FOURTH EDITION
A review of the planning techniques that...
Provide for Protect assets Reduce or Avoid or reduce the long term from the eliminate the delay support of claims of estate taxes and expense of families creditors probate
guidance direction education information
N. Lindsey Smith, Esq. Smith and Condeni LLP
FOURTH EDITION
Wealth Management Through Estate Planning
by
N. Lindsey Smith, Esq. Smith and Condeni LLP
A review of the planning techniques that are available to provide for the long term support of families, maximize family wealth, protect assets from creditors, reduce or eliminate estate taxes and avoid probate.
Table of Contents
Table of Contents Part I — Understanding Estate Planning Chapter 1 What Is Estate Planning...... 1 Chapter 2 The Benefits of Estate Planning...... 7 Part II — The Risk of Taxes Chapter 3 Estate, Gift and Income Tax Issues...... 15 Chapter 4 The Federal Estate Tax...... 21 Chapter 5 The Federal Gift Tax...... 33 Chapter 6 State Estate and Inheritance Taxes...... 41 Chapter 7 The Generation-Skipping Transfer Tax...... 45 Chapter 8 The Federal Income Tax...... 51 Part III — Strategies to Combat Risk and Preserve Wealth Chapter 9 Wills and Trusts...... 63 Chapter 10 The Living Trust...... 75 Chapter 11 Asset Protection Planning Strategies...... 83 Chapter 12 The A-B Trust Strategy...... 95 Chapter 13 Dynasty Planning With Trusts...... 103 Chapter 14 Family Gift Strategies...... 111 Chapter 15 Life Insurance and Estate Planning...... 119 Chapter 16 The Irrevocable Trust...... 131 Chapter 17 Family Limited Partnerships and Limited Liability Companies...... 139 Chapter 18 Business Succession Planning...... 153 Chapter 19 Other Planning Techniques...... 165 Chapter 20 Powers of Attorney and Advance Directives...... 171 Chapter 21 Asset Alignment Strategies...... 177 Part IV — Elder Law Planning Issues Chapter 22 Guardianships and Conservatorships...... 189 Chapter 23 Life Care Planning...... 195 Chapter 24 Long Term Care Insurance...... 209 Part V — Administering an Estate Chapter 25 Probate of an Estate...... 217 Chapter 26 Post-Mortem Planning Opportunities...... 229 Part VI — Other Important Estate Planning Topics Chapter 27 Estate Planning and Investment Strategies...... 245 Table of Contents of Table Chapter 28 Planning With Retirement Accounts...... 253 Chapter 29 Charitable Planning...... 273 Part VII — Create Your Own Estate Plan Chapter 30 Selecting an Attorney...... 287 Chapter 31 Important Decisions You Need to Make...... 293 Chapter 32 Ten Common Mistakes...... 299 Glossary ...... 305 This book will help the reader through the facts, myths and choices regarding the key decisions families, business owners and individuals must make regarding Estate Planning.
Copyright 2012 by N. Lindsey Smith Published by Alexander Publishing • Cleveland, Ohio Layout and Design by Hurshman Design Group, Inc. • 638 Miner Road • Cleveland, Ohio 44143 All rights reserved. No part of this book may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording or by any information storage and retrieval system without the written permission of the author. Printed in the United States of America • ISBN 0-9705713-0-5 Acknowledgements
I would like to give recognition to the assistance that I have been provided with in the writing and preparation of Wealth Management Through Estate Planning.
The attorneys in the Estate Planning and Business Law Group at Smith and Condeni have been very helpful. I have always recognized that the complexity of estate planning requires that a group of dedicated attorneys work together, sharing their technical skills and practical experience, if the goal is to provide clients with the highest quality of legal advice. Of course, that is the goal at our firm.
I called on each of the lawyers in our Estate Planning and Business Law Group to lend their skills in the preparation of some of the topics covered in this book. They also helped to edit and proof this book, locating my errors and helping to make the text more readable. I recognized a long time ago that I could not know everything and am grateful to have the opportunity to work with these dedicated professionals.
I worked very closely with Steve Hurshman of Hurshman Design. Steve provided invaluable assistance on text layout and design and selecting the graphics that accompany this book.
Thirty-five years ago, I started practicing as a lawyer. At the beginning of my career, I had the good fortune to spend several years working for the Trust Counsel for National City Bank, Cleveland, Ohio. Wendell Mathews, Jr. provided me with, among a number of things, a solid foundation in estate planning and trust law. I remain grateful to Wendell for everything that he did for me.
Of course, as an author with a family, I appreciate the patience and support that my family has always shown me when I get involved in various projects and activities.
N. Lindsey Smith
January, 2012 Foreword
I have been practicing in the areas of estate planning, probate administration, business planning and related areas since graduation from law school in 1976. All of my profes- sional time is spent counseling clients on these matters and establishing and administering estate plans.
Wealth Management Through Estate Planning is the second book that I have written on this topic. My first book was The Ohio Estate Planning Manual, originally published in 1993. Wealth Management goes far beyond my first book, not only in terms of content but in terms of the focus of the discussion on the topics that affect estate planning.
Tax planning remains an important component of the estate plans for many of our clients. The remarkable increase in personal wealth has made this aspect of estate planning all the more vital.
Increasingly, however, our clients have also asked us to focus on other matters, such as how they can protect themselves and their families from creditors and other unwelcome intruders on their financial success. Can they protect children and grandchildren with disabilities? Is there a way to guard against the sometimes ruinous costs of divorce? What about second marriages and the desire to provide not only for the financial security of a spouse but also make sure that children from the first marriage receive an inheritance from their parents? This book was written to address the evolving needs of our clients.
Estate planning is a wonderful way for a lawyer to spend his career. Our firm’s practice focuses on creating customized estate plans that are designed to help clients avoid trouble- some, expensive legal predicaments. An ounce of prevention is truly cheaper and better than a pound of cure.
In writing this book, I have struggled to make complex issues as simple to understand as possible. Given the subject, this is not an easy task. However, I have always felt that our cli- ents should be afforded the best opportunity to have at least a working knowledge of their estate plans that can so positively affect and protect them and their families.
One final note is needed. I have been very fortunate to work with so many of our firm’s fine clients. On a personal level, I very much enjoy our conversations on a myriad of topics, not just estate planning.
Moreover, representing them has provided me with an opportunity to peer into their businesses and professions and learn things that I never would have had the chance to otherwise learn. It has been and continues to be a great educational adventure. My family and friends know how much I value the opportunity to learn new things. I hope that writing this book reciprocates this opportunity and is helpful to our clients to understand further the benefits of the work that they have allowed us to do for them. It is truly a privilege.
N. Lindsey Smith • Cleveland, Ohio • January, 2012 Wealth Management Through Estate Planning was written to provide its read- ers with general guidance about estate planning. This book was not written as a “do-it-yourself” manual about estate planning, but was designed to help readers better appreciate the benefits and opportunities that estate planning can provide.
While this book contains detailed infor- mation and opinions about many tax issues, the reader should not undertake a course of action based on this infor- mation without conferring with qualified legal counsel skilled in estate planning matters. There can be many exceptions and qualifications to the information provided. Nothing in this book is to be considered legal advice for any specific purpose.
Estate planning is a very complex area of the law and to make your own plan- ning decisions based on the material contained herein could lead to adverse and unintended results. This book has been written for educational and infor- mational purposes only. Introduction
It is very challenging to write a book on estate planning. This is because there are so many different aspects to this area of the law and a great deal of complexity. Moreover, explaining how decisions are made in putting together an estate plan is difficult because of the interrelationship between many technical issues. Sometimes, choices must be made among competing alternatives and the trade-offs between these alternatives must be carefully weighed against each other. Advising clients how to make these choices is hard to explain in conversations with clients let alone to put on paper. Estate planning is a very intuitive process. To help unravel this difficult topic, I have divided this book into different parts. Each part focuses on a particular theme and the themes build on each other. Understanding the topics discussed in Part I and then Part II should help to understand the planning strategies discussed in Part III.
In Part I, the focus is on understanding the big picture of estate planning. What are the reasons why someone goes through the estate planning process? What are the primary goals? What are the major risks that each of us may face and the most significant benefits of putting together an estate plan?
Taxes are a significant factor in many estate plans. In Part II, we explore the effect that taxes can have on our finances. The rapid growth in personal wealth has made tax planning a critical component of many estate plans. But good estate planning is not just about estate taxes. Other tax considerations are very important and must be factored into the planning strategies.
Part III delves into the planning techniques that estate planning attorneys use. Some of the chapters in this part focus on tax planning strategies. Other chapters focus on the use of estate planning tactics that achieve goals such as protection of assets from claims of creditors, charitable planning and business succession techniques. The objective of all of these is to help families plan ahead to avoid problems and to lock in long term benefits that protect their wealth.
In Part IV, we take a look at elder law issues. This topic has become increasingly more important as our population ages and people live longer. What is a guardianship and what are the guardian’s responsibilities. Many families are concerned about the high cost of nursing home care and how this will affect their finances. Long term care insurance is one alternative that has become increasingly popular as way to provide for these expenses.
Upon a person’s death, there will be some type of estate administration. Part V discusses what happens at that time. If the decedent planned on passing assets on to his heirs in accordance with the terms of his Will, there will be the legal process called probate. However, where the person created a living trust during his lifetime, probate may be avoided and the process focuses on carrying out the decedent’s intent as set forth in his trust agreement. In many cases, for tax and other planning reasons, there will be special planning opportunities that will be pursued. This type of planning carries the curious name of post-mortem planning. One of the consequences of increased personal wealth is the effect that estate planning can have on investment strategies. This is the focus of Part VI. The fact that more personal wealth is being passed intact to the next generation is a factor to be taken into consideration in the investment strategies of parents. Many persons have accumulated large investments inside their retirement accounts. We take a look at the consequences of this and the best planning strategies for managing these accounts. Charitable giving has become more important for many families. Their intentions are not just driven by tax planning goals but by desires to help others and support their favorite causes.
Part VII is written to give the reader insights into the process of estate planning. It is important to know what to look for in selecting the attorney that will move you through this process. What are the most common mistakes that occur? What are the important issues that need to be addressed while putting together an estate plan? The goal of this book is to break estate planning down into understandable elements and then help you put these elements into an understandable sequence. This book will not make you an expert. Hopefully, however, it will give you a working knowledge of the most important aspects of estate planning.
PART I: Understanding Estate Planning Wealth Management Through Estate Planning
PART I:
Chapter 1 What is Estate Planning Chapter 2 The Benefits of Estate Planning Wealth Management Through Estate Planning
Chapter 1: What is Estate Planning
This chapter is written to give the reader a broad overview of the important goals on which estate planning focuses. We also examine how estate planning is frequently a team project involving the family's estate planning attorney, accountant, insurance agent and investment advisor.
Chapter 1: What is Estate Planning 1 Wealth Management Through Estate Planning
Chapter I:
◆ Goals of Estate Planning
◆ Knowledge of Various Areas of the Law
◆ Involvement of Other Professionals
“If you keep doing things like you’ve always
done them, what you’ll get is what you’ve
already got.”
Andy Wayand, Carrollton High School
2 Wealth Management Through Estate Planning
state planning is a distinct area of the the reader with the principal concepts that law that primarily focuses on preparing underlie an estate plan. Later chapters will E for the personal and tax consequences discuss in more detail how these goals are that arise after a death. The benefit of estate achieved. planning is that it allows someone to create a set of rules that are carefully designed to GOALS OF ESTATE PLANNING achieve his goals. The five major goals of The first goal of an estate plan should estate planning that skilled attorneys focus on be to provide a set of rules for managing a are: person’s health and financial situation should ◆ Developing a plan that will manage he or she become incompetent or otherwise the personal care and financial in need of assistance in managing day-to- The five matters of the client in case of inca- day affairs. This has become increasingly major goals pacity; important with advances in medical treatment and care that keep people alive longer than of estate ◆ Creating a plan that allows the cli- ent to control the distribution of his was previously possible. Estate planning planning are property after his death for the benefit documents such as health care and financial powers of attorney are very important. Also, a managing of the client’s family and other chosen beneficiaries; funded living trust can be an efficient way to personal and manage assets and protect financial security. ◆ Using proven strategies that minimize Estate planning can also be invaluable financial estate taxes for the client and poten- for avoiding disputes among family members. matters, tially for other members of his family; When a parent has set forth a clear set of ◆ Designing into the plan strategies that rules for the management of her affairs at a client protect family assets from exposure time when mental capacity was not an issue, control over to risks such as creditors or division of then the chances of arguments among the property in divorce proceedings; children are reduced. distribution and The second goal of an estate plan is of assets, to carry out the wishes of the client with ◆ Utilizing the plan to avoid probate of regard to the distribution of his estate upon protection the estate on the client’s death. his death. Normally, this is not a complex from risk, Each of these general goals will be decision to make upon the death of the first examined in this chapter and throughout this minimization spouse to die; usually the property of the book. We will also investigate how an estate decedent is distributed to his spouse. There of estate taxes planning attorney balances the achievement may be special considerations, such as a of each of these objectives against the others and avoidance second marriage or a disabled spouse, which and assists the client in making the right changes the usual pattern of distribution. of probate. decisions. The problem becomes more complicated Please keep in mind as you read this upon the death of the second spouse when book that estate planning is not only for provisions must be made for the manner in people who are very wealthy. Estate tax which children and other issue are to receive considerations are only one piece of the distributions from the parents’ estates. Estate puzzle. For all clients, an estate plan can planners develop strategies which protect the provide significant benefits, accomplishing interests of the client’s beneficiaries, including goals such as providing for the managed the spouse, children and grandchildren, support of young or disabled family members, through specially designed estate planning avoiding probate or planning for Medicaid. documents. The proper estate plan, closely tailored for The third goal of estate planning is to each person’s own financial and personal develop and pursue a strategy that minimizes situation, can secure significant benefits. the amount of federal and state estate taxes The purpose of this chapter is to acquaint that are paid at death. As we will see later in
Chapter 1: What is Estate Planning 3 Wealth Management Through Estate Planning
achieved through the appropriate titling of Long Term Planning assets and is not as complex and challenging is Critical as pursuing tax and personal goals. Probate administration is less of an issue than it is often To my spouse thought to be and one of the by-products of a good estate plan is the elimination of probate administration. Good estate planning focuses To my children, at the ages I select on the first five goals. The practitioner then blends in the techniques that avoid probate To my grandchildren, at the ages I select into the estate plan. KNOWLEDGE OF VARIOUS this book, specific techniques are used to AREAS OF THE LAW eliminate the estate taxes in many estates and An estate planning lawyer, in applying to minimize the estate taxes in others. The his craft, must use his knowledge of many more wealth that you accumulate during your areas of the law and be able to understand life, the more challenging it is to avoid paying how various events may effect the plan being estate taxes. Long-term planning is used to created. An experienced attorney will have achieve the best tax consequences possible an intricate knowledge of the law in such for the entire family. areas as: Estate planning lawyers have the challenging responsibility to help a client ◆ Probate administration reconcile the goals of saving money on taxes ◆ Federal estate, income and gift taxes and retaining control over the client’s assets ◆ IRA and Qualified Plan distribution during lifetime and after death. Frequently, rules these goals may be in partial conflict with ◆ one another and can not be achieved without Charitable giving sacrificing some part of the other goal. For ◆ Elder law example, many people can, through a regular ◆ State estate taxes lifetime gifting program, eliminate estate ◆ Trust law taxes altogether. However, this is done at the expense of losing the control and the use of ◆ Business law the gifted assets. It may also cause different The lawyer is also required to know and income and estate tax consequences. A understand certain aspects of other areas of thorough estate plan reconciles these two the law so that the planning process will be goals in the best possible manner. Each complete. An understanding of the law in the person, with the assistance of his estate following areas is frequently of value: planning lawyer, must determine what is ◆ Insurance appropriate for his own unique circumstances. ◆ Bankruptcy The fourth goal of estate planning is to maximize the protection of assets from ◆ Divorce claims of creditors. Exposure can come from ◆ Creditor’s rights many directions; a bad business decision, ◆ Guardianship a bad driving decision or a bad marriage. ◆ Protecting assets from exposure to these and Real Estate other claims is a critical component of the While preparing the plan and the comprehensive plan. documents necessary to implement it, the The fifth goal of an estate plan is to lawyer has to understand, for example, how eliminate or minimize probate administration. the divorce of a beneficiary can impact While this is important, it is generally easily the plan and then provide the necessary
4 Chapter 1: What is Estate Planning Wealth Management Through Estate Planning
language in the plan documents to protect a Each of these professionals has a distinct beneficiary’s interest. Similarly, a good plan contribution to make and their involvement can protect a beneficiary’s interest against enhances the long-term benefits of a good the claims of creditors. If we anticipate what estate plan. could happen to a beneficiary and then The role of the accountant can be provide the appropriate response in the plan significant for a number of reasons. The documents, we can widen the scope of the accountant typically has contact with his benefits of the plan. client at least annually and, many times, Estate planning attorneys also must have more frequently. Because of the nature of a working knowledge and familiarity with the relationship, the accountant will know related products such as life insurance and the client’s assets and cash flow and be annuities along with a general understanding able to assist the estate planning lawyer by of investment strategies. Estate planners assembling the detailed information that is need to understand things such as these so necessary to establish the estate plan. that they can integrate the client’s investment Additionally, the accountant will be choices and philosophies into the estate plan. experienced in dealing with issues such Increasingly in certain circumstances, as we as determining the basis of property shall see, investment decisions are influenced for tax purposes, providing an opinion by estate planning issues. regarding income tax issues that may be potentially created by the estate plan and to INVOLVEMENT OF OTHER otherwise aid the estate planning lawyer in PROFESSIONALS implementing the plan. If the client is an owner On a completely different level, estate of a closely held business, the accountant planning lawyers must also coordinate their will have a good working knowledge of this efforts with those of other professionals business and may help in determining the representing the client. Typically, the lawyer value of the business for purposes of the plan. will work with other allied professionals as The accountant serves as a valuable resource. part of the client’s planning team. The client typically acquires life insurance with a particular objective in mind. The importance of insurance in certain estate planning contexts cannot be understated. For many plans, the client’s insurance nning A agent relates needed information such as ate Pla ttorney Est • the cash value built up in current policies, • A the status of the policies, and the cost of cc er ou any additional insurance, along with the n n n ta best product available for the client. Life la n P t l insurance serves several functions, including a i c • creating liquidity at death to pay liabilities n a and providing a source of funds to provide for n i
F P
/ CLIENT'S r the care of the client’s family. The agent can
o e
f v
i
e be consulted for purposes of determining if t
s
u s
c i
o the current insurance coverage of the family
e TEAM n
x
a
E
l is satisfactory as well as making sure that t
T
n
r
e
u the insurance products are appropriate for
s
m
t t e
s
e
e
v
n
I •
•
L
i
f
e
t I n n s e u g r A a n e c
Chapter 1: What is Estate Planning 5 Wealth Management Through Estate Planning
the plan and that the correct beneficiary CONCLUSION designations have been put into place to It is a complex, challenging responsibility coordinate insurance benefits with the plan. to assist a person in determining what Of course, the roles of the investment his goals are and to put together the executive and the financial advisor are necessary plan and documents that will important. They have to provide the estate satisfactorily carry into effect these goals. planning lawyer with information regarding The estate planning process requires the client’s investment accounts as well as close communication between the estate help the estate planning lawyer to understand planning lawyer, his client and other allied the short and long-term financial goals of professionals to help the client the client. While their roles are primarily define his objectives and designed to assist in maximizing the income create and implement a and growth of the client’s financial assets plan that carries them into during his lifetime, it is also useful to involve effect. these persons so that the client’s financial plan can be coordinated with his estate plan. This insures continuity of the client’s financial plan in the event of her incapacity or death. Where the estate plan calls for the My opinion use of one or more trusts after a client’s death, the selection of the appropriate trustee is a crucial step. In Chapter 9: Wills and Trusts, we examine the factors that should be considered in choosing a trustee. I have found that it is essential In many circumstances, the trustee will be that our law firm work closely with doing his most important work after the death of the client and perhaps for many years the client’s other advisors. When thereafter. Because of the potential future impact, the client is best served by selecting I started doing this many years as a successor trustee either an individual or ago, I was surprised how much it corporate trustee who has the requisite skills and abilities and who can be relied on for the helped to improve the quality of long run. our services as attorneys when we coordinated our efforts with these professionals.
6 Chapter 1: What is Estate Planning Wealth Management Through Estate Planning
Chapter 2: The Benefits of Estate Planning
This chapter takes a look at the major types of risk and expense that can impact financial well-being. It is not just the costs and delays of estate administration that are the concerns. We need to be cognizant of all of these risks to appreciate the significant benefits of estate planning.
Chapter 2: The Benefits of Estate Planning 7 Wealth Management Through Estate Planning
Chapter 2:
◆ Protecting Yourself
◆ The High Cost of Dying
◆ Creditors and Predators
◆ Taking Care of Your Family
“When I die it will be like a shipwreck.
It will be worse than anyone imagines.”
Pablo Picasso
8 Wealth Management Through Estate Planning
state planning is a dynamic process that identifies potential problems Observation E as well as opportunities. The estate planning attorney is responsible for setting up I always advise families not to pursue a procedures to solve the problems and capture guardianship for a relative unless they are very the opportunities. It is helpful before we get into certain that the person is incompetent. The all of the issues that affect estate planning to consequences of losing are too severe. Besides look at some fundamental issues that drive the the permanent damage to the relationship, it need to go through this process. quite probably will affect your status as an estate beneficiary! PROTECTING YOURSELF A good estate plan will anticipate taking The most difficult situations are the ones care of the client during periods when this where there are diminished skills that may person may have difficulty managing his or not yet be of a level to support a finding of her affairs or is determined to be incompetent. mental incompetence. It is very challenging to This is becoming a more frequent problem than advise families what to do in these situations. in the past. Probably, this is because of the The concern over competency is frequently increased wealth that has been accumulated heightened by family conflicts that arise at that by the current generation of seniors as time when family members question the motives compared to prior generations and the behind another family member attempting to advances in medical treatment that keep us assist someone with his or her financial affairs. alive longer. A good estate plan done at a time when In my practice, we have seen more you are in good mental and physical health situations where the declining health of a can be the best defense to avoiding these parent or other family member has triggered very difficult situations. The estate plan may very difficult family problems. This usually revolve around the use of a funded living trust, occurs in situations where a parent has discussed in detail in Chapter 10: The Living diminished mental capacity but it is unclear that Trust. Other important planning tools are he or she is mentally incompetent. The trigger health care and financial powers, discussed point is frequently the concern of one part of in Chapter 20: Powers of Attorney and Health the family, be it children, siblings or nieces Care Directives. and nephews, that other parts of the family The most important thing to keep in mind is are going to influence the family member with that estate planning can do a lot to avoid these diminished abilities to do something that they situations and keep the golden years of your think is inappropriate. life golden. Of course, the inappropriate thing they are concerned about is a change by Observation the family member as to the division of his or her property at death. These situations become very ugly very rapidly and the usual Your children may get along great while end result is that everyone gets hurt. you are around but that is no guarantee that It is quite common for many seniors to have these friendly relationships will continue forever. I have seen too many situations where sibling diminished mental skills. However, diminished relationships dissolve at the death of parents. My mental ability does not necessarily mean observation is that the parents were the referees that a person is mentally incompetent. The and/or that the children did not want to upset determination of mental incompetence is made Mom and Dad while they were still around. by a probate court after hearing medical and When Mom and Dad “disappear,” there is no other evidence. Mental incompetence is more reason not to get into a family feud. No family is than short term memory loss or that a person immune from this type of problem. needs help with activities of daily living.
Chapter 2: The Benefits of Estate Planning 9 Wealth Management Through Estate Planning
THE HIGH COST OF DYING I then like to point out to them how much Frequently, when I am meeting with they will be worth 10 years from now if their clients, they will express their concern assets grow at say 6% a year. At 6%, their net about avoiding probate and the delays that worth will double in 12 years; at 8%, it doubles accompany it. What they do not always in 8 years. This is the value of compounding. appreciate are the estate tax costs of death. This is an example of a very common Many clients expect that the applicable situation illustrating potential estate tax costs. exclusion amount, also called the estate tax It includes taking into consideration the credit, will take care of any estate taxes and growth of family wealth over a period of time. that only rich people pay estate taxes. To A goal of estate planning is to reduce this their estimation, yes, they have done well tax burden where we can and finance tax financially but no, their estate will not grow to burdens we cannot otherwise eliminate. As a size where estate taxes are a serious issue. we shall see, there are planning techniques Their thinking overlooks some important that are available that can dramatically considerations. First, the federal estate tax reduce the tax cost of death. maximum rate is 35%. Currently, this applies to estates with a value of $5,120,000 or higher. CREDITORS AND PREDATORS Also, the size of estates has increased rapidly Few of us would argue with the statement over the last decade and many more clients that American society is very litigious. I am a have more money than they ever anticipated lawyer and agree with this. Liability has been having. traditionally based on fault, but this concept One of my favorite questions is to ask seems to be eroding. Did you ever hear of a couples who are in their sixties or older is plane crash where the airline was not at fault? how much they were worth when they got Debating changes in legal theory is beyond married? They are eager to tell me that they the scope of this book; helping the reader did not have any net worth (with a laugh)! understand the risks and the strategies that When I ask them if they ever thought they combat risk is not. would accumulate as much in personal wealth as they have, the answer is typically “no”.
The Rule of 72’s:
If you want a quick, reliable way to estimate the future value of your wealth, then you need to understand the Rule of 72’s. It works like this. Estimate a future rate of growth for your investments. Divide that figure into 72. The quotient is the number of years it will take for your investments to double. Example: 72 divided by 6 (rate of growth in percent) = 12 Years until In 12 years your investments investment doubles will have doubled. Rate of Growth 72
10 Chapter 2: The Benefits of Estate Planning Wealth Management Through Estate Planning
Financial risk comes at us from many different directions. It can arise from a bad Example business decision or a bad driving decision. About one half of the marriages in the United Alex and Sandra have been States end in divorce. Potential liability arises married for eight years. About even when you did nothing wrong! Anyone three years ago, Sandra received can test your resolve and see if you are willing an inheritance from her mother. to pay something to avoid a potentially larger Some of the money went into risk or drawn out legal battle. a new car, home improvements, paying off bills and the mortgage on their house. The balance went Example into their joint investment account. Now they are having marital Larry is married with three problems. Sandra knows about the young children. He is driving home division of marital property when from work one evening. He is tired someone gets divorced but thinks from a long day at the office and that she should first get back the fails to anticipate the driver in front inheritance she received from her of him stopping suddenly. There mother. is a sharp collision that results in serious injury to the driver and Should she? The answer to the question passenger in the other vehicle. is very cloudy and can result in a lot of Larry, only a casual drinker, had arguments. However, there are planning stopped before the accident for techniques available that can keep inherited a couple of drinks with several assets totally out of a divorce proceeding. friends. His auto liability coverage Parents can select asset distribution strategies is $100,000 per person with a at their deaths which avoid all argument and $300,000 maximum. protect inheritances from being divided and Does Larry need to be worried? Are there things he could given to non-family members in divorce actions. have done to protect both him and his family? TAKING CARE OF YOUR FAMILY Good estate planning focuses on the long term protection of your family. It Unfortunately, the facts in the preceding addresses how the finances of minors or example are not an uncommon situation. incapacitated adults can be handled without The potential risks to the financial security of involving expensive, public, time-consuming Larry and his family are enormous. Are there guardianship proceedings. If a beneficiary of things that Larry can do to protect himself any estate property (life insurance, cash, etc.) and his family? The answer is yes and one of is a minor, he cannot receive the inheritance the goals of the estate planning attorney is to outright and it is controlled by a guardian identify the strategies and help the client to appointed by the probate court until he is an implement them. adult (in Ohio and many other states this is at The possibility of divorce presents age 18). Upon attaining majority, there are significant risks. The following example no legal restrictions on the use of money by illustrates a common situation where one the young adult. The child may think this is a spouse has received an inheritance. good idea, but do you? How do parents with young children avoid this result?
Chapter 2: The Benefits of Estate Planning 11 Wealth Management Through Estate Planning
What if the child (or a grandchild) has a serious disability My opinion such as Down syndrome, mental retardation or spina bifada? About 11% of the families in the U.S. have children who are disabled. Many children do not have these types of health problems but have problems of a different nature. Addicts You would be surprised how many struggle with alcohol, drug or gambling families have to deal with issues issues. Other people are never financially responsible. Further, suppose an adult such as those just described. These beneficiary has a stroke, suffers from multiple sclerosis or is manic-depressive. What are situations are common, not uncommon. the planning techniques that are available Recognizing these and other potential to protect him financially for the rest of his life? Is there a way to avoid a guardianship challenges and developing strategies proceeding so that finances and expenditures can be handled privately? that avoid problems and plan for There are many other family issues that are dealt with through an estate plan. In the future are major objectives of the second marriages, spouses usually want efforts of experienced estate planning to take care of each other but also want to make sure that their children from their first attorneys. We have the ability to be marriages receive an inheritance at some point in time. Estate planning balances very creative and allow our clients the these concerns, making sure that the client’s sometimes competing goals are reconciled opportunity to achieve their goals. and the appropriate balance is achieved. Estate planning is all about you making A concern of many persons is that their financial success will spoil their children your own set of rules. and grandchildren. This is a well-founded concern in some cases. Grandchildren who were not around when family wealth was being accumulated do not have the same appreciation for hard work that their grandparents have. Estate planning attorneys can be very creative dealing with this issue. More clients are requesting that trusts be prepared that have incentives for earning performance and career advancement or for achieving specified educational goals. Remember the “Golden Rule.” He (or she) who has the gold, rules. It is your money and you have the legal right to determine how and when your family members are to receive their inheritances.
12 Chapter 2: The Benefits of Estate Planning PART II: The Risk of Taxes
13 Wealth Management Through Estate Planning
PART II:
Chapter 3 Estate, Gift and Income Tax Issues Chapter 4 The Federal Estate Tax Chapter 5 The Federal Gift Tax Chapter 6 State Estate and Inheritance Taxes Chapter 7 The Generation-Skipping Transfer Tax Chapter 8 The Federal Income Tax
14 Wealth Management Through Estate Planning
Chapter 3: Estate, Gift and Income Tax Issues
This is the initial chapter discussing the tax aspects of estate planning. The focus is on providing an overview of the most important tax issues that affect estate planning and briefly comparing the various taxes. The following chapters build on this chapter, analyzing in turn each of the major taxes that play a role in crafting an estate plan.
Chapter 3: Estate, Gift and Income Tax Issues 15 Wealth Management Through Estate Planning
Chapter 3:
◆ The Principal Taxes
◆ Balancing Competing and Conflicting Goals
“There are two tax systems, one for
the informed and another one for the
uninformed.”
Anon.
16 Wealth Management Through Estate Planning
any estate plans begin with There are important differences determining the probable estate between the federal estate tax and M taxes that would be incurred at state estate taxes. Some property of a death if there were no tax planning. This is decedent may be included in the gross a good place to start because an objective estate for the federal estate tax, but determination can be made as to the tax costs. excluded for the state estate tax. Also, The estate planning attorney must then identify the deductions and tax credits may be the tax planning opportunities and create the different for each tax. strategies to be used to secure these benefits Federal estate tax rates are sig- and reduce or eliminate these taxes. nificantly higher than state estate tax Tax planning is complicated by the rates. In states that impose an estate or fact that an estate plan has to take into inheritance tax independent of the fed- consideration a number of different taxes eral estate tax, a credit on the federal which are imposed in a different manner at estate taxes due is no longer given for different times on different types of property the state estate taxes paid. For these at different rates of taxation by different reasons, state estate tax considerations taxing authorities. Does that sound confusing? also play a role in planning for estate Balancing and coordinating different tax taxes. objectives is one of the more challenging ◆ There is a federal gift tax. The federal responsibilities of the attorney. gift tax is unified with the federal estate THE PRINCIPAL TAXES tax. This means that a person’s lifetime gifts are added together with the trans- To unravel this complexity, it is helpful to fers that take place at death to deter- take a moment and look at the major taxes mine his overall estate tax liability. This that have to be considered when creating a aggregation of all gifts made during plan. life and at death eliminates some of the ◆ Federal estate taxes are imposed on motivation for making lifetime gifts to the property of the decedent at death avoid estate taxes. However, there are and his estate generally pays these other benefits to making lifetime gifts. taxes. There is not a federal inheritance These are discussed later in this book. tax that is paid by the beneficiaries ◆ State gift taxes are imposed by only who receive property distributions from a handful of states. Therefore, gift tax the estate. When the beneficiaries planning at the state level is not an receive their inheritances, the federal important issue when doing estate tax has already been paid. All of the planning. property interests (real estate and other property) that someone owns at death ◆ There are certain federal and state are subject to the imposition and pay- income tax consequences that must ment of estate taxes. be considered when creating an estate plan. The income tax consequences of ◆ There are state estate taxes and an estate plan, including any capital inheritance taxes. Some states gains tax impact, must be determined. impose an estate or inheritance tax To further complicate this, there are separate from the federal estate tax. several applicable income tax rates: personal income tax rates, a separate tax rate schedule for corporations and a different rate schedule for trusts and estates.
Chapter 3: Estate, Gift and Income Tax Issues 17 Wealth Management Through Estate Planning
◆ The federal government and many This is a very common example of a basic states impose, in certain circumstances, dilemma some persons face: a special additional tax known as the generation-skipping transfer Example tax. These taxes are primarily designed to put limitations on some Dolores is in her late 80’s and in good of the estate tax planning strategies health. She would like to make gifts to her used to transfer property tax free to children to help them out financially and to successive generations. reduce estate taxes on her death. However, There are other tax considerations such she is concerned that she may need the as the tax benefits of charitable gifts, stepped- money for herself if she becomes ill or has up basis on appreciated stock, IRA and to go into a nursing home. qualified plan distribution rules, taxation of partnerships, corporations and other entities, etc. All of these play a role in the decision- This is a situation that we see all the time. making that goes into an estate plan. Does Dolores decrease her estate by giving away some of her BALANCING COMPETING AND money to achieve tax planning CONFLICTING GOALS goals at the cost of increasing her anxiety about her In crafting an estate plan for his client, financial security? the estate planning attorney must keep many tax considerations in mind. The proper plan carefully considers all of these issues and walks the narrow path that maximizes the client’s long and My opinion short term tax planning opportunities at minimal cost. Tax planning is a process that necessarily involves making choices! An experienced estate planning attorney guides Many of our clients wrestle you through the maze of choices to create a with the dilemma that plan that has an overall beneficial tax result. Dolores in our example has. I tell them that while tax planning is important, they should not let it control their decision-making. Do what you feel comfortable doing. If you are uncomfortable gifting, then do not.
Sometimes, clients face problems of a completely different nature. Do you incur income taxes to avoid estate taxes?
18 Chapter 3: Estate, Gift and Income Tax Issues Wealth Management Through Estate Planning
A thorough plan looks at not only Example current estate tax costs, but also the projected estate tax expenses after Sarah is concerned about estate taxes considering factors such as current and and would like to make gifts to her children. future savings, growth in the value of assets However, the only asset that she can use and projected expenditures. A tax planning to make gifts is the money in her IRA. She model is created so that the estate plan can is understandably reluctant to incur income anticipate all reasonable contingencies and taxes when she makes withdrawals from provide solutions for projected tax costs. the IRA to make gifts that will reduce estate Otherwise, a plan may have to be updated taxes on her death. more frequently than would otherwise be required to address changes in wealth or family circumstances that could have been This is a difficult situation on which to predicted when the plan was implemented. give counsel. Decision-making is affected by many factors such as her marginal CONCLUSION income tax rate, her marginal estate tax Estate taxes can be a major issue at rate and her age and health. A high income death and the more assets accumulated tax bracket and a low estate tax bracket during a lifetime of savings, the larger would direct her towards not making any the potential problem. Other taxes are withdrawals; the reverse would lead to the becoming significant factors in estate opposite result. There is no clear answer planning. For example, many persons have in many of these situations. Frequently, a accumulated substantial amounts in IRA's, choice has to be made between obtaining qualified plans and annuities. Income tax income tax, estate tax or gift tax benefits. considerations in tax-deferred accounts This is especially challenging when planning such as these are of increasing concern. with retirement assets that are potentially The various taxes and their interrelationship tapped several with each other are examined in detail in times at death this book to provide you with a general for federal understanding about them and illustrate estate taxes, how they impact the estate planning state estate process. The tax issues in estate planning taxes, federal are very complex. income taxes and state income taxes. A good plan tries to minimize the impact of all taxes.
Chapter 3: Estate, Gift and Income Tax Issues 19 Wealth Management Through Estate Planning
20 Chapter 3: Estate, Gift and Income Tax Issues Wealth Management Through Estate Planning
Chapter 4: The Federal Estate Tax
The federal estate tax is the most important tax that drives estate planning. With a tax rate of 35% scheduled to increase to 55%, the tax imposes a serious burden on many estates. This chapter explores the manner in which the tax is calculated.
Chapter 4: The Federal Estate Tax 21 Wealth Management Through Estate Planning
Chapter 4:
◆ The Gross Estate
◆ Alternate Value of Property
◆ The Marital Deduction
◆ The Marital Deduction Trust
◆ Qualified Terminable Interest Property
◆ Credits Against the Federal Estate Tax
◆ The Estate tax credit
◆ Computing the Federal Estate Tax
◆ Filing the Federal Estate Tax Return
“There is one difference between a tax collector
and a taxidermist — the taxidermist leaves
the hide.”
Mortimer Caplin, former IRS Commissioner
22 Wealth Management Through Estate Planning
he federal estate tax is imposed on the gross estate has a special meaning for entire worldwide assets of a person federal estate tax (FET) law. Here are some Twho was either a citizen or a resident assets that are typically included in the of the United States at the time of his death. determination of a gross estate: The federal estate tax can be the heaviest ◆ The value of all interests in property cost imposed on an estate. owned by the decedent at the time of Tax issues are very contentious death, including: right now and federal estate tax law is in a state of flux. A little bit of history is - Real Estate helpful to provide some current context. - Life Insurance Proceeds Beginning in 2001, the federal estate tax - Automobiles credit (technically titled the applicable - Jewelry exclusion amount) was raised pursuant - Furniture to a set schedule resulting in a tax credit - Stocks and bonds of $3,500,000 in 2009. To everyone’s - Bank accounts, CD’s surprise, in 2010, estates were given the - Personal effects option of a $5,000,000 estate tax credit - Savings bonds with full stepped up basis on inherited assets - Stock options (eliminating capital gains) or no estate tax - IRA's and 401(k)s and a limited basis adjustment. In 2011 and - Business Interests 2012, the estate tax credit was maintained - Annuities at $5,000,000 with a small upward ◆ The decedent’s interest in property adjustment for inflation. The maximum tax held as a joint tenant with right of rate is currently 35%. survivorship. If the decedent’s joint Under current law, the estate tax credit tenant is his spouse, generally only reverts to $1,000,000 on January 1, 2013, one-half of the property is included in and the maximum tax rate goes up to 55%. the decedent’s gross estate. However, President Obama has proposed an estate if the joint tenant is someone tax credit of $3,500,000 and a maximum other than his spouse, there is a tax rate of 45%. presumption that the decedent owned He also proposes a concept called portability. This allows a surviving Observation spouse to preserve the unused tax credit of his or her spouse by filing an estate Applicable Exclusion Amount tax return. The pros and cons of portability This is the technical name for the are discussed later in this chapter. amount of property that passes No one knows what the future holds. free of federal estate taxes. It is For purposes of this book, we assume a also referred to as the unified tax federal estate tax credit of $3,500,000 credit or the estate tax credit. The and a maximum tax rate of 45%. credit was unified when the estate In order to understand how the tax tax credit was the same as the gift impacts each of us at death, several tax credit. As President Obama’s concepts must be understood. gift tax credit proposal is for a $1,000,000 tax credit, the estate THE GROSS ESTATE and gift tax credits will no longer First, before estate taxes can be be the same so we will not use this calculated, the value of the assets in the phrase to describe the amount of the estate must be determined. The tax system tax credit. In this book, we use the imposes a tax on the gross estate of a phrase estate tax credit. decedent less all deductions. The term
Chapter 4: The Federal Estate Tax 23 Wealth Management Through Estate Planning
the entire property interest, although Barry, as the joint owner. The estate has the decedent’s estate may rebut the the burden of proving the amount of any presumption by showing contribution by contributions made by Barry, such as another joint tenant. amounts Barry may have paid towards ◆ Certain transfers of property within the down payment or for any improve- three years of death including interests ments. Compare this to Michael’s inter- in life insurance policies, transfers where est in the residence with Janice, which the decedent has retained an interest and is automatically included at 50%, not transfers of property where the decedent 100%. When property is owned jointly retained the right to revoke the transfer. with someone other than a spouse, for instance a child, the presumption is that ◆ Property subject to a general power of the decedent owns the entire interest, appointment held by the decedent. A except if contributions by the co-owner power of appointment is a power held can be established. by an individual that allows that person ◆ Putting assets in to direct, without limitation, who should The entire amount of the IRA enjoy and receive the property that is ($750,000) is included in the estate for the joint names of controlled by the power. It is unusual for estate tax purposes (It is also subject to income taxes when withdrawals are a parent and child a person to have a general power of appointment over property unless that made.) does not reduce person is a beneficiary of a will or trust ◆ Only one-half of the stock ($447,500) estate taxes. While that, for estate planning purposes, cre- and one-half of the balance of the check- ates the power for that person. ing and savings accounts ($62,500) the property may ◆ The death benefit paid on life insur- are included because, again, they were avoid probate, ance policies when the decedent either held as joint tenants with Janice. The pre- owned the policy or had “incidents of sumption of equal ownership of property the distribution ownership” associated with the policy. owned jointly between a husband and a wife applies to all types of property. to one child may The concept of the gross estate as used for leave the other FET purposes is very broad and encompasses all of a person’s property interests. The ALTERNATE VALUE children without following example illustrates how the gross OF PROPERTY their share of the estate is determined. The value of property included in the gross For purposes of the FET, Michael’s gross estate is its fair market value at the date of joint asset. Always estate is determined as follows: death. However, the executor of the estate can know all of the ◆ One-half of the residence ($325,000) elect to use the alternate value of the property is included because it is held jointly with for the purpose of computing the estate tax consequences when his spouse. The law presumes that a hus- liability. Alternate value is the fair market value you are adding on band and wife have equal ownership of of the property six months after the date of the property held jointly. decedent’s death or the value on the date of a co-owner to your distribution if that date is prior to the end of the ◆ The total values of the furnishings, per- six month period. property. sonal possessions and the automobile For example, presume that the price of ($30,000) are included in his estate. stock owned by a person dramatically fell ◆ The $700,000 death benefit from following the date of death. The executor can the life insurance is included because decide, after balancing estate tax and income Michael owned the policy. tax considerations, whether or not to use the ◆ The value of the rental property lower value of the stock at the six month mark ($300,000) is included in Michael’s after the decedent’s death for purposes of the estate except to the extent that the estate estate tax return. If an alternate value is used can establish contribution by his brother, for one asset in the estate, it must be used for all
24 Chapter 4: The Federal Estate Tax Wealth Management Through Estate Planning
Example Part 1 At the time of Michael’s death, he owned the following property: Description Value • Residential real property owned as joint tenants with right of survivorship with his spouse, Janice. $650,000 • Interests in furnishings and personal possessions such as jewelry and clothing. $20,000 • Automobile. $10,000 • Death benefit of life insurance owned by Michael on his life. $1,500,000 • Rental property held as joint tenant with right of survivorship with his brother, Barry. $300,000 • IRA with Janice as beneficiary. $750,000 • Stock held in brokerage account as joint tenant with right of survivorship with Janice. $895,000 • Checking and savings accounts held with Janice as joint tenants with right of survivorship. $125,000 Total estate: $4,250,000
Example Part 2 For FET purposes, Michael’s estate is recapitulated as follows: Description Value • Residential real property owned as joint tenants with right of survivorship with his Janice (one-half value). $325,000 • Interest in furnishings and personal possessions such as jewelry and clothing. $20,000 • Automobile. $10,000 • Death benefit of life insurance owned by Michael and on his life. $1,500,000 • Rental property held as joint tenants with right of survivorship with Barry (presume that brother could not show any contribution). $300,000 • IRA with Janice as beneficiary. $750,000 • Stock held in brokerage account as joint tenants with right of survivorship with Janice (one-half value). $447,500 • Checking and savings accounts held with Janice as joint tenants with right of survivorship (one-half value). $62,500 Total Gross Estate: $3,415,000
Chapter 4: The Federal Estate Tax 25 Wealth Management Through Estate Planning
assets in the gross estate (the executor cannot ◆ Miscellaneous expenses such as fees pick and choose among the assets). The to employ appraisers, accountants, election to use alternate values is irrevocable court filing expenses related to probate and must be made on the estate tax return. administration, property transfer costs Also, the election can only be made if it has and all related expenses that were the impact of reducing the estate taxes. incurred as part of the administration At first blush, using the alternate value of the estate. seems attractive if there is a drop in the ◆ The debts of the estate, including value of the estate property over the six the decedent’s final medical expenses, month period following death. However, funeral bill, unpaid mortgages, credit this value is also considered the new cost card bills and other legal obligations basis of the estate property in the hands of of the decedent that were incurred the beneficiaries. This could result in greater prior to death. capital gains or income taxes being paid if ◆ Charitable gifts to organizations that the property is sold. The entire estate tax rate are recognized charitable organiza- should be compared to a possible capital tions. gain being incurred upon the sale of the asset. These competing tax objectives must be taken ◆ An unlimited marital deduction for into consideration. all property passing from the decedent either directly to a surviving spouse DEDUCTIONS FROM or to certain types of trusts held exclu- THE GROSS ESTATE sively for the surviving spouse’s benefit. The next step in calculating the FET is to Some of these deductions may be used reduce the gross estate by any allowable on the estate’s income tax return and the deductions. These deductions are generally attorney or accountant handling this tax summarized as follows: return has to determine where the greater tax savings will be. ◆ The executor’s commission or trustee fees for acting as the fiduciary THE MARITAL DEDUCTION of the decedent’s probate estate and/ or successor trustee of the decedent’s The marital deduction is the most trust. These fees are treated as ordi- important deduction available for married nary income to the executor or suc- couples. It is unlimited in amount and can be cessor trustee. Frequently, when the used to defer all estate taxes until the death of executor or trustee is a beneficiary of the surviving spouse. the estate, he or she will waive the fees Property passing directly to a surviving and instead simply take the share allo- spouse qualifies for the marital deduction cated to them under the Will or trust. (as long as the spouse is a U.S. citizen). For example, all property interests transferred ◆ Fees paid by the executor or successor from the decedent’s estate directly to the trustee for the employment of an attor- surviving spouse qualify for the deduction. ney to assist in the administration of Consequently, if you leave everything to your the estate. surviving spouse, without restriction, it will Observation qualify for the marital deduction and eliminate the FET for your estate. Bear in mind that If no estate taxes are due at death, there is no incentive when the surviving spouse dies, there may be to use the alternate value of the estate property. This occurs a FET on the assets remaining in her name. most commonly where there is a surviving spouse and the This is why the marital deduction is often property passes to that person or where the size of the referred to as a device to defer all estate estate is less than the estate tax credit amount. taxes until both spouses are deceased. As a result of this tax deferral, the surviving spouse
26 Chapter 4: The Federal Estate Tax Wealth Management Through Estate Planning
has all of the resources saved during the estate planning attorney to make sure that marriage available for her support, without the assets can pass to a surviving spouse any diminishment through the imposition of without being diminished by estate taxes estate taxes. through the use of a QDOT. The marital deduction is unlimited in FET law provides a few methods by amount, meaning that no matter the value of which a person may pass an interest in the property passing to the surviving spouse property to be held for the benefit of a (be it $100,000 or $10,000,000), there surviving spouse (besides an outright gift) are no estate taxes. and still have that property qualify for the If the surviving spouse is a not a U.S. marital deduction. There are two ways of citizen, then the unlimited marital deduction doing this: the marital deduction trust for estate taxes is not available. However, and the QTIP trust. taxes on property held in trust for a non- U.S. citizen spouse can be deferred if the THE MARITAL property passes to a special trust, called a DEDUCTION TRUST Qualified Domestic Trust (QDOT), for the A person may transfer property into benefit of the surviving spouse. It is crucial a trust, either during his lifetime or at for non-U.S. citizens to confer with an death, and if that property is held for the exclusive benefit of the surviving spouse, Portability of that property will qualify for the FET marital Marital Deduction deduction. Generally, a marital deduction trust will provide that the surviving spouse Tax law changes in 2010 introduced is entitled to the following benefits from that the concept of portability into federal trust: estate tax law. Portability means that the ◆ All of the income from the trust. unused estate tax credit of a spouse may be used by the surviving spouse. For some ◆ Discretionary principal for the couples, this may mean that they do not spouse’s health, support, mainte- have to plan for funding a credit shelter nance and education. trust on the death of the first spouse. ◆ The right to withdraw the entire While there are positives such as this, principal of the trust at any time and those relying on portability are also giving to designate whom shall receive the up planning opportunities such as asset property after the death of the surviv- protection planning and dynasty planning ing spouse. This right gives the surviv- opportunities. ing spouse absolute control over the At my law firm, we changed our tax final disposition of the trust. planning strategy to allow the surviving This type of trust is commonly spouse in a first marriage flexibility to established as a part of a sophisticated determine if portability makes sense. As estate plan to minimize FET. The surviving to second marriages, especially where spouse has unlimited access to the funds in there are children from a first marriage, the trust. Any property in the trust will pass portability is less desirable as it does not on first as the surviving spouse decides and, ensure that assets will eventually be passed to the extent he or she does not make an on to children from a first marriage. election, to the beneficiaries chosen by the Like other estate tax provisions, the first spouse to die, without going through portability feature is scheduled to end at probate on the death of the surviving the end of 2012. spouse.
Chapter 4: The Federal Estate Tax 27 Wealth Management Through Estate Planning
The assets in this type of trust are included This type of trust is frequently used where in the surviving spouse’s taxable estate on the trust donor has children from a prior his or her death. Again, the unlimited marital marriage and wants to make sure that after deduction serves to defer (not eliminate) the death of his current spouse, his assets will estate taxes until the death of the surviving pass on to his children. By creating a QTIP spouse. The reasons for establishing a marital trust, the donor can achieve all of the above deduction trust, also commonly known as goals. His spouse gets the use of the money “Trust A,” are discussed in Chapter 12: The for support and he insures that the remaining A-B Trust Strategy. A comprehensive estate trust property on the death of his spouse will plan uses a marital deduction trust to its full eventually go to his children. potential if the wealth of the couple dictates the use of a marital trust. QTIP Property QUALIFIED TERMINABLE For property held in trust to qualify as INTEREST PROPERTY qualified terminable interest property, the What if there is a second marriage trust must include several requirements. situation and the husband wants to provide All of the income must be payable to the for his second wife, but not give her absolute spouse/beneficiary at least annually and control over the final disposition of the no other person can be a beneficiary property? The husband can set up for the of the trust during the surviving spouse’s benefit of the wife (or conversely, a wife lifetime. If these provisions are not in the can establish for the benefit of a husband) trust document, the trust will not qualify for a marital deduction trust that is similar in QTIP treatment. The consequence is that nature to the trust described above except the trust is subject to estate taxes in the that the surviving spouse is not given the estate of the deceased spouse. right to withdraw the principal of this trust or name new beneficiaries. On the death of the surviving spouse, the property passes on to In these circumstances, it is crucial to other beneficiaries named in the trust by the name an independent person or bank, spouse who established the trust. This type of someone other than the spouse, as the a trust is known as a Qualified Terminable trustee of the QTIP trust. Naming either the Interest Property trust (QTIP trust). Its spouse or one of the donor’s children as the significant feature is that the surviving spouse trustee presents obvious conflict problems does not have a right to demand distribution regarding how the property can be used of the trust principal. A QTIP trust allows a for the surviving spouse’s benefit. This is a person to achieve multiple benefits including situation where a corporate trustee, with total the following: independence, is recommended. A QTIP trust is also a valuable tool when ◆ Provide funds for his spouse’s support the donor wants to protect his spouse from following his death. financial misfortune or if he questions her ◆ Use the marital deduction against ability to handle the trust fund. With careful estate taxes for the property put into drafting, the QTIP trust can protect the trust the trust to defer estate taxes. principal from the claims of creditors. A ◆ Guarantee that the property remain- spouse who is a beneficiary of a QTIP trust ing in the QTIP trust after the surviving still has the right to receive all of the income spouse’s death passes on to the ben- of the trust and discretionary principal as eficiaries chosen by the spouse who needed for her support. However, she does established the trust. not have a right to withdraw the principal of the trust at will and can only receive the principal if, in the opinion of the trustee, it is
28 Chapter 4: The Federal Estate Tax Wealth Management Through Estate Planning
needed for support. Again, this highlights saving opportunity than deductions. the importance of selecting an independent The most significant credits against the trustee who can make this decision in a FET are the following: reasonable, balanced manner. ◆ An estate tax credit against the A third situation when a QTIP trust is FET. This is a direct reduction in the useful occurs when spouses want to make amount of the FET up to the amount sure that both of their exemptions from the of the credit. generation-skipping transfer tax are used. ◆ A foreign death tax credit against This is a complex technique that enhances the FET for taxes paid to another the dynasty planning aspects of an estate country. plan. In a nutshell, the usefulness of a QTIP There are several credits that are of trust is that while it qualifies for the unlimited lesser importance, either because they are marital deduction (thereby postponing used less frequently or are smaller in value. estate taxes) it also ensures the ultimate Primarily, these are tax credits for taxes disposition of property by limiting the previously paid on certain gifts and a credit surviving spouse’s access to the trust for estate taxes paid on prior transfers. They property. are mostly applicable if people die in quick succession. CREDITS AGAINST THE FEDERAL ESTATE TAX THE Applicable After reducing the gross estate by the Exclusion Amount foregoing deductions, the tentative FET is The applicable exclusion amount, calculated. The estate tax rates are applied also referred to as the estate tax credit, against the amount of the estate less the is generally considered to be the most deductions. The estate is then allowed to important tax credit because it is available deduct certain credits from this tentative to every person and is probably the largest tax. Before we go further, let us review the credit. The credit protects a certain amount difference between deductions and credits. of property from estate taxes, no matter A deduction reduces the amount of who is the beneficiary of the property. The the gross estate for tax purposes. As an protected property does not have to go example, assume the decedent’s gross to a surviving spouse (unlike the marital estate is $2,700,000 and there is a deduction). This property can pass to $6,500 funeral expense. The funeral bill is children, nieces, nephews, other relatives, a deduction that reduces the gross estate to friends, or trusts established for these $2,693,500 for purposes of calculating the individuals. estate tax. The available amount of the estate tax By comparison, a credit is a direct credit has fluctuated wildly over the past dollar for dollar reduction of the amount ten years. In 2009 it was $3,500,000. of the tax. Using the above example, the In 2010, the estate tax credit was either tentative estate tax on a taxable estate of $5,000,000 with a full step up in basis $2,693,500 is $1,106,745. The amount of or no estate tax if the taxpayer’s estate the available estate tax credit available in agreed to limit the amount of property that 2012 is $5,000,000, which eliminates the qualified for stepped up basis treatment. federal estate tax. For 2011 and 2012, the estate tax credit In summary, deductions reduce the is $5,000,000 but in 2013 it reverts gross estate before calculating the estate to $1,000,000. President Obama has tax. Credits reduce the estate tax that is due. proposed a tax credit of $3,500,000. Because of this, credits create a greater tax It has been very difficult for estate
Chapter 4: The Federal Estate Tax 29 Wealth Management Through Estate Planning
planning attorneys and other professionals to advise clients in this Example uncertain environment. Given the current toxic political situation, our Phil, a widower, had at the time of huge annual deficit and the burgeoning his death in 2012 a gross estate for FET national debt, controversy over all tax purposes of $3,075,000. His estate has law will continue. Stay tuned! deductions for administration expenses and debts in the amount of $75,000. The tax COMPUTING THE calculation is as follows: FEDERAL ESTATE TAX FET Calculation Examples are useful for Gross estate $3,075,000 understanding how the federal estate Administration expenses tax is determined. For purposes of this and debts 75,000 discussion, we assume that the estate Net taxable estate 3,000,000 tax credit is $3,500,000. Tentative estate tax 780,800 The following set of facts illustrate Less estate tax credit 780,800 why estates that are less than the estate Net estate tax -0- tax credit amount, after all deductions are taken, do not incur any fet. This example illustrates how the estate tax credit effectively eliminates The next example illustrates how the the tax. In fact, a FET return does not even unlimited marital deduction also eliminates have to be filed where the gross estate is less the estate tax for the estate of the first spouse than the estate tax credit amount. to die. The second example illustrates the serious tax impact of failing to properly plan for the estate tax consequences that occur on the death of the surviving spouse. Keep in mind that the estate tax in the examples was only deferred until the second spouse’s death but not eliminated. There is a better way! In Chapter 12: The A-B Trust Strategy, we will explore how this unfortunate situation can be avoided.
30 Chapter 4: The Federal Estate Tax Wealth Management Through Estate Planning
Example Adam, at the time of his death in 2012, had a gross estate for FET purposes of $3,875,000. His spouse, Michele, survived Adam and was the sole beneficiary of his estate. His estate has deductions for administration expenses and debts in the amount of $62,000.
FET Calculation Gross estate $3,875,000 Administration expenses and debts 62,000 Taxable estate before marital deduction $3,813,000 Marital deduction 3,813,000 Net federal estate tax -0-
The marital deduction is unlimited in estate taxes on the death of the surviving amount. This means that a decedent can spouse when all of the assets are accumulated pass to his surviving spouse any amount of in the surviving spouse’s estate. However, property without causing a FET. As will be the example does illustrate the importance seen in Chapter 12: The A-B Trust Strategy of the marital deduction. The impact of the where we discuss one of the classic estate marital deduction can be further understood planning techniques, leaving everything to by examining what occurs when the surviving the surviving spouse is often not a good tax spouse in the below example dies. strategy to follow. This can lead to higher
Example Michele dies later in 2012. This example assumes an estate tax credit of $3,500,000. Her estate consists of the following: $3,813,000 that she inherited from Adam, $50,000 which represents appreciation in those assets in the interval between their deaths and $512,000 of her own property. Her estate has administration expenses and debts that total $53,000. There is, of course, no marital deduction because Adam has predeceased Michele. Michele’s FET is calculated as follows:
Gross estate $4,375,000 Administration expenses and debts 53,000 Net taxable estate $4,322,000 Marital deduction -0- Taxable estate $4,322,000 Applicable exclusion amount 3,500,000 Net taxable estate 822,000 Federal estate tax rate 45% Federal estate tax $369,900
Chapter 4: The Federal Estate Tax 31 Wealth Management Through Estate Planning
FILING THE FEDERAL ESTATE respects as a tax-planning tool, are not TAX RETURN always a complete and satisfactory method of reducing or eliminating the FET. For many The FET return is due nine months from persons, it may be extremely difficult, if not the date of death, although extensions may impossible, to avoid the payment of all estate be obtained for certain reasons. Additionally, taxes at death. However, a good plan always all estate taxes must be paid within nine seeks to minimize estate taxes. months from the date of death. Some estates Estate planning frequently begins with may elect to pay the FET in installments when creating financial models illustrating potential a material portion of the estate consists of the estate taxes and then moves on to an analysis decedent’s interest in a closely held business. of the available planning techniques that The penalties for failure to timely file the are designed to reduce taxes or provide return and pay any tax that is due can be wealth and liquidity to pay estate taxes. In quite severe. The penalty for failing to timely subsequent chapters, we will discuss some of file the return is 5% of the tax due for each these strategies. There are many tax planning month that the return is late up to five months methods available such as second-to-die life for a maximum penalty of 25%. Failure to pay insurance, leveraging lifetime gifts and making the tax when due causes a penalty of 5% per charitable bequests. An important role of the month until paid. Interest accrues on each of estate planning attorney is to bring to the the penalties along with interest on the unpaid client’s attention the planning tools that are amount of any estate tax due. The United available to reduce or minimize estate taxes, States Estate Tax Return (Form 706) is quite or to pay for taxes that cannot be avoided. complicated and adequate time must always be left to complete the return and make a timely filing.
CONCLUSION Once an estate exceeds the estate tax credit amount in effect for that year, the federal estate tax quickly becomes burdensome because of the high marginal rates. This potential cost is aggravated by the inclusion of virtually all property interests owned by a decedent at death in the taxable estate. There is no better example of the reach of this tax than inclusion of life insurance proceeds in the decedent's estate for determining the estate tax. Lifetime gifts, while helpful in many
32 Chapter 4: The Federal Estate Tax Wealth Management Through Estate Planning
Chapter 5: The Federal Gift Tax
Gifts to others during the donor’s lifetime are subject to the federal gift tax. The overall impact of this tax limits the tax advantages of giving property away during life for the sole purpose of avoiding estate taxes on the gifted property at death. This chapter explores the important aspects of this tax.
Chapter 5: The Federal Gift Tax 33 Wealth Management Through Estate Planning
Chapter 5:
◆ How the Gift Tax Operates
◆ Gift Tax Deductions
◆ The Gift Tax Credit
◆ Annual Exclusion Gifts
◆ Splitting Gifts with a Spouse
◆ Calculating the Gift Tax
◆ Tax Basis of Property Gifted
“Taxation WITH representation ain’t so
hot either.”
Gerald Barzan
34 Wealth Management Through Estate Planning
ederal tax law imposes a gift tax on most gifts of property made Example On February 5, 2012, F during a person’s lifetime. Because Wanda transfers to her of the way the gift tax is structured, the daughter, Lori, 500 shares of common stock with a available deductions to the gift tax and per share value of $100. The total value of the stock is other planning strategies, relatively few $50,000. On April 15, 2013, the stock is worth only persons ever actually pay a gift tax. The $50 per share. The total value of the stock has fallen gift tax applies to all transfers of property to $25,000. that are made from one person to another Wanda is required to file her gift tax return by without consideration (i.e. without anything April 15, 2013. On the return, she will show the value given in exchange) and with the intent to of the gift to Lori as being $50,000. The fact that the make a gift. The person who is making stock dropped in value after the gift does not change the gift is called the donor and the person the value of the gift on the gift tax return. Conversely, receiving the gift is called the donee. if the value of the stock had risen to $150 per share, All types of personal and real property Wanda would still report the value of the gift as being are subject to the tax. In this chapter, $50,000 on the gift tax return. we examine the federal gift tax and the methods that are used to make tax-free gifts. gifts during your lifetime is to remove all of the appreciation in the value of the gifted Observation property that occurs after the gift from your One of the most frequent taxable estate. questions I am asked is: How While it is strongly advisable to timely is the gift taxed to me, the recipient? Good news! The file the gift tax return, the failure to do so gift is not treated as income to the recipient. You do does not result in penalties if the amount not pay taxes when you receive a gift! of the gift is not subject to tax because of the use of the gift tax credit against the tax. However, the failure to timely file a HOW THE GIFT TAX gift tax return where there is a gift tax will result in penalties and interest. Also, if the OPERATES gift tax return is not timely filed, some of the The gift tax applies to all gifts made advantages of allocating your generation- during a calendar year. The person making skipping transfer tax exemption to the gift a gift is required to file a gift tax return. On may be lost. the return, he identifies the amount of the A gift tax return should be filed even gift, the donee and his address, the value if there is not any gift tax due. This makes of the gift and other relevant information. record keeping much easier if the donor All gifts are valued at their fair market value makes both taxable and non-taxable gifts at the time of the transfer of the property. and helps to reconcile lifetime taxable gifts Generally, the gift tax return is due on April with property being transferred at death. 15 of the year following the calendar year A gift tax return does not have to be filed if in which the gift was made. In comparison, all of the gifts qualify as annual exclusion the federal estate tax return is due nine gifts. months after the date of death. The foregoing example only describes The following example illustrates what the basic structure of the gift tax. We now happens when there are fluctuations in the turn our attention to understanding how the value of property that is gifted. gift tax is determined. As we will see in later chapters, one of the most important reasons to make
Chapter 5: The Federal Gift Tax 35 Wealth Management Through Estate Planning
GIFT TAX DEDUCTIONS The Charitable Deduction The donor of a gift is entitled to certain A donor may fully deduct on his gift deductions on the gift tax return before tax return gifts made to a qualifying charity. computing the tax. These deductions are Charities that qualify are organizations such similar to the deductions allowed for the as the following: federal estate tax return. ◆ Charitable organizations approved The Marital Deduction as tax-exempt groups by the IRS; The donor is allowed an unlimited ◆ The United States and any of the marital deduction for transfers to a spouse. states and their political subdivisions; He may transfer to his spouse all or any ◆ A fraternal society such as a lodge, portion of his property without any gift tax but only if the gifts are used exclusively consequences. Gifts between spouses are for religious, charitable, scientific, liter- frequently used to equalize the estates of ary or educational purposes; each spouse so that each spouse will have ◆ A corporation, trust, community sufficient assets available to pursue estate chest, fund or foundation that is tax planning goals. This type of equalization organized and operated exclusively for is recommended when the family assets are religious, charitable, scientific, literary not divided somewhat equally between the or educational purposes or to promote husband and wife. national or international amateur sports The unlimited marital deduction is competition; available only for spouses who are U.S. citizens. If the spouse is not a citizen, then the ◆ Organizations of war veterans and deduction is limited to $139,000 per year for auxiliary units of them. transfers to that spouse. It is important that the donor verify that the Only certain types of gifts to a spouse organization that he wants to give to qualifies qualify for the gift tax marital deduction. as a charity for tax purposes. If it does not, the An outright gift of property to the spouse deduction is not available and a gift tax may qualifies. Also, a gift can be made of be incurred. qualified terminable interest property (QTIP), which is like QTIP property for estate THE Gift tax credit tax purposes. This type of gift might involve After all deductions are used, the gift tax a gift to a trust for the benefit of the spouse on any remaining value is determined. There is where the spouse receives all of the net then a credit available to offset the gift taxes, income and no one but the spouse is entitled up to a specified amount. This is called the gift to receive distributions from the trust. However, tax credit. if the spouse’s interest in the trust will terminate The gift tax credit had been $1,000,000 at a specific time other than the spouse’s since 2002. Surprisingly, this credit was raised death, such as at the end of a term of years, to $5,000,000 for 2011 and 2012, equaling then this gift will not qualify for the unlimited the amount of the estate tax credit. This credit marital deduction. Most gifts to a spouse is scheduled to reduce to $1,000,000 in are outright transfers of property. However, 2013 just like the estate tax credit, unless occasionally QTIP trusts are used in situations Congress and the President can agree on a such as where there is a second marriage. tax compromise. The President has proposed This assures that the property gifted to the a $1,000,000 gift tax credit along with a QTIP trust will eventually pass to the donor $3,500,000 estate tax credit. spouse’s first family. The reason for maintaining a gift tax is
36 Chapter 5: The Federal Gift Tax Wealth Management Through Estate Planning
quite simple, at least from the viewpoint the estate tax law catches up with this by of Congress. If there were no gift tax, a combining all of the transfers. The unification taxpayer could transfer assets to others in of all transfers does not mean that there lower income tax brackets, reducing the is not any advantage to lifetime giving. amount of income taxes collected by the Lifetime transfers still can create substantial federal government. At a later point in time, tax benefits for the donor’s family if made as say when the donor retired, the persons to part of an overall estate planning strategy. whom he transferred could transfer the same property back to the donor who would ANNUAL EXCLUSION GIFTS then collect the income paying taxes at his A gift of $13,000 or less by a donor to current tax bracket. The government needed a donee in any one calendar year is totally to keep assets with the same taxpayers so excluded from the donor’s taxable gifts, if it as to avoid a loss of tax revenue. qualifies as an annual exclusion gift. One Lifetime taxable gifts (other than donor can make as many $13,000 gifts as annual exclusion gifts) are unified with he wishes to different donees in the same transfers at death for determining the federal year. The donees can be family members, estate tax. To the extent that the credit is friends or any natural person. There is no used during your lifetime, its availability at limit on the number of people who can death is proportionately reduced. This is because at death, all lifetime taxable gifts are added together with transfers at death Planning Strategy Using up the unified tax for purposes of determining the estate tax, if credit for gift taxes during any, that is due. lifetime can be advantageous This example highlights the underlying for reducing federal estate taxes. None of the philosophy behind the federal estate and appreciation of property gifted is added back into gift tax laws. These laws seek to tax, at the decedent’s estate for purposes of calculating the some point, all of the transfers that a person federal estate tax. In the previous example, assume makes either during lifetime or at death. Dennis invested the money in stocks that appreciated This is accomplished by combining these to $600,000 in value. None of the appreciation is transfers upon each person’s death. During added back into Harold’s estate when calculating life, the gift tax can be avoided by using federal estate taxes. For this reason, estate planning the estate tax credit; however, at death attorneys frequently recommend to clients using the gift tax credit during lifetime.
Example During his life, Harold made $300,000 worth receive annual exclusion gifts. If a donor of taxable gifts to his son, Dennis. On each of has a taxable estate, these lifetime gifts can his gift tax returns, he applies a portion of his be easily used to decrease the estate before estate tax credit that serves to eliminate the gift the donor dies. tax on all of these gifts. At the time of his death, A gift to an entity, such as a corporation Harold owned assets worth $2,700,000. The or a partnership, will not qualify as an taxable lifetime gifts of $300,000 are combined annual exclusion gift. An annual exclusion (unified) with the $2,700,000 in his estate to gift cannot be made to a trust unless it calculate the estate tax liability. His estate tax is is a special type of trust that gives the determined on $3,000,000 of assets. beneficiaries certain withdrawal rights. This is discussed in Chapter 19: Other Planning
Chapter 5: The Federal Gift Tax 37 Wealth Management Through Estate Planning
Techniques under the heading “Cristofani For example, using 1998 as the base year, Trust.” the annual exclusion amount is not changed Even the tax laws recognize that smaller until the total cumulative inflation since that gifts are made by many persons and if the IRS year is 10%. Once the amount is increased by attempted to levy a gift tax on every gift, the $1,000, then it resets and we start over with resulting bookkeeping would be a nightmare! the inflation adjustment. The following is a common example of an There are a few other gifts which can be outright gift. made totally outside of the gift tax system. These are payments of tuition and medical expenses. The payments must be made Example Sharon gives $7,000 to directly to the provider (i.e. to the school or each of her five grandchildren. to the doctor). Grandparents often take She also gives $13,000 to each of her two children. Because each gift is $13,000 or less, there is no gift My opinion tax. Also, because they are annual exclusion gifts, she does not have to file a gift tax return. Making lifetime gifts is one of the most Annual exclusion gifts can be an important estate tax important component of a family gifting planning strategies program. The most significant benefit is that these gifts do not use up the estate tax credit available. Annual exclusion gifts are nor are they added back into the donor’s very common and there are important estate at death. In Chapter 14: Family Gift advantages to using up the estate tax Strategies, we explore the use of the gift tax annual exclusion in structured family gift credit during lifetime. Some clients will plans. even make gifts that trigger gift taxes so Under the Taxpayer Relief Act of 1997, as to reduce estate taxes at death! the amount allowable as an annual exclusion gift is indexed to inflation. The inflation adjustment does not occur, however, until advantage of all of these types of special gifts the total adjustment would result in increasing in order to help their family and reduce their taxable estates. $ 13,000 SPLITTING GIFTS WITH A The Power Daughter of Multiple SPOUSE Annual Gifts $13,000 One spouse may make all of the gifts and choose to treat one-half of gifts as being Son made by his or her spouse (with the other $ Grandmother $13,000 65,000 spouse’s consent). This is called gift-splitting. Tax Free This occurs when one spouse owns the Grandson gives Gifts assets that are to be gifted but wants to take $13,000 advantage of the other spouse’s available annual exclusions or estate tax credit. Another Granddaughter time this occurs is when there is a second $13,000 marriage and one spouse is making gifts to her children from the first marriage. Her Niece spouse allows the use of his annual exclusion without giving away his property to her children. the exemption amount by a total of $1,000.
38 Chapter 5: The Federal Gift Tax Wealth Management Through Estate Planning
If gift-splitting is elected, it applies to all who made the gift is brought back into the gifts made during the calendar year. To split estate. It is this exclusion of growth from a gifts, however, it is necessary for the spouse decedent’s estate that makes lifetime gifts making the gift to timely file a gift tax return an attractive planning technique to reduce electing to split the gifts and for the other estate taxes. spouse to consent to this in writing on the To be technical for a moment, gift return. taxes and estate taxes have one primary difference. The gift tax is tax exclusive CALCULATING THE GIFT TAX which means the beneficiary receives the The following example demonstrates full amount of the gift and the donor pays how the tax is determined. the tax. The estate tax is tax inclusive This example demonstrates how the which means the beneficiary receives the estate tax credit eliminates the gift tax. gift only after its value is diminished by the However, upon the death of Jason, the payment of estate taxes. This difference taxable gift of $37,000 is added back into between the two tax systems sometimes his estate for purposes of computing the means that a person’s family is best served if federal estate tax. This is also what occurred the donor makes taxable gifts during his or her lifetime. Usually, this type of planning is only indicated with larger estates. It is unusual for someone to make a gift Example Jason gives to that causes a gift tax. This is because the his son, Samuel, annual exclusion, deductions and the estate $50,000. Because the gift exceeds $13,000, tax credit usually eliminate any gift tax. the annual exclusion amount, Jason is Also, making a gift is elective and if making required to file a gift tax return. The tax is the gift would trigger a tax, the prospective calculated as follows: donor usually chooses not to make the Gift Tax Calculation transfer. Total gifts $50,000 Less: annual exclusion 13,000 Taxable gifts $37,000
Tentative Gift tax $ 7,760 Less: estate tax credit applied 7,760 Gift tax -0-
in our discussion of the estate tax credit where the $300,000 in lifetime transfers were added into Harold’s estate at his death for estate tax purposes. The unified tax credit is also resored to its full amount for purposes of calculating any federal estate tax due. Even though the value of the gift is added back into the estate for calculating the estate tax, none of the appreciation in the value of the gift from the date of the gift to the date of death of the person
Chapter 5: The Federal Gift Tax 39 Wealth Management Through Estate Planning
TAX BASIS OF PROPERTY In Chapter 14: Family Gift Strategies, we GIFTED will explore how this potential problem can be minimized by carefully selecting which When a gift is received, the donee retains the same cost basis in the property as the assets to gift. donor had. Compare this to when a donee receives property as an inheritance at death CONCLUSION and receives a step-up in the cost basis to the Careful planning is required before date of death value. This difference between gifts of substantial value are made to others. lifetime gifts and gifts at death can have Important considerations are the type of important capital gain tax consequences for property to be gifted (cash, real estate, the recipient. securities, etc.), the income tax consequences of making the gift, whether the donee should receive the property outright or in a trust Example John and the method of determining the value of gives to the gifted property for tax purposes. In later his son, Ken, stock with a fair chapters, we will examine in detail the various market value of $15,000. John issues that are considered when developing purchased the stock years ago for gifting strategies. $2,000. Ken has the same basis in the property as his father. When he sells the stock, his basis for determining the capital gains tax he pays will be $2,000. If the fair market value of the stock on the date of sale is $20,000, the capital gain is $18,000.
40 Chapter 5: The Federal Gift Tax Wealth Management Through Estate Planning
Chapter 6: State Estate and Inheritance Taxes
There are a variety of ways in which each state taxes the estate of a deceased person. Some impose a tax on a decedent's estate while others tax the beneficiaries who receive the gift.
Chapter 6: State Estate and Inheritance Taxes 41 Wealth Management Through Estate Planning
Chapter 6:
◆ States with Inheritance and Estate Taxes
◆ Other State Tax Issues
◆ The Ohio Estate Tax
“If you like laws and sausages, you should
never watch either one being made.”
Otto Von Bismarck
42 Wealth Management Through Estate Planning
any states have some type of However, tax legislation in 2001 tax on the estate of a decedent, phased out this tax credit over a four Mand there are different ways in year period with full phase-out in 2005. which these taxes are imposed. Some states The consequence of this was to reduce impose an inheritance tax. This is a tax the revenues that the states received. In that is levied against the beneficiaries and is response to this, many states created their based on the amount of the inheritance that own separate stand alone estate tax system each of them receives. Other states impose to replace the lost revenue. Immediately an estate tax, which is levied against the following is a list of the states with some estate of the decedent before distributions form of estate or inheritance tax. Some of are made to the beneficiaries. In this these states always had a separate estate chapter, we will briefly survey the types of tax but the list does not differentiate on that taxes imposed by the states. basis. Taxation of decedent’s estates at the state level is changing in some states. The STATES WITH INHERITANCE reason for this is the phase out of the federal OR ESTATE TAXES estate tax state death tax credit discussed These are the states that impose their below. The elimination of the credit is own taxes on estates of resident decedents. causing a reduction in state revenues across the country and as a response to this, some Connecticut Hawaii states are putting in place their own estate Illinois Indiana tax system to replace the lost revenues. Iowa Kansas While the information contained in this Kentucky Maine Chapter on the states’ estate tax systems is Maryland Massachusetts believed to be accurate as of the date of Minnesota Nebraska printing, it is reasonably certain that there New Jersey New York will be further changes at the state level as North Carolina Oregon to the taxation of decedent’s estates. Pennsylvania Rhode Island This is a generalized discussion as there Tennessee Vermont are so many different ways that each state Virginia Washington approaches the taxation of estates. However, Wisconsin in all states the rate of taxation is relatively The list of states now taxing estates low compared to federal estate tax rates. directly has grown substantially over the last From an estate planning perspective, federal several years. In all of these states, the rate tax laws, not state tax laws, drive the tax of taxation is small, at least relative to the planning in an estate plan. federal estate tax. A previous edition of this book stated that two states were phasing SOME HISTORICAL out their own taxes. One of these states, BACKGROUND Connecticut, reversed course, maintaining its To understand state estate and own taxes on decedent’s estates. inheritance tax law, we need to revisit Three states constitutionally prohibit (briefly) the past. Through 2005, the federal estate and inheritance tax. These are estate tax provided a tax credit (i.e. reduction Florida, Nevada and Alabama. in federal estate taxes) for amounts paid to states for estate taxes. Many states created OTHER STATE TAX ISSUES a tax system that created a tax equal to the For the states which have their own amount of the credit. This did not increase system of taxation, there are many different the overall estate taxes but shifted some rules that control the imposition of their tax. of the federal tax over to the state of the Most taxes are due within nine months from decedent’s residence. the date of death, but some states have
Chapter 6: State Estate and Inheritance Taxes 43 Wealth Management Through Estate Planning
different time periods. There are exemptions Whether or not the reasons for rescinding for transfers to surviving spouses and for the tax are valid, it is currently a fact. The charitable gifts. Ohio estate tax could be reinstated in the Some states tax all property owned by future as many other states have done. It is the decedent wherever located. Others do interesting that when revising the chart on the not tax real property interests of residents that previous page of states that have an estate are outside of their state. Tangible personal tax, only one state came off of the list, Ohio. property outside of the state of residence Eight states have added some form of estate may or may not be taxed depending on or inheritance tax since the last publication of each state’s laws. Intangible property (bank this book in 2006. accounts, stocks, etc.), wherever located, is usually subject to state death taxes in the state CONCLUSION of the decedent’s residence. In some states, Taxation of estates at the state level non-residents may pay state estate taxes. is in a state of change. In January, 1999, There are a wide variety of rules and the Delaware repealed its inheritance tax. Ohio law of each state where a person is either recently repealed its estate tax. The primary domiciled or has property will need to be reason for this trend is to take away a reason examined during the planning process and at why some residents of these states would his death. want to change domicile to a state, such as Florida, that does not have an inheritance THE OHIO ESTATE TAX or estate tax. States making this change Effective January 1, 2013, Ohio will have determined that the loss of estate and no longer have an estate tax. The Ohio inheritance tax revenues is more than made legislature, at the urging of the Governor, up by other tax revenue gains. decided that the estate tax should be Because of the relatively low rate of state eliminated. One basis of the rationale for estate and inheritance taxes and the low this change was that it was unfriendly to amount of available deductions against the businesses that might want to locate here tax, these taxes are not a prominent factor when the owners and executives consider the in creating an estate plan. The high rate potential cost of the estate tax. of federal estate taxes is the driving force A further rationale was that it keeps senior behind estate tax planning. However, the citizens from living in the state. Supporting effect of state taxes needs to be taken into this rationale was the belief that there are consideration in certain circumstances. lost revenues to business owners from citizens relocating to another state, such as Florida, which does not have an estate or inheritance tax. If the rationale is valid, there are also lost retail sales, reduced income tax revenues to the state and local governments and other negative economic consequences. The law to repeal the estate tax was enacted at the end of 2010. At the urging of local governments, it was delayed by two years so that they could adjust to the loss of revenues. A significant portion of the Ohio estate tax was apportioned to these governments.
44 Chapter 6: State Estate and Inheritance Taxes Wealth Management Through Estate Planning
Chapter 7: The Generation- Skipping Transfer Tax
The objective of this tax is to restrict the ability of families to avoid estate taxes on wealth passed down to later generations. The federal government, and many state governments, want to make sure that they get a chance to tax wealth as it is passed down to descendants. Careful planning takes into consideration the potentially expensive consequences of this tax and maximizes the use of available exemptions from this tax.
Chapter 7: The Generation-Skipping Transfer Tax 45 Wealth Management Through Estate Planning
Chapter 7:
◆ Purpose of the GST Tax
◆ Fundamentals of the GST Tax
◆ The GST Tax Trap
◆ Avoiding the GST Tax
◆ State GST Taxes
“Our Constitution is in actual operation;
everything appears to promise that it will last:
but nothing in this world is certain but death
and taxes.”
Benjamin Franklin
46 Wealth Management Through Estate Planning
he Internal Revenue Code imposes a separate tax on Example Bruce bequeaths Ttransfers of property from one to his grandson, person to another person who is Gordon, the sum of $100,000. Bruce’s more than one generation younger than daughter, Darlene (Gordon’s mother), the person making the transfer. As an is living at the time of his death. The example, a gift from a grandparent to a property transferred to Gordon is, grandchild is potentially subject to this tax. of course, not included in Darlene’s This tax is the generation-skipping transfer gross estate for tax purposes at any tax (GST tax). The GST tax is, in many time because she was never given an respects, one of the more incomprehensible ownership interest in that property. parts of the Internal Revenue Code. However, the gift to Gordon is a However, the important consequences generation-skipping transfer because it of this tax cannot be overlooked and the skipped Darlene. implications of the tax must be understood. Any estate plan that focuses on the long- term protection of family wealth must be The federal government does not want carefully crafted to take into consideration to be denied its ability to tax this property in the serious tax consequences of the GST Darlene’s estate. In the above example, the tax. A basic analysis and understanding $100,000 bequest skipped Darlene and is of this tax is necessary, especially before not subject to being taxed in her estate at we review dynasty planning techniques in her death. The skip is illustrated as follows: Chapter 13: Dynasty Planning With Trusts.
PURPOSE OF THE GST TAX The GST tax was established as part Bruce Gordon Grandfather Grandson of the overall scheme of estate taxation. $100,000 Its primary purpose is to ensure that as property passes within a family to successive generations it is taxed in the estates of the members of these generations at their deaths. The GST tax is based on the Darlene Daughter federal government’s belief that it is entitled to tax the transfer of property to each subsequent generation as part of the entire estate tax system. The primary intent of the GST tax The gift from the grandfather directly is to inhibit the transfer of property that to the grandson avoids the taxation of skips over a generation. The tax is quite this property in the daughter’s estate. The complicated in its application. However, the GST tax acts as a roadblock to transfers in following simple example illustrates the type excess of the exempt amount allowed for of distribution of property that is subject to these transfers. The GST tax is a separate its rules. tax on all transfers of property that skip a generation and that are in excess of the exempt amount. It is in addition to estate taxes and income taxes.
Chapter 7: The Generation-Skipping Transfer Tax 47 Wealth Management Through Estate Planning
◆ The exemption can be "split" between GST Tax Proposal a husband and wife in the same man- ner as the gift tax credit. President Obama has proposed ◆ The GST tax does not apply to a trans- a $3,500,000 GST Tax exemption fer to a skip person (i.e. grandchild) if and 45% tax rate beginning in his parent was deceased at the time 2013. If there is no agreement the gift was made. on this and other tax issues, the ◆ The exemption can be allocated to GST Tax exemption will revert to lifetime gifts on a gift tax return filed $1,000,000. The same amount with the IRS. To the extent that it is not will apply to the federal estate tax. specifically allocated, automatic alloca- Also, the rates for the GST Tax and tion rules will apply. the federal estate tax will increase ◆ The GST tax applies both to lifetime from 35% to 45%. gifts and to transfers at death. ◆ The GST tax does not apply to gifts FUNDAMENTALS OF THE made by a donor to a grandchild or GST TAX subsequent generation if such gifts are used to pay directly to the provider The GST tax is difficult to understand, the donee’s education and medi- even for attorneys skilled in estate planning. cal expenses. These gifts are also However, there are two major reasons why a removed from the gift tax system. practitioner must be familiar with how this tax works and incorporate generation-skipping ◆ A gift in the amount of $13,000 or less planning into estate plans. Occasionally, that skips a generation is not subject to affluent families want to intentionally incur the tax if the gift also qualifies for the this tax on a one-time only basis, then keep gift tax annual exclusion and is made the property free of all estate and generation- directly to the skip person (i.e. grand- skipping taxes after the tax has been levied. child) or a trust for the skip person This is discussed in Chapter 13: Dynasty only. Planning with Trusts. More frequently, families ◆ The GST tax applies if the skipped gen- want to make sure that this tax will not be eration is a beneficiary of a trust, and inadvertently levied on their family wealth. the trust is not included in his estate at This chapter focuses on the most important his death. aspects of the GST tax and highlights the ◆ If the donor and donee are related, consequences of failing to properly plan for the generations are calculated based it. In other parts of this book, we review the on family genealogy. If the donor broader implications of this tax. and donee are not related, whether The following are some of the significant the donee is a skip person will depend features of the GST tax: on the difference in ages between the ◆ The GST tax rate is a flat rate that is donor and the donee. the same rate as the current maximum federal estate tax rate of 35%. There are no graduated rates for this tax. ◆ Each person has an exemption from this tax. Starting in 2004, the exemp- tion is the same amount as the estate tax credit. In 2012, the exemption is $5,120,000.
48 Chapter 7: The Generation-Skipping Transfer Tax Wealth Management Through Estate Planning
THE GST TAX TRAP ◆ It shows how a fairly common estate The exemption to GST taxes creates plan can have a hidden GST tax trap a false sense of security. The following in it. example illustrates how a family of ◆ Only Wanda’s exemption was used. moderate wealth can fall into its trap and Harold’s GST exemption was unused emphasizes several important aspects about at his death and vanished. With the GST tax: proper planning, both exemptions could have been used and the GST Example tax completely avoided. In 1986, Harold and ◆ Observe that future appreciation on Wanda , both age 65, GST exempt property is also exempt have combined assets of $550,000 and a life from the GST tax. insurance contract on Harold with a $500,000 ◆ Finally, note that the GST tax applied death benefit. They have one son, Charles, age even though Charles was a benefi- 40, who is married and has two children. They ciary of a trust. His right to receive have their attorney prepare Wills and powers of distributions for support were not suf- attorney, but no trust. ficient to cause the trust to be taxed The assets of Harold and Wanda appreciate in his estate. over the years due to earnings on their investments and additional savings. Harold dies in 1988 with AVOIDING THE GST TAX all assets passing to Wanda. After Harold’s death, There are techniques that can be used Wanda meets with her attorney who recommends to avoid the imposition of this tax. The most that Wanda have a trust to avoid probate straightforward way to avoid the GST tax is administration of her estate and to provide asset to make sure that there is not a generation- protection planning for Charles’ future inheritance. skipping transfer and that all property is The trust provides that all trust property be held taxed in the estates of the immediately for Charles upon Wanda’s death. He is entitled to succeeding generation. Remember that one receive trust distributions of income and principal of the purposes of the tax is to inhibit people for his health, education and support. from making transfers that skip a generation. Wanda dies in 1995. After payment of taxes An outright distribution to children, as an and expenses, a total of $1,500,000 is held in trust example, does not skip anyone and the for Charles. On Wanda’s federal estate tax return, GST tax does not apply. Of course, this her $1,000,000 GST exemption (the amount overlooks the benefits of the planning allowable in 1995) is allocated to the trust. discussed in Chapter 13: Dynasty Planning Charles dies in 2012. At the time of his death, with Trusts. the value of the trust is $3,000,000. Pursuant to the Another way to avoid the GST tax is terms of the trust, it is divided into equal shares for to make sure that there are no transfers Charles’ two children and is not subject to estate that skip a generation that are in excess taxes as part of his estate. of the exemption amount. This is a critical Harold’s GST tax exemption was wasted component of GST tax planning. because all of his assets passed outright to Wanda. Where the amount of property exceeds Wanda’s available exemption only protected a the exemption amount, then the GST tax portion of the trust assets. can be avoided by either distributing the Of the initial $1,500,000 in Charles’ trust, excess amount to the beneficiary’s estate $1,000,000 was exempt and $500,000 was not or by giving him a general power of exempt. Accordingly, 2/3 of the trust property is appointment over this property. A general exempt and 1/3 is not exempt. power of appointment is the right to direct The GST tax due upon Charles’ death is who receives property either during your calculated as follows: life or at your death. This right over the Non-exempt share $1,000,000 GST tax (at 45%) $450,000 Chapter 7: The Generation-Skipping Transfer Tax 49 Wealth Management Through Estate Planning
ultimate disposition of the property causes it compared to the federal estate and gift tax to be taxed in the power holder’s estate. In laws and an attorney who does not practice the above example, if Charles were given a extensively in this area may not understand general power over the property in his trust the intricacies of how the tax is applied and that exceeded the exempt amount, there would how it may be avoided. A conservative estate not have been a GST tax. plan will anticipate and plan for the possibility When someone has a general power of that a GST tax may be incurred and include appointment, the property subject to the power a strategy designed to avoid its impact. A comprehensive estate plan will use the GST exemption as early as possible so as to My opinion maximize its benefit. Dynasty planning techniques where Understanding and planning for the family wealth is held for successive potential consequences of this tax is of major importance for a number of reasons. Quite generations of a family have possibly the most important reason is that rapidly become very popular. many clients have seen their personal wealth increase rapidly due to large increases However, an estate plan in the value of equity holdings. Another using these techniques must very reason is that the children of many clients are earning substantial incomes themselves carefully avoid the almost punitive aspects and are building up their own estates. The of this tax. accumulation of wealth among successive generations has increased the importance of dynasty type planning and this will lead to is included in his estate at death and subject to greater exposure to both the federal estate tax estate taxes. If there is no other way to avoid and the generation-skipping transfer tax. the GST tax, this is may be a fair tradeoff. Elsewhere in this book, we discuss the use Remember that the GST tax is imposed at of planning techniques that intentionally create the highest federal estate tax rate. Charles generation skips for tax as well as for non-tax may not have a substantial estate and the tax reasons. As will be seen, this has become an burden of including the property in his estate important component of plans that are actively may be less than the GST tax that would have designed to provide for and protect multiple been imposed. generations of the same family. It is important to keep in mind that the purpose of the GST tax is to force transfers to be taxed in each generation. In many cases, the failure to properly plan for this tax can result in a GST tax being imposed that is greater than the estate tax that would have been imposed on the property if it were taxed in the estates of the generation that was skipped.
CONCLUSION The GST tax can have a significant impact on the estate planning strategy that is chosen. The failure to properly anticipate the GST tax on an estate may cause transfers of property that inadvertently skip a generation to lead to disastrous financial consequences to a family. The GST tax is relatively new
50 Chapter 7: The Generation-Skipping Transfer Tax Wealth Management Through Estate Planning
Chapter 8: The Federal Income Tax
Estate planning must take into consideration the income and capital gains tax consequences of a potential course of action. Estate taxes are not the only tax planning issue.
Chapter 8: The Federal Income Tax 51 Wealth Management Through Estate Planning
Chapter 8:
◆ The Tax Considerations of Shifting Income
◆ Stepped-up Basis and Capital Gains Taxes
◆ Taxable Income of Children
◆ Deductions for Charitable Contributions
◆ Income Taxation of Estates and Trusts
◆ Retirement Plan Assets and Annuities
◆ Making Choices
“The hardest thing to understand in the
world is the income tax.”
Albert Einstein
52 Wealth Management Through Estate Planning
hen many people think about pursuing particular goals. Sometimes, tax estate planning, the first tax considerations are in conflict and there Wissues that come to mind are must be, for example, an evaluation of estate taxes. This is understandable given the potential estate tax benefit versus the the high rate of the federal estate tax. income tax cost. However, income and capital gains taxes must also be understood in the decision- THE TAX CONSIDERATIONS making process that is part of creating a OF SHIFTING INCOME plan. This chapter is written to highlight the Income tax planning, in the context of important aspects of federal income tax estate planning, requires that the total tax law that relate to estate planning. Later in cost of owning an asset be understood. The this book, when we address the planning following example quantifies the tax cost to strategies, we will discuss the role that the owner. income tax planning plays in creating an estate plan. This information will, Example hopefully, help you to appreciate John holds $50,000 in how income tax planning is factored a certificate of deposit. The into the plan. certificate has an 4% interest rate and John’s Some of the relevant questions include: marginal tax bracket (i.e., the highest percentage ◆ What are the income tax benefits rate taxed on his income) is 28%. The federal and costs of making lifetime gifts? income tax cost of owning that asset each year is ◆ What is stepped-up basis and how $560 ($50,000 x .04 = $2,000 x .28). is its potential benefit used to deter- mine if a lifetime gift of a particular asset is desirable? Giving the asset to someone else may ◆ What are the income tax conse- reduce the income tax cost of owning that quences of transferring income-pro- asset. This shifts the income generated by ducing property to young children? the asset to another person. However, this ◆ What are the tax benefits of making kind of shifting of income should not be charitable gifts during lifetime? done before evaluating all of the tax costs ◆ How is income of an estate or trust to the donor and the recipient of the gift. taxed differently than an individual’s What are the income tax consequences income? of making a gift? The income tax benefits ◆ How are retirement plan assets, of gifting are determined by a comparison such as IRA's, 401(k)s and other tax of the marginal rates of the donor and the deferred plans, treated for income donee. tax purposes upon death and is there In the above example, if John gives his any impact on estate taxes? certificate of deposit to a grandchild who has a marginal income tax rate of 15%, then In this chapter, we review the factors the pure income tax cost of the ownership of that come into play when evaluating the the certificate is reduced to $300 ($2,000 income tax aspects of an estate plan. x .15=$300), for an income tax savings of You will learn that it is not enough to $260. merely analyze the estate and gift tax consequences. A good plan must also look at the income tax consequences of
Chapter 8: The Federal Income Tax 53 Wealth Management Through Estate Planning
STEPPED-UP BASIS AND If Hal transfers the stock to his son, the CAPITAL GAINS TAXES only immediate income tax consequence to Steve will be that he has to pay the income The basis of property (i.e., the purchase tax on any dividends received on the stock. If price plus capital improvements) is also Steve’s marginal income tax rate is less than an important consideration for income tax Hal’s, this will result in an overall income tax planning as well as for estate and gift tax saving based on the difference between their planning. Federal tax law states that property marginal income tax rates. received as the result of the death of another Steve’s basis in the stock will be the same receives a step-up in basis in the hands of as Hal’s basis, $2,000. This is the carry-over the recipient. The new basis for the recipient is basis. If Steve later sells the stock, he will have equal to the fair market value of the property to pay capital gains tax on the amount the on the decedent’s date of death. This rule sale price for the stock exceeds his basis of effectively wipes out all of the capital gain the stock that he acquired from Hal. that has accrued to property before the owner’s death. The one exception is if the property received from the decedent was Son sells stock actually transferred to the decedent within t $10,000 FMV
1 year of the decedent’s death by the Lifetime Gif (2,000) Carry-over Basis person who ends up receiving it through the $ 8,000 Gain decedent’s estate. This is to avoid last minute Dad buys stock for $ shifting of assets just to receive the benefit of 2,000 At Death Beques the step-up in cost basis. $10,000 FMV This step-up rule is quite different than t 10,000 Stepped-Up Cost Basis the rule for determining basis when property $ 0 Gain is gifted during life. With a lifetime gift, the recipient takes over the donor’s basis. This is The lifetime gift of the stock causes called carry-over basis. The only adjustment Steve to forego a significant tax planning is that the recipient’s basis can also include opportunity. If Hal were to hold the stock until any gift tax paid by the donor as a result his death and then transfer it over to Steve as of the gift, to the extent that the gift tax an inheritance, Steve would acquire the stock represents taxes on the appreciation at the with a basis equal to the value of the stock on time of the gift. the date of Hal’s death, under the stepped-up The difference between stepped-up basis basis rule. If Steve immediately sells the stock, and carry-over basis must be considered he would not realize any capital gains from when determining if it is better to give an asset the sale. away during life or at death. The following This is not the end of the analysis, example illustrates that the basis of property is however. If Hal does not make the gift so as often a factor in deciding whether to make a to allow Steve to get a new basis at death, lifetime gift. then the asset is in Hal’s estate for estate tax purposes. Will estate taxes be higher than the Example Hal owns 500 tax benefit of stepped-up basis? Hal has to shares of stock in the decide between saving on estate taxes and ABC Corporation and the total value in 2006 is saving on capital gains taxes. $10,000. Hal purchased the stock in 1972 for In summary, the basis of and the income $2,000 which is his basis for tax purposes. Hal tax consequences of an asset transfer must wants to give the stock to his son, Steve. Now we both be carefully evaluated prior to making a will examine the impact of this gift. transfer of the asset. Estate planning is about making choices.
54 Chapter 8: The Federal Income Tax Wealth Management Through Estate Planning
The effect of this tax is to reduce the Observation Income tax issues benefit of transferring income- producing are having a greater property to children under 18 years of age. impact on estate planning. This is occurring Note that the tax applies to all unearned for a number of reasons including the income without reference to its source. increasing importance of stepped-up basis Income on property transferred to a child to families that have huge gains in their stock under 18 from other persons such as his portfolios and the greater financial ability of grandparents is still taxed in this manner. parents to make lifetime gifts to children and Imposition of the kiddie tax can be partially grandchildren. avoided by the parents of the child electing to include income of the child on their return. This may, however, push the parents into a higher tax bracket, reducing the benefits of TAXABLE INCOME OF certain credits and deductions available to CHILDREN the parents. It is oftentimes better to simply Children are taxed on their income at file a separate return for the child. their own tax rates. If a child is under 18 years of age and has unearned taxable DEDUCTIONS income, then a portion of this income may FOR CHARITABLE be taxed at the parents’ highest marginal CONTRIBUTIONS income tax rate. Unearned income primarily consists of social security payments to a There are income tax benefits for child and interest income on the child’s making lifetime gifts to qualifying charities. savings or securities. An individual may deduct charitable To avoid loss of tax revenues where contributions on his income tax return parents transfer to their minor children for the value of the gifts. The amount of investment assets so that the income can be the deduction depends on the type of taxed at the children’s tax rates, Congress charity (public or private) and the type of imposed a special tax known as the kiddie property contributed (ordinary income or tax. Basically, it states that where a child has long term gain property). For example, the investment income of more than $1,900, deduction is limited to 50% of adjusted the excess is taxed at the parents’ tax rate. gross income (gross income less certain Originally, the tax applied to children 14 deductions) for cash gifts to a public charity. and under but in 2006, Congress raised the For contributions other than cash or for a age to 18. contribution to a private charity, different percentage limitations apply. If an individual cannot use the entire Example Sam, age 12, deduction in the first year because of has investment income this limitation, he can carry over the of $4,500. The first $1,900 of his income charitable income tax deduction and use is taxed at his income tax rate. The excess, it in subsequent years for an additional $2,600, is taxed at his parents’ tax rate. five years. This rule applies to all gifts to The additional tax is due from Sam, not charities. from his parents.
Chapter 8: The Federal Income Tax 55 Wealth Management Through Estate Planning
Only gifts to public tax-exempt distribution of assets. The income of the estate organizations, such as the following, qualify: will be, for example, interest and dividends churches, hospitals, educational institutions, on estate investments and rental income on endowment foundations for a state college property owned by the estate. or university, certain private foundations Under current law, an estate does not and a governmental entity if the gift is used have to file an income tax return if the annual exclusively for public purposes. gross income of the estate is less than $600. There is no income tax deduction The estate is entitled to take a deduction on its available for charitable contributions made income tax return for all estate administration from an estate at death. Therefore, if a person expenses (unless those expenses are taken is considering a charitable gift, it may be as deductions on the decedent’s estate economically better to make the gift during tax return). The estate is also entitled to life to have the opportunity to use the income a deduction for income distributed to the tax deduction. Also, the lifetime gift reduces beneficiaries of the estate. The income the amount of the taxable estate at death. A distributed to the estate beneficiaries is called charitable gift made at the time of death does distributable net income (DNI). qualify for a deduction on the estate tax return A trust may or may not be a separate and there is no limitation as to the amount entity for tax purposes. If the trust is revocable of the deduction. There are several different by the donor, all of the income of the trust is ways to make gifts to charities. Please review taxable to the donor. The income of a living Chapter 29: Charitable Planning to explore trust designed to avoid probate is taxable to this burgeoning area of estate planning. the donor. At the donor’s death when the trust Charitable deductions for gift tax becomes irrevocable, the trust receives its own purposes have already been discussed in tax identification number and is a separate prior chapters. The interrelationship between tax-paying entity. these various taxes is sometimes complex. For example, if a person gifts property, he may be entitled to take a deduction for this gift on his Trust Account Trust Account income tax return if it is to a qualifying charity. $15,000 Income $15,000 Income Also, if the gift qualifies for the charitable deduction for gift taxes, then there is no gift $15,000 No tax. A charitable gift of property must be Distribution OR Distribution evaluated to make sure that it qualifies for both the income tax and gift tax charitable Beneficiary pays tax Trust pays tax deductions, if that is the desire of the donor.
INCOME TAXATION OF Similar to an estate, the income of an ESTATES AND TRUSTS irrevocable trust is taxed to the trust, except The estate of a decedent is a separate to the extent distributed to the beneficiary of tax entity as of the time of his death. When the trust. DNI of a trust is deducted from the a probate estate is established at probate gross income of the trust and reported by the court, the attorney for the estate must obtain beneficiary. Although an estate files a return if from the Internal Revenue Service a tax it has taxable income of $600 or more, trusts identification number for the estate. All are treated differently. Simple trusts (those taxable income of the estate is reported each required to distribute all income annually) year to the Internal Revenue Service using this receive an exemption of $300 and complex tax identification number. This continues until trusts (those that may accumulate income) the estate is closed out and there is a final receive an exemption of $100 from the requirement to file a return.
56 Chapter 8: The Federal Income Tax Wealth Management Through Estate Planning
Estate income and trust income is taxed document control when the beneficiaries at a higher marginal tax rate at much lower are to receive the income of the trust, the levels than an individual’s income. This was attorney drafting the trust document can done intentionally by Congress to help force plan how the trust income is to be taxed. money out of trusts and estates. Executors of From an income tax perspective, it is usually estates and trustees of trusts must keep these advantageous for the beneficiary to receive tax considerations in mind. It may be more all of the income of the trust outright so as to advantageous to distribute income from the have that income taxed at the beneficiary’s estate or trust, and have it taxed in the hands marginal tax rates. In many cases, this will of the beneficiary, instead of accumulating be a lower rate than if the income were it in the estate or trust. The estate planning taxed to the trust. attorney has to design a plan that minimizes There are, however, some income tax the effect of income taxes wherever possible. savings from keeping income in a trust The best plan is to provide flexibility for future and using the lower income tax brackets. planning, because we do not know how For example, if the beneficiary is in the future income tax laws may change. The highest income tax bracket, then he may difference in the tax rates is evidenced in the want to use the lower trust tax brackets up following tax table: to $11,650. Further, not all states tax trust When designing an estate plan, these income and keeping the income in the trust marginal rate differences must be kept may avoid state income taxes. in mind. Because the terms of the trust If a beneficiary is a minor or is irresponsible with his finances 2012 Federal Income Tax Table (among a number of reasons), it may not be wise on a personal Tax Rate on Income in Excess of Column 1 Amount planning level to distribute to that beneficiary all of the income of Taxable Joint Single Estates/ Income Return Return Trusts his trust. Also, if a beneficiary is $ % % % in a very high estate tax bracket (perhaps 45%), it may be better to 0 10 10 15 pay a higher income tax rate and 2,400 10 10 25 5,600 10 10 28 keep the income in the trust, instead 8,500 10 10 33 of adding it to a taxable estate. 8,700 10 15 33 These are only a few of the many 11,650 10 15 35 considerations that go into income 17,400 15 15 35 tax planning for an estate plan. 35,350 15 25 35 70,700 25 25 35 85,650 25 28 35 142,700 28 28 35 178,650 28 33 35 217,450 33 33 35 388,350 35 35 35
Chapter 8: The Federal Income Tax 57 Wealth Management Through Estate Planning
RETIREMENT PLAN ASSETS annuity is recovered without paying income AND ANNUITIES taxes but the growth is subject to income taxation. The great benefit of retirement plan If a person has a substantial portion of his assets, such as 401(k)s, IRA's, pension and wealth in retirement accounts, it increases the profit sharing plans and of annuities is the cost of pursuing estate planning objectives. preferred income tax treatment granted For example, if a person wants to make gifts to them by the government. This special to reduce estate taxes or buy life insurance treatment allows the assets to grow without and wants to use retirement assets to make the the immediate payment of income taxes. gifts, he must make withdrawals not only for Generally, tax-deferred growth will the gifts but may also need to make additional outpace taxable growth. A primary reason for withdrawals to pay the income taxes that this is that income taxes are not annually paid accrue on the withdrawals. on income, dividends and gains, leaving more People with a substantial portion of their to be reinvested. The other important but less wealth in retirement accounts face liquidity obvious reason is that there is more flexibility issues at death. If their heirs need to liquidate in managing the investments in one of these assets in one of these accounts to pay estate accounts because investments can be bought taxes (due 9 months after death), they will and sold without paying long term or short need to pay income taxes on the amounts term capital gains taxes that would otherwise withdrawn before they can use the remaining result from a sale. As a result, many people balance to pay estate taxes. are accumulating an abundance of wealth in A retirement plan asset cannot be retirement plans and annuities. given away by the owner himself during Unfortunately, there are some drawbacks the owner’s life, unless the owner is willing to these retirement assets in an estate planning to recognize the immediate taxation of all context. Many people have recognized income. It also cannot be given to the owner’s that they will never use all or a significant spouse or charity without this income tax portion of the money in these accounts. While burden. the retirement asset is terrific for saving for Retirement plans present many difficult retirement, it is not an easy asset to use in a issues. A common planning goal is to allocate plan created to pass benefits on to successive assets between each spouse so that each can generations. For an estate plan, these fully use his or her estate tax credit. This is the accounts create special planning issues. These planning technique discussed in Chapter 12: retirement assets are subject to both estate The A-B Trust Strategy. However, retirement taxes and income taxes, a double hit on the plan accounts cannot be re-allocated without value of the asset. Let us take a brief look at collapsing the tax deferral. Each of these some of these issues. accounts must stay with the original owner or When the time comes to make contributor. withdrawals (either mandatory or Upon the owner’s death, if the owner discretionary), income taxes are a is survived by a spouse, the spouse may substantial cost. All taxable distributions are rollover the account to the spouse’s own IRA. at the income tax rates, even the realized By exercising this ownership right, the IRA gain from the sale of securities in the account. assets will not be taxed in the estate of the There is no capital gain tax treatment allowed first spouse to die, but instead estate taxes on this gain. on the value will be deferred to the death There is no stepped-up basis at the of the surviving spouse. Depending on the owner’s death on investments in retirement age of the surviving spouse, the surviving plans and annuities. With annuities, the spouse may be able to continue to defer amount of property initially put into the
58 Chapter 8: The Federal Income Tax Wealth Management Through Estate Planning
distributions from the plan until she reaches MAKING CHOICES the mandatory distribution age (typically When is it better to pay some income 1 70 /2 years of age). This is a very powerful taxes to reduce or avoid estate taxes? Do technique because it keeps the IRA intact, you make a gift to reduce estate taxes but which keeps the income tax deferral of the forego the ability to continue tax-deferred assets in the IRA in place. growth? The well conceived estate plan However, if the surviving spouse is in analyzes the income tax issues that may a higher income tax bracket and there are affect the plan and balances them against not enough other assets available to fund estate and gift tax considerations, the the deceased spouse’s Trust B, it may make personal goals of the client and the needs sense for the surviving spouse to disclaim and maturity of his intended beneficiaries. her rights as the primary beneficiary and It also gives the trustee flexibility to permit the retirement plan asset to flow into decide upon the best course of action, Trust B as a contingent beneficiary. The depending on the tax rates and attendant surviving spouse will be entitled to use the circumstances at different times while the retirement plan assets for her support as a trust is in place. beneficiary of Trust B. Factoring the income tax planning issues into an estate plan is a difficult task. In this chapter, we have only examined some of the ways in which income tax law affects Observation Many persons are estate planning decisions. Later in this book, accumulating large we build on these facts and issues when we amount of assets inside retirement plans, take a close look at the planning techniques annuities and IRA's. This presents special that are available. challenges to the estate planning attorney. Of course maintaining tax deferral is important but other planning objectives such as reduction of estate taxes and creating liquidity may be in conflict with income tax deferral.
It is crucial to review the estate tax and income tax situations of the surviving spouse and take into account other considerations (the ultimate distribution of Trust B, any asset protection planning objectives, etc.) to determine the best way to proceed.
Chapter 8: The Federal Income Tax 59 Wealth Management Through Estate Planning
60 Chapter 8: The Federal Income Tax PART III: Strategies to Combat Risk and Preserve Wealth
61 Wealth Management Through Estate Planning
PART III:
Chapter 9 Wills and Trusts Chapter 10 The Living Trust Chapter 11 Asset Protection Planning Strategies Chapter 12 The A-B Trusts Strategy Chapter 13 Dynasty Planning with Trusts Chapter 14 Family Gift Strategies Chapter 15 Life Insurance and Estate Planning Chapter 16 The Irrevocable Trust Chapter 17 Family Limited Partnerships and Limited Liability Companies Chapter 18 Business Succession Planning Chapter 19 Other Planning Techniques Chapter 20 Powers of Attorney and Advance Directives Chapter 21 Asset Alignment Strategies
62 Wealth Management Through Estate Planning
Chapter 9: Wills and Trusts
The two most important documents in an estate plan are the Will and the Trust. This chapter takes a look at the major attributes of each type of document.
Chapter 9: Wills and Trusts 63 Wealth Management Through Estate Planning
Chapter 9:
◆ What is a Will
◆ What Are the Major Benefits of Having a Will
◆ What a Will Cannot Do
◆ What Is a Trust
◆ What Can a Trust Do
◆ Wills with Testamentary Trusts
◆ Selecting a Trustee
◆ The Trustee’s Compensation
“Life is short; live it up.”
Nikita Krushchev
64 Wealth Management Through Estate Planning
n the preceding chapters, we have WHAT IS A WILL examined the tax laws that are involved In its simplest form, a Will is a written I in the estate planning process. We document, created in accordance with now turn our attention to exploring the state law, that allows a person to direct opportunities that estate planning presents the manner in which his estate will be to control the timing and manner of administered and control the distribution of distributing an estate following a death his estate. The Will only takes effect upon and to minimize the effect of estate taxes the death of the maker. The Will can be on a family. Many of these benefits can be modified by a document called a codicil at gained only by the creation of certain legal any time before the maker’s death, unless documents during our lifetimes. The two the maker becomes incapacitated. most important documents used to create an A person making a Will is called estate plan are the Will and the trust. Each a testator if that person is a male or a of these documents becomes your road map testatrix if that person is a female. In for directing how you want your financial order for the Will to be valid, it generally and legal affairs handled. must be executed by the testator and There are times when a Will is perhaps witnessed by a specific number completely adequate for a person’s of individuals. Some states also require particular circumstances, especially when notorization in addition to the signatures of used in conjunction with other planning the witnesses. techniques. Property that is held as Can a witness be a beneficiary? The joint tenants with a right of survivorship answer is yes although it is not a good idea. avoids probate just about as easily as The general approach of the states is that property in a living trust. A comprehensive the witness is not disqualified from proving financial power of attorney can, in many the Will as a witness. However, in some circumstances, avoid the necessity to create states the witness is denied the portion of a guardianship for someone who becomes a bequest that is in excess of the share that incapacitated. he would have received if the person died There are other instances where a without a Will. Some states will cure this if trust provides the best means to address there are two other witnesses to the Will certain tax implications and to help manage who, in effect, make the beneficiary/witness an estate. There is no basic net worth unnecessary. benchmark that someone must pass before The law of the state of the person’s he might consider creating a trust. A trust residence at the time of the Will's execution may be warranted in diverse situations such controls on this issue and it is prudent to as when parents have young children, when make sure that the laws of that state are someone owns a life insurance policy with a being carefully followed. large death benefit or for a person about to get married for the second time. This chapter examines how these documents function and Example John is an Ohio resident compares and contrasts the role and owns a vacation home that each can play in an estate plan. in South Carolina. John dies. John’s Will controls This discussion focuses only on the the disposition of his Ohio property and his South basic concepts behind Wills and trusts. Carolina property, but each state’s laws will control There is no broad uniformity among the process by which the property is distributed. the states as to all matters concerning Wills and trusts and reference to individual state law is necessary.
Chapter 9: Wills and Trusts 65 Wealth Management Through Estate Planning
WHAT ARE THE MAJOR to the estate because the attorney for the BENEFITS OF HAVING A WILL estate is required to do less work, and in most instances, the sale can be completed faster. A valid, properly executed Will can Also, for example, if the executor is given the secure many benefits for the family (or other power to lease property, the executor has the beneficiaries) of the person making a Will: flexibility to decide whether market conditions In a Will, you may specifically name the favor an immediate sale of real estate or person you want to act as your executor (the lease of the property to generate cash flow person who manages your estate). In some and defer sale until later. states, such as Florida, this person is called Most importantly, the Will allows the the personal representative. The executor testator to direct to whom his property is to be does not have to be a family member, but distributed and in what proportions. Also, a may have to be a resident of the same state good Will provides for alternate beneficiaries as the decedent. If you do not have a Will if the primary beneficiary fails to survive the that names this fiduciary, then state law testator. A contingent distribution provision decides who will administer your estate. In eliminates the problem where a beneficiary many states, a family member who is not a dies and a testator forgot to change his Will resident of that state cannot be the executor of to name a new beneficiary. If you die and the estate unless named in the Will. either the named beneficiary predeceased You can waive the requirement of a you or if you die without a Will, state law will bond. If there is no waiver, then state law provide how your property will be divided. may require the executor of the estate to post Dying without a Will is called intestate a bond to insure the faithful performance of succession. his duties. This bond requirement is usually Frequently, state law allows you to name satisfied by purchasing an insurance bond. in your Will who you would like to act as The cost of this bond depends on the value guardian of your minor children. You can of the estate and can range from $100 in expect the probate court supervising the a small estate to several thousand dollars guardianship proceedings to follow your or more in a large estate. In most estates, wishes about the named guardian unless there is not a compelling reason to require there is a serious reason why the person a bond because a trusted family member is you nominated is not suitable to act as the acting as the executor and the chances of guardian. Guardians are frequently required mismanagement or theft is remote. However, by state law to post a bond to insure the if the decedent died without a Will or the Will faithful performance of their duties. This is did not waive the requirement of a bond, this similar to the executor’s bond and may be expense may be incurred. waived if you have requested this in your Will. A properly prepared Will grants to the Otherwise guardians are usually bonded in executor extensive powers to handle the the same manner as an adminstrator. diverse responsibilities of this position. For example, the Will should grant the executor the power to sell real property. The real property owned by the decedent can then be sold without going through a probate court supervised proceeding. This results in savings
66 Chapter 9: Wills and Trusts Wealth Management Through Estate Planning
WHAT A WILL CANNOT DO A Will also does not control property A Will only controls property that is that is distributed in accordance with a in your probate estate. Property that is not beneficiary designation. Life insurance subject to probate is not distributed by the proceeds paid to a named beneficiary terms of your Will. are a good example. The Will does not For example, if you have money in determine the beneficiary of the policy. a bank account with a child as a joint Instead, the beneficiary designation form tenant with right of survivorship, the given to the insurance company controls money passes directly to this child at your and the insurance company distributes the death. Those funds are not distributed in proceeds directly to that named beneficiary. accordance with the terms of your Will, but Assets held in an IRA or in a qualified plan rather are controlled by the survivorship such as a 401(k) are also distributed to the provisions on the bank account. named beneficiary and are not controlled The problem with this is that the by a Will. surviving child is not required to divide that bank account with Observation You still want to have a Will anyone else. A parent who puts even when you have a trust. The money in a joint and survivor Will collects assets that were not placed into the account so that the child can access trust and “pours” them over into the trust during the funds if necessary may be inadvertently probate process. disinheriting his other children. A second problem with this is that the surviving owner of the account may not have to pay any estate taxes on the value of the account because these taxes may A Will alone has limitations. A Will is be paid by the estate in accordance with not equipped to handle the myriad of issues the terms of the Will. The tax burden of the that are raised in a comprehensive estate account may be placed on the probate planning process, including incapacity. To estate beneficiaries. have a coordinated, cohesive plan, some The same concept applies when you type of container must be created that can hold property in an account that says serve as a receptacle for the assets of a the balance is to be payable on death decedent. As we will see in subsequent (POD) or transfer on death (TOD) to your chapters, trusts are the collection point for named beneficiary. The property in these many assets either during lifetime or at accounts passes automatically to the named death. Modern estate planning strategies beneficiary and is not subject to estate utilize the structure of the trust to fully realize administration. the potential of an estate plan. WHAT IS A TRUST Observation It is increasingly The simplest definition of a trust is that it common that only a is similar to a contractual relationship where small portion or even none of a person’s assets a person, referred to as the donor, grantor go through probate at death. What does this or settlor, gives property to another, the say about the importance of a Will as an estate trustee, to be held and distributed by the planning tool if it may only control a fraction of trustee in accordance with the written terms the property owned by the decedent? of the trust document for the benefit of one
Chapter 9: Wills and Trusts 67 Wealth Management Through Estate Planning
or more beneficiaries. The trustee promises services is entitled to compensation. not to use the property for himself. Instead, the The position that the trustee occupies is trustee is entrusted with the duty to hold the a special one; the trustee is more than simply property for the benefit of the beneficiaries of an agent for the donor. The trustee has a very the trust. The donor of the trust, as we will see, high level of responsibility to the donor and has very wide latitude in setting up the terms the trust’s beneficiaries. The trustee is acting of the trust and can use the trust to achieve as a fiduciary, a unique position under law. many objectives. A fiduciary is required to exercise the powers There are two basic categories of trusts. granted to him in good faith at all times and A trust may be revocable, which means to put the interests of the beneficiaries before the donor can change the terms of the those of the trustee. It is a position of trust. trust whenever he wants. Other trusts are A trustee has a higher duty of responsibility irrevocable, which means the donor cannot to a beneficiary than someone has under a change the trust once he has executed the contract. trust document. Later on in this book, we will The use of trusts to hold and control the discuss why and when a donor uses each of use of property goes back to around the early these types of trusts. 1500’s when English landowners placed their The terms of the trust are set forth in a property in trust while maintaining control written document called a trust agreement. over the property. Their reasons for doing this In this document, the donor sets forth precise were to protect themselves from creditors and instructions as to how the property placed feudal obligations. While feudal obligations under the trust is to be held and distributed are no longer a concern, trust planning for the benefit of the trust’s beneficiaries. The techniques have thrived and become trust agreement is, in a sense, a sophisticated widespread. contract where the trustee agrees to carry out the terms of that agreement and for those
Creditor Estate Tax Professional Trust Engine Protection Savings Management
Trusts are the engines Thoughtful Distribution driving many estate planning techniques. Track
68 Chapter 9: Wills and Trusts Wealth Management Through Estate Planning
WHAT CAN A TRUST DO The trust is a valuable tool for estate A Common Trust Distribution Provision planning because it can do so many things. Trusts are invaluable for pursuing The trustee shall distribute to each certain strategies that are designed to beneficiary for whom a trust is held hereunder achieve tax savings goals. Trusts are also so much of the income of the trust held for such important for securing the personal goals beneficiary, and to the extent that the income is of the donor. Let us take a close look at one insufficient, so much of the principal thereof, as type of situation to illustrate the significant the trustee, in its absolute discretion, shall deem benefits that can be secured with a trust. necessary or advisable to provide for the health, support, maintenance and education of such person. Example Melissa and Jason have two children, ages Note that the trustee first uses the 12 and 14. They do not want the children to income of the trust to provide for the child’s receive inheritances outright should they die. care. Trust law does not require this priority Their objectives are to have their assets set aside but this is usually done for income tax to provide for the support of the children and to reasons. In most circumstances, the marginal pay for their college educations. The balance of income tax rate on income retained in the the property is to be held for a period of years to trust (and not paid out to the beneficiary) have funds available to provide for other needs is higher than the marginal income tax of their children that may arise. rate that the beneficiary has to pay on the income distributed to him. The income tax rates are higher for trusts than they are for individuals in most instances. (See the The use of a trust can achieve all income tax table that appears in Chapter 8: of these goals. In our example, Melissa The Federal Income Tax.) and Jason can set up a trust that directs Any income that is not distributed to the the trustee as to how the property is to beneficiary or used to pay income taxes is be distributed to their children and when added to principal and reinvested within distribution is to occur. A typical trust might the trust. To the extent the income generated require that the trustee first divide the by the trust share is not sufficient, the trustee principal of the trust into two equal shares, can use principal to provide the funds one for each child. The trustee then holds needed to support the child. each share in trust for the benefit of each A significant benefit of placing the child. This ensures that each child will be property in trust is that the guardian for treated fairly and receive equal benefits children is responsible only for the children, from the estate. their personal belongings and the income After the trustee has divided the trust and principal actually distributed from each into two equal portions, the trustee will then child’s trust. The guardian does not have to make distributions from the income and worry about the day to day administration principal of each child’s trust to the child of the children’s assets as that responsibility (or for the benefit of the child) following the remains with the trustee. instructions set forth in the trust document. In our example, if there were not a trust, The following directive language is a one-half of the estate would be distributed common format for making distributions to the guardian of each child and this from the trust: property would be subject to probate court
supervision during the child’s minority.
Chapter 9: Wills and Trusts 69 Wealth Management Through Estate Planning
The burden and expense of administering a ◆ If the donor is concerned that a ben- guardianship for minors (and incapacitated eficiary cannot handle finances, he people) can be considerable. Further, the may restrict the timing of distributions guardianship proceeding is a public court of income and principal or direct, for filing. example, that the trust principal be The real shortcoming of not having a held for the beneficiary’s life. trust where there are minor children is that ◆ If a child is disabled or cannot pro- guardianships terminate at the age of majority vide for himself, the trust may direct the (usually age 18) and there is an outright stream of benefits necessary to provide distribution of guardianship property to a care for the rest of that child’s life. If child. How many children have the emotional the child’s care is already being pro- maturity and experience to handle substantial vided for by a governmental agency, inheritances at this age? A trust avoids this the trust may state that distributions problem because it can hold property in trust from the trust are to be used only to for extended periods of time. pay for expenses that are not covered. Trusts frequently hold property for the ◆ Trusts can be used to create incentives beneficiary for some time after majority. The for family members. Good academic trust agreement may tell the trustee when to or career performance can be recog- make a lump-sum distribution of the principal nized with increased distributions from from the trust. An example of a conservative the trust to its beneficiary. pattern of principal distribution is the following: ◆ Property held in a trust is not marital property of the beneficiary and is not subject to being divided in a divorce Sample Trust Language The trustee proceeding. shall distribute ◆ Property in a trust, under certain condi- to a child of mine for whom a separate trust is tions and with careful drafting, can be held one-half of the principal of the trust when protected from the claims of a benefi- such child attains thirty (30) years of age. The ciary’s creditors. remaining balance of the trust shall be distributed to such child when he or she attains thirty-five Trusts are frequently used to provide (35) years of age. for grandchildren. They can be direct beneficiaries of a trust at anytime or have their rights created only upon the death of a parent. A trust typically states that if The trust gives the donor full control a beneficiary dies prior to receiving full over when and how much trust property is distribution of the principal of his trust to be distributed. He can put into his trust then the trust property is to be held for his whatever distribution provisions he wants, children. This keeps the inheritance in the including terms that require all or a portion bloodline of the decedent. However, if the of the trust principal be held for the life of trust provides benefits to grandchildren, then the trust beneficiary. Of course, this ability to the generation-skipping transfer tax must customize your planning allows you to closely be taken into consideration. (See Chapter evaluate your intended beneficiaries and then 7: The Generation-Skipping Transfer Tax have your estate planning lawyer carefully for more information about this tax.) Good draft the trust document to carry out your trust documents cover all such possible intentions. This broad flexibility in drafting contingencies. the terms of a trust can be used to achieve a A person may achieve charitable variety of goals: goals with the use of a trust. The document
70 Chapter 9: Wills and Trusts Wealth Management Through Estate Planning
can provide for a gift to a charity upon do not believe that their trust requires the occurrence of a specific event or the probate court supervision. They put their trust may include terms establishing its faith in the person or corporation selected own charity. (See Chapter 29: Charitable to be the trustee. They also know that Planning) the beneficiaries have legal remedies to Property held in a trust not only avoids enforce the terms of the trust and to deal probate on the death of the donor but also with a trustee who, through commission avoids being in the probate estate of a trust or omission, is not carrying out his beneficiary who dies before full distribution responsibilities. of the trust property. Furthermore, as The use of testamentary trusts is discussed above, property held in a trust for influenced by the law of your domicile. It is you or your beneficiaries is not controlled important to use the services of an estate by a probate court appointed guardianship. planning attorney who can properly advise These are the primary personal you on this. planning goals that can be achieved by using a trust. Additionally, there are SELECTING A TRUSTEE many tax planning objectives that can be Determining who should act as the achieved with a trust. These are discussed trustee of a trust is not a simple matter. later in this book. There are many factors to be taken into The most important point to remember consideration. The following discussion is that trusts are very flexible documents that moves through each of the choices in the you can use to manage the distribution of order that I normally use when discussing your property during your lifetime and after the options with clients. your death. By comparison, if you die and Usually, the donor of a living trust is a Will is your estate plan, then, unless you the initial trustee. This is appropriate for have a testamentary trust (discussed below) most circumstances. Where the donor is the your property cannot be withheld from your trustee, the trust document is called a self- beneficiaries. If you want to manage the declaration of trust. distribution of your property following your Further, the donor will normally select death, you have to use a trust. his spouse to be the successor trustee if something happens to him. This is also WILLS WITH TESTAMENTARY frequently the best thing to do. There TRUSTS are occasions, however, when a spouse When the Will contains the terms of should not be the successor trustee. One the trust, the trust is called a testamentary common example is where there is a second trust. This is because the trust is actually marriage and the goal of the donor is to part of the Last Will and Testament and is have his wealth pass down to his children not a separate document. As a general rule, from a prior marriage either immediately or you do not want your trust to be in your after providing for the financial needs of the Will. The reason is the terms of the trust may second spouse. Another example is where then be subject to probate court supervision, the spouse is not adept at handling finances including possibly mandated periodic or lacks capacity due to age or illness accountings to probate court and other and the donor believes that professional requirements. oversight would be helpful. In situations like The use of a testamentary trust has these, the donor wants to protect his wealth diminished substantially. Most persons and avoid problems in administering a trust.
Chapter 9: Wills and Trusts 71 Wealth Management Through Estate Planning
The selection of the person or entity If there is any doubt or reservation as to that you want to act as the trustee in other whom to name as a trustee, then I recommend circumstances is a little bit more complicated. that a corporate trustee be used. I have Any adult person is legally qualified to serve found from experience that this is the prudent as trustee. It is common for parents to name thing to do. their children to be successor trustees of the The ability of a corporation to act as a trusts established for each of them following trustee is governed by state law. State laws the death of the parents. However, the ages, grant certain corporations the power to act as maturity, health and other factors sometimes trustees. A corporation cannot exercise trustee do not make this a good choice. powers unless explicitly authorized to do so. Selecting someone whom is not a family This is because trustees are given the ability member to be successor trustee is a lot more to exercise fiduciary powers. Remember that complicated. You have to decide if the person a fiduciary has a special responsibility to the you want to choose has the appropriate trust beneficiaries and is held to a very high qualifications for the job. Does he have the standard of responsibility and care. State laws time to take on the diverse responsibilities of are written to protect beneficiaries. this position? Is he experienced in handling Using a corporate trustee upon the the investment duties that the trust requires? death or incapacity of the donor is often Will he have the time to work with each the best choice. Corporate trustees have beneficiary and give that person the attention the experience to handle all of the complex that is necessary to make sure that his needs responsibilities of a trustee. Moreover, a are being satisfied in accordance with the corporate trustee will always be there and is terms of the trust? The position of trustee can not subject to the same mortality rules as the be a great deal of work and responsibility. rest of us. Trusts often last for years to provide Also, in selecting someone, you must take into for successive generations of a donor’s consideration his or her own responsibilities. family and there will be continuity by using a Does she have her own family and career? corporate trustee. The potential duration of the trust also impacts Traditionally, the trust departments the selection of trustee. of commercial banks have filled the role of corporate trustee for many families. However, there have been significant changes My opinion in this area in the last decade. A major When it is not advisable to allow the development has been the development of beneficiary to be Trustee of his or her trust, I trust departments by the major brokerage firms. Examples are Morgan Stanley Smith usually do not recommend that clients use an Barney, Merrill Lynch and Wells Fargo. Other individual as a trustee for that beneficiary’s brokerage firms have created alliances with banks that have the authority to act nationally trust. Instead, I have them name as trustee for their clients. Prominent in using this person as the Trust Advisor this strategy is UBS Financial Services and its relationship with, for example, Comerica Bank and recommend the use of a as its designated trustee. The obvious reason corporate trustee. The trust for brokerage firms to provide this service is so that they have the ability to retain trust advisor supervises the trustee, accounts on the death or incapacity of their leaving the trustee with the day to clients. How do you decide among corporate day responsibilities. trustees? Talk to other families who have used the trust company you are considering and take the time to talk to the trust company
72 Chapter 9: Wills and Trusts Wealth Management Through Estate Planning
representative. Talk to your investment work being done by the trustee and if the advisor. This person has probably helped trustee is willing to negotiate a fee. This is you through many other financial issues. an example of a typical trustee fee schedule Be sure that you feel comfortable with your that includes investment services: selection. Your estate planning attorney should know a representative from each of the major trust companies in your area Trustee Compensation and can help answer your questions ◆$11.00 per $1,000 on the first $200,000 regarding their capabilities, service and experience. She can be a great resource ◆$9.00 per $1,000 on the next $800,000 for selecting a corporate trustee. ◆$7.50 per $1,000 on the balance The trustee position is big business ◆Minimum annual fee of $2,500 because it involves the management of large sums of money and the opportunity ◆1% distribution fee on principal to earn significant trustee fee income. This distributions to beneficiaries has made the environment very competitive which is good for us as consumers. Fees may be less when the trustee is THE TRUSTEE’S not responsible for handling the investment COMPENSATION of the trust principal. Not all trustees It is important to understand the costs charge a distribution fee. A distribution associated with the use of a corporate fee is a charge for making principal trustee. First keep in mind that the majority distributions from the trust of trusts created for estate planning are either periodically, at the revocable self-declarations of trust. This termination of the trust means that the donor is the initial trustee or if there is a change of of his own trust and no trustee fees will trustees. be charged as long as he continues in this capacity. Further, if his spouse or child is the successor trustee (due to My opinion the incapacity or death of the donor), these people will probably not charge a If the trustee trustee fee because they are otherwise charges a benefiting from the trust as beneficiaries. Also, compensation paid to a trustee is distribution includible as part of his taxable income. fee, question it closely on this. To what An individual trustee may have to retain professionals to handle certain matters distributions does it apply? Will it waive which are automatically done in-house by them? Why does it need to be paid a fee to a corporate trustee, for instance, preparing and filing income tax returns. distribute the assets in the trust? Make sure The corporate trustee fee is an annual fee based on the fair market value of the that you understand all potential fees that a assets held in the trust account. Trustee fees corporate trustee may charge. You do not will vary, depending on the nature of the want to be surprised!
Chapter 9: Wills and Trusts 73 Wealth Management Through Estate Planning
SOME FINAL THOUGHTS While a Will is an important document to have as part of your estate plan, it is the trust that secures the most significant benefits. A Will is helpful but cannot control your assets beyond the period of probate administration. Moreover, advanced techniques for estate planning such as living trusts are designed in part to avoid probate and when these techniques are applied, the Will becomes unnecessary and unused. The trust document is the critical planning tool for a successful estate plan for you and future generations of your family.
74 Chapter 9: Wills and Trusts Wealth Management Through Estate Planning
Chapter 10: The Living Trust
Living trusts have become fundamental planning tools for many types of situations. This chapter explores the basic aspects of living trusts and their role in estate planning.
Chapter 10: The Living Trust 75 Wealth Management Through Estate Planning
Chapter 10:
◆ The Benefits of a Living Trust
◆ Limitations of a Living Trust
◆ Reasons Not to Establish a Living Trust
“A journey of a thousand miles begins with
a single step.”
Chinese Proverb
76 Wealth Management Through Estate Planning
ll trusts are living trusts in the sense Example If you die and that they each have a present your house is in existence and at least some nominal A your name, this property needs to go through amount of assets held in them. What probate and be distributed to your beneficiaries distinguishes a living trust from other trusts in accordance with the terms of your Will. is that the donor of a living trust usually Probate is needed to change the title on the transfers ownership of as many of his deed. Conversely, if the property is in your assets as possible into the trust. His primary name as trustee of your living trust, probate is reason for doing this is to avoid probate, avoided because the property is titled in the although there are other valid reasons to name of your trust and your Will is not needed. create and fund this type of trust. It is as straightforward as that. In this chapter, we examine the use of living trusts. Keep in mind that a living trust is a trust that can incorporate all of and the public nature of a probate case. These the things that we discussed in Chapter 9: are important benefits. However, probate is Wills and Trusts. The focus of this chapter is the not as difficult as it is frequently made out to impact that a living trust has on the donor of the be. Administration of an estate by trust and the administration of his estate in case an attorney who is organized of incapacity or death. A well-prepared living and keeps everything on trust, however, will also provide many of the schedule takes away much same benefits that are in any other trust. of the unpleasantness The most common type of living trust is one associated with that is revocable. The donor of the trust reserves probate. the right to make changes to the trust provisions or even revoke the trust at anytime he chooses. In other chapters, we take a look at irrevocable trusts, which are My opinion created for other planning reasons. Also, we are not looking at the potential tax benefits and other reasons for establishing a trust. These As an attorney, I prefer that we avoid too are discussed in other parts of this book. probate administration. I do not enjoy doing THE BENEFITS OF A LIVING legal work that is not necessary. Also, I TRUST frequently have plenty of things to do for my Avoiding Probate clients at that time that are unavoidable! One of the main benefits of having a living trust is that assets placed in it are not subject to probate administration. Remember that the only property that goes through probate is probate Expedited Asset Distribution property. Primarily, this is property that is owned Property held in a living trust can be just in the name of the decedent. Property that administered more rapidly than property in is held in a living trust is not probate property a probate proceeding. Debts can be paid because it is held in the name of a trustee and immediately and directly from the trust. not in the name of the decedent. Distributions to the trust beneficiaries can be The key benefits of avoiding probate made more rapidly. There is no delay while are avoiding the delays of the probate waiting for an executor to be appointed. The administration process, the court and legal trust document will name a successor trustee fees and expenses associated with probate and this person or entity (when a corporate
Chapter 10: The Living Trust 77 Wealth Management Through Estate Planning
trustee is used) takes over immediately and not provide asset protection planning for the automatically. There is no requirement that the donor. new trustee go to probate court to have his However, following the donor’s death this appointment confirmed. changes. The donor controls the authority of The successor trustee must first carefully the trustee to distribute trust property to his analyze the financial obligations of the trust, probate estate to pay debts and claims by the before making a complete distribution of terms he has included in the trust instrument. the trust property to the trust beneficiaries. The trustee generally cannot distribute funds He must reserve in the trust sufficient funds to pay the donor’s debts unless the donor to be able to pay any expenses of the trust, gives him the explicit authority to do so. including estate taxes. Furthermore, he will Therefore, in some states, the trust reserve additional amounts to satisfy any property is not directly subject to the claims requests from the executor of the donor’s of unsecured creditors of the deceased, estate (if there is probate administration of for instance, credit cards, hospital bills and some of the assets of the deceased) to pay other non-secured debts. Usually, the trustee the estate’s obligations. However, he may not is permitted (but not required) by the trust transfer assets to the donor’s estate to pay instrument to pay over to the probate estate debts unless he is specifically authorized to such funds as are requested by the executor. do so by the terms of the trust. If the executor does not make the request, Once the trustee has reserved sufficient then the bills may not be paid. If there is no assets in the trust to satisfy these obligations, probate administration of the decedent’s he may distribute the balance of the trust estate, there is no executor appointed who funds in accordance with the terms of the trust. can make the request. For example, if the trust document so directs, There is some flexibility to determine the assets will be distributed outright to the which of the decedent’s debts and expenses beneficiaries. Remember that the actions of are to be paid following death when a living the trustee are trust has been created. Almost everyone Make distributions not controlled by expects this to happen and the living trust can HOME Helping probate court. easily facilitate payment. Start children Invest Effect Upon Rights of Surviving Spouse wisely Family In many states, a decedent’s spouse Treasure Protection from Claims cannot challenge the distribution of the trust A living trust property in the same manner that she can Save taxes does not insulate challenge the distribution under a Will. If a Pay my the trust principal decedent’s spouse is not satisfied with the debts from the claims terms of his Will, she can elect to take against of the donor’s the Will and receive a portion of the probate The Trust as a creditors while the estate. However, trust law in many states does roadmap donor is living. There are a few exceptions not provide a similar right and the donor of a to this general law in certain states where trust can effectively exclude his spouse from you can set up a trust that can, under specific receiving a portion of the trust. This occurs conditions, insulate your assets from the claims in situations where couples are unhappily of creditors. Alaska, for example, has created married and either intentionally or otherwise by statute a trust that under certain conditions never get around to getting divorced. protects assets in the trust from creditors. There is not widespread use of these types of trusts at this time for a variety of reasons and it is fair to say that generally, living trusts do
78 Chapter 10: The Living Trust Wealth Management Through Estate Planning
guardianships. There is no advance planning Example Rachel transfers all that can be used to streamline guardianship of the investments that procedures. With guardianships, you need she has in her brokerage account over to probate court approval to spend money and her living trust. She dies and the trust directs periodic accountings are required. Investment that the trust property be distributed directly discretion of the ward’s assets is more to her children and that her husband, Mark, restricted. Administration of guardianships is receive nothing. Mark is disinherited from not easy for the guardian or his attorney. receiving these trust assets. Guardianships can be expected to continue longer than estate administrations because, in the case of an incompetent ward, In some states, the ability of someone to the guardianship lasts until the death of the use a living trust (or other form of ownership ward or until the incapacity ends. This can such as joint tenant with right of survivorship) be many years after the guardianship was to reduce or eliminate the portion of his or established. Probate should normally be her property that would otherwise pass to a wrapped up in less than one year. surviving spouse is restricted and the property in the trust may be included Observation for determining the surviving spouse’s I believe it to be of critical elective share. The law of the state importance that people who are of a person’s residence must be carefully older or who have serious health problems should evaluated to determine if assets in a living create and fund a living trust and do so at a time when trust are included in determining the spouse’s there would be no question as to their mental ability rights. to handle their legal affairs. This can reduce, and in The ability of a person to defeat the many cases eliminate, difficult and expensive legal interests of his creditors and disinherit his proceedings among family members. There is perhaps spouse are two examples where the law has no legal proceeding uglier than families fighting over not caught up with the ability of the estate who should be in charge of another family member’s planning attorney to favorably plan for his assets. client. Allowing a person to defeat these Done in a timely fashion, you get to select who will legitimate interests by transferring property to handle your affairs should you become incapacitated a revocable trust may be illogical and unfair and establish your own set of procedures for how your in some circumstances, but is allowable under finances are to be managed. With proper guidance, existing law in many states. you can make your own set of rules. That is infinitely better than an ugly court fight. Avoiding Guardianship Another significant benefit of a living trust is that it can be useful for avoiding guardianship over the assets of the donor. For these reasons, the expenses of a If a person is incapacitated and does guardianship can be substantial. Fortunately, not have a trust, a guardian needs to be living trusts can provide a solution to this appointed by the probate court to handle problem in that property in the living trust the incompetent ward’s financial affairs. is not subject to guardianship proceedings. Guardianship proceedings are frequently Because of this, the trustee can distribute more administratively difficult to handle than the income and principal of the trust for the probate proceedings. In probate, many benefit of the donor (and following his death, procedural rules can be avoided by having a for the benefit of any trust beneficiaries) carefully drawn Will that gives the executor without probate court supervision. expansive powers with regard to handling estate matters. This does not hold true for
Chapter 10: The Living Trust 79 Wealth Management Through Estate Planning
Additionally, it is helpful if the donor has the use of a living trust, the donor will transfer executed a durable power of attorney to the trustee all of his assets. This allows the specially drafted to work in coordination with donor’s estate to avoid probate. It also means a living trust. This allows the attorney-in-fact that there is no legally appointed person, such to handle matters that are not controlled by as an executor, who is required to pay bills. the trust. For example, suppose the ward Earlier, we examined how a person can receives a monthly Social Security check or use a living trust to avoid paying his creditors. a pension benefit. These payments are made Most people would find the idea of using a directly to the recipient. The attorney-in-fact trust for this purpose abhorrent. Most of us can use his power to move these payments want all of our legitimate bills to be paid. into the living trust and have the money Unless the trust document gives the trustee the managed by the trustee and not by a probate direct authority to take care of these debts, a controlled guardianship. What happens if living trust will often prevent the trustee from the ward overlooked transferring one of his cleaning up the donor’s financial affairs at investment accounts into his trust? A properly death. drafted durable power of attorney allows the Also, many people make specific attorney-in-fact to move the account into the bequests of monetary sums under their Will. If living trust and have the investment handled there is no probate property, there is no way by the trustee. to satisfy these bequests unless the Executor can ask the Trustee of a funded trust to pay them. This is why it is important to have a Will Power of Trust Attorney that coordinates and works with a trust. Complete The trust document needs to give the • File Income Tax • Manage Accounts Plan trustee wide latitude to wrap up the financial • Sell Car • Handle Distributions affairs of the decedent whether there is • Handle Home += probate administration or not. Lack of Supervision of the Trustee A living trust and the proper type of a Many persons who create living trusts durable power of attorney can be invaluable name themselves as the trustee of their own tools to avoid the administrative burdens trusts. Following their death, a successor of guardianships and conservatorships trustee is named to take over control of the and provide the flexibility to manage the trust and carry out its terms. At this point, the financial affairs of the ward. Durable powers trustee of a living trust may not be subject to of attorney are discussed in more detail in the direct control of anyone. Chapter 20: Powers of Attorney and Advance The strength of probate is that it is a Directives. judicially controlled proceeding. The actions of the executor are overseen by the judges, LIMITATIONS OF referees/magistrates and the administrative A LIVING TRUST staff of probate court. It is their responsibility It is important to understand that a to make sure that the executor of the estate living trust does not resolve all potential fulfills all of his responsibilities, including planning problems. In fact, this planning tool properly accounting for and distributing all has limitations, which must be recognized, estate assets. understood and appreciated. The probate system is not perfect. Inability to Pay Debts Even with court supervision, there are The imprudent use of a living trust can incidents where the executor (or his leave the donor’s estate with insufficient attorney) mishandles his responsibilities or assets to pay his debts and the administrative misappropriates estate assets. It is important expenses of his estate. To properly implement to choose an attorney you can trust and to
80 Chapter 10: The Living Trust Wealth Management Through Estate Planning
make yourself aware of what is going on in by court order. the probate court process. Another way to handle supervision There is no regular, ongoing judicial of the trustee is for the trust agreement control over a trustee. The trustee is guided to name someone to be the trust advisor. in his actions by the terms of the trust, the Usually this is the beneficiary of the trust legal obligation to act in accordance with but can be anyone the person creating the terms of the trust, his fiduciary obligation the trust designates. The Trust Advisor to trust beneficiaries and his own sense of is given the power to oversee the trustee, duty and honesty. Unfortunately, trustees direct him in his activities and remove the occasionally fail to responsibly carry out trustee. Frequently, the trustee must consult their duties or misappropriate trust property. with the trust advisor before changing The problem is compounded by the fact that trust investments and if the document a trust is a private document and the trust requires, follow the trust advisor’s directions beneficiaries are not always fully apprised regarding investments. of the trustee’s activities. Sometimes, the trust document will There are remedies which the name a corporate beneficiaries can invoke if a trustee is not trustee, which is properly managing the trust. If the trust usually a bank with Beneficiary beneficiaries are concerned about the trust powers or a manner in which the trustee is carrying out trust company set his responsibilities, they can demand an up by one of the accounting of the trust to make sure that major brokerage Trust the trust is being administered properly. firms. Professional Advisor Trustee If this accounting uncovers problems, the management of the remedy is to sue the trustee in court to trust reduces the The Trust force him to correct these problems. At chance of either mismanagement or theft. Triangle this point, the court can use its powers to Using a professional fiduciary, combined protect the beneficiaries. If the trustee with the beneficiary being the trust advisor has committed any serious and overseeing the trustee, reduces the wrongs, he can be removed number of occasions when there is a problem to relatively few occasions. My opinion A Living Trust Does Not Reduce Taxes The primary focus of a living trust is on The lack of avoiding probate. The creation of a living probate court trust does not impact the donor with regard supervision is to either income taxes or estate taxes. This is because the living trust is revocable and not a good can be changed by the donor at any time. reason to not The donor of a living trust has absolute have a living trust. Very few trusts control over the trust and its assets and need to seek judicial intervention to remains responsible for all income of the cure problems created by trustees. property for income tax purposes. All Why? Frequently, the trustee and income, gains and losses are reportable on the beneficiary are the same person. his income tax return. The trust assets are also includible in his gross estate at death If they are different, the trustee is for estate tax purposes for the same reason. usually either a family member or There are other types of trusts that are a corporate trustee. The rate of designed to manage income taxes and reduce incidence of problems is very small estate taxes. These are discussed later in this and there are enforceable remedies book. when they do occur. Chapter 10: The Living Trust 81 Wealth Management Through Estate Planning
REASONS NOT TO ESTABLISH A ferred all of his assets into the name of the trustee. LIVING TRUST Unfortunately, it is quite common for the donor to overlook some asset and fail to transfer it into the The idea of using a living trust to avoid pro- name of the trustee. Also, whenever the donor bate is appealing. However, if avoiding probate transfers assets from an old account to a new is the only important reason to establish a living account or acquires additional assets by gift or trust, then these factors should be considered. inheritance, he has to make sure that these assets Costs of Establishing a Living Trust A periodic review of are titled properly in the name of the trustee. The The legal fees to establish a living trust donor has a continuing responsibility for the rest are significantly larger than the fee for the your estate plan to of his life to make sure that his assets are titled in preparation of a Will. This is due to the increased the name of the trustee. If he fails to place and complexity of the trust document and the addi- keep all of his assets in his living trust, then he make sure that all of tional time that will be needed for consultations wasted his time and money in setting up the trust. regarding the terms of the trust and to discuss This problem highlights an interesting aspect your assets are prop- the steps the donor has to take to make the trust about the probate of an estate. The probate of effective. There may be transfer costs, such as an estate is not proportionately more difficult as erly aligned with the recording fees for real property conveyances an estate gets larger. In other words, once an to the trust from the donor. Also, the donor must estate is subject to full probate administration, it plan is very impor- have a new Will containing special provisions. may have to go through the same steps whether An old Will that is not designed to complement the estate is $100,000 or $1,000,000. This tant. An ounce of the trust can have disastrous effects. means that a small error or oversight by a person This cost of setting up a living trust has to be who has established a living trust essentially prevention is worth a compared to the expected savings from avoid- causes the whole plan of avoiding probate to ing probate. Additionally, a person who is setting unravel. There are no half-steps involved in the pound of cure. up a living trust will be spending his money now probate of an estate. to save money on probate at some indefinite time The estate planning attorney will carefully in the future. Does it make sense economically advise the client about the transfer of his assets to invest money in a living trust to save money into his living trust; however, experience dictates on a probate proceeding that may be years or that many clients who establish living trusts will decades away? Moreover, changes in the law not realize the full potential of their investment may occur in the future that reduce many of the because of inadvertent and unrecognized fail- perceived problems of probate. ures to transfer all of their assets to the trustee. In For most people, they have a living trust pre- Chapter 21: Asset Alignment Strategies, we take pared for more than just the reason of avoiding a close look at this important step in the estate probate. As one example, they may be interested planning process. in long term asset protection planning strategies for their spouse, children and grandchildren. CONCLUSION Other persons are concerned about the manage- ment of their affairs if they become incapacitated. A living trust is not for everyone. However, When the living trust is designed to achieve mul- in carefully controlled circumstances, it can be tiple benefits, the cost is much more attractive. used advantageously. The appeal of a living Before deciding to establish a living trust, a trust is enhanced when the living trust document person must do a cost-benefit analysis with his is also designed to obtain other estate planning estate planning attorney to determine if the cost benefits for the donor such as reducing estate of creating a living trust and transferring assets taxes and controlling distributions to family into it is worth the real and potential benefits. members following the death of the donor. Failure of the Donor to Transfer All Assets into the Trust The donor’s biggest responsibility in setting up a living trust is to make sure that he has trans-
82 Chapter 10: The Living Trust Wealth Management Through Estate Planning
Chapter 11: Asset Protection Planning Strategies
Protecting assets from claims of creditors has become an important estate planning issue for many people. This chapter takes a look at this topic and the most important strategies that are currently available.
Chapter 11: Asset Protection Planning Strategies 83 Wealth Management Through Estate Planning
Chapter 11:
◆ Insuring Against Risk ◆ Life Insurance ◆ State Law Property Exemptions ◆ Trusts and Asset Protection Planning ◆ Annuities ◆ Alaska Trusts ◆ Planning to Protect Support Obligations ◆ Special Needs Planning ◆ Joint and Survivor Property ◆ Entity Protection ◆ Prenuptial Agreements ◆ Pension and Retirement Plans ◆ Fraudulent Conveyances
“The real measure of your wealth is how much you’d be
worth if you lost all your money.”
Anon.
84 Wealth Management Through Estate Planning
sset protection planning has become Asset protection planning is not an more important for a number of easy topic on which to write. State law Areasons. Many of us have more determines if, when and how your assets assets to protect. A claim against our can be protected from a creditor’s claims. personal wealth carries a potentially What is totally protected in one state may higher monetary cost and more risk to the have no protection in another. There is no standard of living to which we have become national controlling legal theory or principle accustomed. that predominates. It is based on what the Also, there is a perceived evolution legislature for each state determines to be in determining liability for negligence appropriate for its citizens. and the increased potential for not just While preparing these materials, I compensation for damages but also punitive wrestled with the way I should handle such damages for reckless conduct. This chapter divergence in controlling law among each was not written to debate the reasons, of the states. The temptation was to avoid source or reality of increased concerns over the issue altogether, especially as I do liability; instead it was written to give the not like to write on a topic where I cannot reader an overview as to the legal options provide some clear advice and direction. currently available to protect family wealth The alternative was to go into great detail from the claims of creditors. In a constantly which would take us too far into the deep changing world, we naturally look for forest of detail and have us lose sight of protection from new and unanticipated risks. the significant issues. Notwithstanding this, In this chapter, the focus is on traditional I determined it was better to at least bring methods of asset protection planning for up the issues so that the reader is alert to the owner of the property. As an attorney, I the possibilities. You must not rely solely on receive on numerous occasions throughout these materials for a final answer but need the course of a year invitations to attend to explore these with legal counsel familiar seminars and buy books on advanced with the law of the state of your residence. asset protection planning strategies that use Some asset protection strategies are exotic techniques, such as setting up trusts hidden inside legal documents that control in locations like the Isle of Man, Bermuda property and are not readily recognizable. and other foreign locales. The number of Asset protection strategy may be based persons interested in using these unusual on the control and ownership of property plans is not very high and for that reason, I inside a legal entity such as a family limited am not going to be reviewing them. partnership or trust, not on a controlling state statute. My opinion In my opinion, everyone should be considering reasonable, proportionate INSURING AGAINST RISK strategies to protect ourselves from The primary technique for protecting potential exposure. You want to assets from claims of creditors is to buy insurance against that risk. All of us have minimize the possibility that liability auto and home insurance. One of the will be determined by our legal shortcomings of these insurance policies system. is that there are dollar limitations on the I tell clients that in assessing risk, the threat amounts of coverage and restrictions on the perils covered. of risk alone creates an emotional impact. Even when you know you are not liable, you will still worry about a lawsuit and think about all of the bad things that can happen. Given the unpredictable nature of our system for resolving disputes, this should be a real concern. Chapter 11: Asset Protection Planning Strategies 85 Wealth Management Through Estate Planning
Many auto insurance policies cover risk to a certain value per person My opinion Everyone should have an with a maximum overall indemnity. For umbrella policy. Do not example, your auto policy may provide $100,000/$300,000 for coverage. This be conservative with the means the company will pay out $100,000 amount of coverage you for each person injured with a purchase. The policies start maximum recovery of $300,000 at $1,000,000 of coverage for any one incident. If one but if you are worth a lot of person’s claim results in more money, buy more than that. than $100,000 of medical bills, lost wages and payments for pain and suffering, the policyholder The other major type of insurance is on the hook for the balance that should be investigated is long above that limit. term care insurance. This topic is reviewed There is a very easy solution in detail in Chapter 24: Long Term Care for protecting against liability in excess of Insurance. This can be an important way to your automobile coverage. Buy an umbrella protect assets from being consumed to pay insurance policy. An umbrella policy is for nursing home and other care expenses. exactly what it says — an umbrella over you for all types of perils. Where your other LIFE INSURANCE coverages stop, it can take over. Check with the company that provides Life insurance is an important component your auto coverage and ask them if they issue of many estate plans. Its primary use is umbrella policies. Most major auto insurers to provide wealth in case of the untimely do, and if yours does not, ask your insurance death of the insured or liquidity to pay advisor for a recommendation. taxes and final expenses. Maintaining Review the terms of the umbrella policy life insurance requires using some of your you are considering very carefully to financial resources to pay the premium costs. understand the perils to which it applies. If it However, unexpected liabilities could put covers liability from operating an automobile, at risk the cash values of policies and in is the coverage the full face value of the some circumstances the death benefit. What policy or is it reduced by your coverage? For protection is granted to life insurance policies example, if your auto coverage is $100,000, from the claims of creditors? will the umbrella carrier on a $1,000,000 State law controls whether or not life policy pay out $1,000,000 or only up insurance death benefits and cash values to $900,000? The policy provisions for in the policies are protected from liabilities. coverage can vary widely. There are no nationally recognized rules that Umbrella policies are not expensive. apply to life insurance policies. However, Quite commonly, $1,000,000 of umbrella some broad generalizations can be made. To coverage is about $300 per year. understand the parameters of life insurance $2,000,000 of coverage will usually be policies and asset protection planning, we will about twice this amount. Umbrella policies work with this simple example. are purchased in blocks of $1,000,000.
86 Chapter 11: Asset Protection Planning Strategies Wealth Management Through Estate Planning
person resides must be looked at very Example John owns an insurance closely to determine the nature and extent policy on his life and the of the protection provided to insurance amount of the death benefit is $250,000. policies. This can be avoided by transferring The cash value in the policy is $27,000. John the life insurance policy to an irrevocable dies. At the time of his death, he was insolvent trust. If you own life insurance to provide and owed creditors $100,000 above and for the financial support of your family, why beyond the value of the assets in his estate. The worry about whether the cash values and beneficiary of the life insurance policy is his life insurance death benefits are subject to wife. She is not legally responsible for his debts. claims from potential creditors? Transfer the policy to an irrevocable trust and it is exempt from these claims. Life insurance trusts are discussed in more detail in What are the consequences? Will Chapter 16: The Irrevocable Trust. the creditors be paid? In many states, the answer is that in all circumstances, the ANNUITIES proceeds will be paid to his wife and the Similar questions arise regarding creditors do not have any claim to the annuities. The questions may be even more proceeds. important to some people because annuities Other states exempt the proceeds almost always have more cash value during from the claims of creditors only if they are life than life insurance policies. Remember paid to the spouse, child or dependent. that an annuity is primarily an investment Presumably, payments to a non-dependent account that allows for tax-deferred savings would not be exempt and the claims of on the growth of the investments in the creditors would have to be satisfied. annuity. The economic value building up in A separate question is whether cash the annuity may be important for providing values on policies owned by a debtor can for the future support of the owner and his be reached by creditors. Again, generally, family during his lifetime. creditors cannot reach the cash values of Again, there are a number of ways in insurance policies. Some states have certain which each state deals with the rights of limitations. For example, Arizona and creditors to reach the assets in an annuity: Colorado protect only the first $25,000 ◆ Some states totally exempt the assets of cash surrender value and Arizona only held in an annuity. exempts this cash value if payable to family members. ◆ Other states exempt assets but only Ohio law takes a pro-debtor to the extent necessary to provide for approach, excluding from attachment cash the support of the annuitant and his values of life insurance policies and all of family. the death benefits if paid to a defined class ◆ Some states protect annuities only of beneficiaries (spouse, child, dependent up to a certain amount of payments or specified creditor). Be aware that from the annuity each month. certain creditors, such as Medicaid, may ◆ Other states do not provide any pro- reach assets that are protected from other tection to annuities. creditors. Again, Ohio takes a pro-debtor The lack of uniformity in state law position, exempting annuities from the claims means that the law of the state where a of creditors if the beneficiary is the owner’s
Chapter 11: Asset Protection Planning Strategies 87 Wealth Management Through Estate Planning
spouse, child or other person dependent on convenient this would be if someone could the owner. As with life insurance, be aware do this. It would also cause a lot of economic that certain creditors can reach these assets, turmoil if all of us could so easily avoid our regardless of the beneficiary. creditors. There is no general rule to be followed However, a person can transfer property and the law of the state of your residence to a trust for the benefit of others and the must be examined closely to determine the property in this trust is protected not only from position that it takes. the donor’s creditors but from the creditors of the beneficiaries of the trust. The use of trusts STATE LAW PROPERTY to protect assets from the claims of creditors EXEMPTIONS is discussed later in this chapter and in other Each state provides other exemptions parts of this book. Trusts can be effective, from attachment by creditors. I do not go into reliable entities for asset protection planning. detail regarding these for several reasons. With these basics in mind, we take a First there is wide variety among the states as closer look at transfers that can be made in to what property may be held exempt. trust that protect the trust corpus from claims of Second, and more importantly, the creditors. exemptions are not significant and would be of small significance to the persons I expect ALASKA TRUSTS to be reading this book. This is not to say Effective April 2, 1997, Alaska enacted that the exemptions may not be important in a statute that allows a person, under certain any situation. For example, Florida exempts circumstances, to transfer assets to a trust that from the claims of creditors the value of a is exempt from the claims of his creditors even residence, regardless of its value. This presents when that person is a permissible beneficiary. some planning opportunities for persons with This constituted a significant departure from serious financial problems to protect their prior law. The right to do this is not unlimited assets by using them to buy an expensive and there are four primary restrictions: home. ◆ The transfer cannot have been made to State law property exemptions should be defraud creditors. closely examined by someone experiencing ◆ The donor cannot have the unilateral financial difficulties but are not an important right to revoke the trust and put all of planning consideration for crafting an estate the assets back in his name. plan. ◆ The trust cannot require that the trust TRUSTS AND ASSET income or principal be distributed to the donor. PROTECTION PLANNING ◆ As a general rule, a person cannot place The donor cannot be in default of pay- assets into a trust when he is the beneficiary, ing child support orders. having structured this trust so as to avoid A creditor may challenge any transfer to paying his creditors. This law applies, an Alaska trust within the later of four years with certain exceptions discussed herein, after the transfer was made or one year from throughout the United States. the time the transfer is or reasonably could The rule is founded on public policy have been discovered by the creditor. This considerations that someone should not time period is included to give creditors a be able to run up his debts and then avoid window of opportunity to collect on debts payment by placing his assets in a trust. How owed to them. After this, the window closes.
88 Chapter 11: Asset Protection Planning Strategies Wealth Management Through Estate Planning
To utilize Alaska law, several protected from creditors if the transfer is requirements must be met. First, some of the not a fraudulent conveyance or the liability assets of the trust must be physically located arose after the transfer. in Alaska. If the trust has stocks and bonds, Also, unless the transfer was done to at least some of them must be in an account avoid paying the creditors of the transferor, in Alaska. the property is no longer attachable by that Secondly, the trustee must be a person’s creditors. qualified person defined as either a bank A parent does not have a legal with trust powers that has its principal place obligation to give any portion of his of business in Alaska or an Alaska resident. property to his children either during his A second state to follow this approach lifetime or at death (although he may have is Delaware. Effective July, 1997, this state an enforceable support obligation in some enacted its own law allowing persons to set circumstances, but that is beyond the scope up trusts for their assets that creditors could of this chapter). Therefore, if a parent does not attach. There are some variations in its not have an obligation to give his children provisions compared to the Alaska statute his property, he should be able to make a but the force of the statute is the same. transfer into a trust for a child that has legal Other states have followed suit and now restrictions as to the time and circumstances allow the creation of an asset protection under which that child has a right to receive trust. benefits from the trust. I have included this discussion on Alaska trusts so that readers are aware of Planning Strategy this development in the law. However, in We advise clients to my experience, very few persons will want put substantial gifts for to go through the ordeal of setting up an children, grandchildren or other loved ones in Alaska trust. This is not to say that the use of an irrevocable family gift trust. The property is the Alaska law could not be of advantage immediately protected from the beneficiary’s in some situations, but those situations are creditors and is not countable as a marital asset of very few and far between for many persons that person. This is a great way to keep it “All in doing estate planning. the Family.”
PLANNING TO PROTECT FAMILY MEMBERS Understanding this principal allows us In the preceding discussion, we have to use it for certain asset protection planning seen that, with certain exceptions, a goals. To insure the long term financial person cannot put assets into a trust for his security of his spouse and children, a person own benefit and defeat the claims of his may make transfers to trusts for them. Unless creditors. However, what a donor cannot do the transfer is a fraudulent conveyance, the for himself, he can do for others. transfer will stand. A person can put assets inside a To obtain the maximum benefits of this trust and have those assets immediately strategy, several things must be done: protected from the claims of the ◆ The trust to which the property is beneficiary’s creditors, including current transferred must be irrevocable. creditors as well as future creditors. The ◆ The beneficiaries should receive ben- legal principal for this lies in the right of efits under an ascertainable standard someone to control the distribution of his related to needs for their health, sup- property including whether to give it to port, maintenance and education. someone or not. The transfers are also
Chapter 11: Asset Protection Planning Strategies 89 Wealth Management Through Estate Planning
◆ The trust should include a spendthrift term care. There is also another important clause which expressly prohibits credi- segment of the population where there is a tors from attaching trust property to sat- growing need for planning for individuals with isfy their claims against a beneficiary. special needs. One in every twenty-six American Observation families reported raising a child with special Extreme care must be taken needs. As a result, there are a vast number in the drafting of spendthrift of families that require additional planning. clauses. State law controls their validity and small, For these families, there are serious concerns seemingly insignificant words can invalidate the about providing for financial security for their intended benefits. If the spendthrift clause permits children who cannot provide for themselves. the trustee to make payments for support, a creditor Many parents, unaware of the planning can claim he should be paid for services provided to opportunities, choose to disinherit these the beneficiary for support. In many states, a court children, leaving all of the assets to the would agree and require the trustee to satisfy the other children with the thought that the other beneficiary’s debt. children will ensure that the child with the special needs is provided for. While these parents have the best of intentions, this When properly done, the assets of strategy has several unintended negative the trust are not attachable by creditors of consequences. There are other planning either the donor or the trust beneficiary. This techniques available that provide a more allows the donor to make sure that his family favorable and alternate solution. is protected financially not only from his While special needs planning is typically creditors but from theirs. This will guarantee done for the parents of child with special that the assets transferred will always be needs, there are other individuals that often available for the financial support of his fall under the category of requiring a special family. needs plan. There are adults that have As with many other planning techniques, acquired an injury or illness later in life that multiple benefits are secured through the now currently depend on their senior parents use of a single planning strategy. Discussed to provide and coordinate care for them. later in this book is the Family Gift Trust (See There are also adult children who living in Chapter 16: The Irrevocable Trust). This type nursing homes, assisted living facilities, group of trust is used for tax-driven estate planning homes or other types of home settings outside goals and is also useful for asset protection of their parents’ residence. Although they are strategies. living in another residential setting, these adult Long term asset protection planning is children with special needs still depend on also a goal of the techniques discussed in their parents or representatives to provide for Chapter 13: Dynasty Planning. them and advocate for them as issues arise or when decisions need to be made. Finally, SPECIAL NEEDS PLANNING there are individuals who find themselves An estate plan is often something that disabled as a result of an accident or other an individual creates once he or she has traumatic event that now require them to plan accumulated wealth or to ensure that their for their special needs. assets are distributed to their family members, Special needs planning focuses on friends or charities based on their wishes. As setting aside financial resources, whether it we all know people are living longer. There be the assets of the parents, grandparents or is a growing population that will require long the individual with special needs, to ensure adequate protection and monitoring of such
90 Chapter 11: Asset Protection Planning Strategies Wealth Management Through Estate Planning
resources. The strength of the strategy is that decedent’s final obligations. the assets are held in a manner that will not Conversely, holding property in this disqualify the individual with special needs manner has risks. If the co-owner has from his or her government benefits. The financial problems, the assets in the joint assets are typically held in a special needs account may be attached to satisfy claims trust that provides for the supplemental against him. This is really a problem if needs of the individual with special needs. the co-owner did not make any financial Distributions can be made from the special contributions to the account. This must be needs trust to provide for the supplemental taken into consideration before setting up needs of the individual to enhance his or her this type of account. quality of life. The main concept is that the individual with special needs will receive ENTITY PROTECTION benefits under the government programs that Assets placed into some types of legal he or she is entitled and then may receive entities, such as limited partnerships or distributions for such items or expenses corporations, can be exempt from the claims that are not covered by such government of creditors of the individual who made the benefits. capital contribution. The interest of a partner There are several different types of in a limited partnership may be protected special needs trusts that may be created from creditors’ claims. The only attachable depending on the appropriateness and interest is the right to take any distribution circumstances of the individual with special declared by the partnership and actually needs. This is a highly specialized area distributed to that partner. of law and extreme care must be taken Another reason why an interest in to ensure that the individual’s financial an entity provides some asset protection security is protected and the risk of losing planning benefits arises from the nature government benefits is eliminated. of the ownership rights. An interest in a business entity does not always have a JOINT AND SURVIVOR readily determinable value that is severable PROPERTY from the whole and is not always saleable. In other parts of this book, we have This interest can be subject to substantial discussed the effect of holding property discounts to value because of minority as a joint tenant with right of survivorship. interest, lack of control and restrictions on The consequence of this is that the property transferability due to reasons such as the interest so held passes automatically to the terms of a buy-sell agreement between the survivor and is not subject to either probate shareholders. Even if a creditor can acquire administration or distribution in accordance an interest in a closely held business, with the decedent’s Will. would he want to do this? How much is a Another aspect to holding property minority interest in a closely held business in this manner is that when it passes to the worth especially when he may have hostile surviving joint owner, it also passes free majority owners? Who would buy it from of any debts of the deceased owner. It is him? not subject to the claims of this person’s The key to implementing this strategy creditors. This is the law of almost every state is creating an entity that maximizes asset in the country. This result was determined by protection and minimizes the value of the litigation and not by statute. interest to a creditor. These results are The effect of this is to have this property achieved by creating documentation that pass not only free of probate but also restricts and controls interests in these without having to be used to pay the entities. These are some of the objectives
Chapter 11: Asset Protection Planning Strategies 91 Wealth Management Through Estate Planning
of the topics discussed in Chapter 17: Family marrying and funding it with separately owned Limited Partnerships and Limited Liability assets. This is not as safe as a prenuptial Companies and Chapter 18: Business agreement but does keep the assets isolated as Succession Planning. separate non-marital property. It also protects a residence from dower interest claims if the PRENUPTIAL AGREEMENTS state of residence allows the non-owner spouse A prenuptial agreement is a contract dower rights in property. entered into between two person before Once the couple is married, trusts can they get married setting forth the financial be modified to provide for the support of arrangements that are to take place if they later the spouse while still keeping the property divorce or die. The essence of this agreement is segregated. If divorce occurs later, it should that each party identifies the property they own be easier to identify the trust property as non- and that each one is allowed to take with them marital property not subject to division in a upon death or divorce. Prenuptial agreements divorce case. Of course, it is also very helpful if may or may not deal with other issues, such assets saved during marriage are not added to as spousal support, but the agreed division of the trust account and the account continues to property is usually the most important issue. own only assets acquired prior to marriage. Prenuptial agreements are valid if done State law must be carefully examined correctly, but this means that any state law rules when considering a prenuptial agreement. It is concerning them must be closely followed. In especially important if you live or plan to live in many states, an agreement that is inherently a community property state. unfair will not be enforced by a divorce court. These agreements may not resolve all PENSION AND issues if there is a divorce. Property acquired RETIREMENT PLANS during the marriage such as homes and Many persons have substantial investments investment accounts is marital property and in retirement plans. Their goal is to accumulate needs to be divided in some fashion, either by in these plans tax deductible dollars that can agreement or by court order. grow tax deferred during life. They also want to Prenuptial agreements are very common make sure that these assets are protected from when there is a second marriage and both the claims of creditors. parties have children from prior marriages. Federally qualified retirement plans are Their mutual goal is to make sure their children exempt from attachment under the provisions of receive an inheritance. This is even more the Employee Retirement Income Security Act important when one of the persons is widowed of 1974 (ERISA). ERISA has mandated anti- and owns property accumulated during her alienation clauses protecting these accounts. marriage to her late spouse. These persons There are only limited exceptions to this, these frequently feel a special sense of responsibility being division of retirement benefits in a divorce to their children. action and attachment to pay federal tax liens. Agreements among younger persons State law controls as to whether or not getting married for the first time is a little more IRA accounts are exempt from the claims of problematic. This oftentimes becomes a very creditors. The rules vary widely. Some states sensitive issue. These persons have more exempt the entire amounts in these accounts difficulty believing there could actually be a (Florida, Ohio and New York as examples). divorce. The innocence of youth. Several states have dollar limitations on the For younger couples addressing this issue, amount that can be held in these accounts free they should resolve this as far in advance of the of potential claims. In Nevada, the amount is marriage as possible. The week before is not $500,000. soon enough! Other states tie the amount of the There is an alternative that should be exemption into an amount that is reasonably considered: creating a living trust prior to necessary for the support of the debtor and his
92 Chapter 11: Asset Protection Planning Strategies Wealth Management Through Estate Planning
FRAUDULENT CONVEYANCES Observation At retirement, While reviewing the strategies to protect many persons roll assets discussed in this chapter, you must their accounts out of their pension plans always keep in mind that state statutes will to IRA's. This can be a good thing to void transfers of property that are done to do for many reasons. However, this defraud creditors. A fraudulent conveyance may cause loss of the asset protection is one that is made by a debtor while he is available under ERISA. This should not insolvent to avoid having that property used be the determining factor on whether to pay his creditors. Insolvency is generally to roll out or not but it should be taken described as a situation where a person’s into consideration, especially if there debts exceed his assets. If you are insolvent is known or anticipated financial and transfer your assets away to protect exposure. You need to understand if them from being attached by your creditors, there is any state law that provides the creditors can attack the transferee creditor protection. and demand that the transfer be revoked because you intended to defraud them of their rights to be paid. dependents. This limitation has difficulties in State law determines what is a its application. What amount is reasonably fraudulent conveyance and you want to be necessary for support, especially looking very careful that any property transfers do out years into the future? What if the owner not run afoul of this restriction. If you are is not currently making withdrawals and has going to make a property transfer because no current need for the funds in one of these you are concerned that it may be attached accounts? by a creditor, you need to discuss this with legal counsel first. Observation It is easy to avoid getting entangled with transfers that are prohibited under fraudulent State law conveyance statutes. However, if you make exempting SEP-IRA a transfer while you are solvent and before accounts, an IRA plan available for you incur a liability to a creditor, then you business owners and their employees, should not have to worry about this type of may be in violation of federal law. A law. The strategies discussed in this chapter federal court of appeals found that a are designed for those who are trying to Michigan statute that exempted IRA's protect their assets from the claims of future from creditors’ claims violated federal and currently unknown creditors. law and was not legal, as applied to a SEP-IRA. Federal law on retirement accounts preempts state law that is in conflict. Before you transfer assets out of a qualified plan such as a 401(k) or pension and profit sharing plan (which under federal law are protected from creditors), check with your estate planning attorney.
Chapter 11: Asset Protection Planning Strategies 93 Wealth Management Through Estate Planning
SOME FINAL THOUGHTS There is no single magic bullet that solves all asset protection planning My opinion problems. This is evidenced by the fact that state law governs many of the Asset protection applicable legal issues and each state is free planning has to handle these issues in different ways. What become a very is allowable in one state may be of no benefit hot topic and is in another. Consultation is necessary with a one of the core goals of our firm’s lawyer in your state who is familiar with these issues. Also, your property interests physically planning strategies. However, keep some located in another state may be controlled by perspective on your potential risks. Every the laws of that state. This is very frequently once in a while, I have to rein in a client true with real property interests. who has no distinct financial exposure but When assessing risk and how you should wants to take extreme measures to protect build asset protection planning techniques his assets. Bermuda is a great place to into your own estate plan, be realistic and visit but do you really need to keep your candidly evaluate your own situation. An money there? obstetrician has more exposure to risk than a school teacher. A retired person has less exposure than a business owner does. This is one area of the law where a skilled estate planning attorney can be of great value. He or she can not only advise you as to available strategies, but also put potential risks in perspective. Designing a plan that reasonably and proportionately deals with the needs for your unique family situation should be your goal.
94 Chapter 11: Asset Protection Planning Strategies Wealth Management Through Estate Planning
Chapter 12: The A-B Trust Strategy
This chapter discusses the primary planning strategy designed to reduce the federal estate taxes of a husband and wife. The goal of this strategy is to take full advantage of the estate tax credit available to each spouse.
Chapter 12: The A-B Trust Strategy 95 Wealth Management Through Estate Planning
Chapter 12:
◆ What is the A-B Trust Strategy
◆ How the Strategy Works
◆ Administration of Trust A
◆ Administration of Trust B
◆ Death of the Surviving Spouse
“You cannot live without the lawyers, and
certainly you cannot die without them.”
Joseph Choate
96 Wealth Management Through Estate Planning
n this chapter, we examine one of the As the estate tax credit increases, so sophisticated estate planning techniques does the amount of property protected from I that are available to reduce or eliminate estate taxes. A husband and wife using the federal estate taxes. The strategy that is A-B Trust Strategy can protect from federal discussed is usually the first tax planning estate taxes an amount of property equal to strategy that a husband and wife use as part twice the available estate tax credit. of their estate plan. However, it is only effective when done while both spouses are living and each of WHAT IS THE A-B TRUST their trusts must be funded with at least an STRATEGY amount of assets equal to the estate tax In Chapter 4: The Federal Estate Tax, we credit. discussed how each person has a tax credit The mistake that many persons make (the applicable exclusion amount) which is that they look at the unlimited marital eliminates the federal estate tax on the first deduction as eliminating estate taxes on portion of an estate. The amount of this portion depends on the Observation As discussed earlier in this book, allowable estate tax credit for that there is great uncertainty in federal year. The focus of the A-B Trust estate tax law. The estate tax credit (applicable strategy is using both spouses’ estate tax exclusion amount) is currently $5,120,000 (includ- credits to reduce estate taxes. ing inflation adjustment for 2012) and is scheduled The essence of the strategy is that to go back to $1,000,000 in 2013. President on the death of the first spouse a portion Obama has proposed a $3,500,000 estate tax of the assets owned by that spouse are credit. For purposes of this discussion, we will use intentionally made subject to estate taxes the $3,500,000 credit amount. The discussion in in that person's estate. This is done by this chapter is focused on how a couple can use having these assets placed in a trust that both of their estate tax credits. does not qualify for the estate tax marital deduction. The amount of the assets put into this trust is the amount that triggers an estate tax equal to the amount of the tax the first death, overlooking the fact that credit. The tax credit wipes out the estate tax this means all marital assets are taxed on on this portion of the assets, resulting in no the second death. The use of the marital estate taxes on the first death. deduction only delays the payment of estate taxes to the second death. Using the A-B Trust strategy requires some foresight and Amount of assets allocated to first trust $3,500,000 planning on the part of couples and their Less: Estate tax credit ($3,500,000) estate planning attorney. Estate Tax due: 0 Amount passing estate tax free $3,500,000 HOW THE STRATEGY WORKS Each spouse sets up a revocable living trust and in each trust document there is The result of this is that there are still no language that splits the trust of the deceased estate taxes on the first death (a combination spouse into two parts on his or her death. of using the marital deduction and the During the life of each spouse, the trusts are estate tax credit). The assets in the trust their living trusts designed to achieve the are not taxed in the estate of the second benefits discussed in the previous chapter. spouse when this person dies. The objective The reason why each spouse has a trust is of the strategy is to avoid stacking all of that we do not usually know which spouse a couple’s assets up in the estate of the will die first and we have to be prepared for survivor. either situation.
Chapter 12: The A-B Trust Strategy 97 Wealth Management Through Estate Planning
Once the trusts are set up, arrangements Because of the estate tax credit, there are no are made to either fund the trusts at that time federal estate taxes on this trust. or upon the death of the first spouse. Lifetime Trust A will receive all of the property funding may be setting up an investment not put into Trust B. This property will not be account in the name of the trust or changing subject to estate taxes at the first spouse's death the title on real estate to the name of the trust. because the trust is designed to qualify for the unlimited marital deduction. The flow chart which follows illustrates the Observation The A-B Trust Strategy only works if it is federal estate tax planning benefits of using this put in place while both spouses are living. strategy. If you wait too long (i.e. once you become widowed) it The chart also shows another benefit of is too late! the use of the A-B Trust strategy. Growth in the value of the assets allocated to Trust B is also protected from estate taxes while growth in the Also, the trust may be funded on the death of assets that pass directly to the surviving spouse the first spouse when, for example, the trust is is not. By setting aside assets in Trust B, the full the beneficiary of life insurance on the spouse value of Trust B, regardless of the amount at the who just died. See Chapter 21: Asset Alignment time of the survivor's death, is protected from Strategies for a discussion on funding a living estate taxation. trust. While the trust may be funded at different The benefit of this is represented by times and in different ways, the important point comparing the left side of the chart where it is that there is a plan in place to fund the trust shows growth in the assets over some period so that on the death of the first spouse, estate of time from $5,000,000 to $7,000,000 with taxes can be triggered in an amount that will the right side of the chart where there is similar equal the available estate tax credit. overall asset growth of $2,000,000 but half Upon the death of the first spouse, the of the growth is in Trust B and the other half is in the assets retained by the surviving spouse. Note on the right side of the chart that on the My opinion second spouse’s death, only a portion of the This is the first strategy used in applicable exclusion amount ($2,500,000) creating an estate plan for was used. The full amount of the exclusion was a couple where estate tax not needed because assets were sheltered in planning is needed. The Trust B. other planning techniques we In my experience, it is not uncommon for one spouse to live many years following the will be discussing build on this death of the first spouse. With reasonable rates fundamental technique. of return and reduced expenditures (financial assets supporting one person instead of two), a significant increase in the value of assets is not property in that spouse’s trust is split into two an uncommon occurrence. shares. The split does not occur until the Note that there is no tax savings on the death of the first spouse. These shares are first death and how the applicable exclusion commonly called Trust A (or the marital trust) amount is used twice on the right side of the and Trust B (or the credit shelter trust). The chart versus only once (at the second death) on amount of property put into each of these the left side of the chart. trusts is determined by the language in the trust The administration of each of Trust A and agreement which mandates the split. Trust B is different. The differences are important The amount put into Trust B is the amount of and lead to the different tax treatment given to property that will trigger an estate tax equal to each trust. the amount of the estate tax credit for that year.
98 Chapter 12: The A-B Trust Strategy Wealth Management Through Estate Planning
ADMINISTRATION OF children may be beneficiaries. However, for TRUST A other reasons, this is not usually done. Remember that Trust B is designed in These are the important rules for Trust A: such a way as to intentionally cause it to be ◆ The surviving spouse is the only taxed. However, the tax is wiped out with permissible beneficiary. If anyone the estate tax credit. else is a beneficiary, then the trust will not qualify for the marital deduc- DEATH OF THE SURVIVING tion. SPOUSE ◆ Trust A must pay out to the spouse at On the death of the second spouse, the least annually all of the income of following occurs: the trust. The amount of the income ◆ must be reasonable. The property in Trust A is included in this spouse’s estate for tax purposes. ◆ The trust may also pay out to the ◆ spouse as much of the principal as Trust B property (including the growth is needed for such purposes as the in the value of the assets in Trust B) is spouse’s health and support. not included in the second spouse's estate. It was subject to estate taxes ◆ Additionally, the trust may allow the on the death of the first spouse. spouse to withdraw from the trust as ◆ much of the principal as the spouse After Trust A is taxed, the balance is wants. usually rolled over into Trust B and the combined trusts are then divided ◆ The trust may also give the spouse among their children or other desig- the power to appoint the trust prop- nated beneficiaries in accordance erty to someone else on his or her with the terms of the trust agreement. death. Alternatively, the trust may not allow the spouse this right and may limit the spouse to receiving all the income for his or her lifetime with the remainder My opinion Do not dismiss the idea of having passing to those persons named an A-B trust just because you by the deceased spouse. When the trust is are not currently worth millions of restricted in this manner, it is called qualified dollars. Here is an example of the terminable interest property (QTIP long term benefits of estate tax property). In Chapter 4: The Federal planning: Estate Tax, this is discussed in more In 1980, a client’s parents set detail. up trusts using the A-B strategy discussed in this chapter. The father died ADMINISTRATION OF in 1981 and Trust B was funded at that time TRUST B with $375,000 of blue chip stocks. At the surviving spouse’s death some 20 years later, Trust B generally has the same the trust was worth $7,500,000. The tax savings provisions except that the surviving was about $3,500,000! spouse does not have the unlimited right to You must consider the long term economic consequences make withdrawals from the trust or appoint of a properly designed estate plan. This is especially it to someone else on this spouse’s death. important when combined with the dynasty planning For these reasons, it will not qualify for the techniques discussed in Chapter 13: Dynasty Planning marital deduction. Because Trust B does not With Trusts. Dynasty planning leverages these benefits qualify for the marital deduction, it is taxed. among many generations. Persons other than a spouse can be Yes this “stuff” really works. beneficiaries. Sometimes, for example, the
Chapter 12: The A-B Trust Strategy 99 Wealth Management Through Estate Planning Federal Estate Tax Benefits of A-B Strategy This chart assumes that there was $2,000,000 in the growth of the assets between the death of the first spouse and the death of the second spouse. This is done so as to illustrate an additional benefit of this tax strategy, that being all growth in the value of the assets allocated to Trust B is protected from estate taxes.
$5,000,000 Estate
No Tax Planning Use of Trust A & B
All to Surviving Spouse $1,500,000 to Trust A $3,500,000 to Trust B for Surviving Spouse for Surviving Spouse
Unlimited Unlimited Applicable Exclusion Marital Deduction Marital Deduction Amount $3,500,000
Tax at First Death Tax at First Death Tax at First Death $0 $0 $0
At Death of Trust B Surviving Spouse $4,500,000
$7,000,000 Taxable Estate At Death of Applicable Surviving Spouse - 3,500,000 Exclusion Amount $3,500,000 Taxable Estate $2,500,000 Taxable Estate - 2,500,000 Applicable Federal Estate Tax Due: Exclusion Amount $1,575,000 $ 0 Taxable Estate
Federal Estate Tax Due: $0
Distributions to Beneficiaries of Trust
100 Chapter 12: The A-B Trust Strategy Wealth Management Through Estate Planning
At this point, the tax planning strategy is completed. The trust document then moves on to other strategies that are included in the agreement. For example, this might mean the planning techniques discussed in Chapter 13: Dynasty Planning With Trusts.
SOME FINAL THOUGHTS This strategy is of value up to an amount equal to both spouses’ estate tax credits. There are no estate tax savings beyond that. As to estates larger than this, it is necessary to turn to other planning strategies such as life insurance planning or the use of annual exclusion gifts. The use of this strategy is a good place to start for many persons but is frequently only the beginning point of a sophisticated estate plan.
Chapter 11 — The Role of Life Insurance in Estate Planning 101 Wealth Management Through Estate Planning
102 Chapter 11: Asset Protection Planning Strategies Wealth Management Through Estate Planning
Chapter 13: Dynasty Planning with Trusts
Dynasty planning is a technique that allows families to provide for the long term care and support of their descendants and protect assets from the claims of creditors, division in a divorce proceeding, and estate taxes.
Chapter 13: Dynasty Planning with Trusts 103 Wealth Management Through Estate Planning
Chapter 13:
◆ What is a Dynasty Plan
◆ Benefits of Dynasty Planning
◆ Increased Taxes on Increased Family Wealth
◆ The Tax Benefits of Dynasty Planning
◆ Effect of the Generation-Skipping Transfer Tax
◆ Leveraging the Use of the GST Exemption
◆ How Long Can a Dynasty Trust Continue
◆ Reasons Not to Do Dynasty Planning
“If you can count your money, you don’t
have a billion dollars.”
J. Paul Getty
104 Wealth Management Through Estate Planning
ome estate plans focus on conserving taxable in their estates. The federal estate family wealth for multiple generations. tax does not apply to property interests S One name that is commonly used held in trust that restrict in certain ways the to describe this technique is dynasty right of the beneficiaries to take out the planning. Its purpose is to protect family trust assets. The effect of this is that on the wealth from being repeatedly subject to death of a beneficiary, his interest can pass estate taxes in each successive generation estate tax free down to the next generation. and to protect family wealth from creditors. A generation is skipped for estate tax Dynasty planning has become important purposes. because of increased family wealth and The children in a dynasty plan are only larger inheritances passing on to children skipped in the sense that the assets in their and grandchildren. This chapter explores trust are not taxed in their estates. They have the important aspects of this planning the beneficial enjoyment of the property in technique. the trust throughout their lifetimes.
BENEFITS OF Observation One of the biggest DYNASTY PLANNING economic risks to family wealth Dynasty planning is all about long term is divorce. 50% of marriages in this country end in asset protection planning for successive divorce. Dynasty planning can take away this risk generations of a family. The dynasty trust to inherited wealth. will include provisions that protect the I explained to a client that estate planning beneficiary’s interest in his trust in case of could save money on taxes and protect her divorce or financial problems caused by daughter’s inheritance if she ever got divorced. a bad business decision, a bad driving She did not care about the tax planning; what decision or the inability to handle finances grabbed her attention was that we could keep her responsibly. money away from her son-in-law! The asset protection planning benefits of trusts are discussed in other parts of this book and apply the same way to dynasty trusts. The important point is that through WHAT IS A DYNASTY PLAN dynasty planning you can make these A dynasty estate plan focuses on strategies available over a longer period of giving family members the right to enjoy time for multiple generations of a family. the benefits of property held in a trust but in such a manner that the trust principal is INCREASED TAXES ON not taxed in their estates at death. This is INCREASED FAMILY WEALTH done by giving them carefully designed To understand the economic importance interests in a trust that are not subject to of this type of planning, we must first being included in their estates for estate tax understand the costs of family wealth being purposes. subject to estate taxes in each generation Typically, a dynasty trust will direct and the limitations on our abilities to reduce discretionary distributions of trust income or eliminate these taxes. and principal for purposes such as The wealth of parents is subject to providing for beneficiaries’ health, support estate taxes on their deaths. Because of and education. The beneficiaries are the estate tax marital deduction, this is not given an absolute right to take out not normally a problem until the death of of the dynasty trust whatever they want, the surviving spouse. A spouse, at death, whenever they want. Because they do not may pass unlimited amounts of property have unlimited access to the trust, it is not to his or her spouse without any federal
Chapter 13: Dynasty Planning with Trusts 105 Wealth Management Through Estate Planning
estate taxes. On the death of the surviving spouse, however, No Dynasty With Dynasty the ability to avoid estate taxes Planning Planning is limited. There is no marital Inheritance to child $1,000,000 $1,000,000 deduction because there is no surviving spouse. This means Tax on death of child ($500,000) (0) that all property in the gross Balance after tax $500,000 $1,000,000 estate of this spouse is subject Tax on death of to the federal estate tax. As we grandchild ($250,000) (0) have seen, the only meaningful Balance $250,000 $1,000,000 deduction or credit is the estate tax credit which may protect only a portion of the estate from estate tax rate and no growth in the value of taxes. assets. Now this property (after taxes) is passed This is a very simplistic description that on to their children. In many families, the does not take into account all factors. The children are enjoying their own financial example, however, focuses on the most success, a product not only of their own important tax benefit of dynasty planning efforts, but of the positive environment in which is avoiding the successive taxation of which they were raised by their parents. family wealth as it passes from generation to Children of successful parents are frequently generation. successful themselves. Inheritances they If growth on inherited money due to might receive are more frequently unneeded investments is taken into consideration, the for living expenses and are saved for their spread between the two figures is even children. It has been forecast that over greater. The following example has the $11,000,000,000 is being passed from same assumptions plus it includes growth on the current senior generation to the next inherited wealth. The assumptions are a 6% generation. growth factor on inherited wealth and the Dynasty planning recognizes this death of each of the child and grandchild 36 phenomenon and addresses, among several years after they receive inheritances. primary objectives, how family assets can be passed inter-generationally without successive taxation. No Dynasty With Dynasty Planning Planning THE TAX BENEFITS OF Inheritance to child $1,000,000 $1,000,000 DYNASTY PLANNING Growth (years 1-36) $8,000,000 $8,000,000 Dynasty planning techniques Tax on death of child ($4,000,000) (0) are very valuable for increasing Balance after tax $4,000,000 $8,000,000 family wealth. With proper Growth (years 37-72) $32,000,000 $64,000,000 planning, some assets can be permanently removed from the Tax on death of grandchild ($16,000,000) (0) federal and state estate tax systems. This avoids the repeated Balance $16,000,000 $64,000,000 taxation of wealth at each generational level. Here are the two alternatives laid side to side showing the Do the math yourself. At 6% growth, tax effects through two generations. Each set of wealth doubles every 12 years. In 36 years, calculations assumes a 50% federal and state it will double three times. Suppose wealth
106 Chapter 13: Dynasty Planning with Trusts Wealth Management Through Estate Planning
grows at 8%. Every 9 years it doubles. In exemption. 36 years it will double four times. What are To illustrate this, assume the following the amounts in our example if you use an facts. The generation-skipping transfer tax 8% growth factor? (GST Tax) credit is $3,500,000 (President When examining the figures, notice that Obama’s proposal) and Amy, who is worth in the left column, wealth is increasing after $4,500,000 dies leaving all of her assets in taxes at a factor of four times the amount a dynasty trust for her daughter, Allison. of the original inheritance that each of the The optimal way to maximize the use of child and grandchild received. In the right the GST Tax credit is for the trust to be broken column, wealth is compounding at a factor of eight. The increased factor is the result of eliminating the effect of estate taxes on the Parents inheritance.
EFFECT OF THE GENERATION- SKIPPING TRANSFER TAX Children's Trust Dynasty planning is such a valuable A generation planning technique that Congress took is skipped steps to put a cap on how much property for estate tax can be passed using this type of planning Grandchildren purposes technique. It did not want family wealth to escape estate taxation as subsequent into two shares, one called an exempt share generations pass property on to the next and the other one called a non-exempt share. generation. In Chapter 7: The Generation- There is allocated to the exempt share the Skipping Transfer Tax, we reviewed this GST Tax credit amount of $3,500,000. The tax and its implications. The maximum balance of $1,000,000 is allocated to the amount that can currently be transferred non-exempt share. without triggering this tax is $5,120,000 On the death of Allison, the entire per person. For a couple with proper value of the exempt share (regardless of the planning, the maximum amount of property growth in its assets) passes estate tax free to that they can exempt from the GST tax is the next generation. The non-exempt share $10,240,000. also passes to the next generation but is Keep in mind that these exemption subject to estate taxes in the estate of Allison amounts are temporary and that the or is subject to the GST Tax rates if it is not exemption is reverting to $1,000,000 in otherwise includable in her taxable estate. 2013 unless there is new tax legislation. Either way, a tax is paid for the transfer to the In our current political and economic next generation. environment, we can only guess at what might happen. The effect of this tax, in most but not all cases, is to limit the amount of property put into the dynasty trust. Where the amount of an inheritance exceeds the available exemptions, the inheritance that a family member receives is split into two shares, a share that is equal to the available generation-skipping exemption and a share for all amounts in excess of the available
Chapter 13: Dynasty Planning with Trusts 107 Wealth Management Through Estate Planning
LEVERAGING THE USE OF THE exemption) at Linda’s death and GST EXEMPTION - The future growth during her life- For wealthy families, the GST exemption time on this excess amount. does present a challenge to dynasty planning ◆ The tax savings to future generations in that it limits the amount of property that can of a family can be very substantial be passed tax free to later generations. In these because estate taxes are avoided for situations, it may be advisable to use planning later generations. techniques that maximize its potential. One of the most important strategies to maximize the value Observation The GST exemption of the exemption is to use it can be used at any time earlier rather than later. This is done and can be selectively applied. This presents by making a gift into a dynasty trust a great planning opportunity to expand the during lifetime and allocating the GST benefits of dynasty planning. exemption on a federal gift tax return. In Chapter 14: Family Gift Strategies, we take a look at Family Gift Trusts, which A second way to leverage the use of can be used for making lifetime gifts. Using the GST exemption is to buy a life insurance this technique also allows an early allocation policy inside an irrevocable life insurance trust of the exemption. Following is an example of and allocate part of the GST exemption to how this works. the annual gifts made to the trust to fund the premium payments. This is how it works. Example In 2012, Dale gives $1,000,000 to a Family Gift Trust with Example Jan dynasty provisions, which money is to be held and for his daughter, Linda. On her death, the trust John set up an irrevocable life is to be held for her children. He files a gift insurance trust with dynasty tax return at that time and allocates part of planning provisions and plan on his GST exemption. Dale dies in 2017 and at giving to the trust $20,000 each the time of his death, the value of the trust has year. The trustee purchases a grown to $2,000,000. second-to-die life insurance policy on the lives of Jan and John with a death benefit of $1,000,000. Each year they file a gift tax What are the consequences of Dale return and allocate $20,000 following this course of action? of their GST exemptions to the ◆ He has used his GST exemption to transfers made to the trust. Jan shelter more than twice as much money dies five years later and John dies from estate taxes on Linda’s death seven years after Jan. than if he waited until his death. This means that her estate will not include the full $2,000,000 nor will it include What is the effect of the insurance plan any future growth in this amount. The that they have put in place? Over twelve tax benefit to Linda’s estate (and to the years, they have allocated $240,000 of their benefit of his grandchildren) is: GST exemptions ($20,000 x 12). However, - The estate tax that would have the full $1,000,000 of the life insurance been assessed on $1,000,000 proceeds, plus all future growth from the ($2,0000,000 - $1,000,000 GST investment of this money is exempt from estate
108 Chapter 13: Dynasty Planning with Trusts Wealth Management Through Estate Planning
taxes and GST tax for the life of the trust. the investments of trust property as a trust The concept is the same as using the advisor or even handle this themselves. estate tax credit on gift taxes during the When beneficiaries are financially donor’s lifetime to leverage the value of the responsible, they can be given special gift. Early use of the GST exemption allows powers of appointment that allow them all of the growth in the assets gifted to be to make distributions to their families at removed from the taxable estate. their own discretion. Trust assets can be distributed pursuant to this type of power to HOW LONG CAN A DYNASTY pay for college education or buy a spouse a TRUST CONTINUE new car or a piece of jewelry. The length of time that property can Trusts do have compacted income tax be retained in a dynasty trust is determined rates (See Chapter 8: The Federal Income by the law of the state that is the legal situs Tax) but carefully drafted trust provisions of the trust. Most states have some version can turn this into a positive and allow of a law known as The Rule Against favorable management of the tax issues. Perpetuities, which restricts the time period that property can be held in Observation trust. Ohio changed its law The trend in law is to allow regarding the Rule Against property to be held in trust for an unlimited Perpetuities a number of years ago. You can time and in some jurisdictions this rule now elect out of the Rule and have property has been revoked. Even where the rule held in trust indefinitely. This is done by putting still applies, the time period can be quite a statement in your trust agreement directing substantial and could easily be for a period that the Rule Against Perpetuities not apply extending out 100 years into the future. as to interests held for trust beneficiaries. Some parents decide to create “mini” However, if nothing is said, the Rule continues dynasty trusts that last only for the lives to apply. of their children and then distribute the trust principal out to their grandchildren at certain ages. Other parents create “maxi” If the estate planning attorney that you dynasty trusts that will last forever. Choosing are working with does not encourage the among these options looks at factors such as creation of dynasty trusts as part of your the amount of wealth at stake, the number estate plan, consider getting a second of children and grandchildren, the parent’s opinion. Many attorneys stay away from feelings about leaving money to future dynasty planning because of a failure to generations that they do not personally understand its benefits and/or because they know and the integration of other goals. are concerned about running afoul of the generation-skipping transfer tax. You owe REASONS NOT TO DO it to your family to at least get an opinion DYNASTY PLANNING from an attorney as to its potential benefits. Getting that opinion will allow you to then There are no significant reasons to make an informed decision. forego dynasty planning. The biggest concern that parents raise is that if they use this technique, their children will not be in control of their inheritances. This is not true and great flexibility and control features can be built into the dynasty trust agreement. Responsible beneficiaries can be given reasonable control over the trust, including being the trustee. They can direct
Chapter 13: Dynasty Planning with Trusts 109 Wealth Management Through Estate Planning
CONCLUSION Dynasty planning is an extremely powerful tool for creating and protecting wealth. Every person creating an estate plan should give strong consideration to having a plan that directs inheritances to be held in trust. There is no good reason why this strategy should not be a part of an estate plan where children and grandchildren will receive any type of meaningful inheritance. On a lighter note, one other benefit of dynasty planning is that your grandchildren (and great-grandchildren) will always know who their grandparents were! (Hint: your name is on the trust)
Observation One of the first times I recommended dynasty planning to clients, I was told by them that they did not think their adult children would like their inheritances held in trust. I told them to go ask their children. The children said that this is exactly the way they want to inherit (although they were not in a rush to receive an inheritance!). The parents were comforted by both responses.
110 Chapter 13: Dynasty Planning with Trusts Wealth Management Through Estate Planning
Chapter 14: Family Gift Strategies
Giving away wealth is an important facet of many estate plans. There are many different ways to make gifts. This chapter focuses on explaining the reasons to make gifts and takes a look at some of the basic strategies.
Chapter 14: Family Gift Strategies 111 Wealth Management Through Estate Planning
Chapter 14:
◆ What is a Gift
◆ Reasons for Family Gifting
◆ Techniques for Family Gifting
◆ Annual Exclusion Gifts
◆ Uniform Transfers to Minors Act
◆ 529 Plans
◆ Family Gift Trusts
◆ What to Gift
◆ Gift-Splitting Between Spouses
◆ Developing a Family Gifting Strategy
“What we do for ourselves dies with us. What
we do for others and the world remains and
is immortal.”
Albert Pine
11 2 Wealth Management Through Estate Planning
aking gifts to family members In this chapter, we will focus only can be an important part of an on gifts that are made from one natural M estate plan. There are several person to another. The person receiving a important benefits of lifetime giving. The gift does not have to be a family member person making the gift can realize not and gifts to non-family members have the only significant tax advantages from doing same consequences. For convenience and so but also experience the satisfaction of because the great majority of gifts made are watching the recipients enjoy the gifts he to family members, we will refer to gifts as has made. However, before any gifts are being to these persons. made it is important to carefully examine Gifts can be made to entities such as and understand the reasons why and how corporations, foundations and organizations we make gifts. Giving should be part of that qualify as charities for tax purposes. a cohesive strategy that blends personal In Chapter 29: Charitable Planning, we reasons for gifting with a strategy designed examine gifts to charities. For purposes of to maximize potential tax benefits. estate planning, we focus on gifts made to either natural persons or to charities because WHAT IS A GIFT gifts to them will satisfy our personal goals Before examining the various gifting and achieve tax benefits. strategies, we need to examine what is a gift. It is traditionally defined as being a REASONS FOR FAMILY transfer of property from the person making GIFTING the gift (the donor) to another person (the There are a number of important donee). A gift must also be made with the reasons why an estate plan may include a intent to make a gift. This means that the program of family gifting: donor must have what is called donative Personal Reasons for Family Gifting intent. Additionally, the donor must part with One of the most important reasons all dominion and control over the property for making gifts to family members is to be gifted and cannot reserve the right to revoke able to watch them enjoy the gifts. Transfers the gift. Finally, the donee must accept the made at death do not have this advantage. gift. This means that the donee knows of the We also may make gifts during our lifetime gift and exercises control over it. to help family members who are in need Keep this definition of a gift in mind because of health problems or financial as you read this chapter. Observe that difficulties. Sometimes, we may make gifts the definition of a gift is different for tax to assist us in determining the ability of the purposes. As we examine gifting strategies donee to maturely handle finances. In fact, that are tax-motivated, we will see that the gifts are frequently made for a combination Internal Revenue Service uses a different of purposes. definition for determining if a transfer is a gift. However, its method for defining a Estate Tax Savings gift can be used advantageously for the Family gifting can generate significant taxpayer. For example, the IRS includes as tax benefits for the donor and his family. a gift property transferred to a trust when Frequently, property that has been gifted the beneficiary has a right to withdraw the is not part of the donor’s gross estate at property even when the beneficiary fails to death. The potential estate tax savings is the exercise that right. This different manner of donor’s marginal estate tax rate times the defining a gift is important and is used to value of the gift. Additionally, any increase advantage in many estate plans. in the value of the gift is carried out of the
Chapter 14: Family Gift Strategies 11 3 Wealth Management Through Estate Planning
gross estate as well. The significance of these If the donee’s marginal tax rate is less factors is illustrated by the following. than that of the donor, then an immediate savings is realized which will recur annually. Conversely, if the marginal rate of the donee Example Wanda transferred shares of is higher, then this must be factored in and stock with a value of $10,000 compared against the potential estate tax to her son, Sam, in 1996. Wanda dies in 2012 savings gained by making the transfer. and at the time of her death, her estate was worth When the gifting program calls for gifts $1,000,000. Sam retained the shares in his name to grandchildren, we must also evaluate and at the time of his mother’s death, this investment the tax consequences to their parents. In had grown to $20,000 in value. Chapter 8: The Federal Income Tax, there is a discussion of the manner in which income to children is taxed in certain circumstances at The overall federal estate tax savings is the parents’ rates. $8,200 when the marginal tax rate is 41%. Finally, if the donor is transferring $4,100 of the savings results because the property that has appreciated in value, when original gift of $10,000 is not included in the donee sells that property, the donee will Wanda’s estate. The balance of the $8,200 experience capital gains and the consequent savings occurs because the $10,000 of tax cost. appreciation in the value of the gift is not included in her estate. Example Of course, before transfers Harold transfers to his are made, the potential estate son, Max, real property tax consequences to the donee must be with a fair market value of $50,000. Harold’s evaluated. It may not be good tax planning basis (his purchase price) for the property was for an elderly parent to make gifts to a child $25,000. Max sells the property immediately for who has had considerable financial success $50,000. He has $25,000 of capital gains. and does not need to receive the gift. When Max sells the property, he will have Property gifted to that child will be included to pay tax on the capital gains. Assuming capital in his estate at death and subject to estate gains are taxed at 15% at the federal level (and taxes. perhaps subject to state income taxes), Max Also, remember that the tax basis of will have additional income taxes of $3,750 the property transferred is the same for the ($25,000 x 15%). If Max did not receive this donee as it was for the donor and upon property until the death of Harold, he would the death of the donor, the donee does not receive a step-up in the basis of the property equal receive a step-up in basis. For this reason, to its value as of that date. This would eliminate the property that has appreciated in value, capital gains and the subsequent tax. such as real property or stock, may not be appropriate for a family gifting strategy, at least not until after other assets have been Asset Protection Planning considered. This is discussed further below. Sometimes, people may make gifts Income Tax Savings either outright or in trust to children or other Transfers of property by gift also remove family members to remove the property from any income earned from the property from their estate and potential claims of creditors. the donor’s taxable income. In our example, Oftentimes, parents choose to make gifts to the dividends on the shares of stock are taxed children and other family members into trusts to Sam and he is responsible for paying the so that creditors or a divorcing spouse of the income tax at his tax rate. family member cannot reach that property. A family gifting program must consider This strategy is discussed in Chapter 11: Asset the income tax consequences of any transfers. Protection Planning Strategies.
11 4 Chapter 14: Family Gift Strategies Wealth Management Through Estate Planning
TECHNIQUES FOR FAMILY 529 PLANS GIFTING A 529 plan is a qualified tuition Surprisingly, many persons do not program provided for in the Internal realize that there are different ways Revenue Code that allows for money to be they can make gifts. Of course, all of us put aside to grow tax-deferred to pay for understand the simplest form of a gift, post-high school education. To the extent an outright transfer of property to the earnings on the deposits are withdrawn donee. However, this type of gift may be and used to pay for post-high school unsatisfactory because once the gift is made education costs, they are also income tax we lose control over it. Additionally, if the free. However, withdrawals of the income gift is to a minor, the question arises as to earned on deposits into these accounts that how the property is to be controlled and are used for other purposes are subject to supervised until the child is old enough to both income taxation and a 10% penalty. manage it. Further, outright gifts may not Here are some other interesting facts about take advantage of asset protection planning 529 Plans. strategies that are available to protect ◆ There is no income limitation on these wealth from the claims of creditors. plans so everyone can make a contri- In later Chapters, such as Chapter 16: bution. The Irrevocable Trust, we will examine more ◆ Gifts to these accounts also remove sophisticated gifting techniques. Before the assets from the estate of the we get to those topics, however, we need donor, potentially reducing estate to take a look at some of the fundamental taxes at death. gifting techniques that are available. ◆ The donor can decide when with- ANNUAL EXCLUSION GIFTS drawals are to be made from the plans. An effective strategy for family gifting begins by focusing on the use of the gift tax ◆ You can use up to five years of annu- annual exclusion. As we saw in Chapter 5: al exclusion gifts in one year, which The Federal Gift Tax, a donor can make an allows for rapid initial funding of the annual gift to a donee of up to $13,000 accounts. per year and that transfer is not subject to a 529 Plans are attractive for gift tax. Moreover, the donor can make this accumulating money for college and other type of gift to any number of donees and post-high school education programs. the donees can be any person, including However, there are disadvantages of these non-family members. The use of annual plans. For example, the investment options exclusion gifts is also important because under the plans are limited. Also, gifts to they do not use up any of the donor’s these accounts use up annual exclusion gifts estate tax credit. This preserves the estate while other gifts for education are gift tax tax credit for pursuing other lifetime gifting free. strategies or to be available upon the death of the donor. UNIFORM TRANSFERS TO Annual exclusion gifts are a very MINORS ACT useful tool when used in conjunction with Gifts can be made to a custodian for irrevocable trusts. For example, in Chapter the benefit of minors under the Uniform 16: The Irrevocable Trust, we examine how Transfers to Minors Act. This law created these gifts are used to fund an irrevocable what amounts to a statutory form of a trust. trust and to pay premiums on life insurance The donor makes a gift to any person whom owned by the trust. he designates as the custodian, the title
Chapter 14: Family Gift Strategies 11 5 Wealth Management Through Estate Planning
given to the person who is to be responsible should be considered. for the property. The donor may name himself Perhaps most importantly, gifts made or any other adult to act as custodian. When pursuant to the Uniform Transfers to Minors estate tax planning is a consideration, it is not Act must be distributed when the child advisable for the donor to name herself as attains the applicable age of majority and custodian. Under federal estate tax law, the the custodian cannot continue to hold the retention of control over property gifted will property. As we saw in Chapter 9: Wills and cause this property to be taxed in the donor’s Trusts, the donor of a trust can dictate with estate on death. The donor may also name great precision the manner and timing of the a successor custodian who is to act if the distributions to the trust’s beneficiaries. original custodian dies, resigns or is otherwise Even though the law is “Uniform”, it is still unable to function as custodian. necessary to check the law of your state to The law directs how the custodian is to make sure that there are not any changes. It hold and invest the property. It also provides is not uncommon that states vary from uniform general guidelines as to what the custodian laws for a variety of reasons. can spend the money on that he is holding. When the child reaches legal majority under FAMILY GIFT TRUSTS the applicable UTMA law, the custodian is Frequently, parents and grandparents directed to distribute the property to the child. will create trusts and use these to receive Some states allow the donor to extend the gifts made for the benefit of family members. age of termination at the time of the gift or Through the use of a trust, donors can transfer continue to control the timing and manner in Although the Uniform Transfers to Minors which trust income and principal is distributed Act does not restrict the amount that can be to the donee. There are other benefits such as transferred, it is most appropriate when the using asset protection planning strategies to amount to be gifted to a minor is relatively protect these gifts from creditors. small. If the donor intends to transfer a large A person may also make gifts to a trust amount of money or property to the custodian, either immediately or in Planning Strategy When clients are making annual gifts over a period substantial gifts or starting an of years, then this type of annual gifting program, we will frequently recommend arrangement is not entirely that they make the gifts to a Family Gift Trust. The satisfactory. For larger gifts, gifts will still qualify for the annual exclusion with a trust provides greater the additional benefit of wrapping in all of the asset flexibility in holding and protection planning opportunities that trusts can investing the property placed provide. At our website (www.smith-condeni.com) in it. under Library is an article that explains this valuable Also, in this circumstance, planning technique in more detail. it may be advantageous to use a corporate trustee to handle the important responsibilities of established by another. For example, if a managing money and making the appropriate parent established a trust for his children, a distributions to the child. A relative or family grandparent may make a gift into that trust, if friend can function effectively as a custodian the terms of the trust allow gifts by others. when the amount to be managed is relatively Persons making gifts to trusts have to be small. However, if the gifts to the custodian very careful that they do not trigger gift taxes. will be substantial, then a professional trustee Trusts can be established that allow the gifts
11 6 Chapter 14: Family Gift Strategies Wealth Management Through Estate Planning
to qualify for the gift tax annual exclusion. estate taxes offsets some of the taxes on the However, the trust must be carefully drafted capital gains. to allow this and the beneficiaries must be There are many considerations that are notified of the gifts and given a right of relevant when determining what to gift. This withdrawal. is one of the roles of the estate planning In succeeding chapters, we take a attorney: helping to determine the most tax look at various gifting strategies that use efficient way to make a gift. trusts. There are many types of planning techniques that are available. GIFT-SPLITTING BETWEEN SPOUSES WHAT TO GIFT Sometimes an effective gifting strategy Careful thinking before making a gift dictates that the gifts be made by only one can provide many benefits. As a general spouse. However, to maximize the use of the rule, do not give away property that has a annual exclusion the spouses can elect to very low tax basis. This saddles the donee treat the gifts made by one spouse as if they with a low tax basis and capital gains taxes were made equally by both spouses. This is when the property is sold. called gift-splitting and is illustrated by the Give away property that has the following example: highest chance of appreciating in value. To avoid any tax consequences from Retain assets that have the lowest potential these transfers, Renee and Michael will appreciation. This will maximize the tax benefits of gifting. Many times assets with the Example Renee desires to lowest tax basis have the highest make gifts of stock to her rate of appreciation. The growth in five grandchildren. The value of the stock is the equities market is the primary reason $130,000. Her spouse, Michael, is not making behind this in most circumstances. How any gifts to these grandchildren during the might you resolve the conflict of avoiding same calendar year. giving away low basis stock and giving away assets that will grow the most? In some cases, where there are not other assets to give, a person may borrow file a federal gift tax return, and on it, against his equity holdings and give away Michael will indicate his consent to these cash. The cash is then invested in the same gifts being treated as if he made one-half of stock or similar investments that have the them. The effect of this is that Michael, for potential to grow rapidly. The loan is either tax purposes, has made gifts of $65,000 repaid over time or paid at death when the to these grandchildren. All of the gifts are stock in the decedent’s estate has stepped not taxed because each qualifies for the up basis as a result of death. This is a good $13,000 annual gift tax exclusion. Of, strategy to consider when the donor is very course this precludes him from using the ill and has a limited life expectancy. Wait annual exclusion to make other non-taxable until death, get stepped-up basis and then transfers to these persons. sell stocks to re-pay the debt. If they did not elect to use gift-splitting, In other situations, the donor will sell then only $65,000 of the transfers would appreciated securities and pay some be protected by the annual exclusions and capital gains taxes. The payment of the the other $65,000 would be taxed. Renee taxes reduces the value of his estate and would be required to use up a portion of reduces his estate taxes. The reduction in her estate tax credit, or if already used for
Chapter 14: Family Gift Strategies 11 7 Wealth Management Through Estate Planning
prior transfers, pay a gift tax. Periodically review your overall strategy Gift-splitting may be desirable for a and determine if adjustments should be made number of reasons. A common situation is to it. Are the estate tax savings so significant where there is a second marriage and one that you should increase the amount of the spouse wants to give to her children from her gifts? If the amount of the gifts is increased, prior marriage. The second spouse’s annual should you re-evaluate the manner in which exclusion gifts can be used to double up the property is being distributed to each the amounts of the gifts without that spouse family member? actually making any gifts. Implement the plan that you have developed. Following through with your DEVELOPING A FAMILY gifting program is essential to its success. GIFTING STRATEGY Re-evaluate the plan periodically, A well-conceived family gifting strategy even if there is no change in your health requires careful consideration of the factors or finances or the health or finances of that we have examined in this chapter. The other family members. A gifting program is analysis that must be made includes the frequently carried out in an environment that following: is constantly changing. The keys to a successful family gifting ◆ What are your personal wishes and program are to first identify and understand desires about making gifts to family the reasons why you want to make gifts and members? Identify specific reasons why then to structure those gifts in such a manner you want to make gifts. A valid family as to achieve those personal goals and gifting strategy should be based on maximize your tax planning opportunities. The this. greater that you understand and identify your ◆ How much money or property do you goals, the better your estate planning attorney want to gift and to whom? This requires can advise you on the proper strategy to you to analyze your own financial follow. needs as well as the needs of the per- sons to whom you want to make gifts. ◆ What are the estate tax savings that may be realized by making gifts to family members? ◆ What are the income tax consequenc- es to you and the persons to whom you want to make gifts? ◆ What methods will you use to make these gifts? Should the property be given outright to each donee or do you want to control the distributions? How should the gifts be structured to gain the largest tax and other estate planning benefits?
11 8 Chapter 14: Family Gift Strategies Wealth Management Through Estate Planning
Chapter 15: Life Insurance and Estate Planning
Life insurance is a valuable source of wealth that can be used to provide for the support of a family and create liquidity for the payment of debts, administration expenses and estate taxes. However, life insurance proceeds can cause major estate tax consequences if careful planning is not done.
Chapter 15: Life Insurance and Estate Planning 11 9 Wealth Management Through Estate Planning
Chapter 15:
◆ General Purpose of Life Insurance
◆ Life Insurance and Income Taxes
◆ Determining Insurance Needs
◆ What Are the Goals
◆ Determining the Amount of Insurance Needed
◆ Types of Insurance Products
◆ Ownership of Life Insurance Policies
“It requires a great deal of boldness and a
great deal of caution to make a great fortune,
and when you have got it, it requires ten
times as much wit to keep it.”
Ralph Waldo Emerson
120 Wealth Management Through Estate Planning
ife insurance has always played an for the overall estate plan. We begin our important role in estate planning. discussion by looking at why life insurance is L As personal wealth has increased in a valuable component of an estate plan. this country, tax and personal planning issues have driven the widespread use of GENERAL PURPOSE OF LIFE life insurance. Significant among its many INSURANCE benefits are that insurance provides a ready, The primary purpose of life insurance is liquid source of cash to pay estate taxes and to create a source of capital upon the death take care of loved ones during a traumatic of the insured that can be used to take care time for a family. It is also very tax-favored as of the insured’s financial and individual compared to some other investments that we obligations. Insurance policies have the can make. unique ability to instantly create a pool of Of course, understanding the benefits liquid funds at death. When the appropriate of life insurance products in the context of insurance products are matched with the estate and insurance planning is not easy. estate planning needs of the individual and A person buying an insurance product is his family, the estate plan can realize its usually putting hard earned dollars into an full potential of preserving wealth for future investment that he or she will never enjoy. It generations. is not like buying a new car. A policy owner The advice of the estate planning can only imagine how the death benefit will attorney has become more important in make things easier for his family. ascertaining how insurance products can assist in achieving an individual’s goals. This advice has traditionally only been available Observation I experienced the from life insurance agents and financial “lack of enjoyment” planners. However, it is also a responsibility aspect of life insurance with my own family. that the attorney must now assume if the My wife asked me why we needed to keep attorney is to create a fully integrated estate spending money on one of our life insurance plan. As part of the planning process, the policies. I responded that the policy was attorney assists the client in determining what for her and our children in case something his individual goals are and the potential happened to me but we could cancel the estate tax exposure. The estate planning policy and I could get a bigger boat. That attorney will be designing the plan and ended the discussion (and I still have the same creating the documents that are necessary boat). to help the individual achieve these goals. Therefore, she must be involved in advising the individual as to if and then how life insurance products can be of value for the Understanding and explaining the role estate plan. that life insurance may play in an estate An estate planning attorney is in the plan is the job of the estate planning lawyer best position to evaluate both the income and the insurance advisor. When other and estate tax impact of insurance products planning techniques have been exhausted or in a particular plan. Also, he will know how do not fit with the plan, these professionals to correctly structure the ownership of a carefully analyze the client’s remaining policy to maximize the financial benefits and needs and select the product and the amount minimize potential tax costs. It is important of coverage that will be necessary to meet for the attorney to have substantial input those needs. Existing policies are also as to the use of life insurance as part of the evaluated from time to time to determine individual’s overall plan. if they remain appropriate and adequate
Chapter 15: Life Insurance and Estate Planning 121 Wealth Management Through Estate Planning
LIFE INSURANCE AND One way to evaluate the benefits of life INCOME TAXES insurance in an estate plan is to compare the different options that are available. The chart There is a characteristic peculiar to life is based on the cost of insurance for a second- insurance that has helped elevate it to being to-die policy with the assumptions listed in the a major estate planning technique: death box. benefits paid under a life insurance policy are Investments in Estate assumes that generally income tax free. Once this attribute the insureds did not buy life insurance but is fully appreciated, it is easier to know when instead saved and the savings were subject to and how life insurance fits with an estate plan. income and estate taxes. Investments out of The primary exception to this rule is Estate assumes money was given to someone when an insurance policy has been sold. In (children or trust for children) and it was this event, the transfer for value rule is triggered and the portion of the insurance proceeds that exceeds the amount paid Assumptions for the policy is taxed as income to the recipient. This is an unusual event and it Amount of Insurance:...... $1,000,000 occurs generally due to inadvertence or a Insurance Premium...... $13,179 Client Age:...... 65 lack of knowledge of the transfer for value Spouse Age:...... 65 rule. There is no benefit to triggering this Years Premium Paid:...... 30 consequence. Pre-Tax Investment ROR:...... 8.0% Effective Income Tax Rate:...... 30.0% Effective Estate Tax Rate:...... 50.0% The Economics End of Year End of Year End of Year of Life Annual Balance After Tax Investments Investments Insurance insurance Year Outlay Forward Earnings in Estate out of Estate out of Estate 1 13,179 13,179 738 6,959 13,917 1,000,000 2 13,179 27,096 1,517 14,307 28,613 1,000,000 (Illustration and 3 13,179 41,792 2,340 22,066 44,133 1,000,000 analysis courtesy 4 13,179 57,312 3,209 30,261 60,521 1,000,000 of NorthCoast 5 13,179 73,700 4,127 38,914 77,827 1,000,000 Brokerage, 6 13,179 91,006 5,096 48,051 96,103 1,000,000 Cleveland, Ohio) 7 13,179 109,282 6,120 57,701 115,402 1,000,000 8 13,179 128,581 7,201 67,891 135,781 1,000,000 9 13,179 148,960 8,342 78,651 157,302 1,000,000 10 13,179 170,481 9,547 90,014 180,028 1,000,000 11 13,179 193,207 10,820 102,013 204,026 1,000,000 12 13,179 217,205 12,164 114,684 229,396 1,000,000 13 13,179 242,548 13,583 128,065 256,131 1,000,000 14 13,179 269,310 15,081 142,195 284,391 1,000,000 15 13,179 297,570 16,664 157,117 314,234 1,000,000 16 13,179 327,413 18,335 172,874 345,748 1,000,000 17 13,179 358,927 20,100 189,513 379,027 1,000,000 18 13,179 392,206 21,964 207,085 414,169 1,000,000 19 13,179 427,348 23,932 225,640 451,280 1,000,000 20 13,179 464,459 26,010 245,234 490,469 1,000,000 21 13,179 503,648 28,204 265,926 531,852 1,000,000 22 13,179 545,031 30,522 287,776 575,553 1,000,000 23 13,179 588,732 32,969 310,850 621,701 1,000,000 24 13,179 634,880 35,553 335,216 670,433 1,000,000 25 13,179 683,612 38,282 360,947 721,894 1,000,000 26 13,179 735,073 41,164 388,119 776,237 1,000,000 27 13,179 789,416 44,207 416,812 833,623 1,000,000 28 13,179 846,802 47,421 447,112 894,223 1,000,000 29 13,179 907,402 50,815 479,108 958,217 1,000,000 30 13,179 971,396 54,398 512,897 1,025,794 1,000,000
122 Chapter 15: Life Insurance and Estate Planning Wealth Management Through Estate Planning
invested. Insurance out of Estate assumes is evident. ownership of life insurance by someone other than the insureds. Usually, this would be DETERMINING INSURANCE where the life insurance policy is owned by an NEEDS The determination as to whether life insurance is appropriate in each individual’s Observation In the chart on the unique circumstances involves three distinct preceding page, I kept inquiries: the 8% rate of return used in the 2006 edition. This only strengthens the potential value of ◆ What are the financial and estate plan- the life insurance as a smaller rate of return ning goals of the individual? reduces the values in the Investments in Estate ◆ What amount of financial resources are and Investments out of Estate columns. needed to achieve these goals? ◆ Which life insurance products are appropriate to fulfill these goals? irrevocable life insurance trust. The insurance component of an estate plan Year 22 is the statistical median age for is examined with these questions in mind. Once a couple who are both age 65. This means these questions are answered, a person can that one half of the couples are deceased by this age and one Opinion I typically half survive past 22 years. At this recommend that clients median point the net economic buy permanent insurance as opposed to value of the life insurance death benefit term insurance (more about this later in this is substantially larger than the amount chapter). One of the reasons is that over time that is available under the other two clients’ goals change and I want to make sure scenarios. The primary reason for the that insurance coverage can be maintained disparity between the scenarios is that for these new, emerging objectives. Life the life insurance death benefit is both insurance purchased to provide for a family income and estate tax free. While the with young children frequently finds another investments outside of the the estate are use later in life after the children are out of the estate tax free, they are not income tax house. I see this very frequently in my practice free. Investments inside the estate are with clients I have had for many years. subject to both taxes and for this reason is the least satisfactory result. The table also illustrates the leveraging of premium dollars. When a client decide what to do. purchases life insurance, a relatively small premium payment translates into a large WHAT ARE THE GOALS amount of money at the insured’s death After listening to the client, the estate whenever it occurs, even if the death occurs planning attorney should have a good one day after the policy has been put into understanding of what the client wants to force. That’s a rate of return that’s hard to beat! achieve with his estate plan. Only then can When this leveraging trait is combined with the the attorney advise the client in regard to how immediate liquidity and tax free attributes of life the use of life insurance products can assist in insurance, the financial power of life insurance
Chapter 15: Life Insurance and Estate Planning 123 Wealth Management Through Estate Planning
achieving these goals. ◆ Create a ready source of capital to Why use life insurance? It has the unique fund a buy-sell agreement with other ability to create at death a large available owners of a closely-held corporation or source of liquid capital without the risk of the partnership to provide an exit strategy fluctuating values of other investments. It is for the shareholder’s family. also protection against an untimely death. ◆ Create a source of funds to pay busi- When determining goals, a client should ness operating expenses, keeping consider both his short-term and long-term in mind that the death of a business responsibilities and objectives. Some of the owner may severely effect the short- major goals that individuals seek to achieve term viability of that business. through the use of insurance are to: ◆ Provide a source of funds to pay feder- ◆ Make sure that there will be an ade- al and state estate taxes, expenses of quate source of capital to provide for estate administration and other debts food, shelter and clothing and other that occur at death. living expenses for their dependents. ◆ Replace wealth for the family in ◆ Have sufficient funds available to pay instances where the client has made debts and final expenses. substantial gifts to charity and wants ◆ Help fund the college education to replace that money, income and of children and, if the individual so estate tax free, at his death so that the desires, grandchildren. family’s inheritance is not reduced. ◆ Provide for any special needs of ◆ Create wealth for future generations survivors, such as funding the costs of that is free of income, capital gains long term care of a child who may be and estate taxes. mentally or physically handicapped There are other goals that over time will or otherwise unable to provide for his become more important. One of these is own care. that the purchase of life insurance will allow ◆ Fulfill charitable goals by making surviving family members to maximize their a direct payment to a charity or to a opportunity to stretch out as far as possible fund, such as a private foundation, that distributions from qualified plans, IRA's and an individual may want to create. annuities and maximize the benefit of deferral of the payment of income taxes on these types of accounts. This is becoming a larger issue as Observation the amounts accumulated in these accounts The new IRA becomes not only a very significant asset but distribution regulations a substantial portion of a family’s wealth. that went into effect in 2002 have Instead of taking money out of these accounts dramatically increased the importance of to pay taxes or provide for financial support, maintaining wealth inside an IRA. Under these insurance death benefits are used for these rules, discussed in more detail in Chapter purposes. The accounts continue to grow tax 28: Planning With Retirement Accounts, deferred. the required distributions to a non-spouse beneficiary can be spread out over the life of DETERMINING THE AMOUNT that person. The new regulations enable long- OF INSURANCE NEEDED term deferral of income taxes. Life insurance is of significant benefit when the dollars to pay After an individual has decided on his taxes or to support a family would otherwise short-term and long-term goals, he then has have to be prematurely withdrawn from IRA's. to determine how much insurance is needed.
124 Chapter 15: Life Insurance and Estate Planning Wealth Management Through Estate Planning
This “gap” is a function of evaluating the The applicability of insurance in any amount of capital needed to fulfill these particular situation is determined by the goals and subtracting the amount that can be unique facts of that individual’s situation and satisfied by present financial resources. his personal and financial obligations. Here In order to properly analyze what are the are two examples which isolate the planning capital needs of an individual and his family, considerations. there must be an assessment of a number of Life Insurance for Liquidity: factors such as the following: A parent has two children, ages 12 and ◆ The ages of the individual and his 14. If the parent wants to make sure that spouse. sufficient funds are available to provide for ◆ The present health of the individual, his the support of these children and their college spouse and other family members and education, then estimates have to be made how this impacts their need for financial as to these costs. In our example, if the parent support . believes that he needs $300,000 per child to provide for the child’s support during the ◆ The present employment of the indi- balance of each child’s minority and for each vidual and his spouse. child’s college education, then the amount of ◆ Current job security and future total need is estimated at $600,000. Once employability. the goal and the “gap” is determined, the ◆ Present income and anticipated future insurance advisor must work with the client earnings. to select the best insurance product to fill the gap. ◆ The number of children in the family, their ages and the anticipated cost of providing for them. ◆ Special needs of any dependent who may be mentally or physically handi- capped. ◆ The present financial resources of the family. ◆ The family’s potential financial resources by reason of savings, inheri- tances, gifts and the like. ◆ Anticipated cash needs at death to pay for any estate taxes and estate administration expenses. ◆ Other financial obligations that may have to be satisfied at death. ◆ The amount of disposable resources available to buy insurance. All of these factors (and perhaps others) must be considered in evaluating the appropriate level of insurance. Each of these factors separately and collectively impact the total amount of need.
Chapter 15: Life Insurance and Estate Planning 125 Wealth Management Through Estate Planning
Life Insurance for Estate Tax Planning: planning goals is to leverage the premium A parent has two children, ages 25 dollars to create liquidity and wealth at death. and 28. It is likely that their educational Term Life Insurance needs have been satisfied and that they are The simplest form of insurance is term life financially independent. The parent has an insurance. The premiums due remain level for estate of $4,000,000, consisting of a house, a “term” i.e., the number of years declared a vacation home, savings and retirement in the policy. At the end of that period, the Generally, you are assets. If the parent wants to ensure that these premium amount increases or the insurance resources pass to the children undiminished better off buying a policy is terminated with no residual benefit by taxes, then the taxes must be estimated left in the policy. permanent insurance both under the current scenario and with Term insurance is “pure” insurance in product such as uni- a projection of reasonable growth. Using the sense that the premium dollars paid versal life than buy- these figures, the parent can determine if life insures the actuarially determined risk of ing term insurance. insurance is advisable to provide a ready death of the insured during the term of the means of payment of estate taxes due 9 As you get older, the policy. The premium dollars also pay for months after death, without requiring the the administrative costs and expenses of the cost of term insur- liquidation of assets. The goal has been insurance company and provide profit to the ance will become too identified and the “gap” must be estimated. insurance company. high. Most people Only after this process is complete can the There is no build up of any cash value insurance product be considered in the full end up dropping within the policy. It is the least expensive way, context. their term insur- at least in the short-term, to insure risk. Term Please understand that the estimates of insurance is advisable in two principal types ance as evidenced need that are made for an individual are of situations: by the fact that no just that, estimates. No one can predict with ◆ The financial resources of the insured mathematical accuracy the amount that will more than 2% of the are limited and keeping the cost of be required. However, insurance is a relatively term policies issued insurance to a minimum is paramount. inexpensive method to solve financial need. pay off with a death In fact, conservative planning dictates that an ◆ The need for insurance is temporary. benefit. Buy a policy individual purchase slightly more insurance In some cases, the risks to be insured that you can not only than the projected need, especially while against may be for a limited time and the live with but can die the insured enjoys good health, to cover individual may have determined that he unforeseen events and increases in the costs does not need to insure for the risk beyond with! of living. that period. For example, a young couple The best estimate of need is made with small children may have limited dollars after full and careful consultation with the they can afford to spend on life insurance. estate planning attorney, financial advisor However, they also have a significant need to and insurance agent. While this detailed insure for the financial consequences of the analysis sounds complicated, it is not difficult untimely death of the primary wage earner. for an experienced professional to assist in Term insurance is likely to be the appropriate determining the “gap.” product in this situation. One of the shortcomings of term life TYPES OF INSURANCE insurance is it becomes more expensive PRODUCTS as an individual gets older. As the insured There are many types of insurance ages, the mortality factor increases and the products. Some products are better suited for cost of insurance rises dramatically. While short-term goals and other products satisfy term insurance is relatively cheap with a long-term goals. Remember that the primary younger insured, the expense is frequently reason to use life insurance to achieve estate unacceptable later in life.
126 Chapter 15: Life Insurance and Estate Planning Wealth Management Through Estate Planning
Term insurance is either renewable or non- There are distinct differences between the renewable. If the term insurance policy is not three products which are discussed below. renewable, the coverage ends at the end of Whole Life Insurance the term. To continue with insurance coverage, A whole life insurance policy, like a a new policy has to be purchased and the term policy, charges a premium expense to insured must be again medically underwritten. insure against the risk of loss, to pay for the Renewable term insurance allows the administrative expenses of the insurance policyholder to renew coverage at one or company and to provide a profit. The more renewal dates, possibly without another significant difference between these two types medical examination. Of course, the ability to of policies is that a whole life policy charges renew the policy effects the premium that is extra premium dollars to provide for a cash paid and the cost of renewable term insurance build-up within the policy. This cash build-up is is more expensive than non-renewable. referred to as the cash surrender value of the To further complicate matters, some policy. policies allow a conversion feature over to Whole life products are less flexible in permanent life insurance (see below) so that that each and every premium payment must coverage may be maintained during the life be made or the policy will lapse. Also, the of the insured. This also adds a cost to the insured takes on less risk in the performance premium. of the policy investments. Instead, this risk is What we see with term insurance is that borne by the insurance company. As we will policy options can be added for greater see, this is not true with universal and variable flexibility, but with each option, there will be insurance products. an additional cost. The tradeoffs have to be The best reason to purchase whole life fully analyzed, understood and appreciated. insurance rather than term insurance is when Permanent Insurance there is a long-term funding need. A whole life The other type of insurance is permanent policy continues for the lifetime of the insured, insurance or insurance that you can keep unlike a term policy. It will be there to meet in force for the rest of your life, without the need when the insured dies. Conservative requiring any further determination of health planning may require that a whole life policy or insurability. The only requirement is that you be purchased to provide for identifiable have to keep paying for it, either over the rest short-term needs and also be available for of your life or for a shorter term that you select unanticipated future requirements. at the inception of the policy. There are three Universal Life basic types of permanent insurance: whole One way to describe a universal life policy life, universal life and variable universal life. is that it allows the owner to buy term and invest These three products have several the rest (on a tax-free basis), all within the same common features. Any earnings on the policy. Premiums paid are first applied to sales investments made within the policy are charges and the balance is put into an account income tax free. While many policies require which is then credited with interest based on payment for life, they can be structured to be the current rate that the insurance company is paid in full in a shorter period, for example, allowing. From this account monthly deductions over ten years. Each annual payment would are made for administration expenses and the be more than a payment over a lifetime, but mortality cost. the extra dollars stuffed in the policy at the Universal policies have a guaranteed rate beginning are invested, so the policy builds up of return, which means in all events there will a cash value. The cash value is then used to be some interest credited to the account. pay mortality costs as you get older.
Chapter 15: Life Insurance and Estate Planning 127 Wealth Management Through Estate Planning
Hopefully, the interest rate credited to the claims against the insurance company. policy will be larger than the guarantee. If Variable policies have become more this occurs, the cash value in the policy will popular for many persons because the initial be larger. This makes the policy stronger and premium cost is less. This is because the in some cases may mean that some premium illustrations usually assume a higher rate of payments may be skipped. return on the cash in the policy that is invested. Universal life policies vary from whole life This is because the funds can be invested in products because the owner does not have to securities, which historically have a higher rate pay a fixed premium cost for the policy and of return than other investments. The higher can vary the amount paid for a number of the rate of return, the more the build up in the reasons. For example, premium payments may policy cash value which is then available to be skipped if there is enough cash value in the pay mortality costs. However, if the policy policy to make the payment. At other times, does not perform as illustrated, then additional when the owner has additional available premium payments may be needed in later funds, he may increase the premium payments, years to support the policy. increasing the cash value. For this reason, variable insurance policies Also, unlike whole life, universal life should be purchased by those persons who policies can provide for increased or reduced can take fluctuations in the market over a long death benefits if the owner so demands, period of time and believe that the market will subject to the terms of the policy. outperform fixed investments. If the insured is The trade off in this flexibility is that older, the owner may not want to take the risk the policy performance must be carefully in a shorter term stock market and may select monitored to make sure that the policy meets the whole life or universal life options. the policy owner’s expectations. The risks Second-to-Die Life Insurance and benefits of a universal life policy versus a Second-to-die life insurance (also called whole life policy must be carefully examined. survivorship life insurance) has rapidly become Variable Universal Life an important tool for estate planning. The A variable life insurance policy is similar primary reason for this is that the risk to be to a universal life policy except that the policy insured is closely matched to the product owner has the right to invest the cash in the being purchased. Second-to-die insurance policy among different investment funds policies insure two lives and only pay off on selected by the owner. For example, the policy the death of the surviving insured. Because of may allow the owner to select among funds this, the premiums for these policies are usually that invest in growth stocks or money market significantly less than the cost of an insurance investments. This is different from a universal policy insuring one life. life policy where the insurance company This type of policy is frequently used determines the interest rate to be credited when a husband and wife want to make sure to the amount in the policy. The investment that funds are available to pay estate taxes options, however, are restricted to those or provide liquidity for other tax or personal offered by the insurance company. Also, the planning reasons on the death of the surviving owner of the policy has the right to change spouse. The money is not needed until that investments. time, asssuming all estate taxes are deferred Variable contracts also are different from until both spouses are deceased, and the universal contracts in that the investments in policy is designed to insure just that risk. these contracts are owned by the owner and Why buy a second-to-die policy instead are separate and distinct from investments of a single life policy? Part of the answer lies owned by the insurance company. The in the financial costs of each of these policies. investments in the account are not subject to The cost of survivorship life insurance is
128 Chapter 15: Life Insurance and Estate Planning Wealth Management Through Estate Planning
significantly less because of joint mortality should we care about the ownership of a life factors, the risks insured and the fact that insurance policy? If a person dies owning any incidents of ownership in a policy of life insurance, the proceeds of that policy Observation The joint life are included in his gross estate for federal expectancy of two estate tax purposes. See Chapter 4: The lives is longer than the life expectancy Federal Estate Tax. Many people do not of either individual life. A 70 year old realize that while the death benefits are and a 75 year old have respectively income tax exempt, they are not exempt life expectancies of 16 and 12.5 from estate taxes. With a comprehensive years. Their joint life expectancy is plan, the ownership of the policy can be set 18.8 years. Both persons need to up so that the proceeds escape estate taxes. die to make the event of both deaths The best solution to this problem is occur. At any point in time two deaths for the insured to create an irrevocable are less likely to occur than one death. life insurance trust which purchases and owns the life insurance policy. When done correctly, this keeps the death benefits of the only one policy is issued for the risk instead policy entirely out of the decedent’s taxable of two separate policies. A second-to-die estate. This can generate an enormous policy on a husband and wife may cost estate tax savings. This strategy is discussed half as much as the same death benefit split in Chapter 16: The Irrevocable Trust. between a policy on the husband’s life and It is usually not advisable to have the a policy on the wife’s life. However, keep in policy owned by other family members. Of mind that with this type of contract you will course, the insured’s spouse should never be probably pay premiums for a longer period the owner. On his death, the proceeds (and of time – until the death of both spouses. any growth in their value) are taxed in his Another reason to purchase this type of estate. policy is that it is easier to get underwritten. It is also not advisable to have the Insurance companies are less concerned insured’s children own the policy. There are about health issues when underwriting one several important reasons for this: of these policies. Both persons must die ◆ If the child dies, the policy may end before the death benefit has to be paid. In up being owned by a son-in-law or some cases, insurance companies will issue daughter-in-law. The future availability this type of policy even if one of the insureds of the death benefit may be severely is uninsurable. compromised. OWNERSHIP OF LIFE ◆ The cash value in the policy is an asset that could be subjected to divi- INSURANCE POLICIES sion in a divorce case. Once the amount and type of ◆ A child may unilaterally decide to insurance is determined, the ownership use the cash values in the policy for and beneficiaries of the policies must be personal expenses, undermining the addressed. The failure to properly address value of the policy. this issue can cause expensive adverse tax consequences. ◆ You cannot control the distribution of If insurance is being purchased the death benefit and the proceeds to fund estate tax liabilities, it is highly cannot be added to an asset protec- advantageous if that insurance is not tion trust to shield its value from credi- owned by that insured person but is owned tors of the child or from future estate by someone other than the insured. Why taxation on the death of a child.
Chapter 15: Life Insurance and Estate Planning 129 Wealth Management Through Estate Planning
How do you handle ownership if there An attorney dedicated to practicing in are several children? If only one child owns the estate planning area will not only provide the policy, she is not legally obligated to objective advice in the selection of the divide the death benefit with her siblings if she insurance product. He can and should also is also the sole beneficiary. offer counsel on the ownership of the policy If all of the children own the policy, in order to maximize the benefits of acquiring what happens if one of them dies before life insurance. the insured? This person’s interest in the policy goes through estate administration CONCLUSION and is distributed to that person’s heirs in The insurance needs of a family engaging accordance with her Will or under the laws of in the estate planning process must be descent and distribution. carefully analyzed. By matching the policies The benefit of setting up an insurance to the needs of a family, the value of life trust to own life insurance is that the insured insurance can be maximized. The services of can guarantee the availability of the death an advisor who is skilled in insurance products benefit for its intended purposes, free from is critical to making the right decisions. interference. If the insurance is purchased to fund a buy-out agreement among shareholders of a closely-held corporation, it may be advisable if that life insurance is cross-owned by the shareholders rather than owned by their corporation. Corporate ownership of life insurance can cause tax problems such as being subject to the alternative minimum tax. In some situations, excess insurance proceeds (i.e. those not needed to purchase stock of a deceased shareholder) that are distributed to officers or shareholders can become subject to income taxes.
130 Chapter 15: Life Insurance and Estate Planning Wealth Management Through Estate Planning
Chapter 16: The Irrevocable Trust
Irrevocable trusts are frequently an important component of an estate plan. They are useful for reducing estate taxes and implementing asset protection planning strategies.
Chapter 16: The Irrevocable Trust 131 Wealth Management Through Estate Planning
Chapter 16:
◆ Reasons for the Trust
◆ Structure of the Irrevocable Trust
◆ Life Insurance and the Irrevocable Trust
◆ Types of Life Insurance Trusts
◆ Family Gift Trust
“He does not possess wealth; it possesses him.”
Benjamin Franklin
132 Wealth Management Through Estate Planning
ne of the most powerful estate planning tools available is the Example Jerry transfers O irrevocable trust. It is a highly $100,000 to the trustee technical document and the administration of the irrevocable trust that he established. He and operation of this trust are strictly retains neither ownership rights nor the ability to governed by many rules and procedures control the property in the trust. The trustee he that must be carefully followed. However, designated is to hold the property in trust and use if everything is done properly, enormous the income and principal of the trust to pay for the benefits, especially with regard to estate support and education of Jerry’s children. tax savings and asset protection planning, can be achieved. Keep in mind while reading this What are the potential consequences chapter that the irrevocable trust is a trust of this set of facts? that has special characteristics that do not ◆ He has set aside money to pay for appear in other trust documents. This is specific obligations that he expects to necessary because of the special benefits incur in the future. The money will be that these types of trusts are designed there and no one (not even Jerry) can to achieve and also because the trust interfere with its use or availability. agreement cannot be changed once it is ◆ If structured properly, the original executed and put into place. gift to the trust is not included in his estate for estate tax purposes. This REASONS FOR THIS TRUST will reduce tax liabilities at death, There are many important benefits that increasing the amount of money flow from creating an irrevocable trust and available to take care of his family. transferring property into it. These trusts ◆ are invaluable for achieving the tax and If properly done, there will be no fed- personal planning goals of the person eral gift tax on the transfers into the creating the trust. While estate planning trust. Within certain parameters, the with these types of trusts can be complex, transfers to the trust can be gift tax the benefits make it well worth the work. free. The initial reason for setting up an ◆ Property in the trust that is not irrevocable trust is to create a separate trust needed for short term purposes will entity to which assets can be transferred. be invested. The growth in the trust Irrevocable trusts can hold virtually any type principal will also be available for of asset. There are some exceptions to this. his children. For instance, these types of trusts cannot ◆ Any appreciation in the value of the own assets such as retirement accounts property held in the trust will also not and annuities. These trusts can hold real be included in his estate. This increas- estate, stocks and bonds, tangible personal es the tax planning benefits of having property such as artwork and collectibles an irrevocable trust. and many other things. As we will see, they ◆ When Jerry sets up the trust, he can are also extremely valuable as owners of select among various options as to life insurance policies. who is responsible for paying any Let us start with a simple example that income and capital gains taxes on identifies some of the important fundamental the trust property. These taxes could benefits of these trusts before we get into the be paid by Jerry, by the trust or by more complex strategies. the beneficiaries. The trust can be structured to maximize income tax planning alternatives.
Chapter 16: The Irrevocable Trust 133 Wealth Management Through Estate Planning
◆ The trust agreement can be written so The donor of this type of trust makes a gift as to protect the principal of the trust of property to the trust. However, this is not from any of his creditors and any credi- sufficient by itself to allow the gift to qualify tors of his children. for the annual $13,000 gift tax exclusion. In ◆ There may be some income tax savings Chapter 5: The Federal Gift Tax, we saw that using the lower rate brackets of the a person can give up to $13,000 per year trust and the beneficiaries. to anyone without incurring a gift tax. This exclusion is only available if the gift is made to The withdrawal The tax benefits of the irrevocable trust a natural person and for this reason a gift to a rights are often will be investigated more thoroughly as we trust does not qualify for this exclusion. closely examine this planning tool. Keep in called Crummey There is an exception to this rule, however. mind that tax planning and long term asset powers. The name If the beneficiaries of the trust have the right protection planning are the primary reasons is derived from the to withdraw the transfers to the trust, then for using an irrevocable trust as part of an lawsuit a taxpayer, the transfers qualify for the annual exclusion. estate plan. These rights of withdrawal make the Dr. Crummey, had The personal planning reasons for using transfers present interests for purposes of the with the IRS over the irrevocable trust are no different than the federal gift tax. the right to claim reasons for using the revocable trust. In fact, Qualifying the gifts for the annual oftentimes a sophisticated estate plan will use that these types exclusion is important. If the gifts do not revocable and irrevocable trusts at the same of transfers quali- qualify, then the donor must use up part of his time with identical provisions for distributing fied for the gift tax estate tax credit to avoid the payment of any trust property to take care of the client’s family. annual exclusion. gift tax. However, the irrevocable trust will be used to Dr. Crummey won achieve tax goals that the revocable trust and this tactic has is incapable of securing. Example been used ever An irrevocable trust is not appropriate John transfers since. for all estate plans. In fact, it should be $50,000 to a trust used only in circumstances where there are and his five children are the beneficiaries. If specifically identified goals to be achieved. the trust document does not provide a right of This is because the terms of the trust cannot withdrawal, then the transfers would be taxed be changed once the document is executed as follows: by the donor and the trustee and any Amount of gift $50,000 property transferred into the trust cannot Tentative tax $10,600 be withdrawn by the donor. The donor Less gift tax credit $10,600 loses direct dominion and control over any Gift tax due $0 property once it is placed in the trust. This is the cost of securing the benefits of this type of trust. The donor still does not have a gift tax due. Use of part of John’s gift tax credit avoids STRUCTURE OF THE the payment of any gift tax. However, in the IRREVOCABLE TRUST above example, he had to use up part of The irrevocable trust usually contains all his estate tax credit to avoid the payment of of the language that we see in a revocable the gift tax. The available gift tax credit for trust. However, for a variety of reasons, later lifetime transfers or to be used to avoid there are additional provisions that must be payment of the federal estate tax at his death included. These provisions are designed to has been effectively reduced by $10,600. secure the potentially enormous benefits of the Furthermore, use of the gift tax annual irrevocable trust. These special provisions can exclusions has been wasted. perhaps be best understood in the context of examining how the irrevocable trust functions.
134 Chapter 16: The Irrevocable Trust Wealth Management Through Estate Planning
These are the mechanics of how There is no gift tax owed by Jane the trust document allows the transfers to because of this transfer. $65,000 of the qualify for the annual exclusion. In the gift is not taxed because of the use of five trust document, the donor gives to each annual exclusion gifts. The other $135,000 beneficiary the right to remove a portion of the gift is not taxed because Jane uses a of the property he has placed into the portion of her estate tax credit. trust. Typically, if there is more than one How has Jane leveraged the use of her beneficiary, each beneficiary is entitled to estate tax credit? The leveraging occurs withdraw an equal share of the property because over time the amount of property transferred. In our example, each of John’s placed in the irrevocable trust grows due to five children would be allowed to withdraw the investment return realized on the assets one-fifth of the property contributed placed in the trust. The trustee is required ($10,000). This amount falls within the by the terms of the document (just as he is annual exclusion and there is no gift tax required by the terms of a revocable trust) consequence to making the transfer. to invest the money placed in the trust in a Usually, the trust document provides prudent manner so that a reasonable rate a time period for exercising each of return will be experienced. If the average beneficiary’s right of withdrawal and if the rate of return over a ten year period is 7% , withdrawal power is not exercised within then the amount of property in the trust will that period, it lapses and the beneficiary have doubled to $400,000. can no longer withdraw that property. By making $200,000 in gifts and The time period for exercising the right of utilizing a small portion of her estate tax withdrawal is frequently of at least 30 days credit, Jane is able to remove $400,000 duration. from her estate for estate tax purposes. If Careful planning goes into the funding she had not made the gifts, an additional of the trust. The amount of property to be $200,000 would still be in her personal added to the trust each year reflects the estate ten years later which, upon death, number of beneficiaries of the trust. The would either use up more of the estate tax first planning goal is to use up all of the credit or cause additional estate taxes in her available $13,000 exclusions. Therefore, estate. The overall tax effect of this strategy if the trust has three beneficiaries, the is very similar to that experienced when donor can make $39,000 of gifts without Trust B of a revocable trust is funded on the experiencing a gift tax or having to use up death of the donor. The growth in the assets part of his estate tax credit. in Trust B, along with the original principal, Sometimes, a donor will gift amounts are not included in the estate of the spouse/ into the trust that exceed the available beneficiary. annual $13,000 exclusions. As indicated in The critical tactical principals are the above example, he can still avoid a gift that the early use of the estate tax credit tax by judicious use of the estate tax credit. and making sure that gifts qualify for the There is a significant tax reason for doing $13,000 annual exclusion whenever this. This leverages the use of the credit as possible captures the best tax benefits for well as the annual exclusion gifts. the person making the gift. Good estate planning requires an appreciation of the Example potential benefits of following a course of Jane transfers into action and the commitment to carrying out her irrevocable trust that action plan. $200,000. The income and principal of the trust is to be used to provide for the care and education of her five children.
Chapter 16: The Irrevocable Trust 135 Wealth Management Through Estate Planning
LIFE INSURANCE AND THE the policy is not brought back into his estate IRREVOCABLE TRUST because the insured never had any incidents of ownership in the policy. It is important Life insurance is a particularly to keep this in mind when considering the appropriate asset to gift into an irrevocable trust. The value of a gift of life insurance is purchase of a new policy. its cash surrender value and not the face value of the policy. By gifting an insurance TYPES OF LIFE INSURANCE policy into an irrevocable trust, the donor is TRUSTS removing from his estate the full amount of There are several types of insurance trusts the proceeds payable at his death. The only that are available. Determining which one is requirement imposed by the Internal Revenue appropriate in any particular circumstance Code is that the donor live at least three depends on a number of factors. One of the years after the transfer. If he does not, the determinants is the type of life insurance that proceeds of the policy are brought back into is appropriate for the overall estate plan. his estate for tax purposes. Insurance Trust Insuring One Life To implement this strategy, the donor of This trust is used where the insurance the irrevocable trust transfers to that trust his policy to be owned by the trust only insures interest in an insurance policy on his life. At one life. A very common example is life this point, the irrevocable trust functions in the insurance on one spouse owned by the trust same way as any other irrevocable trust. The and the other spouse and children are the beneficiaries are notified of the gift and given beneficiaries. the right to make a withdrawal of the policy within the time period specified in the trust Insurance Trust Insuring Two Lives document. The expectation is that they will not In the previous chapter, we discussed the exercise their rights of withdrawal. use of second to die life insurance. Usually, Thereafter, the donor makes annual a life insurance trust that owns this type of contributions to the trust which are used to policy excludes both spouses from being pay the premiums on the policy. Of course, beneficiaries of the trust. The reason for this before the premiums can be paid with these is to avoid inclusion of the life insurance gifts, the beneficiaries are given the right to proceeds in the estate of either spouse. withdraw this property. The concern is that if an insured is a The annual gifts to pay the premium beneficiary of the insurance trust, this person qualify for the annual gift exclusions in the may have incidents of ownership in the same manner as any other gifts. If the amount insurance policy owned by the trust. Where of the gift exceeds the available annual a person dies having any interest or control exclusions, the estate tax credit is used to over a life insurance policy (i.e. incidents of avoid any gift tax. ownership), the proceeds of the policy are The estate tax benefits of an irrevocable included in that person’s estate. To avoid life insurance trust are enormous. By this issue, frequently, neither spouse is the transferring an asset of relatively small value beneficiary of the life insurance trust. Instead, to the trust (the cash value of an insurance the beneficiaries are their children. policy), the donor is able to remove from his Insurance Trust with Spousal Access estate a large asset, the death proceeds of That neither spouse may be a beneficiary the policy. of an insurance trust owning second to die life An even better strategy is for the trustee insurance is a concern to some couples. The of the irrevocable trust to apply for and own reason is obviously not related to the death the policy. By doing this, the three year rule benefit because the policy will only pay off is avoided completely. If the insured/donor when both are deceased. of the trust dies within three years of death,
136 Chapter 16: The Irrevocable Trust Wealth Management Through Estate Planning
The Irrevocable Life Insurance Trust
Donor 1. Donor creates Irrevocable Life Insurance Trust
2. Donor gifts cash to trust
Irrevocable Life Insurance Trust
3. Trustee buys insurance policy on Donor's life
4. Trustee notifies 6. Trustee uses gift to pay beneficiaries of gift insurance premium
5. Beneficiaries fail 7. On death of Donor, proceeds to withdraw gifts distributed to beneficiaries as from trust Donor instructed in trust
Beneficiaries
Chapter 16: The Irrevocable Trust 137 Wealth Management Through Estate Planning
The problem is that some of these secure the benefits of having these gifts in a insurance policies are structured to trust instead of outright to family members. In accumulate large cash values and the other parts of this book, we have taken a look insureds do not want to be totally excluded at the use of trusts for tax planning and asset from accessing these cash values at some protection planning. For many of these trusts, time in the future. Where substantial premiums the planning benefits for family members do are being paid and large cash values may not take effect until the death of the donor. accumulate, consideration should be given For example, a revocable living trust does to creating an insurance trust that avoids the not normally have benefits for children of the incidents of ownership rule. This type of trust is donor until after the donor’s death. frequently called a Spousal Access Trust. Parents and grandparents create Family With a Spousal Access Trust, one of the Gift Trusts so that the significant long-term spouses (but not both) can be a beneficiary benefits of holding property in trust for of the insurance trust. That person is limited descendants can start during their lifetimes to receiving distributions from the trust that and not wait until after their deaths. are limited to an ascertainable standard of The use of this type of trust is also helpful health, support, maintenance and education. in a number of other ways. There is some Policy cash values are accessed by tax-free ability to favorably use the lower portions withdrawals up to the amount of premiums of the income tax brackets for trusts. This is contributed to the policy. For withdrawals especially helpful where children are in high beyond that, the trustee takes out cash as a tax brackets. loan against the policy value. This cash is then In Chapter 13: Dynasty Planning With distributed to the spouse as beneficiary. Trusts, we examined the benefits of allocating This type of trust has to be designed very the exemption to the generation-skipping carefully to avoid having the death benefit transfer tax early, leveraging it to exempt from included in the spouse/beneficiary’s estate. future taxation not just the property transferred For example, this spouse cannot be the trustee but all of the growth of that property. This and should not be the trust advisor. Any strategy is even more useful when the position of authority with the trust could cause exemption is used during lifetime rather than inclusion of the proceeds of the policy in the at death through gifts to Family Gift Trusts. spouse’s estate if this person had any control These trusts can hold an insurance or direction over the life insurance policy. policy as one of the assets. However, for As with many sophisticated estate other planning reasons, this is not normally planning techniques, there are many details recommended. that must be followed to make this insurance planning strategy work. CONCLUSION Irrevocable trusts have many uses in FAMILY GIFT TRUST an estate plan. They are important for tax Another type of trust that is very useful planning, asset protection planning and for lifetime gifting is the Family Gift Trust. obtaining the near and long term goals of a This is the name our law firm has given to an family. The strategies discussed in this chapter irrevocable trust that is designed for lifetime focused on the primary uses of these types of gifts of property to family members. A more trust for achieving these goals. In Chapter 19: detailed explanation of this valuable planning Other Planning Techniques, we take a look at strategy is available at our website, some other strategies based on irrevocable www.smith-condeni.com under Library. trusts. The initial premise for setting up one of these trusts is that a parent wants to make gifts to children and grandchildren but wants to
138 Chapter 16: The Irrevocable Trust Wealth Management Through Estate Planning
Chapter 17: Family Limited Partnerships and Limited Liability Companies
Partnerships and limited liability companies have become important components of many estate plans. They are used for many reasons including management of family assets, estate and income tax planning and asset protection planning. This chapter takes a look at the many facets of these entities.
Chapter 17: Family Limited Partnerships and Limited Liability Companies 139 Wealth Management Through Estate Planning
Chapter 17:
◆ Limited Liability ◆ General Partners ◆ Limited Partners ◆ Partnership Assets ◆ Fractionalization of Partnership Interests ◆ Valuation Discounts ◆ Application of Valuation Discounts ◆ Support for the Application of a Valuation Discount ◆ Business Purpose of the Partnership ◆ Transfer of Partnership Interests ◆ Dissolution of a Limited Partrnership ◆ Income Tax Consequences of Limited Partnerships ◆ Other Estate Planning Benefits of an FLP ◆ The FLP Versus the Limited Liability Company
“Tax avoidance is legal; tax evasion is not.”
Anon.
140 Wealth Management Through Estate Planning
family limited partnership (FLP) is a same tax return that is filed by an FLP. partnership among family members that is When establishing an FLP or LLC, a written Acreated to allow joint ownership of family- agreement should be drafted and signed by all owned assets. The existence of the partnership is parties. In the absence of a written agreement or evidenced by a written agreement that details the for issues not covered by the written agreement, terms of the partnership and the rights, duties and the FLP or LLC is governed by the applicable obligations of each partner. law of the state where the entity was formed. The structure of the partnership permits a The existence of the business entity is publicly partner to transfer a portion of his ownership registered with such state. Both FLP's and LLC's of the assets held within the partnership to need to obtain a separate tax identification other family members who are partners to the number for income tax purposes from the agreement. The use of the limited partnership to Internal Revenue Service. make these lifetime gifts, as well as transfers at death, lays the groundwork to obtain a potential LIMITED LIABILITY discount (valuing a partnership interest at A limited partnership is different from something less than face value) on the value of a general partnership in that there are two the transfers. In addition, holding family assets classes of partners: general partners and in a limited partnership provides a measure of limited partners. Limited partners have limited protection from creditors of the partnership and of liability. This means that the limited partners in individual partners. the partnership are responsible for partnership A limited liability company (LLC) liabilities only to the extent of the value of functions similarly to an FLP and has many of their partnership interests. By comparison, in a the same advantages when used as part of a general partnership, all of the partners have comprehensive estate plan for a family. For ease liability for all of the activities of the partnership of discussion, the text of this chapter focuses primarily on FLP's. However, the issues Example of Limited Liability The Stooges Limited discussed apply equally to Partnership has one general LLC's unless otherwise noted. partner, Mo Brown, and three The trend appears to be limited partners, Mo Brown, Larry Black and Curly White. Mo has towards using LLC's as the a 1% general partnership interest and each of Mo, Larry and Curly preferred entity with the major has a 33% limited partnership interest. The sole asset of the Stooges reason being that the Manager Limited Partnership is an apartment building worth $900,000 with a of an LLC is protected from the $300,000 mortgage. Unfortunately, a guest, Ima Clutz, is seriously claims of creditors of the LLC injured at the apartment building when the rail of a balcony gives as he is acting as the agent of way and she falls. Ima Clutz sues the Stooges Limited Partnership the LLC. By comparison, the and wins a $1,000,000 judgment. The Partnership had insurance Managing Partner of an FLP covering $300,000 per incident. The insurance proceeds are used to retains personal liability. The pay part of the judgment leaving $700,000 left on the liability. The Partners sell the apartment building for $900,000 and pay off the liability issue can be resolved mortgage leaving $600,000 which is all used to pay Ima Clutz. Mo, by creating an LLC to be the Larry and Curly have each lost their entire interest in the Partnership of Managing Partner; however, approximately $200,000. this is an extra step and The Stooges Partnership has no assets left to pay the remaining requires the additional cost of $100,000 ($1,000,000 less $300,000 of insurance proceeds setting up and maintaining the less $600,000 from the sale of the apartment building). As limited LLC. partners, Larry and Curly have no personal liability on the The similarity of the entities remaining debt. However, as the general partner, Mo is personally is evidenced by the fact that liable and will have to use his assets to pay the remaining $100,000 most LLC's elect to be treated owed to Ima Clutz. as partnerships and file the
Chapter 17: Family Limited Partnerships and Limited Liability Companies 141 Wealth Management Through Estate Planning
and that liability is not restricted to the value be in a lower tax bracket. Also, remember that of the partnership interest of each partner. The income paid to a partner is not only taxed as general partner, in both a general partnership ordinary income, but the remaining distributions and a limited partnership, remains liable for all (including any growth in those assets) will be partnership liabilities. includible and subject to tax in the general If a partnership is sued because of its partner’s estate at death. A decision as to activities, the limited partners’ liability is limited whether or not a general partner should take to the value of their partnership interests and compensation for his services will take these no more. They are not personally liable and factors into consideration and, frequently, for their other assets are protected from the claims these reasons, the general partner will forego of a partnership creditor. The general partner, compensation. however, remains liable for all such liabilities. In the event of the death, legal incapacity or resignation of the general partner, the terms GENERAL PARTNERS of the written partnership agreement should do The general partner may be an individual one or more of the following: or multiple individuals or may be another ◆ If co-general partners were serving, state business entity such as a corporation. In a that the remaining general partner will family limited partnership, the general partner continue to serve. frequently is the original owner of property ◆ Directly name who is to serve as succes- transferred into the FLP, such as a father and/ sor general partner. or mother who set up an FLP with children and grandchildren. Ordinarily, the general partner ◆ Allow for a successor general partner to retains only a small percentage of his units be named by agreement of the remain- as a general partner, holding the majority of ing limited partners voting their shares. the units as a limited partner. The reason for Voting for a new general partner is usually this is to minimize exposure of his equity in the determined by a majority of the partnership partnership to his creditors. shares or units voting but the agreement can The general partner is responsible for the provide otherwise. A good FLP agreement day-to-day operations of the FLP and has the full and exclusive power on the partnership’s behalf to manage, control, administer and Observation I am strongly operate its business and affairs and to do or recommending to cause to be done anything he deems necessary clients who are the primary funding or appropriate for the partnership’s business. source of an FLP or an LLC that they not be This is significant because the general partner General Partners (or Managing Members maintains control of all of the partnership assets of an LLC). The IRS has successfully even if he only owns a small percentage of the challenged FLP's where the decedent was FLP. The ability of parents to continue to control the General Partner bringing back into the property transferred to the partnership is one of decedent’s estate the FLP interests gifted the attractions of creating an FLP. away during lifetime. The line of attack is The general partner is entitled to receive that despite the gift of the FLP interests to a reasonable amount of compensation other family members, the General Partner for his services if he believes that it is either retained significant control over these necessary or advisable to be compensated. interests and they should be part of the Any compensation paid is taxed to the general estate. partner as ordinary income. However, one of the benefits of the FLP is to shift income to other partners of the FLP, such directs what is to happen when the general as children of the general partner, who may partner can no longer serve.
142 Chapter 17: Family Limited Partnerships and Limited Liability Companies Wealth Management Through Estate Planning
LIMITED PARTNERS such as stocks, bonds and mutual funds. As the name indicates, the rights and Many families put into their FLP's commercial responsibilities of a limited partner are limited real estate, farm land and business interests. and are set forth in the written partnership Not all assets can be held in a limited agreement. Limited partners, as discussed partnership. S corporation stock and qualified above, have limited liability which means plans and IRA's cannot be transferred into or that they are only responsible for partnership owned by an FLP. Further, holding shares of liabilities to the extent of the value of their stock in a family-owned business that is a partnership interests. C corporation in a limited partnership is Limited partners have no say in the not generally advisable. The retention day-to-day operation and management of of voting rights in the stock by the partnership. However, most partnership the general partner can agreements require the general partner to cause inclusion of all of consult limited partners with respect to major decisions. If a partner wants to sell his partnership interest to a third party, the My opinion limited partners will have the option to exercise a right of first refusal and buy a pro rata portion of the shares up for sale. Typically, the limited partners can vote on In most cases, I believe that an major partnership issues such as whether to irrevocable life insurance trust should be extend the term of the partnership upon its expiration, whether to admit a new partner the owner of life insurance on the life of or to expel a current partner, whether to a partner of an FLP. This reliably avoids make a substantive amendment to the written partnership agreement and whether the the incidents of ownership issue as well as partnership should be dissolved. secures other long term estate planning Limited partners have the right to inspect and examine the books and records of the benefits for the family of the insured. partnership and share in partnership profits and losses. They pay taxes on their pro rata share of partnership income and capital the stock held in the FLP in the estate of the gains, even when the FLP does not make any general partner at his or her death. distributions. An FLP can own an annuity but may have to report all of the income and gains FLP's and LLC's Compared earned by the annuity as they occur and A there is no tax deferral. For this reason, FLP's Limited should not invest in annuities. The tax deferral Partner of an FLP has limited liability while benefit of annuities usually only occurs if they the General Partner is not protected from are owned by individuals. claims against the FLP. All LLC Members, An FLP can own life insurance; however, including the Managing Member, are the partnership agreement should be protected from creditors’ claims. drafted very carefully to avoid inclusion of the proceeds of a policy in the estate of the insured partner. This is a very real PARTNERSHIP ASSETS possibility when the insurance is on the life of Almost all types of assets can be held the general partner. The IRS could take the within a family limited partnership, including position that the general partner’s powers real estate, notes receivables and investments create incidents of ownership over the
Chapter 17: Family Limited Partnerships and Limited Liability Companies 143 Wealth Management Through Estate Planning
policy that cause inclusion of the proceeds losses. The basis in the property (i.e. what was in the general partner’s estate at death. paid for it plus the cost of capital improvements This problem can most likely be avoided by less any depreciation) remains the same for careful drafting of the partnership agreement the partnership. This is also the tax basis of the to include specific language prohibiting the units issued to the partner making the capital general partner from exercising any powers contribution. or ownership rights over life insurance on his life that is owned by the partnership. Even if FRACTIONALIZATION OF the incidents of ownership issue is resolved, PARTNERSHIP INTERESTS when an insured partner dies, an amount of the When property is transferred into an FLP, proceeds equal to his percentage interest in the partnership units or interests are created partnership will be included in the estate of such and assigned a value. The units represent a deceased partner. fractional interest in all the partnership assets, To fund an FLP, assets must be transferred the same as stock in a corporation. This makes into the partnership. Real estate is transferred by the recording of a new deed placing farm the property in the name of the partnership. Andy and Betty Jones Jones FLP Investments are placed into an account in FLP units the name of the partnership using its tax FLP unit gifts identification number. Any non-titled property can be put into an FLP with the execution of a Charlie Dan simple assignment of property. The transfer of property into a limited partnership is a capital it possible and convenient to gift assets which contribution of the partner making the transfer are not easily divisible. The FLP creates a and becomes part of the contributing partner’s currency of partnership units that can be easily capital account. There are no direct tax transferred. consequences to such a transfer. The transfer of Fractionalization of property interests can property to the partnership is not a sale and the best be explained by an example: transferor does not realize any capital gains or VALUATION DISCOUNTS Example Andy and Betty Jones want to One of the biggest tax advantages of using give their children, Charlie and Dan, a family limited partnership is the potential to a portion of an 80 acre farm they own. There are several have a valuation discount apply to partnership reasons for this. They want an organized management interests. A valuation discount is valuing a structure, they want to keep the farm in the family and would minority partnership interest at something less like to reduce potential estate taxes. An FLP is established than its face or fair market value. The basis for and Charlie is named as the General Partner and Andy, doing this is that the owner of a minority interest Betty, Charlie and Dan are Limited Partners. Andy and would not be able to realize the full value of his Betty transfer the farm into the FLP by quit-claim deed. The partnership interest if there was a sale to a third fair market value of the farm is professionally appraised at party. This is due to the fact that: $500,000. The partners agree that the FLP will have 500 ◆ An FLP interest is illiquid when compared units and that each unit is worth $1,000. Andy and Betty to many other types of investments. can now give units of the FLP to Charlie and Dan. Without ◆ A limited partner cannot control the an FLP, the only way to make gifts of partial interests in the distribution of income or profits of real property would be to execute deeds transferring partial the partnership nor can he access or ownership to Charlie and Dan each year, which would be a liquidate the partnership’s underlying cumbersome, confusing process. assets.
144 Chapter 17: Family Limited Partnerships and Limited Liability Companies Wealth Management Through Estate Planning
A valuation discount determination consists of control. Limited partners cannot control either the several types of discounts combined and blended day-to-day operation and management of the FLP into one discount amount. The first type of discount or whether or when distributions are made to the is due to lack of marketability. No public partners. market for limited partnership units exists. FLP's The final type of discount is called a minority usually have a small number of partners, who are interest discount. A discount can also be taken often related, which limits the pool of potential when a partner only holds a minority interest in buyers of an FLP interest. the FLP because a minority interest is less valuable The second type of discount is due to lack of than a controlling interest. free transferability of partnership units. Partners In our example of the Jones Limited are not usually required to buy the interests Partnership, assume Andy and Betty each gifted of a partner who wants to sell his partnership 10 of the 500 units of the FLP to their son, Charlie. Charlie’s ownership of 1/50 of the FLP should be Observation subject to substantial combined discounts for lack There are four major types of marketability and free transferability, lack of of valuation discounts control and minority interest. ◆ Lack of marketability ◆ Lack of control Other types of discounts may be applicable ◆ Lack of free transferability ◆ Minority interest under specific circumstances. For example, if the FLP is a minority owner of real property or a minority partner in another partnership, those interests may be discounted for similar reasons. interest. The written partnership agreement places restrictions on the transfer of units to persons APPLICATION OF VALUATION who are not presently partners and on whether DISCOUNTS such a third party person buying a partnership Valuation discounts potentially can be taken interest can be admitted as a partner or is only when a partnership interest is gifted during life an assignee with no voting rights. These types of from one partner to another and also upon restrictions on transfers of partnership interests the death of a partner on his or her remaining to someone other than an existing partner partnership interest. Many factors, such as the are usually incorporated into a partnership terms of the written partnership agreement and agreement that is part of an estate plan for a the type of assets owned by the partnership, family and further inhibits a partner from selling contribute to the determination of the appropriate his partnership interest. discount to be applied. It is very common to see a The third type of discount is based discount between 25-40% and discounts as high on the fact that limited partners lack as 75% (and greater) have been successfully applied to limited partnerships in special My opinion Where gifting situations. When using FLP's for estate tax planning, it is is being done important to keep in mind that valuation discounts through a limited partnership, I are available not only with regard to transfers recommend that a valuation of during lifetime but also can apply to a decedent’s the partnership be performed by remaining interest in the FLP. Let us look at each of a professional qualified in business valuations. This is these situations separately. necessary to substantiate the value of the discount and Valuation Discounts On Lifetime Gifts maximize the potential tax planning value of the gifts. Invariably, persons who set up FLP's do some The professional appraisal would also be necessary if lifetime gifting of their FLP interests. The gifts first there were an audit by the IRS resulting in a challege focus on annual exclusion gifts to family members. Under current tax law, the annual exclusion of the discount or the amount of the discount. to gift taxes permits a donor to give up to
Chapter 17: Family Limited Partnerships and Limited Liability Companies 145 Wealth Management Through Estate Planning
$13,000 per year (this amount is indexed for Valuation Discounts On Partner’s Interest At inflation) to as many donees as he chooses. Death Thus, if each partnership unit is valued at The potential discounts to the value of $1,000, a partner could gift 13 units to each partnership interests also can reduce estate other partner and have each gift qualify for the taxes by reducing the value of the interest exclusion. However, if a 34% valuation discount owned by the decedent at the time of death. is applied to the value of a partnership unit, the For example, a partner owns 750 donor partner could gift 19 units to each other partnership units and each unit is valued at partner and still have each gift qualify for the $1,000. Absent a discount, the value included annual exclusion. This helps to reduce the value in his estate for tax purposes is $750,000. of the donor’s taxable estate more rapidly, However, if a 33% discount were successfully thereby reducing the amount of estate taxes that taken, the estate would include the partnership may be owed upon his death. units at a value of $500,000. If the estate is The impact of the discount applied to in a 50% marginal estate tax bracket, the tax annual exclusion gifts can be significant if savings to the beneficiaries is $125,000, 50% annual gifts are made for several years. of the reduction in the value of the units because However, to qualify such gifts of partnership of the discount. units for the annual exclusion, the partnership agreement must be carefully drafted. The SUPPORT FOR THE agreement cannot unfairly restrict a limited APPLICATION OF A VALUATION partner’s ability to sell or assign his partnership DISCOUNT interest or allow the general partner to act The specific circumstances surrounding against the best interests of the limited partners, each limited partnership must be evaluated in Without a Valuation Discount: deciding how much of a valuation discount is justified. To determine the appropriate amount Dad Mom of a discount, a valuation of the partnership 12 units 12 units 12 units 12 units and the underlying assets will likely have to be done by a professional qualified to make Son Daughter Son Daughter such a determination. The primary factors that affect the valuation discount determination for a Total units gifted: 48 limited partnership interest are the terms of the written partnership agreement, the applicable With a 34% Valuation Discount: state law and the underlying assets held in the limited partnership. Dad Mom Under the Internal Revenue Code, a 18 units 18 units 18 units 18 units provision in a partnership agreement that is more restrictive than the applicable state law Son Daughter Son Daughter cannot be considered for valuation purposes. If such a provision is included in a partnership Total units gifted: 72 agreement, such provision must be ignored and the default state law used for the valuation. For such as withholding income distributions without this reason, state law on limited partnerships a valid business purpose. should be considered when deciding in which Families who want to be more aggressive state to start a new limited partnership. in their gifting may choose to make gifts that For example, one factor to consider in use up part of their federal estate tax credits. determining the valuation discount amount is They do this to take greater advantage of the how easily can a partner withdraw from the valuation discounts.
146 Chapter 17: Family Limited Partnerships and Limited Liability Companies Wealth Management Through Estate Planning
partnership and receive a distribution equal diversification and conservative asset allocations to the value of his or her partnership interest. among different sectors of available investments. Allowing a partner to withdraw at will at anytime Additionally, collective investment will reduce undercuts the amount of applicable valuation management expenses and related costs. discount. This is because the partner does not Facilitate Investment Management. have to be bound by the terms of the partnership Collective investment makes managing family agreement. assets easier. One cohesive strategy agreed Oftentimes, to support a higher discount, a to by the partners can be implemented and partnership agreement will require that a partner monitored by the general partner with input from who wishes to withdraw from the partnership the limited partners. make a written request to the general partner Asset Protection Planning. With a and receive the unanimous consent of all other properly structured partnership agreement, it limited partners. However, if the applicable state is difficult for creditors of limited partners to law says that a partner can withdraw without reach the underlying partnership assets. This is getting the consent of the other partners, then the significant for parents who want to transfer assets state law rule for withdrawal of a partner is used to their children to reduce estate taxes but are in the analysis of the appropriate amount for the concerned that a child might be sued or divorced valuation discount. This would undermine the in the future. Generally, a creditor’s remedy amount of the discount. against the interest of a partner is limited to a “charging order” and the creditor cannot attach BUSINESS PURPOSE OF THE the partnership interest itself. PARTNERSHIP Keeping Assets in the Family. The transfer To obtain a valuation discount, the of partnership interests is controlled by the partnership must have a valid business purpose terms of the written agreement and is usually for its existence other than just reducing or restricted by giving the partners a right of first avoiding estate taxes. The following are some of refusal if one partner desires to sell his interest the reasons, other than reduction of estate taxes, to a third party. This keeps the assets in the that a family would start a limited partnership family. Further, an FLP coordinates with the with family-owned assets. personal estate planning of one or more Control over Management Succession family members and can also bypass A good FLP agreement sets up a procedure probate court. for the continuity of management of the FLP. The Facilitation of Gifting document should specify both a specific person Among Family Members. who is to become the General Partner and a procedure for the election of a General Partner My opinion if the named successor is not available for any reason. This, of course, also protects against a family member who does not have strong business and management skills from becoming To support the potential valuation discount, I feel the General Partner. Maximization of Investment Return of it is vitally important that the partnership be run Family Assets. By consolidating family assets in a partnership, the family can obtain a higher rate as a business at all times. Accordingly, I strongly of return on their investments. Having a larger recommend to our clients who have established amount of assets under common management should allow them to implement more FLP's and LLC's that they have an annual meeting sophisticated investment strategies. It will also be and that minutes of the meeting be prepared and easier to implement a strategy that recognizes the value of time tested investment principles such as put into the partnership records.
Chapter 17: Family Limited Partnerships and Limited Liability Companies 147 Wealth Management Through Estate Planning
Gifts of partnership interests to other partners Transfer Of Units To A Third Party may be made by a simple assignment. This can Several important features of a limited be done without the expense and administrative partnership are that the partnership document paperwork that would otherwise be incurred if will restrict the sale of shares or units in another type of asset, such as shares of stock or the partnership and require that certain real estate, were transferred. requirements be met before an outside party Monitoring Wealth Transfers Among can become a partner. These are some of the Family Members. Gifts of partnership interests common rules that are imposed. from older members of the family to younger Most written partnership agreements members can be done while maintaining require that a partner who wants to sell any of reasonable investment control over those his partnership units must give written notice partnership interests so gifted. This benefits to existing partners of the potential sale. Each younger family members in that the value of other partner will have the right to buy those the assets so transferred will continue to be units either upon the same terms and conditions managed consistent with the long-term financial offered to a third party or upon terms set forth planning goals of the family. in the partnership agreement. The right to buy Increasing Involvement of Younger units is usually divided among the partners in Family Members in Financial Affairs. proportion to their percentage ownership. The structure of an FLP allows younger If a sale to a third party is allowed, the family members to become involved in the written partnership agreement may state that management of family assets and learn about the third party is only an assignee to the financial planning strategies that have been partnership and that such person does not successful in the family. The FLP will lead to a automatically become a limited partner. An smooth transition of wealth management to assignee is entitled to share in profits and losses, successive generations. but has no right to vote on any partnership It is also important that the partnership issues. Why would a purchaser be limited in be run as a business. This means that the this manner? The partners want to limit who partners have regular meetings, partnership expenses are paid by the partnership and the Observation partnership files a tax return. It must not only At my firm, look like a business but must act like one. we issue unit certificates whenever a capital contribution TRANSFER OF PARTNERSHIP is made to an FLP or an LLC. These are just INTERESTS like stock certificates and are the currency of the partnership. When a partner wants The transfer and sale of partnership units to transfer units, he turns in a certificate, is controlled and restricted by the written terms which is cancelled, and a new one is of the partnership agreement. If there is no issued to the transferee. We also keep a written agreement, then law of the state where unit ledger, which tracks the transfer of the partnership is located controls transfers certificates among the partners. and sales. Partnership units can be transferred or gifted very simply by the execution of an assignment. It is recommended that the number of partnership units owned by each can be a partner. In turn, this type of limitation partner be recorded and updated each time a will probably drive down the value of the change has occurred. units being sold, which is a basis for giving a Administratively, it is easy to transfer valuation discount to shares of the partnership. partnership units. However, for tax planning Frequently, the partnership agreement and other reasons, restrictions are placed on will also require a third party purchaser to how interests in partnerships can be transferred. agree in writing to be bound by the terms of the partnership agreement, to pay to the
148 Chapter 17: Family Limited Partnerships and Limited Liability Companies Wealth Management Through Estate Planning
general partner, if demanded, a fee to that all other partners can maintain the same cover the costs of preparing, executing and relative ownership among each other. recording all pertinent documents due to Gift Of Units From One Partner To Another the addition of a new partner and that all Partner existing partners agree in writing to accept It is expected that the partnership such third party as a new limited partner. agreement will allow a partner to transfer Again, these requirements are expected to to another partner at any time and without have a negative effect on the unit values of obtaining the consent of any other partners partnership interests. so much, none or all of his or her partnership Compare the purchase of partnership units as he shall determine to be appropriate. units where these types of rules are in place This is an important element of family to the purchase of stock that is publicly traded partnerships as gifting of units is necessary to on the New York Stock Exchange. Stock achieve the estate planning reasons for setting purchased on the NYSE is not subject to up this type of business arrangement. any unusual transfer restrictions and price is The transfer is by means of a simple determined by demand. assignment or a transfer of the unit certificates Sale Of Units To Another Partner over to the transferee. The transferee will The sale of partnership units from one have all of the same rights as the transferor partner to another is also governed by the as compared to a sale to a third party as terms of the written agreement. Most often, previously discussed. such a sale is allowed and the other partners Transfer Of Units At Death Of Partner are not offered a right of first refusal as with Partnership interests are personal the sale to a third party. A selling partner may property and unless planned for, such sell all or part of his or her partnership units interests will be subject to probate to other partners for any price and in such administration upon the death of a partner. proportions as he or she chooses. To avoid probate administration, the written Sometimes, the partnership agreement agreement can provide that partnership may require that any sale to a partner interests are allocated to a trust of the be first offered on a pro deceased partner at his death. Another rata basis to all of the option is to assign partnership interests to a other partners and for revocable trust during life. Placing partnership the same price. units into trust at death or during life will insure This restriction the orderly transfer of all assets at death and may be maximize tax planning opportunities. imposed so Partners who do not have a trust can avoid probate either by holding their partnership interests as joint tenants with a My opinion right of survivorship with another person or by having a named successor to their interest in the agreement. One of the advantages of To support and enhance the applicable having a partnership is that it can be used to valuation discount for a limited partnership, avoid probate if the partnership agreement it is very important that the written provides how units are to pass at death. partnership agreement require that a third DISSOLUTION OF A LIMITED party person who purchases partnership PARTNERSHIP units not be automatically admitted as a Dissolution of a partnership means limited partner, but that he be an assignee termination. The events which can cause to the partnership. dissolution of a partnership will be set forth in
Chapter 17: Family Limited Partnerships and Limited Liability Companies 149 Wealth Management Through Estate Planning
the written partnership agreement. Generally, and discharged in the order of priority the following events can cause dissolution. as provided by law. ◆ An affirmative vote of the limited part- ◆ All debts and liabilities to partners are ners holding a majority (or some other paid and discharged in the order of pri- fractional interest greater than a major- ority as provided by law. ity) of the partnership units of all limited ◆ Any remaining assets are distributed pro- partners and a majority (or greater portionately among the partners based fraction) of limited partners. Some agree- on partnership interests. ments may further require the consent of If the partnership property remaining after the general partner, or as determined by payment or discharge of all partnership debts a dissolution committee. and liabilities to persons other than partners ◆ The occurrence of a specific event is insufficient to return the partners’ capital stated in the partnership agreement. contributions, they shall have no recourse ◆ The withdrawal of the general partner, against the partnership or any other partners, unless at least one other co-general except to the extent that such other partners partner remains or the agreement names may have outstanding debts or obligations a successor general partner to imme- owing to the partnership. diately take over for the withdrawing general partner. If there is no co-general INCOME TAX CONSEQUENCES or named successor general partner, OF LIMITED PARTNERSHIPS usually the agreement allows for the An FLP is a separate entity for tax purposes partnership to be continued upon a vote and has its own taxpayer identification number. of the remaining partners. Income And Capital Gains Taxed To Partners ◆ A court order calling for dissolution. A partnership files an income tax return Upon dissolution, a partnership will but does not pay any income tax as an entity. terminate all business and immediately Income and capital gains of the partnership are commence to wind up its affairs. The partners taxed to each of the partners in accordance continue to share in profits and losses during with the terms of the written agreement. Usually, liquidation in the same manner and proportions each partner pays a share of the income tax as they did before dissolution. The partnership’s liability based on his ownership interest in the assets may be sold, if a price deemed partnership. Losses are shared in the same reasonable by the partners is obtained. manner. Proceeds from liquidation of partnership assets For estate planning purposes, it is usually generally are applied in the following order: advisable to shift income from the parents ◆ All partnership debts and liabilities to who make large capital contributions to the persons other than partners are paid partnership to the other partners who are children or other family members and may be in a lower income tax bracket. Observation Children who are Depending upon the activity taking place partners and have within the partnership each year, a partnership received gifts of partnership interests may income tax return using the partnership’s own have to pay more in personal income taxes tax identification number may have to be filed due to their participation in the FLP. However, on an annual basis. Each partner will receive a the general partner may make a distribution form K-1 that states the portion of partnership from the partnership to the limited partners income and/or losses attributable to him or to repay them for increased personal income her. This form will be attached to each partner’s taxes. personal income tax return.
150 Chapter 17: Family Limited Partnerships and Limited Liability Companies Wealth Management Through Estate Planning
Distributions of Partnership Income test used to determine whether a business Distributions of partnership income are to is taxed as a partnership or a corporation. be made in accordance with the terms of the To be taxed as a partnership, the business written agreement. Most often, the agreement must not have at least two of the following calls for income to be distributed to partners characteristics. on a pro rata basis. Limited Liability A partnership may retain income for By definition, a limited partnership has future needs of the partnership and is not limited liability for limited partners. This is what required to distribute all income. The general separates if from a general partnership partner decides whether a distribution Free Transferability of Interests should be made and if so, how much income The transferability of partnership to distribute. However, income retained by interests is usually restricted in that existing the partnership is still taxed to the partners partners have a right of first refusal to buy whether or not a distribution is actually made. a partnership interest that is for sale. This Basis of Partnership Property restriction is important if one of the goals is For tax purposes, the basis of an asset to have a valuation discount be applied to is its original cost plus the cost of capital partnership interests. improvements less depreciation. When assets are transferred into an FLP, the basis of the Centralized Management asset now held by the partnership remains A limited partnership has centralized the same as before the asset was transferred. For example, suppose Mo Brown bought Observation To be taxed as 100 shares of Coca Cola stock for $10 per a partnership, most share. Fifteen years later, when the stock partnerships do not have free transferability is trading for $40 per share, Mo transfers of interests or continuity of life, thereby not those same 100 shares of stock to the Brown having two of the four characteristics. Limited Partnership. The value of Mo’s capital contribution is $4,000 (100 shares x $40). The tax basis of the transferred shares is $1,000 (100 shares x $10). management in that the general partner(s) When assets are transferred into an FLP, has full authority to manage the partnership. the bases of the different assets are combined Continuity of Life so that the entire FLP has a “blended” basis. Usually, the terms of a partnership When a partner dies, the partnership receives agreement limit the life of the partnership to a partial step up in basis based on the value a specified number of years. When that term of the partnership interest of the deceased is up, the partners can vote to continue the partner as of his date of death. partnership if they so choose. IRS Test for Partnership vs. Corporate Treatment of Income OTHER ESTATE PLANNING With regard to income taxation, BENEFITS OF An FLP partnerships have an advantage over In other parts of this chapter, we have traditional corporations (C corporations) reviewed some of the estate planning benefits in that partnership income is only taxed as of using an FLP. Here are several other income to the individual partners whereas a important planning reasons for using FLP's. corporation is taxed at the corporate level If a parent transfers part of his or her and again when income is distributed to partnership interest to family members, the shareholders as dividends. Following is the value of the gifts is out of the parent’s estate
Chapter 17: Family Limited Partnerships and Limited Liability Companies 151 Wealth Management Through Estate Planning
for estate tax purposes. Further, if the value of This is an advantage over a limited partnership. the transferred property increases over time, the An LLC is like a partnership in that the appreciation of such gifted property is also out members have great flexibility in how to run of the parent’s estate for estate tax purposes. the LLC and its operation is governed by the If the gift were not made, the appreciation written agreement between members, called an would be taxed in the parent’s estate. One operating agreement. Additionally, an LLC is not consideration in deciding what assets to a separate tax-paying entity and has only one place into a limited partnership being used level of taxation (to the individual members) like as an estate planning tool is the rate at which a partnership. the assets are appreciating in value. Assets Most states have adopted a law governing appreciating rapidly will maximize the benefit limited liability companies. However, there is of lifetime gifting. no “uniform” law governing LLC's from state An FLP interest can be used to fund Trust A to state. This is significant because an LLC (the marital deduction trust) and/or Trust B (the established in Ohio but doing business in credit shelter trust) to insure that both spouses Michigan would need to familiarize itself with available estate tax credits are fully utilized. The the differences between the LLC laws in each value of the estate tax credit can be maximized state. Further, a court decision regarding an by placing a partnership interest into Trust B LLC in one state is not a good indicator of how and successfully taking a discount on the value the same issue would be decided in another of that partnership interest. This allows for state due to the differences in applicable law. more property to be placed in Trust B thereby On the other hand, most states have adopted protecting more property from being subject to in substantial form the Revised Uniform Limited federal estate tax. Partnership Act, so that partnership laws from By using trusts as a limited partner, a state to state are very similar and, in many partnership interest can be tied into a parent’s respects, identical. personal estate plan to take advantage of Limited partnerships have been used in generation-skipping planning which would the estate planning context for a longer period prevent the parent’s partnership interest from of time than LLC's. A larger body of case being subject to federal estate tax at the death law has been decided to help practitioners of his children and allow such interest to pass draft partnership agreements effectively. On directly to grandchildren upon a child’s death. the other hand, if the assets to be held in the partnership or LLC carry a high risk of potential THE FLP VERSUS THE LIMITED liability, then an LLC may be a better choice, LIABILITY COMPANY (LLC) as no member has personal liability for debts A limited liability company (LLC) functions of the LLC. Each situation should be evaluated similarly to an FLP and has many of the independently as to which business entity same advantages when used as part of a should be used. comprehensive estate plan for a family. Most topics discussed in this chapter apply to both an CONCLUSION FLP and an LLC. Both FLP's and LLC's are good vehicles An LLC is a business entity that has some to help reduce estate taxes. These are aspects of a corporation and some of a sophisticated planning techniques and require partnership. All members of an LLC have limited commitment on the part of the clients to run liability, like a corporation. Therefore, under and manage the entities as real businesses. most circumstances, if an LLC is sued, each They can be of significant benefit to families member’s liability is restricted to his ownership for managing family wealth and gaining tax interest in the LLC and his personal assets are planning benefits. insulated from attachment by business creditors.
152 Chapter 17: Family Limited Partnerships and Limited Liability Companies Wealth Management Through Estate Planning
Chapter 18: Business Succession Planning
Business owners must look beyond the responsibilities of the day to day management of their companies. Strategic planning for when they want to retire or sell the business is important. In this chapter, we take a look at some of the issues that business owners need to consider.
Chapter 18: Business Succession Planning 153 Wealth Management Through Estate Planning
Chapter 18:
◆ Protecting the Value of a Business
◆ The Buy-Sell Agreement
◆ Implementing the Buy-Sell Agreement
◆ Employee Stock Ownership Plans
◆ Private Annuities
◆ Self Cancelling Installment Notes
◆ Consulting Contracts
◆ Estate Taxes and Business Planning
“If you get up early, work late, and pay your
taxes, you will get ahead – if you strike oil.”
J. Paul Getty.
154 Wealth Management Through Estate Planning
usiness succession planning is contributions that the owner and his creating a strategy for the time when employees bring to the table. This is called B the owner of a business wants to retire goodwill. The challenge is how he can or sell. It also focuses on what is to happen protect the intangible value of his business if the owner dies. The importance of these and get someone to pay him for it when he issues must not be overlooked. wants to sell. For the person who is self-employed, his (or her) business may be the most valuable asset he has. It is often his Observation Do you know the primary source of income. How is this difference between source of income to be protected if he strategy and tactics? Strategy is the overall becomes incapacitated or retires? How is plan that you have to get to a specifically his family to be protected if he dies? Will identified goal. Tactics are the procedures the value of the business and the stream of and methods you use to get you there. income vanish with him? Succession planning is becoming increasingly important for a number of reasons. Privately held businesses have Successful business planning thus always been a significant component of requires that the owner identify and the American free enterprise system. As understand the true source of the value of our population ages, the challenges of his business. Where the primary source of transferring businesses and protecting their value is the owner, he has to figure out ways economic value become more pressing. to duplicate himself through his employees, The purpose of this chapter is to explore creating a business culture that enhances some of the major aspects of business the goodwill of the enterprise. Where some planning and take a look at the significant employees also provide value that is not tools and techniques that are available. readily replicated (this is called talent), he First, however, we need to take a look at the needs to figure out ways to keep them in reasons a business owner needs to involve the fold. One way to do this is to create himself in the process of planning. a business succession plan where they will have the opportunity to purchase the PROTECTING THE VALUE OF business at some time in the future upon the A BUSINESS retirement or death of the owner. The business owner has additional Frequently, the business is owned challenges beyond overseeing the day to and operated by a family with members day operation of his business. He needs to in the key positions. This presents not only create a game plan for the time when he opportunities but also special challenges. will no longer be active in management. Does the next generation have the same Unlike an interest in a publicly traded commitment to the success of the business corporation, there is usually no ready as the current generation? Where the market for an interest in a closely-held business is family-owned and operated, it is business. Typically, the value of a business important to convey to the next generation is based on its reputation for providing the value of hard work to guarantee quality goods or services in a timely fashion continued success. and at a competitive price. The value is not This commitment to the enterprise is not because the business owns tangible assets easily taught. In a family-owned business, such as land, buildings or an inventory. it is not uncommon that younger family The value arises from the intangible members lack a keen appreciation for the
Chapter 18: Business Succession Planning 155 Wealth Management Through Estate Planning
value of personal and financial sacrifice Frequently, the business owner does not required for the enterprise to continue to have either family members or unrelated succeed. They were not around when the qualified employees who can be trained business was started from scratch years ago to take over the business. In that situation, and the primary capital was sweat equity. at some point in the business owner’s Oftentimes, they have not had to work career, he may want to consider bringing through difficult times resolving challenging in someone from the outside and provide to problems. that candidate the training and incentives The family members currently running the necessary to allow a smooth transition to new business need to closely evaluate the next ownership. generation. Will these persons be able to get Finally, the responsibility for business along with each other and work together to succession planning may also fall on co- insure the continued success of the venture? owners of businesses. A successful business Do any of them possess the business talents is often the product of the hard work and and skills to meet the challenge? All of these skills of several persons. For various reasons, issues and others must be carefully and one of them will at some point in time want to closely evaluated. have his interest purchased by the other co- Many business owners are not fortunate owner(s). to have reliable and qualified family members In all of these circumstances, the who can step into their shoes at the time they business owner who has carefully planned are no longer actively involved. These owners for ownership and management succession need to evaluate their employees to determine must then build the framework that binds if any of them are potential candidates to the potential successor to the owner for their become owners. Do they have the right mutual benefit. A business succession plan abilities, skills and work ethic to successively that is meticulously crafted by the business succeed the owner? owners, together with their business planning attorney and other advisors, will provide results that are satisfactory to everyone My opinion involved. The details of the plan are reflected in the After you have had a stroke or heart terms of the agreements between the business owners. We now take a look at some of the attack is not the best time to start key agreements that are frequently part of a discussing business succession with co- good business succession plan. owners or valued employees. THE BUY-SELL AGREEMENT It can seriously affect your Perhaps the most important document in a succession plan is the ability to control the agreement between the situation and obtain the owners of the business CONTRACT that requires them to most favorable terms. sell their interests in the business under certain described circumstances. This agreement is known as a buy-sell agreement.
156 Chapter 18: Business Succession Planning Wealth Management Through Estate Planning
These agreements can be very complex interest being sold. The business “redeems” because they must cover all of the events the owner’s interest. The effect of this on that could occur. Fundamentally, however, the co-owners who are not selling is to they deal with these basic issues: proportionately increase their interest in that ◆ Upon death, retirement or termina- business. tion of employment (and some- times in the event of disability), an Example owner (or his estate) is required Allen, Bill and to sell his interest either back to Cathy each own 100 the business (stock redemption) or shares of the ABC Corporation. Pursuant to the other co-owners (cross pur- to the terms of their redemption buy-sell chase). agreement, on the death or retirement of any of them, the ABC Corporation is obligated ◆ The agreement will specify who can to purchase that person’s shares of stock. Bill purchase the shares and in what dies and the ABC Corporation purchases/ proportions. redeems his shares from his estate in ◆ The price of the seller’s interest is accordance with the terms of the agreement. either determined by agreement or by a valuation using a professional qualified to value businesses. ◆ The terms of payment are specified. These are the important facets of this How much is paid as a down pay- transaction: ment, when is the balance due, what ◆ Allen and Cathy now each own 50% is the interest rate, etc. of the ABC Corporation. ◆ The buyer(s) must buy all of the ◆ The number of shares owned by shares offered for sale or are given a Allen and Cathy has not changed. right of first refusal to match any sale ◆ The redemption of Bill’s stock turns to an outsider. that stock into treasury stock of the There are several types of buy- corporation. sell agreements and it is important to ◆ Bill’s estate does not have to pay determine which type is appropriate for any capital gains taxes on the sale each circumstance. As would be expected, of ABC stock because the stock gets tax considerations are very important stepped-up basis on his death. in choosing the correct form of buy-sell agreement. Where the business being sold ◆ The cash paid by ABC to buy the is a C corporation, very close attention stock from Bill’s estate is not tax must be paid to tax issues. C corporations deductible. pay taxes on all of their income. The tax planning is less challenging where the business is a partnership, S corporation Allen ABC Corporation Cathy or limited liability corporation. With these forms of businesses, the tax consequences of income, gains and losses are passed stock$ through the entity to the owners. Redemption Buy-Sell Agreement This form of agreement is used when it is Bill's Estate desired that the business entity purchase the
Chapter 18: Business Succession Planning 157 Wealth Management Through Estate Planning
Redemption buy-sell agreements have and the remaining owner(s) will purchase been quite popular for a number of years. the selling owner’s interest in the business. However, if the business is a C corporation, The shares purchased are transferred to the income tax consequences of them are the buying owners and not back to the sometimes unfavorable and these potential business. The cross-purchase agreement is tax issues must be carefully examined. Unless frequently used because of the favorable tax the redemption meets complex requirements consequences that it creates and because it is imposed by the Internal Revenue Code, the simpler to put in place and understand. amounts distributed on the purchase of shares Refer back to our example of the by a company can be taxed as dividends. ABC Corporation. If their agreement were Dividends are not deductible to the structured as a cross-purchase agreement, the corporation as an expense and are ordinary following would have occurred on the death income to the recipient. Dividends do not of Bill: qualify for the more favorable capital gains ◆ Allen and Cathy would each have tax treatment that a sale of stock receives. purchased 50 shares of stock in the If a redemption at the death of a co- corporation from B’s estate and each owner meets all of the requirements, the would now own 150 shares. They estate does not realize any taxable gain and would still be 50/50 owners. consequently there is no capital gains tax. The ◆ Bill’s estate will still not have any capi- tax cost of failing to plan carefully can create tal gain on the shares as the income a substantial and unnecessary tax cost to the tax basis for the stock when it is sold deceased owner’s estate. by the estate to Allen and Cathy will Another significant potential drawback be its value on the date of Bill’s death with a redemption buy-sell agreement is (i.e. stepped up basis). that when the shares are sold back to the corporation, the remaining co-owners do not ◆ Allen’s and Cathy’s basis in the stock get any step-up in the basis of their shares. they obtain from Bill’s estate is the Assume in the above example that the value at which it is purchased. The 50 corporation redeemed Bill’s 100 shares of shares that each acquires has a basis stock for $100 per share and that Bill’s basis then of $100 per share. This reduces (i.e. what he paid) is $10 per share. Allen the capital gain when they sell their and Cathy do not receive an adjustment in the stock. basis of the stock that they own. Their shares ◆ The payment by Allen and Cathy is still are now worth $150 per share but their basis not tax deductible. is the same as their original basis in their shares. The potential consequence of this is that they will have larger capital gains on the Allen ABC Corporation Cathy sale of their shares. These are two significant tax reasons why redemption buy-sell agreements may stockstock not be the best method to acquire stock of a $$ departing shareholder. The cross-purchase buy-sell agreement is designed to avoid these Bill's Estate and other problems. Cross-Purchase Buy-Sell Agreements With a cross-purchase buy-sell In many situations, the cross purchase agreement, the owners of the business agree buy-sell will be the preferred method for that upon the occurrence of an event, such transferring the interest in a privately held as the death or retirement of one of them, business. the departing (or departed) owner will sell
158 Chapter 18: Business Succession Planning Wealth Management Through Estate Planning
The Hybrid Buy-Sell Agreement This and other considerations go into A third method for handling business structuring the type of buy-sell agreement succession is to create a document that that is appropriate for each business allows business owners the flexibility to situation. The hybrid type agreement is a choose the type of transaction at the time little more technically challenging for the when an event triggering sale occurs. This is attorney, but can have important benefits. the hybrid buy-sell agreement. In this type of arrangement, a determi- IMPLEMENTING THE nation is made at the time a sale is to be BUY-SELL AGREEMENT consummated as to how the transaction is Once the business owners have to be structured. The sale can be a redemp- selected the type of agreement that is tion, cross-purchase or a combination of suitable to their situation, a number of other both. Determining which purchase method issues must be addressed. to use requires an evaluation of a num- Valuing the Business ber of factors. For example, assume ABC Business succession planning requires Corporation is a C corporation and has a that the current value of the business substantial amount of cash accumulated. be determined and that a method for The purchasing shareholders could decide assessing the value of the business upon the to use this cash to fund the purchase rather occurrence of an event triggering the sale of than use their own resources. Why would an owner’s interest is established. The value they do this? If they took the cash out of the of the business needs to be determined business to use it to pay for the stock being by someone with the skills, credentials acquired, they may have to pay income and experience necessary to do business taxes on the distributions. valuations. This may be the accountant for If the distributions are the business or an outside valuation expert. treated as a cash divi- Valuation is a growth industry and has given dend, they will not rise to professional designations such as that get a tax deduc- of a Certified Valuation Analyst. Valuing a tion for the business is critical because the owners need distribu- to have some idea of the cost to buy each tions. other’s interest and how the payment should be structured. My opinion While engaging in this process, the owners also need to discuss whether the valuation is to reflect any discounts for such factors as lack of control or lack of I think that the hybrid buy-sell marketability. Chapter 17 Family Limited Partnerships and Limited Liability Companies agreement is the best way to set up contains a discussion on valuation discounts. a succession plan. It provides the There is no standard rule on this but it is advisable that the issue of discounts to most flexibility for both the selling and value be addressed so that there are no buying shareholders. At the time of a disagreements in the future. Unless the buy- sell agreement specifically states that a sale, all concerned parties can take a value is to be determined without reference look at the situation at that time and to discounts, you should presume that discounts could be factored into the final determine the best course of action. valuation.
Chapter 18: Business Succession Planning 159 Wealth Management Through Estate Planning
Frequently, owners will reach their own Typically, business owners utilizing a agreement as to the value of their business. cross-purchase agreement fund their potential This is the best method but there should be at purchase liability by buying life insurance least some professional consultation so that on each other’s lives. While this is still a the figure reached has some basis in fact. common method for funding a cross-purchase agreement, its shortcoming is the number of policies that must be purchased. If the Observation Many agreements that I have agreement is between three persons, a total done state that the owners will agree of six policies must be purchased. Each of the as to the value and that value will apply for a specified owners must purchase a policy on the life of period. If they cannot agree on a new value at the end of each of the other two owners. any period, then the valuation is to be done in accordance An alternative is to create a separate with the terms of the agreement. If they agree, fine; when entity such as a partnership or limited liability they cannot agree, the agreement controls. company to hold ownership of the life insurance policies that are used to fund the agreement. The benefit of this is The value of a closely held business can having a single owner of the grow significantly and silently over the years. policies and cutting down on Owners often give little thought as to how the number of policies that much their business is worth and as to how are needed. Only one this growth will impact their ability to sell policy is purchased their own shares or purchase a co-owner’s on the life of each share upon a triggering event. In order to co-owner. make a buy-sell agreement a viable arrangement, current and ongoing consideration must be given to the issue My opinion of the value of the business. Funding the Agreement The agreement needs to clearly specify This is one of the situations the terms of payment following a triggering where the use of term life insurance event. This in turn affects how the payment is acceptable. Many business obligation is to be funded. There are several different ways to plan for payment of the owners plan to be with the business purchase amount and, in fact, most buy-sell for a predictable term and once the agreements will address the use of several methods. term has ended, the need for the life Life Insurance insurance evaporates. It also keeps Life insurance is frequently used to the out of pocket costs down and fund the purchase obligations of buy- sell agreements. In many circumstances, eliminates the issue of what to do without life insurance, the liquid cash that with the insurance policy after the is necessary to buy out the interest of a need has expired. deceased shareholder would not otherwise be available. Also, life insurance products that build up cash values may be valuable to help A seldom used and not widely available the business or its owners accumulate within insurance product that is particularly suited the policies on a tax-deferred basis at least for cross-purchase buy-sell agreements is a portion of the funds that will be needed the first to die (FTD) policy. The FTD policy to finance the purchase of an interest in a pays off on the death of the first to die of a business. group consisting of two or more persons. This
160 Chapter 18: Business Succession Planning Wealth Management Through Estate Planning
insurance product is designed to create Financing Provisions in Buy-Sell a pool of cash at the exact time that it is Agreements needed. All buy-sell agreements contain FTD policies are less expensive than provisions as to the terms of payment for buying a single policy for each person in the purchase of an interest in the business. the group. The premium cost may be 25% Typically, an agreement will: to 35% less for the FTD policy as compared ◆ Require a down payment, usually to buying several single life policies. The expressed as a percentage of the policies can also be structured for groups of amount due (10%, 20%, etc.); three or more persons to pay, for example, ◆ Dictate the payment terms of the bal- on the death of the first to die and then ance due (i.e. balance paid over 60 on the second to die of a group of three months); business owners. ◆ Provide a benchmark for determining the rate of interest to be charged on Observation The buy-sell the unpaid balance; and agreement should state ◆ Require a pledge of the shares or that any life insurance proceeds received upon other interest being sold to secure the the death of an owner must be used to satisfy payment of the purchase price. the purchase obligation. If it does not, a buyer Each situation is different and could elect to use other payment terms in the the payment terms should take into agreement, such as installment payments, and consideration a balance between the hold onto the insurance proceeds. selling owner’s desire to be paid out and the financial ability of the business and the purchasing owners to make the payments. Careful thought should go into whether or not a C corporation should own life THE LIFE INSURANCE insurance on one of the owners. While life insurance proceeds are always income tax LIMITED LIABILITY COMPANY free, the distribution of insurance proceeds Where there are multiple owners of a from the corporation is not always free business and a cross purchase agreement is of taxes. This is not a problem where the being used, each owner is usually required business is a partnership, S corporation or to buy an insurance contract on each of the limited liability company. other owners. For example, if the business Life insurance premiums used to fund has four owners, twelve insurance contracts redemption buy-sell agreements are not are required as each owner has to buy deductible expenses for either the business three contracts. or the owners. This is the trade-off for the To avoid this complexity, the attorneys death benefit being income tax free. It may at our Firm developed a planning strategy seem less expensive to pay the premiums called the Life Insurance Limited Liability out of the business; however, there is no Company. This special type of LLC owns distinct tax advantage in doing so. Where the life insurance contracts on the owners. a C corporation owns the policy, the In the above example, only four policies premiums paid are taxed as corporate are purchased, one for each owner. The income. Insurance premiums paid by Operating Agreement of the LLC specifies partnerships, S corporations and limited how the death benefit is to be allocated liability companies are passed through to upon the death of an owner/insured. the partners/shareholders and taxed as At our Firm’s website, www.smith- ordinary income. condeni.com, under News & Publications is an article prepared by the Firm’s attorneys
Chapter 18: Business Succession Planning 161 Wealth Management Through Estate Planning
on Life Insurance Limited Liability Companies to family members. Financing is provided to which explores in detail the many benefits the family members and they do not have of this form of ownership of life insurance to go to outside financing or tie up capital. policies for business succession planning. The advantage to the seller is that he has a stream of income for the rest of his life. That EMPLOYEE STOCK OWNERSHIP the annuitant may or may not live past life PLANS expectancy is of less consequence to family The owner of a privately held business members than it is to an unrelated buyer. If can sell his interest in the business to an the annuitant dies before his projected life Employee Stock Ownership Plan (ESOP) expectancy, there is no real loss of economic and not pay any taxes at the time of the sale. value to the annuitant’s family because they However, a number of important conditions own the business and are the beneficiaries of must be met: the estate. If the annuitant lives longer than life expectancy, the extra payments are not ◆ He must have owned the company for a concern because they go to support the at least three years. family member. If the money is not needed for ◆ The ESOP must own at least 30% of support, the payments can be given back to the company’s stock after the sale. the family as part of a gifting program. ◆ The stock sold to the ESOP must be The payment price and each payment common stock with voting and divi- are divided into three portions for tax dend rights. purposes. A portion is return of capital, the amount being part of the seller’s basis; a ◆ The proceeds must be reinvested in certain types of qualifying securities, second portion is capital gain; and a third commonly referred to as “Qualified portion is interest, representing the interest on Replacement Property.” the unpaid portion of the obligation. To avoid immediate taxation of the gains arising from the sale, the annuity cannot be PRIVATE ANNUITIES secured with any property and the seller A little used but potentially valuable way cannot retain any interest in it. Also, the to buy out the interest of a business owner is payments under the annuity cannot be tied to have the purchasers pay for the interest into income produced by the business. with a private annuity. The buyers agree to There is a substantial tax benefit to the pay to the seller a set amount per month (or family members purchasing the interest. They other period agreed on) for the business for get a new tax basis in the property equal to the lifetime of the seller (annuitant). the amount paid. Should they decide to sell The amount of the payment is determined at some point in time, the new tax basis can by agreeing on the value of the interest to be substantially reduce capital gains taxes. purchased and the interest rate on that value. There are estate tax benefits as well These values are used in determining the in that upon the death of the annuitant, the amount to be paid using the life expectancy interest terminates. There is no residual interest of the seller. The resulting amount is the left that is subject to estate taxes. installment payment amount. It is very similar to the calculation that is used to determine SELF CANCELING the amount you pay on a mortgage using INSTALLMENT NOTES the amount borrowed, the interest rate with A similar type of arrangement is the self- the time period for the loan being the life canceling installment note (SCIN). With a expectancy of the seller. SCIN, the buyer pays the seller installments This technique is suitable for anyone but over a period of time. The payments are not is particularly applicable when the sale is
162 Chapter 18: Business Succession Planning Wealth Management Through Estate Planning
calculated based on life expectancy. If the ESTATE TAXES AND BUSINESS seller fails to survive the specified period, PLANNING the note is cancelled. To avoid part of the Estate tax planning is extremely transaction as being a gift, the seller should valuable when privately held business receive more than the value otherwise interests are significant financial assets bargained for to reflect the possibility of a family. The primary reasons for this that his death would occur prior to the are the inherent lack of liquidity in many satisfaction of the note. businesses and the fact that a business interest is frequently the largest asset owned CONSULTING CONTRACTS by the decedent. Estate taxes are calculated The purchase of an owner’s interest without reference to whether the assets can in his business is sometimes paired with readily be sold to pay taxes. a consulting contract for his continued For this reason, business owners need services. Aside from the value of retaining to plan ahead to avoid a forced sale of a the experience and skills of the business business at death. One way to do this is to owner, there are tax benefits to this create savings that are liquid and available arrangement. to pay estate taxes. For most business Payments to purchase an interest in a owners, this is not a viable option because business are not tax deductible by either they do not want to tie up capital that could the business or the shareholders acquiring otherwise be used to grow their businesses. the interest. These are capital expenditures. Life insurance is frequently the best way However, payments to a consultant are to address liquidity problems. It does not deductible to the business. These payments tie up a lot of capital during the life of the to the consultant are fully taxable as regular business owner. At death, the benefits are income and also subject to FICA taxes. Why paid out immediately with no tax cost. The would a business owner agree to this? cost to the owner of coverage is completely The reason is balancing the tax benefits eliminated where there is a buy-sell to the business of a full deduction against agreement and a co-owner is paying for the the difference between the tax rate the premium cost of the policy. seller pays on a payment subject to capital gains taxes (sale of stock) versus treating the CONCLUSION payment as income. A taxpayer in the 35% Business owners need to contemplate marginal tax rate bracket will pay only 15% what might occur to them and their more in taxes taking a distribution as income families without a comprehensive business versus capital gains if his gains are taxed succession plan being in place. These are at, say, a 20% rate. The business gets a full some of the questions: deduction for the payments. To allow the business to get at the ◆ If they die, will co-owners have the more substantial tax benefits, it may agree ability to buy out their interests? to increase the amount paid under the ◆ What if they have serious disagree- consulting contract to cover the increased ment with a co-owner? Who will buy tax costs. However, care must be taken in out whom and under what condi- balancing the payments between purchase tions? of stock and payments for consulting. The ◆ What is the price to be paid to buy amounts paid for each must be reasonable them out and how is the price deter- and reflect the value of the interest sold and mined? the value of the consulting services to be ◆ How will their families realize the provided. economic value of their interest in
Chapter 18: Business Succession Planning 163 Wealth Management Through Estate Planning
their business? ◆ If a co-owner dies, will that person’s spouse or children become their new “partner”? How do you avoid this? ◆ Who is to take over the business when the owner dies, becomes disabled or retires? ◆ Suppose a co-owner becomes dis- abled. How long will that person continue to receive payments from the business? ◆ If they are sole owners, what happens to their businesses if they die? Does it vanish? The importance of planning ahead to deal with these issues cannot be understated. Planning after an unexpected event is too late. Therefore, owners need to spend some time focusing on planning for both the unexpected and the inevitable events that can affect their businesses.
164 Chapter 18: Business Succession Planning Wealth Management Through Estate Planning
Chapter 19: Other Planning Techniques
There are many ways to make gifts. In this chapter, we take a look at some of the more sophisticated techniques that are available.
Chapter 19: Other Planning Techniques 165 Wealth Management Through Estate Planning
Chapter 19:
◆ Cristofani Trust
◆ Intentionally Defective Grantor Trust
◆ Qualified Personal Residence Trust
◆ Grantor Retained Annuity Trust
◆ Grantor Retained Unitrust
◆ Installment Loan with Forgiveness of Payments
◆ Private Annuity
“First ask yourself: What is the worst that
can happen? Then prepare to accept it. Then
proceed to improve on the worst.”
Dale Carnegie
166 Wealth Management Through Estate Planning
undamentally, there are limited ways beneficiaries did not have any continuing to reduce estate taxes. Gifting is one interest in the trust, then the IRS may not F of these ways. However, there are a recognize the gifts. number of interesting ways to make gifts that This strategy must be used very carefully can be used in an estate plan. This chapter by experienced estate planning counsel. The surveys these special planning techniques. IRS continues to fight the use of variants of this technique. CRISTOFANI TRUST A Cristofani trust is an irrevocable trust INTENTIONALLY DEFECTIVE where certain beneficiaries are given rights GRANTOR TRUST of withdrawal over a gift made to the trust so This is an irrevocable trust where the that the gifts qualify as annual exclusion gifts. donor is still responsible for paying the These rights lapse and, following the lapse of income taxes on the taxable income and the withdrawal rights, all or a portion of the gains of the trust property. While the trust is interest of one or more of the beneficiaries effective for estate tax and gift tax purposes, vanishes, at least for the time being, and the it is defective for income tax purposes. property is held for the benefit of another beneficiary. Example Robert transfers Example $500,000 to a trust John sets up an and his son, Mark, is the beneficiary. The irrevocable trust for his trust is irrevocable. Robert retains the right to daughter and three grandchildren. He puts substitute property of equivalent value. The $5,000 into the trust for each of them. The trust has $20,000 of taxable income a year. beneficiaries are given the right to withdraw the gifts, qualifying the transfers for the gift tax annual exclusion. However, when the Robert’s right to substitute new property withdrawal rights of the grandchildren expire, makes the trust defective for income tax so do their current rights as beneficiaries. The purposes. Because of this, the trust income is transferred property is held for his daughter taxed as if Robert received it. The benefit of and she is the sole beneficiary during her life. this gift technique is that it increases the value On her death, the grandchildren become the of the gift to Mark and increases the amount beneficiaries of the trust. of property transferred out of Robert’s estate. If the trust had to pay the income taxes, the after-tax value of the property in the trust is This type of trust is named from the reduced by this payment. Also, when Robert litigation brought by a taxpayer (Cristofani) pays the taxes, it decreases his estate for against the IRS. She was successful and tax purposes, reducing his estate taxes. The the planning strategy gained widespread payment of a tax liability by a person who is use among sophisticated estate planning legally obligated to pay it is not considered attorneys. Its benefit is the potential use of an additional gift. numerous annual exclusion gifts while still This is always interesting to explain to having the gifts held for the benefit of one or parents. How can you give something away more primary beneficiaries. and still pay the taxes on it? Moreover, why For the trust to work, all gift beneficiaries would you want to do this? It sounds like must have a real, even if contingent, interest. adding insult to injury. However, it works very In the example, the grandchildren become well in the right circumstances. beneficiaries on the death of their mother. The contingency is that they must survive their parent to become beneficiaries. If the
Chapter 19: Other Planning Techniques 167 Wealth Management Through Estate Planning
Before embarking on this type of plan, There are some negative factors and a the estate planning attorney needs to review QPRT should not be used until these have been the different income and estate tax rates of given serious consideration. If the donor does his client, the trust beneficiary and the trust. not survive the term, the full value The ability to structure a trust to achieve these of the property reverts back to his results is based on provisions in the Internal estate. Nothing is accomplished Revenue Code that allow a person to make a and in fact some harm may be gift to a trust but still have the income taxed to done. In using a QPRT, him. It sounds unusual but is perfectly legal. the donor may have foregone other gift QUALIFIED PERSONAL planning strategies. RESIDENCE TRUST With this technique, parents give My opinion their residence to a trust, retaining the right to live in the house for a period of years. Their children are the beneficiaries of the trust. At the end of the term, the children own the The tax planning strategies discussed house. Why would someone ever do this? in this chapter are very complex The reason has to do with estate tax and should only be used after planning and removing assets from a taxable careful consideration and analysis. estate. When the property is transferred to the Qualified Personal Residence Trust (QPRT), The transfers to QPRTs, GRATs and the donors are making a gift of a remainder GRUTs are irrevocable. Once they interest in the property. The value of the are done, they cannot be changed or remainder interest is less than the current reversed. value of the property because the remainder beneficiaries do not get to use or enjoy the property until the time period in which the donors continue to live in the residence has Also, if the donor survives the term, his expired. The value of the remainder interest interest in the trust terminates. He must either at the time of the creation of the QPRT is the move out of his home or start paying rent to value of the remainder interest discounted to its the new owners — his children. Paying rent present value. is not necessarily bad because it reduces an The benefit of the QPRT is that the value of estate for tax purposes but it is taxable income the gift to the children is not the current value to the recipient. Another problem is that the but the remainder value. The calculation of beneficiaries could refuse to rent the property the remainder value is based on a number of to their parents. This problem could be avoided factors including life expectancy, the period of with a binding lease entered into between time the QPRT lasts and the interest rate to be the Trustee of the QPRT as the owner of the used (the applicable federal rate) for assuming property and the donor as the lessee. the rate of return on the investments in the trust. The QPRT can be structured so that if the GRANTOR RETAINED ANNUITY property is sold before the trust terminates, the TRUST sale proceeds remain in the trust and the donor A Grantor Retained Annuity Trust (GRAT) receives a stream of income until the end of the is similar to a QPRT in that the donor makes a trust period. gift to a trust but retains an income interest for A QPRT can be very useful in removing a period of years. The trust is irrevocable. The a vacation home from the donor’s estate at purpose of a GRAT is to remove appreciating a favorable gift tax cost, provided the home property from the donor’s estate and thus meets the residence requirements. reduce estate taxes.
168 Chapter 19: Other Planning Techniques Wealth Management Through Estate Planning
The major benefit of a GRAT is the Example Janice establishes opportunity to transfer all of the appreciation a GRAT and funds it in the property over to family members gift tax with $500,000 worth of stocks. The term free. of the GRAT is ten years. She reserves an To maximize the benefit of a GRAT, the annuity payment of 5%. Each year of the assets in this type of trust should be invested term, she will receive $25,000. At the end of for growth. In the example, if the $500,000 this period, the property in the remainder trust Janice placed in the GRAT were invested passes on to the beneficiaries. in bonds that earned 5%, the value of the GRAT at the end of the term would still be $500,000. The tax savings benefit of this type When the trust is funded, Janice has made of planning technique would not be realized a gift. The value of the gift is the value of the because there was no growth in the value of remainder interest. The computation of the the GRAT’s assets. value of the remainder interest is like the computation done when creating a QPRT. Observation This value is a taxable gift to the remainder Determining if a beneficiaries. Usually there is no tax due GRAT should be used because the donor uses her estate tax credit requires careful analysis. The analysis must to eliminate any tax that would otherwise be take into consideration income, estate and payable. gift tax issues. Balancing and coordinating The 5% annuity payment can be the various tax aspects of a GRAT is determined two ways: challenging. ◆ A payment fixed to the value of the trust at the time it is funded. The annu- ity payment during the term of the trust The risk of a GRAT is that if the donor dies in the example would be $25,000. It during the term, a portion or perhaps all of the is not recalculated each year based on trust property will be included in her estate. the value of the assets in the trust. If the donor decides to use this technique, she may forego the opportunity to use other ◆ A graduated annuity amount. The rate strategies that would have irrevocably of graduation cannot exceed 20% per removed assets from her estate. For this reason, year. if a GRAT is being considered, the term of During the term of the trust, it is treated the GRAT should be less than the donor’s life like a grantor trust. This means that in the expectancy. example, the income, gains and losses from trust investments are taxed to Janice and GRANTOR RETAINED reported on her income tax returns. The UNITRUST annuity payment itself is not taxed. Thus, the A Grantor Retained Unitrust (GRUT) is donor could be taxed on an amount that is very similar to a GRAT except that the value higher than the annuity payment received. of the annuity payment floats with the value of The donor has the ability to structure the assets in the trust. Annually, typically the the distribution of the remainder interest to first day of the year, the amount of the annuity achieve other goals. The remaining principal payment for that year is re-determined. In our can be distributed outright to the beneficiaries example, assume that five years after creating or held in trust for them. This gives the donor the trust, the value of the assets is $800,000. the opportunity to blend the GRAT assets into The amount of the annuity payment for that personal planning objectives that she has year would be $40,000. created in other parts of her estate plan.
Chapter 19: Other Planning Techniques 169 Wealth Management Through Estate Planning
For this reason, a GRUT is not as effective as a GRAT for getting property Observation This can be a out of an estate. Part of the appreciation in very useful technique trust property is brought back to the donor in when a loan is to be made to a child who is the form of an increasing annuity payment. married. If you make annual exclusion gifts However, if the donor is also concerned about to both your child and in-law child and later receiving an increasing flow of cash, then a they get divorced, the in-law child (who now GRUT should be considered. becomes an out-law child) will rightfully claim part of the equity in the home. Contrast with INSTALLMENT LOAN WITH this installment loan technique where the gift FORGIVENESS OF PAYMENTS is made just to your child. This is a relatively straight forward trans- action that is designed to maximize use of annual exclusion gifts (i.e. $13,000 per year) each year of the note reduction. The former in a situation where a family member has an method is not recommended because the IRS immediate financial need that is larger than the could take the position that a gift of the entire amount that can be given gift tax free. amount was intended at the time the loan was made. The latter method has the benefit of allowing the parent to change her mind if her Example Arlene wants to purchase her first relationship with the child changes. It requires, home but does not have the $65,000 however, that annually the obligor receive a needed for the down payment. Her mother, Sophie, wants to written letter advising of the forgiveness of a help her out but does not want to give her the whole amount portion of the loan. at one time and create a taxable gift. Instead, she gives Arlene $13,000 and loans her the balance. A written note PRIVATE ANNUITY is prepared and each year for the succeeding four years, The use of a private annuity was discussed $13,000 of the loan is cancelled out. At the end of the peri- in Chapter 18: Business Succession Planning. od, the note is completely forgiven. It is also useful for the sale of other types of assets and the same rules generally apply. When the property is purchased, the new owners get a tax basis equal to the amount This is a valuable planning strategy where they agreed to pay. However, if the annuitant the parent does not want to use up any estate dies prematurely, the income tax basis is tax credit during her lifetime but wants to take reduced to the amount actually paid for the maximum advantage of annual exclusion gifts. property. Recall that with an annuity sale, It is also useful where prior transfers have con- the payment obligation stops on the death sumed the estate tax credit of the parent. The of the annuitant. If the property purchased is only negative feature of this arrangement is that depreciable, the purchaser can also take a the loan for the unpaid balance should carry deduction for depreciation based on the new interest. In our example, Arlene needs to pay value. this interest to her mother on the declining bal- ance until the note is fully cancelled by the gifts. CONCLUSION If this strategy is used, it needs to be In this chapter, we have briefly examined documented in a written loan agreement several sophisticated planning techniques. specifying the amount of the loan, the interest These strategies serve the function of giving due on the unpaid balance and other terms us flexibility when designing a gifting plan normally found in a note. The note can state for a family. Once it is understood how the that each year the amount of the loan is gift plan will work in the larger context of an reduced by the annual exclusion amount or estate planning strategy, then its economic the parent can advise the child separately advantages can be objectively valued.
170 Chapter 19: Other Planning Techniques Wealth Management Through Estate Planning
Chapter 20: Powers of Attorney and Advance Directives
Everyone has the ability to give someone the authority to make financial and health care decisions on their behalf. These documents round out the personal and economic planning portions of an estate plan.
Chapter 20: Powers of Attorney and Advance Directives 171 Wealth Management Through Estate Planning
Chapter 20:
◆ Financial Powers of Attorney
◆ Advance Directives
◆ Medical Powers of Attorney
◆ Living Wills
◆ Governing Law
“We can try to avoid making choices by doing
nothing, but even that is a decision.”
Gary Collins
172 Wealth Management Through Estate Planning
inancial powers of attorney, health ◆ To sell, buy, invest and reinvest your care directives and living wills are assets; F valuable components of an estate ◆ To write checks on and make plan. Everyone should have in place legal deposits and withdrawals from bank documents which allow someone to handle accounts; his personal and financial affairs if he ◆ To pay bills and other debts; cannot. If you do not have a valid power of attorney and you become incapacitated, ◆ To enter into contracts and lease a guardian may have to be appointed by property; the probate court to act on your behalf ◆ To file suit on your behalf and settle and make decisions. You can decide in any claims that you may have; advance whether or not you would want life ◆ The power to employ agents and support stopped if you are terminally ill or attorneys to assist in the handling of comatose. You can also appoint someone financial matters; to handle your financial matters. These matters are consistent with the overall theme ◆ To prepare, execute and file income of estate planning: we can create our own and gift tax returns; and rules. ◆ To enter into safe deposit boxes.
FINANCIAL POWERS OF Observation ATTORNEY Financial powers should be very detailed Each of us has the legal right to as to the rights given to the attorney-in-fact. appoint someone to act as our attorney- The clearer it is as to what is authorized, the in-fact to handle our legal and financial fewer problems will be experienced when it affairs. This right is exercised by signing comes time to use them. a financial power of attorney. A financial power of attorney is a written document that authorizes your named agent to act on your behalf to handle transactions There are other powers that can be relating to your property. The person giving inserted into a financial power to achieve the power is called the principal. The other objectives. These might include: person who is given the power is called the ◆ The right to apply for and be attorney-in-fact or the agent. You may appointed guardian of the person have already used some sort of a power of the principal, if this designation is of attorney without even knowing that this allowed by state law; is what you did. If you engaged a realtor ◆ The right to make gifts of the princi- when you bought or sold your home, you pal’s property; and appointed the realtor as your agent to do specific activities on your behalf. The same ◆ The right to amend a trust agreement concept applies to a financial power of entered into by the principal and attorney, but the agent is given the authority make transfers to and from the trust. to do many things on your behalf. These can be important provisions A good financial power of attorney will in a financial power of attorney. They include detailed provisions as to the exact provide flexibility to carry out the principal’s nature and extent of the powers being given wishes when the principal cannot do so. to the attorney-in-fact. The standard powers However, they must be very specific. For that you should expect to see in a financial instance, if an attorney-in-fact makes annual power include the right to do all of the gifts of the principal’s property to the following: principal’s children but does not have the
Chapter 20: Powers of Attorney and Advance Directives 173 Wealth Management Through Estate Planning
explicit authority to do so, the gifts may be prepared in New York is good in California. disregarded by the IRS and remain part of the While a health care power of attorney principal’s taxable estate. signed in another state should be valid in a However, before an attorney-in-fact is different state where it is being used, it is often given these types of powers, make sure that expedient to have a document consistent he enjoys your full trust and confidence. with that particular state law. Hospitals and Financial powers can be drafted in ways that nursing homes are most familiar with their own makes them very powerful. Before having one state forms. prepared, think carefully as to whom you are How long do powers of attorney last? going to designate as your attorney-in-fact Most powers do not have an expiration and how much control you want to give her. date. However, powers of attorney are only This usually is not an issue where the power is valid while the principal has legal capacity, being given to a spouse or responsible child. unless the power of attorney is durable. Most Suppose, however, that you are married for people want their powers to be durable the second time and have children from a first because that is exactly the time when they marriage. Can the power given to a spouse to want the attorney-in-fact to be able to act on act as your attorney-in-fact and make gifts be their behalf. A durable power of attorney used to disinherit your children? If so, you may states that it remains in force, even when the want to restrict the powers given to this spouse principal is incapacitated. To make the power or name another person. durable, language such as this is included The type of power of attorney described in the document: This power of attorney above is a general power of attorney. It shall not be affected by the disability of grants broad powers to the agent. If you want the principal. The law of the state of the someone to handle a specific task on your principal’s residence has to be checked as behalf, you might give them a limited power of to any specific language that is required to attorney. For instance, this power of attorney make the power durable. Durable powers of might be used if you wanted to authorize your attorney should only be given to persons who child to sign all of the documents pertaining to have the full faith and trust of the principal. the sale of a vacation home. The agent is given the ability to do many A financial power of attorney is needed things on your behalf and, once you are even if you have a living revocable trust and incapacitated, you lose the ability to supervise you have funded it with all of your assets. the agent. There are legal and financial issues that arise All powers of attorney lose their validity outside of the trust and the financial power upon the death of the principal. At that time, deals with these ancillary matters. These the Will and the trust state what happens in activities might include selling a car, changing the management of the deceased principal’s a mailing address, canceling credit cards and assets. other activities of a more personal nature. Powers of attorney may be revoked by a An estate planning attorney has more written revocation or by destroying the power flexibility in preparing a financial power and all copies. A written revocation is the than is available when preparing an better option to make sure that your intentions advance directive for health care matters. are clear. Health care powers are usually controlled Many times, a power of attorney is by the law of the state where the person immediately effective. You can continue to lives and, oftentimes, specific language is hold all of the original powers so that the mandated by the state law. There are not person you have named does not actually similar requirements for financial powers have in their hands the power of attorney and of attorney. A general power of attorney therefore cannot immediately go forward
174 Chapter 20: Powers of Attorney and Advance Directives Wealth Management Through Estate Planning
and act on your behalf. You can control MEDICAL POWERS OF when you give the attorney-in-fact the actual ATTORNEY signed power. A medical power of attorney allows you Some people prefer not to have an to name someone to make decisions about immediately effective power of attorney. your medical care if you cannot make those They want a power of attorney that will only decisions yourself. It is sometimes called a be active if they are incapacitated. This is health care power of attorney. There are called a springing power of attorney. different names for the person you name to This type of power will spring into effect act in this capacity. They may be called an when you cannot control your own financial attorney-in-fact or health care agent. affairs. The power should state how Having a medical power of attorney incapacity is determined. For example, it is important if you become incapacitated. may say that incapacity is to be determined It avoids delays in providing you medical by your regular physician. treatment and allows someone you trust Powers of attorney do not typically to carry out your intentions regarding the need to be recorded. However, expect that type of treatment you receive. By definition, if the power is used to transfer an interest health care powers are durable and in real property, it will have to be recorded springing. This means that they remain in in the recorder’s office of the county where force when you cannot make your own the real estate is located. Where the power decisions regarding health care and needs to be recorded, it must be executed in actually are not effective unless you cannot the same manner as a deed. In most states, make your own decisions. this requires that the signature of the person Even if you have a living will, you also be witnessed by two witnesses and a notary need a health care power of attorney. You public. Usually, the notary can be also serve may be far from death, but you may still as one of the witnesses. In order to make need someone to oversee your medical sure that the power of attorney can pass care, from selecting your doctors to muster with the recorder if it ever needs to selecting the health care facility be recorded, it is a good idea to have your where you are treated. signature witnessed and notarized at the time you create the power.
ADVANCE DIRECTIVES Each of us has the ability to give My opinion instructions as to how our future medical care is to be handled if there comes a time when we are unable to communicate I recommend that one or two alternates be our wishes. These instructions are called advance directives. There are two types named to act as successor attorneys-in-fact. of advance directives: a medical power of Having a back up in place is advisable to attorney and a living will. make sure that someone will be able to serve if the person originally named is unable or unavailable. I tell clients that this adds “shelf life” to their powers.
Chapter 20: Powers of Attorney and Advance Directives 175 Wealth Management Through Estate Planning
LIVING WILLS You can either call for forms for a small fee A living will is a statement that you or download forms without charge. Another want life support terminated if you have an resource for knowing the law in your state is to illness or injury that is certain to cause death visit the website run by Partnership for Caring, and medical treatment will only delay the Inc. at www.partnershipforcaring.org. The inevitable. toll free number is 1-800-658-8898. Advance Oftentimes, a living will only comes into directives can be ordered by telephone or play for elderly patients. However, a living downloaded from its website. Partnership for will may also be used if there is a catastrophic Caring is a non-profit organization and there accident that robs one of consciousness. is a small charge for getting the forms for your Bear in mind that as long as you can state state. Forms are also available at most health your wishes, neither the health care power of care facilities and nursing homes. As you attorney nor the living will will control. complete the forms, please consult with your With a living will, you are stating that attorney if you have any questions. you prefer that life support be withdrawn and that your life not be artificially prolonged CONCLUSION under certain medical conditions. The person Powers of attorneys and health care you name under your health care power directives are used in circumstances where of attorney cannot override your living will you are unable to manage your own affairs directive. or make your own health care decisions. Typically, living wills have intricate The only alternative to these documents may provisions that must be followed before be the appointment of a court supervised life support is terminated. This includes a guardian. If you want to have a say in how requirement that at least one doctor be of the your financial affairs and health management opinion that the illness is terminal and there is are overseen, these decisions need to be put no medical care that can lead to a cure. into place and periodically reviewed as part Without a living will, state law may of a comprehensive plan. provide a “cooling off” period before life Stating your preferences helps your family support is terminated. The law may also have members. They will have peace of mind in a list of people who have priority to make carrying out your wishes when you have these decisions for you. made these types of decisions in advance. A clear direction eases the burden of managing GOVERNING LAW your legal, financial and health matters and Both state and federal law control the use creates a plan for better management of these of advance directives. The controlling federal decisions. law is the Patient Self-Determination Act. It requires that health care facilities that receive Medicaid and Medicare funds inform patients of their rights to have Living Wills and Medical Powers of Attorney. Now, all 50 states and the District of Columbia have laws that provide for health care powers and living wills. There is a wonderful website called www.compassionandchoices.org that runs through all of the current state laws and forms. Their telephone number is 1-800-247-7421.
176 Chapter 20: Powers of Attorney and Advance Directives Wealth Management Through Estate Planning
Chapter 21: Asset Alignment Strategies
To make an estate plan work, it is important that ownership of assets and beneficiary designations are coordinated with the planning documents.
Chapter 21: Asset Alignment Strategies 177 Wealth Management Through Estate Planning
Chapter 21:
◆ Importance of Asset Alignment
◆ Choices for Ownership of Property
◆ Estate Plans Based on Wills
◆ Estate Plans with Trusts
◆ Responsibility for Asset Alignment
“Personally, I’m always ready to learn,
although I do not always like being taught.”
Winston Churchill
178 Wealth Management Through Estate Planning
n estate plan can achieve many ownership of the account because he is the important tax and personal planning survivor. Abenefits for a family. However, if the Sometimes joint tenant with right of assets are not aligned correctly with the survivorship is not the best way to own an estate plan, the planning goals may never asset. Why is this? When held between be achieved or the cost to achieve the goals spouses, this may result in the trust of the will increase dramatically. first spouse to die being underfunded for In this chapter, we take a look at the estate tax planning purposes. Having all of principal strategies that are used to align a couple’s assets transfer to the surviving assets with the plan documents. Please keep spouse avoids probate and estate taxes on several things in mind as you review these the first death, but leaves the estate of the suggestions. Because all state laws are surviving spouse vulnerable to estate taxes not the same, these may not be the correct on his death. way to handle ownership and beneficiary These are just two examples illustrating designations in your state. Also, these the importance of asset alignment. are general guidelines and should not be Each estate plan must be carefully applied to your particular circumstances scrutinized to determine how assets without the advice of competent legal should be titled and who should counsel. be the beneficiary. This is This chapter is designed primarily to essential to the success of help you understand the rationale behind the plan. the advice that you will be receiving from your estate planning attorney. My opinion IMPORTANCE OF ASSET ALIGNMENT When we talk about asset alignment, Failure to properly coordinate we are looking at how assets need to be owned to accomplish the objectives asset ownership and beneficiary of an estate plan. One of the objectives is to avoid probate administration when designations is kind of like having a someone dies. If investment accounts are left in one person’s name, at her death it nice car but not putting any fuel in will be necessary to open a probate estate and have an administrator appointed so the tank. It is not going anywhere. that the administrator can use his authority to transfer the account to the estate beneficiaries. This process increases the expenses of estate administration. In this chapter, we review the methods However, if the owner re-titles these and reasons for the different ways that accounts to the name of her trust or property needs to be owned when holds them as joint tenants with right of coordinating ownership with an estate plan. survivorship, then probate administration Asset alignment strategies can be broken is avoided at her death. With the trust, down into two general categories, those a successor trustee named in the trust where a Will is the main planning device automatically takes control of the account and those where a trust is used to achieve as trust property. With a joint and survivor estate planning goals. account, the survivor immediately has
Chapter 21: Asset Alignment Strategies 179 Wealth Management Through Estate Planning
Where an estate plan is based on a ◆ Naming a beneficiary when you have Will, the focus is primarily on avoiding or a Will and the property is to pass to minimizing probate administration. Where your spouse then your children: trusts are used, it is important to use asset Primary Beneficiary: James Madison allocation strategies designed to achieve Contingent Beneficiary: My then tax and asset protection planning goals in living issue, per stirpes addition to minimizing estate administration. This may not apply in all states and there are variations in this language Observation Joint and survivor which accomplishes the same thing. and POD accounts should This must be reviewed with legal coun- be used only after careful consideration. The sel before using. survivor or POD designee receives the funds in the ◆ Naming a beneficiary where a trust account by the terms of the account and this is not has been created: controlled by your estate plan. This can lead to Successor Trustee of James hurt feelings or worse. Madison Trust uad 3/1/06 For example, a parent may set up an account jointly with right of survivorship with one child ◆ Account to transfer on death where for the purpose of giving that child the ability allowed by state law: to access finances to take care of the parent’s James Madison, TOD to Dolly financial obligations. The parent may not realize Madison that at death, this child has complete ownership of the account and does not have to share the TOD stands for transfer on death. money with his or her siblings. Some states allow real property to avoid probate by preparing a deed that is TOD to a named beneficiary or to a group of identified people. This deed achieves the same result is CHOICES FOR OWNERSHIP OF an account that is POD (payable on death). PROPERTY Ohio permits the owner of real estate to use a TOD deed to avoid probate. You need to In the following materials, we discuss know what your state allows. how property should be owned or titled to These suggestions are included as a properly coordinate with an estate plan. general summary and for reference. Their These are the general choices that apply and applicability to different circumstances the recommended language to accomplish is discussed below. The recommended each of these: language is repeated in the following text ◆ Joint Tenant with Right of Survivorship: where appropriate to make sure that it is very James and Dolly Madison as joint clear which designation is to be used. tenants with right of survivorship There are several other forms of ◆ Titling account in donor’s trust: ownership available. In many states, accounts can be held in the name of the owner, James Madison, Trustee of James payable on death to a designated person Madison Trust uad 3/1/06 or even a trust. These are usually called UAD means under agreement POD accounts or TOD accounts. The benefit dated. Even where the successor of using these accounts is to avoid estate trustee is designated in the document, administration. These can be used to fund use this format. You do not know if trusts on the death of the owner. a particular successor trustee will be These are not advisable as forms of available at that time to serve. ownership, however, when someone wants
180 Chapter 21: Asset Alignment Strategies Wealth Management Through Estate Planning
to have property in trust during her lifetime. $100,000 Joint Account Child #1 Assets held in POD or TOD accounts are $100,000 subject to probate court administration if a guardianship is needed whereas assets Mother dies placed into a trust are not. For this reason, the discussion in this chapter does not Mother Child #1 include individual ownership as a preferred form of ownership where a revocable trust is involved as part of the estate plan. Problems with Jointly Held ESTATE PLANS BASED ON Child #2 Account WILLS (Disinheirited) Some estate plans use Wills for achieve other planning goals. The survivor directing the transfer of property at death. incurs the expenses of setting up a plan at Wills are commonly used for estates that time. involving a single person with no children Where there is just a single person, or with mature children, a young couple be careful using joint tenant with right of with no children or perhaps an older couple survivorship as a way to avoid probate. with mature children where tax planning Death of the owner may unintentionally is not a consideration. The objective is to disinherit other family members who are avoid probate administration if something not one of the joint tenants. A common happens to one of the spouses. example is a widowed parent with several In husband/wife circumstances, joint children who names one of the children tenant with right of survivorship may to be joint owner. Upon the death of the be the best way to own all property. Also, parent, the child on the account is the legal make sure that the spouse is named as a owner and has no responsibility to share the beneficiary of all life insurance policies and account with his or her siblings. retirement plans. Joint tenancy where there is one child Consider naming contingent may be considered in some circumstances beneficiaries in case something happens to because there is not a sibling issue. both persons at the same time. Where there However, for other reasons, such as control are children and grandchildren, you may of the property by the original owner, want to use the following as the contingent dynasty planning and asset protection beneficiary: My then living issue, per planning strategies, a single person or stirpes. Per stirpes means that upon your widowed parent may turn to the use of a death, the account is divided equally living trust. In this circumstance, the asset among each of your children but if a child alignment issues are controlled by the fails to survive you, his share is divided suggestions contained in the next section of among each of his children. It is a way to this chapter. preserve an equitable division of property in Accounts held in the name of the owner, case one of your children predeceases you. payable on death to one or more persons If a contingent beneficiary is not has an advantage over having the account named and the primary beneficiary does held joint tenant with right of survivorship. not survive the owner, the account will be The account clearly is owned only by the subject to probate administration. person who has her name on the account Following the death of one spouse, the and that person retains total control. surviving spouse can choose to create an Contrast this to joint accounts. Investments in estate plan designed to avoid probate and these accounts may be exposed to claims of
Chapter 21: Asset Alignment Strategies 181 Wealth Management Through Estate Planning
creditors of the other joint owner or become something happens to them. For reasons such an issue in a divorce case involving the joint as these, a Will should still be kept in place. owner. These “owners” may even make withdrawals from the account without first ESTATE PLANS WITH TRUSTS obtaining the permission of the owner who Where the estate plan focuses on the contributed the assets to the account. That use of trusts, asset alignment becomes more would be an unpleasant surprise! complex and more valuable. At this point, To hold accounts POD, the recommended the focus is not just on avoiding estate language is as follows: James Madison, administration but tax planning and asset POD Dolly Madison protection planning. Because everyone’s Beneficiaries of life insurance policies, personal situation is unique, there are not IRA's and similar accounts where there is no precise rules that fit everyone. However, there spouse and there are children should be as are general guidelines as to what has to be follows: My then living issue, per stirpes done. Here are the most important ones. Sometimes, you may need to name minor Residential Real Property children as beneficiaries of life insurance Residential real property owned by a policies or accounts such as IRA's. This might husband and wife should be held between occur where the amount of the account is them as joint tenants with right of not large and setting up a trust is not worth survivorship. This is a general rule and the expense. If you are in a situation such sometimes it is necessary to put a residence as this, consider naming an adult to receive in one spouse’s trust to make sure the trust the benefits as custodian under your state’s is funded for estate tax or asset protection version of the Uniform Transfers to Minors planning. However, this may not be advisable Act or other law that it may have in place if there is a significant mortgage on the that allows the naming of a custodian for property. Mortgage interest on residential minors. Having a minor be a beneficiary of an property held in an irrevocable trust (which investment account or an IRA is not advisable. it would be on the death of the spouse) By naming a custodian, a responsible adult may not be tax deductible. The same can be in charge of the asset until the child recommendations apply to a vacation home. attains the age specified in the state statute. Real estate taxes held in an irrevocable This is usually age 21. This is an example: trust will not be deductible on the trust’s tax James Madison as custodian under return. The deduction for real estate taxes the Uniform Transfers to Minors Act fbo on a home is limited to property owned by a Lawrence Madison person who resides there. Discuss with your Before doing this, check to make sure this accountant how these taxes can be deducted language is acceptable in your state. by the beneficiary. The overall goal in these situations is Finally, the ability to exclude some of the to avoid using the Will. However, a Will gain on the sale of a personal residence is not is still advisable for a number of reasons. available if the residence is held in the B Trust Frequently, the deceased has forgotten to of the deceased spouse. have correct beneficiary designations on all accounts. Also, he may have overlooked Other Real Property Interests titling accounts in his name POD to another. Real property such as commercial There may be benefits payable from an property and vacant land should be held joint employer that can only be paid to the legal tenant with right of survivorship with a spouse, representative of the estate. In some states, in the name of the owner as trustee or transfer parents can designate in their Wills who they on death to the trust. Deductibility of mortgage want to act as guardians of their children if interest and taxes will not be an issue where
182 Chapter 21: Asset Alignment Strategies Wealth Management Through Estate Planning
the property is used in business or leased. exemption, then the donor needs to have These are deductible businesses expenses. his trust funded up to this amount. If the estate plan uses an advanced Once each trust is fully funded to utilize planning tool such as a family limited the full amount of the estate tax credit partnership or a limited liability company, and the generation-skipping transfer tax the property may be titled in the name of exemption, then it is acceptable to keep the partnership or LLC. other assets held joint tenant with right of Checking and Small Savings Accounts survivorship. However, keep in mind that As a matter of convenience, many if both spouses died at the same time, this couples like to maintain a joint account for would trigger estate administration because paying household bills and other day-to- there is no surviving spouse to receive the day expenses. This is perfectly acceptable. property. Significant amounts of money, however, It is recommended that investments should probably not be kept in these such as stocks, bonds and mutual funds be accounts. Keep it in trust accounts and held in a brokerage type account instead transfer over to your checking account as of in share form. There are a number of needed. reasons for this including the safety of stocks A single person, however, should not being held in these accounts, reducing maintain any accounts in her name alone. the difficulty of trust administration if you This makes the account subject to estate become disabled or die and improving administration if the person dies. Single management of your investments. When you persons should set up their accounts in their use one of these accounts, it is also easier names as trustee, using the same format that to know what you have and how much it is is recommended for investment accounts. worth. Other benefits to a brokerage account Investment Accounts include having check writing capability Investment accounts need to be titled and the ability to use margin loans. Also, in the name of the owner as trustee. This many of the major brokerage firms now avoids probate and achieves the estate tax have arrangements where you can use goals. The recommended way to do this your dividends received into the account is like this: James Madison Trustee of to buy stock of the company issuing James Madison Trust uad 1/3/06. the dividend without incurring a sales Where the tax plan uses the strategy commission. Previously, the stock had to be discussed in Chapter 12: The A-B Trust in the custody of the company issuing the Strategy, it is necessary to make sure that dividends to buy additional stock with cash the property held in each person’s trust is dividends (DRIP account). sufficient to fund the deceased spouse’s B Trust up to the maximum amount of property IRA's, 401(k)s and Other Qualified protected from estate taxes by the estate tax Plan Accounts credit. If you are married, generally the For example, if death took place in primary beneficiary should be your spouse 2006, you would want at least $2,000,000 and the contingent beneficiary should be in the trust of the deceased spouse to fully your children in order to retain the income utilize the available estate tax credit. The tax deferral opportunities. For James estate tax credit amount for each year Madison’s IRA, the beneficiary designation appears in Chapter 4: The Federal Estate form might read: Tax. Primary: Dolly Madison If the estate plan also seeks to Contingent: My children, per stirpes maximize the use of the deceased donor’s Sometimes, your attorney may generation-skipping transfer tax recommend naming your trust as the
Chapter 21: Asset Alignment Strategies 183 Wealth Management Through Estate Planning
contingent beneficiary. The reason for this is An IRA cannot be transferred to your trust (You to provide flexibility for estate tax planning can only name your trust as the beneficiary). If instead of maximizing income tax deferral on either of these things occur, the asset loses its the IRA. If this is done and if the IRA is then tax deferral status and income taxes may be needed to fund the deceased owner’s trust immediately due. for estate tax planning benefits, the spouse Business Interests can disclaim his interest in the account and Your interest in a business should either the account is then used to fund the deceased be held in your name as trustee or TOD to owner’s B Trust. your trust. This is how the owner of the shares If you are single, you may want to name of stock in a business could be titled: James your trust as the primary beneficiary, but Madison, Trustee of James Madison Trust this must be carefully reviewed. Naming uad 1/3/06. a trust as a beneficiary may restrict the It may be preferable to title your stock this ability to "stretch" the required distributions. way: James Madison, TOD to Trustee of Alternatively, you may want to specifically James Madison Trust uad 1/3/06. This name certain individuals in order to maximize eliminates questions that sometime arise if you income tax deferral. Also, if you have a need to do something with your stock such as second marriage, naming a QTIP trust as the pledging it to secure a loan. Banks sometimes beneficiary may be appropriate if you do not need additional information if the stock is held want your second spouse to receive all of the in a trust, including demanding a copy of the funds outright at your death. If a trust is named trust, and this avoids disclosure of your trust as the primary beneficiary, you do not need and its terms. to name a contingent beneficiary because If your stock is subject to a buy-sell this will be covered in the trust agreement. agreement, make sure the transfer to Whenever a trust is named as a beneficiary, the trustee is allowed under the terms of you must have experienced legal counsel the document. You should also consider review the trust to make sure that it will not amending the document so that if something thwart any other planning goals. happens to you, the company or other You could name your beneficiaries directly shareholders are directed to deal with your and not have the property pass into the trust. trustee and not with the administrator of your The decision to do this depends on the goals estate. Usually, a buy-sell agreement states of your overall estate plan. In certain situations, that on the death of a shareholder, payments this may be in conflict with your estate planning are made to the deceased shareholder’s goals. Whether your trust should be named estate. It is preferable that the document as beneficiary of these types of accounts is a be amended to say that payments are to question that should be carefully reviewed with be made to the trustee of the deceased your estate planning attorney. shareholder’s trust and that all other activities It is advisable to have written confirmation can be transacted through the trustee. This from the custodian of an IRA or the plan avoids the necessity of opening an estate and administrator of a qualified plan as to the appointing an administrator. beneficiary you have selected. If the records Life Insurance are lost or incomplete, the copies can be The beneficiary of life insurance on used to set the record straight. Of course, they your life will depend on who owns the should have the records but you should not rely policy. If you own the life insurance, then on this. the beneficiary designation should read as An irrevocable trust can own an annuity in follows: certain circumstances but do not do this without Successor Trustee of James Madison first speaking with your estate planning attorney. Trust uad 1/3/06
184 Chapter 21: Asset Alignment Strategies Wealth Management Through Estate Planning
If the insurance is owned by an Notes and accounts receivables should irrevocable life insurance trust, then the be assigned to your trust. One important following beneficiary designation is to be reason for this is that when the debtor used: tenders payment of the obligation following (Name of Trustee), Trustee of James your death, he will want to deal with Madison Irrevocable Trust uad 1/3/06 someone who has the legal authority to give This is also the name that is to be used him a document satisfying the loan. Also, for designating the owner of the policy. if the payments are not assigned to your Never name your estate as the trust, the debtor will make payments to your beneficiary of life insurance. This causes two estate which will require the opening of a things to happen and neither one of them is probate estate. good. The proceeds will have to go through If the obligation was assigned to the estate administration. In some states, life trustee of your trust, the trustee will have the insurance proceeds paid to an estate are ability to give him the document he requires. subject to the state estate tax when they Otherwise, your heirs will have to open up would otherwise be exempt. an estate, have an administrator named Tangible Personal Property and either provide the appropriate release Many states allow residents to assign and satisfaction or transfer the note over to personal property that does not have a the trust so that the trustee can provide the title document (clothing, artwork, jewelry, appropriate documentation. furnishings, etc.) into their trusts by signing This is also a good time to reduce to a simple assignment that describes the writing any loans to family members and assigned property. The assignment should friends and indicate in the document that the also say that all future personal property is loans are payable to your trust. This not only also deemed to have been acquired by the avoids probate and protects your family’s trust and not by the individual. The act of interest in the loans but clears up the details assignment should keep this property out of regarding the loans so that there is not a estate administration. dispute when you die. Any note prepared Titled property such as cars and boats should include the amount of interest, state can be held joint tenants with right of if unpaid interest is simple or compounds survivorship if that is allowed by the law (interest accrues on unpaid interest) and of your state. Alternatively, such property, the due date of the obligation or that it is especially if it has significant value, can be payable on demand if a due date is not put in your name as trustee. specified. Some states allow the transfer of one Some employee benefit plans (stock or two motor vehicles to a surviving spouse options, deferred compensation) allow the even when they are in the name of just one designation of beneficiaries. Occasionally, spouse. For example, Ohio allows up to two this is not allowed and your interest in these vehicles with a total value of no more than types of accounts may have to go through $40,000 to be transferred in this way. In probate at your death. these states, nothing needs to be done as long as the vehicles in each spouse’s name do not exceed the allowable number and value. Other Assets
Chapter 21: Asset Alignment Strategies 185 Wealth Management Through Estate Planning
These matters should be discussed with Deed (home) your attorney so that you can divide up Sam, Trustee your areas of responsibility. You should also Deposit accounts ask if there are any additional fees for him of his Trust helping you with this. Most attorneys include Name beneficiary the explanation of asset alignment as part of Sam their fees but may charge an additional fee if they need to prepare documents such as Align your assets with your plan! deeds or assignments to accomplish the asset alignment. RESPONSIBILITY FOR ASSET It is also good idea to make copies of all beneficiary designations. Keep these in your ALIGNMENT file and give your estate planning attorney a It is the responsibility of the client to copy. If the custodian of the account cannot implement the decisions as to how property is locate these after your death, the copies will to be titled. It is the responsibility of the estate be used to identify the beneficiary. planning attorney to give the correct advice on asset alignment. CONCLUSION Much of the work that is needed to be In order to achieve the maximum benefits done can be done without the involvement that the plan is designed to give you, it is very of the attorney. You do not need your lawyer important that the title to your assets and your to go with you to the bank to set up a jointly beneficiary designations be maintained in held bank account. Because you can do this accordance with your overall estate plan. This legwork, it helps keep your legal fees down. chapter covered the most important issues that You will also be working with your need to be addressed. Please remember that financial advisor on setting up new accounts you should consult carefully with your estate in your name as trustee and she can provide planning attorney as to his advice on asset you with beneficiary designation forms for alignment. The information in this chapter IRA's and similar accounts. Some brokerage will, hopefully, help you to understand the firms allow accounts to be held in the name of reasoning behind his advice and serve as the owner with a transfer on death (TOD) to a guidelines for completing this important part named beneficiary. This is helpful and acts in of an estate plan. the same way as a beneficiary designation on an IRA or insurance policy. There are certain situations where the attorney needs to be involved. The attorney should be responsible for preparing any deeds to retitle real estate. He should also review beneficiary designations and prepare any written assignments of property that are needed to transfer other property interests into your trust.
186 Chapter 21: Asset Alignment Strategies PART IV: Elder Law Planning Issues
187 Wealth Management Through Estate Planning
PART IV:
Chapter 22 Guardianships and Conservatorships Chapter 23 Life Care Planning Chapter 24 Long Term Care Insurance
188 Wealth Management Through Estate Planning
Chapter 22: Guardianships and Conservatorships
In this chapter we explore the statutory provisions covering guardianships and conservatorships. Both of these legal proceedings are supervised by probate court.
Chapter 22: Guardianships and Conservatorships 189 Wealth Management Through Estate Planning
Chapter 22:
◆ Guardianships
◆ Bond Requirements
◆ Court Costs
◆ Guardian’s Compensation
◆ Attorney Fees
◆ Conservatorships
“He who is always his own counselor will often
have a fool for his client.”
Portfolio Magazine 1809
190 Wealth Management Through Estate Planning
GUARDIANSHIPS members who each want to be appointed A guardian is a person appointed by the guardian, the probate court must decide a probate court to handle the care and which person is best suited to be named as management of the person, the estate, or the guardian. The court also has the ability both of a minor or an incompetent. The to appoint a non-interested person as the function of the guardian is to take care of guardian. This is usually a local attorney the ward. There are two types of wards: known to the court and the court may minors and incompetents. A minor is a regularly appoint this attorney as guardian person under a certain age. In most states if there is no suitable person or if the family this is age 18. An incompetent is a person members cannot agree. who is so mentally impaired as a result of a The application provides the court with mental or physical illness or disability that basic information about the proposed ward, he is incapable of taking care of himself or the anticipated size of the estate, the names his property. and addresses of the next-of-kin (who are Guardians can serve in three notified that a guardianship application is capacities. A guardian can be the pending) and whether the guardianship is to guardian of the person, the guardian be limited in scope or duration. of the estate or both. The duties of the The applicant must state a specific guardian of the person only are to protect reason for the guardianship, which is and control his ward, provide for the care often the mental incapacity of the ward. of the ward (which includes making sure Because the law presumes that all adults are the living environment is good and that the competent, the court will need evidence that ward receives appropriate health care) and the ward is incompetent. This is commonly ensure that the ward obtains an education done by providing a medical report if the ward is a minor. The guardian of an on the mental condition of the alleged estate is in charge of the property of the incompetent. After the application is filed, it ward and must file an inventory with the is then the function of the court to determine probate court describing the assets of the the need for the guardianship. ward’s estate, manage the assets for the Once a guardian is appointed, best interests of the ward, pay his debts, the adult ward loses control over his collect any money due to the ward and own affairs. Because the law views self- bring or defend lawsuits on behalf of the determination as a fundamental right of all ward. A guardian named by the probate adults, the law provides specific rights to an court is often the guardian of both the alleged incompetent ward at the hearing on person and the estate of the ward. his competency. For instance, a ward has The probate court has jurisdiction the right to attend the hearing and have an over all guardianships. A guardianship attorney represent him. The ward also might proceeding is initiated by a person filing have the right to have a friend or family an application to appoint a guardian member attend the hearing and the ward with the probate court. Who can file this can present his or her own evidence of application? Anyone who has an interest in competency through an independent expert seeing that the ward receives proper care evaluation. and oversight. If there are dueling family
Chapter 22: Guardianships and Conservatorships 191 Wealth Management Through Estate Planning
BOND REQUIREMENTS Observation I often receive troubling calls The guardian of an estate is required to from the children of clients who are post an insurance bond. The purpose of the having concerns about an aging parent. The children bond is to reimburse the guardianship estate may be concerned that the parent is giving money away in the event the guardian steals from the estate to sweepstake offers and is subject to the persuasions of or mismanages the ward's financial affairs. telephone marketers. The parent may be throwing bills This bond is usually double the amount of the away and otherwise behaving oddly. It is hard to give guardianship assets, excluding real estate advice in these situations. We suggest family meetings and the cost of the bond is paid by the ward’s with the parent’s physician and the attorney to review assets. The premium on the bond can be as what is going on and to recommend a course of action. little as $50 per year or as high as several This is a very sensitive time for all of the family members thousand dollars per year, depending on the and the attorney must help to develop a plan that works value of the ward’s assets. for everyone. When the guardian files his biennial account, the court will review the amount of the bond then in place. If the current bond is In order to assist the court in making its not sufficient, then the guardian must purchase decision as to the need for the appointment of an additional bond or, if the current bond is a guardian, the court appoints an investigator. too high, then the court may order a reduction The investigator talks with the alleged in the bond coverage. incompetent and explains the guardianship process. The investigator’s report to the court COURT COSTS will include the investigator’s observations The cost to establish a guardianship of the alleged incompetent and will have a (either for a minor or an incompetent) is paid recommendation by the investigator as to out of the guardianship funds. Additionally, the need for a guardianship and whether when applications, accounts or other or not the alleged incompetent needs to be documents are filed additional costs are represented by counsel at the hearing. incurred that are paid out of guardianship Once a person is appointed the funds. Compared to the other costs of a guardian, he must file with the probate court guardianship, court costs are low, but they that appointed him a complete inventory of can add up over a long period of time all of the assets of the ward. The inventory especially when there is a lot of activity in the describes in detail each asset and its value. guardianship. Thereafter, the guardian must file a complete account with the probate court. GUARDIAN’S COMPENSATION Usually, the accounting covers a two year The compensation of the guardian is period. The account must include an itemized governed by the local rules of the probate statement of all receipts and disbursements court. The guardian is entitled to be of assets during the accounting period. It is compensated based on a percentage of important that a separate bank account to be the value of the ward’s property managed opened up for the ward’s property and all of by the guardian. If the guardian renders the money received on behalf of the ward is to extraordinary services to the guardianship be deposited into this account. The guardian estate, such as engaging in litigation or cannot commingle the ward’s property with his managing rental real estate, the guardian or her own property. Careful records must be may apply for additional fees. kept of all receipts and expenditures and the The guardian is entitled to compensation guardian must have prior approval by the court each accounting period. The guardian must to make these expenditures. make a request for his compensation when he
192 Chapter 22: Guardianships and Conservatorships Wealth Management Through Estate Planning
Probate Court files the account. This request Trusts usually have more flexibility in for compensation may be set how they can invest their assets. Probate for hearing by the court and courts typically require a very conservative Reports Appoints is subject to approval by the investment approach. This can be good and to court guardian probate court. bad depending on your own viewpoint on investments and the person or corporation ATTORNEY FEES you choose to be your trustee. Guardian In most instances, the If a living trust is used to manage the guardian will retain an financial affairs of the ward, the trustee attorney to assist him with the must be someone who is very careful and guardianship administration. trustworthy or a corporate trustee. In these Manages It is the guardian who situations, I also suggest the appointment of care and hires the attorney and is another person to oversee the trustee and property responsible for the attorney’s review the trust’s accounts. This person is fee. The guardian is called the Trust Advisor. Ward entitled to reimbursement Only use a living trust to manage the of the attorney’s fee if it is financial affairs of the guardian after careful reasonable, the attorney’s consideration and planning with your estate assistance has been planning attorney. Wards are vulnerable by beneficial to the estate definition and a priority must be scrupulous and the guardian is in compliance with all court orders, including the filing of his account. Unlike the guardian’s Observation The guardian compensation, the attorney’s fee is should retain not always determined by statute or an attorney who is experienced with local rule. However, before the guardian guardianship procedures in the area where may pay a fee to the attorney from the the ward lives. This attorney will know the guardianship funds, the guardian must local court rules and, more importantly, may make an application to the court for know the judge or magistrate who is making approval of that proposed expenditure. decisions on the case. The court may hold a hearing on the attorney fee application to ensure that the services were beneficial to the estate and handling of their affairs. reasonable in amount. CONSERVATORSHIPS GUARDIANSHIPS While a conservatorship is similar to a AND LIVING TRUSTS guardianship, there is one major exception: Assets in a living trust established by a conservatorship is entirely voluntary. The the ward while he was competent are ward himself requests the appointment of not subject to probate court supervision. the conservator. A ward must be mentally In some circumstances, this can be useful competent to have a conservatorship for more efficiently handling the financial and the conservatorship terminates if the affairs of the ward. If all of the assets of the ward later becomes incompetent. Also, ward are in the trust, there need be only a a conservatorship may be confidential if guardian of the person. A guardian of the requested by the ward. Guardianships do estate is not needed. This eliminates the not have any of these characteristics. need to file with probate court an inventory The conservatorship proceeding begins and periodic accountings. with the ward making an application for the
Chapter 22: Guardianships and Conservatorships 193 Wealth Management Through Estate Planning
Once the conservator is appointed, the process is the same as that for a guardianship, including the responsibility to file an account. The conservatorship terminates upon: ◆ A judicial determination of the ward’s My opinion incompetence; ◆ The death of the ward; or ◆ The written request of the ward to ter- Because there is no finding of minate the conservatorship. The use of a conservatorship is becoming incompetence, it is often easier for less attractive because of the increased use of living trusts. This is frequently a better, lower an older person to agree that a cost alternative.
conservatorship is a good idea, CONCLUSION especially if the person is fighting a Guardianship and conservatorship proceedings can be quite complicated proposed guardianship. and expensive. Guardian’s compensation, attorney fees, and costs such as for the bond for the guardian can add up to significant amounts of money and are paid from the appointment of a conservator. In order for the guardianship or conservatorship estate. application to be granted, the applicant must The benefit of having a guardianship be a competent adult who is physically infirm. or conservatorship is that the probate court The applicant must also state the name of his supervises the care of the ward and the proposed conservator. management of the assets of the ward. This The ward is given wide latitude in oversight reduces the chance of overreaching determining what duties his conservator by unscrupulous individuals. In the past, the will perform for him. The ward may limit the only legal process available to incompetent conservator to control of his person or of people was a guardianship process and it his estate, or the conservator may fill both served the needs of appointing a suitable roles. The ward may list specific powers of person to help the ward. However, if a person the conservator or may give general powers has reliable, trustworthy family members and reserve certain limited powers for himself. or involves a good trust company, estate However, the ward may not waive the planning offers other alternatives to the requirement that the conservator post a bond guardianship and conservatorship process. for his faithful performance of his duties as a conservator.
194 Chapter 22: Guardianships and Conservatorships Wealth Management Through Estate Planning
Chapter 23: Life Care Planning
The concern over the high cost of long term care forces many individuals to evaluate the availability of Veterans' Benefits and Medicaid to cover these expenses. Qualifying for these programs requires a collaborative effort of all professionals to evaluate and implement a strategic plan.
Chapter 23: Medicaid Planning 195 Wealth Management Through Estate Planning
Chapter 23: ◆ Life Care Planning ◆ Benefits for Veterans and their Families ◆ Medicare Coverage ◆ Medicaid Benefits ◆ Considerations for Married Couples ◆ The Deficit Reduction Act and Qualifying for Medicaid Benefits ◆ Other Planning Strategies ◆ The Medicaid Trust ◆ When is a Medicaid Trust Appropriate ◆ Other Advantages and Disadvantages of Medicaid Trusts ◆ Other Types of Trusts
“Cherish all your happy moments; they make
a fine cushion for your old age.”
Christopher Morley 196 Wealth Management Through Estate Planning
LIFE CARE PLANNING care process that focuses on maximizing the senior’s quality of life as he or she travels The Challenges Facing Seniors and through the long term care system. While Traditional Approach to Planning many of the services are similar to the normal Older Adults and their families are often elder law practices today, Life Care Planners times uninformed about the long term care offer a much wider array of services for their system. In addition, they are often lacking clients and focus on implementing a plan that the proper information to ask specific supports and achieves his or her short and questions regarding legal and financial long term care goals. matters. Many times families find themselves A Life Care Plan combines legal thrust into the long term care system as a representation and asset protection with care result of a traumatic event such as a fall, a coordination and advocacy into a single chronic illness, motor vehicle accident, or convenient package that answers all the any other of the many conditions that can tough questions about the senior’s long term cause a person to require long term care care, now and in the future. Like a traditional services. estate and asset preservation plan, a Life Care There are many challenges with the Plan includes the legal protection needed to long term care system, which makes it a safeguard assets, honor a senior’s wishes and very complicated system to unravel and provide for his or her family members. understand. The consequences of poorly However, a Life Care Planner’s services managed care, missed benefits and not do not end there. A Life Care Plan describes utilizing the many options that are available how the senior’s long term care and financial, can make a difference in a person’s quality physical and psychological needs will be of life. The result of these challenges is that met. It is a “roadmap” for total care. As a people must “rethink” the way they plan for result, the senior gets the appropriate care the future and take into consideration the sooner, maximizes independence for as long very real possibility that long term care may as possible, and has the ability to age with become a part of their lives. dignity. Families get assistance in selecting When seniors and their families the right care and services and guidance seek out information for care, they face with legal, health care and long term care a complex and often mind-boggling maze of publicly supported and private options with no centralized resource Life Care Planning Every Life Care for information. The typical Medicaid/ Objectives Plan is designed to estate planning practice concentrates achieve three primary on planning for the worst – incapacity goals: and death. However, because of the 1. Make sure the senior receives very narrow legal focus, the traditional appropriate care, whether at home or Medicaid/estate planning approach does in a residential facility, to maintain the not aid the senior and their family until the quality of life that the senior deserves senior has reached a financial crisis. Under and desires. the Medicaid/ estate planning approach, 2. Locate public and private sources the services available are normally limited to help pay for long-term care while to the assembly and execution of basic resolving issues created by the high cost estate planning documents and the senior of care. and his or her family are typically left on 3. Offer peace of mind that results when their own again until another crisis occurs. the right choices are made to ensure the The Life Care Plan senior is safe and getting the right care By comparison, Life Care Planning while preserving family resources. takes a different approach to the long term
Chapter 23: Medicaid Planning 197 Wealth Management Through Estate Planning
decisions as their loved one’s condition and assessment of the senior ensuring progresses. those charged with caring for the senior The Components of Life Care Planning are providing the best quality care. ◆ Legal Services The legal issues created by aging, ill- BENEFITS FOR VETERANS AND ness, chronic conditions or disability can THEIR FAMILIES be challenging. This is why every Life The United States Department of Veterans Care Plan includes the legal services the Affairs (VA) offers a broad range of services senior needs to protect his or her inter- for Veterans of all ages. Unfortunately, some est and to provide for dependents and services are underused because many older other family members. Depending on Veterans and their families do not realize the senior’s needs and the family circum- these services exist or that they may qualify. stances, the Life Care Plan will typically They do not apply for VA benefits even include one or more of the following though factors such as low income, disability legal services: wills, trusts and powers of or wartime service may have made them attorney; resolving the asset protection eligible. problems created by the high cost of Requirements for benefits have changed quality long term care; Medicaid asset over time. Some benefits today do not require protection planning, planning and quali- a service-related injury, although they may fication for Veterans’ Affairs benefits; require co-payments for Veterans whose determining public benefits eligibility; family income and assets exceed the annual establishing Special Needs Trusts; and limit for no-cost service. These and other probate and estate administration. Many benefits may apply: of these services and benefit programs ◆ Respite care to relieve family caregiv- are described below and in various ers of Veterans with dementia other chapters. ◆ Medical care for eligible Veterans who ◆ Care Coordination and Client service during wartime Advocacy ◆ An Elder Care Coordinator (ECC) is Disability compensation for Veterans familiar with the costs, quality and avail- with service-related injuries ability of resources in the long term ◆ Non-service connected pension for care community. The ECC guides the low-income Veterans who served dur- senior and their family through the ins ing wartime and outs of the long term care system. ◆ Aid and Attendance for eligible The ECC is responsible for coordinat- Veterans in need of the regular Aid ing care according to the needs and and Attendance of another wishes of the senior. Some of the care ◆ Burial benefits for eligible Veterans coordination services incorporated in a customized Life Care Plan include: assis- ◆ Death pension for low-income surviving tance with locating and hiring in-home spouse and dependents of Veterans help and other services; coordinating who served during wartime with medical and health care providers; General Eligibility for VA Benefits providing support, guidance, and advo- Eligibility for most VA benefits is based cacy during crisis; arranging for alterna- upon discharge from active military service tive housing, if needed; and providing under other than dishonorable conditions. education, counseling and support for Honorable and general discharges qualify a the senior and his or her family. Not Veteran for most VA benefits. Dishonorable only does the ECC assist the attorney in and bad conduct discharges issued by exploring all avenues for resources, but general courts-martial bar VA benefits. VA they also provide ongoing monitoring regional offices can clarify eligibility of
198 Chapter 23: Medicaid Planning Wealth Management Through Estate Planning
prisoners and parolees. Active service under conditions other than dishonorable. means full-time serve as a member of the Payments are made to qualified Veterans Army, Navy, Air Force, Coast Guard, or to bring their total income, including other as a commissioned officer of the Public retirement or Social Security income, to Health Service, the Environmental Services level set by Congress. Countable income Administration or the National Oceanic and may be reduced by unreimbursed medical Atmospheric Administration. expenses. Certain VA benefits including medical The payment is reduced by the amount care require wartime service. Under the of the countable income of the Veteran and law, VA recognizes these war periods (there the income of the spouse or dependent are prior periods too, not listed, such as children. When a Veteran without a spouse World War I): or a child is being furnished a nursing ◆ World War II: December 7, 1941 home or domiciliary care by the VA, the through December 31, 1946 pension is reduced to an amount not to exceed $90.00 per month after the three ◆ Korean War: June 27, 1950 through calendar months of care. The reduction January 31, 1955 may be delayed if nursing home care is ◆ Vietnam War: August 5, 1964 being continued for the primary purpose (February 28, 1961 for those who of providing the Veteran with rehabilitation served “in country” before August 5, services. 1964) through May 7, 1975 Aid and Attendance ◆ Gulf War: August 2, 1990 through a Aid and Attendance is a non-service- date to be set by law or Presidential connected benefit available to Veterans Proclamation or surviving spouses of Veterans whose Disability Compensation medical expenses exceed their income, VA disability compensation benefit is and who need regular help with activities a monetary benefit paid to Veterans who of daily living. The Veteran must show a are disabled by injury or disease incurred medical need before Aid and Attendance and aggravated during active military benefits will be paid. service. The service of the Veteran must To be eligible for Aid and Attendance have been terminated through separation or benefits, the Veteran or the surviving spouse discharge under conditions that were other of a Veteran must have: than dishonorable. Disability compensation ◆ Medical expenses that exceed his or varies with the degree of disability and the her income. Medical expenses can number of dependents. The benefit is paid include in-home care, prescriptions, monthly and is not subject to federal or nursing home or assisted living costs state income tax. The payment of military and more. retirement pay, disability severance pay and ◆ Countable assets of a reasonable separation incentive payments affects the net worth. For a married couple a amount of VA compensation paid. “reasonable net worth” has been Non-Service Connected Pension deemed to be below $80,000 and Veterans who meet the income- below $40,000 for a single person. threshold and who are permanently and ◆ A need for regular aid and atten- totally disabled for reasons other than dance, which means the Veteran or the Veteran’s own willful misconduct surviving spouse must need help with may be eligible for monetary support if at least two activities of daily living. they have ninety (90) days or more of If the Veteran or the surviving spouse active military service, at least one day is bedridden or is mentally or physically of which was during a period of war. The incapacitated and assistance is required on discharge from active must have been
Chapter 23: Medicaid Planning 199 Wealth Management Through Estate Planning
a regular basis, then the criteria will be met. eligibility requirements which apply. These are discussed below. MEDICARE COVERAGE Asset Limitations Contrary to the belief of many seniors, a An individual has to become virtually person cannot rely on Medicare for payment impoverished before he or she qualifies for of long term care costs. Although Medicare is Medicaid. Assets cannot exceed $1,500 to available to most individuals age 65 or older, $2,000, depending on the state. All assets coverage is limited. Medicare only pays for available to the applicant are counted in nursing home care following a hospital stay determining the assets of the Medicaid of at least three days and only if the care applicant, except those which are exempted provided is considered “skilled care”. Skilled by Medicaid. The asset limitation tests are care is provided under the supervision of very restrictive. Exempt assets are those assets a physician, requiring skilled professionals which an applicant may own but which are such as physical therapists or registered not counted for determining the applicant’s nurses, as opposed to “custodial care” which eligibility for Medicaid. Some examples of provides basic personal care and other exempt assets are as follows: maintenance level services. Home health ◆ Personal effects and household goods care may be available in limited amounts, but only if “medically necessary” which is a very ◆ A car with a market value of $4,500 rigorous standard. For all Medicare benefits or less there are deductibles and co-payments which ◆ A burial space for the applicant can be substantial. ◆ A pre-paid funeral irrevocable funeral contract MEDICAID BENEFITS ◆ Income-producing property with Unlike Medicare, Medicaid is a $6,000 or less of equity government program which pays medical costs and long term care costs. To qualify ◆ Assets for which there is no market for Medicaid an individual must meet strict value financial and other eligibility requirements. ◆ The cash value of life insurance when The rules governing Medicaid are complex the combined face values of all life requiring great care in the planning and insurance policies is below $1,500 application for benefits. In some states, a residence owned by an Income Limitations unmarried or widowed applicant is exempt for Before a person will qualify for Medicaid thirteen months after the date the individual benefits in a nursing home, he or she must enters the nursing home. After the thirteen- meet the following general eligibility criteria: month period has expired, the house must be listed for sale and sold within the next six ◆ Be at least 65 years of age, blind or disabled months in order to maintain eligibility. States have differing rules regarding a house owned ◆ Need assistance with at least two by a single applicant. The proceeds will then activities of daily living need to be spent down before continued ◆ Satisfy both the income and asset limi- Medicaid qualification is allowed. tation thresholds A house is exempt for an unlimited period The income limitation for most states of time if the applicant’s spouse or dependent is that the individual’s income must be less child resides therein or if there is a sibling of the than the nursing home charges, less $40 applicant who has an ownership interest in the or $50 for personal needs. Medicaid pays property who has lived in the house for at least the shortfall between the applicant’s income one year prior to the Medicaid application. and the nursing home expense. However, The foregoing is a very general where there is a spouse, there are other description of the asset limitations and is used
200 Chapter 23: Medicaid Planning Wealth Management Through Estate Planning
only to illustrate the limited exemptions to The spouse in the nursing home the asset limitations. may transfer some or all of his income to the community spouse. Currently , if the CONSIDERATIONS FOR community spouse’s income is below the MARRIED COUPLES Minimum Monthly Maintenance Needs There are different income and asset Allowance (MMMNA) this spouse has a rules for married couples. Prior to the right to part of the institutionalized spouse’s implementation of the Medicare Catastrophic income. The MMMNA is equal to 150% of Coverage Act of 1988 (MCCA), Medicaid the federal poverty level for a two-person looked solely to whether the institutionalized household. The MMMNA is currently spouse’s name was on the asset. If it was, $1,839. There is also an Excess Shelter it was counted and if it was not, it was not Allowance (ESA) which is the amount of the counted. community spouse’s monthly housing and utility expenses. The combined amount may be increased up to $2,489 (in 2012) per Medicaid Split of Marital Assets month or higher if mandated by a court. These figures are updated yearly on July 1. Treatment Of Assets For Married Couples In determining the assets of an institutionalized spouse, a snapshot of all In most cases, $136,360 $113,640 of a couple’s assets is taken as of the first day that the patient goes into a nursing the spouse in the home or hospital for at least 30 days. This community can is called the first continuous period keep no more than of institutionalization (FCPI) or the $113,640 Snapshot Date. The snapshot determines the countable This led to harsh outcomes. If a spouse resources as of that date. Those resources are went into a nursing home, and all of the then divided in half. The community spouse assets were in his name, they had to be spent may keep one half of the assets, and the down to $1,500, leaving the spouse totally spouse in the nursing home keeps the other impoverished. To add insult to injury, the non- half. There are limits on the amount that the institutionalized spouse could not have any community spouse may keep. In 2012, the of the spouse’s income for support. This was community spouse may keep one half up to devastating to a spouse who had little other $113,640 of the couples’ assets. income. The chart shown above represents a Now, there are protections to prevent the couple with $250,000 of assets and the split non-institutionalized spouse from becoming that Medicaid will impose. Under the rules, impoverished. An overview of those rules is as the community spouse keeps $113,640, follows. and the spouse in the nursing home has Treatment Of Income For Married Couples $136,360, which must be spent down to Generally, income is distributed as it is $1,500. titled. In other words, the husband’s checks The goal of the estate planner is to go to the husband and the wife’s checks go attempt to re-distribute as much of the to the wife. Once on Medicaid, the spouse $136,360 to the community spouse or other who is in the nursing home will pay his or person without making the institutionalized her check to the nursing home. However, spouse ineligible for Medicaid. This can be there can be some redistribution based done with timely transfers, purchasing exempt upon the income of the non-institutionalized assets or other strategies. spouse. This person is also called the “community spouse.” Chapter 23: Medicaid Planning 201 Wealth Management Through Estate Planning
PLANNING TO QUALIFY FOR This example highlights some very MEDICAID BENEFITS important considerations about Medicaid planning. John has to make a determination On February 8, 2006, President Bush as to whether it is more important to give signed into law the Deficit Reduction Act up ownership now so that he will qualify for of 2005 (DRA). This law made sweeping Medicaid in the future or retain his assets and changes to Medicaid eligibility rules, gamble that he will not need expensive medical particularly as they relate to assets transfers care or require nursing home care. to create Medicaid eligibility. If you were familiar with the Medicaid eligibility rules prior What happens if a transfer of property is to the DRA, these rules may seem strange to made during the look back period? you. First, the DRA extended the look back If a transfer of property occurred within the period, discussed below, from 36 to 60 months, look back period, a period of ineligibility will Second, under the old law, the penalty period be applied. The penalty is applied for a specific began to run on the date someone actually period of time (in months), starting at the date made a gift. As we will see, the new rule has the person is in the nursing home receiving care changed the date the penalty period begins to and would have been eligible for Medicaid run to make qualifying for Medicaid much more except for the fact that he or she gave away difficult. non-exempt assets during the look back period. Persons who want to plan for their future The penalty is a period of time, in months, ability to qualify for Medicaid benefits are equal to the amount of the transfer divided by placed on the horns of a dilemma. In order to the average monthly cost of a nursing home qualify for Medicaid benefits, they must bring in the state in which the transfer is made. This their asset levels within the asset limitations. rate differs from state to state and changes The simplest way for a person to do this is periodically. It is important to seek out skilled to give away all of his or her non-exempt legal assistance before transferring any assets. assets. However, not all persons need nursing An example of the penalty period calculation is home benefits and may unnecessarily give the following: up ownership of their assets when they never need to enter a nursing home or Example apply for Medicaid benefits. This problem Margaret transfers is compounded by the fact that transfers of $60,000 on January assets to someone by the applicant within 60 1, 2012, to her daughter. Margaret enters months of filing an application for Medicaid a nursing home and applies for Medicaid may cause ineligibility. In applying for benefits, on January 1, 2013 when she is down to the agency administering Medicaid is allowed $1,500 of non-exempt assets. Because to look back over these time periods. These are she made the transfer within 60 months of known as the look back rules. The mechanics applying for Medicaid, the Medicaid agency of the look back rules are illustrated by the will apply a penalty period. The penalty following example: period will begin on January 1, 2013 since that is the date she is both institutionalized and eligible for Medicaid. Example John gives his house to his children on January 1, 2012. He then enters Applying too early after transferring a nursing home and applies for Medicaid too much in assets can lead to serious benefits on August 1, 2017. More than 60 problems. Suppose in our example that months have elapsed between the property Margaret transferred $600,000 instead of transfer and the application for Medicaid. The $60,000. Her period of ineligibility would gift of the property will not disqualify him for be 100 months! The penalty period in the Medicaid benefits. example is calculated as follows. Assuming the average nursing home cost in the state 202 Wealth Management Through Estate Planning
is $6,000 per month, the penalty will be 100 subject to creditors’ claims or become an issue in a month ($600,000/$6,000=100). Had she division of property in a divorce case. Therefore, it instead waited to apply until the 60 month period is very important to carefully evaluate the potential elapsed, she would immediately qualify for consequences before transferring assets to another Medicaid benefits. Applying before the look back person. period expires can, in some cases, extend the What Can The Transferred Money Be Used For? period of non-qualification beyond the time period Once property is transferred, it belongs to the that would normally apply. transferee. However, this person can still use these As long as the applicant keeps enough money assets to pay for things that are not covered by to pay for 60 months of nursing home coverage, Medicaid and not effect eligibility. he or she can pay privately for 60 and then apply For instance, Medicaid will not pay for a successfully for Medicaid. private room unless it is medically necessary. Most Sixty months of nursing home and related nursing homes have semi-private beds, which costs (assuming $6,000 per month) would be means two people share a room. After living $360,000. Often a large transfer, even at the time independently for one’s entire adult life, entering a of entering a nursing home, may be advisable. nursing home can often mean sharing a room with a stranger. The money transferred may be used Example for a private room or some other luxury for which Ian has $500,000 in Medicaid will not pay. assets. Facing the prospect These payments, however, may be taxable of a multiple year stay in a nursing home gifts. Transfers to pay for the support of someone due to Alzheimer’s disease, Ian decides to that the transferor does not legally have to support transfer a large portion of his estate. He are in effect gifts. This should be reviewed with receives $24,000 per year in Social Security an estate planning attorney if the gifts are going and pension income. to be significant (more than $13,000 in 2012). Otherwise, there could be tax issues affecting the person making the gift. A transfer of $320,000 may be a wise decision in order to save his estate either for his OTHER PLANNING STRATEGIES children or for himself in the event he needs the There are several options for Medicaid assets. This plan looks as follows: planning available besides making outright gifts Assets at time of Institutionalization $ 500,000 of property. A person may take non-exempt assets Income over 60 months $120,000 and convert them into exempt assets. A very Total Assets and Income $ 620,000 simple example is where the community spouse uses cash to buy exempt personal property such Cost needed for Nursing Care $(360,000) as furniture. In many states, the purchase of an ($6,000 per month x 60 months) annuity by the community spouse will result in Assets to transfer $ 260,000 the conversion of a non-exempt asset into an Income to keep $ 120,000 exempt one, while creating an additional income Assets to keep $ 140,000 stream for the community spouse. However, the annuity must be purchased prior to the filing of the To Whom May Assets Be Transferred? Medicaid application and the income stream from For Medicaid planning, assets can be the annuity contract cannot be longer than the transferred to anyone other than a spouse. Most life expectancy of the community spouse. Other people consider transferring their assets to children special rules apply as a result of Medicaid laws. or other family members. There are dangers to Promissory notes offer another major doing this. Once a transfer is made, the asset planning opportunity. While the requirements becomes the property of the person to whom it of a Medicaid-qualifying promissory note are was transferred. If the person is not good with very technical, a close reading of the current law money, it may be spent unwisely. It may become suggests that a properly-designed plan using a
Chapter 23: Medicaid Planning 203 Wealth Management Through Estate Planning
promissory note will not trigger any penalty the donor. The beneficiaries are then free to use period. Medicaid-qualifying promissory notes the money in any way they see fit, including for can thus be a viable strategy, particularly for the benefit of the institutionalized donor. At a individuals and married couples who do not specified time, typically the death of the donor, have sufficient resources to cover the cost of the principal and interest are distributed to the a nursing home during the entire 60 month named beneficiaries of the trust. look back period yet still wish to qualify for By transferring assets to an irrevocable trust, Medicaid. the donor starts the clock running with regard Additionally, the law allows a spouse to the 60 month look back period. If you delay to assert that she needs a portion of the transferring assets until after entering a nursing institutionalized spouse’s assets in order to home and have to wait for the expiration of this maintain her income. This situation occurs period, the cost can be significant. The benefit of where there is no other income available for timely transferring assets to an irrevocable trust is the community spouse to give her the allowable illustrated by the following example: MMMNA. To create this income, either a portion of the institutionalized spouse's Example income stream or a portion of the assets of Wanda transfers the institutionalized spouse are set aside and $500,000 of assets used to create the income. to an irrevocable trust on June 1, 2012. She Another alternative is to purchase does not reserve to herself the right to receive long term care insurance to provide for income or principal from the trust. On July 1, nursing home expenses. Obviously, the cost 2017, she enters a nursing home and applies is a primary consideration and a reputable for Medicaid. Sixty months have elapsed insurance agent who has experience in this and any assets in the trust will not disqualify area should be consulted. See Chapter 24: Wanda for Medicaid benefits. Long Term Care Insurance for more information on this topic. A third option is to create an irrevocable The foregoing example demonstrates that trust designed to hold assets gifted away to one of the primary purposes of the Irrevocable qualify for Medicaid. As will be seen, it can Trust is to get the look back time period running. be the appropriate strategy to follow when There are several features of the Irrevocable other alternatives do not provide a completely Trust which differentiate it from many other satisfactory result. types of trusts. Briefly, these are the significant differences. THE IRREVOCABLE TRUST The donor (potential Medicaid applicant) To protect assets from being consumed for should never be the Trustee. There is too much nursing home expenses and at the same time not unity of interest if the donor, who is also the have them count as assets for the asset limitation beneficiary of the trust, is the Trustee. Some tests of Medicaid, some persons may choose to other person should be selected to act as the place their assets into an irrevocable trust. Trustee. To implement this strategy, the donor, a The trust is irrevocable. You cannot change potential applicant for Medicaid, gives all the terms of the trust once the trust is established. or a portion of his assets to an irrevocable In the trust, the donor will set forth the persons trust and the trustee of that trust holds these to whom the trust property is to be distributed assets in accordance with the terms of the trust upon his death and that cannot be changed. agreement. The donor does not retain the right The donor has made an absolute transfer that to either the income or principal of the trust. cannot be undone. Conversely, if there was no However, distribution of principal and income trust, the property could pass by the deceased’s can be made to the beneficiaries of the trust. Will and the owner could control its distribution. The beneficiaries are typically the children of The donor will not retain any rights to receive either income or principal of the trust. If
204 Chapter 23: Medicaid Planning Wealth Management Through Estate Planning
these rights were retained, it would negatively The irrevocable trust in this situation may impact the ability to qualify for Medicaid appropriate for a number of reasons: benefits. ◆ Mary is elderly. The older that we get, the more likely it is that we may need WHEN IS AN IRREVOCABLE to enter a nursing home. TRUST APPROPRIATE ◆ Her living arrangements are satisfac- Before a lawyer can advise any client as tory to herself and to her immediate to whether she should have an irrevocable family member and, perhaps most trust, he must have a thorough understanding importantly, to her son-in-law. It is of the client’s personal situation. Specifically, important that she have a satisfactory the lawyer will inquire as to the following: relationship with these family members. ◆ The age of the client and other immedi- This is important because she is giving ate family members. up her ability to use the principal of her ◆ The client’s health status. assets for her support. ◆ ◆ The assets of the client, fully under- Mary has someone whom she can trust standing the nature and extent his cli- to be her Trustee. This is very important ent’s holdings. because she is giving up control of a substantial amount of money and must ◆ The client’s own assessment of the risks have a trustee on whom she can rely. and benefits involved. ◆ She does not need the principal of After an examination of the factors such her assets or the income from it to take as these, one general observation stands care of herself. She also has medical out. Irrevocable Trusts are usually used for insurance. those persons who are elderly and single or widowed and are not appropriate in many ◆ Mary is willing to give up control of situations. The following is a good example her assets. that illustrates why this is true as a matter of ◆ Her daughter will receive the income choice and as a matter of good planning. and then choose to help her with her expenses. Example ◆ The trust will ensure that her assets will Mary is a healthy but pass on to her daughter at death and elderly widow, age 81. she will enjoy the benefit of an inheri- She has resided for more than 10 years with tance. her daughter and son-in-law. She has a good The importance of the client’s relationship with both of them and everyone personal attitude cannot be overstated. If is comfortable with the living arrangements. an irrevocable trust is going to be used, Mary’s assets consist of CDs and bank that person must be willing to part with accounts with a value of $400,000. She ownership, dominion and control of his receives Social Security benefits and a small assets. Some people can do it and others pension. This income, plus the interest from her cannot. It is a decision that each individual investments, is more than sufficient for her living has to make between retaining the power needs, and to help with her share of household to exercise ownership and control versus expenses. Her medical expenses are covered securing your property for the future and by a good insurance policy. Mary establishes protecting it from significant depletion. an irrevocable trust naming her daughter as the Now, let us examine a situation where an Trustee. She deposits into the trust most of her irrevocable trust is not appropriate. CDs and bank accounts and does not reserve the right to receive either income or principal from the trust.
Chapter 23: Medicaid Planning 205 Wealth Management Through Estate Planning
avoided when an irrevocable trust is properly Example Harold and Christine are a established, especially if the individual has also husband and wife, ages 65 and executed a Durable Power of Attorney and 63 respectively. They have been happily married for Durable Power of Attorney for Health Care. See many years, are in good health and recently retired. Chapter 20: Powers of Attorney and Advance Their assets include a home worth $100,000 and Directives. Furthermore, there is privacy in investments of $300,000. irrevocable trust as in the Living Trust. It is not a public document and is not subject to disclosure An irrevocable trust is not appropriate in in the same manner that records of an estate are these circumstances. First, their ages probably do in a probate proceeding. At death, assets are not justify a pronounced concern over Medicaid, distributed to the beneficiaries in the manner and especially given the fact that they have good proportions set forth in the document. health. More importantly, both spouses are living Lastly, if the irrevocable trust is set up prior and may rely on each other. They can take care to the expiration of the 60-month look-back of each other. Additional exemptions from the period, someone may need to pay for the asset limitations test are available because there donor’s care until the look-back period expires. is a spouse. The person paying for the donor’s nursing home If they are concerned about nursing home care can claim the nursing home payment as a expenses, they should be looking at long term tax-deductible medical expense if the donor is a nursing home insurance. This can resolve their dependent of that person. anxieties without taking the extreme step of There are disadvantages to an irrevocable transferring assets to an irrevocable trust. trust . Keep in mind that the major disadvantage is In summary, irrevocable trusts should only the fact that the trust is irrevocable and once you be used in certain limited circumstances and initiate the creation of the trust and fund it with after very careful analysis and discussion. Like your assets, they are no longer in your possession many other decisions that we make in life, there and control. You cannot access the principal of are trade-offs and we have to closely analyze the trust for other health care or personal needs whether the benefits gained by protecting against that may arise although the trust beneficiaries can a future, possible nursing home expense are make gifts to help you with your expenses. worth the expense and restrictions of placing Also, there are legal fees to prepare an property in trust. irrevocable trust and perhaps some transfer costs to place property into the trust (deed OTHER ADVANTAGES preparation and filing costs, as an example). If an AND DISADVANTAGES OF irrevocable trust is believed to be an appropriate vehicle to save on the potential cost of long-term IRREVOCABLE TRUSTS care, the cost is in most circumstances relatively There are other advantages, as well as minor compared to the benefit. However, it disadvantages, to using an irrevocable trust . is a consideration. Once again, you have to Many of the advantages are similar to those assess the risk versus the benefit and the cost which will be obtained if a person sets up a Living of preparing an irrevocable trust is certainly a Trust. Please review the discussion in Chapter 10: component in that analysis. The Living Trust. The irrevocable trust , like the Additionally, it may not be appropriate to Living Trust, provides for a distribution of property place property that has appreciated in value directly to beneficiaries at death without going into an irrevocable trust. Transferring the asset to through probate. an irrevocable trust may create a capital gains Additionally, property placed in the tax problem. Assets in an irrevocable trust do irrevocable trust does not become subject to not receive stepped-up basis on the death of the probate court control at any time. The need donor and the beneficiaries carry forward the to establish a personal guardianship can be basis of the property that the donor had. This tax
206 Chapter 23: Medicaid Planning Wealth Management Through Estate Planning
basis problem may be resolved with some beneficiary each month. Upon death, any careful planning. The person establishing the remaining funds in the account must be paid trust can reserve to himself a special power back to the state to the extent the state has of appointment over the trust property which paid for the care of the individual. keeps it in his estate for estate tax purposes. This device is imposed by federal law This technique must be selectively used, and mandated to the states. It can undercut however. the otherwise harsh consequences imposed For most clients, the transfer of property by income cap states. into an irrevocable trust does not cause Nonprofit Association Trusts For Disabled federal gift tax consequences. The typical Individuals client transferring property into an irrevocable A non-profit agency can establish a trust transfers less than estate tax credit amount trust which accepts funds on behalf of the and gift taxes are erased by the application individual and manages the funds for many of this credit. See Chapter 5: The Federal Gift beneficiaries. Each person maintains a Tax. separate account but assets are pooled for investment purposes. Similar to the special OTHER TYPES OF TRUSTS needs trust discussed above, the assets are Congress has created three types of trusts to be paid to the state upon the death of the whose existence does not disqualify the trust beneficiary. If assets are left over, they can beneficiary from Medicaid eligibility. There be distributed as provided for in the trust are limited circumstances in which these trusts agreement. may be used. Medicaid Payback Trusts Planning Tip Trusts can be created for disabled The establishment persons under 65 years of age by a parent, of a Medicaid Payback grandparent, legal guardian or a court. Trust for the benefit of another is not a These trusts are typically used for persons disqualifying transfer for the person who who are disabled in their younger years established the trust for the beneficiary. (The and perhaps either have assets or obtain establishment of a Nonprofit Association Trust, them from personal injury suit judgments discussed below, however, is treated as a or settlements with persons whom have disqualifying transfer.) caused their disability. The only caveat with these trusts is that the trust must pay the amount paid by Medicaid on behalf of the In addition to the Congressionally beneficiary from the remaining funds upon authorized trusts mentioned above, many the beneficiary’s death. During life, however, individual states have created their own these trusts can provide care and treatment to legislatively approved Medicaid trusts. the beneficiary for which Medicaid will not Because the nature of each of these trusts is pay. If assets are left over after any Medicaid different, it is best to discuss these trust options reimbursement, they can be distributed as with a qualified elder law attorney in your provided in the trust agreement. state. Qualified Income Trusts or “Miller” Trusts Medicaid “Poison Pill” or “Luxury” Trusts Qualified Income trusts are used to create While the precise terms of trusts will Medicaid eligibility in income cap states for vary depending on each state’s laws, some beneficiaries that have income in excess of states, such as Ohio, will allow a parent the cap. Essentially, the trust is funded by the or grandparent to establish a trust for a income of the beneficiary and the trustee can person under the age of 65 to supplement only pay an amount just under the cap to the in the discretion of the Trustee those benefits
Chapter 23: Medicaid Planning 207 Wealth Management Through Estate Planning
typically not covered by Medicaid, such as luxury items, travel expenses and the like. The trust typically must contain a “clear statement” that if the assets in the trust are ever determined to be resources disqualifying the person from Medicaid, then the beneficiary must become some person or entity other than the Medicaid recipient (hence the term “poison pill”). This type of trust cannot use the Medicaid recipient’s own recourses. They are a popular option for leaving assets to children or grandchildren since they do not require any money to be paid back to the state upon the beneficiary’s death. Congress does not require that states permit such trusts, so you need to check your own state’s laws to see if such a trust or a variant of it (called “luxury trusts” in some jurisdictions) are legal in your state.
SOME FINAL THOUGHTS The high cost of nursing home expenses makes long term care planning a consideration for some persons. It is a difficult area for lawyers to give advice on because many of the available strategies focus on giving away assets during lifetime to protect them in case the owner has to go into a nursing home. For many people, an irrevocable trust is not a compelling consideration. Typically, clients are not concerned about using an irrevocable trust when they have sufficient assets such that the income stream from those assets will take care of their potential nursing home expenses. Most persons are concerned about losing their principal and if that is not at risk, there is less need and pressure to consider using this technique.
208 Chapter 23: Medicaid Planning Wealth Management Through Estate Planning
Chapter 24: Long Term Care Insurance
Improvements in medical care allow people to live longer. This also means that there is an increased probability of needing nursing home care at some point. What role can long term care insurance play and what are the important factors to consider in looking at a policy?
Chapter 24: Long Term Care Insurance 209 Wealth Management Through Estate Planning
Chapter 24:
◆ Who Pays for Long Term Care
◆ What is Long Term Care Insurance
◆ Important Aspects of a Long Term Care Policy
◆ Making a Decision
“Man spends his life in reasoning on the past,
in complaining of the present, in fearing for
the future.”
Antoine de Rivarol
210 Wealth Management Through Estate Planning
any persons are living longer term care. In this chapter, we take a look at due to improvements in medical why these policies have become popular Mcare. A consequence of this is that and the most important features that you more Americans than ever are spending want to consider. some of their senior years living in a nursing home. Some estimates are that up to 50% WHO PAYS FOR of people who are 65 or older will spend LONG TERM CARE some time in a nursing home. Another study The chart gives us current information estimated that one person in four will spend on who pays for long term care expenses. at least one year in a nursing home. The About 11% of long term care costs are average stay in a nursing home is about paid directly by residents or their families. three years and nursing home costs usually Medicaid pays almost one half of the total are $7,200 per month and frequently expenses for this care. It is expected that higher. Three years is only the average and long term care insurance will over time in some circumstances a person will stay increase significantly from the 7.5% shown much longer than this, incurring significant on the chart as this product is becoming expense. We should reasonably expect that increasingly popular and is being marketed with continued improvements in medical more effectively by financial advisors. care, we will live longer, increasing, Medicaid is not a resource which however, the likelihood that we will spend financially successful persons use for some time in a nursing home. covering these costs. To qualify, it is Here are some other interesting facts: necessary to exhaust financial assets, except ◆ 47% of people over age 85 have those that can be exempted. In Chapter 23: some form of dementia and these Medicaid Planning, we took a look at the persons live an average 8 years and assets that can be exempted and still qualify many as long as 20 years. for Medicaid. If you are single, the list of ◆ The life expectancy of a man at age exempt assets is very small. 65 is 20 years and a woman at age Medicare only provides a limited time 65 is 23 years. period for coverage of nursing home costs. ◆ Long term care is needed for younger Projected National Health Expenditures in the people. 40% of Americans receiving United States, by Source of Payment, 2010 long term care are under 65. Other Private Spending ◆ One third of the 700,000 Americans 7% who have a stroke each year are Out-of-Pocket Payments under age 65. 11% Private Health ◆ In 2008, 21,000,000 Americans Insurance 32% needed help with their health and personal care. One half of them were Other Public Spending more than 65 years old. 12% ◆ 70% of Americans over age 65 will require some type of long term care and more than 40% of these persons will require care in a nursing home. Medicaid and 1 Medicare CHIP 21% These concerns have led to the 16% development and increasing popularity of Total National Health Expenditures, 2010 = $2.6 Trillion long term care insurance. This type of policy 1 Includes Children’s Health Insurance Program (CHIP) and Children’s Health Insurance Program expansion (Title XIX). is designed to insure against the cost of long Percentages do not sum to 100% due to rounding. SOURCE: Centers for Medicare & Medicaid Services, Office of the Actuary, Updated National Health Expenditure Projections 2009-2019, January 2011.
Chapter 24: Long Term Care Insurance 211 Wealth Management Through Estate Planning
It is designed to provide skilled nursing care consider lifetime coverage. for a person who has just left a hospital and ◆ Is there a maximum amount of benefits who needs help getting back to independent paid under the policy? What is it? living. ◆ Benefits are normally determined on a WHAT IS LONG TERM CARE per day basis, such as up to $200 per day, for stays in a nursing home. INSURANCE ◆ How is qualifying for coverage under This type of insurance focuses on paying the policy determined? The most for a wide variety of services for people with common standard is whether the prolonged illnesses or disabilities. It is insured can perform normal activities not designed to pay for rehabilitation but for of daily living. This is an evaluation of maintaining daily activities such as dressing, the insured’s ability to bathe himself, bathing and personal grooming and making move about, control continence, dress, sure that someone is fed properly and taking eat and go to the toilet. These are all necessary medications. It is primarily for sometimes called the 6 ADLs. For many persons who cannot independently maintain policies, qualification is determined by their activities of daily living. the need for substantial assistance in Frequently, long term care involves skilled performing at least 2 of the 6 ADLs. care in a nursing facility on a 24 hour basis. It may also include skilled care in the patient’s ◆ Severe cognitive impairment may also home with visiting nurses and home health trigger coverage under a long term care specialists. care policy. An example is a person who has Alzheimer’s disease. IMPORTANT ASPECTS OF A ◆ Is there an elimination period before LONG TERM CARE POLICY benefits start? With many policies, cov- There are a number of important features erage does not start immediately when of long term policies that must be understood. the need arises. You have to pay dur- All long term care policies are not the same ing a waiting period which is frequently and each policy under consideration must be a period such as 30, 60 or 90 days. carefully reviewed and compared to other policies that are being offered. These are the most important issues: ◆ Some policies cover only stays in nurs- ing homes while other policies also Recommendation cover home health care. I advise clients to investigate a ◆ If the policy covers home health long term care policy that pays $200 care, carefully review the terms of the per day or $6,000 per month. Compare coverage. the cost of coverage for five years and ◆ Generally, coverage does not include lifetime. Lifetime coverage is usually not benefits for a mental or nervous disease that much higher. If the cost is too high for (except, for example, Alzheimer’s) or your budget, consider a smaller level of drug or alcohol addiction. coverage, keeping in mind that you may ◆ What is the length of time for the have other sources of support such as coverage? This time period is usually social security and pension income that three or four years but policies of can make up the difference. different lengths are available. At least
212 Chapter 24: Long Term Care Insurance Wealth Management Through Estate Planning
◆ Is there an inflation protection provi- MAKING A DECISION sion in the policy? This is helpful for Purchasing long term care insurance is protecting against increased costs. not always an easy decision. When I am However, this feature may add to the asked to give advice on this topic, I look at a premium cost for the policy. number of objective and subjective factors. ◆ Usually, long term care policies pro- These are the most important ones I consider. vide that premiums no longer have to If family wealth is significant, purchasing be paid once coverage is triggered. long term care insurance is primarily driven If the policy provides for waiver of by a desire to hedge against an expense. premium, when does this start, at The client can afford to self-pay but can also the time of the first payment or after afford the premium. He would rather spend a time period such as 60 or 90 some money to cover the expense rather days? than bear the risk and aggravation of a ◆ How are benefits paid? With the large, continuing long term care expense. expense incurred method, the If there is not a lot of wealth, then company either pays you directly or qualifying for Medicaid may be the pays to the provider an amount up best solution. The premium may not be to the limits of the expenses covered affordable and the assets to be protected in the policy. With the indemnity may not be that significant. method, the company pays directly to you the amount specified in the Opinion policy without regard to the specific At our firm, we services rendered. Most policies are routinely advise the expense incurred type. older clients to have their financial advisors investigate for them the cost ◆ Is the policy guaranteed renew- of long term care insurance. Besides able? This means that the insurance potential economic benefits, it can bring company guarantees that it will offer peace of mind. You should at least be you the option to renew the policy aware of the cost and the benefits so that and maintain the coverage. Most you can make an objective assessment as states require the insurance compa- to whether this insurance is right for you. nies licensed to do business in their states to guarantee renewability. This does not guarantee that you will Spouses who are comfortable always have the same premium cost. financially but not wealthy should give However, the insurance company can- strong consideration to long term care not selectively raise the cost on your insurance. There may not be enough money policy just because you get older. If it available to pay for nursing home expenses raises the premium cost, it must do so and allow the spouse remaining at home to on all policies in the same class. maintain her current standard of living free Long term care policies can vary widely from the anxiety of going through the family regarding these types of provisions and you finances to pay for nursing home care. must carefully compare and contrast each Are you married or single? In many policy. Do not be reluctant to ask questions circumstances, one spouse will be able in order to purchase the best policy for your to care for the other, either delaying or premium dollar. eliminating the need for long term care insurance. If you are single, you usually
Chapter 24: Long Term Care Insurance 213 Wealth Management Through Estate Planning
have a higher chance of needing nursing CONCLUSION home insurance. Determining whether you should buy How is your current health? If you have long term care insurance is not always easy. any serious problems, insurance may not The decision involves trying to predict the be available or the cost may be too high. future and spending money for something Remember that the insurance companies that you may never need. For some persons, that issue these policies underwrite them (i.e. the purchase of a policy is not a financial investigate your health and health history). necessity but a way to hedge against This is similar to the underwriting that is done a potentially large expense. For others, for a life insurance policy. however, purchasing a long term care policy Good health may be a reason to buy the may be of critical importance to protect the insurance now. It may not be available later security of a spouse or other family member or the premium will be very high if you have a dependant on you for financial support. I health problem. recommend to my clients that they explore the You also need to pay attention to cost of long term care insurance so that they changes implemented by Washington understand the financial commitment. Only regarding the deductibility of insurance then can they properly evaluate if the cost is premiums for long term care insurance. worth the protection being purchased. Under the 1996 law called the “Health Insurance Portability and Accountability Act,” premiums for this insurance are deductible as part of medical expenses to the extent these expenses exceed 7.5% of your adjusted gross income. Consideration has been given to expanding the deductibility of these premiums.
214 Chapter 24: Long Term Care Insurance PART V: Administrating an Estate
215 Wealth Management Through Estate Planning
PART V:
Chapter 25 Probate of an Estate Chapter 26 Post-Mortem Planning Opportunities
216 Wealth Management Through Estate Planning
Chapter 25: Probate of an Estate
Probate is the legal procedure that a person’s estate goes through at death. It is necessary for the transfer of assets to beneficiaries and to conclude the deceased’s financial affairs.
Chapter 25: Probate of an Estate 217 Wealth Management Through Estate Planning
Chapter 25:
◆ What is Probate
◆ Dying Without a Will – Intestate Succession
◆ Probate and Non-Probate Assets
◆ Procedure for Probating an Estate
◆ Small Estate Procedure
◆ Ancillary Administration
“The taxpayer — that’s someone who works
for the federal government but doesn’t have to
take the civil service examination.”
Ronald Reagan
218 Wealth Management Through Estate Planning
here are many misconceptions and Dying testate is preferred. In the Will, misunderstandings as to exactly what the decedent is able to do such things as Tis involved in probating an estate. designate who shall act as his executor Some of these are rather extreme. For and the powers that the executor has for example, some persons believe that if you administering the estate. Furthermore, the do not have a Will everything goes to the existence of the various powers granted State in which the decedent lived. Others to the executor often reduces the time and believe that property is tied up in probate expense necessary to probate the estate. For and the heirs cannot have access to it for an example, a Will typically gives the executor extended period of time. Mistaken beliefs the power to sell real estate. This allows the such as these have created an atmosphere executor to sell any real estate owned by the where people want to avoid probate, but executor without approval of the probate they are not exactly sure why or how. court and the delay associated with receiving Included in this chapter is basic that approval. Also, the Will directs how and information about probate court and the to whom decedent’s property is distributed. administration of a decedent’s estate. The existence of a Will does not eliminate This information will illuminate what the probate but does serve to expedite the probate process is and the role of probate process and make it more efficient. court. It will be seen that, generally, it is Probate is supervised by the probate advantageous to avoid probate if the court of the county in which the decedent techniques that are employed to do so was a resident at the time of his death. are part of a sound, well thought out Probate court’s responsibilities include estate plan. However, probating an estate overseeing the admission of the Will to does not have to be the nightmare that probate, approving the appointment of many persons believe it to be. If handled the executor or administrator (also called responsibly by the estate fiduciary and his the “personal representative” in many attorney, probate administration of an estate jurisdictions) and making sure the estate can be accomplished fairly rapidly and is administered in an orderly manner. The without undue expense. executor has the authority to administer The following information is a probate property that is either real or generalized discussion of estate personal, tangible or intangible. administration procedures. Each state has its own laws regarding probate and these DYING WITHOUT A WILL — control the disposition of property owned by INTESTATE SUCCESSION a resident decedent. When a person dies without a Will, his estate is distributed in accordance with the WHAT IS PROBATE provisions of state law, which specifically Probate is a court-supervised describe how his property is to be proceeding for collecting the assets of a distributed. That law in Ohio is commonly decedent (house, car, bank and brokerage known as the Statute of Descent and accounts, etc.), paying his debts (doctor Distribution and makes a presumption as bills, credit cards, funeral, etc.) and the to how the decedent would have wanted administrative expenses (court costs, his property to pass if he had prepared a filing fees, fiduciary commission, etc.) Will. In effect, the state has decided how a of the estate and making distributions to decedent’s estate should be distributed in the proper parties. A decedent’s estate the absence of a Will. The following is an goes through probate whether or not the example of the application of the Statute decedent had a Will. If the decedent had a of Descent and Distribution in Ohio where Will, he is said to have died testate. If he there is a second marriage and each did not have a Will, he died intestate. spouse has children from the first marriage.
Chapter 25: Probate of an Estate 219 Wealth Management Through Estate Planning
to apply to probate court to be named Example George died leaving a probate as guardian. This is an unavoidable estate valued at $200,000. George consequence of Ben being a minor is survived by his wife, Martha, Thomas, his son from a when George died without a Will. prior marriage, and Ben, Martha’s son from a previous The Statute of Descent and marriage who was adopted by George. Thomas is 23 Distribution covers all types years of age and Ben is 16 years of age. George did of circumstances as to not have a Will. Under Ohio’s Statute of Descent and how property is to pass Distribution, Martha is entitled to receive the first $60,000 when the decedent did of the probate estate and one-third of the balance. The remaining two-thirds is divided equally between Thomas My opinion and Ben. As a result, the surviving spouse, Martha, receives only $106,666 with Thomas and Ben each receiving $46,667. Dying without a Will reminds me of what I have said to many people. This example is useful to demonstrate several problems that can occur if someone I make a lot more money when dies without a Will. Most persons want someone does not take my advice. their spouse to receive and control all of the couple’s assets when one spouse dies and Cleaning up messy estate situations assume in the above example that this is what is a lot more expensive than creating George asssumed would happen. Under most a good estate plan. state laws, if the decedent spouse has children from a prior marriage, this is not the case. In this example, the surviving spouse received not leave a Will. If the children in the above just over fifty percent of the entire estate. example, Thomas and Ben, were not the The children received a total of $93,334, or children of Martha, but instead were both 47% of the estate, which reduces the amount her step-children, then a different distribution of funds available for the care and support scheme is imposed. Now, Martha (who is not of the surviving spouse. A properly drafted the natural mother of Thomas and Ben) is only and executed Will would have avoided this entitled to receive the first $20,000 of the problem. probate estate and one-third of the balance. Further, part of the estate passes to After the first $20,000, Thomas and Ben will Ben who is a minor child. This creates a receive 2 out of every 3 dollars remaining. separate set of problems. First, because Ben is a minor, the property will not be distributed $ outright but will be distributed to a guardian George's Estate 200,000 appointed for Ben. This means that Martha will have to apply for a guardianship for Ben at probate court. Martha will also have to WILL STATE LAW deal with the time consuming administrative All to Martha $80,000 to Martha $60,000 to Thomas responsibilities of the guardianship for $ Ben, until Ben becomes an adult. Ben’s 60,000 to Ben inheritance will be reduced by the costs of the guardianship (court costs, legal fees, bond The example illustrates how such state premiums, etc.), as these expenses are paid laws can often be at odds with a person’s true from the guardianship account. intentions as to the disposition of his property. Even though Martha is the parent and Most married couples expect that upon natural guardian of Ben, she is still required the death of one spouse, all of the family
220 Chapter 25: Probate of an Estate Wealth Management Through Estate Planning
property will pass to the surviving spouse. passes by right of survivorship to the person Unfortunately, state law often provides or entity specified in the deed. otherwise. The example also shows that the If a person owns property interests that failure to have a Will may cause unexpected allow him to designate a beneficiary, and and unintended consequences, such as the beneficiary is someone other than his requiring the establishment of a probate court estate, that property is not subject to the supervised guardianship. Carrying this a step probate process. For example, benefits in a further, Ben’s guardianship will terminate company sponsored 401(k) plan that are when he reaches the age of majority (18 distributed to a named beneficiary are not in most states, 21 in others). Distributing in probate property. Joint and survivor bank excess of $46,000 (plus growth) to a young accounts and life insurance proceeds paid to person is not what most parents want and can a designated beneficiary are other examples lead to problems. where a person can control distribution of In the above example, if Martha had property that is not subject to the probate been the stepmother to Thomas and Ben (i.e. process. Distinguishing between probate and no blood relation to either) she would only non-probate assets is a very important issue be entitled to the first $20,000 and one-third because only probate assets are subject to of the balance under Ohio law. Conversely, the administrative procedures of probate if Martha had been the natural parent of court and, therefore, the only assets that both Thomas and Ben, she would now inherit will be controlled and distributed under the entire estate from George because the distribution scheme contained in the they would be the natural children of both deceased’s Will. parents. The results are dictated by the legal relationship of the decendent’s spouse to his children. Observation Some people fail to The description of the probate process understand that property that set forth in the remainder of this chapter passes outside of probate is not subject to the terms presumes that the decedent died with a valid of a Will. A bank account held jointly with right of Will. It is doubtful that much would be gained survivorship passes to the surviving joint owner, not by describing the probate process and the under the terms of the Will. This misunderstanding is extra work that is involved where a person why family members sometimes get unintentionally died without a Will. One of the premises disinherited. of this book is that those persons who are reading it will exercise the necessary foresight and have, at the very minimum, a basic Will in place. PROCEDURE FOR PROBATING AN ESTATE PROBATE AND The level of complexity of the NON-PROBATE ASSETS administration of a probate estate depends Before examining probate administration, on the circumstances of each estate. However, it is necessary to understand that not all there are basic steps each estate goes property owned by a person at the time through during the period of administration. of death is subject to the probate process. Application to Probate Will Certain types of property interests of a The first step in the probate process is to decedent are not subject to probate. For apply to probate court to have the decedent’s example, if the decedent owned his house as Will admitted to probate. There are very a joint tenant with right of survivorship, specific requirements for doing this, but most the house is not subject to the probate importantly, the original Will is filed with process. The decedent’s interest in the house probate court. In the typical estate, the Will is
Chapter 25: Probate of an Estate 221 Wealth Management Through Estate Planning
quickly admitted into probate. After the Will The expense of this bond is paid out of the has been admitted, a notice of the admission estate. The minimum annual bond expense of the Will must be served on the beneficiaries is typically around $100 for a $40,000 named in the estate and on those persons bond, but the premium expense increases who would inherit the estate if the decedent with the size of the estate. The amount of the had not left a Will. bond required may be twice the value of the This notice requirement is very important, personal property in the estate. For example, as it starts the time period for challenging the if the estate has personal assets (cash, stock, Will. There are several grounds to challenge tangible personal property etc.) valued a Will including: at $100,000, the executor would need ◆ The Will was not executed in accor- to purchase a $200,000 bond. In larger dance with the statutory requirements. estates, bonds can run several thousand dollars per year. ◆ A challenge as to whether the testa- One of the advantages of having a tor was competent at the time of the well-drafted Will is the Will may contain a execution of the Will. provision waiving the bond requirement, ◆ Whether the Will was executed under thereby avoiding this expense. This is duress or undue influence. frequently done when the person being A challenge to the Will is known as a Will appointed as executor is a trusted family contest. Any legal action to contest the Will member or close friend and there is little or must be started within a statutory time period no concern that the executor will not faithfully after the executor of the estate has filed with carry out his responsibilities. However, some probate court an affidavit indicating that local rules may require a bond if the executor he has given notice to all interested parties is not a state resident. This is to ensure the as to the admission of the Will for probate. assets are available to satisfy the claims of Will contests are uncommon but do occur creditors. occasionally. If the executor is a woman, her proper Appointment as Executor of the Estate. title is executrix. If the decedent died without The next step in the probate process is a Will, then the fiduciary appointed by the for the named executor in the Will to file an Court is known as the administrator or, if a application with the court to be appointed woman, the administratrix. executor of the estate. This application may The fiduciary appointed is responsible be, and typically is, filed at the same time for properly and timely carrying out the that the application to probate the Will is responsibilities of this position. These filed. The executor who is so named is usually responsibilities are generally summarized in quickly appointed by probate court. Once the following paragraphs. appointed, the executor is legally required to Inventory and Appraisal complete his responsibilities in accordance Following his appointment, the executor with state law. His actions as the executor is required to prepare an inventory of the are supervised by probate court to ensure his estate assets. The inventory contains only compliance. those assets that are subject to probate The executor must post a fiduciary’s administration. Remember, all property bond unless that requirement is waived in which the decedent had an interest is by the Will. The reason for the bond is to not probate property. The executor is not have a source of funds to pay to the estate required to list non-probate property on the in the uncommon event that the dishonest probate inventory. Similarly, the executor is conduct of the executor causes the estate not accountable to the probate court for non- financial loss. Purchasing a bond from an probate property. insurance company satisfies this requirement. When George died in the preceding
222 Chapter 25: Probate of an Estate Wealth Management Through Estate Planning
example, his assets were a bank account, own affairs under similar circumstances. This a brokerage account he owned jointly is known as the prudent man rule. with Martha, a coin collection he inherited The executor begins his management from his father and his 401(k),which of the estate by setting up a separate names Martha as the beneficiary of the checking account in his name as executor 401(k). The inventory for George’s probate of the estate. This checking account serves estate will list the bank account and the a valuable function as a depository for coin collection, which will likely have to estate funds that are collected and also as be appraised as its value is not readily a clearing account for the payment of bills ascertainable. The brokerage account and expenses of the estate. It is important to is not included in the probate inventory remember at all times that the executor has as it was owned jointly with Martha. The a fiduciary responsibility to the estate, 401(k) is not included on the inventory as it the beneficiaries of the estate and any passes in accordance with the beneficiary estate creditors. This means that the estate designation. must be conducted in such a manner as When preparing the inventory of assets, to protect the interests of these persons. A certain types of property must be appraised fiduciary duty is a very high level of care. to determine their value. Assets to be valued The executor is well-served to establish this include real estate and assets that do not account as it creates a separate, segregated have a readily ascertainable value (such as account for all estate funds. Estate assets jewelry, coin collections, antiques, etc.). For are never to be commingled with the property that has to be valued, an appraiser executor’s own assets. is appointed by probate court either on Sale of Real and Personal Property its own direction or upon the request of Commonly, real property owned by the executor. The appraiser makes his the decedent will be sold by the estate, determination as to value and returns this especially in cases where there is no appraisal to the executor of the estate. surviving spouse. If the decedent’s Will Once the appraisal is completed, granted a power of sale for real property to the executor files the Inventory and the executor, which most well-drafted Wills Appraisal form with probate court. This do, the executor is authorized to conduct form is required to be filed within a certain the sale with minimal court supervision. time period measured from the date of However, if the Will does not grant this appointment of the executor, although power, then the executor is required extensions of time are often allowed. A to complete a complicated and time common example of the time period would consuming process to sell the real estate, be 90 days from the date of appointment which is commonly known as a land sale but state laws vary. Values stated on the proceeding. inventory are either the values assigned by In most estates, the majority of a the appraiser or the date of death value for decedent’s personal property is distributed non-appraised assets. to the heirs in accordance with the Management of the Estate decedent’s Will. For some estates, the The executor has full responsibility personal property must be sold to pay for the management of the decedent’s decedent’s debts or to equalize distributions probate estate. He must make sure that all to the estate’s beneficiaries. probate assets in his custody and control Payments of Debts and Other Obligations are protected from loss and diminution of If the estate is solvent (e.g., the assets value. The executor is required to exercise of the estate are greater than its debts), the the same degree of care, skill and diligence executor may pay all bona fide debts of the as would be exercised by a man of ordinary estate as they come due. The executor will prudence and skill in the management of his
Chapter 25: Probate of an Estate 223 Wealth Management Through Estate Planning
learn of the debts by reviewing decedent’s Distribution of Assets financial records and decedent’s mail. An executor may begin to distribute Payment of debts should be made out of the the assets of the estate any time after his estate checking account to keep a clean appointment by the probate court. However, record of the handling of the estate’s finances. the distribution of estate assets is usually A creditor of decedent has the right to postponed until the inventory is filed and the make a formal claim against the estate by executor has had an opportunity to determine filing papers that notify probate court and the with confidence the debts of the estate. The executor of the existence, nature and amount executor will want to make sure that he has a of the debt. If a claim is made against the solid understanding as to the financial status estate, the executor must assess the validity of of the estate before making any distributions, the claim and either accept or reject the claim. as he may face personal liability for If accepted, the executor pays the debt in the improperly distributed assets. normal fashion. If the claim is rejected, the creditor is required to commence a lawsuit against the estate in order to receive money Observation All states, other than from the estate. those with community All creditors have a limited time period property laws, have statutes that allow a in which to make a claim against the spouse to elect against the Will if he or she decedent’s estate. In Ohio, that time period does not like the distribution of assets that the is limited to six months commencing on the deceased spouse has dictated in the Will. date of death. If the claim is made after that The statute then prescribes what the spouse time period, the estate is under no obligation is entitled to receive in lieu of the terms in the to make payment on that debt. Ohio law also Will. Community property states do not need provides that the executor may accelerate these laws because spouses in those states the time period for claims to as little as thirty are equal owners of all property acquired days, if adequate notice is provided to the during marriage. creditors. The state law where the estate is being administered must be very carefully checked to determine the time period and If the executor determines that the procedure for the handling of claims. assets of the estate are sufficient to pay all Occasionally, the assets of the estate of the debts, then the portion remaining are insufficient to pay its debts. If the estate may be distributed to the beneficiaries of is insolvent (e.g., the debts of the estate are the estate without further delay. There is no greater than its assets), state law will govern legal requirement that the executor withhold the order of the payment of estate debts distribution of estate funds for any period of by the executor. The executor must follow time as long as the creditors of the estate are the statute exactly in order to prevent one protected. However, expect that state law creditor from being paid more than its share will hold the executor personally liable if he or being paid out of order. A court hearing distributes the assets of the estate and there may be held to determine if the executor’s remains insufficient assets to pay the valid proposed payment plan follows the law. debts of the estate. After the hearing, the court will issue an order Filing of Periodic Accountings and the Final that guides the executor by specifying which Account creditors are to be paid and in what amounts. An executor of an estate is required to provide to the court, as well as to all parties interested in the estate, a periodic accounting of the status of the estate. This accounting is a written document that lists the property of
224 Chapter 25: Probate of an Estate Wealth Management Through Estate Planning
the estate that the executor has received. the final account, because the executor is The account also lists the disbursements usually a trusted family member as well as a to pay estate debts and distributions to beneficiary. beneficiaries made by the executor during The duty to account to the court and the the accounting period. estate beneficiaries emphasizes that one The account is due a set period from of the purposes of probate is to make sure the date of the appointment of the executor. that the beneficiaries are satisfied with the For example, in Ohio, the final account manner in which the executor has carried is due six months after the Executor's out his responsibilities. appointment. In many estates, the first Filing of Income and Estate Tax Returns account is also the final account, as the The executor’s responsibilities include executor is able to wind up the affairs of the properly taking care of any tax returns that estate within that time period. In the event have to be filed for the decedent or the estate. the estate cannot be concluded within that The executor is responsible for period, then the executor is required to file a preparing and filing the personal income partial account. The partial account is very tax return of the decedent for the year similar to the final account and sets forth in which he died. On that return, he will the executor’s receipts and disbursements report income earned by the decedent from during that accounting period. The purpose January 1st through the date of death. of the partial account is to keep the If the estate has income, then this court apprised of the executor’s activities income must be reported on Internal regarding the estate. Revenue Service Form 1041, which is the The earliest time that a final account fiduciary’s income tax return. This income can be filed is frequently several months would arise, for example, from dividends after the date of the appointment of the on investments, interest income and the executor. This is based on the time period in like earned after the decedent’s death and which a person may challenge a Will that before such estate assets are distributed has been admitted to probate. Again, state to the individual beneficiaries. The estate law may vary on this and must be checked. is required to file an income tax return Once the estate has been fully for each year in which it had income that administered, the executor will file a final is equal to at least $600. Usually, the account with probate court. This account income of the estate is distributed out to will show that all estate assets have been the beneficiaries. When this is done, the disbursed to pay expenses and distributed beneficiaries are required to report that to the beneficiaries of the estate. Upon income on their own income tax returns. acceptance of the final account by the Accordingly, the estate gets a deduction probate court, the executor is discharged for the income distributed. By doing this, and the estate proceeding is concluded. the executor transfers the tax liability to the When a periodic or final account is beneficiaries and avoids the payment of filed with the probate court, the executor income taxes by the estate. is required to give notice to all interested The estate is its own separate entity for parties in the estate. These interested parties tax purposes. In most estate administrations, have the right to review the account and if the executor will obtain a separate tax they feel it is improper, they have the right to identification number from the Internal challenge the account. If they challenge it, Revenue Service. For many estates, the a hearing is held before the probate court income tax returns are not complicated but so the court may make a determination as the executor must make sure that if returns to the validity of the account. Most people have to be prepared, they are properly waive their right to have a hearing on completed and timely filed.
Chapter 25: Probate of an Estate 225 Wealth Management Through Estate Planning
In addition, the executor has the a hearing, what is a fair and reasonable fee. responsibility to make sure that all estate tax The fees are then paid from the assets of the returns are filed. The executor has personal estate. liability for any penalties and interest that may Compensation of the Executor accrue if he fails to file these returns when The amount of fees to be paid for the they are due. executor’s services is determined by statute. A more detailed discussion of the tax As an example, in Ohio an executor is returns that must be filed can be found entitled to receive compensation based on the in Chapter 26: Post-Mortem Planning following percentages of the probate estate. Opportunities. ◆ 4% of the first $100,000 of estate Employment of Legal Counsel assets. Invariably, the executor will employ ◆ 3% of the next $300,000 of estate an attorney to assist him in the foregoing assets. responsibilities of administering an estate. Because of the complexity of the process and ◆ 2% percent on all estate assets in the fact that it is unlikely that the executor has excess of $400,000. had any experience in probating an estate, ◆ 1% of all non-probate assets subject the employment of skilled probate counsel is to the Ohio estate tax except joint and wise. survivor property. The attorney can play a valuable role in administering an estate. The attorney For example, if the estate has $800,000 directs and advises the executor as to the of probate assets, then the allowable responsibilities that he is to perform on behalf commission would be $21,000. of the estate. Additionally, the attorney Ohio’s statute, as well as those of undertakes direct responsibility for many many other states, provides that the rate is aspects of the administration of the estate. different for certain types of property. For The attorney prepares the various legal forms example, if the estate contains real property that are necessary to properly work through that is not sold, the executor is only allowed the probate process. The attorney can also a 1% compensation on that property and prepare the tax returns that are required. not 4%. However, the above schedule is a Close coordination between the executor good general guideline. There is no broad and his counsel is important to the successful uniformity on compensation allowable, and and expedient completion of the many state law must be checked on this. responsibilities of probate administration. Any amounts received as compensation It is important to understand that the are taxable income to the executor. For this attorney is employed directly by the executor reason, many executors waive the right to to assist the executor in handling these receive compensation because receiving it diverse responsibilities. The executor has a would create an income tax consequence. For contractual relationship with the attorney example, a spouse receiving all of the estate and is responsible for his fees. However, in assets will certainly not charge compensation, all estates, the executor has the right to seek because if compensation was taken, the reimbursement for these expenses from spouse would be creating an income tax the estate. Most commonly, the executor will liability for assets she would otherwise receive request and receive from the beneficiaries tax-free from the estate. their approval as to the amount to be Other Probate Administration Expenses expended on legal fees. With consent, there is There are additional expenses that have no expense to the executor. Without consent, to be paid by the estate. For example, there an application for attorney fees must be filed is a filing fee with probate court. This is the with the probate court which determines, after deposit to cover court costs for the probate
226 Chapter 25: Probate of an Estate Wealth Management Through Estate Planning
proceeding. There are transfer costs for release from administration procedure deeds for real property and appraiser’s is used to clean up any smaller assets fees. Of course, the executor has to pay all that were somehow overlooked and not administration expenses of the estate, such correctly aligned with the estate plan. as those incurred for the decedent’s burial, There is no uniformity among the states a cemetery plot and related expenses. on the maximum amount of assets that can All of these expenses are payable use this procedure and the process to be from the estate of the decedent, although followed. New York’s maximum is $10,000 the executor is not individually responsible of personal property. For Florida, summary to make sure that they are paid. It is not administration has a limit of $75,000. Each uncommon for the executor to advance state must be investigated separately as to funds to the estate for the payment of how its small estate procedure operates. these bills. He has no legal responsibility to do so and the executor is not personally ANCILLARY ADMINISTRATION responsible for the payment of the debts of Where a person died owning real or the estate if it does not have sufficient assets tangible property located in another state in to pay all of its obligations. If the executor her sole name, estate administration in that does loan money to the estate, he has the state is necessary. The reason for this is to right to be reimbursed as assets of the estate get the legal authority in that state to convey become available. the property over to the estate beneficiaries. This procedure is called ancillary SMALL ESTATE PROCEDURE administration because it is ancillary to the Almost every state provides for an main administration of the estate in the state abbreviated probate procedure where the where the decedent was a resident. decedent’s probate estate is very small. The Ancillary administration only applies rationale is that because of the size of the to property physically located in another estate, full administration is not merited. state and only as to property that needs to In Ohio, this is called release from go through probate. Real estate held joint administration. Where the probate assets tenants with right of survivorship does not of the decedent are $35,000 or less, need to go through ancillary administration or if the decedent’s probate assets are because the property passes by right of $100,000 or less and there is a surviving survivorship to the surviving joint owner. spouse who is entitled to all the assets, the Bank and investment accounts have a legal decedent’s family can use this procedure. situs in the state of the owner, not where the When an estate is being released bank or brokerage firm is headquartered. from administration, an executor is not These types of assets are subject to the appointed. This shortened probate process estate administration in the state of the is completed by the applicant. The number deceased’s residence. of forms to be filed and the responsibilities One of the important goals of estate involved are very much reduced. Obviously, planning is to avoid both probate and this procedure reflects the fact that the ancillary administration. This can easily be expense of full probate administration is not accomplished by re-titling of the assets. For justified in such a circumstance. Because example, real property could be held joint of good estate planning techniques, it has tenants with right of survivorship. If there is a become more common for an estate to living trust, the property could be transferred go through release from administration. into the living trust. The correct alignment of Through comprehensive estate planning, assets is discussed in detail in Chapter 21: more assets are transferred by prior Asset Alignment Strategies. designation and thus avoid probate. The
Chapter 25: Probate of an Estate 227 Wealth Management Through Estate Planning
SOME FINAL THOUGHTS property held as joint tenants with right of The frequency of times that estates have survivorship with another because on death to go through full probate administration the property immediately passes over to has declined. This is due, at least in part, to the survivor. Jointly held property is not part the many estate planning techniques and of a probate estate. Similarly, there is the statutory means that have been developed to opportunity to structure a trust so that at death avoid probate. This trend, however, creates a the deceased’s assets are beyond the reach paradox. of creditors. Implicit in the reason for having probate The power and ability of probate court administration of estates is the desire to have to control the distribution of assets and the a full accounting of a decedent’s affairs payment of debts is clearly diminished in at death. The probate process gives the circumstances where a sophisticated estate decedent’s beneficiaries and those who plan has allowed the decedent’s assets to would normally expect to be his heirs a forum avoid the probate process. If probate court to make sure that the decedent’s true wishes was devised for a purpose, i.e., to supervise regarding the disposition of his property the disposition of a person’s estate at death, are fulfilled. For example, family members and with planning techniques probate can can challenge the provisions of a Will if now be avoided, what should now be done they believe that the Will was signed by to insure the integrity and correctness of the the deceased under duress, fraud or undue disposition of a person’s assets at death? influence. Challenges to the distribution of an These are issues that will have larger estate can be made more difficult where the implications as persons with complex deceased created a living trust and funded estate plans pass away. Some states have it during his lifetime with his assets. In many moved to meet this challenge employing a states, the rights of a surviving spouse can be concept called the augmented estate. The defeated or seriously impaired by creating a augmented estate includes not just probate living trust and funding it with assets during property but property interests passing by life. Statutes designed to protect a surviving right of survivorship, beneficiary designations spouse, for example, by giving him or her or through trusts. The strategy is designed the right to elect against a Will and take a to protect, for example, surviving spouses statutory share, are avoided when these from being denied their statutory share of an statutes only apply to property passing estate. through probate and not to property under These comments are not made to the control and direction of a trust agreement. condemn estate planning and its many Another reason for having a probate benefits. However, they do show the power proceeding is to give creditors an opportunity of estate planning to move beyond the to present their claims and have them satisfied protections granted by current law. Estate out of the decedent’s assets. As we have seen, planning is in large part about people making the creditors are given a forum in probate their own rules. The problem arises when the court to make sure that their claims are rules we create clash with the statutory rules protected. made by governments to protect societal Creditors’ rights can be defeated when values. there are insufficient assets in the probate estate. A creditor cannot have his claim satisfied out of the decedent’s interest in
228 Chapter 25: Probate of an Estate Wealth Management Through Estate Planning
Chapter 26: Post-Mortem Planning Opportunities
Estate planning does not always stop at the death of a client. Significant opportunities might still be available following death for further tax savings or to correct errors and oversights in a plan.
Chapter 26: Post-Mortem Planning Opportunities 229 Wealth Management Through Estate Planning
Chapter 26:
◆ The Chain of Command ◆ Marshalling Assets ◆ Liabilities and Liquidity ◆ Income Tax Returns ◆ Using the Valuation Elections ◆ Marital Deduction Elections ◆ Other Tax Saving Deductions ◆ Filing Gift Tax Returns ◆ Federal Estate Tax Payment ◆ Disclaimers ◆ Helping the Decedent’s Beneficiaries
“The illusion that times that were are better than
those that are has probably pervaded all ages.”
Horace Greeley
230 Wealth Management Through Estate Planning
very estate planning attorney knows that some day a call will come My opinion E advising of the death of a client. This is the moment for which we have planned. The experienced attorney who has handled Often, a spouse post-death affairs starts running through a mental list of the many issues that need to is quick to retitle be addressed. The main objectives of post- accounts into mortem planning are: his or her own ◆ Appointing the person in charge of this process, under the Will or the name. However, this quick action may trust and setting up the “chain of inadvertently cause the loss of a tax command;” ◆ Marshalling assets into one fund, savings opportunity. This is especially estimating liabilities and creating a so with an IRA of the deceased spouse liquid fund to pay the liabilities. being rolled over to an existing IRA of These objectives must be blended 1 together in a seamless transition under the the surviving spouse who is over 70 /2. deadlines imposed by tax and probate Before doing anything drastic, please laws. There are various tax elections that may consult with your advisors. help decrease the overall tax burden on an estate. These elections must be individually addressed when administering an estate. This chapter discusses these issues and Each one may directly impact income taxes, other planning options that are considered estate taxes and/or generation-skipping in post-mortem planning. While we cannot transfer taxes. The available elections give you an exhaustive recap of everything affect the value of an estate for determining that goes into post-mortem planning, we federal estate tax as well as when some of can show you how the tax questions can be the taxes must be paid. The creative use of analyzed and highlight the major aspects of disclaimers is an important technique for post-mortem planning. minimizing taxes due because of a death. A complete post-mortem plan includes THE CHAIN OF COMMAND reviewing and updating the estate plans One person or trust company is placed of the decedent’s beneficiaries, especially in charge of making final decisions. This when there is a surviving spouse. position of decision-maker may be as an Executor under a Will, an Administrator under an intestate Estate or as Trustee under a Trust. The decision-maker may have a team of advisors, including an accountant, a trust advisor, a life insurance agent and, of course, an attorney. No decisions can really be made until it is clear who has the authority and the responsibility to make these decisions.
Chapter 26: Post-Mortem Planning Opportunities 231 Wealth Management Through Estate Planning
MARSHALLING ASSETS Steps for The totality of the circumstances must be Administration known before any decisions are made. The 4 3 value of the estate assets, the identification of 2 Plan the person receiving each asset and the type 1 Estimate Liquidation of the asset drives our analysis of the issues Collect Liabilities Appoint Assets applicable to each estate. Administrator The decision-maker has the responsibility of researching what assets the decedent owned and arranging for title to be INCOME TAX RETURNS transferred either to the decision-maker in his or her name as Executor, Administrator Decedent’s Final Federal Income Tax or Trustee or notifying the joint owner or Returns beneficiary. This is time-consuming if accounts The decedent’s tax year ends on the are scattered throughout many institutions day of his death. A final federal income tax or if the decedent holds multiple parcels return must be filed by April 15th of the of real estate. Many older people start the year following the year of death, unless an important process of consolidating accounts extension is granted. Remember that the while they are still living. They may group granting of an extension does not extend the assets together in the name of their revocable time for paying taxes. This return will show trust. This advance preparation goes a long all income of the decedent and allowable way towards efficient management of an deductions to the date of death. The final estate both during the owner’s life and then return can be filed jointly with a surviving again during the process of administering the spouse. owner’s estate. If the deceased was on an accrual basis, then the return will show all accrued income LIABILITIES AND LIQUIDITY and expense through the date of death. Accrual basis means that the taxpayer was Once an intelligent guesstimate can be counting income as it was earned not when it made on the value of the estate, estate taxes, was actually received. both federal and state, should be calculated. If the deceased was a cash basis Then, the decision-maker needs to sit down taxpayer (counting income only when it was with her partnership of professionals and received), the final income tax return will not decide what assets will be used to pay this include income in respect of a decedent liability. (IRD). This is income earned by the deceased After using cash resources, the estate prior to death but not collected during the may have to also tap into other sources of lifetime of that person. Examples of IRD are: funding. If the estate consists of primarily real estate, arrangements may have to be ◆ Fees earned but not yet paid. made to liquidate some part of the real ◆ Earned and unpaid royalties. estate portfolio. If the estate consists mostly ◆ Accrued rental payments. of marketable securities, the decision will ◆ involve selecting those stocks to be sold. If Accrued interest on bonds. there is an irrevocable life insurance trust, the ◆ Bonuses and salaries earned but not decision-makers of the estate and of the life yet payable. insurance trust must decide which assets the ◆ Accrued dividends on shares of stock life insurance trust will buy from the estate or that have not been paid. make provisions for the life insurance trust to loan funds to the estate. The same analysis needs to occur with any other debts besides estate taxes.
232 Chapter 26: Post-Mortem Planning Opportunities Wealth Management Through Estate Planning
These items trigger both income and estate tax liability. However, Observation If one person is the person who receives preparing the final this income is allowed a income tax return and a different person is deduction for the estate preparing the estate tax return, they must tax that was paid work together and come up with a plan in on that item of regards to these elections so that the best IRD. overall tax results are achieved for the beneficiaries. My opinion There may be other elections available to the estate. For example, an executor can In the quest for information, start elect to have accrued income on the bonds taxed on the final income tax return of the with the person who prepared the decedent rather than taxed to the estate or the beneficiaries on redemption. decedent’s income tax returns. This Estate’s Income Tax Return person will know what is going on An estate is a separate legal entity for tax purposes and must file its own income and can help prepare the year of tax return. The estate income tax return is death income tax return. separate and distinct from the estate tax return. The income tax return will report the income earned by the estate from the date of the deceased’s death until the estate is Payment of income taxes by the closed. The estate income might include decedent’s estate is a deduction from the interest and dividends, capital gains, rental decedent’s gross estate for federal estate income, and income from the operation of a tax purposes. Similarly, if the decedent business. It could also include distributions is entitled to a refund for his last federal from an IRA, qualified plan or an annuity. income tax return, the amount of the refund The estate will either pay the taxes due on is an asset that must be included in the this income or distribute the income to the decedent’s taxable estate for federal estate beneficiaries who are then responsible for tax. If the final income tax return is a joint paying the taxes. return filed with the spouse, the refund Distributions from an estate are first amount will have to be allocated between treated as income to the extent that the the decedent’s estate and the surviving estate had income, regardless of the nature spouse. of the asset distributed. If an estate has Medical expenses that are paid by $5,000 of income and distributes $5,000 the estate in the first twelve months after of stock to its beneficiary, the stock is taxed a death can be taken as a deduction on to the beneficiary as income. the decedent’s income tax return for the Reasonable and necessary year in which the expenses were incurred. administration expenses can be taken Alternatively, the medical expenses can be either on the estate’s income tax return taken as a deduction on the federal estate or on the federal estate tax return. These tax return. A determination needs to be expenses include the costs of collecting and made as to where the deduction will have preserving the assets of the estate, paying the most impact on taxes. debts, court costs, executor’s commissions,
Chapter 26: Post-Mortem Planning Opportunities 233 Wealth Management Through Estate Planning
attorney fees and accountant fees. USING THE VALUATION Whether to take expenses on the estate’s ELECTIONS income tax return or estate tax return depends Certain elections relate only to how on the marginal income and estate tax assets are valued for purposes of determining brackets. If the marginal estate tax rate is the estate tax. These elections should be 50%, the expenses should probably be taken considered on a case by case basis for each on the estate tax return because it will result in estate. greater savings. The executor can elect to split certain expenses between the income and Alternate Valuation Date Election estate tax returns. Generally, estate assets are valued as of the decedent’s date of death. However, an election can be made to value estate Example Carol is the sole beneficiary of assets as of six months after the date her father’s estate and is in the 28% of death. This date is the alternate personal income tax bracket. She serves as executor of valuation date. For example, if the estate and under local law is entitled to a $30,000 decedent died on January 20th, his executor’s fee. The marginal estate tax bracket is 50%. Her federal estate tax return could list his income tax bracket is 22% less than the estate tax rate. assets as valued on January 20th or July Taking the commission as a deduction on the estate tax return 20th, if the conditions of the election are rather than on the estate income tax return will save Carol met. $6,600 ($30,000 times 22%). Carol will still have to claim The alternate valuation date can the $30,000 as income on her personal income tax return in be used only if making the the year it is received. election reduces both the actual size of the gross estate and the federal The executor or administrator of the estate tax liability. estate is entitled to compensation for her This restriction is to services. These fees can be waived. If the fee bar a beneficiary is waived, no deduction is available. If the fee who is not paying is taken, that amount is taxable income to the person receiving the fee and is a My opinion deduction for either the estate’s federal income or estate tax return. Generally, an estate is entitled to a tax deduction for amounts of income distributed. The value of estate assets on the However, beneficiaries who receive specific gifts (e.g. $5,000 to each of my children), do alternate valuation date should not pay income taxes on the gifts. Unlike an always be determined in cases individual return, an estate does not have a standard deduction but instead currently has a where estate tax is due. This election $600 exemption. provides an opportunity to reduce Trust Income Tax Return If there is no estate administration because, estate taxes. for example, all of the assets of the decedent were in a trust at the time of her death, all any federal estate tax from using the alternate income and IRD will be reported on the trust’s valuation date simply to get a higher cost income tax return with income taxes being paid basis in the decedent’s assets. by the trust or by the trust’s beneficiaries to the extent that the trust made distributions to them.
234 Chapter 26: Post-Mortem Planning Opportunities Wealth Management Through Estate Planning
The election is made on the federal management of the business and is not estate tax return and once made, it is established merely by being a shareholder, irrevocable. If the return is filed late, this officer or partner of the business. election is unavailable. This election must be Yet another requirement must made across the board for all estate assets be met. The property must pass and cannot be applied selectively to only to qualified heirs of the certain estate assets. What happens if an decedent, which means asset is sold or otherwise disposed of before certain family members. the alternate valuation date? This asset is Leaving the business to an then valued as of the date of disposition. unrelated employee will not Special Use Valuation Election Real property that is used for farming or small business may be valued on My opinion the federal estate tax return based on its actual use rather than its fair market value. The rules and requirements of this The actual use valuation, in most cases, will election are so complicated that not be lower than the fair market value of the real property. While this is intended to be many estates get to take advantage a tax break for farmers and small business of the estate tax savings it offers. owners with real estate, meeting the complex requirements can be difficult. If the federal government wants to First, the real property must make up at provide estate tax relief to farmers least fifty percent (50%) of the decedent's gross estate and at least twenty-five percent and small business owners, it should (25%) of the decedent’s adjusted gross do it in a simpler, more direct estate. It must have been used as a farm or in a small business on the date of death manner. by the decedent or certain family members of the decedent. The statute excludes real estate held in a small business for passive qualify. investments, including rental property. There are other requirements that The second requirement is a time apply to this election but these are the restriction. Not only must the real estate major rules. have been used in this manner for five out of the eight years preceding the decedent’s MARITAL DEDUCTION death, but the heirs must continue to use the ELECTIONS property in this same manner for at least ten The unlimited marital deduction is the years after the decedent’s death. If the 10 most significant tax deduction available year rule is violated and the property is sold for a married couple. All property passing or otherwise used, some amount of federal to a spouse, either outright or in trust that estate tax savings is recaptured and paid by qualifies for this special treatment, will pass the people who received the property. free of estate taxes. This deduction is useful Another requirement addresses the in that it can be used to postpone all estate involvement of the decedent in the business. taxes until both spouses are deceased. Either the decedent or certain family This preserves the estate for the benefit of members must have materially participated the surviving spouse. However, in several in the operation of such business. Generally, situations it is necessary to take additional material participation means full-time steps to make sure the property passing to
Chapter 26: Post-Mortem Planning Opportunities 235 Wealth Management Through Estate Planning
the spouse is eligible for this favorable tax United States, the government fears that the treatment. spouse will leave the United States with the QTIP Elections inheritance and that the property will never be If a property does not pass outright to a subject to estate taxes. Therefore, no federal spouse or to a trust where the spouse has all of estate tax deduction is allowed for property the control over the property, then the property passing to a non-citizen surviving spouse, will not pass estate tax free unless it meets unless such property is held in a qualified the rules for qualified terminable interest domestic trust (QDOT). One of the QDOT property (QTIP). These rules are as follows: requirements is that this special trust must have at least one trustee who is a U.S. citizen ◆ All of the income from the property is or a domestic corporation and this trustee paid at least annually to the spouse for must be able to withhold the estate tax from life. distributions to the spouse or other heirs. If ◆ While the spouse is living, nobody else this election is not made, then estate taxes are has any right to the property. accelerated and must be paid at the death of the first spouse. ◆ The spouse has the right to require that the property be income producing. An election to treat a trust as a QDOT must be made on the final estate tax return QTIP property is usually property that is filed before the due date or on the first estate held in trust, but can include other types of tax return filed after the due date. The election property such as life estates. A more detailed is irrevocable. discussion of QTIP property is in Chapter 4: There is one way to cure the failure to set The Federal Estate Tax. QTIP trusts are often up a QDOT. If property is passing directly used in second marriage situations when the from a deceased spouse to a non-citizen deceased spouse wants the surviving spouse spouse, such as property held as joint tenants to have the income generated by property with a right of survivorship, a deduction held in a trust for the surviving spouse, but the can be taken if the property is irrevocably property is reunited with the children of the transferred into a qualifying QDOT. The deceased spouse when the surviving spouse surviving spouse will actually set up a trust dies. that will meet all of the requirements for a This election must be made on a QDOT. The transfer must be made by the timely filed federal estate tax return and time the QDOT election is due, so non-citizen is irrevocable. Failure to make the QTIP spouses should not delay in the consultation election, even for reasonable cause, will with an advisor. not be grounds for a later election. In one situation, missing pages from a will were OTHER TAX SAVING found after the filing of the federal estate tax return. The missing pages created a trust that DEDUCTIONS qualified for the election, but the election was Section 2053 of the Internal Revenue still not permitted. Code allows for deductions from the gross A protective QTIP election can be made estate of a decedent that fall into four if, at the time of filing the estate tax return, categories: funeral expenses; administration it is unclear if certain property qualifies for expenses; claims against the estate; and the election. If it is later determined that such unpaid mortgages and other indebtedness of property does not qualify, there is no harm property included in the estate. The combined done. effect of these deductions is to reduce the estate taxes due. Because the deductions Qualified Domestic Trusts reduce the entire estate, they are saving taxes If a surviving spouse is a non-citizen of the at the highest marginal rate applicable to an
236 Chapter 26: Post-Mortem Planning Opportunities Wealth Management Through Estate Planning
estate and so could save as much as 35% deduction for that payment is permissible. of tax that would be due if the deduction Taxes accrued up to the date of death, such were not taken. as property taxes, are deductible as claims Funeral Expenses against the estate. Funeral expenses are deductible. To be deductible, the obligation must Funeral expenses include reasonable costs be allowable under state law and must be of the casket, vault, tombstone, monument or enforceable against the decedent’s estate. mausoleum, undertaking, burial lot for the For example, if a creditor does not assert decedent, and reasonable expenditures for a claim in a timely fashion and therefore care and transportation of the body to the it is unenforceable, it is not an allowable burial site. deduction. Administration Expenses Unpaid Mortgages and Other Executor fees and attorney fees Indebtedness incurred and paid during the administration If a decedent’s estate is liable for of an estate may be taken as a deduction. a mortgage or other indebtedness on To be taken as a deduction, the fees must be property, then the entire value of the allowed under local law. property is included in the decedent’s estate Also, expenses directly related to and the entire amount of the mortgage or selling property of the estate can be taken indebtedness is allowable as a deduction. as a deduction if the sale is necessary to If the estate is not liable for the mortgage, pay estate taxes, debts or expenses, to then the estate tax return should report the preserve the estate or to make distributions property at its value less the mortgage and to beneficiaries. Interest on a personal no deduction is taken. The mortgage or obligation of the decedent that accrued up to indebtedness must be bona fide and for full the date of death is an allowable deduction. and adequate consideration. Other miscellaneous expenses that can Where real property is held as joint be deducted include the cost of appraisals tenants with a right of survivorship between and valuations of estate property, a husband and wife, the estate of the first court costs and filing fees and costs of spouse to die can deduct one-half of the maintaining an estate when immediate mortgage on such property, regardless of distribution is not practical. the actual contributions of the spouses. Some of these administration expenses will not be deductible if the administration of FILING GIFT TAX RETURNS the estate takes an unreasonable amount of If the decedent made taxable gifts for time, as determined by the federal courts. which a gift tax return has not been filed, such Claims Against the Estate return must be filed after the donor’s death. Personal obligations of the decedent If certain requirements are met, the gifts may that are enforceable against the estate be split with the surviving spouse. You may are deductible. An obligation under an recall that gift-splitting is where one spouse agreement signed by the decedent is makes the gift and for tax purposes, the gift deductible to the extent that the agreement is treated as if each spouse made one half of is bona fide and for adequate and full it. Alternatively, if a surviving spouse made consideration. Liabilities imposed by law a gift during the decedent spouse’s lifetime, are fully deductible. If the decedent is the personal representative of the decedent jointly and severally liable on a debt, only may elect to split such gifts. The election must his proportionate share is deductible. If the be made by the executor of the estate and estate pays the debt of another guaranteed cannot be made by the surviving spouse, in a binding manner by the decedent, a unless such spouse has been appointed as
Chapter 26: Post-Mortem Planning Opportunities 237 Wealth Management Through Estate Planning
the executor. terms of a buy-sell agreement and to use If gift tax is owed for a gift made by a the proceeds to pay death taxes. Section decedent, it is a debt and can be taken as a 303 of the Internal Revenue Code allows deduction on the federal estate tax return. a decedent’s stock in a corporation to be redeemed to pay death taxes and expenses FEDERAL ESTATE TAX without treating the redemption as a PAYMENT dividend for federal income tax purposes. The federal estate tax return and any tax Instead, the redemption is treated as a owed are due nine months from the date of distribution in full payment or exchange death. A six month extension will usually be for the redeemed stock and this is a more granted, but estimated taxes must be paid by favorable income tax result. the nine month deadline. A few exceptions To be eligible for a Section 303 to this rule exist that allow the payment of redemption, the value of decedent’s stock federal estate tax to be deferred for a period must exceed 35% of the value of the gross of time. estate less certain deductions. Stock in two or more corporations owned by decedent may Deferred Payment Due to Hardship be aggregated to attain the 35% requirement, The Internal Revenue Code allows an but only if the decedent owned at least 20% extension of time to pay federal estate taxes of each corporation. Gifts of stock made by for reasonable cause. Reasonable cause the decedent within three years of death are can include the following: added back into the estate only for making ◆ Difficulty in gathering assets of the the determination of whether the percentage estate. requirements are met. The gifted stock cannot ◆ Substantial non-liquid assets comprise be redeemed under this section. the estate, such as the right to receive This redemption can generally be made future payments. at any time during the three year period of limitations on assessment of federal estate tax ◆ Insufficient funds are available to pay family allowances and debts of the plus ninety days or four years from the date estate without borrowing money at of death. This time limitation is extended if the excessive interest rates. federal estate tax is being paid in installments. There are other rules that apply to ◆ On-going litigation concerning estate redemptions and you should consult with your assets. business counsel and estate planning counsel The general rule is that an extension may if you are considering a stock redemption. be granted for up to 12 months from the date Installment Payments for Closely Held the tax is due. For estate taxes, this extension Businesses can be lengthened to no more than 10 years, Under IRC Section 6166, an election usually by having an annual review of the 12 may be made to pay the estate tax that is month extension and granting additional 12 attributable to a decedent’s interest in a month extensions. closely held business in equal installments. Interest is due on the unpaid tax The tax laws permit an estate to pay interest obligation and will be at the rate currently only on the deferred tax for the first 5 years charged for tax deficiencies, which is the and then to pay principal and interest for the federal short term rate plus 3%. next 10 years. Stock Redemptions In order to use installment payments, A decedent’s family may want to sell the closely held business must be active, but some of the stock of the decedent back to can be a sole proprietorship, partnership or the corporation in order to comply with the corporation. Also, the value of the business
238 Chapter 26: Post-Mortem Planning Opportunities Wealth Management Through Estate Planning
must be at least 35% of the decedent’s may be possible to combine the interests held adjusted gross estate. When valuing the in several businesses to qualify for this election closely held business interest, only assets used if 20% or more of the total value of each in an active business count and passive assets business is included in the decedent’s gross held by the company are not included. estate. An interest in a partnership qualifies for this election only if the decedent’s gross DISCLAIMERS estate includes 20% or more of the total Disclaimers provide a chance to do some partnership capital or the partnership has 45 estate tax planning after someone has died. or fewer partners. This is akin to the rules for A disclaimer happens when a beneficiary corporations: a decedent’s states that he does not want all or a portion estate must include 20% or of property left to him by a decedent. If more of the voting stock this happens in the right way, this person is in a corporation or the treated as if he predeceased the decedent. corporation must The disclaimed assets then go to the next have 45 or fewer beneficiary in line. shareholders. It Why would someone want to forego a gift? It may be necessary for a spouse My opinion to disclaim certain property to fund the decedent’s credit shelter trust (B Trust). This Relying on disclaimer could generate substantial estate tax benefits. If one spouse dies and everything a deferral is passing to the surviving spouse under beneficiary designations or rights of joint ownership, then there are no assets available of estate taxes is an expensive way to fund the deceased spouse’s B Trust. By a timely disclaimer, the surviving spouse may to do business. Interest is due and be able to save the tax plan and fund the B Trust. The spouse can still enjoy the economic the bill must be paid in the long run. benefits of the property as a beneficiary of the B Trust. Legal fees and accounting fees are A second circumstance is where the beneficiary does not need the property and would rather have someone else be the increased with the additional work recipient. A child of the deceased may be financially well off and would rather have an that must be done. If you have a inheritance from his parents go directly to his own children, instead of inflating his estate. By business, a better way is to develop disclaiming his inheritance, his children, as the next beneficiaries, will receive the property a business succession plan so that instead.
liquidity is not an issue.
Chapter 26: Post-Mortem Planning Opportunities 239 Wealth Management Through Estate Planning
These are only two examples where in the property in another way. The example disclaimers can be very valuable to the above where a spouse disclaims to fund a decedent’s family. Disclaimers can be used credit shelter trust and is the beneficiary of imaginatively in many types of post-mortem that trust is a prime example of this. No one planning situations. else can do this. Requirements of a Valid Disclaimer Types of Property Interests That Can Be All disclaimers are governed by IRC Disclaimed Section 2518 and must meet general A partial disclaimer is possible if the guidelines to be effective: property interest is severable. For example, ◆ The disclaimer must be in writing and if a decedent owned 300 shares of General signed. Electric stock that were to pass to his wife, she could disclaim her interest in 200 shares and ◆ The disclaimer must identify the dis- accept the remaining 100 shares. claimed property. In the case of trusts, the disclaimer may ◆ The disclaimer must be timely deliv- be specific as to a certain trust asset or ered to the transferor of the property. may be of a fractional interest in the trust. A ◆ This delivery must be done within nine fractional interest in a death benefit under a months after the creation of the inter- pension plan or IRA can be disclaimed, so est (with an extension permitted for that the primary beneficiary will receive part people under age 21). of the plan benefits while another beneficiary will receive the remaining benefits. ◆ The disclaimant cannot accept any of the benefits of the disclaimed property. With a partial disclaimer, the value of the disclaimed portion can be determined by ◆ The disclaimer will cause the property a fractional share formula. This allows for an to pass, without any direction from the adjustment in the amount of the disclaimer disclaimant, to the decedent’s surviving when there is a change in the value of the spouse or someone other than the dis- subject assets or if the value is undetermined claimant. or disputed at the time of the disclaimer. For When an interest in property is instance, the formula used can be devised disclaimed, the disclaimed property passes to achieve a certain amount of marital as if the disclaimant had predeceased the deduction, which, in turn, will allow the full property owner. funding of a credit shelter trust. The use of A spouse is the only person who can fractional share formula disclaimers may be disclaim an interest and still receive an interest necessary as the disclaimer will generally need to be completed before the decedent’s Example Jack has passed away and federal estate tax return is finalized. his life insurance has a death A separate interest in property, whether benefit of $2,000,000. Jill, his wife is named as held in trust or otherwise, can be disclaimed. the primary beneficiary. Jack’s Trust is named The disclaimed interest is relinquished while as the contingent beneficiary. If Jill files a timely other interests in the property can be retained. disclaimer, the death benefit would pass into An example is that a trust beneficiary who Jack’s Trust and can be used to fund his B Trust. If is entitled to both income and principal can the policy did not have a contingent beneficiary disclaim his right to income distributions while named, then Jill can still disclaim the policy and retaining his right to principal distributions. the death benefits would then pass under Jack’s Acceptance of Benefits Will. If this is a pour-over Will, then the property One of the rules of a valid disclaimer will eventually be directed into Jack’s Trust, in is that the disclaimant must complete a accordance with his Will.
240 Chapter 26: Post-Mortem Planning Opportunities Wealth Management Through Estate Planning
disclaimer prior to the acceptance of any the property passes away, if done within 9 benefits. Also, the disclaimant cannot months of the joint owner’s date of death. receive any payment “on the side” for Some special rules apply to jointly held agreeing to make the disclaimer. This bank and investment accounts. payment is deemed to be an acceptance of With these types of accounts, if benefits. Any use of the disclaimed property each joint owner can withdraw his own or acceptance of dividends, distributions contribution, then a joint owner can disclaim and interest payments from the disclaimed that portion of the account passing to him property are considered to be acceptance upon the death of a contributor to the of benefits and will invalidate the disclaimer. account. A joint owner can never disclaim There is one exception: a surviving joint the portion of the account that he personally tenant of residential property can continue contributed. Generally, if a joint owner to live at that residence without violating this withdraws part of a bank or brokerage requirement. account after the death of another joint A disclaimant cannot exercise a power owner, a disclaimer will be allowed as long of appointment over the property to be as the joint owner does not withdraw more disclaimed, as this will be deemed either than his pro rata share. to be an acceptance of benefits or, if the A disclaimer of a survivorship interest power is exercised in favor of a third party, in jointly held property allows for such to be direction as to where the disclaimed property to be shifted from one joint owner property passes. Acting as a fiduciary (a to another who does not disclaim or to heirs trustee or an executor) over the disclaimed under the deceased joint owner’s Will if all property is not enough to amount to an surviving joint owners disclaim. acceptance of benefits in and of itself. Disclaimers and Generation-Skipping However, if the fiduciary has discretionary Transfer Tax Planning power to direct payments or distributions of Disclaimers can be used to shift the property, then this will be an acceptance assets of a decedent either to or away of benefits. If the disclaimant is the executor from skip persons (grandchildren and or trustee and wants to disclaim a part of great-grandchildren) for the purpose of maximizing the exemption to generation Observation It is important that skipping transfer taxes or minimizing an legal counsel review imposition of generation-skipping transfer an estate immediately following the death of (GST) taxes. If a decedent’s estate has a family member. Inadvertent acceptance of too much property passing directly to benefits can foreclose the use of disclaimers grandchildren so that GST taxes are as a post-mortem planning technique. incurred, this can be corrected through the use of a qualified disclaimer, probably using a formula to determine the amount to be disclaimed, to re-direct some of the trust assets, it is a very good idea to the decedent’s assets to children. In the have the disclaimant irrevocably resign as alternative, children could disclaim some trustee after reviewing the trust to make sure property that they do not need in order that this is not a problem. to have some of their parent’s assets pass Disclaimers of Jointly Held Property directly to grandchildren to fully utilize the A surviving joint owner can disclaim the parent’s available GST exemption. survivorship interest that would otherwise Disclaimers provide a powerful pass to him when another joint owner of method to re-direct a decedent’s assets to
Chapter 26: Post-Mortem Planning Opportunities 241 Wealth Management Through Estate Planning
enhance estate tax planning. Of course, the surviving spouse. Perhaps the most important cooperation of beneficiaries is needed and reason to consider this is that on the death some beneficiaries are not willing to disclaim of the surviving spouse, the life insurance their interests. Also, a beneficiary gives up proceeds are not only estate tax free the right to enjoy the disclaimed property. A (because they are held in a credit shelter good trust plan will often eliminate the need trust) but are also free of any income taxes. to discuss disclaimers with the beneficiaries. Other investments in the credit shelter trust will not receive a stepped-up basis on the HELPING THE DECEDENT’S death of the spouse because they are in an BENEFICIARIES irrevocable trust and are not eligible for this A thorough post-mortem plan for the basis adjustment. This is an important factor to family of a decedent incorporates a review consider and is a strategy that is getting more of the estate plans of the decedent’s surviving attention as our population ages. spouse, or if no surviving spouse, for the Many estates involve the death of persons children and other beneficiaries. This is a who do not leave a surviving spouse behind. good time to review and/or create trusts for In these situations, it is worthwhile to visit the the survivors and to examine the beneficiary estate plans of the beneficiaries to determine designations and titling of his or her assets. if anything needs to be done for them and With the death of a spouse, there is more their families. An inheritance can create many of a sense of urgency because the burden planning opportunities for the next generation of estate taxes usually occurs on the death and these should be investigated. of the second spouse. Once these taxes are determined, the surviving spouse might CONCLUSION consider a gifting program or accelerate gifts Post-mortem planning is one of the more under the program currently in place in order challenging aspects of the estate planning to minimize the estate tax blow. lawyer’s practice. It requires not just skill and If a credit shelter trust and/or marital experience but imagination and the ability to deduction trust have been established at see the big picture. Strategy and tactics must the death of one spouse, the investment be designed to minimize taxes and achieve strategy for the trust assets should be re- other family goals in a coordinated fashion. examined. With the step-up in cost basis, assets can be repositioned for income or growth without capital gain problems. The trustee needs to determine the needs of the surviving spouse and the long term financial planning goals of the family. When the spouse does not need the assets held in a credit shelter trust for his or her living expenses, the spouse and trustee should look at the financial leveraging that can be achieved with investing these trust assets in a life insurance policy owned by the credit shelter trust on the life of the
242 Chapter 26: Post-Mortem Planning Opportunities PART VI: Other Important Estate Planning Topics
243 Wealth Management Through Estate Planning
PART VI:
Chapter 27 Estate Planning and Investment Strategies Chapter 28 Planning with Retirement Accounts Chapter 29 Charitable Planning
244 Wealth Management Through Estate Planning
Chapter 27: Estate Planning and Investment Strategies
As family wealth increases, estate planning considerations become more important in determining investment strategy. This chapter takes a look at some of the investment strategies that need to be considered and why financial decision making is affected by estate planning issues.
Chapter 27: Estate Planning and Investment Strategies 245 Wealth Management Through Estate Planning
Chapter 27:
◆ The Prudent Man Rule
◆ Equities Versus Bonds and Annuities
◆ Convert IRA's to Roth IRA's
◆ Trust Investment Strategies
◆ Purchase Life Insurance
◆ IRA Withdrawals to Make Gifts
◆ Create a Charitable Remainder Trust
“Never put your money in something that eats
or needs repainting.”
Billy Rose
246 Wealth Management Through Estate Planning
or some persons who are financially tools using family limited partnerships and successful, there comes a point in limited liability companies. F their lives when estate planning considerations become significant factors in the type of investment strategies that Observation they pursue. Investments are made with an I have had a eye on how wealth can be maximized and number of clients taxes minimized for the next generation. tell me that their goal is to spend their last Why would they do this? dollar on their last day. That never seems to Many people have accumulated more happen. Instead, their wealth continues to wealth than they ever planned on and now grow throughout the remainder of their lives. have financial resources far beyond what they need for their own support and living expenses. The careful savings, planning and Where parents are willing to invest investing designed to create resources to with estate planning goals in mind, they support them comfortably in retirement did have made a conscious decision that some much better than expected. of their assets can be invested for the next The current generation of retirees is generation and that not all investments quite probably the first generation of any are made with a goal of protecting their society where there is significant wealth financial security. Sometimes, they break held by so many people that is above their investable assets into two components. and beyond that needed for comfortable One component is invested conservatively support. Retired seniors need only compare with an eye on protecting principal and their net worth to that of their parents at producing current income for living the same age. Talk to investment advisors expenses. The other component is invested and financial planners who spend their more aggressively with a goal of capital professional careers helping clients plan for appreciation. The assets that are part of post-retirement income. the second component are available, if Further proof of this lies in the popularity needed. The goal is to not use these assets of estate planning. Many persons are and rely on the other assets for running their investing substantial dollars in life insurance households, taking vacations and buying premiums. There is no financial benefit that new cars. accrues to them by putting money into an Factoring estate planning decisions insurance policy. Instead, their goal is to into an investment strategy is a new create additional tax-free wealth at death development that has not yet received all of so that there is money to pay estate taxes the recognition that it deserves. However, and keep intact their children’s inheritances. the benefits of some of these strategies If they did not have more than adequate should not be overlooked. In this chapter, assets to take care of their own financial we take a look at some of the important needs, they would not even consider doing considerations where estate planning and this. investment planning intersect. First, however, Other examples range from simple let us take a look at some basic principles gifting programs where parents make that govern the fiduciary when investing annual exclusion gifts of $13,000 each trust principal. to children and grandchildren to the increasingly popular, sophisticated planning
Chapter 27: Estate Planning and Investment Strategies 247 Wealth Management Through Estate Planning
THE PRUDENT MAN RULE EQUITIES VERSUS BONDS AND A trustee is a fiduciary. This means ANNUITIES that he has special responsibilities to the Bonds and annuities are good trust beneficiaries to protect the trust corpus investments that are important components and handle it in accordance with the terms of many investment plans. However, they of the trust document and the requirements do have certain shortcomings when estate of the law. A fiduciary has a higher level of planning is taken into consideration. Bonds responsibility than any other person holding pay current income that is taxed, unless they property that belongs to another. are tax-free bonds, in which event the yield This higher level of responsibility is very is reduced to factor in the financial benefit of evident in the duty of the trustee to invest the tax-free returns. Annuities are valuable for tax- principal of the trust. Generally, trustees are deferred growth. However, at death, they do required to invest the trust principal in the not receive a new basis equal to their date of same manner that a prudent person would death value and all of the growth in annuities invest his own property having as a primary is subject to regular income tax and not the objective the preservation of trust principal. preferable capital gains rates. This is the prudent man rule. This is a very By comparison, equities receive a new conservative rule, but one that is widely tax basis at death equal to their fair market recognized. value at that time. Stepped-up basis erases All good trust agreements have specific all of the capital gains up to the date of language that authorizes the trustee to death. The beneficiaries can then sell equities make investments and generally delineates with little or no capital gains. his authority. Many trusts broaden the Stepped-up basis has become application of the prudent man rule, giving increasingly important as many companies more flexibility to the trustee. A current trend have reduced the amount of dividends they that serves as an example is trust language are paying out. Their focus has been on authorizing the employment of an investment using cash to fuel growth of the size of their manager and the right to delegate to that companies, increasing the value of the stock manager investment authority. This expands for their shareholders. This means that the dramatically the responsibility of the trustee to shareholders have less currently taxable formulate investment policy. The trustee can let dividends and more tax-deferred growth. someone else create the investment policy. When equities are held until death, the tax- The trend is to broaden the authority of deferred growth becomes tax-free growth by the trustee to make investments. However, reason of stepped-up basis. the trustees powers are still circumscribed by This benefit drives investment planning the law of the state that is the legal situs of for some people where their goal is to avoid the trust and the trustee’s investment powers the taxation of capital gains and increase as as set forth in the trust document. With these much as possible the wealth passing on to broad limitations in mind, let us take a look at their families. the most important planning ideas that focus This is not to say that annuities and bonds on estate planning and the maximization of are not good investments. They have a role family wealth for the next generation. in investment planning. However, the fact that there is no stepped-up basis on investments
248 Chapter 27: Estate Planning and Investment Strategies Wealth Management Through Estate Planning
held in an annuity and that income from investments. Paying now only advances many bonds is taxable income makes the time when income taxes are due. The them less attractive when estate planning true cost of paying income taxes on IRA considerations are taken into account. withdrawals is the lost opportunity cost on Generally, the purchase of equities the payment of income taxes before they is advantageous when estate planning would have to be paid. Also, paying income considerations are an important factor. taxes reduces the taxable value of an estate which then reduces estate taxes at death. CONVERT IRA's TO These financial costs may be far ROTH IRA's outweighed by the future income tax-free The benefit of a Roth IRA versus a growth in Roth IRA's. regular IRA is that all of the growth in a Roth IRA is income tax-free and not just income TRUST INVESTMENT tax-deferred. This income tax-free build up STRATEGIES in Roth accounts is not just for the original Irrevocable trusts are separate legal owner, but also for the beneficiaries. When entities for income tax purposes. This IRA's were created by statute, the belief means that trust income is subject to the was that when the owner retired, he or she compressed income tax rates. See Chapter would consume the amounts in the account 8: The Federal Income Tax and the tax during lifetime. To make sure this happened, rate table for trusts. Because trust income the tax law creating IRA's included minimum is taxed very early at the highest tax rate distribution rules requiring withdrawals of 35%, the trustee has to be very careful beginning when the owner attained in managing tax costs. How can a trustee 1 age 70 /2. manage tax costs? What has occurred with IRA's in reality The primary strategy for investing inside was unexpected. The investments in these a trust is to purchase equities. The reason accounts have grown much faster than the for this is that income tax is only paid on the required withdrawals. For a couple age dividends when received and now many 70 and 65, the required withdrawal for stocks do not pay substantial dividends. an account owned by the 70 year old is Most of the return is in increased value of 1/27.4 or about 3.6% of the balance of the the company’s shares of stock. This gain is IRA. To the extent that the IRA account grew not realized until the shares are sold and by a rate in excess of 3.6%, the IRA actually then the tax is subject to taxation at capital grew in value. Many persons have found gains rates. Using this strategy defers their IRA's growing substantially in value, taxation until equities are sold and makes despite the required withdrawals, and that any realized gains subject to the lower they have more money in these accounts capital gains tax rates. than they will ever need. Keep in mind that equities do not Where this has happened, or where receive a new basis upon the death of the there are other assets which provide plenty trust beneficiary where the assets in the trust of financial support, consider converting an are not included in the beneficiary’s taxable IRA to a Roth IRA. Income taxes will have estate. The successor beneficiaries keep the to be paid on the amounts converted; but same basis that the previous beneficiary keep in mind that income taxes will have had in the trust assets. to be paid anyway at some time on IRA Income in a trust can be managed to
Chapter 27: Estate Planning and Investment Strategies 249 Wealth Management Through Estate Planning
reduce the tax bite. One way to do this is PURCHASE LIFE INSURANCE to make distributions to a beneficiary who Life insurance proceeds are income is in a tax bracket that is less than the tax tax-free. Also, they are estate tax-free when bracket that applies to the trust’s income. owned by someone other than the insured. If the beneficiary’s tax rate is significantly When considering a gifting program to family lower, than a distribution to the beneficiary members, keep this in mind. Children can will result in the income being taxed at that invest gifts of money but they will have to person’s marginal rate. To the extent that the pay income taxes on interest and dividends beneficiaries income is lower, then the trust is earned and capital gains taxes on any gains in a position to make investments that produce realized from the sale of stock. currently taxable income. The use of life insurance in estate Also, some trust investments can be planning has particular vitality when the income producing assets to the extent that insurance is purchased in an irrevocable trust. the income will be taxed in the lower trust The use of this strategy is discussed at length income tax brackets. For example, the first in Chapter 16 The Irrevocable Trust. One $2,300 of trust income is taxed at only 15%. reason why this can be a valuable technique Therefore, the trust investment strategy can for increasing the value of the property inside take into consideration the lower tax brackets an irrevocable trust is that the life insurance of the beneficiary as well as those brackets of proceeds received on the death of the insured the trust. inside the trust are not only estate tax-free but We must also keep in mind, however, that income tax-free. in some circumstances, the trust investment When the trust beneficiary dies, strategy has to take into consideration the presuming that the principal of the trust competing interests of the current beneficiary is not in his taxable estate, there is no versus those of the next beneficiaries. A stepped-up basis on the equities inside the beneficiary who is entitled to receive all of irrevocable trust. However, life insurance the trust income may be short-changed where proceeds payable because of the death most of the investments are in equities that of the beneficiary are income tax-free. This produce little income. Conversely, if all of the makes life insurance more attractive from an trust assets were invested in bonds, then the investment perspective. remainder beneficiaries could complain that This is not to suggest that all of your extra their interests are being overlooked because money should go into life insurance or that a of little growth in the trust’s investment trustee should use the trust principal to buy portfolio. the largest policy that he can on the life of The trustee has a fiduciary responsibility the beneficiary. However, the income tax free in this situation to balance current income characteristic of death benefits should not be and long term growth so that the present overlooked as a factor in determining the role beneficiary realizes a reasonable amount that life insurance should play. of income. Trust investment strategy is not Remember, also, that this is only one of governed just by maximizing growth or the factors for considering this product. Life income but must also take into consideration insurance insures against the risk of someone the interests of the present and future dying unexpectedly, thus instantaneously beneficiaries. creating wealth that would not otherwise exist. It is a hedge against an unexpected and untimely death.
250 Chapter 27: Estate Planning and Investment Strategies Wealth Management Through Estate Planning
CREATE A CHARITABLE of assets inside a CRT are also not subject REMAINDER TRUST to capital gains taxes. This is true whether the investments sold are equities, real estate It may sound odd that making a or appreciated personal property. Similarly, charitable gift can be a good investment income earned on CRT investments is also strategy. The phrase that comes to mind is not subject to income taxes. that it is counter-intuitive, meaning that The result of this is that the trustee of it is the opposite of what we would sense the CRT can move in and out of investment to be the correct course of action to take. positions without having to pay any income However, seen in the context of estate or capital gains taxes. This should allow the planning and maximizing income, it is a trustee to improve overall investment returns valid strategy to consider. of the principal of the CRT because the In Chapter 29: Charitable Planning, we trustee does not have to worry about the tax take a look at a planning strategy known costs of selling. as a charitable remainder trust (CRT). In this Keep in mind that with a charitable chapter, I am only going to focus on the use remainder unitrust (rather than a charitable of a CRT to improve investment performance remainder annuity trust), when the value and cash flow. We will see that with a CRT, of the principal increases, there is an a person transfers assets to a trust, retains increase in the amount of the annual the right to a distribution of a set amount or distributions. A charitable remainder unitrust a fixed percentage of the value of the trust with $500,000 of principal and a 6% and on his death, the assets left in the trust payout distributes $30,000 per year. If pass on to a designated charity. the principal increases to $700,000, the Use of a CRT can be a valid strategy payout increases to $42,000. for maximizing cash flow and investment Of course, there are other factors to return from a block of assets. How is this keep in mind when using a CRT as part true? To understand this, we need to focus of an estate plan. Understanding how all on several important aspects of the CRT. of these factors fit together is important to One of the reasons why someone determining if this strategy is appropriate for creates a charitable remainder trust is to you. allow himself to move out of a position where he has unrealized capital gains without having to pay the capital gains Observation Ask your investment taxes. This person may be stuck in a advisor if he can get position where he owns a stock that is you a higher rate of return on your assets under-performing as an investment and inside an IRA versus a regular investment paying a low dividend. account. He will tell you that he can do better When he sells an investment transferred in the IRA because he does not have to factor to a CRT, no capital gains taxes are in the tax cost of selling an asset in the IRA. realized at that time and the proceeds The same principal applies to investing inside from the sale can be repositioned into a a CRT. better investment. The beneficiary, usually the original owner of the securities, then realizes an annual payment from the principal of the CRT. Gain realized from all subsequent sales
Chapter 27: Estate Planning and Investment Strategies 251 Wealth Management Through Estate Planning
CONCLUSION These are some significant examples where estate planning intersects with investment planning. Sound decision making should still take into consideration traditional issues. But for many persons, as they get older and more financially secure, their investment focus changes to looking out for their children and grandchildren and trying to create an investment plan that focuses on minimizing taxes and maximizing wealth for them. Issues such as those discussed in this chapter should be carefully reviewed and analyzed by your estate planning attorney and your investment advisor. Determine the investment strategies that best fit your needs and your comfort level and then take into consideration estate planning factors. Estate planning should not control your investment decisions; however, it should be a component of the decision-making process.
252 Chapter 27: Estate Planning and Investment Strategies Wealth Management Through Estate Planning
Chapter 28: Planning with Retirement Accounts
Working people have experienced dramatic growth in their retirement account investments over their careers. In this chapter, we look at several topics impacting these accounts, such as the rules for account distributions to either the account owner or the beneficiary of the account, and the planning strategies that are designed to protect this particular type of investment.
Chapter 28: Planning with Retirement Accounts 253 Wealth Management Through Estate Planning
Chapter 28:
◆ The Importance of Planning
◆ Required Beginning Date and Beneficiary Designation
◆ Early Withdrawal Penalty
◆ Minimum Required Distributions
◆ Distributions upon the IRA Owner’s Death
◆ Minimizing Taxes on Retirement Accounts
◆ The Deceased’s IRA
“Though this be madness, yet there is
method in’t.”
William Shakespeare, Hamlet
254 Wealth Management Through Estate Planning
etirement accounts have been given a plans and other plans where money is added unique trait: the ability to appreciate to an account on a tax deferred basis. The Rin value within an income tax deferred plans offered by tax exempt employers, such environment, often with a corresponding as 403(b)'s, have slightly different rules. current income tax deduction for contributions This chapter focuses on the traditional IRA to such a retirement account. These because this is the most common plan, either characteristics are bestowed upon retirement because the owner originally chose an IRA accounts because the government wants vehicle or the owner rolled over an account to encourage citizens to save for their own under a company sponsored plan to an IRA retirement needs. However, the government upon the owner’s retirement. These rules does not intend for retirement funds to remain may apply to the other types of tax deferred income tax free forever. Therefore, retirement investment accounts. Roth IRA's are different account rules make mandatory distributions than IRA's in many respects. These differences subject to income taxes. Tax laws also make are highlighted in observation boxes the account itself subject to estate taxes at the throughout the chapter. owner’s death. The combination of these taxes Before we get into the details (income and estate) can, in some cases, erode surrounding retirement account planning, we the value of a retirement account to 30% of need to take a look at why this has become its original value. Also, notwithstanding a such an important topic for so many families. meaningful simplification of the rules requiring distributions of the accounts, many people, THE IMPORTANCE OF especially beneficiaries, inadvertently run PLANNING afoul of the distribution rules (and withdraw The usual approach with a retirement too much or too little) simply because of a account is to make sure that the account lack of a complete understanding on what (and the resulting tax deferred growth) can they have to do. be kept intact for as long as possible. This This chapter reviews the rules regarding worked well when a miniscule percentage of mandatory and permissive distributions from estates were subject to federal estate taxes. retirement accounts. We then take a look Now, there may be other considerations for at some of the planning strategies that are large taxable estates. The tactics for handling available to reduce the tax costs and handle retirement accounts have evolved because the distribution of the account in a manner many families have accumulated wealth far that coordinates with the rest of the owner’s beyond their original expectations. People estate plan. have stuffed money into their retirement An important comment is needed before plans and have not touched the growth we get into these topics. This chapter is not on the funds. Coupled with income tax meant to serve as a complete reference book deferred growth and fueled in part by the for retirement account planning. Indeed, performance of equity markets, the accounts there are entire books on this topic written for have blossomed to become a significant attorneys and other planning professionals portion of many estates. (Natalie B. Choate, a Boston, Massachusetts Another phenomenon has also occurred. attorney, has written a thoroughly detailed Many retirees withdraw only the minimum book called Life and Death Planning For distribution. With reasonable continued Retirement Benefits). Instead, we attempt to growth on the account, it is unlikely that the explain the general rules that are most likely account will be fully depleted during their to affect our clients. retirement. They have other assets and cash The term retirement account is used flow to pay for their living expenses and the here to describe many types of tax deferred desire is to leave as much as possible of the accounts such as IRA's, 401(k)'s, Keogh retirement account to the next generation.
Chapter 28: Planning with Retirement Accounts 255 Wealth Management Through Estate Planning
drawals (and the payment of income Observation Giving advice taxes) for estate planning reasons? to clients with large ◆ If this is done, what is the most effective IRA's is an important challenge for estate use of the money withdrawn for achiev- planning attorneys. Explaining to them the ing estate planning goals? distribution rules and why and when they ◆ How long can required withdrawals be should make withdrawals is not easy. It is delayed? especially difficult when the advice includes ◆ How is this accomplished? recommending they take out more from these accounts than the required minimum ◆ Who can be the beneficiary? distribution. ◆ Who should be the beneficiary (an entirely different question)? The combination of these events has One of the fundamental concepts behind left retirement account owners searching for planning with retirement accounts is that, in viable ways to protect the investments in these some limited circumstances, withdrawals from accounts from income and estate taxes. We these accounts earlier than required by law can know that the retirement account will be taxed be of significant benefit when coordinated with at some point in time. The trade off when using other estate planning strategies. The underlying a retirement account is that because the owner objective behind this concept and the questions did not pay income taxes on the contributions to listed above is the maximization of family the account, the owner (or the beneficiary) must wealth among successive generations of the pay income taxes when distributions are made. same family. If the goal was only to maximize the wealth of the owners of these accounts, the solution is simple: do nothing. When parents recognize that the assets in these accounts are Roth IRA The Roth IRA not needed for their own financial support, then (named after Senator these questions become significant. William Roth) is the reverse of the traditional This chapter surveys the most important IRA. With the Roth IRA, the owner pays rules applicable to retirement accounts. income taxes on the contributions but The discussion then turns to a review of the subsequent withdrawals are income tax free. available techniques that can be used to minimize all taxes on the account and the owner’s overall estate, thereby preserving Someone, whether the account owner or wealth for children and grandchildren. a beneficiary, is going to pay income taxes on Throughout this chapter, we may refer to money in retirement accounts. Recognizing this, the following example. These simple facts are there are some important questions that need useful for illustrating the rules and the planning to be addressed when formulating a plan to opportunities. deal with retirement accounts. Using these facts, and assuming that one of the children has a financial power of attorney ◆ When is the best time to make with- that specifically authorizes that child to make drawals? decisions concerning the retirement account ◆ Is maximum deferral (and minimum with- and John’s other financial matters, let us take a drawals) always the best strategy? look at the important issues and decisions to be ◆ When is it advantageous to take out considered. more than the required distributions? The rules pertaining to retirement plan distributions are contained in section 401(a) ◆ Does it make sense to accelerate with- (9) of the Code. The final regulations for these
256 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
for the 2nd year, the distribution for the 2nd year). If the IRA owner does not want Example John owns a both distributions accumulated in the 2nd $500,000 IRA with a year for income tax purposes (possibility local financial institution holding the account as of being pushed into a higher rate, having custodian. At 75 years of age, John suffers a more of social security subject to tax, losing heart attack and becomes incapable of handling state benefits, and impacting deductions or his financial affairs. John’s children want to have credits subject to an AGI floor in the 2nd access to the IRA to pay certain bills and to year), he should not use the grace period manage the investments within the IRA. for the first year’s distribution. In other cases, the IRA owner may benefit from using the grace period. If the IRA owner thinks that rules were issued in April, 2002, about 15 the income tax bracket in year 2 would be years after the “temporary” proposed rules lower than year 1 or at least won’t cause the were first issued in 1987! distribution to be subject to a higher tax rate, Not only do the final regulations he may be better off using the grace period. make it much easier to understand lifetime The RBD is also an important date when distributions to the IRA owner, but they also it comes to figuring out the distributions that permit a “clean up” period after the IRA happen after the owner’s death. Depending owner’s death that may help ease the income on whether the owner dies before or after tax burdens for a beneficiary. Also, the 2002 his RBD and the beneficiary selected by the regulations adopted new life expectancies owner, the rules regarding the post-death that are longer than the life expectancies distributions from the IRA are different. previously based on 1983 mortality rates. The acknowledgement of longer life expectancies means that an IRA owner can Observation withdraw less from the IRA each year (and There is pay less income tax) and, hopefully, keep the no RBD for the IRA intact for a longer period of time. owner of a Roth IRA. If the owner is survived by his spouse, she can roll REQUIRED BEGINNING the Roth IRA into her name and there DATE AND BENEFICIARY is no RBD for her. For a non-spouse beneficiary of a Roth IRA, the RBD is DESIGNATION December 31st of the year after the John’s age indicates that certain events owner’s year of death. have already passed. Since John is over 1 70 /2 years of age, he is past his Required Beginning Date (RBD). IRA's must commence distributions to the owner on or before The beneficiary designation controls December 31st of the year in which the who receives the asset at the owner’s death. 1 owner turns 70 /2 (with a 3-month grace Obviously, you want to make sure that you period until April 1st for the first year). This name the right person so that: (1) required day (April 1st of the year after the IRA owner distributions are minimized and (2) the 1 is 70 /2 years old) is the RBD. account winds up in the right hands at your Because of the 3 month grace period, death. These two consequences mean that the IRA owner may end up taking 2 the choice of the beneficiary is crucial. If an 1 distributions in the year following his 70 /2 IRA owner dies without naming a beneficiary, birthday (the distribution for the first year then the IRA account will likely be paid to and, because there is no grace period his estate and the opportunity to plan for
Chapter 28: Planning with Retirement Accounts 257 Wealth Management Through Estate Planning
Observation Observation For qualified For Roth plans maintained by IRA's, if the the employee’s company, if the employee owner makes a withdrawal within the 1 is still working at age 70 /2 and if the first 5 tax years of when the Roth IRA employee does not own 5% or more received a contribution or conversion of the company (aggregating shares amount, the owner is also subject to owned by certain family members), then an early withdrawal penalty, unless an distributions from the qualified plan do not exception applies. need to start until retirement.
continued tax deferred growth is lost. joint life expectancies of the taxpayer The importance of the selection of a and his or her beneficiary and continu- contingent beneficiary (the person named ing for the longer of 5 years or until 1 to succeed as beneficiary if the primary age 59 /2. These are referred to as beneficiary does not survive the owner) is 72(t) payments after the code section usually underappreciated. This can be a big authorizing them. There are 3 ways mistake. There should always be a contingent to calculate the payments: over a life beneficiary named on a retirement account expectancy; over an amortization of (and life insurance policies as well). The life expectancy at a reasonable interest same consideration should be given to this rate assumption; or by straight annuiti- designation as is given to the designation of the zation when the account is divided by primary beneficiary. an annuity factor using a reasonable interest rate assumption. The owner must EARLY WITHDRAWAL PENALTY take an amount exactly equal to what The government wants to discourage the the IRS formula allows, no more and no early use of funds set aside for retirement. less. You cannot change the payments Therefore, there is an early withdrawal once you have elected the withdrawal penalty for any distributions received by method. However, when electing to use 1 the owner prior to age 59 /2 . The owner 72(t), it does not have to apply to all of pays a penalty tax of 10% of the amount your accounts. Also, you can break an withdrawn in addition to income tax on the existing IRA into separate accounts cre- amount distributed. Because of this penalty, ating an IRA that will be tailored in size owners of these accounts should avoid making for the amount needed to create the 1 withdrawals from an IRA prior to age 59 /2 . periodic payment that you want. Other The rules allow for exceptions to this IRA accounts can remain untouched. If early withdrawal penalty for certain types of you are considering this option, please distributions. The exceptions are as follows: seek professional advice. ◆ Distributions which are part of a series ◆ Distributions made to a beneficiary or of substantially equal periodic pay- to the estate of the owner on or after ments (at least annually) made over the owner’s death. The age of the ben- the life expectancy of the taxpayer or eficiary is irrelevant. ◆ Distributions to a permanently dis- Observation No new contributions abled employee. can be made to a ◆ Distributions for health insurance pre- 1 traditional IRA after age 70 /2 but a Roth IRA miums if certain unemployment condi- can receive contributions regardless of the tions are met. owner’s age. Both accounts have contribution ◆ Distribution of up to $10,000, one limits and income limitations for contributions time only, for first time homebuyers. which change yearly. This distribution must be made within
258 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
120 days of the payout for qualified to change the distributions from the account in acquisition costs of a qualified first time regards to RMD's. Many people do not want to homebuyer’s principal residence and take any money out of the IRA prior to the RBD the homeowner (or spouse, if married) because it increases their taxable income, so cannot have had an ownership interest this option is not viable for many IRA owners. in a principal residence within 2 years In our example, since John is over age 1 prior, ending on the new home’s acquisi- 70 /2, he has been withdrawing from his IRA tion date. The homeowner can be the the Required Minimum Distribution (RMD). taxpayer, spouse, child, grandchild or Calculating the owner’s RMD under the new ancestor of the IRA owner. regulations is quite simple because almost ◆ Distributions in any amount for quali- everyone uses the same table. Here is how fied higher education expenses of a it’s done. The RMD for an IRA owner during taxpayer, spouse, child or grandchild. the IRA owner’s lifetime is based on the value Expenses include tuition, fees, books, of the account on the previous December supplies, required equipment and room 31 (adjusted only for certain rollovers and transfers) divided by a life expectancy factor and board. that comes from the Uniform Lifetime Table REQUIRED MINIMUM (set forth at the end of this Chapter). The Uniform Lifetime Table life expectancy factor DISTRIBUTIONS is based on the joint life expectancy of the Many IRA owners want to let the retirement IRA owner (using the IRA owner’s age in the account grow for as long as possible. They applicable distribution year) and a person 10 don’t want to withdraw funds if they don’t need years younger than the IRA owner. Even if the the funds because they must pay an income tax beneficiary is older than the owner or there is on each distribution. However, at the owner’s no named beneficiary, this Uniform Lifetime RBD (discussed above), mandatory distributions Table can be used by the IRA owner to calculate RMD's. This “one table for all” greatly Observation simplifies the calculation of the RMD. For Roth IRA's, even There is one exception to the use of this if the distribution is not Uniform table: if the sole beneficiary of the a qualified distribution, a favorable ordering IRA is the IRA owner’s spouse (for the entire rule applies. Distributions from a Roth IRA are applicable distribution year) and the spouse treated first as tax-free return of previously taxed is more than 10 years younger than the IRA income to the extent of the owner’s contributions owner, then the IRA owner can use a Joint and or rollover amount, then as income. Last Survivor Table which will provide for a longer life expectancy and so result in a smaller RMD. If a spouse is the sole beneficiary on January 1, then the spouse is considered the for some amount from the IRA must commence, sole beneficiary for the entire year, even if the even if the IRA owner does not need the funds spouse dies during the year. It is not clear as for support. These distributions are called to what happens if a divorce occurs during the required minimum distributions (RMD). This year. While commentators believe there would section looks at how the RMD's are calculated. be the same result, the author of the regulations Also, before an IRA owner’s RBD, he has stated that instead the owner must use the may elect to take annuity-type distributions. Uniform Table if there is a divorce during the These distributions can continue on if they (a) year. irrevocably began prior to the RBD; (b) are There is another way to satisfy the lifetime paid at least annually and (c) satisfy the RMD distributions to the IRA owner. The entire IRA annuity payout rules when they began. Then, can be used to purchase an annuity payable 1 when the IRA owner is 70 /2, he does not have over a single- or joint life and survivor basis
Chapter 28: Planning with Retirement Accounts 259 Wealth Management Through Estate Planning
and the payouts would then qualify automatically for the RMD's. This special Observation There is no RMD for technique is addressed in Regulation a Roth IRA for the owner Section 1.401(a)(9)-6T and you should of the account. However, upon the owner’s seek professional assistance if you want to death, any beneficiary, other than the spouse use this technique. of the owner, must start taking RMD's based on These lifetime distribution rules permit the beneficiary’s life expectancy. This forces the the IRA owner to designate a beneficiary funds out of the Roth IRA and out of the income without worrying about how that choice tax deferred status that the investments have will impact the RMD's to the owner. Under enjoyed. the old rules, if a charity was named as the beneficiary, RMD's to the owner were accelerated. This forced the IRA owner to amount actually distributed. Obviously, this is take out more income and pay taxes earlier a penalty that should always be avoided. The than he might have otherwise had to do. Secretary of the Treasury has the authority to Charities, older relatives and older spouses waive imposition of this penalty if the shortfall are no longer “bad” choices for a beneficiary is due to reasonable error and steps are being when it comes to thinking about the owner’s taken to remedy the shortfall. RMD's and resulting income tax consequences. If the IRA is rolled from one IRA to another Remember that this is the calculation of the IRA within 60 days or is transferred from trustee- 1 minimum distribution. After attaining age 59 /2, to-trustee, the amount is treated as a distribution the IRA owner (and each beneficiary after the but the RMD can’t be rolled over. Example: In IRA owner’s death) can always withdraw more 2012, Ted, age 74, withdraws $30,000 from than the minimum amount without penalty. IRA-1 which was his only IRA and rolls it to The RMD for each IRA must be separately IRA-2 within 60 days. The RMD from IRA-1 in calculated, but the owner may elect to take 2012 is $20,000. Result: IRA-1 is treated as the RMD from any one or more of his various having distributed its RMD, but only $10,000 IRA accounts. The owner of a 401(k) and of the rollover to IRA-2 is an eligible rollover. an IRA does not have this option. Each plan The $20,000 amount is taxed to Ted and must separately make the RMD to the owner; the $10,000 rollover is subject to an excess the aggregation of distributions between an contributions tax unless it (and its earnings while IRA and 401(k) is not available. Also, the in IRA-2) are withdrawn by the due date for the 2012 tax return. Comparatively, in a trustee- Example to-trustee transfer, the transfer is not treated as John’s IRA was valued a distribution from IRA-1. If a taxpayer used a at $180,000 in the year rollover and the amount is not received by the 1 he turned 70 /2. His life expectancy under receiving IRA by year end in which the rollover the Uniform Table in that year was 26.5 years was distributed, then, for purposes of computing because he reached age 71 by the end of that the RMD, the receiving IRA is treated as having year. The RMD for his first year is $180,000 received the rollover amount in the calendar divided by 26.5 years or $6,792. year in which it was distributed. You must watch IRA rollovers where the 60 day period encompasses December 31. aggregation rules don’t apply to inherited Some IRA owners prefer to think of the IRA's unless they were inherited from the RMD as a percentage distribution. If you divide same decedent (but a Roth IRA can never be 1 by the life expectancy factor in the Uniform aggregated with a traditional IRA). Table, you have the percent that must be If an owner fails to receive the RMD, there withdrawn. For instance, for an IRA owner age is an excise tax of 50% of the RMD less the 70, the percentage that must be withdrawn is
260 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
distributions under a 5 year distribution plan Observation Under the 1987 may be taken in any amount in any year so regulations, an IRA owner long as the account is fully distributed by the had to elect between recalculation and non- 5th year deadline. Even if the beneficiary is recalculation of life expectancies. As of 2003, not an individual (such as an estate or trust), these concepts are (thankfully) no longer relevant the 5 year rule is available. The plan itself for the IRA owner. may have a shorter deadline, so the plan must be reviewed to make sure that the rules are followed. 3.65% (1/27.4). In order to use the life expectancy for post-death RMD's there must be a designated DISTRIBUTIONS UPON THE IRA beneficiary. A designated beneficiary is one OWNER’S DEATH named by the owner with a life expectancy Our discussion so far has focused on capable of being ascertained. Individuals IRA distributions to the living owner. We now qualify as designated beneficiaries. Certain turn our attention to the rules that govern the trusts may also meet this definition (discussed IRA distributions after the owner’s death. The below). If an individual is named, instead of primary controlling factor now is whether the 5 year rule being the “norm” unless the the owner died before or after his RBD. The individual opts out, now the life expectancy tax-deferral offered by an IRA need not end payout is the “norm” unless the individual when the owner dies. The pace at which doesn’t take his first payment in a timely IRA distributions are made after an owner’s fashion. If a beneficiary takes less than the death depends on the RMD rules that apply required amount, there is a 50% excise tax on at that time and the beneficiary’s willingness the shortfall that should have been taken, unless to continue taking RMD's versus taking a lump the entire account is withdrawn subsequently sum. within the first 5 years after death. The 2002 The favorable 2002 regulations apply regulations let beneficiaries who are already to all beneficiaries of IRA's when the owner is involuntarily under the 5 year plan because of deceased, even if the owner died before 2002. the application of the old rules to opt instead The application of the new rules to beneficiaries for a life expectancy measure. To use this, all of inherited IRA's may permit the beneficiary to amounts that would have been required under pull less out of the IRA than would have been the life expectancy rule must be distributed by required under the old rules. the end of the 5th year following the year of the IRA owner’s death. Owner Dies Before RBD The designated beneficiary is determined When distributions have not started during from those beneficiaries named at the IRA the owner’s life and the owner dies before the owner’s death who continue to be beneficiaries RBD, the general rule is the remaining account on September 30th of the year after the IRA balance must be paid out over the remaining owner’s death (“Designation Date”). This life expectancy of the beneficiary, using a means that if a beneficiary is eliminated prior Single Life Table (reproduced at the end of to that date, either by payment of such one’s this Chapter). beneficial interest or by disclaimer, that person, If the beneficiary fails to start these trust or charity is not considered a beneficiary. distributions on time (by December 31 of the By “paying off” a beneficiary who doesn’t year after the owner’s death) or if there is no qualify as a designated beneficiary (i.e. has designated beneficiary, then the owner’s entire no life expectancy), the remaining designated account must be distributed by December 31 beneficiaries are able to reap the rewards of of the calendar year that contains the fifth having a longer payout period. anniversary of the death of the owner. The If the owner names a surviving spouse
Chapter 28: Planning with Retirement Accounts 261 Wealth Management Through Estate Planning
5 year rule applies or the life expectancy of the My opinion oldest beneficiary applies. It is crucial to review the IRA Owner Dies After RBD immediately after the death What happens to the RMD that the owner has to take the year he dies? The beneficiary of the owner. There are receives the RMD which has not already been significant planning issues withdrawn by the owner in the year of the owner’s death. This year of death RMD is still that must be reviewed either based on the method being used by the IRA prior to the beneficiary owner in the year of death. The continued RMD's for a beneficiary taking any benefits or the passage is based on the longer of the IRA owner’s of certain periods of time. remaining life expectancy (starting with the owner’s attained age the year of his death) or the remaining life expectancy of the eldest as the sole beneficiary, there are even more designated beneficiary (starting with the options available to the spouse. She may beneficiary’s attained age the year after the elect to roll the balance into her own IRA, owner’s death). This means that even if the IRA 1 owner was younger than the beneficiary, the even if she is past age 70 /2. This rollover IRA is then treated as the spouse’s own IRA. The beneficiary can elect to use the IRA owner’s spouse may designate a new beneficiary to life expectancy instead of the shorter life receive the account upon the spouse’s death. expectancy of the beneficiary. In either case, Another option: she may take the account the calculation uses the Single Life Table as a beneficiary and elect to wait until her for the IRA owner or the beneficiary. In each deceased spouse would have reached the subsequent year, the life expectancy factor is RBD and postpone distributions until that date, decreased by one. If there is no designated then take distributions over her life expectancy, beneficiary, unlike a death before the RBD recalculating them each year. that requires a 5 year rule to be activated, the Generally, a rollover is preferred unless account may be distributed over the remaining 1 life expectancy of the IRA owner using the the spouse is younger than 59 /2 years of age and needs the money now. If the younger Single Life Table. These RMD's continue at spouse will be using the IRA for current support, the same pace if the beneficiary dies, with the she should retain her beneficiary status and RMD's paid to the beneficiary’s beneficiaries. withdraw the funds without incurring a 10% penalty. Another alternative would be Example Martin died at to roll over only part of the IRA, retaining age 70 (in 2011), some portion for current support. leaving his child, Ralph, as the sole designated If there are multiple beneficiaries, some beneficiary of his IRA. Ralph is 40 in 2011. The post death work is necessary in order to measuring life is Ralph’s single life expectancy achieve the best results. The IRA should be split determined in calendar year 2012. Ralph is into separate accounts for each beneficiary by 41 years old in 2012 and his life expectancy the Designation Date. Each account must have is 42.7 years. In 2012, Ralph must take out the a pro rata amount of gain and loss allocated value of the IRA on 12/31/11 divided by 42.7 to the account. Then, each beneficiary of each (or 2.34%). In succeeding years, he must take separate account can elect to take the IRA out a fraction of the balance of the IRA (as of distributions either over 5 years or over their the end of the year) divided by his original life own life expectancy (but this must start by expectancy (42.7) reduced by one for each 12/31 the year after death). If the IRA is not year since he began withdrawals. In 2014, the split in a timely fashion – then again either the divisor would be 40.7 (42.7-2).
262 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
There are special rules if a spouse is the owner dies, especially if you are not certain sole beneficiary. If an owner dies after the RBD of how these rules impact you. For large IRA's, and his spouse is the sole beneficiary, she may we suggest including the separate account roll over the balance of the IRA into her own language directly in the IRA beneficiary form IRA and get a fresh start. Remember that the so that the accounts will be recognized and IRA must still make the RMD to the beneficiary honored even if the IRA is not actually split in a in the year of the owner’s death, even if the timely fashion. This is especially true for trusts as beneficiary is the spouse. The same rules beneficiaries since the separate share rules do apply for a spousal rollover as discussed in the not apply to trusts. previous section where the owner dies before However, waiting for the Designation the RBD. If the spouse is the beneficiary and Date to occur may cause some problems if elects not to roll over, the spouse calculates her a beneficiary dies in the interim. If the plan RMD's based on a life expectancy differently permits the beneficiary to name a successor than a non-spouse beneficiary (recalculating beneficiary (and this was actually done), then each year instead of subtracting one each the successor beneficiary may use his or her life year) and the result is slightly smaller RMD's expectancy. Not all plans may permit this and for the spouse. She can take RMD's over her the beneficiary may not get around to actually life expectancy recalculated each year or over the remaining life expectancy of the IRA owner in the IRA owner’s year of death, less Observation one for each successive year. If the first way For Roth IRA's, the is used, then when she dies, any remaining designated beneficiary is assets are distributed over the remaining life determined on the Designation Date and that person expectancy of the spouse on a fixed term can use his life expectancy for withdrawals from the basis to the spouse’s beneficiaries (remaining Roth IRA. If there is no designated beneficiary, the life expectancy less one for each subsequent normal rules for IRA's apply as if the owner had died year). before the RBD (5 year rule). It is important to note that a spouse cannot treat the IRA as her own if the IRA pays into a trust, even if the spouse is the sole beneficiary doing it. Then, it is most likely that the IRA will of the trust. pass to the beneficiary’s estate and there will Again, the beneficiary of an IRA is not be no applicable life expectancy. finally determined until September 30th What terminology should be used if an the year after the IRA owner’s death, the IRA owner wants to name a group of people Designation Date. This lets us do some post as beneficiaries? If an IRA owner designates death clean up work (if needed) in order a class of people as a beneficiary of the IRA achieve the best results. (such as “my son’s children”), then as long as For instance, in certain instances, the these children are capable of being identified, primary beneficiary may want to disclaim we can ascertain the class member with his or her interest in favor of the contingent the shortest life expectancy. As a practical beneficiary. Also, the IRA might want to make matter, this is not the ideal way to designate early lump sum distributions to charity to clear beneficiaries. If a son has a child born after that beneficiary “off the books.” the Designation Date, it becomes murky as The postponement of the Designation to whether or not such newborn is also a Date past the date of death also gives the beneficiary of the IRA. Instead, the better beneficiaries some time to establish separate practice is to identify the beneficiaries by name. IRA shares so that each beneficiary can use Importantly, the fact that the IRA passes to his or her own life expectancy for distributions. a beneficiary under a Will or under state law This is why it may be important to consult with (for instance, if the IRA owner dies intestate), tax advisor or legal advisor when an IRA does not make the individual a designated
Chapter 28: Planning with Retirement Accounts 263 Wealth Management Through Estate Planning
beneficiary. No life expectancy is available if the IRA is paid to an estate. Example When ascertaining beneficiaries, any Dad names beneficiary who was a beneficiary at the 2 daughters as IRA beneficiaries, 50% time of the IRA owner’s death but is not each. Dad dies on December 1, 2005. His a beneficiary as of the Designation Date daughter Michele is financially well off. His (because the beneficiary was paid in full daughter Cheryl is mother to three sons and or disclaimed his interest) is not taken into is not financially secure. Michele opts to consideration for purposes of determining disclaim her interest in the IRA so that it all subsequent RMD's. This rule furthers the intent passes to Cheryl. Presuming the disclaimer of a beneficiary who disclaims his or her is a valid qualified disclaimer and Cheryl interest in an IRA so that such beneficiary’s remains the sole beneficiary on 9/30 the life expectancy is no longer relevant to the year after Dad’s death, then Cheryl’s single RMD's. However, if a beneficiary dies before life expectancy is used to determine RMD's the Designation Date, then the beneficiary’s and she receives all of the IRA distributions. life expectancy is still used. Alternatively, if Michele has significant debt and takes her full distribution (instead of MINIMIZING TAXES ON disclaiming) prior to 9/30 the year after RETIREMENT ACCOUNTS death, then Cheryl is still the sole beneficiary of the IRA and her single lie expectancy One of the challenges of retirement is used. Finally, if the IRA is properly split planning is delaying or reducing the payment into 2 separate subaccount IRA's, one of taxes on dollars in tax deferred accounts for each beneficiary, by 12/31 the year and minimizing the tax costs. after the IRA owner’s death, then each of Deduction for Income Taxes Due Michele and Cheryl can use their individual If a retirement account is part of an estate life expectancies to determine RMD's. that has paid federal estate taxes, then the Interestingly, if Michele dies prior to 9/30 beneficiary of the account may deduct a without disclaiming, her life expectancy is still portion of the estate taxes against the income used to determine RMD's. tax that is attributable to later withdrawals from the retirement account. Using an IRA as an example, the funds in the IRA are classified as a calculation is made as if the IRA was not part income in respect of a decedent when the of the taxable estate. The difference between owner dies. This is because if the owner had the estate tax with the IRA as part of the estate lived, the owner would have received the funds and the estate tax without the IRA as part of the as ordinary income. The account retains this estate is the total amount of the deduction that characteristic in the hands of the beneficiary. can be claimed over time by the beneficiaries The deduction is designed to offset part on their individual income tax returns. If the of the estate taxes attributable to the IRA payments from an IRA are spread over many being taxed in an estate. This deduction can years, then annual deductions are used until be especially important if the IRA must be the entire deduction is gone. The record distributed in total by the year after the owner’s keeping can be complicated, especially if there death because of inadequate beneficiary are multiple beneficiaries, but it is worth it to designations, faulty planning or unforeseen decrease the overall tax bite. circumstances. To claim the deduction, the taxpayer must If a federal estate tax return was due, then itemize. Unlike other miscellaneous itemized
264 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
deductions which can be written off only to older than the IRA owner, again it may be the extent they exceed 2% of the taxpayer’s worthwhile not to rollover the IRA (and have adjusted gross income, the deduction from to take distributions). Instead, the spouse may income in respect of a decedent can be remain a beneficiary and not have to take claimed in full. State law must be checked to distributions until the deceased owner would 1 see if the state permits a similar deduction for have been age 70 /2. state income taxes. Naming a Trust as a Beneficiary Selecting the Beneficiary There are often circumstances where It is important to remember that the naming a trust as the beneficiary is desirable. beneficiary of the IRA will receive the asset If there is a second marriage, the owner outside of the deceased owner’s probate may want the IRA assets available for the estate. If the probate estate is left to a spouse support of his spouse but may also want and the IRA left to a son, there may be an to make sure that the assets in the account issue as to who pays what estate taxes, eventually pass on to his children from his first depending on instructions contained in the marriage. Alternatively, the surviving spouse deceased’s Will and state law. The decision may be a spendthrift or incapacitated or may regarding the beneficiary designation should benefit from professional management by a consider several factors, including the overall corporate trustee. financial situation of the family members, If a client is reluctant to relinquish control estate planning objectives, the different needs of the plan or IRA benefits to the surviving of different beneficiaries and the ability to spouse, the client may want to designate a control how funds will be paid from the IRA trust for the spouse as beneficiary. However, to the beneficiary. qualifying this trust for the marital deduction Naming a Spouse as the Beneficiary (and deferral of estate taxes) becomes more Many people name the spouse as the complicated. These trusts must meet certain beneficiary on the IRA. This is usually a income distribution requirements so as not good idea. First, the spouse will have access to run afoul of either tax rules for retirement to the funds to help provide for his or her distributions or estate taxes. In a QTIP trust, support. Second, the spouse can rollover the spouse is entitled to income but may or the deceased spouse’s IRA into his or her may not be entitled to principal. She does own new IRA (and use the Uniform Table for not have the right to demand distributions, RMD's instead of a single life expectancy) which means that she does not have the and name new beneficiaries to take over the right to demand the entire plan benefit or the account at the spouse’s death. minimum distribution. This means that some If the surviving spouse is under age amounts may be accumulated in the trust for 1 59 /2 and plans on using the IRA benefit the children. The children are then considered for immediate support or other purposes, beneficiaries for purposes of the multiple the spouse should not rollover the IRA, but beneficiary rules. While some income tax instead should simply take benefits as a deferral may be lost, the owner gains the beneficiary of the IRA. Once the spouse assurance of knowing that the spouse cannot has rolled the IRA over, he or she cannot name her own beneficiaries instead of the take out money from the IRA prior to age owner’s beneficiaries. For a QTIP trust to be a 1 59 /2 without incurring the 10% penalty. A valid designated beneficiary, the spouse must 1 spouse who is under age 59 /2 and takes have the right to demand the trustee distribute distributions as a beneficiary may later to her the greater of the income earned by the decide to rollover the IRA into her own name. IRA assets or the RMD, with the Trustee being This is allowed at any time. required to at least distribute the RMD if the If the surviving spouse is substantially spouse does not make this demand (Rev. Rul. 2000-2, 200-3 IRB 297). This may conflict
Chapter 28: Planning with Retirement Accounts 265 Wealth Management Through Estate Planning
tax planning opportunities. The beneficiaries Planning with an IRAT Smith and Condeni of a trust will be considered designated attorneys developed a beneficiaries for determining life expectancies customized strategy for taking maximum advantage if the trust meets certain requirements. The four of the IRA stretch rules. We call it an IRA Trust (or requirements are: the trust must be valid under IRAT for those of us who like acronyms). It combines state law, the trust must become irrevocable at the benefits of tax-deferred growth with the asset the IRA owner’s death, certain documentation protection benefits of trusts. Visit the Smith and mentioned below must be provided to the Condeni website at www.smith-condeni.com and IRA custodian by October 31 the year after under Library you will see an article that details how death (and earlier if the owner intends to use a the strategy works and its applications and benefits. spouse’s joint life expectancy to determine the owner’s RMD), and the beneficiary (ies) of the trust must be identifiable individuals, determined with the overall goals of the IRA owner in the as of September 30 of the year after death. ultimate disposition of his assets. There is a documentation requirement for Under the preamble to the regulations, the all post-death distributions involving a trust. As spouse can elect to treat the IRA as hers only if of October 31 of the year after an owner’s she is the sole beneficiary and has an unlimited death, the trustee must supply to the plan right to withdraw the account. This is not administrator (or for an IRA, to the IRA trustees, satisfied if a trust is named as the beneficiary, custodian or issuer) a copy of the trust (easy) even if the spouse is the sole beneficiary or certain compliance information (harder). of the trust. So, if the plan is to permit the If the IRA owner is using a trust for a spouse spousal roll over, you cannot use a QTIP or a who is more than 10 years younger so the conduit trust. However, a grantor trust may be joint life table is being used, the IRA owner permitted, especially for non-citizen spouses or needs to supply this documentation for lifetime incompetent spouses. distributions too. Other trust considerations may apply to The good news is that in trying to figure non-spouse beneficiaries. Are the beneficiaries out which life expectancy can be used, certain mature? Is there a risk of creditor problems? contingent beneficiaries may be ignored. If the If the IRA asset is the main estate asset, who contingent beneficiary is entitled to benefits will be in charge to make sure estate taxes only if another beneficiary dies before the are paid before each beneficiary takes his or entire benefit to which the other beneficiary her share? What if one of the beneficiaries is entitled has been distributed by the plan, predeceases the IRA owner? What happens to then that contigent beneficiary is overlooked. that beneficiary’s share of the IRA? A trust can It may be a good idea to require that the IRA address all of these questions. be distributed to the trust over a period no The major advantage to a trust is that, while longer than the life expectancy of that life the plan must distribute the RMD to the trust, beneficiary. If an IRA distribution to a trust can the trust need not immediately pass the RMD be held back and not distributed but saved for out to the beneficiary. The other advantages later distribution, then you have to consider of naming a trust as the beneficiary include the remainder and contingent beneficiaries the opportunity to name a mature individual as beneficiaries for purposes of the multiple or corporate trustee to manage the investment beneficiary rules. of the IRA assets, creditor-proofing the assets The retirement benefits must pass to under the terms of the trust, avoiding probate individuals under the trust and cannot be court jurisdiction if a minor is the beneficiary, used to pay taxes or estate expenses. This with continuing flexibility on the owner’s part may be the hardest hurdle to meet when the to designate a new beneficiary under the IRA IRA is the sole asset of the trust. Establishing during his lifetime, and maximizing certain separate accounts may help. Also, powers
266 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
of appointment must be carefully reviewed generational IRA. With this strategy, you because if the power can be exercised in name a grandchild (or grandchildren) as the favor of an older beneficiary, the ability IRA beneficiaries. While the owner is living, to use a longer life expectancy may be the owner receives distributions under the eliminated. Uniform Table. After the owner’s death, the Naming the Credit Shelter Trust as grandchild may stretch out distributions over Beneficiary the rest of her life expectancy, which may be If the client is married and the joint assets quite long. of the client and the client’s spouse are in The overall technique works great if: excess of the applicable exclusion amount, 1. The IRA does not have to pass to the client may have put into place a plan to a spouse or a child to provide sup- minimize federal estate taxes through the port. use of an A-B Trust strategy (See Chapter 12 2. The amount of the IRA passing to The A-B Trusts Strategy). If the client’s IRA the grandchild is not subject to a constitutes one of his or her most significant 55% generation-skipping tax or if assets, part or all of the benefits may have there is sufficient exemption from the to be used to fund the client’s Credit Shelter tax. Trust (the Trust B of an A-B Trust plan). 3. There are other assets available to Generally, where an estate plan has pay the estate taxes that may be been created using the A-B Trust strategy, due on the IRA balance. to maximize all options it is advisable that the spouse be named primary beneficiary 4. The grandchild is either old enough of the IRA and the trust of the owner of the to receive the distributions outright IRA be named as the contingent beneficiary. or a trust is created to administer the By doing so, at time of the owner’s death a IRA. determination can be made as to what is the Naming a grandchild is not an all or best way to proceed from a tax standpoint. nothing deal. The IRA may be divided into If it is determined that funding the two separate IRA's, one for the benefit of Credit Shelter Trust (Trust B) in order to more a spouse and another for the benefit of fully utilize the applicable exclusion of the grandchildren. This arrangement can help deceased owner is better than potentially to meet the different goals of the IRA owner maximizing income tax deferral to the spouse to provide for the spouse and to keep the (by a rollover), the surviving spouse would income tax deferral aspect passing to be advised to file a full or partial qualified younger generations. If these sub-accounts disclaimer within nine months of the owner’s are to be effective, they must be created by date of death. This would have the effect the Designation Date. of treating the surviving spouse as if he or The same strategy can be used with she had predeceased the plan owner (but children; however, the stretch out period will only as to the disclaimed assets in the plan) not be as long. resulting in the IRA assets being treated Life Insurance as Part of the Plan as part of Trust B. Trust B must be carefully IRA's tend to be increasingly larger drafted to avoid the IRA distributions being portions of increasingly larger estates. This is treated as trust principal for trust accounting because the investments grow tax deferred purposes and meet other requirements. and owners of these accounts spend other Naming Young Grandchildren as a money in non-tax deferred accounts before Beneficiary — The Multi-Generational IRA invading their IRA's. This increases the tax or Stretch IRA exposure that an estate has at the death of A new planning technique for IRA's the owner. If IRA's must be used to pay estate that is getting a lot of attention is the multi- taxes, income taxes must first be paid. To
Chapter 28: Planning with Retirement Accounts 267 Wealth Management Through Estate Planning
avoid this liquidity problem, many IRA owners Naming Multiple Beneficiaries turn to life insurance. It is not uncommon for an IRA owner IRA owners can transform some of their to name all of his children or all of his heavily taxed IRA accounts into a tax free grandchildren as beneficiaries of the IRA. death benefit. To do this, the IRA owner While the IRA owner is living, RMD's will be withdraws funds from the IRA. Income taxes based on the Uniform Table. When the IRA are paid at the time of withdrawal; however, owner dies, RMD's are based on the single life this is not as bad as it appears. Remember expectancy of the oldest beneficiary unless the that income taxes will be paid sooner or later IRA is timely divided into separate accounts on withdrawals, either by the owner or the as discussed above. This is recommended if beneficiaries. The true economic cost of early the ages of the multiple beneficiaries are quite withdrawals from IRA accounts is not the tax disparate. payment but the opportunity cost on the money Naming A Charity as the Beneficiary used to pay taxes in excess of the tax due on For clients who have charitable the RMD itself and the loss of tax deferred inclinations, the designation of a charity as the growth on assets withdrawn in excess of the beneficiary of a retirement plan account or RMD. Further, the payment of income taxes IRA can be extremely advantageous. Because reduces estate taxes at death because the the charity is a tax-exempt entity, the account tax payment reduces the taxable estate. The can be paid to the charity on the death of the remaining balance of the withdrawal is then owner without any diminution for estate or used to purchase a life insurance policy on the income taxes. Both of these taxes are avoided owner. when a charity is the beneficiary, leaving more On the death of the insured, the insurance for the benefit of the charity. The charity can proceeds can be used to pay estate taxes even be the client’s private foundation! If a (either loaned to the estate or used to buy gift to charity is being made, making the gift illiquid assets from the estate), erasing the need from an IRA also minimizes the reduction in the to make withdrawals from IRA accounts and inheritance family members receive because pay income taxes to have money available to retirement plans distributed to them would be pay estate taxes. reduced by income taxes on the distributions. As part of a comprehensive estate plan, When there are many different types life insurance has it all over retirement plans. of assets in an estate, instead of generally Life insurance policies can be held in trust so directing a distribution to a charity then that the death benefits escape estate taxes, allocating the balance among children or other both in the insured’s estate and the estates beneficiaries, consider the following: allocate of the beneficiaries. Trusts can provide asset the tax deferred account to the charity (or a protection from creditors. The death benefit on specified portion) and the non-tax deferred life insurance is income tax free. The growth assets to children. Because the charity is tax in investments of life insurance proceeds can exempt, it can receive the full benefit of the tax be deferred until sale of the assets and then deferred account without having the account subject to preferential capital gains treatment. depleted by income taxes. The children will Remember that all growth in the value of assets receive the full benefit of non-tax deferred in an IRA is subject to regular income tax assets, only diminished by estate taxes but not treatment at the time of withdrawal. income taxes. As discussed in other portions of this book, If a charity is named as the IRA beneficiary life insurance plays an increasingly important (or one of several beneficiaries), the owner still role in estate planning. This is especially true gets the benefit of the Uniform Table for lifetime in estates where there is substantial amount of distributions. However, after death, if there are family wealth in retirement accounts. also individual beneficiaries and tax deferral
268 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
is desired, the IRA should be divided into THE DECEASED’S IRA separate accounts in a timely fashion. There is one more important rule that Creditor Protection for IRA's must be kept in mind. An IRA of a deceased Each state law is different when it comes owner must be kept in the name of the to determining the level of protection offered deceased owner and reflect that it is an to IRA's from the creditors of the IRA owner. In inherited IRA. The title on the account cannot Ohio, initially, an IRA didn’t have any special change to the beneficiary’s name (other than protection from the owner’s creditors. Then, a spouse) as it is not the beneficiary’s own the Ohio statute was amended to provide IRA. If the title is changed to the name of that an IRA is protected from the claims of the the beneficiary, this will be considered a full owner’s creditors. This amendment was meant distribution of the IRA with all income taxes to offer the same protection from creditors due and the beneficiary will have made an afforded to ERISA plans. However, in 2002 improper contribution (over the limit) to his there was a case out of the Court of Appeals own IRA. for the Sixth Circuit (which covers Ohio) that A deceased owner’s account should be said, based on the specific facts of that case, titled as follows: John Doe, deceased, IRA the creditor could attach the debtor’s IRA. f/b/o (for the benefit of) Sally Smith. Sally The creditor was a secretary for the debtor Smith’s social security number is then placed from 1980 through 1992 and she sued on the account. the debtor/employer because the accrued Where the beneficiary is a trust, the benefits in her pension plan and profit sharing trustee of the trust will control the account for plan were misstated. These plans were the trust beneficiaries but the IRA still stays in administered by her employer as the Trustee. the same account. The trust document should She won the suit and the debtor was ordered have sufficient language in it that gives the to pay her about $11,000 in damages and trustee broad flexibility in dealing with the attorney's fees of about $5,000. The debtor retirement account. stated he had no income (even though he What about creditor protection for was a practicing attorney) and no assets that inherited IRA's? State law controls the the creditor could attach. The creditor found outcome and, to date, there is no consensus; that the debtor owned a SEP IRA account some states give inherited IRA's the same valued at about $90,000. The debtor had creditor protection as that given to the IRA an outstanding loan with the SEP IRA. The owner and others do not. Naming a trust as creditor garnished the account and the the IRA beneficiary may provide the creditor garnishment was upheld. The case turned protection to trust beneficiaries that inherited on Michigan law (also in the 6th Circuit). IRA's may lack. The debtor argued that ERISA precluded Finally, what happens to the IRA the garnishment – but ERISA specifically account when the beneficiary dies? Many exempts IRA's. Even though Michigan law, IRA custodians permit the beneficiary to similar to Ohio, attempted to protect IRA's designate who will receive the account at that had received funds from ERISA plans, the their death (a successor beneficiary). If this court found that state law can not supercede is not done, the account is usually paid as federal law and removed the state offered dictated by the IRA custodial agreement, protection from the debtor’s IRA. often to the beneficiary’s estate, turning a non-probate asset into a probate asset. While the beneficiary will not be able to change the speed at which distributions must be made, she does control the recipient of these distributions.
Chapter 28: Planning with Retirement Accounts 269 Wealth Management Through Estate Planning
chart the best course of action to meet his My opinion goals. Careful planning can result in significant In Ohio, the law has continued benefits. to evolve in favor of IRA's being protected from creditors. IRA's have substantial protection by a state statute and also by judicial determination. A 2005 court decision found that IRA's cannot be attached and that they are retirement plans protected by federal law. Many legal observers believe that the Court of Appeals case discussed in the text of this chapter is limited to employer sponsored SEP IRA accounts. Owners of companies with SEP IRA accounts have to carefully evaluate the risk that their accounts are not exempt from creditors' claims.
SUMMARY So many events and considerations interlock when it comes to discussing retirement accounts. The tax ramifications are significant. Personal planning goals affect tax planning goals and vice versa. There are severe penalties for mistakes. There is no simple, universal rule that applies in all situations. Instead, each person needs to understand the issues impacting that person’s plan and
270 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
This is the table that is used to determine the RMD's for the owner of the IRA account
Uniform Table for Lifetime Distributions
Age Divisor Age Divisor 70 27.4 93 9.6 71 26.5 94 9.1 72 25.6 95 8.6 73 24.7 96 8.1 74 23.8 97 7.6 75 22.9 98 7.1 76 22.0 99 6.7 77 21.2 100 6.3 78 20.3 101 5.9 79 19.5 102 5.5 80 18.7 103 5.2 81 17.9 104 4.9 82 17.1 105 4.5 83 16.3 106 4.2 84 15.5 107 3.9 85 14.8 108 3.7 86 14.1 109 3.4 87 13.4 110 3.1 88 12.7 111 2.9 89 12.0 112 2.6 90 11. 4 113 2.4 91 10.8 114 2.1 92 10.2 115 and older 1.9
Chapter 28: Planning with Retirement Accounts 271 Wealth Management Through Estate Planning
This is the table that is used to for determining RMD's for beneficiaries of IRA accounts
Single Life Expectancy Table
Age Divisor Age Divisor Age Divisor Age Divisor 0 82.4 28 55.3 57 27.9 86 7.1 1 81.6 29 54.3 58 27.0 87 6.7 2 80.6 30 53.3 59 26.1 88 6.3 3 79.7 31 52.4 60 25.2 89 5.9 4 78.7 32 51.4 61 24.4 90 5.5 5 7 7.7 33 50.4 62 23.5 91 5.2 6 76.7 34 49.4 63 22.7 92 4.9 7 75.8 35 48.5 64 21.8 93 4.6 8 74.8 36 47.5 65 21.0 94 4.3 9 73.8 37 46.5 66 20.2 95 4.1 10 72.8 38 45.6 67 19.4 96 3.8 11 71.8 39 44.6 68 18.6 97 3.6 12 70.8 40 43.6 69 17.8 98 3.4 13 69.9 41 42.7 70 17.0 99 3.1 14 68.9 42 41.7 71 16.3 100 2.9 15 67.9 43 40.7 72 15.5 101 2.7 16 66.9 44 39.8 73 14.8 102 2.5 17 66.0 45 38.8 74 14.1 103 2.3 18 65.0 46 37.9 75 13.4 104 2.1 19 64.0 47 37.0 76 12.7 105 1.9 20 63.0 48 36.0 77 12.1 106 1.7 21 62.1 49 35.1 78 11. 4 107 1.5 22 61.1 50 34.2 79 10.8 108 1.4 23 60.1 51 33.3 80 10.2 109 1.2 24 59.1 52 32.3 81 9.7 110 1.1 25 58.2 53 31.4 82 9.1 111 1.0 26 57.2 54 30.5 83 8.6 27 56.2 55 29.6 84 8.1 28 55.3 56 28.7 85 7.6
272 Chapter 28: Planning with Retirement Accounts Wealth Management Through Estate Planning
Chapter 29: Charitable Planning
Increases in personal wealth have generated new growth in charitable gifts. There are many ways to make gifts to charities. The gift techniques often focus on maximizing the tax planning opportunities that complement the personal reasons why people donate to charities.
Chapter 29: Charitable Planning 273 Wealth Management Through Estate Planning
Chapter 29:
◆ Charitable Gift Methods
◆ Charitable Tax Deductions
◆ Charitable Organizations
◆ Life Insurance and Charitable Gifts
“We make a living by what we get; we make a
life by what we give.”
Winston Churchill
274 Wealth Management Through Estate Planning
s personal investment portfolios Direct Transfers to a Charity continue to grow, many people The simplest way to make a charitable Adiscover that their financial situation gift is to write a check to a charity. Transfers permits consideration of a significant gift of property of whatever nature achieve to charity. Even after making sure that the same result. Stock certificates can adequate financial provisions have been be transferred to a charity, deeds to real made for children and other beneficiaries, property can convey title to a charity and there is enough left over to consider life insurance ownership may be assigned charitable gifts. Other donors embrace to a charity. All of these types of transfers charitable giving because they do not have are effective to make a charitable gift. It is a children or other close beneficiaries and good idea to make sure that the charity will they want to leave their estates to charity accept your donation if you plan on giving in a way that will continue to promote their closely held business stock, real estate or ideals and concerns. Charitable gifts are tangible property. a particularly satisfying endeavor because Sometimes a donor has a choice they enable you to create a lasting legacy between giving cash or appreciated stock. to further the causes that are near to your Usually, the stock is a better choice. A gift heart. of appreciated securities gets the donor the In this chapter, we discuss the many same tax deduction as a cash gift and the reasons why and ways in which a gift can amount of the gift received by the charity be made to a charity. There are two primary is not reduced by any capital gains taxes. reasons for making charitable gifts: So, the donor avoids paying capital gains ◆ You have a personal interest in a taxes on the stock and gets a full charitable certain charity and seek to financially deduction. This makes the economic cost to support it. the donor of the gift less without reducing the value of the charitable deduction. ◆ You want to secure certain income or With any direct gift, the donor does not estate tax benefits in exchange for retain any interest in the gifted property and the financial contribution. relinquishes control over the investment and The best charitable gifting strategy use of the gift. This control is vested in the satisfies both of these aims. However, this is charity. a very complex area with a lot of difficult rules. There are intricate IRS regulations that must be carefully followed in order to receive the maximum tax benefit from charitable gifts. To secure these benefits, Charity
donors must work with an experienced legal s advisor who knows how to put together Boat Music these sophisticated projects. Vacations Book Ice Cream CHARITABLE GIFT METHODS There are numerous ways that a person Savings can make charitable gifts. If a gift is not Spouse, made in one of the approved ways, then the Children donor will not receive any tax benefit from the gift. Your charity has a special place in your heart!
Chapter 29: Charitable Planning 275 Wealth Management Through Estate Planning
structured to permit the foundation to enjoy More Information on Private Foundations the same high-quality financial advice that For a more detailed discussion on Private you currently receive from your advisor. Foundations, visit our website at www.smith- Instead of making a gift to a smaller charity condeni.com. Under News & Publications, there is that may not have the “purchasing power” of an article you can print out. a large financial institution, you can assure that your donation will stay in a fund that is professionally managed. This results in your Gifts to a Private Foundation charities receiving more over time than they Many donors who plan on making a might with an outright gift that is not well sizable charitable gift would prefer not to give invested. up all control over the gift. The donor may Creating a private foundation allows want to make sure that the donated funds will families to achieve these goals. A private be used in accordance with her desires. There foundation is created under a personalized may be questions regarding how the funds charitable trust that is designed to achieve will be invested by the charity. Frequently, a family’s charitable goals. To do this, the the donor may want to reserve the right to donor and his estate planning attorney create have many different charities benefit from this a trust document that identifies the donor’s large gift or have the option to select different charitable purposes and describes the manner charities each year. in which distributions to charities are to be Another concern may revolve around made on an annual basis from the trust. how a family uses its “social capital;” the The foundation can be structured to permit family resources that are earmarked for family members to have an active role in charitable endeavors. Grandparents may be running the foundation. The foundation may interested in setting up a program that will also pay reasonable compensation to those encourage children and grandchildren to look individuals and investment professionals who around and discover all of the possible uses are contributing to the success and operation that can be made of their social capital. To of the foundation. achieve these goals, families set up their own Before we go into the structure of a charitable organizations. These are called common private foundation, you should private foundations. be aware of three variations for the typical A major advantage of creating a private foundation. private foundation and funding it during the A family can create an operating donor’s lifetime is that it affords the family foundation to run a museum, library, an opportunity to work together towards a historic site, nursing home or other charitable common goal of identifying and financially endeavor. This type of foundation gives the supporting charitable needs. This team donor a greater income tax deduction and effort, led by the elders of the family, serves the opportunity to deduct the fair market to educate younger family members in value of a gift of tangible property (antique investment strategies and public service. These automobiles, paintings, art collections) if the intangible benefits help to keep young affluent gift is actually being used in the charitable family members connected with the needs of operations of the foundation. The operating others, whether in a cultural, humanitarian, foundation must also follow other rules religious or educational context. specific to this type of foundation. If a donor A private foundation may also be has a unique collection, he may keep the
276 Chapter 29: Charitable Planning Wealth Management Through Estate Planning
collection together by creating an operating foundation to run public Example Maya is an affluent widow viewings of the collection. who wishes to create a trust for the There is also a conduit benefit of students at her high school. The purpose of foundation format, in which all the trust is to provide scholarship money for college. She contributions flow out to charities within creates a trust and funds it with a gift of $400,000. With 1 2 /2 months after a contribution is made. the assistance of the school’s financial aid office, she Because of the flow-through requirement, selects among those students who apply for the aid and the donor receives a greater income tax who are qualified under the terms that the foundation deduction. Because all of the contributions established. The trust filed the grant procedures with the are distributed within a short period of IRS and they were approved. time, however, the opportunity to grow a charitable fund is not available because nothing is retained inside the foundation. By establishing this trust, Maya has Finally, there is a twist on the achieved several goals: foundation structure called a supporting ◆ Provide financial assistance to needy organization. This is a special type students. of foundation that qualifies as a public ◆ Receive an income tax deduction for charity because the organization supports her gift to this trust. designated public charities. If the donor is fairly certain that his funds will be targeted ◆ Make sure that her gift will be used to support a specific public charity and for the specific purpose that she this charity is linked to the foundation, wants. the donor should consider a supporting ◆ Tangibly see the specific effects of organization structure because of the her gifts on the local community. greater flexibility with income tax deductions ◆ Memorialize her own existence or and distributions. that of someone else (perhaps her With the common private foundation, deceased husband) by naming the the trust document must be carefully drafted trust after this person and providing to make sure that contributions will qualify scholarships in the name of her pri- for a charitable income tax and estate tax vate foundation. deduction for the donor. Most importantly, all distributions from the foundation must In order for gifts to a private foundation be made for a charitable purpose and to to generate an income tax deduction for organizations that are qualified charities. the donor, the private foundation needs to The IRS carefully scrutinizes charitable be approved by the IRS as a tax-exempt trusts and their operations to make sure that organization. This is accomplished by filing the distributions are in fact being used for the appropriate application with the IRS and charitable purposes. Reporting requirements receiving a determination letter. may be imposed on grant recipients to Private foundations, as with all ensure that the grants from the foundation charitable trusts, are creatures of tax are being used for permitted purposes. statutes. Because the gift is not being made directly to a public charity, but the
Chapter 29: Charitable Planning 277 Wealth Management Through Estate Planning
donor is receiving an income tax deduction experienced significant gains or a vacation nonetheless, the government has an interest home that has appreciated in value are good in making sure that the gift will actually serve candidates for funding a CRT. While you to benefit the public’s interest in charitable can give the property outright to charity, you enterprises. Therefore, there are certain rules may prefer to retain an income stream from pertaining to each type of charitable trust this valuable property for your retirement, previously discussed. For instance, with a for making gifts to your children, or for the private foundation, generally the foundation enjoyment of life’s pleasures. must annually donate at least 5% of the value of the property owned by the foundation to public charities. Another important restriction More Information on is that there cannot be any self-dealing Charitable Remainder Trusts between the donor, or the donor's family, and At our website, www.smith-condeni.com, the foundation. under News & Publications, there is an extensive In summary, many affluent people turn article on these trusts. Written in a question to a private foundation to take advantage of and answer format, it provides more detailed these benefits: information on this valuable planning tool. ◆ Participation by family members in the charitable gifting process. By transferring the property to a CRT and ◆ Permissible changes in charitable goals having the CRT sell the property, there is no as determined by family members. capital gains tax. This is because CRT's are ◆ Permanence in creating a lasting exempt from income taxes. This sale through legacy for the family and their chosen a CRT leaves the entire amount of the sales charities. price available for investment within the CRT, ◆ Preserving family wealth with tax instead of being depleted by the gains tax. deductions. Why is a CRT exempt from income tax? Because when you set up the CRT, you ◆ Professional investment management by your trusted financial advisor. commit to having whatever property is left at the end of the term of the CRT pass to charity. Charitable Remainder Trusts Here are the major attributes of a CRT: A Charitable Remainder Trust (CRT) ◆ It lets you sell highly appreciated prop- permits you to be generous to charities and to erty without having to immediately yourself! A CRT is a special kind of trust that is pay the capital gains tax. This leaves specifically authorized by tax laws to achieve more money available for you to rein- a specific goal: committing to making a future vest and increases the amount of the gift to charity (and receiving a current income income stream that the CRT pays to tax deduction based on the projected gift you. value), while retaining a stream of payments from the gifted property. ◆ The gift to the CRT generates an imme- CRT's are the answer if you own a diate income tax deduction based on low-basis, high capital gain asset that you the value of the charity’s future interest. would like to sell in order to re-invest in You can take this deduction against income producing property or to diversify your current income, generally up to your portfolio. For instance, stock that has 30% of your adjusted gross income. If
278 Chapter 29: Charitable Planning Wealth Management Through Estate Planning
the deduction is too big to use in one to last over the donor’s longer projected life year, you can use it over the next 5 expectancy. years. There are two major types of charitable ◆ Estate taxes may be reduced at remainder trusts: death because the remainder interest ◆ The charitable remainder annuity passes to the charity or charities that trust.
◆ 3 The charitable remainder unitrust. CRT sells stock The annuity trust pays annually to the with no gain tax donor or other non-charitable beneficiary paid a fixed amount or fixed percentage of 2 1 the initial trust assets. With this type of Couple takes Stock transferred CRT, additional contributions cannot be income tax to CRT Trustee made after the initial funding of the trust. deduction The unitrust pays annually to the donor or other non-charitable beneficiary a 4 6 fixed percentage of the trust assets that CRT pays stated % to At deaths of both is re-determined annually based on the Husband and Wife Husband and Wife, fair market value of the trust property each 5 property goes to each year charity w/o year during the CRT's term. As the value Couple can use funds estate taxes of the trust property fluctuates each year, for retirement, gifts, purchase life the amount payable to the non-charitable insurance beneficiary changes accordingly. Unitrusts are more flexible in that additional property can be added at you selected. anytime. If the CRT is set to end at your death and you live to your anticipated life My opinion expectancy (or beyond), the payments to you from the CRT will quite likely more than offset the removal of the CRT assets from your estate. The economic benefits of a CRT are Assess your own risk tolerance when further enhanced when a portion of the deciding between an annuity trust and payments from the CRT is used for family gifting purposes. Frequently, this includes a unitrust. To share in market gains (and the purchase of a life insurance policy losses), select a unitrust. To be assured a inside an irrevocable life insurance trust with steady stream of income, but without an the death benefit passing to the insured’s family income tax and estate tax free. adjustment for the growth in the value of The policy serves as a hedge against the the assets in the CRT, select an annuity trust. donor’s premature death, which cuts off the payments from the CRT that were supposed In my experience, younger persons choose to set up a unitrust. They like the fact that the payouts may increase over the years, protecting the value of the distributions against inflation or creating extra income.
Chapter 29: Charitable Planning 279 Wealth Management Through Estate Planning
In addition to the two major types of CRT's can include children and others CRT's, there are variations on the theme, such as lifetime beneficiaries. However, if anyone as an income-only CRT, which pays out to other than the donor or the donor’s spouse is the donor only the income earned by the CRT. an immediate beneficiary, then a taxable gift Another recent development is a flip CRT. This is made in the amount of the present value of is a CRT that is funded with real estate, closely the stream of distributions the beneficiary will held business stock, or other property that is receive. not easily marketable and does not have a Occasionally, parents will structure a CRT steady flow of cash that can be used to make where they are the beneficiaries during their payments to the donor. The flip CRT starts out lives and their children are the beneficiaries as an income only CRT and “flips” over to a following the death of the surviving parent. unitrust CRT after the unmarketable property This reduces the amount of the charitable is sold. In short, there are various ways to deduction because the total life expectancies structure a CRT that take into consideration of all the beneficiaries need to be factored the type of property donated to the CRT and into the determination of the value of the the needs of the donor. remainder interest. Also, the CRT must be In some ways, a gift annuity created by carefully drafted to make sure a current gift is a charity is similar to a charitable remainder not made with gift tax consequences. trust. With a gift annuity, the donor gives Children and other family members assets directly to the charity and the charity cannot always be included as beneficiaries. pays the donor the same annuity amount The IRS has imposed a rule that the present each year. However, gift annuities have some value of the remainder interest passing to the drawbacks compared to CRTs: charity must be at least 10% of the value of ◆ The charity is in control of the investments the CRT. Where the age difference between being made with the donor’s assets. the donors and a second set of beneficiaries With a CRT, you can be in charge of the is too large, it will drop the present value of investments made by the CRT. the remainder below the 10% floor. ◆ With a gift annuity, you cannot change Charitable Lead Trusts the charitable beneficiary. It will be the A charitable lead trust is the reverse of charity with whom you set up the annu- the charitable remainder trust. In the lead ity arrangement. Donors to a CRT can trust, the charity receives distributions from the change charitable beneficiaries at any- trust first for the period of years stated in the time and can have multiple beneficiaries. trust agreement. When this period expires, whatever is left in the lead trust is distributed ◆ There is less flexibility in determining to family members, usually the children of the the payout to the donor. With a CRT, person creating the lead trust. you can determine the amount or Charitable lead trusts primarily serve fixed percentage of the principal you to leverage large gifts to family members. want to receive as annual distributions. The lead trust leverages the gift by taking Conversely, with a gift annuity, the char- into account the fact that the family member ity dictates the amount of the payout. must wait a number of years before receiving For gifts of $150,000 or less, a gift the gift. Therefore, the gift to the family annuity with a charity may be appropriate. For member is not the current value, but rather the gifts of more than $150,000, the donor should discounted present value. The longer the consider the control and flexibility offered period the lead trust is held for the charity, by a CRT. The fees and expenses associated the smaller the present value to the remainder with setting up a CRT are outweighed by this beneficiaries. This discount may either increased flexibility and control. eliminate or decrease the gift taxes that would
280 Chapter 29: Charitable Planning Wealth Management Through Estate Planning
otherwise be due with a direct gift to the elects to receive an income tax deduction, beneficiaries. then all of the income earned by the As opposed to a CRT, a lead trust is not lead trust will be taxed to the donor and an income tax exempt trust. The income the donor is not permitted to deduct the earned by the lead trust is subject to income donations being made to charity from the taxes. These taxes are paid by the lead trust. lead trust. Some donors prefer to take However, the lead trust can deduct the gifts the deduction and pay the future income being made to charities before calculating tax if they are eager for a current income the income tax due. tax deduction because of unusually high income taxes being incurred in a specific Example year. Also, the donor acknowledges that Harry is a wealthy payment of income taxes must occur at business owner in his some level (if not the donor, the lead trust 60's with an estate of $5,000,000. He has may pay the tax) and the donor knows that one daughter, Sally, who is 38 years old. his payment of the income tax will reduce Harry has already made lifetime gifts totaling his taxable estate (saving estate taxes) and $1,000,000, the total amount that can be leave more in the lead trust for his charity made without paying gift taxes. Harry would and family members. like to make additional gifts. He has a strong Balancing these tax benefits versus tax interest in supporting the local orchestra. costs is not always easy. How to best sort In October of 2006, Harry gives this out is determined by consultation with $1,000,000 of stock to a lead trust. The lead the donor’s estate planning attorney and trust pays 5% a year to the orchestra for 20 accountant. years. The lead trust investments earn 6% a year. Over the 20 year period, the orchestra CHARITABLE TAX will have received payments totaling about DEDUCTIONS $1,000,000. In 2026, when Sally is 58 years Income, estate and gift tax deductions old and contemplating retirement, the lead are available for contributions made trust will terminate and she will receive about to charities. The value of the charitable $1,345,000 from the lead trust. deduction will depend on whether the gift is If Harry had made a direct gift to Sally of made directly to a public charity, a private $1,000,000, he would have paid gift taxes foundation or to a charitable remainder of about $400,000. Instead, the gift to Sally trust. The value of the deduction also turns is discounted to $322,360 because she must on whether the property contributed is cash, wait 20 years to receive the gift. The gift taxes long-term capital gain property or tangible on this amount are about $133,000, a net gift personal property. tax savings of $267,000. When a gift is made and the donor Sally does not pay any taxes on the retains the cash flow (either a charitable amount she receives and her tax basis in the remainder trust or a gift annuity) the gift property is this amount. The lead trust also to the charity is the amount the charity will provides an ongoing benefit to the charity while receive once the donor’s interest in the cash Harry is still living, and he can receive and flow terminates. This amount is called the enjoy the recognition as a significant donor. remainder interest.
Generally, the donor of a lead trust does not receive an income tax deduction for his contribution to the trust. If the donor
Chapter 29: Charitable Planning 281 Wealth Management Through Estate Planning
This projected value is determined after Once you know your total income tax factoring out the value of the life interest deduction, you then need to know how much retained by the donor. The IRS has a formula, of that deduction you will be able to make use mortality tables and an interest rate assumption of. All charitable deductions have a ceiling (called the applicable federal rate) that are that applies against the donor’s adjusted used to determine the value of both the life gross income (AGI). The rules stated below interest and the remainder interest. are only cursorily summarized. Depending on the nature of the property given to charity, these limitations will change. Please Example consult with your lawyer or tax advisor to Paul is 70 years of age and Joan ascertain your specific deduction. is 68 years of age. They own If the charity to which the gift is made $350,000 of GE stock with a basis of $50,000. In is a public charity, the donor can deduct October of 2006, they give this stock to a unitrust CRT up to 50% of his AGI for cash gifts and that will last for their joint lives. They elect to receive 6% property subject to short term capital gain a year from the unitrust. treatment and up to 30% of his AGI for other property. When the gift is made to a Income Tax Deduction: $127,000 CRT, the CRT agreement must be reviewed Capital Gains Tax Savings: $45,000 to see if only public charities are permitted Annual Distribution: $21,000 recipients. Generally, when a gift is made to a private foundation, the donor can The capital gains tax savings in the deduct up to 30% of his AGI for cash and example above represents the amount that property subject to short term capital gains would have been paid in gains taxes if Paul treatment and up to 20% of his AGI for gifts had sold the stock himself. $21,000 is the of other property. These percentages are amount Paul and Joan will receive annualy subject to change, especially depending on each year from the unitrust CRT. This amount the precise nature of the donated property, is prorated on a calendar year basis for the so this needs to be checked before funding a first year because the transfer was made in private foundation. With all charitable gifts, October. Thereafter, distribution is recalculated if the donor cannot use the entire income tax each calendar year using the value of the deduction in the first year, it may be carried principal of the CRT on a pre-selected day, usually the first day of the year. If the CRT Observation assets don’t grow in excess of 6% per year, The deduction the payout drops each year. limits are lower The income tax deduction of $127,000 for contributions to private foundations. represents the present value of the However, if the full deduction can be taken remainder interest passing to the charity. The over the additional five years, then a person size of the remainder interest is smaller the contributing to a private foundation still gets longer the charity has to wait until Paul and the full benefit of the deduction; it is just Joan's life interest in the CRT terminates. In our spread out over a longer period of time. example, the joint life expectancy of Paul and Joan is about 18 years. From an actuarial perspective, it will be that many years before forward for an additional five years. the charity receives the $350,000. This is why When a gift is made at death to a the income tax deduction is only a fraction of charity, the donor’s estate receives an estate the value of the gift. tax deduction for the entire amount. There
282 Chapter 29: Charitable Planning Wealth Management Through Estate Planning
is, however, no income tax deduction Revenue Code are suitable recipients in a available at that time. charitable giving strategy. Documenting your Tax Benefit A tax qualified public charity is a If the contributed property does not corporation, association or fraternal society have a readily ascertainable value, it organized and operated exclusively for: will be necessary to have the property ◆ Religious, scientific, literary and edu- appraised so that the charitable deduction cational purposes. taken on the donor’s income tax return ◆ For the advancement of amateur ath- can be supported. The value of a transfer letics. to a charity may be scrutinized by the IRS ◆ The prevention of cruelty to animals. to determine if the value used accurately reflects the fair market value of the property A public charity must receive a certain on the date of the transfer. amount of support from the public at large. A professional appraisal should be Without this cross-section of support, the obtained before real estate or closely held charity becomes a private foundation. business stock is given to a charity. There Churches, hospitals, many institutions are specific appraisal rules governing the of higher learning, public museums and valuation of artwork. Make sure that you organizations such as the American Cancer meet all the tax requirements to protect your Society, American Red Cross and the Girl income tax deduction. Scouts of America are common examples of organizations that qualify as public CHARITABLE charitable organizations for tax purposes. ORGANIZATIONS There are many existing charities from which to choose. The Internal Revenue Only charitable Service publishes a list of charities that organizations that qualify qualify for preferential tax treatment for preferential tax and there are approximately 900,000 treatment under organizations on this list at this time. the Internal Cyberspace is also becoming a major source of information on charities. The My opinion electronic age has made it easier for people to see detailed financial information about many charities and private No doubt foundations. One current website that has this information is www.guidestar.org. many children view themselves as the The form of all charitable trusts is strictly controlled by the Internal Revenue Service. As one example, the trustee of a charitable primary charity to be supported by trust is controlled as to the investments it can make. One of the prior abuses of charitable Mom and Dad, but of course your trusts was that the trustee could invest the assets of a charitable trust in high yield but high risk types of investments. This would gifts to your children do not generate benefit the non-charitable beneficiary at the expense of the charitable beneficiary’s any income tax benefits for you. remainder interest.
Chapter 29: Charitable Planning 283 Wealth Management Through Estate Planning
LIFE INSURANCE AND insurance policy, through both the income tax CHARITABLE GIFTS deduction received when the gift is made and the cash flow retained by the donor if a CRT is The marriage of a significant charitable used as the charitable gift vehicle. gift with a life insurance policy is a beneficial Your estate planning team, consisting planning strategy for many donors. Many of your financial advisor, insurance agent, donors want their descendants to be the accountant and legal counsel, can prepare a primary beneficiaries of their estate. Of comprehensive plan that actually preserves course, anything the donor's descendants your estate for your family while at the receive from an estate is first tapped for same time satisfying your desire to make a estate taxes at both the federal and state charitable gift! level. Further, if the estate asset is a retirement account, the asset is also subject to income taxes. Donors know that if they leave part SUMMARY of their estate to charity, this charitable part These summaries of the ways in which a charitable gift may be made brush the surface of these popular planning devices. Pooled Observation It is estimated that income funds, donor advised funds, and from 2000 through community foundations may be other options 2010, more than eleven trillion dollars for a donor. Also, a donor may be interested ($11,000,000,000,000) passed from one in making a bargain sale to charity of certain generation to the next generation. Instead property or giving a home to charity and of giving a chunk of money to Washington retaining a life estate in the home. Each type D.C. and their state government, many of gift has its benefits and drawbacks. donors prefer to earmark funds for their Sophisticated charitable planning brings favorite charities. A charitable gift at death a different perspective to the estate planning redirects the funds that would otherwise have process. It represents the chance to do many been paid in estate taxes to the government good things for other people and for your coffers. own family.
escapes all taxes but leaves less for their descendants to share. The cure for this problem is the acquisition of a life insurance policy held inside an irrevocable life insurance trust. The death benefit on the life insurance policy passes to the descendants free of income taxes and estate taxes. This trust is sometimes called a wealth replacement trust. It replaces the wealth of the estate that was directed to charity. The making of a charitable gift frees up funds that can be used to pay for the life
284 Chapter 29: Charitable Planning PART VII: Create Your Own Estate Plan
285 Wealth Management Through Estate Planning
PART VII:
Chapter 30 Selecting an Attorney Chapter 31 Important Decisions You Need to Make Chapter 32 Ten Common Mistakes
286 Wealth Management Through Estate Planning
Chapter 30: Selecting an Attorney
Employing an attorney who has skills and experience in estate planning is critical. What does one need to know to locate the right person?
Chapter 30: Selecting an Attorney 287 Wealth Management Through Estate Planning
Chapter 30:
◆ How to Find the Right Lawyer
◆ Interviewing an Estate Planning Lawyer
◆ How Does a Lawyer Charge for His Services
“A lawyer is a learned gentleman who rescues
your estate from your enemies and keeps it
for himself.”
Lord Henry Peter Broughham
288 Wealth Management Through Estate Planning
n order to obtain the many benefits specialization in estate planning, this is a of estate planning, you must employ good credential to consider when hiring an I an attorney who is skilled and estate planning attorney. experienced in estate planning matters. There is no substitute for these attributes. This chapter has many suggestions to assist you in selecting the best attorney.
HOW TO FIND THE RIGHT LAWYER The number of estate planning lawyers is relatively small compared to the total number Divorce Bankruptcy Estate Planning Criminal Law of lawyers who are licensed to practice law. Attorney Attorney Attorney Attorney Probably, the primary reason for this is the complexity of estate planning. The technical Not every attorney is skilled in estate planning. skills are not easily learned and demand a Make sure you find the right one! great deal of time to master and maintain, particularly in view of changing legislation. This also means that a lawyer focusing on estate planning will have to turn away other Here are some other things to consider types of legal work and limit his practice. Not when looking for an estate planning attorney. all lawyers want to do this. Seek a referral from friends who have A good estate planning lawyer must had estate planning done for them. Their understand many aspects of the law in order actual experience can be the best judge of to develop a plan that properly coordinates that lawyer’s abilities. the client’s personal goals with his tax Speak with someone who has goals. Identifying an attorney who has the experience in tax and financial planning requisite skills is not easy. As America’s matters such as your accountant, population ages, estate planning work stockbroker, insurance agent or financial has burgeoned. More attorneys and even planner. Probably, they have worked with non-licensed people are seeking clients attorneys who do estate planning and will who need these services. The proliferation know which lawyers have the requisite of advertised seminars by attorneys, skills in this area. These sources should investment advisors, insurance advisors and be reliable because they will not refer financial planners underscore the potential you to an attorney who does not have the financial profitability of estate planning. This necessary skills. That would reflect poorly popularity can make it more difficult to find on them. a good lawyer who has the requisite skills. Some brokerage firms have established There is a trend in the law towards relationships with lawyers who are skilled in specialization. Specialization means that estate planning. Usually, they will investigate the authority in each state that controls the the skills and reputation of the attorney licensing of attorneys allows lawyers who before including them in their program. have demonstrated skill and proficiency in Other lawyers who do not work in the an area of the law to hold themselves out as estate planning area can be a good source. being specialists. Usually, the lawyer must They will know by reputation the lawyers meet certain qualifications such as years of in the community who spend a substantial practice in that area. Also, there may be a amount of time representing estate planning test that must be passed. If your state allows clients.
Chapter 30: Selecting an Attorney 289 Wealth Management Through Estate Planning
The referral service for the local bar keep in mind that when you are employing association is probably not the best source a lawyer, he is working for you. You are the for finding an estate planning lawyer. person who will be paying the bill and you The bar association is not responsible for have a right to understand exactly what skills determining if a lawyer has the requisite skills you are purchasing and what you can expect. and experience to practice in certain areas You should inquire of him and consider the of the law. Its information is based on the following: information provided to them by the lawyer ◆ What percentage of his professional and is merely a directory of local attorneys. time is spent representing clients Also, do not put undue reliance on regarding estate planning matters? advertising. The content of the lawyer’s ◆ Who refers him estate planning cli- advertising may be some indication of the ents? Does he receive referrals from areas of law that he spends most of his time other lawyers and/or does he repre- practicing. However, it may also indicate sent other lawyers in preparing their more the areas in which he would like to own estate plans? This is one way to practice. Besides, anyone can place an measure the lawyer’s reputation in the advertisement. If the lawyer’s advertising has legal community. a laundry list of areas in which he practices, look someplace else. Also, an advertisement ◆ Memberships in bar organizations are that says the lawyer does estate planning, not significant. Lawyers join by paying Wills, living trusts and probate does not mean money and a membership does not that he is skilled in doing estate planning. typically require any special skills or Estate planning is a distinct area of law. abilities. It is important to be very careful in ◆ Ask the lawyer if he speaks or writes selecting the right attorney. After you find on estate planning topics. This is some your skilled attorney, you must then ascertain indication of his level of involvement in whether you can work with this attorney in this area of practice. creating and maintaining your plan. The ◆ Does he practice estate planning as attorney should be willing to take the time to part of a group or is he by himself. listen to your concerns and should be able Estate planning is very complex and to explain, in general terms, the type of plan one lawyer cannot know everything. that is being recommended for you. You need to put your trust in this person and be able to ◆ Do not be afraid to ask the lawyer communicate with him. You are looking for a how many years he has been practic- relationship that can last a lifetime. This is why ing as a lawyer and practicing in the the interview process is important. estate planning area. Also, ask him if he practices in other areas of the law. INTERVIEWING AN ESTATE If he indicates that he practices in a variety of areas, then he may not be a PLANNING LAWYER good choice. The technical demands Once you have the name of a lawyer of estate planning usually restrict a who does practice in the estate planning lawyer from practicing in too many area and have set up a meeting with him, other areas. you should feel perfectly comfortable at your initial meeting in inquiring as to his When you ask the lawyer questions, background, skills and experience. Please watch carefully how he answers them. Does he seem to know a lot about the topic?
290 Chapter 30: Selecting an Attorney Wealth Management Through Estate Planning
Does he take the time to explain to Other attorneys will quote a fixed fee you the concepts that are involved and the for certain projects. They are able to do this basic strategies that he would employ to when they have handled a particular type assist you? While you will not understand of plan many times and understand the time these techniques and strategies to the same commitment that is usually required. degree that he does, it is important that he Fixed fee pricing for estate planning be willing to take the time to answer your is becoming much more common. It has questions and give you a basic working benefits for both the client and the attorney. knowledge of what he proposes. The client knows how much the legal Should you ask for references? You can fees will be at the start. From the lawyer’s if you like but it is probably not a good idea perspective, if he can get the project and of little help anyway. All lawyers should done quickly and efficiently, the project be very cautious about the attorney-client is more profitable for him. Also, lawyers privilege and have a natural reluctance to who charge fixed fees usually disclose the names of clients whom they have happier clients. There are have represented, unless they first receive no surprises when the bill is the permission of those persons. Besides, presented. anyone can get a good reference from someone. My opinion HOW DOES A LAWYER CHARGE FOR HIS SERVICES Most of the estate planning services at my Fees are always an important issue firm are at fixed prices. We have had very for the client as well as for the attorney. The matter should be raised by the lawyer few problems billing this way and it has towards the end of your first meeting. If it made us focus on being more efficient in is not, you should raise the question. Make sure that there is a clear understanding as to providing our services. If we get things done fees before you retain the lawyer. quickly, the job is more profitable. Speed Attorneys charge for their estate planning services in two ways. You may also keeps our clients happy (and coming be charged for legal work based on the time that the lawyer spends multiplied by back or referring family and friends). his hourly rate. This is the traditional way in which attorneys charge for these services. Some of the problems with hourly billing cut each way. A lawyer can provide very Not all legal services will be for fixed valuable advice in a short amount of time. prices. Where the project is complex and Charging by the hour may not compensate presents unusual issues, it is difficult for the him fairly for the value of the advice. attorney to charge this way. If the lawyer is Conversely, charging by the hour may be going to charge you by the hour, then make an incentive to go slow! sure that you are going to get detailed billing which shows the date of the service, a brief description of the service and the Observation If the lawyer quotes time spent, usually in tenths or quarters of an you a fee that is too hour. good to be true, it probably is. This is not an area where price is the controlling factor. Quality and timeliness of service are the most important considerations.
Chapter 30: Selecting an Attorney 291 Wealth Management Through Estate Planning
Some lawyers will use paralegals and charge for their time. A paralegal is Observation Our firm has put someone who has training to assist a lawyer into place a review in carrying out his responsibilities. It is a way program where every four years, the client that lawyers can keep down the charges receives a notice suggesting a review of the for their services and also keep a project estate plan. The review itself is done for fixed on track. Generally speaking, the fact that fee. During the review, we sometimes uncover a lawyer uses paralegals reflects positively problems that would otherwise go unnoticed. on the manner in which he is running his The clients appreciate the attention and practice and handling legal matters. Also, we are fairly compensated for our work. My law firm makes his paralegal is someone whom you can Everyone is happy. also speak with if the lawyer is unavailable. extensive use of It makes it easier to get questions answered paralegals. They have when you call. Finally, make sure that the estate planning The cost of retaining an experienced lawyer you employ is someone with whom made us much more and skilled estate planning lawyer is more you feel comfortable. If at the end of your efficient in handling expensive than having a lawyer prepare a initial meeting with the lawyer, you are not Will for you. There are good reasons for this sure you should retain him, then do not client matters and that relate to the significant personal and tax make a commitment at that time. Go home, help us keep down benefits that you will realize from the estate think about it and make a decision later. The plan. Usually, the expense of legal services is relationship is too important to jump into if you the cost of our ser- dwarfed by the tax and personal benefits that are not sure. vices. Our clients are realized when the plan is implemented. From the lawyer’s point of view, please When you retain the lawyer, he should express to that person at any time any also like the fact that send out to you a statement confirming his questions or concerns that you have. A good lawyer tries to anticipate the concerns of the if the attorney is not representation, the fee that is going to be charged and the service to be rendered. This client; however, he cannot read the client’s available when they makes sure that your obligations to each other mind! It is incumbent on you to provide the are completely clear and reduces the chances estate planning lawyer with all the information call, they can talk to of disagreement. he needs so that he can make sure that your the paralegal. She An estate plan must be reviewed concerns are properly addressed. This is your periodically to maintain its effectiveness and responsibility as well as his. can answer many to take into account changes in the law or the Estate planning is a continuous process questions, or, when client’s personal situation. Do not be reluctant throughout the course of your life. The to ask the estate planning lawyer if he has a employment of an attorney who is skilled and she is not sure of the system for notifying you that the plan should experienced in estate planning and sensitive answer, track it down be reviewed. You want to make sure that your to your needs and concerns will make the plan maintains its effectiveness. relationship very satisfying. and get right back to Also, ask him how you will be charged them. for services rendered after the plan is established. Many estate planning lawyers will not charge for telephone calls to answer simple questions. However, if changes are needed in the plan and your documents, or if you seek advice on another part of your plan, such as minimization of income taxes on your 1 IRA when you reach 70 /2 years of age, you can expect to be charged for those services.
292 Chapter 30: Selecting an Attorney Wealth Management Through Estate Planning
Chapter 31: Important Decisions You Need to Make
Putting in place an estate plan requires commitment to a plan of action. This chapter sets forth the important things to consider and the steps to take.
Chapter 31: Important Decisions You Need to Make 293 Wealth Management Through Estate Planning
Chapter 31:
◆ Important Questions to Consider
◆ Create a Time Table for Your Estate Plan
◆ Make a Commitment
“Never let the fear of striking out get in
your way.”
George “Herman” Babe Ruth
294 Wealth Management Through Estate Planning
hroughout this book, we have ◆ Do you consider a corporate trustee? discussed many of the planning issues ◆ Who should act as the Trust Advisor Tthat go into a sophisticated estate plan. of your trust? Now is the time for you to be thinking about ◆ Who is going to be your attorney-in- the decisions that you need to make. An fact for your health care power and attorney can help, but ultimately you have to for your durable power of attorney give him the input necessary to put the plan for financial matters? together. The best plans are created after you have carefully thought through your ◆ Have you thought about who you concerns. would like to have as alternates for This chapter is written to give you some each of these positions? practical guidance as to the most important ◆ Do you want to have a Living Will? issues you need to think about and a ◆ Do you want to avoid probate when suggested plan of action for putting in place you die? your own estate plan. ◆ How important is saving money on IMPORTANT QUESTIONS TO estate taxes? CONSIDER ◆ Do you want to avoid estate taxes I have listed below some of the things at all expense, do not care about that you need to consider. Of course, it is tax savings or are you somewhere in not all-inclusive of the factors that may come between? up. This is understandable because each ◆ Are you willing to make gifts to fam- of us is unique and has different issues to ily members now if it results in tax evaluate. savings for your family? ◆ Put together a good financial state- ◆ Do you want to help children and ment. At the end of this book, you grandchildren now and for what rea- will find our firm’s form for collecting sons? important financial and personal ◆ Do your children or others owe you data. money? If so, is there a written note ◆ Select the right attorney. Do not be proving the loan and its terms? Is the afraid to ask questions. loan to be repaid on your death or is it forgiven? ◆ Are there other professionals whom you can rely on (accountant, finan- ◆ Where do you want your property to cial advisor, insurance specialist) in go when you die? this process? Assemble your team. ◆ Do you want to divide your property ◆ Make decisions as to the important equally at your death among your positions to be filled in an estate children or do you want some other plan. division of property? ◆ Who do you want to be the executor ◆ How do you think your children will of your estate? respond to your estate plan? ◆ If you have minor children, who do ◆ Do you care and will it make a differ- you want to act as their guardian? ence? ◆ Who is going to act as trustee when ◆ Are there any items of personal prop- you can no longer act or when you erty that are family heirlooms or have die? special sentimental value? Who do you want to receive these items?
Chapter 31: Important Decisions You Need to Make 295 Wealth Management Through Estate Planning
◆ Do you own any property of special ◆ Have you considered meeting with a value, such as a coin collection or art- funeral director and making all of your work? final arrangements? ◆ Is there anything special that you want ◆Do you have any special concerns done with this type of property if some- about the ability of your beneficiaries thing happens to you? to handle finances? ◆ Is there anyone who you do not want ◆ Do any of them have any physical or to receive any of your property under mental limitations that require special any circumstances? planning? ◆ Are you in conflict with anyone in your ◆ Do any of your beneficiaries have family. Does this require any special trouble handling financial matters? planning? ◆ Are any of them dependent on drugs ◆ Do you have children from a prior mar- or alcohol? riage or relationship? ◆ Are you concerned about protecting ◆ Are they to receive an inheritance on your beneficiaries (and their inheri- your death or do they wait until the tance) if a beneficiary goes through a death of your current spouse? divorce? ◆ If you have step-children, how are they ◆ Do you want to protect their inheri- to be treated under your estate plan? tance from the claims of creditors or ◆ If you become incapacitated, who predators? do you want to handle your financial ◆ Is there any property such as a vaca- affairs? tion home or farm that you want to ◆ Do you want to make any specific gifts keep in the family? at your death to persons outside of ◆ Do you have any charitable beneficia- your immediate family? ries that you want to receive part of ◆ Do you have any financial responsibili- your estate? How much? ties to other family members (widowed ◆ Do your charitable goals include mak- parent, incapacitated sibling) that you ing gifts now or do you want to wait want to continue after your death? until after your death? Under what conditions are payments to ◆ If you own a business, have you be made? thought about a business succession ◆ Do you have sufficient personal wealth plan so that you can realize the eco- to take care of your family if something nomic value of your business when you happens to you? want to retire? ◆ Have you considered long term care ◆ Also, does your business plan include insurance to handle nursing home provisions addressing your untimely expenses? incapacity or death that protect your ◆ Is there sufficient liquidity in your estate family financially? to pay all of your final bills, administra- ◆ Are any children or other family mem- tive expenses and estate taxes? bers involved in the business? ◆ Do you anticipate receiving a signifi- ◆ Is provision made for them to take over cant inheritance from your parents or should something happen to you? someone else?
296 Chapter 31: Important Decisions You Need to Make Wealth Management Through Estate Planning
These are some of the questions CREATE A TIMETABLE FOR that you need to be thinking about. The YOUR ESTATE PLAN questions (and the answers) are different One sure way to get an estate plan for each of us. Do not be concerned if you done is to create a timetable of the cannot answer all of them at once. One of important events and stick to it. Here is what the responsibilities of the estate planning a timetable should look like for an estate attorney is to help you figure out the plan that includes Wills, Trusts, Health answers to questions such as these and to Care Powers of Attorney, Living Wills and make the right choices. Financial Powers of Attorney as the major documents. This timeline applies both to couples and single persons. ◆ Have first meeting with lawyer going over your goals and concerns and her recommendations. ◆ Agree on the charges for the services My opinion to be rendered by the lawyer in put- ting together your estate plan. Have her confirm this in writing. ◆ Set up the next meeting. Ideally, this Your estate planning lawyer should should be about two weeks later. Absent some specific reason, an help you make decisions. It is not experienced estate planning attorney enough to tell you the alternatives should not have trouble getting drafts of all of the important estate plan- but not give you any direction. My ning documents prepared. ◆ The lawyer should send you a sum- belief is that clients want a lawyer mary of the important components of your plan that describes what the who can clearly and concisely plan will accomplish. explain what to do and why. I ◆ Meet with lawyer and go over drafts. Agree on changes to be made. Set have distinct opinions and am not up the next meeting for two weeks later. reluctant to express them (actually, ◆ At the third meeting, the documents are reviewed once more and then I enjoy it). As far as I can tell, my executed. The attorney reviews with you the alignment of assets to coor- clients expect and respect this. Do dinate with the estate plan and any other matters that are important for you want a lawyer who presents you putting your plan into effect. with a confusing set of choices and This is the time schedule that the lawyers in our firm follow in most cases. If does not help you make a decision? other planning techniques are to be used, we move on to them in sequence. We will I would not. decide what the next project is, agree on the legal fee to be charged and establish a
Chapter 31: Important Decisions You Need to Make 297 Wealth Management Through Estate Planning
date for the next meeting. This works very well MAKE A COMMITMENT for us and there is no reason why it should not The fundamental key to success in estate work well for you and your lawyer. planning is commitment. Are you ready to An estate plan may have multiple make the commitment to not only start the components. As the “wedding cake” estate planning process but to finish it? Will illustrates, a good estate plan starts with the you be disciplined in being prepared for fundamentals and builds from there. meetings with your attorney, providing her with the information and answers that she needs? Will you make decisions promptly and clearly communicate these to the attorney? Will you help wrap up all of the details including completing beneficiary designation forms and re-titling assets to coordinate with the tax planning and other goals of your Charitable Gifts estate plan? Will you undertake a periodic review of your plan to make sure that nothing Life Insurance is overlooked as you acquire new assets and your personal situation changes? Preparing and completing an estate plan Gifts requires the following from you: ◆ Making decisions. Trusts & Wills ◆ Focusing on understanding the plan set forth in the documents. ◆ Clear, timely communication with your attorney and other professionals. ◆ Organization and commitment. Start the process, work your way through it with your estate planning attorney, wrap up Observation all of the details and then put it away until it is I frequently tell new clients time for a periodic review. that we are going to start their plan and move through it until it is completed. It is not going to go on forever. I also tell them if we take too long, they will forget why they are creating an estate plan and I will forget what I am supposed to do!
298 Chapter 31: Important Decisions You Need to Make Wealth Management Through Estate Planning
Chapter 32: Ten Common Mistakes
Creating and maintaining an estate plan requires commitment and diligence. Many persons fail to recognize the importance of this. The results can be catastrophic.
Chapter 32: Ten Common Mistakes 299 Wealth Management Through Estate Planning
Chapter 32:
◆ Undue Reliance on Joint and Survivor Ownership
◆ Failure to Commit
◆ Selection of the Wrong Legal Counsel
◆ Belief that You Know More Than a Professional
◆ Failure to Have a Master Plan
◆ Failure to Keep Records Organized
◆ Improper Alignment of Assets with Estate Plan
◆ Lack of Liquidity
◆ Improper Life Insurance Planning
◆ Lack of Periodic Review
“Advice is less necessary to the wise than to fools;
but the wise derive most advantage from it.”
Francesco Guicciardini
300 Wealth Management Through Estate Planning
he cost of failing to create and important asset protection planning maintain an estate plan can be quite strategies that could have been used to Tsubstantial. In other parts of this book, protect some of the family assets from we have taken a look at why this is so claims of creditors. Also, there are planning and provided guidance on how to avoid strategies that can be utilized upon the first mistakes. The purpose of this chapter is spouse's passing to preserve and protect the to stop for a moment and focus on things assets against log term care costs.. such as why some people do not have a Sometimes a parent will hold assets plan or why those who have a plan are not jointly with one of his or her children. The maximizing its value. Let us take a look at purpose of this is to allow this child to have some of the most common mistakes that are access to funds if the parent becomes made and why they are made. disabled or incompetent. The problem with this is that on the death of the parent, 1. UNDUE RELIANCE ON this child automatically obtains full legal JOINT AND SURVIVOR ownership of the account and is not legally OWNERSHIP obligated to share it with his or her siblings. Moreover, to the extent that a child does Titling property with another as share a jointly held account with other joint owners with right of survivorship family members following the death of the is advantageous for avoiding probate parent, this child has made a gift that is administration if you die. It is entirely proper subject to federal gift taxes! It can put a in many circumstances as long as its role child in an uncomfortable position. Also, the in the overall estate plan is understood. child (and the child’s creditors) can use the However, this form of ownership has some funds for any purpose, which may not be in serious shortcomings and can lead to line with the parent’s expectations. disastrous results. A good estate plan deals with all of Many spouses hold property in this these issues. There are planning techniques manner as a way to avoid probate. The available that avoid probate without relying result is that on the death of the first spouse, on joint and survivor ownership. Other the property automatically is owned by planning techniques secure tax benefits, the survivor. They also have avoided protect assets and ensure that family wealth estate taxes because property passing to is divided equitably among family members a surviving spouse is not subject to estate in the manner that you decide. taxes. So what is wrong with this picture? The largest potential problem is that 2. FAILURE TO COMMIT they have failed to take advantage of both spouses’ federal estate tax credits. This can For some, the problem is that they know cause a significant increase in estate taxes what needs to be done but cannot make the paid on the death of the surviving spouse. commitment to get it done. Procrastination See Chapter 12: The A-B Trust Strategy is the enemy. They know they should do to review again the benefits of this tax something but need to do a little more planning technique. research before they commit. They will wait Further, many states have an estate tax until next year because they are busy now and joint and survivor property may not with other projects that they deem to be be appropriate for maximizing state estate more important. tax planning. Ohio estate tax planning is What can you say to these people? discussed in Chapter 6: State Estate and Probably not much. I tell clients that estate Inheritance Taxes. planning attorneys can make more money Another problem is that piling all of the when clients do not take their advice. Why assets up in the survivor’s estate overlooks is this? The reason is that legal fees are
Chapter 32: Ten Common Mistakes 301 Wealth Management Through Estate Planning
more on estate administration and post- Unfortunately, this happens too often. mortem planning techniques to try and fix a How do I know this? I have many new clients situation than they are for estate planning. An come in who had a plan done several years ounce of prevention is worth a pound of cure. ago by someone else and want it reviewed. Others come in and tell me that they 3. SELECTION OF THE WRONG spoke with their family attorney and he or she LEGAL COUNSEL advised them that they did not need to do A lawyer is not skilled to handle estate anything. The problems that I see are either planning just because he is licensed to ones of commission (a bad job) or omission practice law. Unfortunately, some lawyers (they were not told of all of the planning insist on doing estate techniques that should be considered planning when they for their situation). In almost every estate do not have either the planning situation I am asked to review, I skills or experience to find something that should have been done provide quality and was not or something that was not done legal correctly. advice. In today’s legal environment, you need a lawyer who has the ability to provide high quality of legal services specific to your needs. My opinion 4. BELIEF THAT YOU KNOW MORE THAN A I have never been reluctant to PROFESSIONAL There are few things more irritating to a tell clients that I am not qualified skilled attorney than having a meeting with a to handle some legal matters. I person who uses the consultation as a forum to tell her about estate planning. I have had have also told them when I am this happen to me on several occasions and not sure what the answer is to an have been dumbfounded by the intellectual arrogance displayed by some persons. They estate planning question. In the have the uncanny ability to make a little bit first situation, I will refer them to of knowledge go a long way! Undoubtedly, this is a product of the many estate planning a lawyer who does have the skills seminars and books on this topic that are they need. In the second situation, I available. Just as treatment of one medical condition will not bestow upon the patient will go out and find the answer. No a medical degree, a limited estate planning client has ever criticized me for my background cannot provide all that a law school education and years of experience candor. I suspect they respect it. gives an attorney. A second situation that also occurs infrequently is where there are clearly mandated reasons why someone should I have always felt some lawyers do not have an estate plan but for reasons even they want to say "no" to clients who are financially cannot explain, they do not choose to do successful and can afford to pay legal fees. anything. It is frustrating to know that in some Also, lawyers are trained to help people and of these cases you could save children and to say they cannot help is contrary to their grandchildren many hundreds of thousands training. of dollars if only the person would take your
302 Chapter 32: Ten Common Mistakes Wealth Management Through Estate Planning
advice. At these times, I remind myself that Where are the Will and other important it is not my money and everyone is entitled estate planning documents located? to make their own decisions regarding their The time when a loved one is lost is finances. not the time to sort out his financial affairs. It is important to retain a skilled Organization saves a lot of frustration, time professional and then rely on his or her and minimizes the chance of mistake. good judgment and advice in crafting together an estate plan. 7. IMPROPER ALIGNMENT OF ASSETS WITH ESTATE 5. FAILURE TO HAVE A PLAN MASTER PLAN The importance of carefully aligning the Many good estate planning strategies assets of an estate plan with the plan cannot are available. Some focus on asset be over-emphasized. Leaving assets just in protection planning strategies; others focus your name instead of putting them in your on tax savings. However, the most effective trust means those assets are going through estate plans are the result of a deliberate probate. Keeping all of your property as course of action, in measured steps, taken joint tenant with right of survivorship with in accordance with an overall estate plan. your spouse or one of your children leads The plan must be both comprehensive and to different issues. Are the beneficiary cohesive. designations correct on your life insurance A plan is comprehensive when it and IRA's? Are they properly coordinated includes all of the major planning strategies with your estate plan? appropriate for your circumstances. It is not just important that assets were A plan is cohesive when all of these properly aligned with the plan when strategies coordinate with each other. To you created it; asset alignment must be make an estate plan both comprehensive maintained going forward. and cohesive, it must be carried out in accordance with a master plan that has 8. LACK OF LIQUIDITY identified the planning goals and the steps Liquidity is having available financial needed to be taken in a specific order. resources to pay expenses when due. Many persons do not recognize that their estates 6. FAILURE TO KEEP lack liquidity and fail to understand the RECORDS ORGANIZED importance of this. The death of a loved one is a The need for liquidity can arise for traumatic event for the family. The pain various reasons. It might be for money to pay is compounded when financial records the last expenses of a loved one. It may be and estate planning documents are not the need for cash to provide for the support organized. of a family that has lost its bread-winner. In During our lifetimes, we do not normally many cases, the need for liquidity arises to keep our families up to date on our finances. pay substantial estate taxes at death. How can we expect them to understand our A couple who has as their principal finances if we become incapacitated or die? asset a closely held business or real estate Picking up the pieces can be very difficult. may not be very liquid. There may not be a Problems that I frequently see are a ready market for the business or real estate if result of disorganized financial records it needs to be sold on the death of the owner. where family members cannot readily Clients who have a substantial portion of determine where assets are located and their wealth in qualified plans and IRA's are what bills have to be paid. Frequently, not liquid. Yes, they can sell the stocks in families have to monitor a decedent’s mail these accounts very quickly, but the income to find out about his or her financial affairs. tax costs of distributions can be enormous.
Chapter 32: Ten Common Mistakes 303 Wealth Management Through Estate Planning
Liquidity is becoming an increasingly There are other consequences from more important issue for many estate plans. failing to periodically review an estate plan. Failure to build in contingencies to provide for Changes in the health of family members liquidity can lead to serious consequences, frequently require adjustment in the planning such as forced sale of assets at distress prices, strategies that are used. Also changes in interest carrying costs for loans and tax costs tax laws and in family wealth may require associated with liquidating assets in tax changes in the plan. deferred accounts. Finally, it is good for the estate planning lawyer to periodically review his or her work. 9. IMPROPER LIFE INSURANCE No one is perfect and mistakes are sometimes PLANNING made. A good review program can catch Life insurance death benefits are subject these mistakes and avoid the costs of errors. to federal estate taxes and sometimes to Yes, lawyers are not supposed to make state estate taxes. This does not need to mistakes but everyone does at some time. occur. Ownership of a life insurance policy by someone other than the insured keeps CONCLUSION the death benefits estate tax free. If the Commitment to a plan, attention to detail, policy is owned by a life insurance trust, placing your trust in a skilled practitioner, other important benefits can be secured as periodic review and the other things discussed discussed in Chapter 16 The Irrevocable Trust. in this chapter are all part of the recipe for It is very common to have new clients who having a successful estate plan. If you avoid face substantial estate taxes yet own their life these mistakes, then it is not difficult to have insurance. They were never advised (or chose and maintain an estate plan that provides not to take the advice) that ownership of life many benefits. insurance can be structured so that the death The one mistake that must first be avoided benefit is not only free of income taxes, but is failing to commit. If you never get started, estate tax free as well. you will never have the estate plan you and your family deserve. In fact, you will have an 10. LACK OF PERIODIC REVIEW estate plan, the one imposed by the law of Periodic review of an estate plan is very your state and federal tax law. I have not and important. There are a number of reasons will never see a client who likes the default for this. The most common benefit is that it estate plan imposed by law over the one that uncovers when clients have failed to keep we can create together. their assets lined up with their estate plan. Perhaps they move an IRA account to a new custodian and forgot to keep the same beneficiary designations. Maybe an account held joint tenant with right of survivorship was transferred to a new account held just in the name of one spouse. The failure to keep assets properly aligned can lead to serious consequences, including probate administration and increased tax costs.
304 Chapter 32: Ten Common Mistakes Glossary of Terms
ADMINISTRATOR/ADMINISTRATRIX: A person appointed by the probate court to manage or take charge of the assets and pay the liabilities of a person who died without leaving a will. If the person so appointed is a male, he is called the administrator; if a female, she is called the administratrix. See also executor/executrix. ADMINISTRATION: The management of a decedent’s estate, including the marshaling of assets, the payment of expenses and debts, the payment or delivery of devises and bequests and the rendition of an account. ALTERNATE VALUE: The value placed on a decedent’s property on a date other than the date of death. The alternate valuation date is the date on which the asset is disposed of or six months from the date of death, whichever date is earlier. An election to use the alternate value is irrevocable. It is available for the federal estate tax return. ANNUAL EXCLUSION: A gift tax exclusion of up to $13,000 per calendar year is allowed for gifts from one person to another as long as the gift is one of a present interest. To qualify for this exclusion, the donee must have an immediate right to possession or enjoyment of the property interest. APPLICABLE EXCLUSION AMOUNT: A tax credit that protects the first portion of a decedent’s estate from the federal estate tax. In 2006, the applicable exclusion amount exempts the first $2,000,000 of an estate from federal estate taxes. Also called the estate tax credit. ATTORNEY-IN-FACT: A person authorized to act on behalf of another by a power of attorney. BASIS: The figure assigned to property in calculating gain or loss for tax purposes when the property is sold or exchanged. The figure is often the purchase price plus the cost of improvements, if any, and minus depreciation, if any. BENEFICIARY: One who inherits a share or part of a decedent’s estate or one who takes a beneficial interest under a trust. BEQUEST: A bequest is a gift of personal property made by a Will. A gift of real property is called a devise. See devise. BOND: See fiduciary bond. CODICIL: A written supplement or addition to a will that adds to it or changes the will. CONSERVATOR: The person appointed by the probate court to manage the affairs of a physically infirm person. This is similar to a guardian but the appointment of a conservator is voluntary and at the request of the ward. Compare to guardian. Terms of Glossary CORPUS: The main body or principal of a trust such as money, stock or other property interests. CRUMMEY POWER: A right granted to the beneficiary of an irrevocable trust whereby the beneficiary is given the power to withdraw money or property contributed to the trust by the donor. The right of the beneficiary to withdraw this money or property creates a present interest in the property. This, in turn, qualifies the first $13,000 of each such gift for the federal gift tax annual exclusion. See annual exclusion. CUSTODIAN: A person or entity that receives property for another. Under the Uniform Transfers to Minors Act, a custodian receives property or money for a minor and retains that property or money under his control until the minor reaches 21. DECEDENT: A person who has died. DEDUCTIONS: Those items which are allowed by the Internal Revenue Code or state law to reduce the gross taxable estate of a decedent. Deductions are typically expenses of the estate such as the funeral bill or medical bills. There are also special deductions such as the marital deduction.
305 Glossary of Terms
DESCENT AND DISTRIBUTION: Descent refers to the passing of real estate to the heirs of one who dies without a will. Distribution refers to the passing of personal property to the heirs of one who dies without a will. The laws of descent relate to real property; those of distribution relate to personal property. By comparison, when a person receives either real property or personal property under a will, he or she takes that property by the terms of the will and not by descent and distribution. See intestate succession. DEVISE: The gift of real property by a Will. For a gift of personal property, see bequest. DISCLAIM: When a person disclaims an interest in property, he is saying that I do not want to receive it as a beneficiary and treat me as if I died prior to the person who wants to make a gift to me. The interest then passes to a contingent beneficiary or as otherwise provided in the estate planning documents. Disclaimers are used for a variety of estate planning reasons. DONEE: The person or entity receiving a gift from a donor. For example, the donee may be a trustee of a trust, a family member, a friend, a religious organization or a charity. DONOR: The person or entity making a gift to a donee. Also, a person who creates a trust. This person is sometimes referred to as the settlor or the grantor. DURABLE POWER OF ATTORNEY: A power of attorney that remains valid even when the principal is incompetent. See power of attorney. ESTATE TAX: The tax levied by each of the federal government and some states on the assets of a deceased person. The tax is imposed on the estate of the decedent and is paid by the estate. Estate taxes are payable nine (9) months from the date of death. ESTATE TAX CREDIT: A dollar for dollar reduction in the amount of the estate tax to be paid. See applicable credit amount. EXECUTOR/EXECUTRIX: The person nominated by a will to carry out the directions of the will upon the death of the maker of the will. If the person so nominated is a male, he is called the executor; if a female, the person is called the executrix. FIDUCIARY: One occupying a position of special responsibility or trust such as an executor, administrator, guardian or trustee. FIDUCIARY BOND: Insurance on the fiduciary (administrator, executor or trustee) administering the estate of a deceased person against that person’s dishonesty. A bond in an amount double the assets of the estate, excluding real estate, is generally required by the probate court. The requirement of a bond may be waived, and often is, by the decedent’s will. FUTURE INTEREST: An interest in real or personal property that will come into being at some future date; an interest that is not capable of being enjoyed at the present. GENERAL POWER OF APPOINTMENT: A right given to someone to designate to whom property shall pass which right is exercisable either during the lifetime of the person who holds the power or at his death. A general power can be exercised without restriction. If a person has the right to exercise a power of appointment at his death, the property over which he can exercise the power is included in his estate for estate tax purposes. GUARDIAN: A person appointed by probate court who has the legal right and obligation to take care of another person and his property because he is unable to do so himself. The person who is being taken care of is called the ward. The process of the guardian taking care of the ward is called a guardianship. GROSS ESTATE: The sum total of all the assets, tangible and intangible, of a person’s estate for estate tax purposes. The gross estate minus allowable deductions equals the net taxable estate on which the estate tax is figured.
306 Glossary of Terms death of death donor.the currently used to refer to a is that trust funded by donor the during his lifetime to avoid probate on the a will. succession Intestate is governed by lawsthe of the Social the Security Act. insurance proceeds payable to and a held property named in beneficiary a trust. having to go through take over deceased that joint tenant’s interest. persons in such a manner upon that of death the one joint tenant or survivor the automatically survivors property as property he wants and it will pass to spouse that being without taxed. in amount which means a that person can give to his spouse during his lifetime or at as death much tax federal return gift for a that property person gives to his spouse. The marital deduction is unlimited and his will is probated. donor’s lifetime as opposed to a under trust will, which does not become operative until donor the dies provides medical aid for people whose income and assets fall belowlevels. certain MARGINAL TAX RATE: TRUST: LIVING LIMITED POWER OF APPOINTMENT: WITH RIGHT OF SURVIVORSHIP:JOINT TENANTS ISSUE: INTESTATE SUCCESSION: INTER VIVOS TRUST: INTANGIBLE PROPERTY: PERSONAL INCOME: INTESTATE: PER CAPITA: NON-PROBATE PROPERTY: NET TAXABLE ESTATE: NET INCOME: MEDICARE: MEDICAID: MARITAL DEDUCTION: the trust’s operatingtrust’s the expenses. allowed by law. INCIDENT OF OWNERSHIP:INCIDENT last last dollar is subject to a 28% tax rate, marginalthe then rate is 28%. professional practice, bank booksof deposit. and Comparecertificates to representative of an item of value. Examplespatents, goodwill the are of certificates, a stock business or policy, right that is an incident of ownership. insurance policy gives policy the away but retains for himself of right the to the name beneficiary the benefit is included in insured’sthe for tax estate estate purposes. For example, if ownerthe of a life life in any way, he is said to have an incident of ownership. The legal consequence is death the that issue of her parents as well as issue the of her grandparents. Adopted children are issue also. trust’s assets. trust’s dividends and like.the Income does not normally include capital gains realized from sale the of the All persons who are blood descendants from a common ancestor. For example, a child is the In planning estate the context, earnings the of a fromtrust its investments, such as interest, A person who dies a without will dies Compare intestate. to A form of public sponsoredassistance jointly by federalthe and governmentsstate that A federal program to provide hospital and medical insurance for senior citizens under A method A of method dividing a deceased person’s among estate person’sthat next line of The income available payment the of of a for after to trust distribution beneficiary the A createdtrust during lifetime the of donor.the See probate. Some examples are held property jointly right with of life survivorship, A createdtrust during donor’sthe lifetime. It becomes operative during the The value of taking an for deductions the tax estate estate purposes after The tax rate on which last the dollar of taxable income is taxed; i.e., if the A deduction is that allowed for federalthe tax estate return and for the The manner of a distributing decedent’s when property he died without passes that Property on to personsother or without beneficiaries If an insured has powerthe to control a life insurance policy on his has that Property no value in and of itself but is See special power of appointment. descent and distribution. The holding of byproperty two or more revocable trust. tangible personal property. personal tangible testate. The term is The term
307 Glossary of Terms Glossary of Terms
descendants. All living children of a decedent and all of the children of a deceased child of that decedent each receive an equal share of the property of a decedent. For example, if a parent leaves her estate to her three children, per capita, it would be divided into thirds with each child receiving one third of the estate. If one of the parent’s children instead predeceased her leaving two children of her own, the parent’s estate would be divided into four equal shares, one each for the children and one for each of the grandchildren. Compare to per stirpes. PER STIRPES: An alternate method of dividing a deceased person’s estate among the next line of descendants. For example, If a parent leaves her estate to her three children, per stirpes, each of her children would receive one third of the estate. This is the same as a per capita distribution. However, if one of the parent’s children predecease her leaving two children of her own, the estate is divided into thirds (not fourths) and the portion that would otherwise be given to the deceased child is given in equal shares to each of that deceased child’s children. The children of the deceased child take by right of representation the share their parent would have received if living and do not take a share that is equal in amount to that which the children receive. Compare to per capita. PERSONAL PROPERTY: All property interests other than real estate, buildings and the fixtures of buildings. Personal property includes tangible personal property and intangible personal property. POUR OVER: A term referring to the transfer of property from an estate or trust to another estate or trust upon the happening of an event defined in the instrument. For example, a will may provide that the residue of the estate shall pour over to a trust established by the donor during his lifetime. POWER OF APPOINTMENT: See general power of appointment and special power of appointment. POWER OF ATTORNEY: A written document whereby a person (the principal) appoints another his agent (attorney-in-fact) and grants the authority to his agent to perform certain specific acts or deeds on behalf of the principal. PRESENT INTEREST: One that entitles the owner to immediate enjoyment of that interest as opposed to enjoyment at a date in the future. See also future interest. PRESENT VALUE: Determining the present value of an amount requires evaluating the time value of money. If a person seeks to have $10,000 in 10 years, how much will he need to invest now in one lump sum to create that amount in the future? That amount is the present value of $10,000. Conversely, how much should a promise to pay a definite sum at a fixed time in the future be reduced if that amount would be paid now. PROBATE: The legal process undertaken in a probate court to have the probate property of a decedent marshaled to pay his debts and the balance of that property distributed to his heirs and other beneficiaries PROBATE COURT: The court which has exclusive jurisdiction to supervise the administration of a decedent’s probate estate. This court also has jurisdiction over will contests, guardianships and adoptions and issues marriage licenses. The court’s primary function is to oversee the probate administration of a decedent’s estate and to supervise each estate’s executor or administrator in the carrying out of his duties. PROBATE PROPERTY: Property that is subject to probate administration such as bank accounts and real property interests that are owned solely by the decedent. QUALIFIED TERMINABLE INTEREST PROPERTY (QTIP PROPERTY): Property transferred to a surviving spouse where that spouse has a “qualifying income interest for life.” An election under the Internal Revenue Code must be made in order for property to be treated as QTIP property. If properly made, this property will qualify for the marital deduction. A decedent may create a QTIP property interest for his spouse where he wants the property to be available for the spouse’s support but does not want her to be able to control the disposition of the property on her death. This is typically done when the decedent has children from a prior marriage.
308 REAL PROPERTY: Land, buildings and things permanently attached to land and buildings. RESIDUE: The property that remains after any specific bequests, devises and legacies have been made and debts and expenses of the estate have been paid. REVOCABLE TRUST: A trust that can be changed or terminated during the donor’s lifetime. See also living trust. RULE AGAINST PERPETUITIES: The Rule states that property cannot be held in trust forever. It is derived from English common law and its purpose was to avoid having land tied up in trusts forever. The law was widely adopted throughout the United States. However, a number of states have revoked it and now allow property to be held in trust for an unlimited duration. SPECIAL POWER OF APPOINTMENT: A power that allows a person to direct who shall receive a distribution of property held in a trust. It is like a general power of appointment except that it may not be exercised in favor of the power holder, his estate or creditors of his estate. These restrictions prevent the property subject to the power from being included in the power holder’s estate for tax purposes. It is a useful tool for allowing someone to direct the distribution of property. STEP-UP IN BASIS: An increase in the income tax basis of property that occurs when a person dies and his property is passed on to others. The value of the property on the date of death becomes the new basis for the property for the persons who receive that property. A step-up in basis can provide significant capital gains tax savings on property that has appreciated during the life of the decedent. TANGIBLE PERSONAL PROPERTY: Property that has physical substance; i.e. it may be touched, seen or felt. The thing itself has value. Examples: house, car, furniture. Compare to intangible personal property. TAX BASIS: See basis. TESTAMENTARY: The disposition of property of a decedent by will. TESTAMENTARY TRUST: A trust created by the terms of the will. TESTATE: A term used when a person died having left a will. Compare to intestate. TESTATOR: A person who dies having executed a will. TRANSFER FOR VALUE: The transfer of life insurance where the transferor receives something for value in return. If this occurs, the life insurance proceeds from the policy received at death are taxed as
income, less the amount of consideration received. This result is to be avoided and there are no benefits Terms of Glossary to the transfer for value rule applying. TRANSFERS IN CONTEMPLATION OF DEATH: A transfer made under a present apprehension on the part of the transferor from some existing bodily or mental condition or impending peril, creating a reasonable fear that death is near. TRUST: A fiduciary arrangement whereby the legal title of property is held and the property managed by one party for the benefit of another. TRUSTEE: The holder of legal title to property for the use or benefit of another. Estate tax credit: This is the former name for the applicable exclusion amount. The term is still used to refer to the credit against estate taxes allowed each decedent. WARD: A person, usually a minor or incompetent, that is unable to care for their own needs and as a result is under the supervision of a guardian or conservator through the probate court.
309 "My dear Kepler, what would you say of the learned here, who, replete with the pertinacity of the asp, have steadfastly refused to cast a glance through the telescope? What shall we make of this? Shall we laugh, or shall we cry?"
--Letter from Galileo Galilei to Johannes Kepler
310
About the Author N. Lindsey Smith is a partner in the law firm of Smith and Condeni, LLP, Cleveland, Ohio. He is in charge of the firm’s Estate Planning and Business Law Group. The firm’s other area of practice is Personal Claims, covering such areas as personal injury, wrongful death, products liability, employment law and class action litigation. Mr. Smith is a graduate of Bowling Green State University and the University of Toledo School of Law. He began his legal career in 1976 as an Attorney in the Legal Department of National City Bank, Cleveland, Ohio, working for its Trust Counsel. In 1980, following this employment, he started the law firm. He has continuously worked in estate planning, probate, trust law and related areas since 1976. Mr. Smith’s experience and skills in estate planning have received significant national recognition. He has been designated as an “Ohio Super Lawyer” and recognized by Worth Magazine as one of the Top 100 Attorneys in the United States. Lindsey has also been honored as the Cleveland Society of Financial Service Professionals Professional of the Year. Mr. Smith and the other attorneys in the firm’s Estate Planning and Business Law Group concentrate all of their professional time in these areas, regularly using the planning strategies discussed in this book.
Wealth Management Through Estate Planning was written to assist the layperson and allied professionals in the fields of life insurance and investment planning in understanding many of the important concepts and planning strategies that have made this such an important topic to so many Americans. Wealth Management takes a serious look at many aspects of estate planning including: ◆ How to Avoid Probate ◆ Asset Protection Planning ◆ Charitable Giving ◆ Strategies to Reduce Estate ◆ IRA Distribution Rules ◆ Business Succession Planning Taxes ◆ Dynasty Planning ◆ Most Common Mistakes ◆ Health Care Powers ◆ Life Insurance Planning ◆ Selecting an Attorney ◆ Financial Powers of Attorney ◆ Gifting Strategies ◆ How to Get Started ◆ Living Wills ◆ Family Partnerships ◆ Life Care Planning
Smith and Condeni LLP 600 East Granger Road Brooklyn Heights, Ohio 44131 (216) 771-1760 Fax (216) 771-3387 (888) 333-7955 www.smith-condeni.com
PRINTER: Add bar code here at proper size. To be supplied by Smith Condeni or outside vendor.