Dying with Debt

Up to this point, Plainly Legal has focused on topics dealing with the transfer of wealth, either through lifetime gifts or at death. Today's blog takes a detour to discuss the question of what happens with a person's debt when they die. Recently, a friend contacted me with a question about information she received from someone at her bank when she attempted to designate beneficiaries for her bank accounts. This bank employee (I did not ask which bank or the job title of the employee) told her that she should not designate a beneficiary because, if she were to die with debt that debt would then pass to her loved ones. Before continuing with today’s blog, it is important to emphasize:

THAT STATEMENT IS SIMPLY NOT TRUE.

The good news is that personal debt is non-inheritable. If a person incurs debt during their lifetime, the beneficiaries of the person’s estate, no matter if they are beneficiaries through a Will, Trust, or the Intestacy Statutes, are not personally liable for any debt left behind. This does not however mean that debt disappears at death.

When a person with personal debt dies, that person's debt becomes the liability of the person's estate. Creditors are then free to try to collect on that debt from the estate. It is the responsibility of the Personal Representative (and Trustee) to pay the enforceable debts of the deceased prior to making distributions to the beneficiaries. To ensure that creditors receive payment prior to making distributions beneficiaries, the Michigan Probate Code mandates that the personal representative of the estate is required to publish a death notice (to inform unknown creditors) and provide notice to known creditors. Those creditors then have four months to present their claims to the Personal Representative. After the four-month window, with some exceptions, the probate statute bars creditors’ claims against the estate.

When a creditor makes a claim against an estate it is the responsibility of the personal representative to determine if the claim is valid and, if so, to provide payment to the creditor. While the personal representative is responsible for making these decisions, they do so in a fiduciary capacity and upon determining that a claim is valid, pay the claim with the estate's assets. Absent extraordinary circumstances, the personal representative is never personally liable to pay the debts of the estate they represent. The practical result of this situation is that a personal representative may determine that a creditor’s claim is valid, but the estate lacks the assets to pay the debt. In that situation, neither the personal representative nor any beneficiaries of the estate become personally liable for the unpaid debt.

At this point, it is important to address a number of minor exceptions to these rules, the largest of which being that the four-month claim window becomes a three-year window if the Personal Representative fails to properly publish notice of the death or fails to inform a known creditor of the death (a "known creditor" is a creditor that's existence is known or reasonably discoverable by the personal representative). A second common exception is that the four-month claim window does not apply to any form of secured debt, such as a lien or mortgage. In almost every circumstance, the holder of a secured debt has the right to enforce their security agreement and take possession of the property in which they have a security interest. For example, a bank may repossess a house that is subject to a mortgage owned by the bank if the estate is unable to make payments on the bank’s loan.

Since probate law requires that creditors receive payment prior to distributions to almost all beneficiaries (there are exceptions for a limited number of distributions to a surviving spouse and minor children), it is possible that the estate assets can be exhausted before a beneficiary receives anything from the estate. In the event that the debts of an estate exceed the estate assets the beneficiaries receive nothing, however those beneficiaries do not incur liability for unpaid debt because of their status as beneficiaries.

While it is the responsibility of the estate to pay the deceased's debts prior to making distributions there are certain assets that are never accessible to the creditors of the estate, including retirement benefits and life insurance proceeds. While creditors cannot attach the assets of a person’s IRA in order to recover debt, once a person receives a distribution from the IRA, creditors can attempt to recover those funds if the person deposits them in a bank or other financial institution. When the owner of an IRA dies with debt the distributions to the beneficiaries of an inherited IRA are protected from the original owner’s creditors. This is true even if the IRA beneficiary is a Trust or the estate.

 We now reach the situation my friend encountered on her trip to the bank. Unlike IRA accounts, beneficiary designations on bank or investment accounts do not enjoy the same protection from the original owner’s creditors. While a beneficiary designation causes those accounts to pass directly to the individual named in the designation, such designations do not limit the rights of creditors of the previous owner. This does not mean that someone named as the beneficiary of a bank account becomes liable for the original owner’s debts. In practical terms this means that a creditor can recover assets in a bank or investment account transferred via beneficiary designation, but that creditor still may not recover in excess of the assets transferred from the deceased individual.

Substantial debt is an understandable concern for many people these days. It is important to remember that when you or your loved ones die, personal debt generally becomes the responsibility of the deceased person’s estate, for the Personal Representative to pay before making distributions to other beneficiaries. Payment of these debts can consume the assets of an estate, but in that circumstance the beneficiaries are not liable for debt in excess of the estate’s assets.

 It is just as important to consult reputable source when dealing with debt as it is when making decisions regarding other planning. While employees of financial institutions may seem like knowledgeable sources of information, you should be aware that not every employee receives the same training. If you have doubts as to the accuracy of information you receive, ask to speak with a manager, contact your attorney for a second opinion, or send us a message and we will attempt to address your issue, directly or in an upcoming blog. 

It is Better to Give than Receive

At this time of the year, our thoughts turn to the holidays and sometimes we get caught up in the hustle and bustle of shopping, parties, family gatherings, and religious services. Our minds race with countless questions; what should I get for everyone; what am I getting; where are we going; what time is that party; and will I survive the stress?

In addition, we also take time to reflect on the blessings of our family, friends, and business acquaintances. We remember that not all people are so fortunate and we reach out a hand to our fellow man through acts of charity. We all feel warmer inside after giving, whether to the Salvation Army Red Kettle at the mall, to our own church or temple, to the local food kitchen, or to countless other groups that seek to assist those in need or find cures for medical conditions. Not only does charitable giving feel good, but also it is good for you.

•      Charitable contributions are income tax deductible: Gifts made directly to charities are income tax deductible and reduce your taxable income in the year of the contribution, if the charity receives the gift by December 31.
•     Charitable contributions are not counted when determining estate tax liability: The value of gifts made at death reduce your taxable estate, saving 35%-50% depending upon the current estate tax rate
•     If structured properly, charitable contributions may avoid capital gains on highly appreciated property: By executing a charitable trust, it is possible to provide funds to charities while also gaining additional tax advantages.

USING CHARITABLE TRUSTS

Some people want to retain control over assets they intend to give away, allowing them to take advantage of a current or future income stream while also guaranteeing a benefit to their favorite charities at some point in time. Achieving these goals is possible with a charitable trust. Charitable trusts take advantage of the differences between present interests (or as I like to refer to them “here” interests) and future interests (“hereafter” interests) to provide benefits to trust beneficiaries.

A Charitable Remainder Trust (CRT) allows you to receive the current income stream from assets transferred to the trust and distributes the remainder portion to the charity after a specified time, or at your death. You get to enjoy the “here” and the charity enjoys the “hereafter.” Through the use of a properly structured CRT, you, your heirs and your chosen charities all benefit, and the IRS receives nothing

The CRT is especially useful where the transferred asset is highly appreciated. If the CRT trustee sells appreciated property, following the property’s transfer to the CRT, there is no capital gains tax liability (unlike if you sold the property yourself). This results in the availability of more assets to provide greater income in the “here.”

While any distributed trust income is taxed to you as ordinary income or capital gains, depending upon its character, you may consider leveraging the CRT by using such income you receive to fund gifts to an Irrevocable Life Insurance Trust so your heirs can receive more value at your death without it being subject to income or estate taxes. Alternatively, some people name their children or grandchildren as the current beneficiaries of the CRT to provide those beneficiaries with income taxed at a lower rate than if the grantor of the CRT took distributions directly.

A final thought on the use of CRTs, the amount of the income tax deduction for contributions to the CRT is determined using IRS tables. The longer the period before the charity gets complete control of the trust property, the smaller the deduction you are able to take.

A Charitable Lead Trust (CLT) functions similar to a CRT but provides for the charity in the “here” by giving the charity the current income stream from assets transferred to the trust and for other beneficiaries in the “hereafter” by distributing the remainder portion to family members after a specified time or your death. Again, the amount of the income tax deduction for contributions to the CLT is determined using IRS tables. The longer the period the charity gets the income from the trust property, the smaller the gift to the remainder beneficiaries, and the larger the deduction you are able to take. However, tax rules require you pay tax on the income as the charitable beneficiary receives in order to take the immediate charitable income tax deduction. By making use of a CLT, you can fulfill your charitable inclinations, shift income and assets to eventual beneficiaries with little gift tax cost, and remove assets form your estate. 

The CRT and the CLT both serve as excellent methods of charitable giving as part of a larger estate plan. If however your charitable inclinations include a long-term, active charitable commitment, it may be appropriate to consider organizing your own Charitable Foundation. While creating and maintaining a Foundation requires substantial administrative effort, the use of a Foundation allows you to receive charitable tax deductions, manage the long-term distribution of assets, choose and change which charities benefit from your philanthropy, and potentially provide a vehicle for a multigenerational commitment to doing good works.

No matter how you decide to satisfy your charitable wishes, with proper planning you can benefit your favorite causes, shift income and assets from your estate to other family members and teach your children and grandchildren the lesson of doing good works. If you have specific questions regarding charitable trusts and foundations, feel free to email us or leave them in the comments section.

Happy Thanksgiving

From Alan, Matt, and everyone at Finkel Whitefield Selik, have a safe and happy Thanksgiving.

Take the time to enjoy time with friends and loved ones, enjoy a parade, root on the Lions, and give thanks.

Also if you decide to deep fry your turkey, make sure to take special care. Desire for a delicious dinner shouldn't result in a fire ball.




If you have any problems today, hopefully the kind people at 1-800-BUTTERBALL can be of assistance. 

The Benefits of an IRA Trust

As we have discussed in previous posts, there are many forms of trusts used in the estate planning process. A special type of trust, known as an “IRA Trust,” is a stand-alone trust, separate from a Living Trust that acts as the beneficiary of IRAs or retirement benefits. The provisions of an IRA Trust satisfy all of the regulations related to the distribution of IRAs and retirement benefits, allowing the beneficiaries to take advantage of their inherited benefits over their lifetime.

While there is nothing barring a Living Trust from being the beneficiary of an IRA, due to the regulations that govern the distribution of retirement benefits it may be difficult if not impossible to take advantage of the most beneficial distribution rules or provide for a lifetime distribution of benefits using only a standard Living Trust. For example, if the Living Trust beneficiaries include charities the Living Trust will not qualify as an "individual beneficiary" and thus the non-charitable beneficiaries will not benefit from the ability to “stretch out” the IRA benefits. In addition, if the Living Trust benefits elderly relatives, the shorter life expectancy of those relatives limits the ability to stretch out distributions and delay or defer income taxation for younger beneficiaries because the regulations base MRD on the life expectancy of the oldest beneficiary. The provisions of an IRA Trust avoid these problems and ensure that the IRA Trust’s beneficiaries enjoy the greatest benefit from their inherited asset.

The beneficiaries of the IRA Trust can be the same as those of the client's Living Trust. However, the distribution terms of an IRA Trust terms are often different from the Living Trust and frequently more restrictive in order to ensure that no matter what happens to the Living Trust assets, the IRA Trust assets will be available to help support children, grandchildren and other beneficiaries. Alternately, an IRA Trust can divide assets between different groups of beneficiaries. For example, the Living Trust may benefit a second spouse while the IRA Trust has children and grandchildren as beneficiaries. Finally, an IRA Trust can help beneficiaries in more difficult or complex situations, such as beneficiaries who are:

1. Spendthrifts and unable to handle money
2. Children with addictions
3. Children with creditor issues
4. Children with bad marriages
5. Special care needs children, including those who qualify for government benefits
6. A surviving spouse who is  unable to say no when children ask for money

In these situations, the IRA Trust Trustee can provide professional management of Trust assets, allowing the IRA assets to grow tax deferred, except for required distributions, and ensure that the beneficiaries do not waste those distributions.

If there are multiple beneficiaries, IRA Trusts are drafted and coordinated with the beneficiary designation of the IRA to allow each of the beneficiaries to use their own life expectancy in determining the minimum required distributions. For example, the beneficiary designation after the death of the client should read as follows: “50% to the sub trust for the benefit of Jane Doe under the John Doe IRA Trust.” With proper drafting, an IRA trust can provide not only for children, but grandchildren and beyond, allowing multiple generations to take advantage of the IRA benefits. In those circumstances, the IRA Trust is often known as a "Dynasty Trust" because it can provide for multiple generations.

Just like a Living Trust, the distribution provisions of an IRA Trust dictate how the beneficiaries receive distributions. One design option for an IRA Trust is the "conduit trust", under which the trustee has no power to accumulate plan distributions in the trust and must allocate any distribution received from the IRA or retirement plan to the beneficiaries. The conduit trust lessens the trustee’s ability to control the income but still allows control over principal distributions as necessary.

Alternatively, when it is desirable or necessary to impose greater control upon the dispersal of the RMD, an "accumulation trust" allows the trustee to hold the RMD in trust for the beneficiary’s benefit. For example, if the beneficiary of the IRA Trust is special needs child, it is important to limit income distributions in order to avoid adversely affecting the beneficiary's right to receive state or federal benefits. It is important to remember however when using an accumulation trust that the federal government taxes income received from the IRA but not distributed to beneficiaries according to the potentially higher trust income tax rates.

Whether a client wants to provide for multiple generations, ensure a lifetime of income for a beneficiary in a difficult personal or financial situation, or simply ensure that different groups of beneficiaries receive the asset that provides them the greatest value, an IRA trust is an extremely useful tool for a wide variety of situations. Due to the complexities surrounding IRA and retirement plan distributions, it is important to work with experienced estate planning attorney familiar with those regulations in order for an IRA Trust to achieve a client's goals.

2012 Tax Planning - Splitting Inherited IRAs

For individuals who inherited a share of an IRA from an IRA owner who died in 2011, December 31, 2012 is an important deadline. This is because the regulations that govern distributions from inherited IRAs require that beneficiaries make decisions regarding the division of inherited IRAs on or before December 31 of the year following the death of the IRA owner. When there are multiple beneficiaries for an inherited IRA, splitting the IRA account into separate accounts for each of the beneficiaries has the potential to yield important tax and investment benefits.

Death beneficiaries of an IRA must take distributions from the IRA either (1) fully within five years or (2) in annual distributions over their life expectancy. The regulations that govern IRA distributions require that, whether the IRA owner died before or after his required beginning date (generally age 70 1/2), if the IRA owner was older than the beneficiaries, the remaining IRA balance is paid out over the remaining life expectancy of the beneficiary. Generally, when there are multiple beneficiaries of a single IRA, those beneficiaries must use the life expectancy of the oldest amongst them (i.e. the shortest life expectancy) when calculating the Required Minimum Distributions (RMDs). This requirement places younger beneficiaries at a disadvantage because the inherited IRA makes larger annual distributions over a shorter time, triggering potentially greater income tax liability.

For example, John designated his children, Bill and Mary, as equal beneficiaries of his IRA. John dies in 2011 at the age of 75 when Bill is age 55 and Mary is age 40. Under the default scenario, Bill's life expectancy dictates the RMDs for both Bill and Mary. Presuming they each are entitled to $500,000 from the account, in the first year the RMD using Bill's life expectancy is almost $17,000. If Mary could calculate the distribution using her life expectancy, her initial distribution would be only about $11,500. The size of the distributions will only accelerate as Bill gets older.

Fortunately for those younger beneficiaries, if they take advantage of the distribution regulations in a timely manner, they can split the IRA into separate accounts and the RMD rules will apply separately to each account. Following the split, each beneficiary will use their own life expectancy in determining the RMDs. Thus, Mary’s required distributions will be smaller than if she were required to use Bill's life expectancy. In addition, Mary would also have more freedom to invest her portion of the IRA, as her investment philosophy is likely to be more aggressive than Bill’s due to the difference in their ages.

In order to take advantage of this opportunity, recent IRA beneficiaries must direct the IRA trustee to split the inherited IRA into separate and equal IRAs no later than December 31, 2012, making each individual the sole beneficiary of their share of the IRA. Additionally, the trustee must allocate all post-death investment gains and losses for the period before the establishment of the separate accounts to each account on a pro rata basis in a reasonable and consistent manner. After establishing separate IRA accounts, each account owner can provide for separate and distinct investments depending upon the needs of the beneficiary's with gains and losses from the investment of the account allocated only to that account.

Time is running out for the beneficiaries of IRAs inherited in 2011 to make this decision. It is important that beneficiaries and their financial advisors communicate regularly to ensure the ability to take advantage of opportunities such as this. The law governing IRA distributions is both long and complex. This article addresses only the potential to split inherited IRAs into separate accounts for each beneficiary, if you have additional questions or concerns regarding IRA distributions please feel free to leave us a comment, send us an e-mail or call us.

An Introduction to Medicaid Planning

Based on a September 2011 poll, conducted by NPR, the Robert Wood Johnson Foundation, and the Harvard School of Public Health, less than 5% of adults considered Medicaid when asked how they would pay for long-term elder care. This stunningly low number sheds light on the fact that while people are living longer and are more aware of the potential need for long-term care as they age, they are unaware of an important method of paying for that care.

Medicaid is a federal program, administered by the states, that pays for nursing home care for individuals who meet the program’s medical, income, and asset requirements. The current average yearly cost of nursing home care in Michigan exceeds $85,000 for a private room. At that rate, even a period of two to three years will deplete the savings of the average person, leaving any surviving spouse with little money to use for their own care. If however, an individual is eligible for Medicaid benefits, the program covers the majority of that cost. The phrase "Medicaid Planning" has become a catchall for the methods used to allow an individual to qualify for Medicaid benefits, while preserving a greater portion of their assets for the well-being of their loved ones.

As a potential applicant contemplates whether to engage in Medicaid planning it is important to consider to consequences and benefits of qualifying for Medicaid. The largest benefit is the applicant’s assets are not consumed by years of expensive medical bills. For a married couple, this insures that the spouse who is not in need of nursing home care has the assets to provide for their own needs. For a single applicant, Medicaid Planning can result in more of the applicant’s assets being passed on to their loved ones.

The consequences of qualifying for Medicaid include the need to leave a home and reside in a nursing home. When faced with that reality, many potential applicants realize that staying in their own home is more important than passing assets to their children. A second often forgotten consequence is that while Medicaid pays for a great deal, if an applicant needs to spend assets in order to qualify for Medicaid, those assets are not available if they are needed for some reason in the future.

Applying for Medicaid benefits is not something to engage in lightly, especially for potential applicants who presently have significant assets, which they could use to pay for care. Proper Medicaid planning is more than spending, giving away, or attempting to protect assets to reach Medicaid’s eligibility requirements. The rules governing Medicaid eligibility consider more than a person’s present financial condition and impose a penalty period of Medicaid ineligibility if the applicant divests wealth to become eligible for Medicaid. The Department of Human Services (DHS) "looks back" 60 months from the date of a person’s application for benefits to determine if that person has given away assets that would impose a penalty on eligibility. There are however ways to spend down assets legally to reach the eligibility threshold.

The first and easiest method requires the client to own a home. DHS considers a single home an exempted asset when determining whether a person meets the asset threshold for Medicaid benefits. The personal property within that home is also exempt. Therefore, a person can pay off mortgages, make necessary repairs, make improvements to the home to increase its value, and purchase new furnishings. All of these techniques are especially useful if one spouse of a married couple needs to take advantage of Medicaid. In addition to the home and personal property, a single car is an exempt asset, this is true even if the applicant never drives the car. Another item that DHS classifies as an exempt asset when determining eligibility for Medicaid, as a pre-paid funeral contract. While many people find it difficult to even think about planning their own funeral, but by taking the time to make those decisions that will eventually become necessary, a Medicaid applicant can both ease the burden on their love ones after their death and remove assets to help qualified for Medicaid.

While spending down assets is a viable method of reaching the Medicaid eligibility threshold when an applicant has few assets, there are times when an applicant desires to qualify for Medicaid, frequently because they are aware that their condition is likely to be prolonged and expensive, leaving them with nothing to pass on to their loved ones, that require more advanced planning.

While it is possible to engage in planning that will assist a potential applicant in becoming Medicaid eligible, the scope of that planning varies greatly based upon the applicant’s present circumstances. Different methods are used when the applicant has a living spouse who is not in need of Medicaid benefits than would be used for a widowed applicant. Furthermore, in a situation where both spouses will potentially require substantial long-term care, still other methods can assist in preserving more assets to pass on to beneficiaries. The complexity of this advanced planning makes it unsuitable to discuss at length in this forum. In addition, potential applicants are cautioned not to attempt such advanced planning without consulting an attorney versed in Medicaid regulations.

 Medicaid planning is a complex area of law, but one with potentially large benefits. Whether a person needs additional care in the near future or simply is aware of the potential need for that care later in life, the proper preparations today, including a complete estate plan, a plan for regular annual gifts, and understanding the pros and cons of the Medicaid program, can insure that any long-term elder care does not leave their loved ones in dire financial straits. 

Using an LLC in your Estate Plan

While trusts of various kinds are important in estate planning, other entities, standing alone or used in conjunction with trusts, are useful in achieving estate planning goals. One such entity is a Limited Liability Company.

A Limited Liability Company (LLC) is a business entity often used instead of a corporation or partnership. It is a hybrid entity that provides the benefit of limiting liability against personal assets for its owners (just like a corporation) as well as the benefits of being taxed for income tax purposes like a partnership.

By establishing an LLC with a "voting interest" component (typically 1%) and a "non-voting interest" component (99%) clients can give away assets, while maintaining substantial control over the administration of those asset during the client’s lifetime. The client (typically a parent) can keep the voting interest and give part or all of the nonvoting interest to children, grandchildren, or other beneficiaries. By retaining the voting interest, the parent maintains control of the operation of the LLC and the assets owned by it, yet is giving away value and future appreciation on the gift portion to others. I liken this to the client sitting in the front seat driving the car and his beneficiaries sitting in the backseat coming along for the ride. By giving away the majority of the non-voting interest during their lifetime (ideally using their Lifetime Gift Tax Exemption), the client reduces the total value of their estate and any potential Estate Tax liability. Another benefit of using the LLC strategy is a potential reduction in the client’s annual income taxes. If the LLC earns annual income, the LLC allocates that income in proportion to the owned interests. Thus instead of the client paying taxes on all of the income, the beneficiaries pay (presumably in a lower bracket) the tax on their share of the income.

The client can transfer any type of asset to the LLC, including cash. Transferring closely held businesses and real estate to an LLC provides additional planning opportunities:

1.    If structured properly, the LLC can take advantage of valuation discounts for minority interests and lack of control. In addition, assets such as real estate and closely held businesses tend to have a range of value rather than a specific value, and the client can take advantage of the lower range of the value in order to make more gifts under the Annual Gift Tax Exclusion or the Lifetime Exemption. It is important, if an LLC desires to take advantage of these valuation discounts, that a valuation expert determines the assets themselves and the valuation discount.

2.   Using an LLC offers the ability for business succession planning and provides a platform for determining who will operate entities in the future.

3.    An LLC provides protection against creditors, both for the client and the succeeding generations.

4.    The LLC offers an ability to plan for estate liquidity by purchasing life insurance in the LLC on the life of the client to eventually purchase the un-gifted client interests at the client's death or simply to replace the "client's wisdom and experience" with cash at death.

Clients can transfer an LLC interest as a gift to an individual or as a gift to a trust set up for the benefit of the individual. This is especially beneficial if a beneficiary has creditor issues, marital issues that may result in divorce, or spendthrift issues and an inability to control spending habits. In addition, gifting an LLC interest to a trust for the benefit of a minor allows for protection well beyond the minor's 18th birthday. The trust can specifically provide for income and principal distributions for the benefit of the minor with the eventual distribution at stated ages or certain events.

While the concept and use of an LLC for estate planning purposes is well-established, it is subject to IRS attack if not properly valued or if not appropriately established:

1.    The LLC must comply with all state law rules for establishing such an entity and must continue to maintain all the required documents. The LLC must be managed and operated as a separate entity and not just another "pocket of the client".

2.    With an LLC, the concept of "if some is good, more is better" is not necessarily a good idea. Clients should not transfer all of their assets to an LLC, because the IRS will argue that the client needs the LLC to maintain their lifestyle and therefore under estate tax rules the assets are deemed to be part of the client’s estate. Based on case law it is an especially bad idea to place the client's residence in the LLC.

3.    When making gifts, valuations are necessary to substantiate the amount of the gift. To the extent the gift is in excess of the $13,000 annual exclusion, a Gift Tax Return is required.

4.    Certain specific provisions must be included in the LLC to protect its integrity, ensure that gifts will be recognized, and allow gifts to be claimed as a "present gift" using the Annual Exclusion.

Use of an LLC for estate planning purposes is an excellent strategy in the right situation. It may be especially appropriate for any clients still interested in making large gifts before December 31, 2012 to take advantage of the $5,120,000.00 lifetime exemption, which may be going away in 2013. However, before taking any steps to include an LLC in an estate plan, clients should carefully review all tax and legal requirements with qualified professionals.

The Value of Annual Gifting to an Estate Plan

As we assist a client preparing their estate plan, we must be aware of a number of factors, one of which is a desire to minimize the amount of assets subject to the Federal Estate Tax. The Federal Estate Tax is the tax levied when the estate of a decedent transfers assets to beneficiaries. Currently the first $5,120,000 transferred is exempt from taxation (this is the “Estate” portion of the Estate and Gift Tax Lifetime Exclusion). The value of gifts (other than "Annual Exclusion" gifts which will be discussed later) that the decedent made during their lifetime reduces the $5,120,000.00 exclusion dollar for dollar (this is the “Gift” portion of the Lifetime Exclusion). After a person has exceeds the $5,120,000.00 mark, further gifting (either during life or at death) results in a tax liability. Keep in mind, each person has their own Lifetime Exclusion, so married couples can transfer  more than  $10,000,000.00 before incurring any tax liability, and the present law even allows a widow to use their deceased spouse’s unused Exclusion.

For most clients, knowing that they need to give away $10,000,000 before the IRS comes knocking is reassuring. It means that even if they succeed in accumulating a substantial estate, they can make gifts with little worry about paying anything extra in taxes. You likely remember however that the current $5,120,000 Lifetime Exclusion is scheduled to decrease to $1 million beginning in 2013. In addition, the top tax rate for gifts is scheduled to increase from 35% to 55%. If Congress does nothing and the default outcomes occur, this change will pace increased emphasis on clients addressing their lifetime gift planning now. Last week we addressed the possibility of making large lifetime gifts before the end of the year in order to take advantage of the current Estate and Gift Tax Lifetime Exclusion. It is important that clients look at those options before the end of the year. However, even if a client is not interested in making large gifts, the client can benefit loved ones by making gifts using another exclusion, the Annual Gift Exclusion.

The Annual Gift Tax Exclusion allows a person to make gifts of $13,000 or less to as many people as they desire each year, whether or not they are related, without incurring any tax liability and without using any portion of the Lifetime Exclusion. This means that a person with two children and four grandchildren could make Annual gifts of $13,000 to each of those people (totaling $78,000) without using any of their Lifetime Exclusion. As with the Lifetime Exclusion, the Annual Gift Exclusion is unique to each person, so a married couple can each make gifts to children and grandchild (using the example above a married couple can give away $156,000 each year without incurring any tax liability). While clients only should make such gifts if they are comfortable they have sufficient assets for their own  needs, a schedule of regular gifting can reduce the assets of person to the point where their estate has minimal tax liability.

For clients that worry that making substantially lifetime gifts will negatively effect their beneficiaries, due to concerns over addiction, problem marriages, or even a concern that the beneficiary will work less due to the Annual gift, additional planning can allay these concerns.

A primary tool to delay a beneficiary’s access to gifted funds is an Irrevocable Trust for the beneficiary’s benefit. The client makes the annual gifts to the Trust, thus limiting the beneficiary’s use of the gift subject to the terms of the Trust. Frequently, the terms of the Irrevocable Trust are similar to the terms of a client’s Living Trust, such that a beneficiary is able to request funds from the trustee for a limited number of reasons and then receives distributions of principal following the client’s death.

A gift to an Irrevocable Trust for a beneficiary must be a "present interest" in order to qualify for the Annual Gift Exclusion. This means that a beneficiary must have the right to immediately take possession of the gift and use the gift as the beneficiary pleases. However, by using a “Crummey Notice” a client is able to side step this limitation. As we have previously discussed while discussing Irrevocable Life Insurance Trusts, a “Crummey Notice” informs a beneficiary of their right to withdraw the Annual gift for a limited period of time, otherwise that gift becomes part of the trust for the beneficiary’s benefit. Most beneficiaries are aware that future gifts may be conditional upon the beneficiary's willingness to let the "Crummey Notice" period lapse and allowing the gift to be held in trust. For minor beneficiaries “Crummey Notices” are signed by Guardians, thus for clients making gifts only to their own minor children, husbands may sign the “Crummey Notice” for the wife’s gift and vice versa.

An additional tool for gifting to minor children is the §529 Education Savings Plan. The primary advantage of a §529 plan is the earnings of the plan are not subject to Federal Income tax and generally not subject to State Income tax when used to pay for “qualified education expenses” including tuition, books, computers, and room and board. While contributions to such plans are not deductible from Income tax purposes, §529 plans do allow individuals to pre-pay up to five years of contributions in one year, which will count as gifts made in the current year and the following four years. Using the example above, the couple with four grandchildren can contribute $130,000 in the first year to a §529 plan for each grandchild, totaling $520,000). §529 plans are flexible and there is no penalty for changing the beneficiary from one family member to another or for combining §529 plans with the same beneficiary. When clients desire to provide for education of family members and have the  ability to pre-pay contributions, §529 plans are an excellent part of a schedule of regular gifting.

A final method of gifting involves the direct payment of medical care and tuition expenses. Using this method, a person may make unlimited payments, directly to a school or medical provider, for the benefit of another person. Gifts made in this fashion do not count toward either the Annual Exclusion or the Lifetime Exclusion. The Internal Revenue Service broadly defines the meaning of medical care to include not only diagnosis, treatment, and prevention of diseases but also payments for transportation to such care and payments for qualified long-term care services. Tuition gifts can pay for both private and public institutions and are not limited to college tuition, private primary and secondary school tuition is also payable. The key for a client making use of this method of gifting is making payment directly to the school or medical provider.

As we have said both earlier in this post and in discussing large lifetime gifts, before making any gift it is important to consider the consequences of that gift. Clients should consider the impact on their own lives, the chance that they will need the gifted funds later in life, and the impact on the beneficiary receiving the gift to determine if the benefits of gifting outweigh the potential consequences. Using the Annual Gift Tax Exclusions and the Lifetime Estate and Gift Tax Exclusion may require the filing of Gift Tax Return, and  making gifts to and Irrevocable Trust requires the existence of a valid trust, so clients should make sure to include their attorney and tax professional are a part of the planning process. Annual gifts are an effective way to pass assets on to future generations without the expense of additional tax liability. The sooner a client begins a regular gifting program, the more effectively they can make use of the process.

Taking Advantage of the Present Gift and Estate Tax Lifetime Exemption

           Many years ago, I stopped trying to use a "crystal ball" to determine what Congress would do with estate tax law. I can only counsel my clients about what the current law is and what opportunities are available today.

           

           As many commentators have discussed, one planning opportunity available through the end of 2012 is the ability to make large lifetime gifts to remove significant assets from an estate before death. The Gift and Estate Tax Lifetime Exemptions are currently $5,120,000.00. This means that in 2012, an estate having a net value of $5,120,000 or less is completely exempt from Estate Tax. In addition, this exemption allows individuals to make large gifts during 2012 that are not subject to the Gift Tax. In 2013, the exemption drops to $1,000,000.00 unless Congress decides to extend or modify the current law in some way.

           By taking advantage of the higher Lifetime Exemption in 2012, clients can make gifts to children and other beneficiaries without any out-of-pocket cost for Gift Tax. In addition, gifts in 2012 can save future estate taxes by removing future appreciation on the gifted assets. Gifts made to multiple generations (e.g. children, grandchildren, etc.) this year, also can avoid any Generation-Skipping Transfer Tax. 

           While taking advantage of this strategy has the potential to reduce the taxes imposed upon large estates, the "tax tail should not wag the dog". This means that achieving a client's goals for their estate plan should take priority over the desire to avoid paying taxes. Before the client takes the steps necessary to utilize this strategy, it is important to ask the following questions:

1. Can I afford to make a large gift?
2. Will I need these funds in the future?
3. Am I concerned that my heirs will not be able to manage the assets I give or may have creditor or divorce problems?
4. If I make gifts, do I want them to be outright gifts or do I prefer gifts into irrevocable trusts for control purposes?

           The client should be careful about gifting any assets they may need to maintain their lifestyle later in life. What is given away cannot be returned without incurring gift tax, income tax and estate tax consequences. The client must be comfortable with giving up control and the use of the asset, subject to restrictions that can be placed on a beneficiary's use. 

           If the client can afford to make a large gift and is comfortable doing so, it is probably advantageous, especially if the tax rates increase from the current 35% maximum bracket to the 55% maximum bracket, as is scheduled in 2013, and the lifetime credit drops to $1,000,000.00. Presuming appreciating assets, heirs can receive significantly more in assets and appreciation from a large gift in 2012 rather than after-tax distributions at death. 

           Two words of warning, first under current law, the donee of a gift receives the donor's income tax basis in the gifted property, while the beneficiary of most inherited property will receive a "step up in basis" to the date of death fair market value of the inherited property. While making a gift may avoid Estate Tax, it may also create additional capital gains income tax when the asset is later sold. Consideration of the income tax consequences should be part of the pre-gifting analysis. Second, there is the possibility that there will be a "tax clawback" in future legislation. That is, an added Estate Tax that takes back some of the tax-free benefits of the 2012 gifts. In the current law, it is not clear that gifts made in 2012 using the larger Lifetime Exemption cannot be added back to the estate of a client who made large gifts, resulting in the imposition of a larger Estate Tax burden at death if the exemption is only $1,000,000 at the time of death. 

           If the client is inclined to take advantage of the current legislation, there are a number of strategies for using the current lifetime exemption to make large gifts, including:

1. Outright gifts to beneficiaries of real estate, business interests (corporations, partnerships and LLCs), investment assets and even cash with no restrictions. If the client gives minority interests in entities, the client can maintain control of the entity, and may even be able to take advantage of minority valuation discounts when determining the value of the gifts made.
2. Gifts to irrevocable trusts for the benefit of minors or children with creditor issues, suspect marriages, or spending problems with provisions that protect these beneficiaries and distribute assets over time. The only limit on restrictions is the imagination of the grantor. The trust can be designed to provide maximum flexibility for distributions to beneficiaries yet protection of the principal.
3. Gifts in trust for a spouse, with the remainder going to children and grandchildren after the death of the spouse. The trust, a "spousal limited access trust", can be designed as a "grantor trust" where the person setting up the trust is considered the owner for income tax purposes, yet is not considered the owner for estate tax purposes. The spouse can receive income and/or principal, which allows the grantor to enjoy the benefits of the trust assets. It may be possible for the beneficiary spouse can even have the right to appoint his or her trust rights back to the grantor at their death without it being considered in the estate of the grantor at the grantor's death. This allows the grantor to continue to have use of the assets
4. Gifts to an irrevocable trust can be used purchase life insurance on the grantor. The gift can provide a significant multiple of insurance coverage, thus providing greater benefit to beneficiaries should
5. For those trying to ensure the maintenance of a family vacation home for the future, that client may want to consider gifting a 49% interest in the home to children, either outright or in the form of an LLC interest. Using this method the client can maintain control of the home and there will be no change in the status for property tax purposes.
6. Gifts of property to "grantor trusts" and then the purchase of assets by the grantor for cash or a promissory note. This type of strategy allows the trust beneficiaries to receive interest income during the repayment of the note, as well as the eventual principal repayment. In addition, because the grantor still owns the assets, they will get a step up in basis for income tax purposes at the death of the grantor.

           Before making any large gifts, clients should have a serious discussion with professional advisors to determine if the gifts are appropriate for the client's financial and family situation. Planning for large gifts does take time, which is obviously limited between now and December 31, 2012. If the client is interested, now is the time to start in order to avoid last-minute decisions that are not productive for the client.