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What Tax Records to Keep and For How Long

Filing your taxes isn't just a once-a-year endeavor. Maintaining good records throughout the year—and disposing of old ones when appropriate—not only provides you with greater confidence now when you prepare your tax return, but it also provides you with documentation you may need down the road.

Lucky number six. One of the most common questions we’re asked is, "How long should I keep my tax returns?" Although you can get away with keeping them only three years, we recommend you keep all federal and state income tax returns and supporting documents for a full six years. Why so long? Once you've filed your returns, the IRS has up to three years to assess additional taxes. However, it can take up to six years to make a tax assessment if the IRS determines that you omitted a substantial amount of income from your return. You may believe your returns are accurate and all-inclusive, but the IRS may feel differently. Be sure to file your U.S. Postal Service or electronic mailing receipts with your returns, too. If your return is ever lost or misplaced, having a receipt showing the date the return was submitted will save you from penalties.

File it, but don't forget it. Some events produce documentation that should be kept permanently: settlement records from all of your home purchases and sales, investment purchases, divorce agreements, etc. But just because an event ends doesn't mean that the documentation process should. Before you move your records to the attic, remember that regularly filing “updates”—home improvement receipts, records that show a return of capital on your investments, estate and gift tax returns under which you received property, etc.—will help to compute your gain/loss when you sell. There are other situations in which you would benefit from keeping records, including any nondeductible contributions you have made to an IRA or Roth IRA. Review your personal and financial history with a professional to ensure you have all your bases covered.

So, how complete are your files?

Potential Constitutional Challenge of I-1098

Below is a news release by the Tax Foundation (nonpartisan and nonprofit tax research group based in Washington, D.C.) headlined Constituional Challenge to Income Tax Would Follow Success of Initiative 1098 in Washington reporting from a new study by Joseph Henchman, tax counsel and director of state projects at the Tax Foundation.


Washington, DC, October 26, 2010 - If Initiative 1098 passes next week, Washington will have its first income tax, and it will almost certainly face a strong constitutional challenge, according to a new study by Joseph Henchman, tax counsel and director of state projects at the Tax Foundation.

"Since the income tax was ruled unconstitutional in Washington," said Henchman, "Evergreen State voters have rejected constitutional amendments to permit one six times. The vote in 1973 was 77% against the tax despite approval by the legislature and the governor."

Popular opposition to income taxation has always been strong in Washington, one of the seven states with no personal income tax. The other six are Wyoming, South Dakota, Nevada, Texas, Florida and Alaska. Tennessee and New Hampshire impose no wage tax but do tax interest and dividends. Washington would be the first state since Connecticut in 1991 to enact a personal income tax.

Even if it is constitutional, it is certainly unlike any other state's income tax, out of the norm in two respects: it would apply to all adjusted gross income with no exemptions or deductions, and it would apply only to high-income earners.

"Just as several other states are overturning so-called millionaires' taxes or allowing them to expire," said Henchman, "Washington would be adopting one."

Comparative rankings of state tax climate by the Tax Foundation and other research groups uniformly praise Washington's current system of forgoing a tax on wages and other personal income, and those rankings would plummet if a personal income tax is enacted. Oregon's competitive posture in the region would rise markedly, as Washington would be matching Oregon's taxation of high wages, while Oregon maintains its competitive advantage of being the only state in the region with no general sales tax.

In many cases, high-income Washington taxpayers would pay a higher fraction of their income when faced with a 9% rate than Oregonians would facing a 9.9% or 11% rate because of more generous treatment in Oregon of some income sources.

The study is Tax Foundation Special Report, No. 186, "Washington Voters to Consider High-Earner Income Tax," by Joseph Henchman, Tax Counsel & Director of State Projects, and is available at http://www.taxfoundation.org/publications/show/26803.html.

The Tax Foundation is a nonpartisan, nonprofit organization that has monitored fiscal policy at the federal, state and local levels since 1937.

Washington Initiative Measure No. 1098 (I-1098)

Washington State is one of a handful of states without a state income tax. Lawmakers have attempted to institute a Washington State income tax in prior years with little success. Currently, Bill Gates Sr., a prominent Seattle area attorney, is promoting a new Washington State income tax on individuals with adjusted gross income above $200,000 and joint-filers with adjusted gross income above $400,000 (the initiative also reduces state property and business taxes). Proponents of I-1098 argue that it would raise $2 billion annually for education and health services from only 1.2 percent of all Washington households. Opponents of the tax believe that it would hinder the state's ability to attract talented executives and business people and argue that state lawmakers could lower the income thresholds with a majority vote two years after the initiative is enacted.

Here is an article from the Olympian that discusses the initiative.

Below is the Ballot Title and Summary from the Secretary of State's website, as well as a hyperlink to the complete text of the initiative:

Ballot Title
Statement of Subject: Initiative Measure No. 1098 concerns establishing a state income tax and reducing other taxes.

Concise Description: This measure would tax “adjusted gross income” above $200,000 (individuals) and $400,000 (joint-filers), reduce state property tax levies, reduce certain business and occupation taxes, and direct any increased revenues to education and health.

Ballot Measure Summary
This measure would establish a tax on “adjusted gross income” (as determined under the federal internal revenue code) above $200,000 for individuals and $400,000 for married couples or domestic partners filing jointly; reduce the limit on statewide property taxes by 20%; and increase the business and occupation tax credit to $4,800. The tax revenues would replace revenues lost from the reduced levy and increased credit; remaining revenues would be directed to education and health services.

Click here to see the complete text of Initiative 1098.

Bush Tax Cuts Quiz and Calculator

The Tax Foundation, which is a nonpartisan tax research group based in Washington, D.C., has created a 10 question quiz that allows users to test their knowledge of the expiring Bush-era tax cuts and what President Obama is proposing to do about them.

The quiz is part of the Tax Foundation's series on the expiring Bush-era tax cuts, which includes blog posts, studies, FAQ's, and a calculator that shows users what their 2011 tax burden will be if the tax cuts expire.

Many of the questions can be answered from some of our prior blog posts and hyper-linked articles.

Ask a Tax & Estate Attorney

Question: Should I use a Will or Living Trust to pass property to my loved ones at death?

Answer: It depends. Both Wills and Living Trusts can effectively pass property to your loved ones at death. Generally, people use Living Trusts to avoid probate because, in many states, the probate process is arduous, time consuming, and expensive. But in Washington, the probate process is, in most cases remarkably simple, efficient, and inexpensive, so Living Trusts, which tend to be more costly to create and require lifetime administration, may not be the best choice. Sometimes people tout taxes as a reason for Living Trusts, but there is no obvious tax advantage to a Living Trust over a Will. Both Wills and Living Trusts can be used to save death and income taxes. So more times than not, unless there are other reasons compelling for trusts (e.g., real estate outside of Washington, asset management concerns, privacy concerns) we recommend Wills. That said, there is no "one size fits all." Determining which vehicle is best for you depends upon your particular circumstances and desires.

Do you have a tax or estate question? Submit your question to askus@brownsterling.com.

Recent Changes to the Tax Law

According to a BNA Tax Management and Weekly Report by Brett Ferguson, the House passed a bill (H.R. 5297) that includes $12 billion in tax cuts for small businesses. The White House said President Obama will sign the bill into law.

Democrats have argued that the bill will create as many as 500,000 jobs, while Republicans argue that the bill provides unnecessary reporting requirements that will burden small business owners.

The bill will extend the 50 percent bonus depreciation provision for one year and increase the dollar limitation of the Section 179 deduction to $500,000 for depreciable property not exceeding $2,000,000. The bill will allow business owners to deduct the cost of health insurance for the purpose of computing 2010 self-employment taxes. In addition, investors in small businesses would be allowed a 100 percent exclusion for capital gains from the sale of certain small business stock. Furthermore, the bill provides an increase in the allowable deduction for startup business expenses.

The tax cuts are offset by a provision that allows individuals with 401(k), 403(b), and 457(b) plans to roll the pretax balances into Roth IRAs. If the rollover is made in 2010, then the taxpayer can pay the tax over two years in 2011 and 2012. Additional revenues would come from a provision that requires individuals who receive rental income from real propety to file 1099 informational returns to the IRS and to service providers if payments have totaled $600 or more during the year for rental property expenses.

We should see more dramatic changes to the tax laws in the coming months. Be sure to stop by for more updates.

Source: House Votes to Send $12 Billion In Small Business Tax Cuts to Obama, 29 TMWR 1283, Brett Ferguson.

You Mean I have to 1099 Office Depot?

Starting in 2010, a provision in the new health care reform law requires self-employed workers, small businesses, charities and government agencies to issue Form 1099s to every vendor that they purchase more than $600 in goods from during the year.

So if your are a small business that buys $700 worth of office supplies from Office Depot then you will be required to send a Form 1099 to the store and the IRS.

This provision in the health care legislations is meant to give the IRS more information about small businesses with the hope that it will reduce the total amount of underreported income in this county.

But this provision will be more of a burden to small business owners than a benefit. Businesses that make qualified purchases from at least 250 vendors during a year will be required to file their 1099s electronically, which means that business owners have to purchase expensive software to comply. Overall you'll find more business owners receiving computer generated nastygrams from the IRS wanting additional taxes and penalties.

Let's hope this law is repealed before 2012.


Source: Small businesses, charities face more reporting rules, Sandra Block, USA Today

What to Expect in 2011? Who knows?

I recently read a good article in the Wall Street Journal about many of the tax changes to come in 2011. The article addresses what's ahead regarding dividend rates, individual income tax rates, capital gains rates, estate taxes, gift taxes, charitable giving, the alternative minimum tax, and various other issues. It provides some good insight as to what readers can expect. It goes without saying that the Obama administration is keeping their sights set on individuals making more than $250,000 a year. Please keep in mind that all of these issues should be considered with a tax professional before making a move.

Non-Profit Filing Deadline

Nearly all tax-exempt organizations must file an annual return with the IRS. As a general rule, tax-exempt organizations must file a Form 990 unless they qualify to file a 990-EZ or 990-N. For several years, the smallest tax-exempt organizations (gross receipts of $25k or less) had no filing requirement. However, the IRS now requires the smallest tax-exempt organizations to electronically file Form 990-N (also called the e-Postcard).


Also any tax-exempt organization that fails to file required returns for three consecutive years, whether it be the Form 990-N, 990-EZ, or 990, automatically loses its federal tax-exempt status. If an organization loses its tax-exempt status, then it must reapply with the IRS to regain its tax exemption. Any income received between the revocation date and renewed exemption may be taxable.


If you are part of a small tax exempt organization, which has failed to file required returns for 2007, 2008, and 2009, then you are in luck. Small tax exempt organizations can preserve their status by filing returns by Oct. 15, 2010, under a one-time relief program provided by the IRS. The smallest tax-exempt organizations required to file Form 990-N can go to the IRS website and submit a simple form to bring itself back into compliance. While small tax-exempt organizations eligible for file a Form 990-EZ may participate in a voluntary compliance program (VCP), file delinquent annual returns, and pay a compliance fee.


If you don't know whehter your organizations has filed to file returns for the last three years, the IRS has posted on the following page the names and last-known addresses of these at-risk organizations, along with guidance about how to come back into compliance.


As always, we generally recommend that you contact a tax professional before doing anything.

Irrevocable Life Insurance Trust (The ILIT)

Let's set up a hypothetical. Married couple age 40. Two children ages 10 and 12. Total value of their combined estate is $2.5 million.

Equity in home = $200k

Qualified Retirement Plan (i.e. IRA) = $200k

Stocks and Bonds = $100k

Term Life Insurance = $2 million

If we take the advice of the previous article and include a credit shelter trust into the couple's Wills, then all but $500k will be exempt from estate taxes (assuming both husband and wife die with a $1 million exemption amount).

The $500k could be subject to estate taxes at a top rate of 55% in 2011. But we can avoid all estate taxes if a life insurance policy is owned by an Irrevocable Life Insurance Trust ("ILIT"). An ILIT is one of a few techniques available to estate planning attorney to enable clients to transfer property to family members without having the property included in their estates at death.

Let's assume the life insurance policy is a ("Survivor Policy"), which insures both husband and wife and pays the proceeds on death of the second spouse to die. Now let's assume the couple establishes an ILIT, then transfers the existing insurance policy to the ILIT. The couple then transfers liquid assets sufficient to pay the first year's premium to the ILIT. Each year, the donor makes a gift to the ILIT sufficient to pay the premiums due. The children, as named beneficiaries, are given a 30 day "Crummy" right to withdraw the contributions (which they never exercise) so that each contribution is exempt from gift taxes.

At death, the life insurance proceeds are paid to the ILIT and distributed to beneficiaries under the terms of the ILIT. If the couple lives for three years after the transfer of the existing policy to the ILIT, then at death, the policy is totally excluded from their estates, which means the last spouse to die will only have a $500k estate and the children won't have to pay any federal estate taxes.

The trustee of the ILIT should be a third party (i.e. a trusted sibling or friend). Upon the death of the both spouses, the trustee will manage the property for any minor children until a certain age or ages at which point the trust proceeds may be distributed to the children outright.

In sum, the ILIT is a great way to transfer wealth to the next generation while avoiding estate taxes. As 2011 draws near, it is becoming more and more likely that we might be looking at a $1 million exemption per person. The lower the exemption the more ILITs will be used to transfer wealth.

Recent Question

Below is a recent question I answered on http://www.avvo.com/. It is a common question of many clients with creditor issues.

Q: does it make sense to purchase/transfer assets in the name of the spouse.: if you are in a profession/job subject to litigation, does acquiring/transferring assets in the name or your spouse keep those assets in the event you are sued. I live and work in the state of Washington.

A: Thomas' answer: Not necessarily. Washington is a community property state. Assets acquired during the marriage are presumed to be community property, which means each spouse has 1/2 interest in the whole. You may rebut the presumption if you can trace the funds used to purchase the asset to a separate property source (i.e. inheritance). But keep in mind, inheritance will only retain its separate character during marriage only if it has not been commingled with community funds. Separate entities such as limited liability companies and certain irrevocable trusts may be a better way to hold title to the assets depending on what assets you are acquiring. Also professionals should probably consider having malpractice insurance as well.

Visit my profile on Avvo.com

The Credit Shelter Trust

Typically people come to our office looking for a Will, which gives all of their assets to their spouse, if living, and if not, their children. Many times our clients know that there is an estate tax, but most have no idea that the estate tax could affect them.

I generally ask our clients to complete a brief asset worksheet which usually reveals something like this:

Equity in the Primary Residence = $200,000

Qualified Retirement Plan (i.e. IRA) = $200,000

Stocks and Bonds = $100,000

Term Life Insurance (Face Value) = $2,000,000

TOTAL = $2,500,000

Most people ask, "Why do you want to know the amount of our life insurance, its not subject to tax anyway?"

They are in part correct. Life insurance is not subject to income tax. But it is subject to the estate tax.

As stated in previous articles, the life-time exclusion amount for each person in 2011 will be $1,000,000 unless Congress acts. This means that if you die in 2011 the amount that exceeds $1,000,000 will be subject to an estate tax with a top rate of 55%.

Let play this out with the above clients. Assume that the above clients are a married couple and they would like an "I love you Will," which gives everything to one another first then their children.

Under current federal and Washington state estate tax laws, a husband and wife may transfer an unlimited amount of property to one another free of estate taxes (called the unlimited marital deduction). Assume that husband dies in January 2011 and gives everything to his wife. Now, the wife's estate is worth $2,500,000. If she dies the following December leaving everything to the kids, then $1,500,000 will be subject to the estate tax at a top rate of 55%. So wife's children could be looking at roughly a $800k tax bill.

However, if the couple had their estate planning attorney draft a "credit shelter trust" in their Will, rather than going with the standard "I love you," they could have saved their children the $800k.

So what's a credit sheleter trust? It is a paragraph in your will that says if I die before my spouse then I want a portion of my estate to go into a trust for the benefit of my spouse's health, education, support and maintence. The suriving spouse can be the trustee of this trust as well as the life-time beneficiary. When she dies, the rest will pass to the children in equal shares.

If husband dies with a credit shelter trust, then an amount equal to the life-time exemption amount ($1 million in 2011) of the husband's total estate goes into the credit shelter trust for the benefit of the surviving spouse. The rest of the husband's estate ($250,000) passes to the surviving spouse outright. No estate tax is paid at husband's death because he used his $1 million exemption amount to shelter the property that went into trust, and the $250,000 that transferred to wife passed tax free under the unlimited marital deduction.

Wife now has a $1,500,000 million dollar estate rather than a $2.5 million dollar estate. Now she can use her $1 million exclusion amount to shelter all but $500,000, saving over $500,000 in estate taxes.

The credit shelter trust is a widely used estate planning tool used by many people in this situtation. However, there are many other tools that can be used to save even more. In the articles to follow, I will address what the wife can do to shelter the remaining $500,000 from the estate tax.

Surprise! You're Wealthy!

Well, here we are almost two-thirds of the way through the year and it appears more and more that, by default, Congress will redefine the definition of what it means to be wealthy in this country. Assuming Congress doesn’t act soon, on January 1, 2011 “wealthy” will mean any person who has the ability to leave more than $1,000,000 to his or her family and friends. Granted, on its face, $1,000,000 is a lot of money and few of us think that we realistically have the ability to leave that much when we died, but when you take a closer look at how that number is calculated, it’s surprising how many of us it includes. Generally the calculation includes any asset you have “dominion and control over” at the time of your death. The obvious things are bank and investment accounts and properties, personal property (e.g., vehicles, home furnishings, jewelry and collectables), and home equity (is there such a thing these days?). Then you have your tax deferred retirement accounts (IRAs, 401(k)s, etc.) and business interests. And finally, the one that surprises most people: the death benefit of life insurance.

If, when you add the value of all of these things together, the total is over $1,000,000, then 55 cents of every dollar over that amount will go to the U.S. Treasury. A couple of things make it even more painful. With life insurance, for example, it just doesn’t seem right that the death benefit should be subject to estate tax – after all, you never see a penny of it while you’re living. For business and real estate owners, the tax is levied on the value of the business or property. That means, unless there are other assets to pay the tax with (like life insurance), the business or the home may have to be liquidated. And then, if you have a qualified retirement plan, all of the unpaid income tax (at a rate of up to 35%) may become due at death in addition to the 55% estate tax.
The simplest strategy for avoiding the estate tax is to be sure to get rid of it all before you die, but that may be difficult to execute and, as might be expected, the government has devised ways to foil that strategy too. That said, there are other things you can do short of impoverishing yourself. In my next article I’ll discuss some of those strategies. Until then, enjoy your wealth.

Geithner to Get Your Green

In the July 8 blog entitled "Bush Tax Cuts," I stated that Congress must act to avoid allowing many of the Bush tax cuts to expire in 2011. Congressional inaction will raise taxes across the board (including income tax rates for low and middle income earners).

The the following article provides that the Treasury Secretary, Timothy Geithner, said "the White House would allow taxes on top earners to increase in 2011 as part of an effort to bring down the U.S. budget deficit. He said the White House plans to extend expiring tax cuts for middle- and lower-income Americans, and expects to undertake a broader revision of the tax code next year."

Although I want to believe Geithner, I don't think Congress will get their act together soon before the cuts expire. However, I think we can expect to see some speeping tax reform some time in 2011, and high incomers ($250,000 +) have a big bullseye on their back.

Plan for the worst, but hope for the best.

Are You THAT Passionate about Estate Planning?

For 2010, the federal estate tax has been repealed. But due to Congressional inaction, it is set to come roaring back in 2011 with only a $1 million exemption amount (the amount that each person may shelter from estate taxes when they die).

Here is an interesting article from the Wall Street Journal that addresses how the failure to address the estate tax issue has incentivized death.

The article indicates that it is unlikely Congress will apply the estate tax retroactively to Jan. 1, 2010. As each day passes, it become less and less likely that Congress will pass new legislation to increase the exemption amount in 2011.

Interestingly enough, our state passed the Death with Dignity Act in 2009. The law allows terminally ill Washington residents, who have less than six months to live, to request a lethal dosage of medication. The law requires that the patient submit a form to request the administration of the life ending medication. The Washington Department of Health's website indicates that it collected 64 forms in 2009 and 49 form in 2010. The questions becomes whether the number of forms collected will increase in 2011 as a result of the the federal estate tax laws.

I hope no one is that passionate about estate planning.

Bush Tax Cuts

During his first term in office, George W. Bush and friends passed several different tax cuts. Bush and company could not obtain enough support to the make cuts permanent. As a result, many of the tax cuts are scheduled to "sunset," or revert back to the provisions that were in effect before the cuts were made, on January 1, 2011.

Sunsetting of the Bush tax cuts will affect nearly all taxpayers in the United States. Here is an article from the Wall Street Journal about how the expiration of some of the Bush tax cuts will be felt by taxpayers.

A few of the notables include changes to individual tax rates as well as changes to the capital gains and dividend rates. If Congress does not act then the current individual tax rates of 10%, 15%, 25%, 28%, 33% and 35% will be replaced with the higher rates of 15%, 28%, 31%, 36% and 39.6%. In addition, without Congressional action, the current 15% tax on long-term capital gains will be revert back to 20%, while the 15% dividend rate will increase to 39.6%.

One change involves the estate tax exemption. In 2009, each person could use a $3.5 million exemption to shelter assets from the estate tax, which carries with it a 45% average rate. If the Bush tax cuts sunset without Congressional action, then the exemption will revert back to a $1 million exemption and with a top rate of 55%.

In short, lawmakers must address these and many other tax issues by the end of the year. If they don't, death taxes will rise, tax rates will rise, and many tax benefits will expire.

Will lawmakers act? So far Congress has been preoccupied with healthcare reform and November elections, and according to the Wall Street Journal, Congress has fewer than 40 working days left before November with no lame-duck session scheduled. What do you think?

I think the Bush tax cuts may be going the way of the Dodo.

SECA and S Corps - Wait and See

The Self-Employment Contributions Act (SECA) imposes a 15.3% tax on wages earned by self-employed people. Many self-employed business owners employ a popular tax saving device and pay themselves a "reasonable" wage and receive the rest of the profit as a dividend. The dividends are exempt from the SECA tax while the wages are not. (Keep in mind the dividends and wages are subject to the income tax at the individual's regular rate).

Lawmakers are fully aware of this and have attempted to impose a SECA tax that will hit all profits of service firms, including accounting, law, health, engineering, architecture, investment management, brokerage, and consulting firms.

The American Institute of Certified Public Accountants (AICPA) has pushed hard to strike this measure, and as a result it may not become law.

We will just have to wait and see.


Sources: The Kiplinger Tax Leter, Vol. 85, No. 11, May 28, 2010

Death Yes...Taxes...Maybe Not

Here is a short article about a Texas oil tycoon, Dan Duncan (pictured below), that I have mentioned to several of our clients. As many of you are aware, the federal estate tax has been repealed for 2010. Mr. Duncan died in 2010 with about a $9 billion dollar estate. If Mr. Duncan died three months earlier, $9 billion would have been subject to a federal estate tax of at least 45 percent, which means the IRS would have received about $4 billion from Duncan's estate. He couldn't have passed at a better time for estate planning purposes (mixed emotions from the heirs I'm sure).

Uncle Sam may find comfort in the fact that the heirs will still have to pay capital gains taxes upon the sale of some of his assets, as well as the fact that Congress may still retroactively apply the federal estate tax to January 1, 2010. But if Congress wants to avoid a strong Constitutional challenge from the heirs, they'll need to get their head out of the healthcare game and into tax policy before year end.