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Tax planning ideas.

Consider income tax rates when making charitable bequests Income and estate tax planning need not always be complicated. Many clients, through wills, provide specific bequests to charitable organizations that are usually funded at death with cash from the estate. Clients and their heirs would benefit more if they simply designated the charitable organization as a beneficiary of their retirement plans up to the amount of the bequest. Since a retirement plan is "pregnant with income taxes," a noncharitable beneficiary will have to pay income taxes on the retirement plan proceeds as they are distributed; this significantly reduces the amount received by the heirs on an after-tax basis. A charitable organization, on the other hand, does not have to pay any income taxes on retirement plan proceeds. Thus, at current income tax rates, as much as $19,800 could be saved in income taxes by restructuring a $50,000 charitable bequest.

Consulting arrangements for retirees

Retirees are often confronted with extreme tax rates if they desire to keep working after retirement. Under the Revenue Reconciliation Act of 1993 (RRA), up to 85% of social security benefits are subject to tax for retirees with "provisional" income in excess of $44,000. In addition, the RRA removed the cap on the Medicare tax and increased marginal income tax rates to 39.6%. Retirees also have earnings limitations for social security purposes; a retiree under 65 years of age loses $1 of social security benefits for every $2 in earnings above $8,040. With such consequences, many advisers recommend that retirees not work.

Still, if arranged properly, many retirees can offer valuable services to their former employers as consultants. In Barrett, 58 TC 284 (1972), the Tax Court ruled that in limited circumstances, the performance of consulting services solely to a former employer did not constitute a "trade or business." Thus, a retiree could avoid social security and Medicare taxes on the income (although the Social Security Administration would have the right to "reclassify" the income as earned income for purposes of the earning limitations).

Note that a different result was reached in Baronet, 69 TC 609 (1978), in which a retired bank executive was held to have received self-employment income because he was only prohibited from providing similar services to banks located in the same town as his former employer.

This strategy does not come without risks for retirees. While the IRS acquiesced to the result in Barrett, the Second and Eleventh Circuits have rejected Barrett outright; see Grosswald v. Schweiker, 653 F2d 58 (2d Cir. 1981), and Steffens, 11th Cir., 1983. Note also Rev. Rul. 82-210, which stated that arrangements to provide services exclusively for one client would not preclude liability for the self-employment tax imposed under Sec. 1401.

Downsizing a personal residence

Once their children are grown, many clients decide to sell their large home and purchase a smaller one more suited to their current needs. As an example, this may mean selling a principal residence with a cost basis of $200,000 for $600,000 If a smaller replacement home were purchased for $300,000 the couple would have a $300,000 taxable gain (reduced to $175,000 if the couple qualifies for the $125,000 exclusion under Sec. 121).

The couple might be able to defer the tax on the sale of the principal residence by converting a portion of the house to rental property. The rental portion of the house is not available for "rollover" purposes under Regs. Sec. 1.1034-1(c)(3)(ii); however, it can be exchanged under Sec. 1031 for like-kind property. In this example, if the rental portion were valued at $300,000, the couple would be able to defer the entire tax on the sale of the principal residence under Secs. 1031 and 1034.

Using valuation discounts for assets' inherent capital gains tax


The repeal of the General Utilities doctrine by the Tax Reform Act of 1986 makes it virtually impossible for a taxable corporation to sell or distribute appreciated assets without incurring a taxable gain. In valuing companies, a discount for the inherent capital gains tax liability was not normally recognized by the courts, since the gain could often be avoided or minimized in a liquidation (see Cruik-shank, 9 TC 162 (1947) and Ward, 87 TC 78 (1986)); likewise, the cost of liquidation is not taken into account for valuation purposes when the prospect of liquidation is speculative.

The IRS reaffirmed this position in Letter Ruling (TAM) 9150001, stating that the inherent capital gains tax liability of a corporation could not be considered in valuing the stock of the corporation, in the absence of evidence that a liquidation is actually contemplated. This position contradicts the language in Rev. Rul. 59-60, which is the basis for valuing companies and generally acknowledges that costs of liquidation should be considered in valuing a business (Rev. Rul. 59-60, Section 5(b)).

In Obermer, 238 F Supp 29 (DC 1964), the taxpayer claimed a discount for the inherent capital gains tax liability. His valuations expert argued successfully that a willing buyer would certainly discount the value of appreciated corporate assets by the capital gains tax if they were sold or otherwise distributed in liquidation. Therefore, the district court distinguished Cruikshank (in which a valuation expert was not used), and held for the taxpayer.

In a recent Georgia case, Est. of Gray, TC Memo 1993-334, the Tax Court held that the taxpayer was able to use a valuation discount for the inherent capital gains tax liability, again based on expert testimony. The taxpayer owned a controlling, majority stock interest in a publicly held company. The company owned, among other things, three television stations and a newspaper company. The court held that a potential buyer would most likely sell the newspaper company (in order to comply with the Federal Communications Commission's cross-ownership rule). As a result, a $2.8 million discount was allowed for selling expenses and taxes. Given this decision, taxpayers should look at documenting the capital gains tax liability through expert valuation. And this court decision can certainly be relied on by taxpayers in the Eleventh Circuit, despite the current IRS stance on this issue.
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Title Annotation:charitable bequests, social security benefits, residence rollovers, capital gains valuation
Author:Lusby, Roger W., III
Publication:The Tax Adviser
Date:Dec 1, 1994
Previous Article:... As deduction.
Next Article:Meals and lodging exclusion for S shareholders.

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