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Question: I have a client who is a small-business owner looking to set up a 401(k) plan for himself and his employees. He’s the only “highly compensated employee.” Should he be worried about contributing too much to his own plan as elective deferrals?

Answer: Your client should be aware of the rules against discrimination in favor of highly compensated employees.

The general rule is that if a 401(k) plan meets one of the following tests, it doesn’t discriminate in favor of highly compensated employees (HCEs):

• The actual deferral percentage (ADP) for all HCEs does not exceed 125% of the ADP for all other eligible employees; or
•  The ADP for eligible HCEs does not exceed twice the ADP for all other eligible employees, and the ADP for eligible HCEs does not exceed the other employees’ ADP by more than two percentage points.

ADP is the ratio of the amount of employee deferrals to the employee’s salary. The maximum salary taken into account for HCEs is $260,000 in 2014.

Let’s say your client’s workforce consists of the following employees, including your client:

Also assume your client made no matching or nonelective employer contributions to any employees, including himself.

Larry, Curly and Moe, the non-highly compensated employees, have an average ADP of 4% (the average of 5%, 0% and 7%). The first ADP test is failed because your client’s ADP exceeds 5% (i.e. 125% of 4%). The second test is also failed because your client’s ADP is more than two percentage points higher than his non-highly compensated employees’ average ADP.

Since both the ADP tests failed, your client’s 401(k) plan discriminated in favor of HCEs, and your client would need to withdraw the excess contributions—that is, distribute $1,900, which brings his ADP down to 6% and passes the second ADP test.

If he withdraws excess contributions after 2 ½ months from the close of the plan year, he incurs a 10% excise tax. He must also withdraw the excess contributions within 12 months from the close of the plan year or the plan will be disqualified.

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Question: I have a client with two separate IRAs. Can he take a distribution from one IRA, roll it over within 60 days, and then do the same with his second IRA, effectively giving him 120 days to have access to his IRA funds?

Answer: No. A taxpayer is only allowed one IRA rollover per year. The Tax Court recently decided Bobrow v. Commissioner, T.C. Memo. 2014-21 (1/28/14), clarifying that the one-year waiting period applies to the IRA owner—not each IRA individually.

In Bobrow, the taxpayer was a tax attorney who owned two IRAs. He withdrew about $65,000 from one IRA and redeposited it within 60 days. He also withdrew the same amount from his second IRA and redeposited this amount within 60 days.

The taxpayer argued that the one-year waiting period applies to each IRA—not the taxpayer’s combined IRAs. The Tax Court disagreed, holding that the one-year limitation applies to all of a taxpayer’s retirement accounts.

Therefore, the taxpayer’s first rollover was respected, but his second was not. He was required to pay (1) ordinary income tax on the second $65,000 distribution, (2) the 10% early distribution penalty, and (3) the 20% accuracy-related penalty on the unpaid tax.

It’s important to note that prior to Bobrow, the answer to your client’s question was most likely “yes” because the IRS, in Publication 590, previously said that the one-year waiting period between rollovers applies to each individual IRA. Bobrow shows that the IRS has likely changed its position to one less advantageous to the taxpayer.

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Question: Can a Coverdell Educational Savings Account be rolled over into a Section 529 qualified tuition program?

Answer: Technically, no—a Coverdell may only be rolled over into another Coverdell for the same beneficiary or a family member of the beneficiary. However, there is another way to achieve the same result: the account holder could withdraw the funds from the Coverdell and, within the same year, contribute such funds into a 529 plan on behalf of the same beneficiary.

Here’s how it works. Distributions from Coverdell accounts are income-tax-free if the funds are applied toward qualified educational expenses—typically tuition, books and other educational costs. A contribution to a 529 plan from a Coverdell on behalf of the same beneficiary is considered a qualified educational expense as long as the transaction is completed within the same calendar year.

There are no yearly contribution limitations on how much an individual can contribute to a 529 plan, so the account holder could distribute the entire Coverdell account into a new 529 plan if he wanted.

The combination of these rules effectively allows a Coverdell account holder to roll over his entire account balance into a 529 plan.

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Question: Are accelerated benefits due to chronic illness subject to income tax if the policy is owned by someone other than the insured?

Answer: Accelerated benefits are generally treated as death benefits and are therefore not subject to ordinary income taxes—with one exception.

If the accelerated benefits are paid to someone other than the insured by reason of the insured being a director, officer, or employee of the policy owner or by reason of the insured being financially interested in any trade or business carried on by the policy owner, then the accelerated benefits are taxable. See Code Section 101(g)(5); IRS Publication 554, pages 16-17.

For example, if the insured’s wife owns the policy, the accelerated benefits would not be subject to income taxes; but if his employer owns the policy, the accelerated benefits would be taxable.

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Question: My client, who’s younger than 59 ½ with multiple IRA accounts, wants to begin receiving a series of substantially equal periodic payments for life (SEPL) from one or more of his accounts to avoid the 10-percent penalty under Section 72(t). Can he base the SEPL payments on multiple accounts while actually distributing the required distributions from only one of the accounts?

Answer: Yes.

When calculating SEPL payments, the taxpayer may, but does not have to aggregate each of his retirement accounts. He can pick and choose which accounts to include into calculating his SEPL payments. If he chooses to aggregate multiple accounts to calculate his SEPL payments, he is permitted to withdraw the required distributions solely from one account, or from a combination of any account.

Let’s say your client has two IRAs of equal value and wants to withdraw $1,000 per month. However, he found that his SEPL payments would require him to withdraw $2,000 per month if he aggregates the accounts. He could take early withdrawals of only one account, resulting in his goal of $1,000 per month in distributions.

On the other hand, let’s say he prefers to aggregate his accounts to maximize his SEPL payments for the full $2,000. He could satisfy the required $2,000 monthly SEPL payment by distributing funds solely from one account, or any combination of the two.

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Question: If the beneficiary of a life insurance policy has the option to receive the death benefits in installments throughout her life, will she still receive the payments tax-free?

Answer: Not entirely. While life insurance proceeds are generally excluded from gross income, if they are received as installments throughout the life of the beneficiary, the interest portion of each payment will be taxable as ordinary income.

To determine the excluded part, divide the total amount held by the insurance company (usually the lump sum payable at death) by the number of installments to be paid.

If the payments are to continue throughout the life of the beneficiary, divide the amount held by the insurance company by the beneficiary’s life expectancy. The amount held by the insurance company is reduced by the actuarial value of any refund or guarantees.

For example, consider a taxpayer who chooses to receive $825 every month for the remainder of her life as opposed to a lump sum of $90,000. If she is expected to live another 10 years, she may exclude $750 ($90,000 ¸ 120 months) from her gross income, resulting in $75 of ordinary income in the first month.

As you might notice, receiving the life insurance proceeds through periodic installments for life reaches the same tax results as accepting a lump sum payment and then purchasing an immediate annuity for life.

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Question: Are accelerated death benefits subject to ordinary income tax treatment?

Answer: Generally, accelerated death benefits are excluded from gross income under Section 101(g) if the insured is either terminally or chronically ill.

The IRS in Publication 554 gives further guidance on terminally and chronically ill persons:

A terminally ill person is one who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months.

A chronically ill person is not terminally ill, but has been certified within the last 12 months by a health care practitioner as meeting either of the following conditions:

• The person is unable to perform (without substantial help) at least two activities of daily living (eating, toileting, transferring, bathing, dressing and continence) for a period of 90 days or more because of a loss of functional capacity.
• The person requires substantial supervision to protect himself or herself from threats to health and safety due to severe cognitive impairment.

Accelerated benefits which pay for long-term-care expenses for chronically ill persons are fully excludible, as are per diem costs up to a reasonable limit.

The exclusion does not apply to amounts paid to another person if the he or she has an insurable interest because the insured is a director, officer or employee of the other person, or has a financial interest in the business of the other person.

If the death benefits are accelerated for a reason other than being terminally or chronically ill, the benefits are not excluded from income under Section 101. However, they might be income tax-free under another Code Section, such as Section 104 with respect to a Critical Illness Rider.

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Question: What advice should I give my clients as the year comes to an end?

Answer: For many, December offers the last big chance to reduce and manage income tax results for the year. Some advice is specific to 2013, but much of the advice is generally applicable at the end of every year.

For individuals:

• Defer income for a year by waiting to sell appreciated stock or other property until the beginning of next year. For clients expecting their incomes to increase next year, though, it might make sense to incur the gain on the sale now while their tax brackets are relatively low.
• Harvest losses by coordinating sales of loss property with gain property to neutralize capital gains.
• Defer income by making elective deferrals to 401(k) or other qualified plans, if possible.
• Make qualified charitable distributions from an IRA to satisfy the required distributions on the year. QCDs are set to expire after 2013.
• Make a $5,500 deductible IRA contribution prior to April 15, if eligible.
• Consider buying an electric car or installing energy efficient improvements before the end of the year in order to take advantage of certain expiring tax credits.

For wealthier clients looking to lower their respective estate taxes:

• Make annual exclusion gifts. The annual exclusion allows an individual to make a $14,000 gift in 2013 without incurring any gift taxes or filing a return.
• Make family gifts of appreciated property.
• Make gifts of family limited partnership interests.

For business owners:

• Take advantage of the expiring bonus depreciation rules which allow business owners to expense half the cost of certain depreciable assets in the first year.
• Take advantage of the ability to expense certain assets under Section 179. This section allows the business to immediately deduct the purchase price of assets that would otherwise be capitalized. Section 179 is significantly weakened after 2013.
• Take advantage of the ability to depreciate certain real property on a shorter, 15-year schedule. This ability is set to expire after 2013.
• Take advantage of the Work Opportunity Tax Credit by hiring individuals from certain targeted groups. To be eligible, the employer must hire the employee before the end of 2013.
• Invest in or purchase small business stock. Under Section 1202, a shareholder of a small business (essentially a C corporation with assets not exceeding $50 million) can exclude a percentage of the gain on the subsequent sale of the stock if held for more than five years. The percentage is 100 percent if the stock was acquired in 2013, but only 50 percent thereafter.

Additionally, as with the end of every year, your client should review his personal and business documents, including any buy-sell agreements, estate planning documents and any other document with a listed beneficiary to make sure everything is up-to-date in the client’s life.

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Question: What portion of my client’s income will be subject to the 3.8 percent tax on net investment income?

Answer: If your client either (a) has no investment income or (b) earns less than the statutory threshold amount, he will not be subject to the 3.8 percent tax.

The threshold amount depends on your client’s filing status. If he’s married filing jointly, the threshold amount is $250,000, or half that if he’s married filing separately. If he’s not married, the threshold amount is $200,000. The threshold amounts are not indexed for inflation.

Assuming your client has both net investment income on the year, and he earns more than the threshold amount, the 3.8 percent surtax is levied on the lesser of:

1. His net investment income for the taxable year, or
2. The excess (if any) of—

a.   His modified adjusted gross income (MAGI) for the taxable year, over

b.   The threshold amount.

Unless your client earned income outside of the United States, his MAGI will simply be his adjusted gross income on the year, which can be found on page one of his Form 1040. Adjusted gross income is essentially gross income after certain deductions are applied.

Net investment income is essentially passively-earned income, including:

Interest income;

• Dividends;
• Capital gains;
• Rental income;
• Royalties;
• NQDAs;
• Income from businesses involved in trading of financial instruments; and
• Businesses that are passive activities.

Net investment income is reduced by certain expenses that are properly allocable to the income. For example, interest expenses can offset gains from investment property. There are numerous exceptions and other rules that are worth looking into if the surtax applies to your client.

Let’s assume your client is a single-filing taxpayer that earned $220,000 on the year, which includes $50,000 of net investment income. He would incur the 3.8 percent tax on $20,000 (the lesser of (a) $50,000 net investment income, or (b) $20,000 excess of his income over the threshold amount), resulting in a $760 tax.

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 Question:  My client is the owner of a policy on his life. He set up an irrevocable life insurance trust (ILIT) as the beneficiary. He also named himself as trustee of the ILIT. Would this bring the insurance proceeds back into his estate at death?

Answer: The general rule under Code section 2042 is that if the insured either (1) is the beneficiary of his life insurance policy, or (2) has any right to the economic benefits of the policy—referred to as “incidents of ownership”—then the proceeds will be included in the insured’s estate at his death.

Incidents of ownership include the power of the insured to—

• Directly or indirectly to change the beneficiary or contingent beneficiary of the policy;
• Surrender or cancel the policy;
• Assign or revoke assignment of the policy;
• Pledge the policy as collateral for a loan; and
• Obtain a loan from the carrier on the surrender value of the policy.

The fact that an insured is the trustee by itself does not constitute an incident of ownership and bring the insurance proceeds into his estate at death, but various powers as trustee might. For example:

Power of substitution. If a life insurance policy is held in trust, and the insured is the trustee, he may not have the power to substitute the life policy with assets of equivalent value. See Rev. Rul. 2011-28.

• Power to remove and replace trustees of an ILIT. An insured-grantor may remove and replace the trustee of his ILIT only if the successor trustee is not related or subordinate to the grantor. See Rev. Rul. 95-58.
• Power to change beneficial ownership. An insured-grantor, as trustee or otherwise, may not change the beneficial ownership in the policy held in the ILIT without it being subject to his estate. See Treas. Reg. Sec. 20.2042-1(c)(4).
• Power to change the time or manner of the proceeds. An insured-grantor may also not have the power to alter the time or manner that the proceeds are distributed, even if the insured, himself, has no beneficial ownership of the proceeds. See Treas. Reg. Sec. 20.2042-1(c)(4).

Even though your client has no beneficial interest in the proceeds, he still may be subject to estate taxes on the proceeds if he, as trustee, holds certain powers exercisable for his own personal benefits.

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