Happy Thoughts

Good morning.

I write more about our newest family member on my other blog CORE Beliefs but Kubae and I are so excited to welcome Ginger into our home!  We picked her up Saturday from the Southwest Washington Humane Society.


Here are my two wonderful young ladies.  Yes, Ginger has her own pink bed, pink walking harness, pink extending leash and collar and even a pink car seat.  She is a corgi-terrier mix, 6 months old and hates being separated from her “mommy”.

No, she does not sleep in her bed.  It is funny, when we put her little bed on top of the chest, I told Kubae that our little sweetheart was going to jump into our bed within 5 minutes.  No sooner did we turn out the lights than we heard her little paws on the foot rail and a soft plop as she hit the mattress.  She curled right up between us!  The good news is she sleeps through the night.

Moving on.

You have no doubt heard the various predictions about the tax reform bill that is currently in committee.  You have probably even formed an opinion as to the effectiveness of this effort at tax reform.  Sadly, your opinion is likely based upon your political disposition instead of really getting to understand what is being done.

When you hear that tax reform never pays for itself, be careful.  I think the evidence is there that within a short time span the tax law does not spur sufficient growth to “pay for itself”.  But I think there is a case that, over a generation, the tax cuts can be effectively stimulative.  The bigger issue is if the pain and suffering are worth the wait.

The 1986 tax act was a major rewrite of the tax code.  It did not really “pay for itself” in the first 5 or 10 years.  I believe, however, that when we look at today’s tax receipts, federal spending and redistribution, we notice that our tax receipts are substantially higher than what they were in 1985.

More importantly, it changed certain behaviors by changing the incentives.  Passive activities were no longer sought after for their generous tax breaks – unless one could find a passive investment that spun off income.  Requiring social security numbers and birthdates for dependents de-incentivized the deduction of, shall we say, dubious dependents.  Yes, I have heard that it created a far more complex tax code – I wouldn’t know for certain because in 1986 I was playing Marine – but I think overall it led to an economic improvement that has enhanced our lives and general prosperity.

As you measure the economic impact of the current tax reform measures, keep in mind that part of what we want to change is how certain behaviors are incentivized.  One code section that comes to mind is section 121.  IRC 121 is the home sale exclusion rules which state that if you own and live in your home 2 of 5 years, the gain can be excluded.  I believe it was enacted in 1999 (or thereabout).

This was a huge benefit to home owners over prior law.  The prior law required you to buy a home of equal or greater value than the home you sold.  Unless you were over 55.

With this change, you could now sell your home and rent until you found the right property.  If you moved from a high cost of living area to a much lower one, you would not have to fear being taxed because your new home was less in value, even if larger.  It provided opportunity – that is, an incentive, to consider moving every few years instead of every decade.

Yes, as with all changes like this, there were lots of attempts to structure transactions to get the benefit without technical compliance.  And there is a link between IRC 121 and the huge run-up in home values in the early 2000’s but I think, overall, that this “reform” served the economy better than under the old law.

Now, congress wants to update IRC 121 and incentivize people to live in their homes longer by requiring 5 years of 8 owning and living in the home.  It remains to be seen if this is a positive or negative incentive – especially with an economy that possibly is going to require citizens to relocate for new job opportunities.   But the point is, it might take more than 5 or 10 years to determine if a change helped or hurt the economy.  And if, after 10 years, congress sees that it is perhaps not working as intended, I would hope they would try to correct it by having a fair and open debate.  Ahh to be a dreamer.

As you read the opinions of your favorite pundits and listen to your talking tax heads, keep in mind that things change constantly.  So, have a happy thought and don’t get wrapped up in the minutia of their debate.  Updating the tax code is a good thing, although I do agree it could have been handled a little more maturely by everyone involved.


Living Trusts and QSSTs

One of the tax projects that we are working on involves a couple where the husband passed away in 2012 who owned a successful small business.  As we go through the process of trying to make sure all the appropriate steps were taken, my research leads me to potential issues related to S Corporations, Living Trusts and QSST elections.  This is a simple thought experiment but the overall issue is likely to be a potential problem as baby boomer’s age and we find their estates have ownership of S Corporation stock.

Husband (H) was the owner of all the shares and owned the shares prior to his marriage to wife (W).  The S Corporations shares were titled to the living trust of Husband.  The shares, per the will, specified that half of the shares were to go to a marital trust and the other half directly to W.  The marital trust stated that W could not sell the shares and they would all go directly to their 4 children at the time of her death.

Husband passed away in 2012.  The problem beings when the 2012 return reports the S Corporation shares on the joint return which reported H as deceased and W as surviving spouse.  The Company’s tax preparer changes the name and tax id number to W’s on the 1120-s K-1 in accordance to W’s statements and their understanding of the living trust document.  All shares are now in W’s name and reported on her 1040 return as the preparer knew about the living trust arrangement.

This creates lots of problems.  The will stated how the assets were to be divided and from the look of it, it wasn’t handled correctly.  Possibly, the shares transferred directly to W through the living trust would be valid, but what about the shares that were supposed to be transferred to the marital trust?  If the shares are owned by the marital trust, was a Qualified Subchapter S Trust (QSST) election filed with the IRS?  Can the marital trust even qualify as a QSST because of the successor beneficiaries listed in the will?

If the QSST is considered invalid or isn’t made, then the S election is terminated.  Without a valid S election, the income is no longer passed to the shareholders.  Income is first taxed at the corporate level and then the dividends – the S Corporation distributions – are taxed to the shareholder at time of receipt.

The tax consequences can be significant.  Let’s say that the Company made $1.0 Million in taxable income as an S Corporation.  It distributes all $1.0 Million to the shareholders.  The shareholders, W in this case, would pay about $390,000 in tax.  Without a valid S election, the Corporation ends up being taxed on that $1.0 Million, which costs about $350,000 and then W is taxed on the $1.0 Million in dividends, which costs her personally about $200,000.

$550,000 in taxes compared to $390,000.  And worse, the Company owed the tax but it may have distributed all its available cash, leaving W to wonder how she is going to pay the tax bill.  And if she used the remaining $610,000 to pay her living expenses, she can’t even loan the money back to the Company to pay its tax bill.

And remember, this is for the last 5 years, so almost $800,000 in additional taxes could be owed.

If you own S Corporation stock and have it titled to your living trust, you may want to talk with your estate planning attorney or CPA to make sure instructions are available to make sure something like this doesn’t happen.  Make sure your will aligns with your living trust and takes into consideration the fact that some assets have special rules about transfers to trusts.  And if you need the name of a practicing attorney or accountant who specializes in trusts and estates in Oregon or Washington, let me know and I will send you a few contacts you can discuss your concerns with.  Proper planning will make sure your wishes are carried out well and your beneficiaries receive what you planned for them.

Have a great weekend.


Where to start.

Depending on which talking head you prefer, the republican control of the legislative, executive and possible the courts will either ruin our great country or propel it into an amazing future.  Just like when the democrats had control, your favorite pundit predicted the death of our great country or the beginning of a new era.

The truth, and clarity, always lies in the middle.

These are trying times for all of us, especially those of us who are not ideological purists.  I personally remain unmoved by the arguments put forth by either side in the current handwringing or jubilant flag waiving of the non-centrist.  But this is a time to take stock and carefully start preparing for things to unravel.

On tax reform.

The real problem is, when the legislative and executive branches change hands, as they inevitably will, do you think that these so-called tax reforms will stand? Will we keep a 20% tax on corporate earnings?  Probably not.  Will we keep the unnecessarily complex “pass-through” tax law?  Probably not. Will individual tax brackets go back to more progressive?  Most likely.

Within 10 years.

When I first started in public accounting a partner took me along to a lunch with a long-time client.  He harvested walnuts.  The most striking thing he said at this lunch was that the crops he is harvesting today comes from trees planted 15 or more years ago.  It takes that long to produce mature enough nuts to take to market.

Consider that.  Someone had to be willing to invest day 1 knowing that there would be no pay back for 15 years.  Believe it or not, that is what strong companies do, they plant, the tend, and then they harvest.  What they need is things to remain somewhat consistent and predictable.  But if tax laws are changing every few years, planning become impossible.  Businesses get whiplash and planning goes out the window.

On our current executive.

He is what we elected.  If you don’t like it, then think about how to address the problem.  But I will be honest, more people voting against him in 2020 in the states of California and New York will not get him voted out of office.  If he really bothers you, then you will need to move you, your family, and the 10,000 close friends you have to the mid-west.  The Elector College matters and yes, sometimes it gives us terrible results, but I think that is why it was put in place.

On jobs and economic growth.

Several years ago I read a paper on the correlation between economic growth and the increase to the labor pool.  Historically, countries tend to grow at the same pace as the participants in the labor force grows, otherwise, countries end up in either inflationary or recessionary cycles.  I believe that our labor force participation rate is growing about 2% a year.  This is the net of new entrants, retirees, immigration and emigration.  Cut immigration and the economy will grow at 1.5%.

This is a huge problem, and not just for meeting the projections in the tax bill.  Japan is a fascinating example of this.

Social security needs a certain minimum number of working adults paying into the system in order for it to receive sufficient funds to pay out claims for retirees.  If I remember my numbers, back in the 1930’s there were 8 working people for every retiree drawing social security.  Today I believe that number is about 3:1.  Again, if the ranks of retirees are growing faster than the ranks of new entrants to the labor market, we have to face the reality that this ratio could drop to 1.5:1.

Oh, and consider that wages are not growing.  That means that social security taxes, which are only on wages, is not growing.

Getting clarity is not hard.  It does, however, require a little effort to look beyond your belief system and ask hard questions.  The most effective answers always lie in the middle.  Let’s see if we can’t start having that conversation there instead of always arguing from the fringes.

Have a great day.


Understanding trusts

We have been involved with a very interesting project related to a trust.  I obviously won’t go into the project details but think the over-arching issues are worth trying to understand so hopefully others won’t run into this particular problem.

Hal and Wilma set up a living trust in 2005.  They have 2 biological children together and Hal has 2 children from a previous marriage and Wilma has one.  The kids are named Adam, Bob, Claire, Denise and Ed.  All are over the age of 21.

There are 3 primary assets in the living trust: The home worth $500,000, a joint investment account worth $500,00 and a business worth $5,000,000.  The business was started by Hal in 1984, prior to his marriage to Wilma.  The shares always remained in his name.  And, the business was treated as a Subchapter S Corporation.

Obviously H&W want to ensure that all the kids are taken care of.  To do this, Hal and Wilma set up a trust where, should Hal die first, Wilma would receive “income for life” from the business and upon her passing, the shares would be distributed to the kids.

Hal passes away in 2014.

The trouble begins almost immediately.

The two children from Hal’s first marriage immediately demand the shares be distributed to the final beneficiaries.  Their argument is that Wilma was entitled to only the income, not the actual ownership of the shares.  Naturally, Wilma didn’t agree but to ensure that the kids would feel like they in fact had “control”, Wilma had an LLC set up.  This LLC was set up with the kids owning a Class A interest and Wilma owning a Class B interest.  The Class B interest paid a Guaranteed return of 8% and did not allow for participation in any increase in value.

Sounds great right?  Wilma gets her $400,000 a year and the kids get control of the growth in value and any cash which may result from a sale of the business.

Bzzzz.  Thanks for playing.

Technically, the transfer of the shares in the business invalidated the S election since the trust was not a Qualified Subchaper S Trust (QSST).  We could probably get around that little headache but it is compounded by the subsequent transfer of the shares to an LLC.

An LLC is not a qualified owner of S Corporation interests.  So even if we could convince the IRS to ignore the QSST issue, the LLC issue killed everything.  And now we have to address 2014, 2015, 2016 and part of 2017 where the business issued distributions to Wilma but where the owner was the LLC.  Like I said, an interesting problem.

What should we take away from this?

  • Do not try to do tax and estate planning on your own.  It is easy to set up and then think you can update your documentation without talking with an expert.  Spend the money and time.  Especially if you own and operate businesses.
  • S Corporations are simple, except for their ownership structure.  Side deals with S Corporations can lead to trouble as it is easy to have nonqualified ownership or two classes of stock – all without meaning to.
  • If you are not going to gift S Corporation stock directly to your kids, then you need to plan and set up the proper trusts to protect the ownership.  To have one person receive the distributions while another gets the vote really requires the correct trust type.  This little detail gets overlooked sometimes and it can cause big problems.
  • If you own an operating business, it may be wiser to avoid titling it to a living trust.  And, if you own in jointly with a spouse, it may be better to issue a separate ownership interest to the spouse to avoid shares going in the wrong direction.
  • An LLC treated as a partnership is a great tool for planning and wealth transfer in many instances.  It can take the place of the Family Limited Partnership.  But somethings can’t be owned by an LLC.  And somethings don’t work well inside one, especially if there are guaranteed returns with insufficient cash being generated.

Thank you for the opportunity to share this little exercise.  If you have questions or thoughts, feel free to comment.  Have a great day.