The general results continued last year’s trend.

In the enforcement area, audits of individuals topped 1 million for the sixth year in a row, with a 1.03% coverage rate out of all tax returns filed. Audits in the upper income ranges remained substantially higher than other categories.

With respect to businesses, the IRS increased examinations across all categories of business returns by more than 12% in FY 2012, with the largest increases coming in audits of flow-through entities, which include partnerships and Subchapter S corporations. The examination rate exceeded 20% for the largest corporations.

IRS enforcement was highly profitable for the U.S. government, especially in the area of voluntary disclosures (such as 2009 OVDP, 2011 OVDI and 2012 OVDP). The IRS collected more than $50 billion in enforcement revenue in FY 2012, the third year in a row topping that figure. However, the 2012 numbers were lower than 2010 and 2011, which were unusual years with enforcement dollars helped by large numbers of offshore tax cases coming in. More than 38,000 disclosures of offshore accounts have been made to date through the IRS’ offshore voluntary disclosure programs. In addition, the economic slowdown contributed to lower enforcement figures, as most enforcement dollars collected resulted from audits of returns for years during the slowdown.

In terms of staffing, however, the IRS again suffered from the cuts to its budget by the Congress, despite extensive evidence that investment in IRS enforcement brings disproportionate amount of income to U.S. government. After a nearly flat budget in FY 2011, the IRS’ FY 2012 budget was reduced by $305 million. This reduction affected the level of staffing available to deliver service and enforcement programs. Overall full-time staffing has declined by more than 8% over the last two years, and staffing for key enforcement occupations fell nearly 6% in the past year.

One exception to the staffing problems has been identify theft. In FY 2012, the IRS more than doubled the number of staff dedicated to preventing refund fraud and assisting taxpayers victimized by identity theft, with more than 3,000 employees working in this area. As a result of these increased efforts, the IRS in FY 2012 was able to prevent the issuance of more than 3 million fraudulent refunds worth more than $20 billion, an increase from approximately 1.8 million refunds worth about $14 billion the previous year.

On the service side, the IRS saw continued strong growth in electronic filing by individuals, as the e-filing rate in FY 2012 exceeded 80% for the first time. Taxpayer interest in online interactions continued to increase as well, with web page visits on IRS.gov up nearly 17% to 372 million.

One of the most surprising trends has been the steady increase in criminal investigations and the growth in the conviction rate. The number of criminal investigations for tax and tax-related matters has gone up from the low of 1,269 investigation in 2009 to 1,846 in 2012 – a whopping 45% increase. During the same time, the conviction rate went up from 87.2% in 2009 to 93.0% in 2012. This means that the IRS is not only radically increasing the number of criminal investigations, but also it is more successful in its prosecution efforts.

Overall, 2012 appears to have been a successful year for the IRS, especially with respect to international tax enforcement.

Tax-Free Transfers to Charity Renewed For Certain IRA Owners

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On January 16, 2013, the IRS confirmed that certain owners of individual retirement arrangements (IRAs) have a limited time to make tax-free transfers to eligible charities and have them count for tax-year 2012.

Pursuant to the American Taxpayer Relief Act of 2012, Congress extended for 2012 and 2013 the tax provision authorizing qualified charitable distributions (QCDs). Under this provision, an otherwise taxable distribution from an IRS, owned by a person who has at least 70.5 years or older, can exclude from gross income up to $100,000 of QCDs paid directly to an eligible charitable organization. The eligible IRA owners have until Thursday, January 31, 2013, to make a direct transfer, or alternatively, if they received IRA distributions during December 2012, to contribute, in cash, part or all of the amounts received to an eligible charity.

The QCD option is available regardless of whether an eligible IRA owner itemizes deductions on Schedule A. Transferred amounts are not taxable and no deduction is available for the transfer.

It is iimportant to note that QCDs are counted in determining whether the IRA owner has met his or her IRA required minimum distributions for the year.

For tax year 2012 only, IRA owners can choose to report QCDs made in January 2013 as if they occurred in 2012. In addition, IRA owners who received IRA distributions during December 2012 can contribute, in cash, part or all of the amounts distributed to eligible charities during January 2013 and have them count as 2012 QCDs.

QCDs are reported on Form 1040 Line 15. The full amount of the QCD is shown on Line 15a. Do not enter any of these amounts on Line 15b but write “QCD” next to that line.

Optional Safe Harbor Method for Claiming Home Office Deduction for 2013

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On January 15, 2013, the IRS today announced a simplified option for claiming home office deduction (i.e. deduction for the business use of a home). The new optional deduction, capped at $1,500 per year based on $5 a square foot for up to 300 square feet, will reduce the paperwork and recordkeeping burden on small businesses by an estimated 1.6 million hours annually.

Background Information

Internal Revenue Code (IRC) Section 280A generally deals with the tax treatment of home office expenses. Generally, IRC Section 280A(a) disallows any deduction for expenses related to a dwelling unit that is used as a residence by the taxpayer during the taxable year. However, Provisions 280A(c)(1) through (4) allow a deduction for expenses related to certain business or rental use of a dwelling unit, subject to the deduction limitation in § 280A(c)(5).

Section 280A(c)(1) permits a taxpayer to deduct expenses that are allocable to a portion of the dwelling unit that is exclusively used on a regular basis (A) as the taxpayer’s principal place of business for any trade or business, (B) as a place to meet with the taxpayer’s patients, clients, or customers in the normal course of the taxpayer’s trade or business, or (C) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.

Section 280A(c)(2) permits a taxpayer to deduct expenses that are allocable to space within the dwelling unit used on a regular basis for the storage of inventory or product samples held for use in the taxpayer’s trade or business of selling products at retail or wholesale, if the dwelling unit is the sole fixed location of the trade or business.

Section 280A(c)(3) permits a taxpayer to deduct expenses that are attributable to the rental of the dwelling unit or a portion of the dwelling unit.

Section 280A(c)(4) permits a taxpayer to deduct expenses that are allocable to the portion of the dwelling unit used on a regular basis in the taxpayer’s trade or business of providing day care for children, for individuals who have attained age 65, or for individuals who are physically or mentally incapable of caring for themselves.

Optional Safe Harbor Method

After recognizing that Section 280A(c)(1) imposes a substantial compliance burden on taxpayers (and, perhaps, with the desire to cut its own enforcement costs), the IRS decided to provide for the very first time a new method of calculating home office deductions – the optional safe harbor method.

Under this safe harbor method, taxpayers determine their allowable deduction for business use of a residence by multiplying a prescribed rate (currently set at $5 per square foot) by the square footage of the portion of the taxpayer’s residence that is used for business purposes (“allowable square footage”). The allowable square footage is the portion of a home used in a “qualified business use” of the home, but not to exceed 300 square feet.

“Qualified Business Use” is a term of art. Under the Rev. Proc. 2013-13, this term means (1) business use that satisfies the requirements of § 280A(c)(1), (2) business storage use that satisfies the requirements of § 280A(c)(2), or (3) day care services use that satisfies the requirements of § 280A(c)(4) (see above).

The safe harbor method provided by this revenue procedure does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home under a reimbursement or other expense allowance arrangement (as defined in § 1.62-2) with his or her employer.

Note that the current restrictions on the home office deduction, such as the requirement that a home office must be used regularly and exclusively for business and the limit tied to the income derived from the particular business, still apply under the new option.

Advantages and Disadvantages of the New Optional Safe Harbor Method

The new option provides eligible taxpayers an easier path to claiming the home office deduction. Currently, they are generally required to fill out a 43-line form (Form 8829) often with complex calculations of allocated expenses, depreciation and carryovers of unused deductions. Taxpayers claiming the optional deduction will complete a significantly simplified form.

The new option does not affect business expenses unrelated to the home (such as advertising, supplies and wages paid to employees). Such expenses are still fully deductible.

The down side of the new option is that the homeowners cannot depreciate the portion of their home used in a trade or business. However, they can still claim allowable mortgage interest, real estate taxes and casualty losses on the home as itemized deductions on Schedule A. These deductions need not be allocated between personal and business use, as is required under the regular method.

A taxpayer using the safe harbor method for a taxable year cannot deduct any depreciation (including any additional first-year depreciation) or § 179 expense for the portion of the home that is used in a qualified business use of the home for that taxable year. The depreciation deduction allowable for that portion of the home for that taxable year is deemed to be zero.

Switching the Methods

The election of whether to use safe harbor method is made on a annual basis. Therefore, in one year, a taxpayer may use the safe harbor method, while the next year he can choose to calculate and substantiate actual expenses for purposes of § 280A. A change from using the safe harbor method in one year to actual expenses in a succeeding taxable year, or vice-versa, is not a change in method of accounting and does not require the IRS consent.

It is important to remember that an election for any taxable year, once made, is irrevocable

More complications arise if the taxpayer depreciates his home subsequent (or even prior to) electing to use the safe harbor method.

Safe Harbor Method Available in 2013

The new simplified option is available starting the tax year 2013.