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

Planning to Protect a Second Wife and Five Adult Daughters

Over the past year our goal in writing Plainly Legal was to discuss many of the technical legal issues in the area of estate planning that impact the practices of financial planners. Using this information as a basis, going forward we will be addressing specific situations raised by our clients and how we dealt with those situations. As we address these examples, we will do our best to link back to previous posts that address the technical issues. If any of you run across an issue or have a question on how to solve a client problem, feel free to e-mail us and we can address it in future posts.

A client of ours, diagnosed with cancer and given only a short time to live, was concerned about protecting his second wife during her lifetime, yet treating his five adult daughters fairly. The client owned a valuable business and also had significant personal assets, but was concerned that some of his daughters might create problems for his wife after his death. He was also concerned that he had not taught his daughters the value of money and worried they would not handle an inheritance well.

Initially, he wanted to leave everything in trust for his wife for use during her lifetime, with distributions to the daughters after her death. Knowing that the wife was somewhat younger than our client was and in good health, I raised the issue that it might be some time before the daughters received anything. To address this concern I suggested we carve out sufficient assets in a Marital Trust, including the residence and sufficient invested assets to maintain the wife's accustomed standard of living, for her use during her lifetime. Since the residence had significant value, we wanted to provide flexibility for the wife if she ever decided to sell the residence, and therefore we provided the Trustee with the power to sell the residence and use the funds to purchase a new residence for the wife, with any remaining funds added to the Marital Trust for the spouse. This power to purchase a new residence gave the wife the flexibility to downsize her residence or move to a different state for health or personal reasons if necessary. We also named the wife as a Co-Trustee of the Marital Trust set aside for her benefit, so that she had a say in the management of the assets held for her benefit.

To protect the daughters from their spending habits and maintain the value of the business, we placed the business and the remaining assets in a Children's Trust for the daughters benefit. The daughters received income automatically from their Trust each year, but principal distributions were totally discretionary until the oldest child reached the age of forty. At that point, the trust began distributing principal at the rate of 20% per year for the next five years. Our client felt comfortable that this would provide an income stream for each of the daughters, allowing them time to learn the value of money and how to manage the business, yet protect the value of the business so that disagreements among his daughters would not result in the sale of the business. To address the client’s concern that his daughters might cause his wife problems, we suggested that the wife be the Trustee of the Children's Trust, with a corporate fiduciary as a Successor Trustee in the event that the wife ever decided to resign as Trustee. Our client liked the idea because it gave the wife control over the children's future assets and distributions, which he felt would lessen the chance that the children would give her problems.

Fourteen years have passed and I am happy to report that the Marital Trust, with good investment advice, has provided sufficient income to maintain the wife's accustomed standard of living. She still lives in and enjoys the residence. Over time, the daughters received all their distributions and now jointly own the still successful family business. They learned the values of hard work and cooperation and the business provides each of them a good income. As an added bonus, some of them even enjoy a good relationship with their stepmother.

This is a good example of how planning can protect families and their assets following a client’s passing. While this particular client was in good health, we completed other planning that facilitated a smooth transition of other business assets and provided funds for payment of Federal Estate taxes when the client passed away. Next week we will address this planning in detail.

Alan Ferrara