Be careful……The problem with naming a Trust as the Beneficiary of an Annuity.

Congress created the “stretch” rules for retirement accounts and annuities that allow distributions to be taken in small amounts over the life expectancy of the beneficiary.

However, the rules for stretching an inherited account are more problematic in the case of a trust as the beneficiary, because a trust is not a living breathing human being, and therefore doesn’t have a life expectancy to stretch against!

Accordingly, beneficiaries of inherited annuities generally have three options for how to take distributions after the death of the original annuity owner

– If the designated beneficiary is a surviving spouse, the beneficiary can continue the contract in his/her own name (known as the “spousal continuation” rule, similar to the spousal rollover of an IRA);

– If the designated beneficiary is a non-spouse (i.e., any other living breathing human being besides the annuity owner’s surviving spouse), the beneficiary can stretch distributions over his/her life expectancy beginning in the year after death; and,

– If the beneficiary is a non-designated beneficiary, the annuity must be liquidated within 5 years of the annuity owner’s death.

In the case of retirement accounts, the IRS and Treasury have created the “see-through” trust rules that allow post-death required minimum distributions to occur based on the life expectancy of the underlying trust beneficiaries.

However, in the case of annuities, no see-through trust rules exist, compelling trusts to instead liquidate inherited annuities over the far-less-favorable 5-year rule!

While non-qualified annuities (i.e., those NOT owned in a retirement account) do not subject their owners to required minimum distributions (RMDs) while alive, the beneficiary of an inherited annuity is subject to post-death RMD rules that are very similar to those applicable to retirement accounts.

In fact, the rules for post-death RMDs from annuities are virtually identical to those for retirement accounts where the word “annuity” is simply substituted for the word “retirement account” instead!

On the other hand, when an annuity is held inside a retirement account, the retirement account rules do apply (as they would for all retirement accounts, regardless of whether the account owns an annuity or some other investment asset).

However, annuities have no such regulations defining how to make a “see-through” trust that can qualify as a designated beneficiary. As a result, when a trust is named as the beneficiary of an annuity, it is “stuck” with the 5-year rule as a non-designated beneficiary! 

Notably, though, this is about a trust as the beneficiary of an annuity. The consequences of having a trust as the owner of an annuity are entirely different.

Explained in another Blog to follow!

Nonetheless, where the trust is necessary, its benefits must be weighed against the adverse consequences of the trust. The primary negative impact of using a trust is losing the tax-deferral opportunity for a “stretch” of the existing gains embedded inside of the annuity at the death of the original owner.

The situation is exacerbated by the fact that trusts are subject to compressed trust tax brackets, with the top 39.6% tax bracket and the 3.8% Medicare surtax that also applies to annuity gains kicking in at just $12,300 of taxable income.

Contact John L Mottram CPA LLC, Certified Public Accountants at www.mottramcpas.com for more details or speak directly with John L Mottram CPA MBA CGMA  at 214-543-1855, text or email at jlm@mottramcpas.com

Something more on annuities! How are they really taxed?

Whether you have to pay taxes on an annuity death benefit will depend on what the death benefit is and the type of annuity originally purchased.

First, it depends on if you’re dealing with a qualified or non-qualified annuity.

Qualified Annuity

In a qualified annuity, the owner originally was able to put the money away on a pre-tax basis, so taxes will be due as soon as money is withdrawn at an ordinary income rate.

Non-Qualified Annuity

In the case of a non-qualified annuity (one purchased with after-tax dollars), the beneficiary might not have to pay tax, depending on the type of death benefit. Some death benefits to beneficiaries are refunds of premium payment, rather than true death benefits.

In a refund case, the beneficiary gets back the remaining amount that represents the premium paid but not recouped by the original annuitant in the form of an income payment or withdrawal.

Hypothetically, if someone had a non-qualified annuity purchased with a $100,000 premium and received $50,000 worth of payments before passing away, his or her beneficiary would get the remaining $50,000. In this case, the beneficiary would not have to pay taxes on the death benefit because the death benefit would be considered a return of premium. This example is for illustrative purposes only and does not reflect how product fees, expenses or withdrawals would impact these figures.

In a true death benefit, however, the beneficiary might actually accumulate interest above and beyond the premium amount. Any annuity growth, which include amounts outside of premiums paid by the original owner, will be taxed as ordinary income.

This also depends on how you receive the annuity death benefit. If you take it out in cash, then the annuity gains will be considered taxable as regular income. But if you’re inheriting a qualified annuity (one in an IRA or 401(k)) from your spouse, then you would be permitted to roll that qualified annuity into a qualified account tax-free. Non-spousal beneficiaries can do this as well, but in that case, the annuity would need to be rolled into an inherited IRA, which would be a special account set up in the decedent's name to benefit you. In the case of a rollover, you’ll pay tax on any withdrawals made, rather than the whole amount.   

  

Trust as a Beneficiary

This topic will be the subject of our next blog on annuities we will go into detail regarding the problem with naming a trust as the beneficiary.

At John L Mottram CPA LLC Certified Public Accountants we have the insights you need to establish the right time of annuity to minimize taxes. Contact John L Mottram directly at jlm@mottramcpas.com or on 214-543-1855. Also go to our website at www.mottramcpas.com to sign up for our regular tax updates.

You’re leaving money on the table! How to deduct business start-up expenses

Start-up expenses are incurred before the business actively commences operations.

Start-up expenses can include costs incurred: 

1. To investigate the creation or acquisition of a business, 
2. To create a new business, or
3. To engage in any for-profit activity before the active conduct of business begins, in anticipation of such an activity becoming an active business. 

Common examples of start-up expenses include employee training, rent, utilities and marketing expenses incurred prior to opening a business. 

In the tax year when active conduct of business commences, the rules allow taxpayers to elect to amortize start-up expenses. The election potentially allows an immediate deduction for up to $5,000 of start-up expenses. However, the $5,000 deduction allowance is reduced dollar-for-dollar by the amount of cumulative start-up expenses in excess of $50,000.

Any start-up expenses that can’t be deducted in the tax year the election is made are amortized over 180 months on a straight-line basis. Amortization starts in the month in which the active conduct of business begins. 

A taxpayer is deemed to have made this election in the tax year when active conduct of business commences unless, on a timely filed tax return for the year, the taxpayer elects instead to capitalize start-up expenses. 

Start-up expenses don’t include interest expense, taxes or research and development costs. Those expenses are subject to specific rules that determine the timing of the deductions. Start-up expenses also don’t include corporate organizational costs or partnership or LLC organizational costs — although the tax treatment of those expenses is similar to the treatment of start-up expenses. 

Factors to Consider 

The IRS has historically focused on these three factors to determine if a taxpayer has commenced the active conduct of a business:

1. Did the taxpayer undertake the activity intending to earn a profit? 
2. Was the taxpayer regularly and actively involved in the activity? 
3. Has the activity actually commenced?

The Tax Court recently concluded that the taxpayer wasn’t engaged in a business during 2009 and 2010, because they didn’t have any income or clients and didn’t bid on any jobs during those years. Though the taxpayer did engage in promotional activities, they didn’t intend to earn a profit in those years, because they didn’t pursue contracts or bid on jobs. 

Therefore, the court ruled that the IRS was correct in denying the deductions reported on the taxpayer’s 2009 and 2010 returns, because they were amortizable  start-up expenses rather than currently deductible business expenses. However, if the taxpayer could properly substantiate the expenses, the opinion notes that the taxpayer could begin amortizing them in the year when his business activity started. 

Finally, the court ruled that the IRS was correct in imposing the 20% substantial understatement penalty, because the taxpayer had failed to establish that there was any reasonable cause for the tax underpayment or that the taxpayer had acted in good faith. 

Important Reminders about Start-Up Costs

When you incur business start-up expenses, it’s important to remember two key points. First, start-up expenses can’t always be deducted in the year when they are paid or incurred. Second, no deductions or amortization write-offs are allowed until the year when active conduct of your new business commences. That usually means the year when the business has all the pieces in place to begin earning revenue. 

Time may be of the essence if you have start-up expenses that could be deducted in the current year. 

Remaining start-up expenses after business is closed

If any unamortized start-up costs or organization costs remain on your books when your business is closed, deduct the balance remaining on your final return.

For example, if you elected to amortize organization costs over five years, and you still have two years of unamortized organized costs remaining when your business is closed, deduct the remaining two-year balance on your final return.

Contact John L Mottram CPA LLC Certified Public Accountants for more ways to apply understand how start-up expenses may reduce your tax liabilities. Reach out to John L Mottram directly at 214-543-1855 or jlm@mottramcpas.com.

Why are allocations of Partnership Liabilities so complicated?

Partnership liabilities are complicated BUT they are important and can lead to over-payment of tax if done wrong!

Under Section 704, a partner in a partnership may only utilize a loss allocated to that partner to the extent of the partner’s “basis” in the partnership interest. This is generally equal to the amount of cash plus the adjusted tax basis of any property contributed by the partner to the partnership.

Unique to subchapter K, a partner includes in his tax basis his share of the partnership's liabilities. This is accomplished by virtue of Section 752, which provides that a partner’s allocable share of the liabilities of the partnership is treated as a cash contribution to the partnership. Conversely, Section 752 also provides that any reduction in a partner’s share of the liabilities of the partnership is treated as a cash distribution to the partner. This deemed distribution may create taxable gain to the partner if it exceeds the partner’s outside basis in his interest.

Determining a partner’s allocable share of the liabilities of the partnership is often critical, as it may enable the partner to utilize a loss or take a tax-free distribution that would otherwise be unavailable. But how do we do it?

Step 1: Identify the Type of Liability

The first step towards properly allocating partnership liabilities is to understand the nature of the three liabilities listed on Schedule K-1.

a)    Recourse Liability

b)    Nonrecourse Liability

c)    Qualified Nonrecourse Liability (QNR)

Step 2: Identify the Type of Partnership

Those three definitions are only useful when understood in conjunction with the types of limited legal liability associated with certain forms of partnerships. Let’s take a look.

Step 3: Allocating Liabilities

The short-hand version is:

“Allocate recourse liabilities according to loss ratio, and nonrecourse liabilities according to profits ratio”, but let’s see:

Allocation of Nonrecourse Debt

The regulations require that nonrecourse liabilities be allocated according to three steps:

1.    First, to the extent of partnership minimum gain,

2.    Next, to any partner that contributed appreciated property to the partnership secured by a liability to an amount equal to the excess of the liability over the tax basis of the property at the time of contribution. (Section 704(c) gain)

3.    Lastly, to each partner based on profit ratio.

Step 1: Partnership Minimum Gain

First, nonrecourse liabilities must be allocated to each partner equal to the partner’s share of “partnership minimum gain.” This will only apply if the partnership owns depreciable property secured by the nonrecourse loan.

“Partnership minimum gain” is the amount by which the principal balance of the nonrecourse loan exceeds the depreciable basis of the property. It is coined as such because under Section 1001, if the partnership simply transfers the property back to the lender for no additional consideration other than the extinguishment of the debt, the partnership will be treated as if it sold the property for the principal amount of the loan, thus giving rise to gain.

Step 2: Section 704(c) Gain

Under Step 2, if a partner contributed appreciated property to the partnership that secured the liability, the contributing partner must be allocated the liability to the extent of the excess of the liability over the tax basis at the time of the contribution.

Step 3: Profit Ratio

If there is no minimum gain or Section 704(c) gain, the allocation of nonrecourse liabilities is straightforward. If the loan was made directly by a partner or if the partner personally guaranteed the liability, that portion of the nonrecourse liability should be treated as a recourse liability and allocated specifically to that partner. Any remaining nonrecourse liability should be allocated according to the rules above. If there is no minimum gain or Section 704(c) gain to be allocated, the entire nonrecourse portion of the gain should be allocated according to the profits ratio.

Summary

After all of that, here are a few shortcuts:

·         General partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level. Thus, it will be rare to see a number on the "nonrecourse liability" line of Schedule K-1. Allocate according to hypothetical loss analysis.

·         Limited partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level, but only to the general partners. Allocate recourse liabilities solely to the general partners unless a limited partner has a deficit capital account or guarantees the debt. Once again, it will be rare to have an allocation of a "nonrecourse liability," on Schedule K-1, and, it would follow, equally rare to have an allocation of any liability to a limited partner.

·         LLC: all liabilities are nonrecourse unless personally guaranteed by a partner, made by a partner, or the partner enters into a DRO. If there is no guarantee, loan from a partner, or DRO, there should never be a recourse liability allocated on Schedule K-1.

It’s complicated….and more than we have space to cover here. To know more, contact John L Mottram CPA LLC or contact John Mottram directly by telephone, text or email at 214-543-1855 or jlm@mottramcpas.com.