TAXING MATTERS
Volume 1, Issue 3 :: Autumn 2006
REMINDER:
REMEMBER TO ORDER YOUR W-2 AND 1099 FORMS SOON!!
New Rules on Company-owned Life insurance
Numerous tax law changes were made in the recently enacted Pension Protection Act. Among these is a significant change in the rules concerning life insurance owned by a company on the life of an employee.
Congress responded to the unseemly scenarios in which huge retailing chains were investing in life insurance on non-key employees, such as janitors and stockers, and making tax-free money on their deaths. In order to counter this disturbing trend, the new law provides that: (1) only highly compensated employees are eligible for coverage; and (2) the insured must consent to the coverage.
If these two requirements are not met, then any life insurance proceeds collected would be partly taxable. (Anything above and beyond the premiums and other amounts paid to the insurance company would be subject to income tax.)
Compliance: The Price of Exempting Life Insurance from Tax.
Unfortunately, compliance with these new rules means that an employer must carefully document its actions. The employer and employee must undergo a formal notice and consent process.
To be specific, the employee must receive from the Company written notice of the policy, the maximum possible face amount, and that the employer will be the beneficiary of the policy.
Then, the employee must give the employer written consent to being insured.
Only eligible employees may be insured. This means that the insured must be: (1) an employee at the time the policy is issued; (2) either a member of the Company Board of Directors or a person who is among the highest paid 35% of all employees.
If these requirements are not met, then the policy proceeds would be taxable.
Effective Date.
The new rules apply to policies issued after August 17, 2006 (the date that President Bush signed the new law into effect.) Policies issued on or before that date are grandfathered in under the old rules and are not subject to income tax.
The alternative minimum tax, however, would still continue to apply to life insurance proceeds collected by a C corporation, even if the policy proceeds are otherwise exempt from regular income tax.
Other Exceptions to the New Rules.
There are two additional exceptions to the rules that would allow a Company to avoid paying income tax on part of the death benefit of a life insurance policy.
If the Company meets the notice and consent requirements but not the highly compensated employee threshhold, then the Company can still avoid income tax if the death benefit is: (1) paid to a member of the deceased employee’s immediate family, the insured’s estate, or a beneficiary designated by the employee; or (2) used to buy out an equity interest (such as shares of Company stock) held by the insured employee by using the proceeds to pay a family member, beneficiary, or the estate of the insured employee.
Companies that purchase new insurance coverage on employees after the effective date should comply with these new rules to avoid tax on life insurance proceeds.
More On Tax free exchanges with real estate
There are a number of twists to the concept of a tax-free exchange that are not widely known. What follows is an outline of some of these interesting techniques:
A Section 1031 exchange does not have to be simultaneous. You have up to 45 days to identify a replace- ment property and 180 days to close on that property. However, you cannot receive or escrow the proceeds from the property you sell. In general, you would need a “Qualified Intermediary” to hold the funds that will be reinvested in the replacement property. Having your attorney or closing agent hold the money won’t work either.
You can exchange real estate with a related party and qualify the transaction as tax free. However, the related party must hold the property for at least two years. If the exchanged real estate is sold within two years, then gain is triggered on the original exchange.
You cannot defer a taxable gain on U.S. real estate by exchanging it for foreign real estate. Doing so would conceivably allow the gain to escape U.S. taxation permanently.
Equipment and vehicles can also qualify for a like kind exchange. However, the rules in that area are more onerous than with real estate. For example, although you might be able to exchange an airplane for an airplane, it is unlikely that exchanging a single engine plane for a double engine plane would be considered like kind.
If you receive cash or other property out of a real estate exchange, that is likely to be considered taxable. The purpose of the like kind exchange rules is to prevent tax when the taxpayer simply “swaps” property and has no cash to pay the tax. If you get cash out of the deal, the IRS will subject it to tax.
Also, you typically cannot get around this rule by having the buyer pay down your mortgage indebtedness. That is treated the same as cash. However, if buyer and seller assume equal mortgages, that will not cause gain recognition.
Charitable Contribution Rules Tougher
The new Pension Protection Act has toughened the rules on deducting charitable contributions.
For contributions of cash or property made after August 17, 2006, the donor must retain any of the following types of documentation in order to deduct the amount given: 1. bank records; or 2. a receipt, letter, or other written communication from the charitable organization showing the name of the organization and the date and amount of the contribution.
If the above records are not kept, then no deduction is allowed.
In another development, a charitable rollover of up to $100,000 per year from a traditional or Roth IRA is allowed for 2006 and 2007 for a person who is at least 70 and ½ years of age. This means that no income has to be reported; however, no deduction is allowed either.
Spotlight on Commercial Real Estate
Starting November 1, 2006, every commercial real estate transaction will be under new federal regulations that establish environmental due diligence standards.
If a buyer does not comply with the regulations, there is potential liability under the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”).
The new CERCLA regulations provide that a Phase I Environmental Site Assessment is now a mandatory part of a commercial real estate purchase. If a buyer does not obtain a Phase I report, then that person risks CERCLA liability.
The new rules also require a much more comprehensive investigation than the previous Phase I standards. Buyers would be well advised to ensure that they retain a “Qualified Environmental Professional” who is well aware of these new standards.
Naturally, it is anticipated that the cost of a Phase I investigation will increase in accordance with the mandated greater scope of the inquiries.
Therefore, developers should budget for the increased cost of such a study.
Failure to comply with the new rules means the loss of statutory defenses to CERCLA liability, including bona fide prospective purchasers, innocent landowners, and contiguous property owners. In essence, Phase I now becomes Step I when buying a commercial property.
Inherited Retirement Plans
Under current tax law, only the surviving spouse can roll over the retirement plan of a deceased person into an IRA.
Thanks to the Pension Protection Act, nonspouse beneficiaries may treat an inherited IRA as a surviving spouse’s IRA and take advantage of a tax-free rollover after December 31, 2006.
To do so, the beneficiary must make a direct trusteee-to-trustee transfer of an inherited IRA, and then take distributions from it according to minimum distribution rules.
This rollover can be done with a Section 401(k) plan or other company-sponsored plan, such as a profit-sharing plan or retirement plan.
The benefit of doing such a rollover is that, when a parent dies, a child named as the beneficiary can postpone income taxes on the rollover amount over his/her lifetime.
The principal downside to a rollover is that estate taxes may be due on the inherited retirement plan, and the money to pay the estate taxes must come from somewhere else, such as life insurance. Otherwise, the tax deferral would be lost.
Inside Corner: Focus on L&G Staff
Here are some updates on what some of our staff are doing:
In all of last issue’s wedding news, we forgot to mention another L&G newlywed – Dustin Zabrocki! Dustin married Kimberly Morris on December 10, 2005 at First United Methodist Church in Lawrenceville. Kimberly is a ballet and jazz instructor in Cumming, Georgia.
A big event at L&G this fall was the Annual Surety Seminar held on September 22 at the Westin Atlanta North. The keynote speaker was Sam Olens, Chairman of Atlanta Regional Commission and Cobb County Board of Commissioners. Mr. Olens gave an informative overview about growth and transportation in the Atlanta area. L&G’s Tom Savage, Rhonda Gilbert, Gary Fortier and Joe Skalski also gave brief presentations.
Finally, the firm celebrated its annual company picnic in September. The festivities included a rock-climbing wall, a spider jump, and a wax hands stand. A Mexican buffet was followed by a visit from the ice cream man! L&G staff and their families enjoyed the opportunity to relax and have one last go at “fun in the sun.”
Frequently Asked Questions
Q1: I wish to sell some appreciated farm land I own, and I’m interested in deferring taxes on the gain. However, I need cash flow and don’t want to just buy more real estate. What should I do?
A1: You could consider doing a 1031 exchange of the farmland for income-producing (rental) property. If you also want to avoid the headaches from managing a rental property, you could consider exchanging the farmland for an interest as a tenant-in-common (TIC) in a shopping center that pays suitable cash flow to the co-owners. Or you could defer gain by taking back a mortgage and financing the buyer.
Q2: Our company recently did a 1035 exchange on policies that fund a key man life insurance policy. Would we then come under the new rules on company-owned life insurance?
A2: Probably not. Section 1035 exchanges are grandfathered into the old rules. However, if you increase the face amount of the policy, then you would come under the new rules.
Q3: Do the new, tougher charitable contribution documentation rules apply only to contributions of more than $250?
A3: No. The new law applies to all charitable contributions, regardless of the amount.
Q4: Any further update on estate tax relief?
A4: Congress recessed on Sept. 29, 2006 without addressing estate taxes. Congress returns for a lame-duck session on November 14. It is possible that estate
tax relief will be considered at that time. However, it is unlikely that anything will happen before 2007. We’ll of course be keeping an eye out on any new legislative developments.
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