Tax and financial advice from the Silicon Valley expert.

Estate planning problems and opportunities

Urgent news if you have a retirement account with a Conduit Trust named beneficiary

Legislation called the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, enacted December 20, 2019, renders any estate plan involving a Conduit Trust beneficiary of a big retirement account (including 401(k) accounts and IRAs) obsolete.

A provision of the Act repeals “stretch” payments over the life expectancy of most successor beneficiaries for inherited retirement accounts of decedents who die after December 31, 2019.  The maximum time for distributions is 10 years after the death of the decedent/plan participant.

What is a Conduit Trust?  The purpose of a Conduit Trust was to control a retirement account, usually with a minor beneficiary, and still qualify for distribution of the account over the beneficiary’s life expectancy, called stretch distributions.  In order to qualify, the account had to be disregarded for income tax reporting with respect to the retirement account distributions.  The way this was accomplished was to require that any retirement account distributions received by the trust be immediately distributed to the beneficiary.

Since life expectancy distributions are usually very small, a huge distribution would be payable to the beneficiary 10 years after the death of the account owner, probably subject to very high federal income tax rates and possibly subject to mismanagement by the beneficiary.

There are some exceptions to the new rule, including (1) the surviving spouse of the employee/participant, (2) a child who is under age 21, (3) certain disabled persons, (4) certain chronically ill persons, and (4) an individual not previously described who is not more than 10 years younger than the employee/participant.

When a child of the decedent reaches age 21, the balance of the account must be distributed within 10 years.

If a beneficiary of a retirement account inherited from a person deceased before 2020 is deceased after 2019, the 10 year limit applies to that person’s successor beneficiaries.

Since the Conduit Trust no longer provides a tax benefit, employees/participants with retirement accounts should consult with their attorney and tax consultant about eliminating the Conduit Trust as a beneficiary and making alternative estate plans for their retirement accounts.

Major federal retirement changes enacted, Kiddie tax change repealed

As part of the domestic spending bill, H.R. 1865, Further Consolidated Appropriations Act, 2020, enacted on December 20, 2019, major federal retirement changes were enacted in Division O, the Setting Every Community Up for Retirement Enhancement Act of 2019, nicknamed the SECURE Act.  As part of the SECURE Act, Congress also repealed changes to the Kiddie tax enacted in the Tax Cuts and Jobs Act of 2017.  Taxpayers may elect to amend their 2017 and 2018 individual income tax returns to use this Kiddie tax change.

Here are highlights.  Please consult with your retirement plan consultant or tax consultant for more details.

  • Effective for plan years beginning after December 31, 2020, the rules for multiple employer plans have been relaxed so that if one employer violates the qualification rules, the entire plan won’t be disqualified.  (The “one bad apple rule.”)
  • Effective for plan years beginning after December 31, 2019, the maximum default contribution for a plan with automatic enrollment is increased from 10% to 15%.
  • Effective for taxable years beginning after December 31, 2019, the tax credit for retirement plan startup cost for small employers is increased from the lesser of (1) $500 or (2) 50% of qualified startup costs to the greater of (1) $500 or (2) the lesser of (a) $250 times the number of nonhighly compensated employees of the employer who are eligible to participate in the plan or (b) $5,000.  The credit applies for the first three years of the adoption of the plan.  It’s also available for employers that convert an existing plan to an automatic enrollment design.
  • Effective for taxable years beginning after December 31, 2019, amounts includable in an individual’s income paid to aid the individual in pursuing graduate or postdoctoral study, such as a fellowship, stipend, or similar amount, is treated as compensation for the limitation on IRA contributions.
  • Effective for taxable years beginning after December 31, 2019, the prohibition of contributions to an IRA by an individual who has reached age 70 ½ has been repealed.  The excludable amount for direct distributions to a charity after age 70 ½ is reduced by any contributions to an IRA after age 70 ½.
  • Effective for plan loans made after December 20, 2019, amounts loaned from a plan using a credit card or similar arrangement will be treated as deemed plan distributions and not as loans.
  • Effective for plan years beginning after December 31, 2019, when a plan will no longer accept a lifetime income option, such as an annuity, as a plan investment, employees will be able to make direct transfers of the lifetime income investment to an IRA or another retirement account within the 90-day period ending on the date when the lifetime income investment is no longer accepted by the plan.
  • Effective for plan years beginning after December 31, 2020, employers are required to permit employees to make elective deferrals if the employee has worked at least 500 hours per year with the employer for three consecutive years and has met the age requirement (age 21) by the end of the three-year period.  Each 12-month period for which the employee has at least 500 hours of service shall be treated as a year of service for vesting purposes.  This (500 hour) requirement will not apply for collectively-bargained plans.   Employers may elect to exclude these employees for the nondiscrimination and top-heavy requirements.  Employer contributions won’t be required for these individuals.
  • Effective for distributions made after December 31, 2019, distributions of up to $5,000 per birth or adoption can be made free of the 10% early distributions penalty during the one-year period beginning on the date on which a child of the individual is born or on which the legal adoption by the individual of an eligible adoptee is finalized.  (An eligible adoptee is any individual, other than a child of the taxpayer’s spouse, who has not reached age 18 or is physically or mentally incapable of self-support.)  Taxpayers must include the name, age, and taxpayer identification number of the child or adoptee on their tax return.  The distributions may be recontributed to an individuals eligible retirement plan, subject to certain requirements.
  • Effective for distributions after December 31, 2019, the age at which distributions are required to be made from an IRA or a qualified plan is increased from age 70 1/2 to age 72.  The age at which qualified charitable distributions of up to $100,000 per year from an IRA is unchanged at 70 1/2.
  • Retroactively effective for plan years beginning after December 31, 2017, the actuarial rules for defined benefit plans of privately-owned community newspapers are relaxed.  This is targeted relief benefiting this group.
  • Retroactively effective for defined contribution plan years beginning after December 31, 2015 and effective for IRA contributions after December 20, 2019 , difficulty of care payments that are excludable from gross income are treated as compensation for nondeductible IRA contribution limits.  These are payments by (1) a state or political subdivision of a state, or (2) a qualified foster care placement agency as compensation for providing additional care needed for qualified foster individuals.  The payments are provided when a qualified foster individual has a physical, mental or emotional disability for which the state has determined (1) there is a need for additional compensation to care for the individual; (2) The care is provided in the home of the foster care provider; and (3) the payments are designated by the payor as compensation for that purpose.
  • Effective for taxable years beginning after December 31, 2019, an employer may adopt a qualified retirement plan up to the extended due date of the employer’s federal income tax return and the plan can be retroactively effective for the taxable year.  Although employee contributions can’t be made after the year-end, employer contributions can be made up to the extended due date of the income tax return.  (This rule currently applies to SEP accounts.)
  • Effective for plan years beginning after December 31, 2021, the IRS is to issue procedures for employers who have similar individual account or defined contribution accounts to elect to file combined annual reports (Form 5500.)
  • The IRS is to issue model disclosures showing the estimated lifetime income based on the account balance of a plan participant, to be reported at least annually.  The IRS is also required to provide guidelines for how the income amount should be computed.
  • A fiduciary safe harbor is adopted so plan fiduciaries will satisfy the prudence requirement when selecting an insurer for a guaranteed retirement income (annuity) contract and will be protected from liability for losses that result to to participant or beneficiary due to an insurer’s inability to satisfy its financial obligations under the contract.  (A favorable provision for insurers, not so great for participants and beneficiaries.)
  • Effective on December 20, 2019, and electively retroactive to plan years beginning after December 31, 2013, the nondiscrimination rules are modified to protect older, longer service participation.  These rules are complex and beyond the scope of this explanation.  The rules will allow a closed or frozen plan to continue in existence.
  • Effective for distributions made after December 31, 2018, from Section 529 (educational savings) plans, registered apprenticeship expenses will be considered “qualified higher education expenses.”  Expenses for fees, books, supplies and equipment required for the designated beneficiary to participate in a registered apprenticeship program are qualified expenses for distributions from such a plan.
  • Effective for distributions made after December 31, 2018, up to $10,000 of qualified education loan repayments will be considered “qualified higher education expenses” for distributions from a Section 529 plan.  Student loan interest paid using distributions from a Section 529 plan won’t otherwise qualify for a tax deduction.
  • Effective for distributions made with respect to employees or plan participants who die after December 31, 2019, inherited retirement accounts must generally be distributed within 10 years after the employee or participant’s death.  There is an exception permitting “stretch” distributions based on life expectancy to (1) the surviving spouse of the employee/participant, (2) a child of the employee/participant who hasn’t reached majority, (3) certain disabled beneficiaries, (4) chronically ill beneficiaries, or (4) other beneficiaries who are not more than 10 years younger than the employee.  Once a child of the employee/participant reaches majority, the balance of the account must be distributed within 10 years after the date majority is reached.

The effective date for collective bargaining agreements and government plans will generally be for distributions with respect to employees or plan participants who die after December 31, 2021.

There is an exception for certain existing annuity contracts.

The ten-year distribution requirement also applies to successor beneficiaries of beneficiaries who inherited accounts before December 20, 2019.  (If an employee/participant was deceased during 2019, a surviving spouse might decide to disclaim IRA survivor benefits so that successor beneficiaries will be able to claim “stretch” distributions of benefits for which the election would otherwise be lost.)

Commenters have suggested  designating a charitable remainder trust as a beneficiary of a retirement account as a way to avoid the 10-year limit.  The plan distribution to the trust isn’t subject to current taxation.  Distributions are required to be made annually to the beneficiary(ies) of the CRT, which will probably carry taxable income.  Depending on how long the beneficiary(ies) live, some or all of the balance could go to a charity.  Seek tax and legal counsel when considering this alternative.

  • A provision of the Tax Cuts and Jobs Act of 2017 changed the Kiddie Tax that apples to the unearned income of certain individuals.  The rule applies to a child who (1) is required to file a tax return; (2) does not file a joint income tax return for the tax year; (3) the child’s investment income exceeds a threshold ($2,200 for 2019); (4) either of the child’s parents are alive at the end of the year; and (5) At the end of the tax year, the child is either (a) under age 18; (b) under age 19 and doesn’t provide more than half of his or her own support with earned income; or (c) under age 24, a full-time student, and does not provide more than half of his or her own support with earned income.  Under the Tax Cuts and Jobs Act, the child’s income tax is computed using the tax rate schedule that applies to estates and trusts.  This provision was causing a hardship, especially for survivors of military casualties.   Under the SECURE Act, this change is repealed, effective for tax years beginning after December 31, 2019.  Taxpayers may elect to retroactively apply the change for tax years 2018 and 2019.   This means children will generally be taxed on their unearned income at their parent’s marginal tax rate.  For 2019, the 37% marginal tax rate applies for single persons with taxable income over $510,300 and for estates and trusts with taxable income over $12,750.

Heterosexual couples under age 62 can now be registered domestic partners in California

Governor Newsom approved Senate Bill No. 30 on July 30, 2019.  The bill was authored by Senator Scott Weiner (Democrat state senator from San Francisco).  Under the new law, California’s Family Code is amended to allow heterosexual couples (a man and a woman) under age 62 to be registered domestic partners.

Before the change, only same-sex couples and heterosexual couples age 62 and greater could be registered domestic partners in California.

This change is important because registered domestic partners have essentially the same legal rights as married couples in California (including community property rights), and the relationship is not recognized as being married by the federal government.  THEREFORE, HETEROSEXUAL COUPLES WHO ARE CALIFORNIA REGISTERED DOMESTIC PARTNERS CAN AVOID THE FEDERAL INCOME TAX MARRIAGE PENALTY.

The federal marriage penalty means that a couple that files their income tax returns as married persons generally pays more income taxes than they would as unmarried persons.  The federal marriage penalty was increased under the Trump tax legislation, the Tax Cuts and Jobs Act of 2017.

Registered domestic partners are treated the same as married persons for California income tax reporting.

Be aware that registered domestic partners don’t qualify for some federal tax benefits that married couples do qualify for.  For example, gifts to a spouse who is a U.S. citizen qualifies for an unlimited marital deduction.  A bequest to a spouse who is a U.S. citizen also qualifies for an unlimited marital deduction.  The executor of a deceased spouse can elect on an estate tax return to give any unused lifetime exemption of the deceased spouse to a surviving spouse.  Only married persons are allowed to treat property settlements incident to a divorce as tax-free.

Heterosexual couples who are California residents and are planning to be married should consider being registered domestic partners, instead.

Heterosexual married couples who are California residents and who are paying a substantial federal marriage penalty should consider terminating their marriages and becoming registered domestic partners.  (Consult with your tax advisor to find out if you actually have a marriage penalty.)

I recommend consulting with a lawyer that specializes in family law and estate planning before making your decision.

(California S.B. 30, July 30, 2019.)

Are you a winner or loser under tax reform?

Many Americans are probably wondering whether they will pay more or less taxes under proposals released by President Trump and the tax-writing committees of Congress.

If you listen to President Trump’s sales presentations for the plan, everyone will be better off, but it ain’t necessarily so.

The proposals are still rather sketchy.  The taxable income amounts for which the various tax brackets will apply haven’t even been announced.  Here is my speculation about who are some of the winners and who are some of the losers under the proposals.  Since a combination of factors may apply, each family will need their own computations of tax before and after the changes when the details of the plan are ultimately released if Congress is successful in passing tax reform legislation.

Winners

U.S. corporations with accumulated earnings “parked” offshore.  U.S. multinational corporations haven’t brought their cash from offshore subsidiaries to the U.S. to avoid having them taxed.  Under the tax proposal, they would be able to repatriate the cash at low tax rates, payable over up to five years.  This could make the cash available to pay as dividends to U.S. shareholders to make investments in the U.S.  It could also be just a transfer from a foreign bank to a U.S. bank.

U.S. multinational corporations.  Under the proposal, dividends paid to U.S. corporations from offshore subsidiaries that are at least 10% owned by the U.S. corporation would be tax exempt.  U.S. corporations would no longer be subject to tax on their worldwide income, but only their U.S. operations.

U.S. business owners.  The maximum corporate tax rate would be reduced from 38% to 20%.  The maximum tax rate for individuals on business income would be reduced from 39.6% to 25%.  Investments in depreciable assets (equipment) other than structures (buildings) would be currently deductible for at least five years.

Employees with incentive stock options.  The exercise of incentive stock options isn’t subject to the regular tax, but is currently taxable under the alternative minimum tax.  Since the alternative minimum tax would be repealed, the exercise of incentive stock options would be deferred until the stock is sold or there is another disqualified disposition.  The original tax benefit of incentive stock options would be restored.

Healthy retired empty nesters.  Many of these taxpayers already use the standard deduction.  Their standard deductions will increase under the tax proposals, likely resulting in a tax reduction.

Very wealthy families.  The federal estate tax would be repealed.  Very few Americans are currently subject to the federal estate tax at death.  The exemption equivalent for 2017 is $5.49 million per individual, or nearly $11 million for a married couple.  The federal estate tax rate is 40% for the excess.  (Note there is no proposal to repeal the federal gift tax!)

High income individuals.  The maximum income tax rate would be reduced from 39.6% to 35%.  The additional 3.8% tax on net investment income is also proposed to be repealed.

Losers

Very large families.  The personal exemption would be repealed.  The rationale is the larger standard deduction would cover the elimination of the personal exemption, but it is a flat amount.  The dependent exemption for 2017 is $4,050.  With the $12,700 standard deduction for married couples for 2017, a family of three would have a combined deduction of $24,850 — exceeding the proposed standard deduction for married couples of $24,000.

Single parent families.  It appears the head of household filing status, a very significant tax break for single parent families, would be eliminated.

People who live in states with high income taxes.  States with high income tax brackets include California, New York, New Jersey, Minnesota and others.  (Note many of them are “blue” states.)  The deduction for state income taxes would be repealed.

People who pay high real estate taxes.  The deduction for real estate taxes would be repealed, eliminating a significant tax benefit of home ownership.

People in nursing homes.  Since the medical deduction would be eliminated, people who are uninsured or underinsured and pay for long-term care will lose a signficant tax benefit.  (For many of them, their medical expenses eliminates most of their taxable income.)

Employees with employee business expenses.  Employee business expenses are an itemized deduction that would be repealed.

Corporations that issue bonds or borrow money.  The deduction for interest expense for C corporations would be partially limited.

People who pay high legal fees.  Some legal fees now qualify to be deducted as miscellaneous itemized deductions.  This deduction would be repealed.

People who have high investment management expenses.  Investment management expenses for taxable investments are miscellaneous itemized deductions.  This deduction would be repealed.

Tax return preparers.  Actually, pluses and minuses.  Taxpayers will be totally confused by the tax law changes and will seek help in sorting them out.  Many tax returns will be simpler to prepare, resulting in lower fees.  Tax professionals will need to approach planning more from a financial planning point of view.  Tax return preparers who serve high net worth clients will still have plenty of business.  These clients will still have complex tax issues to deal with

Let your representatives in Congress know what you think about these proposals.  Here is a web site with contact information:  https://www.usa.gov/elected-officials

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How can a business valuation specialist save taxes for your business or family?

The interview on Financial Insider Weekly to be broadcast in San Jose and Campbell  on Thursday, August 24, is with James Brown, ASA, CFP(R) of Perisho, Tombor & Brown.   Our interview subject is “The role of the business valuation specialist.”  The interview will be broadcast at 6:30 p.m. Pacific Time on CreaTV, Comcast Channel 15 in San Jose and Campbell, and will be broadcast as streaming video at the same time at www.creatvsj.org. Note the change in day and time.  You can find broadcast times for other San Francisco Bay Area cities and past episodes at www.financialinsiderweekly.com.

After eight years of production, this is the final broadcast of a new interview for Financial Insider Weekly.  Thank you to the public access television stations that broadcast the show and to the viewers for watching it.  You will find a wealth of financial information under past episodes at www.financialinsiderweekly.com.

President Trump’s tax proposals and you

On April 26, the Trump administration released an outline of its tax proposals for Congress.  The proposal includes a steep tax cut for corporations and businesses from 35% (39.6% for individual owners) to 15%.  The maximum rate for individuals (other than for business income) would be reduced from 39.6% to 35%, and the 3.8% net investment income tax and the alternative minimum tax would be repealed.  The thresholds for the tax rates haven’t been specified.

No “border tax” for imports is proposed at this time.  Corporations would move from a tax on worldwide taxable income to a “territorial” tax system, which would subject them to U.S. tax only for U.S. income.

On the deductions side, the standard deduction would be doubled to $24,000 for a married couple, and all itemized deductions would be repealed except the deduction for home mortgage interest and charitable contributions.  (So with almost all deductions repealed, who needs an alternative minimum tax?)

A side effect of the increased standard deductions and repealing the deduction for real estate taxes is to eliminate the tax benefits of home ownership for almost all Americans except for those in very high cost areas like the San Francisco Bay Area.

With the high standard deduction, most taxpayers won’t receive a tax benefit for making charitable contributions.

For many taxpayers who live in states like California, the state income tax deduction is their biggest tax deduction.  It would be eliminated under this plan, and they might discover they will pay higher income taxes under these proposed changes.

Although the Trump administration proposes to provide more tax benefits for child care, single parents will probably find that is more than offset by a tax increase from the elimination of head of household status.

Another feature of the proposal is to repeal the federal estate tax, which currently only applies to the very wealthy, since a married couple already has almost an $11 million exclusion.  The proposal didn’t specifiy whether the federal gift tax would be repealed or not.

Many details still need to be provided, and the devil is in the details.  The bare bones of this proposal would result in a huge tax windfall for the wealthy and tax deficits for the nation.

These proposals are only the beginning of a huge negotiation battle in Congress.  Let your representatives in Congress know the changes that you favor and the changes you oppose.  Here is a web site with contact information.  https://www.usa.gov/elected-officials

What are the tax consequences of how title is held?

The interview on Financial Insider Weekly to be broadcast in San Jose and Campbell this Friday, December 16,  is with attorney William D. Mahan. Our interview subject is “Tax and financial considerations of title.”  The interview will be broadcast at 9:30 p.m. Pacific Time on CreaTV, Comcast Channel 15 in San Jose and Campbell, and will be broadcast as streaming video at the same time at www.creatvsj.org. You can find broadcast times for other San Francisco Bay Area cities and past episodes at www.financialinsiderweekly.com.

Tax and financial advice from the Silicon Valley expert.