More Potential Pitfalls of the New Estate Tax Law

     As we discussed in our last post, the increase in the applicable exclusion to $5,250,000, which dramatically reduced the number of estates with estate tax liability, also has the potential to create large problems for surviving beneficiaries if older estate plans are not updated. This is especially true in plans where the existing non-marital share primarily benefits other than the surviving spouse. This situation arises most commonly where clients want their children to receive something immediately upon the death of the first spouse or where the client wanted to provide for the children of a first marriage after remarrying. This strategy may have made sense at the time, because in prior years the applicable exclusion was smaller resulting in a smaller non-marital share and thus leaving sufficient assets to provide for the surviving spouse in the marital share. 

     With the new larger applicable exclusion, existing trusts will allocate significantly more assets to the non-marital share, potentially resulting in an inadvertent disinheritance of the surviving spouse. Some alternatives for protecting the surviving spouse in a situation such as this, while still achieving the goals of older trusts include the following modifications to the trust provisions: 

• Revise the non-marital share to provide the spouse is the sole beneficiary of distributions of income during the spouse's lifetime with the remainder going to children. 
• Revise the non-marital share to include the spouse as a beneficiary or co-beneficiary of income and/or principal together with the children, within the discretion of the trustee. 
• Revise the non-marital portion of the trust to limit the size of the non-marital trust for children and descendants (such as the figure that the client originally intended as the highest estate tax exemption) while providing the remainder of the non-marital portion be used for the exclusive or primary benefit of the surviving spouse. The amount of this cap will depend on the goals of the client and the needs of the surviving spouse. 

     Keep in mind that merely placing an arbitrary cap on the non-marital share, with the remainder going to the marital share will increase the surviving spouse's taxable estate by increasing the marital share. This increase could cause the surviving spouse's estate to be subject to estate taxes where the combination of the surviving spouse's separate assets and the enlarged marital share exceed the surviving spouse's applicable exclusion amount. The permanent adoption of portability has the potential to alleviate this problem in many situations. Portability is a complex topic that we will address in a separate post in the near future. 

     What is important to know is that with careful planning it is possible to provide a surviving spouse with extensive rights in and powers over the trust funds without causing the entire trust fund to be included in the surviving spouse's gross estate. Such rights and powers would include: 

• The right to all income, distributed currently. 
• The right to withdraw or require distributions of principal in such amounts and at such times as are necessary for the surviving spouse's health, education, support, or maintenance. 
• The right to receive distributions of principal in such amounts and at such times as the trustee (other than the surviving spouse) deems appropriate for any or at least a broader purpose. 
• The noncumulative annual right to withdraw the greater of 5% of the value of the trust fund or $5,000 dollars. 
• A testamentary power to appoint the trust fund to a class of beneficiaries that does not include the surviving spouse, his or her creditors, his or her estate, or its creditors. 
• The right to serve as the sole trustee or as a co-trustee or to remove and replace other persons serving as trustees. 

     As you can see, failing to review estate plan documents after tax law changes can lead to significant problems. Those problems can be remedied easily making changes to documents so that they again will reflect the intentions of the clients.

Alan Ferrara

Keeping a Vacation Home in the Family

A number of my clients have family vacation homes or cottages that they and their children have enjoyed for many years. After getting so much enjoyment from owning the cottage those clients often ask how they can set up their estate planning documents to ensure that when they die, that ownership experience passes onto their children and grandchildren. While, in theory, this may be a good idea, it often creates significant problems if a not fully thought out and planned.

One issue that often causes an issue is the gift tax consequence of transferring a valuable piece of property. However, because of the most recent tax legislation, most people have a sufficient exemption amount so that gift tax is not an issue.

Transferring cottages to other family members can create thornier issues because of personal relationships. While family members may have enjoyed their time at the cottage, for many reasons they may have no interest in owning the cottage with their siblings or other family members. Issues that can arise include:

1. What is the most efficient manner of ownership of the cottage?
2. How to insure that the cottage remains in the "family"?
3. How to establish rules for the management and use of the cottage?

Generally, traditional forms of joint ownership, such as tenancy in common and joint tenancy with rights of survivorship, are inefficient methods for family ownership of the cottage. The primary risk in these types of ownership is that over time the ownership interest is subdivided or fractionalized as it is passed down to subsequent generations. While it is the dream or wish of the parents that the children continue to enjoy the cottages they have in the past, as family members grow into adulthood they may have different ideas. A family member might not have had a great experience at the cottage, may live too far away to be able to enjoy it, cannot afford the share of the cottage expenses, or may simply prefer the value of the cottage in cash to use as they may choose. With tenancy in common or joint tenancy, a family member may try to use his or her partition rights under state law, forcing the sale of the cottage or vacation home.

Co-ownership of the cottage may lead to other conflicts, such as:

1. Who controls the operation of the cottage?
2. How are operating, maintenance or repair expenses shared?
3. Who determines when and what improvements to make and how to pay for those improvements?
4. How are the most desired dates for cottage use determined or allocated among family members?
5. Are pets allowed?
6. Can family members rent their time to third parties?
7. Are nonfamily members, such as spouses and siblings, allowed to own an interest in the vacation home?
8. What happens if a family member wants to sell his interest in the cottage?

While many of these issues do not exist while the parents are alive because the parents pay all expenses of the cottage and determine how it is used, after the death of parents, these issues and others can create family disagreements or even permanent rifts.

 If the parents are still interested in trying to establish a "family cottage," a limited liability company (LLC) is an ideal ownership vehicle. An LLC has a perpetual existence. Parents can transfer the property to an LLC and then gift interests in the LLC during lifetime or at death to other family members. The LLC as an entity can protect owners from lawsuits by users of the cottage if injured on the premises. It can also prevent owners from being able to use the right of partition in order to sell the property. If used with a properly structured operating agreement, it can promote shared use and fair governance of the property.

It is possible to use an LLC operating agreement to meet the goals of the family, and should include:

1. A determination of who is the manager of the LLC--all members or a named managing member.
2. A procedure for determining what maintenance or improvement is to occur on the property and a method of allocating associated expenses.
3. A method of equitably allocating among family members the dates for using the cottage, especially during holidays, school vacations and most ideal seasons.
4. Rules for members using the cottage, including restrictions on allowance of pets, ability to invite guests, and the ability to rent out the member's time to outside parties.
5. A method for penalizing a member for violation of usage rules and/or failure to pay the required contribution for expenses.
6. A method for determining the transfer of member interests, including price and terms, for any member desiring to sell their interest. This could include a restriction on any sale to a non-family member.

While gift and estate taxes are unlikely to cause an issue, the consequences in regards to property taxes should not be forgotten when considering the transfer of a vacation home. Under Michigan law, if you convey less than 50% of ownership in real estate to others, there is no change in the property tax assessment rules for determining taxable value. Parents can gift up to 49% of the property to family members without any real estate tax consequence. If they prefer, the parents can first transfer the property to an LLC and then transfer 50% of the LLC to family members.

Because property values are still somewhat depressed, this is an opportune time to transfer the vacation property to family members and move value and future appreciation to family members and out of the parents' estate, while continuing to allow parents to maintain control of the asset.

While parents have the best interests of their family at heart, trying to maintain a vacation home in the family for a number of generations can create a nightmare scenario. It makes good sense to discuss this strategy with qualified counsel and the family itself to make sure there is sufficient interest to maintain the family cottage for future generations and to properly structure the transaction.

The State of Estate Planning Post Fiscal Cliff

2013 is now three days old and we at Plainly Legal are pleased to report we have survived the "fiscal cliff" that loomed so ominously at year-end. While it took a few extra hours, some arm-twisting, and likely more than a few hurt feelings, Congress has managed a compromise and begun to address the expiration of tax cuts and mandatory spending reductions that make up the “fiscal cliff.” While the legislation passed by Congress is broad and addresses many different aspects of taxation, and Congress still needs to address a number of other areas in the next few months, I wanted to take just a few moments of your time to address impact of that legislation on the estate planning process.

The final legislation’s impact on the estate planning process is rather limited as compared to earlier proposed bills, but for the most part there is good news. The most important aspects of the bill are:

• The new law makes permanent the existing $5,000,000 exemption for each taxpayer for the Federal Estate Tax, and the law indexes this exemption to the rate of inflation so the exemption will grow slowly over time. This means that estates smaller than $5,000,000 ($10,000,000 for a married couple) are not subject to Federal Estate Taxation.
• The Lifetime Gift Tax Exemption for making gifts prior to death also remains at $5,000,000. The Lifetime Gift Tax Exemption and the Estate Tax Exemption remain linked, so every dollar of the Lifetime Gift Tax Exemption used counts against the Estate Tax Exemption.
• The legislation makes permanent the exemption portability, which is the ability of a widow or widower to make use of the unused exemption amount of a deceased spouse.
• The only substantive change in the legislation from the rules that governed for the past twelve months is an increase in the highest rate of estate taxation from 35% to 40%.

For better or worse, the legislation makes only limited changes to the law affecting estate planning. Plainly Legal will leave to others the political discourse and countless opinions expressed by elected officials, pundits, and others about the scope of the changes. Instead, we take solace in the fact that this legislation creates a level of certainty in the estate tax law that has not existed for the last few years. The certainty and permanency of exemptions and provisions that no longer have a sunset date (at least until Congress decides to actively make changes again) creates an opportunity to review a client's estate planning and determine whether it is appropriate to make any changes. With higher exemption limits, it may no longer be necessary for both a husband and wife to have a Living Trust, allowing planning simplification. In addition, concerns or issues which have been weighing on clients about family situations until the federal law was clearer can be addressed. It is also a good time to review your assets and confirm they are properly titled to avoid probate.

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.