Trust and estate planners are still catching their breath from the 2020 year-end and dealing with the wave of gifting transactions that many clients completed.  It seems the ink is not dry on those December transactions and we have to pivot and focus on getting gift tax returns completed.

The 2020 year-end was extremely busy due to a concern that there may be a change in the federal gift and estate tax exemption amount.  The federal exemption amount in 2021 is $11.7 million per person (for US persons), and a married couple has $23.4 million of combined exemption.  Under current law, the exemption amount returns to $5 million per person (adjusted for inflation) in 2026.  There is a concern that the Biden administration and Congress may pass legislation lowering the exemption amount earlier than 2026, and also could make changes retroactive to the beginning of this year.  In such an event, a person who made a $10 million gift in February, 2021 thinking that it was entirely within his or her gift tax exemption could turn out to have a made a taxable gift that exceeds the reduced exemption amount.

What should clients do in 2021?  Does the concern about retroactive changes to the gift and estate tax exemption amount mean that clients should do nothing or wait and see?  We think the answer to that question is no.

For a client whose wealth profile indicates for gifting, it is still good tax planning to undertake a gifting transaction.  The “use it or lose it” concept – that is, the idea that it is better to make substantial gifts that use one or both spouses’ $11.7 million exemption while it is available – continues to apply.  For example, if the federal government passes tax legislation that reduces the exemption amount and is effective when enacted or a later effective date (a scenario perhaps much more likely than retroactivity), a client who took advantage of the more generous exemption amount in 2021 should be well served.

In addition, a client can make a gift in one of several ways that will take into account a possible change in the law to reduce the exemption amount.  For example, a client may incorporate a “defined value” provision in the gift that would adjust the amount gifted to the client’s remaining exemption amount, thus protecting for this possibility.

Gifts are usually structured as gifts to trusts, which have many benefits for clients, including control, investment flexibility, asset protection, long-term family wealth planning and more.  This type of planning continues to be important in 2021.

To revitalize a state suffering from the economic and personal hardships wrought by the COVID pandemic, New Jersey Governor Murphy signed into law on Jan. 7, 2021, the New Jersey Economic Recovery Act of 2020.  The Act adopts a series of incentives to both encourage businesses to settle in New Jersey and prevent Garden State businesses from fleeing to greener pastures elsewhere.  Many of these programs will be administered by the New Jersey Economic Development Authority (“Authority”).

The new Emerge Program provides tax credits to encourage economic development, job creation and the retention of significant numbers of jobs in imminent danger of leaving the state. The program will target businesses that build, acquire or lease space in the state with plans to create or retain full-time jobs.

Eligibility is subject to a requirement that the award of tax credits, the resulting capital investment and the resulting job creation or retention will yield a net positive benefit to the state ranging from at least 200 to 400 percent, depending on the location of the requested credit amount.  The Emerge Program has minimum requirements for the necessary capital investment based on the type of project, the size of the business and the types of jobs at stake.

For start-ups, the New Jersey Innovation Evergreen Fund is created to combine state funds with private capital to support innovative new businesses. The Fund will be capitalized by auctioning up to $300 million in tax credits.  The cash will be invested in qualified venture firms for the purposes of investing in qualified businesses in New Jersey.  A qualified venture firm must invest in an early-stage or emerging growth company in exchange for an equity stake in the business.  The Authority will certify whether a firm meets such criteria and require the firm to make a matching contribution from its own funds to invest in a qualified company.

The Fund may generally invest no more than $5 million in an initial investment in a qualified venture firm that will invest in a qualified company.  A qualified company must have its principal business operations in New Jersey and intend to maintain its principal business operations in the state after receiving the investment.  The company must be in a targeted industry (such as high-tech companies) and employ fewer than 250 people at the time of the investment.

The Main Street Recovery Finance Program will provide a direct $50 million appropriation for grants, loans, loan guarantees, and technical assistance to small and micro businesses.

New Jersey also adopted its first historic property tax credit, which acts as a subsidy to cover part of the cost of rehabilitating historic properties.  These properties must be listed in the New Jersey Register of Historic Places.  Many of these properties are in New Jersey’s oldest and most distressed neighborhoods.  The new Brownfields Redevelopment Incentive Program provides tax credits to compensate developers of projects located on brownfield sites for remediation costs, which are also often in economically distressed communities.

The innovative Food Desert Relief Act provides tax credits (and in some cases, grants or loans) to incentivize businesses to establish and retain supermarkets and grocery stores in communities lacking adequate services, which are referred to as food deserts.   Bodegas, corner stores, and mid-sized retailers will be given a chance to stay afloat and expand into healthier food options.

There are numerous additional incentives in the more than 200-page Act covering a diverse set of areas (e.g., tax credits for films and offshore wind facilities).  The procedures for applying for and obtaining benefits under all these new incentives needs to be adopted by the Authority.  While these procedures may be complex to ensure the intended benefits achieve their goal, the good news is the Act will create a massive infusion of state funds to assist business and communities in a time when other sources of funding may be limited.

 


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.

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.