Chapter 1
The Little Blue Book of Estate Planning
Kevin M. Flatley, Esquire
Copyright 2002
All rights reserved. No portion of this book may be republished in any form without the express written consent of Kevin M. Flatley
Chapter 1. An Estate Plan
Chapter 2. Trusts, Estate Taxes, and The First Variable in a Trust: Trust Distributions
Chapter 3. Generation-Skipping
Chapter 4: The Second Variable in a Trust: Trust Management
Chapter 5. Avoiding Probate
Chapter 6. Who Should Own the Family Assets
Chapter 7. Six Rules of Thumb for a Married Couple Without Children
Chapter 8. Estate Taxes and the Unmarried
Chapter 9. Saving Estate Taxes With Real Estate a Major Asset
Chapter 10. Choosing a Trustee
Chapter 11. Gifts
Chapter 12. A Defective Trust
Chapter 13. A Qualified Personal Residence Trust, or “QPRT”
Chapter 14. The Family Limited Partnership
Chapter 15. A Grantor Retained Annuity Trust (a GRAT)
Chapter 16. Irrevocable Insurance Trusts: The Last Great Tax Shelter
Chapter 17. Gifts to Charity
Chapter 18. Planning With A Spouse In Ill Health
Chapter 19. Estate Tax Treatment When a Spouse is Not a U.S. Citizen
Chapter 20. The Three Q’s of Estate Planning
Chapter 21. Gifts to Minors
Chapter 22. The Sale of a Business
Chapter 23. Medicaid Trusts
Chapter 24. So, You’ve Been Named an Executor
Chapter 25. Estate Tax Repeal
Chapter 26. State Estate Taxes
Chapter 1. An Estate Plan
Whether we know it or not, we all have an estate plan.
If I do nothing, and I have assets in my name, my state legislature will provide an estate plan free of charge. In most states, this estate plan will divide my assets equally between my spouse and my children; if I am single and I have no children, the state provides for distribution among parents, then siblings, then on to cousins, aunts, uncles, nephews and nieces and other assorted hangers-on. Look in the paper any day to see what your legislators are doing, and decide for yourself whether you trust them to draft a proper estate plan for you. When you read your paper, you will want to talk to your lawyer about a will, and soon.
Many individuals worry that the state will get their assets if they do not have a will. This almost never happens, since there is usually some distant relative somewhere who will appear when there is an inheritance at stake.
Joint Tenancy
Most of us have at least a simple estate plan. Owning assets in joint names is a simple estate plan. With joint ownership, my joint tenant will receive my bank account or my home immediately upon my death. There is generally no delay, no interference by the probate court, and the process is plain and simple.
The simplicity of a joint tenancy may result in a costly estate plan in the end, though. We will see later that I can leave my assets in joint names, and have them pass to my spouse with no "probate" and with no estate tax; but when my spouse then owns this property, it may ultimately face both probate and tax on my spouse’s death. It will be subjected to probate when my spouse dies if it is worth more than $15,000 to $25,000 in most states; and it will pay an estate tax at my spouse’s death at rates that can easily reach 45% or more if our assets, mine and my spouse’s own assets, exceed $1,000,000.
One witty lawyer refers to owning a home in joint names creating an "expensive joint", again because joint assets over $1,000,000 will pay estate taxes on the death of the second joint tenant. The home my wife and I own as joint tenants will pass to my wife easily and without tax because we hold it in joint names; but the expense occurs at her death, when the home, the expensive joint, is subjected to costly probate and tax procedures.
A Will
Even if most of your assets are in joint names you will still want to have a will. A simple will is not expensive, and you will always have something in your sole name: the clothes on your back, the money in your wallet, the Series E bond you bought in 1980, payable to your estate, and your home furnishings. It would be a shame to have to divide the antique buffet in your dining room into 3 shares just because you did not leave it specifically to your child living with you at your death; and believe me, it is just this type of asset that your kids will split into shares to assure that one child does not get an advantage over the others.
A will also lets you name an individual or an organization to take care of your estate, after you are gone. In some states this individual or organization is called a personal representative, but since most states refer to this individual or organization as an executor, we will use the designation "executor" for this role, but the terms personal representative and executor are interchangeable.
The executor’s role is to assemble your assets, pay your estate taxes, pay your income taxes and the estate’s income taxes, and distribute the assets the way you direct the assets in your will. Some of the executor’s most difficult tasks are determining where the taxes will be paid, distributing the assets to the right parties and places, and holding assets in “pockets” which will minimize income taxes. If your estate is simple, a home, a brokerage account and an IRA, a family member working with a good lawyer can serve as your executor. If your estate is more complex involving a diversified portfolio of securities, or a family business, an IRA or another pension plan, or many parcels of real estate, you should consider a professional executor: a bank, trust company, or other professional involved in settling estates. A professional executor will often assign a senior officer to handle complex issues, but a lower paid staff to perform ministerial duties, which should lower the cost of estate settlement. We go into this role of an executor in more detail in Chapter 7.
A will also lets you decide where your assets will go if assets are in your name or if your joint tenant dies before you. Individuals worry less about the prospect of a joint tenant dying before them, although they are eerily concerned about “dying together” with a spouse. In all of my years in the estate planning business, I can only remember one instance of clients dying together: a husband and wife both killed crossing a busy street. It is much more likely that there will be an orderly progression of assets from one spouse to the other, and it is important to spell out in a will who is to receive the assets at the death of the second spouse. In a will, you can specify which of the children receive specific assets, and if you wish, you can assure that the in-laws do not share in your wealth.
In the estate planning business, we begin to wonder whether there are any decent sons-in-law or daughters-in-law. Most every client with whom I have ever discussed a will or trust wants to be sure these “children-in-law” don’t get a piece of the family inheritance, and usually, it is couched in whispered terms like “he’s a wonderful husband and father but...”; or, “she’s nice, but she has no idea of the value of a dollar...”, coupled with the other spouse’s wink of the eye and “...my glory, can the girl spend money....” There are almost no parents who want these in-laws to see any of their money, and they often want them to be specifically excluded, until they are assured that state law almost always allows assets to follow the family’s blood lines if assets are left “… to my children; but if they are not around, to their children, etc….”
With a will you can also do most anything you choose with your assets. I remember an individual early in my career whose idea of equality was to leave one child his business and to divide the rest of his estate equally between this child and his sister. To me this is grossly unfair, but then, I did not build this estate, and he did. The law will generally let him do anything he wants, with well-defined exceptions: if I completely neglect a child and I do not even refer to the child in the will, this child can demand a share; there is an assumption that he was forgotten, as if we would ever forget the little darling. I can correct this situation in most states by just mentioning this black sheep, without leaving him or her anything.
Most states provide relief to a widow or widower left little or nothing under a will, unless there was a prenuptial agreement. Usually, it is not sufficient to say in a will that you remember your spouse but you are disinheriting your spouse anyway. You may die happy with this term in your will, but the courts will generally leave a portion of your estate to or for your spouse, even if you never liked each other much during your lifetime.
A will can be challenged on the basis of incompetence, undue influence, or carelessness about observing the formalities of executing a will. All you need in many states to invalidate a will is for one witness to leave the room while another witness is signing a will, and bingo!, you have no will!
It is important to have a will drawn by a good lawyer, and executed in the presence of a good lawyer, and even then, you need to be diligent. I once interrupted a will signing when I saw that the husband had just signed his wife’s will, and there have been countless times when I have read wills with missing dates or other important “blank spaces” left empty unintentionally.
A Trust
If a will is all that is required to leave assets to responsible adults who know their way around the financial markets, so is the converse true also. If we are leaving assets to the vulnerable, or to individuals uneducated or disinterested in the financial markets, or to the very young or the extremely old, then more than a will is required, and a trust is the logical extension of a will.
A trust can be as simple as a bank account registered to me as trustee for my son. Ordinarily, this bank account will be at my disposal during my lifetime, and it will pass to my son when I die. This simple trust will be included in my estate for estate tax purposes, if my estate exceeds the estate tax exemption.
A trust can also be created by a simple document of one sentence appointing my daughter, my son, or anyone else I choose, trustee. This trust document too will take care of me during my lifetime, and it will pass the “trust assets” on to my beneficiaries when I die. If the trust specifies that it is to pass to my 3 children when I die, most states will leave the trust assets to my 3 children equally. If one of my 3 children dies before me, leaving 2 children of his own, in most states these grandchildren will receive their parent’s 1/3 share. This is a “per stirpes” distribution favored by the common law and most states, unlike a “per capita” distribution, which would leave 1/4 to each of my 2 surviving children, and 1/4 to each of the two grandchildren in my example.
A trust can also be a more complicated agreement spelling out in great detail what I am to get from the trust during my lifetime, and what my family is to receive at my death. Lawyers are sometimes accused of getting paid “by the page”, since often a fairly uncomplicated trust will run 20 to 40 pages in length. You should not be frightened by the length of a trust, since generally every one of the numerous paragraphs in a trust will keep you out of court, or out of trouble.
A trust can give you and later your beneficiaries the right to take the assets in the trust on demand, but often a trust will put limits on the beneficiaries’ access to trust assets. Our next several chapters are devoted to the reasons individuals put restrictions on beneficiaries' right to take money out of a trust. Restrictions are generally designed to keep assets from those three dreaded enemies of the people: the tax man, the probate judge, and, most dreaded of all, the in-laws, both sons-in-law and daughters-in-law.
Chapter 2. Trusts, Estate Taxes,
and The First Variable in a Trust: Trust Distributions
Before approaching an attorney about an estate plan, it is useful to have in mind a broad outline of how a trust should be structured.
In structuring a trust, there are two major variables you control. In this chapter, we discuss the first variable, the distribution of trust assets; and in Chapter 3, we will look at the second variable: the management of assets in trust. The terms for distribution of trust assets are often dictated by tax considerations, and we will discuss this issue in this chapter first, so this chapter will have a heavy emphasis on taxes; in Chapter 3 we will discuss the investment instructions most often given in a trust document, and we will discuss there and in Chapter 7 how you should go about the process of choosing a trustee.
Trust Distributions
The first major responsibility of a trustee is the payment of funds from the trust. These payments can be a matter of following a clear direction in the trust instrument, or they can involve tremendous latitude given the trustee.
Recall from Chapter 1 that you can create a trust instructing the trustee to pay the trust assets back to you upon request. Further, a trust can be just as open for other beneficiaries, requiring the trustee to pay funds to a surviving spouse, or children, or other beneficiaries on request. Trusts more often leave a trustee with discretion over payments to a spouse or children for tax purposes; or for personal reasons such as a worry about ability to manage money, a concern about the reach of another husband or wife, or the need for control where a divorce is likely on the horizon.
Often, though, a trust is created with a primary focus on estate taxes. The Federal government is quite generous in allowing assets to pass from one spouse to the other: any asset of unlimited value, is allowed to pass to a surviving spouse with no Federal estate tax. Most states now follow the Federal rules, although there is a discussion of state estate taxes in the back pages of this book, in Appendix A.
There is a trap for the unwary in the tax law's apparent generosity to a married couple. The trap lies in the tax assessed against a single person's estate, often a surviving spouse. A single person's estate pays a tax in the 45% to 50% range on all assets in excess of the following sum:
Tax Free Sum
|2002 |$1,000,000 |2006 |$2,000,000 |
|2003 |1,000,000 |2007 |2,000,000 |
|2004 |1,500,000 |2008 |2,000,000 |
|2005 |1,500,000 |2009 |3,500,000 |
Although estate tax repeal is slated for the year 2010, this repeal must pass the Congress again to take full effect. It is our sentiment that you should plan your affairs assuming this repeal will not occur.
The Estate Tax
The following shows these rules in practice. Note that you can leave your spouse your entire estate with no federal tax at all. At the surviving spouse's death, though, this second estate is taxed as the estate of a single person often resulting in a substantial tax before the estate passes to heirs!
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Assets in Trust Save Estate Taxes
The following exhibit provides a contrast to an arrangement leaving all assets from one spouse to the other. This Trust B in a trust agreement might be labeled a Bypass Trust, or a Family Trust, or a “Credit-Shelter” Trust; but for our purposes, we will refer to Trust B as a Bypass Trust.
The facing page shows the impact if the first spouse dies after the year 2006.
THE YEARS 2002 and 2003
$1,000,000 Exemption
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An Additional Example
THE YEAR 2006 to 2008
($2,000,000 exempt)
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Once the second estate reaches the estate tax exemption, every $1,000,000 added to the second estate increases the estate tax on the second estate by $450,000 to $500,000. Notice, though, that assets up to the estate tax exemption left in a Bypass Trust are tax free in the first estate of a married couple, but the essence of a Bypass Trust is that assets left to the Bypass Trust are tax free again in the estate of the surviving spouse. In the following pages we describe your options in structuring a Marital Trust and a Bypass Trust.
A BYPASS TRUST
A properly drawn Bypass Trust left by one spouse for the other will avoid all tax on the assets in the Bypass Trust at the second death. There is a limit to the amount an individual will want to leave to a Bypass Trust, and this limit is generally the amount of the estate tax exemption ($1,000,000 in 2002 and 2003, more later). While more can be left to a Bypass Trust, the excess over this exemption will pay estate taxes, so typically no more than the exemption will be left to a Bypass Trust. As the exemption increases, this increasing limit is the amount to leave to a Bypass Trust.
The Terms of a Bypass Trust
A Bypass Trust can be so generous in its terms that it almost amounts to an outright gift; or it can be restrictive enough to assure that payments will only be made in specified circumstances.
A Generous Bypass Trust
A Bypass Trust can direct a trustee to be very generous with the trust's assets. A Bypass Trust can provide a spouse with all of the following benefits, and still avoid a tax at the spouse's death:
1. all income to the spouse
1. the right of the spouse to take 5% of the capital each year
2. the ability of the trustee to pay additional sums for all the comforts and luxuries of life
3. the right to change the trustees within limits
4. the ability to change the ultimate beneficiaries of the trust
These terms are about as generous as an individual can be with a spouse and still avoid tax at the spouse's death.
Notice #3 gives the trustee discretion to pay funds for “comforts and luxuries” of life. This phrase or others like “to maintain the same comfortable standard of living we enjoyed just prior to my death”, or similar generous instructions can only be included in a Bypass Trust where there is an independent trustee, generally a bank, a trust company, or another professional trustee.
As an alternative, a trust can name a surviving spouse sole trustee of a Bypass Trust, or it can name children or other close relatives trustees. With these “nonprofessional” trustees the trust must limit the surviving spouse’s right to principal to “comfort, health and maintenance”, or similar words. While these words seem to limit payments to the spouse, presumably if it is the spouse who decides what is paid, these words in fact may broaden the spouse’s access to funds.
Family members as trustees, though, tend to rely heavily on lawyers to help sort through trust issues, and this can get expensive. Family members sometimes also let paperwork slide, and the Bypass Trust will only be tax free in an estate if the trustee behaves like a trustee. Family members as trustees are almost always in conflict when another husband or another wife comes on the scene. For all of these reasons, a competent professional trustee is generally a better choice for a Bypass Trust. There is more on this issue later, in Chapter 7.
A Restrictive Bypass Trust
A Bypass Trust can also direct a trustee to exercise more control over the trust's assets. In fact, if the trust is likely to benefit college-age children, the Bypass Trust can instruct the trustee to pay both the income and principal to a spouse, children, and even grandchildren in the trustee's discretion. With this discretion, a trustee paying $40,000 from income for a child's tuition, offers a family income tax benefit. This $40,000 paid to a child over age 14 as a discretionary payment is taxed at the child's presumably low income tax bracket rather than his parent's higher bracket.
Aside from this income tax benefit, often an individual seeks to leave assets more in the control of a trustee for personal reasons. An individual may feel the spouse will have sufficient assets without the Bypass Trust, or an individual may just want the children to benefit prior to the death of the spouse. A discretionary Bypass Trust can be tailored to meet these personal demands.
In a Bypass Trust, you can specify any terms between the extremes of the very generous trust and the restrictive trust. You can exclude your spouse completely from a Bypass Trust (although your spouse can “waive the will” and still receive estate assets if you seek to deprive your spouse of too many rights); a Bypass Trust can exclude the children and benefit only your spouse; it can benefit your spouse, but provide that your spouse loses all benefits in the event of a re-marriage; and it can specify priorities, e.g., a spouse as your primary beneficiary or the children's education taking precedence, etc.
Summary of Bypass Trust Benefits for a Married Couple
A Bypass Trust, then, of as much as $3,500,000 in 2009, will be free from federal tax on the death of a married individual; at the death of the second spouse, it is also free of both state and federal tax, saving as much as $1,700,000 of estate tax. Incidentally, if the Bypass Trust grows in value after the death of the first spouse, all of this growth is also free from tax in the second estate.
An older Bypass Trust
If you have a Bypass Trust in place, don’t get too complacent thinking you have everything in order. You will want to review your Bypass Trust to determine if you are the client out there whose situation I remember well, but whose name totally escapes me. This client left his $3,000,000 estate as follows: my estate tax exemption passes to my Bypass Trust and the rest of my estate passes to a Marital Trust for my wife. He arranged his Bypass Trust for his kids alone, on the assumption that his wife would have plenty of assets in her Marital Trust.
He developed this plan way back in the 1990’s when the estate tax exemption was between $600,000 and $675,000. With an estate tax exemption of $600,000, this sum would have gone to his Bypass Trust for his kids, but now as the exemption increases, the amount passing to the Bypass Trust increases. In fact, his wife better wish he doesn’t live to the year 2009, because in 2009 the estate tax exemption will be $3,500,000, and his kids will get his entire $3,000,000 estate in their Bypass Trust, and nothing will pass to his wife’s Marital Trust.
This is not a huge problem for most individuals who have a Bypass trust, because typically the surviving spouse benefits from the Bypass Trust. Note that the situation I describe here is one where the kids are the sole beneficiary of the Bypass Trust, and this creates the disaster scenario presented here.
If this is your trust, run don’t walk to your lawyer. No, better still walk to your lawyer, we don’t want you to have an accident on your way.
A Bypass Trust if you are Single
If you are single, you may find the benefits of a Bypass Trust just as compelling, when leaving assets to your sister, a friend, or a parent. It may be silly to leave $1,000,000 to your sister in her 70's who already has $2,000,000. You are setting up her estate to pay an estate tax approaching $450,000 on your $1,000,000 left to her. If you leave your $1,000,000 to a Bypass Trust for your sister, her estate will pay no estate tax, so long as her assets remain under the estate tax exemption.
A MARITAL TRUST
Remember, the estate plan we are describing here is one in which the estate tax exemption passes to a Bypass Trust, and the rest of your assets pass to a "Marital Trust". For a married individual, the tax law makes it very attractive to benefit the surviving spouse with assets. If assets in excess of the estate tax exemption are left to any individual other than the spouse, these assets will be taxed. If these assets benefit the spouse, they will pay no federal tax. The question, then, is how should property best be left to a surviving spouse outright, or to a Marital Trust.
An Outright Bequest
Leaving assets outright to a surviving spouse is the simplest way to have property pass free of federal tax. The advantages are obvious and this is the right choice for a spouse who is able, interested, and willing to undertake an investment program. For individuals who may need help, though, or if you want to exert some control over assets, a Marital Trust (Trust A on our prior exhibit) may be helpful.
Assets are often left outright to a spouse, aside from your will or trust. For example, if I have a Marital Trust which restricts my spouse’s rights to take my assets on demand after I am gone, I may die happy, knowing that I have left my affairs in good order. If, however, my spouse is beneficiary of my life insurance or my IRA, these assets will pass to the spouse no matter what my will says, and if these are my predominant assets, I may have wasted my time drafting a trust. The life insurance and IRA will pass to the beneficiary, no matter what my trust says.
Assets in joint names with a spouse will also pass to the spouse irrespective of the terms of your will. In naming a spouse beneficiary, or in placing assets in joint names, remember that these assets pass to the spouse, and deflect assets away from your trust. If you want and IRA or insurance to come to your trust, the trust must be named beneficiary.
Often individuals will name a trust beneficiary of these plans, and then move onto a new job. Sure enough, in the first few days of the new job beneficiary forms are thrust in front of the new employee. A natural reaction is to name a spouse beneficiary of these plans, even though in the old job, you went to great pains to assure that these plans passed to your trust by beneficiary designation.
A Generous Marital Trust
If the assets are not left directly to the spouse, thet are most often left as a Marital Trust. A Marital Trust can be established to give a trustee the responsibility to manage assets left to the trust at death. This trust can give a surviving spouse the right to remove the trustee at will, and it can further give the spouse the right to take all Marital Trust assets at any time with no restrictions.
A Restrictive Marital Trust
A Marital Trust can also put limits on a surviving spouse. In fact, assets left to a Marital Trust are tax free even if the trust provides the spouse with no further benefit than the right to income, and assurance that assets in the trust will generate a reasonable income.
A Common Restrictive Marital Trust: The QTIP Marital Trust
More typically, a restrictive Marital Trust will provide a spouse with all income and with principal in the discretion of the trustee. Since this form of trust by Internal Revenue Service definition creates Qualified Terminable Interest Property, property left in this manner is called QTIP Marital Trust property. A QTIP Marital Trust has just about the most restrictions attached to it as possible, while still assuring that the trust is tax free because it qualifies for the IRS’s “marital deduction”.
Often a Marital Trust will have two components: a Marital portion, giving a spouse the right to take funds at will; and a QTIP Marital portion, limiting the spouse's right to demand principal. A QTIP Trust is very common in a second marriage, providing a second spouse with income for life, and principal as it is needed, but with the assurance that the QTIP property will ultimately pass to the children of the first marriage.
A QTIP Trust assures that at the first death, the assets will be available to the surviving spouse, and nobody but the surviving spouse. A QTIP Trust also can assure that at the second death, the assets will not pass outside the family.
A QTIP Trust says to a spouse “I’m going to leave assets for you for your lifetime, but I’m leaving these assets in a trust because I want the assurance that these assets will pass to our kids, or to our nephews and nieces, or to our favorite charities when you are gone. If you remarry, you will still benefit from the trust, but assets will not be available to a new spouse if you remarry, and they will not be there for the new spouse’s kids, or their problems, or for financial difficulties this spouse may encounter….”
Your QTIP Trust will use words much different from these words, but this is what the words boil down to. The QTIP Trust terms just outlined in quotations sounds very noble, “…if you remarry you will still benefit from the trust…”, and it’s nice that it sounds noble, and it may leave a surviving spouse weepy because it sounds so caring, but in fact the rules say that if your trust disinherits your spouse on remarriage, the trust will not qualify for the marital deduction, and is thereby taxed in the first estate.
A Marital Trust cannot terminate on remarriage of your spouse, and it generally must pay its income to a spouse, but a QTIP Trust can tell the trustee to follow a new course on remarriage, something like:
“During the lifetime of my husband, principal is to be paid to my husband for all the comforts and luxuries of life while he remains unmarried. If my husband remarries or lives with another women either periodically or for extended times for a period in excess of 30 days after I am gone, and if this becomes known to my trustee, my trustee is to pay funds for my husband’s health, welfare, and education for the remainder of his lifetime.” In other words, make him pay for marrying the little creep. Be a little careful here, though, because if this term is built into your trust, chances are a similar term will find its way into your spouse’s trust, too.
There are 5 other things to observe about a QTIP Trust:
1. “What’s good for the goose, may not be what’s good for the gander”. You may have a QTIP Trust built into your trust with the language just discussed, and your spouse may have the same language in a QTIP Trust for you. Assume for the moment you are the woman in the relationship, and you have gone to great pains to build this QTIP Trust language into your estate plan to protect your assets from the reach of a new wife if you die and your husband later remarries. Assume there is $2,000,000 in your name, and you die in a year when the estate tax exemption is $2,000,000. How much will then come to your QTIP Trust? Zero, because the entire $2,000,000 in your name will pass to your Bypass Trust. A Bypass Trust receives assets up to the estate tax exemption, before a Marital Trust gets any assets.
2. Assume now that the husband in this relationship is the first to die, again in a year when the exemption is $2,000,000, but assume there is $5,000,000 in his name. Even though both husband and wife have identical language in his and her trusts, because he has more assets in his name, his assets will pass $2,000,000 to his Bypass Trust, and $3,000,000 to his QTIP Trust. So you see, it matters how much each spouse has in his and her name, before “what’s good for the goose, is good for the gander”.
3. Now, assume that his $5,000,000 is represented by $2,000,000 in stocks, $3,000,000 in an IRA, and additionally, assume you own a home worth $1,000,000 in joint names. What’s going to come to his trust now? Well, the $2,000,000 in stocks will come to his trust, because an estate plan generally leaves assets in his name to his trust. This $2,000,000 will go to the Bypass Trust. That’s good, because the $2,000,000 will be tax free in his estate absorbing his $2,000,000 estate tax exemption; and the Bypass Trust will be tax free again in your estate. The key question, though, is who receives the IRA and the home?
4. The IRA will pass to the IRA beneficiary. If the beneficiary is the surviving spouse, the IRA will pass to the spouse. So, even though the husband in our example arranged a QTIP Trust, thinking he was protecting his assets from another husband, if the trust is not beneficiary of his IRA, the QTIP trust is wasted effort. IRAs, life insurance and annuities pass right to the beneficiary of the IRA, or to the beneficiary of the insurance or to the beneficiary of the annuity contract, no matter what a will or trust says. If the husband in this case wants his IRA to come to his QTIP Trust, he needs to name the trust beneficiary.
5. The home in joint names will also pass spouse to spouse and not to the trust, no matter what their respective wills and trusts provide, because joint property passes right to the joint tenant, no matter what a will or trust says.
Discretion for Personal Reasons
To this point, our emphasis in arranging your trust has been on taxes, but totally aside from tax issues, you may want to leave a trustee with discretion for varied personal reasons. Trusts can protect a spendthrift, they can insulate a beneficiary (other than the person creating the trust) from creditors, and they can keep trust assets away from the in-laws.
Discretion can be very arbitrary, or it can leave the trustee with broad powers of distribution, and the turn of a word can dictate the trust's mandate. We mentioned earlier that “...all the comforts and luxuries of life...” has a totally different meaning than “...health, education, and general well-being.…”. These are two fairly standard clauses giving a trustee discretion, but the first choice allows a trustee to make liberal distributions, while the latter phrase directs the trustee to adopt a more conservative approach.
Discretion can also be left with a trustee when a spouse or a child has a disability. Professional trustees often go to extraordinary limits to assure the well-being of an individual with “special needs” or an elderly beneficiary: doing whatever is needed to keep this individual comfortable in his or her own home if this is appropriate given all the circumstances; or in the alternative, assuring the maintenance of government payments if this is the more appropriate course, with a given amount of money, with input from the family, and with appropriate language in a trust instrument.
Chapter 3. Generation-Skipping
Most individuals I have dealt with over time want their children to receive their assets when they are gone, perhaps at ages when the children are expected to be mature enough to handle large sums of money. So most trusts leave assets to children in trust with a trustee charged with paying funds as the children need money, and then giving the children the right to take their inheritance on demand at staggered ages. When the children are teenagers, most parents want these ages staggered at ages 75, 85, and 95, but when the children begin to return to the human race in their 20’s, trusts give the kids the right to take their inheritance on demand, something like 1/3 @ 25, 30, and 35. These ages may be lengthened for a large inheritance, and there may be only one age if the inheritance is small.
When the issue is thought through, most parents also want to hold back something so it is there for their kids, but also with the assurance that it will be there for their grandchildren. This is most critical to grandparents when the grandchildren are young and cuddly, between newborn, and their pre-teens.
A “generation-skipping trust" can leave funds for children and grandchildren for the life of the children. It can specify that the trustee of the generation-skipping trust can pay funds as the trustee sees a need among all of the beneficiaries; it can mandate that the funds are to be used for the grandchildren’ education, and then for the childrens’retirement when the grandchildren are educated; it can exclude the children completely, on the assumption that the children are already getting their inheritance; or it can exclude the grandchildren during the lifetime of the children, but still leave assets in trust for the lifetime of the children.
Assets left in trust for children are "generation-skipping trusts". Most of the great trusts created over the past century were built on the concept of generation-skipping. The Rockefellers, the Morgans and the Kennedys placed assets in trust, and the trust assets passed estate tax free through several generations. Today, though, because of generation-skipping rules built into the tax code Bill Gates, or Donald Trump creating a trust for grandchildren will have to make the U.S. Treasury an equal beneficiary with the grandchildren upon the death of their own children.
The federal estate tax generation-skipping rules provide that assets will be taxed at a flat rate when they pass to your grandchildren in a plan you create today. The flat rate is the maximum estate tax rate, likely 45% to 50%. This is so if you leave the assets directly to your grandchildren; or if the assets are left in a trust for the grandchildren; or if you are not careful, even when you leave the assets in trust for your children, and they pass on to the grandchildren at the death of your children.
A client of mine went to a lawyer to draft an estate plan, and this lawyer turned to an estate planning expert to draft his trust. The client had a $100 million estate, and he told his lawyer he wanted 1/2 to pass to his son and daughter, and the other 1/2 was to pass to his grandchildren. The "ghost-writing" estate planner, did exactly as he was told. If the client died leaving ½ to his children and ½ to his grandchildren, there would have been a $50 million estate tax paid, leaving about $25 million to his kids and about $25 million to the grandchildren. The $25 million left to the grandchildren would pay an additional $12 million generation-skipping tax! Of the $50 million left to the grandchildren, the following distribution is made:
$37 million goes to taxes, and
the grandchildren receive $13 million
In the end, the children would not have borne the generation-skipping tax, because they would have recovered it from the lawyer's malpractice coverage. The lawyer claimed he had no idea how much the client was worth, but of course, this is a paramount obligation of an estate planning attorney. Our client did much better in the end, leaving his assets at death to his children in a way that will see the assets taxed at the children's death before they pass to the grandchildren. This will not avoid estate tax, but it will avoid the confiscatory generation-skipping tax, and it will delay a second tax until the childrens’ death, giving the children the ability to make gifts and spend and invest the funds that would have gone to the tax man as the plan had been drafted.
Generation-skipping applies not only to assets passing to grandchildren, it applies when assets pass to any individual whose age is about the age your grandchildren would be, whether or not you have grandchildren! A wealthy octogenarian tycoon leaving assets to a 21 year old "friend", likely has generation-skipping problems to add to an already complicated lifestyle.
Avoiding The Generation-Skipping Tax
To ease the harsh impact of the generation-skipping double tax, Congress granted a $1 million “generation-skipping tax exclusion.” It is important to note, though, that this exclusion is different from the estate tax exemption. The $1 million generation-skipping exclusion has no effect on the estate tax at your death; rather, it avoids an additional generation-skipping tax in the 50% range on assets left to your grandchildren. It also avoids the generation-skipping tax at the death of your children on assets left in a generation-skipping trust for the children and grandchildren.
The diagram on the facing page highlights the advantage of the $1 million generation-skipping tax exclusion. The diagram shows that you can leave $1 million in trust for your children and grandchildren: a generation-skipping trust.
This $1 million generation-skipping trust will escape estate tax and generation-skipping tax at your childrens’ generation. The grandchildren will get the $1 million free of tax when their parents die. You also gain the assurance that the trust will pass to your grandchildren when your son or daughter dies, rather than to your daughter-in-law or son-in-law.
There are seven other considerations to keep in mind:
These generation-skipping rules apply equally well to assets left to nieces, nephews, grandnieces, great-grandchildren, younger friends of the family, etc.
the generation-skipping trust can continue for your grandchildren, and perhaps for your great-grandchildren and beyond, often with no tax at the death of your children and your grandchildren.
a married couple has the ability to leave $2 million in a generation-skipping trust, so long as each spouse has $1 million in his and in her name.
the $1 million generation-skipping exclusion is “indexed”, so slightly more than $1,000,000 can be left to a generation-skipping trust. In 2003, $1,100,000 could pass to a generation-skipping trust.
After 2004, the generation-skipping exclusion will increase in tandem with the estate tax exemption, so in 2004 the exemption is $1,500,000 and in 2006, the exemption will be $2,000,000. This means that in 2006, if you have an estate of $10 million, there will be an estate tax of about $4 million (@ about 50% on all but $2,000,000). If you then leave $2,000,000 to a generation-skipping trust, this $2,000,000 will be tax free in your kids' estates. That's what generation-skipping is all about: after estate taxes are paid in your estate, $2,000,000 can be left in trust for your children and your grandchildren, which sum will be tax free in the estates of your children. If you are married, $4,000,000 can be left in a trust for your children after 2006, and this trust will escape estate tax in the estates of your children.
After 2004, generation-skipping gifts during your lifetime get a little more complicated. Assume you are widowed, and you want to make a $3,000,000 gift (during your lifetime!) to a trust for your children and grandchildren, after 2004 when the estate tax exemption is $1,500,000, the generation-skipping exclusion is $1,500,000. As we will see shortly, after 2004, the estate tax exemption rises, but the gift tax exemption stalls at $1,000,000 for the foreseeable future. Your $3,000,000 gift will still face an almost $1,000,000 gift tax. The remaining $2,000,000 gift will be free from generation-skipping tax up to the $1,500,000 generation-skipping exclusion, but there will be a generation-skipping tax at almost 50% on the $500,000 not covered by the $1,500,000 generation-skipping exclusion.
Perhaps leaving $ 1 million in a generation-skipping trust is just right for you, but leaving $4 million in a generation-skipping trust after 2006 is too much, much more than you would like to leave in a generation-skipping trust. You want to be sure that your trust doesn’t have words like “…the maximum generation-skipping exclusion remains in trust for my children and grandchildren…”, because if you have language like this in your trust, $4 million will stay in trust for your children and grandchildren if you die after 2006, and your children may get no inheritance outright from you.
GENERATION SKIPPING
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Generation-skipping and a Corporate Trustee
In reviewing trusts, I have often seen a trust created by an individual intent upon leaving $1 million to a generation-skipping trust. Again, this trust is not designed to save taxes at the death of our client or at the death of the client's spouse. A generation-skipping trust is designed to take advantage of the provision in the tax law permitting a client to leave $1 million in trust for the lifetime of the children, and even the grandchildren, with no further estate tax beyond the client's generation. As we have just seen, this exemption will be increasing over time, as follows:
2004. $1,500,000
2006. $2,000,000
2009. $3,500,000
Most professional trustees welcome a generation-skipping trust in any form appropriate to a family's circumstances. The creativity of the family's attorney drafting a client's trust is welcomed. Often overlooked, though, is how a generation-skipping trust is best structured for ease of trust administration, when the parents are flexible about their arrangements.
To the degree a generation-skipping trust can be held as one fund, this is often to the family's advantage. When a trust is divided, a $1 million trust for several children generally bears a separate trustees' fee against each share. The family never takes advantage of fee efficiencies inherent in a larger trust.
A larger trust protects the family against inflationary forces which put pressure on smaller trusts: higher minimum fees, escalating minimum fees for individually invested accounts, and capital insufficient for proper diversification.
From the perspective of administering a trust, ideally a generation-skipping trust in the $1 million range would be held as one fund to keep the $1 million intact, and the trust might provide the following:
1. Income to the children equally
2. Principal payments can be made for any purpose, but only with the consent of all children
3. On the death of one child, the child's share continues for his or her children, with income paid equally to children of age, but in the discretion of the trustee for younger children.
With both parents using their generation-skipping exclusions and with the generation-skipping exclusion increasing, more flexibility is gained by keeping a generation-skipping trust as one fund, rathere than several small funds. A $2 million trust can meet the divergent needs of many family members, and with the length of time of the average generation-skipping trust, even a $2 million trust kept intact for 25 years or more may provide for several family emergencies or education funds.
Planning Around the Generation-Skipping Exemption
So, what do you do with this $1 million exemption. You generally can consider any one of four steps, each slightly more complicated, each somewhat more costly in the first instance, and each much more beneficial in the long-run.
• The first step is a provision in your trust which says that at your death a sum up to the maximum generation-skipping exclusion will remain in trust for the lifetime of your children, and which will pass at their death to your grandchildren. This maximum exclusion is $1,000,000 increasing in 2004 to $1,500,000 and in 2006 to $2,000,000. Once the estate tax is paid at your death (or the death of your spouse), the trust assets will never pay another estate tax. This trust can even continue for your great-grandchildren: trust law stipulates that a trust must terminate eventually, but the trust can continue at least through the lifetime of all of your heirs alive at your death, plus another 21 years. This is an old rule, now modified in some states (Maine, Delaware, Rhode Island and others) to allow trusts to go on even longer, but generally a 90 year term is about all the federal government will allow for tax favored treatment for a generation-skipping trust.
• One step beyond this transfer at death, is a gift to a generation-skipping trust during your lifetime in an amount less than $1,000,000. If the gift is less than $1,000,000, and if you have never made substantial gifts in the past, this gift is free from gift tax, free from estate tax and free from the generation-skipping tax. You should note, though, that this $1,000,000 gift, like any gift to an individual over $11,000 will, in effect, come back into your estate when computing your estate tax at death. The advantage to the gift is the removal of future income and appreciation of the gifted property from your estate, and from your childrens' estates, and maybe even from your grandchildrens' estates, with further exemption of the entire sum from generation-skipping tax. If you are married, both you and your spouse have a $1,000,000 exemption you can use in this manner.
• A further step is a gift during your lifetime of a sum greater than your $1,000,000 gift tax exemption to a generation-skipping trust. With this trust, if you have never given substantial gifts in the past, $1,000,000 of the gift will be tax free as in the last example, but you will pay a gift tax on the remainder. Here again, the two advantages to this gift in your estate is the removal of growth on the $1 million from your estate, and the removal of the gift tax resulting from your gift.
• Jacqueline Onassis Kennedy created a trust which provided for income to be paid to charity for a number of years. After the charity receives income through these years, the trust will pass to her grandchildren. Her trust looked something like this:
At my death, set aside $5 million in trust
The trust is to pay 7% a year to charity for 20 years
Mrs. Onassis specified the charities
After 20 years, the trust benefits the grandchildren and charities are no longer involved
This was $5,000,000 set aside in this “Charitable Lead Trust”, but the value of the gift to charity, determined by IRS-blessed tables, was $4,000,000. The gift to charity is today’s value of the $350,000 annual payments to charity over 20 years. The value of the gift to the grandchildren at Mrs. Onassis death was $1,000,000, today’s value of the right to receive $5,000,000 but waiting 20 years to receive it. This trust was designed to make the value of the trust in Mrs. Onassis' estate the following:
Gift to charity = $4,000,000 (the value of $350,000 payments for 20 years)
Gift to grandchildren = $1,000,000 (the value of $5,000,000 less the value of 20 payments to charity)
Mrs. Onassis’ was creating a Charitable Lead Trust but we are told her Charitable Lead Trust never came into existence, since she gave away funds to other individuals (mostly family) and charities, so there was nothing left for the Lead Trust.
What she was attempting though, was to leave much more than $1,000,000 to her grandchildren. With the Lead Trust, her grandchildren were to receive a trust worth $5 million in 20 years, plus any growth in this $5 million over the 20 year period. The trust then might have gone on for future generations, even after her grandchildren were gone.
One last point to consider relative to Jacqueline Onassis’ will. We only know the terms of her will because she spelled out things were to be left in her will. We will see in Chapter 5 that anything you spell out in your will is subject to probate, and anyone can read your will. Most individuals who are well-known in the community have very short wills, leaving their assets to a living trust, since the living trust is private and only those authorized can read a trust, usually the trustee and the family. Any of the following are reasons Jacqueline Onassis’ will spelled out so much for us all to read:
1. She just did not know or care that a trust assured privacy and that nobody can read your trust, so nobody knows your business when your disposition of assets is spelled out in your trust; or
2. She wanted us all to know the terms of her will, which was very generous to her family, and very generous to charity; or
3. Her lawyers wanted the world to see the wonderful creative work they did for her, and it would have been a shame to hide all these creative planning tools in a private trust, when they could be exposed to millions of people in a public will.
Note that the benefits to a generation-skipping trust described above are not add-on benefits: you can choose one of these four alternatives, but if you use more than one, each step will result in a further gift or estate tax. You should also note two other possibilities. First, $11,000 outright gifts to grandchildren are not subject to generation-skipping taxes, and this is true of a $22,000 gift if your spouse joins in the gift.
Further, when we describe a $1,000,000 exclusion from estate tax and a $1 million exemption from generation-skipping tax, notice that we indicate that you can double these numbers if you are married. To take advantage of your spouse's $1 million exemption in your estates, your spouse must have at least $1 million in the spouse's sole name to use the spouse's exemption. As the generation-skipping exclusion increases, if you want to take maximum advantage of the increased limits, both spouses need assets up to the increased limits in his and in her name.
To take maximum advantage of the generation-skipping limits, each spouse must either leave assets to the grandchildren, or each spouse must have a trust which will eventually be there for the grandchildren. This is less important if the spouse with less assets is expected to survive you, but the spouse's generation-skipping exclusion is lost forever if a spouse dies first without both a trust created by the spouse and the following sum in the spouse's sole name:
before 2004, $1,000,000
after 2004, $1,500,000
in 2006, $2,000,000
in 2009, $3,500,000
Although it is hard to feel too badly for the effect the generation-skipping tax will have on Donald Trump's empire, individuals with substantially less wealth than The Donald and the present love of his life, can be hurt considerably by leaving assets to younger generations. Conversely, the $1 generation-skipping exclusion should be used wisely, if passing assets on to future generations is important within your family.
Chapter 4: The Second Variable in a Trust: Trust Management
Until now, we have been discussing the first of two substantial duties left with a trustee under a trust agreement, deciding how trust funds are to be paid under instructions laid out by the trust’s creator.
The second major responsibility of a trustee is the management of trust assets. Trusts can be managed any way you choose, but typically trusts give a trustee broad discretion over funds. Professional trustees given this discretion, will usually invest in a mix of stocks and municipal bonds, treasuries, and money market instruments. Generally, trustees are required to invest either as a “prudent man” would invest his own funds, or in certain circumstances trustees may be held to another standard of investing, and the trustee can be held accountable to the court if the applicable standard of care is violated.
If you are giving a trustee discretion, you want to assure the trustee’s integrity. Newspapers are full of stories about trustees running off with trust assets, and the individuals entrusted with money were always “the nicest person”, “a pillar of the community”, and “this is the last person you would ever expect to run off with a client’s money”. Often the Bentley in the driveway of the mansion is a clue, but sometimes we look the other way.
To insulate yourself from these predators, you want to be sure your trustee has “deep pockets” so that if funds disappear, your trustee can cover your losses.
Trustee's Discretion Over Management of Assets
A trustee can be given less than broad discretion, also. Occasionally, a trust will mandate that a trustee is to invest, for example, in U.S. Treasuries only. Often a trust will dictate that a trustee is to hold the family residence or other real estate in trust for a spouse or for children. With a family business, an owner leaves a company in peril without instruction and guidelines relative to the business' retention, management and/or sale.
The following page shows a typical mix of assets when a professional trustee has discretion over the management of trust assets. A professional trustee allocates assets among investment categories; and within these categories, a trustee can be very conservative or fairly aggressive, depending upon your investment goals and income needs.
Investment categories are generally a mix of the following: stocks, bonds and money market instruments. On our exhibit drawn from a professional money manager’s asset allocation, the money manager refers to stocks as “equity” and money market instruments as “cash reserves”.
Stocks involve ownership in companies, and that is the reason they are sometimes called equities, since you have an ownership in a company, or an “equity stake”. The term “equity” is used also because you sound so much smarter when you have an “equity position” rather than a “stock portfolio”, but both mean the exact same thing. Stocks pay small amounts of income, but in good markets they grow in value. Stocks doubling or tripling in value over a generation are not unusual. Stocks also come with a risk, though, if companies lose value in a “bear market”. A trustee might buy individual stocks, or a trustee might buy stock mutual funds, where your investment is pooled with other stock investors.
When a trust invests in bonds, you do not become an owner of a company, but rather your trustee lends your money to a company. With a bond, a company takes your $10,000 and promises to pay you back your $10,000 at a later date, but with interest payments made over the term of the bond. So, if $10,000 is lent to General Motors @ 6% over 20 years, your 20 year bond will pay you an assured 6% over this time, as long as GM remains in business. Bonds can grow in value: if interest rates on new GM bonds drop to 4%, you will have made a smart investment owning a 6% bond, and Wall Street will offer you more than $10,000 for your bond if you want to sell it. Bonds can decline in value, too: if GM becomes a troubled company, for example; or if new GM bonds sell for 8% because interest rates rise, nobody will want your 6% bond, so you will get a statement from your trustee showing that your $10,000 bond is worth less than $10,000.
Bonds can be bought in $10,000 denominations, or you can buy a $100,000 bond, or even a $1,000,000 bond. A trustee might buy individual bonds, or a trustee might buy bond mutual funds, where your investment is pooled with other bond investors, and this might be to your advantage, since there might be a higher interest rate and a lower commission on a $1,000,000 bond than the rate and commission on a $10,000 bond.
There is one other thing you should know about bonds. When bond rates rise from 6% to 6.2%, we have seen that the value of your 6% bond drops, since an investor would be crazy to pay you full price for your bond, when the investor can get a brand new bond with a better return than yours. If your bond is short-term (say 5 years) the fluctuation will not be very much with so short an increase in rates. If your bond is longer term, losing a small amount of income over 20 years can amount to a lot of lost income, so your long-term bond will drop a lot when interest rates rise.
Incidentally, when you are discussing your bond portfolio at a party, you do not want to tell your friends that bond rates have increased 2 percentage points, when rates increase from 6% to 6.2%. In the investment business when rates increase from 6% to 7%, this is an increase of “100 basis points”, and when rates increase from 6% to 6.2%, this is an increase of “20 basis points”. This label for rate increases or decreases was developed because technically when rates rise from 6% to 6.2%, this is not a 2% increase, it is about a 3% increase, so “20 basis points” is not only technically correct, again, “experts” sound so much smarter when they describe a 50 basis point increase in rates.
In addition to stocks and bonds, trustees invest smaller sums in money market instruments. Money market instruments are akin to bank accounts but generally without FDIC insurance. They pay lesser amounts of interest than bonds, and here your money is loaned out to companies for their short-term needs. Money-market funds do not fluctuate in value if they are invested in safe companies looking for short term funds. A trustee might buy individual money market instruments, or a trustee might buy money market mutual funds, where your investment is pooled with other money market investors. In our Asset Allocation summary, money market holdings are described as “cash reserves”. A trustee will want to hold a money market position to reduce fluctuations in stock or bond holdings; or as a temporary holding, anticipating better conditions to buy stocks or bonds later; or as a place to hold funds anticipating a large tax payment due April 15, or a new car or home purchase by a beneficiary, or just to have cash on hand to meet a family’s everyday income needs.
A trustee might also substitute U.S. Treasury bonds or U.S. Treasury money market instruments for corporate bonds or money market instruments. With treasuries, you do not worry about the government going out of business, but a long-term treasury bond can lose value if interest rates on new bonds are greater than the interest rate on your bond. Treasury bonds and money market instruments pay no state income tax on their income.
A trustee might also substitute municipal bonds or municipal money market funds for corporate bonds or corporate money market funds. With municipals, you are lending money to states, cities and towns, and local “authorities”. Municipals are federal tax free, so investors are willing to demand less interest when states, cities and towns issue municipal bonds. Investors looking for a 6% corporate bond, might be willing to settle for a 5% municipal bond of similar quality. Consider this:
An investor putting $100,000 into a 5% municipal bond gets $5000 a year and the investor pays no federal tax on this $5000. There is also no state income tax if the investor lives in the state issuing the bond or if the city or town issuing the bond is in the investor’s state, so the investor keeps the whole $5000 of interest, if the investor puts $100,000 into a municipal issued by his own state government
The investor putting $100,000 into a 6% corporate bond gets $6000, but the investor might pay $2000 of federal tax on this $6000, and another $300 of state tax, so the investor finishes with $3700
The investor investing $100,000 into a 6% U.S. Treasury gets $6000 and might pay $2000 of federal tax, but treasuries pay no state income tax, so the investor keeps $4000
But if the investor has little income, and pays a very small income tax, this investor is going to keep most of the $6000 paid on the investor’s corporate or treasury bond, so a $5000 return on a municipal is lost revenue to this investor
Generally, your trustee will invest in municipals if you are in a high income tax bracket. A trustee might buy individual municipals, or a trustee might buy mutual funds which invest in municipals.
A Trust Officer
In addition to investing funds, a trustee is also charged with maintaining “the books” of the trust in a competent manner. Most professional trustees assign this role to a “trust officer”, who has responsibility for all matters except investment issues. The trust officer is the primary contact with a trust beneficiary, and the trust officer must know the beneficiary's goals, income requirements, and tax situation.
A trustee can also be a family member, and at first blush, this may appear to be the perfect choice; your brother may know your business affairs and your family well, and he may be less rigid than a professional trustee. These strengths can become weaknesses, though, with time. Bookkeeping may become muddled and investment returns may be impossible to measure. It is difficult to second-guess a relative, and the in-laws are always there. Further, a capable 50 or 60-year-old trustee may be less competent with age, and it may be difficult to hold an individual accountable, either for personal reasons, or because the individual just does not have the resources - the “deep pockets” - to cover his mistakes.
ASSET ALLOCATION
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Obviously, these issues should be discussed with a potential trustee when considering either a professional trustee, like a bank or trust company, or a prospective individual trustee. Fees for money management, accounting, tax planning, and safekeeping are included in many professional trustees’ standard charges, but these services can amount to a substantial sum with an individual trustee. As one example, consider a trustee which invests in mutual funds. You may be paying the following fees:
The trustee's fee perhaps 1% a year
The mutual funds annual fee perhaps 1.5% a year
The mutual fund's "front-end load" perhaps 2% to 8% one time
So after you lose 2% to 8% as a "front-end load", you will be paying 2.5% a year to have your money managed. Even if the trustee uses "no load" mutual funds, annual fees may still run to 2.5% or more. A "no load" mutual fund charges no initial fee when you invest, but no load funds do assess annual charges like any other fund.
The total fee charged by many banks will ordinarily not be much more than 1% a year, and for a larger trust, a bank or trust company may charge well under 1%.
Real Estate as a Trust Asset
Professional trustees are generally not well equipped to manage real estate. We tend to think of real estate as a passive investment since landlords often make ownership look so easy. Without the proprietor regularly on site and available to contract repairs, collect and negotiate favorable rents, and keep a sub shop from the lot next door, real estate can quickly lose value.
It may be useful to have multiple trustees when a real estate investment is the major trust asset. A three person group of trustees comprised of a spouse, a professional trustee, and an individual who knows the property well, may be appropriate. In this situation, the role of the professional trustee is to break deadlocks and to assume more responsibility as real estate is liquidated. In the absence of language to the contrary, trustees must act unanimously, but a trust can dictate that a majority vote by the trustees is sufficient to effect an investment change.
A Business as a Trust Asset
Many professional trustees will also welcome an individual co-trustee familiar with the operation of a family business passing to a trust. For a professional trustee to assume ownership of a company, the trustee must be left just the right business: a company with strong successor management and a family interest in keeping the business intact.
Often, because the role of a trustee is to keep the business operating for a short period to show potential buyers the company can survive the death or disability of the owner, the capability of a trustee, professional or personal, should be carefully considered in making this critical selection. Further, if it is important to keep the business operating within your trust, you need language in the trust permitting your trustee to assume the risks of a business person, rather than the usual "prudent person" risk
Self-trusteed Trusts
Individuals create trusts for a variety of reasons: to secure capable money management, to avoid probate, to protect assets against disability, or to avoid the publicity which can accompany the probating of a will. This is discussed more fully in Chapter 5. These benefits of a trust are only gained, however, when assets are physically transferred to a trust. Assets remaining in your name are disposed of by your will and so they will pass through probate. Probate by definition relates to assets left by will.
Many individuals, however, do not want or need assistance in the management of money. A self-trusteed trust can provide many of the benefits accompanying a trust, while leaving control in your hands.
A self-trusteed trust names you trustee and involves a bank or trust company or any other professional as trustee only upon one of three occurrences: death, disability or request. Until death, disability or a request, you are sole trustee and have full control of the trust, and the professional trustee remains passive and earns no fees.
Disability should be spelled out clearly in the trust, and the professional named as successor trustee steps in at the appropriate time. As an example, your trust might stipulate that your physician will determine disability, and you will remain trustee until your physician says you no longer have the capacity to carry on.
To have this trust avoid probate, the family assets must be transferred to the trust, but all income remains taxed to the person creating the trust. We go into more detail on ways to avoid probate in the following chapter.
Chapter 5. Avoiding Probate
Aside from taxes, there is a second factor in managing assets at death, which can sometimes be more difficult than the tax issues. This second factor involves probate, and what can be done to avoid it. Avoiding probate is a prime objective for many people, but before shifting assets to avoid probate, you should know of adverse consequences you can suffer in the name of probate avoidance.
What is Probate
Many individuals confuse avoiding probate with avoiding taxes; but probate involves supervision by the Probate Court (called Surrogate Court or Family Court in some states), and it has nothing at all to do with taxes. Probate involves one agency of government, the Probate Court; and taxes involve another government agency, the taxing authority, the Internal Revenue Service and its state equivalent.
Probate Taxes
Court IRS
Probate assets are assets in your name alone, disposed of by your will. In fact, a nice, basic definition of probate would say that if it is in your name, your will controls the asset, and so it is a probate asset. If an asset goes to your heirs other than by your will, then this asset is not a probate asset.
Probate Assets Non-probate Assets
Home in your sole name Home in joint names
Bank account in your name Joint bank account
Stocks in your name Stocks, bank accounts, or a home held in trust
Life insurance
IRA, 401(k), etc.
If you have a bank account in your name, it will be disposed of by your will, so it is a probate asset. If you have shares in your business in your name, the shares will pass under your will, so the shares are probate assets. If you have a stamp collection in your sole possession, a car in your name, or real estate you own alone, all of these assets are probate assets, since they are in your sole name, and therefore, are disposed of by your will.
Non-probate Assets
If probate involves assets in your sole name left by will, then what is a non-probate asset. If your will leaves everything to your spouse, but your old girlfriend is the beneficiary of your life insurance, who will receive the insurance at your death? Your old girlfriend will! Life insurance is a non-probate asset, since it passes to a named beneficiary. It is not in your sole name, it is not disposed of by your will, so it is not a probate asset.
If your will leaves everything to a friend, but you have a summer cottage held jointly with your brother, who will get the cottage? Your brother will! Joint assets are non-probate property since they are not in your sole name, so they are not disposed of by your will.
If you have assets in a trust, and by the terms of the trust the assets pass to your sister at your death, and later in life you leave all of your assets to your brother by your will, tell your brother not to spend his inheritance too quickly! Since assets in trust are non-probate assets, they pass to your sister under the terms of the trust, not to your brother under the terms of your will.
All of these examples describe non-probate assets: life insurance or an IRA naming a beneficiary (other than your estate); joint assets which pass to the joint tenant at death; and assets in trust, which generally pass to the trust beneficiary at death. Since these assets are not in your sole name, they will not pass under your will, and they are all non-probate assets.
Why Avoid Probate
Having defined what is probate property, we must now examine whether avoiding probate is a desirable endeavor. Most individuals want to avoid probate to save estate settlement expenses, but in fact, probating assets should not be very costly, and conversely, not probating assets should result in very little cost saving. Notice the emphasis on “should”. If your lawyer wants to run back and forth to the probate court 10 times in a week and have a cup of coffee with his buddies each time, he can probably do it, and bill your estate for his time (and for the cup of coffee!). If your lawyer is like most lawyers, though, the cost of probate will be the real cost of presenting your will and the estate’s accountings to the probate court, several times over the course of administering your estate. Placing assets in a trust, though, assures that there will be no temptation for your lawyer to run up a large bill for probate expenses.
Although executors may quote a lower fee for handling non-probate assets, often in settling an estate executors have many added duties in reviewing trust assets, following joint assets, and collecting life insurance, so even though all these assets avoid probate, they still may engage a great deal of a lawyer’s time. In this instance extra fees may be assessed even if you own assets not subject to probate. As a general rule, avoiding probate is not a major cost saving in settling an estate, but it can save hundreds, maybe thousands of dollars. The following are what might be the "right" reasons to avoid probate:
• Assets in trust and joint assets are immediately available to your heirs on your death, without the delays that can accompany probate with the appointment of an executor or a trustee. A bank account in your sole name is frozen until your executor is appointed, but a joint account is immediately available to your joint tenant (although the joint tenant should be careful, since he or she may have to pay a portion back to pay estate taxes. Do not confuse avoiding probate with avoiding taxes!)
• Assets in trust avoid publicity, which is only important if you are worried about newspapers or nosy neighbors knowing your business. This is a very critical issue to a few of us, but for most individuals, it is no issue at all.
Avoiding Probate Can Be Dangerous
Upon hearing that joint assets avoid probate, many individuals place assets in joint names with a spouse. This is often a very sound plan, if your total assets are in the range of $1,000,000 or less, and if your spouse is accustomed to handling financial matters. If your total assets, including your home, are more than $1,000,000, or if your spouse will be left vulnerable with all of the family wealth passing to the spouse, you may be interfering with a sound estate plan by placing assets in joint names.
If your assets total $4 million, for example, and these assets are in joint names with your spouse, the assets will pass to the spouse tax free. At the death of the second spouse, however, the amount in the estate covered by the estate tax exemption will be federally tax free, but the balance will pay an estate tax at about 45% rates. The last $1,000,000 will pay a tax in the $450,000 to $500,000 range! Even though you have an estate plan designed to avoid estate tax, if you place your assets in joint names with your spouse, the assets will avoid your estate plan, and the assets will pass directly to your spouse. You will have wasted the cost of arranging your estate plan, because joint property passes spouse to spouse, no matter what your estate plan says.
Most married couples with a $4 million estate have an estate plan involving a trust which saves most of this tax; a trust creating the Bypass Trust described earlier. Assets come to this trust, however, only:
if the assets are in your sole name, or
if the trust is designated a beneficiary, or
if assets are placed in the trust.
If assets are held in joint names, they will pass directly to the joint tenant without probate, but these assets will not pass to the trust. You will die happy, thinking you have saved thousands of dollars in estate taxes, but in fact, you will have diverted assets you meant to have come to your trust; the assets will now come to your spouse through your joint tenancy.
In this instance, you will have avoided probate by owning joint assets, so you will have avoided the Probate Court, saving relatively little in the way of probate expenses; but before the assets pass to your children they will face enormous estate taxes, most all of which would have been saved if the assets had passed through probate, to a properly structured trust at your death.
So, in summary:
Joint property for married couples
Passes directly to your spouse
Avoids probate in the first estate
May result in high tax and probate in the second spouse’s estate
Assets in your name
Pass to your trust if you have an estate plan
Will save estate tax in the second spouse’s estate if you have a Bypass Trust
It is important to have assets in your spouse’s name, too (our next chapter)
Pass through your will and so they pass through probate
Assets in your trust
Will save estate tax in the spouse’s estate if you have an estate plan
Important to have assets in your spouse’s trust, too (see our next chapter)
Assets in trust avoid probate
A Trust Can be an Ideal Means to Avoid Probate and Taxes: Self-trusteed Trusts
Remember in Chapter 3, we talked about a self-trusteed trust, where you are the trustee and a professional trustee or co-trustee replaces you at death. This self-trusteed trust will avoid probate. Placing assets in a trust has another hidden benefit: generally, we see assets in an estate scattered all over the place. It is silly to pay a lawyer $200 or $300 an hour to run around finding your assets when you die. Assets placed in a trust tend to provide a discipline that makes settling an estate much more orderly, and substantially less expensive.
CHAPTER 6. Who Should Own the Family Assets
His and Her Trusts
Often one of two spouses will have created a trust to avoid probate and taxes, but the other spouse will have no individual assets, and a simple will. If the spouse with the simple will dies first, many of the benefits of their estate plan will be lost, including all of the tax advantages of a Bypass Trust.
It can be to the family's advantage to place assets in each individual name and to have a trust for the husband designed to receive the estate tax exemption ($1,000,000 in 2002 and 2003, more later) if his is the first estate; and to have a separate trust for the wife designed to receive the estate tax exemption if hers is the first estate. When each trust's formula leaves assets to a Bypass Trust the family might save up to $1,000,000 in the second estate.
Accompanying this suggestion, we should re-emphasize a point which cannot be stressed enough: individuals often have wills and trusts drawn to save taxes, but they often leave or accumulate assets in joint names, and joint assets pass to a surviving joint tenant regardless of the terms of a will. Assets generally come to a trust in either of two ways: first, they will come to the trust if the assets are in an individual's sole name and the individual leaves them to a trust by will; or, the assets may be placed in the trust during the individual's lifetime.
Who Should Own the Family Assets
So, we should summarize how a married couple should hold the family assets. There are six rules that should generally be observed by a couple with substantial assets.
It is wise to have a sum up to the estate tax exemption in his name, and an amount up to the exemption in her name, and more as the estate tax exemption rises. The exemption rises as follows:
Before 2004 $1,000,000
2004. 1,500,000
2006. 2,000,000
2009. 3,500,000
• A husband and wife each should have a will leaving this sum to a trust.
• It is even better if these assets are placed in the trust during life; assets placed in a trust avoid the cost, publicity and delays of probate in addition to gaining the tax savings previously discussed. We talk more about probate in Chapter 4.
Life insurance naming a trust beneficiary is counted in determining the sum to be placed in each name. Life insurance naming a revocable trust beneficiary can “fill up” a Bypass Trust just like any other asset in your name.
Life insurance can be kept out of the estate of both spouses, if it is owned by an irrevocable trust. The irrevocable trust can generally be structured with the same terms as a “Bypass Trust”. This irrevocable trust is only needed if you have a very large estate. For example, assume you are a married man with children with an estate worth $2,000,000, and assume that in addition, you have $1,000,000 of life insurance on your life.
You and your wife might divide your assets so you own $500,000 plus the $1,000,000 insurance policy. At your estate, this total of $1,500,000 can pass to a Bypass Trust for your wife and your children any time after 2004. Your Bypass Trust will then be tax free in the estate of your wife, in addition to your wife’s own exemption. Notice in this example, you have placed $500,000 in your name because you own $1,000,000 of insurance which brings your estate to $1,500,000.
As painful as it may be to give up hard, cold cash, you should assure that the other $1,500,000 is in your wife’s name. Then, if hers is the first estate, her $1,500,000 will come to a Bypass Trust, and the Bypass Trust will be tax free again in your estate, in addition to your exemption.
Now, assume your assets are likely to grow to $10 million, and there is still going to be a $1,000,000 life insurance policy on your life. In this instance, you will want to place the life insurance into its own separate irrevocable trust, so the insurance will be tax free in addition to the exemptions of you and your spouse.
If you do not place the insurance into an irrevocable trust, you can still control the insurance during your lifetime: you can borrow the cash value and you can change the beneficiary. If the insurance is owned by an irrevocable trust, you must give up the right to access the cash value, and you can never change the beneficiary. So, you only want to take this step transferring insurance to an irrevocable trust, when your estate exceeds the sum of your estate tax exemption, plus the exemption of your spouse.
There is more on irrevocable trusts owning life insurance in Chapter 16. Incidentally, remember that when we suggest that assets should be in your name and in the name of your spouse, it is even better to place your assets right into your trust, and to place your spouse’s assets right into your spouse’s trust. Assets in trust avoid probate.
If possible, a 401(k) Plan, an IRA or other retirement plan should not be counted when determining the sum to come to a trust. It is generally tax-wise to name your spouse beneficiary of this “pension plan” and to name your children or your trust as alternate beneficiary, unless the 401(k) plan or IRA is needed to assure that the exemption passes to your trust.
It is usually preferable to leave your home or homes in joint names, but if a large percentage of your wealth is real estate and if your estate exceeds the estate tax exemption, it may be wise to divide the real estate much like any other asset. We discuss the proper way to divide real estate between spouses in Chapter 9.
Chapter 7. Six Rules of Thumb for a Married Couple Without Children
So much of estate planning revolves around married couples with children, that we sometimes forget that there are thousands of married couples with no children. When I think how rich we would be without children, it is really silly to not to consider the needs of those of you without children. I have developed the following six rules of thumb I have found to work for many of my clients in your situation:
1. Leave everything to your spouse.
If you and your spouse are good friends, and you are confident your spouse will leave assets to your favorite individuals and charities, and the amount passing to family and friends is less than the estate tax exemption, then leave everything to your spouse. The estate tax exemption is $1,000,000 before 2004, $1,500,000 after 2004, $2,000,000 after 2006, and $3,500,000 after 2006.
2. Leave your estate tax exemption to a Bypass Trust for your spouse.
If you want family and friends to receive an amount greater than the estate tax exemption, then you should leave any amount up to your exemption to a “Bypass Trust” for your spouse. For example, if you leave $1,000,000 to a Bypass Trust, the Bypass Trust of $1,000,000 will be tax free through both your estate and the estate of your spouse; and additionally, your spouse will be able to leave tax free any amount up to the exemption of your spouse. With this option, you must have $1,000,000 in your sole name (or in your trust), or your trust must be beneficiary of life insurance, IRAs, or 401(k) plans. If your spouse has the same objective, there must be $1,000,000 in your spouse’s sole name, or your spouse’s trust must be beneficiary of life insurance, IRAs. Or 401(k) plans.
3. Leave more to a Trust
Leave additional assets to a QTIP[1] Trust, if you want the assurance that these additional funds will pass to your family, friends, and charities. A QTIP Trust pays income to your spouse; and principal as your trustee determines a need; but a QTIP Trust goes to your favorite family, friends and charities on the death of your spouse. A QTIP Trust is tax free in your estate, just as sums left outright to your spouse are tax free, but a QTIP Trust is included in the estate of your spouse. A QTIP Trust’s purpose is to assure that assets will be there for a spouse, but that the assets will ultimately go as you direct. Remember, if you have divided things the right way, your spouse will have assets outside your trust.
4. Trusts to Avoid the Delays, Expense, and Publicity of Probate
Assets placed in trust avoid probate, since assets in trust do not pass through your will. Assets in trust also avoid probate during your lifetime: if a catastrophic illness strikes, a stroke or other disabling injury, trusts keep your affairs out of the probate court for your whole lifetime.
5. Trusts to Assure Management of Assets
If you are married to an individual who is not a skilled investor, or who is just not interested in the stock and bond markets, or if your spouse is likely to be a “soft touch” on every charity’s call list, a trust can protect that spouse.
6. Leaving Assets to Charity
Charitable bequests can be outright, or to a Charitable Fund, or to a Private Foundation. IRA accounts or 401k plans should not name a trust beneficiary if these funds are passing directly to charity. Passing these gifts through your trust will subject these plans to income tax; passing these plans directly to charity, or to a Charitable Fund or a Private Foundation, makes these plans free from income tax and estate tax. See more on a Charitable Fund and a Private Foundation in Chapter XXX
Chapter 8. Estate Taxes and the Unmarried
Whenever we attend a seminar dealing with estate planning, the emphasis is on married couples and how they can save estate taxes. Yet most of the techniques used by married couples are just as readily available to single individuals and unmarried couples.
The basic tax tool we have is the estate tax exemption. If an estate is less than the exemption today, there is no estate tax. However, every dollar over the exemption pays an estate tax likely to reach 45% to 50% quickly.
Life insurance, while income tax free, is taxed in an estate just like every other asset. Joint property for a married couple is considered half his and half hers. Joint assets held with anyone but a spouse are 100% included in the estate of the first joint tenant to die, unless the survivor can prove that he or she contributed to the joint account. So a large estate for a single person can result in an enormous estate tax, and a great burden to an estate.
It is really silly, though, to pay this estate tax, and then leave my $1 million estate outright to another person, and have it taxed again in another estate. A gay or lesbian couple, for example, is often poorly served leaving assets to one another: the assets will be taxed once at the first partner’s death, and again in the estate of the second partner. Likewise, a brother and sister leaving assets one to the other can cause these assets to be taxed in both estates, a “double whammy” if you will.
A wiser course for a gay or lesbian couple or for brothers and sisters, would leave assets in trust for the surviving partner, or for the surviving sibling. This trust can take the form of a “Bypass Trust”, in which the survivor can receive all of the following benefits:
1. Income for life
2. 5% of the principal on demand each year
3. Additional principal for “comforts and luxuries” of life
4. The right to change trustees
5. The right to change the ultimate takers from the trust
Even with all of these benefits, this Bypass Trust will escape estate tax when the second individual dies.
Obviously, a Bypass Trust can be much less generous than the trust described above. For example, a Bypass Trust can benefit parents, nieces, nephews, and siblings, in addition to a partner or a sibling. Alternatively, you may not want to give a partner or sibling the right to change the ultimate takers, because you want your funds to ultimately pass to your family. Or, perhaps “comforts and luxuries” is too broad a standard. Comforts and luxuries is a Lexus lifestyle, as opposed to a good quality, late model Saturn, implied by a standard of “health, maintenance and general well-being....”
In my experience, gay and lesbian clients are often interested in taking care of a partner, but are also very concerned with who will ultimately receive assets when both partners are gone. Brothers and sisters may also want to take care of each other, but control who will ultimately take their wealth. A Bypass Trust provides you with the flexibility to leave assets for a partner or sibling and to determine who ultimately will receive these assets.
This trust reduces taxes at the second death; but unfortunately, it does nothing to reduce the estate tax payable at the first death. At the first death, an unmarried person faces the limitation that only the estate tax exemption can be left estate tax-free. The only plan that will reduce the tax at the first death is an arrangement involving gifts.
If you have substantial wealth, but your partner or sibling has very few assets, it is tax wise to place assets in your partner’s name or in your sibling’s name, to build up their estate. For example, $1,000,000 left to you in a Bypass Trust at the death of your partner or your sibling, can save $500,000 in estate taxes at your later death. Generally, you can only make $11,000 annual gifts to a partner or other individual, but $11,000 gifts of fast-growing assets can increase in value quickly.
Further, at your death, you can leave assets in a special trust arrangement for a partner, under which the partner can receive income for life: either all of the income; or, say, 7% a year for life. If this trust names a charity, or a Charitable Fund or a Private Foundation as the later beneficiary, then the trust results in an estate tax deduction in your estate. The amount of the deduction is the value of the trust, less the actuarial value of the income payments for your partner’s lifetime. Obviously, such a trust can benefit any individual you choose, when you are gone.
This is a Charitable Remainder Trust, and its structure is based on stringent tax rules. The 7% I describe in my example can be 7% of the value of the trust on the day you die, or 7% of the trust as valued each year. The former will be great if the stock market declines; the latter is wonderful with a rising market. The “7% number” can be more or less than 7%, but it must be at least 5%. This issue is discussed in much more detail, in Chapter XXX
Finally, unmarried clients often wonder whether they need life insurance, which is another key element in estate planning. If you have no children, the need for insurance is lessened, but you certainly do not want to leave an estate with a nice home, fine furniture, and a large real estate portfolio, and no liquidity to pay estate taxes. Life insurance can obviously care for needy people in your life. Sometimes you have no choice; your employer buys a group term life insurance policy for you whether you want it or not.
Life insurance is an additional asset an unmarried person can remove from an estate. If I place $500,000 of life insurance on top of a $1 million estate, I am bequeathing $250,000 of this insurance to our friends in Washington. If I place this insurance in an irrevocable trust, the irrevocable trust can be structured exactly like a Bypass Trust and escape estate tax at my death, as well as at the death of my heirs.
So, the next time you are stuck in the middle of a seminar on estate planning, and you are trapped -- there is no way out without spilling coffee or soda – remember that even though the discussion is centered around married couples, most of the discussion can be tailored to unmarried couples and other single individuals. Married couples can leave assets tax-free to one another, but aside from this “marital deduction,” most of the issues facing a married couple are also of concern to a single individual or an unmarried couple.
Chapter 9. Saving Estate Taxes With Real Estate a Major Asset
We have seen that estate planning for most of us revolves around two basic federal estate tax rules. The first rule states that we can leave assets in unlimited amounts free from federal estate tax to a spouse. The second rule states that we can leave the estate tax exemption federal estate tax free, either during lifetime, or at death, to anyone we choose. The exemption is as follows:
Before 2004 $1,000,000
2004. 1,500,000
2006 2,000,000
2009. 3,500,000
Most estate planning is centered on this exemption. If I leave my entire estate to my wife and if we both die when the exemption is $2,000,000, at her later death, she can leave $2,000,000 tax free to our children. If instead, I leave $2,000,000 to a Bypass Trust which benefits my wife, then at her death, she can still leave $2,000,000 tax free, and the Bypass Trust is tax free, so a total of $4,000,000 can pass to our children free from federal estate tax.
It is easy to make this arrangement work if I have $4,000,000 in liquid assets. I simply place $2,000,000 in my name, and my wife places $2,000,000 in her name. My will leaves my assets to my trust, and my trust says that at my death any assets I own up to the estate tax exemption passes to a Bypass Trust for my wife. If I like my kids this week, they may be included as beneficiaries of my Bypass Trust, too. At my wife’s later death her $2,000,000 goes to our kids tax free, and further, my Bypass Trust passes tax free, so $4,000,000 will pass free from federal estate tax at my generation.
My wife arranges a will and trust of her own. Her $2,000.000 passes to her trust by her will, the trust segregates her $2,000,000 into a Bypass Trust for me and the kids. This Bypass Trust is tax free in my later estate, in addition to my estate tax exemption.
Wouldn't life be simple if we all had $4,000,000 in liquid assets! Again, the major tax advantage of estate planning for a married couple, even with a combined estate of several million dollars, involves placing the estate tax exemption in each sole name (or in a separate trust for each), and having this exemption pass to a Bypass Trust at the first death.
Many couples, however, have an estate worth several million dollars with a mix of liquid and illiquid assets. For example, we often find a couple has $2,000,000 in liquid assets, but the remainder of the estate is real estate. Real estate in some cases is a great trust investment, but it does require supervision, inspection, and maintenance. If the real estate is a residence, it may be silly to pay a trustee to supervise your home. If the real estate is commercial property, you may or may not want a professional trustee involved in your business affairs.
A Life Interest
Many of the benefits of a Bypass Trust can be gained by leaving a spouse with a "life interest" in real estate. A life interest (sometimes called a “life estate”) gives the spouse the right to live in property for life. It generally also gives the spouse the obligation to maintain the property for life. The benefit to this life interest is gained when the spouse dies: since all the spouse owns is the right to enjoy the property for life, at the spouse's death the life interest passes to the children free from estate tax, much like a Bypass Trust.
A life interest can be as simple as this, or it can be much more detailed. A more detailed life interest will prescribe that the spouse can sell a piece of property held for life, and buy a substitute property. It can stipulate that if the property is sold, the proceeds are to be held "for life". It can prescribe that if real estate is sold and not invested in additional real estate, the proceeds will pass to a more formal Bypass Trust.
Creating a Life Interest
A life interest can be created in a number of ways. A will can leave property in the form of a life estate, so long as you place the real estate in your sole name. There is one disadvantage to creating a life estate in your will: as with anything disposed of by will, your real estate becomes subject to probate, and the probate of your estate will remain open during the term of the life interest. So you may have the probate court involved in your estate for 20 to 30 years after your death.
A real estate deed can also create a life interest in property. Your home can be owned by your spouse, with the deed prescribing that the ownership extends to you for life at the death of your spouse. The deed can go into detail relative to the issues we have previously discussed, concerning the sale of the property and the purchase of additional real estate, etc.
A trust can also create a life interest. Often our client will create a trust to hold real estate, naming the client trustee, a family member trustee on the death of the client, and a professional successor trustee. The trust can provide that the professional will succeed as trustee only when liquid assets become the more prominent asset in the trust. This trust arrangement avoids probate, and may provide more flexibility than the other two other alternatives.
The Completely Illiquid Estate
It is fairly easy to take care of the situation where a division can be made so one spouse
holds the liquid assets and the other holds the real estate. What about the situation where real estate is the predominant or sole asset in the family? Again, if the real estate is left from one spouse to the other, all but the estate tax exemption will be taxed when the property passes to the children at the death of mom and dad.
In the case of this illiquid estate, mom and dad can create a trust where each of them is an equal owner. As an example, they can arrange a trust for the real estate which stipulates that at the first death, 1/2 of the trust is held in the form of a life interest for the surviving spouse, and the other 1/2 remains in the complete control of the surviving spouse. Here, mom and dad can be sole trustees during their lifetime, but with an independent trustee watching after ½ of the interest following the first death.
Life Estates and Capital Gains
We talk of transferring property back and forth between spouses as if such a transaction is as casual as a transfer of a fur coat. The transfer should, however, be considered with attention to tax issues involved in a transfer between spouses. Particularly important is the issue of forgiveness of capital gain taxes when an asset passes through an estate.
When an asset passes through an estate, all capital gains are forgiven. If you hold real estate in joint names with your spouse, when either spouse dies, 1/2 of the capital gain is completely forgiven. If the surviving spouse sells the home, the spouse will pay a capital gain tax only on 1/2 of the gain.
If I place the real estate in my wife's name, however, when I die nothing passes through my estate, and no capital gains are forgiven. My wife will receive an exclusion from capital gains if the home is our principal residence, but while this exclusion is $500,000 for a married couple, it is only $250,000 for my wife if I am deceased: single individuals only receive a $250,000 exclusion from capital gains on a principal residence.
So assume you own a house, your principal residence, worth $1,100,000, and your basis in the house is $100,000. If you leave the house in joint names and you die, ½ of the $1,000,000 capital gain is extinguished at your estate. If your spouse sells the home after you are gone, $550,000 of the gain will be extinguished in your estate. Add in your spouse’s $250,000 exclusion, and the gain is minimized.
If during your lifetime, though, you transfer your home to your spouse, your spouse may not think kindly of you after you are gone! In this instance, the home does not pass through your estate at all. So, if your spouse sells the home after you are gone, there will only be a $250,000 exclusion applied against a $1,000,000 gain, and there will be tax on $750,000 at capital gains rates!
If the home is not a principal residence, it is even worse, since the whole $1,000,000 gain is taxed. Remember, ½ of the gain would have been extinguished if you each owned ½ the value of the home. Incidentally, this almost always occurs when a home is placed in a “wife’s” name, and this is really a recipe for disaster. If you ever visit a nursing home or an assisted living facility, notice there are almost no men there. Men die first. Men should not place a home in a wife’s name without thinking through this capital gain issue.
This problem was mitigated in another era, because the tax rules at one time did not assess capital gains on the sale of a residence if the proceeds went into a new residence. This is no longer the rule. Now if you sell a $1,000,000 home and buy a new $1,000,000 home, you owe capital gains on the sale despite the new purchase.
In summary, illiquid assets require special considerations. We often find that illiquid assets are best left in the form of a life interest, but the forgiveness of capital gains when an asset passes through an estate must be considered before this option is exercised. One choice is to place ½ of the home into each spouse’s name to build up each spouse’s assets.
Chapter 10. Choosing a Trustee
In choosing a trustee, we are choosing the “fiduciary” who will take care of our property. Trustees are fiduciaries, in that they are held to a very high standard: a trustee for decades in the United States has been required to act as a prudent person would act in similar circumstances, and in many states in recent years statutes have specified what trustees can and cannot do. Generally the trustee must manage trust assets in the same way the trustee would manage his or her own affairs. With this high standard, a trustee can be sued for making improper investments, for making deals where there is a conflict of interest, or for doing silly things with your assets.
A choice of a trustee is often made haphazardly, despite the fact that the choice will determine who takes care of your family’s financial affairs well into the future. Your trustee may serve in this role through your lifetime, then for the lifetime of your spouse, and often beyond, for your children and even your children's children. A trustee can be an individual, a bank, a professional trustee, or a combination of each of these candidates. There is a trust in Boston cited in the local newspapers where 3 old men were trustees during their lifetime, and when they died they assured that their sons and daughters assumed this role from their parents, and while the trust was established for charity, the trustees earn more from the trust as fees than the sums they pay out each year to charity. So you want to think through the role of your trustee carefully.
A Trustee
We saw in Chapter 2 that the first responsibility of a trustee is to distribute assets under the terms of a trust. This can be as simple as a mandate to pay assets on demand, or it can involve discretion in the trustee, often granted to save taxes. With discretion, you will want to be certain that the trustee will be able to adapt as he or she gets older, and you will want to be careful to avoid family conflicts. Often I have heard individuals say their son or daughter would be the perfect trustee, "...but that person they are married to..." often provides an incentive to include a professional co-trustee.
A spouse or child can be a sole trustee, to serve when you are gone, even if you develop a trust to save taxes.
A spouse as trustee works well if your spouse is likely to be a smart investor, but a death in the family is just an awful time to be choosing an advisor. There are also an abundance of people looking to help out. A neighbor of mine in her mid-50’s receiving well over $1,000,000 of insurance proceeds on the death of her husband was approached by a “financial consultant” with a recommendation that practically all of the income generated by this $1,000,000 should be placed in a high-commission insurance policy on her life, that would pay funds to her children when she dies. Very little consideration was given to her lifetime needs, in the rush to get the assets under the “consultant’s” care.
So a spouse as trustee may come under the influence of an advisor intent on charging high fees, or investing imprudently. Additionally, if you develop a living trust that you intend to have there for your spouse, but which assuredly will later pass to your children, this assurance is less likely to happen if your spouse is sole trustee of your trust. While limits may be placed on a spouse as trustee within a trust, it is very easy for a rascal next wife or a rogue next husband to get at assets held in trust, if your spouse is your sole trustee.
Your children may also seem like a logical choice to serve as trustee, or as co-trustees. But there have been many instances of children treating a parent’s trust as the “childrens’ inheritance”, rather than as the parent’s lifetime savings. Further, there is always the risk of the children squablling among themselves over minor issues. One family with whom I dealt was forever divided when the refrigerator from the parents’ home was spotted by one of the children in the summer home of one of the in-laws.
Family friends may also seem a wise choice, except we tend to look at people our own age, our “contemporaries”, as suitable trustees, without considering the fact that these contemporaries of ours are going to get older at exactly the same time we ourselves die or get older ourselves. One client of mine in his 70’s had 3 trustees his age, one in a nursing home, one in an assisted living facility, and the third just hospitalized with a stroke; and none of the 3 saw any reason why they should resign as trustee now, or later when the client dies.
A “professional trustee” will often be a better choice. When seeking a professional trustee, you should determine from a trustee a track record investing funds, but be careful to ask to see an account where this trustee has been given full discretion over the assets in the trust. Most banks have mutual funds they manage, and if a bank is to be your trustee, you should determine how well these funds have done. Although your assets may not be invested in a fund, the performance of a fund gives you a return on an "average" account, with no outside interference, and with full discretion in the bank's hands. Be sure you are not looking at selected bank funds; ask to see a summary of all their common stocks funds, for example.
In naming a professional trustee, you may also want to give your spouse or other family members the power to remove an unsuitable trustee. Trustees are much more inclined to answer their phone, when the family has the power to “fire” the trustee. In the mid 1970’s Attorney Albert Zahka was in-house counsel for the Old Colony Trust Division of The First National Bank of Boston, and he reviewed trusts naming the bank trustee. If a trust gave the family member the right to remove the bank, Al always wanted the assurance that the client understood that this right to remove trustees diluted the bank’s authority, because the bank saying “no” to an inappropriate request for trust funds could be overruled by the family’s power to remove the bank. With time, though, Al retired, and families became much more interested in keeping access to trust funds, rather than having too much authority in the hands of an independent trustee.
A Bank as Trustee
I must add my perspective on the choice of a bank as trustee, based on my 29 years' experience working for one bank in Boston.
I once had a client call me at my office who had left me with well over $1 million for our bank to manage. The money had been left with our bank in our money market mutual fund, anticipating the client's decision on whether to have the bank manage the money long-term. The purpose of his call was to indicate that although he really wanted to do business with our bank, his accountant and his lawyer just wouldn't let him, because "...banks do such a lousy job managing money...." More recently, the widow of a C.P.A. told me "...you wouldn't believe how hard a time I had getting here; every lawyer and C.P.A. I met told me how terrible banks are, managing money...." Now, endorsements like these are tough objections to overcome!
The bank did overcome the objection in both of these cases, and my experience is that banks develop solid relationships with their clients, but these off-handed comments are often repeated by clients, quoting professional advisers; and while it may have been accurate at one time, it certainly is not the case today.
Bank Investment Process and Results
Early in my career in the bank trust business, I had the opportunity to sit through account reviews where at my bank, where holdings in companies like Merck, Johnson & Johnson, and General Electric were the center-piece investment in virtually every account being reviewed, and consistently, these stocks had increased at least ten-fold with most every relationship. Trust banks were very creative in buying stock in these great companies, and in the process, individual fortunes and trust companies grew at impressive multiples.
Banks today compete favorably with mutual fund managers, and large banks even serve as mutual fund managers themselves. They provide income oriented stocks and a preponderance of municipal bonds for a conservative investor, and they offer aggressive alternatives for the growth oriented client. In my experience, they offer returns comparable to other professional investment managers.
In most banks, when the bank is given full discretion over funds, equities will now involve as much as an 80% commitment to as little as a 20% commitment, depending upon the client's objectives
There are, however, many individuals who are not prepared to have funds invested in common stocks at all. Most banks are content to have most, if not all, of a client's funds invested in non-equities, upon the client's request. Assets not invested in equities are typically invested in municipals or a combination of corporate and treasury bonds, notes, and money market instruments. Performance here has also been solid, but performance numbers for fixed income securities are somewhat irrelevant: quality is assumed with a trust investment, and with quality assumed, fixed income performance is largely a function of interest rate trends. Banks should be as well tuned as any professional to gauge interest cycles.
Bank Trust Officers
Many individuals come to a bank trust department today often for investment management, but without involving the bank in the family’s trust. You hear complaints like: "...banks just have too much turnover; while my family would get along great with you, I worry about who will step in if you leave. My lawyer tells me banks have tremendous turnover...."
Well, do banks have too much turnover? Some years ago, I asked banks for the average age of their trust officers, and the average number of years they have been with their bank. Almost universally, Trust Officers across the banks I surveyed were on average in their early 40's and they had been Trust Officers for more than a decade, again, on average. In my last years at my bank, I was still a “junior officer” in the eyes of my fellow Trust Officers, even after my 29 years at the same company.
Turnover is often a relative issue. At my bank, we had a client complain about turnover, and upon investigation, learned that over 25 years, she had three trust officers, the last of whom recently had left the bank after having served her for 17 years! Good people will move on, but bank Trust Officers are drawn to their job by their desire to provide service, and they stay in their role longer than most employees. One associate of mine, Mr. Frank Helyar, who worked for several Boston banks always referred to himself as a “social worker for the rich” during his years as a Trust Officer. Change can be disruptive, so also can lack of turnover create a problem: consider the Trust Officer who was young and vigorous when his bank was appointed trustee, but who has become complacent and opinionated with time. When I became cranky, I was replaced quickly by my bank; try to remove the 3 older individual trustees cited earlier, who probably should be removed as trustees not just because of their age, but because they may not relate to children three generations removed from them.
Bank Fees
Finally, we cannot leave a discussion of Bank trust services without clarifying the issue of bank fees. I have had clients estimate bank fees all the way up to 7% of market value. Most bank trust departments charge just over 1% for a $ 1 million trust. For a trust of $500,000, the fee might be 1 1/2%. For more than $ 1 million, the fee will be much less than 1%. For an all-municipal or all-treasury account, some banks reduce their charge.
Compare this fee to a mutual fund's fees. A mutual fund will often involve a front-end fee, called a "load", which might range all the way up to 8 1/2% of market value. With an 8 1/2% front end load, only $91,500 of your money remains, after your $100,000 investment. Its like having a stock drop from $100.00 to $91.50 in one day, the day you invest your money. “No load” mutual funds do not assess any charges or “loads” on your money on the day you invest.
Aside from this charge, all mutual funds, including "no-load" mutual funds charge a fee taken each year, directly from the fund. This management fee and other expenses are typically taken right out of the fund each year. On a common stock fund, these expenses often approach 1 1/2% of market value; on a bond fund, they are usually well under 1%; on a money market fund, they are often less than .4%.
But a diversified portfolio of mutual funds often costs more than a professional trustees' fees, and a trustee's fee includes not only a money manager, but a Trust Officer, an estate planner, a fiduciary tax return and custody of the securities. Often these are added charges to an individual trustee's standard fees, but they are included in a bank's standard fees.
Money managers in recent years have attracted clients with a “wrap account” concept which matches investors with money managers. While this service will find managers who have done well in the immediate past, an investor may be consistently buying different managers' portfolios at their peak. Additionally, the “wrap fee” may be in the 3% range annually, to cover commissions on trades and portfolio management fees. This creates a 3% hurdle which must be overcome each year before returns begin to benefit the client.
Brokers can be an alternative if you have an individual trustee. So, your son as trustee can hire a broker to help him watch after your trust. Brokers charge commissions for their services and since brokers typically earn most or all of their income from commissions, a client can reasonably expect much more portfolio turnover with a brokerage account, when compared with a trust account at a bank. Bank’s pay brokerage commissions which are charged to your account, but commissions paid by the bank are literally pennies on each share traded.
So, bank trust departments can deliver a solid investment program, with a professional Trust Officer, at a fair price. A bank provides continuity, and even in rare instances where banks have failed, money held in trust is always there for the beneficiaries of the trust, and not for the bank’s creditors.
The final decision, though, rests with you as a consumer. Visit with various varied money managers and consider your choice carefully. Trusts can protect a spendthrift from over-spending, trusts can insulate a beneficiary (other than the person creating the trust) from creditors, and they can keep the trust assets away from the in-laws, but generally your trust is only going to work for your family if you choose the right trustee.
An Executor Distinguished from a Trustee
An Executor is named in your will to settle your estate; a Trustee is named in a trust or in your will, to watch after your money for the long-term. In some states an “executor” is called a “personal representative”, but we will refer to the role as “executor” in this book. See our earlier discussion concerning probate where we summarize the advantage of a trust separate from your will.
An Executor
The executor or personal representative you name in your will is likely to be appointed to fill this role by the court although in most states, it is the court’s final decision. Your executor has the responsibility to assemble your assets, pay your taxes, administer the estate, account to the Probate Court, and distribute the estate to your heirs. This sounds simple, so why do estate planners routinely assume a cost in the range of 5% of the estate's value when settling an estate?
The answer, of course, is that estate settlement will often cost about 5% of the estate. Further, you should not assume that because your spouse or your child is executor, the cost will be less. On the contrary, the cost can often be more with family executors, since family members may miss deadlines, they may let important issues slide, they may put off important decisions that are better settled early in the estate settlement process.
Although a family member may be named executor, if your attorney holds your original will, frequently the will is filed and the estate settlement process is well on its way soon after your death. With all of the family distractions accompanying a death, it is natural to have the trusted family lawyer undertake responsibility for settling the estate, and it may be weeks or months before your spouse or your child as executor discusses responsibilities, timetables, and fees. After this passage of time, it is disruptive and expensive to bring in a new advisor if the right answers are not forthcoming. Be sure you talk about these important issues shortly after a death in your family, or you may find yourself with unexpected bills of thousands of dollars, or even hundred thousands for a larger estate.
Most banks and many law firms publish a charge schedule for settling estates, and the fee looks imposing, often 2 to 3% of the estate's value. Generally, when a bank is named executor, the bank will want to do everything involved in the process from estate tax returns to probate accounting, but a lawyer has to be involved by law in many states. The lawyer's job when a bank is executor, may be as simple as reviewing the bank's documents and filing them; or the lawyer may be as involved as watching after the bank's role day-to-day. In either case, typically, the bank will go back to the lawyer who drew your will to assist in probating your will, unless the family has a better choice of their own, and it is important to discuss not only the bank's fee with the bank, but the lawyer's charge as the attorney for the estate.
The alternative to a published schedule is hourly charges, often quoted by lawyers and accountants. A lawyer may be able in some cases to settle an estate for less than a bank, but an hourly charge can serve as an incentive to keep the estate open for many years, and it may result in several members of the firm billing the estate simultaneously. Further, a quote of an hourly charge may not include functions included in a bank's standard charge: investment of assets, probate accounting, and custody of securities.
In any case, do not count on the fees quoted today by a bank or by an attorney necessarily having any resemblance to fees your estate will pay, even though the quoted fee is in writing. I remember hearing one lawyer quote a fee of $3000 to $5000 to settle an estate of $5 million; but there will always be "unforeseen circumstances" which will justify a higher fee, when you are not around to negotiate and pay the bill.
An executor's role will generally be completed within 2 or 3 years, although funds are generally available to the family during this term. Internal Revenue procedures generally dictate a minimum of 1 1/2 years to complete estate settlement for an estate large enough to pay estate taxes. Additionally, there are often good reasons to keep the estate settlement in place for a longer period, e.g. to keep the estate open as a separate "tax pocket". If a relatively simple estate is still open after 3 or 4 years, though, you are overdue for an explanation.
Chapter 11. Gifts
For many years, you have been allowed to make gifts in any amount up to $10,000 each year to any number of individuals. So, if you had 5 children and a friend to whom you wanted to make gifts, you could give away a total of $60,000. Effective in 2002, the amount you can give away increased to $11,000 a year, so now you could give your 5 children and your friend $66,000 a year. The $11,000 exemption will increase further in the future in $1000 increments, but infrequently, since it only increases when an inflation adjustment reaches set targets.
If you are married, you can double this tax free sum, to $22,000. A husband and wife can give a total of $132,000 to these 6 individuals, without incurring a gift tax. These gifts of $11,000 or less, or $22,000 or less from a married couple can be made right up until your death, and they will be totally excluded from your estate. So you can make a gift of $11,000 on your deathbed to each of your children, but don’t clutter your mind trying to remember this rule, because your children will be there then to remind you. If your children forget, your daughter-in-law will surely be there for you, to let you know a gift to her will also qualify for the $11,000 annual exclusion.
If your estate exceeds the estate tax exemption, a $11,000 gift will save your estate about $5000 in estate taxes. Your children take your gifts totally free from income tax, except that if you give them low basis stock, they will be required to pay capital gains tax based on your basis for the stock, if they later sell the stock. Your basis follows the property when you make gifts, but at least for now, capital gains are extinguished when low basis assets are bequeathed at your death. If you are really old, you will want to go slow on gifts of low basis stock or real estate to your heirs.
Gifts during your lifetime beyond $11,000 are a little trickier. If I am a single person, and I make a gift to my son of $111,000, $11,000 of this gift will be free from tax at my death. The remaining $100,000 gift will not save me any estate taxes at all, even though it decreases my estate by $100,000. In addition to reducing my estate, this $100,000 gift reduces my estate tax exemption, dollar for dollar. If the estate tax exemption is $2,000,000 at the time of my death, then by virtue of my $110,000 gift, I no longer have the ability to leave $2,000,000 tax free at death, I can only leave $1,900,000. I would have been much better off giving my son $11,000 a year for 9 years for a total of $99,000 to come close to my $100,000 gift.
My $110,000 gift will be a much better choice, though, if the gift grows in value during my lifetime! If I give my son $110,000 worth of General Motors stock, and at my death this stock is worth $500,000, then I have made a wise gift of $110,000. The gift itself accomplished little in tax savings, but the growth in value of my GM stock in my son's hands removed this growth from my estate. If I owned the stock and it grew to be worth $500,000 in my hands, the $500,000 holding would pay an approximate $250,000 estate tax when I die. Since I gave it to my son, I removed almost $400,000 from my estate, and saved $200,000 or so in estate taxes.
So, a gift in excess of $11,000 to any individual in any year is a waste of energy, if the property does not grow during my lifetime. Whether I make the further gift or not, the tax impact is the same: I use up a portion of my estate tax exemption. If the property grows in value, though, all of the growth is excluded from my estate. So the message is: give away assets likely to grow, and use your estate tax exemption wisely.
Gifts beyond $1,000,000 add a further complexity. If I give away $1,511,000 to my daughter, this gift has 3 different components:
$11,000 is free from gift tax and estate tax
$1,000,000 is free from gift tax, but it saves estate taxes only on future growth
$500,000 pays a gift tax in the $200,000 range
To review, the $11,000 gift is free from both gift and estate taxes whenever this gift is made. These gifts are tax free when made to any number of people.
The $1,000,000 gift uses the $1,000,000 gift tax exemption, and it also uses $1,000,000 of the estate tax exemption (or the entire exemption if death occurs in a year when the exemption is $1,000,000).
The $500,000 gift results in a gift tax in the $200,000 range, and at the time of your estate, the $500,000 will be brought back into your estate, but you will also get “credit” for the $200,000 tax paid, so it will be as if you paid $200,000 of estate tax in advance.
Again the $1,000,000 gift may be worthwhile: if it grows, the growth is removed from your estate. The $500,000 gift may also be worthwhile. If this $500,000 grows in value, this growth is also removed from your estate. Additionally, while the payment of a $200,000 gift tax is painful, consider this: if you cashed in a municipal bond to pay the $200,000 gift tax, this $200,000 municipal bond is removed from your estate. If you had kept the municipal bond, it would have been taxed in your estate at about 50% rates. By paying a gift tax, you reduce your estate tax by about $100,000 by removing from your estate the asset used to pay the gift tax..
To prevent taxpayers in poor health from making huge gifts just before they die to get gift tax dollars out of an estate, the rules bring back into your estate gift taxes paid within 3 years of your death. As you can see, your tax dollars are going to government lawyers working hard to make sure your tax dollars go to the government!
The $1,000,000 sum in our summary above is a gift tax exemption. This exemption is not increasing with the estate tax exemption, but to the extent you make gifts using the $1,000,000 gift tax exemption, you also exhaust the estate tax exemption. So, again, note the following about our gift of $1,511,000:
$11,000 is free from gift tax and estate tax
$1,000,000 is free from gift tax, but it uses up both your $1,000,000 gift tax exemption and it exhausts $1,000,000 of your estate tax exemption
$500,000 pays a gift tax in the $200,000 range; in your estate, the $500,000 gift has the effect of taxing your gift exactly the same way it would have been taxed in your estate had you not made the gift; except that growth after your gift is excluded from your estate, and the $200,000 gift tax is excluded from your estate.
Until now, we have discussed the estate tax rules and the wisdom of gifts within the rules. In this chapter and in those immediately following, we will focus on how large gifts can be made using a small portion of your gift and estate tax exemptions. In addition, in some of these discussions, we will focus on making $11,000 annual gifts which can reduce your estate by hundreds of thousands of dollars.
Chapter 12. A Defective Trust
Many of the gifts described in the following pages involve gifts to trusts. In these pages we ask you to consider gifts of $11,000, and these gifts can be made on behalf of an unlimited number of individuals; and further we suggest that you consider gifts using some or all of your $1,000,000 gift tax exemption.
Using many of the techniques described on the following pages, the trust you arrange can be a special trust with a horrible name, a “Defective Trust”. With a Defective Trust, if you place an asset into the trust, and if the asset grows and is sold within the Defective Trust get to pay the resulting capital gains tax.
Consider a trust to which you give $44,000 worth of stock in a company with an idea you are tinkering with in your garage. That is $22,000 for each of your 2 children, and you are married, so your gift may be free from gift tax. Assume you also put in an extra $100,000, which uses up $100,000 of both your $1,000,000 gift tax exemption, and your estate tax exemption. Then “boom”! The stock grows to be worth $1,000,000, the company gets sold, and now there is a $200,000 capital gains tax to pay.
If your trust is a Defective Trust, you can pay this $200,000 capital gains tax. This $200,000 tax payment looks like a gift to your children, but the IRS does not consider it a gift. In addition, this payment of tax for the benefit of your children does not use your $1,000,000 gift tax exemption or your estate tax exemption. It does not even use up your $22,000 annual exclusions in the year of payment. Your original gift does count as a gift, but this payment of tax does not.
The name Defective Trust derives from an obscure power over the trust which you keep when you establish the trust. The obscure power is enough to have the trust taxable to you for income tax purposes. So with a Defective Trust, you pay all capital gains tax and all income taxes, too.
The key to a Defective Trust is not to keep so much power over the trust that the trust will be considered part of your estate when you die. If you keep that much power, the benefit of the Defective Trust is lost. You want to keep the following power:
Enough power so the trust will be taxed to you for income tax purposes; but
Not so much power so the trust will be taxed to you for estate tax purposes
There a number of powers you can keep in a trust which will make the trust a Defective Trust. You can also keep the power to clear up the defect later, and let the trust pay the taxes, if your children turn out to be little rich spoiled brats; or even worse, if your kids begin to get richer than you!
Most any of the trusts described in our next few chapters can be structured as Defective Trusts. Structuring the trusts as Defective Trust may give you an added advantage in shifting the burden of income tax payments away from your children’s trusts, so instead you pay these taxes; and these payments are not considered added gifts by the IRS.
Chapter 13. A Qualified Personal Residence Trust, or “QPRT”
The first way to reduce estate taxes using lifetime gifts is through a Qualified Personal Residence Trust, or a QPRT, which is a gift of your home to your children. If you arranged such a gift years ago, you may know a QPRT by its former name, a Grantor Retained Income Trust, or GRIT. I miss that acronym, because I once wrote an article on the subject titled “GRITS, They’re Not Just for Breakfast Anymore”; and “QPRTS, They’re Not Just for Breakfast Anymore” just doesn’t have the same ring to it. GRITs and QPRTs, though, are the same animal.
When we consider gifts to our children over $11,000 per child, we are limited by the $1,000,000 the federal government allows us to give away free of gift and estate tax. We saw in Chapter 8 that this $1,000,000 limit is only available one time: we can use it during our lifetime, but if we use it during our lifetime, it is not available at death. The $1,000,000 limit is in addition to our $11,000 annual gifts, and just as the $11,000 exclusion which increases to $22,000 for a married couple, a husband and wife each has a $1,000,000 gift tax exemption, so a married couple can give away $2,000,000 without paying gift taxes, in addition to $22,000 annual gifts.
We have highlighted several times an advantage in using part of our $1,000,000 limit during lifetime. With a lifetime gift, all growth in the gifted asset is excluded from our estate. If I give away a $700,000 asset during my lifetime, and the asset is worth $5,000,000 at my death, the added $4,300,000 in value is excluded from my estate.
The only tax negative to a $700,000 gift is the loss of a "step-up in basis" on the property: assets I give away during my lifetime keep their old basis for capital gains tax purposes, while assets passing through my estate take my estate value as their basis for capital gain purposes. So, if I paid $200,000 for my home, and I give it to my daughter when it is worth $1,000,000, she will have an $800,000 capital gain if she sells the home for $1,000,000; if I keep it and leave it to her when I die, she will pay no capital gains tax if she sells the home the day after I die.
A QPRT
A Qualified Personal Residence Trust, or a QPRT, allows an individual to leverage the $1,000,000 gift and estate tax exemptions. With a QPRT, I give away a home, but I retain the home as my own for a period of years. At the end of the period, the home belongs to my children or other heirs. For example, I might create a trust (a QPRT) under which I give my daughter my $1,000,000 home, but I keep the home for myself for 9 years, and at the end of the 9 year period, the home passes on to my daughter.
In this example, I have not made a $1,000,000 gift. Rather, I have given away $1,000,000 less the value of the 9 year interest I have retained. If I am in good health and of a reasonable age, nine years worth of value can amount to a substantial reduction in my gift. At the end of 9 years, my daughter receives $1 million, plus (or minus!) any change in value of the home over the nine years. There is an IRS-blessed table on which the value of a 9-year interest can be determined.
Now, if this sounds too good to be true to you, so did it sound too good to be true to the Internal Revenue Service, which has attacked QPRTs at every turn. Initially, individuals arranged a trust of this nature with stocks or real estate likely to grow in value, but the IRS got the Congress to legislate this concept out of existence with one exception: now under the QPRT rules the IRS has limited your right to create a QPRT-type trust only when you are arranging a trust with residential property. So, while you cannot create a QPRT with your IBM stock, you can create a QPRT with your home, your summer home, or any other residential property you own. The only limit you face is the number of QPRTS you can use: you can only create QPRTS with 2 residences, maximum, and one of the 2 must be your principal residence.
So, how significant an advantage is the creation of a QPRT? Well, consider a 70 year old making a gift to a 7 year QPRT of a home worth $700,000. With this gift, the 70 year old keeps a 7 year interest in the home valued under IRS tables, and makes a gift of about $330,000. A 60 year old keeping a 10 year interest in a $700,000 home, makes a gift of about $300,000. Let's look more closely at this 60 year old's gift, to better understand both the mechanics, and some of the nuances of a QPRT.
This individual has given away $700,000 worth of value, but has only used $300,000 of the $1,000,000 gift tax exclusion available to the individual. This gift also exhausts $300,000 of this individual’s estate tax exemption. So long as the individual making the gift survives for the 10 year term selected, the home will be completely excluded from this individual's estate. For gift and estate tax purposes, the only amount included in the estate is $300,000. If over this individual’s lifetime the home grows to be worth $2,000,000, the only impact the home will have in this person’s estate is that way back this person used up $300,000 of the gift tax exemption and in using that exemption, this individual also exhausted $300,000 of his or her estate tax exemption.
If the person making the gift dies within the 10 year period, the QPRT implodes, the advantage of the QPRT is lost, and nothing has been accomplished. In this instance, the full value of the home is included in the individual's estate. Nothing is lost, either; the family is just as well off if the QPRT had not been attempted.
If the 60 year old survives, there are also important considerations. First, this individual no longer owns the property, but rather has kept an interest for a term of years; this may or may not be a problem for obvious reasons. Second, we mentioned earlier, with any gift, including a QPRT, the person taking the gift takes the original basis in the property. So, if the property only cost $100,000, later when it is ultimately sold, there will be a capital gain with this $100,000 as a basis; compare this with the situation where there had been no QPRT, and the home passed through the estate of the owner. Without the QPRT, all capital gains would be extinguished at death. Remember, with a gift, basis is traced back to the person making the gift, but when an asset passes through an estate, it receives a new cost basis from the estate.
A QPRT is a Qualified Personal Residence Trust, with emphasis on the word "trust". As with any trust, there is no requirement that your children get your residence outright when the trust expires. Your trustee can be given a mandate in your trust to continue to hold the property through your lifetime, so long as you do not benefit from the trust in any way. If you continue to live there you will be required to pay market rate rent, just like any other tenant, but remember, you will be older in 10 years and you may be looking for opportunities to shift even more to your heirs then, so rent payments may be an added value.
If you are older now, you may want to arrange multiple QPRTs on one home. You can arrange a 5 year QPRT on 1/3 of your home; a 10 year QPRT on a second 1/3 of your home; and a 15 year QPRT on the final 1/3. You will get less of an advantage on the 5 year QPRT, but if you die in the sixth year, you will have gotten some advantage at least for your effort.
If you are young and wealthy, you may want to arrange a QPRT for 20 or 25 years. If you keep a 20 year interest in a $1,000,000 home, you may be keeping as much as $800,000 of the home’s value, represented by your 20 year interest. Here your gift is just $200,000; you will be using $200,000 of your gift and estate tax exemptions; and if your home grows to be worth $3,000,000 over your lifetime, you will be effectively “freezing” the value of the home at $200,000. All you need to do is to be sure to outlive the 20 year term of your QPRT.
One final caution is in order. The valuation of the QPRT calculated here is an estimate based on IRS interest rates in effect on the day this book is written, but these rates change monthly, so our statements of value should only be considered approximations.
With our final caution, let’s also offer one final positive to QPRTs, too. At the moment, the author knows of no individual who has died within his or her QPRT term. We suspect that maybe the children realize that if you die within your QPRT term they will pay a large estate tax; perhaps the kids do everything possible to keep parents alive, when the parents have arranged a QPRT. Expect to be fed low cholesterol meals and do not be surprised to receive health club memberships for the holidays. Perhaps a 20 year QPRT is the secret to an assured long life.
Chapter 14. The Family Limited Partnership
A second way to reduce estate taxes with lifetime gifts is through the use of a Family Limited Partnership. A small gift using a Family Limited Partnership can be leveraged into a large estate tax saving, later.
We have seen that we can all give $11,000 a year free of gift tax to anyone we choose. If our spouse joins in the gift, we can give $22,000 a year. If we are fond of our son-in-law or daughter-in-law, which happens only occasionally, a married couple can give a son-in-law and daughter-in-law a total of $44,000 a year.
We can afford to make a mistake with these $11,000 gifts, since the amount is relatively small and the opportunity for gifts occurs each year.
We can also give away $1,000,000 once during our lifetime, but there is less room for mistake here. You only get one chance over your lifetime to make a $1,000,000 gift, so it is important to make the most of this gift. If you give away $1,000,000, and it is still worth $1,000,000 when you die, you will have accomplished nothing. If you give away $1,000,000 and at your death the asset has dropped in value to $200,000, you will still have exhausted $1,000,000 of your estate tax exemption.
It is important to give away an asset likely to grow, since it is this growth which escapes tax when you die. If you are married, and you and your spouse give away $2 million, and the $2 million is still worth $2 million when it passes to your children, we know that you will have gained no advantage; but you may have actually cost your kids some tax. If the $2 million passed through your estate, all capital gains would have been forgiven to the date of your death; because you made a gift, your kids keep your basis.
So, it is critical in making gifts to use your $11,000 exclusion and your $1,000,000 gift tax exemption wisely. A married couple should use their $22,000 annual exclusions and their $2 million exemption wisely.
The Family Limited Partnership has been developed to permit you to use these exemptions wisely.
To understand a Family Limited Partnership, consider my 4 daughters, but one special daughter, Kate. What makes Kate special is her ability to spend money: if I gave Kate $1,000,000 today, Kate could easily spend the $1,000,000 in an hour at the Banana Republic store or at The Gap.
With a Family Limited Partnership, I do not give Kate $1,000,000 outright. Instead, I place $1,000,000 worth of assets in a partnership, and I give Kate almost the entire $1,000,000, but in the form of partnership interests. If Kate brings her partnership interests to The Gap, the store will not give her $1,000,000 worth of merchandise, even though technically she has something in her hands worth close to $1,000,000. With a Family Limited Partnership, my control over Kate’s interest in the $1,000,000 stake makes the stake worth less than $1,000,000.
So when you make gifts to your children using a Family Limited Partnership, you do not give your kids cash; rather, you make a gift of an interest in a partnership. If you made a gift of IBM stock to your children outright, your children could easily sell me their shares of IBM, but the children will find it difficult to sell their IBM stock if it is held in a limited partnership, with their cranky old father or mother as the controlling general partner.
It is just this lack of marketability of a partnership interest which gives the concept of a Family Limited Partnership appeal. Because the limited partnership interest is not marketable, and because your child's interest is a minority interest, a gift worth $18,000, might only be worth $11,000 if it is represented by a limited partnership interest in a Family Limited Partnership. A gift of $1,600,000 of publicly traded assets, might be worth less than $1,000,000 if made in the form of a limited partnership interest.
This advantage may be magnified if you own a family business, because of the subjective nature of a business valuation, coupled with the explosive growth which sometimes occurs with a closely held company. If you have the next soft drink likely to compete with Pepsi, you can place stock in your soft drink company into a limited partnership now, and give away value to your children worth much more than the $11,000 or the $1,000,000 limits.
For example, assume you think your business at liquidation today is worth $4 million, but perhaps the appraised value will be much less. Assume an appraisal of $2 million for the business, and assume you place your stock in a Family Limited Partnership. You remain general partner, and as general partner you keep control of the partnership. If you give your child a 49% interest in the $2,000,000 business, you would think this would be a gift of just under $1 million. There has always been a discount allowed, though, for lack of control of the business. With a Family Limited Partnership, there may be additional discounts available for the further reduction in value by virtue of your control as general partner.
In this example, if you could argue for a 20% discount for your gift of a minority interest and lack of marketability of the minority interest you are giving away, then your gift is no longer a gift in the $1,000,000 range, exhausting most of your $1,000,000 gift tax exemption. No, your gift now is closer to $800,000 in value. If the gift is not made outright but rather through a Family Limited Partnership, you may argue for a further 20% discount bringing the value down to the $650,000 range.
Discounts in the 40% range are tossed around as a benchmark in this area, but the IRS is very sensitive to these valuation discounts. Maybe you want to avoid taking too much of a discount, to lessen the threat of IRS intervention. Perhaps you simply want to consider a 40% discount, anticipating that on compromise you may need to settle on a lower amount.
Again, look at the business worth $2,000,000 which you feel may be worth $4,000,000 in a few years. If you give away ½ of the value today, your gift with a 40% discount is $600,000, 40% of your $1,000,000 gift. If the business is later sold for $4,000,000, this ½ interest you gave away will now be worth $2,000,000 to your children, and all you will have used is $600,000 of your $1,000,000 gift tax exemption to shift this $2,000,000 interest to your kids.
Be careful about valuation, though. You want an expert appraiser. Further, you do not want to exert any influence over the appraiser. The minority interest discount and the discount for lack of marketability stand on their own as a means to reduce value substantially, without your interference. Your interference can lessen the credibility of an expert appraisal, and it often amounts to unnecessary meddling, with the discounts routinely granted in recent court cases.
Remember also, you do not need to own a family business to make a Family Limited Partnership work for you. A client in his 90s created a Family Limited Partnership at my urging some years ago. He placed $1,000,000 worth of “blue chip” stocks into the partnership, and he gave limited partnership interests to his children. He claimed his gift was $600,000.
I left my firm while the client was still alive, and I never did determine if the $600,000 value stood up. One possibility was that the IRS never challenged his valuation when he filed his gift tax return. Alternatively, the IRS may have “thrown out” his valuation, or they may have challenged his valuation and granted a lower discount, perhaps only 10%. A challenge by the IRS is more likely with a 90 year old, because the IRS has 3 years to challenge a gift, and if you die within the 3 year term after making a gift, the IRS is more likely to review your gift when they look at your estate tax return.
All of that is irrelevant to my 90 year old client, though, because in his mind he beat the IRS out of gift and estate tax when his gift of $1,000,000 was magically transformed into a $600,000 gift through the magic of discounting. There is something gained from dying happy, even if your gift is challenged by the IRS long after you are gone!
So, use your $11,000 and $1,000,000 exemptions, but use them where possible by giving away assets whose value you can discount using a family limited partnership, and continue to work hard, knowing your assets are growing for you and your children, rather than for the tax man.
Chapter 15. A Grantor Retained Annuity Trust (a GRAT)
So QPRTs and a Family Limited Partnership are means to give away assets, and they both leverage your gift tax exemption. With each of these arrangements, if the gifted asset grows in value you have the potential to pass great sums on to your children and other heirs, with a lessened estate tax.
A Grantor Retained Annuity Trust, or a GRAT, is an even better choice, if you have an asset likely to assuredly take off in value quickly. A GRAT is the perfect choice with a parcel of land about to explode in value, or an interest in a company with great immediate growth prospects.
Let’s assume you have a stake in a company likely to go public soon, and you are convinced that the company will be worth much more than its current value, when it is publicly traded. Assume, for example, that you think the company might grow three-fold in a short time.
Before going any further, lets review the gift and estate tax rules one more time. Remember, estate taxes will take about 50% of your estate at your death. The only exceptions are assets passing to your spouse, assets passing to charity, and the estate tax exemption. This exemption will be $2,000,000 in the years 2006, 2007, and 2008 and may increase to a larger number in later years. Basic estate planning assuring that a husband and wife each has the estate tax exempt sum in his and her name can assure that married couples use each of their exemptions. The estate tax rate is close to 50% once your assets exceed the exemption.
To reduce the estate tax, individuals make gifts of $11,000 a year. If you are married, your gifts can be $22,000 per year if your spouse agrees to your gift. These gifts can be made to children, grandchildren, nieces, nephews, friends, or anyone else you choose; you can even make a gift to your son-in-law within these limits.
You can also make a gift of $1,000,000 once during your lifetime, but this gift reduces your estate tax exemption, dollar for dollar. If you are married, and you make a gift of $1,022,000 this year to your daughter, $22,000 will be a “free gift”, but the other $1,000,000 gift will use up $500,000 of your exemption, and $500,000 of your spouse’s exemption. You will use up $500,000 of both your gift tax exemption, and $500,000 of your estate tax exemption, and your spouse will also exhaust $500,000 of your spouse’s gift tax and estate tax exemptions.
In recent years, individuals have found a way to make gifts of fast-growing assets, without using any of the $22,000 exclusion, and using very little, if any, of the $1,000,000 exemption. The technique is a Grantor Retained Annuity Trust, or a GRAT.
With a GRAT, you create a trust, and you add assets to the trust. The prime asset added to the trust is your stock or real estate with strong growth potential. The GRAT stipulates that you will get the asset back over 2 or 3 years, plus you will get back with each payment, interest at a stated interest rate. The IRS specifies the interest rate, and the IRS publishes the rate each month.
The trust also stipulates that the trust passes to your children or other beneficiaries at the end of the 2 or 3 year term. If the asset has grown markedly over this term, the kids or other beneficiaries receive this growth. The 2 or 3 year term can be longer, but generally clients like to be rid of the paperwork, tax filings, and payments required of a GRAT, so the term is timed to cover the company’s “growth spurt”. You also lose the benefit of a GRAT if you die within the term you select, so the shorter the term the better, so long as the term covers the asset’s “growth spurt”.
You can put any sum you choose into a GRAT, but the following table shows how much value is shifted with differing sums placed in a GRAT. The table does not take into account the interest that must be paid back to you:
You contribute You take back If the stock triples, your kids get
$1,000,000 $1,000,000 $2,000,000
$2,000,000 $2,000,000 $4,000,000
$5,000,000 $5,000,000 $10,000,000
$10 million $10 million $20 million
Early in the GRAT’s term, the GRAT will probably have nothing in it except your stock, so you will need to take back this stock as your early payment or payments. So, if you put $3,000,000 into a 3 year GRAT, after one year you’ll get $1,000,000 back, plus maybe $180,000 of interest. Hopefully the stock will have grown enough after a year so that this payment is much less than 1/3 of the value of the GRAT.
For example, assume that you want to give away to a GRAT 3000 shares of a stock worth $2,000,000. Your GRAT specifies that you are to receive annual payments over 3 years. If the first year the stock has not grown very much, 1000 shares are going to come back to you, along with enough shares to cover one year’s interest.
If the value of the asset actually falls, you are still obligated to receive back from the GRAT your $1,270,000 required payment, and future payments spelled out in the GRAT. Of course nobody will complain if you do not get the payments back if the stock fails miserably, since after all, it is a payment from your trust to you. From the point of view of the IRS, you and the GRAT are one taxpayer, so all of the GRAT’s earnings, capital gains, and capital losses are taxed to you on your tax return. So gains and losses will be taxed to you during our 3 year term here.
The attraction of a GRAT is shifting of value to your loved ones by a great multiple, if the asset placed in the GRAT achieves explosive growth during the GRAT term. You want to place assets into a GRAT as close as possible to this “growth spurt”, so that when payments are made back to you, the payments will be a small percentage of the value of the GRAT because of the GRAT’s explosive growth.
If your stock grows as you expect, there will be a large capital gains tax on sale, and the GRAT can be arranged to put the burden of this tax on you. So, in our example, if the stock worth $3,000,000 grows in value to be worth $7,000,000 and is then sold within the GRAT term, there may be well over $1,000,000 of capital gains tax to pay. You can arrange the GRAT so you pay this gain out of your own funds, and as much as this payment looks like an added gift from you to your kids, the IRS does not consider the payment a gift. You can even keep this feature in the trust receiving the GRAT proceeds after the 2 or 3 year term, if you’d like.
Finally, GRATs are not just for fast-growing stocks. If you have a piece of real estate you see growing fast, or a business for which you see great potential, or a commodity with strong growth prospects, these assets may also be candidates to place in a GRAT.
So, a GRAT is a great way to shift wealth from yourself to your children or other beneficiaries, if you think you have a fast-growing asset on your hands. Assets shifted away from you avoid the likely 45% estate tax that will be imposed on assets you keep, and with a GRAT, you may be able to shift value, and keep most of your estate tax exemption intact.
Chapter 16. Irrevocable Insurance Trusts: The Last Great Tax Shelter
Now you may feel these planning tools are great for individuals with a large estate, but your estate is much less valuable. All you own is your home and your retirement plan, and these assets bring your estate right up to the estate tax exemption.
Life insurance may be the asset which pushes your estate beyond the estate tax exemption. Life insurance is absolutely the best vehicle available to pay estate taxes, but life insurance owned by you will be taxed in your estate just like every other asset you own. Unfair as it may seem, the insurance will be taxed at its full value paid to your beneficiary, even though you could not reach this full value during your lifetime! Even group term life insurance your company purchases for you is include in your estate, and certainly group term insurance you purchase through your employer will be added to your estate.
Remember that all you get to leave tax free in an estate is the estate tax exemption, which is $2,000,000 in 2006. The remainder of your estate will pay an estate tax in the 50% range! Notice that all of this tax falls on the estate of a single person. If you are married, you can leave 100% of your estate tax free to your spouse. When the assets pass to your kids or any other individual, though, there is this approximate 50% estate tax due within 9 months of death.
If you are married and you create a Bypass Trust, you increase the amount you leave tax free to $4,000,000 in 2006, as long as there is $2,000,000 in your name coming to your trust, and $2,000,000 in your spouse’s name, coming to your spouse’s trust. This assumes that Congress does not change its mind, and the $2,000,000 exemption comes into effect.
In recent years, second-to-die life insurance has been the most popular way to deal with estate taxes. This insurance pays nothing when you die; it pays nothing when your spouse dies if you survive. This insurance pays its proceeds when the second of the two of you dies, and, of course, this is just when the estate tax burden is borne, too. The risk with second-to-die insurance is that your spouse finds your policy the day you die, the spouse books a trip to Acapulco, then realizes that the insurance not only pays nothing at your death, it may actually require your spouse to pay premiums after you are gone so the insurance will be paid in your spouse’s death! Just imagine the tears at your funeral with this scenario.
Second-to-die life insurance pays its proceeds only at the death of the second spouse.
Now if I had $5 million in my name which will pay a $1.5 million estate tax when the assets pass to my children, my attitude would be "so what! the little monsters are still getting a cool $3.5 million they didn't work for!" I find, though, that this is not generally the attitude of my clients with $5 million. The client with this wealth wants to leave $5 million to the kids! With second-to-die life insurance, the client is able to leave the estate to the kids intact.
Insurance is also helpful with an illiquid estate. Real estate which cannot be sold in a slow market can be “stolen” by a buyer who knows estate taxes need to be paid. Fine art and jewelry sold to pay estate taxes can result in a distress sale. An IRA or 401(k) plan can cause almost confiscatory taxes to be paid when income tax is due on funds withdrawn to pay estate taxes.
But it is silly for you to own insurance, second-to-die or conventional insurance if your estate is likely to pay estate taxes. If you own a $1 million policy, or if your spouse owns a $1 million policy, the policy will pay an estate tax in the $500,000 range if your estate exceeds the estate tax exemption. An Irrevocable Trust can be structured to remove second-to-die insurance proceeds, or any other life insurance, from your estate at death and the trust can be further arranged to keep the proceeds from the estate of a surviving spouse.
To take advantage of this Last Great Tax Shelter, though, whether you are using second-to-die life insurance or insurance on your life, you must play by the rules stipulated by the tax authorities and court cases. These rules involve two major issues: assignment of policies, and taking care that the gift and estate tax rules are followed.
Assignment of Policies
Assignment of a policy for our purposes means simply transferring ownership of your policy to an irrevocable trust. The owner should not be confused with the beneficiary of the policy. Each insurance policy has an owner who can change the beneficiary; who can borrow against any cash value; and who can exercise other options within the policy. In addition, each policy has a beneficiary who ultimately receives the insurance proceeds.
When you create an irrevocable trust, you typically name the trust owner and beneficiary, but it is the change of ownership that constitutes a gift of your interest in the policy. Once this gift is completed, you can no longer change the beneficiary, borrow the cash value, or exert any other ownership rights in the policy.
Gift Taxes and Irrevocable Trusts
We have seen that we can give away $11,000 per year, and our spouse can also give away $11,000 per year. We have seen that you can give $22,000 per year to as many parties as you wish, if your spouse joins in your gift. All that is required is the filing of a gift tax return when your gift exceeds $11,000.
To qualify for this exclusion, though, your gift must be a present interest gift, and a gift to a trust is generally not a gift of a present interest, since there is no way to know how much each person benefiting from the trust will ultimately receive. If a gift does not qualify as a present interest gift, it will begin to exhaust a portion of your $1,000,000 gift tax exemption, and whenever you use this exemption, you use your estate tax exemption, too. For example, if you make a $200,000 gift which does not qualify as a present interest gift, you will only be able to leave $1,800,000 tax free after 2006, not $2,000,000, at your death.
So, when you make a gift of $9,000 to an irrevocable trust for your son by paying a $9,000 insurance premium, this is a not a gift of a present interest, so it should not be gift tax free; it should use up $9000 of your $1,000,000 gift tax exemption. It should, but it does not, through the efforts of an individual with crummy name, one Mr. Crummey!
A Crummey Power in an Irrevocable Trust
Mr. Crummey devised a way to convert a gift to an irrevocable trust to a present interest gift qualifying for the $11,000 gift tax exclusion. He accomplished this by providing the beneficiaries of an irrevocable trust with the right to take back funds gifted to the trust right after he made his gift. Crummey’s trust provided that if the beneficiaries did not exercise this right, the funds remained in the trust for the term set for the trust.
This "Crummey Power" in an irrevocable trust will make your gift a present interest gift under current interpretation of the law, but the beneficiaries should be notified in writing of the contributions as you make them, and they should be advised of their right to withdraw the contributed funds. So, each year Mr. Crummey’s trustee sent the Crummey kids a letter (and perhaps now an e-mail) saying something like the following:
“Mr. Crummey just made a gift of $9,000 to an irrevocable trust of which you are beneficiary. You and your brother and sister each have the right to demand $3,000 of this contribution from me as trustee of this trust within the next 30 days.”
The 30 days here assumes your trust says the kids have 30 days to make their demand, and you will want to change your notice if a different time period is specified in your trust. You might also add funds in excess of the insurance premium each year to the trust, so your trustee will not have to come back to you for funds each time he receives a premium notice. This also gives the trust the appearance of being a separate giving device independent of an insurance policy, should the irrevocable trust be attacked in future years; and it may keep the last few insurance premiums out of your estate.
I suspect that Mr. Crummey phoned his kids each time he sent them a “Crummey Notice” telling them that a notice was coming, and letting them know he expected them to leave the funds in the trust. He may have told them he was going to break their arms if they withdrew the funds outlined in the Crummey notice, but we have no way to know whether Mr. Crummey made these phone calls.
Other Issues to Consider
You should also consider the following issues when making a gift of insurance to an irrevocable trust:
• if possible, the trustee should be the party buying the policy in the first instance. If you buy the policy and then transfer it to an irrevocable trust, the insurance will be included in your estate if you die within 3 years of the transfer
• most Banks or other professional trustees will charge a fee for processing premiums and providing Crummey notices, so it might be appropriate to have an individual trustee during your lifetime, with the Bank or other professional succeeding the individual at your death
• if you have only group insurance to be owned by the trust, your employer is probably paying premiums on your behalf. These premiums are considered a gift from you each time they are paid to your irrevocable trust, so you need to calculate how much both your employer and you are paying for your premiums
• if you contribute universal life insurance, or whole life insurance, do not count on the cash value taking care of you in your old age. The cash value belongs to the beneficiaries, not to you, once the policy is gifted to an irrevocable trust
• Many advisors feel that an irrevocable insurance trust "wastes" your $11,000 gift tax exclusion. We buy insurance to protect us against premature death, but most of us live long lives. If you have assets likely to grow over time which you can safely give to children or grandchildren, gifts of these assets are a better use of your $11,000 exclusion, since the future growth will be excluded from your estate; if you are not making other gifts, though, gifts to an irrevocable insurance trust can be a prudent use of your $11,000 exclusion
• An irrevocable trust where any one child has the right to take more than 5% of the trust assets in a year may result in an estate tax for the full value of the entire trust in the child's estate; so it may be wise to limit premiums, and the right to take out the contributed premiums, to 5% of the trust’s value, each year
The final, and most critical point to remember with an irrevocable trust, is that it is irrevocable! Although you can add flexible provisions to cover the possibility of death or divorce, the trust can never be changed! Many individuals feel that there is nobody but their spouse and children that they would ever want to benefit from their insurance, and if you have this attitude, an irrevocable insurance trust can result in a substantial estate tax saving, owning your life insurance. Even if your spouse is not your best friend, though, an irrevocable trust can name a "generic" spouse beneficiary, so instead of specifying that the trust is to take care of “…my wife, Cheryl, and my children…”, the trust can take care of “…my wife and children…”; or you want to risk divorce now, the trust can even say that it is for my “…spouse to whom I am married on the date of my death, and my children….”
It would be really tricky, though, if you specified that the trust is for “…the benefit of my wife, Cheryl, and my children…” and then you divorced Cheryl and married a woman named Cheryl. The court case Cheryl vs. Cheryl may be the first probate proceeding ever shown live on Court TV!
Chapter 17. Gifts to Charity
Gifts to charity can serve two noble purposes: they can benefit the needy, and they can serve that most noble of all causes, that of reducing our own burden of income and estate taxes. Assume you have substantial wealth, and you think you would like to leave a legacy to your favorite college, or your local YMCA, or a homeless shelter. What is the best way to accomplish your wish?
Your Will is Nice
Leaving assets by your will or revocable trust is a good choice for charitable giving. With this choice, you save estate taxes at rates that have been reduced, but which still will be in the 45% to 50% range in the near term, when your estate exceeds $2,000,000 or so. This estate tax will all be saved if you leave funds to charity from your estate. This is a sound choice, but there may be better opportunities.
Your IRA or 401k Plan is a Better Choice
Retirement plans are wonderful for us in our retirement years. If you are married, they are also a great resource for your spouse: your spouse can roll over your retirement plan into a “spousal IRA”, and continue to enjoy your retirement plan long after you are gone.
Leaving retirement plans to children or other family members, though, results in one of the largest taxes you can pay: an estate tax which can easily be 50%, and income tax paid by your children or other beneficiaries at 30% to 36% rates. Put these two taxes together, and take whatever deductions you can, and the IRA or 401k plan pays an effective tax of 70% or more! If you leave the retirement plan to charity, you save all of this 70%. Put another way, leaving your $1,000,000 to charity from your IRA saves $700,000 in tax.
Lifetime Giving: Those Nice People at the IRS Pay Most of the Gift
Giving away $1,000,000 during your lifetime is an even better choice, since this too saves $500,000 in estate taxes later if you have an estate worth several million dollars. With this $1,000,000 gift, you also may save close to $400,000 of income taxes. This means your $1,000,000 gift has saved you $900,000 in taxes, and maybe you get your charity to name a building after you!
Further, if you give the charity your low basis stock, the charity can sell the stock without capital gain to you or to the charity.
Lifetime Giving, With Income Back to You
With a Charitable Remainder Trust, you can get most of the benefits just described, and take back an income for life. This trust lets a young couple take back income in the 5% range, but an older couple can take back 7% or even 8% for life. The amount of lifetime income coming back to you reduces your tax deduction, but the deduction is still usually substantial. There are two different types of Charitable Remainder Trust.
Two types of Charitable Remainder Trust
You can create a Charitable Remainder Annuity Trust. Here, the income you take from this trust is a fixed sum for life, e.g., “...a $1,000,000 trust paying $70,000 for the life of me and my spouse....” This is wonderful in a period of declining stock and bond markets, since your $70,000 income continues even if the trust loses value (although the trust does need to have at least $70,000, to pay $70,000).
To summarize, a 7% Charitable Remainder Annuity Trust pays you (and your spouse after you are gone, if you so choose)
If the trust at creation is worth $1,000,000, you get $70,000 a year
If the trust grows to $2,000,000, you get $70,000 a year
If the trust drops to $500,000, you get $70,000 a year until the trust runs out of money
You can also establish a Charitable Remainder Unitrust. Here, the income you take varies each year with the value of the trust, e.g., you set a 7% variable payment for life, and the first year you get $70,000; the trust then grows to $1,100,000, so the second year you get $77,000. These variable payments are great in a rising market.
What about a declining market, though, with this variable payment. The trust starts out at $1,000,000, and the first year you receive $70,000. But now the trust both drops in value and you have taken $70,000. The trust may soon be worth $900,000, which makes your income $63,000 the second year. If you carry this out 3 or 4 years, your income can fall off markedly.
To summarize, with a Charitable Remainder Unitrust you (and later your spouse, if you choose) receive:
If the trust at creation is worth $1,000,000, you get $70,000 a year
If the trust grows to $2,000,000, you get $140,000 a year
If the trust drops to $500,000, you get $35,000 a year until the trust runs out of money
Clients sometimes create two charitable remainder trusts: one Annuity Trust paying a fixed income for life to protect against a declining market; and a second Unitrust paying a variable sum for life, to gain added income should the stock market continue to grow.
Who Benefits From a Charitable Remainder Trust Before it Passes to Charity
The simplest Charitable Remainder Trust pays its income to you for life, with the trust assets ultimately passing to charity. With this arrangement too, you gain an income and estate tax deduction. With this Charitable Remainder Trust, you can have an independent trustee, separate from the charity, or many charities will offer to serve as trustee. This Charitable Remainder Trust where you are the sole beneficiary gets you the highest deduction possible.
Your Charitable Remainder Trust can also provide that on your death, the income is to continue on for your spouse. When you add your spouse’s life to the charitable remainder trust, you reduce your income tax deduction since more income is likely to be paid out with 2 lives, than with one life.
You can also go one step further, keeping the income from a charitable trust for your family following your death. Remember, though, the more people you add to your Charitable Remainder Trust to receive income, the less your charitable deduction will be. Additionally, when you add your spouse as a beneficiary, the IRS says you are making a gift of the income to your spouse, but that is not a problem: you can make a gift to your spouse of any sum you choose, and gifts to your spouse are totally free from gift tax and estate tax.
If you add your son and daughter as beneficiaries of your Charitable Remainder Trust, we said earlier this will reduce your charitable deduction because now you are paying additional income from the trust. The IRS has actuarial tables which determines your deduction, and the rules stipulate that to have a valid Charitable Remainder Trust your deduction as computed by the IRS tables must be at least 10% of the value of your Charitable Remainder Trust on the date you set up the trust. So if you arrange a $500,000 Charitable Remainder Trust, the deduction must be at least $50,000, and if you pile too many income beneficiaries onto your Charitable Remainder Trust, you will not have a Charitable Remainder Trust at all.
Adding your son or daughter, or any other beneficiary to a Charitable Remainder Trust gives rise to another serious issue. When you include anyone other than your spouse as an income taker under a Charitable Remainder Trust, this inclusion of a son, daughter, or other individual who will receive income creates a gift, which gives rise to a gift tax issue. The value of the gift to the beneficiary (other than your spouse) constitutes a gift in the view of the IRS, and your gift uses your $1,000,000 gift tax exemption and your estate tax exemption. The amount of this gift is determined on an actuarial table, which calculates out how much the beneficiary is likely to get over a lifetime.
Of course, you do not need to worry about gift taxes if you create a Charitable Remainder Trust to take effect upon your death. In fact, many individuals say in a will or trust "…I want my estate to go to The Boston Symphony, but I want it to go to my Uncle Joe, first…." Well, with a substantial estate, this may be silly if you do not use a Charitable Remainder Trust. Without a Charitable Remainder Trust your estate will pay an estate tax on the full value of the fund you are leaving for Uncle Joe, and only after this estate tax is paid will Uncle Joe will benefit with whatever is left; and then the charity will receive the leftovers. Something like this:
No Charitable Remainder Trust
You have an estate worth $5,000,000
Each year 5% of your trust is to be paid to Uncle Joe for life when you are gone
Your estate pays an estate tax $2,000,000
When Joe dies charity gets $3,000,000
A much better arrangement is to leave the money to the charity, but prescribe that Uncle Joe will receive an income for life. This is a Charitable Remainder Trust. Here, your estate will likely pay very little estate tax, Uncle Joe will receive an income for life, and after he has lived his life of grandeur, the funds will pass to your favorite charity. Now your estate looks like this:
A Charitable Remainder Trust
You have an estate worth $5,000,000
You create a Charitable Remainder Trust which pays Joe 5% a year for life
Your estate pays an estate tax $ 700,000
When Joe dies charity gets $5,000,000
Charity gets the whole $4,300,000 because the only value included in your estate is the actuarial value of the 5% payments to Joe for life, and if Joe is in his 70s, the payments to Joe are likely to be valued at about ½ the value of your Charitable Remainder Trust. If Joe is very young, or if there are many other beneficiaries, or if the payments to Joe and others is closer to 10% a year, these factors will all increase the actuarial value of gifts to the family and decrease the actuarial value of your gifts to charity. When the actuarial value of gifts to the family exceed your estate tax exemption, your estate will pay estate taxes. For example, if you die in a year when the estate tax exemption is $2,000,000, and if the income value to be paid to family members and others is $2,500,000, there will be about a $250,000 estate tax in your estate; but this is still better than the $2,000,000 tax bite which is paid in our first scenario, where no Charitable Remainder Trust was adopted.
This is a gift to charity using a Charitable Remainder Trust at your death as well as at death. In Chapter XX we develop further a Charitable Remainder Trust to which you contribute assets during your lifetime, specifically to reduce capital gains tax on the sale of an asset..
So, Now You Know How to Make Payments to Charity
Now, What Charities Should Get Your Gifts
You are on your own making gifts outright to charity, and most of us know worthy causes: a cure for Lou Gehrig’s disease, AIDS research, your alma mater, The Nature Conservancy.
A Foundation is a means to create your own personal endowment. You can create a Foundation, and donate funds using any or all of the 4 avenues we have just explored:
1. You can create your Foundation, donate low basis stock, and have your Foundation sell the stock, with no capital gain. You can then ask your Foundation to pay funds to your favorite charities.
2. You can name your Foundation to receive assets from your Charitable Remainder Trust after your death (or after the death of you and your spouse).
3. You can name your Foundation beneficiary under your IRA or 401k plan, or secondary beneficiary when you and your spouse are gone.
4. You can name your Foundation to receive assets from your will or trust.
Your Foundation
Your Foundation can be a Private Foundation, or a Charitable Fund at a Public Foundation which is much simpler to establish and maintain. A Private Foundation has been the avenue of choice for charitable contributions for decades. With a Private Foundation, you can assure continued good works carried on in your name, long after you are gone.
Private Foundations do have limitations, however, which have driven many individuals to use a Charitable Fund as an alternative to a Private Foundation.
A Charitable Fund vs. a Private Foundation
With a Charitable Fund, you gain all the advantages of a Private Foundation, and more. With a Charitable Fund, you can segregate a Fund in your name: The Kevin Flatley Fund, in my case. Any payments to charity from your Charitable Fund are made in your name.
For some people this is not an important issue, witness the number of donations made in the name “anonymous”, which always strikes me as a waste of good publicity. Rather than waste this public proclamation of your good intentions, I would like to offer The Kevin M. Flatley Charitable Gift Fund as a suitable depository for anyone shy about taking credit for gifts. You can have the deduction, I will just take the publicity which comes with being a fat-cat, big time donor.
You can create your Charitable Fund in your name with a one page, off-the-shelf document provided by many banks and mutual fund companies. There can be no lawyers, no CPAs, no contact with charities and their telemarketers. The Fidelity Charitable Gift Fund is the best known vehicle for creating a Charitable Fund, but almost every large bank also operates a Charitable Gift Fund, and your bank’s Charitable Gift Fund may come with added benefits when coupled with your trust fund at the same bank.
A Charitable Fund also frees you from the many traps to a Private Foundation. With a Private Foundation, you need to qualify as a Foundation with the IRS, you pay a 1% or 2% excise tax on income and capital gains, you need to pay out 5% of your Foundation’s value each year, and you are required to file a tax return for the Foundation. Since your Private Foundation stands on its own as a separate entity, your Private Foundation is likely to pay high fees for investment management.
Your Charitable Fund requires no tax filings since it pays no tax; it is only required to pay out its income each year with no 5% requirement; and because your Fund is part of a Charitable Gift Fund, fees are likely to be less than the cost of maintaining a Private Foundation. Gifts to your Fund are also treated like gifts outright to charity for income tax purposes, so you get to take a deduction against your income.
To understand this higher deduction, assume your income from all sources is $200,000, and assume you make a $500,000 cash gift to charity because you had a large gain in a stock this year. You can deduct the following:
For a gift to a public charity, including a Charitable Fund $100,000
For a gift to a Private Foundation $ 60,000
When you give cash to a public charity, including a Charitable Fund, you can deduct up to 50% of your income. When you give cash to a Private Foundation, you can only deduct 30% of your income. In both cases, you can carry the deduction forward for 6 years, this year plus 5 more, so if your income remains stable, you will get to deduct the full $500,000 given to a Charitable Fund over the next 5 years; but notice that with a Private Foundaton, you will only get to deduct $360,000 ($60,000 times 6 years) of your $500,000 gift over 6 years, and then the rest of the deduction is lost.
The case for a Private Foundation gets even worse if you donate low basis assets to give to charity, since here all you can deduct each year with the same $200,000 of income is the following amount:
For a gift to a public charity, including a Charitable Fund $60,000
For a gift to a Private Foundation $40,000
With low basis stock or other low basis assets given to a Charitable Fund, you can deduct 30% of your income each year, but with a Private Foundation you can only deduct 20% of your income when you contribute low basis stock to the Private Foundation. So, a $500,000 gift of Ford Motor Company stock to a Private Foundation in a year when your income is only $200,000 gets you a paltry $40,000 deduction if your income is $200,000, and if your income stays at $200,000 for each of the next 5 years, you will only get to deduct $240,000 in total, with your $500,000 gift.
With appreciated stock given to a Charitable Fund, you are able to give stock at its fair market value. In the 1990s, with the changing of the seasons it seemed, Congress changed the rules governing Private Foundations to only let you deduct the amount of your cost basis when contributing to a Private Foundation. With a gift to your Charitable Fund, Congress has always allowed gifts of stock at current market value.
There are special rules for depreciated real estate, usually real estate used in a business, and for gifts or fine art and other like objects. Generally, these rules value the real estate and the fine art at your cost or your depreciated basis, when figuring your deduction.
So, assume you like the idea of a Charitable Gift Fund. How do you find an appropriate Gift Fund.
Most communities have a foundation designed to receive contributions which can be segregated into a Charitable Gift Fund, The Boston Foundation, The Palm Beach Community Chest, and a similar facility operates in most major metropolitan areas. Again, Fidelity and most banks operate a Charitable Gift Fund. At most Charitable Gift Funds, you can segregate a Charitable Fund in your own name or in the name of your family.
How do you contribute to a Charitable Gift Fund
We began this piece with suggestions for charitable giving: through your will; through your 401k plan or your IRA; or through a gift during your lifetime. Many individuals establish a Charitable Fund during lifetime with cash or securities, and supplement the Charitable Fund with assets later: through a bequest in a will; or to name a Charitable Fund beneficiary of a 401k plan or an IRA; or they name a Charitable Fund to receive assets later, after income has been paid to you or your loved ones, through a Charitable Remainder Trust.
With all of these tax benefits, it is easy to lose sight of the good work the Charitable Fund can sponsor. If during your lifetime, you designate where the income and even the principal, is to go, after you are gone, your family can make this call; and your Charitable Fund can go on in your name all the way to the next millennium. The Charitable Fund is not obligated to take your suggestions for charitable gifts, but I have never seen one yet which has gone against the wishes of the family, as long as the charity is a legitimate, IRS approved entity.
So, use the best option for you to accomplish your charitable giving; then choose between a Private Foundation and a Charitable Fund. If your lawyer is your best friend and you love paying fees to draft a Private Foundation and get it blessed by the IRS; and if you would really like your CPA to earn a little extra income each year doing a Private Foundation tax return; and if you like the way Congress is doing their business so much that you want to pay a 1% or 2% tax on your foundation’s income; and you’d like to see your foundation depleted by a mandatory payout of 5% a year, then go forward and create your own Private Foundation.
If you would prefer to have no lawyers, no tax returns, no excise tax, and no mandatory payments except the net income, then a Charitable Fund at the Charitable Gift Fund may be a far better choice for you.
COMPARISON OF GIFT OPTIONS
Charitable Gift Fund Private Foundation
Immediate income tax deduction Immediate income tax deduction
for full fair market value of gift for full fair market value of gift
Charitable income tax deduction available Charitable income tax deduction
for up to 50% AGI* for cash gifts and 30% available for up to 30% AGI for cash
AGI for gifts of appreciated securities. gifts and 20% AGI for gifts of
appreciated property
No investment control Can exercise investment control
as trustee
No legal costs associated with gift Legal costs incurred in creating
foundation document
($1,000 to $3,500)
No administrative costs to establish fund Administrative costs up to
$1,500 to qualify trust for IRS
No excise tax 2% excise tax on income and capital
gains (Reduced to 1% in certain
circumstances)
Net income must be paid out annually 5% of the net asset value must be
distributed annually
May advise but, technically, have no Complete discretion in distributing
final control over grantmaking disposition funds for philanthropic purposes
*Adjusted gross income
Comparison courtesy of The Fleet National Bank Philanthropic Advisory Group
Chapter 18. Planning With A Spouse In Ill Health
When a spouse is in poor health with an illness likely to be life threatening, there is a natural tendency to stay away from sensitive financial issues. Often, though, a discussion of these issues can be therapeutic: giving an individual issues to consider at a time when distractions are helpful, settling important matters which may be difficult for the spouse to define, perhaps even getting an individual revitalized, channeling energy against the estate tax looming ahead.
An Estate with No Major Estate Tax Problem
For an estate without a federal tax problem, the issue for a spouse in ill health, is probate avoidance. An estate has no federal estate tax problem if it is under $1,000,000, when you consider the value of your home, your life insurance, joint bank accounts and all other assets.
For the estate under the estate tax exemption, avoiding probate is a worthwhile exercise. Probate can involve expense, delays, and unwarranted publicity. As we saw in Chapter 4, assets are subject to probate if they are in your sole name (remember our definition of probate: if it is in your name, it is disposed of by your will, and it is a probate asset!). If you have a $100,000 bank account in your name, this bank account will be disposed of by your will, and it will be subject to probate.
Probate is avoided by disposing of assets other than by your will. If the $100,000 bank account is in joint names or in a trust, the account will generally avoid probate. If you use a trust, the trust can be a very simple document, and the surviving spouse can even be the trustee, if a professional trustee is not needed.
Once again, though, you should be careful moving assets around. For example, if a spouse owns $50,000 in AT&T stock, when this stock passes through his or her estate, all capital gains are forgiven. If the stock is placed in joint names, the stock will avoid probate, but only 1/2 of the stock will pass through the estate, so only 1/2 of the capital gain is forgiven at death. The same rules apply to real estate, and any other investment property.
An Estate Over $1,000,000
If the estate is in excess of $1,000,000, different strategies should be considered. This estate can be left to a spouse with no federal tax, but when the surviving spouse receives this estate, and later passes it on to the children or other heirs, there will be an estate tax at 40% to 50% rates on all assets in excess of $1,000,000. The surviving spouse with this estate is powerless to reduce this tax, except by multiple $11,000 gifts, which can strip the spouse of assets the spouse may need.
An alternative is a trust created by the spouse in poor health, the same trust we discussed in Chapter 2. To review, during her lifetime Mrs. Goodrich should place $1,000,000 in a trust for Mr. Goodrich. When she dies, the trust can benefit him for life with income, he can be given principal by the trustee, the trust can assure that the next Mrs. Goodrich receives nothing from the trust, and the trust can pass to the Goodrich children at his death, with no tax and no probate.
Assume the Goodrichs have $2 million in joint names, and Mrs. Goodrich is in poor health. At her death, there will be no federal estate tax. At Mr. Goodrich's later death, though, this $2,000,000 will pay an estate tax if the exemption is less than $2,000,000 when he dies, or if the assets grow enough to put his estate in a position to pay estate taxes even with a higher exemption.
If Mrs. Goodrich dies with no assets in her name, and with no trust, very little planning can be done following her death. If, however, Mrs. Goodrich places $500,000 of this $2 million in a trust during her lifetime, this trust will be there for her husband for life, but at his death it will pass estate tax free, no matter what his estate is worth. Incidentally, if Mr. Goodrich takes on a new Mrs. Goodrich, at least this $500,000 will come to the Goodrich children if “Heidi Goodrich” squanders the rest.
A Power of Attorney
There are two other issues which should be settled in this process: first, if you want to act for an ill person under a power of attorney, you should know that a power of attorney lapses when an individual loses mental capacity. Many states provide for a power of attorney to survive incapacity if it is a durable power of attorney, durable because by its terms, it says that it will survive your incapacity.
You may create a durable power of attorney which only gives your attorney power to act on your behalf if you become disabled. Many times an individual will create a trust and place nothing in the trust, just because he is lazy, or disinterested in avoiding probate. A Durable Power of Attorney, though, can instruct his attorney to add his assets to his trust on disability. Assets in trust avoid probate, as we saw in Chapter 4, but trust assets also have a wide body of law behind them. For example, it is clear that trusts require regular accounting by the trustee, but attorneys under a durable power may be on their own, without accounting to anyone for years.
Typically, you leave it to your physician, or more than one physician, to determine your state of health. If you have a power of attorney, ask your lawyer if it is "durable", but understand that when we talk about an attorney under a power of attorney, this "attorney" does not have to be a lawyer, but can be your son, a friend, or even your bank.
A living will
Finally, there is so much in the news about living wills. In a living will, you dictate the level of care you will receive if you are totally disabled. In common parlance, a living will indicates whether you want your doctor to "pull the plug", if you are incapacitated. Your attorney probably has a standard form living will, but be sure that this form complies with your wishes before you sign it.
Living wills are not recognized in all states. In Massachusetts, for example, a "health care proxy" is as close as you can come to a living will. With a Massachusetts health care proxy, you appoint an agent to make health care decisions for you, if you are not able. Extraordinary care issues have been pretty well settled by now in court cases. A health care proxy and a living will can dictate your preferences for care far short of your "last illness".
These issues should be discussed with an ill spouse, and often it relieves tension for an individual, knowing these matters are settled.
Chapter 19. Estate Tax Treatment When a Spouse is Not a U.S. Citizen
Although you and your spouse may have lived happily in the United States for many years, if your spouse is not a United States citizen, your spouse may be grieved upon your death; but your spouse will likely be much more grieved upon settling your estate and determining the tax impact on property left to the spouse.
If your estate is less than $1,000,000, this issue is not a concern: we have seen that we can all leave $1,000,000 free from federal estate tax. If your estate is over $1,000,000, assets in excess of this amount which you leave to a non-citizen spouse will be taxed at 40% rate to 55% rates. For example, if you leave $ 1 million to your non-citizen spouse, your estate will pay a $153,000 estate tax, most of which could be avoided if you were married to a United States citizen.
The rationale for this seemingly discriminatory treatment is the government's fear that if they permit assets to pass tax free at death to a non-citizen spouse, the spouse will then return to the "homeland" with these assets, which will never pass through the tax collector's hands. Our government feels that if it allows assets to pass tax free to a spouse, it should be given a fair chance to recover the fruits of its generosity at the spouse's death.
Now before considering divorce so you can re-marry a U.S. citizen, consider two less drastic courses. One choice is to have your spouse become a U. S. citizen, which may or may not be a real choice. A second option is an avenue the Congress carved out for you when they instituted the tax on non-citizen spouses. This option is a Qualified Domestic Trust as described by the Internal Revenue Code
A Qualified Domestic Trust
A Qualified Domestic Trust will permit assets to pass tax free, much as a Marital Deduction trust passes tax free to a citizen spouse. To qualify a trust as a Qualified Domestic Trust, though, you must leave assets in trust, and the trust must meet the following criteria:
• The trust must require at least one trustee to be a U.S. citizen or a U.S. bank or other domestic corporation
• Income must be paid to the spouse
• The trust must give this U.S. trustee the right to decide on principal distributions
• Your executor must make a proper election when the executor files your estate tax return, generally within 9 months of your death
Having met these requirements, assets passing to the Qualified Domestic Trust will pass tax free at your death. As principal is paid from the trust an estate tax will be paid, but this is not much different from the treatment of a citizen spouse: assets passing tax free to a citizen spouse are generally taxed at the spouse's death. Incidentally, the law permits distributions tax free for a "hardship", but this term has not yet been defined by the tax authorities.
An Estate Plan for a Non-citizen Spouse
If you have an estate beyond the $1,000,000 level, and you are married to a non-citizen who will remain a non-citizen, your estate plan should not look too much different from the estate plan of any other individual.
At the death of your spouse, the Qualified Domestic Trust, as well as the remainder of your spouse's assets, will be included in your spouse's estate. As we have seen before, it is at this second death, that taxes are very burdensome. You may delay the tax at the first death with a Qualified Domestic Trust, but at the second death, a federal tax that begins at a 37% rate is paid on all assets in excess of $1,000,000. You will want to avoid this tax, which quickly rises to 50%, and later to 55%, and you can reduce it with a proper estate plan.
A proper estate plan with a non-citizen spouse may work along the following lines: you can create a trust, and under the trust establish a Bypass Trust of $1,000,000; and a Qualified Domestic Trust for the remainder of the estate. A combination of these two trusts will pass $1,200,000 free of tax at your U.S. resident spouse's death, and at your option, all trust assets can be available to your spouse for your spouse's lifetime.
One final issue to consider is a gift to your spouse during your lifetime. These gifts can be in unlimited amounts to a U.S. citizen spouse, but the law limits you to $100,000 per year to a non-citizen spouse. You might consider initiating a program to make $100,000 annual gifts to your spouse, until the spouse has $1,000,000 in the spouse's own name. If this amount is then left in a trust for you, at your death $1,200,000 can pass tax free to your heirs.
In summary, be careful not to leave more than $1,000,000 to a surviving spouse who is not a United States citizen, unless you are prepared to pay a 50% tax on the excess. Further, if you are leaving assets to other individuals, these bequests will reduce this $1,000,000 ceiling. With a Qualified Domestic Trust, though, you can leave assets in trust tax-free for your spouse, and if this trust is part of your estate plan, you can see that $1,200,000 will pass to your heirs free of tax.
Chapter 20. The Three Q’s of Estate Planning
This is probably a good time to take a quick break for a review of the “Q words” of estate planning In talking to your lawyer about estate planning, you sometimes hear so many terms beginning with “Q”, that you feel like throwing up your hands and shouting “I Quit!” with a capital “Q”? Maybe you’ll feel better if you keep in mind that in all of these terms, the “Q” stands for “Qualified”, and qualified in this tax context means you’re going to save some taxes. So, don’t quit just yet, and lets instead look at what these three Q’s are designed to accomplish.
If you Are Married you may want to create a Qualified Terminable Interest Property (whew!) Trust, or a “QTIP Trust
The first of our “Q words” is a QTIP trust, or a “Qualified Terminable Interest Property” trust. While this acronym is unintelligible to most of us, the concept of a QTIP trust assures that assets pass to a spouse free from estate tax, without giving the spouse the right to take the assets on demand.
In an estate plan, after the estate tax exemption passes to a Bypass Trust, about 30% of clients choose to give a surviving spouse the right to take the remaining assets at death, and this surviving spouse can do with the assets whatever he or she chooses. Here, we typically get a reaction like, “… I’m not going to be around. Let him do what he wants with the money. I could care less….” The remaining 70% of clients, though, worry about a second spouse getting their hands on the money. For these clients, a QTIP trust is important.
A QTIP trust must pay all of its income to a spouse, and it must give the spouse the right to demand that a trustee invest in income-producing assets. Generally, the trustee is given the power to pay principal to the spouse, too. This right can be very stingy: health, maintenance, and well-being are common terms in a restrictive QTIP trust. Alternatively, a QTIP trust can be generous: comforts and luxuries of life, for example. It can also be something between these extremes: a “comfortable standard of living” or if you’ve always led the good life, the power to “maintain the comfortable lifestyle we have always lived”, or words to that effect.
A QTIP does not need to be an all-or-nothing arrangement, though. You can give a spouse the right to demand 5% or 10% of the QTIP Trust each year. You can give a spouse 30% outright, and hold the balance in a QTIP Trust. Further, individuals usually hold some assets in joint names. IRAs and other assets often pass to a spouse by beneficiary designation, and these assets will pass to a spouse no matter what your trust says. Usually, good estate planning involves placing some assets in a husband’s name, and some in a wife’s name. These assets will stay with a spouse whether or not you arrange a QTIP trust.
A QTIP trust cannot disinherit a spouse if the surviving spouse does something dastardly, such as a remarriage or moving in with a twenty-five year old. However, that is not all bad. When the twenty-five year old reads the trust, sees the QTIP provision and moves along, the assets are still there for the surviving spouse.
It is sometimes surprising to see how individuals choose trustees for a QTIP trust. Sometimes the spouse is chosen as trustee. With this choice, you might as well give the spouse the money, because the spouse will do what he or she wants with the assets. Sometimes it is the children chosen as trustee. What a great idea to pit the children against their widowed mother or father! You might choose your brother, but your brother will find something wrong with the Dalai Lama or Mary Tyler Moore as a second spouse. If you are going to arrange a QTIP trust, you really want an independent trustee.
If you Are Married to Non-Citizen, Create a Qualified Domestic Trust (QDOT)
Our next “Q” is a QDOT, a Qualified Domestic Trust. This concept only applies if you are married to a non-citizen. If you are married to a citizen, you can leave anything you want tax-free to a spouse -- outright, or by joint tenancy, by beneficiary designation, or in the form of a QTIP Trust. If you are married to a non-citizen and you want assets in excess of your estate tax exemption to pass tax-free, you need to leave these assets to a QDOT. A QDOT is not much more than a QTIP trust with a few more rules attached to it.
Use a Qualified Personal Residence Trust (QPRT) to Reduce the Tax Value of your Home for Estate Purposes
Our final “Q” is a QPRT, or a Qualified Personal Residence Trust. This trust provides a way to reduce the value of a home in your estate. With a QPRT, you take your $1,000,000 house and divide it into two shares, so you own half and your spouse owns half. This “fractionalization” of the home drops its value to $900,000.
You then take your $450,000 one-half interest, and give it to your children. Yet with a QPRT, you keep this interest in the home for a number of years. If you are 30, you might keep your interest in the home for 20 years. The value of the 20-year interest can be computed on an IRS approved actuarial table. Your 20 year interest will be about $350,000; so now your gift is $100,000. Your spouse can make the same arrangement with the spouse’s half interest in the home.
Effectively, you will have made a $100,000 gift to your children, and your spouse will have made a $100,000 gift to the children. Each of you will use up $100,000 of what will be your gift and estate tax exemptions, but other than using up $100,000 of these exemptions, the home will be totally excluded from your estate. This is so, even if the home grows to be worth $2,000,000 in value.
To make a QPRT work, you need to outlive the 20 year term, in my example. For this reason, older clients shorten the term, and this makes the gift a larger sum, but still worth the effort.
QPRTs also need some growth in the value of your home to make them work. If you keep your home and do not arrange a QPRT, and the home passes through your estate, all capital gains are forgiven at your death. This is not the case with gifts; with gifts, your children keep your basis in the home. Clearly, a QPRT is a gift. Yet capital gains taxes are paid only on gains, and only at 20% rates. Estate taxes are assessed on the full value of a home, at rates likely to be in the 50% range.
So, estate planning gives new meaning to the old saw about minding “your p’s and q’s.” However, there is a special emphasis on “minding your Q’s” to assure that assets will pass where you want them to pass, and at a reduced tax rate.
Chapter 21. Gifts to Minors
When you want to make a gift to a minor child, either your own child, or a niece, nephew, or child of a friend, you generally cannot put the gifted asset in the name of the child. A bank or broker needs to have an account registered to someone with authority to buy, sell, and transfer assets, and a minor is too young to have this authority.
UGMA or UTMA
One way to hold assets for a minor is under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). Here, you register an account to an adult as custodian for the benefit of a minor, usually in your state or in the child’s state. UGMA under many state statutes gives children the right to demand the money when they reach age 18; but in all states, UTMA holds the assets for the children until age 21. Prior to age 21, the custodian can pay funds for the child’s tuition, a computer, summer camp, etc.
If you have an estate likely to pay estate taxes, you do not want to be custodian for your child, since this will make the account part of your estate for estate tax purposes if you die. If you have a choice, you would rather have your spouse, your older kids, or a trusted advisor custodian.
UTMA accounts are simple, since they do not require a lawyer to draft the UTMA agreement. The state statute tells a custodian what he can and cannot do.
A Minor’s Trust
A Minor’s Trust acts much like a UTMA account. The funds are there for the minor as a trustee sees a need, and at age 21, the child can demand the funds held in trust. A lawyer is needed to draft a Minor’s Trust, and a separate tax return is required of the trust. Some individuals prefer a Minor’s Trust, though, since these trusts sometimes prescribe that if the child at age 21 does not demand the funds, the funds can remain in trust until a later age.
A Crummey Trust
We mentioned in Chapter XXX, Crummey was an individual with a crummy name, who in the 1970s decided he wanted to place funds in a trust for his kids, but he did not want them to get the funds at age 21. He looked at the rules and found that if he put money into a trust other than a Minor’s Trust for his kids, his gift would not qualify for a married couple’s $22,000 per child annual gift tax exclusion. For gifts to qualify for this $22,000 exclusion, the gifts must be what the IRS calls a “present interest”, and Congress blessed only gifts outright, and UGMA, UTMA, a Minor’s Trust and a College Savings Plan which we discuss later in this chapter, qualified as present interest vehicles.
Crummey put $22,000 for each of his children into a trust, and he gave his children the right to take the funds after they reached an age well past age 21. Crummey stipulated in his trust, though, that within 30 days after each contribution he made to his trust, his kids had the right to take $22,000 each from the trust, but if they did not demand their $22,000, the funds stayed in trust.
Crummey argued that these $22,000 gifts were “present interest” gifts, which should qualify for the $22,000 annual gift tax exclusion, just as gifts outright would qualify. Crummey won his argument, and for better than three decades, courts have followed this Crummey case. Courts have said, though, that it is not enough to give the kids the right to demand their $22,000, notice also needs to be given to the kids each year in which a contribution is made on behalf of the child. These notices are given to a parent of young children, as the natural guardians of the child.
Once the $22,000 per child is placed and left in the trust, it is not necessary to segregate funds for each child, but rather, the whole sum in trust can be used for any child as the trustee sees fit. Crummey trusts can come back later to complicate the child’s estate, since the right to demand more than $5,000 from a trust each year brings the trust into the child’s estate. Generally, though, these trusts are long gone, spent, and forgotten.
As this piece is written, there is a bill in Congress which if passed, will ease the rules, to allow $22,000 gifts to be made to a Crummey-type trust, without notice to the beneficiaries.
A College Savings Plan (a Section 529 Plan)
A College Savings Plan was developed by Congress, to provide one more alternative for putting aside funds for college education. With a College Savings Plan, a married couple can put aside $22,000 a year for college expenses, and this $22,000 gift will be gift tax free, using the $22,000 annual gift tax exclusion. With this plan, you can also “advance” five years of annual $11,000 gifts to your children and grandchildren, with one $55,000 gift this year. If you’re married, your spouse can “advance” another $55,000, so you can create two $55,000 accounts for a child or grandchild this year, which will use your $11,000 annual gift tax exclusion for gifts to this child or grandchild for the next 5 years. Contributions to College Savings Plans must be in the form of cash. If liquidation of existing holdings is required there will be tax consequences.
You can’t die within the 5 years if you give away $55,000 in one year. If you die in 2 years, $33,000 of your “advanced” funds will be back in your estate. In the more likely case that you outlive the 5 years, you can begin adding $11,000 a year additions to each account, or another $55,000 in “advanced” gifts.
With a College Savings Plan, dividends and interest accumulate income tax free. When the funds are withdrawn, accumulated income used for college expenses is free from taxation, but taxed at the parents’ bracket if the child uses the money to buy a Porsche. The Porsche will also cause a 10% penalty on the accumulated earnings.
With a College Savings Plan, if one of your children decides to follow the Rolling Stones World Tour, and the other goes to Stanford, you can use both childrens’ funds to finance the Stanford education, and with private college costs today, you can probably exhaust both funds easily. If you decide to fund the child’s World Tour for its value as a learning experience, this is allowed, but it will trigger a 10% penalty on the earnings, in addition to a tax on the earnings. You could also change the beneficiary to a grandchild, but the funds would then be considered a gift from the original beneficiary to the designated grandchild.
A Family Limited Partnership
In the past few years, the Family Limited Partnership and the Limited Liability Company have become the option of choice for gifting for many individuals. Gifts of limited partnership or limited liability shares allow transfers where you as the general partner, or you as the controlling shareholder, control the asset given well past any age stipulated in the IRS rules. These vehicles are controversial, since individuals often argue that gifts made through these arrangements have diminished value; but there is little controversy about use of these techniques to shift value, while keeping control.
Comparison of Common Gifting Alternatives
|Vehicle |Pros |Cons |
|UGMA |Qualifies for annual $11,000 gift exclusion |Can be demanded by child at age 18 in most states |
| |Easy to set up/administer | |
| |Relatively few restrictions on use of funds | |
|UTMA |Qualifies for annual $11,000 gift exclusion |Can be demanded by child at age 21 in most states |
| |Easy to set up/administer | |
| |Relatively few restrictions on use of funds | |
|Minor’s Trust |Qualifies for annual $11,000 gift exclusion |Can be demanded by child at age 21 |
| |Can be drafted so that funds remain in trust if not |Requires drafting of legal document |
| |demanded by child |Requires separate tax filings |
| |Relatively few restrictions on use of funds | |
|Crummey Trust |Qualifies for annual $11,000 gift exclusion |Requires drafting of legal document |
| |Can delay receipt of funds well past age 21 |Requires separate tax filings |
| |Maximum flexibility on use of funds |Requires right to demand as funds are contributed |
| |Benefits from capital gains treatment |Can complicate a child’s estate |
|College Savings Plan |Can give up to $55,000 in one year |Contributions must be in cash |
|(529 Plan) |Earnings are tax-deferred and tax-free if ultimately |Penalty and tax on accumulated earnings if not |
| |used for qualifying expenses |used for post-secondary education expenses |
| |Can change beneficiaries | |
| |Excess can be passed to next generation, but amount | |
| |transferred is treated as a gift | |
|Family Limited Partnership |Control over gifted asset |Requires drafting of legal documents |
| |Control reduces value of the gifted interest for |Requires annual filings and separate tax returns |
| |gift/estate tax purposes |No official IRS approval |
Chapter 22. The Sale of a Business
Assume you have business, and your competitors are snooping around, wondering if you are interested in selling the company and they are dangling $5,000,000 under your nose. If you sell this company, you will pay $1,000,000 in capital gains tax on sale.
There is a trust arrangement to which you can transfer, say $2,000,000 of this stock, and avoid capital gains tax on this $2,000,000 block of stock. This trust arrangement gets you the following benefits from this $2,000,000 stock holding:
1. There is no capital gains tax on this $2,000,000 block of stock
2. The trust you have arranged will pay you $140,000 a year for life
3. You will get a substantial tax deduction
4. The $2,000,000 will be removed from your estate.
This trust arrangement is the Charitable Remainder Trust we talked about so much in Chapter XX, and notice this Charitable Remainder Trust gives you much more than it offers to charity.
The capital gains tax on your $2,000,000 sale of this stock does get counted, but only when the income is paid to you. Most of the income is taxed as ordinary income, but a smaller portion of your $140,000 in our example will be taxed at capital gain rates. That is generally to your advantage, because capital gains only get taxed at 20%, plus any state tax.
The $140,000 of income gets paid to you for life, and then it can continue for your spouse. If you do the right thing and live a long life, you and your spouse will get back most of your $2,000,000 over your lifetimes, and if you really live right for 20 to 30 years, you will get much more than $2,000,000.
The tax deduction will depend on your age. If a husband and wife in their 60’s are going to get income for life from the Charitable Remainder Trust, they will get a deduction of about $200,000 on a $2,000,000 Charitable Remainder Trust. If they are in their 70’s the deduction will be much higher. If they are in their 50’s, they will need to settle for less income than 7% a year. All lawyers, CPAs, and banks who do estate planning can give you tables to show your deduction.
This same technique can be used if you want to sell a large holding of one stock you own. Assume, for example, you have $1 million in IBM stock, in addition to other assets. Assume the children are dropping subtle hints: their 10 month old Lexus is going out of style and needs to be replaced; or their smallish 10 room home in the suburbs is just getting a little too cramped now that they have a cocker spaniel!
Well, if your $1 million IBM holding is earning $20,000 a year, you are likely paying about $8,000 in income tax on this income, and if you are living a little, you have nothing left with which to do anything, and it is nearly impossible to make substantial gifts from your income. On the other hand, if you give your $1 million to a trustee of a Charitable Remainder Trust for your favorite college, you will receive a substantial income tax deduction, and you may have enough income to make tax-wise gifts to your children.
For example, assume you have one child in his mid 50s, and another in her mid 40s, and you are make our $1 million gift to charity. Assume you give this $1 million to my favorite college, Boston College, but you keep a 5% income from the gift to be paid to your children for life. In this example, you will receive a $170,000 tax deduction, your children will receive $50,000 a year to divide between them for their lifetime, and Boston College will name a building after you. If you would like to shorten the childrens' income span, so they receive income for, say 10 years, rather than for life, you can still give them income of $50,000 ($25,000 each) for this 10 year period, and increase your charitable deduction to $611,000!
In these examples, the more you give to the children, the less your charitable deduction. If you increase the $50,000 to the children for life from 5% to 6%, your childrens' income will increase from $50,000 to $60,000, but your charitable deduction will drop from $170,000 to $122,000. If you create our 10 year trust but increase the income to the kids to 6% ($60,000) you decrease your charitable deduction from $611,000 to $560,000!
As always, there are rules to follow. First, if you want to benefit the children and then benefit charity, the amount you give to the children each year must be at least 5%, unless you jus t give them all of the trust income. Second, when we suggest large tax deductions, every dollar you give to charity reduces your estate tax, but the income tax deductions are determined by the level of your income. In addition, cash and other liquid assets are fully deductible, and if you do not have enough income to take the deduction one year, you can carry it into future years; but gifts of art works, real estate and other hard assets come with rules which limit their tax benefits.
Further the deductions specified here assume your children are 45 and 55 years old, and interest rates get factored into the calculation of the deduction. If the children are younger, your deduction will be less; if the kids are older, the actuaries say they will get less income over their lifetime, so your deduction will be higher. Changes in interest rates will also affect your deduction.
I recently had a client who established a Charitable Remainder Trust contemplating the sale of a residence. He donated the residence to a Charitable Remainder Trust, and the trust pays him and his wife a sum for life which must be 5% of the trust's value, and when the two of them are gone, the trust passes to charity. He received a tax deduction for contributing the residence, and he received a nice income for life. His deduction is the value of the residence less the value of the life interests of the married couple, and he had a choice: the 5% they receive can be a percentage of the value of the building now, or the value of the trust each year. Once they make a choice, though, they are stuck with their choice for life!
So a Charitable Remainder Trust can be a useful tool when contemplating the sale of stock, or the sale of real estate, or the sale of a business interest.
There is another tool useful in the sale of a business which can work in just the right circumstances. When faced with a sale of a company, most advisors suggest strongly that you try to arrange a sale where you sell your stock in the company, since you receive capital gain treatment for the entire sale. Compare this with an asset sale, where each asset is sold individually, and where there is a tax on each sale, and some of the sales do not qualify for capital gain treatment. Sellers love asset sales, though, since with an asset sale the seller can depreciate the corporate assets with a brand new basis.
So often there is tension between a buyer who wants a stock sale, and a seller who wants an asset sale. Often sellers will pay more for an asset sale, and there is a way to make an asset sale beneficial to a buyer, in just the right circumstances.
Several years ago, 2 brothers came to our office in the middle of negotiations to sell their company. On sale they were to each receive $1 million, and they were prepared to pay what today would be a 20% federal capital gain tax, and better than a 5% capital gains tax to the Commonwealth of Massachusetts. Of course, this meant a $300,000 tax payment from each of them.
Instead of paying this tax, they simply sold their buyer all of their corporate assets, and the buyer also bought their corporate name. This left them with a "personal holding company" which was the remains of their old company but now with a new name. The personal holding company held nothing but cash.
Our first reaction is that this is no bargain for these individuals: they will be taxed twice on their income in future years, once at the corporate level, and a second time as the income is paid to them as dividends. Further, we assume that eventually someone is going to pay the capital gain tax. Our two brothers, however, never paid taxes on their income at the corporate level; and when they died some years ago, their death resulted in the forgiveness of all capital gains.
The brothers took advantage of two major benefits in the tax law: first, if a company invests in common and preferred stock of another company, 70% of the income generated by dividends is free from corporate tax; and second, as we have seen several times before in this book, when we die, capital gains are forgiven and assets can be sold after our death without incurring a gain.
Over the years, we have seen this arrangement work for a number of our clients. Ordinarily, an investment manager will invest a client's assets in a mix of municipals and common stocks (see page YYY). With a personal holding company we are looking for dividend income (and not interest income), so typically it is wise to substitute preferred stocks for a more typical municipal holding; so instead of stocks and bonds, a personal holding company will invest in stocks and (preferred) stocks.
If our two brothers were selling their company today, they would each be left with a personal holding company of $1 million, and they would pay no capital gain, except on the sale of individual corporate assets. So, they would keep most of their $1 million intact. The $1 million might be invested 1/2 in common stocks and 1/2 in preferred stocks. The company now with a new name (The Flatley Investment Company, Inc. instead of the old name, The Flatley Weenie Company, Inc.) would then have dividend income in the range of $50,000. With a 70% exclusion available to The Flatley Investment Company, Inc. $35,000 of this income would pay no corporate income tax. The remaining $15,000 will pay a corporate income tax, except to the degree the corporation has deductible expenses for money management, auditing expenses, and a small executive salary.
When the $50,000 is distributed to the shareholders, this income will be taxable, but the income would also be taxable if the $1 million had been put in the bank, or into treasuries. With common and preferred stock holdings, there is a good prospect for growth in both the shareholders' capital as common stocks grow; and there is the further prospect for a growing income stream as companies increase their dividends.
As each brother dies, his share of the company can be liquidated, and the $1 million capital gain is eliminated. In the case of my clients, they even went one step further: they added their personal holding company stock to a revocable living trust, and avoided probate in the process, too.
Of course, as always there are caveats. If you ever want your principal during your lifetime, you will pay a tax if you sell off shares of the personal holding company. Further, the tax law can always change the taxability of dividends at the corporate level, although this provision has been in place for decades. Also, while we like to think the stock market will grow over time, investing in common and preferred stocks does imply a degree of risk taking. Finally, if the estate tax is repealed in 2010 or later, capital gains will be taxed at death; but if this occurs, you can always liquidate your personal holding company later, and there are substantial exemptions from the tax on capital gains at death, if this rule comes to pass.
Generally, selling assets using a personal holding company works best with a corporation holding liquid assets before the sale. If most of the corporate assets are depreciated machinery, land, or low basis inventory, a personal holding company will not work for you. Selling assets at the corporate level is no bargain with low basis assets, since capital gains at the corporate level are fully taxed, without the 20% limit available to us as individuals.
So, before you sell your business, explore with your CPA and your lawyer whether a personal holding company will work to your advantage, and allow you to pass along the full value of your business to your heirs, hopefully many years hence.
Chapter 23. Medicaid Trusts
As we get older, we often worry about the cost of nursing home care, which can easily wipe out a sizable fortune in a very short time. When we look at nursing home care, we find that often find that an individual paying for nursing care receives exactly the same treatment as a resident of the nursing home on Medicaid. Often, this provides the impetus to make ourselves so "poor", we will qualify for Medicaid.
To qualify for Medicaid, though, you must be close to destitute. If you have any assets at all, you are required to "spend them down", or exhaust them, before you qualify for Medicaid. Of course, this creates a natural instinct to "spend down" assets by giving assets to children or to irrevocable trusts.
These gifts have given rise to a continuing sparring match between individuals who wish to give away assets, and our government, which has the attitude that you accumulated assets to take care of you in your old age, and you should be exhausting your assets before you apply for Medicaid. The government views Medicaid as a stop-gap for those who do not have enough money to care for themselves; but individuals often have the sentiment that they worked too hard for money, and it is silly to spend it on nursing home care, when the government will provide the exact same care.
Individuals often give away assets, so they will be so poor that they will qualify for Medicaid, and the government has adopted a set of rules to make it difficult to accomplish this. The following general rules may be helpful:
• Giving away assets to qualify for Medicaid is not something to consider if you have over $1,000,000 in assets. A $1,000,000 portfolio will last a long time, even if nursing home costs run to $70,000 or so, which is about the cost of a nice nursing home today.
• To qualify for Medicaid you truly must part with your assets; if you have substantial assets, and as an alternative the purchase of a long-term care insurance policy can help your family cope with the cost of nursing home care
• If you give away assets to family members, the Medicaid authorities will generally force you to count the gifted assets among your assets, if the gifts are made just before you apply for Medicaid; generally, there is a 2 ½ to 3 year term over which gifted assets will be considered your assets, and these gifted assets must be spent on your nursing home care before you will become eligible for Medicaid
• If you give away assets to an irrevocable trust, the Medicaid authorities will generally force you to count the assets given to an irrevocable among your assets, if the gifts are made to the irrevocable trust within 5 years of the time you apply for Medicaid. Further, the trust must give your trustee no power whatever to pay funds for your benefit, other than the trust income. This is pretty drastic medicine, too dramatic for all but the rare individual who is willing to give away everything but a 5 year supply of funds, because this individual really does not want the family nest egg tapped for nursing home expenses.
• It may be possible to purchase an annuity, and leave funds for your family. For example, a “20 year certain and continuous” annuity pays you an income for life, and if you die within 20 years the annuity payments continue for your family until the end of the 20 year term. Certainly the income you receive will be counted as your income if you need nursing home expenses, but it is less certain whether the annuity contract can be reached by the Medicaid authorities. The theory is that if you cannot get the funds, neither can Medicaid reach the funds, but remember, nobody ever said the Medicaid authorities need to apply logic to their rules, so you will only want to arrange this type annuity with advice of a good Elder Care law practitioner
These rules vary from state to state, but they generally follow the patterns described here. Further, as soon as you think you know the rules, there is an additional change which makes yesterday’s advice obsolete. There are lawyers and financial planners specializing in Elder Care law who keep up with the rules, and they can be a resource for planning around the Medicaid rules.
Chapter 24. So, You’ve Been Named an Executor
You have been named executor of an estate and a friend or loved one has died, and the obvious, rational question is “Eeek… Help… what do I do now?”
In some pretentious states, the role of executor is referred to as a “personal representative”, but for our purposes, we will refer to the role as an executor. The responsibilities of an executor and a personal representative are identical.
If you are not careful, a simple offer by a neighborhood lawyer to file the will in the probate court for you may result in unexpected results. Filing the will in the probate court is the beginning of a process, and often is taken as a license to “probate” the estate for you – which can cost the estate tens of thousands of dollars, or even hundreds of thousands of dollars in a large estate. Your decision about the person who will help you with this process is often made in the middle of the most difficult time in your life, when a good friend or family member has died, and you are distracted, distraught, and searching for someone, anyone, to guide you.
Notice our caution earlier when we talked about “probate”: we said there that where a will is held at death is a critical issue. Even if you are named executor, if a lawyer holds an original will, chances are the will is going to be filed with the Probate Court by the lawyer within days of a death. That’s fine if the lawyer filing the will is the lawyer you wish to have assist you in your role as executor, but once the will is filed, the lawyer will begin a process of “probating” the will at the lawyer’s hourly rate, and the cost may surprise you later.
You do not want surprises in the matter of probating a will. You want to have a serious discussion about your role, your lawyer’s role, and the cost of settling the estate, and a timetable of responsibilities, within days of a death, if you are named executor. You also want to have this discussion memorialized in writing. I cannot tell you how many times individuals have told me the family advisor has told the executor “…not to worry, things are under control…”, or “the tax return will be filed within the 9 months required by the IRS….” If you are named executor, the responsibility rests with you for getting things under control, and the duty to file a tax return in 9 months (if a return is due) falls upon you. Be sure you know how the process will work before you agree to hire professional help.
After filing the will in the probate court, the remaining steps are time consuming and filled with potential hazards. Over a one or two year period, and perhaps even longer, you will be involved with two processes developed mostly in the last century and brought current very slowly over time. The two processes are dealing with the Probate Court and settling with the Internal Revenue Service.
The probate court has an interest in anything passing under a will. If there is an asset in an individual’s sole name, this asset will pass under the will, and it will be subject to probate.
When an asset is subject to probate, you will need to account for the asset to the probate court through the entire settlement of the estate. Before you have the power to account for the asset, though, you must first be appointed executor of the estate. Appointment as executor involves a filing with the probate court, which will usually appoint you executor if you are named to this role in a will. If the will was drawn or revised in the past 15 years or so, in many states you may request appointment as a “temporary executor,” so you can begin to move assets and accounts around quickly. If there is no provision in the will for appointment as temporary executor, your appointment may take a few months to be finalized.
Once you are appointed as executor, you can invest assets. Typically, executors invest conservatively, since the executor is not likely to have the assets for a very long time. If the estate has one large asset, hopefully a large holding of Microsoft, the executor may want to lessen the large holding, to protect against the large holding declining in value in the estate. The tax law will allow you to sell most assets in an estate without capital gains, if you sell the assets before they appreciate further in the estate. This “step up in basis” applies to all assets which carry capital gains, but remember, if the estate tax is repealed, there will be new rules for step up in basis.
All the while settling an estate, you as executor must keep records for the estate, so you can report to the probate court on every detail of the estate’s income, spending, appreciation, or decline in value. To sell real estate from the estate, you will need to seek court approval, unless the will specifically gives you the power to sell the real estate. You will also need to take care of other details. These include:
• Getting a witness to the will into court to “prove the will”
• Placing a notice in the newspaper
• Providing notice to heirs
• Securing a bond if needed, and
• Dealing with a probate system where a “guardian ad litem” is appointed by the court to watch after the interests of future generations.
Some or all of these detailed requirements may not be necessary, depending on the terms of the will, and the formalities by which it was executed.
As executor, you will also need to keep your eye on tax issues. This will involve interacting with the Internal Revenue Service (rather than the Probate Court). The Internal Revenue Service collects both income taxes and estate taxes from an estate. You will need to pay income taxes from the estate, as a separate taxpayer. As executor, you may also distribute assets to various other taxpayers: yourself for your charge as executor, heirs and other takers under the will, or one or more trusts. All of these taxpayers pay their own tax. As executor, your responsibility is to pay the estate’s income tax, and to report income to be taxed to other takers.
You will also need to pay estate taxes. Anything passing to a husband or wife is totally free from estate tax, both on the federal level and in most states. This is true if the assets pass outright to the spouse, or into a trust for the spouse, if the trust has been carefully drafted. Anything passing to anyone other than the spouse will pay estate taxes. So, if assets pass to a son or daughter, these assets will pay estate taxes, and usually, it you as executor wh is required to pay this tax.
The only exception is $1,000,000, which is totally tax free. The only time you lose some or all of this $1,000,000 exemption is if gifts were made during the lifetime of the person who has died, in excess of $11,000 or $22,000 allowable limits, to any one person in any one year. In the estate, if $1,000,000 passes to anyone but a spouse, the estate tax is likely to be close to 50% on all assets over the estate tax exemption.
As executor, you must file an estate tax return accounting for these assets, if the estate will pay an estate tax. Decisions you make in this realm can save or cost the estate thousands of dollars. As executor, you must value all assets. These include both assets you control in the estate, the “probate assets”, and other assets: those passing under a life insurance contract, or to an IRA beneficiary, or by joint ownership. If there is a trust, you need to read the trust, and tell the trustee how to hold the trust assets to gain the greatest tax and family advantage.
Sometimes it is wise to refuse an inheritance, if the taker is already wealthy, to avoid a second 50% estate tax in the taker’s estate. However, decisions need to be made by you as executor almost within days, if assets are to be “disclaimed” in an estate. If the taker spends any funds from an account coming to the taker from an estate, this taker loses the right to disclaim the asset forever. Generally, disclaimers must be completed within the 9 month filing period for filing an estate tax return.
Several years ago, I was introduced to an individual whose wife had died a year earlier. The wife and husband had about $2,500,000 in assets, all in joint names, and they had one daughter. Dad was now in his 80s, and his daughter was in her 50s.
During her lifetime, mother had created a will and trust, and her trust had a “Bypass Trust” for dad. The Bypass Trust receiving mother’s estate tax exemption would be tax free in mother’s estate because of her exemption; and then in dad’s estate, the Bypass Trust would be tax free again. Because everything was in joint names, however, everything passed to dad and nothing came to mother’s Bypass Trust.
Within 9 months of mother’s death, dad could have “disclaimed” the amount of mother’s exemption. By “disclaimer” mother’s exemption would have passed to mother’s Bypass Trust, and the amount of her exemption would be tax free both in mother’s estate and in dad’s estate.
Now it was more than 9 months after mother died, and it was too late for a disclaimer. The whole $2,500,000 was taxed in dad’s later estate, except for his one exemption. Mother’s exemption was “lost”, “wasted”, because nobody told dad about the prospect of a disclaimer. Incidentally, even if mother did not have a trust, dad could have “disclaimed” any amount up to mother’s estate tax exemption, and chances are the disclaimed assets would have passed to his daughter with no estate tax in either mother’s estate, or in dad’s estate.
So, you see, in settling an estate, simple decisions can cost or save hundreds of thousands of dollars.
When all is settled, you close down the estate.
Generally, this system of settling an estate is so cumbersome, you will begin to look for help, and help can take many forms: you can decline to serve as an executor, and the next person named in the will generally will be appointed by the court. You can serve, but delegate the responsibility to a lawyer or other trusted advisor. You can also talk to your bank about assisting in the settlement of the estate. Most banks which manage trusts will provide you with a quote for settling an estate as your “agent”. In this capacity, the bank will do everything involved in settling the estate as if they were named executor, subject to your review of every important decision.
Chapter 25. Estate Tax Repeal
On January 1, 2002, a change in the estate tax rules will initiate an extraordinary benefit to taxpayers and their families, leading the way to repeal of the estate tax in the year 2010. This book takes into account the following increasing estate tax exemption:
Tax Free Sum
|2002 |$1,000,000 |2006 |$2,000,000 |
|2003 |1,000,000 |2007 |2,000,000 |
|2004 |1,500,000 |2008 |2,000,000 |
|2005 |1,500,000 |2009 |3,500,000 |
2010 Total Repeal of the estate tax
Further, the maximum estate tax rate has already dropped from 55% to 50% and then over time down to 45% just prior to total repeal in 2010. Now what does all this mean for you reviewing your estate plan?
Well first, you cannot be too sure that estate tax repeal will ever happen. During the period until the year 2008, the estimated cost of this repeal to the federal treasury is in the $6 billion to $12 billion range, but in the year 2009 the cost jumps to $23 billion a year. In 2010, the cost increases to $53 billion. The tax bill also provides that estate tax repeal must be revisited by Congress before 2011, or repeal will not be implemented. The consensus is that estate tax repeal will be in great jeopardy as we move closer to 2010, but the estate tax limits are likely to remain as formulated in today’s tax bill.
So, what do you do in the interim? First, keep your present estate plan in place, but be sure that it still works. For a married couple, we have encouraged you to have the estate tax exempt sum in each name. If you have this sum come to a trust, and if this sum remains in trust for the lifetime of your spouse, then when the spouse dies this trust will be tax free. Since this trust bypasses the spouse’s estate, it has come to be known as a Bypass Trust.
So, if you die in the year 2005, and if you leave your $1,500,000 exemption to a Bypass Trust for your spouse, then when your spouse dies, this Bypass Trust will be tax free. This will be tax free in addition to the sum your spouse can later leave tax free. In 2005, it will be important to have $1,500,000 in your name, and $1,500,000 in your spouse’s name, so no matter whose estate is first, $1,500,000 will come to a Bypass Trust. Placing $1,500,000 in each name is easy if you have cash or securities, but if your assets are a home; an IRA or another retirement plan; a deferred compensation plan; or stock options, it can be trouble getting assets into each name.
If you have sufficient wealth, you may also be well served increasing the amount in each name to $3,000,000, because of one aspect of the estate tax reform bill which may work against you. Prior to estate tax reform, any asset you owned at death had all of its capital gains extinguished in your estate. So, if you owned Microsoft stock worth $10 million for which you paid $1,000, then your heirs could sell your Microsoft stock with no capital gain after you died.
With estate tax reform this “step up in basis” in an estate is limited to $1.3 million after 2010, and this limitation may be adjusted if you made lifetime gifts. Any asset in excess of this $1.3 million sum (with adjustments) left to heirs will pay capital gains tax on the sale of the asset. One exception to this rule, though, involves assets left to a spouse. Assets left to a spouse are given an extra $3,000,000 step up in basis, so you want to be sure that the first spouse to die has $3,000,000 in his or her name. Of course, the only way to assure this is to have $3,000,000 in each name, with the lowest basis assets in the name of the spouse most likely to die first.
There is an additional benefit afforded by trusts which you may want to re-visit with this latest estate tax reform. Let’s assume that you have $3,000,000 in your name, and we will further assume that the estate tax exemption is $1,000,000 the year you die. In this instance, $1,000,000 goes to a Bypass Trust, and $2,000,000 is left to your spouse. You need to consider whether you want your spouse to be given the right to take this $2,000,000 and do what your spouse pleases with this sum; or whether you would prefer to leave this $2,000,000 in a “QTIP” Trust. A QTIP Trust pays its income to your spouse, but your trustee is told to pay additional funds to your spouse as needed. A QTIP Trust assures that this $2,000,000 will be there for your spouse, but it also assures that this sum will later pass to your children or other heirs, and not to another husband or wife with whom your spouse might get entangled, after you are gone.
The new estate tax rules also make it more attractive to leave assets in trust for children or other heirs when you are gone. Under the old rules, you could leave just over $1,000,000 in a trust for the lifetime of your children, and this trust would avoid estate tax in the estates of your children. Such a “generation-skipping trust” was often just a convenient excuse for clients to do what they wanted to do anyway: our clients wanted to leave a sum in trust for their children, which would be there for the children, but which would pass to the grandchildren when the children are gone.
This “generation-skipping trust” conveniently assured that a son-in-law or daughter-in-law did not inherit this $1,000,000 sum. The new estate tax rules increase the sum which can be left in a generation-skipping trust to a larger amount, and this amount is tied to the estate tax exemption. So, for example, in 2006, when the estate tax exemption is $2,000,000, you can leave $2,000,000 in your estate free of estate tax. If you then leave this $2,000,000 sum in a “generation-skipping trust”, this trust will avoid estate tax in your childrens’ estates too. Incidentally, in the unlikely case that you like your son-in-law or daughter-in-law, a “generation-skipping trust” can benefit these in-laws when your child is gone, and still later pass on to your grandchildren estate tax free.
Estate tax reform also left in place a gift tax, now with its own new set of rules. Within these rules, as always, you will be able to make $11,000 annual gifts to as many individuals as you wish, without worrying about gift taxes. If you are married, your gifts can be $22,000. Additional gifts, though, will begin to whittle away at a newly installed $1,000,000 gift tax exemption, and this exemption will not be rising with the estate tax exemption. Further, if you use this exemption with gifts, you will diminish your estate tax exemption, dollar for dollar.
A major dilemma now is whether it is wise to make gifts using these exemptions. If you have a large estate, and if you expect to die in the next 9 years, you should be aggressive in making $22,000 annual gifts. Even if you expect to live well beyond the year 2010, you may want to consider gifts if you anticipate that estate tax repeal will never happen. In either case, you may want to consider the following arrangements in making gifts:
1. A “Family Limited Partnership” which may allow you to argue that a $32,000 gift is “only worth” $20,000, or that a gift of $1,600,000 is worth less than $1,000,000
2. A “Defective Trust” which lets you shift assets to children and others, but allows you to pay income taxes generated by the trust
3. A “Qualified Personal Residence Trust”, which may bring the value of one or two homes down to as little as 20% of their present value in your estate
4. A “Grantor Retained Annuity Trust” which uses little, if any, of your gift tax exemption and can shift enormous sums to children or others, if the trust receives an asset which “explodes” in value
5. A “Charitable Remainder Trust” which provides added income, a tax deduction, and relief from capital gains tax for a “low cost” asset, and this trust will also be free from estate tax
All of these tools can reduce estate taxes, primarily by removing future growth in gifted assets, and all are discussed in great detail in our Little Blue Book.
Chapter 26. State Estate Taxes
Estate tax reform puts a large share of the cost of reform onto the states. To understand this phenomena, we need to look at a little past history.
In the generation just passed, there were often two sets of taxes at death: a federal estate tax and a separate state death tax. State death taxes were called estate taxes if they were imposed on the deceased’s assets, and they were called inheritance taxes if they were imposed on those receiving an inheritance; but for purposes of this discussion, we will refer to these state taxes as estate taxes.
If you were a single individual and you died in Massachusetts in 1990 with a $3,000,000 estate, the federal estate tax charts told your executor that your federal estate tax was $1,100,000. If you went to the Massachusetts estate tax chart, your Massachusetts estate tax was $400,000. So your total tax was $1,500,000, but your estate was not required to pay all of this tax.
Your estate would pay less because at one time, the $400,000 you paid to Massachusetts was deductible on your federal estate tax return. This deduction reduced your federal estate tax to about $900,000, so your total tax was $1,300,000, $900,000 to the IRS, and $400,000 to Massachusetts.
Florida’s tax authorities did not like this arrangement very much, because Florida has never had an estate tax. So, if an individual died in Florida, the federal government got $1,100,000 from this individual’s estate, but if an individual died in Massachusetts, the federal government only got $900,000. It was as if the federal government was giving Massachusetts $200,000 every time a Massachusetts resident died.
So, Florida got the federal government to change its rules, and the change paid Massachusetts $200,000 if an individual with $3,000,000 died in Massachusetts, and the changed law paid Florida $200,000 if an individual with $3,000,000 died in Florida. This was formulated as a State Death Tax Credit built into the Internal Revenue Code, providing a payment to each state when a resident of the state died. The payment was graduated, depending on the size of its resident’s estate.
Well, this created a new conflict among states. Florida billed itself as a state without an estate tax, since after all, with a $3,000,000 estate, all you paid was the $1,100,000 federal estate tax; and so what if $200,000 of this sum went to Florida when you died. Your tax was still just the $1,100,000 the federal rules mandated. Because Florida was just “soaking up” part of the federal estate tax, this Florida-type tax came to be known as a “sponge tax”.
Massachusetts in the 1980s among other northeastern states, found itself with thousands of its citizens driving around the Boston suburbs with Florida license plates, as older citizens declared Florida their domicile to avoid the Massachusetts estate tax. The tax payment was as follows for a $3,000,000 estate:
Massachusetts Florida Resident Resident
Federal estate tax $1,100,000 $1,100,000
State estate tax 400,000 0
Less sponge tax paid to the state 200,000 200,000
State gets 400,000 200,000
Estate pays $1,300,000 $1,100,000
With this regime, Massachusetts thought they were much better off than Florida, because they got $400,000 every time one of its citizens died with a $3,000,000 estate. Massachusetts citizens, however, realized that if they moved to Boca Raton, the estate would save $200,000, which bought a pretty nice condo in Florida. When Massachusetts citizens made this move and then died, Florida got the sponge tax of $200,000, and Massachusetts got nothing.
In the mid-1990s, Massachusetts followed a trend abolishing its own estate tax, in favor of a Florida-style sponge tax. Now there was no estate tax advantage to Florida over Massachusetts, and the Florida license plates disappeared in Boston. Massachusetts residents lived longer because they no longer needed to risk cardiac arrest living six months in the sweltering Florida heat, but eventually Massachusetts collected its sponge tax.
Now, with repeal of the Federal Estate tax, these sponge tax receipts disappear, both in Florida and in Massachusetts. Congress being Congress, although the federal estate tax does not get repealed until the year 2010, Congress takes away the sponge tax from states starting in January, 2002. In 2002, the sponge tax is reduced by 25%; the following year (2003) the sponge tax is reduced by 50%; in 2004, it is reduced by 75%; and in 2005, the sponge tax is repealed.
This reduction in the sponge tax is not a tax saving for estates, rather it diverts funds from the states to the federal government when an individual dies. Before estate tax repeal, for a single individual dying a Massachusetts resident with a $3,000,000 estate, Massachusetts collected $200,000 in revenue from its sponge tax. In 2002 the collection is $150,000; the following year $100,000; then $50,000; in 2005, Massachusetts will collect nothing. Again, this is not a saving to the taxpayer dying in Massachusetts, but rather, it is a reduction in the sum the federal government pays to Massachusetts when a Massachusetts citizen dies.
In effect, Massachusetts, Florida and other states are paying a large portion of the cost of repeal of the federal estate tax. Massachusetts collected $166 million in “sponge taxes”; Florida, where a millionaire dies every 10 seconds, collected almost $800 million in sponge tax receipts; California colleted over $1 billion. All of these sums disappear from state coffers over the years 2002 to 2004.
Several states enacted legislation to make the “sponge tax” an additional tax, so their receipts would not fall. Other states fell to this “add-on” tax just by a quirk in the drafting of their estate tax legislation.
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[1] Qualified Terminable Interest Property
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TAX FREE:
2002 – $1,000,000
2004 – 1,500,000
2006 – 2,000,000
2009 – 3,500,000
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