Planning for Business Owners

In our previous blog we touched on how planning for clients with a variety of assets can be more challenging, or at least provide the opportunity to make use of more interesting planning strategies. One situation where this is especially common is when the client owns a family business. When that is the case, the relationship between the business and the beneficiaries is a lynchpin in the planning.

Michael and Nancy own a series of businesses, originally inherited from Nancy’s parents and then expanded, that over the years have allowed them to provide very well for their three children Oliver, Pam, and Quinn. All three children are now adults with children of their own, and Michael and Nancy have assisted them with funding their grandchildren’s college costs. Pam is very active in the family businesses, ready to step in and take over control whenever her father is ready to retire. While Oliver and Quinn are not involved in the businesses, Oliver has become a successful CPA and is doing well on his own. Quinn on the other hand has struggled to find her way in the world. A recent divorce has left her in a precarious financial and personal situation.

Adding to the complexity of planning for Michael and Nancy is that a section of their business is very reliant on the work on a particular key employee without whom that portion of the business is likely to suffer. The employee also has expressed interest in owning part of the business. While the complexity of this situation cannot be explained in the confines of our normal word limits we will summarize how proper estate planning can be used to ensure that Michael and Nancy can provide for Oliver, Pam, and Quinn equally, address concerns about differing financial states, and avoid creating a competitor.

First, it is important to note that much of the planning for Michael and Nancy’s situation revolves around the use of a document called a Buy-Sell Agreement (Buy Sell). This document creates an obligation for the owners of a business to sell and a particular party to buy the business under certain predetermined circumstances. The Buy Sell will establish the triggering events (often Death, Incapacity, and/or Retirement of the seller), the sale price (or at least how that price will be determined), and the terms for paying the sale price. Depending on the relationship between the buyers and sellers, there may be a life insurance component to the Buy Sell that guarantees there will be funds for some, if not all, of the purchase price.

For Michael and Nancy we used two different Buy Sells to achieve their goals, one with their daughter Pam and one with their key employee. For the key employee the Buy Sell granted an initial sense of ownership in the part of the business in which he was involved, and guaranteed him the right to buy out that portion of the business when Michael and Nancy retired or passed away. The Buy Sell even included incentives to encourage the key employee to improve the business while Michael and Nancy remained the owners, increasing profits in the near term without significantly increasing the final purchase price. This Buy Sell was part of the planning to create sufficient liquid assets to allow Michael and Nancy to make Pam the sole owner of the remainder of the family business while still having assets to leave to Quinn and Oliver.

In addition to the funds from their key employee’s Buy Sell, Michael and Nancy created a Buy Sell with Pam which controlled the transfer of the majority of the remaining family business assets. Michael and Nancy funded this Buy Sell with the proceeds of a Second to Die Life Insurance policy on Michael and Nancy’s lives that provides the business with the funds to buy Michael and Nancy’s interest in the company from their Living Trust, leaving the Trust with liquid assets to distribute to Oliver and Quinn. In lieu of those liquid assets, Pam will receive her parent’s voting interest in the company, giving her complete control of that asset.

Since the liquid assets for Oliver and Quinn will pass through Michael and Nancy’s Living Trust, they were able to provide their Trustee with the discretion to hold distributions to Quinn in trust in the event the Trustee deemed that she needed additional assistance with the large influx of money. While this creates a situation fraught with potential problems because Michael and Nancy named Oliver as the first successor Trustee, the family dynamic between Oliver and his “baby sister” is strong and Michael and Nancy are comfortable with the situation.
This example touches on the simplest use of a Buy Sell and does not address many of the other strategies available to business owners for transferring wealth to their beneficiaries but clearly, the complexity of even this simple plan requires the involvement of other experienced professionals. As always, do not attempt to implement the strategies you read about here without consulting an attorney experienced in the estate planning field.

Matt and Al

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.

Planning to Meet the Client's Goals and Limit Estate Tax Liability

Last week we profiled a client and the strategies used in his estate plan to protect his loved ones after doctors diagnosed him with a likely fatal disease. While we did a great deal of planning in his final months, as with many endeavors, planning prior to discovering problems leads to greater success. When we began working with this client, we immediately recognized that he faced significant potential issues related to estate planning, tax planning, and family dynamics.

After analyzing his situation, we found three areas of potential concern. First, due to the scope of business and invested assets, as well as his real estate holdings there was likely to be a substantial estate tax liability at both the client’s death and the death of his wife. Second, because he wanted to provide that some of his assets went to his daughters from his first marriage if he predeceased his current wife, we were unable to set up the traditional marital/residuary strategy to eliminate taxes on the first death. Finally, we knew that the value of his real estate holdings continued to increase and increased the potential estate tax liability.

We first discussed the potential estate tax liability and the effect it would have on his business if he died suddenly and a significant tax liability arose. He recognized that while his assets generated significant annual income, most of his assets were illiquid and would not provide cash for taxes without adversely affecting the business itself. Without planning, we would have to "kill the golden goose" to provide sufficient assets to satisfy tax liability. To address this issue we recommended a number of Irrevocable Trusts to own life insurance on the client’s life and on both the client and his wife’s lives jointly.

One Irrevocable Trust held a policy on his life alone, which matured at his death and provided the funds to pay the estate tax liability at that time. Since we could not know at that time if the client or his wife would die first, the second Irrevocable Trust held a second to die policy, which would mature in any event on the second death and provide funds to pay any additional tax liability at that time. After years of continued success and an increasing estate, we also later set up an Irrevocable Trust to own a policy on his wife's life, to provide additional protection against tax liability whenever she passed away. In addition to providing liquidity to the estate to offset potential tax liability, these Trusts freed up estate assets for other family planning. As an added benefit to the client, premiums paid were a fraction of the policy face value, so the client was able to pay estate taxes at his death with cheaper dollars.

When it came time to address the matter of the client’s evermore-valuable real estate holdings, the client indicated that he did not need the asset value or the income from these properties and was willing to gift the property to his five daughters, as long as he could maintain control of them. Using limited liability companies to own the property, we gave our client a 1% voting interest in the entities and gifted the 99% nonvoting interest to the daughters. While he was alive, the client maintained control of the properties with the voting interest and the LLCs held the rental income received for the benefit of the daughters. Eventually we entered into an agreement where the LLCs loaned money to the Irrevocable Trusts to pay life insurance premiums, which freed up a significant amount of cash flow for the client. In order to protect the children, we annually distributed a sufficient amount of money to pay taxes on the "phantom income" they received from the LLCs.

As you can see, while it is possible to complete some planning when emergencies arise, the best planning is done beforehand by anticipating issues and using strategies that protect the client and loved ones. It is important that we as planners anticipate our clients’ needs because they are often too busy to do so themselves.

Alan 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

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

Income Recognition from Cancellation of an Insurance Contract

The general rule is that that the proceeds of a life insurance contract, payable on the death of the insured, does not create taxable income. Consequently, even though the beneficiaries of a life insurance policy may realize a substantial economic gain by the receipt of the proceeds, this gain will not generally be taxable. However, one should be careful in dealing with an insurance policy during the lifetime of the insured. Some policy owners will borrow the cash surrender value prior to death to pay premiums, which may create a tax problem, as illustrated by a recent Tax Court decision.

In that case, a taxpayer purchased a life insurance policy and made premium payments for the first 13 years of the policy. The taxpayer elected an automatic loan premium provision in the event that the owner stopped making premium payments. Eventually, the taxpayer stopped making premium payments and the insurance company used the automatic loan premium provision to borrow the cash surrender value prior to death to pay the premiums. The policy provided it would lapse if its cash value could no longer cover the premium payments. This would occur if the outstanding loan balance and interest exceeded the policy's cash value.  The insurance company notified the taxpayer that the policy had lapsed because the outstanding loan balance and interest exceeded the policy's cash value.

To understand the consequences of this action it is important to understand that Internal Revenue Code Section 61(a) defines gross income as “all income from whatever source derived,” unless otherwise provided. Generally, any amount that is received under a life insurance contract prior to death is included in gross income to the extent it exceeds the investment in the contract. The phrase “investment in the contract” is defined generally as the aggregate amount of premiums or other consideration paid for the contract less the aggregate amount previously received under the contract, to the extent it was excludible from gross income. In the case at hand, the difference between the outstanding loan balance and the investment in the contract was $37,981, and the insurance company issued a Form 1099-R showing this taxable amount.

The taxpayer timely filed his personal income tax return but did not report the taxable amount shown on the Form 1099-R. The IRS eventually sent the taxpayer a notice of deficiency showing an adjustment to income of $37,981 for pensions and annuities. The taxpayer argued the amount was not income for purposes of income taxation.

The Tax Court determined that for Federal income tax purposes, loans against the cash value of a life insurance contract are true loans from the insurance company to the policyholder with the policy serving as collateral and thus not taxable distributions when received. When the insurance company terminated the policy, it charged the amounts of policy loans and capitalized interest against the proceeds from termination made available at that time. This constructive distribution in satisfaction of the loans had the effect of a payment of the policy proceeds to the taxpayer constituting income to the taxpayer to the extent it exceeded his investment in the policy.  In this case, of the Tax Court agreed with the IRS in charging penalties as well as interest because the taxpayer had knowledge of the income because he received the Form 1099-R.

When clients have financial difficulties, they will often use premium policy loans to carry the policy in difficult times, or may cancel the policy altogether. Due to the potential for unintended tax consequences clients considering these actions should seek professional help to determine policy parameters and tax consequences. 

Alan Ferrara

Leveraging IRA Accounts using Life Insurance

One interesting item in President Obama's latest budget proposal is limiting IRA accounts to $3 million, or some number calculated to purchase a maximum benefit of $205,000 at retirement. In addition to limiting the amounts that can be tax-deferred under IRAs, this would probably have the effect of minimizing the benefit of "stretch IRAs". While this idea may never be a part of the final budget it does bring to mind a planning option I have used with IRAs in the right circumstances.

Because IRAs eventually are generally fully taxable, a $3 million IRA, or even a smaller IRA, will be subject to significant income taxation. If the taxpayer's estate is above the $5 million lifetime exemption, the total tax burden on the IRA only gets worse.

If a client desires to maximize the amount going to their heirs, they may want to consider leveraging their IRA using life insurance. The strategy works as follows:

1. Presuming the client does not need IRA distributions to support their lifestyle, Instead of delaying IRA distributions until age 70 1/2, a client begins taking distributions after 59 1/2 when there are no longer penalties for early distributions.
2. After paying the income tax on the IRA distribution, the client gifts the remainder of the distribution to an Irrevocable Trust benefiting family members.
3. The Irrevocable Trust Trustee purchases a life insurance policy on the life of the client. After satisfying some legal requirements (Crummey Notices), the Trustee uses the funds to pay the annual premium of the life insurance policy.
4. At the death of the client, the Trustee collects the insurance proceeds, income tax-free, and uses them for the benefit of the client's family.

The client has succeeded in turning a heavily income (and possibly estate) taxed IRA account into a tax-free account, of significantly greater value, depending on the size of the insurance policy.

If the beneficiaries are minors or adults without a good record of handling money, the Irrevocable Trust can protect them from themselves and their creditors. If all of the beneficiaries are adults and the client is comfortable with their maturity, the client can simply make gifts to the family members who will then use it to purchase a life insurance policy on the client. Either way, the proceeds are income tax-free and, if properly structured, are not part of the client's estate.

The client can go a step further if he/she does not like the idea that the IRA benefits are going to be income and possibly estate taxable after death. The client and the client’s spouse can have full use of the IRA account during their lifetimes, and then provide that at the second death the IRA account be distributed directly to a charity, tax-free. The family members get their benefit, the charity gets its benefit, and the only entity that loses is the Internal Revenue Service.

Most of my clients are not inclined towards making significant charitable gifts, but with the right strategy, they love the idea that their loved ones are protected, they can satisfy any charitable inclinations, and the IRS is essentially paying for it. With proper planning and the help of qualified professionals, family members are better protected.

Alan Ferrara

Prenuptial Agreements

     As part of our estate planning practice, we will often recommend clients execute a Prenuptial Agreement when considering remarriage, whether because of the death of a spouse or a divorce. This recommendation comes from the experience of clients whose parents who remarry, retitle their assets jointly or change their estate planning documents, then die leaving nothing to their children. Frequently that outcome is the accidental result of someone with the best intentions.

     Most of our clients want to protect their new spouse during their lifetime but still ensure that the majority of their assets will eventually pass to their children. A Prenuptial Agreement is a contract between two people considering marriage, that sets forth property rights each will have in the event of death, divorce or separation. Most often agreements of this type focus primarily on the property owned by the wealthier of the two parties, but usually each party desires to protect their own family members too. A properly drafted and executed Prenuptial Agreement can be an important part of a client’s estate plan.

     Until 1991, Prenuptial Agreements in Michigan were invalid because the courts were loath to encourage divorce. That changed with a case decided in 1991. Now, absent a showing of fraud, undue influence, lack of knowledge or mental incapacity, Prenuptial Agreements are valid contracts between parties. A later claim of no consideration or a claim that the agreement is contrary to public policy as not protecting a spouse fails because the courts have said that in addition to any actual benefit a party receives from the Prenuptial Agreement the marriage alone is sufficient consideration.

     In order for a Prenuptial Agreement to be valid, it must clearly define certain provisions:

1. Name and address of each party 
2. Schedule and value of real and personal property owned by each party 
3. Determination of ownership of property acquired during the marriage 
4. Specific provision as to property that will be considered to be owned individually or jointly 
5. What happens upon the death of one of the spouses or upon divorce or separation 
6. An acknowledgment that each party has had an opportunity to consult their own attorney, even if they did not do so 
7. A provision regarding life insurance and pension benefits and who are the beneficiaries 
8. An agreement of who will be responsible for which debts 
9. A listing of rights that each spouse is waiving 
10. Provisions regarding revocation, termination or modification of the agreement

     In addition to all of the above, the agreement must provide full and fair disclosure of all the terms and all of the assets of each party. Full disclosure of assets is essential. If a spouse can prove that there was not full and fair disclosure of assets or that assets were specifically hidden, and that the spouse did not know what he or she was giving up, that is a reason for setting aside the agreement. 

     Finally, the agreement must be executed without any duress. It is important to provide the parties with sufficient time to consult their own attorneys for complete review of the agreement. A party who presents a Prenuptial Agreement to another party the morning of the wedding is likely to find the courts holding that the agreement is unenforceable. It is hard to argue that the agreement was made without any duress if a party is told that the wedding will be canceled if the agreement is not executed. 

     The agreement can be as simple as "I retain ownership of my assets, you retain ownership of your assets and assets we jointly purchase during our marriage are split equally." However, the agreement can be much more complicated, and can include the following:

• A formula amount of how much a spouse will be entitled to upon death or divorce, usually dependent upon length of the marriage--for example $100,000 per year for each year of marriage 
• An agreement to provide a specific amount or income stream for the spouse upon the death of the other party, whether directly to the surviving spouse, or pursuant to terms of a Trust of the decedent spouse 
• A provision that the agreement terminates and is of no force or effect upon a specific anniversary of the marriage, for example after 10 years 
• A provision that the agreement only applies to certain assets, such as a family-owned business 
• Specific disclaimer as to any rights otherwise available under Michigan law in the event of death, divorce or separation 

Even the following unusual provisions are enforceable:

• A spouse being limited to no more than one football game on Sunday during the season. 
• A spouse being allowed to opt out of all vacations with in-laws. 
• Limiting a wife's weight to 120 pounds, with a penalty of $100,000 if she gained a pound or two. 

     As with estate planning, the only limit on prenuptial provisions is one's imagination. Like any other contract, the Prenuptial Agreement can be crafted to meet the needs and desires of the parties to protect their spouse yet ensure an inheritance for their own family members. Because of the potential for problems or accidentally invalidating an agreement, care should be taken in discussing the terms of the agreement and its drafting. Even greater care should be taken in ensuring full and fair disclosure of not only assets but also all of the provisions in the agreement. The hope is that the marriage will be long and loving, but the terms of the agreement should be specifically detailed and agreed upon when there is harmony between the parties, not if problems arise later.

Estate Planning for a Second Marriage

     Recently a colleague asked for information about the use of trusts in estate planning following a divorce and remarriage. Since we have not addressed this topic yet, a post on the subject seemed appropriate. It is important for client to consider estate planning issues following a divorce and remarriage to avoid inadvertently disinheriting either the new spouse or children of the first marriage. Clients (husband and wife) in their first marriage usually have common goals, such as providing for the surviving spouse during their lifetime and leaving any remaining assets to their children equally. This makes estate planning relatively simple, because a living trust holds the assets to limit tax liability, avoid probate, and ensure the assets pass to the surviving spouse for use during the spouse's lifetime and then on to the couple's children.

     Clients in second marriages, whether because of divorce or death, usually have a more complex situation with which to deal. In those circumstances there are concerns regarding the surviving spouse, children from the first marriage, the surviving spouse's children, and possibly children from the second marriage. Clients wish to ensure the surviving spouse has sufficient assets during lifetime, while also ensuring that the assets they brought into the marriage eventually pass to their children.

     A frequent concern of clients in their second marriage is ensuring that both their second spouse and their children receive gifts following the client's death. A common technique used to achieve this goal provides the surviving spouse with a regular stream of income from the trust assets, while reserving distributions of principal for the client’s children following the death of the surviving spouse. When using this technique, it is also common to provide the trustee with the discretion to make distributions of principal to the surviving spouse, under a limited set of circumstances, to ensure that the surviving spouse has sufficient assets to live on following the first spouse's death. It is important in these circumstances that the trustee understand that part of their responsibility is to balance the best interests of both the spouse and children from the first marriage in making distributions. It is a good idea for the client to discuss these issues with the named trustee.

     Alternatively, some clients opt to address this issue by distributing different assets to their surviving spouse and their children. For example, a trust might provide that the client’s children receive immediate distributions from the trust assets equal to the payout from a life insurance policy. The client may also provide that the children are beneficiaries of the client’s IRA or other retirement accounts. The trust then provides that the client's surviving spouse receive all income from the remaining trust assets, and gives the trustee broad discretion to make distributions of principal for the surviving spouse's needs. Any trust assets that remain following the death of the second spouse are distributed to the client’s children. This technique ensures that that the client’s children receive an immediate gift as well as the potential for additional assets should any remain after ensuring that the surviving spouse has sufficient assets during the their lifetime.

     A well-drafted trust is required to make use of these techniques because you need an entity maintain the trust assets instead of passing those assets directly to the surviving spouse. During a first marriage, a common technique for probate avoidance is to own property jointly with rights of survivorship. This allows the surviving spouse to remain the sole owner of the property following the first spouse's death without the property passing through probate. If this same technique is used following a second marriage, the surviving spouse becomes the sole owner of the property or bank account and then is free to do with that property whatever he or she chooses. This means that property the client intended for children to inherit following the second spouse's death could pass directly to the second spouse's children or family and completely disinherit the client's children from the first marriage.

     There is not always controversy about who inherits which assets. In many second marriages, spouses and their children from first marriages live in perfect harmony. Even in these circumstances, the spouses may wish to ensure that particular assets, such as vacation homes or collectibles, that each has brought into their second marriage are eventually inherited by their own children. With proper planning, it is possible to maintain these separate assets for both spouses’ use while ensuring that after the second death the assets will go to each spouse’s children, while assets earned jointly during the marriage are split equally amongst all the children.

     It is clear that the circumstances that exist when contemplating estate planning for a second marriage involve a level of complexity that generally does not exist when planning during a first marriage. These circumstances can become even more complex if either spouse’s children has special needs, dependency issues, creditor problems, or if there are significant personal conflicts between children and second spouses.  You may actually have a case where the new spouse has his or her own issues, which need to be addressed. An example of this occurs if the new spouse has an unpaid federal income tax liability and the spouse transfers a residence originally owned individually to the other spouse as joint tenants. Now the IRS can attach a lien to the residence. It is important to speak with an experienced attorney to ensure that the estate plan meets the goals of both spouses and is implemented with a minimum of conflict.

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.

Dying with Debt

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

THAT STATEMENT IS SIMPLY NOT TRUE.

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

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

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

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

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

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

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

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

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

It is Better to Give than Receive

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

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

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

USING CHARITABLE TRUSTS

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

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

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

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

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

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

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

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

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.