Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

I previously wrote about Edith Windsor, who was required to pay $350,000 of estate taxes because her deceased spouse was a woman rather than a man. This tax was caused by the Defense of Marriage Act (“DOMA”), which classifies same sex married couples as unmarried for purposes of federal taxation and various benefits.

President Obama has decided that certain portions of DOMA are unconstitutional and has directed the Justice Department to stop defending the law in court, including the pending appeal in the Windsor case.

There are many people who agree with the President’s assessment of the constitutionality of DOMA. Nevertheless, it is not the President’s job to determine the constitutionality of laws that have been enacted. Laws may be changed by Congress or ruled to be unconstitutional by the judicial branch of the government. It would create chaos if the President is allowed to prohibit enforcement of laws that he does not like.

If DOMA is overturned by Congress or the U.S. Supreme Court, this will be a watershed event for same sex married couples. There are numerous tax and non-tax benefits provided to couples who are treated as married by the federal government.

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In Kristen Cox Morrison v. Paul Allen et al, the Tennessee Supreme Court allowed a widow to collect $1.9 million on a $1 million life insurance policy. Shortly before his death, the husband applied for a $1 million American General life insurance policy. The agent who filled out the application checked “No” for the question asking whether the applicant had a driving violation within the previous 5 years. In fact, the applicant had been arrested for DUI.

After the decedent’s death, the widow applied for payment of the $1 million life insurance benefit. American General denied the claim due to the incorrect answer on the life insurance application. The widow then sued American General and the life insurance agents who assisted with obtaining the policy. Subsequently, the widow settled with American General and received $900,000.

The widow continued her suit against the agents and was awarded $1 million from the agents due to their failure to procure the policy that had been requested by the applicant. The agents were unsuccessful in their effort to get a credit against their damages for the amount paid to the widow by American General pursuant to the settlement. Even though the husband signed an incorrect application, the court decided that he was not accountable since the agents filled out the application.

The widow actually collected significantly more from the policy than she would have collected if the application had been filled out correctly! Apparently, the court decided that the agents needed to be punished for their sloppiness in filling out the life insurance application.

One lesson to be learned from this case is to be careful about switching from an existing life insurance policy to a new policy. As a general rule, there is a 2 year contestability period for new policies. Therefore, you should consider maintaining the old policy for 2 years to make sure that the new policy cannot be contested.

Another lesson is for both the agent and the applicant to make sure that all of the questions on the life insurance application are answered correctly. An incorrect answer may constitute grounds for the insurance company to deny benefits. Furthermore, the agent can be held accountable for failing to procure an incontestable policy.

A final lesson concerns sympathetic plaintiffs. American General was smart enough to realize that their attempt to deny benefits to a widow would probably not be well received in a trial. They settled for 90% of the claim despite an admittedly fraudulent application which gave them a sound legal reason for denying the claim. The agents took their chances against the widow and paid the price.
 

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The brother of one of our clients recently became convinced that he had sold his soul to the devil. Upon questioning by his psychiatrist, he could not remember where he had met the devil, what the devil looked like, or what he had received in exchange for selling his soul. Perhaps the sale to the devil actually occurred. However, the psychiatrist believes that our client’s brother is having paranoid delusions.

Fortunately, the brother, who is now in his 40s, had prepared a financial power of attorney, a healthcare power of attorney, and a revocable trust when he was 35 years old. He had previously experienced some psychological problems. His doctors were concerned that he could experience severe mental illness in the future. Upon urging from his parents, he signed good estate planning documents.

The powers of attorney have been triggered. The healthcare agent is making medical decisions. The agent under the financial power of attorney, who is also the trustee of the revocable trust, is changing the ownership of various assets into the name of the revocable trust. A court appointed conservator will not be necessary. This will avoid an expensive, cumbersome process.

It is not always possible to foresee potential mental illness in the future. Nevertheless, it is my understanding from healthcare professionals that persons who experience severe mental illness often show signs of things to come before they fall off the deep end. If you or one of your loved ones show these signs, make sure that you put into place good estate planning documents before the major trouble arrives.
 

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This is the fourth article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first three articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents
Part 3 – Temporary $5 Million Estate Tax Exemption

The Act temporarily increases the gift tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. For example, if inflation for 2011 is 2%, the gift tax exemption will be $5.1 million in 2012. The Act decreases the gift tax exemption to $1 million for gifts in 2013 or later.

In addition to increasing the gift tax exemption, the Act set the maximum gift tax rate at 35% for 2011 and 2012. The Act increases the maximum gift tax rate to 55% for 2013 and future years.

The temporary nature of the higher gift tax exemption provides an incentive to make gifts in 2011 and 2012. If you choose not to make gifts and then die in a year when the estate tax exemption is lower than $5 million, you will pay significantly more estate taxes than if you made the gift. Assume for example, that an individual who currently has $6 million of assets dies on January 1, 2013. If he makes $5 million of gifts on or before December 31, 2012, his estate will owe $550,000 of estate taxes based on current law. If he makes $1 million or less of taxable gifts, he will owe approximately $2.6 million based on current law. Thus, making gifts can reduce taxes by as much as $2,050,000. Furthermore, income and appreciation occurring after the date of the gift will be removed from your estate, which increases the reduction in estate taxes.

Some commentators believe that the IRS may attempt to “clawback” as much as $1,385,000 of these tax savings if you die in 2013 or later. The analysis is confusing because you have to make calculations by pretending that the law in prior years was different than it really was. Nevertheless, I do not think the law permits a clawback. Even if a clawback were permitted, making gifts will still yield a substantial reduction in estate taxes.

Many of our clients have already begun to take advantage of the higher gift tax exemption. Several others are evaluating different strategies for taking advantage of the additional exemption.

The simplest method is a straight gift. Due to the current economic environment, a number of our clients have made loans to their children. Some of them are forgiving the loan obligations now that this can be done without federal gift tax consequences.

While a direct gift can be very effective, we often encourage our clients to leverage their gift by transferring a “discounted” asset. Good examples are non-voting stock in a family corporation or limited partnership interests in a limited partnership, or fractional interests in real estate.

We generally recommend that gifts be made to a grantor trust. This enables the donor to continue to pay income taxes on income earned by the trust and to further decrease his or her estate.

Some of our clients want to take advantage of the gift tax exemption yet are concerned that they will run out of cash in their later years. Fortunately, there are some gifting strategies that allow the donor to maintain access to cash flow. These strategies will be discussed in a future article

I am predicting that Tennessee gift tax collections will set all-time records on April 15, 2012 and again on April 15, 2013. Tennessee allows annual exclusion gifts just like the IRS. However, Tennessee does not have any exemption from gift tax. Therefore, you will generally pay Tennessee gift taxes when you make taxable gifts to take advantage of the higher federal gift tax exemption. In a future article, we will discuss methods for making gifts that do not require you to pay Tennessee gift taxes.

In summary, the $5 million federal gift tax exemption creates a two year opportunity for decreasing the size of your taxable estate. If you choose not to take advantage of this opportunity, your children will pay more federal estate taxes unless the law is changed. Some methods of utilizing the exemption allow you to maintain access to cash flow. There are also methods for making gifts that do not require the payment of Tennessee gift taxes.
 

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The attached article recognizes Tennessee as one of four Tier 2 trust states. The four Tier 1 states have only two favorable features that Tennessee does not match.

First, Tennessee imposes an income tax on dividends and interest received by a trust with Tennessee beneficiaries. This is no different than if the beneficiaries owned the assets directly. Therefore, this is not really a trust problem. Nevertheless, there are seven states in the United States that do not impose income taxes on their residents.  Tennessee does not impose income taxes on trusts held for beneficiaries who are not Tennessee residents.

The other slight advantage for some states is the rule against perpetuities. Tennessee trusts must terminate after 360 years due to our state consitution. A few states allow trusts to last into perpetuity. The benefit of perpetual trusts is overrated. I have never had a client complain to me that 360 years is too short.  More than one-half of the other states require trusts to end after approximately 90 years.  The difference between 90 years and 360 years is material to a lot of my clients. 

Our legislature has made a concerted effort to keep our trust laws at the forefront. In addition to our comprehensive Tennessee Uniform Trust Code, our laws permit asset protection trusts, decanting, community property trusts, unitrust conversions, directed trusts, equitable adjustments, and a long perpetuities period.

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This is the third article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first two articles, see:

Part 1 – Charitable IRA Rollovers
Part 2 – Estate Tax/Carryover Basis Election for 2010 Decedents

The Act temporarily increases the estate tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. For example, if inflation for 2011 is 2%, the estate tax exemption will be $5.1 million in 2012. The Act decreases the exemption to $1 million for people dying in 2013 or later.

The Act set the maximum federal estate tax rate at 35% for 2011 and 2012, but increases the maximum rate to 55% for 2013 and future years.

The Act is great news for individuals who die in 2011 or 2012. Very few will owe federal estate taxes. However, the huge increase in estate taxes for people dying in 2013 makes estate planning tricky. Earlier this week, I met with a couple whose estate tax liability will increase from $2.9 million under 2011 law to $9 million if the survivor dies in 2013 or later. A large portion of their net worth involves a family business. They have sufficient liquid assets to pay for the 2011 taxes, but not the 2013 taxes. Should they make gifts to try to reduce estate taxes? Should they buy life insurance to provide liquidity to pay the taxes? It is possible that the $5 million exemption and 35% rate will be extended by future legislation. However, it is dangerous to make plans based on hoped for tax decreases to be enacted in the future.

Tennessee has not changed its exemption from inheritance tax. Tennessee’s exemption is still $1 million. Having different exemption amounts for Tennessee inheritance taxes and federal estate taxes is a matter that we have grown accustomed to since 2001. Most married couples deal with the disparate exemptions by transferring $1 million to a traditional credit shelter trust and transferring the difference between the federal exemption and the Tennessee exemption ($4 million under current law) to a Tennessee QTIP Trust. The Executor will make a Tennessee QTIP election for the Tennessee QTIP Trust, but will not make a federal QTIP election. This will ensure that no Tennessee taxes will have to be paid at the first death. Taxes will be payable with respect to the Tennessee QTIP Trust upon the surviving spouse’s death. However, there will not be any federal estate taxes imposed upon the Tennessee QTIP Trust upon the surviving spouse’s death.

Fortunately, most of the revocable trusts and wills that we have prepared for our clients have formulas that adjusted to the new estate tax exemption so that no changes are necessary. There is a very subtle change that we will recommend for people who otherwise need to amend their documents.. Even though it may not be necessary to amend their documents, married couples may need to rearrange ownership of certain assets. Each spouse should have $5 million of assets titled in their name so that the couple will be able to take full advantage of the higher estate tax exemption regardless of which spouse dies first.  A Tennessee Community Property Trust is a good method for dividing assets between the spouses.

The Act has a portability option which allows the surviving spouse to take advantage of any unused estate tax exemption of the first spouse to die. In theory, the portability option makes it unnecessary to rearrange ownership of assets and to fully fund the estate tax exemption of the first spouse to die in a credit shelter trust and/or Tennessee QTIP trust. As drafted, the portability option is a Trojan horse. We will explain in a future article why we do not recommend planning to take advantage of portability.

In summary, the higher estate tax exemption and lower estate tax rates will significantly reduce estate taxes for individuals dying in 2011 and 2012. There is some rearranging that may need to occur in order to take full advantage of the additional exemption.
 

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