Estate Planning Opportunities Created by the New Tax Law

The Tax Cuts and Jobs Act (“The Act”) passed by Congress and signed by the President at the end of last year included significant changes in the Estate and Gift tax provisions of the Internal Revenue Code that open planning opportunities for limited time. For clients looking to insure their estates take advantage of every opportunity it is now time to review whether more advanced planning strategies are appropriate.

With the adoption of the Act, Congress changed the Estate, Gift, and Generation-Skipping Transfer (GST) tax exemptions under the Internal Revenue Code. The prior law exempted the first $5 million (as adjusted for inflation in years after 2011) of transferred property for each taxpayer from Estate and Gift Tax. This allowed a married couple a total exemption of  $10.9 million of assets in 2017.

Under the new law, for estates of decedents dying and for gifts made during lifetime after December 31, 2017 and before January 1, 2026, the exclusion amount is doubled from $5 million to $10 million (again as adjusted for inflation occurring after 2011) and is expected to be approximately $11.2 million per person or $22.4 million per married couple in 2018. The Act does not make changes to the tax rates for Estate, Gift, and GST, which remain subject to a maximum tax rate of 40 percent. Additionally, the current basis step-up under Code §1014 for property inherited from a decedent remains in place.

Despite the early discussions regarding the Act, it is important to note that there is no provision in the final legislation for ultimate repeal of the Estate, Gift, or GST taxes, and the increased exemptions remain in place only until December 31, 2025, at which time they revert to the current $5 million level (indexed for inflation).  These circumstances open a significant, once in-a-lifetime opportunity for clients with estates above the above the exemption limits to protect more assets from taxation. Some clients may be tempted to take a wait and see attitude given that the new limits do not expire until December 31, 2025, but delaying this discussion comes at their peril as the tax legislation may be modified significantly if the 2018 midterm elections or 2020 Presidential election bring changes in the control of Congress and the White House. In addition, although death is inevitability, none of us knows when, so planning is important.

The tax changes, when combined with valuation discounting, open the door for strategies that can shield significant assets from Estate and Gift taxation through the use of direct gifts, gifts in trust, and gifts of business interests (such as family partnerships, LLCs and corporations). Such gifts will also shift future appreciation of the assets to children and grandchildren, who may also be in lower tax brackets for income tax purposes. It is also possible to make use of legislation adopted in 2017 by the Michigan legislature to create self-settled trusts which are likely to provide creditor protection and allow clients to take advantage of the higher exemptions. 

While clients may initially be reluctant to make larger gifts immediately, a review of the options and strategies to protect assets from Gift or Estate tax while still providing some control of the assets should be considered immediately. As always, the tax rules are complex and retaining attorneys experienced in complex estate planning is important because errors in implementation of sophisticated strategies can be very costly if done incorrectly.

Al and Matt

The Grantor Retained Annuity Trust as a Tool for Wealth Transfer

     We often discuss the benefits of Living Trusts as part of an estate plan, but there are other types of trusts that may provide our clients with significant benefits as part of a larger estate plan, depending upon the client’s particular situation.

     A Grantor Retained Annuity Trust (GRAT) is one method for wealthy clients to maintain an income stream yet transfer property (often which is highly appreciating) to a child with minimal Gift or Estate Tax. A GRAT allows the client to transfer assets into an irrevocable trust and retain the right to annuity payments for a fixed term of years or their lifetime. When the set duration ends, the remainder of the trust, including any appreciation, can go to a named beneficiary. Alternatively, it is possible to structure the GRAT to return the principal and a certain amount of income to the grantor, and distribute the excess income to the remainder beneficiary. While it is possible that the trust will earn insufficient income to cover the required annual payment and thus the Trustee must make that payment from the principal, with proper planning the GRAT is a powerful tool for wealth transfer.

     When using a GRAT to transfer assets, the gift tax value of the assets is determined at the time of trust creation and funding by subtracting the value of the annuity interest from the fair market value of the assets transferred to the trust. The value of the annuity interest will depend on the interest rate used, the value received by the grantor, and the value of the remainder beneficiaries’ interest. The IRS Regulations set rules for determining what interest rates may be used in the calculation of valuations, especially when family members are involved.

     As an example, if a 60-year-old client sets up a GRAT to last two years and uses the following provisions:

• Contributed Asset Value: $1,000,000, 

• The §7520 interest rate required by IRS Regulations: 2%,  

• The asset earns 5% per year 

• The asset appreciates at 5% per year 

Over the term of the Trust, the client will receive two annual payments of approximately $515,000 and the remainder beneficiary will receive approximately $130,000 at the termination of the GRAT. Since the value of the annuity interest exceeds the fair market value of the assets transferred into the GRAT there is no Gift Tax liability to the client, nor do they use any of their Lifetime Gift Tax Exemption. If the client funds their GRAT with assets anticipated to appreciate faster than 5% per year, the benefit to remainder beneficiaries is even greater

     Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments, it is important to treat the GRAT as a grantor trust for income tax purposes. This means the client retains liability for taxes on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate tax saving device because the client pays the income tax, thus reducing the their estate.

     In the right circumstances, the GRAT can be a powerful tool to transfer assets with minimal gift or estate tax consequences, but clients should carefully review their financial situation with both an experienced attorney and financial advisor before entering into such a transaction.

IRA Trusts as a Tool for Protecting Beneficiaries from Themselves

We all have clients who recognize their children's limitations and want to protect those children against their own shortcomings. These shortcomings may take the form of a drug or alcohol dependency, a gambling problem, or a spending problem. I once counseled a client who had two children who spent more than they made, often requiring my client to bail them out of financial trouble, as to how she could protect her children against themselves after she passed away. In addition, she wanted a portion of her estate held for the benefit of her grandson.

While this client had a number of assets, she had a particularly large IRA account. Because of her goals and the existence of this IRA account, I suggested the client set up an "IRA Trust".  An IRA Trust is a stand-alone trust, separate from a Living Trust, which acts as the beneficiary of IRAs or other 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 stretching distributions of their inherited benefits over their lifetime, delaying taxation. Except for the required minimum distributions (RMDs), the IRA assets can continue to grow tax-deferred and protect beneficiaries against their own bad habits of misspending and mismanagement of money.

The IRA beneficiary designation specified that at the client’s death three separate sub-trusts would each be the beneficiary of one-third (1/3) of the IRA. This specific allocation allowed the Trustee to use each beneficiary's separate life expectancy to calculate the required minimum distributions, rather than the life expectancy of the oldest beneficiary of the trust. There was eight years difference in the daughters' ages, which allowed the younger daughter to take a smaller required distribution every year. This strategy was particularly beneficial to the grandson, who was only 13 at the time his grandmother passed away. This allowed the trustee to calculate his required distributions using 70 additional years of life expectancy, resulting in very small taxable distributions, thereby deferring tax.

We also designed the IRA Trust with different sub-trust provisions for each beneficiary. One daughter only would receive the greater of income earned by her sub-trust or the required minimum distribution. This restriction was always in force and that daughter could not accelerate any distributions. The second daughter, who was somewhat more responsible with her finances, also received the greater of income earned by her sub-trust or the required minimum distribution, but after three years was entitled to take up to 10% of the value of her sub-trust each year if she chose to request it. Finally, the share for the grandson was set up to provide for income and principal as needed, but if not used, remained in the trust for later use, such as education, purchasing a home, or starting a business.

Our client did express one final concern that her daughters would be unhappy with the limitations placed on them, but was comforted by the fact that by the time the children were aware of the restrictions she would not be in a position of having to listen to their complaints.

 Our client was somewhat less restrictive with distributions to her daughters from her Living Trust because she knew that even if the daughters spent those assets quickly, the terms of the IRA Trust still protected her daughters and grandson from completely running out of assets. The client was also able to make charitable distributions from her Living Trust without worrying that charitable beneficiaries would negate the "stretch out" of IRA distributions over the other beneficiaries' lifetime.

Clients are often reluctant to place restrictions on their children even if it is for their own good. It is often the difficult obligation of advisors to begin the discussion about ways to protect the beneficiaries from their own shortcomings and let the client eventually find comfort with specific strategies for protecting them. As with all estate planning strategies, careful consideration should be given not only to the relevant tax provisions, but also to understanding a client's true desires. 

Alan Ferrara and Matt Ferrara

Year End Charitable Gifting Strategies

As we discussed last week, many of our clients use this time of year to make annual gifts to family members. A number of those clients also plan their charitable gifting for the end of the year to take advantage of the deduction that such gifts provide against income tax liability. Some of our clients make direct cash gifts to their chosen charities, while others satisfy their charitable inclinations with gifts of property, such as artwork, real estate, or stock. These gifts allow them to deduct the charitable contributions, up to 50%, 30%, or 20% of their adjusted gross income, depending on the type of property contributed and the type of donee. Depending on the client’s financial situation, more advanced gifting techniques can provide greater benefit to both the client and the charity.

One of our clients, who will likely have some estate tax liability, uses Charitable Remainder Trusts (CRT) to maximize the value of her charitable gifts. The CRT stipulates that the client receives an annual payout of a percentage of the value of the trust during her lifetime, with charities receiving the remainder of the trust assets at her death. In addition to satisfying her charitable intentions over the long-term, she reduces her potential estate tax liability, obtains an income stream for her lifetime, and is eligible for an income tax deduction equal to the present value of the remainder interest, determined by using IRS tables. In her case, at age 70, a $1,000,000 transfer to a CRT with a 6% annual payout provided her with $60,000 of annual income for life, and give her a $466,370 charitable deduction.

Another client, who does not need additional current income, chose to take the opposite path and fund a Charitable LeadTrust (CLT). A CLT provides charities with an annual income stream for a period of time, with the remainder interest going to other beneficiaries. In this case, the client just sold a business, had a significant gain, and wanted a tax deduction in the year of sale. We set up the CLT to provide a 6% payout to charities for twenty years. At the end of twenty years, the remaining balance of the trust will be held for the benefit of his three children. This allowed our client to take an immediate charitable deduction of $2,124,000. In order to take the deduction in the year the CLT is funded, the taxpayer must report the income earned by the trust over the next 20 years, which our client was comfortable with because his income in future years would be much less than the current year. As with the CRT and additional benefit of a properly structured CLT is a reduction in the value of the client’s future estate tax liability.

Not all techniques require a long-term trust to facilitate gifting. One of our clients, knowing he was selling his business, sought advice regarding the best way to donate a portion of the proceeds to his favorite charities. To maximize funds received by the charities, we recommended that he donate a portion of the stock to a charitable trust set up for those charities. The trust then joined in the sale, received a portion of the proceeds tax-free, and distributed those proceeds to the charities. By contributing the stock first to the charitable trust and then having the charitable trust join in the sale, the charitable trust received the full amount of the proceeds without liability for income taxes. If the client had sold the stock first, he would have been liable for capital gains tax and there would have been fewer dollars available for the charitable contribution.

Finally, for those clients receiving distributions from an IRA, 2013 provides a unique opportunity. The tax rules provide that if a donor is at least 70 1/2 years of age, he or she can have the IRA distribute up to $100,000 per year directly to a charity and treat it as excludable from income. One of our clients, with a large IRA but little other available assets, has been using direct distributions from an IRA to charities for the last few years. This technique allows her to satisfy her chartable inclinations and reduce her own potential income tax liability. Unfortunately, due to a change in the law, 2013 is the last year this option is available.

There are a number of other creative ways to fund a client's charitable desires, provide them with income tax deductions, and limit liability for future estate taxes, but these techniques require proper planning. If any of your clients are interested in charitable gifting options for this year, they should consult with their advisors soon in order to provide sufficient time to implement strategies that maximize their charitable contributions.

Alan Ferrara and Matt Ferrara

2014 Inflation Adjusted Tax Limits

     As you are aware, a number of tax figures are adjusted each year for inflation. The Government has released Inflation adjusted 2014 figures for Estate and Trust Tax brackets and other Transfer Tax items. The adjustments are based on the average Consumer Price Index (CPI) for the 12-month period ending the previous August 31. The August 2013 CPI has been released by the Labor Department, and using the CPI for August 2013, (and the preceding 11 months) some of the tax figure adjustments for 2014 are: 

• Unified estate and gift tax exclusion amount. For gifts made and estates of decedents dying in 2014, the exclusion amount will be $5,340,000 (up from $5,250,000 for gifts made and estates of decedents dying in 2013).
• Generation-skipping transfer (GST) tax exemption. The exemption from GST tax will be $5,340,000 for transfers in 2014 (up from $5,250,000 for transfers in 2013).
• Gift tax annual exclusion. For gifts made in 2014, the gift tax annual exclusion will be $14,000 (same as for gifts made in 2013).
• Determining 2% portion for interest on deferred estate tax. In determining the part of the estate tax that is deferred on a farm or closely-held business that is subject to interest at a rate of 2% a year, for decedents dying in 2014, the tentative tax will be computed on $1,450,000 (up from $1,430,000 for 2013) plus the applicable exclusion amount.
• Increased annual exclusion for gifts to noncitizen spouses. For gifts made in 2014, the annual exclusion for gifts to noncitizen spouses will be $145,000 (up from $143,000 for 2013).
• Kiddie tax. The exemption from the kiddie tax for 2014 will be $2,000 (same as for 2013). A parent will be able to elect to include a child's income on the parent's return for 2014 if the child's income is more than $1,000 and less than $10,000 (same as for 2013).
• 2014 Estates and Trust tax rate brackets:

If taxable income is                                                                       The tax is:

Not over $2,500..................................................................................... 15% of taxable income

Over $2,500 but not over $5,800........................$375.00 plus 25% of the excess over $2,500

Over $5,800 but not over $8,900.................... $1,200.00 plus 28% of the excess over $5,800
Over $8,900 but not over $12,150...................$2,068.00 plus 33% of the excess over $8,900
Over $12,150..............................................$3,140.50 plus 39.6% of the excess over $12,150

Alan Ferrara

Grantor Retained Annuity Trusts as a Tool for Wealth Transfer

We often discuss the benefits of including Living Trusts as part of an estate plan, but there are other types of trusts that may provide our clients with significant benefits as part of a larger estate plan, depending upon the client’s particular situation.

A Grantor Retained Annuity Trust (GRAT) is one method for wealthy clients to maintain an income stream for a period of time yet transfer property (often which is highly appreciating) to a child with minimal gift or estate tax. A GRAT consists of assets transferred into an irrevocable trust with the transferor retaining the right to annuity payments for a fixed term of years or their lifetime. If income earned by the trust assets is insufficient to cover the annual payment, the Trustee will make the required payments from principal. When the set time period ends, the remainder of the trust, including any appreciation, can go to a named beneficiary. Alternatively, it is possible to structure the GRAT to return the principal and a certain amount of income to the grantor, and distribute the excess income to the remainder beneficiary.

The gift tax value of the transferred assets is determined at the time of trust creation and funding by subtracting the value of the annuity interest from the fair market value of the assets transferred to the trust. The value of the annuity interest will depend on the interest rate used, the value received by the grantor, and the value of the remainder beneficiaries’ interest. The IRS Regulations set rules for determining what interest rates may be used in the calculation of valuations, especially when family members are involved.

As an example, if a 60-year-old client sets up a GRAT to last two years and uses the following provisions:

• Contributed Asset Value: $1,000,000,
• the §7520 interest rate required by IRS Regulations: 2%, 
• the asset earns 5% per year
• the asset appreciates at 5% per year 

Over the term of the Trust, the client will receive two annual payments of approximately $515,000, and the remainder beneficiary will receive approximately $130,000 remaining in the GRAT with no gift tax cost. If the asset is anticipated to appreciate faster than 5% per year, the benefit to remainder beneficiaries is even greater

Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments, it is important to treat the GRAT as a grantor trust for income tax purposes. This means the client retains liability for taxes on income and realized gains on trust assets even if these amounts are greater than the trust's annuity payments. This further enhances this tool's effectiveness as a family wealth-shifting and estate tax saving device because the client pays the income tax, thus reducing the their estate.

         In the right circumstances, the GRAT can be a powerful tool to transfer assets with minimal gift or estate tax consequences, but clients should carefully review their financial situation with both an experienced attorney and financial advisor before entering into such a transaction.

Alan Ferrara

Fairness and Gifting Across Multiple Generations

     Last Thursday we discussed a variety of ways to address clients' concerns regarding lifetime gifts made to their children. Issues such as these stem from the clients’ common concern for treating their beneficiaries equally. Another frequent sticking point when addressing fairness in distributions is a client’s desire to leave bequests to both their children and grandchildren. As clients begin to contemplate leaving gifts to multiple generations, the complexity of achieving fairness multiplies.

     One option when choosing to include grandchildren in trust distributions is to provide that each living grandchild receive a fixed sum prior to dividing the remaining trust assets among the client’s children. This ensures that the client treats each grandchild equally and that each child receives an equal share of the remaining estate. Alternatively, some clients elect to divide their entire trust estate equally between their children, but stipulate that from each child's share a specific dollar amount or percentage is set aside in trust for that child's offspring. While both of these methods ensure that each grandchild receives an equal gift, the second method reduces the gift to each of the client's children proportionate to that child's number of offspring.

     The second method for dividing the trust estate between the client's children and grandchildren requires the trustee to establish an equal share for each of the client's children as well as an additional equal share for the benefit of the client’s grandchildren. The share for the grandchildren is then subdivided, giving each individual grandchild in equal sub share. As with the first option discussed, this method ensures that every member of the same generation receives the same size gift but avoids making a fixed denomination gift to grandchildren that can potentially overwhelm the client's intention to provide for their children.

     A third method for making distributions that include grandchildren involves again dividing the trust assets equally between the clients’ children and then holding each child's share in trust. The terms of these trusts may vary, but a common choice is to provide that a portion of the income from each child's trust is distributed to that child automatically each year, while the remaining income and principal may be used for the grandchild's needs subject to an ascertainable standard. Following the death of the child, each of their offspring receives an equal share of any assets that remain in the trust. This technique, while requiring more substantial involvement from the trustee, allows the client to provide an annual gift to their child while also providing for their grandchildren's long-term needs.

     As you can see from these examples and as we have said before, distribution provisions are limited only by the client's imagination and our ability to draft to those desires. What is important to remember is that clients should not lose sight of their planning goals in order to ensure fairness among their beneficiaries. Engaging in the estate planning process and establishing a living trust serve to provide structure, guidance, and peace of mind to the client and their loved ones. When engaging in planning, clients should work with an experienced professional who takes the time to understand their family situation and assist them in creating documents that address the clients' wants and needs.

Adjusting Estate Plan Documents for Lifetime Gifts or Loans

Clients are often concerned with ensuring that they treat each of their children equally. Clients worry that imbalanced gifting between children, for example providing more funds to one child to attend a private university while their sibling attended a state school, providing one child with the funds to assist with the down payment on a house, or assisting one child with launching a business, will cause tension if not balanced out in the long run. This concern leads to a discussion about which children previously received gifts or loans from the parents and how to adjust the distribution of trust assets to children to be fair to siblings who did not receive such gifts and loans.

One of my favorite phrases with clients is "the only limitation on what you can do is your imagination." I have one client who has chosen to add a provision to his trust that states that all distributions to children whether as a loan or a gift are to be treated as a gift and shares of the children are specifically not to be adjusted for anything received during lifetime. Other clients want options that provide greater equality, but are more complex. While I am happy to provide those options, I will often suggest to a client he or she may want to consider what is "fair" for each child rather than what is "equal.”

There are a number of ways to adjust distributions to account for gifts or loans to children during the client’s lifetime. One example is to have the trustee add all loans and/or gifts made during the client’s lifetime back into the estate at death for calculation purposes. The trustee then provides an equal division for all children, adjusting each child's share for loans and/or gifts they received during lifetime. If clients elect to use this method to adjust bequests, careful records should be kept, to ensure that children are not penalized for loans that were previously repaid.

Another option is to provide a specific dollar amount for each of the children who did not receive loans or gifts during lifetime, which the trustee distributes from the estate before the equal division occurs. Again, good record keeping is important with this method to avoid creating an imbalance in favor of a different child.

There are number of other options, but it is clear that such clauses should be added to a client's documents only after a discussion with the client and careful drafting by a qualified professional.

Alan Ferrara

The Ripple Effect of US v. Windsor on Planning

     Today marks a milestone for Plainly Legal. This is our 100th post, and we would like to thank everyone who has supported this venture and visited our Blog. That said, let's move on to today's topic, as recent weeks have produced significant news that affects our practice and those of our associated professionals.

     As we discussed in July, the Supreme Court's decision in the case of US v. Windsor, holding Section 3 of the Defense of Marriage Act (DOMA) unconstitutional, impacts planning for married same-sex clients. Since that decision, other departments of the Federal government have announced responses to this holding.

     On August 29th the US Department of Treasury and the Internal Revenue Service ruled that same-sex couples, legally married in states that recognize their marriages, would be treated as married for federal tax purposes. This ruling applies to all married same-sex couples regardless of whether their state of residence recognizes same-sex marriage. This ruling applies to all forms of federal taxation including income, gift, and estate tax. Because of this ruling, legally married same-sex couples may file their 2013 federal income tax return using either the married filing jointly or married filing separately filing status. These couples may, but are not required to, file amended returns for the tax years 2010, 2011, and 2012, choosing to be treated as married for those years. However, Michigan has yet to weigh in on whether legally married same-sex couples may file joint returns. 

     While the IRS has readily complied with the Supreme Court's decision, other departments of the Federal government are not as quick to change their policies. The Department of Veterans Affairs Secretary Eric Shinseki announced that the Supreme Court ruling did not specifically strike down a federal regulation defining a spouse as someone of the opposite sex, and therefore the Department of Veterans Affairs would continue to limit VA benefits to opposite sex spouses. This decision was almost immediately challenged, and on August 30th US District Judge Consuelo Marshall of Los Angeles ruled that based on the Supreme Court's decision in US v. Windsor, the regulation in question was unconstitutional and approved an injunction permanently barring the VA from applying that regulation.

     In contrast to the Department of Veterans Affairs, the Pentagon has announced that as of September 3rd same-sex spouses of military members will now be eligible for the same health care, housing, and other benefits enjoyed by opposite sex spouses. This decision has been met with some resistance, especially from the State of Texas, where the Texas National Guard currently refuses to process requests from same-sex couples.

As events unfold and the scope of the Supreme Court's decision becomes clearer, we at Plainly Legal will continue to provide you with commentary that may assist you in new planning for clients covered by the decision. 

     Again, thanks to all of our readers for their regular visits to the site, and we look forward to continuing to provide you with useful and insightful information regarding estate, tax, and business planning.

Matt Ferrara

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

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

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

How the Investment Income Tax Effects Trusts and Estates

The American Taxpayer Relief Act of 2012 imposes a 3.8% tax on the net investment income (NII) of individuals, estates, and trusts to the extent that the taxpayer's adjusted gross income exceeds the applicable thresholds. While the threshold amount for married and single filers are relatively high, the threshold for an estate or trust is only $11,950 for the tax year 2013. Therefore, if the undistributed NII of an estate or trust exceeds $11,950, the excess is subject to the 3.8% Medicare tax.

A trust or estate is only subject to the NII tax if the trust or estate contains undistributed net investment income. Therefore, the trust or estate can avoid this tax entirely by distributing its net investment income to its beneficiaries. With some trusts, especially those that contain mandatory distributions of all income or where the trustee regularly distributes all the trust income to pay the beneficiaries’ expenses, this is simple. However, for trusts that seek to minimize income distributions, such as Supplemental Needs Trusts for beneficiaries receiving government benefits, avoiding this tax becomes more problematic.

In situations where the distribution of trust income has the potential to create problems the Trustee must weigh the benefits of tax avoidance against the drawbacks of giving income to beneficiaries who may waste it or actually do harm to themselves. In these situations, rather than distributing income to avoid the NII tax it may be better to restructure the trust's investments to avoid receipt of NII. Investing in tax-exempt investments such as municipal bonds or tax-deferred investments or accounts such as life insurance or deferred annuity contracts can avoid the net investment income. It may also make sense to select investments producing growth but little or no income. Trustees can sell such assets later when cash is needed for distributions.

Another, less common concern, is that the value of income generated by a trust will exceed the liability threshold for a beneficiary as an individual. This issue may be addressed by including a number of permissible, but not mandatory beneficiaries in the trust, such as including grandchildren as permissible beneficiaries of a trust for their parent. This allows the trustee to make distributions to a number of trust beneficiaries who do not otherwise have sufficient income to subject themselves to this 3.8% Medicare tax, and  spreads the income among taxpayers potentially eliminating the tax liability altogether.

It is important for trustees and personal representatives of trusts and estates containing significant income generating investments to review those entities as soon as possible in order to determine the best results for each trust or estate. Clients should discuss the options with their professionals in order to maximize tax savings.

As a reminder, the IRS treats income distributed from a trust within the first 65 days following the year-end as distributed in the prior year. For example if a Trustee makes distributions from a trust of income earned in 2013 in the first 65 days of 2014, the beneficiaries report that income on their 2013 income tax return. This gives some flexibility in planning, but Planners should not delay acting to avoid problems. 

Alan Ferrara

Veteran's Aid & Attendance Pensions

     Over the past few months, I have heard from a number of financial professionals whose clients are asking questions regarding eligibility for the Veterans Administration's Aid & Attendance Pension. The Aid & Attendance Pension is a benefit available to veterans with 90 days of active duty service during wartime. Due to the World War II, the Korean War, and the Vietnam War, the vast majority of military veterans potentially eligible for the Aid & Attendance pension served during a qualifying wartime. In addition to the wartime service requirement, veterans seeking the Aid & Attendance Pension must qualify medically and financially.

     The Aid & Attendance Pension provides additional funds to veterans or their surviving spouses to pay for assistance in performing daily tasks. A significant goal of the Aid & Attendance Pension is to provide veterans with the care they need to live a full life without the veteran needing to rely on Medicaid for long-term medical care.

Clients who desire to meet the financial qualifications for the Aid & Attendance pension generally consider one of two actions. Either the client wishes to purchase annuities in order to convert assets into an income stream, or the client wants to give away assets to children or other loved ones. Both of these actions, while potentially allowing the client to meet those financial limits, have potential negative consequences.

     Two issues arise for clients wanting to convert their assets into income. First, it is important to note that the Aid & Attendance Pension has both an income and asset limit, so it is possible that converting assets to an income stream will not achieve the goal the client intends. The second issue, involves the financial advisors desire to maximize their clients return on investment. In many cases, especially with elderly clients, an annuity is not the vehicle that will provide the best return on investment. Alternately, clients seeking to give away assets do not consider the choices that continued access to and control of those assets can provide the client.

     Unlike Medicaid, the Aid & Attendance Pension has no divestment penalty, allowing individuals to give away assets in order to meet the financial qualifications. However, it is important for clients to consider what they are giving up by giving away those assets. When considering long-term care, more assets equals more choices. Also, while clients believe that children will retain assets given to them in case the parent ever needs those assets, even in situations where children have the best of intentions, unexpected expenses, lawsuits, and investment mistakes occur, creating a situation where assets are no longer available to pay for care in the future.

     A significant drawback with the Aid & Attendance Pension is the existing backlog of claims for veteran’s benefits. In many cases, it may take over a year to process a claim for the Aid & Attendance Pension, and while the claim may eventually be approved and pay out retroactively, there is a time during which the client must subsist on their artificially lowered assets.

     The Aid & Attendance Pension has the potential to improve significantly the client’s quality of life. However, qualifying for this benefit is not always in the best interest of the client, especially when the client has significant assets with which to pay for their care. Before taking any action designed to assist in qualifying for a government benefit, clients should speak with an attorney experienced in veteran’s benefits to ensure that such actions will achieve the client's goals.

Matt Ferrara

Additional DOMA Issues

     As we discussed in our last post, the United States Supreme Court issued its decision in the case of US v. Windsor, more commonly known as the Defense of Marriage Act (DOMA) case. The Court struck down a provision in the law that required the Federal Government to treat same-sex spouses as unmarried for purposes of federal law. It is still unclear when the decision goes into effect and whether it only covers same-sex couples married in a state allowing same-sex marriages and residing in that state. While not related to estate planning, which is normally our primary focus here, there are important planning issues affected by this change about which you and your clients should be aware.

     One area with potentially far-reaching consequences is retirement planning. When reviewing the retirement planning for married same-sex clients remember:

1. In general, the required minimum distribution (RMD) rules are more liberal for married plan participants whether the participant is in pay status or not.
2. The spouse of a deceased employee can roll over a distribution attributable to the employee subject to the same rollover rules as if the spouse were the employee
3. In certain situations, a participant must have spousal consent before the participant can leave retirement benefits to someone other than the spouse, before a lump sum can be taken in lieu of a joint and survivor annuity, and before the plan account can be used as security for a loan.
4. In a divorce, a spouse's pension benefits are often part of the property settlement. When there are pension benefits involved, courts often use a qualified domestic relations order (QDRO) to handle those benefits. Without a QDRO, taxes for the benefits fall on the spouse who earned the benefits even though the other spouse receives the benefits.

     This case will also have an effect on employer-provided health plan benefits. The employee can exclude from income any amounts received from his employer as reimbursement for medical care expenses as long as the medical expenses represent care provided to the employee, the employee's spouse, or dependents. This ruling will expand the employee's right to exclude from income expenses paid for care provided to the same-sex spouse. The same is true for spousal entitlement to health plan coverage under the COBRA continuation rules. 

     While many details of the ruling remain unclear, it is important that we as planners understand the consequences of this decision in order to best serve both our business and individual clients. 

Alan Ferrara

SCotUS Decides an Important Estate Planning Case (and Overrules DOMA)

     Last week, the United States Supreme Court issued its decision in the case of US v. Windsor. This case, more commonly known as the Defense of Marriage Act (DOMA) case, has received much press coverage. This past week by 5-4 decision the Supreme Court found Section 3 of DOMA violated the Equal Protection Clause of the Fifth Amendment. Somewhat less well known, but equally important, is the estate planning relevance of Windsor.

     At its heart, Windsor was a suit brought by a taxpayer to collect a refund on Federal Estate Taxes. Edie Windsor and Thea Spyer were legally married in Canada in 2007, following an over forty year committed relationship while living in New York City. When Spyer died in 2009 she left her entire estate to Windsor. Since DOMA prevented same-sex married couples from receiving a wide range of Federal government benefits, the estate did not qualify for the unlimited marital deduction available to married couples. As a result, Windsor, as personal representative of the estate paid over $363,000 in Federal Estate Taxes. Windsor then sued for a refund and a declaration that Section 3 of DOMA violates the Constitution.

     While the Windsor decision has far-reaching consequences regarding many different types of federal benefits available to married spouses, with respect to estate planning legally married same-sex couples are now entitled to the following tax benefits:

• the right to file a joint Federal Income Tax return;
• the opportunity to obtain tax-free employer health coverage for the same-sex spouse;
• the opportunity for either spouse to utilize the marital deduction to transfer unlimited amounts during life to the other spouse, free of Federal Gift Tax;
• the opportunity for the estate of the first spouse to die to receive a marital deduction for amounts transferred to the surviving spouse;
• the opportunity for the estate of the first spouse to die to transfer the deceased spouse's unused exclusion amount to the surviving spouse;
• the opportunity to consent to make “split” gifts; and
• the opportunity for a surviving spouse to stretch out distributions from a qualified retirement plan or IRA using the more favorable spousal rules.

     All of these benefits are subject to Federal law and therefore are applicable to legally married couples in all 50 states, whether or not that state recognizes same-sex marriage. This means that clients legally married in any of the 13 states that currently recognize same-sex marriage may take advantage of these benefits no matter their state of residence. For financial planners and other estate planning professionals this change in the law will have a substantial effect on planning for any client that falls into this category.

     Any action regarding estate planning should only be undertaken following consultation with an experienced professional. If you have questions or concerns involving a specific situation, please contact us directly and will be happy to assist you.

Matt Ferrara

The Importance of Reviewing Life Insurance Policies

A potentially important part of a client’s estate planning is life insurance. Life insurance provides liquidity for any estate taxes or other expenses at death, can provide for income replacement on the death of a primary household earner, and provides protection against liabilities that might come due or be difficult to pay at the death of a client. However, clients should not buy a policy and presume that the policy will meet all their needs forever. Like other aspects of the estate planning process, clients should review their insurance policies regularly to ensure that those policies still help to achieve the client’s goals.

Often clients, especially those in their early earning years will purchase term insurance because it meets their needs and is more affordable than permanent life insurance. Clients and their advisors should remember that term insurance is just that—purchased for a specific and definite time. Clients should review their policies annually or set reminders so coverage will not lapse without securing new coverage. It is also a good idea to periodically review the policies and compare them with new offerings that may be less expensive. It also is a good idea, as long as the client is still healthy and insurable, to consider purchasing a replacement policy before the current term is up in order to extend coverage for additional years. For example, a client has a ten-year term policy and five years have elapsed, if the client purchases a new ten year term policy the client has secured additional coverage at a lower rate than they would likely receive at the end of their original ten year policy.

Clients also need to remain aware of where their insurance comes from. Sometimes a client will rely on group insurance provided by their employer to meet the needs mentioned above. If so, care should be taken to insure that replacement insurance is available before the client changes jobs or retires.

Even permanent insurance requires the client’s regular review. Depending on a clients circumstances and changes in the insurance market it may be possible to purchase policies with improved benefits or decreased premiums. Clients also need to keep in mind their reasons for purchasing insurance. If those circumstances change so that insurance is no longer necessary it is often more cost effective to allow a policy to lapse than to pay premiums for an eventual payout.

Finally, clients should review their beneficiary designations to be sure the beneficiaries named are those that should receive life insurance proceeds. It is not unusual for us to review client policies and discover their parents or siblings are named, despite having a spouse and family of their own. We also will discover clients still have their ex-spouses named, even if they have remarried. Sometimes Michigan law will protect against these flawed designations in the case of divorces, but federal law overrides state law and insurance proceeds can go to those who should not receive anything.

Insurance products are constantly evolving, and the client should have their policies reviewed by a professional expert in the industry. We are happy to help our clients in facilitating policy reviews

Alan Ferrara