IN THIS ISSUE:Special Analysis:
Recent Developments:
- Inheritance Taken into Account in Setting Child Support
- Spouse/Guardian May Transfer Residence to Herself
- Gift Checks Uncashed at Death are Included in Estate
- IRS/ABA Web Site Geared Toward Teens
The Lighter Side:
IRS Reform Legislation
Contains Good News
he Internal Revenue Service Restructuring & Reform Act of 1998, signed into law on July 22, does much more than reform the IRS. It lowers the capital gains holding period from 18 months to 12 months and includes a package of "technical corrections" to the Taxpayer Relief Act of 1997. Most of these changes liberalize or expand tax breaks contained in the '97 law. This article briefly summarizes some of the key changes.
The new law...does much more than reform the IRS.
Reduced capital gains holding periodEffective January 1, 1998, the required holding period to qualify for long term capital gain treatment drops from 18 months to 12 months. Thus, assets held for one year are eligible for the reduced maximum capital gains rate of 20% (10% for those in the 15% income tax bracket).
This development enhances the importance of tax planning in formulating investment strategy. It also promises to reduce somewhat the complexity created by the 1997 law's capital gains rules.
Roth IRA changesThe law eases the rules on converting a regular IRA to a Roth IRA in several respects.
First, if that conversion is completed before the end of 1998, the 1997 law provided that the income from the conversion must be spread over a 4-year period. The 1998 law permits you to "opt out" of this treatment, and pay tax on all the income in one year. This isn't advisable for most people, but will come in handy for taxpayers with special circumstances that produce lower tax if the income is recognized all at once.
If the IRA owner dies within the 4 year spread period, the income not yet taxed must be reported on the income tax return for the year of death. But the Reform Act creates an exception to that rule. If the Roth IRA owner is survived by a spouse who is named as beneficiary of the Roth IRA, the spouse may elect to continue to report the income during the remainder of the 4-year period.
Because only taxpayers with adjusted gross income (AGI) under $100,000 are eligible for a Roth conversion, a Roth rollover under the 1997 law was a dicey proposition for many folks. Those making the rollover believing they would be under the $100,000 limit, only to discover at tax time that their AGI exceeded it were out of luck under the '97 law. The Reform Act permits you to change your mind about the Roth conversion. Prior to the due date for the return (including extensions), you can "undo" the conversion by transferring the assets back to the regular IRA. This option applies to everyone, not just to those who discover they've exceeded the AGI limit. But the assets must be moved in a trustee-to-trustee transfer.
For those who have started receiving mandatory distributions from the regular IRA, the $100,000 income limit includes the required distribution in the year of the conversion. The new law eliminates that rule, but only for tax years after 2004.
Home Sale Exclusion RuleThe 1997 law permits up to $250,000 of capital gain ($500,000 for a married couple) to be received tax free from the sale of a principal residence. To qualify, the home must have been owned and used as the residence for two years before the sale. What if the period of ownership and use of the home is less than two years? The Reform Act clarifies that the exclusion is still available, subject to a maximum that is reduced in proportion to the period of ownership. To understand the significance of this generous rule, assume a single taxpayer buys and lives in a home, then sells after one year, realizing a capital gain of $100,000. One possible interpretation of the 1997 act was that only one half, or $50,000, of the gain is tax-free. The new law clarifies that only the maximum exclusion is cut in half -- from $250,000 to $125,000. Since the $100,000 gain in our example is less than that, it is fully sheltered from tax.
Family Business Estate Tax ReliefThe 1997 tax law introduced the estate tax family business exclusion. Tax Code section 2033A, added by the '97 law, allows an exclusion against estate tax of up to $675,000 if some very complex requirements are met. Under that law, the combined amount excluded from tax by the new family business exclusion and the unified credit may not exceed $1.3 million. Although cast as an exclusion under the 1997 law, the family business provision operates in many ways like a tax deduction. It does not exclude specific property from the estate, but rather excludes a dollar amount from taxation. The Reform Act clarifies this and converts the family business tax break from an exclusion to a deduction. It repeals section 2033A and enacts a new section 2057.
The conversion from an exclusion to a deduction potentially saves some income tax. It removes any doubt that the family business assets that have appreciated in value are entitled to a step-up in basis for income tax purposes at the business owner's death. If the business property were really excluded from the estate, the basis would remain unchanged, leaving the potential of a large capital gain on sale.
The combined benefit of the unified credit and the family business provision still may not exceed $1.3 million. And the new section contains all of the details and complex computations of section 2033A, with some technical adjustments. Thus, the 1998 law resolves the confusion over whether qualified family business assets are excluded or deducted from the estate. However, business owners still must climb a mountain of complexity in order to obtain tax relief.
The new law liberalizes the family business exclusion in other respects as well. For example, a business owner may lease business property for cash rent to a family member who uses it in the business. Such a rental could nullify estate tax relief under the old law. The Reform Act also provides that a trust is considered a qualified heir if all of the trust beneficiaries are qualified heirs. This change expands the possibilities for family business succession planning.
RECENT DEVELOPMENTS
Inheritance Taken into Account in Setting Child Support
Connell v. Connell, N.J. Superior Court App. Div. July 1, 1998
When Lorna Connell and David Day Connell, Jr. were divorced in 1993, the amount of child support to be paid by David to Lorna for their three children was fixed at $306 per month. In 1995 it was increased by the court at Lorna's request.
In 1997 Lorna moved to increase child support again, claiming that David had received an inheritance of almost $500,000 from his father's estate. In response, David claimed that the amount of the inheritance was far less than $500,000 after estate taxes. He also asserted that the inheritance should not affect the child support obligation because it did not increase his income. He had spent the inherited funds on a vacation home in Maine, a boat and a Chevrolet Suburban.
The judge held that the inheritance should be taken into account in arriving at the amount of child support. However, the judge found that even if 8% income were imputed to the inheritance, the current support was sufficient, and should not be increased.
On appeal, the Appellate Division noted that the question of whether an inheritance should be considered in calculating child support had not previously been considered by the New Jersey courts. The Appellate Division agreed that it should be taken into account. However, the appeals panel differed with the motion judge concerning the mechanics of applying the child support guidelines, and remanded the case for further consideration.
Comment: Parents of divorced children may wish to consider the implications of this ruling when structuring gifts and bequests to their children.
Spouse/Guardian May Transfer Residence to Herself
In re Labis, N.J. Superior Court, Appellate Division (July 21, 1998)Manuel Labis suffered a debilitating stroke at the age of 63. He is partially paralyzed, and cannot eat or speak. He will require constant medical and nursing care. His wife, Myrna Labis, applied to be appointed as Manuel's legal guardian. The judge approved the appointment.
At the same time, Myrna asked the court to permit her to transfer ownership of the family home from its current joint ownership to her name. Placing the home in her name would permit her to do some planning geared toward helping Manuel qualify for Medicaid in the future. For example, as sole owner of the home, she could alter her will to provide that if she dies before Manuel, the home will pass to the children rather than back to Manuel. Leaving the home to him at a time when he is institutionalized could force a sale of the home to pay his expenses.
The Law Division judge who appointed Myrna as guardian denied her request for permission to transfer the home. He felt that such a transfer would be against public policy because it would enhance the availability of public assistance for Manuel's care. He ruled that a transfer of the home to the children, free from any obligation to contribute towards the cost of nursing care, would be unfair to the public interest. He also agreed with Manuel's court-appointed attorney that a transfer might adversely affect the quality of his care by depriving him of funds that could be used for a better nursing home.
On appeal, the Appellate Division approached the situation differently. According to the appellate panel, the guiding principle should be what Manuel would have done if he were able to make the decision himself. The court noted that the transfer of a residence between spouses is permitted under Medicaid regulations, and is common planning. Court cases in other states have permitted transfers of assets motivated by Medicaid eligibility.
Against this backdrop, the court concluded that the transfer would be in Manuel's best interest, and that he would favor it if he were able to communicate. The court's decision states, "... if Manuel were competent, he would take every lawful and reasonable action to minimize obligations to the State of a nursing home in order to secure the maximum amount available to support his wife of twenty-seven years through the remainder of her life and benefit his children thereafter."
Note: Under a strict interpretation of a 1997 Medicaid law, Myrna's advisors could be put in jail for even suggesting a transfer of assets for the purpose of Medicaid qualification. That law purported to make it a crime to advise or assist a person to transfer assets in order to qualify for medical assistance. The New York State Bar Association challenged the law in court. In March, Attorney General Janet Reno advised Congress that her office will not even attempt to defend the law because, according to Reno, it "is plainly unconstitutional under the First Amendment."
Gift Checks Uncashed at Death are Included in Estate
Estate of Sarah H. Newman v. Commissioner, U.S. Tax Court, July 28, 1998In 1985, Sarah Newman signed a power of attorney authorizing her son Mark to act on her behalf. In 1992, while Sarah was ill and bedridden, Mark wrote six checks totaling $95,000 as gifts to Sarah's children and other relatives. The checks were dated September 23 and September 24, 1992. Sarah died on September 28. None of the checks were paid by the bank until after Sarah's death.
The estate considered the gifts complete at the time the checks were written, and therefore did not include the $95,000 in the taxable estate. The IRS claimed that the funds should be taxed as part of Sarah's estate, since the checks had not been cashed as of her date of death.
The Tax Court agreed with the IRS. Under the law of the District of Columbia, where Sarah lived, a bank customer can stop payment on a check by making a telephone request and following it up with a written letter. This meant that Sarah still had control over the funds at the time of her death, according to the Tax Court. Even though she was ill, she could have made a phone call or asked her son to do so.
The estate argued that the cashing of the checks after the date of death should "relate back" to the date the checks were written. The Court declined to adopt that rule, expressing concern that to do so would encourage estate tax avoidance.
The IRS also argued that the gifts were incomplete because the power of attorney did not specifically authorize donative transfers. The Court did not reach that issue because of its ruling on the timing issue.
Note: A different rule applies to gift checks written and delivered at year-end, but not cashed until January. Those gifts are considered complete when delivered, as long as the check is cashed within a reasonable time. (See the 1st Quarter 1997 issue of Foresight for more details).
NJ Roth IRA Law Finalized
P.L. 1998, c. 57
Our last issue reported on the progress of legislation conforming the income tax treatment of Roth IRAs under New Jersey law to federal law. The measure has now been signed by Governor Whitman. Under the law, distributions from Roth IRAs will be exempt from New Jersey as well as federal income tax.
Marital Deduction Denied in Murder/Suicide Situation
IRS TAM 9815008Husband attacked and killed Wife, then mortally wounded himself. The coroner ruled the deaths a murder and suicide and concluded that Wife's death occurred before Husband's.
A state law provides that the estate of a person who is murdered passes as if the murderer had died before the victim. The law is aimed at preventing the wrongdoer from profiting by receiving any part of the victim's estate.
In this case, Husband's estate claimed that it was entitled to a marital deduction for property that passed to Wife's estate by joint ownership and by beneficiary designation. Although Wife had died first, the law treated her as the survivor, argued his estate. Thus, the marital deduction should be available to his estate.
The IRS disagreed in this private ruling. The law in question only affects the victim's property passes, not the murderer's. Since it was clear that Wife died first, she never received the property, and Husband's estate is not entitled to a marital deduction.
IRS/ABA Web Site Geared Toward Teens
TAXinteractive, http://www.irs.gov/taxi/
The Internal Revenue Service and the American Bar Association Section of Taxation have produced a Web site designed to educate teenagers about taxes. TAXinteractive, or Taxi for short, includes resources teachers can use to integrate tax lessons into classroom settings. Colorful graphics and an informal writing style aspire to catch and retain the interest of young people. Here, for example, is an entry from the compendium of tax terms:
DEPENDENT A person who relies on someone else for financial support. Sound like a mooch? Not really. Think about it - most "young adults" (under 21 years old) are supported by their parents. Is this you? If it is, your parents can claim an exemption for you-their adorable dependent-if dependency tests are met.
More Tax Quotes
The inaugural issue of Foresight, published late 1995, included a sampling of famous quotations concerning taxes. A more extensive list can be found at Dennis Schmidt's Tax and Accounting Sites Directory (http://www.taxsites.com/quotes.html).
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.
De Maio & De Maio is a law firm located in central New Jersey. We provide legal services in the areas of estate planning and administration, tax planning, business formation and transfer, trust administration, and related fields.
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