Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

A lot of my clients recently received a Franchise and Excise Tax Annual Exemption Renewal Form from the Tennessee Department of Revenue. This form applies to Limited Liability Companies and Limited Partnerships that claim an exemption from Tennessee Franchise and Excise Taxes.

The three most common exemptions that apply to my clients are the obligated member entity (“OME”) exemption, the family-owned non-corporate entity (“FONCE”) exemption, and the farm exemption. If your company qualifies for one of these exemptions, you need to fill out the renewal form with the help of your CPA and send it to the Department of Revenue no later than April 15, 2010. If your company qualifies for an exemption and you have not received the form, you can get the form at http://tennessee.gov/revenue/forms/fae/fae183.pdf, or you can call the Department of Revenue at (615) 253-0600.

If you do not file the form by April 15, 2010, you will lose your exemption for 2009. The Department has the discretion to allow a late filing. If they allow a late filing, they will charge you a $1,000 penalty.
 

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This is the sixth article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 5 – The Impact of Investment Returns During the First 21 Months
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

Wealthy individuals who expect to leave a significant portion of their IRA to their children or grandchildren have an additional reason to consider a Roth IRA conversion. The income taxes payable on the conversion will reduce the amount that is subject to estate taxes upon the death of the IRA owner.

The benefit can be illustrated by examining a “deathbed” conversion to a Roth IRA. Assume that a widow has a $5.5 million estate, including a $1 million traditional IRA, that she plans to leave to her children during a year when the federal estate tax exemption is $3.5 million. If a Roth conversion is made immediately prior to death and the widow is in the highest current marginal income tax bracket, herr estate would have to pay $350,000 of income taxes. However, the combined Tennessee and federal death taxes will decrease by approximately $176,000 because the income tax liability becomes an estate tax deduction.

Another way of analyzing the conversion is that the income tax rate on the conversion is 17.4% rather than 35%. Because the income tax rate is lower, the conversion is more likely to be a good idea.

Even though the effective tax rate on the conversion is only 17.4%, this does not guarantee that the conversion will be beneficial. The answer depends on the tax rates that would apply to future distributions to the beneficiaries of the IRA if you had not converted it to a Roth IRA.

Your beneficiaries will get future income tax deductions attributable to the federal (but not Tennessee) death taxes paid with respect to the IRA. This deduction will reduce income taxes on future distributions from the IRA to the beneficiaries. The value of this deduction will never be as good as the $176,000 reduction in estate taxes. Furthermore, federal tax law already imposes hurdles to getting the full benefit of this deduction. I predict that future tax laws will impose additional hurdles.

When calculating the income tax rate that will apply to your beneficiaries, keep in mind that they will also be receiving income from other assets that they inherit from you. The beneficiaries may also live in states that impose state income taxes on distributions from a traditional IRA (unlike Tennessee).

What if you die at a time when there is no federal estate tax? Assume that you convert in January of 2010, then die in December of 2010, and that the current federal estate tax laws are not revised. Your estate will not be subject to federal estate taxes. If you were counting on a reduction in federal estate taxes to make the conversion a good idea, your executor will be able to recharacterize the Roth IRA as a traditional IRA until October 15, 2011. I recommend discussing this matter with your executor and/or adding a codicil to your will.

IRA owners whose estates will pay federal estate taxes when they die can leave their children and grandchildren a more useful inheritance by converting at least a portion of their IRA to a Roth IRA. In most cases, the beneficiaries will receive more spendable after-tax income from their inheritance.
 

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This is the fifth article in a series dealing with the topic of converting your traditional IRA to a Roth IRA. For other articles, see:

Part 1 – Reasons to Consider the Roth Conversion
Part 2 – The Recharacterization Option
Part 3 – The Impact of Income Tax Rates
Part 4 – How Long Can You Stretch?
Part 6 – The Impact of Estate Taxes
Part 7 – Ramifications of Charitable Giving
Part 8 - Putting It All Together

Investment performance has extra significance during the first 21 months after a conversion to a Roth IRA. Your investment performance may determine whether you undo the conversion. The recharacterization option allows you to change your mind about a conversion as late as October 15 of the year following the conversion. This means that if you convert in January, you can make the Roth decision after seeing your investment returns over the prior 21 months.

The ability to make your decision after seeing your investment returns allows you to choose the maximum income tax rate that you are willing to pay. Assume that you are in a 35% income tax bracket and are only willing to make the conversion if the maximum tax rate on the conversion is 25%. This means that you will recharacterize the Roth IRA to a regular IRA unless the value of the IRA has grown by 40% during the first 21 months.

Unless you are a fantastic investor, there is a small likelihood of achieving a 40% rate of return on your entire portfolio over a 21 month period. However, you only need to obtain this return on a portion of your portfolio.

For example, assume that you convert an IRA with a value of $600,000 into six separate Roth IRAs with values of $100,000. You choose the overall investments for the Roth IRAs as if they were one account, yet place different asset classes in different Roth IRAs. Splitting your various asset classes into separate Roth IRAs increases the volatility of returns for each Roth IRA without increasing the risk of the overall portfolio. By increasing volatility, you significantly improve the chances of achieving a higher return on portions of your portfolio during the first 21 months.

Assume that the values of the six Roth IRAs after 21 months are $150,000, $130,000, $110,000, $100,000, $80,000, and $60,000. You will keep the two largest Roth IRAs and recharacterize the four with the lowest values. You will pay $70,000 of tax (35% times $200,000) on the two largest Roth IRA accounts with a combined value of $280,000. This represents an effective tax rate of 25%. The overall return on the portfolio was $30,000, which represents an aggregate return of 5%. However, by splitting the portfolio into its separate asset classes, you were able to achieve a much higher return on the portion of the portfolio that you converted.

Derivatives can be used to further increase the volatility among segments of your overall portfolio, without necessarily increasing the volatility of your combined portfolio. Though derivatives are frequently used by hedge fund managers, they are not utilized by many investors because they are less well understood and because they generally receive unfavorable income tax treatment when they are used in taxable accounts. The tax disadvantage is not a concern for Roth IRAs because Roth IRAs do not pay income taxes.

You will need to closely monitor your investments during the 21 month period following the conversion. On December 2 of the year of the conversion, you should consider recharacterizing accounts that have gone down in value. You can then reconvert on January 2 of the following year. On the other hand, if your investments do very well during the first months after the conversion, you might choose to shift the investment mix of the successful Roth accounts to decrease the risk of going backwards during the remainder of the 21 month period.  Similarly, you might shift investments to increase the volatility of accounts that are positive, yet not positive enough to keep the Roth IRA conversion. Ideally, any investment changes made during the 21 month period will maintain your overall desired portfolio allocation.

After the 21 month period, you can combine all of the Roth IRAs that you did not recharacterize and invest the combined Roth IRA account according to your long-term objectives. You will also need to coordinate the investments in your Roth IRA, your traditional IRA, and your taxable investment accounts.

The ability to decide about keeping a Roth conversion after seeing your investment returns will encourage a lot of investors to take a “free look.”  Careful planning with the assistance of your investment advisors is required to take maximum advantage of this tremendous opportunity.

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2010 is the year where there will be no federal estate taxes due to a law that was passed in 2001. The heirs of wealthy individuals who die this year are set to enjoy a huge windfall.

Several congressmen have vowed to reinstate estate taxes during the year. Indeed, the Senate Finance Committee Chairman, Max Baucus, has vowed that Congress will reinstate federal estate taxes retroactive to January 1, 2010.

The one year repeal of federal estate taxes and the threat of a retroactive repeal of the repeal requires planning for three separate tax systems that have very significant differences. System #1 is the law that currently exists for 2010. Even though you do not have to “worry” about federal estate taxes, planning for someone’s death in 2010 is challenging for several reasons.

First, Tennessee still has an inheritance tax with an exemption of only $1 million. Second, there are numerous Wills containing formulas that will not work if the testator dies in 2010. Third, most outright bequests should be converted to trust bequests in order to avoid estate or generation-skipping tax upon the subsequent death of the beneficiary.

Finally, System #1 eliminates the automatic step-up in basis for inherited assets. Heirs will need to obtain records that establish the decedent’s historical cost basis in his or her assets. Furthermore, if there was substantial appreciation, the heirs will incur capital gains tax when they later sell the assets. Each decedent has $1.3 million worth of basis increase that can be allocated by the executor. There is an additional $3 million worth of basis increase that can be allocated to assets passing to a surviving spouse. These “basis exemptions” will solve problems for most families, but will have numerous complications in their application.

System #2 is the law that will apply beginning in 2011, when the federal estate tax will reappear with a $1 million exemption and a top marginal rate of 60%. Planning for System #2 is very familiar because this system was in place prior to the changes made in 2001. A lot of families have assumed that the federal estate tax exemption was always going to be significantly higher than $1 million. They have failed to take planning steps that seemed to be unnecessary.

System #3 is what Congress might put into place later this year. My best guess is that System #3, if enacted, would be similar to the system that was in place for 2009. The House passed such a bill in December of 2009. The Senate elected not to pass this bill, but could change its mind. If there is a System #3, it is possible that it could make changes that were not part of the bill passed by the House in December of 2009. For example, discounts for Family Limited Partnerships could be eliminated.

Many people will assume that System #1 will not be relevant for them, because they will not die this year and/or the law will be changed before they die. If the law is not changed retroactively, it is inevitable that the families of some wealthy individuals who die this year will be disappointed despite the absence of federal estate tax.

There is widespread sentiment that System #2 will not arrive. I now believe that System #2 might arrive in 2011 because I have no confidence that the Senate will be able to get the 60 votes necessary to enact System #3.

You need to be prepared for all 3 systems. Fortunately, there are practical steps that can be taken to minimize taxes under all 3 systems.

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