FORESIGHT
Devoted to Estate and Tax Planning
2nd Quarter, 1996 -- Vol. 2, No. 2
© 1996 De Maio & De Maio
IN THIS ISSUE:
RECENT DEVELOPMENTS:
THE LIGHTER SIDE:
Feature Article
Tax Planning for the Sale of Securities
By Andrew J. De Maio,
Esq.
It was time. Those home improvement projects had waited long enough.
Dan picked up the telephone and called his financial planner. "Bill, what's
the price on those XYZ mutual fund shares? I want to sell some."
"$18.00," came the reply. "You've been in that fund for a long time."
"Yeah," said Dan. "I've just reinvested everything and let it grow. Sell
$20,000 worth."
"Will do," replied Bill. "Which shares do you want to sell?"
Dan was puzzled. "What do you mean, which shares? They're all the same,
aren't they?"
"Uh huh."
"Each share is worth $18.00, right?"
"Sure. But which shares you sell could make a big difference in your
income tax bill next year."
"Really? How?"
Like Dan, most people don't think about tax planning when they sell securities.
Many sellers in today's market are locking in capital gains. With a little
foresight, you can take steps to minimize the tax cost of securities sales.
This article explains how good recordkeeping and planning can help.
An example
To illustrate, let's assume that you own 1,000 shares of a mutual fund and
have decided to sell 250. The current price is $50 per share. You acquired
shares over time as shown in this table:
|
# of shares |
Purchase date |
Cost/share |
Total cost |
|
|
250 |
1990 |
$20 |
5,000 |
|
|
250 |
1991 |
$30 |
7,500 |
|
|
250 |
1993 |
$60 |
15,000 |
|
|
250 |
1996 |
$45 |
11,250 |
|
Totals |
1,000 |
------- |
$38.75 (avg) |
$38,750 |
|
Any one of four different methods that may be used to calculate the income
tax consequences of the sale. The first two methods may be used for sales
of stocks and bonds as well as for mutual funds. The last two are available
for fund shares only. In all of the calculations below, it is assumed that
no sales charges or commissions are paid.
First In, First Out (FIFO)
Unless you decide to use a different method, the gain is calculated by assuming
the shares sold were the ones you have held the longest. Under this method,
the 1990 shares, with a basis of $20 each, are considered to be the ones
sold. The capital gain is $30 per share, or $7,500.
Specific Share Identification
If you act soon enough, you can choose which shares are considered sold.
For example, to minimize the taxable gain, you may identify the 1993 shares,
purchased at a cost of $60, as the ones sold. This results in a capital
loss of $10 per share, or $2,500.
To use this method, however, you must adequately identify the shares. If
the shares are in certificate form, you can deliver the certificate or
certificates representing the shares to be sold. Another method, available
even you don't have stock certificates, is to obtain a written confirmation
from the broker or transfer agent identifying the shares. To obtain such
a confirmation, according to IRS Publication 564, you must:
1) Specify to your broker or other agent the particular shares to be sold
or transferred at the time of the sale or transfer, and
2) Receive confirmation of your specification from your broker in writing
within a reasonable time.
Obtaining a written confirmation complying with the IRS regulations is the
safest method of identifying shares. However, the U.S. Tax Court held in
a 1994 case that an oral instruction to a broker was sufficient. Concord
Instruments Corporation v. Commissioner, T.C. Memo 1994-248.
Average Cost Method - Single Category
To use this method, you find the average cost of all shares you hold in the
fund by dividing the total cost (including reinvested dividends) by the number
of shares you own. In our example, this is $38,750 divided by 1,000, or $38.75
per share. The capital gain using this method is $11.25 per share, or $2,812.50.
Many mutual fund companies supply average cost information to their shareholders.
Using this figure to compute your tax is simple. But as we've seen, it does
not always produce the best result.
You notify the IRS of your election to use this method by including a statement
on the first return to which the election applies. Once the average cost
method is used for shares in a fund, you must continue to use that method
for all futures sales of the same fund.
Average Cost Method - Double Category
This method is the most complicated of the four. The shares in the account
are divided into two categories: those held for more than one year ("long-term
shares") and those held for one year or less ("short-term shares"). The average
basis is calculated for each category. Unless you specify otherwise, the
shares sold are considered to come from the long-term category. The sale
of short-term shares is not eligible for long-term capital gain treatment.
In our example, the shares purchased in 1996 are short-term shares. Assuming
you designate them as the ones sold, the sale produces $750 of short-term
gain that is taxed as ordinary income.
This graph illustrates the results from the use of the four available methods.
In each case, the amount of cash received from the sale is the same: $12,500.
But the tax results are widely different.
Choosing a Method
Most often, you will want to use the method that produces the lowest gain.
The specific share identification method usually fits the bill by allowing
you to sell the shares with the highest cost.
If you don't have complete records, your range of choices is limited. To
use the specific share method, you need an accurate record of each purchase
and its cost. These records can be voluminous if you have reinvested
distributions over a long time. Often, the failure to keep comprehensive
records is costly in terms of taxes.
Keep in mind that the specific identification method is not available for
a mutual fund if you have previously sold shares of that fund under the average
cost method. That's another reason to think twice before using the average
cost in connection with a sale.
Keeping good records
Your computer can help you keep track
of the information you need for good planning. But you don't have to be a
technical wizard to get the job done. Simply keep a copy of each statement
and each purchase confirmation you receive. These will provide a record of
all cash purchases and reinvestments. You can summarize the information in
a ledger. IRS Publication 564 includes a sample form for creating one.
The computer-literate can choose among many software packages that permit
the tracking of investments. One of the most popular, Intuit's Quicken (Version
5 for Windows), allows the entry of purchases and reinvestments into an
electronic ledger. When you decide to sell, the information that you need
to use the specific share method is at your fingertips. You can designate
the shares to be sold, or instruct the computer to select the shares that
will result in the minimum or maximum capital gain. To comply with the IRS
rules on share identification, you must advise the broker or fund manager
of the share designation at the time of the sale, and obtain a written
confirmation of your request.
Final Thoughts
The tax law offers a range of choices to the investor selling part of a portfolio
position. But this flexibility is denied to those who fail to keep adequate
records of purchases and reinvestments. A little time spent on record keeping,
and careful planning at the time of sale, can pay off handsomely in tax savings.
The Clinton administration's 1997 budget proposes to eliminate this flexibility
and require the use of only one method: average cost. This proposal has been
criticized, and many question its chances for enactment. /1/ Meanwhile, the
debate should help to focus attention on this often-overlooked tax planning
opportunity.
/1/ See, e.g., "A $4 Billion Fiddle" (editorial), Wall Street Journal, March
25, 1996.
Further reading
RECENT DEVELOPMENTS
New Jersey Tax Amnesty Now in
Effect
For a limited time, the State of New Jersey is offering delinquent taxpayers
a chance to come clean, without having to pay interest or penalties.
Here's how it works. If you owe the State tax that was due between January
1, 1987 and December 31, 1995, and you pay the tax before June 1, 1996, any
penalties and interest will be forgiven. The amnesty applies to all taxes
administered by the Division of Taxation, including individual income tax,
corporation business tax, and sales and use tax. Taxpayers who are already
under criminal investigation by the State for tax evasion are not eligible.
Taxes that are eligible for amnesty, but are not paid within the amnesty
period, are subject to an additional 5 % penalty. Information about the New
Jersey Tax Amnesty, including downloadable forms, is posted on the State
of New Jersey Web site, at
http://www.state.nj.us/treasury/taxation/amnesty.htm
Tax Court Recasts Loans as
Gifts
Miller v. Commissioner, T.C. Memo 1996-3
In 1982, Elizabeth Miller transferred $100,000 to each of her two sons. She
described each transfer as a "loan" in her check register. Each son signed
a promissory note agreeing to pay the amounts back without interest within
three years. But Mrs. Miller did not demand repayment of the loans. In a
series of "forgiveness letters" signed over several years, she reduced the
amount due, until both loans were considered paid in full. One son made a
partial repayment of $15,000 in 1992; no other payments were made.
The IRS claimed that Mrs. Miller never expected repayment, and that the $100,000
transfers were gifts, not loans, for tax purposes. After reviewing all of
the circumstances, the United States Tax Court agreed with the IRS. Although
there was a written agreement to repay, the parties did not treat the
transactions as loans in a businesslike manner. For example, the parties
did not discuss repayment when each loan became due, and Mrs. Miller never
took any steps to enforce the obligations. Neither son appeared to have the
ability to repay the loan within the term of the promissory note. The court
also found several inconsistencies between the family's records and the tax
reporting of the transactions.
The Tax Court listed nine factors that should be considered in evaluating
whether a transfer is a loan or a gift for tax purposes. Those factors are:
-
Whether there was a promissory note or other evidence of indebtedness;
-
Whether interest was charged;
-
Whether there was any security or collateral;
-
Whether there was a fixed maturity date;
-
Whether a demand for repayment was made;
-
Whether any actual repayment was made;
-
The ability of the transferee to repay;
-
Whether any records maintained by the transferor and/or the transferee reflected
the transaction as a loan; and
-
Whether the manner in which the transaction was reported for Federal tax
purposes is consistent with a loan.
Comment: We tend to be informal in dealing with those we know and
trust. That informality can sometimes cause problems. Because of the close
scrutiny given to intra-family transactions, any loan between family members
should be carefully structured and documented.
New Law Prohibits Source Taxing of
Pension Benefits
P.L. 104-95
You worked for many years in State A. After retirement, you moved to State
B. You receive pension benefits from your former employer. Can State A impose
income tax on the retirement benefits, even though you no longer live in
that State? Until recently, the answer was yes. Congress recently passed
legislation prohibiting State taxation of retirement benefits of former
residents. The law applies to income received after December 31, 1995.
IRS Establishes Procedure for Valuing
Contributions of Art
Rev. Proc. 96-15
How much is that painting worth? The value has important tax consequences
when the work of art is donated to a charity, given to a family member, or
is included in the taxable estate at death. The IRS has established a procedure
for confirming the value, for tax purposes, of paintings, sculpture, historical
memorabilia and other artwork.
The procedure applies only to items with a value of $50,000 or more. To obtain
a statement of value from the IRS, the taxpayer must submit a qualified appraisal
of the item and pay a user fee of $2,500. If the IRS agrees with the appraiser's
estimate of the item's value, the taxpayer can rely the statement of value
in filing a tax return.
Comment: The IRS will not issue a statement of value for a proposed
gift. This Revenue Procedure applies only to transfers that have been completed..
New Jersey Enacts New Medicaid Estate
Recovery Rules
(P.L. 1995, c. 289)
The Medicaid program pays nursing home and other medical expenses of people
who can't afford to pay themselves. If a person who has received Medicaid
owns assets at the time of death, the State is required by federal law to
try to recoup the benefits from the estate. A new law expands the types of
property that are subject to the estate recovery provisions.
Previously, the State could recover only from property owned by the decedent,
and passing through the probate estate. Under the new law, assets transferred
to a survivor through joint ownership, a life estate, or a trust are also
subject to recovery. The new law applies to the estates of persons who received
Medicaid benefits after September 30, 1993 and died on or after April 1,
1995.
Comment: As under prior law, the State may not impose a lien or
seek recovery of benefits properly paid if there is a surviving spouse, or
a child who is disabled or younger than 21.
Creation of Mortgage is Completed
Gift
Jennings v. Cutler, N.J. Appellate Division, March 15, 1996
Alan Cutler was a wealthy real estate developer. In 1990, he and Michelle
Jennings began dating. Eventually, they began living together, and did so
until mid-1992, when the relationship dissolved. During their relationship,
Cutler gave Jennings many extravagant gifts, including a Mercedes-Benz
automobile. He also paid some of her expenes, such as credit card bills of
up to $10,000 per month, and a $29,000 dental bill.
In early 1992, Jennings asked Cutler for $250,000 because, she claimed, she
was concerned about what she would do if something happened to him. When
Cutler refused to give her cash, Jennings asked for a house at "The Beagle
Club," one of the real estate developments owned by Cutler's corporation.
Eventually, by way of compromise, he agreed to give Jennings a mortgage in
the amount of $150,000 on a sample home located in Voorhees, New Jersey.
The note and mortgage, dated April 10, 1992, provided that the corporation
would pay Jennings $150,000 out of the proceeds of sale of the model home.
By the time the home was sold in June of 1992, the relationship had ended.
Cutler and the corporation refused to pay the mortgage proceeds. Cutler asserted
that he never intended to make a present gift. He claimed that the delivery
of the mortgage was not a completed transfer, but was a promise to make a
gift in the future. Such a promise, Cutler argued, is unenforceable. Jennings
contended that the delivery and recording of the mortgage was evidence of
a valid, complete gift.
The Court, ruling in favor of Jennings, held that the three elements of a
valid gift were present. Those elements are: (1) a donative intent on the
part of the donor; (2) an actual or symbolic delivery of the subject matter
of the gift; and (3) an absolute and irrevocable surrender by the donor of
ownership and dominion over the subject matter of the gift, at least to the
extent practicable or possible, considering the nature of the thing to be
given. These being present, the gift was complete and Jennings was entitled
to enforce the mortgage.
Gifts Under Bank Power of Attorney
Held Ineffective
Goldman Estate v. Commissioner, T.C. Memo 1996-29
Sylvia Goldman was diagnosed with cancer in 1989. On November 1, 1989, she
signed a power of attorney form supplied by a bank, giving her daughter Marsha
the authority to conduct banking transactions. In late 1990 and early 1991,
after Mrs. Goldman's condition had worsened, Marsha wrote sixteen checks
on Mrs. Goldman's account to family members as gifts. Each check was for
$10,000, the amount of the annual exclusion for federal gift tax purposes.
Mrs. Goldman died on January 19, 1991.
Property that is given away during lifetime is usually not subject to estate
tax. But the IRS successfully argued that Mrs. Goldman's gifts were not effective
for tax purposes. The Tax Court did not believe the testimony of the family
members concerning the timing of the gifts. More important for planning purposes,
the court held that the gifts were not authorized under the power of attorney.
The power of attorney did not specifically mention the making of gifts. That
authority could not be implied under New York law, according to the court.
The estate was liable for additional estate tax resulting from the inclusion
of the funds in the taxable estate.
Comment: This is the latest in a line of similar court rulings.
A power of attorney should clearly itemize the types of transactions that
are authorized. Not everyone will want to authorize the making of gifts.
If that power is desired, it should be specifically mentioned.
THE LIGHTER SIDE
From a classic poem by Lord Neaves:
The Jolly Testator Who Makes His Own Will
Ye lawyers who live upon litigants' fees,
And who need a good many to live at your ease,
Grave or gay, wise or witty, whate'er your degree,
Plain stuff or Queen's Counsel, take counsel of me:
When a festive occasion your spirit unbends,
You should never forget the profession's best friends;
So we'll send round the wine, and a light bumper fill
To the jolly testator who makes his own will.
He premises his wish and his purpose to save
All disputes among friends when he's laid to the grave;
Then he straightaway proceeds more disputes to create
Than a long summer's day would give time to relate.
He writes and erases, he blunders and blots,
He produces such puzzles and Gordian knots,
That a lawyer, intending to frame the thing ill,
Couldn't match the testator who makes his own will.
---------------------
FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It
is not intended as and does not constitute legal advice, nor does it create
an attorney-client relationship. The information contained in this publication
should not be acted upon without first obtaining the advice of a professional
advisor.
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