Category Archives: Estate Planning

An ESOP can benefit a business owner’s retirement and estate plans

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Employee stock ownership plans (ESOPs) offer closely held business owners an exit strategy and a tax-efficient technique for sharing equity with employees. But did you know that an ESOP can be a powerful estate planning tool? It can help you address several planning challenges, including lack of liquidity and the need to provide for children outside the business.

An ESOP in action

An ESOP is a qualified retirement plan, similar to a 401(k) plan. But instead of investing in a selection of stocks, bonds and mutual funds, an ESOP invests primarily in the company’s own stock. ESOPs are subject to the same rules and restrictions as qualified plans, including contribution limits and minimum coverage requirements.

Typically, companies make tax-deductible cash contributions to the ESOP, which uses the funds to acquire stock from the current owners. This doesn’t necessarily mean giving up control, though. The owners’ shares are held in a trust, and the trustees vote the shares.

An ESOP’s earnings are tax-deferred: Participants don’t recognize taxable income until they receive benefits — in the form of stock or cash — when they leave the company, die or become disabled.

Retirement and estate planning benefits

If a large portion of your wealth is tied up in a closely held business, lack of liquidity can create challenges as you approach retirement. Short of selling the business, how do you fund your retirement and provide for your family?

An ESOP may provide a solution. By selling some or all of your shares to an ESOP, you convert your shares into liquid assets. Plus, if the ESOP owns 30% or more of the company’s outstanding common stock immediately after the sale, and certain other requirements are met, you can defer or even eliminate capital gains taxes. How? By reinvesting the proceeds in qualified replacement property (QRP) — which includes most securities issued by U.S. public companies — within one year.

QRP provides a source of retirement income and allows you to defer your gain until you sell or otherwise dispose of the QRP. From an estate planning perspective, a simple but effective strategy is to hold the QRP for life. Your heirs receive a stepped-up basis in the assets, eliminating capital gains permanently.

If you want more investment flexibility, you can pay the capital gains tax upfront and invest the proceeds as you see fit. Or you can invest the proceeds in qualifying floating-rate long-term bonds as QRP. You avoid capital gains, but can borrow against the bonds and invest the loan proceeds in other assets.

If estate taxes are a concern, you can remove QRP from your estate, without triggering capital gains, by giving it to your children or other family members. These gifts may be subject to gift and generation-skipping transfer taxes, but you can minimize those taxes using traditional estate planning tools.

Weigh the pros and cons

ESOPs offer significant benefits, but they aren’t without their disadvantages. Contact us to help determine if an ESOP is right for you at 205-345-9898.

© 2019 Covenant CPA

Hastily choosing an executor can lead to problems after your death

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Choosing the right executor — sometimes known as a “personal representative” — is critical to the smooth administration of an estate. Yet many people treat this decision as an afterthought. Given an executor’s many responsibilities and complex tasks, it pays to put some thought into the selection.

Job description

An executor’s duties may include:

  • Collecting, protecting and taking inventory of the estate’s assets,
  • Filing the estate’s tax returns and paying its taxes,
  • Handling creditors’ claims and the estate’s claims against others,
  • Making investment decisions,
  • Distributing property to beneficiaries, and
  • Liquidating assets if necessary.

You don’t necessarily have to choose a professional executor or someone with legal or financial expertise. Often, lay people can handle the job, hiring professionals as needed (at the estate’s expense) to handle matters beyond their expertise.

Candidate considerations

Many people choose a family member or close friend for the job, but this can be a mistake for two reasons. First, a person who’s close to you may be too grief-stricken to function effectively. Second, if your executor stands to gain from the will, he or she may have a conflict of interest — real or perceived — which can lead to will contests or other disputes by disgruntled family members.

If either of these issues is a concern, consider choosing an independent outsider as executor. Some people appoint co-executors — one trusted friend who knows the family and understands its dynamics, and one independent executor with business, financial or legal expertise.

Designate a backup

Regardless of whom you choose, be sure to designate at least one backup executor to serve in the event that your first choice dies or becomes incapacitated before it’s time to settle your estate — or turns down the job. Contact us for answers to your questions about choosing the right executor at 205-345-9898.

© 2019 Covenant CPA

Sudden impact: When a spouse unexpectedly dies

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What if the unthinkable happens and your spouse dies unexpectedly? Would you be prepared to cope emotionally and financially? As the surviving spouse, you’ll face several tasks and challenges.

First steps first

By no means complete, the following are areas that will need to be addressed:

Death certificates. One of the first things to do is obtain death certificates, which you’ll need to provide for various dealings with financial institutions and others. While it may be difficult to estimate how many death certificates will ultimately be requested of you, you’ll probably want to start with at least a dozen.

Notifications. You must get the word out to other interested parties, including your spouse’s employer, if applicable; credit card companies; life insurance companies; retirement plan and IRA administrators; the state motor vehicle agency; the state office for inheritance tax, if applicable; and your attorney.

Social Security benefits. If your spouse was receiving benefits, consult with the Social Security Administration as to the benefits available to a surviving spouse. Frequently, modifications are required if the survivor was the lower-earning spouse. Even if your spouse wasn’t receiving benefits yet, you may be eligible for survivor benefits, depending on your age and other factors.

Insurance. Don’t assume that everything about your insurance will stay the same. Review your various policies to ensure that you’ll have the optimal coverage going forward. Make whatever beneficiary changes are required.

Retirement plans and IRAs. You may face important decisions regarding employer retirement plans, such as 401(k) plans, as well as traditional and Roth IRAs. For example, if your spouse had a traditional IRA, you can complete a timely rollover to an IRA of your own without owing any tax. Conversely, you might opt for a lump-sum payout from a 401(k) or IRA should you need the funds.

Investments. Review the investments that were owned solely by your spouse, as well as those you owned jointly. When you have time, sit down with your financial advisor to chart out a path for the future, focusing on changes in personal objectives, time horizon and risk tolerance.

Estate tax filing. Although federal estate tax returns generally are required for only the wealthiest individuals, you may choose to file a return to establish the value of inherited assets. Generally, the return is due within nine months of the date of the death.

Finally, review your estate plan

Once you’re over the initial shock of the death, sit down with your attorney and review your estate plan. You’ll likely need to make several revisions in areas where you named your spouse as beneficiary. If you need help during this difficult time, please turn to us at 205-345-9898.

© 2019 Covenant CPA

Have you had your annual estate plan checkup?

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An annual estate plan checkup is critical to the health of your estate plan. Because various exclusion, exemption and deduction amounts are adjusted for inflation, they can change from year to year, impacting your plan.

2019 vs. 2018 amounts

Here are a few key figures for 2018 and 2019:

Lifetime gift and estate tax exemption

  • 2018: $11.18 million
  • 2019: $11.40 million

Generation-skipping transfer tax exemption

  • 2018: $11.18 million
  • 2019: $11.40 million

Annual gift tax exclusion

  • 2018: $15,000
  • 2019: $15,000

Marital deduction for gifts to a noncitizen spouse

  • 2018: $152,000
  • 2019: $155,000

You may need to update your estate plan based on these changes. But the beginning of the year isn’t the only time for an estate plan checkup. Whenever there are significant changes in your family, such as births, deaths, marriages or divorces, it’s a good idea to revisit your estate plan. Your plan also merits a look any time your financial situation changes significantly.

Turn to us for help

If you haven’t yet had your annual estate plan checkup, please contact us at 205-345-9898. Or, if you don’t yet have an estate plan, we can help you create one.

© 2019 Covenant CPA

Fraudulent transfer laws could sabotage your estate plan

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Estate planning aims to help individuals achieve several important goals — primary among them, transferring wealth to loved ones at the lowest possible tax cost. However, if you have creditors, you need to be aware of how fraudulent transfer laws can affect your estate plan. Creditors could potentially challenge your gifts, trusts or other estate planning strategies as fraudulent transfers.

Creditor challenges

Most states have adopted the Uniform Fraudulent Transfer Act (UFTA). The act allows creditors to challenge transfers involving two types of fraud.

The first is actual fraud. This means making a transfer or incurring an obligation “with actual intent to hinder, delay or defraud any creditor,” including current creditors and probable future creditors.

The second type is constructive fraud. This is a more significant risk for most people because it doesn’t involve intent to defraud. Under UFTA, a transfer or obligation is constructively fraudulent if you made it without receiving a reasonably equivalent value in exchange for the transfer or obligation and you either were insolvent at the time or became insolvent as a result of the transfer or obligation.

“Insolvent” means that the sum of your debts is greater than all of your assets, at a fair valuation. You’re presumed to be insolvent if you’re not paying your debts as they become due. Generally, constructive fraud rules protect only present creditors — those whose claims arose before the transfer was made or obligation incurred.

Avoid mistakes

When it comes to actual fraud, just because you weren’t purposefully trying to defraud creditors doesn’t mean you’re safe. A court can’t read your mind, and it will consider the surrounding facts and circumstances to determine whether a transfer involves fraudulent intent. So before you make gifts or place assets in a trust, consider how a court might view the transfer.

Constructive fraud is risky because of the definition of insolvency and the nature of making gifts. When you make a gift, either outright or in trust, you don’t receive reasonably equivalent value in exchange. So if you’re insolvent at the time, or the gift you make renders you insolvent, you’ve made a constructively fraudulent transfer. This means a creditor could potentially undo the transfer.

To avoid this risk, calculate your net worth carefully before making substantial gifts. We can help you do this. Even if you’re not having trouble paying your debts, it’s possible you might meet the technical definition of insolvency.

Finally, remember that fraudulent transfer laws vary from state to state. So you should consult an attorney about the law where you live. Call us today at 205-345-9898.

© 2018 Covenant CPA

Estate planning lite: College-aged children need a basic estate plan

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If your son or daughter currently is home from college on winter break, now is a good time to sit down and discuss a few estate planning documents he or she should have at this stage of life. Let’s take a closer look at four such documents:

1. Health care power of attorney. With a health care power of attorney (sometimes referred to as a “health care proxy” or “durable medical power of attorney”), your child appoints someone — probably you or his or her other parent — to make health care decisions on his or her behalf should he or she be unable to do so. A health care power of attorney should provide guidance on how to make health care decisions. Although it’s impossible to anticipate every potential scenario, the document can provide guiding principles.

2. HIPAA authorization. To accompany the health care power of attorney, Health Insurance Portability and Accountability Act (HIPAA) authorization gives health care providers the ability to share information about your child’s medical condition with you. Absent a HIPAA authorization, making health care decisions could be more difficult.

3. Financial power of attorney. A financial power of attorney appoints someone to make financial decisions or execute transactions on your child’s behalf under certain circumstances. For example, a power of attorney might authorize you to handle your child’s financial affairs while he or she is out of the country studying abroad or, in the case of a “durable” power of attorney, incapacitated.

4. Will. Although your child is still in his or her upper teens or early twenties and probably doesn’t have too many assets, he or she isn’t too young to have a will drawn up. A will is a legal document that arranges for the distribution of property after a person dies. It names an executor or personal representative who’ll be responsible for overseeing the estate as it goes through probate.

If you have questions about any of these documents, don’t hesitate to give us a call at 205-345-9898. We can help provide peace of mind that your child’s health and financial affairs will be properly handled should the unthinkable happen.

© 2018 Covenant CPA

Business owners: An exit strategy should be part of your tax planning

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Tax planning is a juggling act for business owners. You have to keep your eye on your company’s income and expenses and applicable tax breaks (especially if you own a pass-through entity). But you also must look out for your own financial future.

For example, you need to develop an exit strategy so that taxes don’t trip you up when you retire or leave the business for some other reason. An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money from the business.

Buy-sell agreement

When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other benefits, a well-drafted agreement:

  • Provides a ready market for the departing owner’s shares,
  • Prescribes a method for setting a price for the shares, and
  • Allows business continuity by preventing disagreements caused by new owners.

A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax issues and opportunities. One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income.

Succession within the family

You can pass your business on to family members by giving them interests, selling them interests or doing some of each. Be sure to consider your income needs, the tax consequences, and how family members will feel about your choice.

Under the annual gift tax exclusion, you can gift up to $15,000 of ownership interests without using up any of your lifetime gift and estate tax exemption. Valuation discounts may further reduce the taxable value of the gift.

With the gift and estate tax exemption approximately doubled through 2025 ($11.4 million for 2019), gift and estate taxes may be less of a concern for some business owners. But others may want to make substantial transfers now to take maximum advantage of the high exemption. What’s right for you will depend on the value of your business and your timeline for transferring ownership.

Plan ahead

If you don’t have co-owners or want to pass the business to family members, other options include a management buyout, an employee stock ownership plan (ESOP) or a sale to an outsider. Each involves a variety of tax and nontax considerations.

Please contact us at 205-345-9898 to discuss your exit strategy. To be successful, your strategy will require planning well in advance of the transition.

© 2018 Covenant CPA

Automatic extension available for making portability election

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Portability allows a surviving spouse to apply a deceased spouse’s unused estate tax exemption amount toward his or her own transfers during life or at death. To secure these benefits, however, the deceased spouse’s executor must have made a portability election on a timely filed estate tax return. The return is due nine months after death, with a six-month extension option.

Unfortunately, estates that aren’t otherwise required to file a return (because they don’t meet the filing threshold) often miss the deadline. Several years ago, the IRS offered a simplified procedure for obtaining an extension, but it was available only through the end of 2014. After that, the only option was to request a private letter ruling from the IRS, a time-consuming, expensive process with no guarantee of success.

In 2017, however, the IRS made it easier (and cheaper) for estates to obtain an extension of time to file a portability election. For all deaths after 2010, IRS Revenue Procedure 2017-34 grants an automatic extension, provided:

  • The deceased was a U.S. citizen or resident,
  • The executor wasn’t otherwise required to file an estate tax return and didn’t file one by the deadline,
  • The executor files a complete and properly prepared estate tax return on Form 706 within two years of the date of death, and
  • The following language appears at the top of the return: “FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A).”

If your spouse predeceases you and you’d benefit from portability, be sure that your spouse’s estate files a portability election by the applicable deadline. Contact us with any questions you have regarding portability at 205-345-9898.

© 2018 Covenant CPA

A prenup or a DAPT: Which is the better choice?

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If you or one of your adult children is getting married, you may be concerned about protecting your family’s assets in the event of a divorce. A prenuptial agreement can be an effective tool for overriding marital property rights and keeping assets in the family. But these agreements have disadvantages. For many families, a better alternative is a domestic asset protection trust (DAPT).

Why assets need protection

The laws regarding division of property in divorce are complex and vary dramatically from state to state. In general, however, spouses retain their “separate property,” which includes property they owned before marriage as well as property received by gift or inheritance during marriage.

Marital property, which is subject to division in divorce, generally includes all property acquired during marriage, regardless of how it’s titled. Depending on applicable state law, marital property may even include the appreciation in value of separate property (including the other spouse’s business) during marriage.

In light of these risks, it may be advisable to take additional steps to protect separate property from potential loss in the event of divorce.

Prenup drawbacks

The emotional issues involved can make putting a prenup in place difficult. In addition, the requirements for an enforceable prenup make it vulnerable to attack in connection with a divorce. For example, a prenup may be unenforceable if one spouse can show that:

  • The agreement was signed under duress,
  • He or she didn’t have independent legal counsel,
  • The agreement was unconscionable when signed, or
  • The other spouse didn’t provide full financial disclosure.

Even if you dot all the i’s and cross all the t’s, there’s a risk that the other spouse will challenge the agreement, which can be costly and time consuming.

Benefits of an asset protection trust

A DAPT can solve many of the problems associated with a prenup. In particular, it eliminates the emotional component, because there’s no need to obtain the consent of, or even inform, the future spouse. Provided the DAPT holds legal title to assets — and an independent trustee has discretionary control over distributions — it generally will be difficult for a divorcing spouse to reach those assets.

A DAPT is an irrevocable, spendthrift trust established in one of the 15 or so states that authorize them. What distinguishes DAPTs from other types of trusts is that, in addition to offering gift and estate tax benefits, they provide creditor protection even if the grantor is a discretionary beneficiary.

DAPT protection varies from state to state, so it’s important to shop around. Ideally, you should look for a jurisdiction that provides grantors with the greatest degree of control over trust investments and protects trust assets from a broad range of creditors, including divorcing spouses.

To take advantage of this strategy, it’s critical to transfer assets to the DAPT well before marriage. Otherwise, the transfer may be deemed fraudulent. Contact us for additional information at 205-345-9898.

© 2018 Covenant CPA

Consider an intrafamily loan to cover estate taxes

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Sometimes estates that are large enough for estate taxes to be a concern are asset rich but cash poor, without the liquidity needed to pay those taxes. An intrafamily loan is one option. While a life insurance policy can be used to cover taxes and other estate expenses, a benefit of using an intrafamily loan is that, if it’s properly structured, the estate can deduct the full amount of interest upfront. Doing so reduces the estate’s size and, thus, its estate tax liability.

Deducting the interest

An estate can deduct interest if it’s a permitted expense under local probate law, actually and necessarily incurred in the administration of the estate, ascertainable with reasonable certainty, and will be paid. Under probate law in most jurisdictions, interest is a permitted expense. And, generally, interest on a loan used to avoid a forced sale or liquidation is considered “actually and necessarily incurred.”

To ensure that interest is “ascertainable with reasonable certainty,” the loan terms shouldn’t allow prepayment and should provide that, in the event of default, all interest for the remainder of the loan’s term will be accelerated. Without these provisions, the IRS or a court would likely conclude that future interest isn’t ascertainable with reasonable certainty and would disallow the upfront deduction. Instead, the estate would deduct interest as it’s accrued and recalculate its estate tax liability in future years.

The requirement that interest “will be paid” generally isn’t an issue, unless there’s some reason to believe that the estate won’t be able to generate sufficient income to cover the interest payments.

Ensuring the loan is bona fide

For the interest to be deductible, the loan also must be bona fide. A loan from a bank or other financial institution shouldn’t have any trouble meeting this standard.

But if the loan is from a related party, such as a family-controlled trust or corporation, the IRS may question whether the transaction is bona fide. So the parties should take steps to demonstrate that the transaction is a true loan.

Among other things, they should:

  • Set a reasonable interest rate (based on current IRS rates),
  • Execute a promissory note,
  • Provide for collateral or other security to ensure the loan is repaid,
  • Pay the interest payments in a timely manner, and
  • Otherwise treat the loan as an arm’s-length transaction.

It’s critical that the loan’s terms be reasonable and that the parties be able to demonstrate a “genuine intention to create a debt with a reasonable expectation of repayment.”

If you’re considering making an intrafamily loan, contact us at 205-345-9898. We’d be pleased to answer any questions you may have.

© 2018 Covenant CPA