The. Estate Planner. Should a trust s beneficiary also be its trustee? Making charitable gifts with a CRT

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1 The Estate Planner November/December 2014 The Sec exchange A powerful estate planning tool Should a trust s beneficiary also be its trustee? Making charitable gifts with a CRT Estate Planning Red Flag You believe all inherited IRAs are protected from creditors in bankruptcy 111 Monument Circle Suite 2700 Indianapolis, IN phone: fax:

2 The Sec exchange A powerful estate planning tool NNow that the combined gift and estate tax exemption amount has topped $5 million ($5.34 million in 2014), many people planning their estates have turned their attention to income taxes. If you own highly appreciated business or investment real estate, one of the most effective tax strategies at your disposal is the Section 1031 like-kind exchange. With careful planning, you can use a Sec exchange to defer capital gains taxes on appreciated property indefinitely, and even eliminate them permanently. Sec in action Despite the term like-kind, Sec allows you to exchange one or more pieces of business or investment real estate for virtually any other business or investment real estate without recognizing capital gain. You can exchange an apartment complex for an office building, for example, or a farm for a strip mall. The only limitation is that the value of the new properties should be equal to or greater than the value of the existing properties. If you receive any cash or other non-real-estate property, it ll be immediately taxable. Few Sec exchanges involve a direct exchange of one property for another most are structured as deferred exchanges. Few Sec exchanges involve a direct exchange of one property for another. Most are structured as deferred exchanges. In other words, you sell your property (the relinquished property) and then use the proceeds to acquire new property (the replacement property). 2 common safe harbors The key to avoiding capital gains tax in an exchange is to ensure that you never possess or control the sale proceeds. And the best way to do that is to use one of several IRS safe harbors. The two most common safe harbors are: 1. Deferred exchanges. You sell the relinquished property (or properties) and engage a qualified intermediary (QI) to hold the proceeds and buy replacement property (or properties). So long as you identify replacement property 2

3 within 45 days and complete the purchase within 180 days after the relinquished property is sold, the capital gain is deferred. 2. Reverse exchanges. You engage a QI to acquire replacement property (or properties) before you sell relinquished property. To defer capital gain, you must identify the relinquished property (or properties) within 45 days and complete the sale within 180 days. Also, to avoid holding title to relinquished and replacement properties at the same time, you must park replacement properties with an exchange accommodation titleholder until the transaction is completed. These and other safe harbors (such as trusts and qualified escrow accounts) aren t the only way to complete a Sec exchange. But if you do an exchange outside the safe harbors, there s always a risk that the IRS will challenge it and treat the transaction as taxable. Can you exchange a personal residence? Generally, the benefits of a Section 1031 exchange (see main article) are limited to business or investment properties. But it may be possible to convert a personal residence into a business or investment property and then enact a Sec exchange. Suppose you wish to dispose of a large home and invest in one or more business properties. To defer the capital gain, you might convert the home to a business use (by renting it out, for example) and then exchange it. To ensure that the IRS treats the home as a legitimate business property, you must use it as a rental property for a substantial period of time (usually, at least two years). Estate planning benefits Although a Sec exchange is best known as a tax-deferral technique, it can also be a powerful estate planning tool. Ordinarily, when you sell appreciated real estate you must pay taxes on the gain at rates as high as 20%, leaving less to pass on to your children or other heirs. If you hold onto property for life, however, the capital gains disappear. Your heirs receive a stepped-up basis in the property equal to its fair market value on your date of death, erasing any previous appreciation in value and allowing them to turn around and sell the property tax-free. But what if you don t want to hold property for life? What if you d prefer to dispose of it in order to invest in income-producing real estate or to diversify your holdings? That s where a Sec exchange comes into play. Rather than selling property, paying capital gains taxes and reinvesting what s left of the proceeds, an exchange allows you to accomplish your goals without losing any of the exchanged property s value to taxes. TIC tactic One specific tactic to consider is exchanging a single property for several tenancy-in-common (TIC) interests. TIC interests are fractional, undivided interests in larger properties. Exchanging real estate for TIC interests not only defers capital gains taxes, but also gives you access to professionally managed, institutional-grade real estate. And it provides some interesting estate planning opportunities. Consider this example: Brian owns a highly appreciated apartment building. He wants to divide his 3

4 estate equally among his three children. But he d prefer not to leave them the building jointly, for fear it ll lead to conflict over whether to sell the building or hold onto it. If Brian sells the building, he ll be hit with a capital gains tax bill, leaving less for his kids. Instead, he opts for a Sec exchange, trading the building for three equally valued TIC interests in a professionally managed real estate investment. When Brian dies, his children each receive a TIC interest with a stepped-up basis and can decide independently whether to sell or hold their interests. Worth a look If you have significant wealth tied up in business or investment real estate, a Sec exchange may minimize your family s income taxes. If your net worth is large enough to make estate taxes a concern, however, be sure to balance the income tax benefits of an exchange strategy against the estate tax benefits of a lifetime gift. Before taking any action, be sure to talk to your estate tax and financial advisors to help you evaluate whether a Sec exchange is right for your particular situation. D Should a trust s beneficiary also be its trustee? IIt s likely that your estate plan includes one or more trusts. Do you know your options when choosing a trustee? Generally, from an asset protection standpoint, it s ideal to name an independent, professional trustee. However, in some instances, it s desirable to name the trust s primary beneficiary as trustee. as trustee? A parent might want to give a financially savvy adult child control over the trust s investments while still providing some creditor protection. Or the creator of a credit shelter (or bypass ) trust may want to give his or her spouse control over how the assets are distributed to their children. Naming a beneficiary as trustee A properly designed trust helps safeguard assets against claims by a beneficiary s creditors as well as the beneficiary s own mismanagement. Generally, the less control a beneficiary has over the trust assets, the more protection the trust offers against creditors. 4 Given that, under what circumstances would a person still want to appoint the trust s beneficiary

5 3 strategies to maximize creditor protection Let s review three strategies for maximizing creditor protection when you name a beneficiary as trustee: 1. Include a spendthrift clause. A spendthrift clause, which is standard in most trusts, prohibits beneficiaries from selling or assigning their interests, either voluntarily or involuntarily. Thus, it prevents a creditor from reaching a beneficiary s trust interest before the beneficiary receives it. (In most states, there are exceptions for certain creditors, including a child, spouse or former spouse with a claim for support or maintenance and certain government creditors.) A spendthrift clause may help protect trust assets even when a beneficiary is also the trustee. In some states, however, appointing a beneficiary as a trustee exposes the trust assets to creditor claims regardless of whether the trust contains such a clause. Generally, the less control a beneficiary has over the trust assets, the more protection the trust offers against creditors. 2. Use ascertainable standards. Discretionary trusts as opposed to trusts that call for mandatory distributions at specified times or for a beneficiary s support generally offer the strongest creditor protection. If distributions are within the trustee s sole discretion, the beneficiary can t compel a distribution and, therefore, neither can a creditor. In some states, naming a beneficiary as trustee of a discretionary trust erases this creditor protection. These states allow a creditor to reach the maximum amount the trustee-beneficiary can properly take, subject to a court s discretion to reserve a portion of that amount for the beneficiary s support. In states that have adopted the Uniform Trust Code, however, a trust is protected from creditor claims to the extent discretionary distributions to a beneficiary-trustee are limited to an ascertainable standard, such as amounts necessary for health, education, support or maintenance. 3. Appoint a co-trustee and name at least one other beneficiary. If you re in a state that permits creditors to reach assets available to a beneficiary-trustee or if the law is unsettled consider naming a co-trustee and at least one other beneficiary. Many states offer creditor protection if a trust includes a spendthrift clause and the beneficiary-trustee holds discretionary distribution power jointly with a co-trustee who owes a fiduciary duty to other trust beneficiaries. Adding a co-trustee or beneficiary also helps avoid the merger doctrine, which provides that, if an individual becomes the sole beneficiary and sole trustee, the trust terminates, exposing the assets to creditor claims. Discuss with your advisor Before taking any action regarding your beneficiary and trustee, talk to your legal and estate planning advisors. The laws regarding creditor protection are complex and vary significantly from state to state. D 5

6 Making charitable gifts with a CRT IIf you re philanthropically inclined but somewhat reluctant to make large gifts because of possible cash-flow problems, a volatile stock market or unsettled tax laws, a charitable remainder trust (CRT) may be worth consideration. A CRT allows you to support a favorite charity while potentially boosting your cash flow, shrinking the size of your taxable estate, reducing or deferring income taxes, and providing investment planning advantages. How does a CRT work? 6 You contribute stock or other assets to an irrevocable trust that provides you and, if you desire, your spouse with an income stream for life or for a term of up to 20 years. At the end of the trust term, the remaining trust assets are distributed to one or more charities you ve selected. When you fund the trust, you re entitled to claim a charitable income tax deduction equal to the present value of the remainder interest (subject to applicable limits on charitable deductions). Your annual payouts from the trust can be based on a fixed percentage of the trust s initial value known as a charitable remainder annuity trust (CRAT). Or they can be based on a fixed percentage of the trust s value recalculated annually known as a charitable remainder unitrust (CRUT). Generally, CRUTs are preferable for two reasons. First, the annual revaluation of the trust assets allows payouts to increase if the trust assets grow, which can allow your income stream to keep up with inflation. Second, donors can make additional contributions to CRUTs, but not to CRATs. The fixed percentage called the unitrust amount can range from 5% to 50%. A higher rate increases the income stream, but it also reduces the value of the remainder interest and, therefore, the charitable deduction. Also, to pass muster with the IRS, the present value of the remainder interest must be at least 10% of the initial value of the trust assets. What are the investment advantages? CRTs facilitate tax-efficient investment strategies. To manage investment risk, diversification is critical. Ordinarily, to diversify your portfolio, you liquidate more concentrated holdings and reallocate the proceeds to a broader range of investments. But rebalancing your portfolio often generates taxable income. By contributing assets to a taxexempt CRT, however, you re essentially free to reallocate the assets to achieve your investment objectives without undue concern about immediate tax consequences. A CRT is particularly effective for selling highly appreciated assets that would otherwise generate substantial immediate capital gains. Instead of selling those assets outright, you contribute them to a CRT. The trustee then sells them, unburdened by capital gains taxes, and reinvests the proceeds in more diversified assets that provide greater returns.

7 Annual payouts from a CRT are taxable generally as a combination of ordinary income, capital gains and tax-exempt income (if any), and tax-free return of principal. But because you pay tax only as you receive the annual payouts, you can defer much of the tax on a large capital gain for a potentially significant period of time (depending on the trust s term). Is a CRT right for you? If a CRT can help you make substantial contributions to your favorite charity while alleviating concerns over future cash flow, discuss your options with your estate planning and financial advisors. This trust type requires careful estate planning and solid investment guidance. D Estate Planning Red Flag You believe all inherited IRAs are protected from creditors in bankruptcy Until recently, it was widely believed that inherited IRAs, like other IRAs, are protected from creditors in bankruptcy. But in a June 2014 decision Clark v. Rameker the U.S. Supreme Court held that an IRA inherited by the owner s daughter was not. Specifically, the Court found that an inherited IRA doesn t meet the definition of retirement fund for federal bankruptcy purposes, because the beneficiary: 1. Can t make additional contributions, 2. Must take required minimum distributions (RMDs) even if he or she is far from retirement age, and 3. Can withdraw the funds at any time, penalty-free. If you re concerned that your beneficiaries may go through bankruptcy, consider protecting your IRA by leaving it to a trust. The trust should be designed carefully to ensure that the assets are protected typically by giving the trustee full discretion over accumulation or distribution of RMDs and that RMDs are stretched out over the oldest beneficiary s life expectancy. Keep in mind that accumulated RMDs will likely be subject to higher income taxes. Currently, trusts are taxed at the highest rate (39.6%) to the extent their income exceeds $12,150. Alternatively, the trust can be designed as a conduit trust, which immediately pays out RMDs to the beneficiaries. This avoids income taxes in the trust, but it also exposes distributions to creditors claims. What happens when a spouse inherits an IRA? The Court didn t say, but the decision may place spouses at risk as well. A spouse can elect to cash out the IRA penalty-free, keep the inherited IRA, or roll the funds into his or her own IRA. The first option and, arguably, the second, would expose the funds to creditors claims. The third option would offer creditor protection, but might be challenged by existing creditors as a fraudulent transfer. If you re concerned about bankruptcy, it s a good idea to leave an IRA in trust, whether the beneficiary is a spouse or nonspouse. This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and accordingly assume no liability whatsoever in connection with its use ESTnd14 7

8 Attorneys and professionals of the Bose McKinney & Evans LLP Estate and Wealth Transfer Planning Group GARY L. CHAPMAN phone: Gary Chapman is a partner in the Estate and Wealth Transfer Planning Group, as well as the chair of the Agribusiness Group. Gary worked as an agricultural chemical sales representative and as owner/manager of his family s Holstein dairy operation before attending law school at Indiana University. Gary s practice centers on estate planning for privately owned businesses. STEPHEN E. DEVOE sdevoe@boselaw.com, phone: Steve DeVoe is of counsel to Bose McKinney & Evans. Steve has been a practicing attorney in Indianapolis since He concentrates his law practice in the area of estate planning and probate, corporate, sports and entertainment law. Previously, he was a senior partner of Henderson Daily Withrow & DeVoe. JANA HAGEMAN jhageman@boselaw.com, phone: Jana Hageman is an associate in the Agribusiness, Estate and Wealth Transfer Planning, and Real Estate Groups at Bose McKinney & Evans. She is a graduate of the Indiana University Maurer School of Law, and currently is working toward an M.B.A. from the Kelley School of Business, and a M.S. in food and agribusiness management from Purdue University. Jana is an owner and manager of her family s land holdings in Indiana and in Texas. SHANE HAGEMAN shageman@boselaw.com, phone: Shane Hageman is an associate who has been involved in the agricultural industry his entire life. He is currently active in his family s farming operation. A graduate of the Indiana University Maurer School of Law, Shane also is working toward an M.B.A. from the Kelley School of Business and an M.S. in food and agribusiness management at Purdue University. Shane earned a B.S. in agricultural economics and B.A. in political science from Purdue University in ADAM J. KLINE akline@boselaw.com, phone: Adam Kline is an associate who utilizes his hands-on knowledge to assist family farms and other agribusinesses in their legal needs. He also works with clients to establish estate planning strategies for individuals and corporate succession plans for closely held businesses. Mr. Kline received his bachelor s degree in agricultural economics from Purdue University and his J.D. from the University of Cincinnati College of Law. R.J. MCCONNELL rmcconnell@boselaw.com, phone: G. PEARSON SMITH, JR. gpsmith@boselaw.com, phone: Pearson Smith is a partner concentrating his practice in estate planning, executive compensation, exempt organizations and employee benefits. Pearson is a frequent lecturer on subjects relating to taxes and estate planning. He is a graduate of Yale Law School where he was on the board of editors of the Yale Law Journal. He has been a practicing attorney and a member of the firm since He is a Board Certified Indiana Trust and Estate Lawyer, certified by the Trust and Estate Specialty Board. ALEXIS N. SUMNER asumner@boselaw.com, phone: Alexis Sumner, an associate, prepares documents including wills, trusts and lifetime documents, reviews assets and suggests asset allocation and beneficiary designation strategies, assists with necessary asset transfers and provides tax minimization advice. Alexis also handles estate administration issues and has experience in establishing non-profit corporations and applying for federal income tax-exempt status. She earned her law degree from the Indiana University School of Law - Indianapolis. CHAD T. WALKER cwalker@boselaw.com, phone: Chad Walker is a partner, concentrating his practice in business transactions, estate planning, MBE / WBE certifications, not-for-profit law, state and federal commercial litigation, and real estate. Chad earned his law degree from Indiana University. He serves on the boards of directors for several not-for-profits and is included in Indiana Super Lawyers - Rising Stars Edition. C. DANIEL YATES dyates@boselaw.com, phone: Dan Yates is a partner, counseling families, business owners, corporate executives, and other individuals and businesses to formulate and achieve financial objectives. He provides clients with counsel regarding taxation, probate, philanthropic giving and other estate planning or business succession planning issues. Dan has practiced law since 1973 and is extremely involved in various professional, civic and charitable organizations. He is a Board Certified Indiana Trust and Estate Lawyer, certified by the Trust and Estate Specialty Board. DAWN M. ZOLNIEREK dzolnierek@boselaw.com, phone: Dawn Zolnierek is a certified public accountant, concentrating in post-mortem tax planning, and helping clients prepare federal estate and state inheritance tax returns. She also completes individual, partnership, foundation and estate income tax as well as corporate tax returns. R.J. McConnell is a partner and chair of the Estate and Wealth Transfer Planning Group. He counsels privately owned businesses in the areas of estate and succession planning, shareholder agreements, business structure, financial institutions, and mergers and acquisitions. R.J. serves on the board of directors of Lincoln Bank and Lincoln Bancorp. J. GREGORY SHELLEY gshelley@boselaw.com, phone: Greg Shelley is a partner with Bose McKinney & Evans and concentrates his practice in wills, trusts, estate planning, trust and estate administration, will contests and trust disputes, guardianships, business succession planning and general business transactions. He also regularly represents corporate fiduciaries in trust and estate matters. He is a Board Certified Indiana Trust and Estate Lawyer, certified by the Trust and Estate Specialty Board.