Irrevocable vs Revocable Trusts, What's the Difference

As we previously discussed, there are different kinds of Trusts that serve different client needs. It is common to have a Living Trust as part of an estate plan because such trusts give the Grantors versatility to adapt their planning as life circumstances change to protect family members and avoid probate. There are other forms of Trusts that provide less flexibility to the Grantor, but they are useful in the right circumstances. Every Living Trust executed as part of an estate plan is revocable (changeable) during lifetime, but at the death of the Grantor becomes an Irrevocable Trust (unchangeable) administered by the Successor Trustee pursuant to the terms set by the Grantor during lifetime. 

This transition from Living to Irrevocable Trust at the death of a Grantor is the most common instance of irrevocable trusts in an estate plan. Generally the terms of the Living Trust provide that at the death of the Grantor no changes may be made to the terms of the trust, and that the successor Trustees have a duty to administer the Trust as a separate legal entity. This duty requires the successor Trustees to apply for a Tax ID number from the IRS, inform the institutions that hold the trust’s assets of the change in status, and provide the Beneficiaries of the trust with sufficient information to allow them to enforce their rights under the trust. The Trustees are charged with following the Grantor’s instructions with respect to administering and distributing assets to trust beneficiaries until the assets of the trust are exhausted or distributed outright to a beneficiary. 

While the “Irrevocable Living Trust” is the most common instance of an irrevocable trust in an estate plan, other forms of irrevocable trusts are available depending upon the need of the client. While clients like the Living Trust because it is changeable, they can control it during lifetime, and they can receive the benefits of the assets in the Living Trust, those benefits can be detrimental in certain tax and printer liability circumstances. Irrevocable trusts are beneficial as part of an estate plan because an irrevocable trust, if properly drafted, is a separate legal entity from the person who created it and therefore is treated differently in a number of respects. If properly drafted, irrevocable trust assets and income are not considered as owned by the Grantor, therefore taxable income is not included in the Grantor’s income nor can creditors up of the Grantor generally reach irrevocable trust assets. The drawbacks of an irrevocable trust generally require that the Grantor cannot be a beneficiary or trustee of an irrevocable trust, prevents the Grantor from changing the terms of the trust and prevents the Grantor from enjoying the benefits of the assets. In addition, income earn by a trust is taxed at a higher rate than that earned by an individual if income is not distributed to beneficiaries.

Even with these downsides, creating an irrevocable trust can address a variety of complex planning circumstances. The Irrevocable Trust can be used to own insurance policies provide cash to pay estate tax on the death of the Grantor, or be used to provide proceeds used to fund a business buyout, while not being includable in the Grantor’s estate. An Irrevocable Trust can also be used to hold funds to care for the needs of children with disabilities and not be subject to the requirement of state agencies that such funds be used in lieu of state funds instead of in addition to any straight funds. A recent change in Michigan law also allows the creation of an irrevocable trust that allows the Grantor to have substantial use of trust assets while shielding those assets from creditors in the event of a lawsuit. These techniques tend to involve individuals with more complex planning situations and significant assets, but can assist in addressing concerns about careers with higher than average liability or to address concerns regarding assets and second marriages. Other sophisticated estate planning strategies also use different types of Irrevocable Trust, but a discussion of these is beyond the scope of this blog.

Care should be taken when considering irrevocable trust strategies because, as with all good planning ideas, some may be taken to a ridiculous and untenable level. While properly executed and administered irrevocable trusts comply with legal provisions, the IRS is always looking for situations where trust are not properly drafted or administered, opening up the client to taxes and penalties Always consult with an attorney experienced in estate planning before signing any documents.

Matt and Al

Domestic Asset Protection Trusts

Michigan Trust Law has remained fairly static in recent years with little change since the adoption of the Estates and Protected Individuals Code and the Michigan Trust Code. That changed recently with the passing of bills which allow the creation of Michigan based, self-settled, asset protection trusts. 

     February 2017 brings us an exciting change in Michigan Trust Law. As of Sunday, February 5, 2017, Michigan becomes the 16th state to permit Domestic Asset Protection Trusts (DAPT). A DAPT allows an individual (the “Grantor”) to create and fund an irrevocable trust which, subject to certain legal requirements, allows the Grantor to shield assets from the claims of a creditor.

     There are number of rules that a Grantor must follow in order to establish a valid DAPT, including the prohibition on the trust Grantor acting as the Trustee. However if properly drafted and funded, a DAPT will provide significant creditor protection while still allowing the Grantor to retain substantial rights with respect to the Trust property, including the ability:

• to receive all of the income produced by the trust’s assets as well as to receive discretionary distributions of the Trust’s principal; 
• to direct the investment of Trust assets 
• to remove and replace trustees; and 
• direct the distribution of assets following the Grant’s death.

While the Grantor cannot act as the Trustee of their own Trust, they do have broad discretion over who to appoint and can even appoint family members to serve in that role. 

     While a DAPT is incredibly powerful tool for creditor protection, it does have limitations. Most prominently, there is a two-year period from the date assets are transferred to the trust before creditor protection is achieved. Additionally, in situations related to bankruptcy or fraudulent concealment, protection takes longer to be applicable or may be completely unavailable. Due to these limitations, it is important to create and fund a DAPT well in advance of any claim arising. 

     DAPTs have the potential to become a very important part of estate planning, especially for those individuals such as doctors and business owners who face higher than average creditor exposure. However in order for them to provide the intended protection it is vital to ensure the DAPT comports with the governing statute. As always, before attempting to include a DAPT in your planning, or the planning of your clients, it is important to consult an experienced estate planning attorney.

Alan and Matt

Gifting $5 Million Without Using $5 Million Worth of Lifetime Exemptions

A few weeks ago we discussed the concept of using limited liability companies ("LLC's") for gifting purposes. We have been working with clients using such a strategy and this gives us an opportunity to explain how the concept works.

     Among other assets, John and Jane have commercial buildings valued at $10,000,000, which are likely to double in value over the next 10 years. The clients also have two children and six grandchildren, all of whom are adults. They were not opposed to lifetime gifting to remove assets and the future appreciation from their estates, but they wanted to maintain control of the assets.

     We suggested that John and Jane transfer the buildings to an LLC, in exchange for a 2% voting interest in the LLC and a 98% nonvoting interest in the LLC, which they then divided equally between themselves. We then discussed what portion of the interests they wanted to gift to their children and grandchildren. Since one goal was to ensure that John and Jane maintained control of the buildings, they will definitely retain ownership of the voting interests. They also wanted to enjoy some of the annual income generated by the buildings, so they will need to retain a portion of the nonvoting interests. Ultimately, John and Jane chose to gift 50% of the nonvoting interests to their children and grandchildren.

     Since John and Jane gifted nonvoting interests, which do not give the owner of that interest control of the business, the IRS will allow a discount of the value of the interest gifted for gift tax purposes. Thus, even though John and Jane gifted an equivalent of $5,000,000, because of the discount (conservatively at 20%) the deemed gift was only $4,000,000. John and Jane each used their annual exclusion gifts of $14,000 to make gifts to each of the children and grandchildren, for a total of $224,000 ($14,000 x 2 grantors x 8 descendants). The remaining gift of $3,776,000 was divided equally between John and Jane's lifetime exemptions against estate tax and we filed a gift tax return providing the IRS with a record of the transaction.

    As an additional protection against creditors and any potential divorce, we also established irrevocable trusts for each of John and Jane’s children and grandchildren to hold the gifted nonvoting interests. These trusts have flexible provisions regarding the distribution of income and principal to the beneficiaries, while also creating a nest egg for later in their lives. 

     The net result of this strategy is that John and Jane maintain control of the buildings during their lifetime and removed assets presently valued at $5,000,000 from their estates using only a portion of their lifetime exemptions. In addition, the transfer removes all of the appreciation on the gifts from John and Jane's estates, saving approximately $2,000,000 of estate taxes at their deaths (appreciation of $5,000,000 x 40% estate tax). In addition, income earned by the gifted interests is now reported on eight different income tax returns and presumably taxed at lower tax rates.

     In this situation, an estate tax savings was one of the desired results. However, even if clients do not have an estate tax issue, gifts of LLC interests to irrevocable trusts can provide children and grandchildren with an income stream, while protecting the interests from creditors or possible marital issues. This strategy is not without additional cost, as appraisals of both the asset value and the minority discount must be completed by a qualified appraiser. In addition, attention must be paid to the administrative requirements and tax filings of both the LLC and the irrevocable trust. As always, clients should seek the advice of a qualified professional before engaging in the strategy.

The Changing Role of the Irrevocable Life Insurance Trust

Today we look at an advance trust, the Irrevocable Life Insurance Trust, whose role in the the estate planning process continues to evolve in response to changes in the tax code.

     With the Estate Tax Exemption now over $5,000,000 for an individual and $10,000,000 for a married couple, the Irrevocable Life Insurance Trust (ILIT), a once common tool for offsetting estate tax liability, is used less often. While the benefits of an ILIT as a tool to offset the estate tax liability have decreased for the majority of individuals, there are other situations where an ILIT can still be a very useful tool in estate planning.

     An ILIT is designed to own a life insurance policy, normally on the life of the Grantor, without the proceeds from that policy being included in the Grantor’s estate for the purposes of estate taxes. The premiums for the insurance policy are paid by the Trustee, most often with contributions made to the trust by the Grantor using the Annual Gift Tax Exclusion. In order for these contributions to qualify for that exclusion, they must be what the IRS regulations refer to as "present gifts". This means that the recipient of the gift must have the ability to take the gift outright and free of trust if they so choose. The terms of the ILIT require the Trustee to give the trust beneficiaries written notice of a limited window of time during which they may withdraw their gift from the trust. After that time period passes, the gift becomes a trust asset and the Trustee can use it to pay the premiums on the insurance policy owned by the trust. This notice is often referred to as a "Crummey Notice", and is named after a tax case named Crummey vs Commissioner.

     A keen observer might ask what is to keep the ILIT beneficiaries from simply withdrawing their gifts immediately and leaving the Trustee without any assets to pay the policy premiums. The answer to this question lies in the beneficiaries' understanding that not withdrawing this gift from the trust in the short term will result in a larger benefit in the long term. If that logic fails, the Grantor can simply refuse to make gifts subject to the Crummey withdrawal rules, not providing the beneficiaries with the ability to withdraw gifts. The negative of this strategy is that the gifts do not qualify for the annual exclusion.

     An ILIT's benefit is that the proceeds from a life insurance policy owned by the trust is not considered to be in the estate of the grantor and therefore not counted for calculation of estate tax liability. For those couples with estates in excess of the $10,000,000 estate tax exemption this means a pool of assets that can offset the portion of an estate used to pay the tax bill. For those clients who do not have a taxable estate, there are also benefits.

• For clients who own small, or not so small, businesses that they intend to leave or sell only to children active in the business, an ILIT allows them to create a pool of assets that can pass to the children who will not inherit the family business, creating equity among children and minimizing interfamily squabbles after death, without increasing the size of the client’s estate and risking potential estate taxes. 
• An ILIT also can be used to provide assets for the benefit of a second spouse, protecting client's other assets for the benefit of children of a prior marriage 
• If a client has substantial charitable inclinations, an ILIT can be used to provide children or other loved ones with a certain amount of inheritance while leaving the remainder of an estate to the client’s favorite charities, creating a charitable estate tax deduction. 
• As with other trusts,  for those clients who want to make gifts, but retain some control over the gifted assets, an ILIT allows them to provide and additional benefit to their loved ones while retaining control over the circumstances under which those loved ones may receive distributions from the trust.
• The ILIT also can leverage the grantor’s generation skipping transfer (GST) tax exemption because the grantor’s GST tax exemption can be allocated to an ILIT holding a life insurance policy that may substantially increase in value. As a result, numerous generations may benefit from the trust assets free of federal estate and GST tax.

     While the value of using an ILIT has been reduced by the current ever-growing Lifetime Estate Tax Exclusion, there are still circumstances where an ILIT may be useful to clients. Like any other tax and estate planning strategy, it is important to consult with experienced professionals before deciding to make use of the technique in order to ensure that clients do not expose themselves to unintended consequences.

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

Insurance as Part of an Estate Plan

When clients are in their early career years, working hard to establish themselves and starting a family, not enough time and effort is placed on setting assets aside to protect the family for the future. The thought process usually is that with hard work, we will be able to save sufficient assets for putting our children through school and providing a nice nest egg for our retirement years. However, what happens if plans go awry and the client dies unexpectedly? The family loses someone who was previously contributing to the payment of day-to-day living expenses. This can have a significant adverse effect on the lifestyle or future plans of the surviving spouse and children. This is the perfect time to consider the need for life insurance to provide that protection.

Life insurance can provide protection for a spouse and children in the event a client dies prematurely. A life insurance policy can provide funds to pay family living expenses and college education costs. It can replace the income stream lost when one spouse passes away unexpectedly, and allows the family to maintain a standard of living is otherwise lost because of that death. At this stage in a client's life, term life insurance is probably the most economical way of funding this family protection. The relatively low cost of term insurance at young ages makes it affordable for families on a limited budget. The policy can be designed to protect for a finite number of years, (for example 10, 15, 20 or 30), depending on the length of the term insurance contract chosen. If the client dies at a young age, funds are available so a family's lifestyle can be maintained and dreams of college for children can be met. If the client lives to middle age and beyond, he builds a significant estate to protect the client and family in retirement years. In that case, the client lets the policy lapse or terminates it because it is no longer necessary.

Sometimes clients have targets for what they would like to leave to their children at their death. Clients often use life insurance to fund the difference between actual assets and the theoretical target set by the client. For example, if a client has five children and wants to pass on $500,000 each of death, a client needs $2,500,000. If the client only has $1,500,000 in assets, the difference can be funded with a life insurance policy at a much smaller cost on an annual basis than hoping to save the difference before the client dies.

Some of my clients have used life insurance fund a bequest to a child while giving a specific asset to another child that values that asset. For example, the largest asset of a client’s estate may be a business in which only one of the children are active. The client desires to leave the business to that child, yet does not want to be unfair to any other children. By purchasing a life insurance policy of equal value to the business, the client can assure that there will be sufficient assets to provide an equal split of value between us children.

On occasion, a client has used a life insurance policy to fund a special needs trust for a particular child, leaving the remainder of assets to other children in order to make certain that none of the estate is required to be used for the special needs child in lieu of government benefits.

Clients who are fortunate enough to have assets in excess of lifetime exclusion of $5,000,000 can use life insurance to replace the amount of the estate loss to estate taxes. These amounts can be replaced on a leveraged basis using life insurance because the cost of a life insurance policy, whether a term policy or a permanent policy will never exceed the face value of the policy. The replacement of the assets using life insurance policy is funded at a fraction of the cost. In a situation such as this, where a life insurance will always be useful, it may be more appropriate to use a permanent policy and continue to pay premiums, because a term policy has a finite existence and may lapse or terminate or become too expensive at a time when it would be most needed. While many clients worry about the costs reducing their livestock, the reality generally is that the life insurance premiums will be paid from excess assets, not assets being currently used to support the client's lifestyle that the payment of premiums will come from excess assets, not assets otherwise used to support a client's lifestyle.

For many years, the funding of a retirement benefit or savings using a permanent life insurance policy has been out of favor for a number of reasons. Some commentators are now suggesting that because of the income tax changes in the most recent tax law, which raise income tax rates on investment income, and dividends for some taxpayers, using a life insurance policy as an estate builder can be valuable because of the tax-deferred buildup of the value of the policy. While this remains to be seen, at least make sense to consider this as a possible planning option.

Whether a term policy or permanent policy makes sense will depend upon the intended use for the proceeds. Whatever type of policy is purchased, it will usually make sense to purchase it sooner than later because life insurance is less expensive for younger, healthier clients, resulting in smaller premiums. Using life insurance, goals can be met even if an unexpected death or other event occurs for a family. Clients should always discuss the purchase of life insurance with an experienced life insurance professional and their estate planning attorney.

It is Better to Give than Receive

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

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

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

USING CHARITABLE TRUSTS

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

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

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

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

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

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

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

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

The Value of Annual Gifting to an Estate Plan

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

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

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

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

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

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

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

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

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

Taking Advantage of the Present Gift and Estate Tax Lifetime Exemption

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

           

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

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

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

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

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

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

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

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

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

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

Irrevocable Life Insurance Trusts

Our prior posts have focused solely on Living, or Revocable, Trusts. However, as a client’s assets increase so does the potential complexity of their estate plan. A frequent concern of higher net worth clients is the prospect of paying estate taxes on the assets they choose to leave to their beneficiaries. Due to the present large estate tax lifetime exclusion of $5,120,000.00 (due to expire on December 31, 2012), planning strategies that address this concern have become less common in the past decade. However, for those clients with a net worth large enough to create an estate tax liability (a group that could increase in size dramatically should the Lifetime Exclusion decline to $1,000,000 or some other amount in 2013) the Irrevocable Life Insurance Trust may be a valuable tool. The greatest benefit of the Irrevocable Life Insurance Trust its ability to provide liquidity and finance a fund to offset expected estate taxes. 

The Irrevocable Trust

An "Irrevocable Life Insurance Trust" is a Trust designed to have as its only asset a life insurance policy on the life of a Grantor or a Grantor and his or her Spouse. It is drafted to provide that the proceeds from the insurance policy will not be a part of the Grantor's estate upon death and will pass to beneficiaries income tax-free. If the Grantor owns an insurance policy and retains control over the policy, then the proceeds from that policy are included in the Grantor's estate even if the proceeds from that policy are payable to someone other than the Grantor. For example, if the Grantor owns a $1,000,000.00 policy, and dies, that policy will be includable in the Grantor's estate and be subject to federal estate tax (taxed at a 35% rate this year and potentially a 50% rate next year), if the Grantor's estate exceeds the Lifetime Exclusion. If the Irrevocable Trust owns the $1,000,000.00 life insurance policy, and the Grantor dies, the policy proceeds are not includable in the Grantor's estate and will not be subject to the estate tax.

The Irrevocable Life Insurance Trust is commonly part of an estate plan when the Grantor's estate exceeds the value of the Lifetime Exclusion and there will be taxes owed at the time of the Grantor's death. Rather than having the taxes paid on a dollar for dollar basis from the Grantor's estate, an Irrevocable Life Insurance Trust holds an insurance policy and receives the proceeds from that policy. Those proceeds offset the taxes paid to the federal government and are distributed to the beneficiaries pursuant to the terms of the Irrevocable Trust, which may be the same or different from the terms of the Grantor’s Living Trust. The benefit to the estate comes from the fact that the cost of the annual insurance premiums are a fraction of the cost of the taxes paid on a dollar for dollar basis from the estate. 

In situations where the estate exceeds the value of the Lifetime Exclusion, an Irrevocable Life Insurance Trust is a good strategy. However, many of my clients are reluctant initially because of their lack of knowledge of life insurance policies and premiums costs. I suggest they consider this strictly from an economic standpoint. If the payment of the premiums will reduce their lifestyle, do they really want to give their children a greater lifestyle at the expense of their own inconvenience? However, the reality for most clients considering this technique is that the payment of premiums will come from excess assets, not assets otherwise used to support a client's lifestyle, and therefore the decision to use an Irrevocable Life Insurance Trust becomes an easier one.

A second use of an Irrevocable Life Insurance Trust is to provide for the needs of a special needs child while preserving any existing government benefits. The proceeds of the life insurance policy held by the Irrevocable Trust are used as appropriate for the child while the remainder of the Grantor's assets can benefit the Grantor's other beneficiaries. When used for this purpose the Trust will include language to ensure that distribution of the proceeds occurs at the Trustee's complete discretion so that the funds are used in addition to and not in lieu of any government benefits. In a similar fashion, an Irrevocable Trust can protect a second spouse by providing funds for him/her while distributing the rest of the Grantor's estate to children of prior marriage. In the alternative, the Irrevocable Trust can protect the Grantor's children by guaranteeing a specified amount, with the remainder the estate going to a second spouse or other beneficiaries.

The Insurance Policy

In order to ensure that the insurance policy is not included in the Grantor's estate, the Grantor must first execute the Irrevocable Life Insurance Trust and then the Trustee of the Trust applies for the policy on behalf of the Trust. It is important to use a new insurance policy to fund the Trust, because if an existing policy on the life of the Grantor is transferred to the Trust, and the Grantor dies within three years of the transfer, the insurance policy is considered part of the estate of the Grantor and subject to the estate tax. If at the time the Trust is established, the Grantor is not insurable and an existing policy must be used, as long as the Grantor survives for three years the policy will not be included in the Grantor's estate.

An additional requirement of an Irrevocable Life Insurance Trust is the requirement that the Grantor normally make annual gifts to the Trust in order to pay the annual premiums. The Grantor typically wants these annual gifts to count as "present gifts" to take advantage of the Gift Tax Annual Exclusion (presently $13,000.00 per donee). For that to occur, the beneficiary or beneficiaries must have at least a short period of time in which to be able to request that his or her portion of the annual premium be distributed to him or her rather than held in the Trust. For this reason, "Crummey Notices" generally are given to each of the beneficiaries, or their guardians if a beneficiary is a minor. The Crummey Notice, named for a tax case, Crummey vs. Commissioner, explains it that each beneficiary has a right to take his or her pro rata portion of the annual gift. If the beneficiary does not exercise that option within 30 days, that option expires, the gift is considered a “present gift’, and the Trustee can then pay the insurance premium.

An insurance policy taken out by the Trustee can be either a permanent policy or a term policy, except that if the policy is on the life of the Grantor and Grantor's spouse, only permanent policies are available. As with other life insurance policies, there are many funding choices. Some Grantors prefer to front-load premiums (pursuant to allowable insurance guidelines) so as to be able cease gifts to the Trust at a certain point in time and have the policy continue indefinitely. Others, who seek to keep gifts to a minimum, may actually use a term policy. The problem with the term policy is it will end after a certain number of years and if the grantor is uninsurable at that time, the strategy fails. Practically speaking, if there is an insurance need to offset estate taxes, that need is probably always there and a permanent policy should be considered. If there is no longer a need for the policy, or if the Grantor decides not to make additional gifts, the Trustee can cease making premium payments and the policy will lapse. 

Even though the trust itself is irrevocable and its terms cannot be changed, the Trustee and the Trustee's advisors should consider reviewing the life insurance policy on a regular basis to determine if the policy is still appropriate. It is possible a new policy with better provisions or with lower premiums would be a better choice for the situation. The duties of a Trustee of an Irrevocable Life Insurance Trust extend beyond simply providing the Crummey Notices and paying the premiums.

A strategy which is available now but which will expire on December 31, 2012, is to make a large gift to an Irrevocable Trust using the current $5,120,000.00 Lifetime Exclusion and purchase a large single pay premium policy. In the event changes in the law reduce the Lifetime Exclusion to $1,000,000.00, the Grantor has already fully funded the policy and need not make any large gifts thereafter. The strategy melds the time-tested strategy of the Irrevocable Life Insurance Trust with the short-term availability of making large gifts currently in the event that the Lifetime Exclusion is reduced significantly.

Just like the other strategies we have discussed, the Irrevocable Life Insurance Trust is another tool to be used where appropriate and can provide significant protection for specific beneficiaries and offset (at a much lower cost) estate taxes that will likely be paid at the death of the Grantor and Grantor's spouse. As is the case with these other tools, it is important to discuss what options are appropriate with a licensed attorney prior to taking any action.