ESTATE PLANNING AND PROBATE LAW UPDATE Steamboat Springs, Colorado FEBRUARY, 2016

Transcription

1 ESTATE PLANNING AND PROBATE LAW UPDATE 2016 Steamboat Springs, Colorado FEBRUARY, 2016 A. Kel Long, III Hendrick, Rascoe, Zitron & Long, LLC 3282 Northside Parkway The Rinaldi, Suite 250 Atlanta, Georgia (404)

2 TABLE OF CONTENTS I. SUMMARY OF TAX REFORM ACT SIGNED BY PRESIDENT OBAMA ON 01/03/ II. FIVE PRIMARY ESTATE PLANNING RULES Unlimited Marital Deduction $14,000 Annual Gift Tax Exclusion $5,000,000 Estate Tax Exemption Equivalent $5,000,000 Gift Tax Exemption Generation Skipping Transfer Tax... 4 III. ELEVEN SPECIFIC ESTATE PLANNING TECHNIQUES WILLS AND THE UNLIMITED MARITAL DEDUCTION REVOCABLE LIVING TRUSTS GST TAX PLANNING LIFE INSURANCE TRUSTS GIFTING TRUSTS FAMILY LIMITED PARTNERSHIPS PERSONAL RESIDENCE TRUSTS GRANTOR RETAINED ANNUITY TRUSTS ( GRATS ) AND GRANTOR RETAINED UNITRUST TRUSTS ( GRUTS ) SHIFTING OF INVESTMENT OPPORTUNITIES DURABLE POWER OF ATTORNEY STATUTORY FREEZE PARTNERSHIPS IV. CREDITOR PROTECTED TRUSTS FOR DESCENDANTS V. ASSET PROTECTION PLANNING THROUGH LLCS VI. NEW GEORGIA TRUST CODE VII. PLANNING CONSIDERATIONS FOR THE DISPOSITION OF RETIREMENT PLAN ASSETS Planning Considerations For Your Retirement Assets During Your Lifetime Planning Considerations For Your Retirement Assets At Your Death VIII. INCOME TAX BASIS CONSIDERATIONS IN ESTATE PLANNING Step-Up in Basis to Current Value Step Up in Basis of Partnership Assets

3 3. Advantage of Community Property Over Joint Tenancy IX. MEDICAID PLANNING Goal General Rules Medicaid Exempt Supplemental Needs Trusts X. CHARITABLE GIFTING - ALTERNATIVE RECIPIENTS OF CHARITABLE GIFTS Public Charities Community Foundations ( CFs ) Supporting Organizations Private Foundations Charitable Remainder Trusts General Rules and Restrictions Applicable to Supporting Organizations, Private Foundations, and CRTs Designation of Charitable Beneficiary for Retirement Plan Assets

4 I. SUMMARY OF TAX REFORM ACT SIGNED BY PRESIDENT OBAMA ON 01/03/2013: (A) Permanent Tax Law. Instead of an extension of The 2010 Act, we now have permanent estate tax rules for the first time in 12 years! On New Year s Day, Congress approved a permanent set of estate, gift and generation-skipping transfer (GST) tax rates and exemptions. The exemptions had been legislatively scheduled to decrease to $1,000,000 on January 1, President Obama s earlier proposal had been a $3,500,000 death exemption but only a $1,000,000 lifetime exemption. Instead, Congress made the 2012 exemptions of $5,000,000 permanent, but did increase the rate from 35% to 40%. The $5,000,000 exemption is inflation adjusted and for 2016, the amount is $5,450,000. (B) Unified Estate and Gift Exemption. The exemption remains at $5,000,000, indexed for inflation since This puts the exemptions at $5,450,000 for estate and gift tax in The same applies to the generation skipping transfer tax exemption. (C) Permanent Portability. The December 2010 legislation introduced the portability of the exemption for gift and estate tax purposes, whereby the exemption not used by the first spouse to dies would be available for use by the surviving spouse for gift tax purposes and the surviving spouse s executor for estate tax purposes (but not for GST tax purposes). Treasury Regulations published in June 2012 provided considerable clarity and welcome guidance regarding portability. Congress has now made portability permanent. (D) GST Tax Exemption is Not Portable. The generation skipping Transfer Tax ( GST Tax ) exemption was increased to $5 million. The GST Tax exemption is also now inflation adjusted. The GST Tax Exemption is not portable between spouses (One more reason to continue to use credit shelter trust wills.) (E) The New Medicare Tax Still Applies. Beginning January 1, 2013, net investment income is subject to the new 3.8 percent Medicare tax if adjusted gross income exceeds $250,000 for joint filers and $200,000 for single filers. For trusts, the 2014 threshold is $12,150. Also check my website for updates: 3

5 II. FIVE PRIMARY ESTATE TAX PLANNING RULES 1. Unlimited Marital Deduction. Transfers to a spouse, whether during lifetime or at death generally qualify for the marital deduction, which means that no gift or estate tax is due on a transfer to a spouse. 2. $14,000 Annual Gift Tax Exclusion. One may give up to $14,000 per year to as many donees as one desires without incurring any gift tax. This is a freebie. There is no requirement that the donees be related to the donor. 3. $5,000,000 Estate Tax Exemption Equivalent. Every person has a $5,000,000 estate tax credit. This credit equates to a $5,000,000 exemption to be used against the estate tax, less any exemption used during life as gift tax exemptions. The exemption is inflation indexed and equals $5,450,000 in The estate tax rate is 40%. 4. $5,000,000 Gift Tax Exemption. The Gift Tax Exemption works similarly to the Estate Tax Exemption Equivalent, but with respect to lifetime transfers, the Gift Tax Exemption is $5,000,000. The gift tax rate is 40%. The following examples illustrate how these 4 rules work together: (1) If one transfers $14,000 to one s spouse, this is a gift, but it is not taxable since it all qualifies for the marital deduction. (2) If one transfers $15,000 to a friend, none of the gift qualifies for the marital deduction. $14,000 of the gift does qualify for the $14,000 annual gift tax exclusion. Therefore, $1,000 is a taxable gift subject to gift tax, to be offset by $1,000 of the $5,000,000 exemption. Going forward, the donor has $4,999,000 of exemption remaining. If no more lifetime taxable transfers are made, then the donor may die with an estate valued at up to $4,999,000, and no estate tax would be due. 5. Generation Skipping Transfer Tax. Historically, wealthy American families have avoided estate taxes by placing unlimited amounts of property in trusts which remained in existence for many generations. Because a beneficiary of such a trust was not considered to own the trust property for estate tax purposes, the trust property passed from generation to generation without being subject to estate tax. 4

6 In 1976 and again in 1986, Congress passed laws restricting the amount of property which can avoid estate tax through the use of such trusts. The result is the generation skipping transfer ( GST ) tax, which, in 2016, is a flat 40% tax on transfers to a person more than one generation removed from the donor (e.g., from a grandparent to a grandchild). The GST Tax also applies to transfers into and/or out of trusts, such as that described above, which are not subject to estate tax at the death of a trust beneficiary. Every individual has a $5,000,000 exemption to apply against the GST Tax. Thus, one can create a multi-generation trust and transfer up to $5,000,000 of property to it. Further, any appreciation on the property transferred is also exempt from the GST Tax. See the discussion and examples below in Section I.3. Similar to the estate tax and gift tax exemptions, the GST Tax exemption is inflation indexed and also equals $5,340,000 in III. ELEVEN SPECIFIC ESTATE PLANNING TECHNIQUES 1. WILLS AND THE UNLIMITED MARITAL DEDUCTION A) Residuary Trust. In the case of a husband and wife, the Residuary Trust is used to receive a portion of the estate ($5,000,000) that can pass estate tax free in any event by operation of the estate tax exemption equivalent. The surviving spouse may be the trustee and a beneficiary (along with the children) of the residuary trust, without causing the residuary trust to be included in the surviving spouse s estate. This is accomplished by limiting the trustee s (the surviving spouse s) distribution discretion to an ascertainable standard of health, education, maintenance and support. B) Unlimited Marital Deduction. As described above in Paragraph 1, there is an unlimited marital deduction for estate tax purposes. Thus, the surviving spouse will receive the balance of the estate in excess of the $5,000,000 passing to the residuary trust. The exact amount passing to the surviving spouse is determined by formulae described below. Once the amount of the marital deduction is determined, it can either be distributed outright to the surviving spouse, or pass to certain trusts which also qualify for the marital deduction. The primary marital trust used is the QTIP marital trust described immediately below. C) Qualified Terminal Interest Property ( QTIP ) Trusts. A QTIP Marital Trust is a trust which provides that all income will be distributed currently to the surviving spouse, and that so long as he or she is living, the 5

7 trust s principal can only be used for his or her benefit, but at the death of said spouse, the trust s assets will be distributed or held as the trust document specifies (usually for the benefit of testator s children). A QTIP Marital Trust thus allows one to provide, if he or she so desires, for his or her surviving spouse - and to take advantage of the unlimited marital deduction so as to avoid any current estate tax liability - without any concern for how the surviving spouse may dispose of such property at their death (thus avoiding the potential problem of the second marriage ). D) Methods of Calculating the Marital Amount - Pecuniary Bequest vs. Fractional Share Marital Deduction Formulae - To maximize the amount of the estate passing to the Residuary Trust (that will escape estate taxation for both husband and wife, and if desired, for children as well) one should utilize the marital deduction formulae called pecuniary bequest pick and choose with true worth as of date of distribution. This will shift all growth in value of your estate during the estate administration process to the Residuary Trust. (a) However, in situations involving second marriages (or where the surviving spouse is not a permissible beneficiary of Residuary Trust), a fractional share formulae may more accurately reflect your desires. (b) A potential negative consequence of this particular pecuniary bequest formulae is the recognition of taxable gain on funding the Marital Bequest with assets that have appreciated from the time the testator died. In practice, by careful timing and selection of assets, this is not a significant problem. In any event, the Executor should be able to fund the Marital Bequest fully or partially with a note to avoid triggering taxable gain. (c) Note, if the value of decedent s estate should actually decline in value during the estate administration process from what then was reported on the estate tax return, the Residuary Trust could receive nothing. 2. REVOCABLE LIVING TRUSTS A) General Description of a Revocable Living Trust. A Revocable Living Trust ( RLT ), is a legal document that is created by an individual, called the Trustor, to hold and own the Trustor s assets. Those assets are invested and spent for the benefit of the Trustor as the primary beneficiary of the Trust. Both the investment and the spending decisions are made by the Trustee based on the direction given by the Trust Agreement. In most cases, the 6

8 Trustor will also be the Trustee unless the Trustor is anticipating a health decline or other oncoming incapacity, or wishes for a third party to manage the trust property. (Note, than in some states the Trustor is known instead as the Grantor, Settlor or Trustmaker.) B) Three Time Periods Covered by a Revocable Living Trust. A Revocable Living Trust covers three time periods, which are: (1) While the Trustor is Alive and Capable. During this phase, the Trustor may amend or revoke the Trust Agreement, and the income and principal may be distributed to the Trustor for any reason. The Trust is not recognized as a separate entity by the IRS and the Trust uses the Trustor s Social Security Number. All trust income is reported on the Trustor s 1040 instead of a trust income tax return (Form 1041). (2) While the Trustor is Alive But Not Capable. The Trustor s incapacity is determined by the method and group of people named by the Trustor and not a Court. This group of people may be referred to as the Trust Protector Committee. By using a Trust Protector Committee, one may avoid a contested court guardianship proceeding. Upon the determination of incapacity, the successor trustee named by the Trustor takes over. The Trustor may also specify how he/she is to be maintained during the period of incapacity, including whether the Trustor is to be cared for at home or in a nursing facility. (3) Upon the Trustor s Death. Upon the Trustor s death, the Trust Agreement directs how the Trustor s property is to be distributed, much like a Will. Because the Trust describes the beneficiaries and any further trusts used for them, those provisions are no longer needed in a Last Will and Testament. This is why the RLT is often described as a Will substitute. C) The Need For A Pour Over Will. Not all assets will be retitled in the name of the RLT during life because of either lack of effort, mistake, or retitling is not allowed by that type of asset class - e.g. employer provided stock options. As a result, one must also have a Last Will and Testament that directs that any assets still in the deceased s name should be paid over to the RLT. Thus, probate is never entirely avoided. D) The Need for a Power of Attorney to Allow Funding of the RLT. It is common for a Trustor to create a RLT, but then not follow thru on transferring title to all of his/her assets to the RLT. If the Trustor suffers from a long incapacity period, then moving the assets from the Trustor s name to 7

9 the RLT can become paramount. One paramount reason is to remove those assets from a Court imposed conservatorship and put them instead into the RLT that includes more flexible provisions and names the successor Trustee as selected by the Trustor (and not a conservator appointed by the Court). A power of attorney should include a provision that specifically allows the agent to fund a RLT. E) Advantages of a Revocable Living Trust (1) Helps Avoid Probate. Since the assets funded into a Revocable Living Trust during the Trustor s lifetime will no longer be owned by the Trustor but by the Trustee of the trust, there will be no need for the trust assets to be probated when the Trustor dies. Instead, the Administrative Trustee can proceed with settling the trust outside of probate and without any court supervision or interference. This can significantly speed up the distribution of assets or cash to the beneficiaries. Probate time and expense does vary from state to state. Georgia is known as one of the easiest and cheapest probate states in the U.S. (2) Avoids Ancillary Probate in Multiple States. A hold over from the formation of the original 13 states is that one state does not recognize the probate of a Will in another state. Instead, the Will must be probated in each state that the decedent held real estate. This will be expensive and lengthen the probate time period. By using a RLT and retitling the out of state real estate into the name of the RLT during lifetime, then the Will does not have to be probated in those other states where real estate is owned. (3) Helps Avoid a Will Contest. RLTs have a higher legal challenge threshold than does a Will. Also, until the Will contest is finalized, all estate assets are frozen; and a Will contest can take many years to resolve. When the RLT is funded during lifetime, the RLT administration of the RLT continues after death until a Court halts the administration, which would only come at the end of the litigation. Thus nothing is frozen in the RLT at death. (4) Allows the Trustor to Name the Desired Successor Trustee in the Event of Incapacity. Without a funded RLT, undesirable family members may try to take over via a guardianship/conservatorship court action. If instead the assets are held by a RLT, then those undesirable family members will be disinterested in applying to become the conservator. This is because, 8

10 even if appointed, they will not have any assets under their control since the assets are held by the Trustee of the RLT. The RLT should also provide that it cannot be revoked by the guardian/conservator. (5) Preferred Vehicle in the Event of Long Term Incapacity. In the event of a short term incapacity, a well written power of attorney will suffice. However, in the event of a long term incapacity, in practice, the RLT is found to be more favorable and honored by more third parties compared to a power of attorney. Third parties such as banks, investment firms and closing attorneys in real estate transactions may refuse to accept the power of attorney. (6) Allows Privacy of the Death Provisions. All Last Wills and Testaments are filed with the Probate Court upon death and are available for public inspection. In some cases the decedent may include death provisions that treat family members differently or otherwise should not be shared outside of the family (e.g., including a trust for a child with a drug addiction which requires ongoing drug testing before a distribution is made.). Since the RLT is not probated and thus not provided to the probate court, the RLT terms do not become public knowledge. This can be more of a concern for celebrities as for most other families, the media or others are not interested in what your Will provides. (7) Conduit for an IRA. If an IRA is payable to one s estate, then the income tax on the entire IRA must be paid over not more than 5 years. If instead the IRA beneficiary is a trust, then in most cases, the IRA taxation can be deferred over the trust beneficiary s lifetime. This tax deferral advantage can be significant over a long period of time. Some instances allow for naming the trust under a Last Will and Testament as the beneficiary of the IRA, which allows for the tax deferral. However, many times the IRA may need to be divided between multiple trusts or beneficiaries depending on estate tax marital deduction planning and desired allocation of asset values between multiple beneficiaries. In those circumstances, the RLT can be named as the IRA beneficiary so that both goals of deferring the income tax and splitting the IRA among possible different beneficiaries are achieved. (8) Ability to Name a Trust Protector Committee. As noted above, the incapacity of the Trustor may be decided by someone or group named in the Trust Agreement rather than by a Court. This group (the Trust Protector Committee) can be selected by the Trustor from family members who have the Trustor s best interest at heart. The Trust Protector 9

11 Committee may also include trusted friends or physicians. The use of the Trust Protector Committee can prevent an undesirable family member from trying to take over via a conservatorship action. The Trust Protector Committee may also be required to approve any changes in the Trustor s living situation. This can be very important where the Trustor strongly desires to be taken care of at home in his/her final days rather than moved to a nursing care facility. The Trust Protector Committee may also be appointed to make future modifications to the Trust for circumstances that cannot be anticipated and would otherwise frustrate the Trustor s intent in creating the Trust. F) Disadvantages, Misconceptions and Caveats of a Revocable Living Trust (1) Cost to Establish a RLT. The cost to create a trust varies depending on the complexity of the estate plan. Also, if the Trustor owns many different properties, assets will need to be retitled into the name of the RLT. These requirements increase the cost to set up the trust. If none of the advantages of a RLT are of significant concern, then using only a Last Will and Testament will be more cost efficient. (2) Complexity and Increased Paperwork. Bank and investment accounts will need to be set up in the name of the RLT. For some clients the legal distinction between the RLT, their personal ownership of assets and any other trusts that they may have is difficult to grasp and leads to frustration. Another common frustration is reapplying for the homestead exemption after the primary residence is retitled into the RLT. One must also notify their home owners insurance company of the title change to see if the policy owner needs to be changed. Automobiles and other tangible personal property retitling presents challenges. The complexity of the RLT and its funding during lifetime was emphasized in an article written by a law professor entitled - Living Trust - Living Hell. (3) Does Not Save Estate Taxes. One common misconception/misstatement about RLTs is that they save estate taxes. Both a Will and a RLT can contain estate tax savings provisions for a married person by using a marital deduction formula. Many publications promoting RLTs misstate that the RLT saves taxes over a Will. That is an incorrect and often intentional misstatement used to motivate one to use the RLT. (4) Promotion of RLTs by Unscrupulous Investment Sales People. Often RLTs are heavily promoted by investment sales people (sometimes 10

12 camouflaged as a financial planner) and prepared by an in house attorney at a very cheap price or even provided for free. They will also, for free, assist you will all the legal transfers of your assets into the RLT. Why would an attorney who does not know you provide significant legal documentation and work to you for free or for at a surprisingly cheap price? Because during the asset transfer process, the investment sales person will have a free shot at viewing all of your holdings and then recommend that you switch your current investments into his/her investments, including annuities. Many of these annuities and other investments have exceedingly high, but hidden, acquisition costs; and this is where the sales person s financial incentive exists. The sales pressure exerted is often excessive. False scare tactics to promote the need for the RLT are often used. As such, beware of free or dirt cheap RLTs. 3. GST TAX PLANNING Qualified Medical and Tuition Costs. In addition to the $5,000,000 GST Tax exemption, direct payments to providers of medical and tuition costs on behalf of skip persons are also exempt. (E.g., tuition payment by a grandparent directly to the grandchild s school.) These payments are also not subject to gift tax. To maximize the use and benefit of the $5,000,000 GST Tax exemption ($10,000,000 for a husband and wife), the Will should include GST Tax planning as diagramed below. Illustration of Operation of a GST Will. Assumptions - Husband Wife $7,000,000 estate $6,000,000 estate ΕHusband predeceases wife ΕIgnores any appreciation or state death taxes (1) Distribution of Husband s Estate of $5,000,000. Marital Trust $2,000,000 Children s Trust (not funded if Wife survives) -0- Residuary Trust $5,000,000 TOTAL $7,000,000 11

13 (2) Distribution of Wife s Estate (and Foregoing Trusts) at Wife s Subsequent Death. Wife s Net Taxable Estate Would be $6,950,000 ($6,000,000 personal assets, plus $2,000,000 in Marital Trust established at husband s death, less $1,050,000 in federal estate taxes net of unified credit). Marital Trust (not applicable since no surviving spouse) -0- Residuary Trusts: Children s Trust ($2,000,000 in Non-GST Tax Exempt $1,950,000 Marital Trust, plus $6,000,000 of personal assets, less $900,000 in federal taxes, and less wife s $5,000,000 GST Tax Exemption) Residuary Trust established under $5,000,000 Husband s Will (GST Tax Exempt) Residuary Trust established $5,000,000 under Wife s Will (GST Tax Exempt) 4. LIFE INSURANCE TRUSTS TOTAL $11,950,000 If an insured has any incidents of ownership over a life insurance policy (e.g., owns the policy, can change the beneficiary, or can assign the policy), then that life insurance policy is included in their taxable estate. An irrevocable Life Insurance Trust can be utilized to insulate life insurance proceeds, plus all growth in value thereon when invested, from estate taxes at the death of the insured, the insured s spouse, and, in some cases, the insured s children (if GST Tax planning is used), as well as to insulate insurance proceeds from creditors. The Insurance Trust is generally structured like the Residuary Trust under one s Will whereby: (3) Income/principal can be used to benefit the spouse, children, and grandchildren. 12

14 (4) At death of spouse, and when youngest child attains the age of 22 for example, the trust is divided into equal trusts for the children, per stirpes. (5) A child s trust is distributed to the child at certain designated ages (e.g., 1/2 at age 30 and the balance at 35) or if GST Tax planning is used, held in trust for the child s lifetime, eventually being distributed to the grandchildren, free of estate tax at child s death. (6) If GST Tax planning is used, such that a child s share is held in trust for the child s lifetime, then the child could be named as trustee of his/her trust upon attaining a designated age (e.g., age 30). Three Year Rule. If the insured gifts an insurance policy to an insurance trust, he must live 3 years in order for the death proceeds to be excluded from his taxable estate. If the policy is instead sold by the insured to the trust (the trust must be grantor trust to avoid the transfer for value rules) for it s full fair market value, then the 3 year rule will not apply. Twelve Common Errors In Using And Structuring Irrevocable Life Insurance Trusts 1) Failure To Consider Reciprocal Trust Doctrine. If separate trusts naming husband and wife as owner and beneficiary of insurance policies on each other s life are established at approximately the same time, and with virtually the same provisions, then the Reciprocal Trust Doctrine will cause the husband and wife to be considered, for estate tax purposes, as the transferor of their spouse s trust. The result of the foregoing is that at least part of the insurance proceeds will be subject to estate tax when both spouses are deceased. (This doctrine applies not just for insurance trusts, but for any kind of gifting trusts.) 2) Possibility Of Divorce. In view of the high incidence of divorce, an irrevocable insurance trust should contain a provision (or at least this possibility should be discussed with the client in advance) that would provide that in the event the insured and the insured s spouse later become legally separated or divorced, that for all purposes of the insurance trust the insured s spouse will thereafter be considered deceased. As a result of this provision, the insured s spouse would, in such an event, immediately cease to serve as a trustee of, or to have any beneficial interest in, the irrevocable life insurance trust. A similar provision should apply to the spouses of any children who are named as trust beneficiaries. 13

15 3) Failure To Document Notification Of A Beneficiary s Withdrawal Right. To cause the insured/trustor s contributions to the insurance trust to qualify as a present interest gift for the $14,000 annual exclusion per donee for gift tax purposes, each adult beneficiary (anyone 18 or older) must have actual and timely notification of his withdrawal right with respect to each contribution. The executed notices should be retained in the event of IRS audit. 4) Ability To Limit Withdrawal Powers Prospectively. The trust document should allow the insured/trustor to limit (by an appropriate writing) which (and/or to what extent) of the trust s originally designated beneficiaries should be precluded from exercising their withdrawal right for certain prospective contributions to the trust. 5) Marital Deduction Provision. The insurance trust should generally include a provision for taking advantage of the unlimited marital deduction (e.g., a QTIP election by the trustee, or a distribution of trust assets to the insured s estate) if (i) the trust s assets are nonetheless included in the insured s estate (e.g., by application of Section the three year rule ), and (ii) the insured is survived by a spouse. 6) Removal Of Corporate Trustee. If the trust document provides for a corporate trustee, then - to insure that the corporate trustee remains responsive - the adult beneficiaries should be given the ability to remove the corporate trustee without cause and to appoint a successor corporate trustee. To prevent a potential problem with Section 2041 due to a provision allowing for such removal, the trustee s discretion to allocate principal should be limited to an ascertainable standard. 7) Insured s Spouse May Serve As Trustee Without Causing A Tax Problem. A common misunderstanding is that the insured s spouse cannot serve as sole trustee or co-trustee of an irrevocable insurance trust holding policies on the insured s life without causing part or all of the trust s assets to be included in the spouse s estate for estate tax purposes. By merely including an ascertainable standard in the trust document, this potential tax problem can be avoided. 8) Improper Documentation Of Ownership And Beneficiary Designation Of Insurance Policies. Probably the most common error associated with the use and structuring of irrevocable life insurance trusts is the failure to transfer ownership of the insured s policies to the trust, and to designate the trust as the beneficiary of said policies. Also, where the insured s spouse already owns a policy that is to be transferred to an insurance trust established by the insured, generally such policy should be sold by the insured s spouse to the trust (provided 14

16 the trust is a grantor trust for income tax purposes) for a price equal to the policy s interpolated terminal reserve. 9) Trustee Should Pay The Premiums. Whenever possible, the insured/trustor should contribute to the trust the necessary funds for paying at least the initial premium for a new policy, so that the trustee can purchase the policy. The transfer to the trustee should not equal the exact amount of the premium. 10) Last To Die Policies. For any insurance trust holding a last to die policy on the joint lives of a husband and wife, neither spouse should ever be a trustee of such trust and, if both spouses are transferors with respect to the trust, then neither spouse should have any beneficial interest in the trust. 11) Effectively Amending An Irrevocable Trust. Everyone knows an irrevocable trust cannot be amended. What is not commonly realized, however, is that an existing insurance trust can be effectively amended by creating a new trust (with the desired provisions), and then selling the policies in the existing trust to the new trust. Assuming the new trust is structured to be a grantor trust for income tax purposes, such a sale is treated as a transfer to the insured, and thus is exempt from the transfer for value rules. 12) Failure To Allocate GST Tax Exemption Or To Make A Timely Allocation. An irrevocable life insurance trust can easily be structured to avoid estate taxes not only for the insured and the insured s spouse, but also, and of equal tax benefit, for the insured s children. A trust so structured would not terminate until after the death of the insured, the insured s spouse, and the insured s children. To avoid the GST Tax, discussed above in Paragraph 5, one should allocate part or all of the insured s $5,000,000 GST Tax exemption to the trust s assets. The allocation should be made on a timely filed gift tax return equal to the amount of the premium, such that the death benefits are also exempt. If the allocation is not made until after death, an amount of GST Tax allocation equal to the death benefit must be used. Permanent Life Insurance As Part of the Estate Plan Life insurance is often part of the estate plan, and can be used to provide for the support of a spouse and minor children, estate taxes or estate equalization between children. If you own a life insurance policy that is either considered a Variable or Universal product, you should have the policy reviewed promptly, given the recent stock market decline and the reduction in interest rates by the Federal Reserve. The performance of both of those life insurance policies depend on the investment rate of 15

17 return. For example, if the cash surrender value of the policy is invested in mutual funds, then the cash value is likely to have decreased significantly in the last 60 days. If that is the case, then you may have to pay significantly more in future premiums in order to keep the life insurance death benefit in place. The same theory applies if the policy is interest rate sensitive (most are) in that the interest income will now be less than anticipated, resulting in additional premiums due. To see how this can affect you, a basic understanding of life insurance is needed. Here is how I often explain life insurance to clients: As you age, the cost of life insurance, per $1,000 unit, increases. For example, a 40 year old can buy $1,000 of life insurance for about $1 per year, but that same $1,000 of insurance costs a 70 year old, say $30; and an 80 year old, say $70. The insurance company charges you the cost of insurance for their exposure in that particular year if you were to die, based upon your age and the mortality tables. The insurance company s exposure in a given year is the difference between the cash value of the policy and the death benefit. For example, if you own a policy with a death benefit of $1,000,000 and a cash value of $300,000, then the insurance company s exposure is $700,000, or 700 $1,000 units. If you are 40 years old, then your cost of insurance for that year is $700; age 70 - $21,000; or age 80 - $49,000. To carry this example further, if the annual scheduled premium payment is $10,000, and the policy pays 5% interest, then the 40 year olds cash value will increase at the end of the year to $324,300 which is the sum of the beginning cash value of $300,000 plus the interest income of $15,000 plus the premium payment of $10,000 less the cost of insurance of $700. In the case of the 70 year old, the cash value will also increase, but only to $304,000 which is the sum of the beginning cash value of $300,000 plus interest income of $15,000, plus the premium payment of $10,000 less the cost of insurance of $21,000. In the case of the 80 year old, the cash value will instead decrease by the end of the year to $276,000, which is the sum of the beginning cash value of $300,000 plus interest income of $15,000, plus the premium payment of $10,000 less the cost of insurance of $49,000. The following year, the cash value will decrease by an even greater margin since the interest income will be less (measured on a smaller cash value) and the cost of insurance will be higher and on a larger exposure amount (since the cash value has decreased). In this example, at about age 86, the policy will lapse meaning that the policy is terminated, the cash value is $0 and there will be no life insurance benefit at death. 16

18 As you can see, the cost of insurance becomes very expensive when you are in your 70 s and older. Unless the cash value of the policy is approaching the death benefit by the time you turn 70, most policies are destined to lapse. Coming full circle, if the cash value of your policy is invested in the stock market, your cash value may be down significantly which will greatly affect the performance of your policy and it could unexpectedly lapse. The same applies if you were expecting to receive 7% interest annually on your cash value and you are now receiving only 4% - the policy will lapse sooner than you expected. 5. GIFTING TRUSTS A. Overview. An irrevocable Gifting Trust can be used to receive: (7) annual exclusion gifts (that is gifts within the $14,000 annual exclusion per donee) and/or (8) credit gifts (that is, gifts in excess of the $14,000 annual exclusion per donee that utilize part of one s $5,000,000 exemption for gift tax purposes). B. Advantages of Gifting Trust. The advantages of utilizing a trust to receive these gifts (rather than making the gifts outright) are: (1) Ability to maximize use of the $14,000 annual exclusion per donee (by counting all descendants and spouses), (1) Ability to maintain parity among children, if desired (e.g., the trust may divide into equal shares for the children at a certain date, normally upon the death of the survivor of the trustor and the trustor s spouse), (2) One can place limitations or controls on the property gifted (via the trust s terms), (3) One can protect the property gifted from the claims of potential creditors of the trust s beneficiaries, including spouses, by utilizing appropriate spendthrift provisions, and (4) One can cause the property gifted to be excluded from their children s estates (for their estate tax purposes) by causing the trust to be a GST Tax Exempt trust. 17

19 Note - one s life insurance trust and gifting trust can be the same trust. C. Principal Considerations. The principal considerations involved in planning and structuring a gifting trust are as follows: (1) Maximizing Annual Exclusions. One should consider including as permissible beneficiaries all of the trustor s descendants and their spouses - and/or any other individuals who the trustor has in the past, or is likely in the future, to help financially. Each beneficiary of the trust needs to be given a withdrawal right (the potential exercise of which is generally limited to 30 days following notification to the beneficiary of this right) that allows the beneficiary to withdraw a proportionate amount of each gift made to the trust (limited to $14,000 per donor) so as to cause the gifts to qualify as present interest gifts for purposes of the $14,000 annual exclusion per donee. These withdrawal powers are referred to as Crummey powers, named after the tax court case approving their use. If a beneficiary were to exercise their withdrawal right, this would frustrate the Patriarch s plan, and thus, rarely, if ever, is the withdrawal right exercised. Trustor has the ability to exclude or restrict the withdrawal right of any particular beneficiary prospectively. (2) Gift Splitting Considerations. Even if the spouse is a trustee and/or beneficiary of the gifting trust, the trustor s spouse can consent (by so signifying on a gift tax return) to treat one-half of the gifts made by trustor to the trust as being made by trustor s spouse for gift tax purposes. By making this gift splitting election, the amount of property that can be gifted to the trust within the $14,000 annual exclusion per donee, or within the $5,000,000 exemption, will be doubled. Note - if the trustor s spouse is a beneficiary of the trust, then only the trustor should gift to the trust. (3) Grantor Trust Status. By structuring the trust to be a grantor trust for income tax purposes (which causes all of the trust s income to be taxable to the grantor notwithstanding that the grantor does not own the trust s assets, and notwithstanding that the trust s assets will be excluded from the grantor s estate for estate tax purposes), one can indirectly make additional non-taxable gifts. Specifically, by causing the trust s income to 18

20 be taxable to the grantor, the grantor pays income taxes on the income benefitting the trust s beneficiaries. The net effect is that the grantor has made additional tax-free gifts - beyond the $14,000 annual exclusion per donee - to the trust s beneficiaries. An example of how one can cause the gifting trust to be a grantor trust for income tax purposes is for the grantor to retain the power to reacquire the trust assets by substituting assets of equivalent value. (See IRC Section 675(4)(c)). (4) GST Tax Considerations. By structuring the gifting trust to be a GST trust, the trust s assets will not be subject to estate tax with respect to the children s estates, and will avoid the GST Tax (to the extent of donor s and donor s spouse s $5,000,000 GST Tax exemptions). A GST Tax gifting trust will typically provide that at the death of trustor, the trust s assets will be equally divided into sub-trusts for each child and their respective family, to be held in trust for the child s lifetime, eventually distributed to the grandchildren, or to the great grandchildren. See Exhibit A for an example of a GST trust. (5) Trustee Provisions. In view of the long term nature of a GST trust, one should build into the trust agreement as much flexibility as possible with regard to the appointment of successor trustees. For example, in the event of a vacancy in the trustee position, the trustor can be given the ability to appoint a successor trustee (other than themselves or their employee) on a contingent and prospective basis. The trust could also provide that each child will become sole Trustee of his or her family s separate trust upon attaining some age. If the trust is structured to be a GST Tax Exempt Trust, then the assets in each child s trust will not be subject to (a) estate tax at the death of child (or at the death of child s spouse), (b) GST Tax, or (c) creditor claims. As sole Trustee of their family s subtrust, the child/trustee should rarely, if ever, make any distributions to themselves. Instead, the child/trustee should use the trust s assets in the same manner as he or she would if the assets were held in their individual name. (E.g., buy a vacation home, make a loan, etc. in the name of the trust). (6) Spouse as Trustee. A common misunderstanding is that the trustor s spouse cannot be a trust beneficiary and serve as sole trustee or co-trustee of an irrevocable Gifting Trust without causing part or all of the trust s assets to be included in the spouse s estate for estate tax purposes. By including an ascertainable standard in the trust document, along with a 19

21 restriction against using trust property to pay obligations of support, the trust property will not be included in the trustee s/ beneficiary s estate. D. Gift Tax Return Requirements. A gift tax return will be required if (i) a spousal gift splitting election is to be made, (ii) the trust is a GST trust (to allocate part of donor s $5,000,000 GST Tax exemption), or (iii) if amount of gift exceeds the $14,000 annual exclusion per donee. E. Income Tax Return Requirements. An income tax return will be required if the trust s gross income exceeds $600 in one year, whether or not the trust is a grantor trust for income tax purposes. 6. FAMILY LIMITED PARTNERSHIPS Overview. The family limited partnership ( FLP ) is simply a limited partnership formed pursuant to the applicable limited partnership act under state law by family members. Usually the family patriarch and one or more other trusted family members will serve as general partners, with the family patriarch named as managing general partner. However, for example, see Kimbell 371 F3d 257 (2004) where a general partner role may be treated as an IRC Section 2036 power, causes estate inclusion of the partnership. A. Advantages Of Limited Partnerships. The advantages of using a family limited partnership to hold investment assets include the following: (1) Control. The family patriarch may retain control, with other family members, over the management of the transferred assets in the role of managing general partner. Limited partners generally cannot demand cash distributions, cannot participate in management, cannot force a liquidation of the partnership, and cannot sell their interest without the general partners approval, thus keeping the family patriarch in control of the partnership assets. (2) Facilitating Gifts. In order to make gifts each year one can simply assign a portion of their limited partner interest, without having to prepare deeds, transfer cash and/or fractionalize ownership interests in the partnership s underlying assets. (3) The Valuation Discount Allows One To Shift More Assets. Valuation discounts associated with a limited partner interest result in leveraging of gifts within the $14,000 annual gift tax exclusion. Due to the lack of control and the lack of marketability associated with a limited partner 20

22 interest, the value of a limited partner interest may be discounted for gift tax purposes relative to the value of the partnership s underlying assets. Assuming a discount of 40% (which discount is supported by numerous court decisions, as well as by expert appraisals I have obtained on behalf of clients), one will effectively be able to shift $23,000 of assets from your estate within the $14,000 annual exclusion per donee ($14,000.60) 1. (4) Protection From Creditors. The restrictions on a limited partner s interest resulting in a valuation discount also serve to make the limited partner interest unattractive to creditors. Absent a creditor being able to show a fraudulent intent by forming a limited partnership (e.g., where the creditors were already closing in on the debtor/partner), substantial protection from creditors can be obtained by utilizing a limited partnership. Specifically, a creditor (or potential plaintiff) vis-a-vis a partner will not be able to attach the partnership s underlying assets. In addition, any involuntary conveyance of a general partner interest (to a creditor or judgment plaintiff) will result in that general partner interest becoming, in effect, a limited partner interest, and thus will not have any of the rights of a general partner. (5) Conduit For Income Tax Purposes. The limited partnership is a flowthrough entity for tax purposes, and allows for tax-free distributions of assets, unlike s corporations. (6) Unlimited Number Of Owners And No Restrictions On Types Of Owners. The owners of limited partnership interests are not limited in number, nor in entity type, unlike s corporations which are limited to 35 shareholders and only certain limited types of trusts may own s corporation stock. B. Caveat - IRC Section 721(b) (Gain Upon Formation). IRC Section 721(b) can trigger the recognition of gain upon formation of a partnership with respect to appreciated assets if 80% or more of assets contributed are marketable securities. C. Income Tax Return. The partnership will need to have a separate income tax return (as an informational return ) filed each year. 1 The same analysis applies in valuing a minority stock interest for gift tax purposes. However, the discount allowed for valuing minority interests in closely-held corporations (25% to 35%) has generally been less than for closely-held partnerships. Further, with respect to fractional interests in real estate, the courts have generally allowed valuation discounts ranging between 15% to 25%. 21

23 D. Appraisals. At certain times we may need to obtain appraisals of the partnership s underlying assets, although such would be required in any event if we were instead to gift these assets without the use of a limited partnership. E. State and Local Transfer Taxes. If real property is to be transferred to the FLP, deed recordation taxes may be due. Note - in some situations, the deed need not be recorded, but rather a nominee agreement may be used in order to avoid the transfer tax. 7. PERSONAL RESIDENCE TRUSTS A. Personal Residence Trust. (7) Overview. A Personal Residence Trust (also known as a Qualified Personal Residence Trust or QPRT ) is a transaction where one transfers a residence (principal and/or secondary, but a maximum of two residences) to a trust in which the grantor retains the right to use the trust s asset(s) as a residence for a specified period of time. For gift tax purposes, the grantor is treated as having made a taxable gift at the time the trust is established. The value of the gift (for gift tax purposes) is the present value of the trust s remainder interest, which is equal to the current value of the residence, less the value of the retained term. The value of the retained term is a function of the length of the retained term (the longer the retained term, the smaller the value of the remainder interest) and of current interest rates (the higher the current interest rates, the lower the value of the remainder interest). (8) Failure to Outlive the Trust Term. The principal tax risk of a QPRT is that if the grantor should die within the retained term, then the residence, at its then current value, will be included in the grantor s estate for estate tax purposes. The net effect, for estate tax purposes, is as if the residence had never been transferred to the trust. In view of the foregoing tax risk, and on the assumption that the surviving spouse would want to continue residing in the residence if the donor should predecease him, the trust should provide that the residence will, in such an event, revert to the grantor s estate so as to qualify for the marital deduction for estate tax purposes. 8. GRANTOR RETAINED ANNUITY TRUSTS ( GRATS ) AND GRANTOR RETAINED UNITRUST TRUSTS ( GRUTS ) Example: Grantor transfers $1,000,000 of property to a GRAT with a retained term of 15 years. Grantor retains a fixed annual annuity return of $80,000 for the term. The gift tax value of the remainder interest in 2016 (that is, the 22

24 present value of the right to receive the Trust s property in 15 years) is approximately $250,000. The value of the remainder interest is a function, in part, of the current IRS interest rate (namely 120% of the mid-term AFR rate), which rate can fluctuate slightly from month to month. If the annual annuity return were $100,000 in the foregoing example, then the transfer to the GRAT has a gift tax value of approximately $50,000. If the property transferred is something that can be discounted, for example, by 40% for lack of control and/or lack of marketability, then an $80,000 annuity with respect to $1,000,000 of property (as discounted) is only a 4.8% return on the underlying assets contributed. ($80,000 ) $1,000,000/.6) 9. SHIFTING OF INVESTMENT OPPORTUNITIES A relatively simple, although potentially significant estate planning opportunity is to utilize new entities (corporations or limited partnerships) to undertake new projects or ventures, and to structure the ownership of these new entities such that the majority of the profits or appreciation realized therefrom is with respect to the ownership interests held directly (or indirectly via trusts) by your children. A. Example of Typical Structure. A typical shifting of investment opportunities might involve the use of a new S corporation (e.g., where mother and/or father own 20% of the stock - as voting stock, and the children own 80% of the stock - as non-voting stock) or of a limited partnership (e.g., where mother and/or father own 20% of the partnership - either as individual general partners or as the controlling stockholders of the partnership s corporate general partner - and with the children owning 80% of the partnership as limited partners). B. Requirements For Structure To Be Respected By The IRS. For the form of the transaction to be respected by the IRS, the following factors should be considered: (9) The new entity should have the appearance of economic reality. For example, the acquisition of a $5,000,000 tract of land by a limited partnership capitalized with $1,000, where the $5,000,000 purchase price is evidenced by a note given by the partnership and guaranteed solely by the general partner probably lacks economic reality - thus allowing the IRS to argue that either the children s limited partner interests should be disregarded, or that such interests should be viewed as constituting a continuing gift by the parents. 23