Unwinding Irrevocable Life Insurance Trusts

     On Tuesday, we addressed the technique of funding insurance policies to an Irrevocable Trust and using the annual gift exclusion to make premium payments. For those clients with potential estate tax liability this technique allows them to help fund the estate tax liability at a fraction of the actual cost because policy proceeds at death that will not be includable in the client's estate will more than offset the premiums paid during lifetime. When collected by the Irrevocable Trust, the proceeds can be used to purchase assets from the Living Trust or loan funds to the Living Trust to pay estate taxes until illiquid assets are sold.

     However, what happens if circumstances change and the purpose for which the Irrevocable Trust was created no longer exist, or if the client has a change of heart about owning the policies? Since the trust is irrevocable, the client cannot unwind the trust through revocation. The client can however discontinue annual gifts to the trust (and its lifetime trust beneficiaries), leaving the Trustee of the Irrevocable Trust without any assets to pay the life insurance premiums. Eventually the insurance coverage will lapse leaving the trust without any assets, at which point the trust ceases to exist as a matter of law.

     Alternatively, as part of the initial planning for the Irrevocable Trust, specially added provisions may allow the Grantor to unwind the trust despite its irrevocable nature. One strategy is to structure the Irrevocable Trust as a "Grantor Trust”. If properly drafted, the Trust can be treated as property of the Grantor for the purposes of income tax liability, excludable from the Grantor's estate for estate tax purposes. If the trust holds only life insurance there should be no income, presuming the Trustee uses all of the gifts made to the trust by the client to pay the premiums on the life insurance owned by the trust, and  there should be no impact on the client’s income tax liability.

     The Internal Revenue Code Sections 671-678 detail the circumstances under which the grantor trust rules apply. One of those provisions gives  the Grantor the right to substitute assets of equivalent value for the assets held by the trust. This allows the Grantor to substitute or exchange other assets equaling the value of the insurance policies contained in the trust for the life insurance policies themselves. Those assets are still subject to the distribution terms of the trust.

     As with any advanced estate planning technique, including the creation or termination of irrevocable trusts, advice and counsel of experienced attorneys is important in order to avoid unintended consequences. 

Matt Ferrara

Transferring Insurance Policies to ILITS

Because of the larger estate tax exclusion of $5,000,000 per person (already $5,125,000 because of the cost of living increase), many clients no longer need an Irrevocable Trust to own their life insurance in order to avoid tax on the proceeds at death. However, an Irrevocable Trust is still an important planning tool for those whose estates already exceed the estate tax exclusion or for those whose estates increase in value faster than anticipated. 

            We previously discussed the basic concepts of an Irrevocable Life Insurance Trust (ILIT), but today we want to focus on how policies are transferred to the ILIT.  There is an estate tax rule that requires the inclusion in a decedent’s estate of life insurance transferred within three years of death.  Because of this rule, the ideal planning technique is for Grantor to execute the ILIT and then for the Trustee to apply for new insurance on the life of the ILIT’s Grantor.  If the Trust is the initial owner and beneficiary of the life insurance policy, and the Grantor never had any incidents of ownership in the policy, the three-year inclusion rule does not apply.  

            If there is existing insurance, a client will often set up an ILIT, have the trustee apply for a new policy, and then terminate the old policy when the new policy is issued with the Trust as the owner.  This protects the Grantor if the new insurance application is declined.  There is usually no need to have twice the insurance coverage, but you want to maintain the existing coverage until the new policy is issued and effective.

            Sometimes there is a need for an ILIT, but the Grantor is unable to secure new insurance coverage or the coverage is too expensive because of age or health issues.  At these times you utilize the next best strategy and transfer an existing policy to an ILIT, knowing the three year inclusion rule applies.  You need to remember that the value of the policy at the time of the transfer is a gift.  In addition, any amounts gifted to the ILIT and later used for payment of premiums are gifts.  If the policy transferred is a term policy, there is probably little value other than the unused premiums for the policy year in question.  However, if the policy is an existing permanent policy, there may be significant cash value requiring consideration for gift tax purposes.  The Crummey rules require notice be given to Crummey beneficiaries so that the gift can be considered a present gift and allow use of the annual gift exclusion.  However, if the total of premiums and cash value of transferred policies exceeds the total of Crummey beneficiaries times $14,000, a portion of the gift will not qualify for the annual exclusion.  Any gift in excess of the available annual exclusions is considered a future gift and will use a portion of the Grantor’s lifetime exclusion.

            Planning for policy transfers can be tricky and confusing and should be done with the guidance of professionals qualified in both insurance and tax issues.

Alan Ferrara

Distributing Potentially Problematic Assets

     Our previous two blogs focused on how estate-planning documents achieve the client's planning goals. Today's blog focuses on how successor Trustees distribute assets to beneficiaries. While sometimes the distribution of trust assets is as simple as writing checks to the beneficiaries, certain assets, such as items of personal property and investment accounts, present special issues.

     With personal property, we provide our clients with the ability to leave a memorandum indicating which individuals receive particular pieces of personal property. After giving effect to this memorandum, the Trustee must distribute the remaining personal property pursuant to the terms of the trust, usually in approximately equal shares amongst a number of people. In many circumstances, this division is amicable, with the beneficiaries each keeping the items of personal and monetary value without issue. The trustee can then dispose of the unwanted remaining personal property through either an estate sale or donation to charity. This of course is the best-case scenario, but there are times beneficiaries are unable to agree as to the division of the property. At this point, the Trustee becomes a mix of accountant and mediator, keeping track of the value of property and sorting out disagreements between beneficiaries over whom receives what from their loved one’s estate. Trusts often provide the Trustee with the final decision as to the distribution of personal property when beneficiaries disagree, allowing the Trustee to settle disagreements as he or she see fit and in compliance with the terms of the trust.

     Investment accounts may also be difficult to divide and distribute. While the actual division of an investment account is a simple matter easily accomplished, the Trustee must first determine when the assets should be distributed and how they should be invested prior to distribution. The Trustee is a fiduciary under a high standard of care, and therefore must make distribution decisions with care. If the Trustee intends to make distributions in the near future, it may be better to liquidate investments to protect the principal against market losses. If assets will be held in trust prior to distribution, the Trustee must decide between the benefit of capturing market gains against the possibility of incurring market losses. If possible, it may be simpler to equally split each of the investments in the portfolio distribute them in kind, and allow each beneficiary to make their own investment decisions.

     It is important that the Trustee consult with knowledgeable advisors to ensure that the interests of both the present and residual beneficiaries receive fair treatment. The employment of such a qualified advisor may relieve the trustee of their duty to ensure that assets are properly invested, so it is important to that the Trustee work closely with the advisor.

     These are just two examples of assets that may cause successor trustees issues when distributing trust assets to the beneficiaries. Because of these potential issues, it is important for the initial trustees to keep good records regarding the assets held in their trust so that their successor trustees can administer the trust to achieve the grantor's goals with a minimum of trouble and inconvenience. If you have questions regarding funding assets to the trust please feel free to contact us directly and we will provide you with additional information.

Matt Ferrara

What Happens When Successor Trustees Take Control?

     In our last blog, we discussed steps a client’s Personal Representative takes as part of the probate process upon the client's death. Today's blog addresses how the client’s Living Trust and their successor Trustee fit into that picture. In most cases, the Successor Trustee plays a significantly larger role in the administration, because a properly funded Living Trust limits the assets that need to pass through the Probate Court.

     Unlike a Personal Representative, the Successor Trustee does not need to wait for the Probate Court to approve their appointment.  The Successor Trustee can sign an Acceptance of Trust indicating acceptance of the trustee position and then take possession of the trust assets on behalf of the trust beneficiaries. The Trustee is responsible for the care and custody of assets and making investment decisions, but may rely on qualified professionals for assistance. It is important to remember that a Trustee is a "fiduciary" and must meet a very high standard of care with respect to all actions.

     One of the first things a Trustee must do is apply for a federal tax identification number for the Trust. While a Living Trust uses the Grantor’s Social Security number during the Grantor’s lifetime, both the Estate of a deceased individual and that person’s Living Trust must have separate tax identification numbers and file income tax returns for as long as the Estate remains open and the Trust continues to hold any assets. In limited circumstances, the Estate and Trust may file a combined return; however, it is important to seek the advice of a qualified professional before filing such return.

     Next, the Trustee should provide the beneficiaries of the Trust with certain information, including informing beneficiaries of the existence of the Trust, the name and contact information of the successor Trustee, and information regarding the scope and terms of their individual bequest. This statutorily required notice serves as a check on the Trustee's powers by giving the beneficiaries sufficient information to hold the Trustee responsible for their actions. The Trust normally provides that the Trustee must provide an annual accounting to beneficiaries during the time the trust owns any assets. Prior to making any distributions to the beneficiaries, the Trustee should coordinate with the Personal Representative to pay the grantor’s creditors as may be required by law.

     When all Trust Matters are completed, the Trustee distributes the trust assets to beneficiaries pursuant to the Grantor’s instructions. In all circumstances, it is important that a successor Trustee seek the advice of competent counsel in order to comply with all of their responsibilities, and to assist in the smooth administration of the trust to achieve the grantor’s goals. Later this week we will discuss how the successor trustee should handle distributions of particular assets, including personal property and investment accounts.

Matt Ferrara

How Estate Planning Works to Protect Your Loved Ones

Recently, while discussing an update to estate plan documents with an existing client, the client stopped me and asked, "What happens when I pass away?” I started to tell him that the documents will minimize or eliminate estate tax, avoid probate, and protect his family. The client stopped me short and said, "I understand all that, but what really happens?". It was then I realized that, my answer to him had been completely precise and yet useless. As professionals, we often focus on the big picture of estate planning, giving little or no explanation as to how clients, or their loved ones, use the estate planning documents we create. Over the course of the next few posts we will discuss what should actually occur when a person dies.

When a client passes away and their family or other loved ones notify us, we often suggest sitting down with the Personal Representative, Trustee, and any other parties who want to attend, after the funeral has occurred. Generally the personal representative and trustee do not need to take any immediate action and our preference is to let the family complete its grieving period before meeting with them.

At that meeting one of the first issues we discuss is whether the decedent owned any assets in their name alone that will require a probate. If there is an asset that is only in the name of the decedent, the probate process facilitates the legal transfer of that asset to the decedent's beneficiaries. The probate process involves a number of steps, depending upon whether or not the probate is a "small probate" or a "full probate.” If the value of assets needing to pass through probate is less than $20,000, a small probate is sufficient to complete the transfer. In a small probate, the personal representative completes one form, and the process of filing the estate, obtaining an order for the distribution to the estate beneficiaries, and closing the estate takes only one day.

A full probate, where the estate contains assets having a value greater than $20,000, requires a number of steps:

1. The Personal Representative opens a probate file with the Probate Court. This includes a petition to the Court requesting that the personal representative be appointed to administer the Estate
2. Notice of the probate must be given to heirs at law as defined by the statute
3. An inventory of assets must be filed with the Court
4. The Personal Representative must notify known creditors and potential creditors are notified by placing a notice in the local legal news that the decedent has died and the creditors have only 90 days to file a claim against the estate.
5. After settling any debts with creditors, the personal representative distributes the estate to the beneficiaries designated in the Will or in the absence of a Will to the heirs at law
6. The Personal Representative gives a final accounting to the heirs at law and the court
7. A request is made to the court to close the estate when there are no longer any assets owned by the estate.

     The probate process can take from six months to a year or longer depending upon the complexity of the estate and the assets within it. As often discussed, this is one of the primary reasons for implementing a Living Trust and funding assets into the Trust prior to one's death. Next week we will discuss what actions should occur with respect to the Living Trust.

Alan Ferrara

Using Trusts to Supplement Existing Benefits

     Often when we discuss trust distributions with clients, a major concern is whether their beneficiaries are capable of responsibly handling a sudden influx of money. In those situations where clients have concerns about the beneficiaries' spendthrift habits, marital difficulties, or potential creditors, we structure distribution provisions to protect the beneficiaries’ assets over a longer period. In other circumstances, clients are less concerned about their beneficiaries' ability to handle money and more concerned about how an influx of assets will affect a beneficiary’s ability to qualify for various forms of government assistance.

     In those situations where clients desire to provide for a loved one receiving some form of state or federal assistance, for example Medicaid or Social Security benefits, the goal is to supplement the government assistance being received, not replace it. A Supplemental Needs Trust, sometimes known as a Wholly Discretionary Trust, is a technique that provides assets to pay for the beneficiary's additional needs that government assistance does not cover.

     This assistance can include providing funds to the beneficiary for a wide variety of uses, including travels, hobbies, cultural experiences, and care not covered by governmental assistance. The trustee of a Supplemental Needs Trust has complete discretion to provide the beneficiary with these funds, limited only by the requirement that a distribution from the trust cannot affect the beneficiary’s ability to qualify for other forms of assistance. This level of discretion does require the client to consider carefully whom they name as trustee of the Supplemental Needs Trust, because that person will have a great deal flexibility and  responsibility for the client’s loved ones after the client passes away.

     An additional benefit of establishing a Supplemental Needs Trust for loved ones who receive government benefits is the ability for others, such as grandparents, to make gifts to that Trust through their estate planning to avoid accidentally jeopardizing the beneficiary’s eligibility for assistance.

     A Supplemental Needs Trust is an advanced planning technique that should be prepared by a professional with experience and expertise in the field. Each trust, just like the beneficiaries of those trusts, is unique and clients should work closely with their professionals to ensure that all the planning they do works together to achieve their planning goals.

Matt Ferrara

Keeping Powers of Attorney Fresh

     In the past year, we have heard from a number of clients letting us know that banks and other financial institutions are reluctant to accept Durable Powers of Attorney dated more than two years ago. The same is also true of doctors and hospitals when it comes to accepting Patient Advocate Designations. All of these institutions share this reluctance because when a significant amount of time passes between the execution and use of the document , there is a concern that the person may have executed a new document in the intervening time, naming a different person to act on their behalf. For this reason, we encourage our clients to regularly “refresh” their Patient Advocate Designations and Durable Powers of Attorney.

     Another benefit of regularly refreshing these documents is the ability to review the choices clients have made in naming people to make decisions on their behalf.  It is a good idea make sure those people named are still living, able to assist the client, and still whom the client wants to make decisions on their behalf. This review is important because Patient Advocate Designations and Powers of Attorney are documents clients generally do not think about after signing, until something goes wrong and the client needs to make use of the documents. This "sign and put in a drawer" philosophy frequently leads to complacency, and clients are surprised to discover, years later, that their documents contain people whom they have not spoken to in years or who would no longer be suitable to assist the client should they be incapacitated.

     A final benefit of regularly refreshing Powers of Attorney and Patient Advocate Designations is the ability to have documents that comply with the most recent statutory language and best practices for creating such documents. Over the last ten years the specific powers enumerated in a comprehensive Durable Power Of Attorney have increased substantially, ensuring that the person named to act has the authority to deal with a wide variety of situations and institutions that all require specific permission prior to releasing any information to a third party.

     The process of refreshing these documents does not need to be expensive nor time-consuming. An experienced attorney, especially one the client has worked with previously, should be able to review the documents with the client over the phone and have updated documents prepared to sign in a matter of days. It is important to work with an experienced professional rather than using a fill in the blank form or other do-it-yourself method because these documents confer substantial power to another person to act on your behalf. 

Matt Ferrara

Annual Gifts and Intra-family Lending

     In June we discussed the subject of intra-family loans, including the very low Applicable Federal Rate (AFR) for interest on such loans, with regards to parents who want to pass wealth to their children without giving up any of their own assets. Parents can also use a similar technique to pass wealth in the form of appreciable assets to a child who might otherwise squander gifts of cash. By tying annual gifts to the repayment of an intra-family loan, clients are able to assist spendthrift children while also not appreciably depleting their own assets.

     Currently a person can give $14,000 tax-free to any other individual every year. This means that a married couple can give $28,000 to their child and $28,000 to that child's spouse for a total gift of $56,000 each year. By combining intra-family loans and a plan of annual gifting it is possible for clients to loan their child money to purchase a new home, or other long-term asset, and use the annual gift to pay down the balance of the loan.

     For example, a client can loan their son $150,000 to purchase a new home (making sure to do so using a mortgage and the AFR for a three-year loan). At the end of each year of the loan, the clients write their son and daughter-in-law a check for the annual payment including interest and the son and daughter-in-law write a check back to the parents for the same amount. After the client’s check clears in the son’s account, the client cashes the son’s check, and the loan is paid for the year. The son and daughter-in-law get a home and the client gets to make a gift to their son without worrying that the gift will go to waste.

     In addition to documenting the loan, charging interest, and having a mortgage on the property, it is important when using this technique for the client to make an actual gift and for the child to write a check for the annual payment. Failing to do so creates the possibility that the IRS could determine that the child has taxable “Forgiveness of Debt Income” that can impact their income tax filing. As with any lifetime gift planning, it is important for clients to seek the advice of experienced professionals in order to minimize the chances of such unforeseen consequence.

Matt Ferrara

Discussing Planning with Family

     Last week I wrote about the increased privacy that clients gain from using trusts in their estate plan. Using Living Trusts, clients who choose to make different distributions to their children can keep the value and terms of those distributions private from other children. While this increased level of privacy can prevent discord in some situations, clients should consider how much information is too little information when discussing estate planning with their children.

     As we have said many times before, estate planning is an ongoing process. After documents are drafted, signed, and the funding process is complete, there is still the implementation of the plan to consider. By discussing their estate plan with beneficiaries, clients can help those beneficiaries understand the reasons for their decisions and ease the beneficiaries into the implementation and administration of the plan. This is not to say that clients need to provide their beneficiaries with the clients complete financial records or inform the beneficiary of the size or terms of their eventual bequest. Instead, clients can use this opportunity to provide the beneficiaries with a general sense of the scope of the client assets and the reasons underlying decisions regarding distribution of those assets.

     For example, for clients with a relatively small estate it is important that all the children understand that their parent does not have significant wealth and that the cost of medical expenses are likely to substantially impact those assets remaining after the parent passes.  While the client may make it clear to children that the intent is to distribute any remaining assets equally to all children, it is important they understand that an equal share may not amount to much. I

     Alternately, for clients with a substantial estate who opt to hold assets in trust for beneficiaries to be distributed over their lifetimes, and perhaps their children's lifetimes, it is important that those beneficiaries understand the reasons their parent has for making this decision. In both of these situations, communication with potential beneficiaries can reduce the chances that a beneficiary will challenge the validity of the parent’s estate plan because they understand that all beneficiaries are being treated equally and that there are long-term fiscal benefits of their parents' plan.

     It may even be more important for the client to discuss estate planning documents with the successor trustee so that that fiduciary understand the reasoning behind the document provisions and can appropriately make decisions with full knowledge. The trustee can also clarify the reasons for the document provisions to the beneficiaries.

     In all cases it is important that children understand who is responsible for administering an estate plan after their parent passes away, what is expected of that person, the location of the parents’ estate plan documents, and information about their parents’ legal and financial advisors. While these discussions are not always easy, they are an important part of the estate planning process that clients should not neglect.

Matt Ferrara