April 2010 Tax Update

April 2010 Tax Update

By: Martin M. Shenkman, CPA, MBA, JD

Recent Tax Acts and Legislation Affect Tax, Estate and Financial Planning

By: Martin M. Shenkman, CPA, MBA, PFS, JD


  • Tax and Related Changes Abound. 1
  • Selected Payroll, Payroll Tax and Related Provisions. 1
  • Payroll Tax Holiday for New Workers. 1
  • Credit for Providing Health Insurance Coverage to Certain Employees. 2
  • Increased Medicare Tax on High Income Earners. 3
  • Expansion of Medicare Tax to Passive Income. 3
  • Introduction. 3
  • Application of Medicare Tax on Investment Income of Trusts and Estates. 4
  • Planning Considerations for Medicare Tax on Investment Income. 5
  • Medical Expense Deductions Restricted. 7
  • Marriage Penalty. 7
  • Estimated Income Tax Payments. 7
  • Economic Substance Doctrine Toughened. 8
  • Introduction. 8
  • History of the Economic Substance and Related Doctrines. 8
  • New Code Section 7701(o)9
  • Some Transactions Excluded. 11
  • Complications and Uncertainty Remain. 12
  • Exclusion of Gain on Small Business Stock. 12
  • Reporting for Real Estate Expanded. 12
  • New Anti-GRAT Rules. 13
  • Introduction. 13
  • Bottom Line: Three Tough GRAT Changes. 13
  • Overview of Traditional GRAT Planning Under Current Law.. 13
  • Proposed GRAT Restrictions. 14
  • Foreign Trust Provisions. 15

Recent Tax Acts and Legislation Affect Tax, Estate and Financial Planning

IRS Circular 230 Legend: Any advice contained herein was not intended or written to be used and cannot be used, for the purpose of avoiding U.S. Federal, State, or Local tax penalties. Unless otherwise specifically indicated herein, you should assume that any statement in this communication relating to any U.S. Federal, State, or Local tax matter was not written to support the promotion, marketing, or recommendation by any parties of the transaction(s) or material(s) addressed in this communication.Anyone to whom this communication is not expressly addressed should seek advice based on their particular circumstances from their tax advisor.

Tax and Related Changes Abound

Congress is at it again. Proposing, and sometimes passing, tax legislation, at a rapid clip. Some of the many recent developments include:

  • The Hiring Incentives to Restore Employment Act (H.R. 2847).
  • 2010 Health Care Act (PL 111-148, 3/23/2010 ).
  • 2010 Reconciliation Act.
  • The Patient Protection and Affordable Care Act (3/23/10).

Also,The House of Representatives passed the Small Business and Infrastructure Jobs Tax Act of 2010 on March 24 (H.R. 4849).

This torrent of new and proposed legislation assures complexity and difficulty in tax planning. Perhaps the only thing that will be certain in tax planning for the near term, is complexity, more change and more difficulties. New developments will likely obsolete this update outline before you read it.

Instead of resolving estate tax uncertainty, and simply raising marginal income tax rates to raise revenues, Congress is using its old tricks of "a little twist here, a little twist there" to start addressing budget issues. Congress has (well at least as of the day this is being written, but who knows) failed to address the estate tax morass. The problem with many quirky tax increases approach is that taxpayers resent these types of changes because they are difficult to understand and harder to plan for. While simply raising tax rates would be direct and honest, it obviously is not politically palatable.

Selected Payroll, Payroll Tax and Related Provisions

Recent tax legislation has included a blizzard of incentives to encourage employment, defray the cost of health care coverage and more. The following discussion is but a brief overview of some of the many changes.

Payroll Tax Holiday for New Workers

If an employer adds new employees to their payroll they may qualify for a payroll tax holiday during which the employer payments for Social Security taxes will be waived. To qualify, the worker must certify to the employer that he or she has not worked for more than 40 hours during the 60 days prior to starting work for you. Form W-11 can be used to obtain the employee's confirmation that he or she meets the requirements of being a qualified employee.

Credit for Providing Health Insurance Coverage to Certain Employees

Businesses can earn a tax credit for their payments for certain health insurance premiums. Act, signed March 23, 2010.

The maximum credit is 35% of premiums paid in 2010 by eligible small business employers (25% for tax-exempt employer organizations). In 2014, this maximum credit increases to 50 percent of premiums paid by eligible small business employers (35% for tax-exempt organizations). Low and moderate income workers are the target for this credit. There are three requirements to qualify:

(1) The employer must employ less than 25 full-time equivalent employees. To assure complexity the new acronym "FTE" has been created for "full-time equivalent" employees.

(2) The employer must pay wages averaging less than $50,000 per employee, per year.

(3) The employer must pay for insurance premiums under a qualifying arrangement. This means that the employer pays premiums for each employee enrolled for health care coverage offered by the employer. The amount paid must be equal to a uniform percentage (which cannot be less than 50%) of the premium cost of the coverage.

Employers with 10 or fewer full-time equivalent employees paying average annual wages of $25,000 get the maximum credit. The credit is phased out as the employer's average wages increase from $25,000 to $50,000, and as the number of full-time equivalent workers increases from 10 and 25. The FTE worker concept can be illustrated by 40 employees working ½ a week each are equivalent to 20 full-time workers.

If the number of FTEs exceeds 10 or if average annual wages exceed $25,000, the amount of the credit is reduced as follows (but not below zero). If the number of FTEs exceeds 10, the reduction is determined by multiplying the otherwise applicable credit amount by a fraction, the numerator of which is the number of FTEs in excess of 10 and the denominator of which is 15.If average annual wages exceed $25,000, the reduction is determined by multiplying the otherwise applicable credit amount by a fraction, the numerator of which is the amount by which average annual wages exceed $25,000 and the denominator of which is $25,000. In both cases, the result of the calculation is subtracted from the otherwise applicable credit to determine the credit to which the employer is entitled. For an employer with both more than 10 FTEs and average annual wages exceeding $25,000, the reduction is the sum of the amount of the two reductions.This sum may reduce the credit to zero for some employers with fewer than 25 FTEs and average annual wages of less than $50,000.

Importantly for closely held businesses, the owner of the business also provides services to it, does not count as an employee. Thus, a sole proprietor, a partner in a partnership, a shareholder owning more than two percent of an S corporation, and any owner of more than five percent of other businesses, are not considered employees for purposes of the credit. Thus, the wages or hours of these business owners and partners are not counted in determining either the number of FTEs or the amount of average annual wages, and premiums paid on their behalf are not counted in determining the amount of the credit.

This health insurance credit is claimed as part of the general business credit. The Patient Protection and Affordable Care

Increased Medicare Tax on High Income Earners

Currently, wages are subject to a 2.9% Medicare payroll tax. Workers and employers each pay ½, or 1.45%. If you're self-employed you pay it all but get an above- the- line income tax write-off for ½. This Medicare tax is assessed on all earnings or wages without a cap. These taxes fund the Medicare hospital insurance trust fund which pays hospital bills for those 65+ or disabled. Starting in 2013 an additional .9% Medicare tax will be imposed on wages and self-employment income over $200,000 for singles and $250,000 for married couples. IRC Sec. 3101(b)(2). That makes the marginal tax rate 2.35% for employees. Self-employed persons will face a 3.8% rate on earnings over the above amounts.

Look for more changes like this, a few percent here, a few percent there instead of just the rate increases needed to raise revenues. The result will make tax planning and preparing projections increasingly complex.

By way of perspective, taxpayers should bear in mind that the Medicare tax is in addition to the Old Age, Survivors and Disability Insurance (OASDI) and Federal Insurance Contributions Act (FICA) taxes which apply to employers and employees. The OASDI rate is 6.2% on wages up to $106,800 (2010). That ceiling is increased yearly.

Expansion of Medicare Tax to Passive Income


Only wages and earnings are subject to the Medicare tax above, but starting in 2013 the 3.8% Medicare tax will apply to net investment income if your adjusted gross income (AGI) is over the $200,000 (single) or $250,000 (joint) threshold amounts. IRC Sec. 1411. More specifically, the greater of net investment income or the excess of your modified adjusted gross income (MAGI) over the threshold, will be subject to this new tax.

These amounts are not supposed to be indexed so inflation will erode these thresholds overtime. Failure to inflation adjust these amounts is a significant departure from many prior tax law changes. Over time these caps and the tax raise will shift from applying to the wealthiest sliver of taxpayers to a broader range of taxpayers, just like the AMT expanded over time.

Net investment income includes interest, dividends, royalties, rents, gross income from a passive business, and net gain from property sales. Income from a trade or business will not be included in definition of net investment income. IRC Sec. 1411(c).

Application of Medicare Tax on Investment Income of Trusts and Estates.

This new tax will apply to the unearned income of individuals, as well as to estates and trusts. IRC Sec. 1411(a)(2). An estate or trust will actually pay the Medicare tax on investment income based on the lesser of the estate or trust's undistributed net investment income, or the excess of the estate or trusts net investment income over the threshold at which the estate or trust is taxed at the highest marginal tax rate. In 2010 that figure is $11,200. However, unlike the thresholds for applying the increased Medicare taxes, this figure for estates and trusts is inflation indexed. The calculations for an estate and trust will be complicated by having to determine expenses that can offset investment income with consideration to the rules under Code Section 67(e) and the special rules for applying the 2%-of-AGI floor on miscellaneous itemized deductions to estates and trusts. These rules will complicate estate and trust administration.

Will it become advantageous to distribute money from a larger estate or trust to the beneficiary quicker to avoid the surcharge? If an estate or trust earns $30,,000 it will face the additional Medicare tax. However, a beneficiary who is entitled to a distribution from the estate, or who holds an interest in the trust, may not have, even with the full distribution of his or her share of the estate or trust, enough income above the threshold to trigger the Medicare investment tax.

Will the fiduciary face a different analysis in determining whether or not to hold assets in the estate or trust if doing so will increase the tax cost? Perhaps an executor is favoring delaying distributions to a later calendar year pending receipt of a tax clearance letter, or confirmation of the exact amount of a liability. Those decisions should be documented if the delay may trigger the additional tax. Instead, the fiduciary could perhaps distribute the funds prior to year end, reducing the fiduciary income to a level below the threshold at which the Medicare investment tax will apply, and have the beneficiaries sign receipts, releases and refunding bonds agreeing to refund the distribution to the estate if the funds are needed for the uncertain liability. This puts the fiduciary between the proverbial rock and the hard place. If the fiduciary distributes funds needed for covering expenses the fiduciary might face personal liability. However, if the fiduciary does not make the distribution the funds will be potentially taxed at a higher rate and the fiduciary could face claims from the beneficiaries.

Some trusts will be exempt from the Medicare investment tax. These include charitable trusts exempt from tax under Code Section 501 and charitable remainder trusts (CRTs) exempt from tax under Code Section 664. Grantor trusts, and simple trusts that distribute all income (or a complex trust that distributes all income) will not face the tax. But that is of little solace as the grantor or other beneficiaries may face the Medicare tax on investment income.

Planning Considerations for Medicare Tax on Investment Income

Planning will be more complex. Consider some of the following possibilities:

  • You can reduce net investment income by properly allocable deductions. Existing rules that determine how you allocate deductions to municipal bonds and other tax exempt income could be used, or other regulatory guidance might be provided.
  • Your advisers may have to allocate their bills by category to help.
  • Investment income derived as part of a trade or business is not subject to the new Medicare tax on investment income. Does that mean that if you retain liquid assets and the income they generate inside your business that the tax will be avoided? Likely not unless the business can justify a business purpose for this. Although there are no rules or guidance yet, creating minutes documenting the business purpose of retaining investment assets in the business might be one of the steps to take to support this type of action. However, one downside for this type of planning will be exposing liquid assets to business creditors and claimants.
  • This extension of the Medicare tax won't apply to distributions from retirement plan assets. IRC Sec. 1411(c)(5). Roth IRAs are perhaps even a better result that initially thought. Earnings on non-IRA investments could be subject to this higher tax, but if used to pay tax on a Roth conversion the earnings will all be inside the tax deferred Roth thereafter.
  • If you earn a salary from an active business the Medicare tax will apply without limit. If you receive a dividend from a passive business the Medicare tax (once the threshold is passed) will apply without limit. But what if you shift income from salary or profits distributions to dividends from an active business. Will those payments escape the increased Medicare tax on all fronts?
  • Passive real estate, as defined under the existing passive loss rules of Code Section 469 could be adversely impacted. Great timing, just as commercial real estate is facing some of the most daunting economic challenges in recent memory. There might be some incentive for real estate owners to re-evaluate their status under the passive loss rules.
  • Hug your insurance agent. Yes, the cash build up inside an insurance policy will remain protected. Coupled with the expectation of most tax advisers that income tax rates on the wealthy will continue to rise and the estate tax will return, permanent life insurance inside an irrevocable life insurance trust is looking quite handsome. However, it does appear that life insurance surrenders and sales will be taxed, along with the realization (i.e. cash out) of the inside build-up of the cash value policy in excess of the policy-holder's basis. Rev. Rul. 2009-13.
  • How will passive versus active distinctions for businesses be determined and what impact will this have on the structure of business and investments? The definitions under the passive loss rules of Code Section 469 will apply. IRC Sec. 1411(c)(2)(A). Cool. That leaves us all with complete uncertainty as to how these rules will apply to trusts. There are two authorities on the issue, and well, they reached polar opposite answers. In Mattie K. Carter Trust v. US the trust managed various assets, including the Carter Ranch which involved cattle, oil and gas. The trustee hired a ranch manager and other employees to carry out most ranching duties. The Service argued that only the trustee's efforts should be considered in determining if the trust met the test of materially participating in the ranch. The trustee's position was that the trust's material participation in the ranching activity should be evaluated with consideration to the efforts of not only its fiduciaries, but also its employees and agents. The U.S. District Court for the Northern District of Texas determined that the law did not mandate that only the trustee's activities could be considered. In the aggregate, the efforts of the trustee, ranch manager and others, showed regular, continuous and substantial involvement so that the trust was deemed to materially participate and could deduct the losses. 256 F. Supp. 2d 536 (Tex. 2003). In a recent ruling, dated August 17, 2007, the Service addressed a trust's effort to characterize losses as not being passive (and hence currently deductible). The Service maintained that the trustee's activities alone should be considered in determining if the trust materially participated in the activity. According to the Service, it is the material participation of the trustee alone that is the litmus test. The Service expressly addressed the Carter court opinion above and stated that it disagreed. TAM 200733023.
  • How will investment location decisions be made? Will it become more advantageous for high income taxpayers to retain income assets inside the tax protective envelope of qualified plans? Will the calculus of investing in tax exempt versus taxable bonds change? Income from tax-exempt municipal bonds will not be subject to the Medicare tax. For wealthy taxpayers with variable year to year income the determination may not be easy or consistent from year to year.
  • Using charitable remainder trusts (CRTs) and non-grantor charitable lead trusts (CLTs) will shift investment income to the trust formed and avoid the new Medicare investment income tax.
  • When planning to harvest gains and losses on security positions this new tax might enter into the analysis. Shifting deductions to the extent feasible to control investment income from year to year, using installment sales and tax deferred Code Section 1031 exchanges might keep you below the threshold.

The 3.8% tax is in addition to the increased Medicare rate of .9% on earnings discussed above so the surcharge for higher earning taxpayers begins to near 5%. This increased marginal rate will have an impact on net of tax calculations for budgets, investments, etc.

The unfortunate bottom line with this type of micro tax change is that while it will be costly, the cost in terms of professional fees and effort of planning around it may be greater than the benefit to many taxpayers.

Medical Expense Deductions Restricted

Raising revenue by taxing those struggling with substantial medical expenses is an immoral and outrageous act, but that is part of what Congress has done! Review the statistics on personal bankruptcy and you'll find that a large portion of personal bankruptcies are not due to folks buying a new Hummer who should be in a used Chevy, but rather good people struggling with costly medical bills. But the folks in Washington have decided to ignore all this.

Under current law, you can only deduct, as an itemized deduction, medical expenses to the extent that they exceed 7.5% of your adjusted gross income (AGI). This restriction is in addition to the others that limit the tax benefits of itemized deductions. That never made much sense. But, why stop when the rules are senseless and unfair. Make 'em worse. So starting with 2013 you'll only be able to deduct medical expenses as an itemized deduction if they exceed 10% of your AGI. IRC Sec. 213. As an attempt to show some compassion, Congress provided that for folks 65+ the 7.5% rule will remain in place until the end of 2016. Why does age alone correlate with a better medical expenses break? What of the millions suffering at young ages with substantial medical costs?

For some the new change won't mean much as the 10% threshold that applies for alternative minimum tax (AMT) purposes under current law. IRC Sec. 56(b)(1)(B).

Marriage Penalty

The new tax regime might encourage some fence-sitting high income couples to avoid marriage if their combined earnings will trigger the additional tax costs and further reduce medical deductions.

Estimated Income Tax Payments

Taxpayer employees will be responsible for the additional Medicare tax on wages. IRC Sec. 3102(f)(2). Employers will not be able to determine for many employees if the extra tax is due because it is the combined income of the married couple, not only the income of the employee involved, that determines if the additional tax applies.

Many of the proposed changes might make it more difficult for taxpayers to monitor the minimum that is required to be paid in order to avoid penalties for underpayment of estimated income taxes by paying in 100% of prior year's tax liability or 90% of the current year's tax liability. IRC Sec. 6654(m). For many taxpayers, it will be difficult to ascertain their marginal tax rate, availability of medical deductions, etc. until calculations are made following the end of each tax year. This will be especially problematic for business owners whose income depends on business developments rather than a fixed salary. Bottom line, many taxpayers who had made calculations for estimated tax purposes will just default to the 100% (or 110% at higher levels of adjusted gross income) of prior year safe harbor.

Economic Substance Doctrine Toughened


The tax law has long included economic substance concepts for transactions to be respected. For a transaction to be respected under current law it should generally have economic substance apart from the hoped for tax benefits and a business purpose. New Section 7701(o), enacted by Section 1409 of the new act codifies as statutory law the economic substance doctrine that heretofore had relied on inconsistent case law for its application.

History of the Economic Substance and Related Doctrines

The Committee Reports stated that the: "...courts have developed several doctrines that can be applied to deny the tax benefits of a tax-motivated transaction, notwithstanding that the transaction may satisfy the literal requirements of a specific tax provision. These common-law doctrines are not entirely distinguishable, and their application to a given set of facts is often blurred by the courts, the IRS, and litigants." Technical explanation of the revenue provision's of the "Reconciliation Act of 2010," as amended, in combination with the "Patient Protection and Affordable Care Act" [JCX-18-10 3/21/2010], prepared by the staff of the Joint Committee on Taxation, March 21, 2010, 111th Congress, hereafter "Committee Reports", ¶ E.

The economic substance doctrine under case law was applied to deny tax benefits arising from transactions that did not result in a meaningful change to the taxpayer's economic position other than a purported reduction in Federal income tax. See, e.g., ACM Partnership v. Commissioner, 157 F.3d 231 (3d Cir. 1998), aff'g 73 T.C.M. (CCH) 2189 (1997), cert. denied 526 U.S. 1017 (1999); Klamath Strategic Investment Fund, LLC v. United States, 472 F. Supp. 2d 885 (E.D. Texas 2007), aff'd 568 F.3d 537 (5th Cir. 2009); Coltec Industries, Inc. v. United States, 454 F.3d 1340 (Fed. Cir. 2006), vacating and remanding 62 Fed. Cl. 716 (2004) (slip opinion at 123-124, 128); cert. denied, 127 S. Ct. 1261 (Mem.) (2007). Closely related doctrines also applied by the courts (sometimes interchangeable with the economic substance doctrine) include the "sham transaction doctrine" and the "business purpose doctrine." See, e.g., Knetsch v. United States, 364 U.S. 361 (1960) (denying interest deductions on a "sham transaction" that lacked "commercial economic substance").

A common law doctrine that often is considered together with the economic substance doctrine is the business purpose doctrine. The business purpose doctrine involves an inquiry into the subjective motives of the taxpayer - that is, whether the taxpayer intended the transaction to serve some useful non-tax purpose. In making this determination, some courts have bifurcated a transaction in which activities with non-tax objectives have been combined with unrelated activities having only tax-avoidance objectives, in order to disallow the tax benefits of the overall transaction. See, ACM Partnership v. Commissioner, 157 F.3d at 256 n.48.

The new law endeavors to clarify these "blurs" and toughen the rules considerably. IRC Sec. 7701(o).

New Code Section 7701(oError! Bookmark not defined.)

If the economic substance doctrine is relevant to a transaction, the transaction will only pass the economic substance test if only both of the following requirements are met:

1. The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and

2. The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. IRC Sec. 7701(o)(1)(A) and (B).

The Committee Report commented: "Key to [the determination of whether a transaction has economic substance] is that the transaction must be rationally related to a useful nontax purpose that is plausible in light of the taxpayer's conduct and useful in light of the taxpayer's economic situation and intentions. Both the utility of the stated purpose and the rationality of the means chosen to effectuate it must be evaluated in accordance with commercial practices in the relevant industry. A rational relationship between purpose and means ordinarily will not be found unless there was a reasonable expectation that the nontax benefits would be at least commensurate with the transaction costs."

Now the fun begins. How do you determine if a transaction might have a substantial purpose apart from the tax effects? Well here's the definition of the new law: The potential for profit of a transaction shall be taken into account in determining whether the requirements above are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. IRC Sec. 7701(o)(2)(A). Notice that completely absent from this test are some of the most important non-tax motivators for folks to engage in what is loosely and broadly referred to as "estate planning." These major motivators include control over assets, asset protection from lawsuits of the parent/benefactor and heirs/donees, divorce protection, and so on. OK, how is the profit potential weighed? Must the bus

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