Tag Archives: IRS

Rising Gas Prices Lead to Larger Deductions

Who says rising gas prices hurt everyone?  Office runner and couriers will cheer the increase to their reimbursements for business trips. The IRS has announced that the mileage allowance for vehicles will increase 4.5¢ from 51¢ to 55.5¢ per mile for business travel from July 1, 2011 to December 31, 2011.  The mileage rate varies based on the annual study of the fixed and variable costs of operating an automobile.

Employees who drive their own vehicles for business purposes may receive reimbursement for business mileage whether the autos are owned or leased.  The rate of reimbursement must not exceed the business mileage allowance.  The employee receives the funds as a tax-free reimbursement if they substantiate the time, place, business purpose and mileage of each trip.

Also, the rate for using a car to receive medical care or in connection with a move that qualified for the moving expense deduction increases to 23.5¢ per mile.

Sloppy Gifting of Real Estate Leads to IRS Mess

The idiom “pigs get fat, hogs get slaughtered,” is directly relevant to the current, generous gift tax exemption.  During 2011 and 2012, donors may gift up to $5 million in assets without paying any federal gift tax.  The limited window of opportunity, depressed real estate prices, and liberal exemption amount are enticing factors for donors to transfer highly appreciated and/or highly valuable real estate.   Typically, the giver transfers the real estate to one or more family members.

Despite the fact that gift tax is not owed on many of these real estate transfers, the giver must report any gift in excess of $13,000 to the Internal Revenue Service (“IRS”).  The donor must file Form 709 to report U.S. gift taxes to the IRS.  Irrespective of whether tax is due and payable or the transfer is made to a family member, Form 709 must be filed for gifts in excess of the annual exclusion amount.

A recent Wall Street Journal article noted that the IRS is scrutinizing gifts of real estate to family members.  The IRS has obtained real property transfer information from 16 states.  The small sample size revealed noncompliance rates  in excess of 50% which will likely spur on additional IRS examinations of real property.   While this is a favorable time to make gifts of real estate, seek assistance from trusted counsel to properly transfer real estate.

by: Jason C. Morris, Esq.

Deductibility of Legal Fees for Estate Planning

**UPDATE: Tax Cuts and Jobs Act (TCJA) enacted on December 22, 2017, provided, “[n]otwithstanding subsection (a) [subjecting certain miscellaneous itemized deductions to the 2 percent floor], no miscellaneous itemized deductions shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.”**

Section 212 of the Internal Revenue Code (the “Code”) provides that a deduction is available for all the ordinary and necessary expenses paid or incurred during the taxable year:

1. for the production or collection of income;

2. for the management, conservation, or maintenance of property held for the production of income; or

3. in connection with the determination, collection, or refund of any tax.

Section 212 is limited by the two percent (2%) floor under § 67 of the Code. Section 67 provides an individual’s “miscellaneous itemized deductions” may only be deducted to the extent that the aggregate of the deductions exceed two (2%) percent of adjusted gross income. IRC §67(a).  Because of the itemized deductions floor, most clients will not benefit from a deduction for legal expenses incurred in estate planning.

The Tax Court has considered numerous cases to determine whether legal fees incurred in estate planning are deductible.  One of the first cases to allow a deduction for estate planning fees, Bagley v. Commissioner, found that the law firm provided deductible legal services under §212(2).  The law firm consulted the clients with regard to tax-favorable investments, loans to the corporation owned by the client family, and the review and creation of estate plans for the family members.

In Merians v. Commissioner, the court allowed a §212(3) deduction for legal fees allocated to tax advice.  The court narrowly construed their decision to a deduction for only the portion of services which it considered tax advice.  The attorney did not maintain accurate time entry or billing records reflecting the amount of time spent on tax-related aspects of his representation.

The Tax Court has disallowed deductions for legal fees paid for estate planning and general business guidance when the taxpayer does not have any evidence of how the fees relate to the §212 categories.  The mere preparation of a will or testamentary trust will not be deductible.  However, an argument can be made that the creation of a revocable living trust is a tax-motivated transaction for the management and conservation of property.  Similarly, the taxpayer could argue the fees were incurred in connection with the determination (minimization) of the taxpayer’s future tax liability. Therefore, the fees should be deductible under §§212(2) and 212(3).


Grantor Retained Annuity Trust (GRAT) Strategy

The acronym “GRAT” stands for the term “grantor retained annuity trust.”  As the name indicates, a GRAT is a trust (an irrevocable trust) to which the grantor (i.e., the person who creates the trust) transfers property but retains the right to receive a fixed annuity from the trust assets for a certain number of years.  The fixed annuity amount is a percentage of the initial value of the assets transferred to the GRAT.  At the end of the term of the GRAT, the remaining property in the trust (net of the annuity payments) passes to the remainder beneficiaries (e.g., the grantor’s children); provided, however, that the trust property will revert to the grantor’s estate if the grantor dies during the term of the GRAT.

Pursuant to IRS regulations, the value of the “gift” of the remainder interest is determined when the GRAT is created.  As described above, the remainder interest is the assets remaining in the GRAT, net of the annuity, when the term of the GRAT expires.  The value of the remainder interest for federal gift tax purposes is equal to (a) the value of the initial principal contribution to the GRAT, PLUS (b) a fluctuating theoretical interest rate earned on the principal (called the “section 7520 rate” after the Internal Revenue Code section which establishes the rate), MINUS (c) the value of the annuity payments to be made during the term of the GRAT.

GRATs are especially beneficial when, as is the case currently, interest rates (and the corresponding section 7520 rate) are low because the annuity paid to the grantor is less than it would otherwise be if the section 7520 rate were higher.  The section 7520 rate is currently only 2.0%.  If the rate of return on the GRAT assets during the term of the GRAT exceeds the applicable section 7520 rate, the remaining trust property after payment of the annuity amounts will be distributed tax-free to the remainder beneficiaries.  Therefore, the strategy with a GRAT is to contribute property to the GRAT which will either appreciate or produce income at a rate substantially in excess of the section 7520 rate.

We often use a “zeroed-out GRAT” to reduce the value of the remainder interest for federal gift tax purposes to zero at the time the grantor funds the trust.  Of course, if we reduce the remainder interest to zero, we must structure the zeroed-out GRAT so that the grantor’s retained interest is approximately equal to the value of the property transferred to the trust.  This results in an annuity equal to the value of the property transferred to the GRAT plus the assumed section 7520 rate.  If the trust property appreciates faster than the section 7520 rate any excess appreciation passes to the remainder beneficiaries free of gift and estate tax as long as the grantor survives the term of the trust.  Under the IRS Regulations, the annuity amount does not have to be the same amount for each year.  But, variations in the annuity amount from year to year may not exceed 120 percent of the amount payable in the previous year.

The length of a GRAT’s term is an important planning consideration.  The shorter the trust term, the more likely it is that the grantor will survive it.  The longer the term, the greater chance that the grantor will not survive it and the property will be included in the grantor’s estate.  However, with a long-term GRAT it is possible to lock in a low section 7520 rate for an extended period.  Also, if a trust’s term is too short, the chance that the property will appreciate diminishes and so does the amount of property passing to the remainder beneficiaries.  One solution to balance some of these risks is for the grantor to create a series of short-term GRATs and reinvest the annuity payments in the successive trusts.  This “rolling GRAT” approach manages the probability of failure by increasing the odds that the donor will survive the trust term and heightens the chance that the property will appreciate over the collective terms of the GRATs.  Note, however, that the rolling GRAT strategy still exposes the grantor to the risk of section 7520 rate increases.

A grantor should fund a short-term GRAT with property that he or she expects to appreciate rapidly.  For example, if a grantor owns a closely-held business and anticipates an initial public offering (IPO) in the near future, the grantor could contribute the stock of the company to the GRAT.  The remainder beneficiaries would then benefit from the appreciation resulting from the IPO during the term of the trust.

The grantor may also want to fund the GRAT with assets that the grantor can discount for gift tax purposes.  Examples include fractional interests in real estate, unmarketable assets such as stock in a closely-held company, and family limited partnership interests.  If the grantor can reduce the value of the asset at the time of funding, the taxable gift will also be lower.  If the business or property is sold at full value or even at a premium during the trust term then there will be substantial assets remaining in the GRAT for the remainder beneficiaries at the end of the trust term.

The fair market value of any non-cash assets initially transferred to a GRAT must be determined.  For example, real estate and unmarketable securities (such as stock or other interests in closely-held companies) must be appraised.  If the value of the asset is to be discounted, a second valuation is generally required to determine the amount of the discount.  Likewise, the trustee must determine the fair market value of any non-cash assets distributed to the grantor as part of an annuity payment.  Just as some assets may be discounted when they are contributed to the GRAT, they will likewise be discounted when they come out of the GRAT as part of an annuity payment.  Distributing discounted assets to the grantor as part of an annuity payment can substantially reduce the potential benefit of the GRAT and is generally discouraged.

In March 2010, a bill passed in the House of Representatives that would radically change some of the aforementioned GRAT strategies.  The bill would, among other things, require GRATs to have a minimum term of ten years and would prohibit zeroed-out GRATs.  Although the bill failed this time around, there is a strong likelihood that it will surface again.  Therefore, the window for establishing short-term GRATs may be closing in a matter of months.  If you have any interest in establishing a short-term GRAT, please contact Woodburn and Wedge.

by Don L. Ross, Esq.