Harnessing the Power of Trusts to Help Your Clients and Grow Your Practice
The Firm focuses on Simple & Complex Estate Planning, Special Needs Planning, Elder & Medicaid Law, Probate Law, Guardianships, Conservatorships, LLCs, S-Corps., FLPs, 501(c)(3) Corps., Mergers & Acquisitions, Trademarks, and Tax & Litigation matters regarding the same.
Trust planning is an area where the work of attorneys and financial advisors interfaces. It can be a powerful and effective tool in helping both disciplines to grow their practices.
In this issue of The Wealth Counselor, we will look at how estate planning is changing after TRUIRJCA 2010, what clients want in estate planning, and how incorporating trust planning will benefit clients, their families and the professional advisors who serve them.
Is There a Crisis in Estate Planning?
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRUIRJCA 2010), which the President signed on December 17, 2010, has had a major impact on estate planning.
TRUIRJCA 2010 increased the applicable exclusion amount to $5 million, made it portable for the first time, adjusts it for inflation starting after 2011, set the maximum estate tax rate at 35%, and restored the gift tax exemption at $5 million – but all only through 2012.
The result is that most families don’t have an estate tax problem, at least not for now. Few families have net estates of more than $5 million; even fewer married couples have combined net estates of more than $10 million. This is causing a crisis for professionals who have promoted estate tax avoidance as the primary reason to do estate planning. Insurance advisors who for years have sold policies to fund estate tax liabilities are now finding fewer buyers for their products. Lawyers who have always sold planning as a way to pass wealth on instead of paying it to Uncle Sam are floundering.
The Danger and Opportunity Before Us
The danger is real. Prospective clients may think there is no need for them to plan because they are exempt from the estate tax, at least for now. They may be lulled into a false confidence that the estate tax does not affect them, when in reality it may in the near future. They may be forgetting that the current tax law is only a two-year deal that Congress made, and the law will change in 2013, or possibly sooner. Or they may be foolishly using “waiting to see what the Congress will do” as an excuse to postpone their planning.
The opportunity is real, too. As estate planners, we need to give up the “addiction” of relying on the estate tax as a primary business driver. We need to re-think our approach and remember why we became estate planners in the first place.
While some may view the new tax law as an end to estate planning as we know it, we can also see it as an opportunity to finally focus on what our clients really want.
What Clients Really Want
Essentially, clients want the same things we all want:
For Themselves — Protection and Control. They want control over their assets and health care decisions. They want financial security. They want to be protected from the risks of life, which include lawsuits, disability and the cost of long-term care. Most have some philanthropic goals.
For Their Surviving Spouse — Financial Security. They want to know that their hard-earned assets will not pass to a new spouse. And they want the surviving spouse protected from taxes, primarily from income tax.
For Their Children and Grandchildren — An Education and Financial Security, including Asset Protection from Immaturity, Divorce and Lawsuits. A big motivator for planning can be protecting assets from gift, estate and income taxes for as long as possible, even for several generations. They want their family members to live successful lives that include a work ethic, integrity, faith, and appreciation and respect for family members. Above all, they want their family members to love each other, spend time together and avoid conflict. They do not want them to be harmed by the wealth that is left to them. This is often far more important than tax planning.
For Their Business or Farm — Attract and keep quality talent and have protection from frivolous lawsuits. They want their business or farm to pass to family members who desire to own and operate it, while treating non-participating family members fairly, or they want to sell it to employees or outsiders.
What We Can Provide
These client needs are timeless. No Congress can ever legislate these needs away. Our solutions are also timeless. We need to build our practices around these needs and solutions, instead of having estate tax avoidance be the main need and motivator.
Planning Tip: Think about why you do what you do. People don’t buy what you sell; they buy why you sell it. If you sell a product, they can always find someone who will sell it for less. If your “why” is protecting your clients, their families, their farm or business, etc., they will see that you are putting these needs first.
Five Ideas that Will Get Results…for You and Your Client
The following planning suggestions will work now for most of your clients, and can help you get on the right track in your practice.
Idea #1: Teamwork Produces Better Work
Use a two- to four-meeting process involving other professionals. This will allow you to provide more thoughtful solutions to your client’s needs. It will also allow time for the team of advisors to meet without the client, discuss the situation and possible solutions, and make sure all advisors are on board so that the client hears a consistent message from each advisor. Also, having a team approach over time allows the client to see that recommended financial products (life insurance, annuities, trusts, long-term care insurance, etc.) are part of the total planning solution and not a sales pitch.
Planning Tip: Ask for the name of any other persons the client will consult (friend, CPA, etc.) in making a decision, and get permission to talk with them before making recommendations to the client. Then have those talks and assure all will endorse the plan ahead of time. It will take more time on the front end, but will keep things from being sabotaged by someone you were not even aware of.
Idea #2: Use the $5 Million Gift Tax Exemption Now
We may only have this for a couple of years, but it could disappear even sooner than 2013 as Congress begins to focus on how to raise revenue and cut spending. Discounts may also go away. You can legitimately create a sense of urgency to use this exemption to start moving appreciation out of a potentially taxable estate.
Use the $5 million gift tax exemption to fund a large life insurance policy in an irrevocable life insurance trust (ILIT) that can build up cash value for a supplemental retirement fund or provide an alternative financial investment. A second-to-die policy to pre-fund estate taxes could also be purchased. The $5 million exemption can also be used to fund a GRAT or seed an IDGT sale using LP, LLC or C- or S-corp stock.
Planning Tip: There are two relatively easy ways to give clients access to insurance owned by an ILIT. First, set up the ILIT so that the trustee can make withdrawals or loans from the cash value of the policy and lend the proceeds to the grantor/insured. It can be an interest-only loan during the grantor’s lifetime, with no additional income tax due; at the grantor’s death, the loan can become a debt of the estate. (It must be a credible loan, fully documented, and the grantor must have the means to make the interest payments.) Alternatively, the distributions can be made to the insured’s spouse, on the assumption that they will stay married and the spouse will “share” the proceeds with the insured.
Planning Tip: Remember that both GRATs and IDGT sales need insurance protection, and insurance is easier to fund with a $5 million gift exemption ($10 million if married). You may even be able to avoid Crummey gifts altogether.
Idea #3: Encourage Clients to Leave Assets in Trust
This is good for your clients, and for your clients’ children and grandchildren. Assets kept in a trust are protected from predators (including the surviving spouse’s next spouse), irresponsible spending, creditors, divorce, etc. Ask your client: “If you could protect the assets, why would you not?”
This is also good for you and for your team of advisors, as it keeps the assets under professional management and establishes a relationship with the next generation. This is an excellent way to protect the financial advisors’ book of business against a very real threat.
Idea #4: Think Differently about Your Client’s IRA and Other Tax Qualified Plans
Most clients want to maximize the stretch out on an IRA, but don’t know how to do it. There’s a way to maximize stretch out, provide long-term divorce and lawsuit protection, and create a large life insurance sale. And it will apply to many families with “average” sized estates and IRAs.
Step 1: Leave the IRA to a stand-alone IRA trust for younger generation family members (children or grandchildren). This will provide the maximum stretch out and protection from divorce and/or creditors. An outside trustee can prevent an early cash out and protect the intended stretch out.
Step 2: Use the required minimum distributions to purchase life insurance on the IRA account holder in an ILIT for the benefit of the surviving spouse. When the account holder dies, the surviving spouse will have lifetime access to the proceeds in the ILIT, tax-free. This can be a much better deal for the surviving spouse than becoming the successor to the IRA. The ILIT design provides for successor beneficiaries if the spouse dies first.
Planning Tip: To make the benefits clear for your client, run projections with the spouse as beneficiary of the IRA and a child/grandchild as the beneficiary. Remind your client that distributions from the IRA will be taxable, while the proceeds from the life insurance in the ILIT will be tax-free.
Planning Tip: For those who are charitably inclined, make a charity or church the beneficiary of the IRA; it will receive the proceeds tax-free. Again, use the required minimum distributions to purchase life insurance on the IRA account holder in an ILIT for the benefit of the surviving spouse.
Idea #5: Use Trusts to Help Clients Create a Non-Financial Legacy
Creating a non-financial legacy helps your clients become more connected to the estate planning process and empowers them. Have them write their motivations for the planning and explain discretionary guidelines. If there is heirloom property that is sentimental or historical, they can provide a handwritten note with a story or significance of the item(s).
Planning Tip: Arrange for family meetings after the trust has been signed. You can have them in person for those who live in the area and/or via Skype for out-of-towners. Talk about the planning that has been done and why. This is good for the beneficiaries, as it brings them into the process and helps them understand the motivations, the planning, and the intended results. It also gives the advisors opportunities to meet and become familiar with the next generation.
Conclusion
While TRUIRJCA 2010 has provided us with challenges and has forced us to re-think our approach to estate planning, it has also freed us to be able to do the estate planning that our clients really want without regard to the need for estate tax avoidance. Trust planning remains an integral and valuable part of estate planning, and is beneficial for the client and the professional team of advisors.
Working with Charities for Fun and Profit
| Developing alliances between non-charitable advisors (attorneys, CPAs and financial advisors) and advisors to charities (e.g., development officers for non-profit organizations) can provide better service to the team’s clients, make fundraising more effective for the charitable advisors, and thus be beneficial for all concerned.In this issue of The Wealth Counselor, instead of focusing on the technical side of charitable planning (tax and estate planning), we will take a look at the marketing side. We will explore the various forms of fundraising, what fundraisers do for charities, how they are compensated, how they can become part of the estate planning team, and how working together will benefit all involved, professionals and clients alike.
Fundraising Overview Annual Giving Capital Campaigns Major Gifts Deferred (“Planned Giving”) Gifts Grants What Charities Do with the Money They Raise How Charities Organize Their Fundraising Efforts How Development Officers Are Compensated How You Can Work Together What the Development Officer Can Bring to the Team
Generally speaking, other advisors should not feel threatened by bringing a development officer onboard, as they won’t go against investment advice, provide tax advice, or draft the needed documents. A development officer, however, will be a dedicated member of the team and can be valuable in helping to define the donor’s desires and goals and align them with the charity’s needs and goals. For example, a donor may be thinking he wants his gift to be used for scholarships, but the development officer, who knows that the scholarship fund has plenty of money, may be able to direct the gift toward a building that needs immediate repairs. A Source of New Business for You Occasionally a development officer will need to refer donors to attorneys, CPAs and financial advisors in order to complete gifts, and will generally give the donor two to three names from which to choose. A development officer will want to refer his or her donor to professionals who are reliable, have experience in planned giving, will be responsive and are in relatively close proximity to the client. It helps if the professional also personally has charitable intent, which gives him or her valuable insight into what a client/donor wants to accomplish. A Source of New Business for the Charity Cultivating Development Officers as Referral Sources Networking Tip #1: Get to know the nonprofits in your area and learn about the resources and services they offer to the community. If your client has charitable desires, it would be very helpful if you already know which organizations would fit well with your client’s intentions and would benefit from your client’s gift. Networking Tip #2: Local and regional planned giving councils have regular meetings with guest speakers. You can join, attend, and even offer to speak at these. Regular attendance will yield the best results. Networking Tip #3: Some national organizations (including The Advisors Forum and WealthCounsel) provide monthly webinars. You could host them at your office and invite local development officers, as well as other professionals with whom you would like to work. Networking Tip #4: Ask other professionals with whom you already work if they know any development officers in your area. Ask for an introduction and/or a lunch meeting. Networking Tip #5: Cold calling. Look up nonprofits in your area, then call the planned giving or fundraising office and explain that you would like to meet the development officer. It’s not as good as a personal introduction, but it will get you noticed. Networking Tip #6: Some nonprofits host their own “Get to Know Us” educational seminars as a way to attract potential volunteers and donors. Attending one is a great way to show your interest, learn about the nonprofit first-hand and meet the development officers. Networking Tip #7: Offer to provide free seminars for the nonprofit’s donors (and potential donors) on estate planning, planned giving or other current financial planning topic. It’s a great way to find new leads for the nonprofit and for you. Repeating seminars at the same time and location will make it easy for attendees to bring or refer others. Conclusion |
Income Tax Planning Concepts in Estate Planning
| Estate planning sometimes has income tax effects. All advisors, therefore, should be at least aware of some basics of income tax planning to best serve their clients.
In this issue of The Wealth Counselor, we will examine some of the basics of income tax planning and some of the techniques used in estate tax planning that have income tax impacts. The Goals of Income Tax Planning Typically, the amount of tax due is reduced by having the income be in a class that has favorable treatment. Favorable rate treatment is granted to long-term capital gains and qualified corporate dividends. Some income is excluded from taxation altogether, such as interest paid by state and local governments, certain gain realized on the sale of the taxpayer’s residence, and certain income earned while not living in the United States. The last two are subject to limiting rules and so not always available. Income tax liability usually arises when an asset changes hands other than by gift or inheritance. However, the tax liability can sometimes be postponed. Examples are certain like-kind exchange transactions and certain installment sales. Sometimes, the fact of an asset changing hands is ignored for income tax purposes because the tax laws treat the transferring party and the transferee as the same taxpayer. Basic Estate Planning Has No Income Tax Impact Advanced Estate Planning Can and Often Does Have Income Tax Implications Sometimes, advanced estate planning is used to reduce income taxes by shifting income from a taxpayer in a high bracket to a taxpayer in a lower bracket. Irrevocable trusts are often used for this purpose when the “kiddie tax” does not apply. The “kiddie tax,” when applicable, imposes the parent’s tax rate to the income of the taxpayer’s child who is under age 24. For this donor to donee income tax liability shift to occur, the trust cannot be a grantor trust with respect to the donor. On the other hand, if the trust is a grantor trust, the donor’s paying the income tax on the trust’s income is not an additional gift. Thus not shifting the tax responsibility can be used to transfer additional wealth to children and grandchildren without using the donor’s gift tax exemption. When an asset is sold, the tax is determined by the amount of gain realized. Gain is generally the difference between the net proceeds of the sale and the taxpayer’s basis in the asset. If the taxpayer receives the asset as a gift, the taxpayer’s basis is the previous owner’s basis plus any subsequent investment by the taxpayer. If the taxpayer received the gift as an inheritance, the basis is the asset’s value at the death of the prior owner plus any subsequent investment by the taxpayer. Advanced estate planning, therefore, weighs the estate and gift tax avoided against the increased capital gain that would be due on the recipient’s sale of a gifted asset as opposed to an inherited asset. Some advanced estate planning involves charities. Trusts with charity and non-charity beneficiaries all have income tax effects. Such trusts are characterized as charitable lead trusts (CLTs) if the charity beneficiaries take before the non-charity beneficiaries and charitable remainder trusts (CRTs) if the charity beneficiaries get what is left over after payment to the non-charity beneficiaries. Both CLTs and CRTs can be grantor trusts or non-grantor trusts, depending on what the client is trying to achieve. Advanced planning with income tax aspects also includes:
Deciding which of these techniques should be used in a particular case requires advanced estate planning experience and probably accounting analysis. It is, however, important for every advisor to be at least aware that they exist so that the appropriate team member can be called on when needed. Planning Tip: Remember, there is nothing illegal or improper about rearranging our clients’ business affairs to take maximum advantage of all lawful strategies to reduce taxes. Taxation of Corporations, Limited Liability Companies, Partnerships, and Non-Grantor Trusts Partnerships, for example, are not taxed at all. They report income and deductions, but the taxes are paid by the partners individually. Some corporations and LLCs are eligible to elect to be taxed under Subchapter S of the Internal Revenue Code’s Chapter 1. They are called S-corporations, and they are treated for income tax purposes very much like partnerships – as pass-through entities. Corporations that do not elect or are not eligible for Subchapter S treatment are taxed as separate taxpayers under Subchapter C. They are called C-corporations. LLCs can elect to be taxed as corporations, otherwise they are taxed as partnerships or are disregarded. Some are eligible to be taxed as Subchapter S corporations. Partnerships and LLCs that are taxed as partnerships, have special allocation rules. S-corporation taxation is available only if a number of qualification conditions are met. Some trusts, for example, are not qualified to be Subchapter S owners. Entities in which they own interests, therefore, are ineligible for Subchapter S tax treatment. And with corporations that are not Subchapter S corporations, there are adverse taxation, liquidation and distribution of property issues. Some Specific Income Tax Planning Techniques Planning Tip: Many clients have more than one residence. With planning and a responsive market, a client can use this exclusion every two years to sell multiple properties. For example, sell the principal residence first. Then move into the vacation home, make it the principal residence for two years, then sell it. Converting Income Taxable Assets into Non-Taxable Assets Solution #1: Stretch out the inherited IRA as long as possible to offset the double tax. The longer tax-deferred growth will allow it to earn back some of the amount paid in estate taxes. Naming a young beneficiary will provide the maximum stretch out, allowing for more growth over a longer period of time. To make sure this happens, consider a special-purpose trust designed to receive and stretch inherited retirement plan benefits. Solution #2: Convert the IRA to a Roth IRA. It may make sense to convert and pay the tax now if the IRA assets are expected to increase substantially over the next few years. As with a regular IRA, naming a young beneficiary will provide the maximum stretch out, allowing for more tax-free growth over a longer period of time. Solution #3: Liquidate the IRA now and pay income tax at the current rates. Then gift the net proceeds to an irrevocable life insurance trust (ILIT) where the trustee can use the money to purchase life insurance. This will work well in 2011 and 2012 when the gift tax exemption is $5 million. Using this approach, a $1 million taxable IRA could be converted to over $1 million in tax-free assets for multiple generations. C-Corporations S-Corporations Getting Out of the C-Corporation Trap A better solution is to liquidate the C-corporation, re-form as an LLC, and make the election to be taxed as an S-corporation. This will eventually eliminate the double taxation. However, a 10-year rule applies, so it is best to get the process started as soon as the problem is detected because any disposition of corporate assets within this 10-year period will result in some double taxation. Deferring Income Recognition Exchange of Insurance Policies (Code Section 1035) Like-Kind Exchange of Tangible Property (Code Section 1031) Certain Corporate Reorganizations (Code Section 368) Installment Sale (Code Section 453) Charitable Trusts Charitable Remainder Trust (CRT) Tax Deferral with a CRT Charitable Lead Trust (CLT) Tax Deferral with a CLT Conclusion |
Continuum of Care: Client Update Meetings/Financial Control System
You want a satisfying, long-term relationship with clients, meaningful recurring revenue and referrals from existing clients. Your clients want a trusted advisor relationship with you and they want coordinated estate, financial and tax planning that protects them, their family, and their business interests.A client update process or financial control system is an essential strategy that will assure these outcomes over time. It also creates the opportunity for recurring, positive contact between the various members of the client’s estate, financial and tax planning team.In this edition of The Wealth Counselor, you will learn some strategies for how to implement and/or improve a client update process/financial control system in your practice. You will also learn how to manage it so that it will produce a winning situation for the client and the various members of the advisory team.
Coming Together as a Financial Lifeguard for the Client
The team approach brings together the attorney, investment advisor, CPA, and insurance professional, among others. Sometimes it is the attorney who holds the team together; other times it is the CPA or financial advisor. Whoever it is, the key thing to remember is that no one advisor is as smart as all of them are together. All are needed to meet the client’s needs, and often the help of one or more team member is required to move the client forward in the planning process.These three questions will guide the team through the process of arriving at a joint planning recommendation:
* For what purpose? This sets up the situation and the next steps.
* By what means? This creates a pattern of expectations. While there may be many options to explore, this helps to structure an agreement as to how the team members will be paid (full disclosure is required).
* What are the consequences? This helps to complete the action and may veer to an unexpected direction requiring innovation when an adverse consequence is identified. The team solves the problems and meets the client’s needs.
The Registered Investment Advisor’s Role
Compliance
Because registered investment advisors may be audited at any time by the SEC or by the State, they must monitor their compliance with the applicable regulations. They must keep careful records, and information must be presented and recorded accurately. Disclosure brochures must also be used.
Planning Tip: Before the client meeting, the advisors can discuss whether sensitive information that might need to be protected by the attorney-client privilege is likely to come up and if team members will, therefore, need to exit the meeting while these private matters are discussed. Letters, memos and other documents passing between the attorney and the client also may need to be kept within the protected environment of the attorney-client privilege
.Investments
Investment advisors develop Investment Policy Statements; provide cash management and long-term investments; establish appropriate performance benchmarks; adapt to changing conditions and family objectives; and monitor and provide performance reporting.
Information Management
Investment advisors maintain account documents and records. An internet service may be used to provide easy, 24/7 accessible storage of these records and the investment advisor shares this information appropriately, as determined by the client.
Planning Tip: It is best to allow the client to determine which advisors and family members will have access to which information. Secure internet-based document vault services (e.g., The Advisors Forum’s ClientDocx) can provide record storage with varying access authorizations depending upon the particular person’s need to access specific information.
Education
Investment advisors keep up to date on investment strategies, tax codes, philanthropic concepts, etc., and can provide ways to teach younger generations about money and financial concepts.
Planning Tip: It can be a good idea to bring in the younger generation to review meetings in order to introduce them to the planning concepts and the team of advisors. With the client’s consent, this can introduce them to the concept of wealth and wealth management over a period of some time, as opposed to their suddenly inheriting wealth with little or no preparation to manage it.
Client Update Meetings/Financial Control System
Using a financial control system for the client meetings lets the team identify tasks (pre-implementation, implementation and ongoing maintenance) and assign responsibilities.
Pre-Implementation Tasks (Planning or Discovery Phase)
* Client meetings will likely occur in person or, in some cases, via teleconference (like “GoToMeeting”). Meetings should have a written agenda, an assigned record-keeper for minutes, information sharing (“DropBox” can be useful) and secured document storage. Keeping notes about follow-up actions to take shows the advisor is organized and provides protection in case of an audit.* Investment evaluation includes making financial projections, determining a risk profile, and developing an investment policy statement with asset allocation and sensitivity analysis.* Insurance evaluation includes determining a need, structuring ownership and beneficiaries, designing policy features, and establishing funding levels and sources. Existing policies can often be replaced with a better product at no extra cost to the client.
Implementation Tasks
Before implementing the plan, the team will need to review legal documents, verify ownership and titling, have signed advisory agreements, fully disclose any fee sharing and continue to update the client checklist.* Investment tasks in this phase include a recommended investment policy, the investment advisory agreement and a letter of intent for funding the investment accounts with different levels of risk. Accounts will then be established and funded.* Insurance tasks in this phase include the application and underwriting process for any new policies and a review of existing policies.
Planning Tip: The attorney and investment or insurance advisor will need to work together, especially if there are multiple beneficiaries in the plan.
Ongoing Tasks
* Investment tasks include monitoring investment results, rebalancing investments and preparing reports, with copies typically going to the attorney and CPA.* Insurance tasks include obtaining in-force illustrations, analyzing results, determining funding levels and allocating cash or variable values.* Legal and Accounting tasks are mostly concerned with compliance and include tax and accounting, funding, payments to beneficiaries, sending Crummey notices, and creative task sharing.
Planning Tip: The attorney, investment advisor and CPA should discuss details in person or by telephone to make sure everything is implemented and reported correctly in order to avoid costly mistakes. For example, Crummey notices should be issued to make sure the annual gifts qualify for the gift tax annual exclusion; QTIP elections must be made (there is no forgiveness if the box is not checked); transfer of trust property after the grantor dies must be implemented properly, etc.* Administrative tasks are also ongoing. Documents and records must be maintained (on paper or electronically). Comprehensive financial information must be provided in custodial, performance and tax reports. Completed planning must be monitored and adapted to changes in the tax laws and regulations; family needs and goals (i.e., there is often concern over how to pay for long term care); financial and investment environment (i.e., there is more risk aversion today after the market meltdown in 2008); and philanthropic strategies (lifetime and/or after-death giving to church, charities).* Client Education: It’s important to connect with clients on an ongoing basis to let them know about new investment and planning strategies through newsletters, bulletins, quarterly education programs and seminars. Annual meetings and family retreats also provide an opportunity and environment to teach younger generations about money.
Conclusion
Everyone benefits when advisors come together to work for a client. The client benefits from the comprehensive estate, tax and investment planning; the younger generation benefits from the protection of these assets; and the advisors benefit again when, after building relationships with the younger generation, assets are kept under management at the incapacity or death of the first-generation client.Using a client update process or financial control system will provide the necessary framework for the advisory team to work from, so that everyone stays informed, on track and accountable to meeting the client’s changing goals and objectives.To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax adviser based on the taxpayer’s particular circumstances.
Top Income Tax Planning Ideas for 2011 and 2012
With the recent discussions about closing tax loopholes and increasing taxes for the “wealthy” incident to increasing the national debt limit, clients are beginning to fear that the taxes on their wealth will increase. Even without higher tax rates, wealthier Americans will pay more in taxes if allowable deductions (possibly charitable) and exemptions (probably estate tax) are lowered.
We need to be prepared to help our clients as they begin to draw down retirement savings and look for more tax-efficient investments for their stocks, bonds, real estate and savings.
In this issue of The Wealth Counselor, we will examine some of the top income tax planning ideas to implement in 2011 and 2012.
Income Tax Overview
Anything can happen between now and January 1, 2013, but, based on current law, that will be the date the top income tax rate increases from 36% to 39.6%, qualified dividends become subject to ordinary income tax rates, the tax on long-term capital gains jumps from 15% to 20%, and the 3.8% Medicare surtax kicks in (unless the Florida Federal District Court decision striking down the health care reform act is upheld). Let’s look more closely at how these taxes can impact your clients, and what you can do to help them.
Qualified Dividends
Under current law, in tax years beginning on or after January 1, 2013, qualified dividends will be subject to ordinary income tax rates. Therefore, C Corporations with accumulated earnings and profits and the cash to do so should consider making larger dividends in 2011 and 2012.
Example, Distribution of C Corp Dividends: Should the sole shareholder of a C Corp make a $1 million dividend to himself in one lump payment in 2012 or in $200,000 increments over five years (2012-2016)? Assuming he is in the highest marginal income tax bracket, 15% capital gains tax rate on dividends in 2012, and 39.6% + 3.8% = 43.4% ordinary income tax rate on dividends for 2013 and beyond, he would pay $150,000 in taxes on the lump sum distribution in 2012 and $377,200 on the incremental distributions paid over five years. He would save $ 227,200 by taking the lump sum in 2012.
Long-Term Capital Gains
Under current law, in tax years beginning on or after January 1, 2013, long-term capital gains will be taxed at a top rate of 20%. Taxpayers should consider selling (or otherwise disposing of) appreciated property and recognizing the taxable gain in 2011 and/or 2012. Taxpayers who have realized capital gains deferred on an installment note may want to consider accelerating the unrecognized gain in 2011 and/or 2012.
Example, Acceleration of Gains: In 2012, Judy sold her business for $1 million in exchange for a nine-year installment note. At the time of the sale, she realized a $900,000 gain. By electing out of the installment treatment, she would pay $135,000 in capital gains tax on the lump sum in 2012 vs. $175,500 on the installments in 2012-2021, and would save $40,500 in taxes (900,000 x .15 = 135,000 versus 900,000 x .1 x .15 = 13,500 plus 900,000 x .9 x .2 = 162,000).
Ordinary Income
Under current law, in tax years beginning on or after January 1, 2013, ordinary income tax rates will increase to their pre-2001 levels. Taxpayers should consider accelerating certain types of ordinary income (bond interest, annuity income, traditional IRA income, compensation income) into 2011 and 2012 if they expect to be in the same tax bracket or higher in future tax years. This is especially true for top bracket taxpayers who may pay the 3.8% Medicare surtax on their “net investment income.”
Example, Accelerating Bond Interest: Mike has $100,000 of accrued bond interest that will be paid on January 3, 2013. Mike is in the 35% tax bracket for 2012 and 39.6% + 3.8% for 2013. If he sells his bonds (at par) before the end of 2012 and recognizes the accrued interest income, he will pay $35,000 in taxes vs. $43,400 if he waits and collects the interest in 2013, and will save $8,400 in taxes.
Example, Sale/Repurchase of Bond: James purchased $1 million of corporate bonds in 1993 at par value; they mature December 31, 2011. On December 31, 2012, he sold them for $1,050,000. On January 3, 2013, he repurchased the same bonds for $1,050,000. Under tax law, this $50,000 premium can be used to offset his interest income over the remaining life of the bond (one year). By selling the bonds in 2012 and repurchasing them in 2013, he realizes a net income tax savings of $14,200 ($21,700 in income tax savings on the bond premium, less $7,500 in capital gains tax on the sale of the bonds = $14,200).
Additional Income Tax Planning Ideas
Oil and Gas Investments
Intangible drilling costs (IDCs) provide a large immediate income tax deduction (up to 85% of the initial investment). Losses, if any, created as a result of IDCs will be ordinary and will lower the taxpayer’s Adjusted Gross Income. Depletion and other depreciation provide for additional deductions during the term of the investment. Additional tax credits may be available for certain oil and gas ventures.
Planning Tip: Be careful with oil and gas investment where the client may be subject to the alternative minimum tax (AMT). The AMT may limit the amount of deductions allowed.
Gold Investments
Generally, gold held as coins or bullion is treated as “collectibles,” for which the long-term capital gain rate is 28%. All short-term capital gains are treated as ordinary income. Therefore, a taxpayer in a lower tax bracket would be better off triggering short-term rather than long-term capital gain on gold coins or bullion. On the plus side, the “wash sale rule” (explained below) does not apply to “collectible” losses.
Planning Tip: The “collectibles” tax rate does not generally apply to gold held in mutual funds or to non-exchange-traded options on gold. Gold futures must be “marked to market” and the unrealized gain/loss must be recognized each tax year. Moreover, gold futures gains are subject to special tax treatment (60% long-term capital gain or 40% short-term capital gain).
Foreign Currency Transactions
Gains and losses in foreign exchange transactions are ordinary income/loss rather than capital gain/loss. Generally, taxpayers will want to recognize ordinary income in 2011 and 2012 and push ordinary losses to 2013 and later years.
Index Options
These have special gains treatment on certain broad-based listed options (60% long-term and 40% short-term). For taxpayers in the highest marginal income tax bracket in 2013, this would result in a blended capital gains tax rate of 29.36% ((.6 x .2) + (.4 x .434)).
Loss Harvesting
Loss harvesting can apply to individuals, trusts/estates, and charitable lead and remainder trusts. Considerations include:
Wash Sale Rule: Capital losses are denied to the extent that a taxpayer has acquired (or has entered into a contract or option to acquire) a “substantially identical” stock or security within a period beginning 30 days before the sale and ending 30 days after the sale of a stock that was sold at a loss (“loss stock”). The disallowed loss on the loss stock is added to the cost basis of the new stock, and the holding period of the loss stock is carried over to the new stock. This rule also applies to ETFs, index funds, IRAs and taxable investment accounts. It does not apply to “collectibles.”
Diminishing Real Value of Capital Losses: Because of the cost of capital, the sooner a capital loss is used the better.
Efficiency of Capital Loss Offsetting: In general, capital losses are more tax effective if they can be used to offset income taxed at higher tax rates (short-term capital gains and ordinary income). Long-term losses used against short-term gains are tax-efficient. Short-term losses used against long-term capital gains are tax inefficient.
Income Shifting to Junior Generations
Income taxes can be saved by shifting income-producing assets from parents or grandparents who are in a high income tax bracket to their children and grandchildren who are in lower tax brackets. Planning considerations include asset protection (accomplished through the use of trusts) and the “kiddie tax” for beneficiaries under age 24.
What makes this most attractive in 2011 and 2012 is the $5 million per person gift tax exemption: a married couple can gift up to $10 million and no gift tax will be incurred on the gift. The gift can be made in trust and then used to invest and/or purchase life insurance on the donors.
Example: Husband and wife, who are taxed at the current top (35%) rate, own $16,000,000 in S Corporation stock. They gift $10 million of it to their four adult children (15 5/8% of the S Corporation stock to each child). The S Corporation income is $2 million per year. After the gift, 37.5% is attributed to the parents and taxed at their rate and 62.5% is attributed to the children and taxed at their lower rates (assume 25%). Annual income tax savings: $10,000,000 x 10% = $100,000.
Planning Tip: Income can also be shifted upwards. For example, a high-earning professional can make the gift to his/her elderly parents who are in a lower tax bracket. The additional income can be used to help pay for medical and/or assisted living expenses. After the parents die, the assets can go to the original donor’s children (if the “kiddie tax” does not apply) for additional income shifting.
Roth IRA Conversions
Benefits of converting include a lowering overall of taxable income long-term; tax-free compounding; no required minimum distributions (RMDs) during the owner’s life; tax-free withdrawals for beneficiaries; and more effective funding of the bypass trust. For most people, converting to a Roth IRA is highly beneficial over the long term.
Planning Tip: When exploring a Roth IRA conversion, consider the tax rate in the year of conversion vs. the tax rate in years of withdrawals; the owner’s ability to use outside assets to pay the income tax on the conversion; and the need for the IRA to meet annual living expenses.
Net Unrealized Appreciation (NUA) Planning
If an employee has employer securities in his/her qualified retirement plan, he/she may be able to convert a portion of the total distribution from the plan from ordinary income into capital gain income. The distribution must be made as a lump-sum distribution due to the employee’s death, attaining age 59 1/2, separation from service, or becoming disabled within the meaning of Code section 72(m)(7).
Taxation of Lump-Sum Distribution
Ordinary income is recognized on the cost basis of the employer securities distributed (a 10% early withdrawal penalty is due if the employee is under age 55 at the time of distribution). The difference between the fair market value at distribution and the cost basis is Net Unrealized Appreciation (NUA). NUA is not taxed at the time of distribution, but at a later time when the stock is sold, and is taxed then at long-term capital gain tax rates. (Ten-year averaging is available to those born before 1/2/1936; 20% capital gain applies to pre-1974 contributions only.)
Planning Tip: NUA does not receive a step-up in basis at death, although subsequent gain above the value at distribution should. Also, if an estate or trust contains NUA stock, a fractional funding clause must be used; otherwise, the NUA will be subject to immediate taxation.
Charitable Planning
If the capital gains tax rate increases to 20% and the 3.8% Medicare surtax applies, charitable remainder trusts (CRTs) could become very attractive again. That’s because appreciated assets that are transferred to a CRT are not taxed, so the full value of these assets is available to provide income to the donor, generating much more income than if the donor had sold the asset, paid the capital gains tax, and re-invested the proceeds.
Planning Tip: With the current historically low 7520 rates, charitable lead trusts can be used now by charitably inclined clients to shift significant wealth while using only an insignificant amount of their estate/gift tax exemption.
Inherited IRAs
An IRA is treated as inherited if the individual for whose benefit the IRA is maintained acquired the IRA upon the death of the original owner. Under the tax law, the IRA assets can be distributed based upon the life expectancy of the beneficiary if the beneficiary is a living person or a trust that meets certain requirements, such as that it is irrevocable, all beneficiaries are natural persons, and the oldest possible beneficiary can be determined.
Spouse as Beneficiary
A surviving spouse named as beneficiary of the deceased spouse’s IRA may roll it over into a new or existing IRA in the spouse’s own name. The spouse is then treated as the owner and may delay taking required minimum distributions (RMDs) until he/she turns age 70 1/2 and then take distributions based on his/her life, often allowing for a greater stretch-out period.
Planning Tip: If the surviving spouse is under 59 1/2, rolling over can expose him/her to the early withdrawal penalty if the IRA funds are needed before the surviving spouse reaches 59 1/2. Safer strategy is to wait until then to roll over and use the inherited IRA withdrawal rules before then.
Non-Spouse as Beneficiary
Naming a non-spouse beneficiary avoids having the IRA assets being subject to estate tax in the surviving spouse’s estate. Required minimum distributions (RMDs) occur over the life expectancy of the designated beneficiary.
Common Inherited IRA Mistakes to Avoid
For non-spouse beneficiaries, it is critical to keep the inherited IRA in the name of the deceased IRA owner. Correct wording for an individual: “John Smith, deceased, IRA for the benefit of James Smith.” Correct wording for a trust: “John Smith, deceased, IRA for the benefit of James Smith as Trustee of the Smith Family Trust dated 1/1/2010.”
Other mistakes include not taking required minimum distributions, not using disclaimers when appropriate, not analyzing contingent beneficiaries, and taking a lump-sum distribution at the death of the IRA owner.
Life Insurance Planning for Inherited IRA
If the IRA owner’s taxable estate does not have sufficient other assets, it could be necessary to use a portion of the IRA to pay estate taxes. Because this use triggers additional income taxes, between 60-80% of the IRA could be lost to taxes.
A solution is to establish an Irrevocable Trust that holds a life insurance policy on the IRA owner’s life. Upon his/her death, the death benefit proceeds can be used to provide liquidity to the IRA owner’s estate and preserve the inherited IRA. To the extent that the grantor does not hold any “incidents of ownership,” none of the trust assets will be included in his/her taxable estate. Another alternative is to annuitize the IRA and contribute the annuity payments to the Irrevocable Trust where they are used to pay premiums for life insurance on the IRA owner.
Conclusion
The current income tax laws and the tax increases that will happen in just 16 months (unless the Congress and President agree otherwise) provide some unique opportunities for estate planning professionals to work together as a team to help our mutual clients. Take advantage of this limited time to meet with your clients, ask the right questions, and make a positive difference for them and their families.
Niche Trusts
| Revocable Living, Irrevocable Life Insurance, Charitable Lead, and Grantor Retained Annuity – these are trust descriptors that are familiar to estate planning professionals. However, there are many less well-known types of trusts that clients may ask about or benefit from having. Some of those other types of trusts will fill an estate planning need like no other arrangement can. Some arrangements called “trusts” do not fit the traditional trust definition. Still other things called “trusts” are outright shams.
As professionals, we need to know about the lesser-known trusts, when to use them, when to avoid them, and when to warn our clients to get out of them. In this issue of The Wealth Counselor, we review some trust basics and then provide an introduction to a number of these lesser-known trusts and things called “trusts.” What Is a Trust? A trust is a fiduciary relationship between the trustee and the beneficiary and between the trustee and the grantor. It involves two distinct elements of ownership of an asset: 1) legal (transferred by the grantor to the trustee) and 2) beneficial (vested in the beneficiaries to the extent specified in the trust agreement). Although a trust is a relationship, for IRS purposes, it is treated as an entity. Under the Treasury Regulations, the key distinguishing factor of a trust is that it exists to protect and conserve property for the benefit of beneficiaries “who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.” Planning Tip: An entity that is not classified as a trust under Treas. Reg. 301.7701-4 is a business entity. Private Trusts Health and Education Exclusions Trust (HEET): The HEET is a multi-generational or “dynasty” trust. Through a HEET, a wealthy grantor can confer even more benefit on grandchildren and generations beyond than the amount that is exempt from the Generation Skipping Transfer (GST) Tax. The HEET does this by limiting distributions for the benefit of “skip persons” to direct payments of their medical and higher education tuition expenses. A skip person is someone two or more generations younger than the grantor. A HEET also prohibits direct payments to skip persons or for purposes that are not exempted from gift, estate, and GST tax. The HEET must have a least one beneficiary with a substantial present economic interest who is a non-skip-person. Typically, the non-skip beneficiary chosen is a charity so that the HEET can continue in existence for as long as the charity exists. Planning Tip: A HEET is frequently created by a taxpayer who has already used their GST exemption, has charitable goals and wishes to create an education and health care safety net for future generations. Delaware Incomplete-gift Non-Grantor (DING) Trust: A DING is a non-grantor self-settled irrevocable trust that gives the grantor creditor protection and avoids state income tax on undistributed ordinary income and capital gains. Delaware was the first state to allow self-settled asset protection trusts. Now, however, DINGs are not limited to Delaware. States where domestic asset protection trusts can be established now include Alaska, Nevada, New Hampshire, Rhode Island, South Dakota, Tennessee, Utah and Wyoming. Assets placed in a DING get a step up in basis on the grantor’s death and are included in the grantor’s estate for estate tax purposes. A DING must require the consent of an adverse party for any trust distribution (typically a committee composed of two beneficiaries of the trust other than the grantor). Rabbi Trust: The first Rabbi Trust was set up for a rabbi; hence, the name. They are used with various nonqualified deferred compensation arrangements for highly compensated executives who wish to defer the receipt of some of their compensation in order to minimize current income taxes. The Rabbi Trust can be revocable or irrevocable and funded or unfunded. A funded Rabbi Trust provides the executive more security; however it must be carefully structured to prevent the employee from being taxed now. The trustee must be an independent third party and the assets must be held separate from the employer’s other funds. Planning Tip: Assets held in a Rabbi Trust are subject to the claims of the employer’s general creditors, so it is important to use this technique only with a financially solid company. The fact that the executive will be an unsecured creditor of the company should the company become insolvent is not especially reassuring, but is necessary in order to prevent the executive from being taxed currently on the deferred compensation. Oral Trust: Although trusts are usually written documents, that is not always required. The Uniform Trust Code (UTC) does acknowledge that under certain circumstances a trust may be created orally. However, oral trusts of real property are not permitted in some states. The biggest problems with an oral trust, of course, are interpretation and enforcement. Disputes about the terms or even the very existence of an oral trust are common. Alimony and Maintenance Trust: These are also called “Section 682″ trusts. They are an exception to the general grantor trust rules in that the income paid from these trusts to an ex-spouse under a dissolution or separation decree/agreement will be taxed to the payee (the ex-spouse) and not to the grantor. Typically the trust’s income is paid to the former spouse for a specified term or amount or until the spouse dies. After the former spouse’s interest has ended, the trust can continue for the benefit of the grantor’s designated successor beneficiaries, typically the children. Planning Tip: An alimony trust may be useful if a business owner cannot or does not want to sell an interest in the family business to make payments to his former spouse or if the business lacks the liquidity to redeem the stock of the former spouse. It can protect the payee in the event the payor should die or become financially insolvent before all payments have been made. Also, the trustee can be a neutral third-party who can act as an intermediary between the former spouses. One downside is that the trust can become under- or over-funded, so care should be taken when drafting the document and funding the trust. Commercial Trusts Investment Trust: This trust is used by multiple individuals to pool funds for common investments. One common type of Investment Trust is the Real Estate Investment Trust (REIT). The trust may provide that beneficial interests in the trust may be bought and sold. Environmental Remediation Trust: These are established to collect and disburse funds for environmental remediation of an existing waste site when the ultimate cost of remediation is uncertain. They are used in sales of contaminated real property. Statutory Land Trust: These private non-charitable trusts are used to hold title to real property while keeping the identity of the beneficiary confidential, and are used to maintain privacy in the transfer of real estate (acquisition or sale). They can avoid probate, but do not provide asset protection. Liquidating Trust: These relate primarily to income tax and bankruptcy. In bankruptcy, they are used to liquidate assets under Chapter 11. Outside bankruptcy, they are used to facilitate a sale. Voting Trust: These allow voting rights in a business entity to be transferred to a trustee, usually for a specified period of time or for a specific event. They are useful in resolving conflicts of interest, in securing continuity, for corporate reorganization, and in divorce when it is necessary to divide an LLC or corporation owned by a divorcing couple. Specific Purpose Trusts Funeral and Cemetery Trust: A funeral trust is an arrangement between the grantor and funeral home or cemetery involving prepayment of funeral expenses. An endowment cemetery trust is a pooled income fund held in the name of the cemetery for ongoing maintenance of cemetery grounds. A service and merchandise cemetery trust, similar to a funeral trust, is for merchandise like a gravesite marker or mausoleum and for burial service. Pet Trust: Many pet owners want to provide for the continuing care of their pets after their own deaths. As a result, many states have adopted some form of pet trust legislation. It is important to specifically identify the animal the trust is to benefit, especially if the pet is valuable or a large sum of money is involved. Special considerations include: how long the trust will need to last, what kind of care is needed and who will provide it, whether to name a separate trustee to manage funds in addition to a caretaker, successor fiduciaries and caretakers, a sanctuary or shelter of last resort if the pet outlives the caretakers or those named cannot serve, liability insurance for potential damage caused by the pet, a trust protector, and reimbursement of taxes if the payee is subject to additional income taxes. Also consider how much money will be required to fund the trust and what will happen to any funds that remain after the pet has died. Gun Trust: Federal, state and local firearms laws strictly regulate possession and transfer of certain weapons and bar certain persons from owning or having access to firearms. When an estate has firearms, the executor must be careful to avoid violating these laws. Transferring a weapon to an heir to fulfill a bequest could subject the executor and/or the heir to criminal penalties. Just having a weapon appraised could result in its seizure. A trust designed specifically for the ownership, transfer and possession of a firearm (known as a gun trust or firearm trust) can avoid some of the rules that regulate such transfers. The trust, which must be carefully drafted to account for the different types of firearms held and comply with firearms laws, establishes a trustee as the owner of the firearms. The trust can name several trustees, each of whom may lawfully possess the weapon without triggering transfer requirements. Once a weapon becomes a trust asset, any beneficiary (including a minor child) may use it. Marketing Tip: There are four million members of the National Rifle Association (NRA) and an estimated 240 million firearms in this country. That means millions of American own guns. Many families also have guns as heirlooms. Providing guns trusts (and pet trusts, for that matter) is an excellent way to reach out to potential clients for estate planning. Other Trusts Coogan Trust: This is a statutory trust account required in some states to protect a part of the earnings of child actors. It is named after the child actor, Jackie Coogan, who learned on becoming an adult that his parents had saved very little of his earnings. Totten Trust: This is a pay-on-death account that, until the death of the depositor, is treated as an informal revocable living trust. While living, the depositor may be the grantor, trustee and beneficiary. Upon the depositor’s death, the proceeds in the account will be paid to the beneficiary previously designated on a signature card by the depositor (who can change the designation any time before his/her death). Sham Trusts Planning Tip: If your client has one of these sham trusts, the risk of an IRS audit with accompanying penalties – civil and criminal – is high. They thus provide the advisor an opportunity to un-do a great harm, providing the client is willing. Constructive Trusts Conclusion |
Trustee Selection for Irrevocable Trusts
Most professionals who work with trusts have plenty of “nightmare stories” about trustees chosen by clients for their irrevocable trusts. No doubt this is because trustees are often chosen without careful consideration of the qualifications required.
In this issue of The Wealth Counselor, we will examine who can, who should, and who should not serve as trustee; non-tax and tax factors that should be considered when selecting a trustee; who can, and should, be given the right to remove and replace a trustee; and using a team approach to segregate duties among lay and professional trustees.
Background
Irrevocable trusts are created in two ways:
- A revocable trust becomes irrevocable after the grantor has died.
- An irrevocable trust is established while the grantor is living to save estate taxes (by removing assets from the grantor’s estate) and/or for asset protection or Medicaid (Medi-Cal in California) planning.
While a grantor may technically be allowed to serve as the trustee of an irrevocable trust he creates, it is not a good idea at best. That is because if the grantor has any discretion with trust asset distributions, it could lead to inclusion of the trust assets in his estate for tax, Medicaid and other purposes, which could frustrate the trust’s objectives.
Often there is someone the grantor knows who the grantor suggests to be the trustee. Typical choices are the grantor’s spouse, sibling, child, or friend. Any of these may be an acceptable choice from a legal perspective, but may be a poor choice for other reasons. For example, some families would be torn apart if one sibling had to ask another for a distribution.
Left to their own devices, clients trustee appointments will frequently be made (out of ignorance) with little consideration of the qualifications the trustee should have. Likewise, those who agree to be trustees typically have no idea what they are getting into. Non-professional trustees often are overworked, underpaid, unappreciated, find they are dealing with unhappy and unappreciative beneficiaries, and may even wind up being sued by the beneficiaries.
With this in mind, let’s look at some factors (non-tax and tax) that should be considered when selecting a trustee.
Non-Tax Considerations for Selecting a Trustee
Here are some of the characteristics that the client should consider in choosing an individual trustee:
Judgment: Clients typically want their trustee to make the same decisions they would. Someone who shares the grantor’s values, virtues, spending habits and faith is more likely to do this. Also, consider whether the trustee candidate will be aware of his own capabilities and weaknesses. If the trustee candidate does not have accounting or investment experience, would she have the judgment to admit this and engage an appropriate qualified professional?
Availability/Location: Does this trustee candidate have the time required to be a trustee? Will he be available when needed or will work and/or family demands leave too little time for trust responsibilities? Where does the candidate live? If the trustee lives in a place different than the trust situs, different laws may apply. Is living near the beneficiary important?
Longevity: How long will the trustee be needed? Many grantors are most comfortable with friends who share their values and have gained wisdom from life experiences, but someone near the grantor’s age may not live long enough to fulfill the job. A trust established for the grantor’s child will likely need a trustee for many years to come. Thus, for trusts that may last a long time, a corporate trustee is often the preferred choice.
Impartiality: The trustee must be capable of being impartial among the beneficiaries. This is especially difficult to do if the trustee is one of several beneficiaries. Corporate trustees, because they can be impartial, are often chosen to prevent a sibling or relative from being placed in an uncomfortable (and often unfair) position.
Interpersonal Skills: The trustee needs to be able to communicate well and effectively to the beneficiaries and to professionals who may be involved with the trust. Some people may be good record keepers or investors, but lousy at diplomacy or feel intimidated or even be offended if a beneficiary gets an attorney. A good trustee will need to be able to work calmly and well with all involved.
Attention to Detail: Does the trustee understand the serious duties that come with the job and is she willing to be accountable for her actions? Fiduciaries are often thought by the beneficiaries to be guilty until proven innocent. While it may not happen, the trustee should assume he will be sued at some point and keep meticulous records as a ready defense. A trustee who expects to be sued will be much better prepared than one who doesn’t think it will happen and, as a result, does not take the record keeping requirement seriously.
Investment Experience: While it is helpful to have investment experience, the trustee can certainly get by without it, as long as he/she recognizes this is an area for which to secure professional help. Also, if the trustee lives in a place different than the trust situs, different investment laws may apply, making it especially prudent or even essential to seek professional assistance.
Planning Tip: CPAs can make good trustees, but often are unwilling or unable (because of insurance considerations) to serve. Sometimes, the best choice would be a corporate trustee. Seldom will the unguided grantor even think of using a team, which can include both various professionals and friends and family members.
Fees: The non-professional trustee rarely discusses fees with the beneficiaries. Often, family members and friends will not charge a fee for their services out of a sense of family duty or respect for the grantor. But trustees should be paid and, more often than not, an unpaid trustee will eventually come to that conclusion or fail to diligently carry out his duties. From the outset, a trustee should keep close track of time and expenses so that a reasonable fee can be substantiated. Generally, a reasonable fee is what a corporate trustee would charge, so thinking that a non-corporate trustee will do the same necessary work for less is false economy.
Planning Tip: Become knowledgeable about the fees charged by corporate trustees in your area as a guideline. Talk about trustee fees when establishing the trust to avoid problems and misunderstandings later.
Insurance: Anyone serving as a trustee needs to have plenty of insurance (errors and omissions or liability). Some of the laws that govern trustees are absolute standards, so a trustee needs to have adequate insurance for protection in the event of a mistake or an innocent error. The amount of insurance needed can depend on the degree to which a trustee is indemnified. However, legal defense costs in trustee litigation can be very large and are typically borne by the insurer.
Indemnification: This often comes up when family members or friends are serving as trustee. Grantors want to indemnify family members and their friends; they do not want them to be sued. It is possible to reduce or eliminate the prudent investor rule for such trustees. However, indemnification is a two-edged sword because it may result in the non-professional trustee not taking the job seriously.
Planning Tip: A good alternative is to have a family member or friend serve with a corporate fiduciary that is assigned the administrative and investment responsibility. The family member or friend trustee could make or veto discretionary distributions, but having no oversight, administration, or investment obligations would be less likely to be sued if something goes wrong.
Planning Tip: Indemnification might be appropriate in a situation with obvious bad family dynamics, where the siblings are already fighting each other yet the grantor insists on naming one sibling as trustee. In such a situation, your recommendation to name a corporate fiduciary instead should be well documented.
Planning Tip: Waiving the prudent investor rule can also be helpful in other situations, depending on the use of the trust. For example, with the sale of an appreciated asset(s) to a grantor trust, the trustee is usually buying hard-to-value assets (real estate, wholesale business interest) from the client in order to shift future appreciation to the trust and away from the grantor. Rather than starting initially with a corporate fiduciary who is not familiar with the asset or situation, it may be more effective (saving both time and money) to have the initial trustee be someone close to the family who better understands the issues, and then change later to a corporate fiduciary. Waiving the prudent investor rule and providing indemnification for the initial trustee in this situation could make sense.
Planning Tip: Being able to waive all or part of the prudent investor rule when using an irrevocable life insurance trust (ILIT) gives greater latitude and peace of mind to make some of the transactions meet the unique needs of the client. Beware, however, of the risk that the trustee, shielded from liability, may fail to do the appropriate work to make sure that the insurance held in the ILIT is appropriate as markets change.
Note: Florida is considering a statute that would relieve trustees of the duty to review the propriety of investments in life insurance policies, which would, in effect, waive the prudent investor rule for life insurance policies owned by ILITs. This would help to solve the problem of corporate trustees not wanting to serve as the trustee of ILITs due to the obligation to review policies that have not performed very well.
Tax Considerations
Estate Tax
If a purpose of the trust is to remove assets from the grantor’s estate, the grantor cannot have any role in determining who gets distributions or when they occur. However, the grantor can have the power to remove and replace the trustee or to control the investments of the trust. Neither of those will cause estate tax inclusion providing the grantor cannot appoint a trustee who is related or subordinate to the grantor (as would be a brother, employee or someone else who will capitulate to the grantor’s wishes). Interestingly, there is no problem appointing, at the inception of the trust, an initial or successor trustee who is related or subordinate to the grantor.
Planning Tip: It is unclear if a grantor can have the right only to remove a trustee and allow the next named successor trustee to take over. While also unclear, it seems that a grantor can reserve the right to remove and replace someone who is not a fiduciary (for example, a trust protector).
Income Tax
A non-adverse trustee having certain powers may trigger grantor trust rules and cause the grantor to be taxed on the trust’s income. In some instances the client may not want the tax to come back to the grantor and instead want a trust that is a separate tax-paying entity for which the income that is distributed to the beneficiaries is be taxed to the beneficiaries.
Planning Tip: Because the trustee’s identity may affect state income tax as well, you may be able to shift the trust situs to a state with a lower income tax rate. Depending on the trust assets, this could be important as some investments (such as oil and gas) may be taxed significantly higher in some states than in others.
Beneficiary Removal and Replacement of Trustee
This is an area that is customizable for each trust and can help maintain some downstream flexibility. Some grantors may not want the beneficiaries to be able to remove the trustee, especially if the grantor is aware of family quarreling. But if the corporate or individual trustee knows it cannot be replaced there is little need for responsiveness or careful attention to investments. Because there does need to be a way to have the trustee removed if things should deteriorate, the document can include that the trustee can only be removed for cause as determined by the court. On the other end, spendthrifts may want to “trustee shop” until they find one that will do whatever they want, so there will need to be some restraints on when a trustee can be replaced.
Team Approach
There are times when a team can do a better job than a single trustee. Having more than one trustee, even with different duties and responsibilities, can work well for many situations. The trust can benefit from assigning the trustees specific duties based on their strengths and experience. Of course, the fewer people who are involved, the less complicated the administration. Also, disagreements will have to be worked out. If there are two trustees or any even number, deadlocks are possible. With an odd number, a simple majority would be needed. If an agreement cannot be reached, the court can be allowed to intervene as a last resort.
Also, as mentioned earlier, family member trustees can work with professionals as paid advisors instead of as trustees. This would allow the advisors to provide valuable input and insight into both the grantor’s desires and the personalities of the beneficiaries, without being so exposed to possible lawsuits.
Planning Tip: Ethical issues can arise if the attorney represents more than one trustee, so she should be sure to have a waiver of conflict or other plan in place.
Planning Tip: Naming someone as trustee is a nomination. The person named is under no obligation to accept the responsibility when the time comes, and it is not unusual for someone to refuse to serve or to step aside once he understands the duties and responsibilities involved. For this reason, it is important for the trust maker to name several successor trustees and to clearly communicate with each before finalizing the choices. Most drafting attorneys will also recommend naming a corporate trustee as trustee of last resort, especially if no procedure for appointing successors is provided to the beneficiaries, short of going to court.
The Trustee’s Duties and Responsibilities
| - administer the trust - be loyal - be impartial - be prudent - control and protect trust property |
- collect trust property - inform and report to beneficiaries - diversify investments - keep records and no commingling - enforce and defend claims |
Conclusion
A competent trustee is as important to the success of a trust as its being well-drafted. Naming a favorite family member as trustee may not be the smartest (or kindest) thing the grantor can do. As experienced professionals who have seen the consequences of unwise choices for trustee, we are in a unique position to counsel our clients with their and their beneficiaries’ best interests in mind.
Retirement Planning: Coordinating with the Client’s Overall Planning Objectives
| Volume 6, Issue 12 | ||
Coordinating retirement plans with wealth transfer planning can be challenging. This is primarily because retirement accounts are driven by income tax laws designed to encourage Americans to accumulate wealth for retirement, not for transferring wealth upon death. In this edition of The Wealth Counselor, we will examine some of the critical rules in using IRAs and qualified retirement plans for wealth transfer planning, common misperceptions in this area, and why naming a trust as beneficiary may be the only way to accomplish some of the client’s planning objectives. Completely covering these subjects requires volumes, so we will cover only the basics. This topic is especially important now as the baby boomer generation begins retiring. At the end of 2010, IRAs and qualified retirement plans held nearly $17.5 trillion, accounting for 37% of all household financial assets. And because of how lifetime minimum required distributions are calculated, IRAs and qualified retirement plans may be the largest assets held at death. The Fundamentals Required Beginning Date (RBD) Minimum Required Distribution (MRD) Planning Tip: Taking only the MRD also means that the account will probably grow for years past the RBD. For example, if an IRA is growing at a rate of 5.5%, at age 100, the participant will still have about 60% of the original account balance is still in the account. Planning for the beneficiaries, therefore, is very important. Minimum Required Distribution for the Year of Death Minimum Required Distributions after Death (1) Whether death occurs before or after the participant’s RBD for that IRA or qualified retirement plan; Note: The rules are different if the spouse is the sole beneficiary; that will be covered later. Planning Tip: If your client is a participant in a qualified retirement plan, make sure you review and understand what the plan will allow as a part of any planning, because, in many cases, plan rules trump the general rules. Who is the Participant’s Beneficiary? Is There a “Designated Beneficiary” (DB)? “Designated beneficiary” does not mean the beneficiary designated by the participant. It is a legal term and understanding its meaning is crucial to planning and for compliance with post-death MRDs. There is a Designated Beneficiary for an account if, on September 30 of the year following the year of the participant’s death, there is no beneficiary that has to be considered in making the analysis that is not a human being or a qualified “look-through” trust and the plan administrator or custodian can know, with certainty, the oldest person who has to be considered in making the analysis. Planning Tip: During this period of at least nine months, clean-up strategies can be used. These include removing non-qualified beneficiaries and division into separate shares (discussed below). Planning Tip: Most IRAs and qualified retirement plans have printed beneficiary designation forms they expect the participant to use. Most, but not all, will accept attachments. Some will accept a separate instrument. Due to the limited space on most forms, it will probably be necessary to add an attachment. When drafting beneficiary designations, make sure the plan permits what you are trying to accomplish. Keys to Achieving “Designated Beneficiary” Status: Only an individual or a qualified “look through” trust can be a Designated Beneficiary. Estates, partnerships, corporations, LLCs, other trusts, and charities do not qualify. If there are multiple beneficiaries, all must be individuals and the oldest must be identifiable. Determining the MRD for the Beneficiary after the Participant Dies If there is a Designated Beneficiary, regardless of when the participant dies, each beneficiary may use the Designated Beneficiary’s age factor as shown in the Single Life Table to determine his or her MRD unless the plan requires more rapid distribution. Using the Designated Beneficiary’s age is commonly known as a “stretch-out,” and, in most cases, maximum stretch-out results in significantly more wealth passing to the beneficiary. Using the Life Expectancy Rule, the beneficiary calculates the MRD for the first year by dividing the account balance by the Designated Beneficiary’s life expectancy. Each subsequent year, calculate the MRD by dividing the remaining account balance by the prior year’s divisor minus “1.” Thus, using this method, a beneficiary will withdraw all of the retirement benefits by the life expectancy of the Designated Beneficiary, even if taking only the MRD each year. Death before Required Beginning Date Planning Tip: The Five-Year Rule only applies if the participant dies before his or her RBD. Death after Required Beginning Date Planning Tip: Because a Roth plan has no RBD, the Five-Year Rule applies to Roth plans with no Designated Beneficiary, even if the participant has reached his or her RBD for other IRAs or qualified retirement plans. Also, distributions from a Roth plan cannot satisfy MRD requirements for non-Roth plans. Multiple Beneficiaries (1) The ability to remove a beneficiary through disclaimer or distribution of that beneficiary’s share. This must be done by September 30 of the year following the year of death. Example: If the beneficiary designation is to a trust that distributes a specified sum to a charity and splits the balance between Child 1 and Child 2, you can make the distribution to charity prior to the critical date. That would leave you with the two individuals, Child 1 and Child 2, and the older of the two would be the Designated Beneficiary. Example: If the beneficiary designation is to a trust that distributes one-third to the participant’s mother and one third each to Child 1 and Child 2, if the beneficiary’s mother disclaims her interest prior to the critical date, the beneficiaries would be Child 1 and Child 2 and the older of the two would be the Designated Beneficiary. (2) The separate accounts rule: If the participant’s benefits under a plan are divided into separate accounts with different beneficiaries, the post-death MRD rules apply separately to each account. This allows multiple beneficiaries to each use their own life expectancy in determining post-death MRDs. (The separate account rule is not applicable to multiple beneficiaries who take their interests through a trust that is named as a beneficiary of the plan.) Planning Tip: In order to satisfy compliance for the separate accounts rule, there must be pro rata sharing in gains and losses, which is normally done by fractional or percentage division. A pecuniary gift would not meet the definition unless (under local law or beneficiary designation) the gift shares in post-death gains and losses pro rata with the other beneficiaries’ shares. However, you can eliminate the recipient of a pecuniary gift from being included in the Designated Beneficiary determination by distributing that gift before September 30 of the year following the year in which the participant died. Planning Tip: Separate accounts must be established by December 31 of the year following the year of the participant’s death to use separate life expectancies. If established later, the separate accounts are still effective for all other purposes. Critical Dates September 30 of the year following the year of death October 31 of the year following the year of death December 31 of the year following the year of death Surviving Spouse as Sole Beneficiary If the surviving spouse is the only beneficiary, he or she can roll over the inherited benefits into his or her own retirement plan or elect to treat an inherited IRA as his or her own IRA. There is no deadline by which the spouse must make the rollover decision, but until the rollover is made, MRDs would have to be under the inherited IRA rules based on the spouse’s age unless the plan requires more rapid distributions. Planning Tip: A spouse who is under 70 1/2 can postpone distributions until reaching his or her own required beginning date, and can take MRDs using the recalculation method from the Uniform Lifetime Table. In addition, after rollover the spouse can name his or her own beneficiaries who can then use their own life expectancies after the surviving spouse dies, resulting in the maximum stretch-out. Planning Tip: If the surviving spouse is under 59 1/2, special care must be taken in deciding whether and when to do a rollover. This is because distributions taken from the account after rollover and before the survivor reaches age 59 1/2 are subject to the 10% early withdrawal penalty. If the participant dies before his or her RBD and the spouse does not do a rollover (i.e., treats the plan as an inherited plan), annual distributions to the surviving spouse can be postponed until the end of the latter of the year following the year in which the participant died or the year in which the participant would have reached age 70 1/2. If, after rollover, the surviving spouse dies before his or her RBD, the MRDs for her beneficiaries will not be based on the participant’s remaining life expectancy. For them, MRDs will be based on either the five-year rule or, if the spouse has a Designated Beneficiary, the life expectancy of that Designated Beneficiary. While the surviving spouse remains the beneficiary and has reached his or her RBD, following the surviving spouse’s death, distributions may be stretched over the surviving spouse’s hypothetical remaining life expectancy under the fixed-term method (life expectancy rule). Trust as Beneficiary The problem with naming an individual as beneficiary is that he or she is likely to cash out the IRA or plan account, thus negating the participant’s careful planning for long-term tax-deferred growth. Example: A 25-year-old inherits a $100,000 IRA. Will he choose a $60,000 automobile (the amount after cashing in the IRA and paying the income tax) or $400,000 in after-tax income over his or her life expectancy (based on 5% growth and combined state and federal income tax of 35%)? If the client’s goal is to preserve tax-deferred growth, it is advisable to have a trustee involved who will ensure that happens. Normally a trust is a non-individual and cannot qualify for Designated Beneficiary status, but it is possible to name a trust as beneficiary and still have a Designated Beneficiary for purposes of determining MRDs. Special rules allow a “see-through trust” that lets you look through the trust and treat the trust beneficiaries as the participant’s beneficiaries, just as if they had been named directly as beneficiaries by the participant. Planning Tip: If a trust is made the beneficiary, neither the spousal rollover nor the special accounts treatment is available. However, if the trust states that property can be distributed out to the spouse, then the IRA could be distributed to the spouse and the spouse could roll over the IRA. Requirements for a See-Through Trust A Designated Beneficiary need not be specified by name as long as the individual who is to be the Designated Beneficiary is identifiable under the plan. Thus, the members of a class of beneficiaries capable of expansion or contraction will be treated as being identifiable if it is possible to identify the class member with the shortest life expectancy. For example, “my descendants” is a class that can be identifiable even if they are not individually named. Which trust beneficiaries are to be included in the Designated Beneficiary determination? The general rule is that contingent and successor beneficiaries count, unless the beneficiary is a “mere potential successor to the interest of one of the beneficiaries upon that beneficiary’s death.” What is a “mere potential successor” beneficiary is demonstrated by an examination of “conduit” and “accumulation” trusts. Conduit Trusts: These specifically require that any distributions that come from the IRA and go into the trust must be immediately distributed to the identifiable current beneficiaries. The IRS regulations say that, with a conduit trust, the Designated Beneficiary analysis has only to look at the current beneficiaries because all others are mere potential successors. Thus, with a conduit trust remainder beneficiaries could be charities and older beneficiaries. Planning Tip: With conduit trusts distributions cannot accumulate in the trust, so there is no asset protection for those distributions. Also, if there is a special needs beneficiary, required distributions could result in the loss of government benefits. Accumulation Trusts: The advantage of these trusts is that distributions can accumulate and do not have to be immediately distributed to the beneficiaries, so they provide asset protection for plan distributions. However, these trusts are more difficult to draft so that there will be a Designated Beneficiary. All potential remainder beneficiaries must be identifiable and they must all be individuals. This is not possible, for example, when the remote contingent beneficiaries are someone’s heirs at law. Stand-Alone Retirement Trust (SRT) An SRT is an inter vivos trust created by the participant as grantor; it can be revocable or irrevocable. It is nominally funded during the grantor’s life and will receive retirement plan benefits upon the death of the participant by means of properly drafted beneficiary designations. Planning Tip: Using an SRT can ensure stretch-out (if that is the client’s objective) while also allowing the financial professional to maintain the assets under management. Conclusion Like other aspects of planning, it is helpful to review client retirement planning objectives and beneficiary designations frequently to ensure they coordinate with the client’s planning. |
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