Tax Season Checklist

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Written by Martin M. Shenkman

This is a tough tax season to prepare a checklist for in advance because so much of the law is uncertain. So, here are some planning ideas that will serve you and your clients well but which won’t be eliminated by legislation passed before you read this article:

Interest Income and Expense

Many clients engaged in intra-family loans in 2010. This was done in part because the historic low interest rates made this a tremendously valuable estate and financial planning tool. These loans were also common because of the tremendous economic disruption and efforts by family members to help out other family members that were in economic distress.

Critical to these loans being respected as loans for tax purposes is the proper reporting of loan interest income and expense by both sides of the transaction. If interest is not paid as required, and not reported properly, the IRS will likely recharacterize these loans as gifts.

Practitioners should inquire as to whether clients engaged in these transactions, obtain copies of the signed notes for their permanent files and verify proper reporting.

Insurance Trust Loans

Irrevocable life insurance trusts (ILITs) are almost ubiquitous in the planning arena. 2010, among other anomalies, changed the way many clients had to fund insurance premium payments through their trusts. If the client’s ILIT was planned to be exempt from the generation skipping transfer (GST) tax in 2010, clients probably should not have made gifts to the trust since no GST exemption could be allocated to the trust. (This is true since there was no GST in 2010.)

Therefore, many of these clients would have loaned the money to the trust that the ILIT needed to pay insurance premiums. These loans need to be respected to avoid undermining the GST status of the trust, which means addressing the recommendations for personal loans in the preceding paragraph.

Late Allocation of GST

So, your client funded trusts in 2010 while interest rates and asset values were low, but could not allocate GST; evaluate whether a late allocation of GST exemption should be made in 2011. If the gift tax return reporting the 2010 gift is not filed in a timely manner, then the GST exemption can still be allocated to protect the transfer of property to the trust. The value of the gifts for purposes of allocating the GST tax exemption will be the value on the date the gift tax return is filed in 2011. IRC Sec. 2642(b)(3).

If your client made a gift transfer to a trust and must make a late allocation of GST exemption to the donee trust in 2011, the client can elect to value the transferred property as of the first day of the month in which the allocation occurs. Reg. 26.2642-2(a)(2). This will be an unusual tax season in that this analysis of late GST allocation may affect far more clients than ever before.

However, many of the laws and issues remain in flux at the time this is written, so practitioners should exercise caution to review recent developments that might affect the late allocation of GST for 2010 gifts.

Title to Assets

In 2010, married clients should have focused on dividing assets they own so that approximately half of the appreciation in their estate was owned by each spouse. This should have been done to capitalize on the carryover basis adjustments permitted while the estate tax was repealed. Many clients have ignored asset title for years once the size of the old federal estate tax exclusion exceeded their net worth ($3.5 million in 2009).

Well, unless Congress has acted before you read this article, the exclusion for 2011 is scheduled to be only $1 million. Even if the amount has been increased, the combination of recession and years of neglecting planning will make it imperative that most clients revisit how their assets are owned, so that whichever spouse dies first a bypass trust can be funded.

When preparing a return and receiving 1099s and other documents indicating ownership, make a follow up note in the file for post-tax season consulting on this issue.

Carryover Basis Returns

These will be due for decedents who died in 2010. The return is new and at the time this article is being written the IRS has withdrawn the draft form they had issued, “Form 8939, Allocation of Increase in Basis for Property Received from a Decedent.” Expect complexity.

The return will allocate the special basis adjustment of $1.3 million available for every decedent on property passing to any beneficiary. For married decedents passing property to a spouse, an additional adjustment of $3 million will be available if the special requirements for Qualified Spousal Property (“QSP”) are met.

Be cautious completing the form as you will need appraisals to determine date of death values, basis information, and the manner in which the adjustment should be allocated if the appreciation in the estate exceeds these amounts.

Roth Conversions

These were popular in 2010. Now you have to make decisions: When should the tax be reported for 2010, or spread over two years? If new tax laws establish the income tax rates for 2011 and later years, you may have more concrete information than the client did when the conversion was consummated.

Clients have until October 15 to recharacterize so perhaps every return that reflects a Roth conversion should be extended. If a client is elderly or infirm, be certain that they have a durable power of attorney that specifically permits recharacterization.

Schedules K-1

Be alert when completing K-1s for partnerships, LLCs and S corporations. Many astute clients made gifts during 2010 to take advantage of depressed asset and business values. While the clients and their estate planners should have involved CPAs in the entire process, too often they don’t.

Practitioners preparing K-1s based on “SALY” (same as last year) could contradict planning. This is an important tax season to be certain that you have up-to-date shareholder, operating or partnership agreements confirming ownership percentages in your entity’s permanent files.

Schedules C and E, One Member LLCs

Many clients have opted to form LLCs for real estate rental properties and small businesses, often using single member LLCs to avoid the cost of filing a Partnership Form 1065. This could be a big mistake, and practitioners should identify clients to warn when completing Schedules C and E.

Single member LLCs provide a measure of asset protection from inside liability (e.g., the tenant on a real estate LLC sues your client, the owner). They do not afford protection from outside liability (e.g. a physician owns a single member LLC and rental property and is sued for malpractice). Adding meaningful additional members may provide important asset protection benefits for your client. (These will vary depending on state law.)

Buy Sell Agreements

Few clients have revised their buy sell agreements during the long recession and tepid recovery. Many are reluctant to incur costs on something they view as non-critical, while they have been struggling to keep their business going through difficult times.

However, many who have buy sell agreements that based on those formulas could have dramatically different results than anticipated. Identify appropriate clients for post-tax season follow up.

Ostriches Must Act

Most clients — not many, most — have ignored critical aspects of estate, tax, financial, insurance and business planning for years as a result of the double whammy of recession and uncertainty about the tax laws. There probably has never been a tax season in memory where practitioners will be able to identify problems that clients will need to address post-tax season. Implement procedures as soon as possible to flag clients and issues for those clients for post-tax season planning.

REVIEW QUESTION

The carryover basis return for decedents who died in 2010 will allocate the special basis adjustment of what amount on property passing to any beneficiary is: $1 million, $1.3 million, $3 million or $3.5 million?

Answer: $1.3 million

$3.5 million is incorrect, because that is the minimum estate amount before federal tax in 2009. $1 million is incorrect, because that is the minimum amount before federal tax for 2011 if Congress fails to act before 12-31-2010.

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