How to Benefit from Net Operating Losses, Roth IRA conversions and Estate Planning in 2011
January 15, 2011
Presented by: Glenn Rodney
Jeff Call Trey Webb
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Outline
What is a net operating loss?
What limits are placed on deducting business losses?
How is a net operating loss used?
What other rules need to be considered?
What planning can be done for the use of net operating losses?
Net Operating Losses
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What is a net operating loss?
Certain tax deductions exceed gross taxable income
Can be a trade or business loss
Or created by employee business expenses
Or created by a casualty or theft loss
Not by personal/non-business deductions
Net Operating Losses
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What is a net operating loss?
Business vs. non-business deductions
Non-business deductions limited to non-business income
Net Operating Losses
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What is a net operating loss?
Business income - examples
• Salary and wages
• Rental income
• Sole proprietorship income
• Income from a partnership or S corporation
• Gain on the sale of business property
Net Operating Losses
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What is a net operating loss?
Business deductions - examples
• Rental losses
• Loss from a partnership or S corporation
• Loss on the sale of business property
• Employee business expense
Net Operating Losses
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What is a net operating loss?
Non-business income - examples
• Dividend income
• Interest income
• Income from annuities
• Capital gains
Net Operating Losses
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What is a net operating loss?
Non-business deductions - examples
• Personal exemptions
• Mortgage interest on personal residence
• Retirement plan contributions
• Charitable contributions
• Real estate taxes
• Investment interest
Net Operating Losses
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What is a net operating loss?
Example – Joe Homebuilder has a tax loss of $2,000: Wages $10,000
Partnership loss $7,000
Mortgage interest of $5,000
What is his net operating loss?
Net Operating Losses
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What is a net operating loss?
Answer - $0
The mortgage interest deduction is limited to his non-business income of $0 in computing the net operating loss. $10,000 wages less $7,000 partnership loss less $0 mortgage interest deduction leaves a positive amount for purposes of the NOL calculation. Note, Joe Homebuilder does not have taxable income for the year even though he does not have an NOL for the year.
Net Operating Losses
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What limits are placed on deducting business losses?
Basis limitations
At risk limitations
Passive activity losses
Net Operating Losses
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What limits are placed on deducting business losses?
Basis Limitations
Taxpayers cannot deduct losses from businesses in excess of their basis in the business
Net Operating Losses
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What limits are placed on deducting business losses?
S Corporations – basis is equal to the assets contributed in the form of capital or a loan plus income reported to the owner less losses and less assets distributed to the owner
Net Operating Losses
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What limits are placed on deducting business losses?
Partnerships – basis is same as S corporations plus the partners share of partnership debt
Net Operating Losses
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What limits are placed on deducting business losses?
At risk limitations
Losses deductible if you are at risk of suffering economically
Non-recourse debts
Related party loans
Net Operating Losses
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What limits are placed on deducting business losses?
Passive activity losses
Passive losses limited to passive income
Material participation key to avoiding passive losses
Special rules apply to rental activities
Net Operating Losses
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What limits are placed on deducting business losses?
Seven tests for material participation(1) The individual participates in the activity for more than 500 hours during
such year;(2) The individual's participation in the activity for the taxable year constitutes
substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;
(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual's participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;
(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such year exceeds 500 hours;
Net Operating Losses
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What limits are placed on deducting business losses?
(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.
Net Operating Losses
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How is a net operating loss used?
Carry losses back to prior years to recover taxes paid
Alternatively, elect to carry the loss forward only
Current law – 2010 losses can be carried back two years and forward twenty years
2008 & 2009 – 5 year elective carryback election
Net Operating Losses
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How is a net operating loss used?
File Form 1045 by the end of the year
Or file an amended return to claim the loss within three years
Net Operating Losses
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What other rules should be considered?
Alternative minimum tax
Special rules apply when calculating the alternative minimum tax NOL
Net Operating Losses
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What other rules should be considered?
Any claim for refund in excess of $2,000,000 is automatically selected for audit
Net Operating Losses
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What other rules should be considered?
State rules can vary
Some states follow the federal net operating loss rules and other do not
Some states do not allow loss carrybacks or carry forwards
There can also be differences in calculation of the carryback or carryforward period
Georgia generally allows 2 year carryback and 20 year carryforward
Net Operating Losses
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What planning can be done for the use of net operating losses?
Material participation
Keep good records of time
Increase time to meet 500 hour threshold
Limit time where attempting to qualify as a significant participation activity
Net Operating Losses
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What planning can be done for the use of net operating losses?
Accelerating losses
Sell unused assets or inventory at a loss to increase NOL
Accelerate income
With loss carry forwards, liquidate appreciated assets to create cash flow without taxes
Match non-business deductions and non-business income
Net Operating Losses
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What planning can be done for the use of net operating losses?
Losses can offset capital gain income as well as ordinary income
Against capital gain income provides lower refund.
Consider foregoing carryback to a year with only capital gain income.
Accelerate ordinary income to utilize losses and pay tax on capital gain income
Net Operating Losses
Estate Tax Planning in 2010/2011/2012 and ROTH IRA Conversions
Presented by:Jeff CallGlenn RodneyTrey Webb
Estate tax planning for 2010
Exclusion amount $5,000,000
Maximum tax rate 35%
Carryover basis Option to elect modified carryover basis regime and no estate tax instead of estate tax with $5 mm exemption
Exclusion amount $1,000,000 (no change)
Maximum tax rate 35% (no change)
Exclusion amount Tax repealed
Maximum tax rate 0%
2010 - Estate Tax
2010 - Gift Tax
2010 - Generation Skipping Tax
Estate tax planning for 2010
*Basic exclusion amount $5,000,000 (formerly called "applicable exclusion amount")
*Maximum tax rate 35%
*Step-up in basis Full step-up, unless estate elects out of estate tax
State death tax deduction Still available on line 3b (as it was in 2005-2009)
*Due date No earlier than nine months after date of enactment
*Carryover basis Applicable only if estate elects out of estate tax
*Max basis increase available $1.3M (plus $3M for property passing to spouse)
*Due date of new form (8939) No earlier than nine months after date of enactmentPenalties:1) Failure to report to the IRS: $10,000 per failure2) Intentional disregard: 5% of FMV of property3) Failure to report to beneficiaries:/donees: $50 per failure
Capital gains rate Proceeds in excess of adjusted tax basis subject to tax at the applicable capital gains rate when sold (currently 15%)
2010 Estate tax details
Estate tax planning for 2011-2012
Exclusion amount $5,000,000
Maximum tax rate 35%
Exclusion amount $5,000,000
Maximum tax rate 35% (no change)
Exclusion amount $5,000,000
Maximum tax rate 35%
2011/2012 - Estate Tax
2011-2012 - Gift Tax
2011-2012 - Generation Skipping Tax
Estate/Gift tax planning for 2011-2012
*DSUEA "Deceased spousal unused exclusion amount" (new in 2011)
Basic estate/gift exclusion amount $5,000,000 [2012: indexed for post-2010 inflation] now reunified
*Maximum tax rate 35%
State death tax deduction Still available on line 3b (as it was in 2005-2009)
Portability of exclusion DSUEA only from estate of spouse who dies in 2011 or 2012
Last deceased spouse DSUEA available only from last deceased spouse. Thus, DSUEA could be lost if
surviving spouse remarries, and is then "rewidowed.“ Unless it is used for gifting
during lifetime then you could benefit from the use of DSUEA’s from multiple deceased spouses during the donor’s lifetime.
*Applicable exclusion amount Basic Exclusion Amount + DSUEA
Step-up in basis Assets in first estate placed in bypass trust get no additional basis step-up at survivor’s (2nd) death, but are protected from tax on any appreciation at 2nd death. Same assets instead given directly to surviving spouse (and protected from tax in 2nd estate by DSUEA) do get step-up. But trade-off is that appreciation of these assets between 1st and 2nd deaths could be taxable if they exceed combined exclusions.
2011-2012 Estate/Gift tax details
Estate tax planning for 2010/2011/2012other notable changes and items
Decoupled State Estate Tax Returns
Currently there are 14 “decoupled” state estate tax returns. These states generally require that a Form706 be attached, either based on the 1999 or 2001 form, or on the form applicable to the year of death. Because there was no federal estate tax return for 2010 (until The Act of 2010), these states required a 2009 Form 706 to be attached. With the reinstatement of a federal estate tax for 2010, we might expect these states to change the requirement from a 2009 return to a 2010 (or 2011 or 2012) return.
Indexing the Basis Exclusion Amount for Inflation (applicable only in 2012)
The average cost-of-living adjustment (“COLA”) for the years 1975-2010 has been 4.2% (COLA for 2009 or 2010 has been 0%). Assuming that the post-2010 COLA is 4.2%, then the basic exclusion amount available in 2012 would be $5,210,000 (assuming no law change prior to that date).
Carryover Basis and Form 8939
Form 8939, “Allocation of Increase in Basis for Property Acquired From a Decedent”. Will be required for all estates with more than $1.3m of non-cash assets valued as of the date of death. This new form implements the allocation of up to $1.3m of basis increase per decedent (plus another $3m for property passing to a spouse).
There could be as few as 3,000 of these forms required to be filed for 2010. The only estates that would elect carryover basis treatment would be those over $5,000,000, and some of those (in the $5M - $7M range) might stay with the default estate tax treatment if it is less expensive than eventual capital gains tax on property that is greatly appreciated.
• 2010 Special Basis Rules only for individuals electing out of $5 mm exemption and Form 8939
• For deaths in 2010, we have a modified carry-over of basis system, unless they elect to utilize the $5 mm exemption rules enacted on Dec. 17, 2010
• A lack of information regarding the decedent’s basis in an asset presumably means a starting basis of -0- for that asset.
• The beneficiary’s (fiduciary’s) starting basis is the lesser of the decedent’s basis or fair market value at death. Under the new rules basis can “step down” but not up.
• The executor may/must allocate the “Special Basis Adjustment” of $1.3 million, as adjusted.
• The $1.3 million is increased by the decedent’s unused capital loss and operating loss carryovers, and by § 165 losses.
• The “Spousal Basis Adjustment” adds an additional $3 million of adjustment, but can only be allocated to assets passing outright to a surviving spouse or to a QTIP Trust – but not other marital trusts.
• Basis cannot be adjusted to more than the market value at death. Cannot “create” losses.
• The “executor” makes the allocations, asset by asset, on Form 8939, due at the same time as the final Form 1040 (now extended to 9 months from Dec. 17th). Failure to file can result in fines of $10,000 or more!
Estate tax planning for 2010 (Modified Carryover Basis)
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What is a Roth IRA?
Overview Non-deductible contributions 100% of growth is tax-free No required minimum distributions (RMD) at age 70½
NOTE: Distributions from Roth IRAs cannot be used to fulfill the RMD from a traditional IRA
Qualifying Distributions are tax-free Modified Adjusted Gross Income (MAGI) limitations on contributions
and conversions RMDs on inherited Roth IRAs Roth 401(k) plans
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Distributions from a Roth IRA
Qualified distributions are not subject to income tax Qualified Distributions
Distributions beginning 5 years after first contribution to Roth IRA or 5 years after conversion to a Roth IRA
AND: Distributions after age 59.5 Distributions due to the death of the original Roth IRA
owner Distributions due to the original Roth IRA owner’s disability Distributions up to $10,000 to acquire a first time home
Non-qualified distributions will be subject to income tax Basis can be withdrawn tax free Distributions are not subject to income tax if they do not exceed
aggregate contributions or conversions to the Roth IRA
What is new with the Roth IRA?
Starting in 2010, the $100,000 MAGI limitation on conversions no longer applies Taxable income recognized on a 2010 Roth IRA conversion may be
spread over the following two tax years (i.e., 2011 and 2012) Retirement plans eligible for conversion to a Roth IRA
Traditional IRA’s 401(k) plans (including in-service distributions) Profit-Sharing plans 403(b) annuity plans 457 plans “Inherited” 401(k) plans
Married Filing Separately taxpayers can convert to a Roth IRA
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Roth IRA Conversion Factors to Consider
Taxpayer’s ability to pay the income tax on the Roth IRA conversion from non- Roth IRA funds
Taxpayer’s expected future tax rate Taxpayer’s need to use IRA funds during retirement (no RMD’s for Roth
IRA)
Taxpayer’s time horizon Taxpayer with favorable tax attributes, such as net operating losses,
charitable contribution carry-forwards, investment tax credits, etc. Taxpayers benefit from paying income tax before estate tax (when a Roth
IRA conversion is made) compared to the income tax deduction for estate taxes paid on a traditional IRA, thus lowering overall taxes.
Taxpayers who need IRA assets to fund their credit shelter trust (estate exemption amount) should consider a Roth IRA election for that portion of their overall IRA funds.
Roth IRA Conversion Examples
The examples that follow illustrate some of the variables to evaluate in considering a Roth IRA conversion
The assumptions on the following slide will be applied to three different hypothetical taxpayers (currently age 40 and 60)
For each taxpayer, there will be three different illustrations of the conversion 1. With no change in tax rates 2. With tax rates lower in the future 3. With tax rates higher in the future
Assumptions
Taxpayer Age 40 60
FMV Traditional IRA $500,000 $500,000
Basis Traditional IRA - -
FMV Roth IRA - -
Traditional and Roth IRA Growth Rates 7% 7%
FMV Taxable Account $450,000 $450,000
Basis Taxable Account $400,000 $400,000
Taxable Account Yield 3% 3%
Taxable Account Growth Rate 4% 4%
Annual Asset Turnover 20% 20%
Distribute Yield No No
Tax Rate at conversion 35% 35%
Increased Tax Rate (5 years after conversion) 40% 40%
Decreased Tax Rate (5 years after conversion) 30% 30%
Capital Gains Tax Rate 20% 20%
Estate Tax Rate 35% 35%
Estate Tax Exemption $5,000,000 $5,000,000
Roth IRA Conversion Amount $500,000 $500,000
Premature Distribution Penalty 10% 10%
Taxpayer has other income to cover living expenses
Age 40 – Tax Rates Remain ConstantNet to Heirs
Age 40 – Tax Rates DecreasingNet to Heirs
Age 40 – Tax Rates IncreasingNet to Heirs
Age 60 – Tax Rates Remain ConstantNet to Heirs
Age 60 – Tax Rates DecreasingNet to Heirs
Age 60 – Tax Rates IncreasingNet to Heirs
Roth IRA Recharacterization
Taxpayers may “recharacterize” (i.e., undo) a Roth IRA conversion in current year or by the filing date of the current year’s tax return Recharacterization can take place as late as October 15 in the year
following year of conversion Reasons a taxpayer would recharacterize
Taxpayer originally planned on being able to pay income tax with non-Roth IRA funds, but now cannot
Roth IRA account value plummets after conversion Taxpayers cannot recharacterize a portion of a Roth conversion by
“cherry picking” only assets that decline in value All gains and losses to the entire Roth IRA must be pro-rated
Taxpayers may choose to “reconvert” Reconversion may only take place at the later of (1) Tax year
following the original conversion or (2) 30 days after the recharacterization
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Conversion Period Recharacterization Period
1/1/2010First day
conversion can take place
2010
12/31/2010Last day
conversion can take place
4/15/2011 Normal filing date for 2010
tax return 10/15/2011Latest filing date
for 2010 tax return/last day
to recharacterize 2010 Roth IRA
conversion
12/31/2011
2011
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Roth IRA Conversion Timeline
Roth IRA Segregation Conversion Strategy
STEP 1: Create separate IRAs for each asset, asset class or investment sector
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Roth IRA #1ABC Fund: $250,000
Roth IRA #2XYZ Fund: $250,000
Traditional IRAABC Fund: $250,000XYZ Fund: $250,000
Income tax liability due on $500,000 conversion amount
April 15, 2011*
* NOTE: Either a tax return or an extension must be filed by this date. In either case, the tax liability due on the Roth IRA conversion must be remitted by this date to avoid late payment penalties and interest.
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Roth IRA Segregation Conversion Strategy
STEP 2: Pay income tax on Roth IRA conversion
IRSTaxpaye
r
Recharacterization of IRA using the value at the date of conversion
(e.g. $250,000)
October 15, 2011*
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Roth IRA Segregation Conversion Strategy
STEP 3: Recharacterize Roth IRA conversion
Roth IRA #1ABC Fund: $100,000
(Current Value)
Roth IRA #2XYZ Fund: $300,000
(Current Value)
Traditional IRA #1
ABC Fund: $100,000 (Current
Value)
* NOTE: October 15, 2011, is the latest date for which a 2010 recharacterization can take place (either by filing extensions or by filing an amended return).
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Refund of overpayment on recharacterization of Roth IRA Conversion
October 15, 2011*IRS
Taxpayer
Roth IRA Segregation Conversion Strategy
STEP 4: File (or amend) income tax return claiming refund for recharacterization
Conclusion
The decision to convert is based on an individual’s facts and circumstances. Taxpayers need to evaluate a variety of factors, including:
Risk tolerance Time horizon Need to use IRA funds in retirement Ability to pay income tax on conversion with taxable investment
account Prospective future tax rates Estate planning considerations
Questions?
Contact Information
Jeff Call Bennett Thrasher PC
Email: [email protected]
Phone: (678) 302-1456
Glenn Rodney Principal Financial
Email: [email protected] Phone: (770) 821-7872
Trey Webb Bennett Thrasher PC
Email: [email protected]
Phone: (678) 302-1457
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Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party.
Disclaimer