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Joint purchases
How a simple estate planning tool can save a lot of taxes

Estate planning seems to get more complicated all the time. But there are still a few techniques available that are straightforward and easy to implement — and produce significant tax savings. One such strategy is the joint purchase, also known as a split purchase.

Timing is everything

The joint purchase technique is based on the concept that property can be divided not only into pieces, but also over time. One person (typically of an older generation) buys a current interest in the property and the other person (typically of a younger generation) buys the remainder interest.

A remainder interest is simply the right to enjoy the property after the current interest ends. If the current interest is a life interest, the remainder interest begins when the owner of the current interest dies.

Joint purchases offer several advantages. The older owner enjoys the property for life and his or her purchase price is reduced by the value of the remainder interest. The younger owner pays only a fraction of the property’s current value and receives the entire property — including any appreciation in its value — when the older owner dies.

Best of all, if both owners pay fair market value for their respective interests, the transfer from one generation to the next should be free of gift and estate taxes. The relative values of the life and remainder interests are determined using IRS tables that take into account the age of the life-interest holder and the applicable federal rate (the “Section 7520 rate”), which is set monthly by the federal government.

Family matters

At one time, the joint purchase was a popular way for parents to leave all types of property to their children — from securities to rental real estate — without transfer taxes. But in 1990, Congress, concerned about the potential for abuse, eliminated the tax advantages for most joint purchases.

Internal Revenue Code Sec. 2702 provides that, when members of the same family acquire a split interest in property, the owner of the current interest is treated as if he or she acquired the entire property and then transferred it to the owner of the remainder interest. In other words, the entire purchase price is treated as a taxable gift.

But there’s an exception for a joint purchase of a home. As long as the owner of the current interest uses the property as his or her primary residence, the transaction is exempt from gift tax.
Let’s look at an example. Allan, age 55, jointly purchases a new home with his daughter, Lauren. The price is $1 million and the Sec. 7520 rate at the time of the purchase is 6%. Under IRS tables, Allan pays $710,750 for a life interest and Lauren pays $289,250 for the remainder interest.

When Allan dies 20 years later, the property, now valued at $3.5 million, passes to Lauren tax free. Assuming a 45% marginal estate tax rate, transferring the property outside of Allan’s estate saves more than $1.5 million in taxes.

The drawbacks

Like many estate planning vehicles, joint purchases have disadvantages. The younger owner must buy the remainder interest with his or her own funds. Also, while the tax basis of inherited property is “stepped up” to its date-of-death value, a remainder interest holder’s basis is equal to his or her purchase price. In our example, if Lauren were to sell the property after Allan’s death, she would realize a capital gain of more than $3.2 million.

But, in most cases, the estate tax savings far outweighs any capital gains tax liability. That’s because the highest capital gains rate is currently 15% and the marginal estate tax rate is 45%. So, the tax due on a $3.2 million long-term gain is $480,000, while the estate tax on the $3.5 million of value is $1.575 million. (Keep in mind that this example doesn’t address state taxes.) Plus, the capital gains tax is due only if Lauren sells the property; the estate tax is due by virtue of Allan’s death.

Enlist tools at your disposal

For purposes of Sec. 2702, “family members” are limited to your spouse, your descendants and your descendants’ spouses. So a joint purchase can be a remarkably effective way to transfer virtually any type of property — not just a home — to a niece or nephew, a domestic partner or anyone else who doesn’t fall under the family member definition. Before adding the joint purchase tool to your estate planning arsenal, be sure to consider its pros and cons.

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Extra credit
Expanded tax benefits for qualified research

The research and development (R&D) credit has been around for more than 20 years. And despite continual efforts by supporters to make the credit permanent, the tax break remains a temporary one. Nevertheless, each time the credit has expired, Congress has renewed it.

Most recently, the R&D credit expired at the end of 2005. But the Tax Relief and Health Care Act of 2006 (TRHCA) extended the credit for another two years, through the end of 2007. The act does more than simply revive the credit, though. It also increases the credit for some companies and establishes an alternative, simplified credit that may make these benefits available to businesses that had trouble qualifying in the past.

Reviewing the prerequisites

If your company invests in new product development, process improvement or software development, it pays to determine whether you’re eligible for the R&D credit. Organizations in a broad range of industries — including manufacturing, distribution, construction, health care, technology, finance, agriculture and retail — have been able to take advantage of this tax break.

To qualify for the credit, your R&D activities must pass these four tests:

1. They must be aimed at discovering information that is technological in nature — this includes research in the physical or biological sciences, engineering and computer science.
2. They must relate to a new or improved “business component,” such as a product, process, technique, formula, or invention or computer software.
3. They must be intended to eliminate uncertainty concerning the development or improvement of a business component.
4. Substantially all of them must be part of a “process of experimentation.”

Several types of activities are ineligible. They include research conducted after commercial production begins; research used to adapt or reproduce existing business components; and research related to style, taste, cosmetic or seasonal design factors.

Doing the math

Once you’ve identified your qualifying research activities, you can determine the related expenses that qualify for the credit. Qualified research expenditures (QREs) generally include supplies, W-2 wages for employees conducting research, and 65% of consultants’ fees.

The “traditional” R&D credit is equal to 20% of the amount by which your QREs exceed a base period amount. That amount is calculated by determining your ratio of QREs to gross receipts from 1984 to 1988 and multiplying it by your average gross receipts (AGR) for the previous four tax years (that is, for 2007 you’d use your AGR for 2003 through 2006). Regardless of that result, your base period amount can’t be less than 50% of your QREs in the current year.

There are special rules for companies that didn’t exist from 1984 to 1988 or that lacked sufficient QREs or gross receipts during that period. Or businesses can elect to use an alternative incremental credit that doesn’t require data from the 1984 to 1988 base period. The TRHCA increases the rates used in this approach. For 2007, the incremental credit is equal to:

• 3% of the amount by which your QREs exceed 1% of your AGR, up to 1.5% of AGR, plus
• 4% of the amount by which your QREs exceed 1.5% of your AGR, up to 2% of AGR, plus
• 5% of the amount by which your QREs exceed 2% of your AGR.

The most significant change is the new alternative simplified credit. In the past, the gross receipts requirement was an obstacle for many companies. If your gross receipts grew rapidly, for instance, you may have had trouble qualifying for the R&D credit. The simplified credit eliminates gross receipts from the equation. Beginning this year, you can claim a credit equal to 12% of the amount by which your current-year QREs exceed 50% of your average QREs for the previous three years. If you had no QREs during those years, the credit is 6% of the current year’s QREs.

Finishing your homework

The TRHCA extends the R&D credit retroactively to the beginning of 2006. If you’ve qualified for this credit in the past or if you believe you may qualify now, review last year’s expenses and be sure you’re getting the credit you deserve. Also, work with your tax advisor to determine which credit calculation offers the greatest benefits. It’s worth taking the time because of the potential tax savings.
 

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Do you qualify for child or dependent tax breaks?

The Internal Revenue Code contains a variety of exemptions, deductions and credits designed to ease the federal tax burden on people with children or other dependents. For many years, these provisions had different definitions of “qualifying child.” This inconsistency caused a great deal of confusion among taxpayers and led to a lot of tax return errors.

The Working Families Tax Relief Act of 2004 (WFTRA) sought to simplify this aspect of the tax code by creating a uniform definition of qualifying child. For the most part, it appears that the act has succeeded. Determining whether someone is a qualifying child for purposes of several of the most common tax breaks is a matter of applying four simple tests. In some cases, the new definition leads to surprising — and arguably unintended — results.

Take the qualifying child test

WFTRA’s uniform definition of a qualifying child applies to the dependency exemption, the child credit, the child and dependent care credit, the earned income credit (EIC) and head-of-household filing status. You can claim a person as your child for purposes of these tax breaks if you meet all four of these tests:

1. Relationship. The person is your child, stepchild, eligible foster child, sibling (including a stepsibling or half-sibling) or one of their descendants.
2. Residency. The person lives with you for more than half the year. Temporary absences — due to illness, military service, or school, for example — count as time living at home.
3. Age. The person is under a certain age, but this is one area where the uniform definition isn’t uniform. Age limits vary depending on the tax break involved. (See “Not for all ages” on sidebar.)
4. Support. Unlike under the definition of a dependent, you need not provide more than half of a qualifying child’s support, so long as the child doesn’t provide more than half of his or her own support. One exception is the EIC, which allows you to claim that credit even if your child provides more than half of his or her own support.

There are special rules for divorced or separated parents, as well as tie-breaking rules in the event that more than one taxpayer claims the same qualifying child. And, as before, a qualifying child can’t file a joint return with his or her spouse and generally must be a citizen or resident of the United States, Canada or Mexico.

Determine if the dependency exemption applies

You can claim a dependency exemption for a qualifying child or for a “qualifying relative.” A qualifying relative is someone who doesn’t meet the definition of qualifying child because of the age requirements but does meet these pre-WFTRA tests:

Relationship. The person is a relative (including any of the qualifying-child relationships, plus your parents, stepparents, grandparents and other direct ancestors, nieces, nephews, aunts, uncles and certain in-laws) or is a member of your household for the entire year.

Joint return. The person doesn’t file a joint tax return with someone else.

Citizenship. The person is a citizen or resident of the United States, Canada or Mexico.

Gross income. The person’s gross income is less than the personal exemption amount (currently $3,400).

Support. You provide more than half of the person’s support during the year.

Keep in mind that you can’t claim someone as a dependent if you’re claimed as a dependent on another person’s return.

Watch for odd results

WFTRA creates some peculiar results involving the dependency exemption. The reason for this is the rule that a person who is a qualifying child of one taxpayer can’t be a qualifying relative of another taxpayer.

Let’s see how this rule can work. Michelle, age nine, and Jennifer, age seven, are sisters. Their parents died a few years ago and now they live with their adult cousin, Amy. Even though Amy fully supports Michelle and Jennifer, she doesn’t qualify for the dependency exemption. Amy can’t claim Michelle and Jennifer as qualifying children, because the relationship requirement doesn’t include cousins. And she can’t claim the sisters as qualifying relatives, even though they live with her year-round, because Michelle and Jennifer meet the definition of qualifying child with respect to each other.

This is just one example of several inequitable results caused by the new rules. There are bills pending that would eliminate many of these issues.

Shift tax breaks

Dependency exemptions and certain other child-related tax breaks are phased out for higher-income taxpayers. In 2007, for instance, the dependency exemption is eliminated for joint filers whose adjusted gross income (AGI) exceeds $357,100 and single filers with an AGI greater than $278,900. And the child credit is eliminated for joint filers with AGIs above $130,000 and single filers with AGIs above $95,000.

By eliminating the requirement that taxpayers provide more than half of their qualifying child’s support, WFTRA creates an opportunity for high-income parents to shift tax breaks to their offspring. To take advantage of this strategy, you must meet other requirements.

Keep an eye out

Congress is considering modifications to the uniform definition of qualifying child. So be sure to keep an eye on legislative developments and consult your tax advisor to see how they, or other changes, may affect your tax planning strategies.

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