The 2017 Tax Act made life harder on individuals living in high tax states (such as New York, New Jersey, and California) by limiting the deduction for state and local taxes (“SALT”) to $10,000.  In an attempt to circumvent this restriction, several states have adopted a new pass-through entity tax imposed on partnerships, LLCs, and S Corps, which is deductible in computing the entity’s taxable income passed through to its partners or shareholders.  The state then allows those partners or shareholders to get a credit for all or a portion of their share of this new tax against their own personal state tax liability.

With the holiday season approaching, the IRS gave affected taxpayers a gift by announcing they will issue proposed regulations allowing the pass-through entity to fully deduct this new tax even though it may be viewed as a surrogate for an impermissible SALT deduction of its owners.  Notice 2020-75.  This approach, however, offers no assistance to wage earners or self-employed individuals who pay state tax and remain subject to the SALT deduction limitation.  It also offers no assistance to business being conducted through a single member LLC.

New Jersey, Connecticut and five other states have adopted this entity tax.   In Connecticut, this tax is mandatory whereas in New Jersey and five other states (Louisiana, Maryland, Oklahoma, Rhode Island, and Wisconsin), the tax is elective, so an entity has the choice to apply it or not.  Elective treatment is beneficial since this new tax may not work to the benefit of all partners.  Without a pass-through entity tax, depending on income sourcing and nexus of the entity, non-resident partners may be able to pay less state tax on the flow through income if they live in a low or no income tax jurisdictions.  On the other hand, with the pass through entity tax election, those same non-resident partners may be unwittingly subsidizing their resident partners personal state income tax.  Each entity should model out the impact on all its partners to determine if it should elect to be subject to this new tax.

New Jersey’s pass-through entity tax is imposed at graduated rates that range from 5.675% to 10.9%, which is slightly higher than the maximum individual income tax rate of 10.75%.  Single member LLCs and sole proprietorships cannot, however, elect to pay the pass-through entity tax.

To illustrate, a New Jersey partnership has five individual partners (each having a 20% interest) and $5M of NJ taxable income.  Without this new tax, each partner has $1M of taxable income and NJ tax paid by the partner is non-deductible due to the SALT limitation.

If the partnership elects, the partnership pays $427,887.50 of this new tax, which is deductible, so the partnership only reports $4,572,112.50 of taxable income ($5M minus $427,887.50).  Each partner includes 20% of $4,572,112.50 taxable income on its tax return, which is $914,422.50, rather than $1M.  Taking into account the maximum 37% federal tax rate, this strategy can reduce the individual’s federal taxes by $31,664.  While each partner is subject to NJ tax on this income, NJ gives the partner a tax credit for 20% of the LLC’s state tax payment of $427,887.50 or $85,577.50, which can eliminate or significantly reduce added NJ tax.

Planning Tip:  Individuals using single member LLCs to conduct business could admit a second member, which makes the LLC into a tax partnership that can take advantage of this new tax.  The second member can have a small interest in the LLC (1%) so the individual still retains control and most of the cash flow from the business.  Alternatively, the individual can incorporate his or her business and elect to treat it as an S Corporation, which can also take advantage of this new tax.

Other states may look to follow the lead of these pioneering states and adopt their own pass-through entity tax.   The good news is there is now an avenue for some taxpayers to reclaim the SALT deduction through this new entity level tax.  Like many other tax changes, its use will not be simple, and it may not work to the benefit of all partners.  Any entity that has a choice to elect or not elect needs to now “crunch the numbers” to see if the new law makes sense for it and its owners.

New Jersey Governor Phil Murphy and State Democratic leaders announced yesterday a revised fiscal year 2021 budget that raises the State’s gross income tax rate on income for families now earning between $1 million and $5 million.

Currently, the State’s top tax rate for income earned in excess of $1 million through $5 million pay 8.97%.  Only when income exceeds $5 million does the marginal tax rate increase to 10.75%.

The Governor’s revised budget now increases the tax rate on income over $1 million to 10.75%, making it equal to the current rate paid on income over $5 million. The tax increase is part of a plan to redistribute funds to New Jersey families hard hit by the coronavirus pandemic by issuing $500 rebates to families who have a single-parent income of less than $75,000 or two-parent household income of less than $150,000.

Both the tax increase and rebate proposals have not yet passed the Legislature, but are likely to prevail given support from Democratic leadership and the fact that the Democrats hold solid majorities in both chambers.  There is also the possibility that the tax may be retroactive to January 1, 2020.

The increased tax rates, which now edge closer to New York City rates, may push families earning in excess of $1 million out of New Jersey to lower tax jurisdictions such as Florida and Texas.

With the growing and widespread use of technology and mobile work spaces as a result of the pandemic, high earners who have not been working in traditional office spaces for the past six months may flee New Jersey to avoid paying more taxes.

Alternatively, there may be planning opportunities for taxpayers that maintain separate residences in a high and low or no tax jurisdiction such as New Jersey and Florida and may consider changing domicile and the number of days in and out of each respective state to achieve considerable tax savings.

On June 10, 2020, in Nelson v. Commissioner, T.C. Memo 2020-81, the Tax Court ruled in favor of the IRS and against a taxpayer who attempted to use a defined value provision to value a transfer of assets.

The taxpayer’s primary business was in heavy equipment relating to the oil and gas industry.  The taxpayer created a new holding company for the business equity, and transferred interests in the holding company to a trust in a gift and sale transaction.  The taxpayer used a defined value provision in valuing the gift and sale, but the defined value provision referred to an amount determined by an appraiser within 90 days or 180 days of the transfer.

The Tax Court, distinguishing the instant case from Wandry v. Commissioner, T.C. Memo 2012-88, 2012 WL 998483, determined that the value of the gift and sale would be determined by a condition subsequent (ie, the valuation by a qualified appraiser).  If the taxpayer had instead included the language “as finally determined for gift tax purposes” to define the amount transferred, and removed the specific dollar amount, the outcome likely would have been different.

The Tax Court has traditionally struck down defined value provisions that are based on a condition subsequent (ie, undue a portion of the gift based on a subsequent revaluation (see Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944)), but permitted such clauses that resulted in an adjustment to the percentage of interest that is transferred based on a later revaluation (see Wandry).  While the result in the Nelson case was a blow to the taxpayer, the court indirectly ratified the defined value provision that had been approved in Wandry.  In addition, the court permitted multiple, layered discounts for gift tax purposes which totaled approximately sixty (60%) percent.

The case is a lesson in using defined value provisions that have been approved in prior cases.

As an estate and trust attorney who has been practicing for over 20 years, I never lose sight of the difficulty we all face when losing a loved one.  Often when I meet a client, sometimes for the very first time, the initial words out of my mouth are  “I am so very truly sorry for your loss.”   I often enter someone’s life while they are grappling with everything from grief, to making funeral arrangements, accessing accounts, paying bills, to answering the overarching question of “what do I do now.” The process is overwhelming and daunting, especially during such a vulnerable and confusing time in someone’s life.  As an older sister, a yoga teacher and as a human being, I have this innate desire to help and to guide those who need it most. So being in the position that I am in, I wanted to share my thoughts on where to start.

After losing a loved one, your focus is and should be on your family and on grieving the loss —not administering an estate.  It is natural  for one to feel overcome with emotions, responsibilities and never-ending to do lists. There will be what seems like an endless barrage of questions – from “where do I even begin” to “how can I ensure that my loved one’s final wishes are respected?”  What seems like a million issues will come up and with no guidance, these issues can very quickly become incredibly overwhelming.

What I have seen over the years is that people generally fall into one of two modes: (1) the “what do I need to do and how quickly can I get it done mode” or (2) the “sweep it under a rug and deal with it later mode.”  While neither of these approaches are ideal, they are very natural responses. Because we will all have to go through the unfortunate and tragic loss of a loved one, I wanted to share a list of 10 things to consider during this difficult time (this is not an all-inclusive list):

  1. First and foremost, take care of yourself and your family.
  2. Do not make any hasty decisions or major changes immediately.
  3. Know that if you held a power of attorney while your loved one was alive; this document is no longer valid after death. The only person permitted to act on behalf of an estate following a death is the personal representative or executor appointed by the court.
  4. Determine if a Will exists.  When it is appropriate, the family should search for an original Will.  Keep in mind that a Will may not be acted upon until the court admits the Will to probate.  Do not assume that just because your loved one may not have had a lot of assets when they died that they do not need to probate the Will or have someone appointed if there is no Will.
  5. Address whether you need to contact the Social Security Office and inquire about lump sum benefits or monthly benefits.
  6. Familiarize yourself with what assets your loved one owned, how were they titled, how to locate and value them.
  7. You will want to know about your loved one’s debts, particularly in what amounts and to whom they are owed.
  8. Be prepared to deal with banks, credit card companies, and any automatic payment plans.
  9. Make sure all appropriate creditors are paid first prior to making distribution to any beneficiaries. It is normal to need advice on how this is handled.  Many families have questions, especially if there are insufficient assets in the estate to satisfy all the debts or tax obligations.
  10. Ensure you are aware of any upcoming estate/inheritance or income tax filing deadlines.

As you are trying to grieve the loss of your loved one, there are so many issues that need to be addressed, questions that will pop up and things that you may not even be able to imagine which go beyond the scope of this short article.  In addition to needing help and comfort from your friends and family, know that in all likelihood, you will need help to address the maze of financial and legal issues that are sure to arise and know that it is alright.  Seeking help sooner rather than later can often alleviate the stress and burden that you will experience.

Everyone’s circumstances are different and knowing where to start is just the beginning.  My hope is that this article guides you in the right direction.

 


The information in this presentation is general in nature and is purely for informational purposes and does not constitute legal advice, nor does it create an attorney-client relationship. You should accept legal advice only from a licensed legal professional with whom you have an attorney-client relationship.

The IRS recently issued Notice 2020-39, which offers relief to both qualified opportunity zone funds (“QOFs”) and persons seeking to invest in QOFs who are affected by the global COVID-19 pandemic.

Investors in QOFs who want to defer capital gains and receive other QOF tax benefits are required to invest in a QOF within 180 days of the date of the sale that generated the gain or a later date applicable to partners, S Corporation shareholders or certain other special situations.  The Notice provides that if a taxpayer’s 180th day to invest in a QOF would have fallen on or after April 1, 2020 and before December 31, 2020, the taxpayer has until December 31, 2020 to invest that gain into a QOF.  Investors still need to make a valid deferral election and file Forms 8949 and 8997 with their tax return to obtain deferral.

QOFs are subject to other time sensitive deadlines.  QOFs who purchase real property are required to substantially improve the property within 30 months.  The Notice provides that the period between April 1, 2020 and December 31, 2020 is suspended for purposes of the 30-month period during which property must be substantially improved.

QOFs are required to hold 90% or more of their assets in eligible QOZ property on certain testing dates each year.  The Notice provides that, due to the pandemic, a QOF’s failure to hold less than the 90% of its assets in QOZ property on any testing dates from April 1, 2020 through Dec. 31, 2020 is due to reasonable cause.  As a result, such failure will not cause loss of QOF status or imposition of penalties.

For QOZ business projects that meet the requirements of the 31-month working capital safe harbor, the Notice states that due to the COVID-19 pandemic, these projects may have up to an additional 24 months in which to spend their working capital.  QOFs must still meet the other requirements for this exception such as having a written schedule of when they expect to invest their working capital.

The Notice offers welcome relief to both investors and funds seeking to comply with the QOF requirements.  Nonetheless, QOFs still need to monitor and comply with these rules especially since prior to the pandemic, QOF investments were coming under greater scrutiny by both the IRS and Congress who wanted to ensure the intended benefits for local communities were being delivered.

 


As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice.  For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.