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BHBM Tax Alert 1/14/2010

Thursday, January 14, 2010

FEDERAL AND STATE

A Look Ahead: 2010 Tax Planning

By: Jason Alley, Esq.

     As we look ahead to 2010 there are a number of items that jump out at us in the tax world, especially in the arena of tax planning.  Among these items, the most significant issues are:  1) the future of the estate tax; 2) the conversion of traditional IRA's to Roth IRA's; and 3) the future tax climate for business owners.  In this brief analysis, we will review the 2010 tax planning environment and determine how to best handle the uncertainties that lie ahead.

The Estate Tax Abyss
 
     Many times, changes in tax laws are another opportunity for tax professionals to contact their clients about planning for the future.  These professionals will analyze the changes in the law and have the ability to individualize each client's tax plan to become as tax efficient as possible.  Unfortunately, the year 2010 offers a broad and sweeping change, namely, elimination of the estate tax with zero foresight into the future with regards to planning.  This leaves tax professionals wondering, "What do I tell my clients?"

     While there is certainly no correct answer to the question posed above due to the total uncertainty that exists with relation to the estate tax, now may still be the time to contact your clients and tell them something.  First, the current repeal of the estate tax could have a negative effect on Wills that were written under the premise that an estate tax would always be in effect.  For instance, in a Will in which the surviving spouse is not the mother of the testator's children, language may exist which says that the testator wishes to leave the surviving spouse an amount . . . "necessary to reduce estate tax to zero" . . . or a Will may have a provision leaving a bequest to one other than the surviving spouse of an amount equal to that amount . . . "which can pass free of estate tax."  As one can see, either of these provisions becomes problematic when there is zero estate tax.  Thus, now is an excellent time to contact estate planning clients and review the terms of their Will with them.

     But what if the client asks, "So what should I do next year?"  This is the question that all tax professionals fear because the only correct answer that we may give is, "I don't know."  Many commentators have recently offered their opinions on what Congress may or may not do.  However, the only common thread among all of the opinions currently being tossed around is that there will be an estate tax.  Therefore, the only advice that one can currently give with regards to the future of the estate tax is, "We will be sure to pay very close attention and keep you abreast of the forthcoming changes."

Traditional IRA's to Roth IRA's
   
     Many tax professionals are currently receiving a common question from many of their clients, "Should I convert my traditional IRA into a Roth IRA?"  For tax years beginning after 2009, the $100,000 modified AGI limit on conversion of traditional IRA's to Roth IRA's has been eliminated.  Additionally, married taxpayers filing separate returns may convert a traditional IRA into a Roth IRA when they could not before.  This ability to convert leaves many clients wondering whether it is in their best interest to do so.

     An analysis of whether to convert a traditional IRA into a Roth IRA is dependent upon two factors:  1) what will the client's future tax rate be; and 2) has the market bottomed out enough that the client has a minimized tax exposure upon conversion?

     The first factor is client dependent.  However, most clients
asking this question likely will have sustainable income over their lifetimes.  Therefore, the question is not so dependent upon the client's future income level, but upon future tax rates.  The Obama administration has proposed increasing tax rates on the wealthy in order to raise approximately $635 billion in revenue over ten years beginning in 2011 to pay for sweeping health care reform.  While no one may be sure, many experts believe that a greater tax increase will be necessary to sustain reform which will require either higher rates or taxing lower incomes.  Either way, it is probable that future tax rates will not decrease.  Thus, if a client has sustainable income when they begin to take IRA distributions, it is probable that tax rates will not have decreased, but, instead, will have increased.

     The second factor is also uncertain.  After recent experience in the stock market, many clients are suspicious of expert opinions that growth will continue.  Therefore, clients are concerned that a conversion of their traditional IRA to a Roth IRA may be followed by a decline in investment value which will expose them to a greater tax burden than necessary.  However, for this concern we can offer our clients a bit of comfort.  Under current law, a person can "back out" of a conversion from a traditional IRA to a Roth IRA by recharacterizing it.  Later on, he can reconvert it back into the Roth IRA, but there are timing issues to consider.  If a person converts an amount from a traditional IRA to a Roth IRA and then transfers that amount back to a traditional IRA in the same year, he can not reconvert that amount from the traditional IRA to a Roth IRA before:  1) the beginning of the year after the year in which the amount was converted to a Roth IRA; or, if later, 2) the end of the 30 day period measured from the day he recharacterizes it back from the Roth IRA.  This recharacterization/reconversion strategy can be a saving grace when the investments held in an IRA drop in value precipitously after a conversion to a Roth IRA.

     Each of the above factors should be considered by an individual client before making a decision to convert.  However, for clients that are capable of sustaining the current taxation, such a conversion could be beneficial.

Future Tax Climate for Business Owners: Time to Sell?
   
     The final issue that we should address for 2010 is the future for business owners, especially those in Louisiana.  As discussed above, due to the increased need for revenue, it is likely that tax rates will be increased starting in 2011.  In addition to rates increasing on the wealthy, the Obama administration plans to increase the preferred tax rate on long term capital gains from 15% to 20%.  This increase will cut into the net proceeds received by business owners when they sell their businesses.  Furthermore, there is a growing fear among business owners that the health care reform measures will also cause an increase in the cost of doing business by requiring business owners to provide health insurance for all employees.  These two negative factors have many business owners wondering if 2010 may be a good time to employ an exit strategy.

     For Louisiana business owners, 2010 may be the perfect year to sell your business.  While the federal government seems poised to raise taxes on operating businesses through health care reform and to increase taxes on the sale of a business, the State of Louisiana has taken opposite measures in the 2009 Regular Session.  H.B. 106 eliminates state taxation of "gains recognized and treated for federal income tax purposes as arising from the sale or exchange of an equity interest in or substantially all of the assets of a nonpublicly traded corporation, partnership, limited liability company, or other business organization commercially domiciled in [Louisiana]."  This equates to a savings of 6% from the proceeds of the sale of a Louisiana business; a savings that will be partially offset by the 5% or more federal capital gains increase which may occur in 2011.  However, it is important to note that there are a number of questions remaining regarding H.B. 106, including:   1) How will amounts subject to recapture under federal tax laws be treated?  2) Does the exemption apply to both short term and long term capital gains?  3) Will single member LLC's be respected, for instance:  Will a single member LLC which is a disregarded entity and owns and operates a single asset qualify if the asset is sold?  A business owner should be aware of each of these issues before estimating the net proceeds from the sale of their business.

Conclusion
   
     The year 2010 may very well become known as "The Year of the Unknown."  Many questions remain to be answered and certainly Congress will be full of surprises.  However, it is also a great time to visit with our clients and assure them that we will be paying close attention and keeping them apprised of the situation.  After all, this is exactly what they ask us to do for them.

If you would like to receive BHBM Email Tax Alerts to stay informed on the latest changes in tax law on the Federal and State level, please email Stacey Lala at slala@bhbmlaw.com.