Author: Haik Chilingaryan

Coronavirus Economic Stimulus Package Highlights

In response to the COVID-19 pandemic, Congress passed a series of legislations including the “Coronavirus Aid, Relief, and Economic Security Act” or the “CARES Act”, which was signed into law by President Trump on March 27, 2020. The CARES Act is designed to provide economic relief for individuals and small businesses who have suffered economic hardships due to the coronavirus pandemic. The $2 trillion CARES package is the largest financial support package in U.S. history.

Overview

This article breaks down the CARES Act (hereinafter, “CARES”) by first analyzing the economic relief provided to individuals followed by small businesses.

The most commonly sought relief under CARES with regard to individuals includes the stimulus checks for people who fall within certain income thresholds, an increase in unemployment benefits, temporary student loan suspensions and modification of retirement plans.

In order to provide economic relief to small businesses, CARES grants the authority to the Small Business Administration (hereinafter, “SBA”) to allocate $377 billion to small businesses that have experienced economic disruptions due to COVID-19 through two loan programs: expansion of the Economic Injury Disaster Loan and creation of the Paycheck Protection Program.

Out of $377 billion amount, $349 billion is allocated to the Paycheck Protection Program. (There are currently discussions on adding $250 billion or more to the Paycheck Protection Program). Small businesses with 500 or less employees including nonprofits (even though small businesses with more than 500 employees may qualify provided that they satisfy the definition of a “small business concern” under section 3 of the Small Business Act, 15 U.S.C. 632), sole proprietors, and independent contractors are all potentially eligible for the Paycheck Protection Program loan.

Other forms of economic relief in response to the coronavirus pandemic include providing potential tax relief to employers affected by COVID-9 and temporary changes in net operating losses.

Economic Relief for Individuals

In a time of an economic crisis, payment of income taxes would most likely cause an additional burden for many people. From all apparent indication, this is why the filing of personal tax returns for the 2019 tax year has been extended to July 15, 2020. The same also holds true for California’s tax returns since the filing of California’s tax returns has also extended by the Franchise Tax Board. However, the taxpayer can still file on or before the April 15, 2020 deadline.

The July 15 extension is automatic as opposed to the filing of Form 4868 which otherwise would have been required but for these extraordinary circumstances. Note that the estimated taxes will not be extended as of now with the exception of Q1. Interestingly, Q2’s estimated taxes can potentially be paid before Q1 if the taxpayer exercises the option of extending Q1’s returns since Q2 traditionally falls on June 15, whereas Q1’s estimated taxes have been extended to July 15.

One of the biggest forms of economic relief provided to individual taxpayers are the stimulus checks. Assuming the taxpayer qualifies, the minimum amount of the stimulus check will be $1,200. Even though the taxpayer will receive capital based on the amount of the qualification, if any, the distribution will be characterized as a tax credit that will be applied towards the 2020 tax year.

If an individual’s Adjusted Gross Income (hereinafter, “AGI”) is under $75,000; married couple’s under $150,000; and head of household’s under $125,000, then they will all qualify for the full benefit based on their filing statuses. The amount of the benefit will be $1,200 for an individual and head of household, $2,400 for a married couple filings their taxes jointly, and an additional $500 for every child who is claimed as a dependent.

There is a $50 phase out for every $1,000 of AGI above their respective income thresholds. Thus, if Amy is single and she makes $125,000, the calculation will be as follows: $50 multiplied by 50 (representing the difference between $125,000 and $75,000), or $1,200. Therefore, if $1,200 (amount of the benefit) is subtracted from $1,200 (amount of the rebate phase out), Amy will not receive a check since her total amount of the benefit would amount to zero (0).

The increase in unemployment insurance is also another relief provided to individuals in response to COVID-19. Those who were receiving unemployment insurance or recently filed for unemployment are now eligible for a $600 per week increase in their unemployment benefits. The $600 increase will not affect the unemployment benefits that were already being received at the state level. Note that those who have been partially unemployed due to the diagnosis of COVID-19 may also potentially qualify for unemployment benefits. Self-employed individuals and independent contractors are also eligible for unemployment benefits.

Other highlights for individuals include temporary suspension of student loans and RMDs. Student loan payments have been suspended until September 30, 2020 with no accrual on interest.  Required Minimum Distributions have also been suspended for 2020. In addition, each person under a qualified plan may withdraw up to $100,000 without facing 10% early withdrawal penalty or having 20% automatic withholdings.

Economic Relief for Small Businesses

Some of the main vehicles designed to provide economic relief under CARES to small businesses include the SBA loans: Economic Injury Disaster Loan and Paycheck Protection Program Loan. Other forms of relief include the Employee Retention Credit and payroll tax deferment until 2021. Note that if a business takes a loan under the Paycheck Protection Program, it will not be eligible for the Employee Retention Credit or the payroll tax deferment.

The Economic Injury Disaster Loan, or EID has been available during many disasters in the past such as Hurricane Harvey. It was recently expanded by the SBA in response to the COVID-19 epidemic. The EID is designed to provide working capital loans to small businesses that are subject to federally designated disaster areas, which in the case of COVID-19 is the entire United States as of March 13, 2020. The Paycheck Protection Program, or PPP, which was also created by the SBA under the authority of CARES, is specifically tailored in response to COVID-19.

The EID loan is entirely funded through the SBA. It consists of an advance of $10,000 and a loan of up to $2 million at a 3.75% interest rate with a maturity period of 30 years. The $10,000 advance will be classified as a grant and no income will be recognized nor will that amount be required to be paid back to the SBA. The EID is a nonrecourse loan, meaning no personal guarantee will be mandated, and no collateral on the loan will be required so long as the loan amount does not exceed $200,000. The loan payments can be deferred for from six months up to one year even though interest will continue to accrue during the deferral period. 

The EID aims to provide for the sick leave of employees who are unable to work because of the coronavirus; for employers to maintain payroll during periods of business disruptions; and other expenses such as satisfying financial obligations that include rent or mortgage that cannot be satisfied due to loss in business revenue.

Nothing prevents the borrower from applying for both the EID loan and the Paycheck Protection Program loan. If the borrower already applied for the EID loan before April 3, 2020, she can refinance the EID loan under the Paycheck Protection Program loan at a much more favorable interest rate, but at a much shorter maturity period. Even though the borrower is not required to return the $10,000 advance under the EID loan, the total amount of the PPP loan may nevertheless be reduced by $10,000.  

The Paycheck Protection Program, or PPP, is guaranteed by the SBA, but it is not funded by the SBA unlike the EID loan. It is funded by private enterprises such as existing SBA lenders and federally insured depository institutions like banks. Unlike the EID loans which are processed by the SBA, PPP loans have to be approved by the private entities that are enrolled in this SBA program.

The PPP has similar intentions as the EID, but it is arguably broader and more restrictive than the EID. PPP’s aim is to provide various incentives to employers so they can maintain payroll during the COVID-19 pandemic and cover basic expenses. The means for reaching that aim is to provide funding to the employer for covered expenses that includes employee salaries, rent, utilities, costs related to insurance premiums, interest on debt that was incurred before February 15, 2020, and continuation of group healthcare benefits during periods of paid sick, medical, or family leave.

The borrower of a PPP loan can borrow up to $10 million at a 1% interest rate with a maturity period of two years (note that the SBA guidelines state that the maturity period can be as much as ten years). The initial payment for the loan can be deferred for six months, but the interest on the loan will accrue during the deferral period. Similar to the EID, no collateral, personal guarantees or borrower or lender fees payable to the SBA such as closing costs will be mandated for the PPP loan.

The distinguishing characteristic of a PPP loan is the potential forgiveness of the entire loan amount if the employers meet the covered expenses requirement and maintain the salary levels of their employees.

To calculate the loan amount, the borrower will use the average of the payroll expenses for the last one year before the loan is made increased by a factor of 2.5. For example, if the borrower’s monthly payroll expenses are $10,000, he will be entitled to receive $25,000 under the loan, which is 2 ½ times his monthly payroll expenses. Payroll expenses covered under PPP per SBA’s guidelines include not only salaries, wages, and commissions, but also group healthcare and retirement benefits, vacation payments and sick leave.

Note that there are salary limitations with respect to the calculation of payroll expenses. The maximum amount of the employee’s wages the employer is entitled to include in the final calculation of the total loan amount is $100,000 per annum. As such, if Avo, who may be one of the borrower’s employees or the borrower himself, makes $120,000 a year or $10,000 per month, Avo will only be entitled to $8,333 per month instead of his full $10,000 monthly salary.

The full loan amount or a portion thereof may be forgiven if the funds are spent on covered expenses for the first eight-week period from the date of the loan disbursement and if no more than 25% of the forgiven amount is used for non-payroll expenses. In other words, 75% of the loan amount must be allocated towards payroll expenses within the meaning of the SBA’s guidelines. For tax purposes, the forgiven portion will be classified as a grant and it will not count as income on the borrower’s tax returns as earned income or forgiveness of debt.

To illustrate the loan forgiveness requirements, suppose that Avo’s loan amount is $25,000. He ends up using $20,000 for the first eight weeks from the date of the loan disbursement on covered expenses. The remaining $5,000 will not be forgiven, but nothing prevents Avo from closing out the loan before interest kicks in since there are no prepayment penalties or fees. However, Avo could not have used more than 25% of the $20,000 forgiven amount, which in this case is $5,000, on non-payroll expenses such as rent and utilities.

Even if the forgiveness requirements are met, the portion of the forgiveness amount may nevertheless be reduced if the business has less employees during the eight-week period after the loan is issued compared to the prior period. However, if the business rehires those employees that were let go within a 30-day period after firing them, the business will be exempt from this rule. There are two formulas used to determine the reduction amount of the forgiveness portion of the loan and the borrower has the luxury of applying the formula that is more favorable to him.

The first formula (“Formula 1”) factors in the average full-time employees the borrower had on a monthly basis between February 15, 2019 and June 30, 2019. The second formula (“Formula 2”) factors in the average full-time employees the borrower had on a monthly basis between January 1, 2020 and February 29, 2020.

Let’s assume that Avo’s potential forgivable loan amount is $20,000 and that he had 20 employees during the time period specified under Formula 1 and 18 employees during the covered period. Formula 1 is calculated as follows: $20,000 x (18/20) or 0.9, which equals $18,000. Therefore, the forgiven portion of Avo’s loan amount would be $18,000 under Formula 1.

Let’s assume that Avo’s potential forgivable loan amount is still $20,000, but he had 18 employees during the time period specified under Formula 2 and 18 employees during the covered period. Formula 2 is calculated as follows: $20,000 x (18/18 ) or 1, which equals $20,000. Therefore, Avo could apply the more favorable Formula 2 and the forgiven portion of his loan would be the full $20,000.

The forgiveness amount, which in the example above may be as much as $20,000, may also be reduced if the employee’s salary is reduced by more than 25% compared to the previous quarter. However, if the reduction is reversed within 30 days, this rule will not apply.

For business owners who do not participate in either of the loan programs (EID and/or PPP), they can utilize the Employee Retention Credit, which in effect is a credit against payroll taxes for the employer; calculated by 50% of the qualified wages of the employee(s) capped at $10,000 per employee with a maximum tax credit of $5,000 per employee.

Another option is to defer the payroll taxes for the 2020 tax year. For payroll taxes that are due for the 2020 tax year, they can now be paid with the following schedule: 50% have to be paid by December 31, 2021, and the remaining balance by December 31, 2022. However, the taxpayer should consider whether to use a payroll company for the 2021 and 2022 tax years, and instead consider placing the funds into a separate account that is accessible by the business owner, since there is a likelihood that the payroll company may go out of business and the deferred amount may be lost, yet the taxes on them will nevertheless be due.

There are also tax credits available for the employer’s portion of the Federal Insurance Contributions Act (“FICA”) contributions if the employee is required to be quarantined due to the coronavirus or take care of a family member who has coronavirus or a child who is not going to school because of school closing. If the employee is required to miss work because she is infected by the coronavirus, the amount of the eligible tax credit for the employer will be $200 per day for a maximum of 10 days. The amount of the credit is limited by the lesser of wages plus healthcare costs the employer provides or $511 per day. If the employee is required to miss employment due to family leave, the amount of the eligible tax credit for the employer will be $200 per day capped at $10,000.

The FICA refunds may be claimed when filing quarterly returns, which are typically due on April 30th, July 31st, Oct 31st, and January 31st. If the tax credit taken was less than the quarterly taxes that were paid in the previous quarter, the taxpayer would have to wait until the following quarter to apply the credit. For example, if the FICA contribution during the last quarter was $500, but the tax credit for the current quarter is $1,000, the taxpayer would not have the $500 difference returned and would instead apply the credit on the following quarter’s return.

One final development that may be of great importance to business owners pertains to net operating losses. Carryback losses were temporarily brought back ever since they were largely eliminated under the GOP Tax Cuts and Jobs Act. For the 2018, 2019 and 2020 tax years, a business can carryback its net operating losses for 5 years and the 80% threshold will no longer apply. Therefore, a business may carryback its net operating losses for those years on 100% of the taxable income to the preceding five years.

Important Note: This article is published for informational purposes only and it is not meant to provide legal, financial, or tax advice. The law and guidance in this area are changing virtually on a daily basis. The information presented above is our understanding of the three complex sets of legislations passed in response to the coronavirus pandemic including the CARES Act. Please consult with your advisors to determine which of the relief efforts mentioned in the article, if any, are applicable to your circumstances.  

What To Expect From A Revocable Living Trust

Living trusts, otherwise known as inter vivos trusts, are created during the lifetime of the person who created the trust, who is otherwise known as the grantor, trustor, or settlor (hereinafter, “Grantor”).  A Revocable Living Trust (“RLT”) can be established for a specified period of time, upon the occurrence (or nonoccurrence) of a specified event, or until the death of the Grantor.  The three essential parties to an RLT are the Grantor, Trustee, and Beneficiary. 

The Trustee manages the trust assets for the benefit of the Beneficiary.  The Grantor of an RLT retains the absolute right, during his lifetime, to alter the terms of the trust, amend the trust in whole or in part, and revoke the trust in its entirety.  A revocable trust morphs into an irrevocable trust when the Grantor dies, or when the Grantor surrenders title to the property held in the trust during his lifetime and relinquishes the right to alter, amend, revoke, or terminate the trust.

In order to create a legally enforceable RLT, the Grantor must transfer the property to the Trustee, who will hold legal title, manage the property, and distribute the income derived from the trust to the Beneficiary.  There are two categories of beneficiaries.  The income Beneficiary is entitled to receive the income derived from the trust assets for life, fixed period of years, or upon the occurrence (or nonoccurrence) of an event.  The principal (or remainder) Beneficiary is entitled to the trust assets (e.g., condominium).  In an RLT, the same person can be the Grantor, Trustee, and Beneficiary (both principal and income).    

Utility of an RLT

An RLT is utilized for a number of reasons, chief among them is the avoidance of probate.  There are other valid reasons for utilizing an RLT.  If the Grantor wants a third party to manage any of his properties or he wants to ensure that his business interest or personal assets will continue to be managed and income will continue to be derived from his assets even when he becomes disabled or dies, an RLT provides an efficient mechanism to accomplish those objectives.  However, one of the biggest incentives for establishing an RLT is the administrative burden that may ensue upon the Grantor’s death if the Grantor does not have an RLT.

The administrative burden may come about in several forms.  For starters, even if the Grantor has a Will, he may still not have a lot of control in passing his estate to the Beneficiary of his choice if he does not have an RLT.  Additionally, Wills, by law, have to be filed with the court (“probate”), which results in the contents of the Will becoming public record.  This means that not only will there be additional costs and time accrued before the assets are passed to the Beneficiary, but anyone in the public domain can potentially challenge the contents of the Will.  A carefully drafted RLT can prevent the additional costs and time by avoiding probate and lessen the likelihood of a challenge of the trust instrument.

Funding

Funding is an essential step for an RLT to be legally enforceable.  Even though some states permit a nominal amount to meet the funding requirement, it is essential for assets that include real property, securities, and accounts holding liquid assets to be transferred to and held by the RLT in order to avoid probate.  However, title to retirement assets or annuities are not recommended to be held by the RLT since it may result in the recognition of income tax by the Grantor. Personal property, especially valuable assets such as paintings and jewelry, should be assigned to the RLT.

Retirement assets, annuities, life insurance, and other assets that have beneficiary designations should name the RLT as a designated (or contingent) beneficiary since it is desired for those assets to end up in the trust upon the Grantor’s death.  In other words, the trust instrument will govern how and when the distribution will be made to the Beneficiary.  Thus, if the assets end up in the trust as opposed to being transferred directly to the Beneficiary, the transfer can prevent the assets from being squandered or from being required to satisfy debts, judgments, or divorces.  Since the assets will be held in the trust’s name under that scenario and not in the Beneficiary’s name, the exposure of these assets to creditors will be less likely.

Choosing the Trustee

Most jurisdictions, including California, have adopted the Uniform Probate Code (“UPC”), which includes the baseline and the more heightened standards for duties imposed on Trustees.  The Prudent Investor Rule, which is the baseline rule, states that a trustee will be liable to a beneficiary for losses if she does not exercise the same care and skill that a person of ordinary prudence would exercise in dealing with her own property.  The more heightened standard under the UPC states that if a person possesses greater skill than that of ordinary prudence (e.g., investment management), she is under a duty to exercise such skill.

The Trustee will be required to periodically analyze the trust, interpret its provisions, and make difficult decisions. Thus, the Trustee must possess some basic legal, financial, and accounting knowledge in order to make the best decisions in the Beneficiary’s interest.  Hence, the standards imposed by the UPC are meant to protect the Beneficiary as well as give guidance to the Trustee on what is expected of her in managing a trust.

An issue that may arise in the selection of a trustee is whether someone who has close ties to the Grantor should be selected as the Trustee.  The advantage for picking such an individual is that she may have direct knowledge of the family dynamics.  The disadvantages, however, tend to outweigh the advantages for several key reasons as discussed below. 

The issues that may arise in picking someone close to the Grantor as a trustee is whether she will be faced with a conflict especially if she is also a beneficiary; whether she will be biased towards one family member over another; and whether she will possess the requisite legal, business, and accounting knowledge to make informed decisions even when she is relying on advice from experts, since identifying whether such advice is accurate is also a critical factor in the decision making process.    

What Not to Expect from a RLT

A common misconception is that an RLT is an asset protection tool.  It is not.  The Grantor of an RLT has the ultimate right to amend and revoke the RLT.  For income tax purposes, all income derived from the RLT is taxed at the Grantor’s personal income tax return.  As a general rule, asset protection is afforded in circumstances where the nexus between the original owner of the asset and the current owner is de minims.  In the case of an RLT, the trust is merely an extension of the Grantor since the Grantor has the absolute right to deal with those assets in any which way he pleases.  

Revocable to Irrevocable

During the lifetime of the Grantor, the trust may become irrevocable if he surrenders the right to alter or revoke the trust.  The trust may also become irrevocable during incapacity because the Grantor would generally lack the power to revoke the trust in the event of incapacity.  As a result, immediate gift tax implications may be triggered.  However, if the Grantor retains a life income interest in the trust’s assets and reserves a testamentary power of appointment over the remainder interest, the gift tax consequence may be avoided because a person is always presumed to regain competency at any point prior to his death.       

At the time of the Grantor’s death, the trust will become irrevocable, since the Grantor will no longer be alive to amend or revoke the trust.  The assets may pass to the Beneficiary outright or they may remain in the trust for future generations.  When the assets remain in the trust, there may be notable advantages from an asset protection standpoint. 

If the assets do not pass outright to the Beneficiary, the trust will hold title to the assets.  Unlike an RLT where the assets are deemed to be an extension of the Grantor, the assets held for the benefit of the so-called “Trust Fund Baby” will not be considered an extension of the Beneficiary.  Thus, the assets themselves (but not the income that may be distributed to the Beneficiary that is generated from the underlying asset) will generally be out of a creditor’s reach. 

Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.

No Estate Plan Is The Same: Part 2 – Finances

For all of our existence, one common misconception among the general public was that estate planning was only for rich people and “Trust Fund Babies”. However, this notion could not be further away from the truth, especially when considering the recent changes we have seen in family dynamics and financial opportunities.

The three major financial institutions of the United States consist of the banking industry, stock brokerage industry, and insurance industry. Under the Glass-Steagall Act, each major industry could not engage in activities that fell within the scope of the other two industries. In 1999, the Glass-Steagall Act was repealed and the door was left open for each major industry to conduct activities and transactions that fell within the scope of the other two industries. This in turn increased the probability for both unlimited prosperity and financial collapse.

The second part of this two-part article analyzes financial planning from an estate planning standpoint. Financial planning is an essential component of estate planning. The amount of wealth you generate prior to retiring will generally determine whether you will have a comfortable retirement and have anything left over to pass on to your descendants after your death. When choosing a retirement plan, you ideally want some combination of the following tax efficient strategies: for the contributions to be tax deductible, the appreciation to be tax deferred, and the distributions to be tax-free.

Longevity

Life expectancy for both males and females in the United States has been on a consistent rise since the 1900s. At the turn of the 20^th century, the average man and woman did not live past the age of 50. At the turn of the 21^st century, the average man lived up to the age of 75, while the average woman lived up to the age of 80.

This data is significant for several reasons. First, since the age of retirement is currently at 65, the average man has to live at least ten more years after retiring without earning any income, while the average woman must live for an additional 15 years without earning any income. Second, living longer may inevitably cause for more people to opt out to work beyond the age of 65, since it is likely that most people would not have secured enough financial resources for a comfortable retirement when they reached the age of 65. Third, federal programs for retirees, such as Social Security and Medicare would now have to presumably be subjected to cuts, since there would now be significantly more people utilizing the resources of these federal programs due to the spike in life expectancy.

Living comfortably during retirement does not include only the necessities one needs to survive, but also includes engaging in activities that derive pleasure. However, the necessities alone can have a hefty price. If you think about the expenses you will have for your housing needs that may include rent, mortgage, insurance, or property tax, then add those expenses to groceries and hygiene products, these expenses alone can be costly. In addition, you will probably need to get from your home to a supermarket or another point of destination by car, train, bus, or other form of transportation. Since most people in California use vehicles as their preferred method of transportation, the fluctuating price of gas, insurance, and car payments may add on yet another set of expenses that may be unsustainable at the time of retirement.

The expenses don’t just end there. One of biggest expenditures during retirement pertains to health care. While Medicare covers some of those expenses, it may not cover them all. Thus, regular checkups even for the healthiest individuals, combined with pharmaceutical drugs and other related products can also be very expensive. If you also add outstanding loans in the mix, such as credit card and student loan debt, the monthly expenses may not even be sustainable for a middle-income earner, let alone a retiree who no longer earns income.

Besides the necessary expenses, there are also expenses associated with leisure. When people are asked about their vision for retirement, some say they plan on traveling at least once a year, some say playing golf and tennis several times a month, others say dining with their spouses at a local restaurant every weekend. Needless to say, all of these activities may cost a considerable amount of money, and in some cases, a significant amount of money.

From the retirees’ standpoint, many of them have been looking forward to retirement by working hard in their prime years. Thus, their aspirations for retirement are warranted in many instances. However, when they approach retirement, many of them realize that they do not have sufficient funds to comfortably enjoy their retirement years. 

Foundational Financial Concepts

There are two foundational concepts related to finance to keep in mind as you are going through this article. The first concept is whether the income you are generating comes from an active or a passive source. The second concept is whether your money will grow or diminish in value as you approach retirement. 

Active income pertains to any source of income where your active involvement will be required in order for the income to be generated. One such example of active income is your salary. Passive income pertains to any source of income where your active involvement will not be required in order for the income to be generated. One such example of passive income is investment income from real estate. The fundamental issue upon retirement is that nearly all of the income you receive must be predominantly derived from a passive source since you will no longer be working to earn a living.

Passive income will be a significant factor in determining the quality of life you will have when you retire. It follows that it is critical to invest in places that will provide an adequate return on your investment. Hence, how much return you will have on your money is a necessary element in determining to what extent your money will grow before you retire. One of the essential indicators that will determine to what extent your money will grow or diminish in value is inflation.

The underlying concept behind inflation is that every time new money is printed by the government, the value of your existing dollar diminishes. No retirement plan is complete unless it factors in inflation. The rate of inflation averages at approximately 3% per year. Thus, if you have $5,000 in your retirement portfolio today and you retire in 20 years, you will need $9,030 to match the purchasing power of today’s value of $5,000.

Money Havens

Depending on your financial goals, there are various avenues available for stockpiling your money. The primary considerations in picking the avenue that is best for you will depend on how much of a return you want on your money and how much control you want to have over your money. Generally, the more control you have over your money, the less of a return you will have on your money. The opposite is also generally true.

Between the three major financial institutions (Banking, Stock Brokerage, and Insurance), there is no shortage of places for putting your money. Some examples include Bank Accounts, Certificate of Deposits (“CD”), Money Market Accounts (“MMA”), Savings and Loans, Credit Unions, Stocks, Bonds, Mutual Funds, Exchange Traded Funds, Annuities, and Life Insurance. A retirement portfolio should generally be diversified to include a combination of several avenues with a special outlook for inflation, taxes, and fees that may be associated with the maintenance and withdrawal of your money. 

When you put your money in an Individual Retirement Account (“IRA”), you will generally pay a 10% penalty if you withdraw your money before you are 59½ years old. On the contrary, when you put your money in a Bank Account, you generally have unfettered access to your money. As such, Bank Accounts provide the lowest return on your investment, generally at 0.01 percent. CDs and MMAs generally provide less than a one percent return on your investment. Stocks and Bonds may provide significantly larger returns, but they are subject to volatility and other market risks.

Economic Conditions

Economic conditions determine not only the overall strength of the economy, but they also have a significant impact on inflation (or deflation), interest rates, and volatility. One of the primary methods for measuring the strength of the economy is the stock market. While the stock market has historically performed well, it has also crashed many times in the last 100 years, most notably in 1929 and 2008. In both instances, the U.S. economy went into a severe recessionary period.

In 2008, the stock market crashed primarily due to the collapse of the housing market. Millions of people lost their jobs and witnessed their 401(k) accounts plummet. The government paid trillions of dollars to businesses and banks. In order to prevent a complete collapse of the economy to the point where ATMs were at the verge of becoming inoperative, the Bush administration paid $700 billion to the major banks. Needless to say, the financial crisis of 2008 caused a severe panic on Wall Street, Main Street, and virtually everywhere else in the United States.

The viability of the stock market is an important consideration for an investor since it generally determines how much activity there is in the economy. During a recessionary period, people generally do not invest in the stock market. In addition, as we saw in 2008, the government printed a significant amount of extra money in case the recession led to a depression. When the recession was over, all of the extra money started circulating in the economy, thereby causing inflation. Thus, not only did many people lose a significant amount of money, but any money they had left was now worth less in value than before the crisis began.

Social Security

In 1935, the social security program was authorized with the passage of the Social Security Act of 1935. The social security program grants benefits to people who reach the age of 65. The program is contributory, where both the employee and employer contribute to the program. Pursuant to the Federal Insurance Contributions Act (“FICA”), the social security program requires for 6.2% of the employee’s income to be paid by the employee and 6.2% to be paid by the employer (capped at $110,000 per year or $2,500 per month).

At the time the law was passed in 1935, the average life expectancy was at age 63. Today, the average life expectancy is nearly at 80. In all likelihood, there will come a point within the next decade where the age of retirement will be raised by at least two to three years to as much as five years. Another likely outcome is that the amount of the benefits received will also be reduced due to longevity and an increase in the population size. In 1935, the U.S. population size was 127.3 million, today it has 325.7 million inhabitants. Therefore, it is not realistic to expect that the social security benefits we will be receiving in the near future will remain at their current form.

Defined Benefit Plans

In addition to the federal social security program, the retiree may also be entitled to receive income from state-funded programs such as public pension plans. Similar to social security, pension plans provide for guaranteed income for life. Pension plans for both public and private employees are Defined Benefit Plans. The income that will be derived from a pension plan is known in advance, hence, the amount is defined.

Most public pension plans across the United States require for the employee to contribute generally between seven to nine percent of his or her gross salary. The same percentage is generally also matched by the employer. Today, pension plans are predominantly available to only government employees. California has over $333 billion in unfunded pension liabilities according to some estimates. California has also seen a significant increase in its population size, which also suggests that California is likely going to implement severe cuts in its pension programs in the near future.

In the private sector, there are significantly less employers who provide pension plans to their employees primarily because of the employers’ exposure to potential liability. The employers have complete oversight over the plans, including funding future benefits and paying fees and expenses associated with the plans. The funding of future benefits became especially burdensome when Congress passed the Employee Retirement Income Security Act of 1974 (“ERISA”), which required for the employers to maintain enough money in a trust to pay for their employees’ future retirement benefits.

Defined Contribution Plans

As opposed to a Defined Benefit Plan where the amount that will be received upon retirement is defined, the money that is put in a Defined Contribution Plan is defined. One of the most famous and infamous types of Defined Contribution Plans are 401(k) plans. The 401(k) plans generally allow for the employee to contribute approximately seven percent of his or her gross salary and for the employer to match the first 3 percent of the contributed amount. The 401(k) plans are popular because they allow for the amount of the contribution to be tax deferred until the withdrawal period. However, as illustrated below, one major downside to a 401(k) plan is its dependence on market volatility since most 401(k) plans invest in a spread of mutual funds, including stocks, bonds, and money market investments.

Let’s assume that a particular 401(k) plan has $1 million. In the first year, the market had a 30 percent increase, which brought the total amount in the account to $1,300,000. In the second year, the market has a 30 percent loss and the plan is now worth $910,000. Even though in both years there was either a 30 percent gain or a 30 percent loss, the net amount is $90,000 less than the initial amount of the investment. During the 2008 recession, it is estimated that 401(k) plans lost between 25 to 50 percent of their value due to their dependence on market risks and volatility.

Combination Plans

Under Treas. Reg. §1.401(a)(4)-(9)(a), a person is permitted to combine one or more Defined Benefit Plans with one or more Defined Contribution Plans. The combination plans are popular particularly among small business owners, especially where the business owner is also an employee of the business. In addition to providing for financial security in retirement, these plans provide for an opportunity to shift large amounts of income thereby reducing the tax liability of the taxpayer.

Annuities

Similar to social security and pension plans, annuities may also provide guaranteed income for life. Annuities are based on mortality credits. In other words, the longer you live, the more benefit you may receive. There are two overarching categories of annuities: Immediate Annuities and Deferred Annuities.

Immediate Annuities can either be for a specified period of time or for a lifetime. The way it generally works is that a person pays a lump sum to an insurance company and in return receives income for either a specified period of time or for life. If you enter a contract for a Deferred Annuity, you may pay a lump sum or make a series of payments to the insurance company and your money will start earning interest without any tax obligations until distributions are made.

There are two types of Deferred Annuities: Fixed Deferred Annuities (“Fixed Annuities”) and Variable Deferred Annuities (“Variable Annuities”). Fixed Annuities provide a fixed return on earned interest, thus it operates like a CD, but generally provides a larger return on your investment. However, unlike a CD where taxes are due on the interest earned each year, taxes are not due for Fixed Annuities until withdrawals are made. Variable Annuities also allow for the taxes earned on the interest to be deferred, but they are subject to market risk and volatility. On the other hand, Fixed Annuities are not subject to market volatility.

Variable Annuities provide guaranteed death benefits, which adds a layer of protection in the event that the value of your annuity is less than your initial investment. However, unlike a death benefit in a life insurance policy, the death benefit under an annuity may not be entirely tax-free. Fixed Annuities also provide significant benefits, such as allowing a family member to be a recipient of the annuity in case the annuitant dies before exhausting the period of the annuity. For example, you are guaranteed to receive $50,000 annually for 25 years. If you die before the 25-year period, your spouse will receive $50,000 until the end of the 25-year period.

Life Insurance 

When the insurance company writes a life insurance policy, the risk is that the insured will die soon, thereby causing a payout that is much larger than the investment. On the other hand, the risk with an annuity is that the annuitant may live long, thereby granting lifetime income in an amount that is much larger than the initial investment. There are two overarching categories of life insurance policies: Term and Permanent.

Term policies are usually between one to twenty years. The premiums for Term policies are generally lower in the beginning, but they tend to rise quickly to the point that it becomes unaffordable to maintain the policies. Permanent policies are generally in two forms: Whole Life and Universal Life.

Whole Life policies generally guarantee that the premium will stay the same and that it will never increase in addition to guaranteeing a death benefit and cash value. Universal Life policies are permanent policies that consist of a combination of low premiums that are available in term policies and tax deferred guaranteed interest fixed accounts. 

Long-Term Care

Prior to purchasing an annuity or life insurance policy, it is important to consider whether Long-Term Care (“LTC”) can be included as a hybrid policy or whether a separate LTC policy should be purchased altogether. LTC is a type of care that a person requires as a result of his or her physical condition in order to engage in basic daily activities.

The activities that fall within the scope of LTC include dressing, bathing, and going to the bathroom. Since such care may be required for the entire duration of all waking hours, these services can be very expensive. Even though Medicare and Medicaid may provide for as much as 50 percent of the cost of those services, there should also be other funding sources since the annual expenses for LTC can be as much as $100,000. An LTC policy may pay for home care, hospice care, nursing facility, or assisted living facility. The policy may potentially apply to a family member if the policy is never exercised by the insured.  

Important Note: Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.

No Estate Plan Is The Same: Part 1 – Families

For all of our existence, one common misconception among the general public was that estate planning was only for rich people and “Trust Fund Babies”. However, this notion could not be further away from the truth, especially when considering the recent changes we have seen in family dynamics and financial opportunities.

Families have historically been composed of one male parent, one female parent, and one child (or children). While traditional families are still very much in existence, there are now compositions of family structures of virtually every imaginable scenario. This includes families with children raised by single mothers or single fathers, cohabiting couples with or without children, and people who neither have children nor cohabiting partners. By no means is this an exhaustive list. Therefore, the internal makeup of virtually every household is unique, which in turn requires carefully crafted planning techniques to be implemented for each individual family.

The first part of this two-part article analyzes planning considerations for families with young children, families with adult children, married couples, unmarried cohabiting couples, and people who neither have children nor cohabiting partners.

Families with Young Children  

Families that have children who are under the age of legal consent or with special needs should consider particular planning strategies for their children. One critical decision in either instance is choosing the right guardian for the child in the event the parent is incapacitated or dies. If there is more than one parent, the first potential dispute that may come up between the couple is whether the guardian will be with the relative of either parent. This decision may inevitably lead to some tension as one parent might believe that his or her relative is better positioned to raise the child than the other parent’s relative. For children with special needs, one additional consideration is whether the child will lose government benefits if he or she inherits any assets.

Families with Adult Children

When analyzing planning strategies for families with adult children, the issues that are particular to the adult child and the issues that are particular to the parent are equally important to consider. From the parent’s standpoint, one problem to anticipate is elder abuse. If a person becomes physically or mentally incapacitated due to old age, it is common in such instances for him to be taken advantage of from people both outside and inside of his family.

Another major consideration from the parent’s standpoint is whether he is adequately prepared to deal with the various problems that may inevitably arise with old age. For example, whether he has determined in advance the degree of assistance he will need from caretakers and medical practitioners if he ends up with a certain disease or disability. Another issue to consider is what type of government benefits he may receive and whether such benefits are going to cause him to lose his personal assets in order to hold on to the benefits. Yet another consideration is whether some planning strategies can be implemented to transfer those assets to the next generation or protect those assets by various planning tools.  

From the adult child’s standpoint, there are also many issues to be resolved in advance including to what extent she is going to be involved in her parent’s daily activities; whether her parent will live with her or in a retirement home. Another consideration is whether the child also has children of her own and how the existence of her own children might have an impact on the level of financial and emotional commitment the adult child may have for her aging parent. 

Married Couples

Many of the considerations for married couples are beyond the scope of this article. Nonetheless, every married couple, just like every individual, has characteristics that are peculiar to that couple. However, some common considerations for all married couples from an estate planning standpoint include the length of marriage, prior marriages (if any), children (if any), children from prior marriages (if any), age of the children; the couple’s age, health condition, financial status, financial goals, estate tax and other tax considerations.

Planning for married couples becomes even more important when there are other marriages factored in that had been formed before or after the death of the first spouse. In the event a person dies and he or she is married at the time of death, two critical inquiries should be immediately sought to be ascertained. The first inquiry is whether any planning techniques were implemented prior to the death of the first spouse. If no planning techniques were implemented, then the distribution of the decedent’s estate is probably going to be determined by the courts. The second inquiry pertains to the process that is going to be implemented immediately after the death of the first spouse.  

The story of Humphrey and Whitney as depicted below demonstrates the potential chain of events that may be set in motion after one of the spouses dies. In order to follow the story more effectively, it is worthwhile to provide some background facts. In this hypothetical, Humphrey was married and had children prior to his marriage with Whitney. Later, Humphrey died and Whitney remarried.

Humphrey and Whitney had three children. Humphrey also had two children from his prior marriage. Humphrey and Whitney met with an estate planning attorney who asked Humphrey how much control he wanted Whitney to have over his assets in the event that he died before Whitney. The attorney also asked whether it was important for Humphrey to provide financial security for his two children from his prior marriage once he was dead.

Humphrey died five years after implementing his estate plan. After three years from his death, Whitney remarried and had one child with her new husband. Prior to his death, Humphrey instructed his attorney to put provisions in his trust instrument that would effectively provide for all five of his children from his estate after his death. Humphrey was concerned that if he died before Whitney and Whitney remarried or incurred debt, some or all of his assets might have fallen into the hands of Whitney’s future spouse or they would have been exposed to creditors, bankruptcies, or lawsuits.

In order to avoid all of the potential pitfalls and protect all five of his children, Humphrey designed a plan that met this end. Upon Humphrey’s death, all of his assets were transferred to an irrevocable trust, where all five of his children and Whitney were the beneficiaries. Other than receiving income from the trust assets that was necessary for her health, education, and support, Whitney did not have any other interest in the trust. For example, she could not take Humphrey’s assets and give them to her own children, including the child she had when she remarried after Humphrey’s death. As a result, Humphrey’s trust protected all five of his children, including his two children from his prior marriage to Whitney.

Humphrey was also concerned that all five of his children were too young to manage his assets, which were worth a considerable amount. He was afraid that some of his children might turn to substance abuse or become accustomed to other potentially harmful lifestyles due to having access to large sums of money. Hence, he enacted provisions in the trust to ensure that his children were provided for throughout their lives and that the trust was managed by a trustee who had the competency to grow the trust assets and preserve them not only for his children, but for any of his grandchildren that might be born in the future. He also included a provision in the trust which allowed his children to manage the trust assets along with the trustee after reaching a certain age and specific level of sophistication.         

Cohabiting Couples

In some instances, couples who cohabitate have no intention of ever getting married. There may be several reasons for such an approach. For example, one of the partners may be wealthy and is afraid of losing a portion of his wealth if the marriage is ultimately unsuccessful. Another example is that the marriage may not be beneficial from a financial standpoint such as tax efficiency.

In other instances, it may be more beneficial for a cohabiting couple to register as domestic partners or form cohabitation agreements. As an example, California provides many of the same benefits to domestic partners that it provides to married couples. However, not every couple in California can qualify to be treated as domestic partners.

For couples who do not qualify for the domestic partnership treatment, a cohabitation agreement should be considered especially if one of the partners is regularly paying for items that benefits both partners (e.g., mortgage payments). These agreements set expectations regarding the rights and obligations of each party. Cohabitation agreements are also a better source for conflict resolution in the event the couple has a dispute, falling out, or if one of the partners dies.    

Even though most cohabiting couples remain as such or end up single, a significant portion of cohabiting partners eventually end up marrying each other. If a marriage is contemplated, the predominant considerations prior to marriage should include prenuptial agreements. As opposed to postnuptial agreements that are executed after the marriage has gone into effect, a prenuptial agreement is a contract that is executed before marriage. This agreement determines how the assets will be divided in the event of a legal separation or divorce.

A prenuptial agreement has historically been frowned upon by the public. Society and our general thought process lead us to believe that if a prenuptial agreement is formed, then we are intending to lose the war before we ever set foot on the battlefield. In other words, we are contemplating a divorce before the marriage even begins. However, this notion is arguably misleading and it is not in accordance with the modern way of life.

There are many reasons for which a prenuptial agreement should be considered. As of 2018, the divorce rate in the United States is as much as 50 percent (depending on the demographic group). Even though some newlyweds have beautiful love stories, the life span of the marriage of such newlyweds is arguably still a toss-up. Therefore, it would be wise to have a plan in place prior to the marriage that will delineate how the married couple’s assets will be distributed in the event of a divorce, as opposed to leaving such decisions in the hands of the courts.

In addition to prenuptial agreements, formalities must be followed to ensure that any property that is designated as separate property prior to the marriage is not only titled as such, but also to ensure that such property is not commingled with any of the assets of the community. This is especially important for couples residing in California, since California presumes that any property acquired after the formation of the marriage is community property.  

In a community property state such as California, all assets and liabilities that have been acquired or incurred during the duration of the marriage are generally equally apportioned to each spouse. This standard invites creditors and predators of either spouse to potentially access the assets of the spouse who has not committed any wrongdoing. If there are also children involved, then there may be little financial protection for the non-debtor spouse and his children.

It may also be the case that the debtor spouse herself did not commit any wrong. She was simply in a risky line of business or she was found liable for the wrongdoing of her employee. Moreover, if she later files for bankruptcy, the non-debtor spouse’s assets may also be within the creditors’ reach. This may be true even if the assets are titled only in the non-debtor spouse’s name.

People without Children, Parents, or Cohabiting Partners

In the last decade, the amount of people who remain married has been steadily descending to the 50 percent zone. In other words, almost half of the population of the United States is either divorced, widowed, or has never been married. However, this does not mean that those who are not married are necessarily single. Many of them are either cohabitating, dating or in serious relationships. People who fall in these categories should also entertain the possibility of executing prenuptial agreements if a marriage is contemplated.

There are arguably many benefits to being married, including physical, emotional, and financial support. From a financial standpoint, the household itself generally ends up having more money than a single person would on her own. In addition, people who file taxes as married couples generally pay taxes at lower rates than single filers, cohabiting couples, or married couples who file separate tax returns.

For everyone, probably more so for single people, the primary concerns for the long-term are who will take care of them once they reach an age or condition where they can no longer care for themselves; who will make health care and financial decisions on their behalf when they can no longer make those decisions for themselves; and who will inherit what they leave behind. It follows that estate planning is as equally important for decisions that are made during a course of a person’s life as well as the legacy the person will leave behind upon death.

Important Note: The story of Humphrey and Whitney is a work of fiction and the product of the author’s imagination. Any resemblance to actual persons, living or dead, or actual events is purely coincidental. Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.

Is Estate Planning Only For Rich People?

Let’s begin by debunking an age-old myth that somehow estate planning is only pertinent to those people who have a significant amount of wealth. There are many compelling reasons for anyone to have an estate plan. One such reason is to prevent the courts from making decisions on your behalf, especially in such a manner that you would probably not want to be made in the first place. In addition to overriding your wishes, the court proceedings may come with a heavy price tag and take a very long time before all the dust settles.

In essence, effective estate planning solves matters of life and death. It allows you to decide who will make health care and financial decisions in the event a mental or physical condition renders you disabled or incapacitated. It also allows you to determine who will inherit your assets and when those assets will be inherited. Similarly, estate planning allows you to determine who will inherit your business in the event you are disabled, incapacitated or dead. It also provides you with the tools you need to protect your children and any family members with special needs.

In today’s world of advance science and medicine, estate planning is evermore essential since people live longer now than in recorded history. Consequently, living longer makes us more susceptible to suffering from complicated illnesses or diseases. The more complicated the condition, the more resources it may take to battle that condition. Additionally, onset and progression of some medical conditions may be acute and rapidly progressive. We have all heard stories of someone in good health tragically passing away within a month of a sudden diagnosis of a terminal illness.

There are also events that occur purely by happenstance. Someone may cross the street in break daylight and get run over by a car. For the rest of his life, the pedestrian is stuck to a wheelchair and his family is forced to find some ways to offset the emotional, physical, financial, and social implications of his disability. To make matters worse, the family may now have to prove to the courts that they should be granted with the authority to make all of the health care and financial decisions on behalf of their disabled family member.

When that family member dies, they may now have to prove to the courts that the decedent intended to pass everything he owned to them after his death. This of course creates an opportunity for predators to intervene in the court proceedings in order to obtain some portion of the estate. Another common downfall in this context is family disputes.

It may be that one family member feels more of an entitlement to the estate than the other. So now, two siblings are set to duel in court to determine who gets the fair share. Of course, each thinks that he or she is entitled to a greater share. One of them claims she should get more of the estate because she was the one who took care of the dying parent, while her brother claims he should get more because he was the one who arranged all of the finances, which resulted in a substantial increase in the value of the estate.

Perhaps the best way to illustrate what set of disasters lack of planning may lead to is to share Eli’s and Vicky’s stories. Eli was a 75-year-old man who suffered from a terminal illness. His niece was a criminal defense attorney, who has been encouraging her uncle to engage in proper estate planning for several years. Eli was a man of modest means and he did not believe he would ever need an estate plan.

Ever since Eli was diagnosed with his terminal illness, his family has suffered tremendous hardships, including conservatorship, because Eli did not have an estate plan that addressed the matters related to his health and finances in advance. While he eventually understood the value of estate planning as a result of these hardships, the last thing Eli wanted to think about while he was in his deathbed was consulting with an attorney who would craft a plan according to his wishes. As a man of faith, Eli firmly believed that he was going to defeat his terminal illness. Therefore, he decided to postpone the design and implementation of his estate plan until he was cured of his illness.

On a beautiful sunny Sunday afternoon, Eli started experiencing chest pains, which quickly progressed to a heart attack. His wife of 45 years bursted into tears as she felt that she was about to lose the only man she ever loved. After taking several deep breaths, she called 911. Ten minutes after her call, the paramedics arrived. Upon arrival, they realized that if they did not get Eli to the hospital immediately, he would die.

While the paramedics were rushing Eli to the hospital, Vicky was in her car grooving to her favorite song, “Hit the Road Jack”. As she approached the middle of the intersection, the paramedics ran the red light and crashed into her coupe. The paramedics ran some tests and realized that Vicky was also facing death. Another emergency vehicle arrived at the scene and took both Eli and Vicky to the hospital.

Shortly after arriving at the hospital, Vicky fell into a coma, which eventually led to her being on life support. Since the hospital was not in possession of any relevant documents, the doctors began searching for Vicky’s next of kin in order to determine whether Vicky should remain on life support. Unfortunately, Vicky did not have documents that revealed who might have authority to make health care decisions on her behalf, especially decisions that dealt with end-of-life matters.

At the time of her hospitalization, Vicky’s only living relatives were her two young boys and her cousin Connie who lived in Boston. Connie immediately petitioned with the court to become Vicky’s conservator in order to have the authority on the decision of life support on Vicky’s behalf. Even though Connie had to spend $2,000 on the proceeding, she was eventually appointed as Vicky’s conservator.

Over the next few days, there was an intense debate between Connie and Vicky’s friends on whether they should take Vicky off life support. Following the debate, Connie decided to turn off Vicky’s life support, which led to Vicky’s death. Vicky was 38 years old at the time of her death. Upon her death, the only significant asset she owned was a 50% interest in a hair salon, which was worth $350,000.

Shortly after Vicky died, the police were forced to take her children into protective custody and place them in foster care. No documentation was provided that would establish who would be the legal guardian of the children in the event of Vicky’s death. This was the case not only until the custody hearings concluded, but also after their conclusion. Thus, the children were to remain in foster care until the court determined the legal guardianship and custody status of the children.

In the meantime, Vicky’s best friend Franny tried to convince the authorities to allow the boys to stay with her until the custody hearings concluded. However, the authorities could not honor her request because she did not have the legal authority to look after the boys. Even though Connie arrived in Los Angeles from Boston shortly after Vicky’s hospitalization, she also did not have the legal authority to look after the boys.

The terrible situation the boys were placed in was beyond imagination. Not only did they just lose the only person they relied on for emotional and financial support, but they now had to live in uncomfortable circumstances with complete strangers. In the midst of all the hardship, they were constantly being dragged into court for the hearings.

There were two separate hearings that were set to take place following Vicky’s death. The probate proceeding would determine who was going to inherit Vicky’s assets. The custody proceeding would determine who was going to raise Vicky’s children.

Vicky’s ex-boyfriend and the father of her two sons, Doug, intervened in both hearings after learning of Vicky’s net worth. The custody battle ensued between Doug and Connie. During the hearings, Doug met his two boys for the first time in over ten years. Even though Vicky and Connie had a falling out over the years, Vicky told many of her friends that if something happened to her, she wanted Connie to raise her children; especially since Doug was a drug addict and she did not trust him with the responsibility of raising her children. However, she did not effectuate her wishes in a legally enforceable document.

The probate proceeding was not a smooth process either, especially since Vicky’s business partner, Pat, was also faced with a dilemma. Pat is a savvy businessman who owned 50% of the hair salon that Vicky operated. Pat provided the initial funding for the business, but he was a passive investor and he did not want to get involved in the day-to-day operations of the hair salon. He also did not have any experience with cutting hair.

Despite being a savvy businessman, it never crossed Pat’s mind to form a succession plan with Vicky that would solve substantial issues including how the business would be impacted in the event that either he or Vicky became disabled, incapacitated or died. As such, the probate proceeding would ultimately determine who would inherit Vicky’s interest in the business. During the proceeding, the court appointed the personal representative of Vicky’s estate. The primary role of the personal representative was to negotiate with Pat in order to determine the best strategy for the business going forward.

If there were any previous agreements or other relevant legally enforceable documents available, not only would the issue of succession planning be solved without interference from the court, but also the transfer of Vicky’s interest in the business to her heirs would likely not have been determined by the court. As the hearings were taking place, the business was not making any money. Due to the urgent nature of the transaction, Pat and the personal representative sold the business to a nationwide chain of hair salons for a price far below its market value.

Approximately fifteen months after Vicky’s death, all of the hearings concluded. The total legal and other related fees amounted to $35,000. Doug was awarded full custody of the boys. Both hearings determined that Doug and Vicky had a putative marriage. In other words, there was ample evidence supporting Doug’s claim that he believed in good faith that they were married, but there was a legal impediment which prevented their marriage from being recognized by the law. As such, the probate court granted Doug with nearly everything Vicky owned at the time of her death, while Connie received nothing.

At around the same time Vicky’s estate was settled, Eli had another stroke. While he was recovering at the hospital, a doctor informed him of a new treatment that has been shown to treat Eli’s illness. Even though the treatment has been effective on only one-tenth of the tested subjects, the doctor believed it may work on Eli since the subjects with a similar blood type as Eli have shown positive results at almost 90% of the time.

Fortunately for Eli, the treatment worked and he was cured of his illness. Even though his conviction in his faith paid off, he learned a valuable lesson. He recognized that all of the uncertainty that his wife, children and grandchildren faced when he was battling with his illness compounded the pain they felt while they were witnessing his suffering. After truly appreciating the hardships his family endured, his first act after leaving the hospital was to schedule an appointment with one of the leading attorneys in estate planning to help him craft his estate plan and pass on his legacy to his future generations.

Important Note: The stories of Eli and Vicky are a work of fiction. Names, characters, businesses, places, events, locales, and incidents are either the products of the author’s imagination or used in a fictitious manner. Any resemblance to actual persons, living or dead, or actual events is purely coincidental. Chilingaryan Law or its affiliates are not rendering legal, financial, or tax advice by providing the content above. No attorney-client relationship is formed based on the information provided above. The above content is designated only for educational use. Accordingly, Chilingaryan Law assumes no liability whatsoever in reliance on its use. Additionally, certain changes in law may affect the legality of the information provided above and certain circumstances of the reader may vary the applicability of the above content to his or her situation.

New Deduction For Pass-Through Entities

Under the new tax laws (“TCJA”), there is a new deduction available to owners of pass-through entities. Section 199A of the Internal Revenue Code allows owners of pass-through entities to deduct up to 20% of their business income from their income taxes. The first portion of this article provides an overview on the various types of pass-through entities that are included under Section 199A. The second portion of the article provides an analysis on the conditions that the owners of pass-through entities must satisfy in order to qualify for the 199A deduction.

PASS-THROUGH ENTITIES

For purposes of Section 199A, the following entities are entitled to the deduction: sole proprietorships, partnerships, limited liability companies, S corporations, trusts, and estates. The most distinguishing characteristic of pass-through entities is that the entities themselves generally do not pay tax. Instead, all of the earnings and expenses are passed through to the owners who pay the taxes on their individual tax returns. The sections below provide an overview on the general characteristics of each type of pass-through entity.

Sole Proprietorships

A sole proprietorship is not a separate entity from the business owner. It is operated by a specific individual. All benefits and obligations alike are limited to only the business owner. It cannot be passed to a different person unless the new owner creates a different sole proprietorship or a different type of business entity. Even if the business has employees, the risks and liabilities of the business are assumed only by the single individual.

Sole proprietors often receive Forms 1099-MISC during the course of their business dealings, which they must report along with their other income. The income and expenses pass through to the business owner and they are reported on the individual’s personal tax return on Schedule C (or Schedule C-EZ) of Form 1040. If the sole proprietor accumulates net earnings of $400 or more from his self-employment, he must pay self-employment tax by filing Schedule SE with his Form 1040.

Partnerships

A partnership is generally a business venture between two or more persons who agree to carry on a trade or business. In essence, it is a contractual relationship, which can be written or oral. Each partner contributes money, property, or labor in return for a share in the profits and losses of the business. The rights and responsibilities of the partners are generally included in the Partnership Agreement.

Partners owe fiduciary duties to each other and to the partnership. These duties include the duty of loyalty, care, and the duty to act in good faith. A partner may legally bind the partnership provided that she has authority to engage in a particular course of conduct on behalf of the partnership. Authority is generally presumed if the transaction was part of the usual and ordinary course of the partnership’s business operations.

For federal tax compliance purposes, a partnership must report the income, deductions, gains, and losses from its business operations on Form 1065, but the partnership itself generally does not pay tax on its income. However, the partnership must issue Schedule K-1 to each partner. The partner’s share of partnership income is reported on Schedule E.

In a General Partnership (“GP”), all partners are jointly and severally liable for the debts and obligations of the partnerships. For example, if a partnership has two partners and it defaults on a loan, each partner may be personally obligated to satisfy the balance on the loan. Similar to sole proprietorships, this factor is problematic from asset protection standpoint because it does not protect the business owner’s assets from the risks that may arise during the course of business operations.

A Limited Partnership (“LP”) is a two-tiered partnership entity with at least one general partner and one limited partner. In California, the Partnership Agreement must be in writing and the Certificate of Limited Partnership must be filed with the Secretary of State of California. The general partner legally binds the partnership for any decision she may make throughout the duration of the partnership. She is also liable for all the debts of the LP. On the other hand, a limited partner will generally not be subject to liability unless he loses the protection of limited liability for various reasons, such as when he actively participates in the management of the partnership.

In California, a Limited Liability Partnership (“LLP”) is restricted to only certain class of professionals such as lawyers and accountants. The underlying purpose of an LLP is to avoid liability on the members of the partnership for the malpractice of their partners. For instance, if the law firm is an LP instead of an LLP, all of the attorneys who participate in the management of the law firm may be jointly and severally liable for the malpractice of their partners. Since California forbids law firms from forming LLCs, the law firm may in the alternative incorporate. However, corporate formalities can be much more complex than the management of a partnership under a Partnership Agreement.

Limited Liability Companies

A Limited Liability Company (“LLC”) is a hybrid business entity which contains elements of a partnership and a corporation. LLCs consist of members and managers. An LLC may provide tremendous benefits for its members, which include asset protection, intergenerational transfers, tax saving strategies, wealth preservation, and flexible management structures.

There are two types of structures in which LLCs operate. There are member-managed and manager-managed LLCs. In member-managed LLCs, the members of the company manage the company by voting in accordance with each member’s interest in the LLC. In manager-managed LLCs, members may appoint one or more managers to conduct the business activities that fall within the scope authorized by the company’s members.

An LLC can be taxed as a disregarded entity, partnership, cooperative, or corporation. By default, a multi-member LLC is taxed as a partnership. By default, a single-member LLC is taxed as a sole proprietorship (i.e., disregarded entity). Under such classification, the member is considered self-employed and is consequently responsible for self-employment taxes. If the LLC is not taxed as a C corporation, then it will be taxed as a pass-through entity. The earnings and expenses will pass through to the member’s personal tax returns. Under a pass-through scenario, the LLC itself will file Form 1065, but it will not pay the income taxes on the LLC’s profits.

Five Fundamentals of LLCs

S Corporations

There are generally two types of tax treatments available to corporations under the federal rules. By default, a corporation is taxed under Subchapter C of the Internal Revenue Code. However, a corporation may elect to be taxed under Subchapter S of the Internal Revenue Code.

In order to qualify as an S corporation, (1) the entity must be a domestic corporation, (2) it generally cannot have more than 100 shareholders, (3) it must have only one class of stock, (4) the business must satisfy the definition of a small business corporation under Section 1361 of the Internal Revenue Code, and (5) shareholders that are individuals must generally be U.S. citizens or residents (shareholders that are corporations or partnerships are generally excluded).

The shareholders of S corporations are required to pay estimated taxes if their own tax returns have exceeded or are expected to exceed $500 when the returns are filed. The shareholders are required to report all applicable categories of earnings and losses on Schedule K-1. The shareholders must pay taxes on their share of the corporate income regardless of whether distributions are made.

Anatomy Of A Corporation

Trusts

Trusts are created and operated under the laws of the state in which they are formed. A typical trust generally consists of a Trustor, Trustee and Beneficiary. The Trustor (a.k.a., Grantor, Settlor) is the original owner of the property. The Trustee is the fiduciary party that manages the trust assets. The Beneficiary is the designated party that is entitled to receive the trust income or assets.

A trust may be created during an individual’s life or after death under an individual’s will. A trust may also be a grantor trust or a non-grantor trust. If it is a grantor trust, then it is not recognized as a separate entity for federal income tax purposes. The most common types of grantor trusts are Revocable Living Trusts, which allow the Trustor (i.e., Grantor) to make changes or end the trust during his lifetime. Many people use Revocable Living Trusts as alternatives or supplemental to wills.

A non-grantor trust is any trust where the assets are not held by the grantor either directly or indirectly. A non-grantor trust is considered a separate legal entity. The most common of these trusts are irrevocable trusts, where the trust cannot be revoked once it is created. The transfer of the asset is deemed a complete gift with gift tax implications. The income and deductions of non-grantor trusts are reported on Form 1041 (Income Tax Return for Estates and Trusts).

Estate Planning In A Nutshell

Estates

An estate is created when a person dies. Upon the distribution of all assets and satisfaction of all liabilities, both estates and trusts generally cease to exist. The assets of the estate must generally be treated on the beneficiary’s return in the same manner as they are treated on the estate’s return. In addition, the estate’s gross income, deductions and credits are calculated in the same manner as that of an individual. However, they are reported on Form 1041 only if the estate’s annual gross income exceeds $600.

The beneficiary who inherits the property is generally not taxed on the transfer. However, until the distribution is made, the beneficiary may be subject to income tax if she is receiving distributions before the final distribution of the estate (e.g., during the course of a litigation dispute). Any distributions made to a beneficiary are reported on Schedule K-1.

NEW DEDUCTION UNDER TCJA

The Section 199A deduction is only available to owners of pass-through entities. It will take effect from the 2018 tax year and it is set to expire after December 31, 2025 unless otherwise extended by Congress. The maximum potential amount of the deduction is 20% of the Qualified Business Income (“QBI”) from each business the taxpayer owns. For active business owners, the portion of the business income is generally the remaining portion after a business owner receives reasonable compensation (e.g., W-2s).

The eligibility for the QBI deduction is first determined by the taxpayer’s total taxable income (e.g., business and investment income) minus adjustments (e.g., deductions). The second inquiry is how much the taxpayer is entitled to deduct. There is generally an “overall limitation” which is determined by the lesser of the combined net business income or 20% of the total taxable income (in excess of any net capital gain). For taxpayers who only receive business income from passive avenues (e.g., rental real estate), the overall limitation is generally sufficient to determine the QBI deduction. It gets more complicated for taxpayers who operate active businesses.

The analysis below focuses on owners of active businesses, such as professionals or entrepreneurs who own and also operate their businesses. Besides the overall limitation test, there are primarily two overarching tests that are used to determine the amount the taxpayer may deduct: the type of business the taxpayer operates and the taxpayer’s total taxable income.

Type of Business Test

Whether the taxpayer provides services in a Specified Service Trade or Business (“SSTB”) within the meaning Section 199A is a significant factor in determining how much the taxpayer is entitled to deduct. If the taxpayer falls in any of the enumerated classifications as outlined in Section 199A, her deduction may either be reduced or she may not be entitled to any deduction. If the taxpayer provides services in a SSTB, she may not be entitled to any deduction beyond a certain threshold, even though a similarly situated taxpayer may otherwise be entitled to receive a deduction.

There are two classifications of SSTBs within the meaning of Section 199A. The first classification defines SSTB as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services” (architects and engineers are expressly excluded under 199A). The second classification involves the performance of services in the areas of investing and investment management, trading or dealing in securities, partnership interests, and commodities.

The first classification also includes a catch-all category of “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.” Even though the term “trade or business” is not defined by statute, the factors that may be considered include the profit motive of the business owner and the continuous and regular activity of the business. The proposed regulations limit the definition of “reputation or skill” to (1) income from endorsing products or services, (2) licensing or receiving income for the use of an individual’s likeness, or (3) receiving appearance fees from various media platforms such as television.

Total Taxable Income Test

The key factor for determining the QBI deduction is the taxpayer’s total taxable income. If the total taxable income falls in Tier 1, regardless of whether the taxpayer’s business meets the SSTB test, the taxpayer may be entitled to the maximum deduction. If the taxable income falls in Tier 2, the amount of the QBI deduction is generally reduced. If Tier 3, depending on whether it is SSTB, the QBI deduction is either limited or the taxpayer is not entitled to any deduction.

The threshold of the total taxable income for Tier 1 is $157,500 ($315,000 if filing a joint return), Tier 2 is $207,500 ($415,000 if filing a joint return), Tier 3 is any amount that is in excess of $207,500 ($415,000 if filing a joint return).

Assuming the taxpayer falls in Tier 1, the maximum the taxpayer may deduct is 20% of his combined net business income. This means that the taxpayer who earns $100,000 on his QBI may pay tax only on $80,000. If we assume that the taxpayer falls in the 24% tax bracket, the taxpayer would pay 24% tax on the $80,000 portion (as opposed to the full $100,000). Therefore, the taxpayer would pay only $19,200 on the QBI portion (instead of $24,000).

If the taxpayer falls in Tier 2 or Tier 3, there is a wage and capital (i.e., Qualified Property) limitation. Qualified property is any tangible property that is subject to depreciation and is available for use during the tax year. The depreciation period is determined by the later of the regular depreciation period that would apply to the particular property or 10 years. The 2.5% calculation in the formula is determined by the unadjusted basis of the property, meaning, the basis of the property immediately after its acquisition.

Taxpayers who fall in Tier 2 are subject to a phase-in of the W-2 and Qualified Property limitation. This is true regardless of whether the taxpayer operates an SSTB. However, there are differences between owners of SSTBs versus owners of non-SSTBs when calculating the QBI deduction for Tier 2.

Generally, the formula used to calculate the QBI deduction for taxpayers who fall in Tier 2 is determined by the portion of the taxpayer’s total taxable income that is in excess of the Tier 1 threshold yet below the Tier 3 threshold. The difference is then divided by $50,000 ($100,000 for joint filers). For MFJ taxpayers who operate SSTBs, the formula for the QBI deduction is [1 – (taxable income – $315,000) / $100,000)] x (QBI x 20%).

To illustrate the application of the SSTB formula for Tier 2, let’s assume that Larry and his wife operate a law firm (SSTB), which is taxed as an S corporation. In 2018, the couple’s taxable income is $345,000 and QBI is $95,000. If we apply the formula above, their QBI deduction for 2018 is $13,300 based on [1 – ($345,000 – $315,000) / $100,000)] x ($95,000 x 20%).

If the taxpayer’s taxable income falls in Tier 3, the next inquiry is whether the taxpayer’s business falls within the realm of SSTB. If it is SSTB, the inquiry ends here and the taxpayer is not entitled to any QBI deduction. If it is not SSTB, then the deduction is equal to the lesser of: (a) 20% of net business income or (b) greater of (i) W-2 x 50% or (ii) W-2 x 25% + 2.5% of Qualified Property.

In order to understand the application of the formula for Tier 3, assume that Ronald owns and operates a golf course (not SSTB). In 2018, Ronald’s total taxable income is $400,000. His entire income is from the operation of the golf course. Ronald also purchased $1,000,000 worth of golf clubs and other Qualified Property that have not fully depreciated. Since Ronald operates as a sole proprietor, he cannot receive W-2s. Thus, his QBI deduction is $25,000 because $25,000 is the lesser of: (a) $80,000 (20% x $400,000) or (b) greater of (i) 0 (zero W-2 x 50%) or (ii) $25,000 [0 (zero W-2 x 25%)] + [$25,000 ($1,000,0000 x 2.5%)].

Assume the same facts as in the example above, except that Ronald is a shareholder-employee of an S corporation and received $100,000 in W-2s. He does not have any Qualified Property (e.g., golf clubs). His QBI deduction is $50,000 because $50,000 is the lesser of: (a) $80,000 (20% x $400,000) or (b) greater of (i) 50,000 ($100,000 W-2 x 50%) or (ii) $25,000 [$25,000 ($100,000 W-2 x 25%) + 0 (zero x 25%)].

Planning Techniques

Since the taxpayer’s total taxable income is arguably the biggest factor in determining eligibility for the QBI deduction, one technique is to reduce the taxable income to the extent possible. There are various ways to achieve that end. One way is to implement defined benefit or defined contribution plans. If done correctly, these plans may reduce the taxable income, provide asset protection, and secure a peace of mind for the latter years of a person’s life.

Another technique is to restructure the business entity. For shareholder-employees of C corporations, it may be better to restructure as a S corporation since 199A is available only to pass-through entities. For sole proprietors and partners of partnerships who fall in Tier 2 or Tier 3, they are generally not entitled to the deduction because they cannot receive W-2s. However, if there is Qualified Property, they may be entitled to the deduction. In any event, converting to a S corporation is not only beneficial for asset protection purposes and reducing the AGI, but it may now also be beneficial for the QBI deduction.

To illustrate the significance of the impact of entity structures, let’s assume that Tommy and Dolly (a married couple) operate an online shopping business. The business has no Qualified Property, but in 2018, it generated $500,000 of QBI and $550,000 of taxable income. If the business is treated as a sole proprietorship or partnership, the couple will not be entitled to any QBI deduction. If it is treated as an S corporation, they may be entitled to a deduction in the amount of $50,000 assuming that they pay themselves $100,000 in W-2s.

Taxation Of Corporations

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