Category: Estates & Trusts

Tax Court Holds that a Trust can Qualify for the "Real Estate Professional Exception" of Section 469(c)(7)

Proskauer

The Tax Court recently handed down its decision in Frank Aragona Trust v. Commissioner, ruling that a trust can qualify for the real estate professional exception of Section 469(c)(7). By taking into account the actions of the trustees, a trust can be considered to be materially participating in real estate activities. This means that losses from real estate activities can be treated as nonpassive and therefore deductible in determining the trust’s taxable income. This decision is especially relevant to trusts that own business as it affects the application of the passive activity loss rules in Section 469 and whether income from those activities is subject to the new 3.8% net investment income Medicare surtax under Section 1411.

The Frank Aragona Trust (the “Trust”) was a Michigan trust that owned several pieces of real property and was also involved in the business aspects of developing and maintaining the property. The Trust had six trustees, three of whom were also employees of Holiday Enterprises, LLC (the “LLC”). The LLC was owned 100% by the Trust. The LLC also employed other professionals.

The Trust had losses in 2005 and 2006 from its real estate activities and deducted those losses(on the basis that they resulted from nonpassive activities) on its income tax returns. In issuing a notice of deficiency for those tax years, the Service determined that the real estate activities were passive under Section 469 and therefore any related losses were not deductible.

In general, real estate rental activity is considered passive regardless of whether the taxpayer materially participates in the real estate business. However, there is an exception for “real estate professionals” under Section 469(c)(7). Before the Tax Court, the Trustees argued that the Trust was a “real estate professional” as defined in Section 469(c)(7) so that the losses were considered to be from nonpassive activities and therefore deductible. To qualify for the real estate professional exception, a taxpayer must pass two tests. First, more than one-half of the personal services performed in a taxable year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours or services during the taxable year in real property trades or businesses in which the taxpayer materially participates. The Service argued that the regulations to Section 469(c)(7) define “personal services” as “work performed by an individual in connection with a trade or business [emphasis added].” Because the trust was not an individual, it could not perform personal services and therefore did not fall under the Section 469(c)(7) exception.

The Tax Court rejected the Service’s argument that the trust could not be considered an individual under Section 469(c)(7) and the associated regulations. Further, the Court found that the Trustees’ participation in the real estate activities met the material participation requirements of Section 469(c)(7) because they were regular, continuous and substantial. The Court determined that the participation of the Trustees should be considered in determining whether the taxpayer (the Trust) materially participated in the real estate activities. The Service argued that the activities of the Trustee should only apply if they are performed in their capacity as Trustees (as opposed to employees of the LLC). Here, the Court looked to Michigan law, under which trustees are required to administer trusts solely for the benefit of the trust beneficiaries. The Court explained that the Trustees could not simply stop acting as Trustees because they were also employees of the LLC, so that their activities in other capacities could be considered in whether the Trust was a material participant in the real estate activities.

In summary, a trust may be able to qualify for the real estate professional exception of Section 469(c)(7). If the trust qualifies for the exception, losses from the associated real estate activities may be deductible on the trust’s income tax return. This distinction has increased importance with the application of the new 3.8% net investment income Medicare surtax under Section 1411.

Article By:

Albert W Gortz
George D Karibjanian
David Pratt
Mitchell M Gaswirth
Andrew M Katzenstein
Henry J Leibowitz
Of:
Proskauer Rose LLP

 

U.S. Tax Court Rejects Internal Revenue Service's (IRS) Restrictive View of Trust Material Participation

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The U.S. Tax Court recently issued a taxpayer favorable opinion regarding how a trust materially participates in its activities. The court’s holding will make it easier for trusts to currently deduct expenses against non-passive income and to exclude income from the reach of the new 3.8% net investment income tax.

In Frank Aragona Trust v. Comm’r, the court held that in determining whether a trust materially participates in its activities, the activities of the trustees, including their activities as employees of the businesses owned by the trust, should be considered. The court’s opinion directly conflicts with recent IRS guidance that only a trustee’s time spent acting in a fiduciary capacity counts toward the trust’s material participation – a standard that would be very difficult for most trusts to meet. See Technical Advice Memorandum 201317010.

In Frank Aragona Trust, a Michigan trust owned rental real estate activities and engaged in holding and developing real estate. The trust conducted some of its activities directly, and others through its wholly-owned business, Holiday Enterprises, LLC. The trust had six trustees, three of whom worked full-time for Holiday Enterprises. The IRS argued that the participation of the trustee-employees should be disregarded. The court disagreed and concluded that the participation of the trustee-employees should be counted and further, that the participation of the trust’s six trustees was sufficient to meet the material participation standard. The court based its decision, in part, on the fact that Michigan law requires trustees to “administer the trust solely in the interest of the trust beneficiaries” even when they are participating through a business wholly-owned by the trust. This decision provides helpful authority for trusts, their trustees and their advisors in navigating the complex passive activity loss and net investment income tax rules.

However, the decision in Frank Aragona Trust does not answer all of the outstanding questions regarding material participation of trusts. In recently finalized regulations implementing the net investment income tax, the Treasury Department and the IRS requested public comments on rules regarding material participation of trusts, which indicates that the IRS may finally undertake a formal project to provide long-awaited guidance on this issue.

Article By:

Michala P. Irons
Randal J. Kaltenmark
William M. Pope
Douglas S. Robson
Howard J. Rubin
Of:
Barnes & Thornburg LLP

Happy National Healthcare Decisions Day: Why an Advance Directive is a Crucial Part of Estate Planning

Varnum LLP

Today is a day that, until recently, I wasn’t aware had any independent significance other than being April 16. However, April 16 is – and has been for the past seven years – National Healthcare Decisions Day. You can see the website dedicated to this purpose here: www.nhdd.org

Planning with an advance directive for health care decisions is only one piece of the larger estate planning puzzle. But it is a crucial component of any estate plan, and far too few people take the advice of their doctors or lawyers to implement their own advance directives. Some polls suggest only 30% of the population has implemented an advance directive.  However,this clip from NPR tells the story of La Crosse, Wisconsin, where over 96%  of the population has an advance directive. This has had at least two very important results: first, individuals are able to receive the medical care they want at a time when they cannot express their opinions; and second, medical costs for end of life care in La Crosse are far below the national average.

At a minimum, a carefully crafted advance directive will inform your family members about your wishes for your health care in the event you cannot make your own decisions. You can ensure that your family and your health care professionals know what you intend. You can avoid the need for the cost and hassle of a guardianship proceeding in probate court. And you can avoid unwanted medical procedures. The bottom line: an advance directive is an important part of ensuring that you receive the care you want when you cannot make your own decisions.

Article By:

Christopher J. Caldwell
Of: 
Varnum LLP

Illinois Trust Taxation Deemed Unconstitutional

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In Linn v. Department of Revenue, the Illinois Fourth District Appellate Court reviewed the state’s statutory framework for taxing trusts. Linn v. Department of Revenue, 2013 Il App (4th) 121055.  On constitutional grounds, the court limited Illinois’ power to impose taxes under its “once subject to tax, forever subject to tax” regime.

This case creates planning opportunities to minimize Illinois income taxes.  However, it should be noted that the Linn case applies to trusts that pay Illinois income tax on trust dividends, interest, capital gains or other income retained by the trust and not distributed to a beneficiary.  This case does not apply to income distributed to an Illinois beneficiary; that income clearly can be taxed by Illinois.

Illinois Trusts

Illinois trusts are subject to a 5 percent income tax plus a 1.5 percent personal property replacement tax.  A nonresident trust is subject to taxation only on income generated within Illinois or apportioned to the state.  Resident trusts, on the other hand, are subject to tax on all income, regardless of the source of that income.  For an individual, state income taxation on a resident basis generally requires domicile or residence within the taxing state.  With respect to a trust, one or more of the grantor, trustees and beneficiaries may have contacts with a state sufficient to uphold as constitutional a tax on all of the trust income.

Illinois defines a resident trust based solely on the domicile of the grantor. 35 ILCS 5/1501(a)(20).  A resident trust means:

  • A trust created by a will of a decedent who at death was domiciled in Illinois or
  • An irrevocable trust, the grantor of which was domiciled in Illinois at the time the trust became irrevocable.  For purposes of the statute, a trust is irrevocable when it’s no longer treated as a grantor trust under Sections 671 through 678 of the Internal Revenue Code.

The Illinois statute would forever tax the income generated by the trust property, regardless of the trust’s continuing connection to Illinois.  One can analogize the Illinois statute to a hypothetical statute providing that any person born in Illinois to resident parents is deemed an Illinois resident and subject to Illinois taxation no matter where that person eventually resides or earns income.  Many lawyers believe that the Illinois statute is unconstitutional.

Linn

Linn involved a trust established in 1961 by A.N. Pritzker, an Illinois resident.  The trust was initially administered under Illinois law by trustees who lived in Illinois.  In 2002, the trustee exercised a power granted in the trust instrument to distribute the trust property to a new trust (the Texas Trust).  Although the Texas Trust generally provided for administration under Texas law, certain provisions of the trust instrument continued to be interpreted under Illinois law.  The Texas Trust was subsequently modified by a Texas court to eliminate all references to Illinois law, and the trustee filed the Texas Trust’s 2006 Illinois tax return as a nonresident.  At that time:

  • No current trust beneficiary resided in Illinois;
  • No trustee or other trust officeholder resided in Illinois;
  • All trust assets were located outside Illinois; and
  • Illinois law wasn’t referred to in the modified trust instrument

The Illinois Department of Revenue (the IDR) asserted that the trust was a resident trust for 2006 and that, as such, the trust pay Illinois income tax on all income.  The trustee countered that the imposition of Illinois tax under these circumstances was unconstitutional as a violation of the due process clause and the commerce clause.  The court held the statute was unconstitutional based on due process grounds (not reaching the commerce clause arguments), and stated that the following are the requirements for a statute to sustain a due process challenge:  (1) a minimum connection must exist between the state and the person, property or transaction it seeks to tax during the period in issue and (2) the income attributed to the state for tax purposes must be rationally related to values with the taxing state. Quill Corp. v. North Dakota, 504 U.S. 298, 306 (1992).

This was the first case in Illinois on this issue so the court cited cases from other jurisdictions, including Chase Manhattan Bank v. Gavin, 733 A. 2d 782 (Conn. 1999), McCulloch v. Franchise Tax Board, 390 P.2d 412 (Cal. 1964), Blue v. Department of Treasury, 462 N.W.2d 762 (Mich. Ct. App. 1990) and Mercantile-Safe Deposit & Trust Co. v. Murphy, 242 N.Y.S.2d 26 (N.Y. App. Div. 1963).  Gavin, which upheld the application of the Connecticut income tax on the undistributed income of a lifetime trust created by a Connecticut grantor, was cited at length by the court.  A critical fact in that case was that the beneficiary resided within the state for the year in question and the court assumed that the beneficiary would receive all trust property shortly.  In Linn, the court noted, there were no Illinois beneficiaries.  Relying on Blue and Mercantile, the court found that a grantor’s residence within a state isn’t itself enough to satisfy due process.

The IDR argued that significant connections with Illinois existed, maintaining that the trust owed its existence to Illinois law and listing legal benefits Illinois provides to the trustees and beneficiaries. The IDR cited some cases that involved trusts created by a will (i.e.,testamentary trusts).  The Illinois court disagreed with the testamentary trust cases the IDR relied on, finding that a lifetime trust’s connections with a state are more attenuated than in the case of a testamentary trust.  Further, the court found that the Texas Trust wasn’t created under Illinois law, but rather by a power granted to the trustees under the original trust instrument.  The court proceeded to dismiss the trust’s historical connections to Illinois and focused on contemporaneous connections, finding that “what happened historically with the trust in Illinois courts and under Illinois law has no bearing on the 2006 tax year.”  Linn at ¶30.  For 2006, the court concluded that the trust received the benefits and protections of Texas law, not Illinois law.

Steps to Consider

The IDR did not appeal the Linn decision to the Illinois Supreme Court.  We anticipate that additional cases will test and define the boundaries of the Linn decision.  Of course, Illinois might change its statute. For the time being, however, the Linn decision is binding authority for trustees of trusts that can eliminate all contact with Illinois.

Trustees of resident trusts with limited contacts to Illinois (in particular, those trusts without trustees, assets or non-contingent beneficiaries in Illinois) should consider the following issues.

  • Review state taxation:  The trustee should review connections to Illinois and consider whether actions could be taken to fall within theLinn holding.  Contacts with other states and those states’ rules for taxing trusts should also be reviewed.
  • File Illinois return with no tax due:  Pending guidance from the IDR, the trustee could consider filing an IL Form 1041, referencing theLinn case and reporting no tax due.  For each tax year, a tax return must be filed in order to commence the running of the statute of limitations.  An Illinois appellate court decision that supports the taxpayer’s position will ordinarily provide a basis for the abatement of tax penalties. 86 Ill. Admin Code Section 700.400(e)(8). However, if the facts are not exactly like those in Linn, a penalty cold be imposed on the trustee.  A safer method for trusts when the facts are not the same as in Linn would be to file and pay the Illinois tax in full but then file a claim for refund.  This should eliminate penalties but likely will result in a dispute with the IDR.
  • Amend prior tax returns:  The trustee could consider filing amended tax returns for prior years and claim a refund.  A trustee that has timely filed prior year tax returns may file an amended tax return at any time prior to the third anniversary of the due date of the tax return, including extensions.  For example, the 2010 tax year return may be amended at any time prior to October 15, 2014.

Other Considerations

Given the holding in Linn and uncertainty regarding trust tax law, trusts that offer flexibility and can adapt to changing circumstances may have a distinct advantage.

  • Officeholders:  Carefully consider the residency of trustees and other trust officeholders (such as investment advisers) and provisions regarding the appointment and removal of those officeholders.
  • Decanting provision:  Consider providing the trustee with broad authority to distribute trust property in further trust.
  • Lifetime trusts:  While the legal basis for the continued income taxation of a testamentary trust may also be questionable, testamentary trusts can be avoided by creating lifetime trusts.
  • Situs and administration:  Consider establishing and administering the trust in a state that doesn’t assess an income tax against trust income.
  • Governing law:  Consider including trust provisions that allow the trustee to elect the laws of another state to govern the trust.
  • Discretionary dispositive provisions:  Consider including discretionary rather than mandatory trust distribution provisions, as some states may tax a trust based on the residence of beneficiaries with non-contingent trust interests.
  • Division provisions:  Consider including provisions authorizing a trustee to divide a trust without altering trust dispositive provisions.  This type of provision may allow a trustee to divide a trust into separate trusts and isolate the elements of a trust attracting state taxation.  For example, a trust may simply be divided into two separate trusts, one trust for the benefit of a child and his descendants that live in Illinois and a second trust that might not be subject to Illinois taxation, for a child and his descendants that don’t live in Illinois.
Article By:

James H. Cundiff
L. Timothy Halleron
Of: 
McDermott Will & Emery

 

Has Your Trust Lost Touch With Illinois? If So, It May Not Be Subject to Illinois Income Tax

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Overview

In December 2013, an Illinois Appellate Court of the Fourth District held that an inter vivos trust – that had no connections with Illinois other than the fact that the settlor of the trust was residing in Illinois when the trust was created – was not subject to Illinois income taxation.  Linn v. Department of Revenue, 213 IL App (4th) 121055.  Even though the Illinois Department of Revenue (“IDOR”) had the opportunity to appeal the ruling, it did not do so.  As a result, there may be an opportunity for inter vivos trusts established by an Illinois settlor to avoid Illinois income tax – if such trusts no longer have sufficient contact with the State of Illinois.

Background

The relevant portion of the Illinois Income Tax Act defines an Illinois resident as “[a]n irrevocable trust, the grantor of which was domiciled in [Illinois] at the time such trust became irrevocable.” 35 ILCS 5/1501(a)(20)(D).  The trust at issue in Linn was established in 1961 when the grantor and trustee of the trust were Illinois residents.  At the time the trust was established, the beneficiary of the trust resided in Illinois, and the trust assets were deposited in Illinois.  The trust instrument provided that Illinois law would govern the construction, administration and validity of the trust.

In 2007, the trust filed a 2006 nonresident Illinois income tax return – as the trustee and beneficiaries were no longer residents of Illinois and the trust had no Illinois situs income.  Additionally, the trust agreement had been modified in 2002 to provide that it shall be construed and regulated under Texas law.  Due to the lack of sufficient contact with Illinois, the Illinois Appellate Court held that the imposition of Illinois income tax on the trust was unconstitutional in violation of the due process clause – as the trust did not meet any factors that would give Illinois personal jurisdiction over the trust.

Review of Existing Irrevocable Trusts

As a result of the decision in Linn, there may be an opportunity for certain trusts that have no contact with Illinois to avoid Illinois income tax.  In spite of Illinois law that deems a trust to be an Illinois resident if the grantor of a trust resides within the State when it becomes irrevocable, the decision in Linn effectively invalidates that law when a trust no longer has any connections to Illinois.  In the wake of Linn decision, we recommend that you review any irrevocable trusts established by a grantor who resided in Illinois (at the time of creation) to consider the following:

  • The current residence or location of the trustee and the beneficiaries, and the present location of the trust assets.
  • Whether the trust agreement contains provisions that (i) allow a trustee to be appointed outside the State of Illinois, or (ii) permit the law governing the trust to be changed to another state.
  • Whether the trust allows “decanting” – which is a process authorized by a recent Illinois statute that allows the transfer of assets to a new trust, which could be governed by the law of another state.
  • Whether a trust with no connections to Illinois for the past several years (and which filed Illinois income tax returns and paid Illinois income taxes) should file a claim for refund.  Generally, there is a three year period from the due date (or filing date) of an income tax return to file an amended return and claim a refund.

Conclusion

The Linn decision is now the law in Illinois.  Therefore, if you are a beneficiary or a trustee of a trust originally created in Illinois (or an advisor to any such beneficiary or trustee), you should examine whether the trust has sufficient connections to Illinois to be taxed.

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The Complicated Landscape of US Estate Tax

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Canadians who own assets in the U.S. may be subject to U.S. estate tax.

This tax is based on the fair market value of all U.S. assets owned at the time of death. It can reach 40%, depending on the value of U.S. assets and the world-wide estate.

But not all Canadians who own U.S. assets will be subject to U.S. estate tax. A close look at the new U.S. estate tax rules will help you determine whether your Canadian clients are exposed to U.S. estate tax.

New U.S. estate tax rules

On January 2, 2013, President Obama signed the American Taxpayer Relief Act of 2013 (the Act) into law. The Act resolves many of the issues raised by the fiscal cliff.

Pursuant to the Act, U.S. estate tax liability of non-U.S. residents depends on the answers to the following two questions:

  1. Is the value of the U.S. estate more than $60,000?
  2. Is the value of the worldwide estate greater than $5,250,000?

If the fair market value (FMV) of U.S. assets is less than $60,000 on the date of death, then there is no U.S. estate tax. If the value of U.S. assets on death exceeds $60,000, a Canadian’s estate may still be exempt from U.S. estate tax if the value of his or her worldwide estate upon death is less than what is known as the “exemption.”

Worldwide exemption for 2013 and beyond

The Act provides an exemption from U.S. estate tax if a non-resident dies with a worldwide estate with a FMV of less than $5,250,000. This exemption amount is inflation-adjusted. Everything counts when calculating a Canadian client’s worldwide estate—including RRSPs and life insurance.

Additionally, when advising a married couple about U.S. estate tax exposure, it’s important to calculate the value of both spouses’ estates combined.

Clients often ask whether the U.S. estate tax is on the worldwide estate. The answer is no; the IRS does not tax a Canadian resident (who is not a U.S. citizen) on his or her worldwide estate.

The only assets that are subject to U.S. estate tax for Canadians are U.S. assets.

What are U.S. assets?

Common U.S. assets include real estate in the U.S. and personally held stocks of U.S. corporations, both public and private.

Here’s a complete list of U.S. assets subject to U.S. tax:

  • real estate property located in the U.S;
  • certain tangible personal property located in the U.S., such as furniture, vehicles, boats and airplanes;
  • golf club equity memberships;
  • shares of U.S. corporations, regardless of the location of the share certificates (even inside RRSPs or RRIFs);
  • interests in partnerships owning U.S. real estate or carrying on business in the U.S.;
  • U.S. pension plans and annuity amounts (IRAs and 401K plans);
  • stock options of a U.S. company;
  • U.S. mutual funds;
  • money owed to Canadians by American persons; and
  • money market accounts with U.S. brokerage firms.

The following is a list of U.S. assets not subject to U.S. estate tax:

  • U.S. bank deposits;
  • certain debt obligations, such as U.S. government bonds;
  • American depository receipts;
  • term deposits/guaranteed investment certificates;
  • real estate situated outside the U.S.;
  • Canadian mutual funds denominated in U.S. dollars that invest in U.S. stocks;
  • life insurance proceeds payable on the death of a Canadian citizen and resident who is not an American citizen; and
  • non-U.S. stocks, bonds and mutual funds.

Many Canadians own assets subject to U.S. estate tax with vacation homes and shares of U.S. corporations topping the list. How can you help clients who own these assets?

The following scenario provides some answers.

Strategies for Canadians who own U.S. assets

Richard is a Canadian citizen and resident, single, with a worldwide estate of $10 million. He owns an $800,000 property in Ft. Lauderdale, Fla.

Richard’s inherited 25% of the shares of four Florida corporations from his deceased father, which he estimates have a value of $200,000. Each corporation owns an apartment building in South Florida.

The chart “Example estimates” (this page) approximates Richard’s 2013 exposure to U.S. estate tax.

Tax planning for U.S. real estate

The goal of any tax-planning for a Canadian owner of U.S. real estate is to ensure the estate of the Canadian decedent is not subject to U.S. estate tax. Consequently, title should not be in his or her name. Alternative ownership structures include:

  • corporation;
  • cross-border trust (irrevocable or revocable); and
  • limited partnership.

These ownership structures avoid probate and guardianship proceedings in the case of incapacity and can defer or avoid U.S. estate tax.

Tax planning for stocks

Although Richard’s shares of U.S. stock are considered U.S. assets, there are tax-planning techniques for avoiding U.S. estate tax.

01 Sell

This may trigger capital gains tax in Canada, though Richard may have some capital losses to apply against it.

02 Create a Canadian holding corporation

Transfer the shares of U.S. stocks on a tax-free basis into a Canadian corporation, of which Richard is the shareholder.

Should Richard pass away with U.S. stock in his Canadian holding company, there will be no U.S. estate tax because Richard no longer owns shares of a U.S. company; he only owns shares of a Canadian holding corporation that owns shares of the Florida companies that Richard’s father passed on to him.

The U.S. Foreign Investment in Real Property Tax Act (FIRPTA) may apply to Richard’s transfer of U.S. stocks into a Canadian company. FIRPTA requires that 10% of the sale price or transfer value of U.S. real estate by a non-resident of the U.S. be withheld and remitted to the IRS. Richard can avoid this with proper structuring and reporting, which we’ll explain next time. No withholding will be required and no disposition will have occurred.

Example estimates of U.S. Estate Tax Payable for 2013

Article by:

David A. Altro

Of:

Altro Levy LLP

Planning for Disabled Beneficiaries in Ontario

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Whether you own Cross-Border assets or not, when dealing with the transfer of assets to a disabled beneficiary who is resident in Ontario, special planning may be needed to preserve your disabled beneficiary’s entitlement to certain benefits he or she may be receiving, or may be entitled to receive in future.

The Ontario Disability Support Program (“ODSP”) is a provincial program offering income and employment support to adults with physical and/or mental disabilities.

An eligible applicant must show financial need, which is determined by calculating the assets held by such applicant. A single adult is entitled to hold up to $5,000 worth of assets. If he or she has a spouse (whether married or common-law), the limit rises to $7,500. The limit increases by $500 for each dependent child living with the disabled beneficiary.

Certain assets are exempt from counting toward the asset limit, including, but not limited to, an interest in a principal residence, a car and a prepaid funeral. Other assets may be exempt up to certain limits or as determined by specified rules.

For instance, an interest in a second property, such as a cottage or vacation property in Florida, may be exempt if it can be shown that the property is an asset necessary for the health and well-being of the ODSP applicant. If the second property is not exempt, the owner may not be eligible for ODSP benefits. Where this is so, the property will be exempt for only 6-months, during which time the property would be expected to be sold. If reasonable efforts to sell the property fail to produce a bona fide purchaser, the property may remain exempt until such time as the property is sold, provided that reasonable efforts to sell are maintained. Following the sale, attention must be paid to structuring the holding of the proceeds of sale in order to ensure such proceeds do not put the ODSP recipient offside of the asset limitations.

The ODSP regulations are complex, with many restrictions, of which the consequence of breaking may be ineligibility or permanent loss of ODSP income benefits. Some of the notable restrictions include limitations on ownership of assets above the thresholds outlined above as well as asset class. For instance, an ODSP recipient is restricted from owning more than $100,000, in aggregate, of life insurance (cash value), segregated funds (similar to a mutual fund but offered only by insurance companies) and any inheritance, whether received outright or held in trust for the recipient’s benefit.

You might ask why go through the trouble of trying to protect such income benefits when you plan to leave your disabled beneficiary much more than what he or she would receive from ODSP? Although ODSP provides financial benefit to your disabled beneficiary, there are also social programs, such as employment assistance, that may be lost. Such programs can be valuable to disabled persons of all financial backgrounds.

A special type of trust, referred to as a “Henson Trust” (named after the precedent-setting Ontario Court of Appeal case: The Director of the Income Maintenance Branch of the Ministry of Community and Social Services v. Henson, 36 Estates and Trusts Reporter 192, and also referred to as an absolute discretionary trust), may alleviate many of the foregoing issues.

Where drafted appropriately, a Henson Trust provides a means to leave unlimited assets to a disabled beneficiary without jeopardizing the benefits he or she may receive from ODSP or other government sources, both financial and otherwise. In other words, your disabled beneficiary can benefit from the substantial inheritance you may leave in such Henson Trust for his or her benefit, while continuing to collect the financial (and other) benefits available pursuant to the ODSP.

Whether a Henson Trust is an appropriate structure requires some fact gathering and analysis, coupled with a consideration of whether the beneficiary is disabled but has capacity, versus disabled but does not have capacity. In the case of the former, a trust structure may not be ideal where the beneficiary manages or is involved in managing his or her own finances. Further, where a Henson Trust is implemented, selection of one or more trustees to administer the trust is critical as there is a greater potential for abuse than in non-Henson Trusts.

Consideration should also be given to whether to utilize the federal government’s Registered Disability Savings Plan (“RDSP”), a registered matched savings plan for people with disabilities. An RDSP may be used in conjunction with a Henson Trust or on its own.

Article by:

Heela Donsky

Of:

Altro Levy LLP

Same Sex Marriages: Are You Filing Your Taxes Properly?

Poyner Spruill

 

In late 2013, I met with my first same sex couple clients since the U.S. Supreme Court overruled the Defense of Marriage Act (DOMA) last year.  If you recall, DOMA  was the federal law barring the federal government from recognizing same sex marriages legalized by states.  It was ruled unconstitutional by the U.S. Supreme Court as violative of the Fifth Amendment.  The IRS issued a statement on August 29, 2013 that provided that same sex couples legally married in a jurisdiction that recognizes their marriage would be treated as married for federal tax purposes regardless of the laws of their domiciliary state.  As a result, same sex couples married in a state that legally recognizes their marriage will be entitled to the estate and gift tax marital deduction, and they must also file their federal income tax returns with the status of married or married filing separately.  (The Department of Labor issued a similar statement in Technical Release No. 2013-4, meaning that for purposes of ERISA, legally married couples are treated as married, regardless of the laws of their domiciliary state.)

North Carolina does not recognize same sex marriage as valid, so for purposes of North Carolina taxes, where does that leave our North Carolina-residing same sex couple clients that were legally married in another state?  NCDOR directive PD-13-1 provides that “Because North Carolina does not recognize same-sex marriage as valid… individuals who enter into a same-sex marriage in another state cannot file a North Carolina income tax return using the filing status of married. Such individuals who file a federal income tax return as married must each complete a separate pro forma federal return for North Carolina purposes with the filing status of single  to determine each individual’s proper adjusted gross income, deductions and tax credits allowed under the Code for the filing status used for North Carolina purposes.”

My clients are considering getting married in a state that recognizes same sex marriage, but they want to understand the legal implications for them if they do.  They are concerned about the “marriage penalty” for federal income tax purposes and the complexity of having different laws and rules for federal and  state purposes. They do not have an estate tax problem, so the availability of the unlimited estate tax marital deduction is of no consequence to them. However, they are considering retitling the house currently owned by one of them into their joint names.  I cautioned them that such transfer would constitute a taxable gift to the extent the value of the interest transferred exceeded the donor owner’s $14,000 annual exclusion. In fact, one partner’s use of funds for the benefit of the other in excess of the donor-partner’s annual exclusion in any year will require the donor-partner to file a gift tax return. If they are legally married, there would be no taxable gifts in those circumstances due to the unlimited marital gift tax deduction. My clients each have a 401(k) plan, so if they were to marry, under ERISA, they must be designated beneficiary of each other’s accounts unless the spouse waives that right.

As an advisor, if you have same sex couple clients who have been married in a state that recognizes same sex marriage and they have paid taxes or used exemptions (income, gift or estate tax) based on separate status, you may consider whether they can and should file amended returns based on married filing status to recoup taxes or exemptions. And they should be advised to revisit their beneficiary designations and their estate planning documents if they have not done so already.

Article by:

Westray B. Veasey

Of:

Poyner Spruill LLP

Is a U.S. Revocable Trust Okay for Canadians?

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Revocable trusts are a common estate planning tool in the U.S. Also referred to as living trusts and grantor trusts, they provide a method of avoiding costly probate and incapacity proceedings. A well written revocable trust will also include tax and creditor protection planning for future generations. In addition to all of these benefits, the individual setting up the trust remains in control of the trust and trust property during his or her lifetime.

A revocable trust does not provide creditor protection to the grantor, nor does it shield the grantor from U.S. estate tax liability. Rather, it is a powerful and popular tool for U.S. citizens and residents who are below the U.S. estate tax exemption amount to hold their personal residences. The revocable trust is popular among Americans, and rightly so.

Unfortunately, the benefits a Canadian may receive by using a U.S. revocable trust to avoid the issues of probate and incapacity proceedings will likely be negated by the numerous tax disadvantages a U.S. revocable trust faces in Canada.

How a U.S. Revocable Trust Works

As with any trust, a revocable trust must have a grantor (also known as a settlor), a trustee, and a beneficiary. The grantor creates and settles the trust, meaning he or she chooses the parameters of the trust agreement and donates the initial capital to the trust. The trustee is the individual or company named to manage the trust property for the benefit the beneficiary. Finally, the beneficiary is the individual who enjoys the beneficial use of the trust property, which may include income or other payments from the trust.

In the U.S., a revocable trust allows the same individual to act as grantor, trustee, and beneficiary, as long as future beneficiaries (also known as remainder beneficiaries) are named. This allows the individual to maintain complete control of the trust and trust property, and streamline the management of the trust property during his or her lifetime. Often, married couples will go a step further and create a joint revocable trust for jointly owned properties.

The U.S. Internal Revenue Service (“IRS”) disregards the existence of the U.S. revocable trust for tax purposes due to the control and reversionary rights retained by the grantor of the revocable trust. This means any income or capital gains earned on trust property is taxable in the hands of the grantor during his or her lifetime. This is normally not an issue, since the grantor of a revocable trust is almost always the initial beneficiary. It also means that property with accrued gains can be transferred to a U.S. revocable trust without triggering a tax on this capital gain.

U.S. revocable trusts do not provide protection from U.S. estate tax to the grantor, but certain planning can be included to reduce or defer this tax where a surviving spouse is inheriting the trust property.

There is no creditor protection for a property held in a U.S. revocable trust. Similar to the above-described tax treatment, the trust will be disregarded should creditors pursue the grantor.

Canadians and U.S. Revocable Trusts

Canadians who seek tax and estate planning advice from U.S. attorneys are often counseled to take title to their U.S. vacation residences through a U.S. revocable trust. These attorneys are trying to help their clients avoid the expensive and time-consuming issues of probate and incapacity, and take advantage of other tax and estate planning opportunities within the trust document. Unfortunately, a U.S. revocable trust is often not the ideal structure for a Canadian resident.

In Canada, trusts are considered separate taxpayers, meaning trusts are not normally disregarded like the U.S. revocable trust is in the U.S. There are limited exceptions to this rule, such as the Alter Ego trust available to Canadian residents over age 65.

Tax on income or capital gains earned by trust property could result in a double taxation scenario where tax is paid personally by the grantor in the U.S., but the income or gains are not attributed or distributed to the same individual as a beneficiary in Canada, therefore triggering income or capital gains tax at the trust level in Canada.

Such double taxation may be avoided by function of section 75(2) of the Canadian Income Tax Act (“ITA”). This section says that where an individual contributes property to a Canadian resident trust in which he or she is a controlling trustee and potential capital beneficiary, and he or she has the power to decide who will receive the property, then all income, capital gains, and capital losses associated with the donated property will be attributed back to that person during his or her lifetime.

Example 1:

Let’s say Mr. Smith, a Canadian citizen and resident, agrees with his U.S. attorney’s advice on how to avoid U.S. probate and incapacity proceedings, and has a U.S. revocable trust drawn up in which he is the grantor, trustee, and sole beneficiary during his lifetime. Section 75(2) of the ITA will cause all income, capital gains, and capital losses related to any property contributed by Mr. Smith to the trust to be attributed back to him individually. The trust will therefore essentially be disregarded for income and capital gains tax purposes on both sides of the border.

Result: During Mr. Smith’s lifetime, there should be no double taxation on income and capital gains earned on property he contributed to the trust.

The application of section 75(2) of the ITA does not protect against tax on the rollover of a property with accrued gain by a Canadian resident into a U.S. revocable trust. While not recognized for tax purposes in the U.S., such a rollover would cause an immediate disposition on the gain in Canada.

Example 2:

Let’s take Mr. Smith as an example again, but look at a slightly different situation. He has a condominium in Naples, Florida that he purchased 15 years ago for $150,000. His US attorney has informed him that he needs proper planning to avoid probate and incapacity issues for his family. If he continues to own the property in his name personally they could face lengthy court proceedings and high fees should he ever become incapacitated, and certainly upon his eventual death.

Mr. Smith would therefore like to put his condominium, which now has a fair market value of $250,000 into the U.S. revocable trust prepared by his U.S. attorney, since the trust would allow him to avoid these two issues. There is no tax on this rollover in the U.S. Such a rollover would trigger tax in Canada though, on the existing $100,000 in capital gain. To make matters worse, since no corresponding gain would be triggered in the U.S., if Mr. Smith then sells the same property five years later he would potentially be faced with taxation in the U.S. on the same $100,000 in gain for which he has already paid tax in Canada.

Result: Capital gains tax on the rollover of property in the U.S. revocable trust by a Canadian resident. Potential double taxation on an eventual sale of the U.S. property.

The situation gets even more complicated. Under section 104 of the ITA all Canadian trusts are subject to a 21 year deemed disposition rule. This means that the trust is treated as having sold and reacquired its property on the 21 year anniversary of the trust. Any accrued gains are taxed, even if the property is not actually sold. It does not matter if the property has not been in the trust for the full 21 years. A trust is generally considered resident in Canada when central management and control of the trust is carried out in Canada.

Example 3:

To continue with Mr. Smith as an example, say he purchased a condominium in Fort Lauderdale, Florida, in his U.S. revocable trust ten years after the trust was created. The property is still in the trust on the 21st anniversary of the trust. This condominium was purchased by the trust for $200,000, but is currently worth $325,000. Mr. Smith has no intention of selling the property anytime soon. Unfortunately, on the 21st anniversary of his trust he must pay tax on the gain of $125,000 in Canada. Like the last example, if Mr. Smith later sells this property he will potentially face a double taxation on the gain in the U.S., because no corresponding gain was recognized in the U.S. on the 21 year anniversary.

Result: U.S. revocable trusts are subject to Canada’s 21 year deemed disposition rule, which may also result in double taxation upon an eventual sale of the U.S. property.

Finally, Canadians who own property through a U.S. revocable trust face potential double taxation on the assets when they die owning property in the trust. Since the assets in the U.S. revocable trust are included in an individual’s estate upon death in the U.S., they may be subject to U.S. estate tax upon death. Estate tax is on the fair market value of the property at the time of death, not on the accrued gain. No credit for taxes paid by the estate in the U.S. will be available to the trust in Canada. Even if no U.S. estate tax is due, the IRS considers the value, also known as the adjusted cost basis, of the asset to have increased to its fair market value when inherited by the grantor’s heirs.

No such increase in adjusted cost basis will take place on this asset in Canada, which means that there may be tax on the total accrued gain either on the 21 year anniversary of the trust or when the deceased’s heirs eventually dispose of the trust assets. This could turn into a double taxation scenario where the deceased’s estate had to pay U.S. estate tax on the property at the time of death, since no credit is available for the tax already paid in the U.S.

Example 4:

As a final example, let’s say Mr. Smith dies leaving a Miami condominium in his U.S. revocable trust worth $500,000 that he originally purchased for $400,000, and a worldwide estate of $10 Million. As a Canadian citizen and resident, US estate tax only applies to his US situs assets, which include, but are not limited to real property held in a revocable trust. Should Mr. Smith pass away in 2013, his U.S. estate tax would be about $53,510.

If Mr. Smith had owned the property in his name personally at time of death, Canada would have also assessed a deemed disposition on the $100,000 in capital gain. Mr. Smith’s estate should have been able to use the U.S. estate tax paid as a foreign tax credit against the capital gains tax owed on the property in Canada, eliminating the double taxation.

Since the property is held in a U.S. revocable trust though, tax is not due in Canada until the 21 year anniversary of the trust, the sale of the property, or, in certain situations the distribution of the property to the trust beneficiaries. No foreign tax credit will be given for the U.S. estate tax paid by Mr. Smith’s estate.

Result: Potential for double taxation where U.S. estate tax is due on property held in a U.S. revocable trust.

Conclusion

On the rare occasion a U.S. revocable trust may be used effectively by a Canadian resident. Due to the potential for double taxation scenarios though, U.S. revocable trusts are best avoided by Canadian residents, especially when not used under the watchful eye of an informed cross border tax and estate planning attorney.

Alternatives to the U.S. revocable trust that still allow you to avoid issues of U.S. probate and incapacity proceedings do exist. Due to the revocable nature of such a trust, steps may be taken even with an existing U.S. revocable trust to implement an appropriate alternative and bring the structure into line with Canadian tax rules. You can contact Altro Levy LLP to learn more about the various alternatives available to you as a Canadian resident owning property in the U.S.

Article by:

Melissa V. La Venia

Of:

Altro Levy LLP

2013 Year-End Planning for Lesbian, Gay, Bisexual and Transgender (LGBT) Taxpayers

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2013 has been a year of historic change for the LGBT community. The landmark Supreme Court decision in U. S. v. Windsor, decided on June 26, 2013, held that Section 3 of the Defense of Marriage Act (DOMA) (defining marriage for federal purposes as being between a man and a woman) violates the equal protection clause of the Constitution and is therefore unconstitutional.

For married same-sex couples living in one of the 14 states (as of this writing) or District of Columbia which recognize same-sex marriages, their marriages are now recognized for both federal and state purposes. Married same-sex couples living in a state that does not recognize same-sex marriages are left with many questions.

Place of Celebration

On August 29, 2013 the IRS released Revenue Ruling 2013-17 clarifying that where a couple was married (place of celebration) rather than where a couple resides (place of domicile) determines a same-sex couple’s marital status for federal tax purposes. A tremendous benefit of this decision is that married same-sex couples can now travel freely across state lines and be considered married in each state for federal tax purposes. This ruling applies to same-sex marriages legally entered into in a US state, the District of Columbia, a US territory or foreign country. The ruling does not apply to civil unions, registered domestic partnerships or similar relationships that might be recognized under state law but do not necessarily guarantee the same protection as marriage.

Impact on Gift and Estate Taxes

Before the Windsor decision, transfers between same-sex married couples could result in significant gift and estate taxes. Now transfers between same-sex spouses can generally be made with no tax consequences. In addition, certain estate provisions such as portability, the marital deduction and qualified terminable interest property (QTIP) trusts are now available to same-sex married couples. Other commonly used estate and gift planning tools for married couples, such as gift splitting and spousal rollover IRA’s, are also now available to a same sex married couple.

If you die in a state that does not recognize same-sex marriage, your spouse will not automatically inherit under state spousal rights statutes. Therefore, if the couple intends to inherit from each other, a will or living trust is still needed.

Planning tip: An important part of 2013 year-end planning is to review and update wills and estate documents to make sure to take advantage of the new rules and to properly designate beneficiaries.

Impact on Income Taxes

Many married couples have a lower joint tax liability because of netting income and deductions, eligibility for certain tax credits and income exclusions, or have an increased tax liability due to the marriage penalty tax or because of limitations on deductions based on their combined adjusted gross income. For 2013, LGBT couples considered married under the state of celebration rule will have to file their federal tax return as married filing joint or married filing separate, which may cause a shift in tax planning.

Planning tips: As part of 2013 year-end planning, same-sex couples should work with their tax advisors to determine if original or amended returns, using married filing joint or married filing separate status, should be filed for years open under the statute of limitations. The statute for a refund claim is open for three years from the date the return was filed or two years from the date the tax was paid, whichever is later. Projections should be run to compare the potential benefit or cost of a married-joint filing versus separate-single or head of household filing, as there may be a better tax result to leave the returns as filed and not amend.

In addition, same-sex couples should consider credits that might not have been available as single filers, or consider the traditional year-end planning ideas for married couples mentioned in other sections of this guide.

Impact on Benefits

Before the fall of DOMA, benefits provided to the non-employee same-sex spouse, such as employer provided health insurance, flexible spending plans, etc. were paid with after-tax dollars and the benefit was included in the employee’s taxable income. Now, same-sex couples can pay for these benefits with pre-tax dollars and the coverage will not be included in their taxable income. Employees can file amended returns (for years prior to 2013) excluding those benefits from taxable income and request refunds. Also, employers who paid payroll taxes based on previously taxed health insurance and fringe benefits can also file amended returns (Notice 2013-61 provides guidance to employers for correcting overpayments of employment taxes (FICA) for 2013).

On August 9, 2013, the US Department of Labor (DOL) announced that the Family and Medical Leave Act (FMLA) extends only to same-sex marriage couples who reside in states that recognize same-sex marriage.

On September 18, 2013 the DOL announced (in Technical Release 2013-04) that same-sex couples legally married in a jurisdiction that recognizes their marriage will be treated as married for purposes of the Employee Retirement Income Security Act of 1975 (ERISA) and the Health Insurance Portability and Accountability Act of 1996 (HIPAA). The DOL recognizes the marriage regardless of where the legally married couple currently resides. This announcement covers pensions, 401K’s, and health plans.

The Social Security Administration (SSA) also announced that it will process and pay out spousal retirement claims for same-sex spouses. The SSA urges people who believe they are eligible for benefits to apply as soon as possible in order to establish a protective filing date, which is used to determine the start of potential benefits. Under the SSA’s “Windsor instructions”, claims can be filed when the holder of a social security number was married in a state that permits same-sex marriages and resides in a state that recognizes same-sex marriage at the time of application. Once benefits are approved, the recipient can move to any state without disqualification. Applications that don’t meet these criteria are being held for later processing when further guidance is issued.

Planning tips for employees: Employees in a same-sex marriage should consider amending their tax returns if they were paying for employer-provided benefits to their spouse. Employees in a same sex-marriage should also review the benefits their employer offers to married couples to make sure they are taking full advantage of all benefits. Also, same-sex married couples should provide their Human Resource Department with a copy of their marriage license and confirm that the spouse’s insurance coverage is no longer being included in taxable income and/or that an appropriate adjustment will be made for the 2013 calendar year.

Planning tips for employers: Employers should ensure that their benefits packages are in compliance with the new laws. See Rev. Rul. 2013-61 for guidance on how to correct overpayments of employment taxes for 2013 by either adjusting 4th QTR 2013 Form 941, (correcting the 1st -3rd Quarterly filings) or by filing Form 941-X (correcting all quarters of 2013).

Pre- and Post-Nuptial Agreements

Consider agreements for same-sex couples to avoid disagreements and litigation expenses for future possible divorce. State uncertainty remains.The majority of states currently do not recognize same-sex marriages. There are prominent court cases challenging these state laws, and the resulting impacts on tax and estate planning for same-sex married couples are as yet unknown.

Article by:

Janis Cowhey McDonagh

Of:

Marcum LLP