PRESERVING VALUABLE HOMES FROM THE ESTATE TAX

Adapted from Wealth Watch, a publication of Goldstein, Golub, Kessler & Company P.C.

Under your present estate plan, will your children be forced to sell your home to pay your estate taxes? This is a question that is both discomforting to ask and to hear, and so it is often avoided by tax advisers and clients alike. And yet, if the answer is a reluctant "yes," there is a way out--blessed by the tax law--to keep your home in the family, if that is your wish. Is the question relevant in your circumstances?

If you have been successful in your business or investing, income tax is a burden with which you are very familiar. But, if you also have accumulated assets over the years, it will be the estate tax that will be your greatest contribution to the running of government. You probably are not seeing it here first, but it is worth repeating: the New York State resident who has accumulated wealth over the years will pay Federal and state estate taxes of 60%. The "great escape" from estate taxes by moving to Florida or other so-called no tax state will hardly cause the top rate to plummet--it will decline a mere five percent from 60 to 55%, which is the Federal tax rate.

Yet the high, steeply progressive rates of estate tax are not exclusively the problem of the very rich. Homes and retirement plans often push estates of a husband and wife beyond their exemptions ($600,000 each) into estate taxability. Once past the exemptions, the estate taxes are severe, starting in the Federal bracket of 37%.

Qualified Personal Residence Trust ­ "QPRT"

One of our favorite recommendations is the qualified personal residence trust (QPRT), which is designed to substantially cut gift and estate taxes on the transfer of valuable homes. QPRTs are Congress's tangible recognition that homes hold a special place in the hearts of American families and forced sales to pay estate taxes could cause a political backlash.

Taking advantage of what Congress has devised is not a complicated process. Under a document prepared by your estate attorney, you transfer ownership of a residence to a trust--a QPRT. You keep the right to live there for a specific number of years. The number is your choice. You pay the expenses of the house as before. If the house is sold, the proceeds can be used to buy another one for you to occupy.

But if the house is not replaced, the proceeds will serve as an investment fund out of which you will be paid an annuity for the remaining years of the trust. At the end of the QPRT's term, the residence or the invested proceeds belong to your children. At that time, you can, if you wish, invoke a common provision found in QPRTs--the right to continue your occupancy by renting the residence from your children at a fair price.

You may ask, "Why would I possibly want to go through this procedure?" The reason is that a QPRT need not interrupt your living patterns, nor result in removal from your home. The achievable transfer tax savings would be hard to match by any other legitimate means.

How a "QPRT" Works

The transfer of your residence into a QPRT is a gift to your children of the present value of their right to own the house after the trust ends. The years of occupancy you reserve for yourself drop the value of your gift: the longer the trust term the lower the gift. For example, if you select the term of your use as 12 years, and you are 60 years old, the gift value is only about 30% of the current appraised value of the house. If the house is worth $1,000,000, the gift is $300,000. Your remaining exemptions may totally eliminate the Federal gift tax. At worst, if you have made very substantial prior gifts which drove you into the highest brackets, the gift tax would be $180,000 (60% of $300,000). If you live beyond the 12 years of the set term, your children receive a house for the maximum gift tax cost of $180,000, which also reduces the size of your estate. They also benefit from any appreciation that takes place over the years free of additional transfer taxes.

Estate Tax Savings

Contrast this gift with the estate tax cost of not making the transfer. If you keep title to the house for the rest of your life and give it to your children in your will, the tax cost to them (which may consume your liquid assets) will be astounding. The estate tax is not based upon what you give your children: It is based upon your wealth at the time of your death. An estate falls into the top bracket when its assets exceed $3,000,000. The children receive what is left after the estate tax is paid. So, if an estate is in a 60% tax bracket, the children receive only 40%. In order to receive a bequest of the $1,000,000 house, $2,500,000 of assets are required (taxed @ 60% or $1,500,000).

But that is not all. It is likely that from this point forward the value of the house will increase during your lifetime, at least keeping up with inflation. That means that today's $1,000,000 house may be appraised for $1,500,000 or $2,000,000 in your estate. In that case, the correlated estate tax would be even higher.

We have made a point of saying that a QPRT is ideal when you wish to keep the residence for your children and future generations. Suppose that you have no idea whether your children will want to keep the house beyond your lifetime. That should not dissuade you. The estate tax savings for those with a high bracket estate should substantially exceed both the potential gift tax cost and any capital gains taxes the children may bear in the sale of a house (since the house was transferred through a gift there is no step up in basis).

Similar to other tax-favored IRC provisions, there are technical requirements to fulfill before reaping the benefits of a QPRT. If you do own a valuable home, the concept of a QPRT may have appeal. It has been our experience that the requirements will not stand in the way once an analysis of your circumstances quantifies your potential estate tax savings. *

"CHECK-THE-BOX" REGULATIONS

By David Marcus, JD, CPA, Paneth Haber & Zimmerman LLP (First published in CPA Advisor)

A business' classification for Federal tax purposes as a partnership or a corporation has depended on more than how the entity is legally established. An organization that had more corporate characteristics--continuity of life, centralization of management, limited liability, and free transferability of interests--than partnership characteristics was treated as a corporation for tax purposes, even if it was established as a partnership under state law. Because partnerships and other unincorporated organizations have some corporate characteristics, taxpayers were spending a lot of time and money determining whether their businesses were partnerships or corporations for tax purposes. New regulations should make it easier for business to adopt a classification for Federal tax purposes.

The IRS has finalized new entity classification rules which were effective January 1, 1997. The rules generally permit an unincorporated entity to choose to be taxed as a partnership or a corporation by simply checking a box on a form. The new regulations, commonly called "check-the-box," simplify the entity classification process and provide some flexibility in forming entities.

Eligible Entities

Eligible entities may elect the classification that best suits their owners' needs. To be eligible to make an election, a business entity must have at least two or more members that carry on a business and divide the profits from the business. Trusts are not eligible to elect entity classification as a partnership or a corporation and must be classified as trusts for Federal tax purposes. Entities incorporated under state or Federal law or required to be classified as a corporation are also not eligible to check the box. A corporation must be taxed as a corporation and cannot elect partnership
treatment.

Entities that are not automatically classified as corporations have a choice. A business with two or more members may choose to be classified as either an association (taxable as a corporation) or a partnership. On the other hand, a one-member business entity, such as a sole proprietorship, may elect to be treated as an association or disregarded and not treated as separate from its owner--it may not be treated as a partnership.

Default Classification

The check-the-box rules provide for a default system of classification. Newly formed eligible business entities with at least two members are automatically classified as partnerships. To be taxed as corporations, new unincorporated entities will need to make an election. Eligible businesses in existence before January 1, 1997, will generally retain their current classification, unless an election to the contrary is filed.

Checking the Box

Electing a nondefault classification or changing an existing classification can be done by filing Form 8832, Entity Classification Election. Once a newly formed entity makes an election, a different election cannot be made for 60 months unless there is more than a 50% ownership change and the IRS consents. For existing entities, a change in classification could have tax consequences under the rules for partnership terminations or corporate liquidations. As a result, existing entities should carefully consider the tax effects before making a classification change.

Most taxpayers and tax practitioners welcome the check-the-box regulations as a simpler method of determining entity classification. But, while the new regulations make it easy to elect entity classification, tax planning is essential to evaluate the benefits and drawbacks of electing partnership or association classification. *

Editors:
Milton Miller, CPA
Consultant

William Bregman, CPA\PFS

Contributing Editors:
Alan Fogelman, CPA
Clarfield & Company P.C.