Remember you can find past episodes at www.financialinsiderweekly.com under “past episodes”.

The federal estate and gift exemption equivalent (by way of an exemption credit) for U.S. citizens and residents for 2011 and 2012 is $5 million. For a married couple, the total amount that could potentially transferred free of estate and gift tax is $10 million. The tax rate for transfers in 2011 and 2012 is 35%.

After 2012, unless Congress takes further action, the exemption equivalent will return to the amount before 2002, $1 million, and the maximum tax rate that will apply to estate and gift transfers will be 55%. Nobody expects this to happen, but with our federal spending deficits, there could be pressure to reduce the breaks that are now available.

The 2011 and 2012 “window” provides an opportunity to possibly avoid future transfer taxes and to shift future appreciation to the beneficiaries. In addition, shifting the assets could result in lower income tax liabilities by giving income-generating assets to taxpayers in lower tax brackets.

The higher exemptions may provide an opportunity to “clean up” items like family loans and installment sales to defective trusts. By eliminating these items now, the transactions may be “old and cold” when the individual who makes the gift passes away.

The exemption can be further leveraged using fractionalization techniques, such as transferring minority interests in family limited partnerships or limited liability companies.

There is a risk involved in making these large gifts now. Gifts made during your lifetime are added to your accumulated transfers for computing the estate tax. Unless Congress passes a technical correction, gifts made during 2011 and 2012 could be “clawed back” when computing the federal estate tax after a death of an individual who made a big gift during 2011 or 2012. This was not the intent of Congress, so it seems likely that a technical correction will be enacted to fix the problem, but it is a cloud of uncertainty until the correction is made, and reserves should be kept to pay the potential tax.

Remember some states also have transfer taxes that apply for estates and gifts that should be considered in your estate and gift planning. (California isn’t one of them.)

Also remember that property that is transferred by gift isn’t eligible for a “fresh start” basis adjustment like inherited property.

If you have a very large estate, say exceeding $10 million, you should meet with your tax advisor and estate planning attorney to discuss whether you should make big gifts during 2011 or 2012, which assets are good candidates for gifts, and how they should be transferred.

IRS Circular 230 Disclosure:

As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

Remember you can find past episodes at www.financialinsiderweekly.com under “past episodes”.

The IRS has issued an audit guide on this issue that is a very helpful reference. Here is a link to the guide. http://www.irs.gov/businesses/small/article/0,,id=208400,00.html. Also see Publication 535, page 5. http://www.irs.gov/pub/irs-pdf/p535.pdf.

If an activity is found not to be for profit, the income is not to be reported as business income on Schedule C, but as other income. Since the deductions are not considered to be from a trade or business, they are reported on Schedule A. Mortgage interest for a home office would be reported as mortgage interest. Property taxes are reported as a deduction for taxes. Most other deductions are reported as miscellaneous itemized deductions.

Since deductions for taxes and miscellaneous itemized deductions are added back to taxable income on the alternative minimum tax form, Form 6251, having an activity classified as not conducted for profit can not only result in having deductions disallowed for the regular tax, but can result in an additional alternative minimum tax liability.

The limitation on deductions for activities not engaged in for profit applies for individual income tax returns, S corporations, partnerships and trusts (any pass-through activity that can flow to an individual income tax return.)

An activity is presumed to be conducted for a profit if it generates a net profit for three or more tax years of five consecutive years, or two or more of seven consecutive years for horse racing, breeding, training or showing. This presumption can be overcome by the IRS. Taxpayers elect to postpone the determination of a profit motive by including Form 5213 within three years after the due date, determined without extensions of time to file, of their income tax return. The taxpayer agrees to extend the statute of limitations when he or she makes the election.

Real estate activities that generate losses generally can still be considered to be activities conducted for a profit, because the expectation of appreciation in value is a factor that indicates an expectation of a profit. Some vacation home rentals have been found to be activities not conducted for a profit when they weren’t operated in a businesslike fashion.

There is an order of allowed deductions for activities not conducted for a profit. (Treasury Regulations Section 183-1(b)(1).)

(1) Amounts deductible without regard to whether the activity was conducted for a profit are allowed in full. This category includes residential housing interest that would otherwise be deductible and property taxes.

(2) Amounts deductible that don’t adjust basis of property. These are deductions other than depreciation, amortization and bad debts. They can’t exceed the excess of gross income less the deductions in category (1).

(3) Amounts deductible that adjust the basis of property. These are deductions for depreciation, amortization and bad debts. They can’t exceed the excess of gross income less the deductions for categories (1) and (2).

Here are factors that are considered in determining whether activities are engaged in for profit. (Treasury Regulations Section 1.183-2.)

1) The taxpayer’s history of income or losses for the activity.
2) The amount of occasional profits, if any, which are earned.
3) The cause of the losses.
4) The success of the taxpayer in carrying on other similar or dissimilar activities.
5) The financial status of the taxpayer.
6) The time and effort expended by the taxpayer for the activity.
7) The expertise of the taxpayer or his advisors.
8 ) The manner in which the taxpayer carries on the activity.
9) Expectation of profit by the taxpayer.
10) Expectation that assets used in the activity may appreciated in value.
11) Elements of personal pleasure or recreation.

Having a business plan, a separate bank account for the business, and separate formal books and records for the business help establish a profit intention. Also, records of evaluation of results and plans and actions taken to improve results also are helpful for defending a profit intention.

Distributorships for multi-level marketing operations, like Amway, have been successfully attacked by the IRS as not-for-profit when they aren’t conducted in a business-like fashion and have consistent losses.

The decision to start and have a business is a serious one. Give your business serious attention so that it generates profits, and the limitation on losses for activities not conducted for profit shouldn’t be a concern for you.

In a typical deferred exchange, the proceeds from the sale of property are deposited with a qualified intermediary, which later uses the funds to pay for a replacement property.

Recently some high-profile intermediaries filed for bankruptcy and failed to pay the funds to complete exchange transactions. This is potentially a taxable event, for which the exchanging taxpayer could owe a tax and not have cash to pay it. For example, Edward Okun owned 1031 Tax Group and 16 other exchange intermediary affiliates that owed more than $150 million of exchange funds and filed for bankruptcy. LandAmerica was another exchange intermediary that owed more than $419 million of exchange funds when it filed for bankruptcy.

According to Revenue Procedure 2010-14, the taxpayer will generally report the failed exchange as an installment sale. Income is only reported as cash is received, so cash not yet received because the bankruptcy is in process won’t be taxable until it is paid as a bankruptcy settlement.

The amount of debt for the sold property that was paid off using the sale proceeds and is in excess of the tax basis (cost for determining tax gain or loss) is counted as cash received in the year the debt was paid (usually the year of the sale). For example, if a $60,000 mortgage is paid off from the sales proceeds of land that cost $40,000, $20,000 would be treated as cash received in the year of sale.

If the bankruptcy is completed in the year of sale, the sales price and contract price are reduced for any amounts that won’t be paid. For example, if a property is sold in 2010 for $100,000 cash, deposited with a qualified intermediary and it’s determined by December 31, 2010 that $40,000 is cancelled in bankruptcy, the sales price and contract price will be adjusted to $60,000.

Depreciation recapture income is included in income to the extent of gain recognized in a taxable year based on cash received, and such income is taxable before other (capital) gains.

Unstated interest can still be imputed for a failed exchange, but the taxpayer is treated as selling the relinquished property on a safe harbor date, which is the date the confirmation of the bankruptcy plan or other court order that resolves the taxpayer’s claim against the qualified intermediary. If the payment is made within six months after that date, no interest is required to be imputed.

In some cases, taxpayers may be entitled to claim a loss when the bankruptcy is done and the amount of loss can be determined. The loss would be the total amount of cash received (including cash used to pay off mortgages for the sold property) less the tax basis of the property and any gain for which income taxes were paid.

Although the Revenue Procedure is generally effective for taxpayers whose like-kind exchanges fail due to a qualified intermediary default occurring after January 1, 2009, taxpayers in that situation may still use the Revenue Procedure to file an original or amended income tax return for previous open years.

(Revenue Procedure 2010-14, March 8, 2010.)

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained on this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.