2013 Year-End Tax Planning, including Income, Estate and Gift Tax Issues

1. 2013 Year-End Tax Planning, including Income, Estate and Gift Tax Issues Thomas B. Anthony, CPA - Anthony & Dodge, P.C. George Cushing, Esq. - McLane, Graf, Raulerson & Middleton, P.A.

2. Agenda Introduction – George Cushing Income Tax Planning – Tom Anthony Estate and Gift Tax Planning – George Cushing Top Tax Considerations for Individuals and Businesses – Tom Anthony Questions 2

3. Introduction Taxes Lifetime Gift and Estate Tax Exemption • 2013 Exemption increased to $5,250,000 – now “permanent” • Adjusted for inflation annually (2014 exemption will be $5,340,000) • Low gift/estate/GST tax rate: 40% • Federal Estate/Gift Tax Exemption Portability – now “permanent” 3

4. Introduction 2013 Tax Rates will increase for some taxpayers • 15% capital gains tax rate and 15% tax rate on qualified dividends increases to 20% if taxpayer’s AGI exceeds $400,000 ($450,000 if married) • Highest marginal rate increased to 39.6% • New health care tax on Net Investment Income 3.8% - applied to interest, dividends and capital gains, as well as income from passive activities, if taxpayer’s AGI exceeds $200,000 ($250,000 if married). Economy • Still recovering, but “fragile”. • Low interest rates continue. • Good opportunity for making investments? 4

5. Introduction Low Interest Rates • Interest rates somewhat higher, but still historically low • 7520 rate – • November 2013 – 2.0% (compare December 2012 – 1.2%) • AFRs: Short Term – 0.27% per annum Mid Term – 1.73% per annum Long Term – 3.37% per annum • Debt is still cheap. Consider: • Accelerating large purchases • Using leverage to develop/enhance cash reserves 5

6. Introduction Uncertainty about 2014 and beyond: • Republicans still have control of House of Representatives • Democrats still have slender majority in Senate • Highly polarized political environment continues • Difficult to foresee any lessening of political acrimony • 2014 Congressional elections may be crucial 6

7. Individual Tax Planning American Taxpayer Relief Act of 2012 A. Individual changes 1. Individual income tax rates reductionsThe 10-, 15-, 25-, 28-, 33-, and 35-percent regular income tax brackets were made permanent for taxable incomes below the threshold amount. For taxable income above the threshold amount, the 39.6-percent rate, which applied prior to the 2001 law, applies. The threshold amounts are: (1) $450,000 in the case of a joint return or surviving spouse; (2) $425,000 in the case of a head of household; (3) $400,000 in the case of an unmarried person who is not a surviving spouse or head of household; and (4) $225,000 in the case of a married individual filing a separate return. For estates and trusts, the 39.6-percent rate applies to all taxable income in the highest rate bracket (there is no 35-percent bracket).

8. Individual Tax Planning • Overall limitation on itemized deductions and the phase out of personal exemptions The total amount of otherwise allowable itemized deductions (other than medical expenses; investment interest; and casualty, theft, or wagering losses) will be limited for upper-income taxpayers (this is called the “Pease” limitation). Under the Act, the “Pease” thresholds amounts are modified. The AGI thresholds for taxable years beginning in 2013 are: (1) $250,000 for single individuals; (2) $300,000 for married couples filing joint returns and surviving spouses; (3) $275,000 for heads of households; and (4) $150,000 for a married individual filing a separate return. These are higher than the amounts would have been by merely adjusting levels from 2001 for inflation. These amounts are indexed for inflation for taxable years beginning after 2013.

9. Individual Tax Planning 3. Capital gains and dividends Under the Act, the tax rates in effect before 2013 for adjusted net capital gain and qualified dividend income are made permanent, except that the 15-percent rate applies only to adjusted net capital gain and qualified dividend income which otherwise would be taxed at a rate below 39.6 percent under the regular tax. A 20-percent rate applies to amounts which would otherwise be taxed at a 39.6-percent rate. These rates apply for purposes of both the regular tax and the alternative minimum tax.

10. Individual Tax Planning 4. Permanent change in individual AMT The basic AMT exemption amounts for taxable years beginning in 2012 were increased retroactively to: (1) $78,750 in the case of married individuals filing a joint return and surviving spouses; (2) $50,600 in the case of other unmarried individuals; and (3) $39,375 in the case of married individuals filing separate returns. For taxable years beginning after 2012, the Act permanently indexes the following dollar amounts for inflation: i. The dollar amounts dividing the 26- and 28- percent rates (now $179,500/$89,750 MFS). ii. The dollar amounts of the basic AMT exemption (now $80,800/$51,900/$40,400/$23,100, respectively).

11. Individual Tax Planning • Marriage penalty Marriage penalty relief The Act permanently increases the basic standard deduction for a married couple filing a joint return to twice the basic standard deduction for an unmarried individual filing a single return. It also permanently increases the size of the 15-percent regular income tax rate bracket for a married couple filing a joint return to twice the 15-percent regular income tax rate bracket for an unmarried individual filing a single return.

12. Individual Tax Planning Marriage penalty is back SingleMarried Medicare Contributor Tax Threshold $200,000 $250,000 Tax Bracket 28% $ 87,500 $146,400 33% 183,250 223,050 35% 393,350 398,350 39% 400,000 450,000 Capital Gains to 20% $400,000 $450,000 Pease Threshold (Itemized ded. phase out) $250,000 $300,000

13. Individual Tax Planning 6. Amounts in applicable retirement plans may be transferred to designated Roth accounts without distribution The provision expands the amounts eligible for in-plan Roth direct rollover to include amounts that are not distributable under the plan. Under the provision, a §401(k) plan (including a thrift savings plan, or “TSP”), a §403(b) plan, or a governmental §457(b) plan that includes a qualified Roth contribution program is permitted to allow individuals to elect an in-plan transfer of any amount not otherwise distributable under the plan from an account that is not a designated Roth account under the plan to a designated Roth account maintained under the plan for the benefit of the individual.(Employer Plan must allow for the conversion)

14. Individual Tax Planning 7. Tax-free distributions from individual retirement plans for charitable purposes • Until December 31, 2013, taxpayers who have attained age 70 ½ may cause funds held in an IRA to be distributed directly to public charitable organizations (note that the payment may not be designated for a Donor Advised Fund) • The consequences of such payment are as follows: i. the distribution to charity will be treated as nontaxable to the account owner and will not be treated as part of AGI nor will it affect the account owner’s itemized deductions or alternative minimum tax calculation;

15. Individual Tax Planning Tax-free distributions from individual retirement plans for charitable purposes (continued) ii. the charity will not be subject to income tax on the distribution; iii. the account owner will be able to treat the distribution to charity as satisfying the account owner’s RMD for the IRA for 2013, if the account owner has not already received the RMD this year; iv. the account owner will not be entitled to any income tax deduction for the payment to charity

16. Tax Provisions Expiring in 2013 The Joint Committee of Taxation has listed the provisions expiring by the end of 2013. See “Tax Provision Expiring” handout.

17. Windsor v. United States A. Background The Supreme Court has held that Section 3 of the Defense of Marriage Act (DOMA) -- which provided a federal definition of marriage that limited its scope for purposes of federal law to a legal union between a man and a woman, and of a spouse as only a person of the opposite sex who is a husband or wife -- as unconstitutional. It did not address Section 2 of DOMA, which provides that a state is not required to give effect to any public act, record, or judicial proceeding of another state respecting a relationship between members of the same sex that is treated as a marriage under the laws of another state. It appears that for the time being, states that do not permit same-sex marriages are not required to permit them or recognize them. Note: The word marriage is critical. The Supreme Court’s ruling only applied to such relationships and not either to domestic partnerships or civil unions (also excluded by Service guidance)

18. Windsor v. United States • What the decision did With the overturn of Section 3, many same-sex couples -- specifically, those legally married (the “state of celebration”) who are domiciliaries of a state that recognizes same sex marriages (the “state of domicile”) -- will have access to the rights and duties imposed and conferred on married couples and spouses under federal law. C. Which laws are implicated 1. Social Security 2. Qualified plan spousal benefits and qualified domesticrelations orders 3. Availability of spousal rollover IRAs 4. Exclusion of health insurance premium attributable to spouse 5. COBRA rights 6. Income tax provisionsSee “Windsor v. United States” handout.

19. Individual Tax Planning MedicareContribution Tax • Imposed on individuals, estates, and trusts • Tax is equal to 3.8% of the lesser of • Net investment income (including passive activities) or • The excess of MAGI over the threshold amount • Gross income does not included excluded items suchas tax exempt bonds or excluded gain on main home sale

20. Individual Tax Planning MedicareContribution Tax (cont.) • Threshold amounts • MFJ - $250,000 • MFS - $125,000 • HOH/S - $200,000 • (Not indexed for inflation) • In addition, 0.9% HI tax on employee wages in excess of stated threshold amounts • Employer required to withhold • Spouse’s wages disregarded

21. Individual Tax Planning Medicare Contribution Tax (cont.) • Note: • Investment income = all passive income from dividends, interest, annuities, royalties, and rents, net gain from property disposition • Taxpayers with both high wages and high investment income may be hit with both taxes

22. Individual Tax Planning Roth conversions • No income limit for Roth IRA conversions • Full or partial conversions • Re-characterization • Avoid possible hikes in future tax rates • Change mind before return is filed 22

23. Business Tax Planning Tips Acquire business assets in 2013 • Immediate write-off of up to $500,000 (subject to income limit) plus 50% bonus depreciation • 15-year Depreciation for Qualified Leasehold Improvement Property, Qualified Restaurant Property and Qualified Retail Property Buy a Vehicle • 2013 max deduction is $11,160 • 2013 SUV over 6,000 lbs. max deduction is $25,000 plus 50% bonus on remainder and 20% remaining cost recovered through normal depreciation

24. Estate and Gift Tax Planning “Permanent” Federal Transfer Tax Rates • In 2013 and hereafter, the estate and gift tax rate is 40% on transfers in excess of the exemption amount. • The GST tax rate remains equal to the maximum federal estate tax rate is therefore 40%. • Massachusetts estate tax exemption remains at $1,000,000 with a top rate of 16%; there is no gift tax in Massachusetts. 24

25. Estate and Gift Tax Planning Why Act Now 1. Although federal gift/estate tax exemptions are now “permanent” these exemptions are subject to change, depending on which party controls the congress and/or the White House. 2. The values of clients assets, particularly real estate, may still be depressed due to recent economic downturn and may offer good potential for appreciation when economic recovery has been achieved. 3. Massachusetts clients should, where feasible, use gifts to reduce their gross estate during their lifetime because the Massachusetts estate tax exemption amount remains at $1,000,000. Massachusetts does not impose a gift tax, so lifetime transfers are especially attractive to a Massachusetts resident. Even a gift shortly before death can save Massachusetts estate taxes at as high as 16% (on estates of more than $10,100,000) 25

26. Estate and Gift Tax Planning Taxable Gifts 1. The most direct way for a client to take advantage of the increased gift and GST tax exemption amount is to make a taxable gift to his/her beneficiaries, either outright or (preferably), in trust (in order to take advantage not only of the 2013 gift tax exemption but also the 2013 GST exemption). 2. The client will need to consider carefully how much she is willing to part with and how much she will need to retain in order to sustain her accustomed lifestyle, as well as potential future needs for care in illness or old age. 26

27. Estate and Gift Tax Planning Taxable Gifts (continued) 3. If a client is concerned about loss of income/access to transferred funds and is married, the client should consider creating a lifetime irrevocable trust for benefit of his spouse and children - a spousal Lifetime Access Trust or “SLAT”. The spouse can also create similar trust for the client so long as the “reciprocal trust” rules are avoided. Both trusts can be structured as “grantor-type” trusts as to each grantor and both trusts can be structured to avoid inclusion in grantor’s estate at death of each grantor. 27

28. Estate and Gift Tax Planning Taxable Gifts (continued) 4. Clients with illiquid assets, such as residential real estate, can still take advantage of the current exemption: • Give residence/vacation property to an irrevocable trust for the benefit of appropriate family members (possibly including donor’s spouse). • Donor can rent back the residence upon payment of market rate rent. This rent can be set at the high end of the range, if desirable. • All future appreciation in value of residence will belong to the donee(s). • Trust should be structured as grantor-type trust. 28

29. Estate and Gift Tax Planning Taxable Gifts (continued) e) Expected Tax Results of grantor trust status: i) Amounts paid to trust as “rent” will not be taxable income to trust or its beneficiaries ii) Rent payments should not be treated as taxable gifts to the trust; iii) Items of expense which would be deductible by owner (i.e. real estate taxes) remain deductible by owner; iv) No reduction in basis of real property due to depreciation. 29

30. Estate and Gift Tax Planning Technical Points 1. Use of reciprocal trusts. Classically, the “reciprocal trust” doctrine allowed the IRS to reverse the anticipated estate/gift tax benefits normally derived from making an irrevocable gift to a trust for the benefit of others i) If grantors - usually husband and wife – create trusts for the benefit of each other at the same time and with parallel terms, IRS view is that each is treated thereafter as the creator of the trust of which he or she is also a beneficiary with the result that the assets of such trust are included in the gross estate of the beneficiary spouse ii) Typical differences relate to the grant of a power of appointment in one trust (but not in the other) or making the terms for discretionary distribution different 30

31. Estate and Gift Tax Planning Technical Points (continued) • Safer course is not to use such trust; even if court concludes that trusts are not reciprocal, cost of defending the estate tax audit and, possibly, the court proceedings that follow may be substantial 2. Trust for spouse only. The planning preference is to create an irrevocable trust for the primary benefit of the less wealthy spouse; if the grantor is concerned about the potential loss of access to the transferred funds in the event that the beneficiary spouse should predecease the grantor, the beneficiary spouse may be granted a power of appointment which could theoretically be exercised in favor of a continuing trust for the grantor’s benefit, if the grantor is then living. 31

32. Estate and Gift Tax Planning Technical Points (continued) Legal concerns include: a) the possible inclusion of the appointed assets in the grantor’s estate due to “pre-arrangement” such that the spouse may be considered to have been acting as the grantor’s agent, resulting in the application of the retained interest rule of Code §2036(a) b) even if there is no pre-arrangement, in Massachusetts there may be a claim that, because the grantor’s creditors can reach assets placed into a self-settled trust and because the exercise of a power of appointment is treated as if the original grantor had designated the ultimate beneficiaries of the appointed property, the assets in the appointment trust may be subject to the claims of the grantor’s creditors. 32

33. Estate and Gift Tax Planning Technical Points (continued) Legal concerns include: c) that being the case, the IRS might argue that the appointment back for the benefit of the grantor will result in estate tax inclusion under Code §2033 • this outcome can be avoided by establishing the irrevocable trust in a jurisdiction that authorizes the creation of a domestic asset Protection Trust (“DAPT”) such as NH. If that is done, the grantor’s creditors cannot reach the property transferred into the trust, even if the power of appointment is exercised in further trust for the benefit of the grantor. And absent pre-arrangement, that should cause the trust property to be excluded from the grantor’s gross estate. e) Utilizing the 2013 exemption of both spouses: 33

34. Estate and Gift Tax Planning Technical Points (continued) Legal concerns include: • Utilizing the 2013 exemption of both spouses: • Gift - splitting enables one spouse to use the federal estate tax exemption of both spouses even though the entire gift is made by only one spouse • Gift - splitting also applies for GST tax exemption allocation purposes • Gift - splitting permits a wealthy donor to give away $10,240,000 in 2012, assuming that if the donor’s spouse consents to gift - splitting on the gift tax return for the year in which the gift is made. The donor could also make the gift fully GST tax exempt using gift - splitting • This raises no issues if the gift is made to a trust for the benefit of persons other than a spouse 34

35. Estate and Gift Tax Planning Technical Points (continued) Legal concerns include: • If the spouse is a beneficiary, gift splitting is permitted but only with respect to the interests of the beneficiaries other than the spouse and then only if the interest of those other beneficiaries is both “ascertainable” and “severable” from the interests of the spouse Solutions: • Limit spouse’s interest in the trust by an ascertainable standard • Have each spouse create a non-reciprocal trust using his/her own exemption (i.e. dispense with gift - splitting) • Have each spouse create a DAPT in an “Asset Protection” jurisdiction grant a named non-adverse party • To add beneficiaries from a class which includes the spouse (NOTE: spouse should not be added as a beneficiary for a substantial period of time) 35

36. Estate and Gift Tax Planning Other Planning Techniques and Considerations 1. Short-Term GRAT still available: • A client with an asset with significant appreciation potential transfers that asset to a GRAT with a 2-year term. • The GRAT pays to the client an annuity during each year of the GRAT’s term which is designed to be actuarially close in value to the initial market value of the GRAT assets. • Assuming the client survives the GRAT term, any assets remaining in the GRAT at the end of the term are distributed to the remainder beneficiaries, either outright or in trust as specified in the GRAT. • Annuity payments can be “back loaded” (i.e. designed to increase) by up to 20% each year. 36

37. Estate and Gift Tax Planning GRAT (continued) • Example: In December 2013, when the § 7520 rate was 1.2%, Connie transferred $1,000,000 in marketable securities to a GRAT with a 2-year term. The GRAT paid Connie an annuity of $509,009.47 in December, 2013 and will pay her $509,009.47 in December of 2014. Connie’s 2012 taxable gift with respect to her original transfer to the GRAT was $0. • Connie will receive total payments of $1,018,018.94. 37

38. Estate and Gift Tax Planning GRAT (continued) • The amount passing to the GRAT’s remainder beneficiaries will depend on the rate of return achieved by the assets in the GRAT during the two-year term: Annual Investment Share of Remainder Return Benefiaricies 10% $141,080.00 20% $320,179.00 30% $519,278.22 40% $738,377.27 50% $977,473.33 • GRAT assets had appreciated by more than 20% by October 31, 2013 38

39. Estate and Gift Tax Planning GRAT (continued) • Why the current environment is favorable to GRATs: • Because the § 7520 rate is still relatively low, it is easier for the return on the GRAT assets to “beat” the § 7520 rate, thereby transferring assets to the remainder beneficiaries free of transfer tax. As demonstrated by the foregoing table, as the amount by which the average investment return exceeds the § 7520 rate increases, so does the amount passing to the GRAT’s remainder beneficiaries. • The November, 2013 § 7520 rate is only 2.0%; the lowest rate was 1.0% (in November, 2012). The stock market returns in 2013 have been in the range of 20-25% YTD. 39

40. Estate and Gift Tax Planning GRAT (continued) • Note what the “Sensible Estate Tax Act of 2011” would do to GRATs: • Minimum term of 10 years • A “zeroed-out” GRAT would not qualifying as a GRAT • GRAT annuity amounts could not decline 40

41. Estate and Gift Tax Planning • Sale to Intentionally Defective Grantor Trust (IDGT) • Example of how the strategy works: • The taxpayer creates an IDGT and makes a gift of “seed money” to the IDGT (traditionally at least 10% of the value of the assets which will be sold to the IDGT). • The taxpayer then enters into an installment sale agreement with the IDGT for the sale of an income-producing asset to the IDGT. The value of the asset is determined by an independent appraiser, perhaps taking into account a valuation discount. • The IDGT uses the seed money to make a down payment on the purchase of the asset and issues a promissory note for the balance of the asset’s value. The note provides for annual payments of interest with a balloon payment at the end of the term. The interest is equal to the appropriate applicable federal rate (AFR), which depends on the note’s term. 41

42. Estate and Gift Tax Planning IDGT (continued) • Ideally, the asset sold to the IDGT appreciates and continues to produce income after the sale, free of gift and GST tax. If the asset grows faster than the AFR, then the additional growth is not subject to transfer tax. • The grantor pays the income tax on the IDGT’s income, which is effectively an additional “tax-free” gift to the IDGT. 42

43. Estate and Gift Tax Planning IDGT (continued) • Why the current environment is favorable to an IDGT sale • Interest rates remain low, making it easier for the asset’s appreciation to “beat” the AFR. The annual mid-term rate (used for a note with a term between 3 and 9 years) in November, 2013 is 1.73% (interest payable annually). • Furthermore, the increased exemption amount makes it easier for a taxpayer to make the gift of essential “seed money” to the IDGT. For example, a married couple can now make a total “seed money” gift of up to $10,500,000, presumably enabling a future sale of assets to the IDGT with a value in excess to $100M. 3. If consequences of Grantor Trust status are changed (as is currently proposed by Obama Administration), grantor trusts already in existence and funded to the extent of the “seed money’ gift are likely to be grandfathered from application of new rules. 43

44. Estate and Gift Tax Planning • Qualified Personal Residence Trust (QPRT) • A gift to a QPRT always results in a taxable gift, which is equal the heirs’ right to receive the residence at the end of the term of retained use by the client. • If a couple wishes to transfer their home to a QPRT, they may each transfer a 50% interest and perhaps take advantage of a valuation discount on each of their interests in the property. • A client who could not previously establish a QPRT because he had used up his lifetime exemption amount may now reconsider this estate planning strategy. • QPRTs work better in a high-interest environment than a low-interest environment, so this is a strategy to keep in mind as interest rates rise. • Even in a low interest rate environment, however, an older client achieves a significant valuation discount because of the value attributed to the reversionary interest normally retained in addition to the term of retained use. 44

45. Estate and Gift Tax Planning QPRT (continued) • Example: Connie, who is 60 years old, transferred her house, valued at $1,000,000, to a 15-year QPRT in December 2012, when the § 7520 rate was 1.2%. Connie has made a taxable gift of $590,920. If the applicable § 7520 rate were instead 5.0%, Connie’s taxable gift would be only $339,940. • Connie’s actuarial interest in this example is valued at $409,080 (40.08%). If Connie were 75 years old, her actuarial interest would increase to $764,210 (76.421%). • The value of the gift will be enhanced if the underlying value of the residence increases during the term. 45

46. Estate and Gift Tax Planning • Low-Interest Loans • Example of how the strategy can work: • An older-generation transferor loans funds to a younger-generation transferee, documented by a promissory note bearing interest at the AFR. For example, an 8-year note signed in November, 2013 will bear annual interest at a rate of 1.73% (the mid-term rate for December 2012). • Remember, the applicable AFR depends on the term of the note: • The short-term AFR applies to a note with a term of 3 years or less. • The mid-term AFR to a note with a term more than 3 years and 9 years or less. • The long-term AFR to a note with a term of more than 9 years. 46

47. Estate and Gift Tax Planning Low-Interest Loans (continued) • Why the current environment is favorable to intra-family loans: • The younger-generation borrower can use the low interest loan to pay down higher-rate debt or invest in fixed income assets (or in investments with appreciation potential) that yield a return higher than the AFR. • Any returns in excess of the AFR will be retained by the younger-generation borrower free of gift or estate tax. 47

48. Top Tax Considerations for Individuals and Businesses • End of Year Gifting Opportunities • Business Tax Planning • Business Opportunities • Plan for Medicare/HI tax 48

49. 1. End of Year Gifting Opportunities • Use your Annual Exclusion - $14,000/person per year for 2013 and 2014 • Establish 529 Plans • Consider larger gifting opportunities to take advantage of increased lifetime exemption amount of $5.25 million in 2013 and $5.34 million in 2014 • Pay medical bills and tuition payments directly to providers • Year end charitable giving 49

50. 2. Business Tax Planning Issues • Review executive compensation plans to ensure retention of key employees • Document bonus payments • Adopt 409A deferred compensation plan • Make deferral election for 2013 • Establish and fund a pension plan • Accelerate equipment purchases to maximize depreciation/expense deduction 50