Personal Wealth Law News

Part of planning for the future is deciding where to spend the golden years, as marketing types like to call them. For those people who have an option where to live in retirement, there are the usual suspects: Florida, Arizona, North Carolina and there is the state that is one of the most popular among retirees, Pennsylvania.

By the way, the idea that you need to remain in the city where your law practice is located in order to continue to have an involvement in that practice is fast fading away. Just last week, a lawyer from a suburb of Detroit, who is suing one of my clients, called me from somewhere deep in the heart of North Carolina, from where he is able to be heavily involved in the frivolous litigation he is pursuing.

Why is Pennsylvania so popular among retirees, especially those in the neighboring states of New York, New Jersey, Delaware and Maryland? One important reason is the taxation of retirement income, such as Social Security and retirement plan distributions. There is no income tax imposed by Pennsylvania on bona fide retirement income, which is not the case in the neighboring states. If your income in retirement consists only of Social Security benefits and amounts you withdraw from a 401(k) plan, for example, your Pa. income tax will be zero. That is not the case, again for example, in New Jersey. And if you worked in New Jersey to earn a retirement benefit, New Jersey can’t reach across the river to tax it if you move to Pennsylvania, under federal law. (But here’s a caveat: Be sure to check the Pennsylvania rules to be certain that your retirement distributions qualify. Nearly all distributions after age 59 1/2 will qualify, but check the rules anyway.)

Yes, we have a sales tax, which Delaware does not have (although there are a large number of “big box” stores suspiciously close to the Pennsylvania border) and yes, we still have the state store system (again, some really good wine stores just across the border in New Jersey and Delaware, I’m told), but Pennsylvania has a big advantage in the taxation of retirement income. That, combined with reasonable property taxes and access to a world of sports, culture and recreational activities, is why Pennsylvania has one of the largest populations of retirees of any state.

Republished with permission of The Legal Intelligencer.

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Actually, the Warren Zevon song refers to “Lawyers, Guns and Money,” but the Internal Revenue Code can also be a dangerous weapon. Now that the campaign for president has reached the general election stage, it’s time to realize that whoever wins the election; there are massive changes in our federal tax system looming ahead. These changes will affect us and our clients in various ways. In some cases, there will be little that can be done but to accept the changes; in other situations, there may be planning that can be used to reach a better result. Here are a couple of areas where change may occur:

• Federal estate tax: This discussion has been going on for several years, with much misinformation being spread about. (Read “Wealth and Our Commonwealth” by William H. Gates and Chuck Collins for a good review of this debate.) But there will be changes in our federal estate tax system in the future because leaders in both parties agree that the tax must be revised to include only the truly wealthy, not those who bought a home in a good neighborhood. There might be relief for small businesses and farmers, but in general the tax should be one that allows people to pass on some of the fruits of their life’s work without destroying the incentive of the next generation to take part in life’s struggle.
• Federal income tax: The reductions in income tax rates that were enacted in 2001 are scheduled to phase out in a few years. One solution is to extend indefinitely, but this easy answer has to be balanced against the colossal budget deficits that have resulted, in part, from those tax reductions. The view that those budget deficits can go on forever and will somehow be resolved or will disappear as a result of future growth is now classified with bedtime stories.
• Alternative minimum tax: Whose idea was this anyway? In the past few years, we’ve had small bandages applied to this gaping wound in our tax system. Some have suggested just repealing it, which would only result in even larger budget deficits. But reducing its effect to those who are perceived as not paying a fair share of taxes, which was the original intent of the law, will require that some difficult choices be made. Doing nothing (which is a skill of both political parties): not an option.
• Social Security taxes: Someone will have to finally accept that this problem also can’t be ignored or magically wished away with private accounts, and that higher taxes will only be acceptable to a limited degree. As last week’s blog indicated, you can either increase revenues or reduce benefits; there’s no third way.

All of these problems will have to be addressed by our next president, either John or Barack. In the course of resolving them, many provisions of our tax laws will be placed on the table: taxation of life insurance, employee benefit taxation, relief for older taxpayers and those with children. Many constituencies will be contending for their interests. It’s important for all of us to know what’s happening, and to plan for change, for us and for our clients.

Republished with permission of The Legal Intelligencer.

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This title will be familiar to readers of the adventures of Sherlock Holmes. It’s a story mentioned in one of the Holmes stories as one for which the world was not yet ready. Apparently, the world was never ready for the story, because the author died without having written about a giant rat, from Sumatra or elsewhere.

I think of this passage in the works of Sir Arthur Conan Doyle as an example of things left undone. We often have plans we would like to carry out but for some reason can’t get to. Sometimes, like Doyle, we never get to them. In my practice, I see this kind of procrastination frequently when the subject of life insurance comes up. (By the way, I neither sell nor benefit from the sale of life insurance.) Life insurance is a product with many useful tax characteristics, and its use has become more…useful in recent years because of developments in the insurance industry and businesses related to the insurance industry.

Among the valuable tax benefits of life insurance is that the receipt of the proceeds is generally free of federal income tax. I say generally because it’s possible to lose that tax exemption if, for example, the insurance policy is transferred for value, such as by selling it. There are ways of avoiding that problem, depending on the type of transfer.

The proceeds of life insurance may be subject to federal estate tax, which could reduce the amount of the proceeds significantly. But there’s a way to avoid estate taxation that is frequently used, especially for large amounts of insurance. If the life insurance policy is not owned by the insured but instead by an irrevocable life insurance trust, the proceeds will escape federal estate taxation. The trust document will determine where the proceeds will go. Often they’re held in trust for the surviving spouse for life and then paid to the children. Not having to pay estate tax, in addition to the exemption from income tax, is a doubly valuable benefit.

But if the trust is irrevocable, it’s difficult, if not impossible, to change it. Suppose you change your mind about where the proceeds should go, which could happen for any number of reasons. Are you stuck leaving the proceeds to those you might consider the wrong people, or the right people but on the wrong terms? One solution that people have considered is to set up a new trust and sell the policy, for its fair market value, from the old trust to the new trust. But that creates the potential transfer for value problem described above. Is there a way around this problem?

The IRS has just issued a revenue ruling, 2008-22, which confirms the ability to make such a transfer without jeopardizing either the income tax or the estate tax exemption. If the new trust is a grantor trust, which means a trust that is treated effectively as the same person as the grantor, then the transfer for value rule won’t apply. (In this situation, the grantor would be the insured.) But how do you make the trust a grantor trust? The Internal Revenue Code says that one way is to give the grantor the right to substitute property of equal value for the property in the trust. The grantor might never make such a substitution, but the right to substitute is enough. The ruling just issued tells us that having such a power need not cause the proceeds to become subject to federal estate tax. It’s one of those intricate drafting situations that actually works very simply and preserves the excellent tax benefits life insurance offers.

Like writing a will, buying life insurance is something that people sometimes avoid, with its suggestion of mortality. There are some complexities to it, but careful planning can make it an important part of your financial “story.”

Republished with permission of The Legal Intelligencer.

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For many people, their largest financial asset will be the balance in their retirement plan. The growth in 401(k) plans and the increases in the limits on deductible contributions to retirement plans have resulted in growth of such plans to overall levels of trillions of dollars. This growth has generated a number of issues, but a requirement covering all such plans and raising many issues is the necessity of taking withdrawals from such plans beginning at a specified age and at a specified rate.

Why are there such rules, called minimum distribution rules and imposed by Section 401(a)(9) of the Internal Revenue Code, and a mountain of IRS regulations? The ability to deduct contributions to such plans causes a loss of tax revenue to the Treasury, and they want the money back…eventually. The longer the wait to get the lost tax revenue, the less value it has to the Treasury. So the specified age for beginning distributions is 70.5, and the rate can be over life expectancies or a specified number of years. The failure to comply with these rules can result in a penalty of 50 percent of the amount that should have been taken out but was not. This creates a powerful incentive to take distributions as required by law.

But the rules are complicated, and it’s easy to make mistakes and to forget to take distributions when they are required. This is especially true when the plan owner dies and leaves the remaining benefits to family members. The naming of individuals as beneficiaries, or trusts for a group of beneficiaries, or separate trusts for each beneficiary can lead to different requirements for minimum distributions. Several books have been written on the subject of retirement plan distributions, and even they don’t cover every situation.

In private letter rulings, the IRS responds to inquiries by and on behalf of taxpayers. The responses they give are to the particular taxpayer and fact pattern, and they cannot be relied upon as authority for other transactions. Despite this limitation, they are useful in showing the thinking of the IRS on difficult tax questions. A recent private letter ruling, No. 200811028, illustrates a solution to a problem of late distributions. In this ruling, a decedent’s IRA was left to a beneficiary. The IRA indicated that distributions were to be made to the beneficiary over his life expectancy, unless he elected a faster payout over five years. The beneficiary did not make such an election, but he also forgot to start taking distributions over his life expectancy. Those distributions should have begun a year after the year of death of the IRA owner, and the first few payments were missed. When this error was discovered, the beneficiary caught up on the late payments, and he paid the 50 percent penalty tax on the late payments. The IRS ruled that he could continue payments over his life expectancy, enjoying the stretched-out deferral of tax, despite having missed the first few payments. In effect, the IRS said that the failure to take the necessary payments was not an election of the shorter five-year payout method.

The lesson of this private letter ruling, and many others on the subject of required minimum distributions, is that considerable care is needed in choosing how and when retirement benefits are to be paid, especially to beneficiaries. But if the distribution process gets off to a rocky start, there are some techniques available to preserve the favorable tax treatment for retirement distributions.

Republished with permission of The Legal Intelligencer.

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Megatrends is a name given to important changes in the economy or in the behavior of many people. People write books and articles about megatrends, hoping to identify them before others do and to benefit in some way (usually by selling more books). There are several megatrends that have a definite impact on trusts and estates work, and that will be discussed in future blogs:

• People are becoming wealthier, even with the current stock market setbacks. This is a worldwide phenomenon and contributes to the international flavor of much estate planning.
• A large number of people (the always demanding baby boom generation) are getting close to retirement and to a “final” disposition of their assets.
• There is a strong interest in business succession planning, particularly in this part of the country, where there are so many family-owned businesses. To deal with these issues, trusts and estates lawyers often have to act like psychologists, or at least hire them.
• People want to protect their assets against litigation and divorce, among other threats.
• There is and will continue to be a need for increased tax revenues, which leads inevitably to more complex tax laws and the need to plan for them. When Congress talks about tax simplification, tax lawyers go car shopping.

The combination of these megatrends demonstrates the growing importance of the broad practice area of trusts and estates, often referred to by more general names such as personal wealth, private client or wealth transmission, and ensures that this will be an area of growing importance for lawyers, one that focuses not on death but on the enjoyment of life.

In the next blog, we’ll review the campaign to repeal the federal estate tax and the likely future of the tax and the exemption from tax, as well as efforts to repeal the Pa. inheritance tax.

Republished with permission of The Legal Intelligencer.

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Each year, at about this time, the Internal Revenue Service and Social Security Administration issue numbers for various transactions and planning for 2008. Here are a handful of those numbers:

Social Security wage base for 2008: $102,000, up from $97,500 in 2007.

Cost of living Social Sceurity benefit increase: 2.3%

Maximum Social Security benefit at full retirement: $2,185 per month, up from $2,116.

Maximum contribution to defined contribution retirement plans: $46,000 per year, up from $45,000.

Maximum 401(k) deferral amount: unchanged at $15,500 per year.

Fringe benefit exclusion for commuting costs: $115; for parking, $220.

Annual gift tax exclusion: unchanged at $12,000.

These and many other numbers will be included in our benefits card, which will be issued shortly. If you would like to receive that card, at no cost, please send an e-mail to rlouis@saul.com.

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In recent years, several tax laws have reduced federal income tax rates and added to the ability to set aside amounts for retirement in a tax-advantaged way. At the same time, other changes in tax law, by limiting deductions, for example, have actually increased tax burdens. And, the inattention to the growth of the alternative minimum tax has resulted in millions of people having to pay that additional tax. A tax bill just passed by Congress, that will shortly be signed by the President, provides another example of this. The kiddie tax, which taxes children, up to a certain age, at the same rates paid by their parents on much higher income, has been amended to increase the age at which the higher tax rates apply to age 18, and to age 24 if the child is a student. So tax benefits for others are paid for by increasing taxes on children, most of whom won’t be able to vote out the politicians who increased their taxes.   

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