Chicago Tax Guy: Demystifying Wealth Taxes
With advances in medical science being what they are, the only sure thing in life is that everyone will have to pay taxes. Taxes come in all sorts of shapes, forms and varieties. There is one little understood tax genre broadly known as “wealth” taxes…I think you should know more.
The federal and all of the various local governments around the country like to levy taxes on their citizens. It’s fun for them, and they’ve thought of many different ways of doing just that.
There are sales taxes, income taxes, property taxes, luxury taxes, sin taxes and, of course, wealth taxes. Wealth taxes breakdown into three specific taxes: Gift, Estate, and Generation Skipping Transfer taxes. I’ll “skip” (pun, get it?) talking about the Generation Skipping Tax for another post, and focus on Gift and Estate taxes.
The underlying policy of Gift and Estate taxes is basically two-fold: (1) if you’re wealthy you can pay more tax and (2) lawyers need jobs. The primary concept to remember in this area is that these are taxes on wealth…money and property accumulated (usually over the course of a lifetime) by a person. Although similar, these taxes have different triggers.
Estate Tax
The Estate Tax is imposed by the federal government and almost all of the states. Fear-mongers refer to this tax as the “Death Tax” because it sounds scary and unfair. Basically, at the moment just before a person’s death, he/she has or is deemed to have ownership of certain assets. The value of all of these assets is added up, which figure becomes that person’s Gross Estate. A few deductions later and the Gross Estate becomes the Taxable Estate. Apply tax rate and voila, you have an amount of Estate Tax that must be paid from the person’s assets. Pretty straightforward all in all.
Want an example? Okay. Imagine Joe dies after a long, fulfilling life. At Joe’s death, he had a bank account as his only asset with $10M in it. All other deductions, credits and complicated concepts aside…assume the estate tax rate is 30%. Joe’s family will need to pay an estate tax of $3M. If they don’t, the government will come down hard.
Gift Tax
The Gift Tax is a necessary supplement to the Estate Tax. The Estate Tax, as described above, is basically a tax on wealth at the death of the owner. So death is the triggering event. The tax would be applied even if the owner was buried with all of his money.
The Gift Tax is applied in the case of lifetime transfers, known in legalese as “inter vivos” gifts. So your Grandma gives you a $50 birthday gift…that’s a gift and theoretically if the gift was large enough, the Gift Tax would apply.
A major concept to understand in terms of the Gift Tax is that the person giving the gift pays the tax, not the person receiving the gift. In this respect, the Gift Tax differs from the Income Tax. Again, just to be clear, the person GIVING the gift pays the Gift Tax, not the person RECEIVING the gift.
Why? Well…in part, a Gift Tax is needed to make sure the Estate Tax has any teeth. If people could just give everything away before death, then nobody would have a taxable estate and the Estate Tax would be pointless. The other reason is similar to that of the Estate Tax…if you can give away a bunch of money you can pay some extra tax.
One more example? Okay.
Joe gives his friend Jake a gift of $25,000. If the gift tax rate is 10%, Joe owes the government $2500 in respect of his $25,000 gift to Jake. Joe should learn not to be so generous.
Many, many, many planning opportunities exist with respect to both the Gift and Estate Taxes. I’ll talk about more in later posts.
Chicago Lawsuits: Anatomy of a Litigation (from a transactional point of view)
As a transactional lawyer, I draft agreements, analyze tax consequences, and put together estate and asset protection plans with an eye toward litigation. Our system is based on the notion that any wrong can be righted in front of a judge…or at least that if one has enough money, he/she can wage psychological warfare on another party. This being recognized, it is important to understand just how a lawsuit/litigation works. Here goes:
1. Piss and Moan Stage: Litigation is begun far before any court filing. Your business receives a nasty letter from someone (or their attorney if they’re really serious) outlining some wrong and demanding some action…and we’re off to the races. Such a letter could begin a several month-long process during which the two sides threaten each other like the Jets and the Sharks …maybe things get resolved at this stage, maybe they don’t.
2. I’m Really Serious Stage: If the problem isn’t solved at the Piss and Moan Stage, then one of the parties files a Complaint and serves it on the other party. I’ll dispell a myth right here: you’re not going to dodge service. Yes, it’s true that if the parties aren’t served with the Complaint, they can’t be dragged into court. Guess what…you’re not the first person to think of this. There are Private Investigators out there who specialize in tracking people down and putting a Complaint in their hands…you can’t avoid it. The Complaint will state some basic facts and legal theories. Note: Anyone can file a complaint and sue another for any reason…whether the suit will be upheld or not is another story, but the mere filing of a complaint really means nothing and does not speak to the merits of the case.
3. Nitpick Stage: After the filing of the complaint, the lawyers metaphorically chase after each other like drugged monkeys with axes. Generally, the fights during this stage are procedural: “You didn’t use 10 point font / You didn’t reply by Monday / etc.” If the complaint has any merit, it will move forward. If not, case closed.
4. I’m for Real Stage: Once it has been determined what meritorious claims the parties have, each side gets into the nitty gritty. The facts underlying each claim are determined. At this stage, just about everything is “find-out-able” (or “discoverable” in legalese). This doesn’t mean that everything that can be found out can be used in court. At this stage, the parties are trying to size up each other’s cases and figure out if they should proceed. The parties may settle here, or they may proceed.
5. Choking Stage: If the parties don’t choose to settle (which occurs about 95% of the time) then it’s full steam ahead to trial. Don’t get me wrong…sometimes proceeding to trial is a smoke and mirrors game in which the parties fake willingness to go to trial but don’t really have the heart for it. But, other times, both sides are pig-headed enough to go for the gusto. This is the point at which each case is laid out…prior to trial. There are no surprises. Each side knows what the other side will do and how they will do it…the wildcard here is the jury and the bet that one side will be victorious. The parties here basically try to choke each other to see who is left standing at the end.
6. Show me the Money Stage: Somebody wins at trial, and the judge orders a money judgment against the losing party (or, for you new-agers “the party that was not victorious”). At this point, the winning party has to try to get money out of the losing party. This is where asset protection planning can really be helpful. The loser can either pony up the dough (or make arrangements for payment) willingly, or he/she/it can try to avoid making payment. If the avoidance route is taken, a whole new set of court procedures begins.
7. I’m Really Tired of this Game Stage: The winner now has to go back to court and have the judge approve orders for the loser’s assets to be discovered…this results in the issuance of a “Citation to Discover” which requires third parties to show the winner what the loser has in terms of assets. The winner would serve these on the bank, stock broker, wife, brother, business partner, etc. of the loser until its clear what the loser has. This can be a never-ending process that can take as long as the litigation itself.
8. Finally…Collection Stage: The winner brings information about the loser’s assets back to court, and the court decides if those assets are subject to “garnishment” (this has nothing to do with sprigs of parsley or tomato rosettes). If assets are subject to garnishment, the court will order the assets seized by the Sheriff or otherwise and sold at public auction or possibly delivered to the winner in satisfaction of the judgment. This process continues until the judgment is paid in full, or the winner gives up trying.
So there you go…litigation in 800 words. Best course of action usually: settle.
Chicago Start-Up Businesses: Deduct your Start-Up Expenses…Seriously
Normally, in order to deduct a “business” expense, one must actually be engaged in…well…a business. We can all think of business expenses: office rent; employee salaries; paper and staples. Usually, these types of expenses don’t show up until the business has started. But what about all the money spent prior to the big ribbon cutting ceremony? These expenses can be deducted…but in a special way.
I’m talking about Section 195 (and regulations) of the Internal Revenue Code…aptly titled “Start-up expenditures” (very imaginative of Congress).
What’s deductible? Start-up expenditures, of course. The primary expenses here are “investigation” and “creation” expenses.
Investigation
Think of investigation expenses as your Sherlock Holmes expenses. You’re out there with your magnifying glass trying to sniff out a good business. Maybe you have to go talk to the Dalai Lama as part of this process. Maybe (more likely) you go to one of those big franchising trade shows and talk with 50 different salesmen about your dream to run a hotdog cart. Either way…these expenses are “investigation” expenses and deductible.
Creation
Creation expenses…these expenses are what they sound like. You hire someone to help you get the business up and running…boom, creation expense. You travel to Abu Dhabi to get a blessing for your business from a monk…boom, creation expense. The main difference here from an investigation expense is that you incur creation expenses once the investigation phase is over.
A few other details. First, these expenses are deductible in the same way they would be if the business was operating. So, if you incur meals and entertainment expenses you still only get a 50% deduction. Also, these expenses are not necessarily deductible all at once. Much depends on the total amount of these deductions…generally, you can deduct up to $5,000 in the first year. Then, you can deduct the rest over a 180-month (that’s 15 years) period. But, if you have more than $50,000 in start-up expenses these rules change a bit (I’m not trying to be difficult…the rules really are nuanced and complicated).
This deduction can be forgone if the owner decides to “capitalize” rather than deduct these expenses. If these amounts are capitalized, it means the owner adds this amount to his or her basis in the business. The decision whether to deduct or capitalize is one that should be analyzed…if the business has a big upside, capitalizing may make more sense.
Chicago Venture Capital: Entrepreneurs grab your Calculators
Here is a really nice article on the numbers/considerations underlying a first-round venture capital funding. It is so important in these deals to work the calculator…otherwise I don’t know how you figure out the real terms of the deal.
Chicago Estate Planning: Planning for the Special Needs Child or Adult
Having a special needs child can, I am sure, be both the biggest challenge and greatest reward of parenting. One of the biggest challenges for many is the fact that often, the parent will likely not out-live the special needs child. At some point, the special needs child will grow into an adult and will not be able to rely on the parent for all of his or her needs. This is the basis for what is known as Special Needs Planning.
Special Needs Planning is concerned with balancing two competing priorities: (1) conserving assets to the extent possible; while (2) assuring that the special needs child is provided for. The two underlying rules for special needs planning are: (1) 24/7 medical care and supervision costs A LOT; and (2) Medicaid/Social Security are in the best position to pay for this type of care.
So let’s assume the following example: Ma and Pa Smith have a child named Joe who is born with Down’s Syndrome. Ma and Pa take care of Joe up through Joe’s mid-20s. At some point, Joe qualifies for Medicaid and SSI (Supplemental Security Income…disability). Joe is placed in a group home and does well, with Ma and Pa visiting often. Joe has three other siblings as well. As Ma and Pa get on in years, they realize that they will not out-live Joe and they have to decide what to do with their assets. They certainly don’t want Joe left out in the cold after they die.
The primary planning tool for situations like this is the Third-Party Discretionary Special Needs Trust. This type of trust is designed to provide for Joe if needed, while maintaining his Medicaid and SSI eligibility. See, if Ma and Pa were to simply bequeath to Joe his share of inheritance, the assets could disqualify Joe for Medicaid and SSI. Why? Becuase these assets would be considered Joe’s and now maybe he doesn’t qualify under the Medicaid needs test…unless Joe is receiving $100M or some very large amount, there is no way this inheritance can pay for Joe’s care for years to come, so these assets will have to be “spent down” (on Joe’s medical care) before he would be able to re-qualify for Medicaid.
Don’t forget rules (1) and (2).
So how does the Third Party Discretionary Special Needs Trust (“SNT”) work? Let’s assume Ma and Pa want to equally divide their assets among their children. Basically, they would take care of this in their estate plan as normal. But, Joe’s share would not go directly to him…his share would go into an SNT for his benefit. The trustee of the SNT would likely be one of Joe’s siblings, or another loved one that Ma and Pa trust. The trustee would make sure that Joe has everything he needs and could use the money in the trust to buy things for Joe that Medicaid/SSI don’t cover (perhaps a television or food or additional clothing). But, these assets are not counted as Joe’s because Joe has no right to compel the trustee to make any distributions…distributions are completely discretionary on the part of the trustee.
The assets in the trust could then be split among Joe’s siblings after Joe’s death (Joe’s life expectancy is likely much less than that of his siblings).
So there you have it…a device that can bring some security to a special needs child after the death of his or her parents…making a tough situation a little bit easier. Of course, this type of arrangement can extend to others who have or may have special needs…like elderly or infirm parents or grandparents. Anyone for whom Medicaid/SSI is a needed resource can benefit from an SNT.
