Tax Duties of an Executor

May 21, 2012 by

When someone dies, a personal representative is in charge of the estate to collect assets, pay off the debts, and distribute the remaining assets to heirs or beneficiaries. (FYI – The personal representative is called an “Executor” if the person was identified in the will, or an “Administrator” if he or she was appointed by the court because there was no Will).  The personal representative is also in charge of taxes, both federal and state, for the individual and for the estate. Here are a few important points for tax purposes:

1.     Form 1040 – Individual Income Tax Return

The personal representative will file a Form 1040 tax return for the year the individual died, covering January 1 until the date of death. Form 1040 is due on the usual date, April 15. If the individual was married at death, this can be a joint return.

2.    Form 1041 – Estate Income Tax Return

Any income earned on assets after the decedent’s death but before the asset is distributed to a beneficiary is treated as income to the estate. Uncle Sam won’t let that income slide past his reach, so the estate files an income tax return if the annual gross income to the estate is $600 or greater.  Small estates or estates with assets that can be distributed quickly often avoid this tax. Form 1041 is due on the 15th day of the 4th month following the close of the tax year. If the estate uses the calendar year, the return is due April 15.

3.     Form 706 – Inheritance and/or Estate Tax Return

 A federal estate tax return must be filed (and estate tax due) if the gross estate exceeds the exemption amount, which is $5.12 million in 2012. Form 706 is due nine months after death, but can be extended for six months. An Iowa inheritance return will likely be required if the estate is distributed to persons other than a spouse, lineal descendants or lineal ascendants.  

 4.    EIN Number

 If the estate will be filing Form 1041 and/or Form 706, the estate must get its own Federal Employer Identification Number (EIN or FEIN).  An EIN for an estate is equivalent to a social security number for an individual. An EIN will be needed to open a checking account for the estate.

 A personal representative has many duties when it comes to administering an estate, which is probably why most personal representatives hire a tax professional to complete the tax matters. After all, if you dread doing your own taxes, doing someone else’s taxes probably isn’t too appealing.

Reporting All Income

May 9, 2012 by

As a follow-up to my post on keeping tax records, I came across this article on 1099s and reporting income (acknowledgment to the Roth & Company Tax Update Blog for pointing out the article in their May 8th Tax Roundup).  My prior post focused on keeping records after you file a tax return. This article reminds us of the records to keep throughout the tax year. Specifically, it discusses the misconception that if you don’t receive a Form 1099 for income, you do not have to report the income. Wrong. All income must be reported, whether or not you received a 1099, W-2, etc. For example, most banks will not issue a Form 1099-INT if the interest on the account is less than $10, but that interest is still income and needs to be reported on your tax return.

Moral of the story:  Save records like bank account statements throughout the year so you know how much income to report, even if you don’t get a 1099. For more information, read the full article here.

Can I write my children and/or spouse out of my will?

April 23, 2012 by

The short answer is yes, you can write your spouse and children out of your will, but there is of course a “but.”  Multiple times recently I have found myself explaining to clients and friends just what “testamentary freedom” means in Iowa.  As a general rule in the United States, we are free to choose who gets what property when we leave the world behind. I will spare us all the history lesson, but historically this was not the case and many countries still limit the ability to completely disinherit a surviving spouse or children. Iowa still has protections in place for those individuals also.

Children have no “right” to inherit from their parents, but there are certain assumptions in place that protect the children. For instance, children born or adopted after the execution of a will (referred to as “pretermitted heirs”) typically receive a share of the estate. Some wills specifically provide for this by defining the term “children” in the will to include any children born to or adopted by the testator after the date of the will. Including such a statement saves a couple from needing to change their wills every time a child is born.  Even if the will does not address it, Iowa law provides a share to children born after the date of the will unless it appears the omission was intentional. (Iowa Code Section 633.267).  Also, children and grandchildren are among the classes of beneficiaries who are not charged inheritance tax in Iowa.  Does inheritance tax really stop someone from disinheriting a distant child? Probably not, but if a parent is indifferent between leaving property to nieces and nephews or estranged children, the tax difference may be a factor.

Spouses in Iowa have more protection than children. While you can draft a will leaving nothing to your spouse, the surviving spouse has a right to an elective share, meaning he or she can “elect” to take approximately one-third of your property instead of the share given under the will. (Iowa Code 633.238). (The exception here is if the couple had a valid prenuptial agreement. If the couple is already married, it is too late for that, but that is a topic for another day.)  The elective share is not discussed with most couples during estate planning because the surviving spouse often receives all or most of the assets, which is more than the one-third elective share. The biggest thing to remember about the elective share in Iowa is that the law is unclear as to whether retirement assets or life insurance can be reached by the one-third election. In some estates. that can make a huge difference.

After the long explanation, the conclusion is yes, you can write family members out of your will, but the will needs to be carefully drafted in light of these state law protections.

Keeping Tax Records

April 12, 2012 by

Now that we have all filed our taxes (or are close to filing, hopefully), what do you do with your records? How long do you keep them? How do you organize them? Well, here are some tips from the IRS:

  1.  Tax records should be kept for a minimum of three years. Be sure to keep a copy of your filed tax returns. In addition, keep the records that prove your income and expenses, including W2s, 1099s, K-1s, receipts for deductions, bank statements, statements for investment accounts, mileage logs, and canceled checks. The three years represents the time period in which the IRS can audit your return and assess additional tax. If you failed to report income, that time period is 6 years, and there is no time limit if the return was fraudulent or if you failed to file (and should have).
  2. Organize/store the documents in a way that is sensible to you. There is no specific way to keep the records, though logically the information would be broken down by tax year. The important part is that you can find a specific piece of information if the IRS asks for it two or three years from now. Most documents can be kept electronically now, making it easier to organize (but be sure to back up those files).
  3. Certain documents need to be kept longer. These include records for a home purchase or sale, purchase or sale of stock, and IRA contributions. The records should enable you to determine your basis in the investment so you may determine gain or loss when you sell the property. Real estate used for business or as a rental property also requires more detailed records.

When in doubt, DON’T throw it out.  I am by no means telling you to keep every receipt for a tax return you filed 10 years ago, rarely would that be useful, but if it relates to an asset you still have (such as a home or retirement accounts) you likely still need it.

Identity Theft and the IRS

April 5, 2012 by

A client called the other day to say that she had received correspondence from the IRS. The first line of the letter read:

Dear Taxpayer: 

We have received your income tax return and are holding your refund until we complete a thorough review of your return.

The problem is my client has not yet filed her tax return.

Someone had stolen her identity and filed a fraudulent return using her social security number. My client and I are working on straightening out this situation. Listed below are the steps recommended to her by the IRS:

  • Review the portion of the IRS Website devoted to identity theft
  • Call your state Department of Revenue to report the identity theft. In Iowa, the number is 1-866-339-7912 or visit the Iowa Department of Revenue’s website.
  • If you receive a similar notice from the IRS (it will come by regular mail, not email), call them immediately.  It is a long wait on the telephone this time of year, but you need to report it right away.  Follow up with a letter to the IRS even if they say it is not necessary.
  •  Call the FTC Hotline – 877-438-4338 – and report that a fraudulent tax return has been filed using your social security number.
  • Call the Social Security Administration at 1-800-772-1213 and report the theft of your identity.
  • Call one of the three credit bureaus to report the fraudulent activity and to see if there is theft other than the fraudulent return.  If you call one bureau, they will report to the others:
    • Experian – 1-888-397-3742
    •  Trans Union –  1-800-888-4213
    • Equifax – 1-800-685-1111

Although you will not lose your refund, you can expect delays in the processing of your return if a fraudulent return has been filed using your name and social security number. A special affidavit concerning the identity theft must be filed with your actual return and the return must be filed in paper form. An electronic filing will not be acceptable.

My Accountant Told Me I Have Until April 17th to Make a Contribution to an IRA, What is an IRA?

March 30, 2012 by

An Individual Retirement Account (known as the IRA) is a way to start saving for retirement that comes with some tax advantages.  You have until April 17,2012 to contribute to a 2011 IRA and still have the ability to deduct the contributions on your 2011 tax return if you qualify.

The Traditional IRA and Roth IRA are two different types of individual retirement accounts with different qualifications and benefits.  With a Traditional IRA contributions can be tax-deductible and you pay tax at the back end, which means when you withdraw the money in retirement.  With a Roth IRA you pay taxes on your contributions and then distributions are tax-free.

For a Roth IRA for 2011, the amount you can contribute can be limited or reduced to zero if you are single and have a modified adjusted gross income between $107,000 and $122,000 or are married filing jointly and household income is between $169,000 and $179,000.  If you are under age 50 and under the gross income limits, you can contribute $5,000 to your Roth IRA in 2011.  You can withdraw your contributions to a Roth IRA at any time but any withdrawal of the earnings before you reach age 59 1/2 will result in tax and may result in a 10% early-withdrawal penalty.

For a Traditional IRA for 2011, the amount you can deduct as contributions may be limited if you are covered by a retirement plan at work and are single with a modified adjusted gross income between $56,000 and $66,000 or are married filing jointly with a household income between $90,000 and $110,000 (However, if you are covered by a company plan but your spouse is not, then the deduction is phased out between $173,000 and $183,000).  If you are under age 50, you can contribute $5,000 to your Traditional IRA in 2011.  Withdrawals can be taken after age 59 1/2 without penalty and must be taken by age 70 1/2 in order to avoid penalties.

If you qualify for both types of IRAs, you will need to make a determination of which one is better for you.  This type of analysis would include estimating the amount of earnings you expect to make in the IRA and what tax rates you will be subject to when you make withdrawals to determine which would result in the payment of less tax.

Part 2: Are Frequent Flyer Miles Taxable Income?

March 29, 2012 by

In a February post, I discussed Citibank issuing a Form 1099 to customers who received frequent flyer miles in exchange for opening a bank account. Little did I know that two months later, it would still be highly publicized. This article, also from February, has more detail on the many ways you could receive frequent flyer miles (credit card use, rewards for flying, prizes), and the likely tax implications of each method. A March 2012 article in the Journal of Taxation is what prompted this post. The article discusses the possible ways to calculate the value of the miles to report on the 1099. The main conclusion to the article seems to be that there are many methods, and it seems there is a reasonable cause defense for each.  Here are some of the methods discussed in the article:

  • Sale Price:  Look at the price the miles would sell for in the open market. For example, if you could purchase 5,000 miles from the airline for $100, a mile is worth two cents. But the problem here is most airlines will charge a different price per mile for 5,000 miles than for 10,000 miles.
  • Cost to Company:   Look at the cost to the company to get the miles. How much did the bank pay the airline per mile?  This seems logical, but an IRS spokesperson has already pointed out that income is valued at the value of the property received, not at the cost to the company.
  • Average:  Why not just determine the average price per mile, looking at the average ticket price across all companies and average number of frequent flyer miles to purchase the same ticket. That hardly seems like a method the IRS would follow.

The debate continues as to (1) whether the miles are taxable, and (2) if taxable, how to determine the value.  The IRS has stated that any guidance on how to value the miles (and presumably whether or not the miles are taxed) would be prospective only.  Until then, the uncertainty continues.

Fascinating Questions Surround Section 103 of the Internal Revenue Code

March 20, 2012 by

On March 19, 2012 the United States Court of Appeals for the Third Circuit filed an opinion in a case involving a claim by a taxpayer that interest paid by the State of Pennsylvania under a settlement agreement reached in a condemnation case was exempt from Federal income tax under Section 103 of the Internal Revenue Code of 1986.  The Court overturned the Tax Court in holding that interest payments by the State under a negotiated agreement were exempt under Section 103 since the agreement constituted an exercise of the State’s borrowing power and the extension of credit, payment of interest and interest rate under the agreement were negotiated terms.

This holding seems consistent with prior decisions on the distinction between negotiated interest paid by state and local governments (which is exempt under Section 103) and statutory interest (that is, interest dictated by statute such as, for instance, pre-judgment interest).  But there are several interesting questions that are never mentioned in the opinion and have significant implications.

For instance, did the State intend that the interest be exempt from Federal income taxes?  These days it is not unusual for a governmental entity to borrow on a taxable basis for any one of several reasons including the market at the time, the type of project being financed, and issues with “bank qualified” bonds, as well as others.  Normally, the issuer can make the determination of whether the issue is tax-exempt, although usually we like to see some affirmative act or omission to enforce that determination (such as not filing a form 8038 or 8038G which is normally required for an issue to be tax-exempt).

Here, the Court did not focus on the issuer at all but only the taxpayer, the recipient of the interest. Can the taxpayer claim the interest is tax-exempt regardless of what the issuer intends?  Is tax-exemption a feature that the issuer is entitled to or that the taxpayer is entitled to?  Since there is no mention of the State’s intent in the opinion, it leaves these questions up in the air.

Also, there is no mention of whether the State filed an 8038G. Normally, under Section 147, interest is only tax-exempt if you complete the required filing with the IRS (as well as follow the other procedural requirements under the Code). There is no mention one way or the other in the opinion yet the interest is held to be tax-exempt.  Does this suggest that interest on state and local government obligations can be tax-exempt regardless of whether the issuer follows the procedural requirements under the Code? Are state and local governments entitled under the Constitution to issue tax-exempt debt?  This, of course, is a question which has fascinated bond lawyers since 1913 and the ratification of the Sixteenth Amendment authorizing the federal income tax.

About Me:
My name is David Van Sickel and I am a senior shareholder at the Davis Brown Law Firm. As a member of the firm’s Business Division, I maintain a general practice in, but not limited to, Finance and Public Finance.

I Just Started a New Business, How Do I Avoid Tax Trouble?

March 14, 2012 by

So you’ve started a new business and hired an attorney to make sure that your business is properly formed in order to give you some liability protection.  What is the next step?

Another important step in the process is making sure that you follow all the proper federal and state tax laws as the failure to do so could result not only in liability for your new company but also for you personally.  Besides just filing annual returns, there are also a number of other requirements.  Below is a list of some of the major items to consider when starting your business:

  • Sales and Use Tax.  Are the goods or services you are selling subject to Iowa sales or use tax?  The Iowa Department of Revenue has posted an Iowa Sales and Use Tax Guide to help business owners determine if they need to pay for these taxes and how to go about getting a permit to collect such taxes or an exemption certificate to give to suppliers to purchase items without paying the sales tax.
  •  Employee v. Independent Contractor.  Will your workers be classified as Employees or Independent Contractors?  There is a big tax difference between those two classifications.  Generally for employees you must withhold income taxes and pay Social Security and Medicare taxes and unemployment tax on wages but you do not have to pay these items on payments to independent contractors.  The problem with misclassifying individuals who do perform work for you is that the company may ultimately be liable to pay the employment taxes for the misclassified worker.
  •  Employee Withholdings.  Will your business have employees?  If so, each employee will need to fill out a Form W-4 at both the federal and state level to determine how much to withhold from each employee’s paycheck for state and federal income taxes.  In addition to just withholding amounts for federal and state taxes, employees and employers are required to withhold amounts for Social Security and Medicare taxes and remit payments in a timely manner. Your new business will then need to make sure to comply with all filing and deposit requirements of such withholdings to the IRS and Iowa Department of Revenue.
  •  Estimated Tax Payments.  Are you required to make estimated tax payments?  If you receive income from your business that is not subject to withholding, you may be required to pay estimated income tax at both the federal and state level.  Typically this applies to self-employed individuals or individuals that receive large amounts of interest, dividends, capital gains, rents, royalties, business income, or farm income.

In addition to these items, Iowa also has unemployment tax and employer’s can set up an account through Iowa Workforce Development.  The IRS also has some additional guidance for new start-ups on their website.

It is much easier and less costly for new businesses to make sure they are complying with all tax laws in the formation stage rather than waiting until they receive a notice from the IRS or Iowa Department of Revenue for failure to comply with such rules and regulations.  Penalties and interest can be very steep and tax debts may not be dischargeable in bankruptcy.

Dynasty Trusts – A Trust that Lasts Forever

March 12, 2012 by

The Iowa Legislature is considering legislation that will authorize an individual to create a trust that will last forever.  If passed by the Senate (the House has passed it) the legislation will require such a trust if (i) the trustee is given the authority to sell assets of the trust or (ii) the trustee or another person is given the authority to terminate the trust.  Many other states have authorized trusts to be created that will last forever.  These trusts are called generation skipping trusts or dynasty trusts.

Although I think people should be given the option of creating a dynasty trust, I wonder how wise it would be to create a trust that exists for more than a few generations.

Of course, one of the benefits of these trusts is the possibility of avoiding estate tax in the successive generations.  For example, if Mr. and Mrs. Smith put $10 million into a dynasty trust in 2012, their three children’s estates will each be $3.3 million lower than if they had inherited that money outright. Even at a 35% estate tax rate, that saves $3.5 million of taxes at the children’s level, or $1.5 million each.  Add to that any appreciation in the assets, and the amount passing to the next generation without taxes can be very significant.  If the fund grows in value by an average of only 2% more than the amount distributed to the beneficiaries each year, the money will approximately double every generation.

On the other hand, with each generation, the familiarity between the grantors and their descendants becomes more tenuous.  I only remember one of my grandparents and certainly do not remember my great grandparents.  My mom and dad, however, had great grandchildren who will remember them well.  Once you get beyond the great-grandchildren’s generation, however, the donor is a stranger and the donor’s values will certainly be only a family legend at best.

A more interesting issue is that there may be a lot of beneficiaries as the trust continues.  If each generation is defined as 25 years, and if each beneficiary has an average of 2.5 children, the number of beneficiaries after 250 years (which is longer than our country is old) would be almost 30,000.  If the family is less prolific, and has only an average of 2 children, there would be only 1,500 beneficiaries or so after 250 years.  And if there are 3 children per family, the number of beneficiaries in the 10th generation would be almost 60,000.

That’s enough to give me pause about recommending a ‘true’ perpetuities trust to my clients.  On the other hand, potentially saving taxes in the next couple of generations is worth thinking about.

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