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

Some people mistakenly assume that their Will controls the disposition of all of their assets. There are several ways that your assets pass to someone outside of your Will.

Assets that are owned as tenants by the entirety with your spouse or joint with right of survivorship will pass to the other owner or owners by operation of law.

A large number of assets pass by beneficiary designation. Common examples are bank accounts, retirement accounts such as 401(k) plans and IRAs, and life insurance. See the enclosed article from Fidelity regarding important considerations in your choice of beneficiary designation.

If you transfer ownership of your assets to a trust before you die, the trust will dictate how the assets pass upon your death. A number of my clients have transferred all or a portion of their assets to a revocable trust or an asset protection trust.

Under Tennessee law, your spouse is entitled to elect against your Will and receive a share of your estate, year’s support, exempt property, and homestead. As a general rule, your spouse will elect to receive these benefits when they are better than the Will.

Even if your Will does not direct your Executor to pay your debts, your creditors will file claims against your estate and will be paid prior to the beneficiaries named under your Will.

Even if your Will does not direct your Executor to pay your tax obligations, the IRS and the State of Tennessee have priority over the beneficiaries of your Estate regarding the payment of income, inheritance, estate and generation-skipping transfer taxes, including interest and penalties. They have a “secret” lien against all of the assets of your Estate. If the Executor of your Estate fails to pay your tax obligations, the IRS and the State of Tennessee will be able to collect taxes from your Executor (to the extent that the Executor has distributed assets to the beneficiaries) or from the beneficiaries of your Estate (to the extent that they received assets from your Estate or from other methods such as beneficiary designations).

Because there are so many ways to receive assets that are not dependent on the terms of your Will, it is very important to make sure that you account for all of these potential non-testamentary transfers when planning for the disposition of your assets.

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I came across an interesting article regarding estate planning for second marriages. The article highlights some of the most common issues faced by male business owners who have children from a prior marriage. Women, of course, face many of the same issues.

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 I currently represent an 88 year old widower whose wife died less than 9 months ago. The wife’s estate is approximately $1.6 million. The husband’s assets, including a $1 million brokerage account that had been owned jointly with his wife, are worth approximately $1.8 million. Because the husband’s estate exceeds $1 million, his estate will owe more than $300,000 of estate taxes if he dies after January 1, 2011 and Congress does not change the tax laws prior to his death.

In an effort to reduce or eliminate his potential federal estate tax liability, I have recommended a disclaimer of the husband’s one-half survivorship interest in the brokerage account. If the husband chooses to file a disclaimer, his children will receive one-half of the brokerage account now, rather than following his death. Under federal law, the disclaimer will not be treated as a gift by the husband. This means that no federal gift or estate taxes will be charged on the $500,000 passing to his children.  The disclaimer will reduce his federal estate taxes by more than $200,000.

Tennessee treats a disclaimer of a joint brokerage account as a gift. The husband will have to pay $36,000 of Tennessee gift tax on April 15, 2011. Upon the husband’s death, the inheritance taxes imposed on his estate will be reduced by $36,000 as a result of the disclaimer. Therefore, the net effect of the disclaimer is to accelerate the payment of $36,000 from 9 months after the husband’s death to April 15, 2011.

The husband has a modest lifestyle and feels comfortable that he will have sufficient assets for his remaining lifetime after he executes the disclaimer. He also likes the idea of getting assets to his children sooner.

If we knew that Congress would change the federal estate tax exemption to $2 million or more prior to the husband’s death, it would be unnecessary to make the disclaimer. Unfortunately, the disclaimer must be filed within 9 months after the death of the wife. Congress has been in a stalemate for more than 9 years regarding the “estate tax fix.” Because the 9 month deadline will occur in a few weeks, the husband will have to make the disclaimer decision prior to finding out whether Congress changes the law.

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 In less than 6 months, federal estate taxes are scheduled to return with an exemption of $1 million and a maximum rate of 55%. Numerous bills have been submitted to provide relief from these taxes. Most of the bills would increase the exemption to $3.5 million or more and decrease the top rate to 45% or less.

These bills have not passed because they would significantly decrease tax revenues. The latest such failure was an amendment offered to a Jobs Bill by Senators Jon Kyl of Arizona and Blanche Lincoln of Arkansas. Apparently the Senate decided against combining a large tax decrease with a bill that proposes to increase spending by $33.9 billion.

A lot of Senators are hesitant to pass another large spending bill. Many of these same Senators believe that taxes, including estate taxes, should be reduced. In the enclosed LA Times article, Tennessee’s Lamar Alexander explained why it is logical to support decreasing taxes while at the same time fighting increasing spending as follows: “If you’re going to spend more, you have to have a revenue source or you run up the debt.” Reducing taxes "reduces the amount of revenue we have to spend, and we should reduce spending by the same amount.”

What Lamar says by implication is that the national debt will increase if you reduce taxes without reducing spending. There appears to be a lot of support for reducing taxes. There does not appear to be a lot of support for spending less. It will be very difficult to solve the estate tax dilemna if the fix requires a commitment to decrease spending. I am counseling my clients to be prepared for the return of federal estate taxes in 2011 with the $1 million exemption and 55% top rate.

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 It is very typical for a Will to direct the Executor to pay the Decedent’s valid debts. When my clients own real estate encumbered by a mortgage, they often want the successor owner of the real estate to continue paying the mortgage. For these clients, I place a provision in their Wills giving the Executor the discretion to continue paying the mortgage until the successor owner takes over the payments.

When the successor owner of the real estate is also the residuary beneficiary of your estate, it may not matter whether your estate or the successor owner pays the mortgage. If your estate pays the mortgage, the residuary estate passing to the successor owner will be less. Nevertheless, it provides more flexibility for the successor owner if you allow the mortgage to remain in place. The successor beneficiary can pay off the mortgage early if there is not a need to maintain the mortgage.

Things are not as easy when the successor owner of the real estate is not the residuary beneficiary of your estate. Now it makes a big difference as to whether your estate or the successor owner pays the mortgage.

If you decide that you want the successor owner to pay the mortgage, there is another consideration. The bank may file a claim against your estate and require the Executor to pay the mortgage. Depending upon whether the successor owner was jointly liable on the debt, your estate may have a claim against the successor owner to pay at least a portion of the debt. If you do not want your Executor to be in the position of having to sue the successor owner of the house, you should condition any bequest to the successor owner on their agreement to assume the mortgage. If you take this approach, the bequest to the successor owner will be reduced to the extent, if any, that your estate is required to make payments on the mortgage.

There are 2 methods by which the successor owner can acquire the property.

First, when you own the property, your Will simply devises the property to the successor owner. You can make the devise conditional on the devisee’s assumption of the mortgage.

Alternatively, when you own the property as tenants by the entirety with your spouse or jointly with right of survivorship, the successor owner will acquire the property by operation of law. Your Will cannot require the successor owner to assume the mortgage. However, if your Will makes a bequest of other assets to the successor owner, this bequest can be conditioned upon the successor owner’s assumption of the mortgage. If the bequest is less valuable than the mortgage, the successor owner might forfeit the bequest rather than assume the mortgage.

In summary, you need to decide who you want to pay your mortgage and draft your Will accordingly.

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One of my clients has been diagnosed with a rare disease that will very likely end her life in 2010. Due to the peculiar estate tax laws that apply to decedents dying in 2010, there are some unusual planning steps that my client and her husband are taking.

As a general rule, you want to make sure that the first spouse to die has sufficient assets titled in their name so that they can take maximum advantage of federal and Tennessee estate and inheritance tax exemptions. In 2009, the magic number was $3,500,000. This year, the amount is unlimited.

We previously split assets between the husband and the wife with each of them owning assets worth approximately $6 million. The husband is in the process of transferring most of his assets to his wife.

Another change that we are making is to create a revocable trust for the wife that will replace her will. The wife’s revocable trust will own her assets so that it will be unnecessary to probate her will. The revocable trust will transfer $1 million to a typical credit shelter trust of which the husband and children are beneficiaries. The remaining $11 million of assets will be transferred to a marital trust for the husband’s sole benefit during his lifetime. Assuming the wife dies when there is no federal estate tax, it will not be necessary to claim a marital deduction for the marital trust for federal estate tax purposes. We will elect to qualify for the marital deduction for Tennessee inheritance tax purposes so that no Tennessee taxes will be owed.

The overall result of this plan is that all of the couple's assets are eligible for a basis step up. Since the combined built-in appreciation of their assets is $4 million and there is $4.3 million of basis step up available, they will receive a full basis increase. Since they own some significant rental properties, the higher basis will increase the husband’s depreciation deductions.

More importantly, the $11 million marital trust will not be subject to federal estate taxes upon the husband’s subsequent death. This will be a tremendous advantage to the family if they do not ever have to worry about paying federal estate taxes.

In summary, simple planning steps are needed to take full advantage of the absence of federal estate taxes in 2010.
 

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One of the sad things about my profession is that my clients eventually die. Some deaths are sudden and unexpected, but most deaths occur after an accident or illness that makes death imminent within a few days or perhaps a few weeks. Though I am sensitive to the feelings of grief and stress that my clients and their families are experiencing, I have the unpleasant task of explaining to my clients and their families the heavy penalties they will pay to the federal and Tennessee governments if they decline to take advantage of “last minute” tax reduction opportunities.

I am currently working with one of my clients who has been given a life expectancy of 2 months or less. Because my client is likely to die in 2010, some of the planning issues are unique. However, some of the planning opportunities are the same as they would be for a death in a different year. Some of the major issues we have considered:

1. Make sure all assets are owned by the Revocable Trust so that probate can be avoided. My client has done an excellent job of funding her revocable trust. However, she recently loaned some money to a friend and the Note is payable to her rather than her trust. We are doing a simple assignment of the Note to make sure that it is owned by her trust.
2. Make annual exclusion gifts of $13,000. My client is making gifts of $13,000 to all of her children and grandchildren, as well as to spouses of her children. At a minimum, this will reduce Tennesse inheritance taxes. If federal estate taxes are reinstated with an effective date prior to the date of my client’s death, or, if she survives until 2011, the gifts will also reduce federal estate taxes.
3. My client is converting her IRA to a Roth IRA.
4. My client’s revocable trust makes charitable bequests totaling $500,000. My client trusts her children to make these gifts. Therefore, she is amending her trust to give the money to her children. The children will pay Tennessee inheritance taxes on this bequest at the rate of 9.5%. However, they will receive charitable income tax deductions which will reduce their federal income taxes by approximately 35%. Furthermore, two of the children live in states with state income taxes. The charitable bequests will also reduce state income taxes. This plan will backfire if federal estate taxes are reinstated retroactively. If this were to happen, federal estate taxes would be higher than the income tax savings. In order to account for this possibility, the revocable trust will provide that if the children disclaim the bequest, then the bequest will go to the charities. This will allow the children to see what happens over the next nine months before they must decide whether to disclaim.
5. Should appreciated assets be sold to avoid losing the benefit of a capital loss carryover? Fortunately, no sales are necessary, because the carryover basis law that applies for decedents dying in 2010 allows the unused capital loss carryover to be added to the $1.3 million basis increase. My client’s executor will have more flexibility to avoid future capital gains if the capital loss carryover is preserved.
6. Finally, my client is researching her records regarding her income tax basis for several assets. She can find this information much more easily than her Executor.

Estate planning when death is imminent can reduce taxes and other problems. Even though the circumstances are unpleasant, the potential benefits are substantial. I have been told by some of my former clients and/or their families that they took comfort in their final days from the knowledge that financial matters were in good shape.
 

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A recent article discussed the use of Inter Vivos Marital Trusts to reduce estate taxes. These trusts can also be used to provide asset protection from future creditors. When the objective is asset protection, the trust is designed differently.

One spouse transfers property to a trust for the benefit of the other spouse. If the donee spouse predeceases the donor spouse, the donor spouse becomes the beneficiary of the trust. The donor spouse’s retention of a successor beneficial interest in the trust represents the key distinction of a marital trust that is used for asset protection rather than reducing estate taxes.

This type of trust has always been exempt from future creditors during the donee spouse’s lifetime because it is a third party created spendthrift trust. When the donor spouse becomes the beneficiary, the trust has traditionally been available to all creditors of the donor spouse since the transfer was made to a trust of which the donor is a beneficiary.

A new Tennessee law will make these trusts exempt from the donor spouse’s future creditors after July 1, 2010. This means that one spouse can transfer substantially all of his or her assets to a trust and protect the assets from future creditors of both spouses.

Inter Vivos Marital Trusts may not be used to avoid the donor’s obligations to creditors that already exist at the time of the transfer to the trust. If the donor spouse does not retain sufficient assets to pay existing creditors, the preexisting creditors can attack the trust as a fraudulent conveyance.

Another potential benefit of an Inter Vivos Marital Trust is to make sure that the donee spouse has sufficient assets to utilize his or her federal estate tax exemption and Tennessee inheritance tax exemption. This will reduce estate taxes upon the surviving spouse’s death. No gift taxes will be payable if the donor spouse files timely federal and Tennessee gift tax returns which make a QTIP election.

For federal income tax purposes, the donor spouse will be taxed on all of the taxable income of the trust, including capital gains, during his or her lifetime. The donee spouse will be taxable on the ordinary income of the trust following the death of the donor spouse and may be taxed on some or all of the capital gains of the trust.
 

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I recently met with a couple for whom I prepared Wills in 2006. They want to make a change to their Will because a member of their family died unexpectedly. When they went to their lockbox, they were unable to find their original Wills. Fortunately, they still have the ability to sign new Wills.

What would have happened if one of my clients had died and the survivor was unable to find the Will? It is likely that we could have probated a copy of the Will. Tennessee law allows a Court to probate a copy of the Will when there is credible testimony that the Will has been lost and that there was no intention to revoke the Will. I have successfully probated copies of Wills on 6 or 7 occasions. Every time that I have probated a copy, no one objected and a close family member was able to give credible testimony about the Will being lost.

You should assume that your heirs will be unsuccessful in probating a copy of your Will. When the original Will cannot be found, there is a strong presumption under Tennessee law that the Will was revoked. There have been numerous cases where the Court refused to probate a copy of a Will. If the Court refuses to probate the copy, the Court will choose an administrator to manage your estate and distribute your assets according to the intestate succession laws of Tennessee.

Due to the problems caused when your original Will cannot be located, it is very important that you keep your original Will in a lockbox or other safe location. You also need to make sure that one or more trustworthy persons knows the location of your original Will.

Revocable trusts do not have the same problem. The Trustee does not have to produce the original Trust Agreement in order to carry out its duties. This is another potential benefit of a revocable trust.
 

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Short-term capital gains are taxed at a significantly higher rate than long-term capital gains. In 2010, the maximum rates are 35% for short-term capital gains and 15% for long-term capital gains. In 2011, the maximum rates will increase to 39.6% and 20%.

Prior to 2010, gains from sales of assets by an estate were automatically treated as long-term capital gains, regardless of when the decedent bought the asset. For decedents dying in 2010, this rule does not apply. It is now necessary to determine when the decedent bought the asset. If the asset is sold within a year after it was acquired, the gain will be short-term.

Tax on pre-mortem gain can be eliminated by allocating the decedent’s basis increase to the property. Every decedent has $1.3 million of basis increase that may be allocated by the Executor. Married decedents potentially have an additional $3 million of basis increase that can be allocated.

The basis increase can not be used to eliminate post-mortem gains. Assume the decedent bought a stock for $200,000 on November 1, 2009. The decedent died on March 31, 2010 when the stock was worth $260,000. If the Executor sells the stock for $300,000 on October 15, 2010, there will be a short-term capital gain of $100,000. The pre-mortem gain of $60,000 can potentially be eliminated if the Executor chooses to allocate a portion of the decedent’s basis increase to this particular asset. The basis increase cannot be used to wipe out the $40,000 post-mortem gain.

The gain could be converted from short-term capital gain to long-term capital gain if the Executor waits to sell until November 1, 2010.

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Making a lifetime gift of the $1,000,000 federal gift tax exemption amount can substantially reduce estate taxes. Appreciation and income from the gifted property between the date of the gift and the donor’s death can escape federal transfer taxes. My clients are generally unwilling to make such a gift because it would require the payment of Tennessee gift taxes. A second problem is that the donor loses access to the income from the gift.

A Tennessee QTIP Trust™ provides an opportunity for making a lifetime gift without paying Tennessee gift tax while retaining indirect access to the income through your spouse. A Tennessee QTIP Trust™ is a trust that would qualify for the federal gift tax marital deduction but for which the donor elects not to make a QTIP election on the federal gift tax return. The donor does make the QTIP Trust election on the Tennessee gift tax return.

The Tennessee QTIP Trust must make income available to the donee spouse. Rather than requiring income to be paid to the spouse, the spouse should be given the right to withdraw income. There are two benefits from using the right to withdraw income as opposed to the mandatory payment of income. First, to the extent that income accumulates in the trust, it will escape federal transfer tax. The second benefit is that either the donor spouse or the donee spouse will be required to pay federal income taxes attributable to trust income even though the income remains in the trust. Thus, the trust is able to grow in value on a pre-tax basis.

The donor spouse should not have a successor life estate or discretionary principal interest following the death of the donee spouse. This would cause estate tax inclusion for the donor spouse.

The downside with a Tennessee QTIP Trust occurs when the donee spouse predeceases the donor spouse. If the value of the trust upon the donee spouse’s death exceeds the $1,000,000 Tennessee inheritance tax exemption, the donee spouse’s estate will pay Tennessee inheritance tax. This means that some transfer tax will be paid prior to the death of the survivor. Because the lifetime Tennessee QTIP Trust will exhaust the donee spouse’s Tennessee inheritance tax exemption, the donee spouse’s Will should establish a testamentary Tennessee QTIP Trust (as opposed to a traditional credit shelter trust) for the donee spouse’s federal estate tax exemption amount.

Due to the potential Tennessee inheritance tax upon the death of the donee spouse, and the necessity of the donee spouse’s establishment of a testamentary Tennessee QTIP Trust, it may be advisable for the spouse with the shortest life expectancy to be the one who establishes the lifetime trust. Access to income will also be preserved if the survivor is the donee spouse. Nevertheless, the greatest benefit from accelerating the use of the federal gift tax exemption will occur if the trust is established by the spouse with the longest life expectancy.

A Tennessee QTIP Trust™ can reduce estate taxes while allowing the donee spouse to retain access to the income and corpus of the trust.

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I recently read that 43% of the 91,000 babies born in Tennessee in 2008 were born out of wedlock. Babies with unwed parents are now so common that the social stigma from yesteryear has largely disappeared.  Nevertheless, there are still circumstances where the law discriminates against children born out of wedlock.

When someone dies without a Will, the state of Tennessee decides who will inherit the person’s estate. The laws governing this process are known as "Intestate Succession." When the decedent has no surviving spouse or descendants, the property is distributed to the decedent’s parents or descendants of the parents if they are deceased, i.e., brothers, sisters, nieces and nephews. If the parents are deceased and have no then living descendants, then the property is distributed to descendants of the decedent’s grandparents (i.e. aunts, uncles, first cousins, second cousins, third cousins). Children born out of wedlock frequently claim to be a member of the class who inherits from an intestate decedent.

The Cleo Snapp case is the most recent of several Tennessee cases that have treated children born out of wedlock as creditors of the estate. Tennessee law requires creditors to file a claim against the estate within 1 year of the decedent's death if they want to receive a share of the estate. Furthermore, if the executor notifies the creditor that they need to file a claim, they have only 4 months after receiving the notification. If the creditor does not file a timely claim, they forfeit their share of the estate.

The problem presents itself when inheritance rights flow through the potential inheritor's father. There is no requirement for filing a claim when your “blood” relationship to the decedent is through your mother.

When a potential inheritor files a timely claim, he or she must still prove the identity of their father by clear and convincing evidence.

The paternity issue most often arises when there is not a Will, but can also arise when there is a Will which does not clearly specify who inherits the decedent's estate.

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 Qualified Personal Residence Trusts significantly reduce estate taxes that will be assessed on a personal residence. For married couples, I often recommend that the husband and wife each transfer a 50% interest in the residence to separate QPRTs. When both spouses establish separate trusts, you hedge the mortality risk associated with QPRTs. The other benefit from separate QPRTs was demonstrated by the recent Ludwick case in which the husband and wife each transferred 50% of their $7 million Hawaiian home to a separate QPRT. The court ruled that the value of each 50% interest was 17% less than 50% of the value of the entire home. The 17% fractional interest discount significantly reduced the gift tax cost of establishing the QPRTs.

There is also a way to take advantage of fractional interest QPRTs when it is not possible or practical to establish separate husband and wife QPRTs. One person can establish two separate QPRTs with different terms, for example, 6 years and 8 years, and transfer a 50% interest to the two separate QPRTs.

My clients seldom establish QPRTs for their Tennessee residences because they do not want to pay Tennessee gift taxes. Therefore, most QPRTs that my clients establish are for vacation homes located in other states. Generally, QPRTS in other states do not generate any federal or state gift taxes.

If you are buying an expensive home in Tennessee or elsewhere, there is a technique called a joint purchase trust that can be used without any gift taxes having to be paid. Joint purchase trusts have a lot in common with QPRTs. However, they must be established prior to purchasing the home.

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The term “dynasty trust” refers to a trust that will last for several generations. Since 2007, Tennesseans have been able to establish dynasty trusts that can last for 360 years. Prior to 2007, trusts had to terminate after approximately 100 years.

In order to qualify for the longer duration, the trust must provide a testamentary limited power of appointment to at least one member of each generation of your descendants who dies more than 90 years after the trust is established. A testamentary limited power of appointment provides the beneficiary with the right, through a provision in his or her Will, to terminate the trust in favor of certain beneficiaries or charities or to keep the property in trust with different provisions. Tennessee’s law is unique in requiring this power of appointment in order to qualify for the longer term.

The required power of appointment will be eliminated for trusts established on or after July 1, 2010. Even though the power of appointment will no longer be required, I still recommend that you provide future generations with the ability to modify the trust.  Imagine that your great great grandparents had established a trust in 1910 which now benefits you. Could they have possibly anticipated all of the changes that have occurred over the past 100 years and determined a sensible trust design for your descendants? It is much more likely that you can design a better trust to accommodate the specific attributes of your children and grandchildren and numerous changes that have occurred in the world over the last century.

If 360 years is not long enough for you, there are several states that allow trusts to last into perpetuity. Even if you live in Tennessee, you can take advantage of the laws in one of these other states. To date, only one of my clients has not been satisfied with 360 years.
 

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Over the past 6 trading days, the Dow Jones Industrial Average has dropped from 11,167 to 10,380, which is a drop of 7.6%. If you have not already converted your IRA to a Roth IRA, this is a golden opportunity to make the conversion.  By converting now, you might lose the opportunity to convert at the bottom if the market drops further. However, if it turns out that this is merely a temporary correction, you will be glad you made the conversion even if you slightly miss the bottom. If this turns out to be the beginning of a bear market, you can recharacterize your Roth IRA to a traditional IRA and try again next year. The recharacterization option lets you “win” if the market rebounds and “break even” if the market goes down further.

A market correction is also a good opportunity for establishing a GRAT. GRATs are similar to Roth IRAs in terms of letting you start over without a penalty if the market declines after you establish the GRAT. This may be your last chance to make a tax-free transfer of wealth to younger generations through the utilization of short-term GRATs. Congress is considering legislation that would eliminate this opportunity.  
 

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Charitable remainder trusts (CRTs”) are a popular technique for obtaining income tax benefits and providing money to charity. Due to a law passed in 2001 as part of the Act that repealed estate taxes for this year, there is a significant gift tax risk associated with CRTs established this year.

Many CRTs make payments to the grantor of the trust for lifetime or for a period of years. The unintended effect of the law is to treat the Grantor’s retained interest in a CRT as a taxable gift. The "phantom" taxable gift will cause unnecessary gift taxes to be paid and/or increase estate taxes payable upon the Grantor's death.

Several groups have written letters to the IRS requesting relief from the gift tax problem. Treasury officials have informally advised certain attorneys that guidance concerning this issue will be forthcoming in the near future. It is not certain what the guidance will say. Therefore, you should not create a CRT until the guidance is issued.

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If you are a beneficiary of a trust that requires income to be distributed to you, you may be able to increase your trust distributions by taking advantage of a new Tennessee law that will become effective on July 1, 2010. Section 21 of Public Chapter No. 725 of the Tennessee Public Acts of 2010 authorizes a trustee of a trust that requires mandatory distributions of net income to convert the trust to a total return unitrust.

The effect of a conversion is to change the trust distributions from “income” to a fixed percentage of the value of the trust. Assume that your trust has $1 million of assets and generates net income of $25,000 per year. If the trust is converted to a 4% unitrust, your distributions will increase to $40,000.

The fixed percentage must be between three percent (3%) and five percent (5%). Ideally, the income and remainder beneficiaries of the trust will agree to the percentage in advance. If the beneficiaries fail to agree in advance, the trustee will either not make the conversion or will choose the percentage on its own.

The conversion can be made without a court proceding if certain procedures are followed. If the Trustee is not “disinterested,” the Trustee must appoint a disinterested person to determine the unitrust percentage, the method to be used in determining the fair market value of the trust, and which assets are to be excluded in determining the unitrust amount. The trustee must send written notice of the proposed conversion to all qualified beneficiaries of the trust and not receive an objection within thirty (30) days. If a beneficiary objects, the Trustee can petition the Court to approve the conversion.

The main benefit of making a conversion is to eliminate an inherent conflict of interest between the income and remainder beneficiaries. With an all income trust, the income beneficiaries generally want the trustee to purchase investments that generate a lot of income and remainder beneficiaries want the Trustee to purchase assets that will appreciate in value. As a general rule, high income investments do not appreciate as much in value. When payments to the income beneficiary are dependent on the value of the trust rather than income received, the income beneficiary prefers for the trustee to maintain an investment policy that results in growth of the value of the trust over time. Growth will increase distributions to the income beneficiary and will also benefit the remainder beneficiaries of the trust.

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I came across an interesting article which concludes that federal estate and gift taxes account for the elimination of numerous small businesses, thereby promoting the concentration of wealth in larger firms. I can attest to the accuracy of this conclusion based upon several family businesses that I have worked with over the years.

All businesses have market risks, including competitors and obsolescence of their products. Family businesses have two significant additional risks, succession and estate and gift taxes.

The succession risks are two-fold. First, is there a manager or management team that can continue to operate the business in a profitable manner after current management retires or dies? For example, one of my clients is ready to retire, but has no one in his family or company who would be able to run the business if he retires or dies. He is entertaining offers from larger competitors and venture capital funds.

The second succession issue relates to financial and emotional family issues. Is there a way to treat everyone fairly and keep everyone happy after the patriarch or matriarch dies? As businesses move down generations, family issues often place a heavy burden on the business.

Estate and gift taxes present a major obstacle to successfully passing down the family business. I am currently working with the owners of a third generation family business that has been very successful for approximately 70 years. The management and family succession are aligned in a manner that will allow this business to pass smoothly to the fourth generation. However, finding a way to deal with estate and gift taxes is an enormous problem.

My clients are aggressively attacking the estate and gift tax issue on several fronts. First, they purchased $5 million of life insurance while they were insurable. Second, they have established various trusts to which they have been making gifts over several years. This effort has taken away part of their time that could have been spent in growing the business. More importantly, they have spent significant legal, accounting, appraisal and insurance costs. Despite taking all of these steps, they are still looking at an estate tax bill of $12 million. The estate taxes will drain the house and cash and will force the family to borrow money from the government to pay the remaining estate tax.  If the family finances a portion of its estate tax liabilities, profits from the business will be dedicated to paying this liability for several years, leaving the family with insufficient funds to pay for anticipated living expenses.  Because of these estate tax issues, the family is evaluating offers from some of its publicly traded competitors. 

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Tennessee has enacted a new law that will allow Courts to modify the terms of a Will to achieve the decedent’s probable tax objectives. Because the decedent will not be available, the Court will have to rely upon guidance from the decedent in the Will or another document and/or testimony from the decedent’s estate planning attorney and/or other advisors who were aware of the decedent’s tax objectives.

Courts will prefer to rely upon written guidance from the decedent. Therefore, I plan to add a new paragraph to Wills that I draft stating “I want my family to pay the least amount of federal and state, estate, inheritance, income and generation-skipping transfer taxes.” This provision will need to be modified for testators who do not mind paying higher taxes when it allows them to better accomplish their objectives.

When the decedent does not provide guidance of his or her tax intentions in the Will or another document, the Court will have to rely upon testimony from the decedent’s advisors and/or family members. I can envision cases where this works well. I also anticipate more difficult cases where determining the decedent’s intent will be more problematic for the Court.

The new law will become effective July 1, 2010. However, the Court is allowed to provide that the modification has retroactive effect.

The new law only applies to Wills and not revocable trusts. However, the Tennessee Uniform Trust Code already contains provisions that allow a Court to modify the terms of a trust to achieve the Settlor’s tax objectives. T.C.A. § 35-15-416.
 

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The Tennessee legislature has enacted the Tennessee Community Property Trust Act of 2010. If the Governor signs the bill, the new law will allow resident and nonresident married couples to convert their property to community property by transferring the property to a new type of trust known as a Tennessee Community Property Trust. Alaska is the only other state that allows residents of common law states to voluntarily convert some of their assets to community property.

There are three types of benefits that a Tennessee Community Property Trust will provide. First, community property is a property ownership system that provides for equal ownership of property by husband and wife, including a sharing in the appreciation and income from the property. Some couples may find this equality and sharing arrangement to be a preferred form of property ownership.

Second, community property receives a significant federal income tax advantage. At the death of the first spouse to die, both spouses’ interests in the community property will be eligible to receive a basis increase (not to exceed fair market value), up to a maximum increase of $4,300,000 in 2010, and a full basis adjustment to the fair market value of the property for deaths in 2011 and later years. As a result, there will be no capital gains tax payable if the first spouse dies in 2011 or later and the property is sold for its value after the first spouse’s death. Further, the increased basis will allow for increased depreciation deductions for business and investment depreciable property. If the property had been jointly-owned by the husband and wife in a common law state such as Tennessee, only one-half of the property would receive such an adjustment in basis.

Assume that in 1983 John and Martha Brown paid $200,000 for a farm that is worth $600,000 at the time of John’s death in 2011. Federal tax law allows Martha to increase the income tax basis of John’s half of the farm to $300,000 (one-half of the fair market value of the entire farm). Martha’s basis for her half of the farm will remain at $100,000 (one-half of the original purchase price). Thus, Martha’s total basis in the farm will be $400,000. When Martha sells the farm for $600,000, she will realize a capital gain of $200,000 and pay a federal capital gains tax of $40,000. Federal tax law would allow Martha to increase the basis of the farm to $600,000 if the farm had been held in a Community Property Trust. Thus, when Martha sells the property, she will not pay any capital gains tax.

The third advantage of a Tennessee Community Property Trust is the division of assets owned by the trust for purposes of  funding a credit shelter trust upon the death of the first spouse and obtaining fractional interest discounts upon the death of the surviving spouse. Funding the credit shelter trust and obtaining fractional interest discounts will reduce Federal estate tax and Tennessee inheritance tax upon the death of the surviving spouse. These same advantages can be obtained by converting ownership to tenancy-in-common; however, tenancy-in-common will not allow the favorable income tax advantage discussed above.

A Community Property Trust has the following requirements:
(1) It must declare that the trust is a Tennessee Community Property Trust and contain certain language that gives notice of the consequences of the trust;
(2) At least one trustee must be Tennessee resident or a Tennessee bank or trust company; and
(3) It must be signed by both spouses.

If the spouses divorce, the trust will terminate and the trustee must distribute one-half of the trust assets to each spouse. When property is distributed from a community property trust, it will no longer constitute community property. The equal division of the trust assets upon divorce may be different than the division that would have occurred if assets had not been transferred to the trust.

A debt incurred by only one spouse before or during marriage may be satisfied from that spouse’s one-half share of a community property trust and a debt incurred by both spouses during marriage may be satisfied from all of the trust assets. Thus, a Tennessee Community Property Trust has inferior creditor protection to tenancy by the entirety ownership, and should not be utilized by couples with potential creditor problems.

The new law will become effective July 1, 2010. I expect that Tennesseans will establish a lot of these trusts in July of 2010, similar to the wave of Tennessee Investment Services Trusts that were established in July of 2007 when the Tennessee Investment Services Trust Act became effective. It will take longer for Tennessee banks and trust companies to market the advantages of this opportunity to nonresidents. The advantages will be greater for nonresidents who live in states that impose income taxes on capital gains and rental income.
 

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People who die in 2010 do not have to pay federal estate taxes (unless Congress enacts a retroactive change in the law). However, most people have assumed that there would be federal estate taxes at the time of their death. Based on this assumption, numerous Wills have formulas that are based on the federal estate tax system. In many cases, these formulas are either difficult or impossible to interpret in the current environment. These broken formulas will lead to distorted estate plans and needless litigation.

The Tennessee legislature has taken a bold move to revise wills of people dying in 2010 which contain references to the federal estate tax system. On Monday, March 1, 2010, the House approved SB 3045, which had previously been approved by the Senate. Assuming the bill is signed by the Governor, all references to the federal estate and generation-skipping transfer tax laws will be interpreted as they applied with respect to estates of decedents dying on December 31, 2009.

In order for the new law to apply, the Will must:

1. contain a formula referring to the "unified credit," "estate tax exemption," "applicable exemption  amount," "applicable credit amount," " applicable exclusion amount," "generation-skipping transfer tax exemption," "GST exemption," "marital deduction," " maximum marital deduction," or " unlimited marital deduction."
2. measure a share of an estate or trust, based on the amount that can pass free of federal estate taxes or the amount that can pass free of federal generation-skipping transfer taxes; or.
3. is otherwise based on a similar provision of federal estate tax or generation-skipping transfer tax law.

The new law will apply to decedents who die after December 31, 2009, but before January 1, 2011. The new law will also apply to formulas contained in revocable trusts.

The new law will not apply if:

1. federal estate taxes are reinstated retroactive to January 1, 2010;
2. the Will or trust is executed or amended after December 31, 2009;
3. the Will or trust manifests an intent that a contrary rule will apply if the decedent dies on a date on which there is no then-applicable federal estate or generation-skipping transfer tax;
4. the Executor, or Trustee of a revocable trust, and all beneficiaries who would be affected by the new law, opt for the new law not to apply within nine months of the decedent's death; or
5. the Executor, or any affected beneficiary, files a court proceeding within 12 months following the decedent's death, and convinces the court that the decedent intended for the formula to be construed based upon the law as it existed after December 31, 2009.

The great majority of wills that I have drafted over the last several years will actually work better without the new law. In order to get the full benefit allowed by the absence of federal estate taxes, the family will be forced to opt out of the new Tennessee law. There is always a danger that one or more family members will withhold their consent as a bargaining chip or because they are disappointed with the Will.

I knew several of my clients had a problem. I have been busy preparing codicils and amendments to revocable trusts to correct these problems. Though I hope to identify and fix all of the problem documents, it is certainly possible that one of my clients could die before fixing the problem and I will be glad that the new law was passed.

The new law will help numerous individuals who were unable to make changes or chose not to amend their documents. However, in some cases, the new law will be harmful and will force families to sign a unanimous agreement or file a court proceeding. In all cases, it is better to make sure that your documents clearly state your wishes without having to rely on the new law, or a lawsuit, or a document to be signed by your family after you die.
 

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The simplest estate plan for a married couple is for them to own everything jointly, with the result that everything will be owned by the survivor after the death of the first spouse to die. Unfortunately, the Federal estate tax and Tennessee inheritance tax laws penalize couples for taking the simple approach if their combined assets exceed $1 million in value. This is because the survivor’s estate will exceed the available exemptions from federal and Tennessee inheritance tax.

A better tax plan is for the couple to each own separate assets or to own assets as tenants-in-common. If the first spouse to die owns a tenancy-in-common interest in real estate or a brokerage account, the decedent’s Will can transfer these assets to a credit shelter trust for the primary benefit of the survivor. The credit shelter trust will not be subject to tax upon the subsequent death of the survivor.

The first spouse to die must own assets that can be transferred to the credit shelter trust. For Tennessee residents, this is not possible with assets that are owned jointly with a spouse, unless the form of ownership is specifically designated as tenancy-in-common. As in most states, there is a presumption in Tennessee that property held jointly by a husband and wife is held as tenants-by-entirety, rather than as tenants-in-common. This means that the assets will not be available to fund a credit shelter trust upon the death of the survivor.

In the Estate of Oscar Goldberg, the failure to change ownership of real estate to tenancy-in-common resulted in litigation with the IRS and unnecessary estate taxes of almost $400,000. When it comes to estate planning, simplicity may carry a high price tag for your children.
 

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2010 is the year where there will be no federal estate taxes due to a law that was passed in 2001. The heirs of wealthy individuals who die this year are set to enjoy a huge windfall.

Several congressmen have vowed to reinstate estate taxes during the year. Indeed, the Senate Finance Committee Chairman, Max Baucus, has vowed that Congress will reinstate federal estate taxes retroactive to January 1, 2010.

The one year repeal of federal estate taxes and the threat of a retroactive repeal of the repeal requires planning for three separate tax systems that have very significant differences. System #1 is the law that currently exists for 2010. Even though you do not have to “worry” about federal estate taxes, planning for someone’s death in 2010 is challenging for several reasons.

First, Tennessee still has an inheritance tax with an exemption of only $1 million. Second, there are numerous Wills containing formulas that will not work if the testator dies in 2010. Third, most outright bequests should be converted to trust bequests in order to avoid estate or generation-skipping tax upon the subsequent death of the beneficiary.

Finally, System #1 eliminates the automatic step-up in basis for inherited assets. Heirs will need to obtain records that establish the decedent’s historical cost basis in his or her assets. Furthermore, if there was substantial appreciation, the heirs will incur capital gains tax when they later sell the assets. Each decedent has $1.3 million worth of basis increase that can be allocated by the executor. There is an additional $3 million worth of basis increase that can be allocated to assets passing to a surviving spouse. These “basis exemptions” will solve problems for most families, but will have numerous complications in their application.

System #2 is the law that will apply beginning in 2011, when the federal estate tax will reappear with a $1 million exemption and a top marginal rate of 60%. Planning for System #2 is very familiar because this system was in place prior to the changes made in 2001. A lot of families have assumed that the federal estate tax exemption was always going to be significantly higher than $1 million. They have failed to take planning steps that seemed to be unnecessary.

System #3 is what Congress might put into place later this year. My best guess is that System #3, if enacted, would be similar to the system that was in place for 2009. The House passed such a bill in December of 2009. The Senate elected not to pass this bill, but could change its mind. If there is a System #3, it is possible that it could make changes that were not part of the bill passed by the House in December of 2009. For example, discounts for Family Limited Partnerships could be eliminated.

Many people will assume that System #1 will not be relevant for them, because they will not die this year and/or the law will be changed before they die. If the law is not changed retroactively, it is inevitable that the families of some wealthy individuals who die this year will be disappointed despite the absence of federal estate tax.

There is widespread sentiment that System #2 will not arrive. I now believe that System #2 might arrive in 2011 because I have no confidence that the Senate will be able to get the 60 votes necessary to enact System #3.

You need to be prepared for all 3 systems. Fortunately, there are practical steps that can be taken to minimize taxes under all 3 systems.

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It now appears very likely that we will begin the new year with no Federal estate tax in place. A law passed in 2001 repealed Federal estate taxes for the year 2010. That same law provided that the estate tax would reappear in the year 2011 with a $1 million exemption amount and a top rate of 55%.

Congress has known about this anomaly for the last 8 years. There has been universal agreement that the law needed to be amended in some fashion. Nevertheless, the law has not been changed because Congress could never agree on how to change it.

One group of legislators wants to permanently repeal estate taxes. Another group wants to retain estate taxes with a higher exemption amount than $1 million. It is widely predicted that Congress will address this issue early in 2010 and perhaps reinstate estate taxes effective as of January 1, 2010. An attempt to enact a retroactive tax might be a violation of the United States Constitution. There is some precedent suggesting that a retroactive tax would be allowed if enacted.

There is another significant issue for persons dying in 2010. Assets will no longer receive a basis equal to the date of death value of the assets, which is current law. Instead there will be a "carryover basis" regime, with the ability to obtain a "step-up" in basis for a limited amount of assets. A similar regime was briefly enacted in the 1970s, and was repealed almost immediately because it was so impractical. It is very difficult to establish the historical basis of inherited assets. Additionally, heirs of many estates that would not have been required to pay Federal estate tax under current law will now have to pay capital gains taxes when they sell inherited assets.

Planning your estate amidst this uncertainty is challenging. You need to be prepared for the law that is on the books, i.e., a federal exemption of only $1 million per person in future years. You also need to make sure that your Will will work in the manner intended if you die during the year 2010. In particular, you need to review any formulas in your Will that are based on an estate tax system that may not exist at the time of your death.

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The father of one of my clients is considering a move to Nashville in order to be closer to his daughter and grandchildren. He called me regarding the state tax consequences of moving to Tennessee.

The good news is that his income taxes will decrease slightly because Tennessee will not tax his IRA distributions. He will pay the Hall income tax on his dividends and interest, but he is already paying taxes on that income in the state where he currently lives.

The bad news is that Tennessee inheritance tax will apply to his estate when he dies. He currently lives in one of the many states that does not have a state inheritance tax. Based on his estate of $3.5 million, his Tennessee inheritance tax bill will be approximately $225,000.

Inheritance taxes would be much higher if his estate has to pay inheritance tax on the $6 million marital trust that his wife established upon her death. The marital trust will be taxable for federal estate tax purposes. However, Tennessee does not tax marital trusts that were established by residents of other states. Since the Tennessee inheritance tax rate is 9.5%, not having to pay Tennessee tax on the marital trust will reduce his estate’s Tennessee inheritance tax bill by $570,000. He told me that this tax reduction is good enough to allow him to move to Tennessee.  If the marital trust would be subject to Tennessee inheritance tax, he probably would not move.

The planning opportunity is to have a marital trust established for your benefit prior to moving to Tennessee. If you know friends or family members such as parents who are considering a move to Tennessee, encourage them to establish and fund a marital trust prior to moving to Tennessee. For example, a husband might establish a marital trust for his wife prior to moving. The marital trust will not escape federal taxes; however, it will escape Tennessee inheritance taxes because it was established by a non-resident of Tennessee.
 

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Yesterday, I met with a spry 90 year old widow who believed that her Will gave $1 million to her grandchildren. I determined that her will actually gives $3.5 million to her grandchildren. If she had died with this Will, her grandchildren would have received significantly more than her two sons.

The reason for my client’s misunderstanding was her Will’s use of a formula. The bequest to the grandchildren was an amount equal to her “available GST exemption”. When her Will was drafted, her "available GST exemption" was $1 million. However, due to law changes that have occurred over the last several years, her GST exemption increased to $3.5 million.

It is very common for Wills to contain formulas that are based upon tax laws. This allows your Will to take advantage of changing exemption amounts without having to redraft your Will every time there is a law change. However, when a Will uses a formula, your attorney should explain the effect of the formula. I suspect that my client’s former attorney did explain the formula. Nevertheless, all she remembered was that the formula resulted in a bequest of $1 million.

There are a lot of formulas that are going to be distorted if Congress does not amend the estate tax laws within the next three weeks. As the law is currently written, there will be no federal estate taxes in the calendar year 2010. Because a lot of formulas are written based upon laws that simply will not exist for people dying in 2010, numerous formulas will not make any sense. Other formulas will be open for debate. As an example, I believe that my client’s Will will result in a bequest of $0 to her grandchildren, because it refers to an exemption amount that will simply not exist in 2010. The grandchildren might challenge that result as not representing their grandmother’s intent. I predict that there will be multiple lawsuits regarding these types of results if Congress does not change the law for 2010.

Tax-driven formula provisions in Wills are widely used and serve a useful purpose. Make sure you know what your formula means, and recalculate the results of your formula from time to time. If Congress does not change the tax laws in the next three weeks, everybody needs to check their formulas.
 

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The Congressional Research Service (“CRS”) has issued a report titled “Estate and Gift Taxes: Economic Issues.” The CRS is a “think tank” that provides reports to members of Congress on a variety of topics. Taxpayers spend over $80 million per year to fund the CRS. One controversial conclusion of the report is that

“…Only a tiny fraction of farms and small businesses face the estate and gift tax and it has been estimated that the majority of those who do have sufficient non-business assets to pay the tax. Moreover, only a small portion of the estate tax is collected from these family owned farms and small businesses, so that dramatically reducing estate tax rates or eliminating the tax for the purpose of helping these family businesses is not very target efficient.”

This report is supposedly based upon data from estate tax returns that have been filed. However, the conclusions drawn in the report are not realistic.

A lot of my clients have farms and small businesses. These clients worry a great deal about estate taxes. They purchase large life insurance policies to provide funds to be used to pay taxes. They establish and fund irrevocable trusts and various entities including limited liability companies and/or limited partnerships. They make gifts and sales to trusts for their children sooner than they would prefer if there were no estate taxes.

As mentioned in the report, some families are able to accumulate enough liquidity outside the business to pay taxes. In some cases, this means that the only asset left to pass on to children is the family business. When one or more children do not work in the business and cannot draw a salary from the business, this is not a happy result.

Perhaps my view is distorted because of the region in which I practice. Middle Tennessee probably has more valuable farmland than other areas of the country. The value is not necessarily based on the value of the land for farming. In many cases, the value of the farmland is artificially inflated by the development potential of the property.

Middle Tennessee also has a keen entrepreneurial spirit. I am constantly amazed by the ingenuity of my clients and how they have amassed a fortune from one or more business opportunities.

Nevertheless, the notion that reducing taxes on family businesses is not worthwhile clearly misses the mark. Owners of farms and successful family businesses spend a lot of time and money on planning strategies to cope with the liquidity crunch and distortions to their estate plan that are caused by estate taxes.

Members of the House of Representatives were not fooled by the Report. They understand that estate taxes create severe problems for owners of farms and family businesses. On December 3, 2009, they passed the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. Though this bill does not eliminate estate taxes, it seeks to ensure that married couples will be able to leave up to $7 million to their children without paying federal estate taxes. This bill has been forwarded to the Senate, where it faces an uncertain fate.
 

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The estates of a lot of Tennessee decedents pay Tennessee inheritance taxes but do not pay federal estate taxes. The federal estate tax exemption is currently $3.5 million. As of the date of this article, various members of Congress favor extending this exemption amount indefinitely into the future. The Tennessee inheritance tax exemption is currently $1 million. There does not appear to be much likelihood that Tennessee will increase its exemption to match the federal exemption.

The difference between the federal and Tennessee exemptions means that unmarried decedents who die with a taxable estate with a value between $1 million and $3.5 million will pay Tennessee inheritance taxes but not federal estate taxes. There are several things that can be done to reduce the value of assets for Tennessee inheritance tax purposes.

Some of these steps can be taken shortly before death. As an example, a parent might make a deathbed gift of a fractional interest in real property to a child with the goal of capturing a fractional interest discount for the remaining portion of the property when the parent dies. There are also various post-mortem decisions that can affect the value of the assets owned by the estate.

Even though the estate is not subject to federal estate taxes, the date of death value of the assets becomes the basis of the assets for federal income tax purposes. Basis will be relevant when the estate or the beneficiaries later sell the assets. Federal capital gains taxes are 15% and are scheduled to increase to 20% in the year 2011. If the beneficiaries live in a state outside of Tennessee that imposes a capital gains tax, this will make the capital gains tax rate even higher. The maximum Tennessee inheritance tax rate is 9.5%.

Since capital gains tax rates are higher than the maximum Tennessee inheritance tax rate, it is generally not advisable to take steps that reduce the value of the decedent’s assets for Tennessee inheritance tax purposes, unless it is known that the beneficiaries will continue to own the assets in the estate for several years. The reduction in the value of the estate will increase capital gains taxes by more than the Tennessee inheritance taxes that are saved.

Making tax-free annual exclusion gifts is still a good idea. It is better to give cash as opposed to an appreciated asset that will receive a free basis increase upon death. A cash gift reduces Tennessee inheritance taxes without increasing capital gains taxes.
 

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I am currently working with a client who plans to make $2 million of bequests to his favorite charities upon his death. His estate will receive an estate tax deduction for these bequests; however his estate will not receive an income tax deduction for these bequests.

I told him about a different method for making the payments that will require the cooperation of his wife. The plan works as follows:

1. His Will makes a $2 million cash bequest to his wife.
2. The Will makes a non-binding request for his wife to consider making gifts to his favorite charities.
3. After my client dies, his wife will receive $2 million and will make charitable gifts of $2 million.

The revised plan will have the following tax consequences: My client’s estate will receive a $2 million marital deduction for estate tax purposes. This replaces the $2 million charitable estate tax deduction that he would have otherwise received. His wife will get a $2 million income tax deduction. Since his wife will be in the highest income tax bracket (currently 35%), she will save $700,000 on her income taxes. Her income will not be large enough to receive the entire deduction in the first year. Rather, it will take about four years. Nevertheless, she will receive substantial income tax savings that would not have been realized if her husband had given the money directly to charity.

The risk for my client is that his wife will not make the charitable gifts. Legally, she can keep the money. My client trusts his wife to honor his wishes, especially since his wife likes most of his favorite charities.
 

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I discourage the use of a marital trust for a surviving spouse when the decedent’s children from a prior marriage will be the remainder beneficiaries. Such trusts have an inherent conflict of interest and should be avoided when possible.

Most marital trusts base the payments to the surviving spouse on the trust’s income. The surviving spouse wants the Trustee to purchase investments that produce a lot of income. Conversely, the stepchildren prefer the Trustee to invest in assets that will appreciate in value over time.

When a marital trust is the only practical solution, I recommend a marital unitrust, which works as follows: The surviving spouse receives the greater of the income earned by the trust or five percent (5%) of the value of the trust determined as of the beginning of each calendar year. In order to reduce volatility in the amount of the annual payments to the spouse, payments should be based on a 3 year average of the value of the trust.

The Trustee invests in a mixed portfolio of equities and fixed income investments. Principal assets will need to be liquidated each year to make the payments to the spouse because income will be significantly less than 5%.

The spouse wants growth because it will increase distributions in the future without reducing current distributions. The Trustee’s job will be much easier to accomplish because the spouse and the stepchildren will have the same goals.  
 

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Family limited partnerships (or LLCs) are often used to obtain valuation discounts for estate and gift tax purposes. Appraisers typically conclude that the fair market value of an interest in a family limited partnership (“FLP”) is at least 35% less than the value of the assets owned by the FLP.

The IRS dislikes these discounts and has successfully challenged the discounts in several court decisions. As a general rule, the taxpayers were "sloppy" in the cases that the IRS has won. Errors were made either in funding, distributions, or record keeping.

When the FLP is properly funded and administered, taxpayers are able to substantiate the discounts. For every case in which the IRS has successfully disallowed discounts, there are many others where the court approved a discount or the IRS agreed to a discount without going to trial.

A case in point is the recent Rayford L. Keller et al v. United States decision. Mrs. Williams was in the hospital, dying from cancer. Six days before her death, she signed documents to establish an FLP to be funded with $240 million of bonds and $10 million cash.

The assets were not transferred to the FLP until one year after she died. Nevertheless, the Court ruled that her family was entitled to a 47.5% discount on the value of the bonds and cash that were transferred to the FLP.

I do not recommend waiting until death is imminent to establish an FLP. It is far better to establish the FLP when you have several years to live, and then to make gifts or sales of FLP interests when that is appropriate.

Detailed summary of Keller case by Steve Akers of Bessemer Trust Company, N.A.

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More than 50% of marriages end in divorce. When one spouse enters the marriage with significant assets, they often leave with less than they started with.

The traditional method for protecting your assets is to enter into a prenuptial agreement before you get married. I recommend this to all of my clients who are getting married.

In lieu of or in addition to a prenuptial agreement, Tennessee residents can protect their assets by transferring them to an asset protection trust {pdf} before they get married. Even if they do not have a prenuptial agreement, their spouse will not be entitled to any of the trust assets upon divorce. Furthermore, their spouse will not be able to claim any portion of the trust assets upon death. This latter point is especially important for later-in-life marriages when one or both spouses have children from prior marriages.

I have mostly used pre-marital asset protection trusts for young adults who have received substantial gifts and/or inheritances from their parents and grandparents. As a general rule, these young adults have relied solely upon the protection afforded by the trust because they were not willing to discuss a prenuptial agreement with their future spouse.

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