Compare these numbers to the approximately 4,000 estate tax returns that will be required to be filed annually under the new “permanent” estate tax exemption of $5 million adjusted for inflation, and it is easy to see that planning for retirement accounts presents a more significant opportunity for the estate planning advisory team than does estate tax planning.

Clients want to protect their IRA and retirement plan assets for their families, but most do not understand what can happen to those accounts after they die. And, unfortunately, much of the information plan owners and beneficiaries receive from family members, other lay sources, and, surprisingly, even some advisors is outdated or incorrect.

Without proper planning, trillions of dollars in IRAs and qualified plans that are passed down to clients’ beneficiaries upon death could be exposed to the beneficiaries’ creditors and other beneficiary-associated risks. By using specially designed IRA trusts, the plan owner’s beneficiaries can be protected from creditors, predators, and the temptation inherent in “found” money and thus ensure that the beneficiary achieves the maximum tax deferral that the client intends.

In this issue of The Wealth Counselor, we will explain some of the rules about retirement plans that every member of the advisory team must know and how a properly prepared retirement plan trust (which we will here refer to as an “IRA trust”) can protect the plan assets after the owner’s death.

Problems with Inherited IRAs and Retirement Assets
Impact of Income Taxes
Unless the client’s retirement plan assets are in a Roth IRA or other Roth vehicle, income taxes must be paid whenever assets are withdrawn from these accounts. The top federal income tax rate is now 39.5% and state income taxes, where applicable, are in addition. (The 3.8% Medicare surcharge does not apply to retirement account withdrawals but the withdrawals from non-Roth accounts do get counted in determining if and by how much the taxpayer has exceeded the applicable threshold amount for the surtax.)

Impact of Income Tax Deferral
Different Levels of Protection for IRAs and Inherited IRAs
Qualified retirement plans, including SEP and Simple IRA plans, are protected under ERISA, but traditional, Roth, and inherited IRAs are protected under state laws, which vary greatly. For example, during the original IRA owner’s lifetime, protection can range from unlimited protection to a specified dollar amount or, as in California, to an amount reasonably necessary for the owner and any dependents. Protection for inherited IRAs may be different than that provided to the owner. This varies from state to state and is determined by the beneficiary’s state of residence when the protection question arises. Therefore, only the surest result is obtained through good, proactive planning.

Planning Tip: It is critical to understand how the laws in your state apply to an original owner and to someone who has inherited an IRA. You cannot assume that the beneficiary residing in another, often currently unknown state will have the same asset protection as the owner or a beneficiary residing in your state.

“Found” Money Is Extremely Slippery
We have all heard of the result of studies of how fast the average beneficiary goes through life insurance proceeds. Spending “found” money simply does not carry the significance of spending one’s own hard earned money. An IRA or other retirement account passing to an individual beneficiary is also “found” money and just as slippery.

IRAs and other retirement plans offer the substantial tax benefit of income tax deferral. Stretching out the inherited retirement plan’s distributions over a beneficiary’s actuarial life expectancy yields a much greater return than if the beneficiary cashes out the plan and pays taxes immediately on the full distribution plus on any future earnings on those assets.

Planning Tip: It can be very helpful to have a chart or calculator that illustrates to clients the benefits of income tax deferral based on his/her actual account balance, actuarial life expectancy, and beneficiaries’ ages.

Divorce and Unintended Beneficiaries
Although an inherited IRA is not a marital asset, it is “on the table” in a divorce because it can be transferred as part of a divorce settlement. Also, the beneficiary of an inherited IRA will make his/her own beneficiary designation in case of death before the account is depleted. Most clients do not want a child’s ex-spouse to get their IRA or a child’s new spouse to inherit because both carry the risk that the client’s grandchildren will be disinherited.

Loss of SSI/Medicaid
Any inheritance, including assets in an inherited IRA, are considered “resources” for determining SSI/Medicaid eligibility. At least temporary loss of SSI/Medicaid or other government benefits by a disabled beneficiary is hard to avoid if there is more than $2,000 in the inherited IRA.

Planning Tip: Assets held in a properly drafted IRA trust can provide much better protection and ensure maximum stretch out.

Basic Retirement Plan Concepts
A major advantage of qualified retirement plans and IRAs is that the income tax on plan earnings is deferred until withdrawal. With the exception of a Roth IRA or plan account, the account owner (referred to herein as “the owner”) must commence Required Minimum Distributions (RMDs) by his or her Required Beginning Date (RBD). The owner is never required by tax law to make withdrawals from any Roth account but the Roth account beneficiary is.

Required Beginning Date (RBD)
Generally the RBD is April 1 in the year following the calendar year in which the owner reaches age 70 ½ or, for a qualified plan, the calendar year in which the owner retires from employment. There is a qualified plan exception for less than 5% owners. In each year beginning with the year of the RBD, the owner must withdraw at least the Required Minimum Distribution (RMD).

Calculating Required Minimum Distributions (RMDs)
RMDs are calculated by dividing the prior year’s 12/31 account balance by the applicable life expectancy factor as provided by the IRS.

Life Expectancy Factors
There are different life expectancy factors for different account holders. That from the Uniform Table is used for an owner’s lifetime distributions. (This table recalculates life expectancy every year so that even someone age 110 has a life expectancy and will not be required to empty the account.) However, if the owner’s spouse is the owner’s sole beneficiary and is more than ten years younger than the owner, the Joint & Last Survivor Table is used instead of the Uniform Life Table during the owner’s life. The Single Life Table is used by all qualified beneficiaries after the owner’s death.

Planning Tip: When working with a qualified plan, be sure to read the plan agreement and become aware of optional plan provisions. If the custodian is not willing to do what the client wants, consider changing to a new custodian where possible or rolling the account assets into an IRA.

Spousal Rollovers
Only a surviving spouse can rollover an IRA (or qualified plan) into his/her own IRA. Once rolled over, the IRA is treated as if all contributions to it had been made by the surviving spouse. In other words, the surviving spouse uses the Uniform Table to determine RMDs, which must begin by the surviving spouse’s RBD.

Planning Tip: A surviving spouse can defer a rollover indefinitely. If the surviving spouse is younger than 59 ½, rolling over before attaining age 59 ½ risks incurring the 10% early withdrawal penalty. In such cases, consider establishing an inherited IRA and rolling over when the surviving spouse attains age 59 ½. If the surviving spouse is the sole beneficiary, his or her RBD from the inherited IRA is the same as was his or her deceased spouse’s RBD.

Qualified Plan Rollovers by Non-Spouse Beneficiaries
A non-spouse beneficiary is now allowed to do a trustee-to-trustee rollover of a qualified plan to his or her own Inherited IRA.

NOTE: All inherited IRA accounts must be titled in the original owner’s name for the benefit of the beneficiary (e.g., Mary Smith, Deceased, IRA f/b/o Jim Smith). Anything else is considered a 100% taxable distribution.

Designated Beneficiary
If there is a designated beneficiary of the inherited IRA or plan account, the designated beneficiary’s life expectancy is used to determine RMDs in years following the year of the owner’s death. This allows the inherited account to be distributed over the beneficiary’s actual life expectancy, resulting in maximum stretch out and tax deferral.

*    If there is not a designated beneficiary and the owner died before his or her Required Beginning Date, the account must be completely distributed by the December 31 following the fifth anniversary of the owner’s death (the “five-year rule”).
*    If there is not a designated beneficiary and the owner died on or after his or her RBD, the RMD is determined using the Single Life Table as if the owner were still living (the “ghost life expectancy rule”).

A designated beneficiary (as defined by Treas. Reg Section 1.401(a)(9)-4):
*    Must be named a designated beneficiary under the terms of the plan or by an affirmative election by the employee;
*    Need not be specified by name but must be identifiable on the date of death;
*    May be a class of beneficiaries capable of expansion or contraction (e.g., my children or grandchildren);
*    Must be an individual alive on the date of the owner’s death;
*    May be a trust if all of its beneficiaries who have to be considered are individuals alive on the date of the owner’s death, the oldest of whom may be determined (a “qualifying” trust).

A designated beneficiary is NOT:
*    an estate;
*    a charity;
*    a non-qualifying trust;
*    any non-individual other than a qualifying trust; or
*    an individual born after the date of the owner’s death.

The IRA Trust
The advantages of using trusts in general include spendthrift protection, creditor and predator protection, beneficiary divorce protection, special needs planning, consistent investment management, estate planning, and exercising control over the trust assets after the death of the trust maker.

Disadvantages of trusts include greater complexity; legal, accounting and trustee fees; and for trusts that are not required to distribute all their taxable income, greatly compressed income tax brackets (the 39.5% top income tax bracket for individuals begins at $400,000, for such trusts it begins at $11,950).

To be a qualified trust, and thus qualify as a designated beneficiary of an IRA or retirement plan account, an IRA trust must:
1.   Be valid under state law;
2.   Be irrevocable not later than the death of the owner; and
3.   Have beneficiaries all of whom are individuals who are identifiable from the trust instrument when considered on September 1 of the year following the owner’s death.

In addition, the documentation requirement for a trust beneficiary must be satisfied.

Planning Tip: A single revocable living trust would meet requirement #2 because it becomes irrevocable upon the trust maker’s death. However, unless it contains a “conduit” provision, discussed below, a single RLT is unlikely to satisfy requirement #3. A joint revocable living trust would not satisfy requirement #2 because it continues to be revocable until the death of the second spouse. For these and many other reasons, a specialized IRA trust is a preferable IRA beneficiary.

Planning Tip: The documentation requirement is fairly easy to satisfy, but it is vital not to miss the documentation deadline. The trust document must be provided to the account custodian by October 1 of the year following the owner’s death.

Types of IRA Trusts
Conduit Trust
The IRS regulations for IRA trusts provide an example that is commonly referred to as a “conduit” trust. This is a trust in which all distributions from the IRA are required to be immediately distributed to the trust’s beneficiary(ies). With a conduit trust, identification of countable beneficiaries and qualifying the trust as a designated beneficiary is easier because “downstream” and contingent beneficiaries are not considered. On the other hand, because all distributions, including RMDs, must be immediately distributed to the beneficiary(ies), those distributions are not asset protected as they would be if they could stay in the trust.

Accumulation Trust
An accumulation trust is one in which distributions from the inherited IRA may be kept within the trust rather than being distributed to the beneficiary(ies). That way, the trust assets have more protection against creditors and predators. This also more easily allows the beneficiary(ies) SSI/Medicaid eligibility to be preserved. On the other hand, an accumulation trust is a separate taxpayer and is subject to the compressed income tax brackets for undistributed income. Plus, the risk of the trust not being a designated beneficiary (and thus able to take advantage of the stretch) is greater because all beneficiaries have to be considered except those who are “mere potential successor” beneficiaries.

Example: The owner’s child is the primary beneficiary and a charity is the contingent beneficiary. With a conduit trust, the charity would not be counted and the child’s life expectancy would be used to determine the trust’s RMDs, which would produce maximum stretch out and tax deferral opportunity. With an accumulation trust, the charity would be counted and the trust would not be a “designated beneficiary.” That would cause the trust’s RMDs to be determined using the five-year rule or the owner’s ghost life expectancy, depending on whether the owner’s death occurred before or on/after his or her RBD.

In PLR 100537044, the IRS permitted a one-time “toggle” from conduit to accumulation trust. Having such a provision could be important if there is a change in circumstances of a beneficiary (disability, drug problems, etc.) between the time the owner set up the trust and September 1 of the year following the owner’s death. In the “toggle,” any general power of appointment given to a beneficiary must be converted to a limited power of appointment, which can create a Generation-Skipping Transfer Tax issue.

Planning Tip: Consider giving the Trust Protector the “toggle” power in any IRA trust to provide flexibility to deal with possible future events.

Separate IRA Trust vs. Trust in a Revocable Living Trust or Will
A separate IRA Trust is more likely to qualify as a designated beneficiary than is either a non-conduit RLT or trust established under a will.

Commonly encountered issues with using RLTs and trusts in wills as IRA/retirement plan beneficiaries include the possible adverse effects of formula funding clauses; pecuniary clauses and recognition of income; powers of appointment (can expand the class of potential beneficiaries); adoption effect clauses; provisions for payment of debts, taxes and expenses; apportionment language/firewall provisions; older or unidentifiable contingent beneficiary(ies), and non-individual remote contingent beneficiaries.

Drafting Issues and Beneficiary Designations
Revocable vs. Irrevocable
A revocable IRA trust allows for changes to be made easily, but it may open the IRA to the account owner’s creditors at death. See, Commerce Bank v. Bolander, 2007 WL 1041760, Kan. App. 2007. Making the IRA trust irrevocable will protect against the Commerce Bank case problem. Making the IRA trust irrevocable does not have to be a final decision by the IRA owner. While an irrevocable trust may not be changed by its maker, a competent IRA owner can always create a new IRA trust and make a new beneficiary designation pointing to the new IRA trust.

Beneficiary Designations—Separate Shares
If an IRA is payable to an IRA trust rather than the separate beneficiaries’ shares of the trust, the trust’s RMD will be determined by the life expectancy of the oldest trust beneficiary (problematic if one beneficiary is age 60 and another beneficiary is age 2). By contrast, if multiple sub-trusts of an IRA trust are allocated shares of an IRA in the beneficiary designation form, the IRA share of each sub-trust will be paid over the life expectancy of the oldest beneficiary of that sub-trust.

Disclaimer Planning
IRA trusts can contain credit shelter and QTIP trusts for the benefit of the surviving spouse. Proper structuring of the beneficiary designation allows for disclaimer planning for the spouse and other beneficiaries. Note that no further stretch is allowed after the death of the spouse with regard to IRAs not rolled over to the surviving spouse’s own IRA by instead going to a credit shelter or QTIP trust established by the IRA owner.

Planning Tip: The general treatment for disclaimer planning is 1) spouse; 2) if spouse disclaims, IRA trust (for funding of credit shelter/QTIP); 3) if spouse is deceased, to the separate IRA sub-trusts for descendants, per stirpes. Also, children can be given the power to disclaim so that IRA distributions can be stretched out over the owner’s grandchildren’s lifetimes.

Custom-drafted beneficiary designations are required to allow proper disclaimer planning and separate share treatment. (See planning tip above.) However, some IRA custodians will not accept custom beneficiary designations and insist on using their own forms, especially for “smaller” accounts (those under $500,000). In such cases, giving the custodian a choice between losing the account to a more reasonable custodian and accepting the proposed custom beneficiary designation may produce the desired result.

Conclusion
Naming a separate IRA trust as designated IRA or retirement plan beneficiary is preferable to naming beneficiaries outright. It ensures that the client’s goals are carried out, including that the client’s beneficiaries will use the IRA stretch out potential. It provides asset protection against predators, the beneficiaries’ creditors and loss upon divorce. It can provide bloodline protection, preventing unintentional beneficiaries and disinheriting of descendants. It provides for beneficiaries who have or later develop special needs without jeopardizing their valuable government benefits. And it can even keep the IRA assets under the client’s current advisor’s management.

Each client’s situation is different. For IRA trust planning, individual, case-by-case analysis with input from all advisors is essential.

With so much outdated and incorrect information about IRAs and IRA planning being tossed around, current and knowledgeable advisors will stand out and prove invaluable to both clients and the other members of the advisory team.

To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.

This simple income and capital gains tax planning trust strategy is one that advisor teams in those 40 states can use to distinguish themselves from other advisors and bring real value to their clients.[1] While this strategy has been underutilized in the 15 years since the Alaska Community Property Act was passed, the recent changes in income and capital gains tax rates have made it especially valuable.

In this edition of The Wealth Counselor, we will review the 2013 changes to the federal income and capital gains tax laws, explain community property law basics and tax benefits, explain how an Alaska Community Property Trust works, and identify some appropriate applications.

The Problem of Capital Gains Tax
Clients hate to pay capital gains tax to the point that they sometimes put themselves at risk to avoid this tax. Portfolios become unbalanced or over-weighted in one or two stocks because clients refuse to sell. Elderly clients are tired of managing rental real estate but won’t sell the property because of the capital gains tax.

Current Capital Gains Tax Rates
Under the Taxpayer Relief Act of 2013 and the Patient Protection and Affordable Care Act of 2010, the capital gains problem is much worse in 2013 for high income taxpayers. Here are the 2012 and 2013 capital gains tax rates for married couples filing jointly:

Adjusted Gross Income                            2012 Rate        2013 Rate
$250,000 to $450,000                               15%                 18.8%
Over $450,000                                          15%                 23.8%

Add State Capital Gains Tax
Several states now have their own capital gains tax. For example, Iowa’s is 8.98%; Hawaii’s is 11%; New Jersey’s is 8.97%. Alaska does not currently have a state capital gains tax.

Add Recapture of Depreciation
For depreciated property, a 25% tax rate will apply to recaptured depreciation. The 3.8% Medicare surtax will also apply to recaptured depreciation if the couple has adjusted gross income of more than $250,000.

Example: John and his wife Mary own an apartment building in Illinois that they purchased for $1 million in 1978. It is now worth $10 million. If they sell it, they will have a gain of $9 million. The property has a depreciated basis of zero, so they will also have $1 million of depreciation recapture. They have more than $450,000 in other income. Here’s what will happen if they sell their apartment building and why they may not want to:

20% Federal capital gains tax (on $9 million)       $1,800,000
25% Depreciation recapture tax (on $1 million)         250,000
3.8% Medicare surtax (on $10 million)                      380,000
5% Illinois capital gains tax (on $10 million)              500,000
Total Tax                                                              $2,930,000

 
The Hold Until Death Strategy
IRC Section 1014 provides that the basis of property acquired from a decedent that is included in the decedent’s estate for estate tax purposes is its fair market value at 1) the date of the decedent’s death or 2) optionally in a few cases, six months after the date of the decedent’s death. Generally, this results in a “step up” in basis as most property appreciates in value over time due to the effect of inflation. (A “step down” in basis occurs if the market value goes down instead of up between acquisition and death.)

Planning Tip: Many people are tempted to hold onto appreciated property until they die so their children will get the step up in basis.

Example Variation #1: Assume that John is the sole owner of the apartment building and leaves it to Mary upon his death in 2013. Under IRC Section 1014, Mary receives a “step up” in basis to $10 million, the fair market value of the property. If Mary then sells, there is no tax on the gain or depreciation recapture – a tax savings of more than $2.9 million.

Example Variation #2: Assume John and Mary own the building jointly and John dies. IRC Section 1014 provides Mary a “step up” in basis on John’s half of the property to $5 million. Added to Mary’s basis on the other half, that results in a new basis for Mary of $5 million. Upon sale by Mary at $10 million, capital gains tax and recapture is still over $1.4 million.

Community Property
Community property states have marital property laws that were derived from Spanish or French law whereas the “common law” states’ marital property laws were derived from English law. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. In 1998 Alaska adopted a law that allows a married couple to opt in by written agreement to the community property regime.

Each state’s community property law is slightly different from those of the other community property states, but, in general, a community property regime is similar to a partnership. Each spouse has a one-half undivided interest in the community property, so the property is held as a whole and cannot be divided into his/her shares.

Death Basis Adjustment of Community Property
IRC Section 1014 also provides a special rule for any community property owned by the decedent and the decedent’s spouse. For such property, the IRC Section 1014 basis adjustment applies to both the decedent’s interest in the property and the “property which represents the surviving spouse’s one-half share of community property held by the decedent and the surviving spouse under the community property laws of any state or possession of the United States.”

Here’s how that works:

Example Variation #3: Assume John and Mary own the building as community property. When John dies, the property will receive a full “step up” in basis for Mary to fair market value of $10 million. If she sells it at $10 million, there will be no capital gains tax. Community property treatment thus saves about $1.4 million in capital gains tax. If Mary doesn’t sell, she can depreciate the property’s improvements at its new basis of $10 million minus the value of the land.

Planning Tip: The result is that appreciated real estate, marketable stocks or family businesses held as community property can avoid all capital gains tax upon sale after the death of the first spouse.

The Alaska Community Property Trust
In our example, John and Mary do not have to move from Illinois to a community property state (and there enter into an agreement converting their marital property into community property) to achieve the result of Example Variation #3. Instead, they can, while remaining Illinois residents, establish an Alaska Community Property Trust and transfer the appreciated property to it while converting it to community property.

An Alaska Community Property Trust thus allows John and Mary to take advantage of Alaska’s community property laws and have their Chicago apartment building characterized as community property.

How It Works
Under the Alaska Community Property Act, Alaska resident married couples may “opt in” to the community property regime, thereby converting some or all of their marital property to community property by written agreement. Under the Alaska Community Property Act, married couples who are not Alaska residents also may “opt in” to Alaska’s community property regime by creating an Alaska Community Property Trust. Such couples may also specify which trust assets they want to become community property.

An Alaska Community Property Trust is a joint revocable living trust. However, the Alaska Community Property Act imposes certain conditions on it. It must have an Alaska trustee, which can be a bank or trust company that exercises trust powers in Alaska or an individual whose true and permanent home is in Alaska. Also, the Alaska trustee must have at least certain specified powers or responsibilities regarding the trust, which do not have to be exclusive. Thus the trustmakers may serve as co-trustees to manage the property and assets held in the trust, and to take the income and, upon the death of the first spouse, have the trust assets “pour over” into the spouses’ home state revocable living trusts.

Planning Tip: Assets transferred to the Alaska Community Property Trust will be titled in a way similar to: “John and Mary Smith, Trustees, and ABC Trust Company, Administrative Trustee, of the John and Mary Smith Alaska Community Property Trust dated ____________.”

Planning Tip: Asset accounts can continue to be managed by the current advisor. An additional statement will need to be provided to the Alaska trustee.

Planning Tip: An Alaska bank or trust company’s annual trustee fee for the minimum services and responsibilities required by the law is likely to be around $2500 per year. Fees are not fixed by law and so a trustee may charge less, especially if the client has another relationship with the bank or trust company. The client can determine if the benefits exceed the costs by comparing the trust creation and maintenance fees over the oldest client’s life expectancy to the amount of capital gains tax that having the trust will avoid.

What to Look for When Evaluating Clients for this Strategy
Clients who are good prospects for establishing an Alaska Community Property Trust are married couples who are not community property state residents and who have one or more of these characteristics:
*    They are in a long-term, stable marriage;
*    They own (or one of them owns) highly appreciated property, stocks, real estate or business interests;
*    Their financial portfolio is over-weighted in one or two stocks that they refuse to sell because of exposure to capital gains tax;
*    They have rental real estate that the likely survivor does not want to manage;
*    They are older or at least one has a reduced life expectancy.

Couples Less Likely to Benefit from Using this Strategy
Clients who are not good prospects for establishing an Alaska Community Property Trust are those with one or more of these characteristics:
*    They have a recent marriage, especially one where property is kept separate;
*    They have an unstable marriage;
*    They have limited low basis property;
*    They are in a second (or subsequent) marriage with prior-marriage children where property is kept separate.

Planning Tip: Advisors in community property states should also be aware of this strategy for their clients who have relocated to a non-community property state.

Alaska Community Property Trusts Benefit Clients and Advisors
Clients
The Alaska Community Property Trust is value-added planning for your clients and is only a part of a more comprehensive plan. It can provide substantial tax savings for the right clients and particularly benefits the surviving spouse more so than the children. It can empower a surviving spouse to diversify their portfolio by removing the capital gains tax exposure. For example, a surviving spouse who has not been involved in the management of rental properties can sell them without paying any capital gains tax.

Advisors
The financial advisor can continue to manage accounts while the property is in the Alaska Community Property Trust and increase capital under management when non-managed property is sold following the death of the first spouse. The advisor who begins to actively promote these trusts has an opportunity to distinguish himself or herself in the community.

Educating the Client and Advisors
The Alaska Community Property Trust is not a well-known strategy and is underutilized by many estate planning lawyers and CPAs. It is often confused with the Alaska Domestic Asset Protection Trust, which is completely different.

Here are some suggestions to help you get started:
*    Identify clients with appreciated property.
*    Calculate their current capital gains tax exposure, including recapture of depreciation.
*    Calculate their capital gains tax exposure if the surviving spouse sells and receives a “step up” in basis on half of the property.
*    Demonstrate the real tax savings potential to clients who would benefit greatly from using the technique.
*    Estimate the costs, including legal and trustee fees, over the life expectancy of the spouse who is expected to die first.
*    Compare those costs to the estimated tax savings at the time of sale (and don’t forget to factor in anticipated asset appreciation to the first death).
*    Team with a WealthCounsel attorney who is familiar with drafting Alaska Community Property Trusts, and who can discuss this strategy with clients and other advisors as needed.

Planning Tip: The Alaska Community Property Trust works well with assets that have been placed in a Limited Liability Company or Family Limited Partnership. (The Alaska Community Property Trust will simply hold a membership interest in the LLC or limited partner interest in the FLP.) It also can work well with buy/sell agreements for family businesses.

Conclusion
The Alaska Community Property Trust offers an exceptional opportunity for the advisory team to collaborate to provide powerful tax savings for their clients. In addition, when an asset is sold without having to pay capital gains tax, the client will have more capital available for additional planning, such as dynasty trusts, and money management for the investment advisor.  Therefore, Alaska Community Property Trusts offer a true win-win for clients and the advisors who recommend this strategy.

[1] The Alaska Community Property Trust is a completely different vehicle than the Alaska Domestic Asset Protection Trust.

A Passive Foreign Investment Company, or PFIC, is a foreign corporation where passive income constitutes 75% or more of gross income during a year. A corporation is also considered to be a PFIC if 50% or more of corporate assets are held for production of passive income.

The PFIC rules deter taxpayers from seeking unlimited income tax deferral inside foreign corporations. They also seek to limit the ability of investors to convert ordinary income into capital gains through the same foreign entities. The PFIC rules impose a hefty interest charge on any deferred payments within a PFIC, and they treat all PFIC distributions as ordinary income regardless of its capital gains status.

In trying to determine if a foreign corporation might be classified as a PFIC, it is important for this discussion to know that income that is derived from “active banking” is excluded from the definition of “passive income.” In other words, banks are allowed to engage in banking activities without the threat of income from those activities being classified as passive, and without the banks being deemed PFICs. For investors, that means you can invest in foreign banks without the risk of hefty charges and the loss of capital gains status under the PFIC tax laws. This exception exists as a policy matter, so that investors in the US won’t fear investing in foreign bank shares.

The Problem

In recent years, economies have been shaky and foreign banks have invested quite heavily in US government securities (bond investments produce passive, non-banking income), rather than putting those funds to work in “active banking” (lending, etc.). The question this forces is, whether the increased degree of passive income in the foreign banks push them over the limit and trigger the harsh application of the PFIC rules? Will foreign banks be deemed PFICs, and will US taxpayers be punished with harsh charges on those investments?

The Solution

To address this question, the IRS issued a notice in late June of 2012. The notice stated that for tax years 2011 thru 2013, income from certain government bonds held by “active banks” will be treated as if it was earned from active banking. Thus, foreign banks can invest in US government securities, US taxpayers can invest in foreign banks, and otherwise passive income from the banks’ US securities investments will be ignored for PFIC determination.

It is important to understand that this does not avoid investor income tax obligations, but rather the imposition of the burdensome PFIC tax penalties. Essentially the IRS is recognizing that in the current global economic environment (low interest rates, soft economies, etc.) banks are going to need to invest more in government securities. Foreign banks investing in US government bonds are not having that income interest counted as passive income, and US investors are being allowed to avoid PFIC penalties on investments in these foreign banks.

You don’t — if you fall into one of two groups:

• Owners who are sure that their business exits are more than 10 years away.
• Owners who are certain that the value of their companies is miniscule compared to what they will need upon sale or transfer.

Most owners, however, look to the value of their businesses as the chief source of liquidity for their post-exit lives. We intend to leave as soon as it is feasible rather than when we are completely burned out. Therefore, most of us need to know the value of our companies now so we can be smart about creating greater business value in as short a time as possible.

Knowing the value of your business today is critical whether you plan to leave your business tomorrow, or in five years because:

1. An estimate of value establishes your starting line and distance to the finish.
   An estimate of value tells you where your unique race to your exit begins. Your job, whether your company is worth $500,000 or $50M, is to fill the gap between today’s value (the starting line) and the value you need when you exit (the finish line). Based on today’s value, your race to the finish may be shorter, longer, or perhaps much longer, than you expect. Once you know how far you and your business need to travel, you can begin to create timelines and implement actions to foster growth in business value.
2. An estimate of value tests your exit objectives.
   An estimate of value helps you to determine if your exit objectives are achievable. Let’s assume that you decide that your finish line (financial objective) is to receive $7,000,000 (after taxes) from the transfer of your business interest. You also want to complete your race in three years (timing objective). An estimate of value will tell you if the distance between today’s value and the finish line is too great to reach in three years. If a growth rate is unrealistic for your business, you must either extend your time line or lower your financial expectations.
3. An estimate of value provides important tax information.
   First, an estimate of value gives you a basis for analyzing the tax consequences of Exit Path alternatives. Once you choose your path, the value estimate provides a basis for your tax-minimization efforts. Taxes can take a significant chunk out of a business sale price so the value of your company (what a buyer pays for it) must usually exceed the amount of money you need to fund your post-exit life. The size of that excess depends on how you and your advisors design your exit, and exit design in turn begins with knowing starting value and the distance to your finish line.
4. An estimate of value gives owners a litmus test.
   When owners know how much value they need to create to meet their objectives, it helps them determine where they need to concentrate their time and effort. Instead of growing value for the heck of it, dedication to a goal enables many owners to exit sooner with the same amount of after-tax cash than owners who do little or no planning. Exit plan success all begins with a starting value.
5. An estimate of value provides an objective basis for incentive plans.
   As you design incentive plans for key employees (such as Stock Purchase, Stock Bonus and Non-Qualified Deferred Compensation Plans) to motivate them to increase the value of your company (so you can successfully exit) you must base these plans on an objective estimate of value. You and your employees need a current value (or starting line) that you all can confidently rely on.

This is Not a Full-Blown Valuation!

I know you are thinking, “How much is this going to cost me?” But I’m only suggesting that you need an estimate of value to establish a benchmark, not the opinion of value which precedes your transfer of ownership, years from now.

Estimate of Value

An estimate of value:

• Costs about half as much as a standard valuation opinion,
• Is the basis for the (later and) complete valuation, but
• Lacks the supporting information contained in a written opinion of value, and
• Is used for planning only. It cannot be relied upon for tax or other purposes.

Failure to Value

On some level, we all recognize that we will leave our businesses some day. While you may not yet have a vision for the second half of your life, you do understand that the exit from your company is likely to be the largest financial transaction of your life. Does it make sense to go into that transaction and into the second part of your life without an objective understanding of your company’s value?

An estimate of value can save precious time as you build value and achieve the exit of your dreams.

If you would like a copy of our White Paper that explains the hows and whys of valuation in more detail, please contact me.

Subsequent issues of The Exit Planning Review™ provide balanced and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

What information is the IRS seeking?

The IRS wants better information on foreign account-holders who are subject to US tax authority.

Participating FFIs will have to report the following to the IRS:

• Information about financial accounts held by U.S. taxpayers:
  • Account numbers
  • Account balances
  • Income paid or credited to the foreign account
  • Identification of each U.S. taxpaying account holder
  • Foreign entities in which U.S. taxpayers hold a substantial ownership

Why is the IRS seeking this information?

With increased globalization of investments, securities, and financial institutions, there is a strong tax incentive to “jurisdiction shop” for lower taxes or, in the case the IRS is most concerned about, to hide income and assets from the view of the IRS in an effort to unlawfully avoid taxes altogether. These information-sharing requirements seek to capture information that the IRS would not otherwise have access to.

How is the IRS going to incentivize and enforce the agreements?

Questions arise regarding the ability of the IRS to engage FFIs in these agreements and in the ability of the IRS to then enforce them. After all, tracking and reporting all this information will come at a huge cost and that cost will be imposed upon the shoulders of the FFIs. Also, the IRS has no jurisdictional legal backing to exercise authority over non-U.S. foreign institutions, so why should they take on this duty to report?

The IRS may not have the ability to directly incentivized or enforce the FFIs, but they can influence US Persons (those subject to US federal tax laws) who are depositors and investors abroad. So, what will the IRS do? If an FFI chooses not to participate, the IRS will impose a FATCA withholding on payments received by US taxpayers. This withholding, a tax on failure to report, will be implemented in 2014. This increased tax on no reporting FFIs will be sure to drive away US tax-paying depositors and investors. So, FFIs will be highly incentivized to agree, comply, and report, in order to keep their foreign account holders happy. The same withholding will also be imposed where FFIs are signed up to report, but where account-holders fail to provide required reporting documentation directly to the FFIs.

What are the Filing Requirements for US Taxpayers?

Any taxpayer holding foreign financial assets totaling more than $50,000 ($100,000 for jointly filed returns) must report information about those assets on Form 8938. This informational return is attached to annual tax returns. There is a $10,000 penalty for failure to report foreign financial assets. That penalty can go up to $50,000 for continued failure to report. Additionally, filing Form TD-F 90-22.1, Report of Foreign Bank and Financial Accounts, may also be required.

The clearest example of a failure to set objectives may be Bill Wilson (not his real name), a business owner who recently told us that he wanted:

• To leave his business within three years, but he was ready to leave today;
• Financial security, defined as a seamless continuation of his current lifestyle; and
• To transfer the business to his key employees.

A quick review of Bill’s personal financial statement, however, revealed that most of the income required to maintain his lifestyle would have to come from the business. Unfortunately, his business wasn’t large enough to attract a cash buyer. And, since Bill had done no Exit Planning, his employees had no funds with which to purchase his ownership interest. A long term installment note seemed to be the only answer — a risk Bill was unwilling to take.

Contrast this unpalatable solution with Bill’s objectives — objectives which could have been achieved had he taken the time (well before he wanted to leave the business) to establish and to prioritize his Exit Objectives.

If, for example, an owner’s need for financial security prevails, selling a business to a third party for cash may be the best and quickest exit path.

If, however, attracting a qualified third party is unlikely, an owner may need more time to devise and to implement a transfer to an insider (child or employee) that provides the owner adequate cash.

On the other hand, if an owner’s desire to transfer the business to a specific person or group trumps his or her need for financial security, and his/her deadline for departure draws near, financial security in the form of “up-front” cash must take a backseat.

As you can see, owners must consider—simultaneously—the three primary exit goals (listed below). Ask yourself which is your most important exit objective and rank your answers from 1 (most important) to 3 (least important).

• Financial security:
  1    2    3
• Transferring the business to the person of my choice (may include key employees, co-owner or child):
  1    2    3
• Leaving the business when I want (could be immediately or never):
  1    2    3

Prioritizing your objectives will help you choose your overall path. For example, if you want out—soon and with cash—but your business cannot be sold today, do you wait until market conditions improve or sell now to your employees? While prioritizing your objectives is not easy, doing so gives you a framework to decision making.

We suggest that you print this issue of The Exit Planning Review™ so you can complete the rankings above and share this information with members of your Advisor Team. We encourage you to contact us as you work through these decisions. With fresh eyes and experience with other owners we can help you to balance these competing objectives.

Subsequent issues of The Exit Planning Review™ provide balanced and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

The features of the Roth 401(k) mirror those of the Roth IRA, but have a higher contribution limit ($17,000 for 2013) like a traditional 401(k). Specifically, contributions are not deductible and withdrawals are tax-free. By paying taxes now, one doesn’t have to worry about paying taxes when he withdraws money from his Roth 401(k) later. Money withdrawn from a traditional 401(k), of course, will be taxed as ordinary income.

The big question investors have to grapple with is why they would rather pay taxes now instead of later — especially when there is no way to know where tax rates will be in the future. It’s a decision that should be carefully weighed, but a mix of tax-free and taxable income in retirement clearly has its benefits.

A Roth 401(k) also provides more flexibility when it comes to managing income and some less obvious payoffs as well. A traditional 401(k) requires you to begin taking distributions in the year your turn age 70½ (or, if later, the year you retire) — and then you pay taxes on that income. With the Roth 401(k), there is no required minimum distribution (if you roll the Roth 401(k) into a Roth IRA). That means you can choose to leave your funds invested and reduce your gross income.

Regardless of what happens to tax rates, if you have to take a distribution from a traditional 401(k) that could bump you into a higher marginal tax bracket as well as reduce the net value of your Social Security benefit and increase your Medicare costs.

It should also be noted that any employer-match contributions made to the plan must be deposited into a traditional 401(k), so participants in the Roth 401(k) will essentially have two plans. The traditional portion can be rolled into a traditional IRA upon retirement and the Roth portion to a Roth IRA.

If the Roth 401(k) sounds like an appealing option for your personal situation, we recommend inquiring with your employer to see if it is offered at your company.

Know that in your indecision, you are making a decision. As Winston Churchill observed, “I never worry about action, but only about inaction.” When you take a passive attitude toward the irrefutable fact that you will–one way or another–leave your business, you are deciding to settle for a least profitable exit for yourself and for your family.

If you are an owner who isn’t sure about what you want, or when you want to leave, why is it so important to decide to act today? Why can’t you wait?

• Preparing and transferring a company for top dollar takes time—on average about 5 years. Most of those years will be spent preparing the business for the transfer. If you decide to sell to employees or children (two groups who rarely have any money), they’ll need that time to earn the money to pay you for your interest.
• More time often equals greater reductions in risk. Time can be used to design and implement income tax-saving strategies, build value, strengthen your management team, begin a gradual transfer of ownership (not control) to key employees or children. If you wait too long, you probably won’t have time to implement these strategies and you’ll likely end up transferring your business on less-than-ideal terms.
• The market does not operate on your schedule and may not be paying peak prices when you are ready to sell to an outside party. Witness the state of the M&A market in 2008 and 2009: activity is almost non-existent in many business sectors and down in almost all.

If leaving a company you’ve worked so hard to build and having little or nothing to show for it, is unacceptable to you, let’s look at a few of your options.

Wait for a buyer. According to Deloitte’s Entrepreneurship UK: 2008 survey, 35 percent of business owners said they will wait for a third-party offer for their businesses. Owners in this group believe that one day a buyer will contact them, negotiate a sale, and that will be that. Well, this is a decision of sorts—but one that flies in the face of reality. While few businesses are being sold today, there will likely be a significant number of Baby Boomer business owners vying with you to sell their businesses when the M&A market recovers.

In a competitive buyer’s market, only the best-prepared businesses sell for top dollar. And the owners of those well-prepared businesses will be those who made the decision to act to prepare their company years ahead of the actual sale.

Liquidate. Liquidation is a common exit path for owners of companies whose cash flow is flat and has little probability of improving—absent the design and execution of a business/exit plan. If you find yourself in this group, we recommend that you meet with your tax and other advisors to do the planning necessary to create the most tax-efficient liquidation possible.

Decide to exit and plan accordingly. Start today and take the following steps:

1. Fix a departure date.
2. Determine your financial needs.
3. Decide whom you want to succeed you.
4. Have your business valued to see if: a) should you sell today; and/or b) it has the value necessary to meet your financial and other exit objectives.

Based on your objectives and the realities of your business, use a skilled Exit Planning Professional to forge a plan with accountability/decision deadlines.

Deciding to do something now to create the best possible exit path is not difficult. The failure to act, however, can potentially be fatal to a successful exit. The success of your business exit is simply too important to you (your family and your employees) to leave to chance. Why wait? Why decide not to decide?

Subsequent issues of The Exit Planning Review™ provide unbiased and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.

For example, many foreign countries income tax an employee’s incentives stock options at the time of grant. The US income taxes the worldwide income of US expatriates, and, more specifically, recognizes incentive stock options that are given to an employee not at the time of grant, but at the time they are exercised. If the year of exercise is in a later tax year than the year of grant, the foreign jurisdiction would impose a tax in the year of grant, and the US would impose a tax in the year of exercise. There would be no foreign income tax credit for the options in the year of exercise since that tax was imposed in a prior year. This would result in very unfortunate double taxation!

Fortunately, there is a way to avoid this terrible outcome. The US expatriate should make an Internal Revenue Code section 83(b) election upon grant of the options. This code section permits taxpayers to make an election to recognize options as income, recognized at the time of the grant, rather than at the later time of option exercise. Doing this should sidestep the double taxation issue by bringing foreign and US income taxation of the options into the same year and allowing the foreign tax credit to offset US income tax on the options.

An additional benefit of making the election is that any gain realized between option grant and exercise would be taxed at the preferential capital gains rate instead of at the ordinary income tax rate.

Example—Double Taxation!

Assume a $1 million option grant is made to a US expatriate, residing in a foreign country. Assume, as well, that the applicable US income tax rate is 35% and that the foreign rate is 20%. At the time the options are granted, foreign income tax would be due in the amount of 20% of $1 million, or $200,000. In the next year, the US expatriate exercised the options, and the US tax is triggered in the amount of 35% of $1 million, or $350,000. Total taxes paid are about $550,000!

Example—83(b) Election, No Double Taxation!

Same facts as above with the exception that the US expatriate elects for the options to be taxed by the US at the time of grant (instead of at the time of exercise). US taxes would be 35% of $1 million and foreign taxes would be 20% of $1 million. On the surface this looks like $550,000 in taxes, just like the previous example. However, since both taxes applied in the same year, the foreign tax credit is triggered to offset US taxes in an amount up to the amount of foreign taxes already paid. Thus, $200,000 in foreign taxes paid is credited against the US tax burden of $350,000, leaving a US taxes owed at only $150,000. The final tax rate is only $350,000 ($150,000 to the US and $200,000 to the foreign jurisdiction).

Separately, it is noteworthy that if a foreign tax is imposed at option grant, rather than at exercise, there is a chance that the options might be taxed and yet expire worthless before they can be exercised in-the-money.

Options can be complex. International taxation can be complex. Combine the two and expert assistance is essential.

Many of you find yourself in the same predicament. You are able to envision your life beyond business ownership, but you don’t have a clear picture of how best to “leave your business in style.” So what do you and the Nora Chapmans of the world do? Here is what we told Nora.

First, understand that leaving your company is a process. Realizing that life after your business exit can be as fulfilling as your life as a successful owner is simply the first step. The next step is to figure out a way to approach your exit in a methodical, logical, rational manner. Most owners do not put enough thought and planning into their exits because they don’t know how to begin, that there’s a proven process available to them, or exactly what issues to consider and analyze.

If that describes your situation, you are not alone. Most owners, and their advisors for that matter, don’t know that there is a planning and an implementation process that is methodical, rational and can be tailored to your unique exit goals. It is The Seven-Step Exit Planning Process™.

This Process begins with setting your exit objectives and understanding the value of your business. Based upon what you want and what you have, you can then examine and choose a proper path for you: be it a sale to a third party, a transfer to children, a sale to an ESOP, a sale to a co-owner, or an orderly liquidation. As part of this Process, you also must consider what would happen to the business and to your family in the event your death or disability precedes your planned exit.

Simply knowing the process and proceeding down the Exit Planning path, however, is insufficient. According to the Small Business Administration (SBA) most business owners who begin the planning process fail because they fail to plan. To succeed, you need a written plan that:

• Identifies your exit, financial and other objectives that must be considered; and
• Documents how you are going to achieve those objectives.

Along with this written plan you must have a checklist that:

• Assigns responsibility for each task to be completed throughout the Exit Planning process;
• Sets dates for each task to be completed; and
• Designates the person responsible for completing each task.

How do you begin? 

“Let us, therefore, decide upon the goal and upon the way and not fail to find some experienced guide who has explored the region towards which we are advancing; for the conditions of this journey are different from those most travel.” — Seneca, “On the Happy Life” (AD 58)

As skilled and as successful as most business owners are, they cannot, working alone, create and execute their Exit Plans. Rarely have owners made a career of exiting businesses. Those owners who do attempt to craft their own Exit Plans usually fail and, at best, they leave a lot on the table: a lot of money, time and/or their own happiness.

And, as skilled as is your attorney, CPA or financial and insurance representative, acting alone, each is unable to craft a successful Exit Plan. Successful Exit Planning is a multi-disciplinary effort that requires you and your advisors working together. No one profession possesses the breadth of knowledge necessary to advise a business owner on the wide variety of Exit Planning issues.

For your Exit Plan to succeed, you need legal expertise, financial advice, tax planning, financial advisory input, and often, consulting ideas. If you decide to sell to a third party, you may require the services of a Business Broker or Investment Banker. No one advisor can be an expert in all aspects of exiting a business.

What does it take to create an Exit Plan?

• Understand that there is a proven Exit Planning process. Learn as much as you can before you make final decisions.
• Commit to see the process through—holding yourself and others accountable.
• Document your decisions and create a written plan.
• Hire an experienced team of professionals—attorney, CPA and financial or insurance representative (at a minimum) to help guide you through this process. These professionals should more than pay for themselves by putting money in your pocket. If they cannot, you have the wrong team.

If you are to exit successfully, there is much to do. We can help by providing more detailed information on Exit Planning in general, and by giving you a sense of the time and resources this planning and implementation process will take.

Stay tuned for future issues of this newsletter for more information about various aspects of the planning process. Expect hints to save taxes, money, and time.

Subsequent issues of The Exit Planning Review™ provide balanced and advertising-free information about all aspects of Exit Planning. We have newsletter articles and detailed White Papers related to this and other Exit Planning topics. If you have any questions or want additional Exit Planning information, please contact us.

Article presented by Katie Horton, Integrated Wealth Counsel, katie@integratedwealth.com, a Member of Business Enterprise Institute’s International Network of Exit Planning Professionals™.  © 2012 Business Enterprise Institute, Inc.