1996 Year End Summary -Tax Group

8 min

At one time, many taxpayers believed that subchapter S corporations were tremendous tax planning vehicles because they combined the flow-through tax treatment of a partnership with the liability protection of a corporation. Indeed, because of the tax benefits associated with S corporation status, taxpayers often tolerated the restrictive S corporation qualification rules. Over the past few years, however, new business entities providing similar benefits and involving fewer restrictions, such as LLCs and LLPs, have emerged. As a result, fewer taxpayers have been electing S corporation status for their businesses. In an effort to once again make S corporations attractive to taxpayers, Congress passed a number of provisions that significantly reduce the restrictions associated with operating an S corporation. The S corporation, consequently, once again may become an attractive business vehicle for taxpayers.

In general, the new S corporation provisions are directed at easing the qualification requirements of subchapter S and making S corporations more attractive. For example, the new provisions expand the limit on the number of S corporation shareholders from 35 to 75 to allow S corporations greater access to outside capital. In addition, the types of trusts and other organizations eligible to be S corporation shareholders have been expanded. Further, in what may be the most significant change made by the new provisions, corporations with stock ownership of 80% or more in other corporations are now permitted to elect to be S corporations. As a result, S corporations no longer need to restrict their stock ownership of other corporations to 79%.

To sweeten the benefits of subchapter S even more, the new provisions enhanced the ability of S corporation shareholders to receive nontaxable distributions and extended the period within which shareholders can receive tax-free distributions after the termination of an S election. Moreover, to reduce the likelihood of older S corporations making taxable distributions to their shareholders, the earnings and profits accounts of certain S corporations were eliminated. The new tax bill also reduced some of the administrative headaches associated with operating an S corporation and made certain technical clarifications. For instance, the new provisions eased the requirements for closing the corporation's books upon departure of an S corporation shareholder and provided the IRS with the authority to waive certain errors occurring when a corporation makes an S election.

In general, by reducing some, but not all, of the restrictions and administrative headaches applicable to S corporations, the new provisions increase the overall flexibility of subchapter S and make it more available and attractive. Although some of the new provisions are effective immediately, most of the new rules will not take effect until January 1, 1997. As a final note, in order to allow corporations who terminated their S corporation elections within the last five years to re-elect S status as soon as possible, the typical five-year waiting period for re-election of S status will not apply to those corporations.

For more information regarding the new subchapter S provisions, contact Brian J. O'Connor, (410) 244-7863. E-mail address BJOConnor@Venable.com

Planning for your Qualified Retirement Plan or IRA

For many people, their profit sharing, 401(k), pension or IRA account is their largest asset. But now that you have accumulated a huge nest egg, you may be shocked at how much the tax bill can be if and when the funds come out. Seemingly simple decisions such as "who do I designate as my beneficiary?" can have far-reaching income and estate tax consequences.

Here are a few tips to consider:

  • Be aware of the built-in tax liability. Plan and IRA money is "deferred compensation" amounts left on your death are not only potentially subject to an estate tax of up to 55%, but also to federal and state income tax! You may be surprised at how little is left.
  • "A tax deferred is a tax unpaid". Although taxes will eventually hit your plan or IRA money, it generally pays to defer the tax as long as possible. There are exceptions, however, and there is a 15% penalty tax on accumulating too much. Recent legislation gives a 3-year "window," beginning in 1997, for avoiding the 15% penalty tax on excess distributions, but depending on your individual situation, you may not want to rush into this "opportunity."
  • Retirement funds are meant for you and your spouse. Congress has designed the laws to encourage naming your spouse as beneficiary. With careful planning, you can take advantage of these rules to provide for your spouse and children, while still preserving some control and allowing maximum deferral of taxes.
  • Beware of naming trusts or estates as beneficiaries. While a carefully drawn trust can help in this area, naming a "garden variety" revocable living trust or your estate as beneficiary of your qualified plan or IRA can produce disastrous tax results.

If you would like more information, or to schedule a review of your plan or IRA benefit payout strategy, call Matthew F. Kadish at (202) 962-4876, or in Baltimore at (410) 244-7617, or e-mail MFKadish@venable.com.

Estate Planning with Family Limited Partnerships

Federal estate and gift tax rates run from 37% quickly up to 55%. With proper planning, however, you can "package," "shrink" and "protect" your assets so that they pass how you want them to to the right people, at the right time, and with much lower taxes and hassle than you might expect.

Placing assets in a family limited partnership can help in several ways.

  • Control ("packaging"). You can retain control of your assets while maintaining a steady income interest. Family limited partnerships are great for business succession and containing estate and gift tax exposure on rapidly appreciating assets.
  • Taxes ("shrinking"). Would you rather buy something at full retail or on sale? With proper valuation of the family limited partnership, you can discount, or "shrink" what your assets are worth for estate and gift tax purposes. Transferring assets with a family limited partnership is like getting a sale price on your estate taxes, with 30% or more off. More sophisticated family limited partnerships can yield even greater discounts.
  • Creditors ("protecting"). A properly designed family limited partnership can make your assets much safer from future creditors, assuring that you and your heirs retain what is yours. Exciting new laws also allow the use of a family limited liability company in lieu of a family limited partnership to achieve better, simpler creditor protection without sacrificing tax planning.

Family limited partnerships are a safe, proven way to achieve a "win-win" result for you and your family. For more information about family limited partnerships or other estate planning matters, call Matthew F. Kadish at (202) 962-4876, or in Baltimore at (410) 244-7617, or or e-mail MFKadish@venable.com.

Year-End Tax Traps for the Unwary

At the end of 1995, Bob, a successful executive earning approximately $100,000 in salary each year, decided to sell his interest in recently-acquired initial public offering stock which had quadrupled in value since his purchase. Bob didn't want to defer his sale until 1996 and wasn't interested in taking advantage of techniques allowing him to "lock-in" his profit in 1995 without triggering a taxable sale until a later year. Accordingly, Bob sold his stock in December 1995 and collected approximately $1,000,000 in proceeds from the sale. Because Bob had only a $250,000 tax basis in the stock and had held the stock for only three months, his sale generated $750,000 in short-term capital gain. Thus, after combining this short-term capital gain with his salary income, Bob had a federal tax liability for 1995 of approximately $315,200.

When Bob discussed his 1995 income tax return with his accountant in April 1996, he received an unpleasant surprise. According to Bob's accountant, Bob had fallen into one of the many year-end traps for the unwary. Indeed, by selling his stock portfolio and generating a large short-term capital gain, Bob discovered that he owed an additional state and local tax of $56,250 in April of 1996. This state and local tax payment, of course, would provide Bob with a deduction in determining his federal taxes. However, because Bob didn't pay his state and local taxes until April 1996, the state tax deduction would only be available on his 1996 federal tax return. Thus, Bob could not use the state and local tax payment to reduce his overall federal tax for 1995.

After hearing this, Bob at first was not overly concerned because he figured that a $56,250 deduction for state and local taxes would save him a significant amount of tax when he filed his 1996 return. The accountant explained, however, that Bob's problems were far from over. Because of the alternative minimum tax ("AMT"), the $56,250 deduction for state and local taxes in 1996 would only have limited utility to Bob. For example, without the AMT, Bob's state and local tax deduction would reduce his 1996 taxable income from $100,000 to $43,750 and save him approximately $15,850 in tax. However, because of the AMT, Bob's tax benefit from the state and local tax deduction would be reduced by approximately $8,000. Thus, the AMT in effect would reduce the value of Bob's state and local tax deduction in 1996 by over 50%. Once again, Bob was trapped.

When Bob asked his accountant about how he could have avoided these year-end traps, Bob's accountant explained that he could have made an extra payment of state and local taxes in the year he sold his stock portfolio, 1995. According to Bob's accountant, if Bob had paid the $56,250 in state and local taxes in 1995, he would have received a federal tax deduction for that amount in 1995 rather than 1996. Bob's accountant further explained that a $56,250 deduction in 1995 would have reduced Bob's overall federal tax by approximately $13,500 because, even taking into account the AMT and a phase out of itemized deductions for high income taxpayers, Bob would have received more of a benefit from the $56,250 deduction. As a result, by making an additional $56,250 payment of state and local taxes in 1995, Bob could have received the deduction in a tax year where more of the deduction could be used.

This example illustrates how easy it can be for taxpayers to fall prey to certain traps for the unwary. Beware of these and other tax traps for the unwary as you make year-end tax decisions for 1996.

For more information regarding year-end traps for the unwary, contact Brian J. O'Connor, (410) 244-7863. E-mail address BJOConnor@Venable.com

Editorial Information


Robert H. Geis, Jr., 410-244-7599, RHGeis@Venable.com.

Wallace E. Christner, 202-962-4988, WEChristner@Venable.com.