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.  

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.

Judge Promotes Ex-Spouse to Primary Beneficiary of Trust

Imagine that you set up a trust for your son and give an independent trustee the discretion to make distributions to your son for his health, education, maintenance and support.  Next, imagine that your son gets divorced, loses his job, and is unable to pay his alimony.  Can your son’s ex-wife access the trust to satisfy the unpaid alimony.  In Tennessee and some other states, the answer is a resounding “No.”  These states zealously protect a person’s right to determine the beneficiaries of the person’s largesse.  Other states have determined that the public policy of making sure that alimony is paid is a higher priority.

Florida is one of the states that places more importance on satisfying alimony claims.  In the recent case of Berlinger v. Casselberry, the Court prohibited the trustee from making distributions to the primary beneficiary of the trust unless and until the beneficiary was current on his alimony obligations.  The Judge’s Order effectively meant that the alimony had to be paid first, and thus, the beneficiary’s ex-wife became the primary beneficiary of the trust.  The reason that the ex-wife sought the Court’s help is because her ex-husband was not working and was receiving no income that she could attach to satisfy her alimony.  Her ex-husband’s trust was directly paying all of his living expenses.  This technique of paying a beneficiary’s expenses out of the trust is specifically authorized by a recent Tennessee statute, but it was not allowed in the Florida case.

The Berlinger case highlights the significance of choosing the state law that will govern the trusts that you establish.  Tennessee passed substantial changes to its trust laws in 2013 to strengthen the rights of a grantor to choose who will benefit from the trust.  If you believe you can do a better job of picking your beneficiaries than a judge, you should make Tennessee law the governing law for your trusts.

Two-Trust Gifting Plan Finesses Tennessee Inheritance Tax and Wandry Formula Concerns

 I am currently working with an elderly gentleman who wants to make a gift of $5.25 million of LLC units to a trust for his wife and children.  The value of the LLC units is uncertain.  We are obtaining an appraisal of the LLC units; however, the IRS may disagree with the appraisal.

In addition to the valuation issue, my client may die within the next two years, which will cause the value of the gift to be added to his estate for Tennessee inheritance tax purposes.  Unless the gift qualifies for the Tennessee inheritance tax marital deduction, his estate will owe Tennessee inheritance taxes which could be as much as $400,000.  This tax will apply even if he gives his entire estate to his wife.

In order to address the valuation issue and the Tennessee inheritance tax issue, my client will establish a typical family trust, and a Tennessee QTIP Trust.  The family trust will receive LLC units equal in value to $1.25 million as finally determined for federal gift tax purposes.  The technique of making a gift that depends on the value determined for federal gift tax purposes is known as a “Wandry” formula, based upon a recent Tax Court case involving an analogous gift by Mr. Wandry.

The Tennessee QTIP trust will receive my client’s remaining LLC units that he intends to give which have an appraised value of $4 million.  When my client files his 2013 federal gift tax return, he will make a QTIP election for the gift to the Tennessee QTIP trust of whatever amount is necessary to reduce federal gift taxes to $0.  This formula marital deduction will ensure that no federal gift tax is payable even if the appraised value of the LLC units is successfully challenged by the IRS.

If my client dies before 2016, the gifts to both trusts will be added to his estate for Tennessee inheritance tax purposes.  His estate will make a Tennessee QTIP election for the Tennessee QTIP trust pursuant to T.C.A. § 67‑8‑315(a)(6).  By making the Tennessee QTIP election, inheritance tax will be avoided upon his death.  If his wife also dies before 2016, the assets of the Tennessee QTIP trust must be included on her Tennessee inheritance tax return.  However, if she lives to 2016 or beyond, Tennessee inheritance tax will be totally avoided.

Decanting Case Approves Transfer of Minor's Trust to Special Needs Trust

There have been very few cases involving decanting, a technique that allows the trustees of an irrevocable trust to distribute the assets of the trust to a second irrevocable trust with different terms.

In the attached case, Matter of Schreiber, the New York Attorney General tried to overturn a decision made by the Trustees of a Minor’s Trust to decant the assets of the Trust to a Special Needs Trust prior to the beneficiary’s 21st birthday.  The Special Needs Trust allowed the beneficiary to qualify for Medicaid benefits in New York.  If the Trustee had not decanted the Trust assets from the Minor’s Trust, the beneficiary would have been able to withdraw the Trust assets upon his 21st birthday and would have been ineligible for Medicaid.  The Court analyzed the decanting statute in New York (which is very similar to the statute in Tennessee) and concluded that the Trustee’s exercise of the decanting power was valid under New York law.

If you are a Trustee of a trust for a minor or young adult that will be terminating in the near future, you should consider decanting the trust to a different trust to maintain eligibility for government benefits or to otherwise protect the assets from the numerous bad things that can happen to money placed in the hands of a young adult.

Tennessee Now Recognizes Grantor Trusts

Prior to this year, all Tennessee trusts were required to file annual Tennessee income tax returns. This includes garden variety revocable trusts as well as irrevocable grantor trusts that use the grantor's social security number as their EIN.

Fortunately, the Tennessee legislature decided to solve this problem. Public Chapter 480 now allows grantor trusts to avoid filing a Tennessee income tax return. Instead of filing a return, the trustee must report the trust income to the grantor so that the grantor may include it on the grantor's personal Tennessee income tax return. In order to take advantage of this simplified filing procedure, you must use the grantor's social security number as the EIN for the trust. The Internal Revenue Service regulations allow revocable and irrevocable grantor trusts to use the grantor's social security number as their EIN if certain procedures are followed. We routinely recommend this approach, because it avoids the need to file a federal income tax return for the trust. Now, it will also avoid the need to file a Tennessee income tax return.

Even though the IRS regulations have allowed irrevocable grantor trusts to use the grantor's social security number as their EIN for approximately 15 years, there are numerous financial institutions that will attempt to make you obtain a separate EIN for any irrevocable trust, whether or not it is a grantor trust. I occasionally have to show the IRS regulations to these financial institutions, and I have to overcome some very strong misinformation that has been in the marketplace. If you encounter a financial institution that refuses to open an account without a separate EIN for the trust, let them know that several of their competitors permit what is allowed by the IRS regulations.

Tennessee Named Fourth Best State In Dynasty Trust Rankings

Steve Oshins, an attorney in Nevada, has compiled the first annual ranking of the best states for the creation of Dynasty Trusts. He ranks Tennessee as the fourth best state. Ironically, our high ranking is a tribute to our laws other than our rule against perpetuities. Approximately 20 states have totally repealed their rule against perpetuities, which means that trusts established under the laws of these states can last forever. Tennessee allows a trust to last for a maximum of 360 years. Certain trust companies located in these other states claim that Tennessee is a bad state for dynasty trusts, because a trust can only last 360 years. I have never talked to a client who cared whether the trust had to end after 360 years. Ask yourself this question: Do you even know the names of any of your relatives who were alive in the year 1652?

One of the reasons that Tennessee scores well despite our 360 year rule is because of our good spendthrift trust laws that protect assets from spouses of beneficiaries in the event of a divorce. This is not the case in a lot of other states. I think Mr. Oshins accurately determined that protecting trust assets in the event of divorce is substantially more important than being able to extend the life of a trust for more than 360 years. If assets are lost in a divorce, the trust is not going to last 360 years anyway.

Modifying Irrevocable Trusts Without Going to Court

Until 2004, it was very difficult to modify an irrevocable trust without going to court. That year, Tennessee adopted the Tennessee Uniform Trust Code which allows various changes to be made to irrevocable trusts without going to court.

Earlier this month, Christy Reid, from Charlotte, North Carolina, and I presented a paper on this topic. We discussed four tools for modifying trusts:  non-judicial settlement agreements, non-judicial consent modifications, decanting, and trust divisions. This is not the exclusive list of tools for making modifications. These are the tools that we use most often to help our clients improve the operation of their trusts.

While preparing for the presentation, I reviewed the laws of other states and concluded that Tennessee has the most flexible laws. I found a couple of places where our laws could be improved, and I will attempt to have these changes made.

It is also possible for judges to modify trusts. Sometimes, going to court is the only viable solution. We prefer to use a non-judicial method when available because it is less expensive for our clients and takes less time.

The Great 2012 Gifting Opportunity - Part 2: Can You Afford to Make a Large Gift?

This is the second article of a series designed to provide guidance for those individuals who are considering making a large gift in 2012 to take advantage of the $5.12 million federal gift tax exemption that will expire at the end of the year. For the first article in the series, see Part 1: Use It or Lose It.

Prior to 2011, clients seldom made gifts of several million dollars unless they were very wealthy.  Due to the temporary expanded gift tax exemption, clients who are not so wealthy are considering gifts worth several million dollars. If you have $100 million, you might not miss the income that you will lose if you make a gift of $5 million. However, what if you have $20 million, or $8 million? The income you lose from a gift of $5 million might easily impact your lifestyle choices. Everyone has their breaking point.

Several of our clients who really cannot afford to lose the income from a gift have nevertheless made large gifts to take advantage of the temporary higher gift tax exemptions. In order for the gift to be prudent, our clients have taken several different approaches. One approach is to create more cash flow from another source prior to making a gift. Assume that you are 85 years old and you would like to have guaranteed cash flow of $200,000 per year. Also assume that your children, or a trust that you previously established for their benefit, are financially secure. You could transfer $1,157,000 of cash to your children or the trust in exchange for their obligation to pay you $200,000 per year for the remainder of your life. This transaction will not be considered a gift because the present value of the annuity payments that you are receiving equals the amount of property you are transferring to your children. After implementing the private annuity, you are then free to make a gift of other assets without worrying about losing the income from the assets that you gift.

Many of our clients have given away nonvoting interests in entities such as limited liability companies, limited partnerships, and corporations. By retaining voting control of these companies, our clients have the ability to pay themselves reasonable salaries for the services that they provide to the companies.

A very popular approach that our clients are using is to make a gift to a spousal access trust. There are two general types of spousal access trusts. One is a trust which includes your spouse and descendants as discretionary beneficiaries of the trust. Often the spouse serves as the trustee of the trust. Since your spouse has the ability to access income from the trust, you should be more comfortable about making gifts.

The other type of spousal access trust is a marital trust, which does not include your descendants as beneficiaries. As will be discussed in a later article, this trust can also be used to avoid the payment of Tennessee gift taxes on the trust.

The “flaw” with gifts to spousal access trusts is the danger that your spouse could predecease you. In that case, income from the trust will not be available for your benefit. Some of our clients have been willing to take the gamble that their spouse would not predecease them by a long period of time. Perhaps the donee spouse is younger and/or in better health than the donor spouse. Another factor to keep in mind is that your expenses will go down when one spouse dies because there is only one mouth to feed.

Another option when the donee spouse is young enough and healthy enough is to purchase life insurance on the life of the donee spouse. If the donee spouse dies too soon, the life insurance could provide a source of funds for the donor spouse.

Another hedging technique is to have each spouse make a gift to a spousal access trust for the other spouse. There is a tax concept known as the reciprocal trust doctrine, which requires careful planning if both spouses intend to establish spousal access trusts.

Another aspect of increasing your cash flow is to decrease your expenses. A lot of our clients have established grantor trusts that allow them to pay income taxes on income earned by the trust. This basically allows them to make tax-free gifts to their children. Generally, these grantor trusts have been designed to allow the grantor to discontinue paying income taxes in the future. When you have the opportunity to “turn off” a grantor trust, you need to factor this into your cash flow planning.

Another factor that affects your expenses is whether you will pay Tennessee gift taxes. Future articles will discuss various ways to make gifts without paying Tennessee gift taxes. When there is pressure on your cash flow, it might be preferable to make gifts in a manner that does not require you to pay Tennessee gift taxes. The Tennessee gift taxes “saved” can be used to shore up the income lost from the assets that you give away.

Before making a large gift, you need to be totally comfortable with your future access to cash flow.

Comparison of Asset Protection Trust Statutes

Dave Shaftel has prepared a detailed comparison of the various Domestic Asset Protection Trust statutes. He analyzes 33 different aspects of the statutes. Tennessee’s laws stack up very well in terms of protection from creditors.

You can see from the enclosed map that Tennessee is the only southeastern state that allows Asset Protection Trusts. Advisors in neighboring states are beginning to recommend Tennessee as the state in which to establish an Asset Protection Trust. 

Delaware is the leading provider of Asset Protection Trusts because they have done the best job of advertising. Unlike Tennessee, Delaware allows certain tort claimants to assert claims against Asset Protection Trusts. Except for this significant difference in Tennessee’s favor, the Delaware and Tennessee statutes are very similar.

Will the $5 Million Gift Window Close Early?

Unconfirmed rumors are circulating that the Super Committee may propose to reduce the current $5 million gift tax exemption to $1 million, potentially effective as early as November 23, 2011. It seems unlikely to me, but the rumor could be based upon “leaks” from insiders who are familiar with the Super Committee deliberations.

A lot of our clients have already made their $5 million gifts. Others are taking their time and studying their options. A couple of our clients who were studying their options are now mobilizing to complete their gifts prior to November 23, 2011. 

If you are concerned about a potential law change but will not be able to complete your gift by November 23, 2011, there is one technique that you should consider. An inter vivos QTIP trust would allow you to beat the law change, if there is one, yet provide you with the flexibility to unwind the transaction if there is no law change. Assume that Husband makes a $4 million gift to a marital trust that benefits Wife for her lifetime and then continues in trust for the benefit of their children. If the Super Committee does not change the law, and the gift tax exemption remains in place until December 31, 2012, the marital trust will be liquidated and the assets will be distributed to the wife. The couple will then decide how to best use their $5 million gift tax exemption. If this course is followed, Husband will need to file Tennessee and federal gift tax returns on April 15, 2012 (or October 15, 2012 with an extension), and make QTIP elections on both returns.

Alternatively, if the $5 million gift tax exemption is eliminated as of November 23, 2011, the QTIP trust will stay in place and the husband’s federal gift tax return for 2011 will not make a QTIP election.   The Tennessee gift tax return for 2011 will still make a QTIP election in order to avoid paying Tennessee gift taxes for 2011.

The QTIP plan will allow the husband to utilize his gift tax exemption but does not allow the wife to utilize her exemption. If the wife establishes a similar $4 million trust for the husband, there is a danger that the reciprocal trust doctrine will eliminate all of the proposed benefits from the transaction. In theory, the separate trusts for the husband and the wife can have different provisions that will avoid the application of the reciprocal trust doctrine. However, it is my opinion that there is still some risk if they each establish trusts that benefit the other, especially since the two trusts will be created very near in time to each other. Accordingly, I do not recommend the establishment of QTIP trusts by both spouses.

I am very skeptical about Congress closing the gift tax window as of November 23, 2011. Nevertheless, you might as well consider acting before that date if you are committed to making a gift anyway. An inter vivos QTIP trust is one method for hedging your bets.

FDIC Insurance Explained

The FDIC has published a brochure explaining the amount of FDIC insurance for various situations including revocable trusts, irrevocable trusts, and entities such as corporations and LLCs.

Revocable trusts can easily qualify for $1,250,000 of coverage, and may qualify for even higher coverage in very narrow circumstances. Irrevocable trusts generally are limited to $250,000 of coverage. Likewise, entities are limited to $250,000 of coverage. The good news is that it is easy to expand the amount of coverage well beyond $250,000 by setting up accounts in the names of trusts and entities.

A lot of my clients add the names of their children on various accounts in order to expand FDIC coverage.  These arrangements have gift tax risks and may distort the client's overall estate plan because the accounts will belong to the children after the client dies. 

IRS Interest Rates Drop to New All-Time Low

One year ago, I wrote about interest rates reaching an all-time low. They dipped a little more late last year, then increased before heading lower again. Now, they have reached another all-time low.

The 7520 Rate for transactions in October of 2011 will be 1.4%. This represents a 30% decrease from the September rate of 2%.  

Grantor retained annuity trusts (“GRATS”) and charitable lead annuity trusts (“CLATS”) work well when the Section 7520 Rate is low. Installment sales to grantor trusts and intra-family loans also work well when interest rates are low. These transactions use different interest rates than the 7520 Rate, but these rates are also near the all-time low.

One of my clients is currently evaluating a sale to a grantor trust in exchange for a private annuity. Private annuities work better in a low interest rate environment. I seldom recommend private annuities because they work best in terms of reducing estate taxes when my client dies sooner. This particular client is not expected to live beyond 3 years, though he has at least a 50% chance of living at least one year. This 50% threshold is required in order to use the IRS actuarial tables.

The low interest rate environment is not good for charitable remainder annuity trusts (“CRATS”) and qualified personal residence trusts (“QPRTS”). Even though low interest rates are not favorable for QPRTS, some of my clients are establishing QPRTs to take advantage of the current low values of residential real estate. One of my clients will be establishing two QPRTs for her Florida vacation home before the end of September in order to take advantage of the higher rates.

You should consider acting now to take advantage of the opportunities presented by the record low IRS interest rates and the $5 million federal gift tax exemption that is in effect for 2011 and 2012. 

QPRTs Can Also Be Used to Avoid Ancillary Probate

I recently met with clients who own a very valuable home in Florida. We discussed the potential use of a revocable trust to avoid the need for ancillary probate in Florida following their deaths. We subsequently discussed ideas for reducing their estate taxes, including the use of a QPRT for their Florida home. My clients decided to proceed with a QPRT, but decided not to use a revocable trust since it is not needed for avoiding Florida probate.

The wife is a few years younger and has no known health concerns; therefore, she is the better candidate to establish the QPRT. She will transfer one-half of the home to a QPRT with a 10-year term and one-half of the home to a QPRT with a 13-year term.

Using two QPRTs instead of one accomplishes two purposes: First, it allows a fractional interest discount for both halves of the house. This can be as much as 25 or 30 percent. Second, the mortality risk is hedged somewhat. If the wife dies after 11 years, she will have succeeded in removing one-half of the home from her estate. We are hoping that she survives at least 13 years and removes the whole house from her estate.

The combined GRAT discount and fractional interest discount amount to about 50% of the current value of the home. This means that my clients will be making a $2.2 million gift at the current time. There are no federal gift tax concerns due to the current $5 million federal gift tax exemption. Because the gift is Florida real estate, it will not be subject to Tennessee gift taxes. Thus, this asset is an ideal way to take advantage of the current high federal gift tax exemption without having to pay Tennessee gift taxes.

It is likely that the home will appreciate between now and the date of death of my clients. Assuming the wife lives at least 13 years, none of the appreciation will ever be subject to transfer taxes.

In summary, when you own a home in another state, you might consider using a QPRT to avoid ancillary probate and to reduce estate taxes.
 

Stock Price Drop Is a Great GRAT Opportunity

A lot of my clients own stocks in the healthcare industry. Many stocks in that industry have been battered the last three days, primarily due to concern over Medicare cuts.

I have one of my clients trained to recognize a dip in the market as a good time to establish a GRAT. He previously established 3 GRATs with 2 year terms. We started his first GRAT in the spring of 2008. As you might imagine, this GRAT did not perform well due to the collapse of the stock market. However, his other two GRATs are performing very well and will provide a lot of tax-free funds to his children, who will use the funds to repay loans made to them by their mother.

Recognizing that the significant decline in the value of his healthcare stocks creates a gifting opportunity, he called me today to initiate a fourth GRAT. Only time will tell whether this is a temporary price decrease or a prolonged decrease in the value of the stock. If the combined appreciation and dividends from the stocks exceed 2% over the next 2 years, his children will receive all of the excess.

The great thing about a GRAT is that if the stock goes up, your children win; if the stock stays even or goes down, all of the stock and dividends will be returned to you and your children do not lose anything.
 

Beneficiary Can be Trustee Without Estate Tax Inclusion

When my clients want to make substantial outright bequests, I encourage them to switch from an outright bequest to a trust with the beneficiary as the trustee.  The trust provides the beneficiary with creditor protection, divorce protection, and estate and inheritance tax protection.  Occasionally, I hear questions from my clients or their advisors concerning whether the trust will be included in the beneficiary/trustee’s estate for estate tax purposes.

The beneficiary can be a trustee of a trust for his or her benefit if distributions to the beneficiary are limited to an ascertainable standard, as defined by the IRS. The IRS definition of ascertainable standard is defined as health, education, maintenance, or support. If the purposes for which the beneficiary/trustee can make distributions are limited to these categories, the trust will not be included in the beneficiary’s estate upon the beneficiary’s death.

Occasionally, someone uses a slightly different standard and the IRS will attack the standard. In Estate of Ann R. Chancellor, T.C. Memo 2011-172, the decedent was a trustee and beneficiary of a trust that allowed corpus distributions for “necessary maintenance, education, healthcare, sustenance, welfare or other appropriate expenditures needed by the beneficiaries… taking into consideration the standard of living to which they are accustomed.” The IRS argued that this was not an ascertainable standard. The Court undertook an analysis of Mississippi law and determined that the standard was ascertainable. Therefore, the trust was not subject to estate taxes.

Even though the taxpayers won this case, they incurred stress and unnecessary legal fees due to the trust using language that did not track the IRS definition of an ascertainable standard. In my opinion, the more expansive language did not accomplish anything.

Tennessee law, as well as the law of most other states, has interpreted the phrase “health, education, maintenance, and support” to include expenditures to maintain the beneficiary’s standard of living to which they are accustomed. Therefore, expanding the distribution standard to refer to “accustomed standard of living” does not increase the purposes for which distributions can be made. However, the more expansive language may invite unnecessary IRS scrutiny.

If you are concerned that an ascertainable standard is too restrictive, you can also give the beneficiary the right to withdraw up to 5% of the trust per year for any reason. I recommend limiting the withdrawal right to one day each year. If the beneficiary dies on the day that you have chosen (typically December 31), 5% of the value of the trust will be included in the beneficiary’s estate. However, if the beneficiary dies on any other day during the year, the 5% withdrawal power will not cause any portion of the trust to be included in the beneficiary’s estate.

In summary, rather than leaving significant bequests outright, you should leave them in trust with the beneficiary as trustee. The standard for distributions should be limited to health, education, maintenance, and support. You should also give the beneficiary the right to withdraw up to 5% of the trust for any reason. If you follow these guidelines, your beneficiaries will thank you and you will avoid creating estate tax issues for your beneficiaries.

Tax Relief Act of 2010 - Part 7 - Making Gifts to Tennessee QTIP Trusts

This is the seventh article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first six 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
Part 4 – Temporary $5 Million Gift Tax Exemption: Use it or Lose It
Part 5 – Gifting Without Making Yourself a Pauper
Part 6 – Making Gifts Without Paying Tennessee Gift Taxes

Part 5 discussed methods for maintaining access to cash flow from gifted assets. Part 6 discussed methods for avoiding Tennessee gift taxes. This article will discuss a method for combining the concepts discussed in Parts 5 and 6.

A Tennessee QTIP Trust allows you to make a completed taxable gift for federal gift tax purposes without paying Tennessee gift taxes. The reason you do not pay Tennessee gift taxes is because the trust qualifies for the Tennessee gift tax marital deduction. This is not a new technique. We have been using it for 12 years. There has always been a difference between the federal gift tax exemption and the Tennessee gift tax exemption. However, due to the higher federal gift tax exemption, we plan to establish more Tennessee QTIP Trusts in 2011 and 2012 than all prior years combined.

Another appealing feature of a Tennessee QTIP Trust is the spouse’s access to cash flow from the trust. A lot of our clients would make no gift at all or would make a much smaller gift if they could not obtain access to cash flow.

Tennessee QTIP Trusts do not provide cash flow for your children.  If one of your objectives is to increase cash flow for your children, you should consdier other techniques, perhaps in conjunction with a Tennessee QTIP Trust.

In summary, if you would like to take advantage of the temporary $5 million federal gift tax exemption but are unwilling to pay Tennessee gift taxes or need to maintain indirect access to cash flow, you should consider establishing a Tennessee QTIP Trust.
 

Trust Saves the Day for Cancer-Stricken Beneficiary With Creditor Problems

I just talked with the daughter of a deceased client regarding a trust established a few years ago. When I worked with her father on his estate planning a few years ago, his three children were all happily married and doing well financially. I encouraged him to leave each child’s inheritance in a trust just in case one of the children had marital difficulties and/or creditor difficulties.

My client was somewhat unsure of my recommendation, but agreed to establish separate trusts for his three children, with each child being the Trustee of their own trust. Each child has discretion to make distributions to the child and descendants of the child for their health, education, maintenance, and support. The child also has a testamentary limited power of appointment which gives them the power to decide how the trust will be distributed following their death.

The daughter has had a bad run of luck. The business owned by the daughter and her husband has done poorly due to the economy. Furthermore, her husband had a stroke and she has been recently diagnosed with cancer. They have serious creditor problems and are most likely headed for bankruptcy.

The good news is that the trust is protected from their creditors. The daughter will be able to live comfortably for the rest of her life. Furthermore, she has the ability to provide for her husband in the event that she predeceases him. If the father had not had the foresight to leave the daughter’s inheritance in a trust, it would all belong to creditors. This is exactly what the father wanted to avoid.

Tax Relief Act of 2010 - Part 5 - Gifting Without Making Yourself a Pauper

This is the fifth article of a series dealing with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“Act”). For the first four 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
Part 4 – Temporary $5 Million Gift Tax Exemption: Use It or Lose It

The Act temporarily increases the gift tax exemption to $5 million for 2011 and $5 million increased by inflation for 2012. The Act decreases the gift tax exemption to $1 million for gifts in 2013 or later. Our clients are actively considering methods to take advantage of this 2 year window of opportunity to make large tax-free gifts.

The first commandment of gift planning is to take care of yourself. This article will explain techniques for taking advantage of the gift tax exemption without decreasing your cash flow below your comfort zone.

Valuable assets that do not provide much cash flow are good candidates for gifting. Typical examples are stock of a family business that does not declare dividends and real estate that does not generate income.

Personal residences can also be gifted. A Qualified Personal Residence Trust is the favored technique for gifts of a personal residence.

If you are married, you should consider making gifts to a spousal access trust and maintaining a good relationship with their spouse. Spousal access trusts allow distributions to be made to your spouse. Assuming that you can persuade your spouse to use distributions for the joint benefit of the two of you, this gives you indirect access to the trust assets. The flaw with this plan is that your spouse could predecease you. You might hedge this risk by purchasing life insurance on your spouse. Also keep in mind that your expenses will decrease after your spouse dies.

Spouses sometimes ask whether they can set up spousal access trusts for each other. This is dangerous due to the reciprocal trust doctrine. Careful design of the trusts can minimize, though not totally eliminate this risk. Due to the potential estate tax risk associated with reciprocal trusts, I encourage other alternatives.

We generally recommend that gifts be made to “grantor” trusts so that the donor can pay income taxes on the income of the trust. We design these trusts with an escape hatch so that the donor can cease paying taxes if the taxes become too much of a burden. The most common power that we use to make the trust a grantor trust is a power of substitution that allows the donor to swap assets with the trust as long as the swap has equivalent value. Assume that you give a high income asset to a spousal access trust and your spouse predeceases you. You could use the power of substitution to swap low income assets such as undeveloped land for cash in the trust or for the income producing property.

We frequently recommend gifts of non-voting stock in a corporation, non-voting units of an LLC, or limited partnership interests in a limited partnership. Generally, the donor and/or spouse maintain voting control of the entity that is being gifted. By maintaining voting control, they determine who runs the company and a reasonable salary to be paid to the managers of the company. Assuming the donor still participates in management, the company can pay the donor a reasonable salary.

One of our favorite gifting techniques involves a gift combined with an installment sale to a grantor trust. The trust will have an obligation to make payments to your over time. Your continued access to cash flow through note payments makes it more feasible to give assets to the trust.

Another popular gifting technique is a grantor retained annuity trust. These trusts allow you to receive payments from the trust for a period of years.

To this point, I have discussed gifts of non income producing property and methods for obtaining access to cash flow from property gifted to a trust. Other techniques reduce expenses that you would otherwise have to pay, which has the same effect as if you had maintained access to the cash flow.

One type of gift that relieves an expense is a Charitable Lead Trust. Assume that you plan to give at least $50,000 per year to charity for the next 10 years. If you make a gift to a Charitable Lead Trust that pays $50,000 to charity for 10 years, this will reduce the funds that you would otherwise have to spend for the charitable donation. Charitable Lead Trusts represent a fantastic opportunity for leveraging your gift tax exemption, especially when the amount going to charity does not increase.

Another technique for reducing your expenses involves the “leapfrog” (also referred to as “decanting”) power under the Tennessee Uniform Trust Code. The leapfrog power allows a trustee of one trust to make distributions to another trust that benefits the same beneficiaries. Assume that you previously established a life insurance trust (“ILIT”) that requires premium payments of $30,000 per year. If you make a gift to another trust that benefits the same beneficiaries, the trustee could distribute income from the new trust to the ILIT to enable it to pay life insurance premiums. The donor cannot ensure this result because the donor must give up all control over the gift. However, trustees generally can be counted on to assist with an overall plan that helps the beneficiaries of the trust.

There are several methods of taking advantage of the $5 million federal gift tax exemption without decreasing your cash flow. You can give away non income producing property. Some techniques provide cash flow directly to you or your spouse. Others reduce your expenses.
 

Estate Planning Fixes

James Gooch and I recently made a presentation to the Tennessee Federal Tax Conference. The title of our presentation was “Estate Planning Fixes.” We discussed solutions to problems that can arise with respect to Life Insurance Trusts, Family Limited Partnerships (“FLPs”), Grantor Retained Annuity Trusts (“GRATs”), Qualified Personal Residence Trusts (“QPRTs”), Charitable Remainder Trusts (“CRTs”) and Uniform Transfers to Minors accounts.

Planning for the presentation caused me to realize how much time I spend helping clients to improve prior estate planning arrangements. The good news is that there are lots of tools available to fix problems. Furthermore, more transactions are being structured with “escape hatches” that allow modifications to accommodate changed circumstances. 

Payment of Health Care Expenses for Your Son-in-Law's Next Wife

One of my clients recently told me a story about a waylaid inheritance. In the 1980s, my client’s grandparents left an inheritance of $500,000 to my client’s mother. The grandparents loved their son-in-law and were not concerned that their daughter might die before their son-in-law and leave her inheritance to the son-in-law. In fact, the daughter died in 1993 and left her entire inheritance to her husband.

The daughter’s husband remarried in 1997. His second wife was stricken with cancer. He used all of his assets, including those that he had inherited from his first wife, to pay for medical expenses associated with his second wife’s cancer. When the son-in-law later died, he was virtually penniless. The bottom line is that the inheritance from the grandparents was used to pay for health care expenses of a woman whom the grandparents never met.  I doubt this is what the grandparents would have wanted.

Should this be written off as a case of bad luck, or was it a case of poor planning? There were two opportunities to create a different result that would have worked out better for the grandchildren. First, the grandparents could have established a trust for the daughter’s inheritance. Since they liked their son-in-law, the trust could have provided that the son-in-law would continue to receive income if he survived the daughter. Alternatively, the trust could have given the daughter the power to specify that her husband would receive all or part of the trust income following her death. The ultimate beneficiaries of the trust would be the grandchildren.
 

After the grandparents failed to establish a trust, their daughter could have established a trust for the primary benefit of her husband, with the remainder passing to her children. In either case, the principal of the trust would not have been available to pay for health care expenses of the second wife, and the grandchildren would have eventually received the principal of the trust.

Neither the grandparents nor the daughter anticipated that the son-in-law would get remarried and use the funds for the benefit of his second wife. Trusts should be used for significant inheritances to guard against unanticipated circumstances.
 

Tax Court Approves 17% Discount for Fractional Gifts of Vacation Home

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.

Tennessee Dynasty Trusts

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.
 

Increase Your Trust Distributions With A Unitrust Conversion

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.

Tennessee Improves Its Trust Laws Yet Again

The past decade has seen a vast improvement in Tennessee's trust laws, making it one of the leading states for establishing a trust. Major laws that have been enacted include the Uniform Principal and Income Act (2000), the Tennessee Uniform Prudent Investor Act of 2002, the Tennessee Uniform Trust Code (2004), the Tennessee Investment Services Act of 2007, and the Tennessee Community Property Trust Act of 2010.

On April 9, 2010, the Governor signed another law that makes numerous improvements to the trust laws. The new law includes provisions providing enhanced creditor protection for various trusts, including special needs trusts and inter vivos marital trusts, and contains a provision allowing a Trustee to convert a mandatory income trust to a “unitrust” with an annual payment of between three percent (3%) and five percent (5%). I will be writing additional articles to provide more details about these changes.
 

List of Trusts

Federal and state lawmakers continue to pass laws that provide tax and non-tax benefits to trusts. I have often wondered why legislators love trusts so much.

Richard Johnson and I did a presentation to the Nashville Estate Planning Council titled “60 Trusts in 60 minutes.” We came up with 65 different types of trusts. Let me know if we forgot any.
 

Switch ILIT Solves Estate Planning Dilemma for Wife in Second Marriage

Recently, a client told me “as is so often the case second marriages, the value of the wife’s estate that she can leave her children will vary significantly depending on whether she predeceases her husband.” My client’s observation is so accurate. I have encountered this dilemma when working with other clients, but had not understood that this problem affects numerous second marriages.

My client’s husband is very wealthy and plans to make a generous bequest to her in his Will. Furthermore, they jointly own a valuable house.

If her husband dies first, she will own the house and will receive the bequest from her husband’s Will. If she dies first, she will have neither the house nor the bequest.

She is comfortable with the amount that she will be able to leave her children if she survives her husband. However, she is concerned that the inheritance for her children will be insufficient if she predeceases her husband.

The solution that I proposed works as follows:

The couple establishes an irrevocable life insurance trust (“ILIT”) that will buy a last to die insurance policy on the lives of the husband and wife. If the wife dies first, her children will be the beneficiaries of the ILIT. If the husband dies first, his children will be the beneficiaries of the ILIT.
The parties agreed to split the premium payments during their joint lives. The will of the first to die will make a bequest to the trust that is sufficient to pay premiums during the period of survivorship.

The “Switch ILIT” solved my client’s dilemma of making sure that her children will be well provided for regardless of whether she predeceases her husband.
 

Marital Unitrust Reduces Friction with Stepchildren

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.  
 

Give Your Life Insurance Trust a Tune-Up

My clients often want to make changes to an irrevocable life insurance trust (“ILIT”). Fortunately, there are at least 6 methods for making changes to an ILIT.

I recently worked with a business owner who used 4 different techniques to restructure a series of ILITs that he established over a 25 year period. Two of the ILITs owned insurance on his life. Two other ILITs owned last-to-die policies insuring the business owner and his wife.

 

The first step was to create two new ILITs. The wife is a beneficiary of the new Family Trust which now owns the single life policies. The other new ILIT was designed as a Dynasty Trust and now owns the last-to-die policies, as well as one single life policy.

 

Next, the wife exercised a power to appoint the assets of one ILIT to the Dynasty Trust. The trustee of another ILIT used the leapfrog power of TCA Section 35-15-816(27) to distribute its policy to the Family Trust.

 

The trustee of a third ILIT merged that trust into the Dynasty Trust pursuant to TCA Section 35-15-417. Finally, the trustee of the fourth ILIT sold its policy to the Dynasty Trust, which was structured as a grantor trust in order to avoid potential income tax issues associated with this sale.

 

I would have preferred to use the same technique for moving all 4 of the old ILITs into the Family Trust and the Dynasty Trust. However, different techniques were required due to the specific wording of the trusts, and other factors including tax consequences. Even though it was complicated, the business owner accomplished his goals and several generations of his family will benefit from these changes.

 

Incidentally, the two techniques that we did not use were: (i) amending the trust pursuant to TCA Section 35-15-411; and (ii) buying a new policy, which was not a viable alternative due to the age of the policies involved and health changes that have occurred.

See the enclosed article (PDF) for more detail on these techniques.

Joint Purchase Trust - A Smart Way to Buy a Home

If you are planning to buy a new home, you might want to know about Joint Purchase Trusts. These trusts can provide significant estate tax savings.

One of my clients named John asked me whether he or his children should buy a vacation home that will cost $900,000. I recommended that John and his children establish a Joint Purchase Trust.

John will contribute $630,000 (70%) to the Trust and his children will contribute the remaining $270,000 (30%). John’s children have the ability to fund this investment due to prior gifts they have received from John and his parents.

John will have the use of the home for his lifetime and will pay all taxes, insurance and maintenance costs. With John’s permission, his children will also be able to use the home.

John can sell the home if he chooses. If the home is sold, the Trust would either purchase another home or other investments.

Upon John’s death, the trust will terminate, and the home will belong to his children. Nothing will be included in John’s estate for estate tax purposes.

Neither the $630,000 paid by John nor the appreciation of the home will ever be subject to estate or gift tax. This will be a substantial estate tax savings as compared to John buying the home in his name.

A Joint Purchase Trust can also be established by married couples. The husband and wife would retain the right to live in the home until the death of the survivor.

I do not recommend these trusts if you plan to borrow money to buy the home or to use the home as collateral for a home equity line of credit.
 

Pre-Marital Asset Protection Trust Enhances Divorce Protection

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.

 

Receiving Your Inheritance in Trust

If one of your parents is alive, you should consider asking your parent to give you any inheritance that you will receive in a beneficiary-controlled trust.

A properly designed beneficiary-controlled trust can provide protection from creditors, including divorced spouses, and from estate taxes upon your death. When discussing this matter with your parents, blame your attorney for raising the issue.

At my suggestion, one of my clients persuaded his mother to amend her Will to leave his future inheritance in a trust controlled by my client. The amendment did not affect the bequests to my client’s siblings. His mother died last year and the trust has been funded with approximately $800,000. My client is currently distributing cash from the trust to his son, who recently lost his job. This is not a taxable gift by my client. My client's son is in a low income tax bracket, which significantly reduces the income taxes payable with respect to the trust’s income.

The ability to divert income to a child without losing control of the assets is one of the many benefits from receiving your inheritance in a trust.