Tag: planning

Living Trusts and QSSTs

~ C.O.R.E. Beliefs ~ Leave a comment

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.

Clarity

~ C.O.R.E. Beliefs ~ Leave a comment

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

~ C.O.R.E. Beliefs ~ Leave a comment

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.

 

Thoughts on change

~ C.O.R.E. Beliefs ~ Leave a comment

Happy Friday.

Have you noticed that many people are afraid of change?  That somehow the way it was is good enough and so should be continued into the future unnecessary.  Or worse, because it didn’t work before it can’t work today.   While looking back at history is a decent guide to making a decision, it cannot be the only tool we use when deciding how we should do things today.  Or tomorrow.  Things are changing and small business has to get on top of this or suffer the consequences.

Last night Kubae and I had dinner with Wes and Dianne – good friends for many years.  We got onto the topic of change – technically we were discussing the Brexit and the Trump issue – and the things that both sides had in common.  Dianne pointed out that that the supporters of both movements lived in fear of the change that is happening.  Kubae then pointed out that it isn’t just the change but the pace of change that is possibly a driver.

The pace of change. I think they are onto something.

Look at the last 100 years. in 100 years we have gone from being essentially foot-mobile to autonomous vehicles.  We have gone from handwritten letters to text messages.  We have gone from biplanes to space shuttles. All this in 100 years.

Look at the last 50 years. We have gone from 3 major automobile manufacturers to 15. From leaded gasoline to electric and solar. From princess phones to Bluetooth.  From large global mass manufacturing to 3D printing of single pieces.  Amazing changes in my lifetime.

As an accountant, I am a trained historian.  Historians look at the past and try to make sense of it.  All accounting is really is ensuring that the business history (its transactions) are recorded clearly and concisely for future use.  History is useful but I have found that history alone is insufficient to help chart a course of action.

As a business developer, I am a futurist.  A futurist looks at today and asks how it might look tomorrow.  A futurist needs history to provide a starting point and trends that can help guess what tomorrow will look like.  Guessing about the future is fun, although it is often seen as science fiction or worse a waste of time.

And yet, a futurist is a planner.  Businesses must plan what their future is going to look like and then remain flexible enough to adapt to the unforeseen changes and also record things so that the historical reality can be compared to that future guess.

And this is the rub isn’t it?  I have often joked that I think most small business owners are frustrated accountants. They love the history of their business -how hard they’ve worked, how much money they’ve made.  But when asked what the future holds for their business, the response is typically, “same as last year but add 10%”.  That might have worked in 1960, but I don’t think this is going to hold true in 2020; and that is only 4 years away.

That’s right. four short years.  Are you asking yourself what your business is going to look like with

  • Drones doing delivery
  • cars that drive themselves
  • trucks that drive themselves
  • equipment that warns before it malfuctions
  • a printer that can make parts by adding and not subtracting raw materials
  • energy without being connected to the power grid
  • food grown locally instead of on large farms and trucked
  • and a million other things

This is the easily predicted future because most of this is here now.   What about the things we haven’t even dreamed of yet?  Are you positioning your business to be part of these changes or are you going to defiantly wave your buggy-whip until the end?

Typically, I would sign off by suggesting you have a conversation with your accountant, but not today.  Take someone two generations removed from you out to lunch and ask them these questions.  Find a good science fiction book and read about what their vision of the future looks like.  Let your mind explore the fascinating potential that your business has before it and start thinking about your future. Because it doesn’t have to be about fearing the change – it can be about embracing it.

Have a great weekend.