ESTATE PLANNING TECHNIQUES

BY MILT KAHN CPA
PARTNER

There may be estate planning techniques that will minimize the taxes on your estate. Consider some of these ideas.

Annual Exclusions and Lifetime Exemptions
Currently, every person is allowed a combined federal gift and estate tax exemption that shelters the first $1,000,000 of value from estate and gift taxes. In addition, every person during their lifetime is entitled to give up to $11,000 annually to another person gift tax-free without dipping into their $1,000,000 exemption. Married couples thus have between them a $22,000 annual gift tax exclusion and a $2,000,000 combined gift and estate tax exemption. By establishing gift giving programs early on, substantial amounts of assets and the future appreciation on those assets can be transferred out of an individual's estate.

It is important to realize, however, that it may be advantageous to transfer property that has already appreciated substantially in value during your lifetime through your estate at your death, rather than in the form of lifetime gifts. Your estate or beneficiaries will receive a step-up in basis for income tax purposes to the fair market value of the property at the date of death. As a result, if the property is sold, there may be little or no income tax due on the ensuing gain. In comparison, when a gift of appreciated property is made, the basis of the property in the hands of the transferee will equal your tax basis. The result upon disposition will be the payment of a hefty capital gains tax.

Examples of different types of lifetime programs that can be instituted include outright gifts to children, the creation of inter vivos trusts, qualified personal residence trusts, planned charitable giving and use of Family Limited Partnerships. These programs are extremely important to consider based on the estate tax rate structure in effect. As an estate passes the $1,000,000 exemption, it is immediately taxed at a rate of 41% and the rate continues to climb quickly until it reaches a maximum rate of 55% at $3,000,000. The top marginal rate can reach 60% as a result of a 5% surtax imposed on estates in excess of $10,000,000. As you can see, the result can be a large and possible unnecessary tax bite.

Unlimited Marital Deduction
Lifetime and testamentary transfers between spouses are exempt from both estate and gift taxes. This so called unlimited marital deduction paves the way for the deferral of all estate taxes until the death of the second spouse. In utilizing the benefits of the unlimited marital deduction, it is ever so important to make sure that the $1,000,000 exemption available in the estate of the spouse who dies first is not wasted. This would happen if the combined estates of both spouses were in excess of $1,000,000 and the first spouse to die left everything outright to the surviving spouse. The key to proper planning is to know how to combine the benefits of the unlimited marital deduction with the exemptions available to each spouse to shelter assets of $2,000,000 between the two estates. For combined estates of over $2,000,000, one such strategy is to leave at least $1,000,000 of each spouse's estate in trust for the surviving spouse. (For combined estates under $2,000,000, the trust could be funded with the difference between the value of the combined estates and $1,000,000.) The surviving spouse would have the right to receive income annually from the trust and the lifetime right to invade the principal of the trust if needed. Upon the death of the surviving spouse, the assets of the trust would "by-pass" the surviving spouses' estate and would pass to the children or other beneficiaries. That is why this type of trust is referred to as a Credit Shelter Trust or By-Pass Trust.

Jointly Owned Property
One of the common misunderstandings that most married couples have is that it is not wise to own assets in joint names. Although the ease of transferring property jointly owned with the right of survivorship is unquestionable, the interplay of the unlimited marital deduction and owning jointly held property can do more harm than good if at least $1,000,000 of assets are not titled just in the name of the first spouse to die. You would then fall into the same tax trap as outlined above, as complete ownership of the joint property would vest with the surviving spouse. Consideration should be given to switching the title of property from the jointly owned with rights of survivorship to either individual ownership or Tenancy in Common to take advantage of the two exemptions of $1,000,000 in each estate.

Your estate planning should culminate with the execution of your Will. Your Will should be drafted by an attorney who is experienced not only in federal estate tax law, but also the estate tax laws of your state of residence. Remember, generally your Will can be amended, revised or rewritten as many times as you like. Therefore, be certain that your current Will reflects your current wishes.

BY DANIEL J. GIBSON CPA, EA

The 2002 Tax Act, passed in March 2002, created a new category of depreciable assets called "qualified leasehold improvement property" and made it eligible for the so called "bonus first-year 30% depreciation deduction" if the original use, timely acquisition and placed-in-service requirements (before 2005) are met.

What is "qualified leasehold improvement property?"
This term is defined as any improvement to an interior portion of a building that is nonresidential real property, if (1) the improvement is made either by the lessee, sublessee or lessor of the building portion, (2) the portion of the building is to be occupied exclusively by the lessee (or any sublessee) of the portion and (3) the improvement is placed in service more than three years after the date the building was first placed in service.

For purposes of this definition of qualified leasehold improvement property, a lease between related persons is not considered a lease.

What types of building improvements are eligible for the bonus depreciation allowance?
The 2002 Act does not define what types of building improvements are eligible to be treated as qualified leasehold improvement property. Rather, it lists the types of property that cannot be so treated. Qualified leasehold improvement property does not include any improvement for which the expense is attributable to:

• enlargement of the building,
• any elevator(s) or escalator(s),
• any structural component benefiting a common area, and the internal structural framework of the building.

What kinds of improvements are qualified leasehold improvements after eliminating those that are ineligible?
Generally, assets are treated as structural components of a building for depreciation purposes, but are not part of the "internal structural framework of a building." This is a term defined by the Treasury Regulations to include all load bearing internal walls and any other internal structural supports, including the columns, girders, beams, trusses, spandrels and all other members that are essential to the stability of the building.

Taxpayers should be aware that many states that ordinarily allow federal depreciation for state income tax purposes disallow the use of the bonus first-year 30% depreciation deduction.

A number of assets installed in commercial buildings can actually be classified as personal property depreciable over five or seven years, rather than building components depreciable over 39 years. As a result, these assets are potentially eligible for a bonus depreciation allowance whether or not they are qualified leasehold improvements. These shorter-lived assets include, movable and removable partitions and electrical and plumbing equipment necessary for the operation of specialized equipment (rather than for overall building maintenance and operation). The difference between depreciating an asset over five or seven years versus 39 years can save a taxpayer sizable present value tax dollars.

HOW DO YOU SPELL RISK

BY MARC SCUDILLO CPA, CFP, MBA, MS
MANAGING PARTNER, FINANCIAL SERVICES

Today, it's easier than ever to get information about investing. In addition to the old reliable sources of advice, like your cousin's wife or the guys you play poker with, there are many new and easily accessible sources-books, magazines, the internet, radio and tv financial advice shows. If there's a way to communicate information that hasn't been tried, I certainly haven't heard of it.

But remember-information is not knowledge! You can have all kinds of information about almost anything, but if you can't relate the pieces of information to each other and to the topic you're trying to learn, you will never really understand that topic.

Decoding the Message
Much of the difficulty we encounter in trying to learn something new comes from not having the right vocabulary. Every four years, many of us learn or re-learn words like "luge," "axle" and "pike." We struggle to remember the "new" definitions of these words while the Olympic torch burns, then revert to our earlier understanding of them.

The vocabulary of investments is like that, and one of the most frequently misunderstood terms in all of investing is another four-letter word: risk. The fact is, most individual investors don't understand that "risk" can have two meanings when an investment professional uses it, and don't know that the advice they're getting may well be based on a definition of risk that doesn't apply to them at all.

Etymology 101
Most of us have a pretty good idea of what "risk" means in our lives. Risk is the chance that it will rain on your daughter's wedding day or that the bungee cord is too long. Risk is the chance that something won't turn out the way you want it to.

But when your investment information source talks about "risk" in your portfolio, you have to check to see how the source is using the word. That's because of the way its meaning has developed within the context of investmentspeak.

Before the 1980s, the universe of investors was heavily dominated by institutions — pension plans, endowment funds and the like. These pools of assets were usually the responsibility of an Administrator in the institution that sponsored the programs. The Administrator's approach to investing was framed by the following considerations:

• An infinite time horizon — the institution never plans to go out of existence.
• No concern about taxes, because these types of institutional investors don't pay taxes on investment gains.
• Lots of concern about meeting the benchmark every quarter, because that is typically the focus of the Board of Directors to which the Administrator reports.

However, over the past two decades, the individual investor has become a significant presence in the world of investing. As investors, individuals share a different set of characteristics:

• A specific point in time when they want to have accumulated enough money to fund their objective.
• A concern about how much of their investment return is being lost to taxes every year.
• An understanding that any given quarterly investment return is only a data point in a long-term plan.

Institutions, therefore, believe that "risk" means underperforming the benchmark this quarter, an event that is incidental to a longterm individual investor whose strategy is properly defined and implemented.

For individuals, "risk" means the chance that they will arrive at retirement age, or the children's college years, or some other time when they need lots of money, and not have accumulated enough to do the job. It's a critical difference.

These days, millions of individual investors have set themselves the task of learning how to invest intelligently. If you're one of them, you need to understand that "risk" has two meanings among investment advisors — one for institutions and one for individuals. When you're making investment decisions, be sure your investment advisor is talking about the kind of risk that is important to you.

THE URGE TO MERGE

BY SEAN DENHAM CPA

Small businesses looking to grow and increase profits may want to contemplate merging. Combining companies may help to cut overhead, increase efficiency, compete in the marketplace or enter a new geographic territory. But merging even just two organizations can be complicated and fraught with pitfalls. For any merger to be successful, the key is to clearly define what each party hopes to gain from the transaction.

Mergers can take many forms. Regardless of the structure, the merging companies should first determine the potential benefits of the transaction, such as reducing overhead, acquiring a new client base or the opportunity to market in a new geographic territory. Most mergers require a careful analysis of the customers served, the products offered and associated overhead costs.

Before a merger occurs, management must ensure that existing staff is able to assimilate the business and administrative operations to minimize costs.

The merger of two or more companies can serve to increase the combined entity's purchasing power by allowing the new organization to purchase in volume. It will also be more cost effective, for example, for the post-merged business to undertake an advertising campaign which would have been cost-prohibitive for any of the smaller, individual companies.

Maintaining customer relationships should be a priority for all merging parties. Early on, the companies should communicate with their clients, informing them of the change and assuring them that services will be enhanced through the merger. Owners need to be highly visible during this time, personally contacting their clients to describe how the merger will benefit them.

Mergers are very often difficult — more planning usually results in greater success.

NOT ALL CUSTOMERS ARE CREATED EQUAL

BY ALAN N. WINK, MBA
Director, Consultants to Management Group.

Unprofitable customers can be a significant problem for any business, but it is potentially disastrous for a small business. The ability to identify less than profitable customers can be the difference between success and failure for a business owner. If an unprofitable customer cannot be turned around, then drastic measures, such as discontinuing business with them, must sometimes be taken.

Most companies have easy access to the data necessary to discover and analyze an unprofitable customer situation. Some indicators to a problem customer include: customers that continuously demand lower prices in an already low margin business, customers that habitually pay their bills late, customers that are always returning merchandise and customers that need inordinate amounts of computer or customer service support. Successful companies try to rid themselves of customers who drive up costs without adding something extra to the bottom line.

In reviewing customer profitability, the first step is an analysis of "gross profit" by customer. What this actually means is sorting your customers by revenue and comparing this to the cost of serving each customer. This will tell you quite early which are your most profitable customers relationships. You might determine that you are spending more time, energy and resources on a customer that is worth less than you originally thought. Other areas to look at include: hours of business operations, geographic proximity to customers, required and expected levels of customer service and manufacturing schedule disruptions caused by special requests and order changes. The key question to ask yourself is "should my business model be built on low prices or high levels of customer support?" Attempting to be low price and high service can sometimes pull your company in opposite directions.

Once you identify the best and worst performers, take steps to transform an unprofitable into a profitable customer. The first step to tighten your business practices is to eliminate discounts, especially for large customers that tend to place many small orders. Insist on minimum order quantities, thereby reducing or eliminating transaction costs.

Next, ensure that customers pay for everything that they get. Customers should be charged for special deliveries, special packaging and special features in a product.

Never be afraid to renegotiate a contract, even with a large customer. When customers do things to increase the cost of fulfilling orders, these changes need to be communicated to the customer and reflected in a renegotiated contract. Explain to your customer what the problem is and why changes in the contract are necessary. Illustrate how their constant changes to quantity and delivery dates can negatively impact your profitability.

If you exhaust all efforts to turn your unprofitable customer into a profitable one, it might be time to stop doing business with them. Maintaining good relationships is crucial for small business, so be very careful when "firing" customers. Some tactful ways to rid a company of unprofitable customers include:

• Confront your customer directly.
• Fail to renew the contract when it comes up.
• Implement tiered services and pricing, thereby forcing your worst customers to go elsewhere.
• Attempt to transfer the business to another similar vendor.