2009 year end tax guide

Year-end tax guide for 2009

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Top 20 tax planning opportunities

6 Opportunity 1: Increase withholding instead of estimated tax payments

8 Opportunity 2: Bunch itemized deductions to get over AGI floors

8 Opportunity 3: Take full advantage of above-the-line deductions

10 Opportunity 4: Accelerate income to “zero out” the AMT

12 Opportunity 5: Avoid the wash sale rule with a bond swap

12 Opportunity 6: Don’t fear the wash sale rule to accelerate gains

14 Opportunity 7: Defer investment interest for a bigger deduction

16 Opportunity 8: Consider an 83(b) election on your restricted stock

18 Opportunity 9: Set salary wisely if you’re a corporate employee-shareholder

20 Opportunity 10: Give directly from an IRA if you’re 70½ or older

20 Opportunity 11: Give appreciated property to enhance savings

24 Opportunity 12: Make payments directly to educational institutions

24 Opportunity 13: Plan around gift taxes with your 529 plan

28 Opportunity 14: Wait to make your retirement account withdrawals

30 Opportunity 15: Get kids started with a Roth IRA

30 Opportunity 16: Roll yourself over into a Roth IRA

32 Opportunity 17: Review and update your estate plan

32 Opportunity 18: Exhaust your gift-tax exemption

34 Opportunity 19: Use second-to-die life insurance for extra liquidity

34 Opportunity 20: Zero out your GRAT to save more

Charts

5 Chart 1: Individual income tax rates

6 Chart 2: Employment tax rates

9 Chart 3: AMT rate schedule and exemptions

11 Chart 4: Top tax rates according to character of income

17 Chart 5: Corporate income tax rates

18 Chart 6: Tax differences based on business structure

19 Chart 7: AGI-based limits on charitable contributions

23 Chart 8: AGI phaseout levels for education tax breaks

27 Chart 9: Retirement plan contribution limits

31 Chart 10: Gift and estate tax rates and exemptions

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Year-end tax guide 2009

How much will you pay?

Managing your finances and tax burden can feel like juggling and jumping through hoops: You’ve got lots of moving pieces and only two hands. But tax planning has never been more important. Drastic changes in the economic environment can force a shift in tax strategy, especially if your own situation is evolving.

On top of that, the tax code is only becoming more complex. The economic turmoil of the last year has spurred the passage of more new tax laws. While there are now more ways than ever to help you reduce your tax liability, taking full advantage of them is becoming harder. The outlook for future tax legislation can be even more confusing. You need to think farther ahead, employ clearer strategies and use every tax break you can.

To help you save as much as possible, this Grant Thornton guide discusses recent tax law changes and provides an overview of strategies to help you reduce your tax liability. It will show you how to tax-efficiently invest for education and retirement, and transfer your wealth to family members. For action steps to jump-start the planning process, look for our top 20 tax planning opportunities. However, this guide simply can’t cover all possible strategies. So be sure to contact us to find out what will work best for you.

Contents

3 Chapter 1: Tax law changes: What’s new this year

5 Chapter 2: Getting started: Ordinary income taxes, rates and rules

7 Chapter 3: Basic strategies: Timing and deductions

9 Chapter 4: Alternative minimum tax

11 Chapter 5: Investment income

15 Chapter 6: Executive compensation

17 Chapter 7: Business ownership

19 Chapter 8: Charitable giving

23 Chapter 9: Education savings

27 Chapter 10: Retirement savings

31 Chapter 11: Estate planning

As of the publication date of this guide, Congress was still considering legislation that could have major tax implications, including a healthcare reform bill and an estate tax reform bill. While the 2009 tax laws won’t likely be affected, new legislation could change your planning strategies. Our National Tax Office tracks tax legislation as it moves through Congress, so visit our website regularly to read updates at www.GrantThornton.com/yearendtaxguide.

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Congress and the president enacted a major economic stimulus bill in 2009, which came just a few months after a number of important tax provisions were extended in a financial rescue bill in late 2008. More tax legislation was still possible as this guide went to print, but the stimulus bill alone included $326 billion in new tax cuts. Virtually no revenue raisers were included. Lawmakers decided that with the economy in trouble, it was not the right time to apply the kinds of tax increases that have been used to pay for legislation in past years.

Most of the tax provisions from the new tax bills are designed either to stimulate economic activity or provide relief to taxpayers that have suffered from the downturn. Many are geared toward individuals, and these will provide scores of taxpayers with fresh opportunities for tax savings.

Take a new look at education incentives You may need to reexamine education credits this year, even if you assumed you earn too much to qualify. The stimulus bill enhanced the Hope Scholarship credit for 2009 and 2010 and renamed it the American Opportunity credit. The credit is now more generous, equal to 100 percent of the first $2,000 of tuition and 25 percent of the next $2,000, for a total credit of up to $2,500. It is also 40 percent refundable.

But most importantly, it is allowed against the alternative minimum tax (AMT) and phases out at a much higher income level. For 2009 and 2010, the credit will phase out between adjusted gross incomes of $80,000 and $90,000 for single filers and $160,000 and $180,000 for married couples filing jointly. (See page 23 for a full discussion of tax planning for education expenses.)

Did you make any home improvements?You may be entitled to a larger tax credit than you think if you made energy-efficient improvements to your home this year. The stimulus bill enhanced both the Section 25C home improvement tax credit and the Section 25D residential energy-efficient property tax credit.

Section 25C provides a credit for installing energy-saving property, such as insulation, energy-efficient windows and roofs, and highly efficient air conditioners, furnaces and water heaters. In 2008, the credit rate was 10 percent and had a lifetime limit of $500. For 2009, the credit rate has been increased to 30 percent with an additional $1,500 added to the lifetime limit.

Section 25D provides a 30-percent personal tax credit for energy-efficient property, such as solar water heaters, geothermal heat pumps and fuel cells. Previously, this credit was generally capped between $500 and $4,000 depending on the property. The stimulus bill eliminates the credit caps for solar, geothermal and wind property and allows the use of subsidized energy financing.

Did you buy a car this year?The “cash for clunkers” program stole all the press this year, but many car-buyers who didn’t have a clunker to trade in will still get a substantial deduction for a new car purchase. The stimulus bill created an above-the-line deduction for state and local sales tax on new car purchases made between Feb. 17 and the end of the year.

The deduction is allowed for taxes on the first $49,500 of the car’s price, and the phaseout range is unusually high for this type of targeted benefit. The deduction phases out between the adjusted gross income (AGI) levels of $125,000 and $135,000 for single individuals and $250,000 and $260,000 for joint filers. Above-the-line deductions are especially valuable because they reduce AGI (see more on this strategy on page 8), but this deduction is not available if you elect to claim state and local taxes as an itemized deduction.

Chapter 1: Tax law changes: What’s new this year

Relief and opportunity

Would you consider investing in a small business?Qualified small business (QSP) stock has become an even more attractive investment. The stimulus bill increased the exclusion on the gain from the sale of QSP stock from 50 percent to 75 percent for stock bought after Feb. 17, 2009, and before Jan. 1, 2011. This stock is taxed at a long-term capital gains rate of 28 percent, so the increased exclusion drives the effective rate down from 14 percent to 7 percent. Investments in qualified small business stock also come with several other tax benefits. (See page 12 for more details.)

Are you required to make distributions from your retirement plan?Normally, taxpayers must begin making required minimum distributions (RMDs) from tax-preferred retirement savings accounts such as IRAs, 401(k)s, 403(b) plans and some 457(b) plans once they reach age 70½. These distributions are calculated using your account balance and life expectancy table and generally must be taken each year by Dec. 31. If not, you can be charged a 50-percent penalty on the amount that should have been withdrawn.

Lawmakers late last year were concerned that the distribution requirements were unfair to taxpayers whose retirement accounts were battered by the downturn, so they enacted a provision to waive all RMDs for 2009. The normal RMD rules are suspended completely, so no taxpayer has to make an RMD for 2009. This includes taxpayers reaching 70½ during calendar-year 2009. The suspension is permanent. You will not have to increase distributions in a later year to make up for 2009. (See Tax planning opportunity 14 for strategies on dealing with RMDs.)

Are you a business owner?Business owners should be aware of several additional opportunities provided by the stimulus bill. The bill allows qualifying small businesses with under $15 million in annual gross receipts to carry 2008 losses farther back to receive refunds

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against taxes paid in prior years. Normally, the net operating loss carryback period is only two years, but businesses that meet all the restrictions in the bill can elect a carryback period of three, four or five years.

The stimulus bill also will allow taxpayers to defer cancellation of debt (COD) income incurred in 2009 and 2010. COD income arises from virtually any “forgiveness” of debt, whether it comes from retiring a debt at a discount, refinancing an existing debt, exchanging an old debt for a new one or any other modification. The deferred COD income will be recognized ratably over the five years beginning in 2014.

The stimulus bill also lowered withholding and estimated tax requirements for certain taxpayers with AGIs under $500,000 who earn at least half of their income from a small trade or business. Qualifying taxpayers will only need to pay the equivalent of 90 percent of their 2008 tax throughout 2009 to avoid 2009 underpayment penalties, rather than 100 percent or 110 percent. (For a more detailed discussion on payment requirements, see page 6.)

Be aware of what Congress hasn’t done yetAs this guide went to print, Congress was still considering several bills that could have major tax implications. Most significantly, a healthcare reform bill, if enacted, is likely to carry a large tax component.

Congress was also planning to consider a bill to reform the estate tax before it is scheduled to disappear for one year in 2010. (For more information on the estate tax, see page 31.) That bill could also extend many popular tax provisions that remain in place for 2009, but are scheduled to expire in 2010. While these changes won’t likely affect the tax laws in 2009, they could change planning strategies right away.

Call Grant Thornton to find out the latest status of tax legislation and to discuss any tax-saving opportunities arising from provisions enacted this year.

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Chapter 2: Getting started: Ordinary income taxes, rates and rules

Our tax system

Our income tax system seems straightforward at first glance. Individuals are taxed according to their income, with rates increasing as income goes up. So, the more you make, the higher percentage of tax you’re expected to pay. These increasing rates are often referred to as “tax brackets.” The top rate that applies to you, or your tax bracket, is usually considered your marginal tax rate. It’s the rate you will pay on an additional dollar of income.

For 2009, the ordinary income tax brackets range from 10 percent to 35 percent. (See chart 1 for the full schedule.) Ordinary income includes things such as salary and bonuses, self-employment and business income, interest, retirement plan distributions and more.

Looking beyond the tax bracketsUnfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may be much different than the actual rate in your tax bracket. For one, not everything is ordinary income. Different types of income are taxed in different ways. (See page 11 for information on investment income.) But more importantly, hidden taxes that kick in at higher income levels when you reach the top tax brackets can drive your marginal tax rate higher.

Many tax credits and deductions phase out as your income increases, meaning an extra dollar of income actually increases your tax liability more than the top tax rate. Two of the most costly phaseouts apply to your personal exemptions and itemized deductions.

In 2009, the personal exemption of $3,650 that taxpayers receive for themselves, their spouses and their dependents phases out by $24.33 for every $2,500 (or fraction thereof) of adjusted gross income (AGI) above a designated high-income threshold. This threshold in 2009 is: • $166,800forsinglefilers,• $250,200forjointfilers,• $208,500forheadsofhousehold,and• $125,100formarriedcouplesfilingseparately.

In 2009, each personal exemption can be reduced to no lower than $2,433.

Chart 1: 2009 individual income tax brackets

Tax rate Single Head of household Married filing jointly

Married filing separately or surviving spouse

10% $0 – $8,350 $0 – $11,950 $0 – $16,700 $0 – $8,35015% $8,351 – $33,950 $11,951 – $45,500 $16,701 – $67,900 $8,351 – $33,95025% $33,951 – $82,250 $45,501 – $117,450 $67,901 – $137,050 $33,951 – $68,52528% $82,251 – $171,550 $117,451 – $190,200 $137,051 – $208,850 $68,526 – $104,42533% $171,551 – $372,950 $190,201 – $372,950 $208,851 – $372,950 $104,426 – $186,47535% Over $372,950 Over $372,950 Over $372,950 Over $186,475

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The phaseout for itemized deductions operates a little differently. Some deductions — such as medical expenses, investment interest, casualty losses and certain contributions to disaster relief — are not included in the phaseout. But many of the most popular and valuable deductions — such as mortgage interest and employee business expenses — are affected. In 2009, the affected deductions are reduced by an amount equal to one percent of any AGI that exceeds $166,800 ($83,400 for married couples filing separately) up to a maximum reduction of 26.67 percent.

The effects of the phaseouts of both itemized deductions and personal exemptions have been shrinking gradually thanks to a 2001 tax bill. In 2010, both are scheduled to disappear completely for one year. But in 2011, they are scheduled to come back at triple their 2009 rates. If that occurs, beginning in 2011 your personal exemptions can be eliminated completely and the applicable itemized deductions can be reduced by up to 80 percent.

It’s worth noting that both of these phaseouts are tied to AGI, as are nearly all of the tax-benefit phaseouts in the code that apply to individuals. That’s why above-the-line deductions are so valuable. They reduce AGI. Most other deductions and credits only reduce taxable income or tax, itself, without affecting AGI. (See Tax planning opportunity 3 for information on taking full advantage of above-the-line deductions.)

Phaseouts of tax benefits aren’t the only things you need to worry about. Many high-income taxpayers could also face the alternative minimum tax (see page 9 on the AMT), and anyone with earned income will have to pay employment taxes.

Employment taxes take a biteEmployment taxes are made up of Social Security and Medicare taxes and apply to earned income. Social Security taxes are capped, but you must pay Medicare tax on all of your earned income. (See chart 2 for the current employment tax rates and Social Security tax ceiling.)

If you are employed and your earned income consists of salaries and bonus, your employer will withhold your share of these taxes and pay them directly to the government. If you are self-employed, you must pay both the employee and the employer portions of employment tax, though you can take

an above-the-line deduction for 50 percent of the total tax. There are also special employment tax considerations if you’re a business owner who works in the business. (See Tax planning opportunity 9.)

Taxes are due year roundAlthough you don’t file your return until after the end of the year, it’s important to remember that you must pay tax throughout the year with estimated tax payments or withholding. You will be penalized if you haven’t paid enough.

If your AGI was over $150,000 in 2008, you can generally avoid penalties by paying at least 90 percent of your 2009 tax liability or 110 percent of your 2008 liability through withholding and estimated taxes (taxpayers under $150,000 need only pay 100 percent of 2008 liability). Additionally, the stimulus bill enacted in February 2009 allows certain taxpayers with a 2008 AGI of under $500,000, and at least half their income from a small business, to prepay an amount equal to just 90 percent of their 2008 liability.

If your income is often irregular due to bonuses, investments or seasonal income, consider the annualized income installment method. This method allows you to estimate the tax due based on income, gains, losses and deductions through each estimated tax period. If you’ve found you’ve underpaid, try and have the shortfall withheld from your salary or bonus. (See Tax planning opportunity 1.)

You also want to avoid early withdrawals from tax-advantaged retirement plans, such as 401(k) accounts and individual retirement accounts (IRAs). Distributions generally must be made after reaching the age of 59½ to avoid penalties. Distributions from these plans are treated as ordinary income, and you’ll pay an extra 10-percent penalty on any premature withdrawals. This can raise your effective federal tax rate to as high as 45 percent on the income.

Chart 2: Employment taxes

Social Security Medicare Total tax 2009 income limit $106,800 no limit NAEmployee rate 6.2% 1.45% 7.65%Employer rate 6.2% 1.45% 7.65%Self-employed rate 12.4% 2.90% 15.30%

Make up any estimated tax shortfall with increased withholding, not estimated tax paymentsIf you’re in danger of being penalized for not paying enough tax throughout the year, try to make up the shortfall through increased withholding on your salary or bonuses.

Paying the shortfall through an increase in your last quarterly estimated tax payment can still leave you exposed to penalties for underpayments in previous quarters.

But withholding is considered to have been paid ratably throughout the year. So a big bump in withholding on high year-end wages can save you in penalties when a similar increase in an estimated tax payment might not.

Tax planning opportunities

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Chapter 3: Basic strategies: Timing and deductions

Timing income and expenses

Why pay tax now when you can pay tomorrow? Deferring tax is a traditional cornerstone of good tax planning. Generally this means you want to accelerate deductions into the current year and defer income into next year. So it’s important to review your income and deductible expenses well before Dec. 31. You need to take action before the new year to affect your 2009 return.

However, deferring income and accelerating deductions may not always make sense. If you are going to be subject to the alternative minimum tax (AMT) in one year and not another, it can affect your timing strategy. (See page 9 for more on coping with the AMT). More importantly, if you believe that tax rates are going up, you may feel it is beneficial to do the opposite. In that case, you want to realize more income now when rates are low and save your deductions for later when rates are higher.

Timing your income and expenses properly can clearly reduce your tax liability. Currently, many tax benefits are scheduled to remain in place and even improve from 2009 to 2010, but then disappear in 2011. Taxpayers may want to consider deferring tax into 2010 and then accelerating income ahead of a potential tax increase in 2011.

But be cautious. Legislative action is likely to make a big difference in this area, as will your personal situation. Income acceleration can be a powerful strategy, but it should only be employed if you are comfortable with your own political analysis and are prepared to accept the consequences if you are wrong.

There are many reasons to believe that existing tax benefits scheduled to expire in 2011 will be extended, at least for taxpayers with incomes below $250,000 (for a married couple filing a joint return). President Obama has proposed an extension of current tax benefits for these taxpayers, and Republican leaders have indicated they support an even broader extension. Legislation addressing this issue may not be considered until 2010. So call Grant Thornton to discuss the latest legislative developments and to find out how you, personally, may want to approach timing.

Whether it eventually makes more sense for you to defer or accelerate your taxes, there are many items with which you may be able to control timing:

Income• Bonuses• Consultingincome• Otherself-employmentincome• Realestatesales• Otherpropertysales• Retirementplandistributions

Expenses• Stateandlocalincometaxes• Realestatetaxes• Mortgageinterest• Margininterest• Charitablecontributions

It’s important to remember that prepaid expenses can be deducted only in the year they apply. So you can prepay 2009 state income taxes to receive a 2009 deduction even if the taxes aren’t due until 2010. But you can’t prepay state taxes on your 2010 income and deduct the payment on your 2009 return.

But don’t forget the AMT. If you are going to be subject to the AMT in both 2009 and 2010, it won’t matter when you pay your state income tax, because it will not reduce your AMT liability in either year.

Timing deductions can make a big differenceTiming can often have the biggest impact on your itemized deductions. How and when you take these deductions is important because many itemized deductions have AGI floors. For instance, miscellaneous expenses are deductible only to the extent they exceed two percent of your AGI, and medical expenses are only deductible to the extent they exceed 7.5 percent of your AGI. Bunching these deductions into a single year may allow you to exceed these floors and save more. (See Tax planning opportunity 2 to find out how to make this strategy work.)

Keep in mind that medical expenses aren’t deductible if they are reimbursable through insurance or paid through a pretax Health Savings Account or Flexible Spending Account. The AMT can also complicate this strategy. For AMT purposes, only medical expenses in excess of 10 percent of your AGI are deductible.

You also want to take full advantage of above-the-line deductions to the extent possible. They are not subject to the AGI floors that hamper many itemized deductions. They even reduce AGI, which provides a number of tax benefits. (See Tax planning opportunity 3.)

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Bunch itemized deductions to get over AGI floorsBunching deductible expenses into a single year can help you get over AGI floors for itemized deductions, such as the two-percent AGI floor for miscellaneous expenses and the 7.5-percent floor for medical expenses. Miscellaneous expenses you may be able to accelerate and pay now include:• deductibleinvestmentexpenses,suchasinvestmentadvisoryfees,custodialfees,safedepositboxrentalsandinvestmentpublications;• professionalfees,suchastaxplanningandpreparation,accountingandcertainlegalfees;and• unreimbursedemployeebusinessexpenses,suchastravel,meals,entertainment,vehiclecostsandpublications—allexclusiveofpersonaluse.

Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your non-urgent medical procedures and other controllable expenses into one year to take advantage of the deductions. Deductible medical expenses include:• healthinsurancepremiums,• prescriptiondrugs,and• medicalanddentalcostsandservices.

In extreme cases, and assuming you are not subject to AMT, it may even be possible to claim a standard deduction in one year, while bunching two years’ worth of itemized deductions in another.

Take full advantage of above-the-line deductionsAbove-the-line deductions are especially valuable. They aren’t reduced by AGI floors like many itemized deductions and have the enormous benefit of actually reducing AGI. Nearly all of the tax benefits that phase out at high income levels are tied to AGI. The list includes personal exemptions and itemized deductions, education incentives, charitable giving deductions, the alternative minimum tax exemption, some retirement accounts and real estate loss deductions.

Above-the-line deductions that reduce AGI could increase your chances of enjoying other tax preferences. Common above-the-line deductions include traditional Individual Retirement Account (IRA) and Health Savings Account (HSA) contributions, moving expenses, self-employed health insurance costs and alimony payments.

Take full advantage of these deductions by contributing as much as possible to retirement vehicles that provide them, such as IRAs and SEP IRAs. Don’t skimp on HSA contributions either. When possible, give the maximum amount allowed. And don’t forget that if you’re self-employed, the cost of the high deductible health plan tied to your HSA is also an above-the-line deduction.


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Chapter 4: Alternative minimum tax

Don’t let the AMT take you by surprise

The alternative minimum tax (AMT) is perhaps the most unpleasant surprise lurking in the tax code. It was originally conceived to ensure all taxpayers paid at least some tax, but has long since outgrown its intended use.

The AMT is essentially a separate tax system with its own set of rules. How do you know if you will be subjected to the AMT? Each year you must calculate your tax liability under the regular income tax system and the AMT, and then pay the higher amount.

The AMT is made up of two tax brackets, with a top rate of 28 percent. Many deductions and credits are not allowed under the AMT, so taxpayers with substantial deductions that are reduced or not allowed under the AMT are the ones stuck paying. Common AMT triggers include:• stateandlocalincomeandsalestaxes,especially

in high-tax states;• realestateorpersonalpropertytaxes;• investmentadvisoryfees;• employeebusinessexpenses;• incentivestockoptions;• interestonahomeequityloannotusedtobuild

or improve your residence;• tax-exemptinterestoncertainprivateactivitybonds;and• accelerateddepreciationadjustmentsandrelatedgainor

loss differences on disposition.

The AMT includes a large exemption, but this exemption phases out at high-income levels. And unlike the regular tax system, the AMT isn’t adjusted regularly for inflation. Instead, Congress must legislate any adjustments. Congress has been doing this on an approximately year-by-year basis for several years, and they have already made an adjustment for 2009. But it’s important to remember that so far, Congress has only increased the exemption amount with each year’s “patch,” while the phaseout of the exemption and the AMT tax brackets remain unchanged. (See chart 3.)

Chart 3: 2009 individual AMT rate schedule and exemptions

AMT brackets AMT exemption 26% tax rate 28% tax rate Exemption Phaseout

Single or head of household $0 – $175,000 Over $175,000 $46,700 $112,500 – $299,300Married filing jointly $0 – $175,000 Over $175,000 $69,950 $150,000 – $429,800Married filing separately $0 – $87,500 Over $87,500 $34,975 $75,000 – $214,900

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Proper planning can help you mitigate, or even eliminate, the impact of the AMT. The first step is to work with Grant Thornton to determine whether you could be subject to the AMT this year or in the future. In years you’ll be subject to the AMT, you want to defer deductions that are erased by the AMT and possibly accelerate income to take advantage of the lower AMT rate. (See Tax planning opportunity 4 on zeroing out your AMT.)

Capital gains and qualified dividends deserve special consideration for the AMT. They are taxed at the same 15-percent rate either under the AMT or regular tax structure, but the additional income they generate can reduce your AMT exemption and result in a higher AMT bill. So consider your AMT implications before selling any stock that could generate a large gain.

If you have to pay the AMT, you may be able to take advantage of an AMT credit that has become more generous recently. You can qualify for the AMT credit by paying AMT on timing items like depreciation adjustments, passive activity adjustments and incentive stock options. The credit can be taken against regular tax in future years, as it is meant to account for timing differences that reverse in the future.

The AMT credit may only provide partial relief, but just got a little more generous. A tax bill enacted late in 2008 now allows you to use AMT credits at least four years old in 50-percent increments over a period of two years, even in years when the AMT continues to apply. The AGI phaseout of this special tax break has also been removed.

Accelerate income to “zero out” the AMTYou have to pay the AMT when it results in more tax than your regular income tax calculation, typically because the AMT has taken away key deductions. The silver lining is that the top AMT tax rate is only 28 percent. So you can “zero out” the AMT by accelerating income into the AMT year until the tax you calculate for regular tax and AMT are the same.

Although you will have paid tax sooner, you will have paid at an effective tax rate of only 26 percent or 28 percent on the accelerated income, which is less than the top rate of 35 percent that is paid in a year you’re not subject to the AMT. If the income you accelerate would otherwise be taxed in a future year with a potential top rate of 39.6 percent, the savings could be even greater. But be careful. If the additional income falls in the AMT exemption phaseout range, the effective rate may be a higher 31.5 percent. The additional income may also reduce itemized deductions and exemptions (as discussed on page 6), so you need to consider the overall tax impact.


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Chapter 5: Investment income

Making tax-smart investment decisions

Not all income is created equal. The character of income determines its tax rate and treatment. Investment income alone comes in a variety of forms. Income such as dividends and interest arises from holding investments, while capital gains income results from the sale of investments.

Investment income is often treated more favorably than ordinary income, but the rules are complex. Long-term capital gains and qualifying dividends can be taxed as low as 15 percent, while nonqualified dividends, interest and short-term capital gains are taxed at ordinary income tax rates as high as 35 percent. Special rates also apply to specific types of capital gains and other investments, such as mutual funds and passive activities. But these rates aren’t scheduled to last forever. Unless Congress acts, rates will increase on all types of income in 2011. (See chart 4.)

The various rules and rates on investment income offer many opportunities for you to minimize your tax burden. Understanding the tax costs of various types of investment income can also help you make tax smart decisions. But remember that tax planning is just one part of investing. You must also consider your risk tolerance, desired asset allocation and whether an investment makes sense for your financial and personal situation.

Capital gains and lossesTo benefit from long-term capital gains treatment, you must hold a capital asset for more than 12 months before it is sold. Selling an asset you’ve held for 12 months or less results in less favorable short-term capital gains treatment. Several specific types of assets have special, higher capital gains rates, and taxpayers in the bottom two tax brackets enjoy a zero rate on their capital gains and dividends in 2009 and 2010.

Your total capital gain or loss for tax purposes is generally calculated by netting all the capital gains and losses throughout the year. You can offset both short-term and long-term gains with either short-term or long-term losses. Taxpayers facing a large capital gains tax bill often find it beneficial to look for unrealized losses in their portfolio so they can sell the assets to offset their gains. But keep the wash sale rule in mind. You can’t use the loss if you buy the same — or a substantially identical — security within 30 days before or after you sell the security that creates the loss.

Chart 4: Top tax rates of different types of income under current code

2009–10 2011+ Ordinary income 35% 39.6%Qualifying dividends 15% 39.6%Short-term capital gains 35% 39.6%Long-term capital gains 15% 20% Key exceptions to regular capital gains rates 2009–10 2011+ Qualified small business stock held more than 5 years1 7%2 14% Gain that would be taxed in the 10% or 15% brackets based on the taxpayer’s income level3 0% 10%

1 The effective rate for qualified small business stock is based on 28% rate and the applicable gain exclusion.2 The 7% effective rate applies for stock acquired after Feb. 17, 2009, and before Jan. 1, 2011. Otherwise qualified small business stock will have 14% effective rate.3 The 10% bracket is scheduled to disappear in 2011.

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There are ways to mitigate the wash sale rule. You may be able to buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold. Alternatively, consider a bond swap. (See Tax planning opportunity 5 on bond swaps.)

It may prove unwise to try and offset your capital gains at all. Up to $3,000 in net capital loss can be claimed against ordinary income (with a top rate of 35 percent in 2009 and 2010), and the rest can be carried forward to offset future short-term loss or ordinary income. More importantly, long-term capital gains rates in 2009 and 2010 are a low 15 percent, but are scheduled to increase to 20 percent in 2011. It may actually be time to consider selling assets with unrealized gains now to take advantage of the current low rates. (See Tax planning opportunity 6 for more on recognizing gains.)

Be careful, however. The 15-percent rate could be extended beyond 2010, at least to the extent the net capital gain does not push taxable income above $250,000 for a married couple filing a joint return. (See page 7 for more on the legislative prospects of tax increases.)

Regardless of whether you want to accelerate or mitigate a net capital gain, the tax consequences of a sale can come as a surprise, unless you remember the following rules: • Ifyouboughtthesamesecurityatdifferenttimesand

prices, you should specifically identify in writing which shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or increase your losses.

• Fortaxpurposes,thetradedateandnotthesettlementdateof publicly traded securities determines the year in which you recognize the gain or loss.

Use zero capital gains rate to benefit childrenTaxpayers in the bottom two tax brackets pay no taxes on long-term capital gains and qualifying dividends in 2009 and 2010. If income from these items would be in the 10-percent or 15-percent bracket based on a taxpayer’s income, than the tax rate is zero.

If you have adult children in these tax brackets, consider giving them dividend-producing stock or long-term appreciated stock. They can sell the stock for gains or hold the stock for dividends without owing any taxes.

Keep in mind there could be gift tax and estate planning consequences. (See page 32 to learn about gifting strategies.) Gifts to children up to the age of 23 can also be subject to the “kiddie tax.” (See page 26 for more information.)

Mutual fund pitfallsInvesting in mutual funds is an easy way to diversify your portfolio, but comes with tax pitfalls. Earnings on mutual funds are typically reinvested. Unless you (or your broker or investment advisor) keep track of these additions to your basis, and you designate which shares you are selling, you may report more gain than required when you sell the fund.

It is often a good idea to avoid buying shares in an equity mutual fund right before it declares a large capital gains distribution, typically at year-end. If you own the shares on the record date of the distribution, you’ll be taxed on the full distribution amount even though it may include significant gains realized by the fund before you owned the shares. Worse yet, you’ll end up paying taxes on those gains in the current year — even if you reinvest the distribution in the fund and regardless of whether your position in the fund has appreciated.

Small business stock comes with tax rewardsBuying stock in a qualified small business (QSB) comes with several tax benefits, assuming you comply with specific requirements and limitations. If you sell QSB stock at a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary loss, regardless of your holding period. This means you can use it to offset ordinary income taxed at a 35-percent rate, such as salary and interest.

You can also roll over QSB stock without realizing gain. If you buy QSB stock with the proceeds of a sale of QSB stock within 60 days, you can defer the tax on your gain until you dispose of the new stock. The new stock’s holding period for long-term capital gains treatment includes the holding period of the stock you sold.

Avoid the wash sale rule with a bond swapBond swaps are a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality from a different issuer. You’ll avoid the wash sale rule because the bonds are not considered substantially identical.

Don’t fear the wash sale rule to accelerate gainsRemember, there is no wash sale rule for gains, only losses. You can recognize gains anytime by selling your stock and repurchasing it immediately. This may be helpful if you have a large net capital loss you don’t want to carry forward or want to take advantage of today’s low rates. Waiting until after 2010 to pay tax on unrealized gains could result in a larger tax bill, if rates do indeed go up.


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Most importantly, you may only have to pay an effective rate as low as seven percent on long-term gain of QSB stock. The gain is normally taxed at a 28-percent rate, but a 50-percent exclusion allows for an effective tax rate of 14 percent. However, the stimulus bill enacted in February 2009 allows taxpayers to exclude 75 percent of the gain from qualifying stock bought after Feb. 17, 2009, and before Jan. 1, 2011, for an effective tax rate of just seven percent.

Rethinking dividend tax treatmentThe tax treatment of income-producing assets can affect investment strategy. Qualifying dividends generally are taxed at the reduced rate of 15 percent, while interest income is taxed at ordinary-income rates of up to 35 percent. So, dividend-paying stocks may be more attractive from a tax perspective than investments like CDs and bonds. But there are exceptions.

Some dividends are subject to ordinary-income rates. These may include certain dividends from:• moneymarketmutualfunds,• mutualsavingsbanks,• realestateinvestmenttrusts(REITs),• foreigninvestments,• regulatedinvestmentcompanies,and• stocks,totheextentthedividendsareoffsetbymargindebt.

Some bond interest is exempt from income tax. Interest on U.S. government bonds is taxable on your federal return, but it’s generally exempt on your state and local returns. Interest on state and local government bonds is excludible on your federal return. If the state or local bonds were issued in your home state, interest also may be excludible on your state return. Although state and municipal bonds usually pay a lower interest rate, their rate of return may be higher than the after-tax rate of return for a taxable investment.

Review portfolio for tax balance You should consider which investments to hold inside and outside your retirement accounts. If you hold taxable bonds to generate income and diversify your overall portfolio, consider holding them in a retirement account where there won’t be a current tax cost.

Bonds with original issue discount (OID) build up “interest” as they rise toward maturity. You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay you this interest annually — and you must pay tax on it. They also may be best suited for retirement accounts.

Try to own dividend-paying stocks that qualify for the 15-percent tax rate outside of retirement plans so you’ll benefit from the lower rate.

It’s also important to reallocate your retirement plan assets periodically. For example, the allocation you set up for your 401(k) plan 10 years ago may not be appropriate now that you’re closer to retirement. (See page 27 on saving for retirement.)

Planning for passive lossesThere are special rules for income and losses from a passive activity. Investments in a trade or business in which you don’t materially participate are passive activities. You can prove your material participation by participating in the trade or business for more than 500 hours during the year or by demonstrating that your involvement represents substantially all of the participation in the activity.

The designation of a passive activity is important, because passive activity losses are generally deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limitations. There are options for turning passive losses into tax-saving opportunities.

You can increase your activity to more than 500 hours. Alternatively, you can limit your activities in another business to less than 500 hours or invest in another income-producing business that will be passive to you. Either way, the other businesses can give passive income to offset your passive losses. Finally, consider disposing of the activity to deduct all the losses. The disposition rules can be complex, so consult with a Grant Thornton tax advisor.

Rental activity has its own set of passive loss rules. Losses from real estate activities are passive by definition unless you’re a real estate professional. If you’re a real estate professional, you can deduct real estate losses in full, but you must perform more than half of your personal services in real property trades and businesses annually and spend more than 750 hours in these services during the year.

If you actively participate in a rental real estate activity but you aren’t a real estate professional, you may be able to deduct up to $25,000 of real estate losses each year. This deduction is subject to a phaseout beginning when adjusted gross income (AGI) reaches $100,000 ($50,000 for married taxpayers filing separately).

Leveraging investment expensesYou are allowed to deduct expenses used to generate investment income unless they are related to tax-exempt income. Investment expenses can include investment firm fees, research costs, security costs such as a safe deposit box, and most significantly, investment interest. Apart from investment interest, these expenses are considered miscellaneous itemized deductions and are deductible only to the extent they exceed two percent of your AGI.

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Investment interest is interest on debt used to buy assets held for investment, such as margin debt used to buy securities. Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. Your investment interest deduction is limited to your net investment income, which generally includes taxable interest, dividends and short-term capital gains. Any disallowed interest is carried forward for a deduction in a later year, which may provide a beneficial opportunity. (See Tax planning opportunity 7.)

If you don’t want to carry forward investment interest expense, you can elect to treat net long-term capital gain or qualified dividends as investment income in order to deduct more of your investment interest, but it will be taxed at ordinary-income rates. Remember that interest on debt used to buy securities that pay tax-exempt income, such as municipal bonds, isn’t deductible. Also keep in mind that passive interest expense — interest on debt incurred to fund passive activity expenditures — becomes part of your overall passive activity income or loss, subject to limitations.

Be wary of deferral strategiesDeferring taxes is normally a large part of good planning. But with capital gains rates scheduled to go up, the benefits of deferring income may be outweighed by the burden of higher tax rates in the future. If you believe your rates will go up, consider avoiding or fine tuning strategies to defer gain, such as an installment sale or like-kind exchange.

Like-kind exchanges under Section 1031 allow you to exchange real estate without incurring capital gains tax. Under a like-kind exchange, you defer paying tax on the gain until you sell your replacement property.

An installment sale allows you to defer capital gains on most assets other than publicly traded securities by spreading gain over several years as you receive the proceeds. If you’re engaging in an installment sale, consider creating a future exit strategy. You may want to build in the ability to pledge the installment obligation. Deferred income on most installment sales made after 1987 can be accelerated by pledging the installment note for a loan. The proceeds of the loan are treated as a payment on the installment note itself. If legislation is enacted that increases the capital gains rate in the future (or makes clear the scheduled increase will occur), this technique can essentially accelerate the proceeds of the installment sale.

Your home as an investmentThere are many home-related tax breaks. Whether you own one home or several, it’s important to take advantage of your deductions and plan for any gains or rental income.

Property tax is generally deductible as an itemized deduction. Even if you don’t itemize, a provision scheduled to expire in 2010 allows you an above-the-line deduction of up to $500 ($1,000 if filing jointly) on personal property taxes. But remember, property tax isn’t deductible for alternative minimum tax (AMT) purposes.

You can also deduct mortgage interest and points on your principal residence and a second home. The deduction is good for interest on up to $1 million in total mortgage debt used to purchase, build or improve your homes. In addition, you can deduct interest on a home equity loan with a balance up to $100,000. Consumer interest isn’t deductible, so consider using home equity debt (up to the $100,000 limit) to pay off credit cards or auto loans. But remember, home equity debt is not deductible for the AMT unless it’s used for home improvements.

When you sell your home, you can generally exclude up to $250,000 ($500,000 for joint filers) of gain if you’ve used it as your principal residence for two of the preceding five years. But under a recently enacted provision, you will have to include gain on a pro-rata basis for any years after 2009 that the home was not used as your principal residence. Maintain thorough records to support an accurate tax basis, and remember, you can only deduct losses attributable exclusively for business or rental use (subject to various limitations).

The rules for rental income are complicated, but you can rent out all or a portion of your primary residence and second home for up to 14 days without having to report the income. No rental expenses will be deductible. If you rent out your property for 15 days or more, you have to report the income, but can also claim all or a portion of your rental expenses — such as utilities, repairs, insurance and depreciation. Any deductible expenses in excess of rental income can be carried forward.

If the home is classified as a rental for tax purposes, you can deduct interest that’s attributable to its business use but not any interest attributable to personal use.

Defer investment interest for a bigger deductionUnused investment interest expense can be carried forward indefinitely and may be usable in later years. It could make sense to carry forward your unused investment interest until after 2010, when tax rates are scheduled to go up and the 15-percent rate on long-term capital gains and dividends is scheduled to disappear. The deduction could save you more at that time if rates do go up.


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Chapter 6: Executive compensation

Thinking through your options

You may be compensated with more than just salary, fringe benefits and bonuses. Many people are rewarded with incentives like stock options, deferred compensation plans and restricted stock. These benefits come with complicated tax consequences, giving you perils to avoid and opportunities to consider.

Benefitting from incentive stock optionsStock options remain one of the most popular types of incentive compensation, and incentive stock options (ISOs) deserve special attention in your tax planning. If your options qualify as ISOs, you may be able to take advantage of favorable tax treatment.

ISOs give you the option of buying company stock in the future. The price must be set when the options are granted and must be at least the fair market value of the stock at that time. Therefore, the stock must rise before the ISOs have any value. If it does, you have the option to buy the shares for less than they’re worth on the market.

ISOs have several potential tax benefits• Thereisnotaxwhentheoptionsaregranted.• Long-termcapitalgainstreatmentisavailableif

the stock is held for one year after exercise and two years after the grant date.

• Thereisnotaxwhentheoptionsareexercised as long as the stock is held long enough to qualify for long-term capital gains treatment.

However, there is potential alternative minimum tax (AMT) liability when the options are exercised. The difference between the fair market value of the stock at the time of exercise and the exercise price is included as income for AMT purposes. The liability on this bargain element is a problem because exercising the option alone doesn’t generate any cash to pay the tax. If the stock price falls before the shares are sold, you can be left with a large AMT bill in the year of exercise even though the stock actually produced no income. Congress has provided some relief from past ISO-related AMT liabilities, and a new more generous AMT credit is also available. (See page 10 for more information on the AMT credit.) Talk to a Grant Thornton advisor if you have questions about AMT-ISO liability.

If the stock from an ISO exercise is sold before the holding period for long-term capital gains treatment expires, the gain is taxed at ordinary income tax rates in a disqualifying disposition. The employer is entitled to a compensation deduction only if the employee makes a disqualifying disposition.

If you’ve received ISOs, you should decide carefully when to exercise them and whether to sell immediately or hold the shares received from an exercise. Waiting to exercise until immediately before the ISOs expire (when the stock value may be highest) and then holding on to the stock long enough for long-term capital gains treatment is often beneficial.

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But acting earlier can also be advantageous in some situations• Exerciseearliertostarttheholdingperiod

for long-term capital gains treatment sooner. • Exercisewhenthebargainelementissmallorthe

market price is low to reduce or eliminate AMT liability. • Exerciseannuallyandbuyonlythenumberofsharesthat

will achieve a break-even point between the AMT and regular tax.

But beware; exercising early accelerates the need for funds to buy the stock. It also exposes you to a loss if the value of the shares drops below your exercise cost and may create a tax cost if the exercise generates an AMT liability. If the stock price may fall, you can also consider selling early in a disqualifying disposition to pay the higher ordinary-income rate and avoid the AMT. Tax planning for ISOs is truly a numbers game. With the help of Grant Thornton, you can evaluate the risks and crunch the numbers using various assumptions.

Considerations for restricted stockRestricted stock provides different tax considerations. Restricted stock is stock that’s granted subject to vesting. The vesting is often time-based, but can also be performance-based, so that the vesting is linked to company performance.

Income recognition is normally deferred until the restricted stock vests. You then pay taxes on the fair market value of the stock at the ordinary-income rate. However, there is an election under Section 83(b) to recognize ordinary income when you receive the stock. This election must be made within 30 days after receiving the stock and can be very beneficial in certain situations. (See Tax planning opportunity 8.)

Understanding nonqualified deferred compensationNonqualified deferred compensation (NQDC) plans pay executives in the future for services being performed now. They are not like many other traditional plans for deferring compensation. NQDC plans can favor certain highly compensated employees and can offer executives an excellent way to defer income and tax.

However, there are drawbacks. Employers cannot deduct any NQDC until the executive recognizes it as income, and NQDC plan funding is not protected from an employer’s creditors. Employers also must now be in full compliance with relatively new IRS rules under Section 409A that govern NQDC plans. The rules are strict, and the penalties for noncompliance are severe. If a plan fails to comply with the rules, plan participants are taxed on plan benefits immediately with interest charges and an additional 20-percent tax.

The new rules under Section 409A made several important changes. Executives generally must make an initial deferral election before the year they perform the services for the compensation that will be deferred. So, an executive who wants to defer some 2010 compensation to 2011 or beyond generally must make the election by the end of 2009. Additionally:• Benefitsmusteitherbepaidonaspecifieddateaccording

to a fixed payment schedule or after the occurrence of a specified event — defined as a death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.

• Thetimingofbenefitpaymentscanbedelayedbut not accelerated.

• Electionstochangethetimingorformofapayment must be made at least 12 months in advance of the original payment commencement date.

• Newpaymentdatesmustbeatleastfiveyearsafter the date the payment would have been made originally.

It is also important to note that employment taxes are generally due when the benefits become vested. This is true even though the compensation isn’t actually paid or recognized for income tax purposes until later years. Some employers withhold an executive’s portion of the tax from the executive’s salary or ask the executive to write a check for the liability. Others pay the executive’s portion, but this must be reported as additional taxable income.

Consider an 83(b) election on your restricted stockWith an 83(b) election, you immediately recognize the value of the restricted stock as ordinary income when the stock is granted. In exchange, you don’t recognize any income when the stock actually vests. You only recognize gain when the stock is eventually sold.

So why make an 83(b) election and recognize income now, when you could wait to recognize income when the stock actually vests? Because the value of the stock may be much higher when it vests. The election may make sense if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. In these cases, the election allows you to convert future appreciation from ordinary income to long-term capital gains income.

The biggest drawback may be that any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or the stock’s value decreases. But if the stock’s value decreases, you’ll be able to report a capital loss when you sell the stock.


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Chapter 7: Business ownership

How to structure your enterprises

How you structure, buy and sell business interests has never been more important. There are many tax considerations that can cost or save you money. The most important factor may be the structure you choose for your company.

Tax treatment of business structuresBusiness structures generally fall into two categories: C corporations and pass-through entities. C corporations are taxed as separate entities from their shareholders and offer shareholders limited liability protection. (See chart 5 for corporate income tax rates.)

Pass-through entities effectively “pass through” taxation to individual owners, so the business income is taxed at the individual level. (See page 5 for more on individual taxes and the individual rate schedule.) Some pass-through entities, such as sole proprietorships and general partnerships, don’t provide limited liability protection, while other pass-through entities, such as S corporations, limited partnerships, limited liability partnerships and limited liability companies, can.

Because some pass-through entities can offer the same limited liability protection as a C corporation, tax treatment should be a major consideration when deciding between the two structures. (See chart 6 for an overview of key differences.) The biggest difference is that C corporations endure two levels of taxation. First, a C corporation’s income is taxed at the corporate level. Then the income is taxed again at the individual level when it is distributed to shareholders as dividends. The income from pass-through entities is generally only taxed at the individual owner level, not at the business level.

Although this benefit is significant, it is not the only consideration. There are many other important differences in the tax rules, deductions and credits for each business structure that also need to be considered. You always want to assess the impact of state and local taxes where your company does business, and owners who are also employees have several other unique considerations. Also, the choice of business structure

can affect the ability to finance the business and may determine which exit strategies will be available. Each structure has its own pluses and minuses, and you should examine carefully how each will affect you. Call a Grant Thornton advisor to discuss your individual situation in more detail.

If you work in a business in which you have an ownership interest, you need to think about employment taxes. Generally all trade or business income that flows through to you from a partnership or limited liability company is subject to self-employment tax — even if the income isn’t actually distributed to you. But if you’re an S corporation or C corporation employee-owner, only income you receive as salary is subject to employment taxes. How much of your income from a corporation comes from salary can have a big impact on how much tax you pay. (See Tax planning opportunity 9 for more information.)

Don’t wait to develop an exit strategyMany business owners have most of their money tied up in their business, making retirement a challenge. Others want to make sure their business — or at least the bulk of its value — will be passed to their family members without a significant loss to estate taxes. If you’re facing either situation, now is the time to start developing an exit strategy that will minimize the tax bite.

Chart 5: 2009 corporate income tax brackets

Tax rate Tax bracket 15% $0 – $50,000 25% $50,001 – $75,000 34% $75,001 – $100,000 39% $100,001 – $335,000 34% $335,001 – $10,000,000 35% $10,000,001 – $15,000,000 38% $15,000,001 – $18,333,333 35% Over $18,333,333

Note: Personal service corporations are taxed at a flat 35% rate.

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Chart 6: Tax differences based on business structure

Pass-through entity C corporation

Tax treatment One level of taxation: Two levels of taxation: •Incomeisnottaxedatbusinesslevelandflowsthrough •Incometaxedatcorporatelevelatcorporaterates toownerswhereitistaxedatindividualrates •ShareholdersthentaxedonanydividendstheyreceiveLosstreatment •Lossesflowthroughtotheownerswheretheycanbe •Lossesremainatthecorporatelevelandarecarriedbackward taken individually (subject to basis and at-risk limitations) or forward to offset past or future corporate-level incomeTaxrates •Topindividualtaxrateiscurrently35%,butisscheduled •Topcorporatetaxrateisgenerally35% toincreasein2011 •Incomedistributedasdividendsistaxedasecondtime, generally at 15% (scheduled to increase to 39.6%)

An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money. To pass on your business within the family, you can give away or sell interests. But be sure to consider the gift, estate and generation-skipping tax consequences. (See page 31.)

A buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Buy-sell agreements are complicated by the need to provide the buyer with a means of funding the purchase. Life or disability insurance can often help and can also give rise to several tax and nontax issues and opportunities.

One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions to this, however, so be sure to consult a Grant Thornton tax advisor.

You may also want to consider a management buyout or an employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan created primarily so employees can purchase your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or supplementing an employee benefit program, an ESOP can offer you many advantages.

Assess tax consequences when buying or sellingWhen you do decide to sell your business — or are acquiring another business — the tax consequences can have a major impact on your transaction’s success or failure.

The first consideration should be whether to structure your transaction as an asset sale or a stock sale. If it’s a C corporation, the seller will typically prefer a stock sale for the capital gains treatment and to avoid double taxation. The buyer will generally want an asset sale to maximize future depreciation write-offs.

Sellers should also consider whether they prefer a taxable sale or a tax-deferred transfer. The transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization, but the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are advantages to performing a taxable sale: • Taxratesarescheduledtoincreasein2011.• Thesellerdoesn’thavetoworryaboutthequality

of buyer stock or other business risks that might come with a tax-deferred sale.

• Thebuyerbenefitsbyreceivingastepped-upbasis in the acquisition’s assets and does not have to deal with the seller as a continuing equity owner, as would be the case in a tax-deferred transfer.

• Thepartiesdon’thavetomeetthestringenttechnicalrequirements of a tax-deferred transaction.

A taxable sale may be structured as an installment sale if the buyer lacks sufficient cash or the seller wants to spread the gain over a number of years. Contingent sales prices that allow the seller to continue to benefit from the success of the business are common. But be careful, the installment sale rules create a trap for sellers if the contingency is unlikely to be fulfilled. Also, installment sales may not make as much sense in the current environment because tax rates are scheduled to go up. (See page 14 for more information on installment sale considerations when tax rates have the potential to increase.)

Careful planning while the sale is still being negotiated is essential. Grant Thornton can help you see any trap and find the exit strategy that best suits your needs.

Set salary wisely if you’re a corporate employee-shareholderIf you are an owner of a corporation who works in the business, you need to consider employment taxes in your salary structure. The 2.9-percent Medicare tax is not capped and will be levied against all income received as salary. S corporation shareholder-employees may want to keep their salaries reasonably low and increase their distributions of company income in order to avoid the Medicare tax. But C corporation owners may prefer to take more salary (which is deductible at the corporate level), because the Medicare tax rate is typically lower than the 15-percent tax rate they would pay personally on dividends.

But remember to tread carefully. You must take a reasonable salary to avoid potential back taxes and penalties, and the IRS is cracking down on misclassification of corporate payments to shareholder-employees.


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Chapter 8: Charitable giving

Saving more by giving better

Giving to charity is one of the best tax planning opportunities because you enjoy not only a sizable tax deduction, but also the satisfaction of doing good. Plus you can control the timing to maximize your tax benefits. Well-planned gifts can trim the estate tax while allowing you to take care of your heirs in the manner you choose.

Choosing what to giveThe first thing to determine is what you want to give to charity: cash or property. There are adjusted gross income (AGI) limits on how much of your gift you get to deduct depending on what you give and who you give it to. Giving directly from an individual retirement account (IRA) may lower your AGI. (See Tax planning opportunity 10 to find out if you are eligible.) Contributions disallowed due to the AGI limit can be carried forward for up to five years. (See chart 7 for the deduction limit by donation and the type of charity.)

Outright gifts of cash (which include gifts made via check, credit card and payroll deduction) are the easiest. The key is to make sure you substantiate them. Cash donations under $250 must be supported by a canceled check, credit card receipt or written communication from the charity. Cash donations of $250 or more must be substantiated by the charity. Despite the simplicity and high AGI limits for outright cash gifts, it may prove more beneficial to make gifts of property.

Gifts of property are a little more complicated, but they may provide more tax benefits when planned properly. Your deduction depends in part on the type of property donated: long-term capital gains property, ordinary-income property or tangible personal property.

Ordinary-income property includes items such as stock held less than a year, inventory and property subject to depreciation recapture. You can receive a deduction equal to only the lesser of fair market value or your tax basis.

Long-term capital gains property includes stocks and other securities you’ve held more than one year. It’s one of the best charitable gifts because you can take a charitable deduction equal to its current fair market value. Consider donating appreciated property to charity because you avoid paying tax on the long-term capital gain you’d incur if you sold the property. (See Tax planning opportunity 11.)

But beware. It may be better to elect to deduct the basis rather than the fair market value because the AGI limitation will be higher. Whether this is beneficial will depend on your AGI and the likelihood of using — within the next five years — the carryover you’d have if you deducted the fair market value and the 30-percent limit applied.

Chart 7: AGI limitations on charitable contribution deductions

The deduction for your total charitable contributions for the year is subject to a limitation based on your adjusted gross income (AGI) and the type of charity.

Public charity or operating foundation Private nonoperating foundation

Cash, ordinary-income property and unappreciated property 50% 30%Long-term capital gains property deducted at fair market value 30% 20%Long-term capital gains property deducted at basis 50% 30%

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Tangible personal property can include things such as a piece of art or an antique. Your deduction depends on the type of property and the charity, and there are several rules to consider:• Personalpropertyvaluedatmorethan$5,000

(other than publicly traded securities) must be supported by a qualified appraisal.

• Ifthepropertyisn’trelatedtothecharity’stax-exemptfunction (such as a painting donated for a charity auction), your deduction is limited to your basis in the property.

• Ifthepropertyisrelatedtothecharity’stax-exempt function (such as a painting donated to a museum), you can deduct the property’s fair market value.

Benefit yourself and a charity with a CRTA charitable remainder trust (CRT) may be appropriate if you wish to donate property to charity and would like to receive (or would like someone else to receive) an income stream for a period of years or for your expected lifetime. The property is contributed to a trust and you, or your beneficiary, receive income for the period you specify. The property is distributed to the charity at the end of the trust term.

So long as certain requirements are met, the property is deductible from your estate for estate tax purposes and you receive a current income tax deduction for the present value of the remainder interest transferred to charity. You don’t immediately pay capital gains tax if you contribute appreciated property. Distributions from the CRT generally carry taxable income to the noncharitable beneficiary. If someone other than you is the income beneficiary, there may be gift tax consequences.

A CRT can work particularly well in cases where you own non-income-producing property that would generate a large capital gain if sold. Because a CRT is a tax-exempt entity, it can sell the property without having to pay tax on the gain. The trust can then invest the proceeds in income-producing property. This technique can also be used as a tax-advantaged way to diversify your investment portfolio.

To keep CRTs from being used primarily as tax avoidance tools, however, the value of the charity’s remainder interest must be equal to at least 10 percent of the initial net fair market value of the property at the time it’s contributed to the trust. There are other rules concerning distributions and the types of transactions into which the trust may enter.

Give directly from an IRA if 70½ or olderCongress just extended a helpful tax provision that allows taxpayers 70½ and older to make tax-free charitable distributions from individual retirement accounts (IRAs). Using your IRA distributions for charitable giving could save you more than taking a charitable deduction on a normal gift.

That’s because these IRA distributions for charitable giving won’t be included in income at all, lowering your AGI. You’ll see the difference in many AGI-based computations where the below-the-line deduction for charitable giving doesn’t have any effect.

Give appreciated property to enhance savingsThink about giving property that has appreciated to charity. You avoid paying the capital gains taxes you would incur if you sold the property, so donating property with a lot of built-in gain can lighten your tax bill.

But don’t donate depreciated property. Sell it first and give the proceeds to charity so you can take the capital loss and the charitable deduction.


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Reverse the strategy with a CLTA grantor charitable lead trust (CLT) is basically the opposite of the CRT. For a given term, the trust pays income to one or more charities and the trust’s remaining assets pass to you or your designated beneficiary at the term’s end. When you fund the trust, you receive an income tax deduction for the present value of the annual income expected to be paid to the charity. (You also pay tax on the trust income.) The trust assets remain in your estate.

With a non-grantor CLT, you name someone other than yourself as remainder beneficiary. You won’t have to pay tax on trust income, but you also won’t receive an income tax deduction. The trust assets will be removed from your estate, but there also may be gift tax consequences. Alternatively, the trust can be funded at your death, and your estate will receive an estate tax deduction (but not an income tax deduction).

A CLT can work well if you don’t need the current income but want to keep an asset in the family. As with other strategies, consider contributing income-producing stocks or other highly appreciated assets held long-term.

Keep control with a private foundationConsider forming a private foundation if you want to make large donations but also want a degree of control over how that money will be used. A foundation is particularly useful if you haven’t determined what specific charities you want to support.

But be aware that increased control comes at a price: You must follow a number of rules designed to ensure that the private foundation serves charitable interests and not private interests. There are requirements on the minimum percentage of annual payouts to charity and restrictions on most transactions between the foundation and its donors or managers.

Violations can result in substantial penalties. Ensuring compliance with the rules can also make a foundation expensive to run. In addition, the AGI limitations for deductibility of contributions to nonoperating foundations are lower.

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Provide influence with a donor-advised fundIf you’d like to influence how your donations are spent but you want to avoid the tight rules and high expenses of a private foundation, consider a donor-advised fund. They are offered by many larger public charities, particularly those that support a variety of charitable activities and organizations.

The fund is simply an agreement between you and the charity: The charity agrees to consider your wishes regarding use of your donations. This agreement is nonbinding, and the charity must exercise final control over the funds, consistent with the charitable purposes of the organization.

To deduct your contribution, you must obtain a written acknowledgment from the sponsoring organization that it has exclusive legal control over the assets contributed.

Key rules to rememberWhatever giving strategy ultimately makes the most sense for you, keep in mind several important rules on giving: • Ifyoucontributeyourservicestocharity,youmay

deduct only your out-of-pocket expenses, not the fair market value of your services.

• Youreceivenodeductionbydonatingtheuseofpropertybecause it isn’t considered a completed gift to the charity.

• Ifyoudriveforcharitablepurposes,youmaydeduct 14 cents for each charitable mile driven.

• Givingacartocharityonlyresultsinadeductionequal to what the charity receives when it sells the vehicle unless it is used by the charity in its tax-exempt function.

• Ifyoudonateclothingorhouseholdgoods,theymust be in at least “good used condition” to be deductible.

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Chapter 9: Education savings

The ABCs of tax-saving education

The tax code provides myriad incentives to encourage education. This means you have plenty of opportunities to save on your tax bill while giving your children and grandchildren the best education possible. But it also means you have to consider your options carefully to make sure you use the tax preferences that will best help your bottom line.

There are generally two ways the tax code offers savings on education. First, there are deductions and credits for education expenses, including the American Opportunity credit, the Lifetime Learning credit, the tuition and fees deduction, and the student loan interest deduction. The second and often better opportunity is a tax-preferred savings account, which comes in the form of either a 529 plan or Coverdell education savings account (ESA).

Unfortunately, all of these tax incentives — except 529 savings plans — phase out based on adjusted gross income (AGI). (See chart 8 for the various phaseout thresholds.) Regardless of your approach, making payments directly to educational institutions can help you save in gift taxes. (See Tax planning opportunity 12 for more information.)

Deductions and creditsThe American Opportunity credit was added by the 2009 economic stimulus bill and temporarily replaces the Hope Scholarship credit for 2009 and 2010. The new credit is more generous and has a higher AGI phaseout than the Hope Scholarship credit. It is equal to 100 percent of the first $2,000 of tuition and 25 percent of the next $2,000, for a total credit of up to $2,500. It is also 40 percent refundable and allowed

against the alternative minimum tax (AMT). The credit is only available for the first two years of college education (not room, board or books), and it covers only tuition and certain fees at colleges, universities or vocational or technical schools.

The Lifetime Learning credit can be used anytime during the college years as well as for graduate education. But it is less generous. It provides a credit of up to 20 percent of qualified college tuition and fees up to $10,000, for a maximum credit of $2,000. For 2009 and 2010, it also phases out at much lower income threshold than the American Opportunity credit. (See chart 8.)

Chart 8: 2009 education tax break AGI phaseouts

Single filers Joint filers

529 plan contributions No limit No limitCoverdell ESA contributions $95,000 – $110,000 $190,000 – $220,000American Opportunity credit (formerly Hope Scholarship credit) $80,000 – $90,000 $160,000 – $180,000Lifetime Learning credit $50,000 – $60,000 $100,000 – $120,000Tuition and fees deduction $65,000 – $80,000 $130,000 – $160,000Student loan interest deduction $60,000 – $75,000 $120,000 – $150,000

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Bear in mind that you cannot use both credits in the same year for the same student. If your AGI is too high to claim either credit, consider letting your child take the credit. But neither you nor the child will be able to claim the child as an exemption.

The maximum tuition and fees deduction is either $2,000 or $4,000, depending on your AGI. If you have children who are out of college and paying back student loans, remind them they may be eligible for the student loan interest deduction.

Section 529 savings plansSection 529 savings plans allow taxpayers to save in special accounts and make tax-free distributions to pay for tuition, fees, books, supplies and equipment required for college enrollment. The economic stimulus bill passed in February 2009 clarified that computer technology, computer equipment and internet access are allowed as qualified expenses for 529 plans in 2009 and 2010.

529 plans come in two forms, prepaid tuition plans and college savings plans. Prepaid tuition plans allow you to “buy” tuition at current levels on behalf of a designated child. They can be offered by states or private educational institutions,

and if your contract is for four full years of tuition, tuition is guaranteed when your child attends regardless of the cost at that time. Your state may also offer tax benefits for investments in the state qualified tuition programs.

College savings plans can only be offered by states and can be used to pay a student’s qualifying tuition at any eligible educational institution. They offer more flexibility in choosing schools and more certainty on benefits. If the student doesn’t use all of the account funds, the excess can be rolled over into the plan for another student.

529 plans have many benefits• Theplanassetsgrowtax-deferred,anddistributionsused

to pay qualified higher education expenses are tax-free. • Contributionsaren’tdeductibleforfederaltaxpurposes,

but some states offer state tax benefits. • Therearenoincomelimitsforcontributingandthe

plans typically offer much higher contribution limits than ESAs (set by state or private institution sponsors).

• Thereisgenerallynobeneficiaryagelimitforcontributionsor distributions.

Make payments directly to educational institutionsIf you have children or grandchildren in private school or college, consider making direct payments of tuition to their educational institutions. Your payments will be gift-tax free, and they will not count against the annual exclusion amount of $13,000 (for 2009) or your $1 million lifetime gift tax exemption. Just make sure the payments are made directly to the educational institution and not given to children or grandchildren to cover the cost.

Plan around gift taxes with your 529 planA 529 plan can be a powerful estate planning tool for parents or grandparents. Contributions to 529 plans are eligible for the $13,000 per beneficiary annualgifttaxexclusion,soyoucanalsoavoidanygeneration-skippingtransfer(GST)taxwhenyoufunda529planforagrandchild—withoutusingup any of your $3.5 million GST tax exemption.

Plus, a special break for 529 plans allows you to front-load five years’ worth of annual exclusion gifts ($65,000) in one year, and married couples splitting gifts can double this amount to $130,000. And that’s per beneficiary.


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But there are disadvantages• Youdon’thavedirectcontroloverinvestmentdecisionsand

the investments may not earn as high a return as they could earn elsewhere. (But you can roll over into a different 529 plan if you’re unhappy with one plan’s performance.)

• Thereisalsoariskthechildmaynotattendcollegeandtheremay not be another qualifying beneficiary in the family.

Contributions to a 529 plan are subject to gift tax, so contributions over the annual gift tax exclusion ($13,000 in 2009) will use up your $1 million lifetime gift tax exemption (or be subject to gift tax). But there are opportunities to boost the account without creating gift tax headaches. (See Tax planning opportunity 13.)

Coverdell ESAsCoverdell ESAs are similar to 529 plans. The plan assets grow tax-deferred and distributions used to pay qualified higher education expenses are income tax-free for federal tax purposes and may be tax free for state tax purposes. Contributions are also not deductible.

ESAs have two distinct advantages over 529 plans• Theycanbeusedtopayforelementaryand

secondary school expenses.• Youcontrolhowtheaccountisinvested.

However, they also have disadvantages• Theyarenotavailableforsomehigh-incometaxpayers

due to the AGI phaseout. (Consider allowing others, such as grandparents, to contribute to an ESA if your AGI is above the phaseout threshold.)

• Theannualcontributionlimitisonly$2,000perbeneficiary.• Contributionsgenerallycannotbemadeafterthebeneficiary

reaches 18.• Anybalanceleftintheaccountwhenthebeneficiary

turns 30 will be distributed subject to tax.• Anotherfamilymemberunder30hastobenamed

the beneficiary to avoid a mandatory distribution and maintain the account’s tax-advantaged status.

• Aswith529plans,thereisalwaysariskthechildwillnotattend college and there is no other qualified beneficiary.

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Watch out for the kiddie taxBe careful with an alternative technique that was popular in past years: transferring assets to children to pay for education with an account under the Uniform Gift to Minors Act (UGTA) or Uniform Transfer to Minors Act (UTGA).

These accounts allow you to irrevocably transfer cash, stocks or bonds to a minor while maintaining control over the assets until the age at which the account terminates (age 18 or 21 in most states). The transfer qualifies for the annual gift tax exclusion, but the expanding “kiddie tax” could limit any tax benefits. The kiddie tax was recently expanded to apply to children up to the age of 23 if they are full-time students (unless they provide over half of their own support from earned income). For those subject to the kiddie tax, unearned income beyond $1,900 in 2009 will be taxed at their parents’ marginal rate.

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Chapter 10: Retirement savings

Using tax incentives for a golden retirement

Lawmakers have loaded the tax code with incentives for saving for retirement. You may need these tax-advantaged retirement vehicles to build your nest egg unless you can count on a generous defined benefit plan to take care of your retirement needs.

Defined benefit plans set a future pension benefit and then actuarially calculate the contributions needed to attain the benefit. Because they are actuarially driven, the contribution limits are often higher than other types of plans. But fewer and fewer employers are offering them.

Fortunately, the tax code provides a number of tax-advantaged defined contribution options to help you build enough wealth to live comfortably in retirement. Even if you’ve already amassed your fortune, you may want to leverage as many retirement tax incentives as possible to mitigate your tax burden.

Defined contributions plansDefined contribution plans let you control how much is contributed. They come in employer-sponsored versions like 401(k)s, 403(b)s, 457s, SIMPLE IRAs and SEP IRAs, or in non-employment versions like Individual Retirement Accounts (IRAs). All of these accounts have contribution limits, and some allow extra “catch-up” contributions if you’re 50 or older. (See chart 9 for these limits.)

Because of their tax advantages, contributing the maximum amount allowed is likely a smart move. The tax benefits of these accounts (in the traditional versions) are twofold. Contributions are usually pretax or deductible, so they reduce your taxable income. And assets in the accounts grow tax-deferred — meaning you pay no income tax until you make distributions.

Unfortunately, you must begin making annual minimum withdrawals from most retirement plans at age 70½. These required minimum distributions (RMDs) are calculated using your account balance and a life expectancy table. They must be made each year by Dec. 31 or you can be subject to a 50-percent penalty on the amount you should have taken out (although your initial RMD can be deferred until April 1 the following year). You may not be required to make distributions if you’re still working for the employer who sponsors your plan. (See Tax planning opportunity 14 to find out when it makes the most sense to make distributions and see page 4 for information on 2009 RMD relief.)

Employer-sponsored defined contribution accounts have several advantages over IRAs. For one, many employers offer matching contributions for these accounts, and there are no income limits for contributing. IRAs have strict income limits, but many high-income taxpayers maintain accounts that were opened when they were earning less or consist of rollovers from employer-sponsored plans.

1IncludesRothversionswhereapplicable;thehigher457plancontributionlimitsfortaxpayersover50areonlyavailableforgovernment457plans. Note: Other factors may further limit your contribution.

Chart 9: 2009 retirement plan contribution limits

“Catch-up” contributions mean higher retirement plan contribution limits for workers age 50 or older.

Limit for taxpayers under age 50 Limit for taxpayers age 50 and older

Traditional and Roth IRAs $5,000 $6,000401(k)s, 403(b)s, 457s1 $16,500 $22,000SIMPLE IRAs $11,500 $14,000SEP-IRAs and defined contribution Keoghs $49,000 $49,000

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When to choose a Roth versionThree of the defined contribution plans — 401(k)s, 403(b)s and IRAs — offer “Roth” versions. The tax benefits of Roth accounts are slightly different from traditional accounts. They allow for tax-free growth and tax-free distributions, but contributions are not pretax or deductible.

The difference is in when you pay the tax. With a traditional retirement account, you don’t pay tax on the contributions — you only pay taxes on the back end when you take your money out. For a Roth account, you pay taxes on the contributions up front, but never pay tax again if distributions are made properly.

A traditional account may look like the best approach because it often makes sense to defer tax as long as possible. But this isn’t always the case. Roth plans can save you more if you’re in a higher tax bracket when making distributions during retirement, or if tax rates have gone up. Plus, there are no required minimum distributions for Roth IRAs. (See Tax planning opportunity 15 for the benefits of setting up a Roth IRA for a child, and check Tax planning opportunity 16 to learn about a new opportunity to roll over from a traditional IRA into a Roth IRA.)

Set up your own planIf you’re a business owner or self-employed, you have more flexibility because you can set up a retirement plan that allows you to maximize your contributions. Keep in mind that if you have employees, they generally must be allowed to participate in the plan.

One option is a profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and offers increased flexibility in plan design. The maximum 2009 contribution is $49,000 or, for those who include a 401(k) arrangement in the plan and are eligible to make catch-up contributions, $54,500. Your specific contribution limit is a function of your income. You can make deductible 2009 contributions as late as the due date of your 2009 income tax return, including extensions — provided your plan exists on Dec. 31, 2009.

A Simplified Employee Pension (SEP) is a defined contribution plan that provides benefits similar to those of a profit-sharing plan. The maximum 2009 contribution is the lesser of $49,000 or 25 percent of your eligible compensation (net of the deduction for the contributions), which means you can contribute $49,000 if your eligible compensation exceeds $245,000. Catch-up contributions aren’t available with SEPs.

Wait to make your retirement account withdrawalsTaxpayers have no choice but to begin making distributions from IRAs, 401(k) and 403(b) plans, and some 457(b) plans, once they reach 70½. (See page 4 to learn about the temporary reprieve from required minimum distributions in 2009). But many taxpayers want to know whether they should begin making distributions earlier or wait and make only the required distributions.

If your account is appreciating and you don’t need the money immediately, consider waiting to make withdrawals until required. Your assets will continue growing tax-free. Not only will your account balance likely be larger if you wait, but if you live long enough, your total distributions should also be greater.


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You can establish the SEP in 2010 and still make deductible 2009 contributions as late as the due date of your 2009 income tax return, including extensions. Another benefit of a SEP is that it’s much easier to administer than a profit-sharing plan. So if you have eligible compensation in excess of $245,000 and would be ineligible to make catch-up contributions to a profit-sharing plan, setting up a SEP may be a better option.

Considerations after a job changeWhen you change jobs or retire, you’ll need to decide what to do with your employer-sponsored plan. You may have several options.

It is generally not a good idea to make a lump sum withdrawal. You’ll have to pay taxes on the withdrawal, as well as a 10-percent penalty if you’re under the age of 59½. Your employer is also required to withhold 20 percent for federal income taxes.

If you have more than $5,000 in your account, you can leave the money there. You’ll avoid current income tax and any penalties and the plan assets can continue to grow tax-deferred. This may seem like the simplest solution, but it may not be the best. Keeping track of both the old plan and a plan with a new employer can make managing your retirement assets more difficult. Plus, you’ll have to be mindful of any rules specific to the old plan.

You can still avoid any penalties and continue to defer taxes if you roll over to your new employer’s plan. And this may leave you with only one retirement plan to keep track of. It can be a good solution, but be sure to first compare the new plan’s investment options to the old plan’s options.

Rolling over into an IRA may be the best alternative. You avoid penalties and continue to defer taxes, and you have nearly unlimited investment choices. Plus, you can roll over new retirement plan assets into the same IRA if you change jobs again. Such consolidation can make managing your retirement assets easier.

If you choose a rollover, request a direct rollover from your old plan to your new employer’s plan or IRA. If the funds from the old plan are instead paid to you, you’ll need to make an indirect rollover to your new plan or IRA within 60 days to avoid the tax and potential penalty on those funds. The check you receive from your old plan will be net of federal income tax withholding, but if you don’t roll over the gross amount you’ll be subject to income tax and a potential 10-percent penalty on the difference.

Avoid early distribution penaltiesMost withdrawals from tax-deferred retirement plans before age 59½ will be subject to a 10-percent penalty in addition to the normal income tax on the distributions. There are a few exceptions to the early withdrawal penalty. You won’t have to pay if:• Youbecomedisabled.• Thedistributionsarearesultofinheritingthe

plan account.• Youtakedistributionsassubstantiallyequal

periodic payments for at least five years, with the last payment received on or after age 59½.

• Distributionsbeginbecauseofearlyretirement or other job separation, and the separation occurs during or after the year you reach age 55 (except IRAs).

• Thedistributionisusedfordeductiblemedicalexpensesexceeding 7.5 percent of adjusted gross income.

• Yougetdivorcedandthedistributions(exceptfrom IRAs) are made pursuant to a qualified domestic relations order (QDRO).

401(k) plans have their own “hardship” distribution rules based on “immediate and heavy financial need.” But those rules merely allow a participant to get funds out, not to escape the income tax or the 10-percent penalty.

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Get kids started with a Roth IRAIt’s never too early to start saving, and a Roth IRA can offer your children unique benefits. For one, Roth IRA contributions can be withdrawn tax- and penalty-free at any time and for any reason. Early withdrawals are subject to tax and a 10-percent early withdrawal penalty only when they exceed contributions.

Additionally, if a Roth IRA has been open for five years, there are two exceptions to early withdrawal penalties that can be particularly helpful to young IRA owners:• Withdrawalsinexcessofcontributionsusedtopayqualifiedhighereducationexpensesarepenalty-free,butthey’resubjecttoincometax.• Withdrawalsupto$10,000inexcessofcontributionsusedforafirst-timehomepurchasearebothtax-andpenalty-free.

To make IRA contributions, children must have earned income. If your children or grandchildren don’t want to invest their hard-earned money, considergivingthemtheamountthey’reeligibletocontribute—butkeepthegifttaxinmind. (See page 31 for information on the gift tax.)

Roll yourself over into a Roth IRAIt’s time to prepare for a unique opportunity in 2010 to roll your traditional IRA into a Roth IRA. Starting next year, there will no longer be a $100,000 AGI limit on this option. And it couldn’t have come at a better time.

This type of rollover requires you to pay taxes on the investments in your IRA immediately in exchange for no taxes at withdrawal. So why pay taxes now instead of later?• Taxratesarelikelytogoup.Thecurrenttopindividualtaxrateisscheduledtoincreasefrom35percentto39.6percentin2011.• Youraccountmayalsobeatitsweakestthankstoadownturnthathasbatteredstocks.Theupsideisthatlessvalueinyouraccountmeansless

tax you have to pay on the rollover. Taxes could be a lot higher when your account recovers.• Youpaythetaxonyourrolloverfrommoneyoutsidetheaccount.Thistoohasasilverlining.Yourfullaccountbalanceaftertherolloverbecomes

tax-free, effectively increasing the amount of your tax-preferred investment.• TherearenorequiredminimumdistributionsforaRothIRA.Soyoucantakeyourmoneyoutifandwhenyouwantto,andwhateverisleftover

can be left to your heirs.


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Chapter 11: Estate planning

Preserve your wealth for family members

You’ve spent a lifetime building your wealth, and you’d like to provide for your family and perhaps even future generations after you’re gone. With proper planning, you can do just that — regardless of what happens to the estate and gift taxes in the future.

There are three main transfer taxes: the gift tax, estate tax and generation-skipping transfer (GST) tax. Estate taxes are levied on a taxpayer’s estate at the time of death, while gift taxes are applied on gifts made during a taxpayer’s lifetime. The GST tax is an additional tax applied to transfers of assets to grandchildren or other family members that skip a generation (including non-relatives 37½ years younger than the donor). Each transfer tax has its own rates and exemption amounts, which are scheduled to change drastically in the coming years. (See chart 10.)

The estate tax and GST tax are scheduled for full repeal in 2010, before coming back in 2011 with higher rates and lower exemptions. This may be unlikely to occur. As this guide went to print, Congress was scheduled to begin considering estate tax reform options before the year’s end. You always want to keep your estate planning strategies up to date for both changes in law and your personal situation. (See Tax planning opportunity 17.)

Check with Grant Thornton for an update on the progress of legislation, and keep in mind that a full repeal of the estate tax is unlikely any time in the foreseeable future.

Planning for transfer taxes in uncertain timesTaking steps to minimize transfer taxes is as important as ever. Regardless of where exactly the exemption amounts and rates end up in the future, there are strategies that can help you minimize your transfer tax burden. First you want to make sure you maximize the exemptions, deductions and exclusions available for each transfer tax.

The estate and gift tax have unlimited marital deductions for transfers between spouses. Your estate can generally deduct the value of all assets passed to your spouse at death if your spouse is a U.S. citizen, and no gift tax is due if you passed the assets while alive. There is also no limit on the estate and gift tax charitable deductions. If you bequeath your entire estate to charity or give it all away while alive, no estate or gift tax will be due.

The GST includes a lifetime exemption. Your estate may benefit in the long run if you use up this exemption while you’re alive. But remember, you’ll also need to use your gift and estate tax exemptions to make these transfers completely tax-free.

Chart 10: Estate, gift and generation-skipping tax rates and exemptions under current law

Estate tax Gift tax GST tax Exemption Top rate Exemption Top rate Exemption Top rate2009 $3,500,000 45% $1,000,000 45% $3,500,000 45%2010 Estate tax repealed Estate tax repealed $1,000,000 35% GST tax repealed GST tax repealed2011+ $1,000,000 55% $1,000,000 55% $1,000,000 (+inflation adjustment) 55%

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The gift tax also offers both a lifetime exemption and a yearly exclusion. Gifting remains one of the best estate planning strategies. You definitely need to consider using part or all of your lifetime exemption. (See Tax planning opportunity 18 for more information.) But first, formulate a gifting plan to take advantage of the annual gift tax exclusion. The annual exclusion is indexed for inflation in $1,000 increments and reached $13,000 per beneficiary in 2009.

You can double this generous exclusion by electing to split a gift with your spouse. So, even if you want to give to just four beneficiaries, you and your spouse could gift a total of $104,000 this year with no gift tax consequences. If you have more beneficiaries you’d like to include, you can remove even more from your estate every year.

You can also avoid gift taxes by paying tuition and medical expenses for a loved one. As long as you make payments directly to the provider, you can pay these expenses gift-tax free without using up your annual exemption.

When deciding what assets to gift, keep in mind the step-up in basis at death. If it’s likely that the loved ones you give property to won’t sell it before you die, think twice about giving it to them. If it stays in your estate, the property gets an automatic step-up in basis to fair market value at the time of your death. This could result in significant income tax savings for your heirs upon later sale. Keep in mind that the rules regarding the step-up in basis could be more complex in 2010 if the temporary repeal of the estate tax is not amended.

Using business interests in giftingInterests in a business can save you in transfer taxes, whether it is a business you own or a limited partnership you set up. There is a pair of special breaks for business owners:• Section 303 redemptions. Your company can buy back

stock from your estate without the risk of the payment to the estate being treated as a dividend for income tax purposes. Such a distribution generally must not exceed the tax, funeral and administration expenses of the estate, and the value of your business must exceed 35 percent of the value of your adjusted gross estate. But be careful. If there isn’t a non-tax reason for setting up this structure, the IRS can challenge its validity.

• Estate tax deferral. Normally, estate taxes are due within nine months of death. But if closely held business interests exceed 35 percent of your adjusted gross estate, the estate may qualify for a deferral. No payment (other than interest) for taxes owed on the value of the business is due until five years after the normal due date. The tax then can be paid over as many as 10 equal annual installments. Thus, a portion of your tax can be deferred for as long as 14 years from the original due date.

If you’re a business owner, you may be able leverage your gift tax exclusions by gifting ownership interests that are eligible for valuation discounts. So, for example, if the discounts total 30 percent, you can gift an ownership interest equal to as much as $18,571 tax-free because the discounted value doesn’t exceed the $13,000 annual exclusion. But the IRS may challenge the value, and an independent and professional appraisal is highly recommended to substantiate it.

Review and update your estate planEstate planning is an ongoing process. You should review your plan regularly to ensure it fits in with any changes in tax law or in your circumstances.

Family changes like marriages, divorces, births, adoptions, disabilities and deaths can all lead to the need for estate plan modifications. Geographic moves also matter. Different states have different estate planning regulations. Any time you move from one state to another, you should review your estate plan. It’s especially important if you’re married and move into or out of a community property state.

Stay mindful of increases in income and net worth. What may have been an appropriate estate plan when your income and net worth were much lower may no longer be effective today. Remember that estate planning is about more than just reducing taxes. It’s about ensuring that your family is provided for and that you leave the legacy you desire.

Exhaust your gift-tax exemptionConsider exhausting your lifetime gift tax exemption. Using all of the $1 million exemption to give away assets now can save you in the long run. That’s because giving away an asset not only removes it from your estate, but also lowers future estate tax by removing future appreciation and any annual earnings.

Assuming modest five-percent after-tax growth, $1 million can easily turn into almost $2.7 million over 20 years. If you gave away the assets during your life, onlytheoriginal$1milliongiftwillbeaddedtoyourestateforestatetaxpurposes—notthelargervaluecreatedbytheappreciationofthegiftedassets.

To maximize tax benefits, choose your gifts wisely. Give property with the greatest potential to appreciate. Don’t give property that has declined in value. Instead, sell the property so you can take the tax loss, and then give the sale proceeds. Be aware that giving assets to children under 24 may have unexpected income tax consequences because of the “kiddie tax.” (See page 26 for more information on the kiddie tax.)


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Whether or not you own a business, there are many reasons to consider a family limited partnership (FLP) or limited liability company, including the ability to consolidate and protect assets, increase investment opportunities and provide business education to your family. Another major benefit of these structures is the potential for valuation discounts when interests are transferred. For example, you can transfer assets, such as rental property or investments, to an FLP, and then gift FLP interests to family members. The valuation discount, combined with careful timing of the gifts, may enable you to transfer substantial value free from gift tax. An FLP can work especially well for transfers of rapidly appreciating property.

But be careful because the IRS is scrutinizing FLPs. The IRS has had some success challenging FLPs in which the donor retains the actual or implied right to enjoy the FLP assets, or when the donor retains the right to manage the FLP. You shouldn’t transfer personal-use assets to an FLP, transfer so much of your assets as to leave insufficient means to pay for living expenses or have unfettered access to FLP assets for your own use. If you wish to create an FLP, you should discuss the risks with Grant Thornton and determine the best way to proceed.

Leverage life insuranceLife insurance can replace income, provide cash to pay estate taxes, offer a way to equalize assets among children active and inactive in a family business, or be a vehicle for passing leveraged funds free of estate tax.

Life insurance proceeds generally aren’t subject to income tax, but if you own the policy, the proceeds will be included in your estate. Ownership is determined by several factors, including who has the right to name the beneficiaries of the proceeds.

To reap maximum tax benefits you generally must sacrifice some control and flexibility as well as some ease and cost of administration. Determining who should own insurance on

your life is a complex task because there are many possible owners, including you or your spouse, your children, your business and an irrevocable life insurance trust (ILIT).

To choose the best owner, consider why you want the insurance — to replace income, to provide liquidity or to transfer wealth to your heirs. You must also consider tax implications, control, flexibility, and ease and cost of administration. You also may want to consider a second-to-die policy. (See Tax planning opportunity 19.)

Trusts offer versatile planning toolsTrusts are often part of an estate plan because they can be versatile and binding. Used correctly, they can provide significant tax savings while preserving some control over what happens to the transferred assets. There are many different types of trusts you may want to consider:• Marital trust. This trust is created to benefit the surviving

spouse and is often funded with just enough assets to ensure that no estate tax will be due upon the first spouse’s death. The remainder of the estate, which would equal the estate tax exemption amount, is used to fund a credit shelter trust.

• Credit shelter trust. This trust is funded at the first spouse’s death to take advantage of his or her full estate tax exemption. The trust primarily benefits the children, but the surviving spouse can receive income, and perhaps a portion of principal, during the spouse’s lifetime.

• Qualified domestic trust (QDOT). This marital trust can allow you and your non-U.S.-citizen spouse to take advantage of the unlimited marital deduction.

• Qualified terminable interest property (QTIP) trust. This type of trust passes trust income to your spouse for life with the remainder of the trust assets passing as you’ve designated. A QTIP trust gives you (not your surviving spouse) control over the final disposition of your property and is often used to protect the interests of children from a previous marriage.

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• Irrevocable life insurance trust (ILIT). The ILIT owns one or more insurance policies on your life, and it manages and distributes policy proceeds according to your wishes. An ILIT keeps insurance proceeds, which would otherwise be subject to estate tax, out of your estate (and possibly your spouse’s). You aren’t allowed to retain any powers over the policy, such as the right to change the beneficiary. The trust can be designed so that it can make a loan to your estate or buy assets from your estate for liquidity needs, such as paying estate tax.

• Crummey trust. This trust allows you to enjoy both the control of a trust that will transfer assets at a later date and the tax-savings of an outright gift. ILITs are often structured as Crummey trusts so annual exclusion gifts can fund the ILIT’s payment of insurance premiums.

• Grantor-retained trusts. Both grantor retained annuity trusts (GRATs) and grantor-retained unitrusts (GRUTs) allow you to give assets to your children today — removing them from your taxable estate at a reduced value for gift tax purposes (provided you survive the trust’s term) — while you receive payments from the trust for a specified

term. At the end of the term, the principal may pass to the beneficiaries or remain in the trust. It’s possible to plan the trust term and payouts to minimize — or even avoid — a taxable gift. (See Tax planning opportunity 20 for more on the benefits of zeroing out a GRAT.)

• Qualified personal residence trust (QPRT). This trust is similar to a GRAT except that instead of holding assets, the trust holds your home — and instead of receiving annuity payments, you enjoy the right to live in your home for a set number of years. At the end of the term, your beneficiaries own the home. You may continue to live there if the trustees or owners agree and you pay fair market rent.

• Dynasty trust. The dynasty trust allows assets to skip several generations of taxation. You can fund the trust either during your lifetime by making gifts or at death in the form of bequests. The trust remains in existence from generation to generation. Because the heirs have restrictions on their access to the trust funds, the trust is excluded from their estates. If any of the heirs have a real need for funds, the trust can make distributions to them. Special planning is required if you live in a state that hasn’t abolished the rule against perpetuities.

Use second-to-die life insurance for extra liquidityBecause a properly structured estate plan can defer all estate taxes on the first spouse’s death, some families find they do not need any life insurance at that point. But significant estate taxes may be due on the second spouse’s death, and a second-to-die policy can be the perfect vehicle for providing cash to pay those taxes.

A second-to-die policy also has other advantages over insurance on a single life: Premiums are typically lower than those on two individual policies, and a second-to-die policy will generally permit an otherwise uninsurable spouse to be covered. Work with a Grant Thornton estate planner to determine whether a second-to-die policy should be part of your planning strategy.

Zero out your GRAT to save moreGrantor retained annuity trusts (GRATs) allow you to remove assets from your taxable estate at a reduced value for gift tax purposes while you receive payments from the trust. The income you receive from the trust is an annuity based on the assets’ value on the date the trust is formed. At the end of the term, the principal may pass to the beneficiaries.

It’s possible to plan the trust term and payouts to avoid a taxable gift by zeroing out the GRAT. A GRAT is “zeroed out” when it is structured so the value of the remainder interest at the time the GRAT is created is at or just above zero. So, the remainder’s value for gift tax purposes is zero or close to zero.


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