2016 Estate Tax and the Presidential Candidates

One of the frequent topics around these parts involves the estate tax. There is nothing new here: taxes on the transfers of wealth date back to ancient Egypt. Pyramids don’t come cheap. And Caesar Augustus taxed transfers on death, though he made an exception for transfers between certain close family members.

These taxes can have odd effects. Similar taxes in the late Middle Ages were one of the forces that resulted in the Church owning a large percentage of the land in Europe by the time of the Reformation. Later in England, when a handful of families controlled most of the land, these taxes had the effect of breaking up these large estates and make what we would recognize as ownership of real estate possible for many more people (and ushering in modernism). In the United States, the similar taxes were among the tools used to break up the monopolies held by people like Carnegie, Rockefeller, and Morgan.

And—oh, yes, it was also a revenue source in all of the above cases… One thing all governments throughout time and space have had in common: a thirst for other-people’s wealth.

The estate tax as we have it dates to 1916. It was substantially reshaped during the 1970s, when exemptions for gift and estate taxes were combined in a 1976 bill that resulted in the unified gift and estate tax system we have today. (Prior to 1976 there were two separate tax-schemes, one gift and one estate, which resulted in numerous loop-holes.) The result of the 1976 bill is a genuine wealth transfer tax: the federal government limits the amount of wealth that you can transfer without being taxed (called the “unified credit”), subject to certain exceptions. It does not matter whether you transfer the wealth during your lifetime (a gift) or when you die (through your estate). Furthermore, if you sell property to a family member for substantially less than fair market value the government will call the difference a gift, and count that against your credit.

So the credit amount becomes a key to proper estate planning (though not the only one). Today, the credit amount (which, again, is the amount you can pass to others without paying the tax) is $5.45M (2016). The two presidential campaigns have different views on this. The Trump campaign wants to eliminate the tax (on the federal level). The Clinton campaign wants to drop the credit to $3.5M, and raise the tax rate from 40% to 45%. Of course neither of them can accomplish this in isolation, tax bills originate in the House of Representatives. But it is an indication of their thinking. And it is an indication of something else—you recall the old saying “Two things are certain: death and taxes.” It was not that long ago that many well-intentioned advisors were telling people that they really need not worry about the estate tax—“look how high the exemption is!”. Well, today. But maybe not tomorrow. And in terms of effect it is really not very high, but that is a different post. The point is that you cannot simply disregard the estate tax. Even if repealed, it could come back with one vote. It has before, it will again. And failure to plan for that reality creates real problems: The tax is a tax on wealth, but it is paid out of income. Depending upon the nature of one’s estate and assets, this can create an insurmountable burden for those you leave behind. Which is why planning is so important…

So the point of this post is not that you should vote for Clinton so that American wealth isn’t locked up in a few families. The point is not that you should vote for Trump because estate taxes have bad effects. The point is not that you shouldn’t vote for either one of them because they are both full of corn flakes. The point is that you should plan for what will happen when you pass away, and then review the plan periodically based upon changes in your life circumstances, the life circumstances of your prospective heirs, and changes in the law. And you should not count on any relevant factor remaining static; things change and estate plans need to be fluid. The only thing that doesn’t change is that things change. So formulate your goals, and then let’s work together to help your family accomplish them.

Family Members, Loans, and the IRS

Here is my second stock photo attempt, just in time for tax season.  This one didn't require any expensive props either  but I did have to use my son's glue stick to hold the sheets together. Feel free to use this image, just link to www.SeniorLiving.Org

Image Credit Ken Teegardin

We frequently run into situations where someone wants to loan money to a family member (or has already done it). Often, the idea of charging interest is distasteful to them. This is—after all—family. It probably will not surprise you to find out that the IRS has ideas about this, and that they are happy to use those ideas to impose complications on your life.

The Theory: As a very general matter, the IRS imposes tax on income, gain-in-value, and certain transfers of wealth. The ability to use someone else’s money has value. Generally, when we use someone else’s money (to buy a car, for example), we pay them for the use of the money (in the form of interest and other fees). We are paying for value (the use of the money that allows us to have the car now rather than later). If there is no charge for the use of the money, we are getting the same value, but at no cost. The IRS says that looks like income. (There is actually some history here that is really interesting to those of us who are full-fledged members of the Geekdom, but we will save that…)

Now, if you go to the appliance store, and they give you 2 years same-as-cash (i.e., 0% interest) on your new dishwasher that you can control from the moon with your phone, the IRS doesn’t tax that. That is a ‘third-party’ or ‘arms-length’ transaction. The store is not doing it to be nice, they are not really ‘giving’ you anything in the true sense of the idea. It is just part of “the deal”, and they are getting paid—it is just somewhere else in the transaction.

But when the loan is to an “insider” (a family member, business partner, etc.) the IRS sees it differently. They say this may not be ‘part of a bigger transaction’, and so it may be taxable as income. And if you do not charge interest, the IRS may impute interest. (They love to impute things.) This means you may have to follow complicated rules (called ‘below-market interest rules’) to compute imaginary interest on the loan, after which you get to pay real tax on the imaginary interest. As a bonus, the IRS might decide that the imaginary interest is a gift, which can present further complications.

There are numerous exceptions to the below market rules for loans under $100,000.00. Maybe we will cover those someday. But this post is about the get-out-of-jail for free card.

And here it is: Document the loan and charge interest. As an aside, you should document the loan anyway. People’s memory grows foggy with time, and you or your family member may get sick, die, or whatever. Avoid future fights between yourselves and potentially other family members and much bad will — write down what you are doing.

As to the interest: It is not enough just to charge some interest. The IRS publishes an interest rate (actually a series of rates based on the length of the loan and how the interest compounds) called the Applicable Federal Rate (AFR). They are below market and based on the bond market. You can find them published monthly on the IRS website. If you charge at least this rate on a term loan you avoid all of the problems. (A ‘term’ loan has a specific repayment schedule or a specific due date; as opposed to a ‘demand’ loan that is due on demand rather than having a specific due date).

As of the day I am writing this, the current AFRs for term loans are as follows (based on loans made this month that charge interest based on annual compounding):
0.64% for “short-term” loans of up to three years.
1.41% for “mid-term” loans over three years but not over nine years.
2.24% for “long-term” loans over nine years.

For a term loan, the minimum interest rate can in effect on the date of the loan can apply to the entire term of the loan. But be careful: for a demand loan (one where you can demand payment at any time) the rate must ‘float’. For each month a balance remains outstanding, the rate must be at least equal to the AFR for that month. This means you must keep up with it, but it also means that the rate could go up, maybe a lot—it is certainly not likely to go down much.
Now—you must include the interest income on your tax return (no surprise). Your family member cannot deduct the interest unless it would be otherwise deductible (mortgage or certain business loans).

Finally, again, please put the loan in writing to make sure the IRS (and the borrower) will respect the deal as a loan rather than a gift. Also because things happen—it could really help to have the intentions recorded in writing and not dependent of recollection and/or the impressions of people that weren’t a part of the original conversation (like siblings). You should also require at least some payment once per year, even if only the accumulated interest. This will keep the statute of limitations from tolling on the note, which could trigger gift issues again.
Follow these simple precautions, and you can give your family-member borrower some great loan terms, avoid family fights in the future, and keep your friends at the IRS off your back.

New Year, New Tax Laws

Well, it is a New Year.  And one of the joys of a New Year is new tax laws.  So just in time for New Year’s fun, here is a brief look at tax changes for 2014: Read more

Post-Windsor Notes x 3: NC Taxes, Retirement Benefits, and Social Security

It is not breaking news that North Carolina seems to be making a point of not recognizing marriages between same-sex partners.  It also is not breaking news that there are other states that are recognizing these marriages, and there are some conflicts between the laws of the states, between Federal law and the laws of the states, and even in the body of the Federal rules themselves.  A few important implications that apply in North Carolina—


Act One:  I earlier told readers that in the wake of the Windsor decision (133 S.Ct. 2675), the Read more