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

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

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

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

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

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

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

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

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.  

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.

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.

 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.

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.

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.

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.

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.

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.