Decanting to Increase Income Tax Basis

I am currently working with an elderly client named John who is the beneficiary of a $6 million trust established by his father.  Upon his death, half of the trust will be distributed to his daughter; the other half will be distributed in equal shares to the children of his deceased son.  The trust owns a lot of stocks that were transferred to the trust upon his father’s death in 1989.  These stocks have a very low basis in comparison to the current fair market value of the stocks.  The trust is exempt from GST taxes and will not be subject to estate tax or GST tax upon his death.  Because the trust will not be subject to estate or GST tax, there will not be any change in the basis in the stocks of the trust upon his death. Therefore, when the daughter and grandchildren eventually sell the stocks, they will incur substantial capital gains taxes.  John would like for his daughter and grandchildren to receive a higher basis in the stocks, if that is possible. 

One approach is for the trust to distribute low-basis stocks worth approximately $3.4 million to John.  Since he already owns assets of $2 million, the distribution would give him a combined estate of $5.4 million, which is below the current federal estate tax exemption of $5.43 million.  His Will distributes his estate consistently with the trust.  Therefore, distributing assets out of the trust to John will not change the ultimate beneficiaries of the assets.  Because the stocks will be in his estate, they will receive a stepped-up basis upon his death. 

The danger with this approach is that the stocks will appreciate, which could result in estate taxes being owed upon John's death.  Another danger is that the federal estate tax exemption could be decreased by future law change.  For example, the President has proposed a decrease of the exemption to $3.5 million. 

In order to accomplish John's goals, while hedging against the appreciation and legislative risks, I have proposed the following solution:

Step One - The Trustee of the trust will establish a new trust that is identical to the 1989 trust, except that John will have a power in his Will to appoint a portion of the trust assets to creditors of his estate.  The amount that can be appointed will equal the maximum amount that does not result in estate taxes being payable.  The power of appointment will apply in sequential order to the most highly appreciated assets. 

Step Two – The Trustee of the 1989 Trust will distribute approximately $4 million in appreciated assets to the new trust.  Tennessee law allows the transfer of assets between trusts for the same beneficiaries in certain circumstances.  This process is referred to as “Decanting.”

The power of appointment will have the following consequences upon John's death.  John does not have any creditors, therefore, there is very little risk that he will exercise his power of appointment in favor of creditors.  Even though the power is virtually meaningless, the Internal Revenue Code requires the amount that could be appointed to be included in John's estate for estate tax purposes.  However, since the amount that can be appointed is limited to the amount that will not cause estate taxes, no estate tax will be owed.  Once the formula amount is determined, the Trustee will then determine which assets had the most appreciation and, thus, which assets are subject to the power of appointment.  These assets will receive a stepped-up basis upon John's death.  His daughter and grandchildren would then be able to sell those assets without any capital gains (except for appreciation that may occur following John's death).  Based upon the current disparity between basis and fair market value of the stocks in the trust, there would be approximately $2.7 million of additional basis gained by this technique.  John's daughter lives in California (which has state income taxes on capital gains), while the grandchildren live in Tennessee.  Based upon the maximum federal and state income tax rates, the increased basis could reduce future income taxes by as much as $800,000.

Your $5.43 million federal estate exemption is a very generous gift that Congress has provided to you.  You should look for opportunities to leverage the exemption to give your heirs a higher basis for income tax purposes.

LLCs Need to Renew Exemption from Franchise and Excise Tax

Two of my clients have already contacted me about the renewal form sent to them by the Tennessee Department of Revenue regarding the exemption of their LLC from Tennessee franchise and excise tax.  If your LLC (or limited partnership) is exempt from Tennessee franchise and excise tax, it is very important to fill out this form each year.  You do not have to pay anything to renew the exemption. 

The most common exemption is obligated member entity (“OME”).  The OME exemption applies when the members waive liability protection.  If you are relying on this exemption, check the obligated member entity box and all the boxes on Schedule F.  Additionally, if any new members have been admitted, they must sign an Amendment to the Articles of Organization that waives liability protection and file it with the Tennessee Secretary of State. 

The two most common other exemptions for our clients are the family owned non-corporate entity (“FONCE”) and the farming/personal residence exemptions.  My recommendation is to allow your CPA who prepares the tax return for the LLC to complete the form, if you are relying on either of these exemptions.  There is information from the LLC’s federal income tax return (Form 1065) that will be needed. 

Not all LLCs are exempt from franchise and excise taxes.  Generally, these LLCs operate a business or own commercial real estate.  Even though not exempt, the earnings from an LLC operating a business may not be subject to tax if they are treated as self-employment income by the owners of the LLC for federal income tax purposes.  No application for exemption is filed to claim this benefit.

In summary, you can avoid an unpleasant tax bill for your LLC if you or your CPA annually renews the exemption of your LLC from Tennessee franchise and excise taxes.

Two Statutes of Limitation to Watch Out For With Creditors' Claims

A recent case, In re: Estate of Lois Whitten, illustrated a tricky area of the law for creditors’ claims against an estate.

When you probate a Will, the Court publishes a Notice to Creditors. Creditors have 4 months from the first publication of Notice to file their claims against the Estate. In order to benefit from the 4 month statute of limitations, the Executor must search the Decedent’s records and send a copy of the Notice to any likely creditors. The 4 month deadline also applies to any creditors that the Executor should not have expected after searching the Decedent’s records. If the Executor fails to send a copy of the Notice to a creditor whom the Executor should have known about, then the creditor has 1 year from the date of death to file a claim.

Instead of sending the Notice to Creditors in Whitten, the Executor sent a letter to the creditor with a check. The letter stated “This pays her bill in full. If not, please do not cash the check but return it to me.” The creditor rejected the check and returned it to the Executor. Six months after the Notice to Creditors had been published, the creditor then filed a claim against the estate for a larger amount. Had the Executor included the Notice to Creditors with the letter, this claim would have been disallowed. However, the court allowed the claim because the Executor did not send the required Notice.

Lessons from this case:

1. If you are a creditor of someone who dies, file your claim promptly (especially if your claim is such that the Executor may not discover it).

2. If you are an Executor, send all potential creditors a copy of the Notice to Creditors.

Inherited IRAs Are Not Exempt From Creditors

When an IRA account owner dies, his or her designated beneficiary can choose to withdraw the account or maintain the IRA as an “Inherited IRA.”  Numerous beneficiaries of Inherited IRAs have declared bankruptcy and claimed that the Inherited IRA was exempt from attachment by the creditors.  Some Circuit Courts of Appeal had held that inherited IRAs are exempt funds in a bankruptcy setting.  Other Circuits had ruled to the contrary. 

The Supreme Court has resolved the conflict by ruling that inherited IRAs are not exempt for bankruptcy purposes.  The court’s rationale was that the purpose of the bankruptcy exemption for retirement funds is to protect the money for the person who earned the money.  The exemption was not meant to protect heirs of the person who earned the money.

Some states have exempted Inherited IRAs from bankruptcy.  Depending on where the beneficiary of the Inherited IRA lives, he or she may be able to use the state exemption and not be affected by the Supreme Court ruling. 

The practical effect of the ruling for debtors living in the wrong states is to make Inherited IRAs the same as any other account owned in the debtor’s name.  The account will not be protected if the debtor declares bankruptcy. 

In light of this ruling, surviving spouses should consider segregating an IRA that they inherit from their spouse in a separate account.  The law allows you to combine your spouse’s IRA with your own IRA; however, that may bring into question the creditor protection benefits of your own IRA.  Further, if you maintain separate accounts, you should make withdrawals from the Inherited IRA rather than your own IRA.

When designating the beneficiary of your own IRA, you should consider establishing a trust as the beneficiary.  A properly drafted trust will give your beneficiary the flexibility to withdraw the funds over several years without exposing the funds to the beneficiary’s creditors.

Despite the Supreme Court’s ruling, you can still achieve creditor protection for the portion of your IRA that you pass on to your beneficiaries.  However, the process to obtain the creditor protection has become more complicated.  

Tennessee Approves Tenants by the Entirety Trusts

On April 14, 2014, the Tennessee Legislature approved a new type of trust known as a Tenants by the Entirety Trust (“TBET”).

A TBET is a joint trust for a married couple that provides the same protection from the claims of the separate creditors of the husband and wife as would exist if the husband and wife owned the trust assets directly as tenants by the entirety. 

Being able to transfer tenants by the entirety property to a TBET without sacrificing creditor protection will make it more feasible for couples to use revocable trusts for their various benefits, including incapacity management, probate avoidance, and privacy.

A TBET only provides creditor protection for property that was held by the spouses as tenants by the entirety property prior to the conveyance of the property to the trust.  The additional requirements of a TBET include: (1) the husband and wife must remain married; (2) the property must continue to be held in trust by the trustee(s) or their successors in trust; (3) while both the husband and wife are living, the trust must be revocable by either spouse or by both of them acting together; (4) both spouses must be beneficiaries of the trust; and (5) the trust instrument, deed, or other instrument of conveyance must specify that the provisions of the new statute apply to the property. 

Traditional tenants by the entirety property automatically passes to the survivor upon the death of the first spouse.  A TBET is more flexible.  For example, the TBET could convert to an irrevocable trust for the benefit of the survivor, with the remainder to pass to children after the survivor’s death.  This structure would provide better asset protection for the survivor as well as better protection to the children if the survivor remarries.

After the death of the first spouse to die, the property will continue to be exempt from the claims of the decedent’s separate creditors.  To the extent the survivor may withdraw the trust assets, the property will be subject to the claims of the survivor’s separate creditors.

Creditor protection may be waived as to any specific creditor or any specifically described trust property, but only if expressly permitted by the trust instrument, deed, or other instrument of conveyance or if the husband and wife both give their written consent.  This provision allows a house subject to a mortgage to be transferred to a TBET.

TBETs may be created on or after July 1, 2014. 

2014 Trust and Estate Planning Steps - PART 3: Asset Protection Trusts Facilitate Income Tax Savings

This is the third article of a series regarding 2014 Trust and Estate Planning

For the prior articles, see:

[Link to PART 1:  Introduction]

[Link to PART 2:  65 Day Rule for Trust Distributions]

The previous article highlighted the opportunity of making a distribution from a trust by March 6th in order to reduce income taxes.  The problem for some of our clients is that they don’t want the beneficiary to get their hands on a large sum of money.  One trust would like to make a distribution of $265,000 in order to reduce overall income taxes.

Several of our clients have utilized asset protection trusts to capture income tax savings in a manner that does not result in their children receiving a lot of cash.  These clients have been able to persuade their child to establish an asset protection trust with the parent as the trustee.  The child’s trust (typically established by the child’s parent or grandparent) then makes a distribution directly to the asset protection trust

The asset protection trust uses the social security number of the child as its taxpayer identification number.  The trust income tax rules treat the distribution from the child’s trust to the asset protection trust as a distribution to the child.  The income will be taxed on the child’s Form 1040 where it will enjoy a lower tax rate than if the child’s trust had not made a distribution.

You can use an asset protection trust even if it is established after March 6.  First, make a distribution to the child on March 6 and have the child deposit the distribution in a savings account.  After the asset protection trust is established, the child will then move the funds to the asset protection trust.  This technique is not as good as the direct trust-to-trust transfer, because the child has access to the funds for some period of time.

Minors are not able to establish asset protection trusts.  However, there are other techniques that can be used to make a distribution to a minor in order to reduce income taxes.  All of these techniques have flaws, but the flaws should be evaluated against the potential income tax savings.

Service Grants Extension to Make Portability Election

Since 2010, the Federal estate tax exemption has been $5 million or higher. When a person dies and does not use all of his or her estate tax exemption, his spouse is able to add the unused exemption to his or her exemption if an estate tax return is filed, which elects to carry over the decedent’s unused exemption to the surviving spouse. This election is referred to as a portability election.

The IRS previously ruled that the portability election could only be made on a timely filed estate tax return, either nine months after the decedent’s death or 15 months if an extension is requested. A lot of surviving spouses who might benefit from electing portability neglected to file a timely estate tax return. Fortunately, the IRS has published Revenue Procedure 2014-18, which gives an extension until the end of 2014 to file the estate tax return to make the portability election. The Revenue Procedure will only help for a decedent who died between January 1, 2011 and December 31, 2013 and whose estate was below the estate tax filing threshold.

The Revenue Procedure will also help the surviving spouse of a same-sex marriage. Prior to the Windsor decision by the Supreme Court, a federal law known as the Defense of Marriage Act (“DOMA”) did not allow the surviving spouse of a same-sex marriage to make the portability election. Now that the Supreme Court has ruled DOMA to be unconstitutional, the surviving spouse is allowed to make a portability election. The new Revenue Procedure will allow an estate tax return to be filed in 2014 so that the surviving spouse can benefit from portability, even if the deadline for filing the return has already passed.


Tennessee Ranks 5th in Decanting

Tennessee adopted its decanting statute in 2004 and made improvements to the statute in 2013.  Decanting has allowed many of our clients to improve troublesome provisions contained in prior trust agreements.  There are now 22 states that have adopted decanting statutes.  I predict that all states will adopt some version of decanting within the next 10 years. 

Steve Oshins has compiled a ranking of the decanting statutes.  Tennessee ranks 5th on his list.  Two of the three areas where Tennessee loses points are misleading.  Tennessee does allow a trust with an ascertainable standard to be decanted into a discretionary trust.  Mr. Oshins correctly points that our statute does not allow a mandatory income interest to be removed.  We included this prohibition in the statute due to a concern that eliminating a mandatory income interest might create adverse income, gift, and generation-skipping tax results.

Attached is a decanting paper I presented last year when there were only 18 states that allowed decanting.

2014 Trust and Estate Planning - PART 2: 65 Day Rule for Trust Distributions

This is the second article of a series regarding 2014 Trust and Estate Planning

For the prior article, see:

PART 1:  Introduction

Trusts that are not treated as grantor trusts are now subject to income tax at much higher rates.  Trusts are taxed at the maximum individual income tax rates on all income beyond $11,950 for 2013 and $12,150 for 2014.  As a general rule, non-grantor trusts are taxed as follows: to the extent income is distributed to the beneficiaries, the beneficiaries are taxed; the portion of the income retained in the trust is taxed to the trust.  There is a special rule for capital gains, which generally makes capital gains taxable to the trust whether or not the proceeds are distributed to the beneficiary. 

When the beneficiary of the trust is not in the top income tax bracket, it is often possible to reduce overall income taxes by making distributions to the beneficiary.  This assumes that circumstances are appropriate for making distributions.  First, the trust must authorize the trustee to make the distributions.  Second, the beneficiary must not waste the distribution.  It is better to pay a high tax within the trust and keep the after-tax proceeds than to make a distribution and have it wasted by the beneficiary. 

There is a special election that allows the trust to treat distributions made within the first 65 days of the following calendar year as having been made in the previous calendar year.  Thus, if there is a beneficiary who is in a lower tax bracket and circumstances are appropriate for making a distribution to the beneficiary, the trust may be able to reduce its taxes for 2013 by making a distribution on or before March 5, 2014.

Due to certain rules that apply to individuals but not to trusts, the maximum tax bracket for individuals is slightly higher than the maximum tax bracket for trusts.  When the beneficiary is in the top bracket, it may work out better for the trust to pay tax on the income than for the beneficiary.  If circumstances warrant, consideration should be given to accumulating income within the trust.  If income is distributed within the 65-day period, the trust is not required to treat it as having been made in the prior year.

In addition to the federal income tax consequences, state income taxes may also be relevant.  When the beneficiary lives in Tennessee, the Hall income tax will be paid whether or not a distribution is made.  However, if the beneficiary lives in another state, Tennessee taxes will not be payable.  Whether or not taxes are paid to the beneficiary’s state of residence may depend on whether or not distributions are made from the trust.

As you can see, the timing and amounts of trust distributions can affect the amount of federal and state income taxes that are paid.  You should analyze these opportunities now in case distributions need to be made prior to March 6, 2014.

2014 Trust And Estate Planning Steps - Part 1: Introduction

2013 was a year of tremendous change in the estate planning field.  The American Taxpayer Relief Act of 2012 (“ATRA”) gave us higher income tax rates, a “permanent” unified estate, gift, and generation-skipping transfer tax exemption of $5 million indexed for inflation, portability of the estate tax exemption, and an estate tax rate of 40%.  The Affordable Care Act imposed a new 3.8% tax, the Net Investment Income Tax (“NIIT”), on many types of passive income received by high-income taxpayers.  Finally, the Tennessee inheritance tax exemption increased to $1.25 million per person, with scheduled increases to $2 million in 2014 and $5 million in 2015 before this tax disappears in 2016.

The net effect of all these changes is that fewer people need to worry about estate and inheritance taxes.  For individuals who have more than $5 million, or couples who have more than $10 million, the higher estate and gift tax exemption and portability open up a lot of planning opportunities to reduce or eliminate estate taxes.

The news is not so good on the income tax side.  Most of you will be paying significantly more income taxes for 2013 and later years than you paid prior to 2013.

The combination of lower estate taxes and higher income taxes has led to a new tax environment in which some familiar planning techniques need to be discarded and new planning techniques have emerged.  In some cases, income taxes can be reduced by unwinding or modifying trusts or business entities that you previously established.  We will examine these new opportunities in a series of articles over the coming weeks.