Your Trusted Advisor, Fall 2006

December 28, 2006

What Has Really Changed in Estate Planning?

Over the past few months, the U.S. Senate has labored, with little success, to permanently repeal the estate tax. Despite their best efforts, proponents of the repeal were unable to marshal the 60 votes needed. The results of the recent election make total repeal less likely than ever. In the meantime, however, several other changes and opportunities have occurred which may have a significant impact on your estate planning.

This issue of Your Trusted Advisor highlights several important legislative and judicial actions that deserve your attention:

 

• FLPs and the New Texas Margin Tax
• Kiddie Tax Age Raised
• Tax-Free IRA Distribution to Charities
• Enhancing Deferrals by Placing Pension Assets in IRAs
• Executing a Sound Power of Attorney

Some FLPs Exempt from New Texas Margin Tax

For years, the Texas Legislature has discussed the idea of extending the franchise tax to limited partnerships. In the summer 2006 special session, a new version of that tax, known as the Margin Tax, was applied to a wide array of business organizations, including many limited partnerships.

Because many individuals and families conduct investment activities through limited partnerships, the statute exempts entities that meet the definition of a “family limited partnership (FLP)” and are considered a “passive entity.”

While the exemption for FLPs could be expected to apply broadly to all closely held partnerships, the statutory definition specifies that an exempt FLP must be a “passive entity” with at least 80 percent of the interests held, directly or indirectly, by members of the same family.

Since a passive entity is not subject to the tax, regardless of its ownership, the exemption for FLPs seems largely irrelevant. Passive entities are exempt regardless of whether they are FLPs.

Not all FLPs are passive entities. To avoid having to pay the new tax, at least 90 percent of the FLP’s gross income must consist of dividends, interest, and similar payments from the following sources:

• Financial instruments
• Limited liability companies and distributed shares of partnership income
• Gains from the sale of real property, securities, and commodities traded on an exchange
• Royalties, bonuses, or delay rental income from mineral properties and income from other non-operating mineral interests. Significantly, rental income and income from operating interests in mineral property are not considered passive.

The implementation of the new Margin Tax is complex, and is likely to be subject to many changes and challenges.

For most businesses, the Margin Tax will affect income earned in 2007. Watch for updates from Bracewell & Giuliani’s Wealth Management Practice for further developments on this controversial topic.

Kiddie Tax Age Rises

Years ago, wealthy families could achieve significant income tax savings by shifting or giving income-producing assets to minor children to take advantage of their lower income tax rates. This strategy was particularly attractive because tax rates for long-term capital gains and dividends are 5 percent for the individuals in the lowest bracket through 2007.

In 1986, however, Congress limited the opportunity to shift income to children with the enactment of a “kiddie tax.

Under that law, children under 14 had to pay tax on investment income at their parents’ income tax rates. Recently, Congress made it even harder to benefit from this income shifting technique by raising the age limit for the kiddie tax from 14 to 18, effective Jan. 1, 2006.

The kiddie tax, however, only applies to unearned income, typically investment income, above the threshold of $1,700 per year for 2006. Earned income from a job or self-employment income is exempt from the kiddie tax.

This new rule will have a significant impact on a broad spectrum of the population, particularly families with college bound children. The break between ages 14 and 18 was formerly a good time to liquidate high risk, appreciated assets in anticipation of college expenses. Now, income earned on assets held by a child or in a Uniform Transfer to Minors Act account may be subject to an unanticipated increase in income tax liability.

A renewed interest in Code Section 529 savings accounts and other state tuition programs is expected as families seek tax advantageous vehicles in which to save for college and other educational expenses.

At a minimum, when making decisions on how to invest children’s assets, parents and Uniform Transfers to Minors Act custodians should consider long-term growth investments that do not have to be liquidated until after the child’s 18th birthday.

Short-term and dividend-producing investments are likely to lose their appeal.

Benefits of Pension Protection Act

The huge Pension Protection Act of 2006, approved by Congress this summer, focuses primarily on keeping workers’ pensions safe and fully funded. There are, however, a number of provisions and incentives aimed at encouraging charitable giving while, at the same time, tightening reporting requirements.

Tax-Free IRA Distributions—Take What You Need, Donate the Rest

A major incentive of the Pension Protection Act of 2006 provides for a tax-free distribution from your IRA directly to a charity in years 2006 and 2007. Formerly, if IRA distributions were transferred to a charity, the normal limitations on charitable deductions applied. Under the new Act, taxpayers over age 70 1/2 can now donate up to $100,000 directly to a charity from their traditional and Roth IRAs without having to include the distribution in taxable income.

Here’s how it works:

• Transfers must be made directly by the IRA trustee to a charitable organization like United Way or Red Cross, not a private foundation, supporting organization or a donor-advised fund.
• Individuals can not claim a deduction for the charitable contribution because the distribution will not be included in taxable income.
• Direct donations will apply towards an IRA participant’s required minimum distributions, achieving up to 100 percent of the required annual withdrawal.

For Example: John, age 72, is required to withdraw $50,000 from his IRA this year. Because of John’s other income, he only needs about $10,000 for living expenses. If John takes the entire $50,000 and gives $40,000 to charity, he must report $50,000 as income, but may not be able to take a full $40,000 deduction. In other words, he may have to pay tax on the charitable donation. Under the new rules, John can instruct his IRA custodian to distribute $10,000 to himself, and $40,000 directly to an appropriate charity. These distributions satisfy John’s $50,000 minimum required distribution, but the $40,000 passing to charity is not taxable to John. Instead, he pays tax only on the $10,000 he actually receives.

These new charitable distribution rules will be particularly attractive for donors seeking a simple way to make gifts, and for charitably-inclined donors who wish to make donations in excess of the current 50 percent deduction limitation. Wealthy donors will benefit from the strategy because the distribution will not complicate their tax returns or increase their adjusted gross income by the amount of the gift.

Tax Free IRA distributions also provide incentives for taxpayers who do not itemize deductions, and who would otherwise receive no other tax benefits from their charitable gifts.

Rollover Pension Plan Inheritance into IRAs

Another notable provision of the Pension Protection Act of 2006 helps children who inherit money from a parent’s retirement plan to defer tax.

When a parent dies, IRS rules generally permit children to receive distributions from the parent’s retirement plan over the remainder of the child’s life expectancy. Although the tax law permits deferral, many employer-sponsored retirement plans require all funds to be paid out to the beneficiary in the year of (or following) the employee’s death.

One way to avoid immediate taxation of these benefits is to “rollover” the pension money into an IRA in the benefi-ciary’s name. Under prior law, only the spouse of a plan participant could rollover plan benefits, but the new act permits any beneficiary to transfer inherited retirement plan benefits into an IRA.

To better understand the potential benefits of the act, let’s look at the framework of retirement plan distributions. A retirement plan participant may name a “designated beneficiary” to receive the plan proceeds over the beneficiary’s life expectancy, calculated using tables provided by the Internal Revenue Service. The beneficiary pays income tax every year on the distributions from the plan. Designating a beneficiary allows for the longest deferral of income tax liability of the plan proceeds.

Even though the law allows for distributions over a beneficiary’s lifetime, this option may not be available. For amounts held in an employer sponsored plan, a retirement plan may require a beneficiary to withdraw his or her entire proceeds within five years of the plan participant’s death, if the participant dies before he or she is required to start taking distributions from the plan. Such mandates may keep the designated beneficiary from stretching out the receipt of plan benefits and result in a loss of income tax deferral.

If a retirement plan contains such a mandate, the new Act permits a designated beneficiary to transfer the plan benefits into a new IRA and then take distributions over his or her life expectancy. This transfer allows for the greatest deferral of income tax liability. However, unlike a spousal IRA rollover, non-spouse beneficiaries cannot defer taking distributions until they turn 70 1/2.

If no designated beneficiary is named, the ultimate recipients of the plan proceeds will usually receive the benefits over a shorter time period than if the plan participant named a designated beneficiary, again resulting in a loss of income tax deferral. Under the new law, this result can be avoided if the beneficiary elects to rollover the plan proceeds into a new IRA.

The rollover of eligible plan benefits to non-spouse beneficiaries is available for distributions from eligible retirement plans made after 2006.

Executing a Sound Power of Attorney

A recent Texas Court of Appeals decision dealing with a son and daughter’s use of their mother’s power of attorney demonstrates how assigning this power can impact and often alter an individual’s distribution of property at the time of his or her death.

In this case, an 81-year-old mother of eight executed a power of attorney naming Son and Daughter One as her agents. When mother became ill and doctors advised the family that long-term nursing care would be required, Son and Daughter One began to consolidate mother’s funds by cashing out various certificates of deposit and transferring them all to a central checking account in which Son and Daughter One had rights of survivorship.

The CDs that were cashed had various children named as joint tenants with right of survivorship. When the CDs were cashed, however, the survivorship status disappeared. Daughter Two sued Son and Daughter One claiming that they had breached their fiduciary duty to mother by thwarting her intent to leave one of the CDs to Daughter Two.

In framing the issue for deliberation, the court instructed the jury on the fiduciary duties Son and Daughter One (the “agents”) owed to their mother, (the “principal”) under the power of attorney:

1. The transactions in question must be fair and equitable to the principal.

2. The agents must make reasonable use of the trust the principal has placed in them.

3. The agents must act in the utmost good faith and must exercise the most scrupulous honesty toward the principal.

4. The agents must place the interest of the principal before their own.

5. The agents must not use their position to gain any advantage for themselves.

6. The agents must not place themselves in any position where their self interest would conflict with their principal’s best interest.

7. The agents must fully and fairly disclose all important information concerning the transactions to the principal.

These instructions serve as helpful reminders of the code of conduct required of agents using a power of attorney.

These same rules apply, whether the person acting under the power of attorney is your spouse, your children or a friend. After a careful analysis of the circumstances surrounding the creation of the various CDs and the transfer of the funds, the jury decided that Son and Daughter One’s transfer of the funds to one account to ease the payment of expenses related to mother’s last illness was a legitimate exercise of the power of attorney. Additionally, because Daughter One testified that she would ensure that the remaining funds would pass equally to mother’s children under the terms of the will, the court found no breach of fiduciary duty.

When you execute a power of attorney, you may be well-advised to give clear instructions to your agent regarding any assets or funds which should not be sold or used except as a last resort to preserve any specific gifts or survivorship rights. Additionally, be sure that any beneficiary designations or account signature cards do not disrupt the careful estate plan you have implemented by the execution of your will.

Quick Tips: Nine Ways to Keep Estate Planning in Check at Year End

1. Consider making annual exclusion gifts: The 2006 maximum annual exclusion is $12,000 per recipients. Married couples can each use their personal exclusion, so they can jointly donate up to $24,000 per person. A gift is tax free income to the recipient.

2. Pay for a family member’s tuition or medical expenses: In addition to the annual exclusion, payments made on another person’s behalf are gift tax free if the payment is for tuition to a tax exempt school for education or training; or for medical expenses that would qualify as an income tax deduction (such as doctor bills, prescription drugs or medical insurance premiums). The trick here is that the payment must be made directly to the educational institution or medical provider and not as a reimbursement to family members who have paid these expenses themselves.

3. Contribute to a Section 529 college savings plan: If children or grandchildren aren’t in college yet, you can take advantage of all or a portion of the $12,000 annual exclusion for tax-exempt college savings. A special rule allows up to five annual exclusions when funding a Section 529 college savings plan, so you can contribute up to $60,000 this year, and then file a gift tax return electing to spread this gift out over five years for gift tax purposes.

4. Notify irrevocable trust beneficiaries of withdrawal rights: If you have created an irrevocable trust, and have made (or will make) gifts to the trust this year, be sure that the trustee sends a notice to the trust beneficiaries regarding any withdrawal rights that they may have. The $12,000 annual exclusion may not apply to gifts made to trusts unless this notice is properly given.

5. Schedule annual meetings for FLPs and LLCs: If you have a family limited partnership (FLP), a corporation or limited liability company (LLC), review the documents regarding your annual meeting. Holding regular meetings and following other formalities in operating these businesses helps to ensure that they will be respected for tax and creditor purposes.

6. Review charitable giving for maximum tax efficiency: If you are over 70 ½ and have an IRA, see the article on tax-free IRA distributions for a new technique to consider. Other taxpayers may wish to consider making gifts of appreciated stock to charity. You can receive a deduction for the full market value of stock passing to the charity, and, when the charity sells the stock, it pays no tax on the gain.

7. Review assignments for executors, guardians and agents: This is a great time to review your estate planning documents, and especially the people you have designated as executors, guardians for your children, and agents under your financial and medical powers of attorney. Are these people still best suited to carry out those roles? If not, it may be time to update your plan.

8. Contribute to personal or family IRAs: If you are eligible to make contributions to your IRA or retirement plan, then do so. Often, children or grandchildren eligible to make contributions do not have the funds to do so. A gift from you into an IRA for a child or grandchild (subject to the limitation on IRA contributions and the $12,000 annual exclusion on all gifts in any year) may be a great way to help them start saving for retirement.

9. Contact Bracewell’s Wealth Management Group with questions: Feel free to contact us for help or advice in implementing any of these strategies.

Year-end Checklist:

Consider making annual exclusion gifts. The maximum amount of the annual exclusion for 2006 is $12,000 per recipient. There is no limit to the number of people to whom you can make gifts, and married couples can each use their exclusion, so that they can give up to $24,000 per person. A gift is income tax free to the recipient.

In addition to the annual exclusion, payments that you make on another person’s behalf are gift tax free if the payments are for:

1. Tuition to a tax-exempt school for purposes of education or training.

2. Medical expenses that would qualify as an income tax deduction (such as doctor bills, prescription drugs or medical insurance premiums).

The trick here is that the payment must be made directly to the educational institution or medical provider and not as a reimbursement to a family member who has paid these expenses themselves.

Contributions to a Section 529 college savings plan for children or grandchildren do not qualify for the unlimited “tuition” exemption, but can be used to take advantage of all or a portion of the $12,000 annual exclusion. A special rule allows you to use up to five annual exclusions when funding a Section 529 college savings plan, so you can contribute up to $60,000 this year, and then file a gift tax return electing to spread this gift out over five years for gift tax purposes.

If you have created an irrevocable trust and have made (or will make) gifts to the trust this year, be sure that the trustee sends a notice to the trust beneficiaries regarding any withdrawal rights that they may have. The $12,000 annual exclusion may not apply to gifts made to trusts unless this notice is properly given.

If you have a family limited partnership, a corporation or limited liability company, review the documents regarding your annual meeting. Holding regular meetings and following other formalities in operating these businesses helps to ensure that they will be respected for tax and creditor purposes.

Year end is a good time to review charitable giving to make sure that it is done in the most tax-efficient manner. If you are over 70 ½ and have an IRA, see the article on tax-free IRA distributions for a new technique to consider. Other taxpayers may wish to consider gifts of appreciated stock to charity. You can receive a deduction for the full market value of stock passing to the charity and, of course, when the charity sells the stock, it pays no tax on the gain.

This is a great time to review your estate planning documents, and especially with respect to the people you have named to serve as executors, guardians for your children and agents under your financial and medical powers of attorney. Are these people still the ones best suited to carry out those jobs? If not, it may be time to update your plan.

If you are eligible to make contributions to your IRA or retirement plan, you should do so. Many times, children or grandchildren may be eligible to make contributions to an IRA, but may not have the funds to do so. A gift by you into an IRA for a child or grandchild (subject to the limitation on IRA contributions and the $12,000 annual exclusion on all gifts in any year) may be a great way to help them start saving for retirement.

Naturally, you should feel free to contact us about how the foregoing matters may relate to your specific situation, or if you would like our assistance in implementing any of these strategies.

Meet our Wealth Management team:

Mickey R. Davis, Partner
Mickey Davis joined Bracewell after an earlier career of founding two Houston law firms that focused on wealth and estate planning. Individual and family-owned business clients have long-relied on Mr. Davis for all aspects of wealth transfer planning, including sophisticated strategies for maximizing assets, minimizing taxation and preserving wealth for future generations. He has special strength in crafting customized tax-efficient estate planning instruments, including bypass trusts, insurance trusts, charitable trusts, private foundations and family limited partnerships.

In addition to writing and speaking at dozens of professional association meetings and seminars, Mr. Davis is co-author of Retirement Planning–Tax and Financial Strategies, second edition (Warren, Gorham & Lamont, 2005).

He received a J.D., with high honors and Order of the Coif, at The University of Texas School of Law, 1982, and B.B.A., with high distinction at University of Arizona, 1979. Mr. Davis is board certified in estate planning and probate law by the Texas Board of Legal Specialization. He is a fellow of the prestigious American College of Trust and Estate Counsel, a certified public accountant and an adjunct professor of law at the University of Houston Law Center.

Bridget O’Toole Purdie, Counsel

With a focus on trusts and estates administration, fiduciary litigation, and guardianships, Bridget O’Toole Purdie assists clients in all aspects of estate and trust administration, probate and trust litigation in federal and state courts. She handles contested estate and gift tax matters, guardianships, statutory special needs and management trusts. Ms. Purdie represents “fiduciaries,” including executors, trustees, agents or attorneys-in-fact, both individuals and financial institutions. Her experience also includes negotiation and settlement of disputes arising out of fiduciary responsibilities.

A Houston native, she received her J.D. from University of Houston Law Center, 1990, and B.A. from Vanderbilt University, 1985.

Christine Borrett, Associate

Experienced in estate and tax planning, Christine Borrett advises business clients on tax and general business matters. Ms. Borrett concentrates her wealth management practice in the areas of income, gift and estate tax planning. She advises clients on all aspects of probate and estate administration, including preparing estate and gift tax returns, general business representation, entity formation, franchise tax planning, and business transition planning.

During law school she interned in the Internal Revenue Service Office of Chief Counsel, Houston, where she worked on cases involving family limited partnerships, federal and corporate income tax evasion, foreign income tax credits, retirement plans, and estate administration.

Ms. Borrett is board certified in estate planning and probate law by the Texas Board of Legal Specialization.
She received her J.D. from University of Houston Law Center, 2001, and a B.A. from The University of Texas at Austin, 1998.

Matthew J. White, Associate

Focusing on tax and estate planning, Matt White works with closely-held business owners on a variety of income taxation of trust and estate matters. His clients rely on him for counsel on lifetime and charitable giving strategies, administration of trusts and estates and representation of executors and trustees.

Mr. White is board certified in estate planning and probate law by the Texas Board of Legal Specialization. He received his J.D. from South Texas College of Law, 1995, and a B.B.A. in accounting, cum laude, from Texas A&M University, 1992.