GENERAL PRINCIPLES OF



ESTATE PLANNING

PART II

|Satisfying liquidity needs | |

a) Sale of assets

i) Possibly very little income tax due to step-up in basis

b) Life insurance

i) If estate has a substantial amount of illiquid assets

c) Other

|Powers of appointment | |

d) Use and purpose

i) As a general rule holding a power of appointment over an asset results in asset’s inclusion in holder’s estate

e) General and special (limited) powers

i) 5+5 power

1) allows beneficiary to withdraw up to 5% or $5,000 of trust contributions

ii) Crummey provisions

1) Crummey powers (provisions) are often incorporated into trusts where the grantor wishes to avail of the annual gift tax exclusion in conjunction with gifts made to a trust.  Under a Crummey Power, a beneficiary holds the non-cumulative right to withdraw the annual addition to the trust.  Because the annual withdrawal right is indeed a present interest, gifts in trust to irrevocable trusts with Crummey provisions may qualify for the annual gift tax exclusion if certain rules are observed.

a) Annual withdrawals generally limited to greater of $5,000 or 5% of trust assets

iii) Distributions for health, education, maintenance and support

iv) O t h e r

f) Tax implications

|Types, features and taxation of trusts | |

g) Issues in drafting trust instruments

i) Explain clearly in the trust document the objectives of the grantor

ii) Include flexibility. Some trusts may be in effect for several decades.

1) Allow for majority of beneficiaries to replace trustee, for example.

2) Permit non pro-rata distributions of property, if desired

a) Distribute cash to one beneficiary and stocks to a second beneficiary

iii) Include provision to allow trust to make charitable contributions, if so desired

h) Classification

i) Simple and complex

1) Simple: all income earned each year must be distributed

a) It is taxed to beneficiaries even if the trust fails to distribute the income

2) Complex: can accumulate income

a) Deducts income and corpus distributed each year in calculating taxable income

ii) Revocable and irrevocable

1) Revocable living trust: has developed into primary document for disposing of individual’s assets

a) Indicates how property will be transferred at death

b) Considered a will substitute

c) Advantages

i) Avoids cost of probate

1. Can be substantial if executor and/or attorney fees are based on percentage of probate estate

2. Good if have real estate in more than one state to avoid multiple probate proceedings

3. Privacy: assets in probate estate are part of public record

d) Disadvantages

i) All assets must be retitled

e) If have revocable living trust, still need a will to avoid intestacy rules but will simply status assets will be distributed in accordance with terms of trust

f) All assets in revocable trust included in estate

g) Income in revocable trust is taxed to the grantor

i) No income tax or estate tax advantages to revocable trust; simply a tool to avoid probate and to assist in incapacity planning

1. Incapacity planning: grantor can be trustee but have an institution as a backup trustee if he becomes disabled

ii) Grantor should use his Social Security number on accounts placed in revocable trust

iii) In year of death, can make a Section 645 election to include income from revocable trust in estate

1. This eliminates need to divide income between decedent and estate

2. Allows deferral of tax by a year if estate has a 1/31 year-end, for example

2) Irrevocable: assets are not included in decedent’s estate if decedent had no incidents of ownership

a) To permit contributions to a irrevocable trust to qualify for an annual gift tax exclusión a Crummey provision is included in the trust to allow the beneficiary to withdraw the annual contributions to the trust

i) Rule against perpetuities

1) terms of noncharitable trusts are limited to no later than 21 years and 9 months following the death of any persons living at the time the trust is established.

j) Selected provisions

i) Spendthrift clauses

1) To protect trust principal from beneficiary(s) creditors, the beneficiary is prohibited from transferring his/her interest in the trust for consideration or satisfaction of an indebtedness

2) Also provides protection against future ex-spouses of beneficiaries

ii) Perpetuity clauses

iii) Other

1) Distributions made according to the needs of beneficiaries

a) Most states have adopted Revised Uniform Principal and Income Act (RUPIA) which allows a trustee to adjust between principal and income when the trustee invests and manages assets pursuant to the state’s prudent investor statute

b) Some states are revising definition of trust income to be a unitrust amount such as 4% of trust principal determined annually

c) Uniform Prudent Investor Act allows trustee to invest for total return so long as the approach is appropriate for the beneficiaries and consistent with the grantor’s objectives

i) Trustee has obligation to diversify investments

2) Some experts maintain trust language governing distributions should state trust may make distributions rather than requiring distributions

k) Income taxation of trusts and estates (income, gift and estate)

i) Distributable net income (DNI) is taxable income (rather than accounting income).  DNI determines the amount of income that may be taxable to beneficiaries; the taxable amount may not exceed the DNI amount, although amounts distributed to beneficiaries may, in fact, exceed the trust's DNI.

1) In general, trust is taxed on income it retains

2) In general, beneficiaries taxed on income distributed to them

a) Distributions must be made within 65 days after the end of the taxable year

ii) Trusts are subject to very high marginal tax rates 

iii) Trustee and investment fees are not subject to a 2% of adjusted gross income limitation

iv) No limit (such as 50% of adjusted gross income) on charitable contributions

v) Income that would otherwise be tax-exempt to the trust, such as interest from public purpose municipal bonds, remain tax exempt to trust beneficiaries receiving such income.

1) Expenses allocable to tax-exempt income are not deductible

vi) Distribution of appreciated property, such as appreciated stocks, to beneficiaries causes the trust to recognize capital gains on the amount of appreciation

|Qualified interest trusts | |

l) Grantor trusts

i) Often, individuals having accumulated sufficient wealth to transfer assets to irrevocable trusts are in high marginal income tax brackets.  Not only do they wish to reduce the amount of their taxable estates, such grantors may further wish that income produced by trust assets be distributed to, and thus taxed to one or more individual beneficiaries enjoying lower income tax rates than that imposed on the grantor. When the grantor has such intent, it is critical that the trust satisfies certain rules applicable to grantor trusts.

ii) Standard planning technique when estate exceeds the value of the unified credit

iii) Allows grantor to transfer property at a discounted value for gift tax purposes while retaining rights in the property for a specified period

iv) Cautions:

1) If grantor dies during the trust term, some of the trust assets will be included in the grantor’s estate

2) The recipient of the property does not receive a step-up in basis

m) Grantor Retained Annuity Trusts ( GRATs)

i) An irrevocable trust in which grantor retains right to receive fixed amounts payable at least annually from the trust for life or a period of years

ii) At the end of the life interest or term, remaining trust corpus is paid to remaindermen

iii) No additions to the trust are permitted after it is established

iv) Gift of future interest

1) Does not qualify for annual gift tax exclusion

2) Amount of gift is reduced by fair market value of grantor’s retained interest

3) If grantor survives the retained interest term, the trust assets, including any appreciation, are not included in grantor’s estate

4) If grantor does not survive term of trust the amount of principal required to make the annual distribution

n) Grantor Retained Unitrusts (GRUTs )

i) An irrevocable trust in which grantor retains right to receive fixed percentage of the trust assets payable at least annually from the trust for life or a period of years

ii) At the end of the life interest or term, remaining trust corpus is paid to remaindermen

iii) Gift of future interest

1) Does not qualify for annual gift tax exclusion

2) Amount of gift is reduced by fair market value of grantor’s retained interest

3) If grantor survives the retained interest term, the trust assets, including any appreciation, are not included in grantor’s estate

4) If grantor does not survive term of trust the amount of principal required to make the annual distribution

o) Qualified Personal Residence Trusts (QPRTs or House-GRITs )

i) Grantor retains the use of his home or vacation home for a specified number of years

ii) Then remainder beneficiaries receive residence at termination of trust

iii) The longer the term of the retained interest, the lower the value of the gift to the remaindermen

1) Freezes the value of the residence for estate tax purposes

iv) Gift of future interest

1) Does not qualify for annual gift tax exclusion

2) Amount of gift is reduced by fair market value of grantor’s retained interest

3) If grantor survives the retained interest term, the trust assets, including any appreciation, are not included in grantor’s estate

a) However, no step up in basis for the remaindermen

4) If grantor does not survive term of trust the full value of the trust property is included in the estate

a) Advisable to select a term the grantor is likely to survive

b) However, shortening the trust term increases the value of the gift to the remaindermen

p) Tangible personal property trusts

q) Limitations on the valuation of remainder interests of qualified interest trusts (§2702)

|Charitable giving | |

r) Considerations for contributions and transfers

i) A popular estate planning technique is to gift IRAs to charity. The funds in the IRA will be subject to income taxes (when the proceeds are withdrawn by beneficiaries) and may be subject to estate taxes (if the estate is large enough) so the tax burden on the IRA funds can be quite high. If the IRA funds are left to charity, the income taxes and possible estate taxes are avoided so this is an effective means of fulfilling charitable intentions with funds that would otherwise be subject to a substantial amount of tax.

s) Requirements for a gift to qualify for a charitable deduction

t) Charitable remainder trusts

i) Pay a fixed dollar amount or percent of assets to donor and then remainder interest goes to charity

ii) Should only be used if grantor has charitable intentions; not just to reduce tax liability

iii) Good planning tool for individuals with one appreciated stock or real estate and they need to diversify

1) Capital gains on sale of appreciated asset is only recognized as distributions are made out of the trust

2) Consider using tax savings to buy life insurance on grantor to replace assets transferred to charity instead of children

iv) Unit trusts (CRUT)

v) A charitable remainder unit trust (commonly known as a CRUT) is the most common kind of charitable remainder trust. After setting up the trust, you receive an annual lifetime income and upon your death the charity receives the rest. Your annual income is determined by the value of the assets in the trust, and it can’t be less than 5% of the actual trust’s value. That percentage is paid annually, and when you (and your spouse, if he or she is also named the beneficiary) die, the charity gets the rest.

vi) Advantages of a CRUT:

1) Assuming the trust assets appreciate in value each year, your income increases (hopefully faster than inflation).

2) You can add assets to the trust at any time.

vii) Disadvantages of a CRUT:

1) The trust must be revalued each year to determine the amount of income you’ll receive -- an administrative hassle.

2) If the trust’s assets decrease, your income decreases as well, so choose a trustee who will invest wisely.

viii) Annuity trusts (CRAT )

1) charitable remainder annuity trust (CRAT) is a simpler version of the CRUT. The CRAT works on the same principle as the unitrust, except that instead of receiving an annual income based on a percentage of the trust’s assets, you receive either a fixed dollar amount or a fixed percentage of the initial value of the trust.

2) Advantages of the CRAT:

a) No annual evaluation is required.

b) You know what your annual income will be for life.

c) You will still receive the fixed amount if the value of the trust assets goes down.

3) Disadvantages of the CRAT:

a) Because your income doesn’t increase, it isn’t likely to keep up with inflation.

b) The fixed-income amount must be paid every year (whether or not there is enough cash in the trust), so the trustee may have to sell or borrow against its assets.

c) Once you set up a CRAT, you cannot put any more assets into it.

u) Charitable lead trusts

i) Unitrusts (CLUT)

1) Pays a fixed annuity to a charity for a given period of time then remainder of assets goes to designated beneficiaries

2) Advantages of a charitable lead trust:

a) You save on taxes when your assets pass to your heirs and not back into your estate.

b) This allows you to delay giving money to your children until they’re older.

c) Any appreciation in the assets remains outside your estate.

3) Disadvantage of a charitable lead trust:

a) You lose the income from your assets while they are in the trust and after they pass to your heirs.

v) Annuity trusts (CLAT )

w) Pooled income funds

i) Created by a charity, pays annual interest to donors while remainder interest goes to charity

ii) Advantages of a pooled income fund:

1) You don’t have to go through the hassle of setting up a trust yourself or worry about maintaining it (which is useful for smaller gifts that don’t warrant the cost of setting up and handling a trust on your own).

2) You don’t need to think twice about your gift once you have made it.

iii) Disadvantage of a pooled income fund:

1) Your income is limited to your pro-rata share (how much of the total pooled income fund is comprised of the assets you gave) of the annual income based on the rate of return earned by the fund.

x) Private foundations

y) Other types of charitable gifts

z) Income tax charitable deduction limitations

|Use of life insurance in estate planning | |

aa) Advantages and disadvantages

i) Advantages

1) Can provide liquidity

2) Proceeds not subject to income tax

3) Also not subject to estate tax if estate not beneficiary and incidents of ownership have been transferred

ii) Disadvantages

1) Will be included in estate unless decedent had no incidents of ownership

ab) Ownership, beneficiary designation and settlement options

ac) Life insurance trusts

i) Irrevocable

1) Trust pays premiums and distributes proceeds to beneficiary when you die

2) Removes insurance proceeds from estate

3) Transfers to life insurance trusts is a taxable gift

ad) Gift and estate taxation

ae) Income taxation

|Valuation issues | |

af) Property is generally included in estate based on value at date of death

i) Alternate valuation date is six months alter the date of death

1) Irrevocable election

ag) Sec 2032 valuation of farm land and closely held businesses

i) Based on capitalization of rents

ii) Reduction in fair market value per recipient is $820,000

iii) Requirements

1) At least 25% of estate must pass to qualified heirs

2) Must have material participation by heirs

3) Must have been owned by decedent’s family for 5 out of the last eight years

4) Qualified heir must generally be family member

5) Can substitute property acquired in a sec 1031 exchange to maintain qualifications for sec 2032

iv) Recapture

1) During following 10 years if qualified heir sells property

ah) Estate freezes

i) Corporate and partnership recapitalizations (§2701)

1) Transfers future appreciation to children

ii) Transfers in trust

ai) Valuation issues with family partnerships and LLCs

i) Minority discounts

ii) Marketability discounts

iii) Blockage discounts

iv) Key person discounts

aj) Valuation techniques and the federal gross estate

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