Virginia State Bar

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Trusts and Estates

A Section of the Virginia State Bar.

Spring 2010 Newsletter

Newsletters - Trusts and Estates

Volume 22, No. 2

The Fourth Dimension of the Planning Process: Reducing Income Taxes for the Family Group

By: Patrick J. Vaughan, C. Daniel Vaughan and Kathi L. Ayers


As estate planning attorneys, we assist our clients in developing tax reduction strategies. To this end, we generally focus our attention on the three dimensions of the wealth transfer tax system: gift taxes, estate taxes and generation-skipping transfer taxes. (For purposes of this article, we assume that the latter two taxes will be resurrected no later than January 1, 2011.) With government spending and budget deficits on the rise, we expect marked increases in federal and state income tax rates. This development will pose a significant threat to family wealth preservation. In this environment, we encourage estate planning attorneys to add a fourth dimension to their tax reduction approach – a specific focus on strategies which reduce exposure to income taxes for the client’s family group.

There are many strategies that present unique opportunities to achieve significant “fourth dimension” planning results. In this article we will identify some of those opportunities and will examine specific examples of how they can be applied to achieve tax savings for clients and their families.


A. Converting Traditional IRAs to Roth IRAs.

Qualified retirement accounts play a significant role in our clients’ financial portfolios, primarily because of the benefits associated with tax-free growth and deferral of income tax liability. In the retirement account universe, Roth IRAs stand supreme. The participant is not subject to the IRS’s minimum distribution rules, and distributions from the account are not subject to income taxes. Unfortunately, given relatively severe eligibility restrictions, many of our clients have not been able to contribute to Roth IRA accounts (or convert traditional IRAs to Roth IRAs). However, in 2010, the restrictions on converting traditional IRAs to Roth IRAs are suspended.1 This presents a unique opportunity for our clients to achieve significant income tax savings – not only during their lifetime, but throughout the lifetimes of beneficiaries in future generations.

1. The Roth Conversion – Triggering Recognition of Income. A client electing to convert a traditional IRA to a Roth IRA will recognize ordinary income on the converted assets; however, if the conversion occurs in 2010, the client can elect to defer tax payments between the 2011 and 2012 tax years.2 This acceleration of income seems antithetical to the central advantage of the retirement account strategy - why would this be advantageous? Because as the participant of the newly converted Roth IRA, the client will not be subject to the distribution rules that govern traditional IRAs (requiring minimum taxable distributions at age seventy and one-half), and as a result, the account can grow tax-free during the client’s entire lifetime.3 Therefore, for clients who have ample wealth from other sources and will not need to access retirement account assets during their lifetimes, Roth IRAs can supercharge their ability to generate income tax free benefits for successive generations.

Case Study. Mary Client has $1,000,000 in a traditional IRA. In this standard model, minimum distribution rules will begin to shift the account balance from the IRA’s tax-deferred environment to Mary’s taxable accounts beginning in the year in which Mary attains age seventy and one-half. In order to prevent this shift, Mary converts the account to a Roth IRA in 2010 and owes $350,000 in federal and state income taxes due to her combined federal and state marginal income tax bracket (referred to in this article collectively as “income tax bracket”). Mary pays the income tax bill with non-IRA funds. Assume that Mary lives for twenty-four more years, she earns six percent per year in her Roth IRA and she takes no distributions from the account during her lifetime. The Roth IRA account will be worth approximately $4,000,000 at Mary’s death. If Mary’s son, Jim, is the beneficiary of the Roth IRA, the minimum distribution rules will require that he begin taking distributions from the account following Mary’s death, but those distributions can be stretched over his remaining lifetime and all distributions will be income tax free.

2. Offsetting Conversion Income with Deductions. When a client converts a traditional IRA to a Roth IRA, he or she will have recognition of ordinary income from the conversion. That income may help the client utilize deductions that could not be utilized in prior tax years and would expire if not used in the near future. Examples of tax deductions that could become worthless for lack of income include net operating losses, ordinary losses and charitable contribution deductions. Clients considering Roth conversions should consult with a CPA to determine if deductions may be available or generated to reduce the amount of income taxes payable on the conversion.

Case Study. John Client is retired with modest taxable income. Several years ago, he made a substantial donation to his alma mater. John’s charitable deductions each year are limited to fifty percent of his adjusted gross income.4 If John does not use all of his deductions within five years after the year of the donation, they will be lost.5 John converts his traditional IRA to a Roth IRA, generating the recognition of ordinary income, thereby enabling him to utilize the rest of his charitable income tax deduction. John has converted his tax-deferred traditional IRA to a tax-free Roth IRA in a tax efficient manner.

3. Making Lemonade From Lemons. Many taxpayers invest IRA funds in marketable securities. Because the stock market is currently about thirty percent below its peak, it may be an optimal time to make a Roth IRA conversion. If a client’s traditional IRA has lost value in the past few years, the tax triggered by a 2010 Roth IRA conversion may be a bargain in disguise.

Case Study. Jane Client’s traditional IRA was worth $300,000 in 2008. In her forty percent income tax bracket, Jane would have paid $120,000 in income taxes to convert her traditional IRA to a Roth IRA. Jane’s traditional IRA is now worth $210,000. She would now owe only $84,000 in income taxes on a Roth IRA conversion, which is $36,000 less than the conversion would have cost her in 2008. If Jane’s Roth IRA grows back to $300,000, she can eventually withdraw the restored $90,000 without any income tax liability. Without a Roth IRA conversion, Jane would owe income taxes on withdrawals from her traditional IRA, making her $90,000 gain taxable.

4. Reversing a Roth Conversion. Given the unpredictability of financial markets, clients may be concerned that assets in a converted Roth IRA may lose value, thereby turning the Roth conversion transaction into a financial mistake. Fortunately, the client may reverse or “unconvert” a Roth conversion if the reversal is made by the due date for filing the federal income tax return, as validly extended, for the year in which the conversion was made.6 This allows a client to reverse the income recognition associated with a Roth conversion, if the performance of the assets inside the Roth IRA account results in “converter’s remorse” prior to the filing of the income tax return.

Case Study. In 2010, Bob Client converts his traditional IRA into two separate Roth IRA accounts, employing different investment strategies in the separate accounts. By March of 2011, one account has performed well, but the other has performed poorly. At Bob’s request, his CPA extends the time for filing Bob’s 2010 income tax returns until October 15, 2011. Bob has until then to reverse or “unconvert” either or both Roth accounts. This flexible option affords Bob the opportunity to “look back” and to reverse the conversion, or any segregated part thereof, if the cost-benefit analysis so warrants.

B. Making Gifts Which Will Permanently Eliminate Exposure to Income Taxes.

By optimizing gifting opportunities, clients are able to achieve transfer tax efficiency as they shift wealth to successive generations. As estate planning attorneys, we carefully utilize clients’ federal gift tax and genera-tion-skipping transfer tax annual exclusions and strategically “spend” clients’ lifetime gift exemptions, all in an attempt to reduce exposure to transfer taxes upon death. In some cases, gifts can be structured in order to achieve “fourth dimension” planning success. By gifting assets to income tax free vehicles, clients are not only able to remove wealth from the transfer tax system upon death, but also to place that wealth outside the income tax system during their lifetime and enable it to flower and provide benefits to successive generations.

1. Section 529 Education Savings Accounts – Case Study. Mark and Ann Client have five grandchildren ranging from two to eight years old. They want to establish a Section 529 education savings account for each grandchild and take advantage of the five year acceleration rule which will permit Mark and Ann each to fund each grandchild’s 529 plan with $65,000 (i.e., $13,000 annual gift exclusion times five).7 They transfer $650,000 ($13,000 per grandparent per grandchild, times five) into the 529 accounts. As long as the assets in the 529 accounts are used to pay qualified education expenses, there will be no federal or state income tax liability associated with the $650,000 gift base, or the growth on that base. The family group will enjoy the benefits of those assets, as well as the growth on those assets, without exposure to income tax liability.

Gifts to Roth IRAs – Case Study. Bill Client wants to assist his six grandchildren in establishing and funding accounts for their retirement. Each of the grandchildren has enough earned income to make a $5,000 Roth IRA contribution. In 2010, Bill makes a gift of $5,000 to each of his six grandchildren to enable them to establish and fund Roth IRA accounts. Each year thereafter Bill will make an additional gift of $5,000 to each grandchild to fund his or her Roth IRA account for that particular year. All of Bill’s gifts will be made from his income-producing taxable investment accounts. Each year, $30,000 ($5,000 per grandchild times six) will be transferred into Roth IRA accounts and be liberated from the burden of future income tax liability. Over a period of ten years, Bill is able to place $300,000 of assets in income tax free vehicles owned by grandchildren, thereby allowing those assets to grow income tax free for decades.

State Income Tax Planning – Case Study. Tom Client, age seventy-one, makes annual gifts to Section 529 education accounts established for his children. Because Tom has attained seventy years of age, all of his gifts to the Section 529 accounts are deductible for Virginia income tax purposes.8 Although this represents a modest tax savings given the relatively lower state income tax rate, the cumulative effect over time can translate into significant tax savings for Tom and his family group.

C. Making Gifts Which Will Shift the Recognition of Income to Lower Bracket Family Members.

Advisors routinely identify opportunities to structure gift transactions for transfer tax purposes. Gifts generally shift the recognition of future income from the donor to the donee. Given that the donee’s income tax bracket is typically lower than that of the donor, gifting transactions present excellent opportunities to reduce future income taxes within the family group.

1. Outright Gifts to Lower Bracket Family Members – Case Study. Ted and Karen Client want to make gifts of income-producing assets to lower income tax bracket family members to reduce the overall income tax liability for the family group. They make outright annual exclusion gifts (i.e., $13,000 per donor per donee) to each of their children and grandchildren.9 Because all of their grandchildren are older than twenty-three, there is no application of the “kiddie tax” rule.10 Given that the recipients of the gifts have substantially lower income tax brackets than Ted and Karen, the overall tax burden for the family group is significantly reduced.

Gifts with Retained Management Control – Case Study. Dave and Nancy Client want to make gifts of income-producing assets to their children but want to maintain decision-making control over those assets. They establish a family LLC, the members of which are Dave (two percent), Nancy (two percent) and each of their four children (twenty-four percent each). Each year Dave and Nancy transfer $100,000 of income-producing assets into the LLC. The LLC governing documents are drafted to ensure that these transfers qualify as annual exclusion gifts. Dave and Nancy may also exceed their annual exclusions if they want to utilize some or all of their $1,000,000 lifetime gift tax exemptions. Because the income tax bracket for Dave and Nancy is more than twice the income tax brackets of their children, the family group achieves significant income tax savings on an annual basis.

Expanding the Scope of Annual Giving – Case Study. Laura Client, who is in a high income tax bracket, wants to maximize annual gifts to her children, grandchildren and their spouses without utilizing any of her $1,000,000 lifetime gift tax exemption. All donees are in lower income tax brackets than Laura. In addition to her annual gift exclusion per donee (i.e., $13,000 in 2010), Laura can make unlimited qualified payments for tuition and medical expenses (including health insurance) on behalf of each donee.11 If Laura makes gifts of income-producing assets to her family members, those assets will no longer generate income tax liability for Laura on an annual basis. Consequently, as the amount of assets gifted from Laura to her family members increases, the income tax obligation for the family group will be significantly reduced.

D. Using Trusts to Achieve Generational Income Shifting.

Estate planning attorneys implement trust arrangements for a variety of purposes. From providing clients with control over the future management and distribution of assets, to achieving creditor and predator protection, to creating transfer tax efficiency as assets pass through the generations, we routinely structure trust provisions to assist our clients in achieving their goals. As a trust is administered, the income it generates will either be recognized and attributed to the trust itself or to one or more beneficiaries of the trust, depending upon the distribution provisions and, where applicable, the discretion exercised by the trustee. This presents the opportunity to structure trust planning in ways that achieve significant “fourth dimension” planning success.

Shifting Income in a Dynasty Trust – Case Study. Carol Client (age eighty-five), a widow, has a substantial estate, comprised of income-producing marketable securities and cash equivalents. Carol, as well as her son Tim and his wife Linda, are in a high income tax bracket. Tim and Linda have three children whose ages are twenty-eight, twenty-six and twenty-four. Carol establishes and funds a family trust with $1,000,000, utilizing her lifetime gift exemption. Additionally, Carol funds this family trust on an annual basis, utilizing her annual gift tax exclusions (i.e., $13,000 per donor per donee as of 2010). (Of course, each $13,000 gift to the trust will not itself be exempt from the generation-skipping transfer tax. Carol should allocate some of her GST exemption to the trust each year to preserve its zero inclusion ratio). The family trust is structured so that Tim is the primary trustee and Linda is the successor trustee. The family trust is designed to take advantage of Carol’s generation-skipping transfer tax exemption. The trustee of the trust is directed to distribute all of the trust income to or for the benefit of Carol’s grandchildren. The trustee has discretion to distribute trust principal to Tim, Linda and their descendants for their reasonable support, maintenance, education and medical care. Distributions of trust income to Carol’s grandchildren will be taxed at their lower income tax brackets. Upon Carol’s death, she will leave the balance of her generation-skipping transfer tax exemption to the family trust, and the rest of her assets, if any, to Tim.

By implementing this trust arrangement, Carol is not only able to remove the gifted assets (as well as the growth on the gifted assets) from inclusion in Tim’s and Linda’s taxable estates for estate tax purposes upon their respective deaths, but she is also able to shift the income from the gifted assets (as well as the growth on the gifted assets) from her high income tax bracket to the much lower income tax brackets of her grandchildren. The income tax savings for the family group over the combined lifetimes of Carol, Tim and Linda will be substantial.

Using Conduit Trusts to Guarantee the “Stretch” For Inherited IRAs -Case Study. Mike Client (age eighty), a widower, has $1,800,000 in a traditional IRA. His daughter, Beth, is a wealthy businesswoman who is in a high income tax bracket. Mike wants to name his grandchildren, ages twenty-eight, twenty-six and twenty-four, as equal beneficiaries of his IRA account. Mike is familiar with the rule which will enable his grandchildren to stretch withdrawals from the inherited IRAs over their lifetimes and thereby maximize deferral of income tax obligations.12 However, he is concerned that the grandchildren may unwisely accelerate their withdrawals and defeat his purpose. Mike’s estate planning attorney assists him in structuring his revocable living trust to incorporate a lifetime conduit trust for each grandchild and designates the conduit trusts as beneficiaries of the IRA upon his death, thus permitting the trustee of each grandchild’s trust share to use the grandchild’s life expectancy to stretch distributions from the retirement account assets over the grandchild’s life expectancy. This will allow Mike’s planning to achieve the best of both worlds – the control afforded by the trust structure, and the income tax deferral benefits of the stretch IRA model.


We believe that the foregoing examples are illustrative of an emerging paradigm. Estate planning advisors have traditionally focused on the three wealth transfer taxes in developing tax reduction strategies for their clients. With increased income tax burdens on the horizon, we submit that that there is a new kid in town – a fourth dimension – income tax reduction planning for the family group. Our central responsibility as estate planning attorneys, from a tax planning perspective, is to assist our clients in maximizing the wealth they can pass to younger generations. By increasing our awareness of income tax reduction solutions and incorporating them into our design process, we can add another layer of wealth preservation. We wish to express our sincere gratitude to Charles P. Cocke, CPA, and Howard M. Zaritsky, Esq. for their generous contributions to this article.

Patrick J. Vaughan, a principal at Vaughan, Fincher and Sotelo, P.C., is listed in The Best Lawyers in America and was recently recognized as a leading trusts and estates attorney in Worth magazine, Washingtonian magazine, and Legal Times. Pat has been practicing law for over thirty-five years, focusing his career on Estate Planning and Administration. He obtained both his B.S. in Accounting and his Bachelors of Law from the University of Virginia and his Masters of Law in Taxation from Georgetown University. He is a member of the Bars of Virginia, Maryland and the District of Columbia, the American College of Trusts and Estates Counsel, the Northern Virginia Estate Planning Council and the Virginia Society of Certified Public Accountants.

C. Daniel Vaughan, a principal at Vaughan, Fincher and Sotelo, P.C., obtained his B.A. in Religious Studies from the University of Virginia and graduated Order of the Coif with his J.D. from the College of William and Mary. Dan was a member of the Law Review and served as a teaching assistant at William & Mary. He is a member of the Virginia State Bar, the Wills, Trusts and Estates section of the Fairfax Bar Association, the Loudoun County Bar Association and the Northern Virginia Estate Planning Council.

Kathi L. Ayers, an associate at Vaughan, Fincher & Sotelo, P.C., received her B.A. in Biochemistry, cum laude, from Eastern College in St. Davids, Pennsylvania, and her J.D. from George Mason University School of Law. She is a member of the Virginia State Bar, the Wills, Trusts and Estates section of the Fairfax Bar Association and the Northern Virginia Estate Planning Council.

1. I.R.C. § 408A(c)(3).

2. I.R.C. § 408A(d)(3)(A).

3. I.R.C. § 408A(c)(5).

4. I.R.C. § 170(b)(1).

5. I.R.C. § 170(d)(1).

6. I.R.C. § 408A(d)(6).

7. I.R.C. § 529(c)(2)(b), I.R.C. § 2503(b).

8. Va. Code § 58.1-322(D)(7)(a).

9. I.R.C. § 2503(b)(1).

10. I.R.C. § 1(g)(2)(A), as amended by Act § 8241(a).

11. I.R.C. § 2503(e).

12. Treas. Reg. § 1.401(a)(9)-5, Q&A 5(a)(1).