The Employee Retention Credit remains one of the best tax benefits for small to medium businesses and tax-exempt entities. The ERC provides eligible employers up to $7,000 per employee per quarter in refundable tax relief for the first three quarters of 2021 and a reduced benefit for 2020. Businesses and tax-exempts can still apply for the ERC on an amended return. However, slow processing of amended returns has meant significant delays in business owners and charities getting much-needed relief checks in their hand. In addition, the limited interaction between the IRS and taxpayers asking about the status of their ERC refund applications has only served to heighten taxpayers’ frustration.

The overall impact is that taxpayers do not realize the benefits of ERC in a timely manner. The delays are even discouraging some eligible taxpayers from even taking the ERC. As much attention and focus Congress and the Treasury place on creating tax credits and incentives, equal attention and focus are needed on administering these tax credits and incentives if they are going to be utilized by small and medium businesses. With Congress recently increasing funding for IRS staffing, the Treasury and IRS need to make a priority of taxpayer service, and a good place to start would be with the ERC program.

IRS Processing Of ERC Claims

The Treasury Inspector General for Tax Administration recently issued a report on IRS administration of ERC and other Covid-19 tax relief. The report notes a backlog of 447,435 unprocessed 941-X Forms, although the IRS says that number is now down to 207,000 unprocessed 941-X Forma as of August 31, 2022.

The delay in processing means some business owners have to take funds out of pocket and pay taxes now, while they may wait many months for these pandemic relief funds. Delays are bringing real costs and burdens to small and medium businesses. Adding to the frustration for business owners is not having any sense of timing or update from the IRS on when their ERC payment will be processed and check issued. Business owners and their CPAs should not have to spend hours on the phone to finally get through to talk to someone at the IRS. Further, too often, when they finally speak to an IRS representative, they cannot provide any substantive and useful information about the specific claim and when a check will be issued.

IRS Needs To Focus On Taxpayer Services

With Congress recently emptying the money sacks for IRS staffing – an additional $80 billion over ten years – the Treasury and IRS need to make a priority of taxpayer services and a good place to start would be with the ERC program. The new funds for the IRS have a strong tilt toward enforcement but not nearly enough for taxpayer services. Of the $80 billion in additional money, about 57% of funds are for enforcement, with only 4% for taxpayer services and 6% in new money for business systems modernization.

The Treasury Secretary outlined priorities in a memorandum to the IRS Commissioner, clearing the backlog of filings to be processed, including the ERC; improved taxpayer service; systems modernization; and hiring. The Secretary’s taxpayer service and processing priorities are heartening, although the proposed budget numbers are not balanced to reflect those priorities. The Secretary and Commissioner need to establish clear benchmarks for services to taxpayers and their tax advisors and provide sufficient funds and staffing to meet those goals.

The ERC dollars have been extremely meaningful for many small and medium businesses as well as charities. However, the impact of the difficulties of administration of ERC and processing of amended returns requesting ERC funds should serve as a great caution to Congress since it provides a window to the problems for small and medium businesses when there is no focus on tax administration and providing meaningful taxpayer service. The new funding provides an opportunity to fix these problems and ensure that taxpayer service is of high quality and that processing is done promptly.

Talley’s team of tax professionals provides comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

The Internal Revenue Service is providing penalty relief to most individual taxpayers and businesses that filed their 2019 or 2020 returns late due to the COVID pandemic by refunding $1.2 billion in penalties. The IRS is going further to help the taxpayers who have already paid the penalties by refunding them with automatic payments expected to be completed by the end of this month. Along with providing relief to individuals and businesses affected by the COVID-19 pandemic, the IRS will be able to focus its resources on processing backlogged tax returns and taxpayer correspondence to help return to normal operations for the 2023 filing season.

The relief applies to the penalty imposed for failing to file, which is usually assessed at a rate of 5% per month and up to 25% of the unpaid tax when a federal income tax return is filed late. This relief applies to forms in the Form 1040 and 1120 series and others listed in Notice 2022-36. To qualify for the relief, any eligible income tax return must be filed on or before Sept. 30, 2022.

The IRS also offers penalty relief to banks, employers, and other businesses required to file various information returns, such as those in the 1099 series. To qualify for relief, eligible 2019 returns must have been filed by Aug. 1, 2020, and eligible 2020 returns must have been filed by Aug. 1, 2021. As both deadlines fell on a weekend, a 2019 return will still be considered timely for purposes of relief provided under the notice if it was filed by Aug. 3, 2020, and a 2020 return will be considered timely for purposes of relief provided under the notice if it was filed by Aug. 2, 2021. The notice provides details on the information returns that are eligible for relief.

The notice also provides details on relief for filers of various international information returns, such as those reporting transactions with foreign trusts, receipt of foreign gifts, and ownership interests in foreign corporations. To qualify for the relief, any eligible tax return needs to be filed on or before Sept. 30, 2022.

The penalty relief is available for Form 1040 and related forms, as well as Form 1041 and related forms, Form 1120 and related forms, Form 1066, Form 990-PF, and related forms. It also applies to some international information returns, including Forms 5471 and 3520. For businesses, it applies to Forms 1065 and 1120-S. The relief also relieves penalties for failure to timely file certain information returns that meet the following requirements: 

  • 2019 information returns filed on or before Aug. 1, 2020, with an original due date of Jan. 31, 2020, Feb. 28, 2020 (if filed on paper) or Mar. 31, 2020 (if filed electronically), or Mar. 15, 2020; and
  • 2020 information returns filed on or before Aug. 1, 2021, with an original due date of Jan. 31, 2021, Feb. 28, 2021 (if filed on paper) or Mar. 31, 2021 (if filed electronically), or Mar. 15, 2021.

However, the penalty relief does not apply to any penalties not explicitly listed in the notice or fraud situations. It also does not apply to an accepted offer in compromise, a settled closing agreement, or a finally determined judicial proceeding.

Talley’s team of tax professionals provides comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

Since its approval in July 2021, much information has been written about the California Pass-Through Entity Tax Credit. The California Small Business Relief Act established the PTE tax credit largely in reaction to the $10,000 limit on the amount that individual filers could deduct in state taxes on their federal tax returns as a result of the 2017 Tax Cuts and Jobs Act.

For instance, a taxpayer earning $200,000 in a state with a 10% tax rate incurs a $20,000 state tax, but only $10,000 of that amount is potentially deductible on their Form 1040. The $10,000 SALT deduction limitation includes all state, local, real, and personal property taxes. To offset this limitation, the legislature of California and 26 other states sought a workaround, and the result was the PTE, pass-through entities.

What is the PTE all about? The California Franchise Tax Board states that for taxable years beginning on or after Jan. 1, 2021, and before Jan. 1, 2026, qualifying PTEs, which are usually private partnerships or S corporations, may annually elect to pay an entity-level state tax on behalf of its members. The elective tax is 9.3% of the entity’s qualified net income. Eligible taxpayers receive a credit for their share of the entity-level tax, reducing their California personal income tax; any unused credits can be carried over for up to five years. The FTB specifies that a qualified taxpayer is a partner, member, or shareholder of an electing qualified entity that is:

  • An individual, fiduciary, estate, or trust subject to California personal income tax; or,
  • A disregarded single-member LLC owned by an individual, fiduciary, estate, or trust subject to California personal income tax.

A taxpayer must consent to have their pro rata or distributive share and guaranteed payments included in the qualified net income of the electing qualified PTE. An annual election is made on an original, timely filed tax return. Once the election is made, it is irrevocable for that year and is binding on all partners, shareholders, and members of the PTE.

In February 2022, the California State Senate made changes to the PTE tax and tax credit using Senate Bill 113. These changes include:

  • PTE credits reduce net tax below a taxpayer’s tentative minimum tax;
  • Qualified partnerships can have partners who are partnerships;
  • Qualified taxpayers can include certain single-members LLCs;
  • Qualified net income includes guaranteed payments; and,
  • Other state tax credits will be used before the PTE tax credits.

What should filers and tax preparers be aware of? The law has only been on the books for one tax season. With the 2022 filing year upon us, California entities, owners, and their preparers must recognize the many issues affecting their PTE tax credit. If a pass-through entity has nonresident shareholders, members, or partners, the credit is applicable only for the California-sourced income. Additionally, S corporations must be cautious when making the election for qualified owners. Compensating distributions must be made to non-qualified shareholders to avoid jeopardizing the entity’s S corporation status.

The PTE’s timely filing is critical, as the pass-through entity must make minimum estimated tax payments on or before June 15, 2022, and each succeeding year through 2026. For California only, each qualified taxpayer is entitled to a nonrefundable credit that can be carried forward for up to five years or until used up. It is crucial that whoever oversees financial reporting for the entity should ensure that all the owners are aware of their elections and the amount paid on their behalf.

What can we expect going forward? For 2022 and subsequent years, the PTE elections must be made in a timely manner, and any overpayment that results in a refund needs to be applied to that year’s estimated tax payment. Thus, ample time should be provided to evaluate the election’s benefits and to obtain consent from eligible taxpayers.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

On August 18, 2022,  President Biden signed the Inflation Reduction Act into law. This act has a lesser-known provision that may benefit many small business startups, allowing them to potentially double the amount they can claim on the research and development tax credit from $250,000 to $500,000 per year against payroll taxes. Under current law, small businesses that may not have enough income tax liability to take advantage of their research and development credit can apply up to $250,000 of the credit toward their Social Security payroll tax liability.

To qualify for the expanded credit, the small business would need less than $5 million of gross receipts and be less than five years old. The Inflation Reduction Act would permit an additional credit of up to $250,000 to be applied against the Medicare payroll tax for tax years starting after December 31, 2022. The expanded R&D tax credit will not show up on tax returns until 2024 since it can first be claimed for tax year 2023, but it could boost small businesses, particularly the startups it can incentivize.

Many are waiting for additional guidance on claiming the tax credit to be released by the Internal Revenue Service and the Treasury Department. As more details will be needed, the Inflation Reduction Act essentially raises the cap for small businesses from $250,000 to $500,000, which will be allowed against the Medicare hospital insurance coverage. A recent study shows that only about half the people who are qualified to take the credit actually take it. With more opportunities coming to use the credit and the higher limits, many more opportunities will be created to fund innovation for today’s R&D customers. 

However, there will be some hurdles as the IRS has been increasing the requirements lately for documenting R&D activities. A September 2021 memorandum from the IRS Office of Chief Counsel said it wants more detailed information about all the business components for that year’s research credit claims. For each business component, companies will need to identify all the research activities they have performed and name the individuals who performed each research activity, along with the information each individual sought to discover. Refund claims for the research and development credit will also need to detail the total qualified employee wage expenses, total qualified supply expenses, and total qualified contract research expenses for the claim year, using Form 6765. The additional requirements have led to some consternation among companies and tax professionals. However, expanding the R&D credit under the Inflation Reduction Act should spur more interest in claiming the credits among companies, especially tech startups.

Talley shares the same entrepreneurial spirit that has helped propel our clients to their current levels of success. With over 25 years of experience assisting high net worth individuals and business owners, Talley has the expertise necessary to help entrepreneurs throughout their entire journey, from formation to succession.

Senate Majority Leader Chuck Schumer’s plan to increase taxes on some businesses to bolster Medicare raised alarms about inflation, potentially complicating attempts to pass a broad economic package. Schumer’s plan would expand a 3.8% net investment income tax to the profits pass-through entities distribute to their owners, so long as those individuals earn more than $400,000. Under current law, the investment tax only applies to individuals and estates.

Lawmakers expressed concern about the impact of federal spending on inflation just hours after the government reported that the consumer price index shot up 9.1% in June. Due to this, some lawmakers urge that the proposal rolled out to increase taxes on pass-through entities, like limited partnerships and other small businesses, should be analyzed to ensure that it does not fuel inflation or harm taxpayers. Despite weeks of talks between lawmakers about a climate, health, and deficit reduction plan funded by tax hikes, there are few public signs of progress in reaching an agreement. Business groups are urging lawmakers to scale back the proposed levies, while progressives are urging lawmakers to preserve the tax increases for wealthy individuals.

In addition to the debate over the tax increase on pass-throughs, progressives are urging Senators to preserve other tax increases that would affect the wealthy. One focus is the millionaires’ surtax, which would put a 5% surcharge on incomes over $10 million and an additional 3% levy on incomes over $25 million, which is at risk of being cut from the package. Last year, other tax hikes, such as raising the top tax bracket or increasing capital gains rates, were eliminated from the negotiations. Progressives fear that dropping proposals like the pass-through tax expansion and a surcharge on the ultra-wealthy would mean that high net-worth individuals would face little to no tax increases in a bill initially envisioned as a significant tax hike on top earners.

Talley’s experienced team of tax professionals provides comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on to the next generation the assets and wealth that you have worked hard to build. We welcome the opportunity to discuss the current options available to you. For more information, contact us today.

In the CARES Act of 2020, Congress created the ERTC, Employee Retention Tax Credit , to reward and encourage businesses to keep their employees on payroll during the COVID-related shutdowns. The ERTC aimed to incentivize employee retention by offering employers a quarterly credit for each qualified employee. The ERTC has a maximum credit of $5,000 per employee in 2020 and $21,000 per employee in 2021. Employers can still retroactively take advantage of this credit against federal employment taxes on qualified wages paid to their employees from March 13, 2020, through September 30, 2021.

ERTC Eligibility. Eligibility rules changed from 2020 to 2021, as well as the amount of wages available to claim. Eligible businesses or tax-exempt organizations that conduct a trade or business must have experienced one or both of the following criteria:

  • The business was forced to partially or fully suspend or limit operations by a federal, state, or local governmental order.
  • The business experienced a 50% decline in gross receipts during any quarter of 2020 versus the same quarter in 2019 and a 20% decline in gross receipts in 2021 against the same quarter in 2019.

Claiming ERTC. Your ERTC claim will include total qualified wages and healthcare costs. To claim the credit, start with these steps:

  • Amend previously filed 941
  • For each qualifiable quarter, fill out and submit a 941X

Qualifying Wages. For 2020, if you averaged more than 100 full-time employees (FTEs), only wages for those you retained who are not working can be claimed. If you employed 100 or fewer FTEs, you can claim wages for all employees whether or not they are working. For 2021, the threshold is raised to 500 full-time employees, meaning if you employ more than 500 FTEs, you can only claim the ERTC for those who are not providing services. If you have 500 or fewer FTEs, you can claim the credit for all of them, working or not.

How does it work? The Employee Retention Credit is taken off the employer’s share of Social Security taxes. However, the credit is fully refundable. So, if the credit were to exceed the employer’s total amount owed to Social Security in any calendar quarter, the excess is refunded to the employer.

The credit was initially set to expire on January 1, 2022, allowing employers to claim it for all four quarters of 2021. However, in November of 2021, a bipartisan physical infrastructure law included a provision changing the ERTC’s timeframe to only apply for the first three quarters of 2021 and not Q4.

Talley’s professionals have spent literally hundreds of hours reviewing the law, regulations, and FAQs issued on an almost daily basis regarding the ERC and PPP, and we are happy to assist you in the process. We are available to simply answer a quick question or assist in the application and/or refund process.

According to a report released recently by the Government Accountability Office (GAO), it has been found that in recent years the IRS has been auditing fewer taxpayers since 2010, with audit rates for wealthier taxpayers decreasing the most. The IRS officials blame the decline in audit rates on staffing decreases and the fact that it takes more staff time and expertise to handle complex higher-income audits. From tax years 2010 to 2019, audit rates of individual income tax returns decreased for all income levels, according to the findings. On average, the audit rate for these returns decreased from 0.9% to 0.25%. However, while audit rates saw a greater decline for higher-income taxpayers, the IRS generally audited them at higher rates than lower-income taxpayers. 

The average number of hours spent per audit was generally stable for lower-income taxpayers but more than doubled for those with incomes of $200,000 and above. According to IRS officials, the greater complexity of higher-income audits and increased case transfers due to auditor attrition contributed to the time increase. In response to the report, the deputy commissioner of services and enforcement at the IRS, Douglas O’Donnell, commented that auditing requires auditors to appropriately respond to taxpayers with increasingly complex business and investment activities. The greater the complexity, the more sophistication, skill, and time to perform the necessary review of information and correctly apply the law. 

House Ways and Means Oversight Subcommittee chair Bill Pascrell, had requested the GAO report and criticized the findings. His office found that except for those with over $5 million in income, audits of the lowest-income taxpayers resulted in higher amounts of recommended tax per audit hour. The IRS collected about one-half of all recommended taxes between 2011 and 2020, with collection rates generally higher for those taxpayers with incomes under $200,000, including Earned Income Tax Credits (EITC) recipients. That is probably because the IRS conducts EITC audits before issuing refunds. According to the IRS, high-income audits are more likely to have recommended tax amounts that are abated or more challenging to collect fully.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

Wealthy investors may face new restrictions when transferring assets to heirs, due to a recent proposal by the Treasury Department. The Department stated that it would “claw back” the tax savings of several wealth planning strategies come 2026 when historically high exemption levels for gift and estate taxes are due to be sliced in half. The proposal reflects the Biden administration’s concern that affluent Americans are racing to use clever strategies during the window to create “artificial” gifts to pass on tax-free wealth to future generations. The proposal targets strategies in which a taxpayer gives assets to a beneficiary while maintaining control over a substantial interest in them. These strategies are what the IRS considers to be a disguised gift that is taxable. It is a fresh blow to affluent investors and their advisors who thought their careful plans were laid in stone. 

Under scrutiny. One arrangement in the crosshairs is a partnership in which a regular interest is given to an heir while the donor retains a preferred interest. Another scenario concerns a promise by a donor to make gifts to a recipient in the future. A third example involves a trust to which a grantor transfers assets but also receives income from the gifted property. In all three instances, the moves use up some or all of a donor’s exemption, which this year is just over $12 million, $24 million for married couples. These higher levels, a product of the 2017 tax-code overhaul, will fall roughly by half come 2026. The Treasury proposal would claw back taxes on transferred amounts that exceed the lower exemption levels for people using the strategies who may die that year. The lifetime gift and estate tax rate is 40%. The goal of this is not to allow wealthy taxpayers to lock in the currently high use-it-or-lose exemption amount.

GRATs. A common estate planning technique, Grantor Retained Annuity Trusts (GRATs), may also get caught even though the strategy does not technically involve artificial gifts. Under the Treasury’s proposal, the IRS would calculate the tax bill of a donor who retains an interest of more than 5% of the value of assets they transfer to a GRAT under the lower exemption. If the donor dies before the trust’s term ends, their stake is pulled back into their estate, resulting in a bigger tax bill on assets they thought they had moved out. For example, suppose a donor put $100 million into a GRAT for the benefit of their children last year, under IRS rules. In that case, the trust pays them a yearly “annuity” that totals slightly more than the value of the contributed property or cash over time. In the eyes of the tax agency, the paybacks reduce the taxable value of the gift, say in this case, to $10 million. So the donor has shifted $100 million out of their estate to benefit their kids but used up only $10 million of her current exemption. Meanwhile, the trust appreciates, and its gains go to the children tax-free. Under the proposal, because the taxable value of the gift is more than 5% of the transferred amount, the donor has not locked that $10 million of their currently higher exemption. Meaning they would thus face a higher tax bill come 2026. One big issue is that the strategies on the firing line are irrevocable. They are legal contracts that cannot be unwound. 

Saved by Zero. However, there seems to be a silver lining to the 5% rule. It will not apply to so-called zeroed-out GRATs, in which annuities equal the original value of what was put into the trust. This is because, under current IRS rules, such a trust does not use up any of a donor’s exemption, even as it moves money out of the estate. Assets in that trust, a staple with the 1 percent, appreciate over time, and the left over after annuities goes to heirs tax-free. The proposal also does not affect nuts-and-bolts planning in which a donor bequeaths property while keeping control or possession of it while alive. For example, suppose Grandma and Grandpa have an estate worth $20 million and set their son up to inherit $7 million when they die. In that case, they can safely use their current exemption of over $24 million if they pass away after 2026.

The 10-year itch. Wealth advisors are already chafing from severe curbs on inherited retirement accounts. Under a law that Congress passed in 2019, heirs to traditional individual retirement accounts (IRAs) and workplace retirement plans, including 401(k)s, 403(b)s for educators and 457(b) deferred compensation plans, can no longer “stretch” required minimum withdrawals out over their lifetimes. Instead, they have to drain the accounts within ten years. In May 2021, the IRS said that beneficiaries of the accounts were not required to take annual distributions before the 10-year deadline. Advisors breathed a sigh of relief because it gave the tax-deferred accounts more time to appreciate. But on Feb. 23, Treasury reversed course, issuing another little-noticed proposal to require minimum annual distributions in years one through nine. That rule applies to heirs who are not spouses or children under age 18 and inherit a retirement account starting in 2020. However, this does not include Roth Plans.

Talley’s team of tax professionals provide comprehensive tax compliance and consulting services so you can preserve, enhance, and pass on your assets and wealth to the next generation. We welcome the opportunity to discuss the current options available for you. For more information, contact us today.

In response to the pandemic, Congress provided billions of dollars in tax credits to employers, which helped pay for sick and family leave, as well as retaining employees, but now the IRS needs to step up its compliance efforts, according to a new report. The report, released in early May by the Government Accountability Office (GAO), examined the impact of Congress’ various pandemic relief laws since 2020. This includes the CARES Act and the Families First Coronavirus Response Act. Provisions in those laws established paid sick and family leave credits, the Employee Retention Credit and payroll tax deferrals. As Congress enacted the new laws, the IRS continued to revise the relevant employment tax returns and guidance. The IRS managed to implement those complex provisions despite facing delays caused by facility closures and other challenges. Paid sick and family leave credits and Employee Retention Credits for 2020 totaled about $20.7 billion, including $9.8 billion for the leave credits claimed by over 1.5 million employers and $10.9 billion for the ERC claimed by 199,834 employers. Payroll tax deferrals totaled about $123.6 billion claimed by over 1 million employers. The totals seem to have been even higher last year, according to preliminary data.

The GAO noted that the IRS took steps to identify and plan for compliance risks associated with the leave credits and the ERC. Both types of credits expired last year but will be subject to examination by the IRS for several years after filing. The report found the IRS could strengthen its efforts by expanding the use of some of its project management practices. The IRS’ compliance objectives did not evolve to reflect statutory changes made after the CARES Act, are not measurable, and do not include criteria to measure success. In preliminary data, GAO found 337 filings, totaling $100 million, from employers that were established in April 2020 or later but then stopped filing employment tax returns. IRS screening filters flagged more than 65% of these filers for review. However, the GAO said those controls may still overlook ineligible entities because they do not consider certain factors, such as refund amounts and employer establishment dates.

The GAO recommended that the IRS could bolster its controls by using dates from the relevant legislation, refund amount and filing data, the establishment date for the employer, and other variables in filters to help identify tax credit recipients that may be ineligible employers. The GAO noted that one area of potential fraud was employer identification numbers. Although the employment tax return screening process flagged many of the returns identified with potentially ineligible credit claims, the report said it is possible some returns from fabricated EINs may have passed through the filters and received refunds. Annual employment tax returns are subject to fewer filters. In addition, none of the filters contains specific criteria to identify entities established after the enactment of the Families First Coronavirus Response Act and the CARES Act. IRS officials shared a list of compliance areas under consideration for using computerized filters to identify potential noncompliance specific to the tax credits. However, those areas are still under development, and the IRS did not have any further information in the most recent compliance plan. The GAO made other recommendations in the report, including the IRS developing a compliance plan consistent with project management principles, document compliance processes for adjusted returns and tax credits using restricted wages, and identify ineligible entities. The IRS agreed with two of the report’s recommendations but disagreed with the other three. The IRS contended that its current processes are sufficient, but the GAO insisted its recommendations are warranted.

Talley’s professionals have spent literally hundreds of hours reviewing the law, regulations, and FAQs issued regarding the ERC and PPP, and we are happy to assist you in the process.

One well-heeled couple in Florida, who own a private real estate development business, are passing on hundreds of millions in wealth to their two daughters free of gift and estate taxes. Their method: shuffling buildings, stocks, and other investments through more than two dozen short-term trusts. They use grantor-retained annuity trusts, which have three major tax benefits: Grantor Retained Annuity Trusts move assets out of a taxable estate, they don’t trigger any gift taxes for the donor, and they “freeze” the value of contributed assets, making their future appreciation free of the 40% gift tax and estate tax.

By setting up a GRAT so that assets can be swapped in and out, a taxpayer can extract declined stocks and substitute them with stable Treasury bills. The impacted shares are then placed into a new GRAT, restarting the two-to-three-year clock to give them time to bounce back. But even when a GRAT goes “under water” because a battered asset doesn’t bounce back, the grantor comes out ahead if the trust allows asset substitutions, which means GRATs are like a free pull at a slot machine. If the GRAT ‘hits,’ assets are transferred to the beneficiaries free of gift tax. If it doesn’t, the grantor is in the same tax situation as before the GRAT was executed. Advisors see the recent market drop as an attractive opportunity to play those odds and avoid estate taxes. Taxpayers don’t pay that levy until their estates reach just over $24 million for married couples, half that for single persons. The levels are set to revert to half those amounts come 2026.

Once a taxpayer puts stocks, bonds, or stakes in funds or businesses into a GRAT they control, the vehicle pays them a yearly annuity, calculated as slightly more than the contributed property or cash value. At the end of the trust’s life, typically two or three years, whatever is left over goes to the trust’s heirs free of gift tax. The donor, known as the grantor, doesn’t owe gift tax because they retain control of the trust during its lifetime and thus doesn’t owe that levy on transfers to themself. The annual payments back to the grantor have to clear what the IRS calls its 7520 hurdle, which is 3% for May 2022. The trick is to put in an asset whose value is expected to boom, like property or stock in a startup, or has declined but is expected to pop back, like shares in Amazon. This is because it’s easy to outpace the low interest rate hurdle, and the excess gains eventually pass to heirs tax free. When the total payments back to the grantor equal the original value of what was put into the trust — even though that number has subsequently swelled — the vehicle is called a “zeroed-out GRAT.” 

Since its inception in 1990, GRATs have been periodically attacked by Democratic lawmakers as an unfair loophole that allows the ultra-affluent to funnel tax-free wealth to the next generation. President Joe Biden’s federal budget proposal in March revives some of the curbs, including forcing trust owners to pay capital gains tax on unrealized appreciation when the trust goes to beneficiaries and requiring it to hold at least $500,000 or 25% of the value of assets contributed, whichever is greater. That latter amount would be taxable. Biden would also require GRATS to have a minimum life of 10 years and end their tax-free asset swaps. While there would be exceptions for heirs who are spouses, those recipients would owe capital gains tax when they die or sell a GRAT’s assets. Many financial advisors are skeptical that Biden’s proposed curb will win approval.

Though your options are virtually limitless, proper estate planning, deciding on the “who, what, when, and how”, and executing this with the least amount paid in taxes, legal fees and court costs can be a challenging and emotional affair to wrestle with alone. For more information, contact Talley LLP today. 


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