Requirement of Executors to Report Basis of Assets When Administering an Estate - FollowUp

The IRS has released new regulations that have extended the due date for filing Form 8971 to March 31, 2016.  Executors and administrators of estates that are required to file a federal Form 706 Estate Tax Return are now also required to file Form 8971 and report the basis of the assets included in the estate to the beneficiaries of the estate.

As discussed in my post on February 7, 2016, the IRS is trying to consistently tax assets for estate tax and capital gains tax purposes.  Requiring executors to supply this information to beneficiaries and the government is their attempt to better track this information.  

Additionally, there was an open question as to whether all estates had to file the Form 8971 or just those that were over the federal estate tax exemption threshold.  According to this publication from Bessemer Trust, the IRS has issued regulations that state that if you are filing a form 706 merely to elect portability, you do not also need to file form 8971. 

Thanks again to Abby Moller for bringing this to my attention 

IRS Releases Form 8971 - Executors Now Required to Report Basis of Assets When Administering Estate

For many years the IRS and beneficiaries of estates had a problem figuring out how much gain should be imposed on an inherited asset because the beneficiaries did not know the basis.  The IRS did not like the fact that frequently the value reported by an Executor was not the value reported by a beneficiary when an inherited asset was sold.   

Accordingly, the government enacted Internal Revenue Code Section 1014(f) and is requiring that any estate which is required to file an estate tax return (Form 706) also file Form 8971 (including all attached Schedule(s) A), retro-active to decedents who died after July 2015. The executor must also provide Schedule A to each beneficiary receiving assets from the estate. Both requirements must be met within 30 days after the date on which Form 706 is required to be filed with the IRS, or the date that is 30 days after the date Form 706 is filed with the IRS, whichever is earlier. 

Notice 2015-57 has made February 29, 2016 the due date for all Forms 8971 (including all attached Schedule(s) A) required to be filed with the IRS after July 31, 2015, and before February 29, 2016. Penalties may be imposed for failure to comply with this new filing requirement.

If an estate is not required to file a Form 706, then there is no corresponding requirement to file a Form 8971.  However, it is probably good practice for the executor to advise the beneficiaries of the value of assets as determined on a decedent's date of death so that everyone knows what the new basis is in the inherited assets. 

Instructions for Form 8971 can be found here: https://www.irs.gov/instructions/i8971/ch01.html

I note that there are a number of important items that are not clear:
1)  Does Form 8971 need to be filed when an estate files Form 706 for purposes of porting the DSUE of a deceased spouse. Accordingly, until we receive clarification, it would probably be best practice to do so.

2) Which beneficiaries should actually receive a copy of the Form?  For example, it would make sense to give the form to the beneficiaries of a trust.  It would make more sense to give it to the trustee of a trust.

3) Form 8971 asks "Did this asset increase the estate tax liability?"  I am a little unclear on what this actually means.  I would think that you should pretty much always answer yes to this question.  However, I have heard one commentator state that this really muddies the waters because theoretically assets that qualify for the Marital Deduction, Charitable Deduction, or other similar deductions do not increase the estate tax liability.  Nevertheless, I do not believe the IRS now saying we don't get a step up in basis for those assets.  I believe this is primarily to identify non-qualified preferred stock options and potentially negative value assets.  After all, it would be shocking for the IRS to say that assets passing to a spouse do not receive a step up under the normal 1014 basis rules.  If I here otherwise, I will be sure to let you know... and join in the revolt against the politicians!

4) What about situations where a beneficiary is actually allowed to have a basis higher than a decedent's date of death value?  Examples of this potentially include:  situations where a beneficiary gifted away an asset within one (1) year of death, where a decedent dies owning an interest in a partnership or limited liability company subject to a debt, or real estate subject to a non-recourse debt. 

The American Bar Association Taxation Section has submitted a letter to the IRS requesting clarification of many of these items.  I hope we will all hear a response soon.

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Updated 3/23/16 - Thanks to Abby Moller for finding a few typos in this article. Additionally, she has advised me that apparently you do not need to file Form 8971 just for purposes of portability.  I will try to find additional support for this.

Deathbed Transfers in New Jersey

Often times, a person who is on his or her deathbed will make gifts to family members in an effort to reduce the potential taxes owed.

For transfers to anyone other than a charity, making gifts in a way that minimizes taxes is actually a very complex process. In deciding whether to make a gift, you must consider the amount of the gift, the type of asset you wish to transfer, to whom it is going to and the basis in the gifted item.

Taxes That Must be Considered When Making Gifts

There are generally six taxes that might be triggered as result of the gift. These include the New Jersey estate tax, the New Jersey inheritance tax, the federal estate tax, the federal gift tax, the capital gains tax and the generation skipping transfer (GST) tax.

I discuss all of these taxes in more detail elsewhere, but to quickly review the general purpose of each tax:

1. The New Jersey estate tax is imposed by the state on transfers at death to the extent the decedent's net estate exceeds $675,000 and the money passes to someone other than a charity, surviving spouse, domestic partner or civil union partner.


2. The New Jersey inheritance tax is also a tax imposed on transfers at death. However, the inheritance tax is based more upon who the money is going to rather than the amount involved. New Jersey does offer a dollar for dollar credit against its estate tax for any inheritance tax paid.


3. The federal estate tax is imposed by the federal government on transfers at death to the extent the decedent's estate exceeds $5,000,000 and the money passes to someone other than a charity or a surviving spouse.


4. The federal gift tax is imposed by the federal government on transfers during a person's lifetime to the extent the person's lifetime gifts exceed $5,000,000 and the money is transferred to someone other than a charity or a spouse.


5. The generation skipping transfer tax (also known as the GST Tax) is generally assessed by the federal government on transfers during life or at death to a person's grandchildren, or more remote descendants to the extent such transfers exceed $5,000,000.


6. The capital gains tax imposed on the sale of appreciated property, stock or similar assets.

As you may have noticed, only four of the six taxes named above are directly attributable to a transfer being made as the result of someone dying. The reason that a lifetime gift can be taxed at the donor's death is because New Jersey and the federal government have lookback provisions. Lookback provisions basically say that if you make a certain kind of transfer, the government can tax it at your death even if you gave the money away during your life. As you can imagine, this creates a host of problems including finding a way to pay for the tax.

What is a Deathbed Gift?

New Jersey defines deathbed gifts as gifts made in contemplation of death (N.J.S.A. 54:34-1(c)). People usually know the deathbed gift rule as the three year lookback rule because gifts made within three years of death are presumed to be in contemplation of death. If a gift is made in contemplation of death, and the gift was over $500, then New Jersey asserts it was really a transfer at death subject to the inheritance tax.

For New Jersey tax purposes, this particular three year rule ONLY appears under the NJ inheritance tax statutes. There is a very different rule for the New Jersey estate tax because the New Jersey estate tax generally follows the federal estate tax for determining what is taxable and what is not taxable. I will discuss this in more detail below.

Since gifts made in contemplation of death are subject to an inheritance tax, and the inheritance tax only applies for transfers to certain beneficiaries, it is important to know how New Jersey classifies the beneficiaries of the gift.

Determining the Class of the Beneficiary

To determine if a lifetime gift will result in a New Jersey inheritance tax, the first thing that you must do is differentiate between gifts made to Class A beneficiaries, Class C beneficiaries and Class D beneficiaries.

Class A beneficiaries include the decedent's spouse, civil union partner, domestic partner, all lineal descendants (such as children, grandchildren and great-grandchildren), all lineal ascendants (such as parents, grandparents and great-grandparents) and step-children. An adopted child, grandchild or great-grandchild is also considered a lineal descendant. Transfers to Class A beneficiaries are exempt from the NJ inheritance tax, meaning there is no inheritance tax on deathbed gifts or transfers at death to such individuals.
Class C beneficiaries include the decedent's brother or sister and son-in-law or daughter-in-law of the decedent even if the decedent's child is also deceased. Class D beneficiaries includes everyone else (most notably nieces and nephews).

If the gift is made to a Class C Beneficiary, and the gift was over $25,000, there definitely will be a NJ inheritance tax if the gift was made "in contemplation of death". If the gift was made more than 3 years prior to the decedent passing, it will not be subject to a NJ inheritance tax.

If the gift is made to a Class D Beneficiary, and the gift was over $500, there definitely will be a NJ inheritance tax if the gift was made in contemplation of death. If the gift was made more than 3 years prior to the decedent passing, it will not be subject to a NJ inheritance tax.

If the deathbed gift is subject to the New Jersey inheritance tax, there will be a tax due of 11-16% of the transferred amount. There is an 11-16% tax on transfers to Class C beneficiaries on the gifted amount in excess of $25,000 and a 15-16% tax on the entire transfer to Class D beneficiaries if the gift is in excess of $500. The more that is transferred, the higher the rate will be.

As an example, assume I owned $5,000,000, and I gifted away $1,000,000 to my nieces and nephews four years ago, $3,500,000 to my nieces and nephews this year and then died within three years, leaving the remaining $500,000 to my two siblings. The $1,000,000 gift to my nieces and nephews would not be subject to a New Jersey inheritance tax because it was longer than three years ago. The first $700,000 of the $3,500,000 deathbed gift to my nieces and nephews would be taxed at a 15% inheritance tax rate ($105,000). The remaining $2,800,000 would be taxed at a 16% inheritance tax rate ($448,000). For the transfers to my siblings, $50,000 will pass free of taxes, and the remaining $450,000 will be taxed at an 11% inheritance tax rate ($49,500). In total, there will be a $602,500 NJ inheritance tax.

For gifts to charity in any amount and gifts of less than $500 to any person, there is an easy answer - it is not subject to an inheritance tax in New Jersey.
Regardless of what classification a beneficiary is in, there MAY BE a New Jersey estate tax and/or federal estate tax if the gift is subject to a three year lookback under the federal estate tax rules or a lifetime lookback if the gifted items are in excess of the annual exclusion amount.

Certain Transfers are Automatically Subject to a Three Year Lookback for Estate Tax Purposes

Under Section 2035 of the Internal Revenue Code there is a limited three year lookback that most significantly applies to life insurance policies transferred within three years of death.
A. Life Insurance: If you learn nothing else from this post, make sure you learn this:

1. If a decedent OWNS a life insurance policy insuring his or her own life, the entire death benefit is subject to both the New Jersey estate tax AND the federal estate tax. Many people assume life insurance proceeds are tax free. While this is true for income tax, it is not true for estate tax. The only relief is if the beneficiary is a charity, a surviving spouse, a civil union partner or domestic partner because then the estate may be entitled to a deduction;


2. If the decedent transferred OWNERSHIP of the policy on his life to another party within three years of death, the 2035 rule kicks in and it is considered a taxable deathbed gift.

B. You should also be aware that the Section 2035 lookback rule also applies to certain interests in trusts and real estate. This does not affect most people, so I will not discuss them here.

Gifts in Excess of the Annual Exclusion Amount

Currently, each United States citizen and permanent resident alien can give away $13,000 to as many donees as he or she wishes. This is known as the federal annual exclusion amount or 2503(b) exclusion. Gifts in excess of the federal annual exclusion amount result in a "taxable gift". Usually there is no immediate out of pocket expense though because New Jersey does not have a gift tax and the federal government will only institute a gift tax if the sum of these gifts exceeds the lifetime exclusion amount (currently $5,000,000).

When calculating the New Jersey estate tax, we are required to look not just at what a person owned when he or she died, but also the taxable gifts that the decedent made over his or her lifetime.

In most situations, if the decedent's taxable estate, including prior taxable gifts, is in excess of the New Jersey estate tax exemption amount (currently $675,000), there will be a New Jersey estate tax. However, there is a big difference in the tax depending upon whether the decedent died with estate over the $675,000 threshhold or died with an estate under the $675,000 threshhold, but is deemed to have an estate in excess of $675,000 due to the lookback provisions.

As an example, assume I owned $5,000,000, and I gifted away $4,500,000 to my daughters and then died in 2012 as a widower, leaving the remaining $500,000 in my estate to my children. Normally, there would be no estate tax on a New Jersey estate of only $500,000, but we must add back the prior gifts. Even adding back the prior taxable gifts, it would only produce a $10,000 NJ estate tax. (To learn how this is calculated, you will need to prepare a 2001 Form 706 federal estate tax return and a New Jersey estate tax return. I will discuss this in future post, entitled "Deathbed Transfers in New Jersey - Advanced")

To realize the benefit of making this gift, you should know that if I had died with the entire $5,000,000, my estate would have to pay a $391,600 New Jersey estate tax. In years past, nobody would give away more than a $1,000,000 because that was the old lifetime gift limit for federal gift tax purposes. Any gifts above $1,000,000 were taxed at a very high gift tax rate. However, with a $5,000,000 lifetime federal gifting limit and no New Jersey gift tax, there is ample opportunity for planning to avoid or drastically reduce the New Jersey estate tax.

You should also be aware that if you do make a gift in excess of the annual exclusion amount, you should file a federal gift tax return (Form 706). If a lifetime transfer is in excess of the federal annual exclusion amount, it could lead to a federal estate tax or a federal gift tax at some future time. To minimize this possibility, you should try to structure gifts over longer periods of time and for an amount equal to or less than the annual exclusion amount. To read more about this, see my article entitled: Federal Estate and Gift Taxation of Deathbed Gifts.

The Importance of Knowing the Basis of the Gifted Item

It is important to know the basis of the property that is being gifted. If the donor is gifting cash, the basis is exactly the amount of the gift. If the donor is gifting property or stock, it may be unwise to make the deathbed gift because there could be substantial built-in capital gains.

When property is gifted away, the donee usually takes the property with a basis equal to that of the donor's basis. (For more on basis, see my post on Understanding Basis.) If the donor keeps property until his or her death, the recepient will receive the property with a new basis equal to the fair market value of that property on the date of the death. This is often referred to as a step-up in basis rule, although in this economy it may be a step-down in basis.

Let's assume I give away a real estate property worth $4,500,000 to my daughters shortly before I die to save on the New Jersey estate tax. If my basis in the property was only $1,000,000, the kids will take the property with that same basis. If my kids sell it immediately after I die for $4,500,000, there will be a 15% capital gains tax on the $3,500,000 of built in gain. This will produce a federal capital gains tax of $525,000 and probably a New Jersey income tax of $315,000. As discussed above, the New Jersey estate tax would have only been $391,600 if I had held onto the property.

Due to the carryover basis rule, it is usually best not to give away appreciated property during life. It is usually better to pay a smaller estate or inheritance tax than to risk losing the step-up in basis on the decedent's death.

Summary

In summary, large deathbed gifts are not necessarily going to be taxed after the donor passes. Whether there will be a New Jersey tax on a deathbed gift is based upon whether the transaction has occurred in the last three years, to whom the item is being gifted, the type of asset being gifted and on the size of the donor's net estate after factoring in prior gifts.

When all is said and done, even if there is a New Jersey tax (estate or inheritance), large gifts made to Class A beneficiaries prior to death and large gifts made to Class C and D beneficiaries more than three years prior to death will greatly reduce the overall estate and inheritance tax liability unless the donor is making a gift of a highly appreciated asset.

Simple, right?

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I want to give a special thank you to Martin Bearg, Esq., Rekha Rao, Esq., Rebecca Esmi, Esq., and to individuals at the New Jersey Transfer Inheritance Tax Branch (who wish to remain anonymous) for taking the time to speak with me about this and helping me to gather my thoughts.

Japanese Inheritance Tax vs. US Estate Tax (2011 Update)

BRIEF OVERVIEW OF
JAPANESE INHERITANCE AND GIFT TAXES
vs.
AMERICAN ESTATE AND GIFT TAXES

(2011 Update)

NOTE: This information has been updated. The new post can be found at: http://willstrustsestates.blogspot.com/2014/08/japanese-inheritance-tax-vs-us-estate.html

I. Estate Taxes

A. America

1. Citizens and Permanent Residents

a. Tax on Worldwide property (credit for taxes paid to foreign countries)
b. Exemption of $5,000,000 in 2011 and 2012 (theoretically back to $1,000,000 in 2013 if no change to Federal Estate Tax). For married couples, the exemption amount is $10,000,000 as a result of portability.
c. Tax of 35% on amount over $5,000,000
d. Unlimited Marital Deduction for Surviving Spouse if Surviving Spouse is a citizen

2. Non-Citizens/Non-Permanent Residents

a. Tax only on Real Property and business interests in the United States (Cash in foreign banks and foreign stocks are not taxed)
b. Exemption of $13,000
c. Tax of between 18%-35% on amount over $13,000
d. Unlimited Marital deduction if Surviving Spouse a citizen

B. Japan (Actually an Inheritance tax, not an estate tax)

1. Japanese Citizens and Permanent Residents

a. Exemption of ¥50,000,000 + (¥10,000,000 for each statutory heir); Possible additional exemption for insurance money, retirement savings, and money left to handicapped individuals
b. Additional exemption for life insurance received of ¥5,000,000 multiplied by the number of statutory heirs
c. Tax between 10%-50% for statutory heirs; Tax between 30% to 70% for everyone other else (except charities);
d. For property outside of Japan, a beneficiary that acquires property will be subject to Japanese inheritance tax if the beneficiary is a Japanese national and the beneficiary was domiciled in Japan at any time during the five years preceding the receipt of the inheritance.
e. A surviving spouse is entitled to a tax deduction. This is a complex formula based upon who is living at the time of the Decedent's death and where the money goes. Generally, a surviving spouse can deduct about 1/2 to 2/3 of the tax.

2. Non-Citizens/Non-Permanent Residents

a. If beneficiary is not Japanese and not living in Japan and property is not in Japan, appears Country where property located will tax such property.
b. If there is a tax, it appears a surviving spouse is entitled to the same marital tax deduction as for Japanese citizens.

II. Gift Taxes

A. America

1. Citizens and Permanent Residents

a. Tax on all gift transfers of Worldwide property
b. Annual exemption of $13,000 per person/per donee (unlimited gifts for donees if different donors)
c. An annual gift to a non-citizen, permanent resident spouse, of $136,000 is available.
d. Lifetime exemption of $5,000,000 (for years 2011 and 2012)
e. Gifts may be split with spouse
f. Tax rate of 35% if lifetime gifts exceed $5,000,000

2. Non-Citizens/Non-Permanent Residents

a. Tax on all gift transfers of US Property (including Cash and Stocks in US companies)
b. Annual exemption of $13,000 per person/per donee (unlimited gifts for donees if different donors)
c. No Lifetime exemption
d. Gifts may be split with spouse
e. Tax rate of 18%-35% if lifetime gifts exceed $13,000

B. Japan (Rates between 10%-50%)

1. Citizens and Permanent Residents of Japan

a. Annual exemption of ¥1,100,000 for each beneficiary (beneficiary taxed after this)
b. One time spouse exemption of ¥20,000,000
c. For property outside of Japan, a donee that acquires property will be subject to Japanese gift tax if the donee is a Japanese national and the donee was domiciled in Japan at any time during the five years preceding the receipt of the gift.

2. Non-Citizens/Non-Permanent Residents

a. Annual exemption of ¥1,100,000 for each beneficiary(unclear – enforcement is almost impossible)

III. Generation Skipping Taxes (Taxes on gifts or bequests to grandchildren)

A. America

1. Exemption of $5,000,000 in 2011 and 2012 (theoretically a return to a $1,000,000 exemption in 2013, but indexed for inflation)
2. Tax of 35% on rest

B. Japan

1. None

For more information on Japanese taxes, the Japanese government has a nice website in English with some helpful facts. This is a link directly to the inheritance tax information:
http://www.mof.go.jp/english/tax_policy/publication/taxes2010e/taxes2010e_d.pdf
It is worthwhile reading the Japanese publication if you have business interests in Japan or if one of other special circumstances (like a handicapped heir) as there are many credits available.

Pennsylvania (and Philadelphia)Tax Amnesty Programs

Starting April 26, 2010, Pennsylvania will offer partial amnesty for taxpayers who are delinquent in paying their taxes. The program runs through June 18, 2010. Frankly, this is an incredibly generous amnesty because Pennsylvania is agreeing to waive 100% of any penalties plus 50% of the interest.

The city of Philadelphia is also showing a little brotherly love by offering its own tax amnesty program, starting on May 3, 2010 and ending on June 25, 2010.

For those of you who owe back taxes, it is usually advisable to try and take advantage of the amnesty programs to reduce your overall tax liability and clean up your credit. Moreover, the government will frequently issue additional penalties to those who do not come forward during the amnesty.

A Good Time to Buy that First House – But How?

Many experts think this is a great time to buy a new house, especially if you are a first time home-buyer. Interest rates are low and home values are depressed. The problem, however, with this credit crunch is having enough cash for the down-payment. There are programs out there so that you can buy a home with almost no money down, but that can lead to the monthly payment of Private Mortgage Insurance (PMI), which is expensive, and opens the homeowner to the possibility of owing more than the home is worth if the value declines.

In order to put have an adequate down-payment, many prospective homeowners will consider dipping into their IRAs, 401(k)s or 403(b)s for the down payment. Tapping into these retirement accounts options have significant drawbacks and the cost of such withdrawals should be carefully considered.

IRAs

Best features:

* You can withdraw up to $10,000 without a 10% early withdrawal penalty. (A husband and wife can each withdraw $10,000 to make a $20,000 down-payment.)
* You may withdraw for immediate family such as a spouse, child, grandchild, parent or other ancestor.

Pitfalls:

* The withdrawal amount will be taxable as ordinary income.
* There is no ability to re-contribute money.
* Funds can only be used towards: buying, building or rebuilding the primary residence; and any usual or reasonable settlement, financing or other closing costs.

401(k)s/403(b)s

401(k)s and 403(b)s function in very similar fashion to each other. There are 2 ways to access your retirement fund to purchase a home: withdrawing it outright, or taking a loan out against it. It is usually a far better option to borrow against a 401(k)/403(b) than to withdraw from it due to the pitfalls.

1. If you withdraw money from your 401(k)/403(b):

Best features

* You do not have to be a first-time homebuyer to withdraw 401(k)/403(b) funds (any financial hardship as described by the IRS will suffice).

Pitfalls

* You need to be purchasing a primary residence, as withdrawals are only permitted under “hardship” circumstances. (The government considers the need to purchase a primary residence as a hardship circumstance.)
* The withdrawal amount will be considered taxable income.
* You will be assessed a 10% early withdrawal penalty if you are under age 59.5.
* You lose the compounding interest.
* You may also be prohibited from making any additional contributions for a period of one year.

2. If you borrow against your 401(k)/403(b):

Best Features

* You may borrow the lesser of $50,000 or ½ of your account balance. However, if ½ your account balance is less than $10,000, it may be possible to borrow $10,000.
* A loan from a 401(k) allows you time to pay it back. (This is usually at prime + 1% and the typical payback period is 10-15 years, but it may be as long as 30 years.) A 403(b) typically has a payback period equal to the duration of the first mortgage. However, you should check the specific payback period identified in your plan.
* There is no penalty for borrowing against your 401(k).
* Assuming that you pay the loan back in a timely manner, there are no adverse income tax consequences to receiving the loan.

Pitfalls

* If you lose your job, any unpaid loan amount would either be due in a period as short as 60 days. If you do not pay back the loan, the unpaid amount will be considered income, which is then both taxable and possibly also subject to a 10% early withdrawal penalty.
* Most plans prevent you from contributing extra savings until the loan is repaid.
Conclusion

While IRA, 401(k) and 403(b) funds could be used to fund the deposit on a first time home purchase, the tax drawbacks and risks are significant. You will want to consider how use of these funds will affect your retirement and your estate and the tax implications before taking such drastic measures. Obviously, if you are in your 20s with many years until retirement, and perhaps not at the peak of your earning potential, the use of your IRA and/or 401(k) and/or 403(b) funds can help you buy a piece of the American dream. However, if you are looking towards retirement or the rate of return on these funds makes withdrawing funds a particularly costly proposition, it is best to look elsewhere for your down-payment.

Special thanks to Nancy McMillin in the preparation of this post.

Links to Important US-Japanese Tax Treaties

It is not always easy to find the treaties between America and Japan, so I have decided to post them here in case you would like to read them for yourself.

Here is the US-Japan Income TaxTreaty (2003) courtesy of the IRS.

This is an official version of the US-Japan Estate & Gift Tax Treaty (1954) thanks to the Ministry of Foreign Affairs of Japanese.

Business Succession Planning

Some of you may have seen these scary statistics:

According to the U.S. Small Business Administration, 90 percent of the 21 million small businesses in the U.S. are family-owned, but less than one-third of family-run companies succeed into the second generation, while only half of that make it to the third. Most often, the lack of a proper succession planning is to blame.

Proper business succession planning is particularly vital in the Northeast where taxes are so high.

Let's assume that an unmarried NJ decedent (Jane) has a company worth $5,000,000 at the time of her death. Without looking at Jane's other assets, I can tell you that her heirs have a potential federal estate tax liability of close to $1,350,000 plus a NJ Estate Tax liability of almost $400,000 for a total tax liability of close to $1,750,000. If she had no issue or parents living, this would also be subject to a $750,000 New Jersey inheritance tax. These taxes could decimate a small company at a time when the key person involved is not around.

The benefits of proper planning are countless.At a minimum, proper strategy will help you minimize taxes, maximize control and provide a clear path for continuity of the business. Planning an exit strategy is important as soon as you go into a business. This includes planning for death, divorce or a sale upon retirement.

Some popular planning techniques include:

1. Setting up an entity structure (LLC, C Corporation, S Corporation, Partnerships, etc.);
2. Purchasing Life Insurance (combined with Buy-Sell Agreements);
3. Creating agreements limiting control of potential takers to the business;
4. The use of promissory notes;
5. Selling or gifting ownership in the business to family members; and
6. Selling or gifting ownership in the business to other entities or trusts that will benefit family members.

Valuation Discounts

One of the most important aspects of proper planning is gaining the ability to maximize the amount that you can pass down to your heirs through the use of Valuation Discounts.

When a person has a small business, it is often difficult to sell. The IRS recognizes this lack of marketability. Additionally, as many small business owners get on in years, they are not as involved in running the business. The IRS also recognizes this lack of control.

It is not uncommon to have restrictive agreements in place that will allow an owner to pass on his or her interest with a one-third discount for lack of marketability PLUS another one-third discount for lack of control. Discounts are very specific to each business and a proper appraisal is a MUST.

So how does it work?

Let's go back to our example above. Let's assume that Jane has one child, Dave, who is 35 years old and has shown some interest in the business. Ten years ago, Jane sets up an entity, let's say an LLC, with a restrictive operating agreement. As a result, the appraisal comes back and states that there is a 1/3 discount for lack of marketability. Jane can transfer Dave $1,012,000 of this company without any out of pocket gift tax consequences. Without the appraisal, this would result in a transfer of 20% of the company. With the appraisal, Jane could transfer as much as $1,518,000 of the LLC (a little over 30%) without gift taxes. Additionally, Dave could buy another 20% of the company with a promissory note at the lowest rate available for tax purposes. Let's say a ten year note of $666,666 at 6% interest. Finally, Jane is in good health, so for the next 10 years she uses her annual exclusion amount to gift Dave another $12,000 worth of the company annually. (Since annual appraisals would be expensive, let's assume we don't discount this.)

The result is that upon Jane's death 10 years later, her 100% interest in the company, which started at $5,000,000 company, has been reduced as follows:
1) Through the lifetime gift to Dave, her interest is reduced to a 70% interest, worth $3,500,000;
2) Through the promissory note, her interest is reduced just under 50%, with a value of just under $2,500,000.
3) Through the annual gifting, her interest in the business is reduced to $2,380,000.

Upon Jane's death her $2,380,000 interest will receive a 1/3 discount for lack of marketability and another 1/3 discount for lack of control. This will result in a tax valuation of approximately $1,060,000. After we add back in the $666,666 that she received for the 20 interest plus another $220,000 for interest payments, she will pass with a taxable estate of about $1,950,000.

Accordingly, upon Jane's death, her estate will not be subject to any federal estate tax liability. Additionally, the NJ Estate tax liability will be reduced to $96,000. This is a tax savings of over $1,600,000 - which far outweighs the costs involved in such preparation.

Obviously, there are many different ways to structure this type of transaction, but they are usually based upon the same methodology. The numbers and techniques involved will depend upon the individual needs of the client. For example, if Dave were not responsible or had no interest in running the business, Jane could give him his shares in trust. If Jane had a business partner, this structure could be done for each partner and combined with a buy-sell agreement funded by life insurance.

Japanese Inheritance Tax vs. US Estate Tax

BRIEF OVERVIEW OF
JAPANESE INHERITANCE AND GIFT TAXES
vs.
AMERICAN ESTATE AND GIFT TAXES

NOTE: This information has been updated. The new post can be found at: http://willstrustsestates.blogspot.com/2014/08/japanese-inheritance-tax-vs-us-estate.html

I. Estate Taxes

A. America

1. Citizens and Permanent Residents

a. Tax on Worldwide property (credit for taxes paid to foreign countries)
b. Exemption of $2,000,000 in 2006; $3,500,000 in 2009; unlimited in 2010; and back to $1,000,000 in 2011)
c. Tax between 18%-46%
d. Unlimited Marital Deduction for Surviving Spouse if a citizen

2. Non-Citizens/Non-Permanent Residents

a. Tax only on Property in the United States (Cash in foreign banks and foreign stocks are not taxed)
b. Exemption of $13,000
c. Tax of between 18%-49% on rest
d. Unlimited Marital deduction if Surviving Spouse a citizen

B. Japan (Actually an Inheritance tax, not an estate tax)

1. Japanese Citizens and Permanent Residents

a. Exemption of ¥50,000,000 + (¥10,000,000 for each statutory heir); Possible additional exemption for insurance money, retirement savings, and money left to handicapped individuals
b. Tax between (10%-50%)
c. For property outside of Japan, a beneficiary that acquires property will be subject to Japanese inheritance tax if the beneficiary is a Japanese national and the beneficiary was domiciled in Japan at any time during the five years preceding the receipt of the inheritance.
d. A surviving spouse is entitled to a tax deduction. This is a complex formula based upon who is living at the time of the Decedent's death and where the money goes. Generally, a surviving spouse can deduct about 1/2 to 2/3 of the tax.

2. Non-Citizens/Non-Permanent Residents

a. If beneficiary is not Japanese and not living in Japan and property is not in Japan, appears Country where property located will tax such property.
b. If there is a tax, it appears a surviving spouse is entitled to the same marital tax deduction as for Japanese citizens.

II. Gift Taxes

A. America (18%-46%)

1. Citizens and Permanent Residents

a. Tax on all gift transfers of Worldwide property
b. Annual exemption of $12,000 per person/per donee (unlimited gifts for donees if different donors)
c. An annual gift to a non-citizen, permanent resident spouse, of $120,000 is available.
d. Lifetime exemption of $1,000,000
e. Gifts may be split with spouse

2. Non-Citizens/Non-Permanent Residents

a. Tax on all gift transfers of US Property (including Cash and Stocks in US companies)
b. Annual exemption of $12,000 per person/per donee (unlimited gifts for donees if different donors)
c. No Lifetime exemption
d. Gifts may be split with spouse

B. Japan (10%-50%)

1. Citizens and Permanent Residents

a. Annual exemption of ¥1,100,000 for each beneficiary (beneficiary taxed after this)
b. One time spouse exemption of ¥20,000,000
c. For property outside of Japan, a donee that acquires property will be subject to Japanese gift tax if the donee is a Japanese national and the donee was domiciled in Japan at any time during the five years preceding the receipt of the gift.

2. Non-Citizens/Non-Permanent Residents

a. Annual exemption of ¥1,100,000 for each beneficiary(unclear – enforcement is almost impossible)

III. Generation Skipping Taxes (Taxes on gifts or bequests to grandchildren)

A. America

1. Approximately $2,000,000 in 2006 is exempt; $3,500,000 in 2009 is exempt; there is no GST tax in 2010; $1,000,000 exemption in 2011 (but indexed for inflation)
2. Tax of 55% on rest

B. Japan

1. None

For more information on Japanese taxes, the Japanese government has a nice website in English with some helpful facts. This is a link directly to the inheritance tax information: http://www.mof.go.jp/english/tax/taxes2006e_d.pdf

(Revised on 2/2/09 to correct Japanese tax rates)