FEDERAL
Section 409A Can Have Significant Impact on Companies in Several Areas Part II: Deferred Compensation and Risk of Forfeiture

As discussed in the Summer 2006 issue of TaxView, Internal Revenue Code Section 409A, enacted as part of the American Jobs Creation Act of 2004, makes sweeping changes to the treatment of nonqualified deferred compensation (NQDC) plans. A failure to meet the Section 409A requirements may result in the early inclusion of amounts in gross income, an additional tax of 20% of the compensation required to be included in gross income and interest at the underpayment rate plus 1%.

Deferred compensation paid under an NQDC plan is compensation or payment that has been earned by an employee, but not yet received from the employer. Under prior law, if compensation had not been paid or constructively received by the employee, it was not yet considered part of the employee’s earned income and was not taxable income for such year. Section 409A generally requires that amounts earned by an employee be included in gross income, once the individual’s right to the compensation is no longer subject to a substantial risk of forfeiture.

Substantial Risk of Forfeiture
IRS guidance on this matter states that a substantial risk of forfeiture exists if the compensated person’s rights to such compensation are conditioned upon the future performance of substantial services by such person. Although this guidance adequately adopts the definition of substantial risk of forfeiture spelled out in IRC Section 83, it differs in that it does not accept “refraining from performance of services” as a condition creating a substantial risk of forfeiture.

For example, in 2006 a company promises an employee a bonus for past services to be paid at the end of a five-year period, provided the employee is still employed with the company. The employee has a legally binding right to the bonus in 2006, but the amount is subject to a substantial risk of forfeiture because the employee must work until 2011 to become entitled to the bonus. The employee completes the five-year period and receives the bonus in 2011. Pursuant to Section 409A, the employee would be taxable on his bonus in 2011 when there would no longer be a substantial risk of forfeiture attached to the bonus.

Exemptions and Guidance
As noted in Part I of this series, the exceedingly broad definition of deferred compensation adopted by Section 409A is narrowed through statutory and regulatory exceptions for qualified plans, such as 401(k), 403(b), SEP and SIMPLE plans; bona fide vacation leave, sick leave, compensatory time, disability pay and death benefit plans; and Archer Medical Savings Accounts, health savings accounts and most other medical reimbursement arrangements.

More recent guidance and proposed regulations go even further, specifying additional exemptions from Section 409A, including short-term deferrals (i.e., paid within 2½ months from the end of the tax year in which the services were performed), fair market value stock options and stock appreciation rights, restricted property, certain foreign plans and certain severance plans.

IRS officials recently indicated that the release of final regulations under Section 409A is not imminent and the officials would not predict when the government will issue final Section 409A regulations. However, the IRS has stated that taxpayers can rely on current proposals and guidance to show good-faith compliance until then.

For more information, please contact Carolyn Makuen at cmakuen@gellerco.com.

STATE & LOCAL
New York City’s Unincorporated Business Tax

Among the most common types of trusts used in estate planning are the credit shelter trust, also known as a bypass trust; the marital deduction or QTIP trust; and the irrevocable life insurance trust. Each can provide different benefits, depending on the desired goals of the estate plan.

Credit Shelter Trust
Each U.S. citizen or resident has available to them a unified credit exemption equivalent of $2 million through 2008, rising to $3.5 million in 2009. An important planning arrangement is to ensure that the maximum utilization of the unified credit exemption be accomplished. The credit shelter or bypass trust is most often used to eliminate or reduce federal estate tax in the estate plans of married couples, thereby enabling the property to pass to the next generation without being taxed in the estate of a decedent or the surviving spouse. If used correctly, the credit shelter trust can effectively eliminate the estate tax on the first $4 million of assets, through 2008.

While a married person may bequeath an estate of unlimited size to his or her spouse without using up any of the estate tax credit, problems may arise if the surviving spouse subsequently dies with an estate valued at greater than the exempted amount. The survivor’s estate is then subject to estate tax, and since the first spouse’s estate tax credit was never used, it was essentially wasted.

To optimize the estate tax credit, the first spouse should establish a trust that would not be includible in the surviving spouse’s gross estate. The amount would be equal to all or a portion of the estate tax exemption or $2 million for 2006. The assets may be left to someone other than the surviving spouse, such as children. In the alternative, a credit shelter trust may be set up for the benefit of the surviving spouse with the residuary going to the children. However, the principal of the trust can be used for the surviving spouse’s support.

With a credit shelter trust, each spouse’s unified credit may effectively be used to shield property from estate taxes, thereby reducing estate taxes dramatically.

Marital Deduction
The marital deduction or qualified terminable interest property (QTIP) trust has more limited applications and is often used in cases of second marriages with combined families. A marital deduction trust can provide lifetime income for a surviving spouse while avoiding estate taxes upon the death of the first spouse. The trust assets are taxable in the second spouse’s estate.

Upon the death of the surviving spouse, the remaining assets in the trust pass to a beneficiary or beneficiaries named in a clause included in the trust. A QTIP trust may be used to prevent the diversion of assets from the first spouse’s family. An advantage of this type of trust is that an independent trustee can be named to control and manage the assets for the surviving spouse. It provides some flexibility in post-death planning by enabling the executor to choose to qualify all or a portion of the trust for the marital deduction.

Life Insurance Trust
Generally, life insurance proceeds paid on a policy owned by the insured are included in the insured’s estate and can trigger substantial estate tax liability. To avoid estate tax on life insurance proceeds, the insured should not be the owner of the policy.

One way to avoid an estate tax liability on life insurance is with an irrevocable trust. An irrevocable life insurance trust avoids that liability by shifting ownership of the policy from the individual to a trust. With an irrevocable life insurance trust, the insured surrenders all control and lifetime interest in the policy and passes the control to a trustee under terms selected by the insured.

The irrevocable life insurance trust may be funded or unfunded. An unfunded irrevocable life insurance trust is created solely by the transfer of the life insurance policy. The funds to pay the policy would be paid by someone other than the trustee, such as the grantor or trust beneficiary. A funded irrevocable life insurance trust is created by the transfer of assets sufficient to pay the premiums, as well as the life insurance policy.

An irrevocable life insurance trust can also provide liquidity and borrowing opportunities. It can also provide income and/or principal distributions to the surviving spouse, and at the surviving spouse’s death, it provides for distributions to the children.

For more information, please contact Sherry Reisch at sreisch@gellerco.com.

INDIVIDUAL
Basic Estate Planning Techniques: Credit Shelter, Marital Deduction and Life Insurance Trusts

People who choose to live and work in big cities get used to the tradeoffs and compromises that accompany city life—putting up with more traffic, noise and congestion in exchange for easier access to theaters, museums and business centers, for example. But some residents of New York City must also deal with a unique issue that many consider an ugly worm in the Big Apple: the City’s infamous Unincorporated Business Tax (UBT).

The UBT “is imposed on the business income of every unincorporated business that is carried on—wholly or partly—in New York City,” according to information posted on www.nyc.gov, the City’s official Web site.

The City’s definition of an unincorporated business includes trades, businesses, professions and occupations conducted by, engaged in or in the process of being liquidated by an individual, partnership, limited liability company, fiduciary, association, estate or trust. If an individual carries on multiple unincorporated businesses, all are treated as a single business for the purpose of the UBT.

UBT Qualifiers and Exemptions
An unincorporated business must file a New York City return if it meets either of two criteria:

• It has a total gross income of more than $25,000 for a partnership or more than $75,000 for any other type of unincorporated business, prior to any deduction for the cost of goods sold or services performed.
• It has an unincorporated business taxable income of more than $15,000 for a partnership or more than $35,000 for any other type of unincorporated business.

• Performance of services by an individual as an employee (with the facts and circumstances of each determining whether or not an individual is performing services as an employee).
• A person or entity other than a dealer engaged only in the purchase, holding and sale of property for its own account.
• A person or entity that is an owner, lessee or fiduciary and is engaged in holding, leasing or managing real property for its own account.

Additionally, unincorporated entities engaged primarily in qualifying investment activities are partially exempt from UBT on income derived from those activities.

Unincorporated associations and publicly traded partnerships treated as corporations for federal income tax purposes are subject to the City’s General Corporation Tax (GCT) unless they elected on their 1996 returns to remain subject to the UBT. Subchapter S corporations are subject to the GCT rather than the UBT, regardless of their size.

The UBT Burden and Calls for Repeal
Opponents of the UBT claim it amounts to double taxation, especially for independent workers who do not operate as traditional small businesses. The City taxes their earnings first as personal income and again as business income, they argue. In perhaps the most infamous UBT case ever, Andrew Tobias, a well known writer and native-born New Yorker, packed up and moved to Florida after losing a long-running battle with the City’s Department of Finance—but not without paying almost $45,000 in back UBT taxes for his exit visa.

Although the City recently enacted changes to the UBT to make its treatment of sourcing of income less burdensome, opponents say more radical change is needed. A bipartisan City Council coalition supported by the Partnership for New York City, a prominent business group, is working to repeal the tax. They may be encouraged in their efforts by a recent court decision in Washington, D.C., one of the few other cities imposing a UBT, which struck down that City’s tax. The case is currently being appealed.

For more information, please contact Carolyn Makuen at cmakuen@gellerco.com.

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The information contained in TaxView is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Geller & Company to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors.