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

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

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

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

For the prior article, see:

PART 1:  Introduction

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

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

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

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

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

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

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

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

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

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

Last week, two clients scheduled appointments with me while their children were home for the holidays.  The goal of the meetings was to explain the parents’ estate plan to the children.  I did not disclose the extent of the parents’ net worth.  We discussed various trusts that would be established, the identity of executors and trustees, and the disposition of specific assets.  We also covered some premarital asset protection planning concepts.  Both meetings were positive.

I am often asked whether children should be informed about their parents’ estate plan and, if so, when is the appropriate time.  The answer is: It depends.

On the positive side, making sure that your children know about your estate plan can make things go smoother during your senior years and after you die.  As we are living longer, it becomes more likely that you will live for some period of time in which you need assistance from your children.  If they understand your overall plan, they can better carry out your wishes. 

Knowledge of your estate plan may assist your child with their financial or estate planning.  For example, if you have established a trust that gives your child a testamentary limited power of appointment, your child may want to exercise the power in a way that coordinates with the child’s estate plan.

On the negative side, if children are disappointed with their future inheritance they might whine or connive to change the outcome.  This might accelerate a stressful condition that would otherwise not manifest itself until after your death.  Your child may have a mental illness or might be married to a person whose family values differ markedly from your own.  Conversations about estate planning might be uncomfortable.  Some of my clients understandably have the attitude of “Why should I put up with that during my lifetime?”

Knowledge about a substantial future inheritance might cause your child not to realize their maximum potential.  In my practice, I have encountered children who seem to be waiting on their parents to die.  They expect that their parents will take care of the child’s retirement years, so the child does not work as hard.

Overall, I believe that sharing your estate plan with your children is healthy.  You need to judge when your children are mature enough to receive this information.  If you have a dysfunctional child, it may be best to wait until after your funeral.

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.

The American Taxpayer Relief Act of 2012 established a $5,000,000 estate and gift tax exemption to be adjusted on a yearly basis due to changes in inflation.  The IRS has announced that the indexed exemption for 2014 will increase from $5,250,000 to $5,340,000.  This means that, with proper planning, a married couple can transfer $10,680,000 to their children without paying estate or gift taxes. 

A lot of our clients used their full exemption in 2012 ($5,120,000) and are taking a breather in 2013.  However, some of them have also given away the extra $130,000 that can be given in 2013 without paying gift taxes. 

The increased exemption also applies for generation-skipping transfer tax purposes.  A few of our clients who made the maximum gift in 2012 did not have sufficient generation-skipping transfer tax exemption to totally protect the trust.  They can now file a gift tax return to use the extra exemption to protect the trust from future generation-skipping transfer taxes. 

The annual gift tax exclusion will remain at $14,000 per donee in 2014.  

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.

On Thursday, August 29, 2013, the IRS issued Revenue Ruling 2013-17 regarding the tax treatment of same-sex spouses. Effective immediately, same-sex spouses will be treated the same as a heterosexual married couple for federal tax purposes. The District of Columbia and 13 states now allow same-sex spouses to become legally married. Prior to the issuance of the Revenue Ruling, the IRS did not recognize a same sex marriage for purposes of federal tax laws. The change in policy does not apply to civil unions or registered domestic partnerships.

There are numerous tax ramifications to this change. One consequence is that same-sex couples are now required to file a joint income tax return, even if they live in a state that does not recognize same-sex marriages. For 2012, they have an option to file as two single persons or as a married couple. However, if they want to file as two single persons, they must file or amend their 2012 income tax returns on or before September 16, 2013. If they file their 2012 income tax returns after September 16, 2013, they are required to file as a married couple. Due to the so called "marriage penalty," it is hard to predict whether it is better to file together or separately. In general, if there is a wide disparity between the amounts of income earned by the spouses, it will be better to file a joint return. If the spouses earn approximately the same amount of income, it will probably be better to file as two single persons.

In addition to the very quick decision that must be made with respect to 2012 income tax returns, a decision also needs to be made about filing claims for refund. If it would result in a tax refund, the spouses can amend their tax returns for 2011 and 2010, and perhaps 2009 (depending upon when their 2009 tax returns were filed), to file their returns as married filing joint. They do not have to amend their returns if it would cause additional taxes to be paid.

A gift or bequest to your spouse now qualifies for the federal gift or estate tax marital deduction. If taxes have been paid on a gift or bequest to a same-sex spouse within the last 3 years, or if gift tax exemption has been used, you should consider filing a refund claim. If your Will makes a bequest to a trust for your spouse, you should consider modifying the trust to qualify for the estate tax marital deduction. If you are not married, have an estate of more than $5.25 million, and plan to make a bequest to a same-sex partner, you should consider getting married in one of the states that allows same-sex marriages.

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.