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North Bay Business Journal

Monday, April 14, 2014, 6:30 am

New federal tax adds twist for trusts

‘Many … surprised to see that extra line item’ of 3.8%

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    A new federal tax on passive income has created another layer of complexity for the exit strategy of business owners, with particular nuance added for those planning the transfer of ownership to the next generation, according to business succession advisers in the North Bay.

    Jim Petray, Jay Silverstein, Genevieve Larson, Raymond Pounds

    Jim Petray, Jay Silverstein, Genevieve Larson, Raymond Pounds

    While the vast majority of filers are below the highest federal bracket and will thus avoid eligibility for the 3.8 percent “Net Investment Income Tax,” the far lower thresholds for trust income have added a new wrinkle to the widely used mechanism for passing ownership to heirs, they said.

    Those advisers emphasized that tax concerns are but one component of an effective succession plan, and that trusts can carry benefits that are well worth potential costs. Yet in an income tax landscape that many argue looms large in the state of California, the new tax represents another example where insufficient planning can leave owners and heirs with less than expected from a sale or transition.

    “Many people, despite what they read about it, were surprised to see that extra line item,” said Jim Petray, partner in the private company services group in the North Bay offices of Burr Pilger Mayer (BPM), accountants and consultants, of the new tax. “It can — and should — be factored in.”

    While many have anticipated the NIIT’s implementation in the 2013 tax year, it wasn’t until Feb. 26 of this year that the Internal Revenue Service issued its final payment instructions. The tax was enacted as part of the Affordable Care Act, and joins a 0.9 percent “additional Medicare tax” on high-income earners also effective as of the 2013 tax year.

    Undistributed ownership interests passed to a trust — often on behalf of heirs –  are considered part of a wide definition of passive income eligible for the NIIT. And while the upper-end federal bracket threshold for individuals to qualify for the tax is relatively high, the condensed thresholds for trusts topped out at a comparably small $11,950 in 2013.

    That lower bracket for trusts, revised to $12,150 for 2014, means that even relatively small businesses or estates could likely face the tax on an ongoing basis while transferring ownership to the next generation, advisers said.

    “It’s certainly something that’s coming up now, in addition to the higher state and federal tax rates,” said Jay Silverstein, leader of the wealth services practice for Moss Adams in both Santa Rosa and San Francisco.

    Among those ongoing questions have been the finer details of when a trust and its participants may have an active or “material” involvement in the business, thus passing out of eligibility for the tax, he said. A late-March ruling in the United States Tax Court case Frank Aragona Trust v. Commissioner is among the latest clarifications for determining material participation of a trust, further resolving the current framework for succession planners and their clients.

    Though scrutiny from the IRS remains high and ownership transfers can be complex, having a current owner, officer or employee serve as a trustee in the case of succession to heirs is likely to qualify for material participation, Mr. Silverstein said.

    “There’s a lot more scrutiny now for that income,” he said. “The IRS is being very strict for trustees.”

    The situation has added another layer of nuance to trustee selection: while appointment of a material participant in the business may avoid the tax, that individual may lack the expertise to properly manage the trust’s assets at a time when such work is increasingly complex.

    “It puts a lot more onus on the trustee to evaluate the holdings of the trust. It can be a difficult position to put someone in,” said Genevieve Larson, senior associate in Farella Braun + Martel’s family wealth and exempt organizations groups in San Francisco and the North Bay.

    Advisers recommended selecting that trustee based on expertise over tax concerns, and cast the NIIT in the context of a current income tax environment where many filers are likely to see increases in some capacity. A third-party fiduciary, for example, would be unlikely to qualify as a material participant yet may bring long-term benefits from professional trust administration.

    “That’s an example that may not be best from an income tax standpoint, but it’s good from a wealth management standpoint,” Mr. Silverstein said.

    Passing ownership directly to heirs with the higher brackets granted to individuals is another option, though one that many owners would rather avoid via a managed trust until those offspring are of sufficient age and maturity, advisers said.

    The 3.8 percent tax comes into play at a time when the continuation of a historically large gift and estate tax exemption has cast a spotlight on income taxes in succession planning. A combined exemption of over $10 million for married couples allows many to pass on their estate or business tax-free, a situation that many planners expect to remain intact after a period of congressional wrangling.

    “I think they found a place where they’re comfortable,” said Raymond Pounds, senior partner at Pisenti & Brinker LLP. He noted that the estate tax has never been a major revenue generator for the federal government. “I think there’s more concern on structuring deals to avoid that higher income tax.”

    That combined state and federal income tax can reach nearly 52 percent for the highest-income earners in California, not including the 3.8 percent NIIT and 0.9 percent additional Medicare tax.

    While most individuals are unlikely to regularly face those rates during the course of their careers, the flow of assets and income during an ownership transition or sale can highlight those issues as part of an overall exit strategy.

    “We never want to do things for tax purposes only. We do things that make economic sense, and a good tax situation can be a bonus,” said Mr. Petray of BPM. “The financial aspect has its complexity. But it’s the  non-financial aspects that are most important.”

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