The Strategist
4th Quarter 1996 - Volume 3 Issue 5
Someone once said that the only constant is
change. 1996 has been no exception. Between IRS rulings and new tax legislation
this year, numerous changes have occurred in the wealth transfer area. Because
these changes have been so numerous and we feel inaccurately summarized, we
thought we would review what we feel are the major changes in these areas.
However, first we wanted to let you know about a new revenue ruling that
impacts annual exclusion gifts.
Although we encourage all of our readers to
make annual exclusion gifts ($10,000 per year that you can give away tax free
to anyone) as early in the year as possible many of our readers wait until the
month of December to make these gifts. Previously, the IRS had indicated under
Revenue Ruling #67-396 that a gift by check was not complete for federal gift
tax purposes until the check was paid by the drawee bank. In other words, if I
wrote a check on December 31st to my child and the child deposited the check on
the same day but the check did not clear until January 2nd of the next year (2
days later), the IRS indicated that I had not given up control over the funds
until January 2nd and, therefore, no gift until January 2nd. What is
interesting about this is that if I had made the check to a charitable donee,
the IRS indicated that I had given up control upon delivery of the check
to the charitable donee and, therefore, qualified for a charitable income tax
deduction.
In 1994, the 4th Circuit Court in a case
referred to as Metzger, ruled that if a check is delivered to a non-charitable
donee (i.e., child), the gift is complete on the date the check was deposited
by the donee provided that (1) the check is paid by the bank while the donor is
alive, (2) the donor intended to make the gift, (3) delivery of the check was
unconditional, and (4) the donee presented the check for payment in the year
that the completed gift treatment is sought, and within a reasonable time of
issuance.
Because of this case, the IRS has issued
Revenue Ruling 96-56 that basically follows the Metzger decision. In other
words, if I now write a check to my child for $10,000 on December 31st and he
immediately deposits the check on the same day, the gift is considered complete
for the year that I wrote the check as long as (1) the check is paid by the
drawee bank even if not paid until January, (2) I am alive when the check is
paid by the bank, (3) I intended to make the gift, and (4) by me giving him the
check, it was unconditional. It is important to note that the donor must be
alive on the date that the bank clears the check (pays the funds).
Now, let's review some of the major changes
in the tax laws that have favorable wealth transfer planning opportunities. In
our opinion, the biggest changes are the ones involving subchapter S
corporations.
To quickly review, the number of allowable
shareholders in a subchapter S corporation has increased from 35 to 75
shareholders. Subchapter S corporations can now have 80% or more C corporation
subsidiaries and 100% S corporation subsidiaries. Additionally and perhaps most
important, a new type of trust can be an eligible shareholder. This type of
trust is known as an Electing Small Business Trust (ESBT). An ESBT is like a
"sprinkle" or "spray" trust. In other words, this type of
trust could have numerous discretionary income and principal beneficiaries. The
trustee is not required to pay or distribute the income it receives from the
subchapter S each year to the beneficiaries.
Previously, only one type of trust, known as
a QSST, was eligible to be a subchapter S shareholder. A QSST trust only
allowed a single beneficiary and required all the income each year to be paid
out to the beneficiary of the trust.
The ESBT allows multiple potential
beneficiaries of the trust with no requirement for the income to be paid out
each year.
All subchapter S income will be taxed to the
trust at the highest federal income tax rate (currently 39.6%) on all S
earnings of the ESBT. However, once taxes are paid on those earnings and there
are excess funds, any distribution of the S income that was previously taxed at
the trust level can be distributed tax free to the beneficiary.
Additionally, S corporations that
inadvertently terminated their S status can now immediately re-elect S status
without the previously required 5 year waiting period. No IRS consent is
required for this.
Beginning in 1997, 40% of health insurance
costs on a greater than 2% shareholder of an S corporation can now be deducted
for income tax purposes by the S corporation. This will increase to 80% by the
year 2006.
There has been a change in charitable income
tax deductions as well. Until May 31, 1997, an individual can gift
highly-appreciated publicly-traded stock to a private foundation and take an income
tax deduction equal to its fair market value. After May 31, 1997, an individual
may only deduct the cost basis in the stock.
In other words, if I have highly-appreciated
securities worth $100,000 in which I have a $10,000 cost basis and I gift these
securities to my private foundation prior to May 31, 1997, I can deduct the
entire $100,000 gift from my income taxes. However, if I wait until June 1997,
I can only deduct $10,000 from my income taxes for a charitable contribution.
In 1996, the IRS also issued a private
letter ruling and a technical advice memorandum on split dollar insurance. The
private letter ruling is very favorable and the technical advice memorandum
(TAM) is potentially negative. Let's begin with the TAM.
In TAM 96-04001, the IRS indicated that
there may be additional taxation involved in a split dollar agreement. The
particular type of split dollar agreement the IRS addressed is known by many as
"equity split dollar". In this situation, the insured, or a trust
established by the insured, owns a policy that the insured's corporation pays
most of the premium with the insured or the trust paying what is known as the
economic benefit (term cost). These types of split dollar agreements state that
the corporation is entitled to receive back all premium advances upon surrender
or death.
In this case, the IRS has now indicated that
if this type of agreement is in force and the cash surrender value of the
policy is in excess of the total premiums paid, then the insured receives taxation
on the difference between the premiums paid (cost basis) and the cash surrender
value of the policy.
Please keep in mind that this technical
advice memorandum is directed only to the taxpayer that requested the ruling
and is not current law but does indicate where the IRS is attempting to attack
split dollar. We believe there are several ways that are valid to get around
this potential negative taxation treatment of equity split dollar. Do not
hesitate to give us a call if you are concerned about this and we will address
this with you and your advisors.
The IRS also recently issued a very
favorable private letter ruling (PLR 96-36033) that has great potential for
estate planning using private split dollar. In this PLR, the IRS acknowledged
that split dollar can be done without a corporation where a parent or family
member can take the place of the corporation.
In this situation, Dad established an
irrevocable trust for the eventual benefit of his son and placed a large amount
of cash into the trust. The trustee of the trust (Dad's brother) wanted to
purchase a large life insurance policy on Dad but could not afford all of the
premiums going forward. In this situation, the trustee of the trust entered
into a split dollar agreement with Dad's wife whereby Dad's wife would provide
the majority of the funds and the trust would pay the economic benefit. In
other words, she acted like the corporation in a normal split dollar
transaction.
The IRS indicated that this is an allowable
transaction and is not considered a gift by Dad's wife since Dad's wife was a
discretionary income and principal beneficiary of the trust along with the son.
Again, it is important to point out that a private letter ruling is not
applicable other than to the person requesting the ruling but, again, it gives
us an idea of what the IRS is thinking.
Finally, as a reminder, if you have not made
your 1996 annual exclusion gifts ($10,000 per donee), make them immediately.
Based on the new Revenue Ruling 96-56, if the check is delivered to the donee
and he or she deposits the check this year (1996), the check will qualify for
the annual exclusion gift for 1996 as along as you are alive when the check is
cashed.
We wish all of you a very, very prosperous
1997.
The
Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting
nor are any of its employees, representatives, or agents. Tax and legal advice
should be obtained from qualified personnel.
(c) 1996 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407)
339-5787
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