News, Events & Blog
Congress recently passed the Tax Cut and Jobs Act (“TCJA”) earlier this year, the largest revision to the tax code in thirty (30) years. Among the many changes are significant increases in the Estate, Gift, and Generation-Skipping Transfer (GST) tax exclusion amounts. In effect, this means that fewer families will be subject to such transfer taxes and that many estate plans will need to be updated to properly address the new law. The changes under the TCJA present an important opportunity for high net-worth individuals and families to review their current estate planning documents and ensure that their plan is properly tailored to achieve their goals.
Overview of Changes
The most significant change is the doubling of the unified Estate and Gift tax exclusion amount – the combined amount that individuals can give away during life or at death before paying transfer taxes – from $5.59 million to $11.18 million per person. The new tax law also preserves “portability,” a surviving spouse’s ability to retain any estate or gift exclusion unused by a deceased spouse, meaning that for married couples, the exclusion is effectively $22.36 million. This exclusion is inflation adjusted, but current law provides that this doubled exclusion sunsets December 31, 2025, after which estate taxes are slated to revert to current levels.
The new law also increases the amount each person can make exempt from the GST tax. As with the estate and gift tax exclusion, the new GST exclusion will increase from $5.59 million to $11.18 million per person (in 2018 as indexed for inflation). Unlike with the estate and gift tax, however, there is no “portability” for GST taxes. Thus, each spouse must use their own GST exclusion before they pass.
In addition to the changes made by the new tax bill, 2018 also brings a routine increase in the annual exclusion from the Gift tax to $15,000 per person, per year. This annual exclusion allows each individual to make a gift of $15,000 to any other individual (and in some cases trusts) without reducing their lifetime Estate and Gift tax exclusion amount.
Review of Your Estate Plan
The changes in the Estate, Gift and GST tax law mean that many estate plans should be revised to take advantage of tax changes, ensure existing tax formulas still achieve the intended results, or simplify complex planning that is no longer necessary and shift a focus towards income tax planning for beneficiaries. There are also certain planning opportunities that you may want to explore.
First, the increased exclusion amount may be an opportunity to unwind complex planning that may no longer be needed to minimize transfer taxes. For instance, many estate plans created under assumptions of prior law provide that at the death of the first spouse, the deceased spouse’s assets are divided into two (2) separate trust shares: a Marital Trust for the benefit of the surviving spouse and a Credit Shelter Trust that may benefit the surviving spouse, your children and/or grandchildren, or combinations of those people. For married couples with large estates, this technique defers payment of any Estate tax until the passing of the second spouse. The trade-off is that the Credit Shelter Trust may not benefit the surviving spouse solely and the income tax basis of the Credit Shelter Trust is locked into place upon the first spouse’s death. Many couples who used such techniques to minimize Estate tax prior to the new increased exclusion amounts will prefer for the surviving spouse to retain greater control of assets and plan for the remainder beneficiaries to receive a step-up in income tax basis for all of the assets upon the surviving spouse’s passing. ShuffieldLowman can assist you with weighing that control over the asset protection and the certainty of the Credit Shelter Trust to determine what is best for each family.
As mentioned above, another scenario involving Marital and Credit Shelter Trusts may play out in other plans containing “formula gifts.” Certain estate plans leave assets up to the Estate tax exclusion amount to a Credit Shelter Trust for the benefit of children or grandchildren and leave assets in excess of that amount to a Marital Trust for the benefit of the spouse. Because the Estate tax exclusion amount is now so large, this could mean unintentionally disinheriting the spouse and leaving all assets to the Family Trust or just leaving significantly less to the surviving spouse than intended.
Next, we do not know if the federal increased exclusion amounts will not be extended and will in fact expire in 2025, which is what the TCJA provides. Under a subsequent administration the exclusion amounts may even return to the lower levels of the past that existed for most of the 2000s. If either of these events does indeed occur, then the current increase in the exclusion amounts provides a temporary, “use it or lose it” opportunity to transfer assets outside your taxable estate, thereby “locking in” the current exclusion amount before it is reduced and freezing values from future appreciation. This estate tax planning might involve increased contributions to Irrevocable Trusts such as Irrevocable Life Insurance Trusts, Intentionally Defective Grantor Trusts (IDGTs), sales to these types of trusts, forgiveness of intra-family promissory notes, or other wealth transfer vehicles. You may want to consider further planning using the increased exemption amounts to remove assets from the estate.
Finally, some clients may even wish to use the increased exclusion amount to unwind prior planning and bring assets back into their gross estate to obtain a step-up in basis in those assets to fair market value at the time of their death. This type of planning is geared toward reducing income tax liability of your beneficiaries upon the sale of the inherited assets.
These are just a few examples of the many ways in which the TCJA may affect your estate plan. The TCJA makes significant changes to the Estate, Gift and GST tax regimes. If your estate plan was implemented under previous law, it would be beneficial to review your plan to ensure it accomplishes your current goals in light of these changes. If you would like a comprehensive review of your estate plan, contact ShuffieldLowman today.
The IRS has announced two new and highly sophisticated approaches to criminal tax enforcement. The first, called the “data initiative”, sounds similar to the data analysis first used by FinCen to uncover money laundering operations. It will consist of data analysis from information provided by field offices throughout the country. This will allow the IRS to identify areas of non-compliance that have nationwide impact and use its resources to coordinate investigations and provide greater support to the field agents. It will also help to deal with decreasing personnel and resources due to budget constraints. The initial projects will focus on international tax enforcement, employment tax and SEC microcap fraud. It is also expected to identify new areas of non-compliance and start investigations in these new areas.
The second “new” program will be a specialized group of agents already experienced in international tax enforcement. Their expertise will provide specialized skills and knowledge in this area of enforcement. Their efforts, along with the Department of Justice, international tax partners and information gathered from the Bank Secrecy Act, FATCA, whistleblowers, the Offshore Voluntary Disclosure Programs, the Panama Papers, etc., will allow them to identify, through data analysis, new or continuing non-compliance in the international area. Initially, the group will consist of 10 to 12 special agents working out of the Washington D.C. field office. Others will be located at “strategic” locations around the country.
These new programs should give further incentive to those who have yet to avail themselves of the Offshore Voluntary Disclosure programs to give further serious consideration to doing so. Time continues to run out for those continuing to believe they will not be discovered.
Tax filing time is upon us again. But some taxpayers are in a tough spot. They may not have filed for prior years and are afraid that, if they do so now, their prior failure to file will come to light and lead to serious consequences, including criminal prosecution. This is known as the “snowball effect”, where one failure to file leads to another resembling a snowball rolling down a hill and getting bigger and bigger as each year goes by.
The consequences of not filing your tax return can be both criminal and civil. On the criminal side, if the failure is “willful”, meaning you knew you had a duty to file but chose not to, the government could charge a violation of 26 U.S.C. 7301, punishable by up to 1 year in prison and a $25,000 fine for each year. In more elaborate circumstances, the government has also charged a felony violation under 26 U.S.C. 7201, the evasion statute, citing the failure to file as the method of evasion. This crime is punishable by up to 5 years in prison and a $100,000 fine for each year involved.
In the past 4 years, the IRS initiated 977 criminal investigations of non-filers. Of these, the IRS recommended prosecution in 712 cases. Over 751 (not all cases are completed in the same year) were convicted and sentenced. Of these, approximately 83.2 percent received prison time with an average incarceration sentence of 39.7 months (there is usually more than 1 year involved).
So how does the IRS discover non-filers? The IRS has computer programs that match information returns (1099s; W-2s; etc.) to filed returns. If there is no match because the taxpayer didn’t file, an investigation is initiated. Another computer program, called the “Stopfiler” program, which identifies those who have filed a return in the past and then stopped filing, which also results in an investigation. Add to this informants, undercover operations of return preparers and tax protest leaders. The list of informants runs the gamut of whistleblowers, motivated by hopes of an award, to disgruntled ex-employees (especially book keepers), ex-spouses, scorned lovers, jealous neighbors and business partners. Often, an audit of someone or something else can lead to you as the other party may reflect payments to you and the IRS contacts you to confirm you received the payment. With the recent enactment of the Foreign Account Tax Compliance Act (FACTA), the IRS is now receiving information from foreign banks about their American customers, thus eliminating the former secrecy of those overseas accounts.
On the civil side, there can be other serious consequences. If you are convicted of a tax crime, there is a 75 per cent of the tax penalty. Accordingly, if you would have owed $100 in tax, now you owe $175. There are other civil penalties including a failure to file penalty that caps out at 25 percent of the tax owed. There is another failure to file penalty, called the fraudulent failure to file, which is a civil penalty but higher than the “normal” late filing penalty. It is 75 per cent of the tax due.
Another dangerous possibility is that the IRS can and does prepare what are known as 6020(B) returns or substitute for returns. They take the information received from third party payers, such as 1099s and W-2s and prepare a return for the taxpayer. Only the standard deduction and 1 exemption is used in computing the tax. This is then sent out to the last address of record of the taxpayer and, if he doesn’t respond, they assess that amount of tax against him. This is usually a much higher tax than that the taxpayer would have computed had he filed. While the IRS may reduce this assessment when returns are filed later, several courts have said it doesn’t have to do so.
So, what to do? The obvious answer is to file the returns. But there are a lot of considerations in doing so. Is the taxpayer already under investigation? Is any of his income from unlawful activities? Is any of it from off-shore entities or bank accounts? How much does he owe? What is his compliance history? Is he or a related entity under audit? The taxpayer needs to consult and retain an attorney who has experience in this area. While some accountants try to resolve these issues on their own, they do so at their and the taxpayer’s peril. This is because there is no accountant privilege in the Federal tax system in criminal cases. Accordingly, should a criminal investigation exist or arise while the accountant is working on the matter, everything a taxpayer tells that accountant must be disclosed by the accountant if he is interviewed pursuant to an IRS subpoena or a Grand Jury subpoena. Further, if such an investigation arises, the returns themselves may be exhibit “A” in the case. However, if an attorney, who has been retained by a taxpayer, in turn retains an accountant, the attorney/client work product privilege then extends to the accountant, thus preventing disclosure by the accountant without the taxpayer’s consent. This is pursuant to a case called KOVEL. Hence, the appellation, “Kovel accountant”. Further, there are considerations as to whether the filing of delinquent returns should be done by “quiet” disclosure or formal disclosure pursuant to the IRS voluntary disclosure policies for domestic and foreign disclosure.
The goal is to get the taxpayer into compliance while limiting the potential that he may be prosecuted. Understanding how the IRS deals with these types of cases is critical to accomplishing the desired result.
This year will be the first to see the implementation of new filing deadlines for many forms. The first new deadline, that will occur shortly, is for filing W-2’s, which is now January 31 instead of the previous February deadlines. March 15 is the new deadline for Form 1065 (partnership returns) and Form 1120 (S-corporation returns). This includes the K-1s. Each is extendable to September 15.
Next comes April 15. Forms 1040 continue to be due on this date, but FINCEN 114 (Report of Foreign Bank Account) is now due at the same time instead of June 30, as in the past. Form 1041 (Income Tax Return for Estates and Trusts) and Form 1120 (Corporate Tax Return) are due on April 15 and are extendable to September 30 and September 15, respectively.
Other forms, such as Form 5471 (Report of Foreign –Owned Corporations), that are due at the same time as some of the income tax returns, will change their due dates to correspond to the new due dates of these returns. Caution is advised in checking all deadlines and not simply relying on past experience.
In April 2016, over 11.5 million documents, some dating as far back as the 1970’s, were hacked from the Panamanian law firm Mossack Fonseca and released to the worldwide media. The papers include detailed information for over 214,500 offshore entities. Much of the information would normally be considered attorney client communications. These “Panama Papers” have disclosed that some U.S. taxpayers may have tax liabilities and possible criminal exposure.
The U.S. Justice Department has initiated a criminal investigation into these offshore tax schemes and the use of “shell” foreign entities to conceal the offshore holdings by both individuals and corporate entities. This may result in foreign banks turning over any records relating to the Mossack Fonseca firm. Of course, as these documents are analyzed, they may lead to others who were not clients of Mossack, but simply dealt with or were involved with their clients. These events further emphasize that owners of offshore companies and bank accounts must act immediately to identify and mitigate risks of criminal and tax sanctions.
The IRS as of this date has not announced whether taxpayers disclosed in the “Panama Papers” will be eligible for Offshore Voluntary Disclosure Program (OVDP) protection. Taxpayers who have reason to think they or their entities may be disclosed in the” Panama Papers” should immediately seek counsel to explore possible legal and tax exposures.
Regardless of any involvement with the “Panama Papers”, anyone with an offshore entity, bank account or other offshore interests or holdings, should consider a review of their obligations to file various forms with the IRS, including Foreign Bank Account Reports (FBAR), Foreign Trusts Reports (3520 and 3520-A), Interest in a Foreign Corporation (5471), to mention just a few. The OVDP is an opportunity to resolve many of these issues. However, as it recites, it could be discontinued at any time. Further, the penalties to be paid under the program have been periodically increased as the IRS has determined that there is greater public awareness of these requirements. Waiting will not make these issues go away.
ShuffieldLowman’s four downtown offices are located in Orlando, Tavares, DeLand and Daytona Beach. The firm is a 37 attorney, full service, business law firm, practicing in the areas of corporate law, estate planning, real estate and litigation. Specific areas include, tax law, securities, mergers and acquisitions, intellectual property, estate planning and probate, planning for families with closely held businesses, guardianship and elder law, tax controversy – Federal and State, non-profit organization law, banking and finance, land use and government law, commercial and civil litigation, fiduciary litigation, construction law, association law, bankruptcy and creditors’ rights, labor and employment, environmental law and mediation.
PART II — What are the U.S. Tax Implications?
Prospective foreign purchasers of real estate situated in the U.S. should pay careful attention to the U.S. tax ramifications of their acquisition. In particular, the manner in which rental income or sale proceeds are taxed, the impact of repatriation of those profits, and transfer tax consequences, e.g., taxes on the transfer of property to heirs, warrant special consideration. In addition, there is a somewhat onerous tax withholding requirement imposed on buyers when U.S. real estate is acquired from sellers who are foreign persons, which withholding requirement is elaborated on in Part I of this article.
In many ways the tax consequences of the ownership of U.S. real estate hinge upon the manner in which the real estate is held, i.e., titled in the individual name of the foreign person or owned indirectly by the foreign person through some form of business entity or trust. In addition, the U.S. taxation of foreign persons may be modified by an applicable bi-lateral treaty between the applicable foreign jurisdiction and the U.S.
Depending on the manner in which the foreign person owns the real estate, tax planning in this area generally implicates a combination of some or all of the following goals:
- An attempt to minimize taxation of operating income;
- The avoidance of a double tax on corporate profits;
- To ensure sale proceeds qualify for long-term capital gains tax treatment;
- The avoidance of transfer taxes, e.g., estate and gift taxes;
- An attempt to minimize withholding;
- To avoid taxation of the same income by both the U.S. and foreign tax authority; and
- An attempt to minimize tax reporting in the U.S.
In most cases it is impossible to achieve all of these objectives, so the planning needs to be specifically tailored to the particular facts and circumstances of each case.
For example, if a foreign person owns U.S. real estate directly in his or her individual capacity, then the gross rental income attributable to such real estate is subject to a flat 30% tax via withholding unless the foreign person elects “net basis” taxation, in which latter case the graduated income tax rate brackets for individuals apply (up to 39.6%) to net rental income taking account of certain expense deductions allowable depending on the use of the property (personal or business). If the U.S. real estate is held by the foreign person for more than one year, then the long-term capital gains tax rate (20%) is applicable to the gain on sale. In the case of personal use property, the foreign person and family members can enjoy the use of the property without imputation of rental income but if the “net basis” election is made then deductions are limited to real property taxes and qualified mortgage interest. The big disadvantages of direct ownership by a foreign person are (i) exposure to U.S. estate tax (applies at 40%) in the event of the death of the foreign owner; (ii) that a gift of U.S. real estate by a foreign person is subject to U.S. gift tax without the benefit of the lifetime gift tax exemption available to U.S. persons; and (iii) to ensure the collection of U.S. tax upon the sale of the U.S. real estate, the foreign owner will be exposed to the Foreign Investment in Real Property Tax Act (“FIRPTA”), which, subject to certain exceptions discussed in Part I of this article, requires the buyer to withhold an amount generally equal to 10% of the gross sale price at closing (“FIRPTA Withholding”).
By way of comparison, if a foreign person owns U.S. real property through a foreign corporation, then both U.S. estate tax and U.S. gift tax can be avoided. This structure also provides the advantages of limited liability and anonymity for the foreign shareholder(s). If shareholders or officers of the corporation will enjoy ‘personal use’ of the U.S. real estate, then a major disadvantage of this structure is the imputation of rental income to such persons; that is, unless the foreign corporation charges fair market value rent to such persons, such rent is imputed to the corporation and will trigger income tax. Another major disadvantage is exposure to the “branch profits tax”, subject to potential reduction via bi-lateral treaty. In lieu of withholding on dividends paid by the foreign corporation that owns the U.S. real estate to its beneficial owners that are foreign persons, the “branch profits tax” imposes a 30% tax on the operating profits of the foreign corporation attributable to the operations of its U.S. real estate that are “deemed” for this purpose to be repatriated to the applicable foreign country. It is important to note that this 30% “branch profit tax” is in addition to the corporate tax on the foreign corporation’s earnings in the U.S. (15% to 35% on net rental income or 30% on gross rental income via withholding by lessee), potentially resulting in an effective tax rate up to 54.5%. Gain on the sale of U.S. real estate by a foreign corporation is taxable at a 35% rate, and FIRPTA Withholding is required. Thus, if income from the U.S. real estate is expected to be significant and there is no relief available from a bi-lateral treaty then this structure may not be the most attractive option.
There are additional alternative ownership structures that can be utilized, including (i) ownership through a U.S. corporation owned by a foreign corporation; or (ii) ownership through a partnership (U.S. or foreign) or a limited liability company taxed as a partnership; or (iii) ownership though a trust (U.S. or foreign trust, grantor or non-grantor trust). Again, all of these structures are designed to achieve as many of the above-enumerated planning goals as possible, and the optimal structure always depends on the facts and circumstances of the particular case; that is, there is no ‘one size fits all’ structure.
At the end of the day, foreign persons intent on acquiring U.S. real estate should consult with tax advisors with knowledge of the legion of complex tax rules that confront the foreign owner of U.S. real estate. The failure to do so could easily result in dramatically higher than anticipated tax rates, an inadvertent but costly failure to comply with U.S. tax reporting and compliance rules, and exposure to U.S. transfer taxes as a result of the untimely death of a foreign owner or a gift of the U.S. real estate without proper planning. If you would like to discuss any of these issues, please feel free to contact our firm and we will be happy to evaluate your options.