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CONTINUING EDUCATION INSURANCE SCHOOL OF FLORIDA, INC. 12360 US Hwy 19 Hudson, FL 34667 1-800-783-9440 ii ESTATE PLANNING TABLE OF CONTENTS WHAT IS ESTATE PLANNING? INTRODUCTION 1 1 HISTORY FEUDALISM WHAT IS ESTATE PLANNING? WHO NEEDS ESTATE PLANNING? AN ESTATE PLANNING CHECKUP MINIMUM ESTATE PLANNING DOCUMENTATION 2 2 4 4 5 5 OBJECTIVES OF ESTATE PLANNING 1. CREATE LIQUIDITY SOLUTIONS TO LACK OF LIQUIDITY 2. AVOID PROBATE COSTS 3. REDUCE TAXES 4. EXECUTE DISPOSITIVE DOCUMENTS THE PROBATE PROCESS TODAY 1. DEATH 2. FILE PETITION 3. PUBLICATION 4. FIRST HEARING 4. UNUSUAL CIRCUMSTANCES 5. ASSETS FROZEN / INVENTORY ESTATE 6. FAMILY LIVING ALLOWANCE 7. PRESENTATION AND PAYMENT OF DEBTS, CLAIMS & TAXES 8. FINAL DISTRIBUTION / CLOSING OF THE ESTATE 9. MULTIPLE PROBATE NOTED EXCEPTIONS EIGHT COMMON PROBLEMS IN ESTATE PLANNING 6 6 7 7 8 8 8 9 9 9 9 10 10 10 11 11 11 11 12 ESTATE PLANNING GOALS THE ESTATE PLANNING TEAM CHAPTER 1 STUDY QUESTIONS 13 13 15 CHAPTER TWO - ESTATE PLANNING PROCESS INTRODUCTION AN OVERVIEW 16 16 16 ESTATE PLANNING PROCESS - SIX STEPS 1. DATA MUST BE GATHERED AND COMPILED LIQUIDITY CONCERNS BUSINESS INFORMATION ESTATE INFORMATION 2. IDENTIFYING THE PROBLEMS. 3. DEVELOPING THE PLAN. 4. PRESENTING THE PLAN 16 16 17 18 18 20 20 20 iii 5. IMPLEMENTING THE PLAN. 6. REVIEWING AND UPDATING THE PLAN. 21 22 PROSPECTING 1. EXISTING CLIENTS 2. NATURAL MARKETS 3. SEMINARS 4. REFERRALS 5. ORPHAN POLICY HOLDERS QUALIFICATION THE FIRST INTERVIEW ESTATE PLANNING SOFTWARE SUMMARY CHAPTER 2 STUDY QUESTIONS 24 24 24 24 25 26 26 27 27 27 28 CHAPTER THREE - PROPERTY OWNERSHIP HOW DO YOU OWN IT? PROPERTY OWNERSHIP OUTRIGHT OWNERSHIP JOINT TENANCY WITH RIGHTS OF SURVIVORSHIP TENANCY BY THE ENTIRETY TENANCY IN COMMON COMMUNITY PROPERTY ADVANTAGES SPOUSAL ELECTIVE SHARE PRENUPTIAL (OR ANTENUPTIAL) AGREEMENTS: 1. POSTNUPTIAL AGREEMENTS: 1. SITUS 2. DOMICILE 3. ESTABLISHING DOMICILE 4. TAXATION OF PROPERTY BY SITUS/DOMICILE: SUMMARY OF OWNERSHIP USING REAL ESTATE DEEDS IN ESTATE PLANNING SOLE OWNERSHIP – “OWNERSHIP IN SEVERALTY” JOINT TENANCY, “JOINT TENANTS WITH RIGHT OF SURVIVORSHIP” TENANTS BY THE ENTIRETY TENANTS IN COMMON LIFE ESTATE PARTNERSHIP OWNERSHIP SPECIFIC USES OF THE LIFE-ESTATE DEED THE CHARITABLE LIFE-ESTATE DEED ESTATE PROPERTY OWNERSHIP INTERESTS ESTATES OTHER PROPERTY RIGHTS 1. REMAINDER INTEREST 2. REVERSIONARY INTEREST 3. EXECUTORY INTEREST LEGAL/EQUITABLE OWNERSHIP LEGAL OWNER EQUITABLE OWNER 29 29 29 29 30 31 32 33 33 34 34 34 34 34 35 35 35 36 36 36 36 36 37 37 37 38 38 38 39 39 39 40 40 40 40 iv ADVANTAGES AND DISADVANTAGES OF JOINTLY HELD PROPERTY ADVANTAGES OF JOINT OWNERSHIP DISADVANTAGES OF JOINT OWNERSHIP HOLDING TITLE COMMUNITY PROPERTY: JOINT TENANCY: SEVERALTY: TENANCY-IN-PARTNERSHIP: CUSTODIAN FOR A MINOR: TRUSTEE: LIFE ESTATE: CHAPTER 3 STUDY QUESTIONS CHAPTER FOUR – GIFT, TAX & LIFETIME TRANSFERS NEW (2011-2012) ESTATE TAX LAWS LIFETIME GIFTS GIFT GIVING BASICS MEDICAL OR EDUCATIONAL EXPENSES Gifts to pay medical or educational expenses. QUALIFIED TUITION PROGRAMS – SECTION 529 PLANS GIFT APPRECIATION IN VALUE CONSIDERATION IN MARITAL/SUPPORT RIGHTS POTENTIAL PROBLEMS WITH COMPLETED TRANSFERS USING TRUSTS Avoiding probate Legal Guardianship IRREVOCABLE TRUSTS Using an Independent Trustee TYPES OF GIFTS INDIRECT GIFTS GIVING GIFTS WITH NO GIFT TAX GIFTS TO MINORS ABSOLUTE GIFTS TO MINORS GUARDIANSHIP UNIFORM GIFTS TO MINORS ACT PRESENT INTEREST TRUST GRATUITOUS TRANSFERS SERVICES NOT CONSIDERED AS A GIFT SERVICES RENDERED GRATUITOUSLY DISCLAIMERS PROMISE TO MAKE A GIFT TRANSFERS IN THE ORDINARY COURSE OF BUSINESS 1. COMPENSATION FOR PERSONAL SERVICES 2. BAD BARGAINS 3. SHAM GIFTS 4. EXEMPT GIFTS VALUATION OF PROPERTY FOR GIFT TAX PURPOSES INDEBTEDNESS AND TRANSFERRED PROPERTY RESTRICTIONS ON USE v 40 43 43 43 43 43 43 43 43 44 44 44 45 45 46 46 48 48 48 48 49 49 50 51 51 51 51 52 52 53 54 54 54 55 55 55 55 55 56 56 56 56 56 56 57 57 58 58 LIFE INSURANCE/ANNUITY CONTRACTS FEDERAL GIFT TAXATION CONCEPTS TO REMEMBER 58 59 59 FILING A GIFT TAX RETURN Filing the Gift Tax Return Extension of time Gift Tax Return-Form 709 GENERATION-SKIPPING TRANSFER TAX (GST) GIFTS TO MINORS REQUIREMENTS FOR A “C” TRUST UNIFORM GIFTS TO MINOR ACT (MGMA) GIFT TAX MARITAL DEDUCTION CHARITABLE DEDUCTIONS OUTRIGHT GIFTS GIFT SELECTION FACTORS 1. COST BASIS OF THE GIFT PROPERTY: 2. INCOME TAX BRACKET OF DONEE: 3. APPRECIATION: 4. INDEBTEDNESS OF GIFT PROPERTY: UNIFIED GIFT TAX CREDIT Applying the Unified Credit to Estate Tax Filing an Estate Tax Return ESTATE TAX GROSS ESTATE TAXABLE ESTATE INCOME TAX ON AN ESTATE CHAPTER 4 STUDY QUESTIONS 59 60 60 60 61 61 62 62 63 63 64 65 65 65 65 65 65 66 66 67 67 67 67 68 CHAPTER FIVE - TRANSFERS AT DEATH AND THE ESTATE ADMINISTRATION INTRODUCTION HOW PROPERTY PASSES AT DEATH 1. CONTRACT DESIGNATION 2. TRANSFER BY OPERATION OF LAW 3. TRANSFER BY WILL (TESTATE SUCCESSION) COMMENTS ON THE LAST WILL AND TESTAMENT WILLS HISTORY OF WILLS WILL REQUIREMENTS CONTESTING A WILL ADVANTAGES OF A WILL PROBLEMS WITH WILLS WILLS QUIZ ANSWERS TO THE WILL QUIZ ADMINISTERING THE ESTATE SIMPLIFIED ESTATE ADMINISTRATION CHOICE OF A PERSONAL REPRESENTATIVE CONTINUATION OF BUSINESS CLAIMS AGAINST THE ESTATE ESTATE INVENTORY AND VALUATION 69 69 69 69 70 71 71 72 72 73 73 74 74 77 78 82 83 83 83 84 84 vi ESTATE INCOME TAX RETURNS DISTRIBUTION TO HEIRS OR BENEFICIARIES EXECUTORS FEE 84 84 84 84 PAYING ESTATE TAXES Stock Redemptions Payment of Estate Taxes in Installments Community Property in the Equation Present Actions to be Taken for Estate Planning CHAPTER 5 STUDY QUESTIONS 85 85 85 86 86 88 CHAPTER SIX - FEDERAL ESTATE TAX: THE GROSS ESTATE INTRODUCTION ESTATE TAXES WHO IS REQUIRED TO PAY FEDERAL ESTATE? TYPES OF PROPERTY INCLUDED IN THE GROSS ESTATE Tangible personal property, real estate, and other assets. Jointly owned property Life insurance Employee benefits part of gross estate Gift Tax paid within three years of death Deductions and exclusions Funeral and administration expenses Other deductible estate expenses Valuation of estate property Beneficiary’s tax status 89 89 89 89 91 91 91 91 92 92 92 92 92 92 93 CALCULATING ESTATE TAXES. Credits and exemptions Estate tax exemption MARITAL DEDUCTION PORTABILITY State death tax Foreign death tax credit Credit for tax on prior transfers Qualified Domestic Trust (for Non-citizens) THE GROSS ESTATE OBSERVATION I: OBSERVATION II: OBSERVATION III: OBSERVATION IV: OBSERVATION V: STATE INHERITANCE TAXES AND REAL ESTATE I.R.S. SECTION 2033-2042 SECTION 2033 Value of Property Interests at Time of Death FOURTEEN ITEMS OF INCLUSION SECTION 2033A Family-Owned Business Interests 94 94 94 94 94 96 96 97 97 97 97 97 97 97 97 98 98 98 98 99 99 99 vii Section 2033A – Exclusion of Farmland SECTION 2034 Dower or Courtesy Interests SECTION 2035 Certain gifts and transfers made and gift taxes paid within three years of death BASIS FOR TRANSFERRED PROPERTY INCLUDIBLE Sec. 2035. Adjustments for certain gifts made within 3 years of decedent's death REVALUATION OF GIFTS FOR ESTATE TAX PURPOSES SECTION 2036 Transfer with retention of a life interest SUMMARY SECTION 2037 Transfer that takes effect at death SECTION 2038 Revocable transfer SECTION 2039 Annuities Amount includible ESTATE TAXATION OF ANNUITIES. SECTION 2040 Jointly held property with right of survivorship between spouses. ADVANTAGES OF JOINT TENANCIES: MAJOR DISADVANTAGES OF JOINT TENANCIES: SECTION 2040 Joint interests SECTION 2041 Powers of appointment Key Points: POWER OF APPOINTMENT AS USED IN ESTATE PLANNING SECTION 2042 Life Insurance GROUP LIFE INSURANCE MARITAL DEDUCTION AND LIFE INSURANCE NOT IN DECEDENTS GROSS ESTATE Transfers of Life Insurance SECTION 6166A Deferment for Closely Held Business SUMMARY CHAPTER 6 STUDY QUESTIONS CHAPTER SEVEN - COMPUTATION OF THE ESTATE TAX INTRODUCTION BACKGROUND OF THE MARITAL DEDUCTION MARITAL DEDUCTION BASIC RULES GENERAL RULE: NET VALUE OF GROSS ESTATE: PROPERTY PASSAGE: RESIDENCE OR CITIZENSHIP REQUIREMENT: INCLUSION OF PROPERTY REQUIREMENT: MARITAL STATUS REQUIREMENT: viii 100 101 101 101 101 103 103 104 105 105 107 107 107 108 108 108 108 109 110 110 110 111 111 112 112 113 113 113 115 115 115 116 116 116 116 117 117 117 122 123 123 123 123 123 123 124 124 125 125 TERMINABLE INTEREST RULE: DISQUALIFICATION RULES EXAMPLES OF TERMINABLE INTERESTS: TRUSTS AND THE MARITAL DEDUCTION ESTATE TRUST ADVANTAGES OF ESTATE TRUST DISADVANTAGES FORMS OF MARITAL BEQUESTS OUTRIGHT BEQUEST ADVANTAGES OF MARITAL BEQUESTS DISADVANTAGES CHARACTERISTICS OF CHARITABLE DEDUCTIONS CHARITABLE DEDUCTION DENIALS TYPES OF CHARITABLE BEQUESTS VALUATION OF CHARITABLE GIFTS ADJUSTABLE TAXABLE GIFTS EXCLUSIONS TENTATIVE TAX BASE FEDERAL ESTATE TAX CREDITS 1. PRIOR TRANSFER TAX 2. FOREIGN DEATH TAXES 3. GIFT TAX PAID ON PRE-1977 GIFTS 4. STATE DEATH TAXES 125 125 126 127 127 127 127 128 128 128 128 129 129 129 131 131 131 131 132 132 132 132 133 STATE DEATH TAX REQUIREMENTS SUMMARY CHAPTER 7 STUDY QUESTIONS 134 138 CHAPTER EIGHT – AVOIDING ESTATE SHRINKAGE & LIFE INSURANCE INTRODUCTION ESTATE SHRINKAGE SIZE OF THE ESTATE NATURE OF THE ESTATE ASSETS DEBTS LEFT BY THE DECEDENT COMPLEXITY OF THE ESTATE DEGREE OF PROBATE USED ESTATE LIQUIDITY LIFE INSURANCE LIQUIDITY SOURCES ADVANTAGES OF LIFE INSURANCE FOR LIQUIDITY OWNERSHIP AND BENEFICIARIES OF ESTATE LIQUIDITY OWNERSHIP BENEFICIARY CONCERNS BENEFICIARY DESIGNATIONS 1. ESTATE BENEFICIARY: 2. INDIVIDUAL BENEFICIARY: Disadvantages 3. TRUST AS BENEFICIARY: THE LIFE INSURANCE TRUST ASSIGNMENT OF GROUP INSURANCE THE BASICS OF LIFE INSURANCE AND ANNUITIES IN ESTATE PLANNING SETTLEMENT OPTIONS 139 139 139 139 140 140 141 141 141 142 143 144 145 145 145 145 145 146 146 146 147 147 147 ix 1. LUMP SUM OPTION 2. FIXED YEARS INSTALLMENT OPTION 3. INTEREST OPTION 4. LIFE INCOME OPTION 5. FIXED AMOUNT INSTALLMENT OPTION ESTATE TAXATION OF LIFE INSURANCE POLICIES ON OTHER LIVES PROCEEDS PAYABLE TO AN ESTATE PROCEEDS PAID TO A TRUST ESTATE TAXATION OF ANNUITIES TYPES OF ANNUITIES USED IN ESTATE PLANNING STRATEGIES FOR USING LIFE INSURANCE IN THE ESTATE THE BASICS TYPES OF LIFE INSURANCE TERM LIFE INSURANCE PERMANENT (CASH VALUE) INSURANCE POLICY OWNER AND LIFE INSURANCE TRUSTS LIFE SETTLEMENTS PRESENT STATE OF LIFE SETTLEMENTS USED IN ILIT’S VIATICALS VS. LIFE SETTLEMENTS PROTECTING AN ESTATE WITH LIFE INSURANCE SECTION 1035 (LIFE INSURANCE POLICY EXCHANGES) LIFE INSURANCE PROCEEDS PROCEEDS NOT RECEIVED IN INSTALLMENTS PROCEEDS RECEIVED IN INSTALLMENTS SURVIVING SPOUSE SURRENDER OF POLICY FOR CASH ENDOWMENT CONTRACT PROCEEDS ACCELERATED DEATH BENEFITS LIFE INSURANCE SINCE THE ECONOMIC RECOVERY TAX ACT THE IRREVOCABLE LIFE INSURANCE TRUST CHAPTER 8 STUDY QUESTIONS 147 148 148 148 148 148 149 149 149 149 150 150 150 151 151 151 152 152 153 155 156 157 157 157 158 158 158 158 158 159 159 161 CHAPTER NINE - TRUSTS INTRODUCTION HISTORY 162 162 162 TRUST BASICS DEFINITION PURPOSE OF A TRUST ELEMENTS OF A TRUST 1. GRANTOR (Creator or Settlor) 2. TRUSTEE 3. BENEFICIARY 4. CORPUS 5. TRUST INCOME 6. LAWFUL PURPOSE 7. TERMS SELECTION OF TRUSTEE DUTIES OF TRUSTEES 163 163 163 164 164 164 164 164 164 164 164 165 165 x POWERS OF TRUSTEES LIABILITIES OF TRUSTEE THE TRUST AGREEMENT COMMON PROBLEM AREAS ILLEGAL TRUSTEE ACTIVITIES INVESTMENTS BY TRUSTEES TYPES OF TRUSTS ADVANTAGES OF TRUSTS DISADVANTAGES OF A TRUST BASIC TRUSTS INTEREST RATES AND TRUSTS TRUST LOCATION FLEXIBILITY IN BENEFICIARIES TRUST INTEREST RATES QUALIFYING TERMINABLE INTEREST PROPERTY TRUST (Q-TIP) ADVANTAGES OF Q-TIP TRUST DISADVANTAGES QTIP TRUSTS – FOR SPOUSES QPERT TRUSTS FOR REAL ESTATE “GRAT”-TRUSTS FOR APPRECIATED ASSETS DYNASTY TRUST ASSET PROTECTION CHARITABLE REMAINDER TRUST HOW THE TRUST WORKS TYPES OF CHARITABLE REMAINDER TRUSTS UNI-TRUST TYPES OF ASSETS SUITABLE FOR THE TRUST SELECTING A TRUSTEE WHO CAN RECEIVE INCOME FROM THE TRUST Charitable remainder unitrust Requirements State Law Requirements Income Tax Requirements Fixed percentage payment No other payments Transfer remainder interest when termination of payments Portion of remainder interest in contributions to trusts NICRUTS & NIMCRUTS GRANTOR-RETAINED ANNUITY TRUST (grat) THE CRUMMEY TRUST SPRINKLING POWERS POUR-OVER TRUSTS ADVANTAGES: TESTAMENTARY TRUSTS SUPPORT TRUSTS ESPOUSAL REMAINDER TRUSTS SECTION 2503C. TRUSTS MARITAL TRUST NON-MARITAL TRUST xi 165 166 166 167 167 167 167 168 169 169 169 170 170 170 171 171 171 171 172 173 174 174 174 174 175 176 176 176 177 177 178 178 178 178 178 179 179 179 179 180 180 181 181 181 181 182 182 182 183 GENERATION-SKIPPING TRUSTS CONCLUSION CHAPTER 9 STUDY QUESTIONS 183 184 185 CHAPTER TEN - ESTATE PLANNING STRATEGIES 186 Income, Gift, and Estate Tax Consequences Charitable Deductions Gift Tax Implications Estate Tax Unrelated Business Taxable Income WIFO 186 186 186 186 186 187 Tax Planning REPLACING THE ASSET INCOME TAXES ESTATE TAXES THE MARITAL DEDUCTION QPRT – QUALIFIED PERSONAL RESIDENCE TRUST GRANTOR RETAINED INCOME TRUST (GRIT) SECTION 2032A SECTION 303 REDEMPTIONS RECAPITALIZATIONS AND ESTATE FREEZES THE SPENDTHRIFT TRUST THE LIVING REVOCABLE TRUST THE SOLUTION: "A-B LIVING TRUSTS" ADVANTAGES DIVIDING ASSETS BETWEEN TRUST A AND TRUST B ADVANTAGES OF THE A-B LIVING TRUST QUALIFIED TERMINABLE INTEREST PROPERTY TRUST (Q-TIP) THE BY-PASS TRUST DELAYING ESTATE TAXES USING AN A-B-C TRUST ADVANTAGES ESTATE PLANNING STRATEGIES PLANNING FOR CHILDREN SELECTING THE GUARDIAN LEAVING PROPERTY TO CHILDREN WHEN SHOULD PROPERTY BE DIVIDED AMONG CHILDREN WHEN SHOULD PROPERTY BE DISTRIBUTED TO CHILDREN GETTING PROPERTY TO MINORS PROTECT ASSETS FOR KIDS TRUST DIVORCE-PROOFING AN ESTATE ESTATE PLANNING SUMMARY CAPSULES Unauthorized Entities Updated Verbiage: CHAPTER 10 STUDY QUESTIONS SYNOPSIS xii 187 188 188 188 188 189 189 190 191 192 193 193 194 194 195 195 196 197 197 198 199 199 199 200 200 200 201 201 202 203 Error! Bookmark not defined. 205 206 WHAT IS ESTATE PLANNING? "Estate planning is the process of passing from this world to the next without passing through the Internal Revenue Service." Robert Brosterman NOTICE: During the preparation of this text, the U.S. Congress passed the Federal Estate Tax Reform Bill that which, in addition to keeping most of the income tax rates at the 2010 level, the Act created a major change to the federal estate tax (as outlined in this text) and gift tax taxation. At this time the country is in the middle of a presidential campaign and a change of administration may change the tax structure for estates drastically. Both parties are campaigning on changing the morass of laws and any change will affect other laws, etc. The new tax laws changes the tax-free amounts of estate tax exclusions and also gift tax exclusion. As indicated in the text, there are changes in the transfer of a decedent’s estate tax exclusions of the surviving spouse—known as the portability provision. For the vast majority of the (more than 99%) this means that they will not have to pay an estate tax if they die in 2011 or 2012, and there is a possibility that they will not have to pay a large estate tax if death occurs after 2012. This could be an advantage those who have not prepared a Will and have not equalized their estates. For the majority of the tax laws however, they remain under the Tax laws of 2001 and are so discussed in this text. NOTE The contents of this text are not to be considered as legal advice. Estate planning requires legal expertise, from probate and Will formation, to the complicated legalities of an estate of large amounts where decisions must be made in order to protect the estate, spouse and heirs at the death of the principal. Many items discussed herein may be subject to situations where professional legal help is needed and is mandatory. INTRODUCTION There have been many books, articles, etc. written on this important topic and this text will cover such topics as the estate planning process; forms of property ownership, transfer during life time and at death, Wills, trusts, federal gift taxes and state death taxes, federal estate taxation and estate planning techniques. There are two objectives: (1) to attempt to provide you with a basic knowledge of the estate planning process; (2) to keep a rather complex body of knowledge as understandable and precise as possible. It is not within the scope of this book to go beyond the basics. Once the basics are learned, applying advanced strategies to a given situation should be explored with the advice of specialists in the estate planning field. 1 HISTORY The origin and development of estate planning is important in order to understand the true nature of this process. Estate planning is by no means an American development. Primitive people did not recognize that land could be owned, as the land belonged to all people. Only personal property was possessed and owned by primitive people, and at death, our early ancestors either destroyed or buried such property with its owner. When people began to realize the value in their possession, they became concerned with passing those possessions upon death. Perhaps the earliest written evidence of the passing of property can be found in the hieroglyphics of the early Egyptians. Although our knowledge of the early Wills is limited, we do know they passed property to select heirs. In Babylonia, as a result of the Code of Hamurabi, property (with only a few exceptions) had to pass to heirs on death. This was also true under the law of Solon in Greece. Roman law, especially under Caesar Augustus, followed this practice as well. In fact, it appears that Augustus was the inventor of the estate tax because he levied a tax of 5 percent on the value of all estates to help support his army. Emperor Justin of the Byzantine Empire created the Justinian Code and the Code recommended the first formal requirements of Wills. This code also allowed a certain form of contract that is remarkably similar to modern day trusts. Many of our current Will and Estate Law can be traced to both Rome and the Justinian Code. Rome extended its rule to most of the known world and its rule included creating a system of law for each territory it conquered, and Great Britain was no exception. Even though the Romans were pushed out of Great Britain by the Anglo Saxons, much Roman Law remained. Up until the Norman conquest in A.D. 1066, the Anglo Saxon Law allowed people to pass title to most of their property through the use of a Will at their death. All of this changed after the Norman invasion in England and the advent of feudalism. FEUDALISM The foundation of the English Feudal system was that the King owned all the land which could only be disposed of by the King, and even though the King distributed land among his nobles he would still retain an interest called a Military Tenure. The nobles were only allowed to have property if they made financial contributions to the King who had a large war need. To prevent the division of land into smaller parcels by inheritance, the English Law prohibited land from being left by Will, passing automatically to the eldest living male heir, allowing wealth to accumulate to a small group of people. English feudal Wills passed only personal property. There was a constant battle between the Church and the King about who had the authority to administer their feudal Wills. At first the King took on this task and charged for his services, which created revenue for the King. When the Church began to administer these estates, it also charged a fee. It inherited substantial property through deathbed persuasion and the bequests that resulted from that persuasion. The King feared the power the Church was accumulating by its increased wealth and the saga of their power struggle began. Over the years, property vested in fewer and fewer hands were distributed to nobles. The nobles wanted to control the passing of their land; thus, two courts and systems of law developed. The first was the system of the common-law Courts which applied the Kings law strictly and without compassion. Participants would appeal to the King and thus a second system started, Royal Courts of the Equity. 2 The Royal Courts started when a King appointed a Chancellor to take charge. During this time a new concept was developing that allowed a noble to sell property to a third person (not leave it - but sell it while alive). Legal Title would be in the name of that third party; however, the property was to be used for the benefit of another person named in the seller’s Will. This was called Beneficial Ownership, which was the beginning of the Law of Trust. The King was not very happy about this new arrangement so in 1540 the Statute of Will was passed. The Statute of Will for the first time allowed a person to pass title to Real Estate through a Will. By the mid 1660's all property was allowed to pass by Will and in the later part of the 17th century the Statute of Frauds was passed. The Statute of Frauds required that all transfers of land be in writing, signed by the transferor and witnessed. Most of the rules created through this historic process have been adopted in the U.S. and are referred to as our English Common Law heritage. Out of this Heritage came the idea and ability for government to tax property at the owner’s death. In the late 1700's, England passed the Stamp Act which required people to write their Will on paper which contained certain stamps, and was printed by the Government. Different paper and stamps were used depending upon the size of the estate. When the decedent's estate was administered, the Court would check the size of the estate against the stamps on the Will paper to make sure that the proper tax was paid. They would also check to see whether any gifts were made in contemplation of death (first gift tax law). The first American attempt at a Federal Estate Tax was the Revolutionary War Tax passed in 1797. The purpose of this tax was to pay the war debt. This was adopted from the English Stamp Act and the person who inherited the estate paid the Stamp Duty. In 1826, the State of Pennsylvania adopted the first inheritance tax. By the late 1800's nine states were taxing the recipient of an inheritance. The second federal estate tax was passed in 1862. This also was a Stamp Act Tax to raise revenue for the Civil War, which was repealed in 1870. The forerunner of our current federal estate tax was the German War Tax passed in 1916. This tax, like the others, was to raise revenue for the war. This tax however, did not go away. The federal estate tax was held constitutional by the Supreme Court of the U.S. when it stated, "The Congress Shall have the power to lay and collect taxes, duties, imports and excises, to pay debts and provide for the common defense and general welfare of the U.S., but all duties, imports and excises shall be uniform throughout the U.S.” The result was that the new federal estate tax was not a direct tax on property. The federal estate tax was, and still remains, as a tax on the transfer of assets from deceased persons to their heirs. Technically, it is not a tax against property. Thus, unlike the income tax, which, to become legal, had to be added as a constitutional amendment, the federal estate tax did fit within the strict original confines of the Constitution. The gift tax was a natural extension of the federal estate tax. When the federal estate tax began in 1916, it was constantly amended. The major amendment came in 1926 as the gift tax was formally recognized. It was found that substantial revenue was being lost because people were making gifts during their lifetimes and these gifts were free from tax. In the past, the U.S. enacted estate taxes to fund specific military escapades. However, according to President F. Roosevelt, the federal estate tax was based on "the very sound policy of encouraging a wider distribution of wealth,” or, redistribution of wealth. His words have stood for reality for a very long time; but thanks to the Economic Recovery Tax Act and Tax Recov3 ery Act of 1986, the pendulum has started to swing back. WHAT IS ESTATE PLANNING? Estate planning is the process of creating a master plan for the disposition of an individual's assets. This will involve the disposition of such assets at death, and may also involve lifetime transfers of property and certain things must be considered. Limit administration costs Limit tax liabilities Facilitating timely payment of estate obligation and taxes Satisfying the desires of the estate owner as to property distribution Many individuals initiate estate plans for the purpose of tax planning. But as the plan develops, a much more comprehensive view emerges with the emphasis on the safe guarding of assets for the benefit of heirs, playing the critical role. In everyday life, estate planning involves people - spouses, children, grandchildren, favorite family members and close friends. Estate planning is attempting to provide for an individual’s security and prosperity without the "bread winner.” Estate planning has also been labeled a bundle of (taxes state, federal, income, death and gift) with an army of Lawyers, Accountants, Insurance people, Banks and Financial Planners to help administer the estate. There are four basic characteristics of estate planning: 1. Estate planning takes time: a little now or a lot later; time to identify and accomplish goals that are personally important. 2. Estate planning involves money, business, and finance. It involves dollars needed to create and maintain a life style for loved ones after death. It also involves the sacrifice of dollars to purchase life insurance or to invest in a portfolio. 3. Estate planning is human ambition and the fulfillment of that ambition by acquiring and holding property. It is a life statement of commitment to others. 4. Estate planning is "living" planning. It is an attempt to use resources to create an environment beyond death. It is the ability to share success with others. It is apparent that estate planning will have different meanings for different individuals. WHO NEEDS ESTATE PLANNING? It is never too early to start thinking about estate planning even if an estate is just a few personal possessions. If an individual dies without leaving any legal instructions for distributions of their property, the state, in which one lives, will make the decision for the individual. Which government bureaucrat should be trusted to assess the value of property and decide when and how it should be distributed, or who will get custody of the children? Many people procrastinate in preparing an estate plan because just thinking about the subject makes them uncomfortably aware of their own mortality. It may be difficult for individuals to meet with a qualified attorney to get affairs in order. But until this is done there will always be a gap in the best laid financial plans. Of course, the greater the value of the assets, the more complex the plan will be. As stated above, estate planning is not just for wealthy individuals. It could be just as vital to an individual with a small estate because of the lack of cash necessary to provide for loved 4 ones. The smaller estate individual may require more urgent attention due to the fact that each individual asset and its ultimate disposition has greater impact overall. The waste of any single asset could cause for greater suffering for the heirs of a small estate than the same occurrence in a larger estate. In summary, an estate plan can turn an uncertain distribution of assets into a certainty. AN ESTATE PLANNING CHECKUP There are a number of events that can occur in a life that will directly affect an estate plan. The birth of a child may add people to the list of those who will receive an inheritance; a sudden windfall may bring additional assets for which an individual must account. If any of the following situations or circumstances has occurred, an estate plan must be reviewed and changes made which reflect the new situation(s). 1. Marriage 2. Divorce 3. Birth of a child 4. Adoption of a child 5. Death of a child 6. Birth of a grandchild 7. Death of a grandchild 8. Marriage of a child 9. Divorce of a child 10. Death of a spouse 11. Increase or decrease in personal wealth 12. Receipt of substantial inheritance or gift 13. Giving a substantial sum to others 14. Purchase of a life insurance policy 15. Participation in a new retirement plan 16. Moving to another state MINIMUM ESTATE PLANNING DOCUMENTATION There are certain documents that should be in any estate plan as a minimum. They should always be kept up to date and reflect the current situation of the family and financial situation. Will – outlines how property is to be distributed. Power of Attorney for finances and for health care (usually separate documents) appointing a person to manage financial affairs and health care decisions if the person cannot do so. Living Will – lists the end-of-life and disability preferences. Guardianship – names certain person(s) to raise children if the person dies or becomes severely incapacitated. Beneficiary Designates – forms that need to be completed for retirement plans. Trusts are certainly essential in many cases, and are discussed in detail later in this text. 5 OBJECTIVES OF ESTATE PLANNING There are four distinct objectives of a proper estate plan. Many times a plan is perceived as only having one, or possibly two, of those objectives. Since there may be different specialists involved in the Estate Planning process, such as Attorneys or Accountants, an individual should be sure to not only realize such shortcomings in a plan, but to safeguard against it. A truly comprehensive estate plan will address all four of these objectives: 1. CREATE LIQUIDITY Liquidity means the ability to convert assets to cash without giving up value. Because of death and its related costs that must be paid within a short time following death, one must be absolutely certain that the estate has sufficient liquid assets to cover such costs. Realistically it would seem that the annual increase in the cost of dying has exceeded the annual increase in the cost of living. Costs of burial plots, cemetery monuments, funeral director's fee and attorney fees have risen. Thus, if an individual’s estate presently lacks liquidity, it can be assumed that the liquidity problem would continue to increase in the future. The need for liquidity arises because of four general grouping of expenses materialize upon death. These expenses generally must be paid within one year of death. A. Administration expenses - these are the expenses of opening, administering and closing the decedent's estate. Executor's fees and fees for the Executor's attorney represent the majority of expenses. Other expenses will include Court costs; costs of appraising estate property; costs of insuring estate property while estate is opened; maintenance or repair of estate property; expenses of defending a Will contested by disgruntled heirs; auction fees; and the cost of administration. Studies of I.R.S. statistics reveal that these expenses will shrink the estate by 4-5%. B. Indebtedness of the decedent - mortgages is usually the most significant debts. Many families will want to retire the mortgage at the death of the first spouse so that the surviving widower and children are not burdened with this debt. Other debts would include automobile loan balances, credit card accounts and other installment credit, and final expenses of the decedent's last illness. Accrued taxes would also be considered debt. This would include accrued but unpaid income taxes, (federal, state, local), property taxes and any other taxes which the decedent had incurred but not paid. It should be noted creditors have a limited period of time in which to file claims against the estate. The Executor then has a period of time, usually the first six months after death, in which to decide the validity of such claims and settle or pay them. Debts will vary according to the estate but they (generally) average 5-6% of the total estate. C. Funeral expenses and related costs are a major cause of shrinkage. Expenses paid to funeral homes, burial expenses, tombstone, monument or mausoleum expresses, the cost of a burial plot, the cost of transportation of the body, florist's fees and prepaid expenses for future care of the burial site are all included. D. Death taxes, federal and state, are another cause of estate shrinkage. Such taxes are important in the large, unplanned (or poorly planned) estate. This tax presents a serious threat to individuals but there are several techniques to minimize them. NOTE: Estate and Gift Taxes are discussed in detail later as these are the most affected by recent legislation. 6 In summary an estate that is not liquid, may have to borrow in order to provide living allowances for spouse and children and to pay estate obligations. Sometimes the value of estate assets rises or falls dramatically due simply to the owner's death. Thus, the death of an artist, author or entertainer often increases the values of his/her work. On the other hand, the death of a business owner has the opposite effect. SOLUTIONS TO LACK OF LIQUIDITY There are two ways to solve the liquidity problem: (1) minimize the need for cash at the time of death and (2) create additional liquidity at death. By minimizing the need for cash at the time of death a proper estate plan should avoid Probate and reduce taxes. If, after achieving this objective the estate will probably still have liquidity problems, then the proper estate plan must find a way to create additional liquidity. Life insurance is probably the best way because of its unique characteristic of maturing at death just when it is needed the most. 2. AVOID PROBATE COSTS Since Probate expenses tend to vary directly with the size of the Probate estate (the assets passing under the decedent’s Will) actions which reduce the size of the Probate also reduce Probate's costs. Probate avoidance has become a routine and long overdue part of estate planning. To understand ways to avoid Probate we must first define Probate and why it has become burdensome. Probate is the legal process of passing ownership of property from a deceased person to others. Probate Courts have been a part of our legal heritage for centuries. Generally speaking, every county in every state in the U.S. has its own Probate Court. These courts all have the same purpose; passing ownership of property to the heirs of people who died with a Will plan or with no plan at all. Probate is designed to protect the rights of beneficiaries and creditors and to help ensure an orderly transfer of the decedent’s property. The primary duty of the Executor is to see the will to through the probate process. In 1965, Norman Dacy authored a national best seller book entitled “How to Avoid Probate”. Mr. Dace's thesis was that Probate should and could be avoided. The book generated a new crisis in the relationship between attorneys and clients. One must understand that if one dies either with a Will or without, the Probate process begins. Getting the decedent's property into the hands of his/her beneficiaries or the state's beneficiaries is but one part of the Probate process. The Probate Agent (Executor/Administrator) is responsible for most of the work to be accomplished in the process. The Agent will report and answer to the Probate Judge through the Estate's Attorney. There are four problems with Probate: 1. Probate is public. The process can be played out in the media thus creating more problems. 2. Probate is time-consuming. Anywhere from nine months to 10 years has been documented. 3. Probate is expensive. It is not uncommon to see shrinkage of 10% of the estate. 4. Probate puts the real control in the judge’s chamber. 7 3. REDUCE TAXES To the extent one can reduce the tax bite at death the estate will not need extra liquidity for tax payments thus conserving estate assets for the decedent dependents and heirs. As with Probate avoidance, tax considerations should not drive everything else. The estate owner should not engage in "off the wall" estate planning techniques which may save taxes but which would be inconsistent with the individual’s fundamental objectives. There is a tendency among some estate planners to consider and plan for federal estate tax consequences only. However, the total situation should be evaluated, including the Federal Income Gift Tax and estate taxes and any other applicable estate income, gift and death taxes. 4. EXECUTE DISPOSITIVE DOCUMENTS Transactions and techniques in the estate planning area are subject to more formality than is usual in the normal course of personal and business affair. If the proper formalities are not observed a well-planned estate plan may fail in the implementation phase. There are five areas where these disposition techniques are critical. 1. Wills are the best example. While some states honor Wills written by the individuals own hand (holographic Wills), and even oral Wills (nuncupative Wills) it is always a good idea to have a Will typewritten and executed in accordance with state law requirements. "Home Made Wills" may be valid but often times fall into trouble when the witnessing requirement is not met—which could invalidate the will regardless of how careful the document has been drawn. 2. Deeds for real property are also subject to proper formalities and must normally be recorded in the office of a designated local official. 3. Trust agreements are contracts and must comply with the rules for valid and enforceable contracts. The chief advantages of trusts are professional management of assets by the trustee, potential income tax and estate tax savings if the trust is irrevocable, control over disposition of trust income and principal through the trust terms or discretion vested in the trustee, and the flexibility possible in trusts design so that virtually any plan of disposition can be achieved. 4. Lifetime gifts should also be looked upon as a disposition device. Gifts are a way of disposing of an estate before death. Gifts are potentially subject to the federal gift tax and to state gift taxes in a few states. Gift tax avoidance or minimization is a critical part of lifetime gift planning. Gifts may be made in a variety of ways - outright transfer, transfer in trust, transfer into joint names, etc. 5. Jointly owned property is an area that needs particular care to disposition. Example - in some states one creates a tenancy by entirety by transferring title to "Mr. and Mrs. Fred Snow, husband and wife.” If "husband and wife” were omitted, state law would create a different presumption, either that there was a tenancy in common or a joint tenancy with right of survivorship. (Discussed in detail in a later chapter). THE PROBATE PROCESS TODAY To further understand the Probate process, the eight steps listed below provides an insight into how it works, assuming a Will was in place. 8 1. DEATH The Executor (if one is named in the Will) has not yet been formally appointed by the Court and takes only limited action at time of death - such as notifying employer and bank, and requesting cancellation of the utilities to the decedents home. Family and friends cannot legally take any of the belongings before the Probate Process has been completed, unless they get specific approval from the Court. In fact there could be serious consequences if they do. 2. FILE PETITION Probate does not automatically occur upon death. Someone must request that Probate proceedings begin - usually when property needs to be sold, checks need to be written from a bank account, money withdrawn from an account, or when other assets need to be liquidated or transferred to a new owner; the Executor will request that Probate Proceedings begin. This is a formal process. A written petition prepared by an attorney, is submitted to the Court to start the proceedings and will usually include the original Will. A filing fee, paid from estate assets, will be charged when the petition is presented to the court. 3. PUBLICATION After the petition is filed, in most states the Court will order a formal notice of the death published in a local newspaper for several weeks or months before the first hearing. This procedure notifies the public of the death, requests that creditors present any unpaid debts to the Court, and invites anyone who feels he/she has a right to part of the estate to come forward and make a claim. The cost of this advertising is paid from assets of the estate. At the same time, the Executor notifies the named heirs of the death, sends each of them a copy of the Will and advises them where the Probate proceedings will be held. This is when heirs discover how much the decedent left them, or didn't leave them. 4. FIRST HEARING The first hearing is usually held six weeks to two months after the filing of the petition. Assuming there is no contest of the Will or any other unusual circumstances, the following steps usually occur at this hearing. A. A Will is validated. The Judge must make sure the Will meets the legal requirements, that it is the correct Will (if more than one was left), and that the decedent was in a competent state of mind when it was drawn. Also the Judge must certify that all the proper signatures are on it and that it was witnessed. If a Will is not accepted as valid, the Judge will declare that the decedent died without a Will and will apply the State's Will instead. B. After the Will is validated (and "admitted" into Probate) the Court will formally appoint the Executor (sometimes called a Personal Representative) to manage the estate for the Court. If the named Executor in the Will is still alive and able to act in this capacity, the Judge will usually go along with the wishes of the decedent. If not, the Judge will appoint someone else, usually a relative but sometimes an attorney or a Bank's Trust Department. The Executor helps the Court to inventory all possessions of the decedent and determine the values. The Executor is also responsible for collecting bills and preparing the final tax returns and presenting them to the Court to be approved and paid. The Executor also applies to Social Security, Veterans Administration, Union or Fraternal Organizations and other groups or organizations for 9 any death benefits to which the estate is entitled. C. The Court will grant the Executor "Letter Testamentary.” This is a legal document, an order signed by the Judge, which formally appoints the Executor giving him/her the authority to act in the decedent’s place under Court supervision. These "Letters" are documents the Bank and others need to close out the decedent’s accounts and turn the assets over to the Executor. In effect, the titles of the property are transferred from the decedent to the Executor, who is responsible for their safe keeping while the estate is Probated. Executors are entitled to receive payment for their services and are often required to post a bond, both of which are normally paid from the assets in the estate. 4. UNUSUAL CIRCUMSTANCES If the Will is contested or if there are any other unusual circumstances, the Court will try to resolve them at the first hearing. If the differences cannot be resolved at this time, there will be subsequent hearings until the conflict can be resolved by the Court. The Court will decide if anyone who claims to be an "heir" has a valid right to part of the estate whether or not the decedent included him/her in the Will. It is not uncommon for these "heirs" to find out how much an estate is worth from the newspaper publication and Court files, and hire an attorney to contest the Will - sometimes when they have no real hope of receiving any assets. Contesting a Will can get very expensive and prolongs Probate. Families very often pay off contesting "heirs" just to get rid of them. Since Executors are entitled to be paid for their services, more than one of the decedent's relatives or friends may want this responsibility, resulting in additional Court hearings to appoint the Executor. This can significantly increase the time and costs of Probate and could result in hurt feelings as well. Even if one specifies an Executor in the Will, the choice can be contested. 5. ASSETS FROZEN / INVENTORY ESTATE During Probate, assets are usually frozen so that an accurate inventory of property and possessions can be taken. This means that heirs cannot receive their inheritances nor can any property or asset be sold or liquidated without the Court's permission. After the first hearing, the Executor must locate all of the decedent's possessions and property, compile a list of them and their values, and present it to the Court. This can be very time-consuming and a difficult process, especially if there is no current and accurate records. The Court will usually require formal appraisals (usually by a certified, Court-approved appraiser) for many items, such as real estate, antiques, collectibles, automobiles, furniture, etc. Appraisal fees can be an expensive estate expense. 6. FAMILY LIVING ALLOWANCE During this time, the decedent's dependents (spouse, minor children, and perhaps elderly parents) will probably be allowed a living allowance but it must be "reasonable" and approved by the Court. To request the allowance, dependents must submit a written request to the Court though an attorney. If there are a number of outstanding debts or if the Will is being contested, a Judge 10 may insist that the assets remain intact and reduce - or even deny - the request. However, proceeds from assets with beneficiary designations (such as life insurance, IRA's, retirement plans, etc.) are usually paid directly to the named beneficiary without Probate, so the family will probably have some money for living expenses. (However if the decedent named "my estate" as the beneficiary on a life insurance policy, the proceeds must go through Probate first). The Court will allow the dependents to continue living in the decedent’s home during Probate, even if it will eventually go to someone else. 7. PRESENTATION AND PAYMENT OF DEBTS, CLAIMS & TAXES Creditors have a certain number of days from first publication notice of the decedent’s death to come forward and submit their claims against the estate for payment. After this time has passed, the Executor will audit the claims and present them to the Court for approval to pay them from the assets in the estate. If there are any disputes over a claim, there could be additional hearing (at additional costs), with the Judge ultimately making the final decision. 8. FINAL DISTRIBUTION / CLOSING OF THE ESTATE Finally after the Court is satisfied that the legal process has been completed - in most cases at least a year or more later - it will order another publication to announce a final hearing to close the estate. At the hearing, the Judge will review all the paperwork and order all debts, claims, taxes and Probate expenses (including attorney and Executor fees, Probate fees, bonds and appraisals) paid. The cash assets in an estate can be greatly reduced, even consumed, because of the ongoing expenses of Probate. If there is not enough cash in the estate to pay debts, the Judge can order property, including personal belongings sold at a public auction or estate sale. Many times this will be on a "distressed sale" basis or in a depressed market. After all bills have been paid, the Court will order the remaining property distributed to the heirs according to the Will. The Judge will then order the Executor relieved of his/her duties and the file closed. 9. MULTIPLE PROBATE If one owns real estate in more than one state, this entire process (and its expenses) will probably have to be repeated in each state in which the real estate is located. NOTED EXCEPTIONS The only real exception to the process is that in some states there is a shortened process for very small estates. Estates that qualify can be Probated without an attorney or Executor fairly quickly and with just a minimum filing fee. But very few qualify for this special process because the limits on the total estate value are usually extremely low, as low as $15,000 in same states. 11 Estate Value EXAMPLE OF PROBATE FEES Combined Fees For attorney and Executor* California Missouri New York $100,000.................$6,300...............$6,600..........$10,000 $200,000...............$10,000.............$12,000..........$18,000 $500,000...............$22,300.............$28,100..........$38,000 $1,000,000............$42,300..............$53,100.........$68,000 $2,000,000............$62,300..............$93,100….....$118,000 $5,000,000..........$122,300............$213,100..…...$268,000 *Minimum fees for California and Missouri; Average fees in New York. As previously stated, Probate is expensive as attorney and Executor fees are difficult to predict. To Probate an estate could cost anywhere from 5-10% of the estate gross value. Generally speaking, Probate costs take a greater percentage from smaller estates than larger ones. Probate causes families to lose control and does take valuable time. The fact that the estate becomes public record can cause emotional distress. EIGHT COMMON PROBLEMS IN ESTATE PLANNING 1. Tax liability. Although a major concern, as stated before, it should not be the primary objective of estate planning. Estate disposition must be planned to reduce potential tax liability to the lowest level consistent with client’s needs/goals. However, with the possibility (probability) of substantial changes in estate and gift taxation, tax liability raises the importance of property estate planning. 2. Outdated plan. The Will must be reviewed periodically to stay consistent with client's most recent intentions. 3. Psychological impediments. There are two: (1) Dealing with one's own mortality, making an estate plan requires the client to acknowledge the fact that the client is going to die eventually; and (2) Procrastination, as the client puts off planning an estate because of the magnitude of the task. 4. Failure to plan. If a person dies intestate (without a valid Will) state law of succession will govern property disposition. A Will is a legal instrument indicating a person's desire of disposition of property after death. Wills need to be periodically reviewed and updated to ensure the property owner's most recent interests are handled correctly at death. 5. Improper position / Ownership of assets. The estate tax liability is calculated on the asset ownership form of when the owner's death occurred. (Tenants in common, joint tenants with rights of survivorship, etc.). 6. Effects of inflation. What seems to be an adequate sum in terms of today's dollars may have little real purchasing power in the future. 7. Lack of liquidity. There are three main considerations in assessing liquidity needs: 12 A. Types of assets making up the estate. B. Amount of estate owners debt obligations. C. Projected estate tax liability. 8. Disability / Last illness. Cost of a lingering illness or disability may eat up valuable estate assets. Medical expense and disability insurance should help with these costs thus saving assets. ESTATE PLANNING GOALS In order to properly plan an estate and to make sure that everyone is “playing on the same field”, it is necessary for the estate owner to clearly establish what they expect an estate plan to accomplish. One method of notifying others as to what the owner expects is to have the owner to complete an Estate Planning Questionnaire. As an example, the following list could be used, with the owner assigning a number from one to ten with the 1 being of no importance, 10 being of the utmost importance. In any event, such a list will probably make the owner aware of situations that they had not considered previously. 1. Avoid Estate taxes and probate 2. Provide for my natural children 3. Provide for stepchildren 4. Plan for possible total disability 5. Provide for my Charities or particular Charity 6. Disinherit a relative that would otherwise be an heir 7. Provide for a handicapped person 8. Avoid Capital Gain taxes 9. Provide for grandchildren 10. Protect heirs from spending all of their inheritance foolishly 11. Get personal effects to particular people 12. Keep all of my estate effect confidential 13. Designate Guardians for my children 14. Designate particular person or firm to handle the estate after my death 15. Avoid unnecessary or excessive estate planning costs 16. Provide for my parents and get their affairs in order 17. Avoid quarrels by family members of the estate 18. Make gifts to specific persons during my lifetime THE ESTATE PLANNING TEAM One must keep in mind that the following discussion is for individuals with average sized estate and higher. In today's economy, one who may own a home, furnishing, automobiles, some personal savings and retirement benefits could easily qualify as an individual who would require assistance in developing an estate plan. Generally there are five important members of the Estate Planning team consisting of the client, the life underwriter, the attorney, the trust officer and the accountant. Often, in large estates, the investment advisor may also be part of the team. 13 The client is obviously the most important member of the team. The client will define what the team is attempting to accomplish and is the ultimate decision maker. The underwriter will probably be the "initiator.” The life underwriter is not restricted in the manner that he/she obtains clients (as Attorneys and Accountants are). This individual tends to gain the advantage in the process. Since the life underwriter is an expert in his/her chosen field (just as is the Accountant and Attorney) this person will be needed to provide crucial solutions to many problems. Without a life underwriter the team is incomplete and estate plans attempted without the life underwriter will not be complete. An Attorney is an essential member of the team because it is he/she who will determine the legal and tax consequences of each aspect of the estate plan. It is simply impossible to be involved in Estate Planning without working with an attorney. The Trust Officer advises on the practicality of the estate plan as well as often playing a major role in the estate administration process. While performing their duties to conserve and manage estate assets, trust officers are often in a position to suggest the use of life insurance as a major estate conservation tool. The Accountant, often a CPA, is the adviser who is most closely acquainted with the prospects financial affairs. Additionally, it is the accountants responsibility to advise on asset valuation. This task could prove to be quite frustrating especially in the case of a business owner or farmer. The Accountant's talents and expertise are indispensable and his/her knowledge of tax law is of great value to the team as the members seek to solve the problems that arise in many estates. Investment advisors are usually seen in very large estates. Usually this person will want to take part to assure that the prospect's investment desires are safeguarded and not overlooked by the other advisors. It must be emphasized that cooperation and mutual respect should be the foundations of the team. Although each brings a specific specialty and knowledge to the team none are more important than the other. In order to develop a highly efficient estate plan with your client's objectives as the motivation force, all the team members must communicate and must be offered an opportunity render their expertise to the plan. 14 CHAPTER 1 STUDY QUESTIONS 1. The forerunner of our current Federal Estate Tax was the A. State of Frauds. B. German War Tax passed in 1916. C. Federal Gift Tax. 2. During probate A. assets are usually frozen. B. a Will must be presented or the proceedings cannot go forward. C. the executor completes his/her duties without compensation. 3. The deceased owned real estate in more than one state, so probate would be A. only in the state when the deceased was resided. B. in the residence state of the principle heir only. C. in all states where real property is located. Chapter 1 Study Question - Answers & Sections 1 B – page 2 – Feudalism 2 A – page 10 – 5. Assets Frozen/Inventory Estate 3 C – page 11 – 9. Multiple Probate 15 CHAPTER TWO - ESTATE PLANNING PROCESS Don’t be afraid of a little opposition. Remember that the “kite” of Success, generally rises against to wind of adversity – not with it. INTRODUCTION Estate Planning enhances and maintains an individual’s or family's financial welfare. Included in Estate Planning are not only arrangements made for the disposition of a client's property at death but also overall wealth and security while the client is alive. In planning for people and property disposition the estate planner must have a broad knowledge of law, economics, insurance and finance. Important laws include those dealing with Wills and trusts, corporations, insurance and taxation. As one can see the Estate Planning Process will be quite detailed and requires professionalism through all stages of the Estate Planning Process. AN OVERVIEW Before exploring the Estate Planning Process the planner must keep three concepts in mind: 1. The design and formulation of an estate plan is always a custom tailored effort. 2. The general format may be similar from one situation to another. 3. Preconceived ideas will not work in Estate Planning thus the plan must match the needs of the client. Two key observations about the Estate Planning Process must be made before discussing the actual workings of the process: 1. The process cannot begin until the client is able to discuss his/her particular needs and objectives. 2. The Estate Planning Process is extremely objective and comprehensive. The estate planner must be flexible and come to the planning meeting totally objective. The planner must prepare for the unexpected and help uncover important issues that the client must address for an efficient estate plan. ESTATE PLANNING PROCESS - SIX STEPS The six steps represent a "Pure Estate Plan.” Later, two other possible steps will be discussed. 1. DATA MUST BE GATHERED AND COMPILED Estate Planning concerns people as well as property and should be highly personalized. The planner must have information such as the client's domicile, identifying family members, and inventorying the prospects property. Family facts should include general identifying information as well as personal characteristics, behaviors, and overall health. The planner must have a feeling for the attitudes, expectations, and wealth of the different family members. 16 LIQUIDITY CONCERNS Husband's Death 1.Family Income Desired (70% of Current Wife's Death $ __________ $ __________ Less Social Security (Annual) $ __________ $ __________ Less Other Income $ __________ $ __________ Less Surviving Spouse Income $ __________ $ __________ Income Need $ __________ $ __________ Capital Need to Produce Income $ __________ $ __________ 2. Final Expenses (Probate, Taxes, Debt Liabilities $ __________ $ __________ 3. Mortgages Cancellations, or Rent Payments 4.Education Funds $ ___________ $ __________ $ ___________ $ __________ $ ___________ $ __________ Less Present Liquid Assets $ ___________ $ __________ Less Present Life Insurance $ ___________ $ __________ New Liquidity Needed $ __________ $ __________ Divide income by rate of return Ex: $ 10,000 - 8% + 125,000 5. Other Total Capital Needed (Sum of 1,2,3,4 and 5) 17 BUSINESS INFORMATION (if applicable) ( ) Corporation ( ) Partnership ( ) Proprietorship Average Book value........ $_________ Capitalization Rate............... $__________ Average Annual Earning. $_________ Reasonable Rates of Return. $__________ Excess of Current Salaries Earnings Multiple Over Replacements ........ $_________ PE. Ratio...... $_________ Years of Goodwill.......... _________ Number of Shares._______ ESTATE INFORMATION WILLS AND TRUSTS Do you have a Will? ( ) yes ( ) no A trust? ( ) yes ( ) no (Obtain a copy for those marked "yes") Attorney's Name__________________ Accountant’s Name________________ PRIOR TAXABLE GIFTS CHARITABLE REQUESTS Amount $ ________ Date _________Donee______________________ Taxes Paid $ _________ Amount $ __________ Amount $ ________Date _________ Donee ______________________ Taxes Paid $ _________ Amount $__________ LIFE INSURANCE Insured Amount ____________ ____________ ____________ $ ______ $ ______ $ ______ Kind ________ ________ ________ 18 Company/Institution ___________________ ___________________ ___________________ Assets* ASSETS AND LIABILITIES Liabilities Real Property $_______ Personal Property $_______ Bank Accounts $_______ IRAs $_______ Securities $_______ Trust Property $_______ Business Interest $_______ Retirement Benefits $_______ Insurance & Annuities $_______ Other Assets $_______ Total Assets $_______ Mortgage $___________ Installment Loan $_______ Notes $______________ Charge Accounts $_______ Business Debts $________ Insurance Loan $________ Other Liabilities $_______ Total Liabilities$________ Net Worth $____________ Identifying Assets and liabilities is a particular challenge. This part of the process may be quite detailed. The key idea here is that the plan can only be effective with accurate facts and figures. Identifying current plans is an important step. Copies of Wills and trusts should be gathered. Objectives should be noted, discussed and recorded. Definite and specific objectives are the goals of fact-finding. This can only be achieved through comprehensive interviews with family members, other client advisors, and the client his/her self. After an exhaustive interview process the planner and client can proceed to the next logical step: Identifying the Problems. A general guideline for an estate planner to remember is that plans become inconsistent for three general reasons: 1. The client provides incorrect information. Consumers are inclined to overstate or understate their true financial situation. The polished planner will ask tactful but necessary probing questions whenever the planner has reason to doubt the validity of client-furnished data. 2. The planner assumes too much. The planner brings preconceived ideas about the client to the meeting which then makes incorrect assumptions about the client. 3. The planner fails to uncover important facts. The planner must take responsibility for this failure. As the estate planner develops his/her practice a comprehensive fact finder will help avoid many of these problems. Many planners double their fact-finding forms as a computer input form which saves time in transferring the data to input sheets for computer calculations. As one can imagine there are many fact-finding forms used today, ranking from 3 pages to over 40 pages. Some planners ask clients to complete such forms after the first interview and bring the completed data form to the next interview. Some planners, on the other hand, will request the data form be completed prior to the first interview. Regardless of when the form is completed it is a crucial tool for the estate planner in the initial steps of estate planning preparation and must be completed before any other steps are taken. 19 2. IDENTIFYING THE PROBLEMS. The area of identifying and evaluating problem situations will tax the entire team that represents estate planning. Some of the problem areas could be: 1. Is Probate necessary or should a trust be implemented? 2. How much should be set aside for the last illness and burial expenses? 3. What are the projected costs and fees to be incurred at death? 4. What percentage of shrinkage will the estate suffer? 5. What debts will come due at death? 6. Are there any charitable requests? 7. Are there any business interests? If so, how will the interest be handled at death? 8. How much will taxes take and how will they be paid? Obviously, these are but a few of the problems that may arise. By identifying the various areas of concern in the estate plan, the planner will be able to call upon the estate planning team (life underwriter, accountant, attorney, banker, and advisor) for assistance in solving such problem areas. Once the planner is able to identify the problem areas and then take corrective actions necessary for the client, the next step in the process becomes evident - the Development of the Estate Plan. 3. DEVELOPING THE PLAN. Once the fact-finding has been completed and the proper questions asked leading to problem areas the planner must now exercise creativity. The planner must help the client find ways to meet objectives, through the process of elimination and trial and error. Thus, an action plan can be created to make necessary corrective solution. The ultimate concept is "what will work best", not necessarily "what will work.” Usually at this stage, the full impact of the other advisors will be seen for legal matters along with an accountant's view on the tax ramifications of a changed document. The life underwriter could offer valuable solutions to estate shrinkage and business continuation problems. The trust officer at the bank might have ideas on the necessity of providing funds for dependents thus urging conservative and guaranteed investment vehicles in a trust account. The estate planner must keep in mind that all the members of the team are working together and should be careful not to alienate any of the members. This will make the job much easier and because of the various fields of expertise, will make the plan much more likely to stand the tests of time. Once the plan is developed, it must be tested. Does it satisfy the needs of estate liquidity? Are the retirement objectives being met? Does the plan dispose of assets the way the client wishes? Are the needs of the survivors met? Will the plan minimize the shrinkage of the estate? If all these questions are affirmative, then the plan could pass the test of time. 4. PRESENTING THE PLAN When the plan is completed the planner should meet with the client and spouse. This should be a face-to-face meeting, either at the planner's office or client's home. Different planners have different ideas as to the presentation of the plan. It would not be advisable to mail 20 the plan to the client as confusion and irritation could develop. If the plan took time to develop with input from the various team members, then it is imperative that the planner review the contents of the plan with all involved parties. In today's litigious environment it would be advisable to have a checklist of the various changes being suggested and have the clients initialize that the changes were reviewed. When opening the presentation, the planner should restate the assumptions and key facts on which the plan is based. Do not assume that the client will remember all-or-any of prior discussions. The planner must reiterate that the plan was molded around the clients input and objectives and not developed in a vacuum. Finally, any action steps recommended by the planner should be reviewed and analyzed as to time frames when instituted. Once this is completed the needed steps of implementation have been satisfied. The final stage of presenting the plan is to have the client's acceptance. If the client has objections, the planner's duty is to uncover the reason for the objection. Did the client understand what was being asked? Possibly an objection might be a "smokescreen" hiding another objection. Is the client uncomfortable with any of the recommendations? If so, why? The planner should not be hesitant to probe further and determine the true reason for any problem. The emphasis on objectivity can be appreciated at this point. Since the fact-finding interview asked for client’s input on specific related client information, the client will understand that the planner is not attempting to market a particular product or service. The importance of other team members can be seen at this critical stage as they will lend credibility to problem areas. In many situations the planner must go "back to the drawing board" and implement changes. With a revised plan a second presentation will be needed. Usually, the revised plan will defuse any further objection and the plan will be accepted. Please note that although the client might not have accepted the first plan, this is not an adverse reflection on the planner. It is important to remember that the client's wishes are paramount and it is of primary importance to develop a plan that satisfies the client's needs and objectives. 5. IMPLEMENTING THE PLAN. Once the Plan has been accepted, the planner's responsibilities are only half-completed. The professional planner must now prove his/her worth by insisting that the accepted recommendations be implemented in a timely fashion. Several steps are usually needed in Plan Implementation such as: a. Various tax-motivated strategies might need to be implemented. The client's accountant should be consulted, and become apprised of any such situation. b. Insurance products could be needed for retirement income, estate liquidity, estate creation and survivor income. c. An attorney must prepare any necessary legal documents, such as Wills, trusts, and sale or purchase agreements. The estate planner must perform the needed duties as he/she coordinates the implementation of the plan. The planner is looked upon as the "quarterback" who will make certain that the needed actions do, in fact, take place. The planner should help the client shop for financial products and work with the advisors as the need arises. 21 An organizational tool needed to tabulate the various actions required would be an Action Calendar. The calendar would identify each action that must be taken, who is responsible for such action, and when the action is to be accomplished. Of course the calendar will be updated periodically, and reviewed with the client. By formalizing such actions, accountability on all parties involved in the plan is established. For those who are procrastinators by nature the calendar will be a reminder of needed action on a timely basis. (See enclosed calendar). SAMPLE ACTION CALENDAR WHAT WHO WHEN 1. Draft a codicil to the client’s John Birnbaum Will to change specific legatees, Esq. And to name a revocable trust As residuary legatee. Feb. 10 2. Draft the revocable pourover trust referred to in # 1 above. John Birnbaum Esq. Feb 10 Ross Perot VP and Trust Officer Feb 20 3. Review codicil and trust. 4. Execute the documents referred into # 1 above. 5.Select and recommend life insurance for estate liquid needs. John J. Client Bernie Seratan, CLU Feb 28 Mar. 1 6. Purchase life insurance John J. Client Mar 15 7 . Purchase tax-exempt Mutual fund shares John J. Client Apr. 10 9. Open a self-direct IRA For retirement income needs. John J. Client Apr. 15 6. REVIEWING AND UPDATING THE PLAN. The final step of the Planning Process is a periodic view and update of the plan. Laws 22 change, tax codes are modified, but most importantly, client's situations change. Keep in mind that the economy is cyclical and what seems appropriate today may be considered a major mistake years down the road. People tend to move around constantly and planning problems can be triggered by such mobility. Through periodic reviews such changes and their negative impact on estate plans can be minimized. Inflation and its impact on estate planning must be monitored. If a higher-thanactual average rate of inflation was assumed, this would obviously have a positive influence on expected financial needs, such as retirement income, survivor income and college educational needs. However, if the trend was reversed the client's needs could be woefully unfunded and additional funding needed. Tax law changes have always been an enormous hindrance to estate planning. The following twenty major federal tax Laws enacted since 1974 should give the planner some idea of this problem: 1974 Employee Retirement Income Security Act (better known as ERISA). 1975 Tax Reduction Act 1976 Tax Reform Act 1978 Revenue Act 1980 Crude Oil Windfall Profit Tax Act 1980 Installment Sales Revision Act 1981 Economic Recovery Tax Act (ERTA) 1982 Tax Equity and Fiscal Responsibility Act (TEFRA) 1982 Subchapter S Revision Act 1984 Deficit Reduction Act (DEFRA) 1984 Retirement Equity Act 1985 Imputed Interest Adjustment Act 1986 Tax Reform Act 1987 Omnibus Budget Reconciliation Act 1988 Technical And Miscellaneous Revenue Act (TAMRA) 1989 Omnibus Budget Reconciliation Act 1990 Revenue Reconciliation Act 1993 Revenue Reconciliation Act 1997 The Taxpayer Relief Act of 1997 2001 The Economic Growth and Tax Relief Reconciliation Act of 2001 2010 Federal Estate Tax 2010-2-11, Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 These are the major federal tax laws, and in addition, there are many minor tax laws and regulations It is apparent that the estate plan cannot remain a static plan as it will only solve yesterday's problems, not today's. The plan must be reviewed and kept up-to-date through periodic reviews specifically due to the constraints imposed by current tax laws. The client's personal, family and financial circumstances and priorities also change as time passes. Children may start out with financial assistance from parents, and eventually become financial independent. Client's parents might necessitate a helping hand from younger family members. People come into inheritances or windfalls and also experience sudden financial reverses. Domestic relations between client and family may change. Client objectives could change for no apparent reason other than the client themselves changed. The only thing that a planner can count on is that situations will change. 23 As previously mentioned, these six steps represent a "pure" estate plan. Two other steps must be recognized as part of the estate planning process - prospecting and the first interview. PROSPECTING The estate planning process must start with the identification of individuals who are most likely to understand the importance of estate planning. As stated in the beginning of this chapter just about anyone with property would be a likely candidate. There are five basic ways to find potential prospect for this much needed service. 1. EXISTING CLIENTS Depending on the type of product/service one might have offered in the past, the best methods to begin an Estate Planning Practice is to research existing files for clients who could be ideal clients for Estate Planning. It should be started with individuals whose careers have been successful or whose business has been profitable. Those who have many assets will probably deem estate planning much more valuable than those with few assets. A simple direct mail piece offering a way to prevent estate shrinkage could be mailed along with a follow up phone call. This method is an obvious one and should not be overlooked by the planner. 2. NATURAL MARKETS Everyone has a natural market which is defined as the social systems and subcultures one belongs to in a community. If one is a youth coach, for example, the natural market will be the coaches and youth coordinators who work in this field. If one plays golf, then the social contacts made at the club and on the golf course would be a natural market. If a spouse is a teacher at the local high school then a natural market exists among the educators that one will meet at the various social functions held through the year. It is important to realize that natural markets may provide the planner with numerous opportunities to introduce the need for estate planning services. 3. SEMINARS At times, existing clientele and natural markets are not large enough to sustain an estate planning practice, so one must find alternate ways to find new prospects. Many Estate Planners prospect by using the seminar system. They invite either a targeted group of people (business owners, executives, doctors) or the public at large to attend a seminar to discuss a particular financial or estate planning topic. Seminars will offer the planner flexibility. Some planners like to team up with a bank or other recognized institutions as cosponsor of the seminar. Some planners prefer to work through employers to set up seminars for their employees. One can see the multiple opportunities this particular seminar would offer the planner; not only the business owner and key executives become ideal prospects, but also the rank and file employees. Some planners conduct the seminar themselves while some others will hire attorneys, 24 CPAs, investment analysts, or some other expert to help them. The key in all cases is to use the seminar as a bridge to one-on-one follow-up sessions with the interested attendees. Often, the seminar will present specific estate planning problems in general, and attendees will be invited to seek individual counseling as to how it may apply to their particular situation. Attendees are asked to complete an evaluation form at the end of the seminar, which are often times used to separate the serious prospects from the others. Seminar presentations have become quite popular in the last ten years. There are numerous advantages as the planner becomes much more visible in the community. One major advantage of seminars is the credibility the planner receives when working and being associated with other experts in their chosen field of specialties. Some key points that make seminars successful: 1. 2. 3. 4. 5. Identify your target market. Create a successful direct mail programs with proper telephone contact follow-up. Be sure of the room set up before the day of seminar. Make sure the seminar starts on time and end at the appropriate time. Have the attendees fill out a personal information card and offer a complementary consultation. As the planner implements seminars as part of the prospective technique a system will develop which will afford the planner numerous prospecting opportunities, not only with attendees, but also with the panel of experts being used in the seminar. 4. REFERRALS The most cost efficient way to build an estate planning practice would be the total utilization of referrals. Referrals may come from two sources; (1) existing clients and (2) centers of influence. A satisfied client is the best sales tool for any estate planner, and when an Estate Plan of a business owner is updated, and the planner saves taxes through income taxes and retirement security is increased by modifying a retirement plan, it almost guaranteed that the planner’s name will be repeated in the business, locker rooms and golf courses where the business owner frequents. The planner must remember that every time a client is satisfied, a new "sales" member is added to the team. The most important marketing ever done in any practice is the quality work performed for existing clients. It is imperative that the planner focus foremost on this precept as it will become the foundation of the practice. The second referral source will be from centers of influence. A center of influence is considered any institution or professional who is in a position to refer estate planning prospects to a planner. Some examples of prime referral center of influence would be attorneys, accountants, and bankers. The planner must remember that by cultivating personal and professional relationships with these professionals a steady stream of referrals could develop. Also, a "reversal" flow of prospects could take place. The planner must understand that the attorney, accountant and banker are also searching for new prospects and by helping the planner they, in fact, could also help themselves. 25 5. ORPHAN POLICY HOLDERS With today's mobile society many opportunities exist to help new state residents update Wills, review new financial responsibilities or just to inspect insurance coverages. Laws for the validity of Wills vary from state to state. Even if the “orphan” had a Will that was valid in the old state, it may be invalid in the new state. By alerting them to this fact and helping them find an attorney to review their documents, it could be the first step in an estate planning review and possible sales and referrals for the planner. There are also many clients who no longer have active insurance representatives. With the attrition rate present in this industry many opportunities could exist in the planner’s general locality. By contacting a home office and offering to service such policyholders, often times insurance companies will compile such a list as it will remove servicing requests from their overworked staffs. QUALIFICATION Once the prospect has been identified as a possible estate planning prospect, the planner must qualify them for their services. Some generic questions would be: 1. Does the prospect have an insurable need? 2. Can the prospect pay premiums? 3. Is the prospect insurable? 4. Can the prospect be seen on a favorable basis? If all four questions can be answered "yes" then the planner has an ideal prospect for his/her services. When approaching the prospect for the first time, the planner should have three goals: 1. Establish personal rapport and a feeling of trust between both parties. There are cases that the planner will not like the individual and feel as if the person would be difficult to work with. One advantage in this type of business is that the planner does not need to work with everyone he/she comes in contact with, nor should they. If a planner and the client are not comfortable with each other, the relationship will probably not succeed. 2. Make the prospect aware of who you are and what you do. It should be noted that by clearly stating "what you do" could be an actual relief for the prospect. Just as garbage pick-up collectors refer to themselves as "Sanitary Engineers" the financial service industry is just as guilty by "blurring" the various duties that are performed. Prospects will understand and appreciate the fact the planner simply reiterates the services provided, clearly and concisely. 3. Give the prospect an idea on how estate planning can benefit him/her. By using the standard "shrinkage of estate" and heavy taxation explanations, most prospects will recognize the need to, at least, consider a review of their plans. Planners often use a pre-approach letter to make the initial contact with a prospect. This personalized letter may be accompanied by a booklet on Wills, trusts or estate liquidity. The letter and booklet are intended to be educational but also to entice the prospect into thinking that possibly their estate and financial affairs are not quite right. Sometimes the planner will catch a prospect at just the right time - someone who knows that something needs to be done. It is important for the planner to realize that this situation will not occur very often. Therefore, the planner, or a telemarketer should follow up the pre26 approach letter with a telephone call for an appointment. If the planner's target market is accurate and the pre-approach letter and booklet make the proper impression then a certain number of appointments should follow. THE FIRST INTERVIEW This first meeting is truly the most important. It is in this meeting that the planner begins the rapport building process. The client must feel comfortable with the planner and cannot do so if the planner does not allow the client to express him/herself. The planner must create a good first impression and establish trust at this initial meeting. These are necessary steps before the client will freely share confidential personal, family and financial information. During this first interview the planner should discuss the manner of compensation and the responsibilities of both client and planner. Some planners prefer to collect the facts personally at the end of the first interview while others give the client a “fact finder” to complete before the next interview. The first interview should conclude with the establishment of a follow up date in order to seriously begin the Estate Planning Process. ESTATE PLANNING SOFTWARE "Computers are to personal finance salesmen what gourds and thistles are to witch doctors: magical tools to compel belief. You answer a questionnaire on your income, assets, taxes, insurance and financial goals, this data goes into a computer, which ram's around among its preprogrammed paragraphs and regurgitates dozens of pages of standardized advice." -Jane Bryant Quinn Newsweek Magazine, 12-26-83 A planner must keep in mind that having a great piece of estate planning Software will help the practice tremendously but will not make one an estate planner. The software is a tool, like a hammer. The hammer can drive a nail but only the person holding the nail can be sure the nail is in the right place. Software is by no means a substitute for the art and science of estate planning. In fact, the more powerful and sophisticated the software, the more responsibility there is to use it wisely. One can only learn to use it wisely by acquiring the knowledge and developing the skills needed by an estate planner. The more sophisticated programs available provide texts as well as numbers. That is, there will be both word processing and spread sheet capabilities in the software and hopefully graphics as well. Narrative text to tell the story behind the numbers is good, so long as it is not just boilerplate as stated in the above quotation. The estate planner must make every effort to personalize the plan generated by the software, ideally in the text of the plan itself, but certainty in the verbal presentation of it to the client. The client must believe that the plan addresses his/her unique situation, and that it is not just restatement of the obvious. Used properly, estate planning software is an indispensable tool in case analysis, plan development and plan presentation. SUMMARY Estate planning is a much needed service. For a planner to be successful one must be honest, diligent, confidential, trustworthy, competent and professional. Nothing less will suffice. A planner must be what one would expect of those whom they will call upon for their own 27 needs. As the leader of the estate planning team, you are the most visible member. The Planner must remember to defer to those other experts when deference is needed. A planner cannot be all things to all people but by being the best in an area of specialty will be reward enough. Clients simply want to complete the estate planning process as best as possible. Helping them identifying and then, reaching their objectives is the pure essence of estate planning. CHAPTER 2 STUDY QUESTIONS 1. When the plan is completed the planner should A. present his/her bill and go home. B. require the client to accept it, in that it is based on information the client supplied. C. meet with the client and spouse and present the plan. 2. The last step in preparing a valid estate plan would be A. collecting data. B. make provisions for updating the plan. C. presenting the plan. 3. An Action Calendar A. reminds the planner when they last took action on a plan. B. is a formal document outlining the progress of the executor through the management of the descendant’s estate. C. identifies each action to be taken in Estate Planning, who is responsible for such action, and when the action is to be accomplished. Chapter 2 Study Question – Answers & Sections 1 C – page 20 – 4. Presenting the Plan 2 B – page 22 – 6. Reviewing and Updating the Plan 3 C – page 21 – 5. Implementing the Plan 28 CHAPTER THREE - PROPERTY OWNERSHIP “Something in human nature makes us resent the impact of new ideas” HOW DO YOU OWN IT? The arrangement of property is a key aspect of estate planning. As a planner, one should be familiar with the tax and non-tax advantages of titling property in various ways. Once a plan's instruments are drafted, appropriate transfers are made and gift or sales are implemented. Planning centers around property rights and the planner must be familiar with acquiring and transferring title to property and the rights and obligations that follow property. Before beginning the study of property one must keep in mind the definition of property. Property is anything capable of being owned. Property includes: A. Material objects held in outright ownership. B. Rights to possess, enjoy, use or transfer something. There are two classes of property: 1. Real property: Land and all that is permanently attached to the land (includes house, garage, trees, shrubs, and growing crop); it does not include mobile homes. 2. Personal property: All property that is not real property. There are two types of personal property: A. Tangible: Can be touched, felt, seen (e.g., cars, furniture, and cloths). Represents the property and has intrinsic value. B. Intangible: Has no intrinsic value but represents something of value (e.g., bonds, mortgages, and stock certificates.)—Includes everything that is not tangible. The planner must keep in mind that most individuals will not know how they own particular property. One of the major problems confronting estate planners is that people frequently buy and sell assets without the foggiest idea of how those assets should properly be held. Not understanding how property should be owned makes estate planning a frustrating and impossible exercise. One cannot plan for property that they do not own, and if for some reason, one does attempt to do some planning with what they do not own, the attempt will obviously be to no avail. PROPERTY OWNERSHIP There are two general methods of owning property with four types of joint ownership. OUTRIGHT OWNERSHIP The easiest type of ownership to understand is property that is owned in full and outright ownership by one person and is commonly known as fee simple ownership. 29 The fee simple owner is a sole and absolute owner. An outright owner may freely sell or exchange the property without the consent of any other person. He/she is also entitled to all income from the property, and all gain upon the disposition of the property. Interest in the property belongs to an individual and to that individual’s designated heirs forever. This includes most individually owned property. Eve is a Widow and is the sole owner of a large Colonial type house in Baltimore. Eve has a legal and witnessed Will, which in part states that her house should go to her oldest son, Edward. Upon Eve’s death, Ed inherits the house, which he allows a younger brother, Sam, to use as a residence as Ed has a large house of his own. Ed is killed in an auto accident, leaving a wife and daughter. According to Ed’s Will, his mother’s house is willed to his wife. Ed’s widow decides to sell the house but Sam insists that he should get the house. Ed’s widow would prevail and she can do whatever she wants with the house. There are four types of joint ownership: 1. Joint tenancy with right of survivorship 2. Tenancy by the entirety 3. Tenancy in common 4. Community property JOINT TENANCY WITH RIGHTS OF SURVIVORSHIP This is the most common form of co-ownership. Two or more people who are not necessarily related own property in common. The tenant's share cannot be transferred by Will. At a joint tenant's death, that tenant's share goes to the surviving tenants. There are four basic characteristics of joint tenancies: 1. When a joint tenancy is created, the tenant contributing more than the proportionate share of the personal funds to buy the property, has basically made a gift to the other joint tenants. 2. Each tenant may sell their interests in the property during their lifetime, without the consent of the other tenants. The new owner becomes a tenant-in-common with the other joint tenants. 3. If the property cannot be divided and a joint tenant wants to sell their interests, the property must be sold and the proceeds divided among the tenants. 4. At the death of all the other joint tenants, the last surviving tenant has all rights in the property and can dispose of the property as they wish. There is a Legal relationship between joint tenants pertaining to: Bank Accounts: Interests in bank accounts should be reported by each tenant proportionately to the amount the tenant put in the account. Also, if the account creates immediate vesting, each joint tenant is entitled to an equal share of the balance and is taxed on an equal share of the interest. A gift is made when the other joint tenant removes funds in excess of their own contribution. Saving Bonds: A gift is made when a joint tenant redeems the bond and keeps a bigger share of the proceeds than the tenant who put up money to buy the bond (gift is from the other 30 joint tenants). Safety Deposit Box: Contents remain the property of the depositing tenant. Securities. If securities are registered in the names of the co-owners as joint tenants a gift is made from the contributing joint tenants when securities are added to the account. If securities are registered in street names, a gift occurs only when one of the joint tenants withdraws more than their proportionate share of the account. A planner must remember that this method of taking title is greatly misunderstood by the public. In fact, it is a form of ownership that is extremely confusing. Seven Springs Real Estate Development is owned by Joe, Bill, Henry, Art and Frank, in Joint Tenancy. Each of the owners owns 20% of the firm, i.e., all of the owners collectively owns the entire firm. Joe dies and his Will leaves all of his assets to his son Phillip. Even though the Will is legal and witnessed, Joe’s ownership of Seven Springs company passed to the remaining four owners in equal shares. Therefore, the firm is now owned by the four surviving owners, and each survivor now has 25% of the firm. Joint ownership is a fictional form of ownership created by our English common-law heritage. Fictional in that, yes, two or more people can own the whole thing. What occurs to breathe realism into this fictional method of owning property is the added survivorship feature. This method of ownership is correctly called “Joint tenancy with right of survivorship.” The survivorship feature means that as each individual joint tenant dies, that person simply falls off the ownership charts. Upon death, title is in the hands of the surviving tenants. Each of the survivors now owns a much greater percentage of the property. Specifically, if there were three tenants and one died, the remaining two would own the asset. It is almost as if the deceased tenant never really owned it in the first place. Joint tenancy with right of survivorship is an automatic method of planning property because this method of taking title functions as a mini estate plan. It automatically passes ownership by law to the surviving tenants. Please realize that there is no reason for individuals to plan their jointly held interest in their Will or trust. As long as there is a joint tenant that survives, the passage of the asset is already planned. TENANCY BY THE ENTIRETY Similar to joint tenancy with right of survivorship, but limited to co-ownership of property by a husband and wife. Three basic characteristics are associated with this form of joint ownership: 1. Tenancy is automatically terminated by divorce. 2. Neither tenant can sell the interest without the consent of the other tenant. 3. Property automatically passes to the survivorship co-tenant when one of the tenants dies. Keep in mind that while both spouses are alive, each is a 50% owner. In a tenancy by the entirety, neither spouse can convey his/her interest in the property without the consent of the other spouse (with joint tenancy with right of survivorship, joint tenants do not require such consent.) 31 Advantages of joint tenancy with right of survivorship and tenancy by the entirety: 1. 2. 3. 4. 5. Property cannot be reached by one of the tenants creditors. Convenient (e.g., use of a joint checking account). No Probate delays at death. May be exempt from state death taxes (this will depend on State Law). Privacy: Passing of property at death is not subject to public scrutiny. Property passes to survivor by operation of law. 6. Security for tenants. There are five disadvantages of joint tenancy with right of survivorship and tenancy by the entirety: 1. Possible gift tax. 2. Possible double federal estate taxation. 3. Loss of control by a decedent tenant that is once property is titled jointly the decedent’s Will/trust cannot affect the title to the property. 4. Liquidity problem for decedent's estate. 5. Property owned as joint tenancy with right of survivorship can be reached by creditors of individual surviving tenant. TENANCY IN COMMON Tenancy in common is co-ownership in which two or more individuals who are not necessarily related own property in common. Each tenant's share is an undivided interest in the property but shares may be unequal. There are seven characteristics of this form of ownership: 1. Each tenant may dispose of his/her shares (through sale/gift/Will as the tenant wishes), without the knowledge or consent of the other tenants (no survivorship rights for other tenants. 2. Co-tenant is treated as a separate owner of co-tenant's share of the property for tax purposes. 3. Each tenant is entitled to tenant's proportionate share of income, and each tenant must pay proportionate share of maintenance/operation expense. 4. When a co-tenant sells or gives interest in a property to others, the gain or loss may be realized on the transaction. The new owner becomes a tenant-in-common with the other cotenants. 5. If the property cannot be divided and a tenant wants to sell his/her interest, the entire property can be sold and the sale proceeds distributed proportionally among the co-tenants. 6. When an interest in tenancy-in-common property is disposed of, new owner becomes “tenant-in-common.” 7. Tenant in common's interest is freely alienable, descendible and devisable. There is no limit to the number of tenants who can own something with others in tenancy in common. The only real problem occasioned by tenancy in common would be if one of the tenants wants to sell his/her interest. If the buyer wants to know what it is he/she is purchasing, the selling tenant in common would not know the precise share of what is being sold. All the seller would know is the percentage of what is being sold. All in all, tenancy in common is a frequently used method of owning property. The important thing to understand about this method of owning property is that if one is a tenant in common, he/she will absolutely own their percentage share in the property. The percentage 32 share can be sold or given away during lifetime and can be left to chosen beneficiaries at death. A potential drawback of this form of ownership is that if the other tenants do not particularly like the person to whom the deceased tenant has left the percentage share in the property; they can do nothing about it. This is commonly called "Breaks of the Game.” If an individual chooses this form of ownership, that person's co-owners and beneficiaries may face co-owners they do not like. COMMUNITY PROPERTY People who live in Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Puerto Rico, Texas, Washington or Wisconsin, must be aware of how community property is treated for estate planning purposes. Even if one lives elsewhere, you need to understand these laws. The reason is that property generally retains its original ownership identity throughout the life of the owner (regardless of whether the owner moves). In other words, community property will retain its character if the owner moves to a non-communal property state. One must keep in mind that separate property owned by either spouse prior to marriage; gifts; inheritances and property acquired with individual funds before marriage are considered non community property. However for any property acquired during marriage, both husband and wife each own a one-half interest. It is assumed that property acquired during marriage is the product of the effort and consideration of both spouses, regardless of the employment status or actual contribution of either at death. Neither spouse can pass on more than one half the community properties by Will. In community property states, the basis of the surviving spouse’s one-half share of community property assets will also receive a step-up in basis, normally to hits full market value, at the date of the decedent spouse’s death. Assets held jointly by spouses and not as community property will only receive a step up for the decedent spouse’s one half share of the asset. There are advantages and disadvantages for the various forms of holding title to assets. Information in respect to how to hold title to property in the state should be obtained from a tax advisor. If a couple moves from a community property state to a common-law state, the community property remains community property (unless the spouses mutually adjust rights). If on the other hand, a couple moves from a common-law state to a community property state, the property brought with the couple retains its original character. There are two important exceptions to the community property laws: 1. Property received by one spouse or the other after marriage as a gift or inheritance remains separate property. It does not become community property. 2. Property acquired prior to marriage by either party also remains separate property. ADVANTAGES Community property can have advantages for estate planning, such as when one spouse in a community property state dies, BOTH spouses’ shares of the property receive a step-up in cost basis. The cost basis if the original value of an asset by either the original purchase price or, if inherited, the value of the shares when the original owner dies (used to determine capital gains or losses for tax purposes when the asset is eventually sold. CONSUMER APPLICATION 33 Bill and Susie live in a Community Property state in a home that they bought for $100,000 and which is now $400,000—prior to the recent real estate market crash for example purposes) when Bill dies. Under Community Property rules, only half of the home is considered to be part of his estate. But the cost basis rises for the entire house, including Susie’s portion. If Susie sells the house, her cost basis is now $400,000 instead of the $100,000 – the original purchase price). Susie would not owe capital gains taxes when the house was sold. If Bill and Susie lived in a separate property state, only Bill’s half of the house would get the step-up in costs basis. Susie’s half would still have a cost basis of $100,000, if she sold the house when Bill died. SPOUSAL ELECTIVE SHARE If a couple lives in one of the states that do not have community property laws, the spouse is still entitled to some part of the estate under state law. It should be noted that this is not necessarily the one-half portion under community property states. This portion that the spouse is entitled to is called the Spousal Elective Share, and varies among states, often depending upon how long the couple has been married. If the spouses create a prenuptial or postnuptial contract, they may be able to waive the spousal elective share. There are two additional considerations to be made when discussing property rights: PRENUPTIAL (OR ANTENUPTIAL) AGREEMENTS: (Contracts between intended spouses governing property interests). The prospective groom may transfer property to the intended bride in exchange for promise to marry. A Prospective bride may give up certain rights the bride would have in her intended husband's estate in exchange for a specific property settlement. (These are legally enforceable contracts as the consideration is the promise of something of value in exchange for relinquishing some marital rights). 1. POSTNUPTIAL AGREEMENTS: Postnuptial (after marriage) is a property settlement between a divorcing husband and wife in which either release any interest held in the other's estate. At the completion of this section on property ownership, there are a number of factors and definitions affecting property ownership that the planner must keep in mind. 1. SITUS Refers to the place where property is located or kept. All real property and tangible personal property are subject to the tax laws of the jurisdiction in which property is located. 2. DOMICILE Permanent residence. When a person dies, the estate is Probated (distributed) and taxed under the laws of the state in which the person was domiciled. Property may be taxed by the state of domicile, the state of location or both. 34 3. ESTABLISHING DOMICILE A person may have several residences and only one domicile. Actions that establish domicile would be: A. Bank accounts/safe deposit boxes. B. Residing at present location for more than half of the year. C. Automobile registration. D. Voter registration. E. Establishing membership in social clubs/religious organizations. F. Situs of principal residence. 4. TAXATION OF PROPERTY BY SITUS/DOMICILE: Real Estate: Taxed by state where property is located, regardless of decedent's domicile. Tangible Personal Property: Taxed by state where property is kept, and may also be taxed by the state of domicile. Intangible Personal Property: Taxed by the state of domicile, regardless of where the property is located. Multiple Taxation: The Supreme Court has ruled that more than one state may have an interest in an individual's property. Fred Flintstone was domiciled in Florida. Fred also owned real property in North Carolina, tangible personal property in Vermont and intangible personal property located in Utah. At Fred's death, his state of domicile, Florida, would have a right to tax all of his property except the real property located in North Carolina. Since real estate is always taxed in the state in which the property is located, North Carolina has the right to tax real estate located there. Fred's tangible personal property may be taxed by the state where taxable Situs exists (Vermont). The intangible personal property is subject to tax by the state of domicile, Florida. Utah may also tax his intangible personal property as a nonresident form of taxation. SUMMARY OF OWNERSHIP The following is a short summary of ownership characteristics: FEE SIMPLE TENANCY IN COMMON You own all of it. You own part of it. You can: You can: Give it away. Give your part away. Sell it. Sell your part. Leave it on death. Leave your part on death. JOINT TENANCY You own an interest with someone else; But you can: Give your interest away. 35 Sell your interest. You cannot leave your interest on death. USING REAL ESTATE DEEDS IN ESTATE PLANNING One of the most serious estate planning decisions that a person makes, actually may be given little thought. As a new property owner takes ownership of Real Estate, seldom do they pay any attention as to the particular way that they take title to the Real Estate and many, if not most, people don’t even realize that they have a choice. This decision is often made in relationship to the most precious and personal piece of real estate – the family home. Therefore, even though it may be repetitious in some areas, it is of enough importance that Real Estate Deeds used in estate planning should be discussed as a separate section in this text. An individual has a choice of how to take title to property, and the form of ownership can be changed at any time (if all owners agree to the change). The use of the word “Tenant” normally refers to a renter of property, however in reference to a form of ownership, “Tenancy” should be considered as a form of ownership. SOLE OWNERSHIP – “OWNERSHIP IN SEVERALTY” The “ownership in severalty” is a common method of ownership in real estate for a single person, but married people can also own property in this fashion. However, a married person owning property in “Severalty” does not keep assets out of a divorce settlement. The laws as to divorce and death in sole ownership are different in common law states and community property states. Therefore, an attorney should be consulted if a married person is considering title in Severalty. JOINT TENANCY, “JOINT TENANTS WITH RIGHT OF SURVIVORSHIP” This form of property ownership is used when property is owned by two or more people who may, or may not, be related. This type of Deed merely means that the survivor owns the property. If four persons own property as Joint Tenants with Right of Survivorship, and one of them dies, the property is then held by the three owners still living. At the death of another owner, it is now owned by two persons. Property under such a deed does not pass by the Will of the decedent, but passes by the power of the deed. TENANTS BY THE ENTIRETY This is discussed elsewhere in this text. This type of deed is the same as with Joint Tenancy, except it can be held ONLY by husband and wife. TENANTS IN COMMON Two or more people own a particular piece of real estate by owning an undivided half of the property. As an example, if two people own a Section of land (640 acres), each of the owners owns an undivided half of the land, and not a particular 320 acres. The undivided half passes by each person’s Will and if there is no Will, that ownership interest passes by the state’s laws of intestacy. 36 Pearl and Etta are twin sisters. Their parents had left them with a sizeable piece of Real Estate. The property was left to them “together.” Technically, they owned the land as Tenants in Common, meaning that each owns an undivided half of the property without any stipulation as to anyone owning a specified half of the property. Their ownership is “undivided.” While the twins got along great, neither got along well with the other’s children. Presently, if one of the sisters died, the surviving sister would be partners with the other’s 3 children, and they simply do not want that to happen. The ownership of the property could be changed to “Joint, with Right of Survivorship” which would leave the survivor with 100% ownership of the property. They could give each other the “Right to Purchase” the deceased party’s interest and fund it with life insurance. In addition, there are several Trusts that could be used. (Trusts are discussed in detail later ) LIFE ESTATE A Life Estate means that a person owns his/her interest in the real estate only as long as he/she lives. For instance, the title to a house could read: “The property at 123 Main Street is being held as a Life Estate by me. At my death my daughter, Hanna, will hold this property as a Life Estate. At her death, her daughter, Anna, will receive this property outright.” PARTNERSHIP OWNERSHIP A partnership can own real estate and each partner would enjoy some benefit of ownership. This is an excellent means of ownership for a family that wants to progressively, give the younger generations more ownership. Note: To leave the property to a Charity, the deed could state “I have a life estate in the property at 23 Main Street and at my death, ownership will pass to St. James Methodist Church outright.” SPECIFIC USES OF THE LIFE-ESTATE DEED A life estate deed can be used to pass property specifically without using a Will. (A Will can be used if you want a trust to be the Remainder man). A Life Estate deed can be used to fulfill the wishes of the property owners to have real estate go to a daughter and to her son, but not to the owner’s son-in-law. This could be accomplished by (1) the owner retaining a life estate, (2) give the daughter a consecutive life estate, and (3) make the grandson a remainder man. This way the owner would own it as long as he/she lived, then the daughter would own it as long as she lives, and then the grandson would own the property outright. Another common situation is for a couple who have been married previously, each having children by previous marriage. If a substantial part of the estate was put into a house, the residence, the couple may choose to take title in a “Joint and Concurrent Life Estate” and name several children as remainder men. With the Joint and Concurrent Life Estate, the husband and wife are both owners at this time, with whichever spouses survives the other is the owner of the house for life. Upon the death of the survivor, the property will be left to the designated children. 37 THE CHARITABLE LIFE-ESTATE DEED In order to encourage charitable gifts, the tax law is very generous to a person who wishes to leave his/her home (or farm) to charity at his/her death. If the owner makes an irrevocable transfer of his home or farm to charity at his/her death by means of a life estate deed, he/she receives an income tax deduction in the year that they make the irrevocable decision. Donald is a widower and has no children. He has an estate worth about $2 million, and the only living relative is a niece. He would like to leave something for his Church at his death. Donald has a home worth about $500,000, with no mortgage. Donald could deed his home to the Church so that it would pass to the Church at his death. By doing so, Donald can live in the home for the rest of his life. But when Donald dies, it will belong to the Church with no probate, no estate tax, and no complications. In addition, Donald will get an income tax deduction of nearly $250,000 and although he cannot get it in one year, he can take it over the following five years. ESTATE PROPERTY OWNERSHIP INTERESTS When dealing with forms of property and ownership rights one should keep in mind there are three basic forms of estate ownership with four other property interests. It is important for the planner to understand the various interests in property and the manner in which they may be used in the planning process: ESTATES This section refers to ownership interests in real property. The three main types of estates are: 1. FEE SIMPLE ESTATE: Interest in the property belongs to an individual, then to the designated heir forever. This estate includes most individually owned property. 2. LIFE ESTATE: Refers to an individual who has an absolute right-to-possession (enjoyment) and profit from the property for the duration of life; the individual's interest in the property ends at death. If Eve’s Will gave her son Ed, the possession of her house at the time of her death, upon Eve’s death, Ed would own the house. In addition, if Eve’s Will listed her son Sam as Beneficiary in case of Ed’s demise, then the house would pass to Sam upon Ed’s death, and not to Ed’s heirs. Two components of this type of estate are: (A) Can be measured by life tenant's life or someone else's life if another person's life has been designated as the measuring life; (B) Owner of a life estate for his/her life has no interest in the property to transfer at death. 3. ESTATE FOR A TERM OF YEARS Interest in the property is for a set period of time only. 38 A. B. C. If tenant dies before the end of the term of years the right to possess the property for the rest of the term will be determined by Will or intestacy statutes. Tenant does not have the right to transfer the property at the end of the term of property interest. Leasehold is the most common example of an estate for a term of years. OTHER PROPERTY RIGHTS 1. REMAINDER INTEREST Interest in the property takes effect at a specified future time; before that time, the remainder man has no interest in the property. It must take effect immediately upon expiration of another interest. In the above Consumer Application, the person designated by Eve (Elvira) to take over the property after the 5 years, is the “remainder man” (even if the person is female). They may have either Vested or Contingent interest in the property. Vested interest: The right to receive the property at a future time is fixed and absolute. Contingent interest: The right to receive the property may or may not come to effect at a future date, depending on the occurrence/nonoccurrence of a specific condition. If Elvira's remainder interest in her mother's house was vested she would have absolute ownership of the house when Ed moved out after five years. But suppose the Will had stipulated that Elvira was-to-get possession of the house only if she were married by the time Ed’s five years in the house were up? This would be a contingent remainder interest for Elvira. (Remember that a contingent property right may never come into existence; if Elvira was still single when Sam's five year interest expired, Elvira would lose her right to the house). 2. REVERSIONARY INTEREST Property owner transfers property but reserves the right to have all or part of the property returned (like remainder interests, reversionary interests may be vested or contingent). Eve decides to move into an apartment and rent her house. She gives her son Ed, the right to collect and keep the rents for the next 20 years. When the 20 years are up, the rents will belong to Eve again. Note: Remainder and reversionary interests must be carefully structured to avoid the tax liability of incomplete transfers (i.e., the property transferred is taxed to the original grantor as if grantor were still in possession of the property). 39 3. EXECUTORY INTEREST Future interest always held by someone other than the original owner of the property (i.e., conferred rather than retained rights). This was created to solve problems of old English Common Law, which stated that no gaps in property ownership could exist. LEGAL/EQUITABLE OWNERSHIP LEGAL OWNER -Has legal title to the property; the title is absolute with all related rights and duties. EQUITABLE OWNER -Entitled to all the benefits of the property (e.g., in a trust, the trustee is vested with legal title, but the income generated by the trust goes to others who have equitable title). ADVANTAGES AND DISADVANTAGES OF JOINTLY HELD PROPERTY Historically, joint ownership has had some good attributes but basically, it is common but it can be quite complicated. Joint tenancy is a convenient form of ownership. It is a form of ownership that has been encouraged in the marketplace by financial institutions, by some merchants and by numerous professional advisors. Joint ownership appears to be psychologically pleasing to people, particularly to married couples. The name itself implies "the two of us," a partnership, a marriage of title as well as of love. Joint ownership creates, because of its survivorship feature, an instant mini-estate plan for joint owners. Jointly held property requires no Will, trust, or other estate-planning device. It does not go through Probate court on the death of the first joint tenant. In fact, this has been one of the main selling points. "If there is no Probate, owning property jointly has got to be good". Jointly held property has been most attractive among close family members. Unfortunately, perception is not reality! Traditionally, however, there have been significant problems with this form of property ownership. Jointly held property can pass property to the wrong folks, to the other joint tenant rather than chosen beneficiaries. On the death of a joint tenant there is absolutely no question as to where that property interest is going. It is going to the surviving owner by operation of law. On death, a joint owner cannot control the way the property passes nor the time of its passage. Death has its own timing. Who outlives whom is an unknown, so are the results of owning property jointly. Marie, a widow with two adult children meets and marries a lonely widower Henry, with one adult child. They combine their assets and title them jointly. Two days later Marie dies. Since this estate is now in joint ownership, the widower receives everything, the widow's children nothing. Joint ownership only works if there is a surviving joint tenant. If both property owners die at the same time most states have adopted the Uniform Simultaneous Death Act. Under this law, joint property is distributed in proportion to the number of joint tenants. 40 Simultaneous Death and Joint Ownership just do not mix well. Remember the survivorship feature. If one owner outlives the other by one second, it all goes to the heirs of the one who survived by one second. It is because of the survivorship problem that many critics allege that jointly owned property may go to unintended heirs. Jointly owned property is generally beneficial to creditors of the owners. Property taken in both names is generally sizable on the default or misdeed of either owner. Either or each joint owner could lose ownership in the property, which is not good estate-creditor planning. Joint ownership, as one might have concluded by now, is complicated; and Congress's ignorance in this area was not unique. Another hurdle to clear with jointly held property is the federal estate tax. Federal estate laws attempted to tax all the jointly held property in the estate of the first owner to die. When the remaining tenant died, it was taxed all over again! Joint property was generally taxed twice, In other words, 200 per cent taxable. Fortunately Congress came to its senses and enacted the Economic Recovery Act of 1981 (ERTA). (NOTE: Not to be confused with Economic Recovery Act and Investment Act of 2009 which is an attempt by the President to help the country recover from its economic problems.) Today, spouses who are citizens of the U.S. can acquire property jointly without incurring a federal gift tax. The law is absolutely clear on this point, and there are no limits to the amounts involved. Regardless of which spouse's funds are used, no federal gift tax will result from U.S. citizen spouses taking property jointly. The law states that unlimited tax free gifts are allowed between U.S. citizen spouses. This unlimited gift rule between U.S. citizen spouses is referred to as an unlimited lifetime "Martial Deduction". If the spouse receiving the gift is not a U.S. citizen, there is no unlimited lifetime marital deduction. There is instead an exclusion from the gift tax of the first $100,000 in value of gifts to the non- U.S. citizen spouse. With passage of ERTA, the Federal Government finally recognized husband and wife as one family unit. For purposes of federal gift taxation, inter-spousal property transfers, when made to a U.S. citizen spouse, have no federal gift tax consequence. The law has not materially changed with respect to owning property jointly with people other than with spouses. The aware individual will continue to be wary and sensitive to potential federal and state gift-taxtraps when putting property in joint names. ERTA also dramatically changed the federal estate tax rules with regard to jointly held property. Under the law prior to ERTA, all joint property was taxed in the estate of the first joint owner to die. This was always so unless it could be proven that the other owner contributed funds toward the property's acquisition. As to spouses, ERTA drastically changed the law. The estate of the first spouse to die will include only half the value of the jointly held property, rather than potentially all of it under the old law. When the second spouse dies, the estate will be taxed on the value of the entire asset. Jointly held property automatically belongs to the survivor tenant. If it all belongs to the survivor, it will all be taxed in the survivor’ estate. Spouses can leave everything they own, including property held jointly with spouses, to their spouses free of Federal Estate Tax. Just remember: There is no federal estate tax on property held jointly with a spouse when the first spouse dies. Great care and caution must be used in creating joint ownership with non-spouses. Do not forget that the jointly owned property will always belong to the surviving owners. Here your estate might have to pay tax on the value of your interest in the property even though the prop41 erty is going to a non-family member on your death. Remember that cabin owned jointly with your brother? He will get the cabin if you die first, and your estate may pay the federal estate tax on half its value. The law created another problem with property held jointly between spouses. It has to do with after-death income tax planning and a concept called "Stepped-up Basis" Rules. These rules state that upon the death of a taxpayer, property in the estate gets a new cost basis for income tax purposes. Ellen dies with a small portfolio of stock. She paid $1,000 for it several years ago. Prior to her death, she could have sold the stock for $9,000. At her death, the portfolio was valued at $10,000 for Federal Estate Tax purposes. If her heirs sold it after her death for $10,000, there would be no income tax. However, if Ellen had sold the stock just prior to her death, it would be subject to income tax. Her cost basis in the stock would be increased (stepped-up) by operation of the law, from $1,000 to $10,000 – its date-of-death value. In the above Application, if Ellen owned the stock jointly with her husband, when she died only half of the stock would be valued on a stepped-up basis. If her husband sold the stock after her death for $10,000, he would have a $4,500 taxable gain. His starting cost was $500 (half the $1,000 paid), so his half of the gain would be $5,000 (half of $10,000). By subtracting the cost of $500 from the $5,000, he has a $4,500 gain. He does not report any gain on Ellen’s behalf because her half of the portfolio received a stepped up basis of $5,000. For illustrative purposes, contrast the tax problem of Ellen's spouse with this situation: Ellen owns the stock in her name (not in joint names). Ellen dies and leaves it to her spouse. There would be no federal estate tax (spouses can leave everything tax-free to surviving spouses). The entire value of the stock sets up a step-up basis to $10,000. Ellen's spouse sells the stock the day after her death for $10,000. There is no income taxable gain to Ellen's spouse. Joint property does not get a 100% step-up basis for income tax purposes but rather only a 50% step-up because only 50% is included in the estate of the first spouse to die. When the planning is for spouses, jointly owned property becomes unattractive in many cases. For example, if the surviving spouse is not a U.S. citizen or if the property is not held between spouses, the step-up in basis generally will depend upon the amount each joint tenant contributed to obtain the property. The planner must think "hard and long" before recommending the use of joint ownership to clients. In spite of the many changes in our federal estate, gift and income tax laws, it would probably be advisable to emphasize that joint ownership is a potential planning pitfall that should be avoided in most instances. 42 ADVANTAGES OF JOINT OWNERSHIP 1. 2. 3. 4. 5. 6. 7. Easy and convenient. Psychologically pleasing. Mini-estate plan. Not complicated on surface. No gift tax to U.S. citizen spouse. No death tax on the death of the first spouse, if the surviving spouse is a U.S. citizen. Avoids Probate as title to assets held in joint tenancy pass automatically at the death of one joint tenant to the others. There is no need for a formal Probate unless all the joint tenants die. 8. Convenience. Bank accounts in joint tenancy can be withdrawn by any joint tenant. This could be an advantage if one party becomes incompetent due to an accident, a stroke, or advanced age. DISADVANTAGES OF JOINT OWNERSHIP 1. May pass property to unintended heirs. 2. Affords no planning opportunities. 3. No control. A Will or trust will have no effect on joint tenancy assets, even if the individuals change their mind as to the persons they would like to receive their share when they die. Also, the entire asset may be available to the creditors of either joint tenant. 4. Gift taxes to non-espousal owners or non-U.S. citizen spouses. 5. Loss of complete step-up basis. 6. Potential gift tax penalties. HOLDING TITLE Holding Title refers to property owned by a husband or wife which is not community property. Generally it is property acquired by either, prior to marriage or by gift, Will, inheritance or money damages for personal injury, and all of the rents, issues and profits thereof. COMMUNITY PROPERTY: Community Property is both real and personal property earned or accumulated after marriage through the efforts of either husband or wife living together in a community property state. Deceased spouse's Will has control over one-half of community property. JOINT TENANCY: Joint Tenancy is joint ownership of equal shares by two or more persons who hold undivided interests without right of survivorship. Interests need not be equal and will pass under the terms of the owner's Will. SEVERALTY: Severalty refers to ownership held by one person only. Person can be a natural person or a "legal" person, such as a corporation. TENANCY-IN-PARTNERSHIP: Tenancy in Partnership is the method by which property is owned by a partnership. Specific interest in the property cannot be conveyed by one partner alone. CUSTODIAN FOR A MINOR: Under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act an adult person can hold title to property for the benefit of a minor. 43 TRUSTEE: The trustee of a Living or Testamentary Trust holds legal title to property for beneficiaries, who have equitable title. LIFE ESTATE: A Life Estate is the use of ownership in real property which terminates upon death of the life tenant. Note: Advice as to how to hold title to specific assets is within the exclusive realm of the practice of law. These laws may vary from state to state. CHAPTER 3 STUDY QUESTIONS 1. Property A. is anything capable of being owned. B. is not considered part of the estate planning. C. refers to real estate only. 2. An agreement between divorcing husband and wife in which either releases any interest held is the other’s estate is called a A. prenuptial agreement. B. postnuptial agreements. C. tenancy is common agreement. 3. What type of estate refers to an individual who has an absolute right-to-possession, as long as he/she lives? A. Life Estate. B. Term Life. C. Tenant estate. Chapter 2 Study Question – Answers & Sections 1 A – page 29 – Outright Ownership 2 B – page 34 – 1. Postnuptial Agreements 3 A – page 37 – Life Estate 44 CHAPTER FOUR – GIFT, TAX & LIFETIME TRANSFERS "There are those who give little of the much which they have, and they give it for recognition and their hidden desire makes their gifts unwholesome. And there are those who have little and give it all. These are the believers in life and the bounty of life and their coffer is never empty." Kahlil Gibran NEW (2011-2012) ESTATE TAX LAWS Starting in 2011, each U.S. citizen and permanent resident alien will be entitled to a $5 million lifetime gift and estate tax exclusion amount. Anything over the $5 million will be taxed at 35%. Starting January 1, 2011, a person will be allowed to give away (gift) during the person’s lifetime or at the person’s death BUT FOR ONLY TWO YEARS. This new law ends (sunsets) on Dec. 31, 2012. Further, the new “Portability Provision” law now allows for the transfer of a decedent’s estate tax exclusion amount to his/her surviving spouse. As an example, the husband dies in 2011, leaving $3 million to his children and the surviving spouse may receive $2 million as an unused exclusion amount. Therefore, she can pass on $7 million to her children free of federal estate tax. For those who have not prepared a Will (probably too busy making money…) this is great for those couples, and also it is good news for those who have not equalized their estates. This is also an advantage inasmuch as the vast majority of decedents passing away in 2011 or 2012 will not have to pay federal estate tax. Whether this will continue will probably hinge on the November 2012 elections. State laws may apply, particularly in Florida, New Jersey, New York or Pennsylvania. In Florida, the advantages of entering a revocable living trust and avoiding probate have not changed. Also, if real property is owned in another state, the individual may have to pay an inheritance or estate tax in that jurisdiction. [NOTE: See STATE INCOME TAX table in Chapter Seven.] For instance, New Jersey, if an estate is larger than $675,000 there is still an estate tax and there is no portability provision. New Jersey also has an inheritance tax which is up to 16% on transfers to specified individuals, such as siblings, nieces, nephews and friends. New York has an estate tax that applies to estates of $1 million or higher in assets. New York does not have a portability provision. Estate planners would be wise to title assets in a manner that will avoid probate. Pennsylvania has an inheritance tax of up to 15% which is applicable to all parties who plan on leaving assets to anyone other than a spouse or charity. 45 LIFETIME GIFTS Lifetime gifts can be effective estate planning tools as they can result in substantial tax savings and provide a source of personal satisfaction to the donor. Tax considerations are but one factor to consider in estate planning. No one should ever give away property that may be needed some day for support and maintenance. As an estate planner one must be familiar with the gift tax laws because gifts over a certain amount are taxable. Gifts are a tool by which a property owner may direct the disposition of property during lifetime. Also the property owner would have the immediate satisfaction of seeing the recipient enjoy the property, and also realizing that the given property will be avoiding Probate and its related high fees. Another advantage would be that the transfer would avoid long delays or would not be subject to attack by estate creditors or disgruntled heirs. Also, the original owner is relieved of any property management by transferring the property during life. This can be very important to elderly clients. Since Wills become a matter of public record after death, lifetime gifts provide an alternative means of property disposition in which privacy is important to the individual. There are many advantages of gifting in an Estate Plan. The gift tax works like a stopgap to the estate tax as it prevents very wealthy people from giving all their money to their children before they die in order to avoid estate taxes. There are two other major considerations that should be examined when making gifts. For instance, one major consideration involves the removal of highly appreciating assets from estates. The key is picking assets which will actually appreciate in value. However, if a highly appreciative asset is given to your spouse, and you die first, the asset with all its appreciation will not be subject to estate tax on your death; the asset and its appreciated value will be subject to estate tax on your spouse’s death. If you give highly appreciating property to someone other than your spouse, you will remove both the assets and all its future appreciation from your estate, and your spouse's estate. If one gives highly appreciating property to someone other than the spouse, they may pay federal gift tax on its value, as of the date of the gift, but neither husband or wife nor their respective estates will ever pay federal estate tax on the appreciation of the property. Another consideration in making lifetime gifts involves reducing federal income tax. If one owns property, which generates taxable income, they may wish to give the property to one or more family members who are, or will be, in lower federal income tax brackets. GIFT GIVING BASICS RULE NUMBER ONE: For a gift to be considered as a gift for tax purposes, the gifts must be irrevocable, i.e. the donor cannot take it back. Further, gifts to adults must be a gift of present interest, meaning that the recipient has unrestricted and autonomous access to the gift. If the Donor dies within three years of making a taxable gift, the money is considered as part of the estate. A gift is defined as any transfer of property for which the giver receives less than the full value in return. To the extent the transfer is for less than full value, a gift has been made. Intent or desire to make a gift is generally irrelevant for federal gift tax purposes. The mere act of delivering the property to its recipient is enough to create a gift subject to federal gift tax 46 laws. A person who makes a gift is called a "Donor,” and the person who receives the gift is "Donee.” Three criteria must be met for a transfer to qualify as a gift. 1. There must be a transfer for less-than-adequate consideration. 2. Donor must deliver the subject matter of the gift. 3. Donee must accept the gift. Further, the federal gift tax only applies when the gifts during a lifetime total more than $5 million (exception amount in 2012, indexed for inflation) to any one person. This is a substantial increase from the $1 million previous exemption. Under the new tax law, the federal gift tax rate is 35%. (Presently this would apply in all states except Connecticut and Tennessee so it is wise to keep abreast of the rule in other states. States, also, are particularly hungry for added income at this time.) Spouses can give unlimited amounts to each other with no taxes. This rule excepts if one spouse is not a U.S. citizen, or in case of same-sex marriage. The annual gift tax exclusion which determines how much can be given in (2011) $13,000 to any one person, and to as many people, as wanted without any gift tax considerations, or even reporting such amount to the IRS. In effect, a person can give up to $13,000 to any number of people or to a trust, such as children, any relatives (that are US citizens or same-sex situations) as long as each gift is to a different individual or trust. The gift tax exclusion is indexed for inflation and the gift can be money or a non-cash item, such as stocks, bonds, or jewelry—or even in gold bullion. Married couples can give up to twice the exclusion ($26,000 this year) and through the procedure of making a special election, the entire $26,000 may come from one partner’s assets or from a joint account. Applying some figures to this—you and your spouse, together, can give your three (as example) children a total of $78,000 a year without having to account for the taxable gift. What you would be doing is giving each of your three children $13,000, for a total of $87,000. In this situation, if you were to give each child $14,000 in 2012, the extra amount is subtracted from your lifetime exemption of $5 million. If my daughter is getting married this year and you want to help by making her a gift of $50,000, then $13,000 would be counted against your lifetime exemption ($50,000 less $13,000). Needless to say, the government tracks such gifts and if one gives money away in excess of the gift tax exclusion, IRS Form 709 must be filed with the annual tax returns. However, gift tax is not due until one has given away in excess of $5 million – the present lifetime exemption. Any taxable gifts made during lifetime reduce the amount that can be sheltered during your lifetime—dollar for dollar. For instance, if $2 million is given away during your lifetime, your estate could leave $3 million to heirs estate-tax free. Except for charitable gifts, gifts to another person cannot be deducted on your income tax forms. The beauty of this transaction is that those to whom gifts have been given, pay no income taxes on the gift received. There are, of course, certain stipulations provided under a gifting transaction. 47 MEDICAL OR EDUCATIONAL EXPENSES GIFTS TO PAY MEDICAL OR EDUCATIONAL EXPENSES. In addition to the annual exclusion, an unlimited gift tax exclusion is available to pay someone's medical or educational expenses. The beneficiary does not have to be the donor’s dependent or even related to the donor, although payment of a grandchild's education expenses is perhaps the most common use of the exclusion. Also, contributions to a qualified tuition program (QTP) or a Section 529 plan will be eligible for the regular $13,000 exclusion. (See later discussion re: Qualified Tuition Programs under Giving Gifts to Minors.) In order for a gift to be exempt from taxes, the payment must make the payment directly to the medical or educational institution providing the service. The beneficiary of the gift should not actually receive the payment, even incidentally. In addition, educational expenses include only tuition— room and board, books, and other fees will not qualify for the unlimited exclusion, although they can, of course, qualify for the annual gift tax exclusion. A donor who makes contributions to a qualified tuition program (commonly known as a "Section 529 plan") in excess of the $13,000 annual exclusion amount may elect to recognize the contributions for gift tax purposes ratably over the five-year period starting with the year of the contributions. This means a donor can make a $65,000 tax-free contribution in one year-or $130,000 if the donor is married and the donor's spouse consents to gift-splitting. If the donor dies before the end of the five-year period, the portion of the contribution allocable to the period after the donor's date of death is included in the donor's gross estate. QUALIFIED TUITION PROGRAMS – SECTION 529 PLANS Section 529 plans allow a donor to either buy tuition credits or contribute to a special higher-education savings account for a designated beneficiary. A donor can leverage the 2011 gift tax exclusion of $13,000 under a special gift tax rule that allows the donor to recognize any contribution to a qualified tuition program in excess of the annual exclusion amount as if it were made ratably over five years. This permits a donor to contribute up to $65,000 in one year-or $130,000 if gift-splitting with spouse-per beneficiary, free of gift tax. Although the funds in a Section 529 account are treated as a completed gift, one still retains ownership and control over them which allows a donor to decide when to distribute funds to the beneficiary. A donor can even substitute a different beneficiary or revoke the account and take back the funds under specified guidelines. Earnings in the account are allowed to grow on a tax-deferred basis. In addition, under current law, no federal income tax is imposed on the earnings IF the funds are used to pay for qualifying higher education expenditures. Although contributions to Section 529 plans are not deductible for federal income tax purposes, several states offer a deduction against state income tax for contributions made to their programs. GIFT APPRECIATION IN VALUE Another major tax advantage of making a gift is that future appreciation in the value of the gift and after-tax income earned on the property are not included in the estate. For instance, a donor gives stock worth $50,000 to his children now. If the donor dies in ten years and the 48 stock is then worth $130,000, the $80,000 appreciation will not be included in his estate and the donor or estate will not include dividends paid on the stock after the gift. The valuation of a gift is the equal value of property transferred minus consideration received when property is transferred for less than “adequate and full consideration in money and money's worth.” The definition of “adequate and full consideration" in money or money's worth is that the consideration given must equal the value of the property transferred. Debbie transferred her $ 100,000 house to her son, who pays her $ 100,000 in cash. The cash equals the value of the house and there is no gift. If Debbie transfers the house to the son, and the son merely gives her a big hug, then there has been no adequate consideration; and the transfer is a gift, subject to the gift tax. Consideration must also be evaluated. If consideration is not "in money or money's worth" or if the consideration is a moral consideration; a past consideration or a consideration that does not benefit the transferor, we have a gift. Debbie transfers her house to her son in exchange for his promise to give up smoking. The promise is not consideration in money/money's worth - that is - the promise has no real monetary value so the transfer is a gift. CONSIDERATION IN MARITAL/SUPPORT RIGHTS 1. If in a written agreement, one spouse relinquishes certain marital rights to the other spouse in exchange for a property settlement, the transfer is not a gift. 2. If one spouse gives up the right to support by the other spouse in exchange for a property settlement, full and adequate consideration has been received and there is no gift. These transfers are exempt from the gift tax if the divorce occurs within a three-year period beginning one year before entering into the agreement. Martha agrees to give her husband Bob, $ 150,000 as a lump-sum settlement upon a divorce. In turn, Bob agrees to give up all marital rights he may have had in her estate. The $ 150,000 transfer is not subject to the gift tax. POTENTIAL PROBLEMS WITH COMPLETED TRANSFERS Incomplete delivery occurs when technical details are left out or when a stage in the transfer process is not completed. With incomplete delivery requirements there are usually four situations that may occur to create an incomplete delivery: 1. A gift made by a dying person who later recovers is an incomplete transfer; the gift is not complete until the donor's death. 2. A Gift of money made by check is not complete until the check is cashed. 3. When one party transfers money to a joint bank account with another individual, the gift is not complete until the other joint tenant withdraws the funds. 4. Transfer of U.S. Government Bonds is governed by Federal rather than State Law. 49 Therefore no completed gift has been made until the registration is changed in accordance with Federal Regulations. Robert purchased a U.S. Savings Bond that is registered as payable to Robert and Bob and Rob, his two grandsons. There is no gift under gift-tax laws, until one of the grandsons surrenders the bond and claims the cash. Another potential problem with a completed transfer would be the cancellation of notes. A donor transfers property, and later takes back notes from the donee. If the donee pays off the notes, the transaction is a sale. However, if the donor forgives (cancels) the notes—the transaction is a gift. Special note: If debtor/creditor is unrelated and the debtor performs a service for the creditor as a repayment for the note, a gift has not been made when the creditor cancels the note. The cancellation is a form of income to the debtor for services rendered. The third problem area for completed transfer would be incomplete gifts in trust. Property transferred to a revocable trust (that is -the donor retains the right to revoke the transfer) is not a completed gift. Only when the trust becomes an irrevocable (donor gives up all retained control) is the gift completed. For example, a Totten Trust (Bank savings account where donor makes deposit for donee and keeps the savings book) is revocable. Two examples can best illustrate this point: Bertha establishes an irrevocable trust for her son, Ernie, and her daughter Erin. Bertha placed $50,000 of common stock into the trust. 1. If Bertha retains the federal gift taxes to alter the amount of income and principal for each of her children, the gift is incomplete. 2. If Bertha relinquishes the right to allocate income to her beneficiaries at some future time, the stock may substantially increase in value, which would increase the gift tax Bunny must pay. USING TRUSTS A trust is arguably one of the most useful personal financial planning tools available. Technically, a trust involves three elements, namely, (1) a trustee who holds the trust property and is subject to equitable duties to deal with it for the benefit of another; (2) a beneficiary, to whom the trustee owes equitable duties to deal with the trust property for benefit; (3) trust property which is held by the trustee for the beneficiary. The right, enforceable solely in equity to the beneficial enjoyment of property to which another holds legal title; a property interest held by one party (the trustee) at the request of another (the settlor—used interchangeably in this text with “owner” when the “settlor owns the trust) for the benefit of a third party; (the beneficiary). Simply put, a trust is an arrangement under which one person or institution holds legal title to real or personal property for the benefit of another person or persons, usually under the terms of a written document setting forth the rights and responsibilities of all parties. The value of a trust is basically that it can hold property for the benefit of other persons, now or in the future, and often avoid some taxes that otherwise would have to be paid. 50 AVOIDING PROBATE Revocable trusts assets pass to the beneficiaries named in the trust document and are not controlled by the Will of the settlor, thereby eliminating costs and delays arising from the probate process (some states may differ on this – check the laws). Many states have shortened the probate process and reduced the associated costs. It should be noted that unlike probate, with a revocable trust the identity and instructions for distributing estate property are not part of the public record. If real property is owned in another state outside state of domicile, a revocable trust will avoid the ancillary probate administration in that state that would otherwise be required. LEGAL GUARDIANSHIP If the trust owner becomes incapacitated, any assets kept in their living trust would be managed by a trustee named in the trust document, thereby eliminating public, and potentially costly, guardianship proceedings. (Note: A durable power of attorney can also be an effective tool for prearranging the management of their affairs in case they become incapacitated.) IRREVOCABLE TRUSTS As the name implies, an irrevocable trust may not be changed or revoked after its creation. The purpose of such a trust is generally for the purpose of removing property and its future income and appreciation from the estate of the creator of the trust. A present interest trust and a Crummey trust, both of which are discussed herein, are irrevocable trusts. In irrevocable trust may be used if the settlor wants to keep the assets from being spent too quickly. Another major use is to protect assets from the beneficiary's creditors. This can be a little tricky because property placed in an irrevocable trust will not be removed from the estate if the settlor retains certain interests or powers in the trust—such as an interest that entitles the settlor to receive the income from the trust for the rest of their life or the power to determine which beneficiaries will receive distributions. Also, any transfer to an irrevocable trust will be subject to gift tax to the extent that the settlor relinquishes control over the property. If another person will receive the current income from the trust, or if it is a present income trust, the $13,000 annual gift tax exclusion in 2011 can shield at least part of the property transferred to the trust from gift tax. In addition to saving estate taxes, irrevocable trusts created for children can cut settlor’s income taxes, with amount depending upon much other income the children already receive and whether the "kiddie tax" applies to them. There are strict rules limiting the amount of control the settlor or spouse may keep over the trust in order not to include the trust's income on their tax return. ` USING AN INDEPENDENT TRUSTEE Often the trust owner does not want to manage the details of property and/or investment management so an independent trustee can be used immediately to assume these duties and maintain the trust, and usually even prepare and file income tax returns. Living trusts are not suited for everyone as the owner must pay legal fees and other ex51 penses, such as recording fees, to set up the trust and transfer property to it. Further, one will also owe recurring trustee and administrative charges if they use a corporate trustee rather than personally managing the trust. It should be mentioned that they may not save on other legal, accounting, and executor's fees paid to handle the estate. Regardless whether assets are held in a living trust or pass through probate, the same kind of work will generally be needed to value the assets, prepare federal and state tax returns, settle creditors' claims, and resolve disputes among beneficiaries. It is important to know that if a living trust is established, any property covered by the trust is legally titled in the trust's name. The trust owner or settlor must remember to conduct their personal business affairs through the trust. While this not a difficult task it has to be done and can be a “pain in the neck.” Any property held outside the trust at death will be subject to probate-except for life insurance proceeds (payable to a beneficiary other than the estate) and property held jointly with right of survivorship, which by law would avoid probate. TYPES OF GIFTS There are two types of gifts, direct and indirect gifts. Direct gifts come in four basic forms: 1. When cash/tangible personal property is transferred from one individual to another. 2. An author gives a right to future royalties to another (this type of transfer is taxed as a single gift, valued on the date the right to future income is given). 3. Forgiving a debt in non-business situations. 4. Payments in excess of support obligations. INDIRECT GIFTS While there are many situations, six of the more popular indirect gifts are illustrated. 1. Paying someone else's expenses such as making car payments for an adult child; life insurance premiums etc. 2. Shifting property rights 3. Third-party transfers. Herbert Forbes gave his son, Steve, $200,000 with the provision that Steve would wisely invest this money and use the proceeds to provide an aunt a lifetime income. This would be an indirect gift to the aunt. 4. Creating a family partnership in which some family-member partners provide no services/assets. 52 Henry is the sole proprietor of a bookstore worth $ 300,000. He makes his 12-year-old daughter, Keitha, a one-third partner. A gift has been made because Keitha is performing no services for the partnership and has contributed no capital to the partnership formation. A gift has still been made to Keitha if she is an adult and performs managerial services for the firm without a salary. Because the managerial services have a value of less than $ 100,000, the gift value will be the $ 100,000 minus the value of the services. 5. Transfers by/to corporation (e.g., a transfer to a corporation for inadequate consideration is deemed a gift by the transferor to the other corporate shareholder). Jim and his wife, Mabel, are the only stockholders in the JM Corporation, a Real Estate Development Firm that owns small parcels of underdeveloped real estate. Jim and Mabel are contemplating having the JM Corporation transfer certain individual parcels of real estate to their children for a price that is well below the property's true market value. Jim and Mabel may be considered by the I.R.S. to have received a taxable dividend (equal to the value of the transferred real estate minus the price paid by the children). Also Jim and Mabel would then be considered to have made a gift to the children (equal to the amount of the dividend). 6. Life insurance is an indirect gift if the insured buys a policy on his/her own life and: A. Retains no reversionary interest. B. Makes the beneficiary designation irrevocable C. Names a beneficiary other than own estate. 7. If an insured makes an absolute assignment of a policy or in some way relinquishes all rights and powers in a previous policy, a gift is made which ismeasurable by the policy's replacement cost. This can lead to a tax trap. Laura owns a policy on the life of her husband, Larry. Laura names her children as beneficiaries because she has a large estate. At Larry's death, the I.R.S. could argue that Laura has made a constructive gift to the children equal to the entire amount of the death proceeds (Laura received the proceeds and gave that money to her children). GIVING GIFTS WITH NO GIFT TAX It is possible to give gifts without paying gift taxes. This can best be explained using an example which uses part of the %million gift tax exemption: 53 CONSUMER APPLICATION During 2010, Gene made outright gifts of $200,000 to his wife, Ellen, and $60,000 to each of his three children, for a total of $380,000. Gene incurred no gift tax on Ellen’s gift because of the unlimited marital deduction. They both were entitled to a total of $78,000 in annual exclusions—$26,000 for each child— because they elected to treat one-half of those gifts as made by Ellen. There is still left a taxable gift of $102,000 to the three children. Since Gene and Ellen have elected to treat the onehalf of the gifts made by Gene as made by Ellen, each parent has made $51,000 in gifts. By applying part of their respective gift tax exemptions, Gene and Ellen have eliminated the necessity of paying a gift tax. Further, if that this was their first gift using their exemptions, they will have reduced the remaining assets that will be considered tax-free for taxable gifts made in future year, from $5 million to $4,949,000 each. GIFTS TO MINORS One should be careful giving a gift to a minor child, primarily because since they are children, there are certain legal and practical matters that need to be considered, and primarily since parents usually do not want to give property to children who are too young to maintain proper control of the property. Therefore there needs to be some kind of special arrangements made. The tax law also poses some challenges since only gifts of a "present interest”' —property for the beneficiary's immediate enjoyment—qualify for the annual gift tax exclusion of $13,000 (in 2011). Additionally, state laws frequently discourage outright gifts to minors and many states prohibit or discourage the registration of securities in the name of a minor, plus they usually impose supervisory restrictions upon the sale of a minor's property. Gifts to minors are not as simple as it seems to be at first blush. ABSOLUTE GIFTS TO MINORS The $13,000 annual gift tax exclusion is available for these gifts with the exception that the gift is a gift of "future interest." Any income from the property is taxed to the minor, and the property is included in the minor's estate if he or she should die. However, because of the "kiddie tax"—requiring that a child's unearned income be taxed at the parent's rate until the child reaches age 18 (or age 24 if a student)—the child may actually be taxed at the parent’s rates on any income he or she receives from the property. GUARDIANSHIP A guardianship is an arrangement whereby property is under a guardian's legal control subject to formal (and possibly burdensome) accounting to a court. The gift, income, and estate tax consequences are the same as for outright gifts, thereby causing such gifts also to qualify for the $13,000 (in 2011) gift tax exclusion. 54 UNIFORM GIFTS TO MINORS ACT Because there are various legal problems in minors owning property completely, all 50 states, the District of Columbia, and the Virgin Islands have adopted the Uniform Gifts (or Transfers) to Minors Act whereby a custodian may hold both cash and securities for a minor until he or she reaches adulthood. Securities may be registered in the name of any bank, trust company, or adult as custodian for the minor. For gift tax purposes, custodial gifts to minors are considered completed gifts and such gifts are eligible for the annual gift tax exclusion. The income from the gift property during the custodial period is taxable to the minor (subject to kiddie tax provisions). However, if one uses the income for their minor child's maintenance and support, it is taxable to the donor (parent usually) because they are the person legally obligated to support the minor. As a general rule, one should never be custodian of their own gifts to their minor children because if the parent dies before the child becomes an adult, the value of the custodial account maintained for that child's benefit will be included in the parent’s estate. A better arrangement may be where the spouse is the custodian. Also if an individual and his spouse both make gifts to their minor child, in essence splitting your gifts to take advantage of the annual gift tax exclusion, they should consider making a third party the custodian for the child. PRESENT INTEREST TRUST Congress enacted special rules that provide a method of making gifts to minors that qualify for the annual exclusion. Basically, a gift to a qualifying trust established for an individual under the age of 21 will be considered a gift of a present interest and qualifies for the annual gift tax exclusion. There are two requirements, the trust instrument must provide that the gift property and its income (1) may be expended for the benefit of the beneficiary before reaching age 21, and (2) to the extent it has not been so expended, it will pass to the beneficiary upon becoming age 21. If the child dies before reaching age 21, the funds must be payable to the child's estate or as the child may designate under a general power of appointment. This rule applies to trusts for children under the age of 21, even if a state law has reduced the age of majority to age 19 or 18. GRATUITOUS TRANSFERS There are three categories of gratuitous transfers that are not considered gifts: 1. Property/Interest in property that has not been transferred. 2. Transfers in the ordinary course of business. 3. Sham gifts. SERVICES NOT CONSIDERED AS A GIFT SERVICES RENDERED GRATUITOUSLY Property does not include services rendered gratuitously. Even though services are of economic benefit, no gift tax will occur. 55 Herbie, a retired executive, takes over and managers the business owned by his son, Hal, during his illness. Hal would have had to pay $25,000 for a comparable replacement, but Herbie makes no charge for his services. A gift has not been made because the rendering of services is not considered to be a gift. DISCLAIMERS An intended donee refuses to take the gift. A qualified disclaimer is not subject to a gift tax. There are four requirements for a qualified disclaimer: 1. Intended donee must refuse in writing. 2. Written refusal must be received by transferor/representative within nine months after date of transfer or date the disclaiming donee is age 21, whichever is later. 3. Disclaiming donee must not have accepted any benefits of the gift (including interest). 4. Because of the refusal, someone else must receive the property interest. PROMISE TO MAKE A GIFT A promise of a future gift is not taxable. (Only when the promise is enforceable does the promise become capable of valuation and subject to gift tax). TRANSFERS IN THE ORDINARY COURSE OF BUSINESS An ordinary business transaction is a bona fide transfer of property, made at arm's length and free from donating intent. 1. COMPENSATION FOR PERSONAL SERVICES There is a gift tax on transfers from corporate employers to individuals as compensation for personal service if payment is made as a legal/moral duty or in anticipation of an economic benefit. Donating intent on payments to employees is determined by: 1. Length and value of employee's services. 2. How the employer determined the value of the payment. 3. Whether the payment was deducted as a business expense. 2. BAD BARGAINS A transfer for less than adequate consideration made in the ordinary course of business is not taxable as a gift (for example, the selling of stock to key employees at less than fair value as an impetus to heightened performance is not a gift). 3. SHAM GIFTS Refers to a transfer whose only purpose is to shift the income tax burden from a high bracket tax payer to a lower bracket family member is not considered a gift by the I.R.S./Courts and will not shift the incidence of taxation. 56 4. EXEMPT GIFTS Gratuitous transfers of property exempted by law from the gift tax. There are five main types of exempt gifts: 1. Qualified disclaimer 2. Certain property transfers between spouses upon divorce and a choice of settlement options and beneficiary designations for receipt of qualified plan death benefits. 3. Tuition paid to an educational institution. 4. Payment for medical care. 5. Transfer of money/property to a political organization if the transfer is for use of the organization, not an individual. Jim is married but is unable to have children, but he is a “doting uncle.” Recently, he made a “killing” in the stock market, and decided to spread his good fortune to others in his family. One of his favorite niece’s, Katherine, wants to go to an Ivy League school in the Fall, so he discovers that the tuition and room and board will cost about $30,000 a year. He goes to his bank and gets a Certified Check for $30,000 and puts it in a graduation card. However, before he hands it to her, he commented to his accountant what he was doing. The accountant told him to not give Katherine the $30,000, but to send a check to the University paying for her tuition. Therefore he will not have to pay gift tax on that amount. For the money for room and board, etc., he can make an annual gift up to $26,000 to her ($13,000 from him and $13,000 from his wife) without paying gift taxes. Jim discovers that a nephew, Peter, who recently graduated from college, had a bad motorcycle accident and has spent several days in the hospital, with extended physical therapy needed. Peter had not started to work as yet, and had no insurance of any kind. He was not able to be covered under his father’s insurance, so he faced large hospitalization and other medical costs. Jim’s brother (Peter’s father) did not have the money and was having a hard time of it financially without having to pay for any of these medical costs. Jim called his accountant and said in effect, “I don’t care what the taxes are going to be, I am going to give Peter $50,000 for his medical bills.” The accountant told Jim to pay for the costs directly, by writing checks to the hospitals, physical therapists, etc. That way, there would be no gift tax. Otherwise, the I.R.S. might look upon it as a simple gift to Peter, and then at the very least, there would be accountant fees trying to get the I.R.S. to understand that it was for medical costs. VALUATION OF PROPERTY FOR GIFT TAX PURPOSES The basic premise of gift tax valuation is that property and property interest transferred during lifetime is valued on the date the gift is made (fair market value is used). If donee must pay tax on property, gift value is reduced by the tax imposed. 57 INDEBTEDNESS AND TRANSFERRED PROPERTY A. If the donor is personally liable for indebtedness secured by a mortgage on the gifted property, the amount of the gift is the entire value of the property, unreduced by the debt. B. If the donee has no right to recover the debt from the donor, the amount of the gift is merely the amount of the donor's equity in the property. Biff owns land worth $ 50,000 with a mortgage of $ 10,000 against the land. Biff gives the property to his son, Jake. 1. If Biff is not personally liable for the debt, the amount of the gift is the property's net value of $40,000. 2. If Biff is personally liable for the debt in a state where the donee is subrogated to the rights of Biffs creditors, the amount of the gift is the value of the property unreduced by the debt or $ 50,000. 3. If the donee has no right to proceed against Biff to recover the debt, the amount of the gift is the amount of the donor's equity in the property or $40,000. However, if Biff later decides to pay the mortgage debt, Jake will have an additional gift of $10,000. RESTRICTIONS ON USE Restrictions limiting the donee's use/disposition of the property do not fix the value of the property, but may have a persuasive effect on price. Mutual fund shares gifts are valued at the shares' net asset value (bid price). LIFE INSURANCE/ANNUITY CONTRACTS There are certain tax-related rules upon transfer of a life insurance or annuity policy to another person. If the policy is transferred within the first year of purchase, the gift is valued at the gross premium paid to the insurer. A single premium or paid-up policy is valued at the replacement value (premium amount the insurer would change for the same type of policy of equal face amount on the insured's life), based on the insured's age at time of transfer. A policy in the premium-paying stage is valued at the sum of the interpolated terminal reserve (roughly equal to the policy's cash value) and the unearned premiums on the date of transfer. Once it is established that (1) a gift has been made (2) its value is known and (3) it did not fit one of the exempt categories, it is now possible to determine if a gift tax will be assessed. For estate planning purposes, a person can transfer ownership of a life insurance policy to their children or to a trust for your family's benefit and reap significant tax advantages. To be effective in keeping the proceeds out of the estate, the gift must be made more than three years before death. The three-year waiting period can be avoided for a newly purchased policy if proper steps are taken to have someone else (e.g., a trustee of an irrevocable life insurance trust) apply for the policy and own it from its inception. These types of irrevocable life insurance trusts can be structured so that your contributions each year to the trust can qualify for the 58 annual gift tax exclusion. Setting up such a trust can be an effective way to get insurance proceeds to your heirs without incurring gift or estate tax. FEDERAL GIFT TAXATION Gift taxes were instituted to discourage persons from transferring property during lifetime to avoid estate tax. Reductions to the federal gift tax are allowed, including gift splitting, the annual exclusion, the marital deduction and the charitable deductions. Three gifts to minors which qualify for the annual exclusion are the 2503 (B) trust, the 2503 (C) trust and the uniform gifts to minor act (UGMA) arrangement. CONCEPTS TO REMEMBER 1. 2. 3. 4. 5. 6. The purpose of the federal gift tax was to discourage gifts that would avoid estate and income taxes. For federal gift tax, gifts are all transfers of property/capital for less than adequate consideration. The federal gift tax is an excise tax levied on the right to transfer property to another person. The federal gift tax is imposed regardless of property's exemption from any income tax. A good rule of thumb: If a transfer during life shifts either the income or estate tax liability from one person to another, there will be a gift tax consequence. The donor is primarily liable for the federal gift tax. If donor fails to pay the tax then the donee becomes liable to the extent of the value of the gift. •Federal gift tax must be paid when federal gift tax return is filed. •Extension of time for payment can be granted by the I.R.S. The true test for an extension would be undue hardship. •Federal gift tax return is filed annually. Under Economic Recovery Tax Act the due date for filing a gift tax return is April 15. If a gift is made in the year the donor of the gift died, the gift tax return must be filed no later than the date for filing the state tax return. The federal gift tax is imposed only on the transfer of property and is not imposed on services that are rendered gratuitously. The relationship of the federal gift tax to the Federal estate tax involving the following three concepts: A. Identical tax rates are used for both Testamentary transfers and gifts made during life. B. The unified credit (discussed later) can be applied to both lifetime gifts and transfers made at death. Any remaining credit is available for use against estate tax payable at death. C. The federal estate tax is computed by adding lifetime gifts to the taxable estate. FILING A GIFT TAX RETURN Only individuals are required to file a gift tax return. If a trust, estate, partnership, or corporation makes a gift, the individual beneficiaries, partners, or stockholders are considered donors and may be liable for the gift tax. If a donor dies before filing a return, the donor's executor must file the gift tax return. Although a person may have made gifts during the year, he does not need to file a gift tax 59 return so long as all of the following requirements are met: 1. There were no gifts during the year made to the spouse; 2. Not more than $13,000 in 2011 during the year to any one recipient; and 3. All of the gifts made were of present interests. Additionally, except in limited circumstances, one does not have to file a gift tax return solely to report gifts to a spouse (regardless of the amount of these gifts and regardless of whether the gifts are present or future interests). A gift tax return must be filed if: • The spouse is not a U.S. citizen and the total gifts you made to the spouse during 2011 exceed $136,000; • There were no gifts of a terminable interest to the spouse that does not meet certain exceptions; • A Qualified Terminable Interest Property election has been made; • The person gave gifts to any donee, other than a spouse, which are not fully excluded under the $13,000 annual exclusion. Therefore, a gift tax return must be filed to report any gift of a future interest (regardless of amount) or to report gifts to any donee that total more than $13,000 for the year; or • The person elects to split gifts with their spouse (regardless of the amount of the gifts). If required to file a gift tax return, use Form 709, United States Gift Tax Return. FILING THE GIFT TAX RETURN The gift tax return is an annual return and must be filed on or after January 1 but not later than April 15 (without extensions) of the year following the calendar year when the gifts were made. If the donor of the gifts died during the year in which the gifts were made, the executor must file the donor's gift tax return not later than the earlier of (1) the due date (with extensions) for filing the donor's estate tax return; or (2) April 15 of the year following the calendar year when the gifts were made. If no estate tax return is required to be filed, the due date for the gift tax return (without extensions) is April 15. EXTENSION OF TIME Time to file the gift tax return may be extended by (1) requesting an extension by filing Form 8892 if the donor is not extending our Form 1040; (2) any extension of time to file their income tax return will also extend the time to file their gift tax return. Like the income tax return, an extension to file a gift tax return does not extend the time to pay the gift tax due. If one wants an extension of time to pay the gift tax, they must make a separate request using Form 8892-V. GIFT TAX RETURN-FORM 709 Form 709 is used to report transfers subject to the federal gift tax (as well as the generation-skipping transfer tax, not discussed here) and also to compute the tax, if any, due on those transfers. A married couple may not file a joint Form 709, even if the spouses elect giftsplitting, in which case both the donor spouse and the consenting spouse must each file a separate gift tax return, unless (1) during the calendar year only one spouse made any gifts, the to60 tal value of these gifts to each third-party donee does not exceed $26,000 and all of the gifts were of present interests—or—during the calendar year only one spouse (the donor spouse) made gifts of more than $13,000, but not more than $26,000 to any third-party done, the only gifts made by the other spouse (the consenting spouse) were gifts of not more than $13,000 to third-party donees other than those to whom the donor spouse made gifts; and all of the gifts by both spouses were of present interests. If either of these two situations is met, only the donor spouse must file a return and the consenting spouse signifies consent on that return. GENERATION-SKIPPING TRANSFER TAX (GST) An additional tax may apply to gifts or bequests that skip a generation, which generally involves a gift of property directly from a grandparent to a grandchild (which effectively "skips" the intervening generation) and such gift would be subject to the generation-skipping transfer (GST) tax. The purpose of this tax is simply that it imposes the equivalent of the gift or estate tax that would have been paid if the intervening generation had received the gift or bequest. Simply put, for a direct gift from a grandparent to a grandchild, the GST tax represents the amount of tax that would have been paid if the property had first been transferred to the child, who then died leaving the property to the grandchild. One should be aware that this tax is harsh! Under current law, the top tax rate on GST tax transfers in 2011 is 35% which will be payable in addition to any estate or gift tax otherwise payable as a result of the transfer. Fortunately, most individuals will escape paying it because an outright gift under $13,000 from a grandparent to a grandchild ($26,000 if made with the consent of a spouse) that qualifies for the annual gift tax exclusion is exempt from this tax. Furthermore, each individual is entitled to an aggregate GST tax exemption for lifetime gifts and transfers at death. A wealthy individual can maximize his or her opportunity to avoid the imposition of the GST tax on transfers to grandchildren and later generations by allocating the $5 million exemption for gifts during his or her lifetime. Therefore, if the living descendants are already well provided for, the donor may want to consider establishing a "dynasty trust." As its name implies, the trust can benefit future descendants by sheltering assets from estate, gift, and GST taxes for several generations. GIFTS TO MINORS An unqualified and unrestricted gift to a minor, with or without the appointment of a guardian, is a gift of present interest. This means that the gift does qualify for the $ 10,000 annual exclusion. A. If the gift is made to a trust (to provide management and control), does the transfer still qualify as a present-interest gift? Section 2503 of the Internal Revenue Code provides three ways of qualifying gifts to minors for the exclusion: Section 2503(B) Trust; Section 2503(C) Trusts; Uniform Gift to Minors Act Arrangement. B. Section 2503(B) Trust: Gifts are made to a trust; the trust is required to distribute income annually to or for the use of the minor beneficiary. 1. Distribution of the trust assets (corpus) does not have to be made at age 21. The corpus may be held in trust for as long as the beneficiary lives of the corpus may 61 pass the beneficiary and go to someone else. The trust agreement controls corpus disposition should a minor die before receiving the trust assets. 2. The gift placed in trust is divided into two parts for federal gift tax purposes: C. Principal: Does not qualify for the $13,000 annual exclusion; this is not a present interest. D. Income: The present value of the income to be paid will qualify for the annual exclusion. 3. Key points about a 2503(B) Trust: A. Advantage: Distribution of principal is not required when the minor reaches age 21. B. Disadvantage: Annual distribution of income is required. C. Section 2503 - C Trust: Income and principal must be distributed when the minor reaches age 21. Income does not have to be distributed annually. REQUIREMENTS FOR A “C” TRUST The three requirements for a "C Trust” are (1) the income and principal may be expended by or on behalf of the beneficiary (the child); (2) income and principal must pass to the beneficiary at age 21; and (3) if the beneficiary dies before age 21 (or legal age of majority) , income and principal will go to beneficiary’s estate or appointees under general powers of appointment. The tax court has stipulated that the following six items are essential elements of a bona fide gift: 1) A donor is competent to make a gift. 2) A donee capable of taking the gift. 3) An actual irrevocable transfer of the present legal title and of the dominion and control of the entire gift to the donee, so that the donor can exercise no further active dominion or control over gift. 4) A clear and unmistakable intention on the part of the donor to absolutely and irrevocable divest self of the title, dominion and control of the subject matter of the present-interest gift. 5) A delivery of the donee of the subject of the gift or of the most effective means of commanding the control of the gift (e.g., a gift of a car may be evidenced by delivery of the car keys). 6) Acceptance (exercise of the control over the gift) of the gift by the donee. UNIFORM GIFTS TO MINOR ACT (MGMA) During life an adult can make a gift of stock, a life insurance policy, endowment policy or an annuity contract, cash or other property to a minor. The adult becomes the custodian for the minor's property; smaller gifts are normally involved. The custodian has limited powers as defined by state statute. Custodial assets must be paid to the beneficiary upon reaching majority. If a donee is not age 21 on the date of the transfer, no part of the gift is a gift of future interest where all three of these conditions are met. Both the income and the property may be spent by the donee-or for the benefit of the donee before donee attains age 21. When the donee reaches age 21 any part of the property and property's income which has 62 not been spent by/for the use of the donee will pass to the donee at that time. If the donee dies before age 21, any part of the property and income not spent by or for the use of the donee will be payable to the estate of the donee or as the donee appoints under a general power of appointment. Typically, the donor irrevocably transfers annuities, cash, securities or life insurance to a minor by registering the property in the name of a custodian designated by the donor, further, The donor would not be the custodian. GIFT TAX MARITAL DEDUCTION Spouses who transfer property to each other are allowed an unlimited deduction on such transfer. The purpose of this gift tax marital deduction was to finally treat spouses as one economic unit. There are two requirements for the gift tax marital deduction: 1. Donor must be a United States resident or a citizen at the time of gift. 2. Recipient must be the donor's spouse at the time of gift. This 100 percent unlimited marital deduction provision also applies to married taxpayers in community - property states. A lady from Florida approached an Estate Planner for assistance in the following manner: She and her husband have two sons, and the lady and her husband own hundreds of acres of citrus groves which are now becoming prime residential areas. Recognizing that because of the rapid appreciation of the land and that they could each give away their $600,000 (at that time) exemption from estate taxation for life. Therefore they decided to give each son $600,000 worth of citrus groves with the understanding that their future wives would sign a release stating that the gift was not part of the marital estate. However, the sons are now married, and one of the wives refuses to sign the release. Apparently, she had consulted with her own attorney who suggested that she not sign the release. There is no way to force the wife to sign the release. When they planned their estate, they included the term “with the understanding that..” and thought that it would carry some weight … it doesn’t! CHARITABLE DEDUCTIONS There is no limit on the amount of tax-free gifts made to a qualified charity (certain religious, scientific or charitable organizations). However, there may be limitations in income taxation on some gifts. The charitable deduction is equal to the value of the gift to the extent that value is not already excluded by the annual exclusion. Also, where a charitable remainder is transferred to a qualified charity, a current income tax deduction is permitted for the present value of the remainder interest only if one of the following conditions is met: 1. Personal residence or farm was transferred. 2. Transfer was made to a charitable remainder annuity trust. Charitable gifting falls into a few general categories. These categories include outright gifts, gifts of a part of or an interest in property, and gifts in trust. All these methods can be used during one's lifetime or at death but remember each one has separate Federal income tax and Estate tax implication. 63 NOTE: Any property that is given to a private citizen will not qualify for the gift tax charitable deduction, even if the gift is made for charitable purposes or motive. Bart purchased real estate so that his business could expand. He found that there was a small house on the property that he couldn’t use, so he gave it to his cousin Jeff, who was on welfare and Medicaid as he had Parkinson’s disease and was unable to work. The house was valued at $25,000. Bart expected that this would be considered a charitable gift, for gift tax purposes, but the I.R.S. Code does not allow gift to private citizens. If Bart had made a gift to a charitable agency of the property, and then they had let Jess live in the house, it would have then passed without a gift tax. OUTRIGHT GIFTS Outright gifts of property are probably the most commonly used form of giving. People making an outright gift can make their gifts in money, personal property, or real property. To receive all the tax benefits that can result from a charitable gift, the gift must be made to an Internal Revenue Code qualified charity. To qualify, the charity must be public, semipublic, or a private foundation which has received special approval from the I.R.S. I.R.S. approval is generally given if the charity is a governmental agency; a religious, charitable, scientific, literary, or educational organization; or a war veterans or domestic fraternal organization. A lifetime charitable gift has two distinct tax advantages. The first is that an income tax deduction is generated. The second is that assets, along with their future appreciation are removed from the value of an estate. Adjusted gross income is not taxable income; it is all income less certain deductions. The income tax deduction is limited to 30% of the adjusted gross income when the gift is made to semipublic or private charities. If one wishes to use the 50% limitation, then the total amount of the deduction is not allowed. The deduction is limited to the basis or cost of the property. This amount is then subject to the 50% limitation. Any excess cannot be carried forward. Terry has an Adjusted Gross Income of $ 100,000. If he gives $ 60,000 in cash to a public charity, then only $ 50,000 can be deducted in the current year. The remaining can be used in the future for up to five years. But if the $ 60,000 is given to a semipublic or private charity, only $ 30,000 can be deducted in the current year (30% of $ 100,000). The remainder can be carried forward to the next five years. Keep in mind that while charitable gifting almost always has income tax ramifications, direct charitable gifting, providing it follows the rules, never results in gift taxes. A charitable gift made within three years of death generally cannot be brought back into an estate for federal estate tax purposes. 64 GIFT SELECTION FACTORS There are four factors to consider in determining what property to give: 1. COST BASIS OF THE GIFT PROPERTY: A. If cost basis is above the fair market value, no capital loss can be recognized. B. If cost basis is lower than the fair market value, property should be retained to take advantage, at death, of the stepped-up basis. C. If the donor is seriously ill or elderly, gift of cash or property valued at close to the original cost should be made, as opposed to making gifts of greatly appreciated property. 2. INCOME TAX BRACKET OF DONEE: If lower than the donor's income tax bracket, high income producing property is desired. If the donee's bracket is higher (e.g., retired father, successful son), the father would be best advised to make a gift of growth-type stock with a current low yield! 3. APPRECIATION: If property is likely to appreciate in value, there can be little doubt that this property should be used! 4. INDEBTEDNESS OF GIFT PROPERTY: Are there any debts on the potential gift property? If so, it would be best to eliminate such debts before gifting such property. Before re starting to tabulate the various gifts and calculate the tentative gift tax due, the following four factors must be considered: UNIFIED GIFT TAX CREDIT A credit is an amount that reduces of eliminated tax. The unified credit applies to both the gift tax and the estate tax and it equals the tax on the applicable exclusion amount. One must subtract the unified credit from any gift or estate tax that is owed. Any unified credit that is used against gift tax in one year reduces the amount of credit that can be used against gift or estate taxes in a later year. Beginning in 2011, the amount of unified credit available to a person will equal the tax on the basic exclusion amount plus the tax on any deceased spousal unused exclusion (DSUE) amount. The DSUE is only available if an election was made on the deceased spouse’s Form 706. The unified credit on the basic exclusion amount for 2011 sis $1,730,800 (exempting $5 million from tax) is $1,730,800 (exempting $5 million from tax) and is $1,772,800 for 2012 (exempting $5,120,000 from tax. The following table shows the unified credit (recalculated at current rates) for the calendar years in which a gift is made or a decedent dies after 2001. 65 Table of Unified Credits (Recalculated at Current Rates) Period Recalculated Unified Credit 1977 (quarters 1 & 2) $6,000 1977 (quarters 3 & 4) $30,000 1978 $34,000 1979 $38,000 1980 $42,500 1981 $47,000 1982 $62,800 1983 $79,300 1984 $96,300 1985 $121,800 1986 $155,800 1987 thru 1997 $190,800 1998 $199,500 1999 $208,300 2000 & 2001 $217,050 2002 thru 2010 $330,800 2011 $1,730,800 2012 $1,772,800 APPLYING THE UNIFIED CREDIT TO ESTATE TAX Basically, any unified credit not used to eliminate gift tax can be used to eliminate or reduce estate tax. However, to determine the unified credit available for use against the estate tax, you must complete Form 706. FILING AN ESTATE TAX RETURN An estate tax return must be filed if the gross estate, plus any adjusted taxable gifts and specific gift tax exemption, is more than the basic exclusion amount. Beginning in 2010, the basic exclusion amount is $5,000,000; it will be indexed for inflation starting in 2012. The basic exclusion amount is generally equal to the filing requirement. An adjusted taxable gift is the total of the taxable gifts made after 1976 that are not included in the gross estate. The specific gift tax exemption applies only to gifts made after September 8, 1976, and before January 1, 1977. The applicable exclusion amount is the total amount exempted from gift and/or estate tax. 66 For estates of decedents dying after December 31, 2010, the applicable exclusion amount equals the basic exclusion amount plus any deceased spousal unused exclusion (DSUE) amount. The DSUE is the remaining applicable exclusion amount from the estate of a predeceased spouse who died after December 31, 2010. The DSUE is only available where an election was made on the Form 706 filed by the deceased spouse's estate. Filing requirement. The following table lists the filing requirements for estates of decedents dying after 2001. File return if estate value is Year of Death more than: _______________________________________________________________ 2002 & 2003 1,000,000 2004 and 2005 1,500,000 2006, 2007, 2008 2,000,000 2009 3,500,000 2010 & 2011 5,000,000 2012 5,120,000 ESTATE TAX Estate tax may apply to your taxable estate at your death. The taxable estate is the gross estate less allowable deductions. GROSS ESTATE The Gross Estate includes the value of all property owned partially or outright at time of death. The gross estate also includes: Life insurance proceeds payable to the estate or, if the decedent owned the policy, to his heirs; The value of certain annuities payable to the estate or heirs; and The value of certain property that was transferred within three years prior to death. TAXABLE ESTATE The allowable deductions used in determining the taxable estate include Funeral expenses paid out of the estate. Also, for the final year of the estate, a beneficiary may receive the following tax benefits from the estate: Excess deductions on termination, which are treated as itemized deductions; Unused capital loss carryovers; Unused net operating loss carryovers; and Payment of estimated taxes. INCOME TAX ON AN ESTATE The estate may have an income tax filing requirement for each year that it has $600 or 67 more of gross income or a beneficiary who is a non-resident alien. The tax is figured on the estate’s income in a manner similar to that for individuals. Filing an income tax return is accomplished using Form 1041. Schedule K-1 (of Form 1041) Beneficiary’s Share of Income, Deductions, Credits, etc., reports a beneficiary’s portion of income, deductions and credits from the estate. CHAPTER 4 STUDY QUESTIONS 1. A direct gift would be A. paying another’s expenses. B. the donor promises to transfer property to the donee in the future. C. when a donor gives the donee cash. 2. The annual exclusion applies to gifts (2011) A. up to $13,000.00 to any number of persons each year. B. between spouses. C. to relatives only. 3. The Unlimited Marital Deduction A. applies to all married couples. B. does not apply to real estate. C. allows married couples, when the donor is a U.S. resident or citizen an unlimited deduction on property transfers between each other. Chapter 4 Study Question – Answers & Sections 1 A – page 46 – Gift Giving Basic 2 A – page 51 – Irrevocable Trusts 3 A – page 63 – Gift Tax Marital Deduction 68 CHAPTER FIVE - TRANSFERS AT DEATH AND THE ESTATE ADMINISTRATION “The road of the truth - teller has always been rocky” INTRODUCTION There are several ways property owned by the decedent can be transferred at death; by contract designation, by Will, by law or by allowing state law to dictate how the estate will be distributed. The objective of this text is to explain the methods of all four and also to describe the duties and responsibilities of an Executor, Administrator or personal Administrator when administering an estate. All three positions require the assembling and management of property and the paying of estate debts and taxes. Also the proper distribution of estate assets crucial while administering an estate will be discussed. HOW PROPERTY PASSES AT DEATH When an individual dies there are three ways property may pass: 1. Contract designation. 2. By law. 3. By Will. 1. CONTRACT DESIGNATION Probably the best examples of property passing by contract are life insurance, annuity contracts and trust agreements. The benefits of owning a life insurance policy are numerous but for estate planning purposes the critical benefit is the right the individual has in naming his/her own beneficiary. By naming a beneficiary the owner obligates the insurance company to pay the proceeds to the designated beneficiary. If the policy owner named a beneficiary for the policy in his/her Will, this would have no effect if the beneficiary designation in the policy was different. One consideration that is usually not conducive to proper estate planning is to name the estate of the insured as the beneficiary as the proceeds will now be tied up in the probating of the estate and thus subject to possible long delays. Trust agreements are another example of transfer by contract. (These vehicles have become so popular we have devoted an entire chapter to them.) Basically the trust agreement is a contract between the “grantor” and the “trustee.” The beneficiary is not a party to the agreement but does have an equitable interest in the trust property. The trustee will hold the actual legal title to property in the Trust until it is distributed. When the grantor dies, property rights of the beneficiaries in the trust take place. Depending on the trust agreement many different situations may be played out. For example, certain beneficiaries may become entitled to trust income while others only receive a certain percentage of trust assets per year. The trust agreement will define such responsibilities of the trustee. Another example would be a qualified retirement plan that provides a death benefit. The death 69 benefit would be-in-accordance with the plans terms and the participant’s election. Another example would be property that is owned jointly with rights of survivorship. A final example would be the use of prenuptial or ante nuptial agreements. These agreements tend to limit the transfer of property between spouses in line with marital rights. The reason why prenuptial is popular is because it is used by persons who wish to marry but who also wish to establish their right to leave their property to their loved ones prior to taking their marriage vows. These pre-marriage contracts make it possible for the spouses to protect the inheritance rights of their respective children by prior marriages, and, as a result, prevent strife over the disposition of their estates. The laws of all states favor these contracts if they are properly prepared. After marriage contracts can also be used to set forth the spouse's inheritance wishes. Be careful when dealing with these types of contracts as they are looked upon with suspicion by courts and, as a result, must be entered into very carefully. The requirements of an after marriage contract, where permitted, are much more complicated and rigorous. 2. TRANSFER BY OPERATION OF LAW There are six transfers dictated by law: 1. Joint tenants with right of survivorship refer to property that is jointly held and would automatically pass to the surviving joint tenant. We see this occurring in the case of tenancies by the entirety and joint tenancies with rights of survivorship. 2. Family allowances occur when money is "given to a decedent's family to provide for a family's support until the estate is settled”. 3. Homestead allowance makes a certain amount of decedent's property inaccessible to creditors. 4. Dower provision is seen in common law states. These are provisions made for a wife from her husband's property. 5. Courtesy provision is also seen in common law states. This is a provision made for a husband from a wife's property. Both of these provisions deprive a spouse of the right to "disinherit" the other spouse. Many times, the surviving spouse is entitled by law to no less than one-third the Probate assets of the deceased spouse. 6. Intestate succession is another way that property may pass by law. When an individual fails to prepare a Will and dies intestate, state law prescribes by statute how the decedent's property will be distributed. In reality those closest to the decedent will usually secure many assets of the estate. The problem with the state deciding is that often times estate property may be divided and given to very young children when the decedent would have preferred that all property go to the surviving spouse. Many people believe that the state will ultimately end up with the assets if no Will has been drawn up. This would happen only if there are no blood relatives alive to receive it. When this occurs the property passes (escheats) to the state. 70 Robert lives in a Community Property state. Robert and his wife, Stella, have grown apart over the years, and unknown to Stella, Robert has had a relationship with his Secretary, Willa, for the past 7 years. Robert had his Will changed so that Willa would inherit everything and Stella would not receive anything. Robert was killed in an accident and when the Will was read leaving everything to Willa, Stella contacted her attorney and was given 1/3 of the estate, contrary to Robert’s wishes, under the state law. 3. TRANSFER BY WILL (TESTATE SUCCESSION) COMMENTS ON THE LAST WILL AND TESTAMENT Only 27% of Americans have a Will, however most people should have a Will as the Will passes any assets that a person owns in his own name. It doesn’t pass jointly-owned assets, or assets in a living trust or other such instrument. Even though most states allow a person to write their Will in their own handwriting, it is still better to have an attorney draw up a Will as the laws governing Wills vary by state. Although a person can leave any assets they own to anyone they wish, some states will allow a widow to claim a part of the estate through a procedure called “The Widow’s Election”, and some states give preferential treatment to descendants. State laws differ on the question of naming disinherited heirs in the Will, so if one wants an heir disinherited, they should research the state law. NOTE: In order to be sure that no widow was every completely disinherited by her husband, many states have Widow’s Election laws. It must be noted that this is an ACTIVE (not a passive) election. If a Widow has been completely disinherited, the Widow can go the Probate Court and file the Widow’s Election – it is not done automatically. Also, the Widow’s Election pertains only to those items in the probatable estate, i.e. those items that pass from the Will. For instance, it would not include a house that the decedent owned jointly with some other person, or a bank account owned jointly. Insurance proceeds and pension plan proceeds are generally outside of the Widow’s Election. In any event, a person may not libel anyone by making a disparaging statement (such as: “It gives me great pleasure to leave nothing to by son-in-law who has been cruel to my daughter, stolen from my family, beat his children, and who does not deserve to be a member of my, or anyone else’s, family.”) Such a statement can lead to a lawsuit. The Will should be kept in an attorney’s office. It can be changed or re-written at any time by a person with a sound mind, however it is better to write an entire new Will and destroy the old one. Upon the completion of the previous section, this text shall discuss using Wills for the transfer of property at death. Wills have recently come under severe criticism and many believe are quite antiquated. The planner must decide the good and “not-so-good” points of Wills and use such information at their own discretion. 71 WILLS A Will is a set of written instructions drawn under legal formalities that directs how a person's property will be disposed of upon death. Wills often are fraught with technicalities and very formal procedures. HISTORY OF WILLS Most of the Law of Wills used today is steeped in English tradition. For many years common folks were unable to leave all their property to their loved ones. Upon their deaths, much of their property passed to royalty. In A.D. 1540, the English Parliament passed the Statute of Wills, which allowed common folks the right, under a body of rules, to pass all their property to others on death. The legislation was revolutionary and led to many new rules. As cases followed the laws of Wills became numerous and complex—thus the reason for its complex nature in today's society. A Will only controls property belonging to its maker. There is, however, an exception to this rule. If someone else left property for one to use during their lifetime and specifically gave that person the right to dispose of it on their subsequent death, that person would have a "Power of Appointment," the person entrusted with this power would have the right to say in his/her Will who gets that property. A Will controls the passage of property to others on its maker's death. Wills do not control property that goes to others by other planning devices or by operation of law. Jointly held property, for example, is not controlled by a Will. Jointly held property automatically belongs to the other joint owners on death. The same is true for property owned in tenancy by the entirety. Life insurance proceeds are not controlled by a Will if the owner names a beneficiary other than his/her estate. Wills which are prepared in one's own handwriting are called “holographic Wills” while an oral Will is a “nuncupative” Will. A Will with two makers to dispose of their property on the death of the second maker is referred to as a “Joint Will.” A “Codicil” is an amendment to a Will. Keep in mind that homemade Wills rarely work and joint Wills can create planning nightmares, especially in the areas of taxation. A codicil is a way to alter a Will without preparing a new Will but codicils must be signed with all, and no less than all, of the formalities of a regular Will. There are three other terms we must become familiar with before discussing Will requirements and advantages of a Will, these are: 1. Executor: Male chosen by decedent who is responsible for administering the estate. (Executrix = female). The Will may allow Executor to serve without a bond. 2. Personal Representative: The Estate administration process begins with the appointment of a Personal Representative for the estate. This may be a person or a bank. 3. Attesting Witness: A witness who swears to the validity of a decedent's signature on the Will when the Will enters Probate. 72 WILL REQUIREMENTS There are five general requirements: 1. Execution of the Will must be signed at the end and witnessed by two or three competent witnesses. 2. Maker of the Will must have legal capacity to make a Will. The age of majority varies from state to state but usually is 18 years of age. They also must be of sound mind. 3. No beneficiary may also be a witness. 4. Even states that do not require witnesses at execution do require witnesses when the Will enters Probate. 5. Distribution. Two choices: 1. Per Stirpes Distribution: (by branches). Legally refers to a progression through the branch of a particular family member. Walter had four sons and his property is to be distributed Per Stirpes according to his Will. Before Walter’s death, his oldest son died from a lingering illness. This son was married and had stipulated in his own Will that his property would be passed to his daughter. Upon his death, his share of Walter’s property would be passed to his daughter. Therefore, Walter’s property is now owned by his 3 sons and his granddaughter. 2. Per Capita Distribution: ("Per Head"). This designation is used to indicate that any remaining beneficiaries share all of the proceeds equally. If Walter (see above) had left instructions in his Will for his property to be distributed Per Capita, after Walter’s death, his four sons would inherit the property. Upon the death of the oldest son, the property that was inherited from Walter would be redistributed and each of the surviving sons would own 1/3 of the property. To summarize, the use of per stirpes and per capita provides a precise way to create a property distribution pattern. CONTESTING A WILL A Will may be contested. This would be an attempt to have the Will set aside through legal channels. Any interested party (anyone who stands to gain if the Will is overturned) can contest the Will. There are five possible grounds. 1. 2. 3. 4. 5. Improper Execution: Something vital is missing such as a witness signature. Incompetent Testator: For example, senility would make a Testator incompetent. Fraud: The testator was misled by lies, for example. Forgery: As an example, the Signature at the end is not that of the testator's. Revocation: Testator revoked the Will prior to death. 73 Special Note: The aim of contesting a Will is to destroy the entire Will. Electing to take against a Will, on the other hand, gives the spouse a certain portion but leaves the rest of the Will alone. ADVANTAGES OF A WILL Although the Will "industry" has been under constant criticism since the publication of Norman F. Dacy's national best-selling book entitled "How to Avoid Probate", there are nine advantages of preparing a Will: 1. The Executor of choice may be named to insure that estate wishes are followed. (Note, however, the nomination does not guarantee that the court will appoint said person. Further, the appointment does not guarantee that the Executor will fulfill the wishes of the decedent.) 2. Executor may transfer real estate, stock or business interests as decedent wishes. 3. Testator can direct disposition of tangible personal property separately from the residue (that in the remaining part of the estate after all other gifts have been made). 4. Testator can assure the maximum marital deduction decedent desires for property passing to a spouse. 5. Testator can specify the estate's share of the tax burden. 6. Testator can designate guardians for minor children or other legally incompetent dependents. 7. The Will can contain trust provisions to protect the interests of beneficiaries from creditors. 8. Testator can name charitable beneficiaries in the Will. 9. Testator can designate the order of survival of self and spouse in the event of a common disaster. PROBLEMS WITH WILLS Wills are only effective on death and may not control all property. They involve complex legal rules and must go through Probate. (This fact, in itself, should give reason to look at Will preparation with a critical eye). The primary disadvantage of a Will is that all Wills must go through Probate. Please remember, as discussed in Chapter One, Probate can be a needlessly expensive and a time consuming process that can be avoided. The use of a Will guarantees Probate. Many planners in the past believed estate planning was Will planning. Things have changed. A Will is but one method of disposing of property upon death. Unfortunately, many people give little or no thought to other methods as they relate to the estate planning process. In order to illustrate problems with Wills we will have an estate planner - Ken - meet with his client - Jim - and ask a few questions typical in the estate planning interview. Estate Planner, Ken: “Well Jim before we can make any recommendations, we need to know what you own and how you own it.” 74 Jim (Client): “Ok. What do I own? Well, Betty and I own our home. The deed is in both our names as joint owners. That should be okay because that's the way our realtor said it would work best. Oh! We also have savings account, four of them. One is in both of our names - jointly held. One's just in my name. The other two are with the kids, one in my name with our son, Bob; the other is in our son Jamie's name, but Betty and I are both on it as well. The person at the bank said it would be better this way. Something about our being custodians, but I think we're all on with the kids as joint owners.” Estate Planner. Ken: “Are you sure exactly how the accounts read, Jim?” Jim: “Not really, but there's not much there. Then, we have life insurance. There's my group at the office. That goes to Betty and then to the kids if she dies before I do. I also have my G.I. insurance. That goes the same way. I also have two other policies. One's not too large, but it's permanent insurance and the other in six figures. Its term insurance, and they both go the same way.” Ken: “What else do you have?” Jim: “Our checking, one's joint; one's in Betty's name. I've got my pension and profit sharing plan at the company. I signed a card at the Personnel Office. I think the proceeds go to Betty and the kids.” Ken: “What else do you have Jim?” Jim: “We have the cabin. That's in our names with my brother and his wife jointly. Some stocks, some in Betty’s and my name; some we put in the kid's names. One's with my sister and both names are on it. That's about it!” Ken: “Any personal possessions?” Jim: “Oh. Do we ever. Two cars in both names, furniture, furnishing, you know, my stamp collection, been collecting since I was a kid; clothing. The usual stuff. I don't know who owns it. I guess we both do.” Ken: “Thank you Jim.” (At this point, it would be proper to review Jim’s assets again in order to determine exactly how they are titled, and whether or not Jim's new Will can control them on Jim's death or whether they will go directly to others because Jim used an alternative method of planning.) Residence Joint with spouse Savings accounts No. 1 No. 2 Joint with spouse Jim's name 75 No. 3 No. 4 Joint with son Joint with spouse &son. Life Insurance All policies have named beneficiaries: spouse and children. Checking Accounts. No. 1 No. 2 Joint with spouse Spouse's name Pension and Profit Beneficiaries on cards Sharing accounts at work Spouse and children Cabin Jointly between families Personal Possessions Cars Others Joint with spouse Who knows? Reviewing this summary leads to some obvious conclusions. Those items that Jim owns solely in his name will be controlled by and pass under the terms of his Will. The balance will automatically pass by contract or by operation of law: 1. All joint property will automatically pass to the surviving joint tenants. They will be the exclusive new owners. 2. All life insurance will go to the name beneficiaries under the terms of the policy and the beneficiary designations. 3. The pension and profit sharing proceeds will also go according to those beneficiary cards Jim signed. 4. Checking account No. 2 is in Jim's spouse’s name, and as such, cannot be controlled by Jim's Will. The obvious point is that the only property that Jim's Will can control would be one savings account and the personal property deemed to be owned by Jim as his death. Wills may not control the disposition of property as much as a client might think. The key point is that a Will is but one tool available to the client and the estate planner to dispose of property on death. Will planning is Will planning and is only a part of estate planning. Estate planning envisions how those "other assets" will pass. How they will pay or avoid tax, to whom they will pass and how they will pass. It is important to understand that other planning techniques are of critical importance. (The other techniques are, in reality, Will substitutes). To summarize, a Will is but one golf club in the estate planning golf bag; a club which should be used only in the appropriate situations to make the right shot. 76 WILLS QUIZ The following “quiz” has been used by some Estate Planners to “test” their clients regarding Wills. There are no “trick” questions here, and if nothing else, it will point up to the person taking the “quiz” that there is a lot of misinformation about Wills floating about. Answer True or False. The answers appear after the “quiz.” 1. Both spouses should have their own Wills. 2. By the fact that a person has a Will, means that his estate will avoid probate. 3. If the decedents have a Joint Bank Account, a Will control this money. 4. If a Trust is created by a Will, they are called Testamentary Trusts. 5. If you have no Will, your estate will pass under the laws of your state. 6. If you own property in more than one state, the estate may be probated in each state. 7. A Will must be written on legal-sized paper. 8. The Witnesses to a Will, must read the Will. 9. A life insurance policy proceeds must be distributed by the terms of the Will. 10. An average estate going through probate will take 3 months. 11. A Joint Deed is more powerful that the terms of a Will. 12. A Spendthrift Trust can be created by a Will. 13. A Will must be signed to be Valid. 14. If there is no Will, but you have stated in front of witnesses that you want your brother to be the Guardians of your children if you predecease him, then your brother will automatically become Guardian. 15. A Will must be “current”, which means that a 20-year old Will is not valid. 16. A Will for two persons in one Will is called a “Joint Will.” 17. Your heirs will have to pay income tax on the proceeds of a Will. 18. The original copy of your Will should be kept with a family member. 19. Wills are considered legally sacrosanct and cannot be challenged in court. 20. Wills are normally probated prior to a funeral. 21. Joint ownership of property is a good substitute for a Will. 22. If a Will is handwritten, it must be notarized. 23. A Will is the only way of transferring property from one generation to the next. 24. A Taxable estate does not include assets passed by Will. 25. A Pour-over Will is designed to pass assets into a Living Trust. 26. When you move from one state to another, you should have your Will reviewed. 27. If there is more than one Will submitted for probate, the judge decides which one is correct. 28. A Deed can pass property to the next generation, outside of a Will. 29. You do not need a Will if you have a Living Trust. 77 ANSWERS TO THE WILL QUIZ 1. 2. 3. 4. 5. 6. True. Spouses do not always agree and situations change. False. A Will does not keep an estate from being probated. False. A Joint Bank Account passes outside of the Will. True. True. This is called Intestacy. True. Even if you no longer reside in a state in which you own property, it will still have to be probated in that state. 7. False. In some states it can be written on a “brown paper bag with crayons” and still be legal. 8. False. A Witness merely states that the owner of a Will has signed the Will. 9. False. One of the main advantages of life insurance is that proceeds will be distributed by the terms of the policy. 10. True. Three months is average. 11. True. This is discussed later in the text. 12. True. This keeps an heir with a “hole in his pocket” from squandering his inheritance. 13. True. Otherwise it is just a proposal or a “wish list.” 14. False. This is one of the greatest arguments for having a Will. Parents should want to have the right to name their children’s Guardians, and not having some judge make the designation. 15. False. A Will does not become invalid because of age. 16. True. 17. True. Uncle Sam is always going to get a piece of any money transfer. 18. False. The best scenario is for your Will to be kept by your Attorney. 19. False. Wills are challenged all the time. 20. False. As stated earlier, it can take as much as 3 months for probate. 21. False. Joint ownership only has the authority to decide who owns property after a joint-owner’s death. A Will is much, much broader. 22. False. It is a good idea to have a Will notarized, but it is not legally required. 23. False. Multitudes of attorneys, public accountants and insurance agents have as a livelihood transferring property inter-generational. 24. False. Taxable Estates will be discussed later in this text. 25. True. Hence, the name “pour-over.” 26. True. Laws differ from state to state. 27. True. An argument for destroying old Wills when new ones are written. 28. True. Yes, indeed, as various sections in this text illustrates. 29. False. As discussed later in the text, a Living Trust can work with a will, but is not an end-all in determining who gets what upon the death of the principal. 78 Al Worthington and his wife, Bess, decided to make out a Will. They had one child, Bob, and their property was set up so that it would automatically transfer to Bob if they should both die. Their Bank Accounts were in joint names with their son, and their investments were set up in Trust for Bob. Therefore, being a relatively young couple, they felt they did not need a Will. However, Bess became pregnant again and presented Al with Twin Daughters, Rhonda and Renee. Bess’s mother died soon after the twins were born, and left Bess with a small farm in Indiana valued at $250,000, and other articles worth about $100,000. The farm had a Manager already in place that had worked for Bess’s mother for many years, and was willing to continue as a tenant farmer. In talking over the inheritance from Bess’s mother with their Attorney, it was pointed out to them that without a Will, if Al and his wife were to die before the children were grown, the court would appoint a guardian. The farm would probably be distributed 1/3 to each of the children, and then if one of them wanted to sell the farm, or to live on the farm, there would be family problems. Therefore, Al and Bess elected to make out a simple Will for the present, and then to update it as Al & Bess’s net worth grew in the future. In the meantime, they would leave the farm to be sold and the money from the sale to be evenly divided among the children. They felt that as the children got older and if one of the children wanted to live on the farm, they could make changes at that time. An example of a Will for them would read similar to the following Simple Will. (This is for illustrative purposes only, and may not meet all of the requirements of some states and should not be used as a template without local legal opinion Bess would also have a similar Will. ) SIMPLE WILL LAST WILL AND TESTAMENT OF Albert T. Worthington I, Albert T. Worthington, born Aug. 23, 1967, residing at 1154 Oak Lane, Clearwater, Country of Pinellas, Florida, 42567, hereby revoke all wills and codicils heretofore made by me and I now publish and declare this to be my last will and testament. I. Personal Representative I hereby designate Bess Worthington the Personal representative of my estate. I request that my said Personal Representative be permitted to serve without a bond or with a bond in the smallest amount allowable. In the event Bess Worthington fails to qualify or ceases to serve as a Personal Representative, I designate Grand National Bank as Personal Representative of my estate. II. Settlement Costs I direct that the expenses of the administration of my estate, claims duly allowed against my estate, and all death taxes levied or assessed against my estate, against 79 the beneficiaries under this will, or against any person by reason of the ownership of property included in my estate for tax purposes, be paid, or provision made therefore, out of the residue of my estate and not charged against any particular beneficiary (including, but not limited to, any joint owner, any insurance beneficiary, or any other owner of property included in my estate for tax purposes),other than the beneficiaries of the residue of my estate. III. Specific Legacy I hereby devise all of my tangible personal property including, but not limited to, my jewelry, clothing, objects of art, personal effects, household goods and furnishings, and automobiles to my wife, Bess W. Worthington if she survives me; if she does not survive me, then I devise such property to my children who survive me in equal shares, or all to the survivor of them. IV. Residuary Legacy I devise the residue of my estate to Bess Worthington if she survives me; if she does not survive me, then devise such property equally to my children who survive me, or all to the survivor of them. V. Guardian If my spouse does not survive me, I hereby request my brother, Bryan L. Worthington be appointed as Guardian of the person of any child of mine who survives me and who has not attained the age of twenty-one (21) years at the time of my death. In the event Bryan L. Worthington fails to qualify or ceases to serve as such Guardian, I hereby request that my sister-in-law Elizabeth Sunderson be appointed at Guardian of the person of any such child. VI. Powers of Personal Representative In extension of and not in limitation of the powers given by law, my Personal Representative shall have all powers granted to trustees under the laws of the State of Florida and the following powers with respect to the property of my estate to be exercised in the discretion of my Personal Representative without prior authorization or subsequent approval of any court. All powers and discretion’s bestow on my Personal Representative herein may be exercised by any joint, alternate or successor personal representatives. a) To sell, exchange, transfer, convey, lease, mortgage or otherwise encumber, and deal in any other manner with, the property of my estate, real and personal, tangible and intangible, for such periods, including periods extending beyond the term of the administration of my estate, and upon such terms and conditions, including terms of credit, as my Personal Representative may determine to be necessary to advisable: to give options therefore; to perform any contract made by me and binding upon my estate, including contracts to convey or to lease real estate; and to execute all documents and instruments necessary or incidental to the exercise of the foregoing powers. b) To borrow money from my Personal Representative or from others as my PR 80 may determine to be necessary or advisable in connection with the payment of debts, claims, administration expenses, and taxes or in connection with the exercise of options owned by me at my death to acquire property. Such loans may be obtained on the security of the properties of my estate which, in such event, may be distributed to the beneficiaries under this will subject to such loans. c) To invest and reinvest in any kind of personal or real property including but not limited to, interests in investment trusts, mutual funds and common trust funds and to exercise options owned by me at my death to acquire property; not withstanding that such investments may not be permitted by the laws of the State of Florida governing investments by fiduciaries. d) To deposit securities with, or transfer them to, protective committees, voting trusts or similar bodies; to consent to and participate in any plan for the redemption of the stock or of the liquidation, reorganization, consolidation or merger of any corporation any securities of which are held by my Personal Representative; and to pay assessments or subscriptions called for in connection with securities held by my Personal Representative. e) To employ and compensate from the property of my estate, such custodians, brokers, investment counsel, agents and attorneys as my Personal Representative deems necessary or advisable. My Personal Representative is authorized to hold securities and other investments in the name of an agent of nominee or to hold securities unregistered and in bearer form. f) To improve or develop real estate; to construct, alter, repair or demolish building or structures on real estate; to settle boundary lines; to grant or obtain easements and other rights with respect to real estate; to partition and to join with co-owners and others in dealing with real estate in any way. g) To continue the operation or management of any businesses owned by me on the date of my death and to continue to participate as a partner of any partnership of which I am a partner on the date of my death; to dispose of any such business or partnership interests; to change the form of organization of any such business or partnership; to delegate to others management of any such business or partnership; and to take all such action with respect to any such business or partnership that my Personal Representative determines to be necessary or advisable. h) To deal with the trustee of any trust established by me, my spouse, or any ancestor or descendant of me of my spouse, or with the personal representatives of any such persons, as freely as with a stranger, notwithstanding that such fiduciary may be the same person or corporation as the Personal Representative hereunder. i) To make distribution of a minor’s property either to the minor, a parent of the minor or to the legal guardian of the minor, and the receipt of the person to whom payment is made shall be a valid release and complete discharge of my PA with respect to such distribution. 81 IN WITNESS WHEREOF, I have subscribed my name to this, my last will and testament, consisting of 3 typewritten pages, affixing my initials to each of said pages for better identification, and I have this called upon James T. Applegarth Hilda Rassmussen Pam Dirthwilder as witnesses to the same at Clearwater, Florida, this 14 day of April, 1998 ___________________________________ (Albert T. Worthington) The forgoing instrument was signed, sealed and acknowledged by the abovenamed Albert T. Worthington, and for his last will and testament in our presence, and we, at his request, in his presence and in the presence of each other, have subscribed our names as witnesses thereto this 14th day of April, 1998. ________________________ residing at 2222 Oakview, Clearwater, FL (James T. Applegarth) _________________________ residing at Route 3, Box 34, Ocono, FL (Hilda Rasmussen) __________________________ residing at 5777 U.S. 19, Seminole, FL (Pam Dirthwilder) ADMINISTERING THE ESTATE The purpose of estate administration is to resolve decedent's responsibility and transfer all property. There are eight steps in the settlement process. Steps are basically the same whether a person dies with a Will or without one. 1. Fulfill the initial responsibilities. Basically means making the funeral arrangements. This is an important first step as the Executor must make such decisions at a time of much grief. It is best for one individual to make such arrangements and to try to prevent "committee" decisions at this stage. 2. Appoint Administrator/Executor (also called Personal Representative). The administration must petition court for acceptance and post bond (to protect beneficiaries and creditors) unless the Will provides otherwise. 3. Begin to assemble property in a timely basis. This step should occur immediately. It has been documented many times where well-meaning family member have "helped" themselves to a decedent's possessions before the Executor can start this step. 4. Keep property safe from outside intruders. An unoccupied home with rooms full of possessions becomes an easy target. Any security device, timed light, alarms and light82 5. 6. 7. 8. ed entrances should be considered. Provide interim management as the paperwork and other legal requirements are being met. Oversee the debts and expenses of the estate. By opening up an estate checking account the Administrator will be able to pay current debts as they come due thus saving the estate unnecessary late fees. One of the first debts will be the payment of the funeral expenses. Perform basic accounting duties. One of the most important functions will be having property appraised. Real estate and personal possessions must have a value for estate settlement purposes and states accept a qualified, certified appraiser's estimate for fair market value. After all the above conditions are met the final step is to distribute the net estate. SIMPLIFIED ESTATE ADMINISTRATION Many States have provided a method of simplified administration for small estates. The Probate court must give its approval and the beneficiaries of the estate must agree to this method. The specific requirements for simplified administration will vary by state. Unless this simplified method is used, the administration of the estate will occur under the supervision of the Probate Court. CHOICE OF A PERSONAL REPRESENTATIVE While it can be a simple decision to name a Personal Representative, a well thought out process should take place. The Personal Representative acts in behalf of the estate owner. Usually an individual's first option will be a spouse (which could be the worst choice of all). A bereaved widow(er) will not always make the best Executor especially if she or he does not know the way finances work. Sometimes another family member - possibly an adult child would be a better choice. The advantage of naming a family member is that this person will be sensitive to the family's situation. A corporate Executor probably will not have the same insight as the family member. The disadvantage of naming a family member is that they could possibly be hindered by family heirs. If objectivity and impartiality are important considerations, then some consideration of a corporate Executor should be made. Bank Trust Departments have specialists in estate administration. They are experienced in the Probate process and are familiar with competent appraisers who may render the various assets in the estate a much needed service. CONTINUATION OF BUSINESS State laws usually do not allow a Personal Representative authority to continue to operate the decedents business. Although the decedents may provide the authorization, the Personal Representative must be extremely careful while doing this. Any downturn in the business could cause the heirs to resent this and could lead to many problems for the Personal Representative. 83 CLAIMS AGAINST THE ESTATE A notice to creditors is usually published in a commercial newspaper. This method presumes that the creditors will be aware of the tentative nature of the estate and should file any claim against the estate. Most states have a cutoff for such claims. If a claim is not filed with the court within six months after publication of notice, the Personal Representative need not honor the claim. This allows some estates to be settled quickly. ESTATE INVENTORY AND VALUATION Probably the most difficult part of the Executors responsibility is to gather all the decedent's assets and then place a valuation of each item. Some of the assets will not be difficult to value. Life insurance, retirement benefits, etc. can be easily valued, but real estate, long held securities, family heirlooms, each has valuation problems. For this purpose the use of qualified appraiser is most important in the valuation of property. When long held stock must be valued often times a local library can be of assistance or contacting directly the issuer of the security is needed. Appraiser's fee are paid out of estate assets as they are a necessary expense to the estate and are also tax-deductible as an estate Administrator expense. ESTATE INCOME Oftentimes in larger estates the Personal Representative will be required to make investments. Since the primary duty of a Personal Representative is to conserve estate assets speculative assets will be frowned upon. TAX RETURNS The Personal Representative is responsible for filing a federal estate tax return. A state death tax return for the estate, and the decedent's final income tax return for the year of death must also be filed. DISTRIBUTION TO HEIRS OR BENEFICIARIES If the Probate court approves the final accounting, it will sign a decree of final distribution which finally authorizes the distribution of the net estate to the heirs (intestate) or beneficiaries (Will). The court must be satisfied that all the debts, expenses and taxes have been paid and that the distribution is in compliance with the intestacy laws or wishes of the decedent's Will. Any premature distribution by the Personal Representative could expose them to liability if a disgruntled beneficiary finds out. EXECUTORS FEE Part of the estate expenses will be Executor's own fee. This fee is usually a declining percentage of assets under estate administration. At times individual Executors often waive the fee as a favor to beneficiaries especially if a family member has been charged with settlement of the estate. Executor's fees are chargeable against estate assets, and are estate tax deductible. To summarize, it is important for the planner to review the duties of an Executor/Personal Representative before recommending such a responsible position to clients. Most individuals 84 will become Personal Representatives before discovering the immense responsibilities associated with such a position. It is important to keep in mind the three important objectives of the Personal Representative’s job: 1. Conserve estate assets. 2. Pay the claims of eligible creditors. 3. After the final accounting has been approved by the Probate Court, distribute the remaining assets to the designated beneficiaries. PAYING ESTATE TAXES More often than one would think, and particularly in today’s economy, the estate owner may not have sufficient liquid funds to pay all of the estate’s obligations—in particular, estate taxes. Without sufficient liquidity, the estate may be forced to sell a portion of the business to raise the necessary cash. Fortunately, there are special rules for the estates of owners of closely held businesses. STOCK REDEMPTIONS A special tax provision (Section 303 of the Internal Revenue Code) allows certain redemptions or partial redemptions of closely held stock to be treated as a sale or exchange, not as a dividend. Since the estate's basis in the decedent's stock will be the stock's fair market value at the date of death, only post-death appreciation will be taxed upon the redemption and only up to the maximum long-term capital gains tax rate (generally 15% for sales and exchanges). In order to qualify for a “Section 303 redemption,” the value of all the stock of the corporation included in the decedent's gross estate must exceed 35% of the decedent's adjusted gross estate. The adjusted gross estate is the gross estate less the allowable deductions for funeral and administration expenses, debts, the family-owned business deduction, and certain losses (but before any charitable deduction or marital deduction). A qualifying redemption under Section 303 is limited in amount to the sum of the following items: • Federal and state death taxes, • Funeral expenses, and • Estate administration expenses. The advantages of sale and exchange treatment under Section 303 may be somewhat diminished under the tax law, which taxes certain qualified dividends at the lower capital gains (vs. ordinary income) rate. As long as the redemption by the estate results in qualified dividend treatment, the estate would be taxed at 15% on post-death appreciation without meeting the Section 303 requirements. It should be noted that an estate does not actually have to be illiquid in order to qualify for this special redemption. The estate may redeem stock up to the maximum amount referred to above, if the estate otherwise has sufficient liquid assets to take care of its expenses and taxes. PAYMENT OF ESTATE TAXES IN INSTALLMENTS The estate taxes attributable to a decedent's closely held business can be paid over a 14year period under certain conditions. It offers a very favorable interest rate plus a 5-year deferral on the first installment of estate taxes. It must be noted that the deferral provision only ap85 plies to an "interest in a closely held business" requiring that the value of the closely held business must exceed 35% of the adjusted gross estate—the amount of estate tax that qualifies for a deferred payout is limited to the portion of the total tax that is attributable to the decedent's business interest. AS an example, if the decedent's qualifying stock constitutes 70% of the adjusted gross estate, then 70% of the total estate tax liability may be deferred. None of the tax attributable to the closely held business interest is due for five years but the interest on the tax for the first four years must be paid annually. Starting in the fifth year, the estate tax due plus interest may be paid in up to 10 yearly installments. The interest rate charged on the deferred estate tax attributable to the first $1.36 million (in 2011) in value of the closely held business interest is 2%. An interest rate equal to 45% of the rate applicable to tax underpayments applies to the deferred estate tax in excess of that amount. COMMUNITY PROPERTY IN THE EQUATION Community property is usually property acquired by spouses while they are married and residing in a community property state, however, not all property acquired during the marriage is community property. If one spouse individually receives a gift or inheritance, it is not community property but rather is "separate property" owned solely by the recipient. Property acquired or otherwise owned by each spouse prior to marriage is also considered separate property. Community property and marital property are treated differently from non-community property when someone dies. In a non-community property state, the basis of the decedent's property is increased or decreased for tax purposes to fair market value as of the date generally of the decedent's death. However, when one spouse in a community property state dies, the basis of both spouses' interest in all community property is increased or decreased to the fair market value at date of death. PRESENT ACTIONS TO BE TAKEN FOR ESTATE PLANNING When actually performing estate planning, there are certain measures that must be considered at a minimum. Review with the spouse their current financial situation and entire personal financial plan (including plans for retirement in addition to plans for survivor after death of one party). If any adult member of the family does not have a will, GET ONE MADE. If any wills have not been reviewed within the last three years, contact your attorney because tax laws change often. Compile a list documenting where all important financial and legal papers are located and let all interested persons as to the location of the papers. Make an up-to-date list of attorney, accountant, trust officer, broker, insurance advisor, and other appropriate persons. Determine and compile information on the cost and approximate purchase date of all your assets, including your residence (which needs to be updated frequently in line with local property values). Think about assigning ownership rights of your group term life insurance to 86 children, a trust, or other appropriate recipient in order to reduce federal estate taxes. Review those who are designated as a beneficiary for your employee retirement or Keogh plan and other employee benefits. List carefully how assets will be passed on to beneficiaries. Resolve any items, regardless of how remote it may seem, in respect to the legal guardianship and personal custody of minor children. Review the will and any trust in effect, you have set up with your attorney. Be sure that you have considered the possibility if both spouses should die simultaneously or within a short time frame. This should include division of assets in order to take advantage of marital deduction and the estate tax exemption. If you and your spouse do not have durable powers of attorney, health care proxies, or living wills, consider having them drawn up soon. Are you considering or actually making significant cash gifts to members of your family that are likely to continue indefinitely? Are you planning to provide gifts to grandchildren within the next few years and is this in the will document? Is there any legitimate anticipation of a significant inheritance for you or spouse (winning at Lotto doesn’t count…)? Is either you or your spouse a non-U.S. citizen? Are assets held jointly with your spouse, other than residence and a working banking account? Do you have a have a simple will that leaves all property you own at the date of your death outright to your spouse? Do you or your spouse own any real property in a state other than the state of your residence? Is there a child or other relative with a serious medical problem who may require special consideration that should be considered in your will or trust instrument? Do you have substantially more or less property than your spouse? Have you moved your residence to a different state since you last executed your will? Have you named your estate as the beneficiary of your life insurance or your retirement plan benefits? 87 CHAPTER 5 STUDY QUESTIONS 1. 2. 3. When an individual dies their property can pass by contract designation, an example would be A. a codicil. B. a life insurance policy. C. joint tenancy with the right of survivorship. A Will A. controls the passage of property to others on its maker’s death. B. controls the disposition of jointly held property. C. must be prepared by an attorney. A Will may be contested for A. improper execution. B. incompetent beneficiary. C. the maker of the Will is over the age of 65. Chapter 5 Study Question – Answers & Sections 1 B – page 69 – 1. Contract Designation 2 A – page 72 – History of Wills 3 A – page 73 – Contesting Wills 88 CHAPTER SIX - FEDERAL ESTATE TAX: THE GROSS ESTATE Some men see things as they are and say "why?” I dream things that never were, and say, "why not?” George Bernard Shaw. INTRODUCTION The contents of the gross estate will vary in the number and amount of annuities, joint property, powers of appointment or life insurance. Basically the gross estate will include all items owned or controlled by the deceased at the time of death. Of course the amount included will always depend upon the value and the percentage of ownership the deceased had in the property. ESTATE TAXES The purpose of Federal Estate and Gift Taxes is to prevent the transmission of large estates without being taxed. It is often said that this tax is a legacy of the late 19th century when John Rockefeller and Andrew Carnegie created huge estates that Congress felt should be taxed. Now the estate tax reaches estates of middle and even lower-middle income class. Unfortunately, the larger estates usually have proper estate planning, so it is the middle and lowermiddle income classes which are the hardest hit by this tax. For most of 2010, the estate tax was repealed. However, the December 2010 tax law that extended the so-called Bush tax cuts retroactively reinstated the estate tax for 2010. This law also allowed the executor of an estate of a decedent who died during 2010 a choice of having the estate tax apply. If the estate tax applied to a decedent who died during 2010, then the capital gain or loss on any later disposition of that property is long-term capital gain or loss. Conversely, if the executor chose not to have the estate tax apply, then the holding period (and basis) are determined under special rules. If one sells property that was originally inherited from a decedent who died in 2010, they should contact the executor of the decedent's estate to confirm the holding period-and basis-in any property received. Also, they should also request a copy of Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent, if it was filed by the executor. WHO IS REQUIRED TO PAY FEDERAL ESTATE? Until late in 2010, there was no estate tax for people who died (i.e., decedents) in 2010. However, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 reinstated the estate tax but with some changes from prior law. The estate tax will apply for estates of decedents who died in 2010 and who die in 2011-2012. The estate exemption is $5 million and the top rate is 35%. The exemption is "portable" between spouses for 2011 and 2012, meaning the exemption amount of one spouse can pass on to the other at death. And, a spouse can still pass unlimited amounts to his or her surviving spouse without tax. 89 Unless Congress acts, after 2012, the estate tax laws will revert to 2001 levels-a 55% tax rate on estates worth more than $1 million. The changes to the estate tax in 2010 mentioned above refer to the fact that while the estate tax will apply for estates of decedents who died in 2010, the executor is able to choose the method to calculate basis for inherited assets. The first method is to automatically apply the estate tax and a stepped-up basis on the assets held within the estate. A "stepped-up" basis means that the basis of the property is valued at its fair market price at the time of the decedent's death. The alternative method is to elect to apply the rules that had been in place in 2010 prior to the new law by adopting a carryover basis. A "carryover basis" means that the basis of the assets is the same as in the hands of the decedent before death. The automatic stepped-up basis rules will be the default method; the carryover basis must be specifically elected by the executor. Generally, estates below $5 million would use the default method in order to get a stepped-up basis while not paying estate tax. You should consult your tax advisor to determine which method will be more favorable. Estate, Gift and Generation-skipping Transfer (GST) Tax Rates & Unified Credit Exemption Amount Estate, Gift and GST Highest Estate, Gift and Calendar Year Tax Exemption GST Tax Rates 2010 $5 million for estate, gift & GST tax Estate & Gift Tax 35%, GST 0% 2011, 2012 $5 million for estate, gift & GST tax 35% 2013 $1 million for estate, gift & GST tax 55% Note: Executor will be able to elect whether to apply the estate tax and use a stepped up basis for the rules that had been in place for 2010, i.e. no estate tax but using a carryover basis. While the estate tax exempts estates worth under $5 million from tax, it does not mean that tax planning is unnecessary. The-person(s) may be worth more than they think, such as real estate—even though there is a slump in real estate values, many people own homes that are worth more than what they paid for them. Further, regardless of the present economic turmoil and heightened volatility in stock and bond prices, there are those who still hold significant investment portfolios. And, in many cases, the proceeds of life insurance are also included in your taxable estate regardless of the beneficiary. The value of assets does not remain static and regardless of the economy, there are many who will have estates worth more than $5 million before they die. This means that a prudent person will focus on strategies that help to freeze the value of assets in the estate. Federal estate tax is a levy on the transfer of property at death. One’s gross estate will include the value of all property to the extent of their interest in it at the time of death. 90 TYPES OF PROPERTY INCLUDED IN THE GROSS ESTATE TANGIBLE PERSONAL PROPERTY, REAL ESTATE, AND OTHER ASSETS. This is property that one owns in their own name that is passed at death by will (or intestacy law), and is commonly referred to as “probate estate” and includes real estate, stocks, bonds, furniture, personal effects, jewelry, works of art and interest in his category includes property you own in your own name that is passed at death by your will or by state intestacy laws. Such property is commonly referred to as the probate estate. Examples include real estate, stocks, bonds, furniture, personal effects, jewelry, works of art, an interest in a partnership, an interest in a sole proprietorship, a bank account, and a promissory note or other evidence of indebtedness held by the individual. JOINTLY OWNED PROPERTY Normally, half of the value of property owned jointly by a husband and wife will be included in the estate of the first spouse to die and the unlimited marital deduction allows the transfer of the property from the deceased to the surviving spouse without being subject to federal estate tax. However, at the survivor's death the entire property will be subject to tax (provided that it is still held at the time of death). However, if two people who are not married own property jointly, the entire value of the property is included in the gross estate of the first to die except in those instances where the estate can prove that all or part of the payment for acquiring the property was actually furnished by the other joint owner. Further, if joint owners acquired property by gift or inheritance, only the fractional share of the property owned by the deceased is included. Jointly held property passes to the other owner automatically on death regardless if there is a Will or not. In many states, Transfer on Death (TOD) (or Totten Trust accounts) allows securities and bank accounts to pass directly to a beneficiary even if the property is not held in joint name. LIFE INSURANCE A decedent’s gross estate will include life insurance proceeds that are received (1) by or for the benefit of their estate or (2) by other beneficiaries if the deceased owned all or part of the policies at the time of death. "Ownership" is defined for this purpose as the power to change the beneficiary of the policy, the right to cancel the policy and receive the cash value, the right to borrow against the policy, and the right to assign the policy, among other things. One can transfer ownership of a life insurance policy to their children or to a trust for their family's benefit which can provide significant tax advantages. In order to keep the proceeds out of the estate, the gift must be made more than three years before death. The three-year waiting period can be avoided for a newly purchased policy if proper steps are taken to have someone else (e.g., a trustee of an irrevocable life insurance trust) apply for the policy and own it from its inception. These types of irrevocable life insurance trusts can be designed so that contributions each year to the trust by the insured can qualify for the annual gift tax exclusion (explained below). Setting up such a trust can be an effective way to get insurance proceeds to 91 without incurring gift or estate tax. EMPLOYEE BENEFITS PART OF GROSS ESTATE The value of payments from qualified pension plans, IRAs, and other qualified or nonqualified retirement plans payable to surviving beneficiaries or the estate of an employee (or the owner, in the case of a Keogh/HR 10 plan) generally is included in your gross estate. GIFT TAX PAID WITHIN THREE YEARS OF DEATH Gifts of property made during the lifetime of the taxpayer are generally not included in their gross estate, but must be figured in the estate tax calculation if they exceed the $13,000 annual gift tax exclusion. Life insurance proceeds are included in your estate if the policies or ownership of the policies were given away within three years of death, as are any gift tax paid within three years of the taxpayer’s death. Lifetime gifts in which a decedent retains some interest (e.g., a life income interest) or control (e.g., voting rights in closely held stock given as a gift) will be included in the gross estate. DEDUCTIONS AND EXCLUSIONS Deductions are allowed for funeral and estate administration expenses, and debts-such such as unpaid mortgages-and other indebtedness on property included in the gross estate and special deductions such as the marital deduction and the charitable deduction. FUNERAL AND ADMINISTRATION EXPENSES Funeral expenses include burial costs, costs for a burial lot, costs for future care of a grave site, and so on. Deductible administration costs include executor's commissions, attorney's fees, accounting fees, appraisal fees, and court costs. OTHER DEDUCTIBLE ESTATE EXPENSES For debts to be deductible, they must be enforceable personal obligations of the decedent, such as mortgages or personal bank loans, auto loans, credit card balances, utility bills, etc. The deductible amount also includes any interest accrued on such debt at the date of death. Transfers made under a marital property settlement because of a divorce may be treated as estate expenses. Taxes such as accrued property taxes, gift taxes unpaid at death, and income taxes are also deductible debts if they are accrued and unpaid at date of death. VALUATION OF ESTATE PROPERTY The value of property is included in an estate at its "fair market value," defined as the price at which property would change hands between a willing buyer and a willing seller. Property that trades on an established market are valued at the market value, e.g., publicly traded stocks and bonds are valued based on the average of the high and low selling price on the date of death (or, if elected, the date six months after death). The value of interests in closely held businesses or partnerships must generally be appraised, taking into account the business's as92 sets, earning capacity and other normal accounting factors. (Such information must be calculated by a qualified accountant or tax attorney.). The gross estate is valued as of the date of decedent’s death or six months later (also known as the alternative valuation date), whichever your personal representative elects. An election to value the estate six months after the date of death will generally apply to all assets in the estate, but is available only if the election results in a decrease in the gross estate and estate tax liability. The amount remaining after subtracting any allowable deductions is the decedent’s taxable estate. The federal estate tax is computed on this amount. Gifts made after 1976 are also factored in and can increase the marginal tax bracket of the estate. BENEFICIARY’S TAX STATUS In most cases, property acquired from a decedent gets a new basis. The Basis is generally the cost of an asset or the amount used to calculate the tax when the asset is sold. In most cases, the new basis is the fair market value at date of death or alternative valuation date, whichever is used for estate tax purposes. If the new basis is greater than the old basis, this is known as the "stepped-up" basis. The basis of property acquired from a decedent who passed away in 2010 will depend on whether the executor of the estate elects to apply the estate tax and stepped-up basis rules or the rules formerly in place in 2010 (i.e., no estate tax but "carryover basis"). The stepped-up basis rules will be the default. Therefore, if the property is inherited from a decedent who died in 2010 and the estate's executor did not opt out of the estate tax, then the beneficiary will get a stepped-up basis. On the other hand, if the estate did elect to not be subject to the estate tax, then they will generally receive a "carryover basis" equal to the lesser of the fair market value of the property on the decedent's date of death or the decedent's adjusted basis in the property. Putting some figures to this helps to explain this tax status. Assume that Bill had an estate valued at $4 million when he died in 2010. His adjusted cost basis in his assets totaled $2.5 million. If the executor of Bill’s estate did not make an election when preparing his estate tax return, the stepped-up basis rules would apply, and the recipient of his assets would receive a basis equal to the fair market value on the date of Bill’s death or $4 million. If the executor elected to use the carryover basis rules, transferred assets would only receive a basis equal to $2.5 million. However, the executor of a 2010 decedent can increase the basis of assets transferred by a total of $1.3 million plus any unused capital losses and net operating losses. An additional $3 million basis increase is allowed for property transferred to a surviving spouse, which means that property transferred to a spouse will be allowed a basis increase of $4.3 million. Specified types of assets are not eligible for this increase in basis. Nonresident aliens would only be allowed an increase in basis of $60,000, indexed for inflation after 2011. This would give the executor a conundrum as he would have to decide which family members (or other heirs) get tax-free assets and which ones would get assets with a “built-in capital gain. 93 CALCULATING ESTATE TAXES. The federal estate tax is progressive, ranging from a marginal rate of 18% to 35% in 2011. The 35% top rate will apply to estates larger than $5 million. CREDITS AND EXEMPTIONS ESTATE TAX EXEMPTION Each individual is entitled to an estate tax exemption and for years 2011 and 2012, the exemption is $5 million—meaning that the first $5 million of an individual's combined taxable gifts and transfers at death will not be taxed. If the exemption is used to offset gifts made by the decedent during his lifetime, the estate is reduced proportionately. This amount can change because of tax law changes, so the estate owned should make sure that the plan takes advantage of the estate tax exemption available under the law in existence at the time of your death. As an example if the decedent (Martha) had given a sizeable sum, say $500,000, to his daughter in 2009, when Martha dies, only $4.5 million of her state will qualify for the exemption. MARITAL DEDUCTION The Marital Deduction is a special deduction available only to married persons and applies only if the spouse receiving the assets is a U.S. citizen. An estate is allowed an unlimited deduction for the value of property transferred to the spouse of the deceased that, in effect, permits a couple to postpone paying any estate tax until the surviving spouse dies. There is an advantage when married individuals take advantage of both the estate tax exemption and the unlimited marital deduction as it reduces the federal estate tax to zero for the estate of the first spouse to die. Combining the exemption and the marital deduction is accomplished in most situations by placing property in a bypass trust which is used to take full advantage of a spouse's estate tax exemption. Usually, it provides income and discretionary distributions of principal to the deceased's surviving spouse. The amount that goes into these trusts is typically determined by a formula that puts the maximum possible amount into the trust without generating federal estate tax in the deceased spouse's estate. Any assets in excess of the remaining exemption either pass to the surviving spouse outright or remain in a trust that will qualify for the estate tax marital deduction. The bypass trust is advantageous as it allows assets to not be included in the surviving spouse's estate at his or her death, regardless of the amount in that trust at that time. PORTABILITY The tax law changes of 2011 provides that when a spouse passes away the surviving spouse can add to his or her own $5 million exemption, whatever amount of the exemption the deceased had not used during his or her lifetime. It requires that an election be made with a timely filed estate tax return for the deceased spouse, even though the estate of the deceased spouse many not be large enough to require the filing of an estate tax return. After 2010, a surviving spouse will be able to use the deceased spouse's unused exemption 94 for lifetime transfers as well as at the death of the surviving spouse. There is an exception, as portability does not extend to the generation-skipping transfer (GST) tax exemption. For reference, prior to 2011 for estates in excess of the estate tax exemption equivalent, a typical estate plan would fund a bypass trust with the decedent's remaining unused amount of estate tax exemption equivalent. However, the full value of the exemption of the deceased could go unused or even lost. Even though no estate tax would be due upon the death of the first spouse, a larger estate tax would be due upon the death of the surviving spouse. Now, under the new portability rules, there would still be no tax due on the first-to-die, however the deceased's exemption would not be unexploited as any of the deceased's unused exemption carries over to the surviving spouse. While the portability rules are valuable in allowing a deceased's unused exemption, the funding of a bypass trust should continue to be considered in an estate plan because portability is not allowed for GST tax exemptions—this means that a surviving spouse would not be able to use the unused GST exemption of the firstto-die. Further, the funding of a bypass trust at the death of the first spouse removes the exemption equivalent amount and the associated future appreciation from the surviving spouse's estate. Also, the traditional benefits of using a trust, such as creditor protection, should be considered as well as the possibility of the surviving spouse remarrying and the potential inability to use the first deceased spouse's unused exemption amount. The following examples explain the mechanics of how an estate or gift tax exemption can be transferred from a deceased spouse to a surviving spouse. If a husband died in 2011, having made taxable transfers of $3 million and having no taxable estate, an election is made on his estate tax return that allows his Wife to use his deceased spousal unused exclusion amount. In this example, as of the death of the husband, the wife has made no taxable gifts. Thereafter, the wife's applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from her dead husband), which she may use for lifetime gifts or for transfers at death— whatever her little heart desires. Taking this another step, for explanatory purposes, everything is the same except that the grieving widow subsequently marries again (Husband B) who, unfortunately, also predeceases his wife, having made $4 million in taxable transfers and having no taxable estate. An election was made on Husband B's estate tax return to permit his wife to use Husband B's deceased spousal unused exclusion amount. Even though the combined amount of unused exclusion of first and second husbands is $3 million ($2 million for the first husband and $1 million for Husband B), only Husband B's $1 million unused exclusion is available for use by the widow because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse of the surviving spouse (here, Husband B's $1 million unused exclusion). Now, the double-widow has an applicable exclusion amount of $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband B), which she may use for lifetime gifts or for transfers at death. But what would happen if the wife dies before Husband B assumes room temperature? This would mean that her applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from first husband). If the wife made no taxable transfers she would have a taxable estate of $3 million. An 95 election is made on the wife’s estate tax return to permit her second husband to use his wife’s deceased spousal unused exclusion amount, which is $4 million —her $7 million applicable exclusion amount less her $3 million taxable estate). Under this provision, her second husband’s applicable exclusion amount is increased by $4 million (i.e., the amount of deceased spousal unused exclusion amount of the wife). STATE DEATH TAX Most states impose some kind of inheritance or estate tax, often simply the amount of the federal credit for state death taxes. But since the federal state death tax credit had been eliminated for decedents dying in 2005 through 2009, there would be no state estate tax. This amount that would be lost is too valuable to ignore, so in order to avoid this result, many states enacted estate taxes that are not tied to the federal credit. Also, some states revised their tax laws to set their estate tax exemption at an amount that is less than the federal estate tax exemption. Also, there are a few states that do not allow an unlimited marital deduction, as the federal government does. Consequently, in many states it is possible to have a taxable estate for state estate tax purposes but not for federal purposes. In these states, state death tax considerations may influence how your estate plan should be structured. To further complicate this situation, some states have much lower estate tax exemptions than the federal exemption. That means that in more money might be subject to estate taxes in the state of residence under federal rules—however, if the person is over the exemption, they may be lower than the federal tax rate. For instance In New Jersey in 2011 was only $675,000 but the tax rate was 16%. Therefore, residents of New Jersey (and those who own real estate in New Jersey may face an unexpected tax bill if they are worth more than $675,000 which is considerably less than the federal estate exemption of $ 1 million. This problem can be solved by using a flexible estate plan that allows for changes as laws, both federal and state, change. Another way to save on state estate taxes is to give money to heirs during lifetime—of course, there can be some states that impose gift taxes so one must check this out. There are estate planners and estate lawyers who are encouraging their clients to who reside in a high tax area, to relocate their residence to a state with no state estate tax, such as Florida (as if weather is not the only reason people move to Florida!). A few states allow married couples to put the amount of money subject only to state income taxes into a “state qualified terminable interest property tax (QTIP) which provide a surviving spouse with an income stream but delay estate tax until after the surviving spouse dies. For those who live in a state with no estate tax but who have homes in taxable states, sometimes by placing the taxable state’s property into an entity such as a limited liability company (LLC) whereby the property may be taxed under the estate of the state where the person resides, rather than those of the state where the property is located. FOREIGN DEATH TAX CREDIT A credit is allowed against the federal estate tax for any death taxes actually paid to a foreign country, Puerto Rico, or the Virgin Islands on property that is also subject to the federal estate tax. The credit is limited to the U.S. tax attributable to the property taxed by the foreign country. 96 CREDIT FOR TAX ON PRIOR TRANSFERS Under certain circumstances a credit is allowed against the federal estate tax for part or all of any estate tax paid on property transferred to the present decedent. QUALIFIED DOMESTIC TRUST (FOR NON-CITIZENS) A will can be drafted so that a person’s property is placed in a special type of trust that benefits a spouse who is not a U.S. citizen called a Qualified Domestic Trust (QDOT). The trust enables estate tax on the property to be postponed until the property is distributed out of the trust or the surviving spouse dies. It permits property to qualify for the marital deduction if certain requirements-which provide that the property will eventually be subject to estate taxare met. “Gross Estate” will be discussed in more detail later, but as a general rule, a Gross Estate for tax purposes is all the property owned by the individual, or over which he/she has a controlling interest. Another general rule is that property is included in the gross estate at its fair market value at the time of death. THE GROSS ESTATE The Internal Revenue Code devotes ten sections to include property in an estate. Some general observations are in order prior to discussing the various categories. OBSERVATION I: The gross estate includes the fair market value of all assets owned by the decedent as of the date of death, including life insurance policies. OBSERVATION II: Transfers between spouses generally qualify for the unlimited marital deduction and are free of current tax, (I.R.S. Section. 2056). OBSERVATION III: If the value of the estate assets decline during the first six months after death (which often happens if the decedent owned a business) the value as of six months after death may be used on the tax return. OBSERVATION IV: Lifetime gifts which exceed the annual exclusion ($ 13,000 per donee per year) will also reduce the estate owner's unified credit. OBSERVATION V: Some transfers made during one's lifetime may be brought back into the decedent's estate. Four examples would be: 1. Transfer of life insurance policies with three years prior to death. (I.R.S. Sec. 2035). 2. Transfer of an asset from which the donor retains an income for his/her life (I.R.S. Sec 2036). 3. Transfer of an asset where donor retains the right to alter or terminate the transfer. (I.R.S.. Sec. 2038). 4. Assets placed in joint tenancy with another are included in the gross estate. The federal estate tax, paid by the estate, is a tax on the right to transfer property when a person dies. The gross estate is the total value of the person's property at the time of death. The estate tax is paid by the estate and not by the individuals receiving the property. Con97 stitutionally, the federal estate tax is not a tax on the property but is a tax on the privilege of transmitting property. In reality, the federal estate tax is a tax on the transfer or relationships (ownership) to the property at death. Also same states levy an inheritance tax, which is a tax on the right to receive property. An inheritance tax is paid by the individuals who receive the property that was transferred by the decedent. STATE INHERITANCE TAXES AND REAL ESTATE State Inheritance taxes are always a consideration in Estate Planning, and real estate investors can have the biggest problem with those particular taxes. The Federal Estate Tax doesn’t raise much revenue as it is designed to limit the ability of person to pass wealth on to subsequent generations. But state inheritance taxes are used to bringing considerable revenue to the states and state inheritance taxes can be quite high. It should be noted that the state in which the property is located is the one that imposes the inheritance tax. Even if one moves to a tax-free state, such as Florida, if property is owned in another state – such as New York – the property in New York will be hit with a high inheritance tax. One solution is to incorporate the property or put it into a partnership. That way, the property owner is not an "owner” of property, but an owner of stock. Personal assets such as this stock, would be taxed in the state of residence at time of death. Since inheritance taxes vary from state to state, an attorney should always be consulted to make sure that this will work in the state in which the property is located. I.R.S. SECTION 2033-2042 SECTION 2033 VALUE OF PROPERTY INTERESTS AT TIME OF DEATH I.R.S. Section 2033 refers to the value of any property interests at the time of death to the extent of that interest—“The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death. A. General inclusion rule: Generally means that the gross estate includes the value of all property interests, real or person, tangible or intangible, of an individual on the date of death to the extent of the individual's interest in the property. Remember that property rights are determined by state law and federal law dictates whether those rights are taxed. B. Types of includible property interests must be those that are beneficial. A mere legal title does not mean the property is includible. C. Limitations of Section 2033: interests in which the decedent possessed no right to pass the property at death, are not includible. If the decedent is one of five owners (20%) tenant-in-common of a piece of land, only the 20% is included in the gross estate. Also, if the decedent only had a life estate in the property (right to enjoy the property for life, but not to leave the property to others), then only the value of this life estate is included in the gross estate. D. Three factors to determine inclusion: 1. Types of property includible under State or Federal Law. 98 2. If decedents’ interest was large enough to warrant inclusion. 3. Whether decedents possessed interest at time of death and to what extent. FOURTEEN ITEMS OF INCLUSION A listing of all of the property that would be included in the gross estate illustrates why this section can be called the "catch-all" section. 1. Any interest in real estate. 2. Cash, money equivalents. 3. Stocks, bonds, notes, mortgages, outstanding loans to others. 4. Income tax refunds not yet paid. 5. Patent, copyrights. 6. Property subject to indebtedness. 7. Amounts to which decedent was entitled before death such as legitimate claims for damages for pain and suffering. 8. Medical insurance reimbursement due to a decedent. 9. Dividends declared and payable before death but not yet received. 10. Income in respect of a decedent, all rights to income accrued as of the date of death (renewals!). 11. Miscellaneous property such as partnership or corporate interests. 12. Tangible personal property (furniture, jewelry) but not property belonging to a spouse. 13. Vested rights to property in the future. Alex creates a trust under which his mother, Sally, is to have the income off the trust for life. At the death of Sally, the trust will revert to Alex. (Reversionary Trust). A’s interest in the trust would be computed actuarially (i.e., Alex’s interest prior to Sally’s death, would be based upon the life expectancy of Sally). 14. Value of decedent’s share of property held in conjunction with others (property held as a tenant is common). SECTION 2033A FAMILY-OWNED BUSINESS INTERESTS The Taxpayer Relief Act of 1997 (TRA 97) attempts to assist owners of family-owned businesses in the estate tax area. This Section authorizes an estate to exclude a qualified family-owned business interest from the decedent’s gross estate, to the extent that the exclusion plus the unified credit does not exceed $1,300,000. The maximum amount excludable under Section 2033A for a person that dies in 1999 will be $650,000 ($1,300,000 minus the 1999 unified credit amount of $650,000). It has been reported that an unanticipated problem under this Section arises, because of the lack of coordination between the new family-owned business exclusion and the increase in the unified credit. The unified credit under TRA 97, increases by specified amounts as stated earlier in this text. Over a 9-year period, the amounts range from $625,000 in 1998, to $1,000,000 in 2006 and thereafter. For instance, in 1998, the family business interest excluda99 ble in 1998 would have been $675,000 ($1,300,000 minus the $625,000 exclusion) and so the maximum excludable amount in 2006 would be only $300,000 ($1,300,000 minus $1,000,000). To correct this problem, the Tax Technical Corrections Bill of 1997 coordinates the increase in the unified credit with the decrease in the family owned business exclusion so that there will be neither an increase nor a decrease in the total estate tax on estate holding qualified family-owned businesses as increased in the unified credit are phased in. By the time that this text is published, this problem may have been totally corrected, but it is discussed here in case the question ever arises. There are very strict eligibility requirements for the use of the exclusions under this Section 2033A. The major requirements are: A. The business interest must exceed 50% of the decedent’s adjusted gross estate. B. The business must pass complex “material participation” tests which requires that the business must have been operated by the decedent or members of the family during five of the preceding eight years. C. “Qualified heirs” which includes certain employees, must have acquired the business. D. Qualified heirs must agree to pay an additional estate tax if within ten years after the decedent’s death, certain disqualifying events occur, such as the sales of the business to “outsiders”, i.e. not family members or certain employees. E. The Estate must elect the exclusion, i.e. the exclusion is not automatic. While these exclusions may be detailed and considered as “strict”, the fact remains that if the business can be passed on to family members or to long-time employees, a very substantial tax savings has been provided. In any event, this is a complicated legal provision of TRA 97, and most certainly should be reviewed by an attorney in those cases of family farms or family-owned businesses passing to family members or to long-time employees. SECTION 2033A – EXCLUSION OF FARMLAND Section 2033 A pertains to determining the value of the gross estate when farmland is concerned, with the basic rule that the value of the gross estate shall not include the adjusted value of qualified farmland included in the estate. In order to qualify, this pertains to a citizen or resident of the US and the decedent for 3-taxable years period had an average adjusted income not exceeding the average adjusted gross income as stated in the Section; this also applies to qualified farmland defined in the Section. 50% of more of adjusted value of the gross estate consisted of real or personal property used as a farm for farming purposes and 25% of the adjusted value of the farmland is used as property for farming. The decedent prior to death for 8 years, there have been 5-year or more periods when the farmland was owned by the decedent or a family member and there was “material participation” by decedent and/or family member in operating the farm. “Qualified Farmland” and “Adjusted Value are defined basically, as farmland used for farming in the US and the Adjusted Value means the value of the farmland reduced by amounts set forth in the Section. “Recapture Tax” is discussed as a leveling method between taxable amounts of value in farmland if such tax is greater than adjusted value of farmland at time of death. 100 There is an exception for “woodlands” property, defined as standing timber on qualified woodland under the forest stewardship plan (16 U.S.C, 2103a). Further, a qualified conservation contribution by gift or otherwise will not be considered a disposition of property under the Section. The dollar limits for this Section are as stated under the IRS Code (section 2031(c) ) The limitation on the exclusion is $5 million. Any increase in percent of value of land excludable is amended to 50% and percentage points to 2.5 percentage points. SECTION 2034 DOWER OR COURTESY INTERESTS Dower rights refers to property set aside for a widow under state law if decedents’ interest in the property has been established. These are rights provided for females. Courtesy rights are widowers’ rights in a deceased wife's property. Both rights are an inalienable right that a wife and husband have to a share of the deceased spouse's property. These rights have been abolished in half of the states. SECTION 2035 CERTAIN GIFTS AND TRANSFERS MADE AND GIFT TAXES PAID WITHIN THREE YEARS OF DEATH. Sec. 2035. Adjustments for certain gifts made within 3 years of decedent's death (a) Inclusion of certain property in gross estate If (1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent's death, and (2) the value of such property (or an interest therein) would have been included in the decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included. (b) Inclusion of gift tax on gifts made during 3 years before decedent's death The amount of the gross estate (determined without regard to this subsection) shall be increased by the amount of any tax paid under chapter 12 by the decedent or his estate on any gift made by the decedent or his spouse during the 3-year period ending on the date of the decedent's death. (c) Other rules relating to transfers within 3 years of death (1) In general For purposes of (A) section 303(b) (relating to distributions in redemption of stock to pay death taxes), (B) section 2032A (relating to special valuation of certain farms, etc., real property), and 101 (C) subchapter C of chapter 64 (relating to lien for taxes), the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, during the 3-year period ending on the date of the decedent's death. (2) Coordination with section 6166 An estate shall be treated as meeting the 35 percent of adjusted gross estate requirement of section 6166(a)(1) only if the estate meets such requirement both with and without the application of subsection (a). (3) Marital and small transfers Paragraph (1) shall not apply to any transfer (other than a transfer with respect to a life insurance policy) made during a calendar year to any donee if the decedent was not required by section 6019 (other than by reason of section 6019(2)) to file any gift tax return for such year with respect to transfers to such donee. (d) Exception: Subsection (a) and paragraph (1) of subsection (c) shall not apply to any bona fide sale for an adequate and full consideration in money or money's worth. (e) Treatment of certain transfers from revocable trusts. For purposes of this section and section 2038, any transfer from any portion of a trust during any period that such portion was treated under section 676 as owned by the decedent by reason of a power in the grantor (determined without regard to section 672(e)) shall be treated as a transfer made directly by the decedent. This rule has undergone changes throughout the years as Congress grappled with what was fair and equitable. Finally in 1981 the Economic Recovery Tax Act stated that gifts made within three years of death are not included in the gross estate for decedents dying after December 31, 1981. There are five exceptions: Exception 1: Transfers with retained interest for life. This could include transfers in which the decedent reserved the right to: 1. Receive or determine who receives income from the property unless given up more than three years before death. 2. Designate who is entitled to possession or enjoyment of the property either for life or for a period that did not actually end before death or that cannot be determined without reference to the death unless the property was given up more than three years before death. Lifetime transfers are included in the gross estate would be: 1. Use, possession or other enjoyment of the transferred property for the decedent. 2. Right to name other persons who may possess or enjoy the transferred property or income for the property. Exception 2. Transfers taking effect upon death. These transfers are included in the gross estate: A. Transfers to other that can be obtained only by surviving the decedents and if the decedent retained a reversionary interest in the property's value at death. B. These transfers are includible if the decedent exercised the power or transferred the power within three years prior to death. C. If the decedent retained the power, the property is includible under Section 2037. 102 Exception 3. Transfer in which decedent reserved the right to alter, amend, revoke or terminate the transfer or the power to affect the beneficial interest in the transferred property. If the decedent disposed of these rights within three years before death, the property's value is includible under Section 2035. Exception 4. Transfers by the insured of life insurance policies. Gifts of life insurance within three years of death are includible in the gross estate at full value of the proceeds whether or not a gift tax return was required. Note: However, premiums paid or deemed paid within three years of death to the extent that the payments would not have caused policy proceeds to be included in the gross estate under prior law, are not included. Exception 5. Gift Taxes Paid. Gift taxes on gifts within three years of death made by the decedent or the decedent's spouse are includible in the gross estate. Exceptions To The Three Year Rule 1. Gifts worth less than the amount of the annual exclusion ($ 13,000) because no gift tax return is required. 2. The value of all property effectively transferred within three years of death is included only for determining qualification for: A. Section 6166 Estate Tax Deferral. B. Stock redemption to pay administration, and funeral expenses and Estate Taxes under Section 303. C. Estate Tax liens. BASIS FOR TRANSFERRED PROPERTY INCLUDIBLE (For reference, the Section is quoted with explanation following) SEC. 2035. ADJUSTMENTS FOR CERTAIN GIFTS MADE WITHIN 3 YEARS OF DECEDENT'S DEATH (a) Inclusion of certain property in gross estate If (1) the decedent made a transfer (by trust or otherwise) of an interest in any property, or relinquished a power with respect to any property, during the 3-year period ending on the date of the decedent's death, and (2) the value of such property (or an interest therein) would have been included in the decedent's gross estate under section 2036, 2037, 2038, or 2042 if such transferred interest or relinquished power had been retained by the decedent on the date of his death, the value of the gross estate shall include the value of any property (or interest therein) which would have been so included. (b) Inclusion of gift tax on gifts made during 3 years before decedent's death The amount of the gross estate (determined without regard to this subsection) shall be increased by the amount of any tax paid under chapter 12 by the decedent or his estate on any gift made by the decedent or his spouse during the 3-year period ending on the date of the de103 cedent's death. (c) Other rules relating to transfers within 3 years of death (1) In general For purposes of (A) section 303(b) (relating to distributions in redemption of stock to pay death taxes), (B) section 2032A (relating to special valuation of certain farms, etc., real property), and (C) subchapter C of chapter 64 (relating to lien for taxes), the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer, by trust or otherwise, during the 3-year period ending on the date of the decedent's death. (2) Coordination with section 6166 An estate shall be treated as meeting the 35 percent of adjusted gross estate requirement of section 6166(a)(1) only if the estate meets such requirement both with and without the application of subsection (a). (3) Marital and small transfers Paragraph (1) shall not apply to any transfer (other than a transfer with respect to a life insurance policy) made during a calendar year to any donee if the decedent was not required by section 6019 (other than by reason of section 6019(2)) to file any gift tax return for such year with respect to transfers to such donee. (d) Exception Subsection (a) and paragraph (1) of subsection (c) shall not apply to any bona fide sale for an adequate and full consideration in money or money's worth. (e) Treatment of certain transfers from revocable trusts For purposes of this section and section 2038, any transfer from any portion of a trust during any period that such portion was treated under section 676 as owned by the decedent by reason of a power in the grantor (determined without regard to section 672(e)) shall be treated as a transfer made directly by the decedent. Because of the three-year rule: 1. Section 2035 property receives the date of death value for Federal Estate purposes with a stepped-up basis (property kept until death). 2. Property given away during lifetime but more than three years before death retains the donor's basis plus gift tax attributable to pre-transfer appreciation. In 1979 Don purchased real estate for $2,000,000 and immediately gave the land to his daughter. Don died four years later when the real estate was valued at $2,500,000. If Don held the property, his daughter's basis would be $ 2,500,000 because of the step-up rule. But the daughter's basis will be $ 2,000,000 (same as Don's basis) since Don gave the property to his daughter. The daughter must pay capital gain taxes upon the sale of the property. REVALUATION OF GIFTS FOR ESTATE TAX PURPOSES 104 The Tax Relief Act of 1997 (TRA 97) addressed the three-year statute of limitations for Gift Taxes in the following manner: After a gift tax return has been filed and the three-year statute of limitations has expired without the I.R.S. challenging it, a taxpayer would normally assume that the value of the gift could not be altered by the I.R.S. later. However, because of the unification procedure of gift and estate taxes, courts have allowed for a predetermination of a gift subsequent to expiration of the statute of limitations in order to permit determination of the appropriate tax rate bracket and unified credit for estate tax purposes. In other words, once a person had filed a gift tax return and there had been no challenge by the I.R.S. for a period of 3 years, the taxpayer thought that the I.R.S. could not go back and reevaluate the gift. But because the estate tax and the gift tax both apply for the unified gift, some courts decided that for estate tax purposes the I.R.S. could re-evaluate the gift. TRA 97 now provides that a gift cannot be revalued for purposes of estate taxation after the statute of limitations has expired, provided that the value of the gift had been disclosed in a manner adequate to appraise the I.R.S. of the nature of the gift. Further, the Tax Technical Corrections Bill which was passed following TRA 97 for the purpose of defining some of the provisions of TRA 97, states that the value of a prior gift is the value of such gift as finally determined, even if no gift tax was assessed or paid on the gift. It has been suggested that the three-year rule ramifications can be avoided in respect to life insurance. Often, persons use life insurance for estate planning by placing the policy in an irrevocable life insurance trust (discussed later). This avoids being subject to Section 2035 by creating such trust and then have the trust apply for the life insurance policy (instead of purchasing life insurance and then creating the trust. While may appear to solve the problem, a tax attorney or accountant should be consulted. SECTION 2036 TRANSFER WITH RETENTION OF A LIFE INTEREST The gross estate will include all property transferred gratuitously by the decedent during the decedent's lifetime in which the decedent retained or reserved either the right to use, possess or enjoy the property or to receive the property income or the right to designate, (either alone or with someone else) the persons who should possess or enjoy the property or the property's income. These rights must be retained or reserved in situations as illustrated in the following Consumer Applications: Hal makes a gift of an original Hawthorne Manuscript to Terry but reserves the right to keep the manuscript in his home for life. The manuscript's value will be included in Hal's gross estate. Hal conveys his personal residence to Terry by deed but reserves the right to live in the house 105 rent-free for life. The value of the property at the time of death is includible in Hal's gross estate. Note: The Donor’s retention of a substantial economic benefit is all that is necessary for the including in the Donor’s gross estate Kay, a decedent, was the life income beneficiary of a Testamentary trust created by Kay's uncle. Kay did not retain a life estate because she did not possess the original trust property, but she was allowed to transfer additional property to the trust. Kay added $100,000 to the existing $ 400,000 principal during her lifetime. At Kay's death, all trust property passed to her heirs. If the trust was required to distribute all income currently and the trust's value at Kay’ death was $500,000, $100,000 is includible in Kay's gross estate. Note: Principal contributed by a decedent to a Testamentary trust created by someone else is considered a retained interest and is includible in the gross estate. A decedent retains the right to income to the extent that the income is to be used to discharge the decedent's legal obligation (for example: Support of dependent children). Reciprocal trusts which are created by a husband and wife for each other as life beneficiaries are included in the gross estates. The property of each trust is includible in the life beneficiary's estate if the arrangement leaves both grantors in the same economic circumstances in which the grantors would have been had the grantors named themselves as life income beneficiaries. 1. Transfers of stock of controlled corporation with the retention of voting rights are considered retention of the enjoyment of the property and the stock's value is includible in the gross estate. 2. Decedent's retention or reservation of property for a period not determinable without preference to the decedent's death is includible in the gross estate. John transferred property to a trust with the stipulation that he receives quarterly income installments. Also there is a condition that no part of the income accruing during the quarter in which John dies is to be paid to John or to John's Estate. The value of the trust property is includible in the gross estate. 3. Any period that does not end before the decedent's death. Keep in mind that the value of property includible under this section is reduced by the value of any interest income that is: a. Not subject to the decedent's interest and power. b. Actually being enjoyed by someone else at the time of death. 106 Jamie transferred 3,000 shares of IBM stock to his son but retained the right to receive dividends from one-third of the shares. The value of 1,000 shares will be included in Jamie's gross estate upon death. Carl transferred a tract of law to his son, Adam, and reserved the right to the property income for five years. Carl died after three years. The entire value of the property is includible in Carl's Estate. SUMMARY “The value of all property over which the decedent retained the right to designate alone or with someone else who may enjoy or possess the property as well as the right to vary beneficial interests, is includible in the gross estate”. This would include the situation when a decedent created an irrevocable trust, naming someone else as beneficiary but naming the decedent as trustee and the decedent had the power to accumulate or distribute income because the beneficiaries are denied the possession or enjoyment of the income. Property held in an irrevocable trust will not be included in the grantor's gross estate if the grantor merely retained the right to appoint a successor trustee other than the grantor upon resignation of the original trustee. If a grantor retains the ability to change corporate trustees without cause, the trust corpus is includible in the grantor’s gross estate. Note: The amount includible in the gross estate under Sec. 2036 is the value of the entire property transferred as of the date of death, not just the value of the interest retained or controlled. SECTION 2037 TRANSFER THAT TAKES EFFECT AT DEATH The gross estate includes the value of property transferred by the decedent for less than full and adequate consideration if the possession or enjoyment of the transferred property can be obtained only by the beneficiary surviving the death and if the decedent retained a reversionary interest worth more than 5% of the transferred property value immediately before death. A reversionary interest means the ability to have transferred property returned to the decedent. The important aspects of reversionary interest are: 1. It would include the possibility that the transferred property either may return to the decedent or the estate or may be subject to the decedent's power of disposition. 2. It does not apply to the reservation of a life estate or to the possibility of receiving income solely from the transferred property only after someone else's death. 3. It would not include the possibility that the decedent may receive an interest in the transferred property by inheriting the property through another's estate. 107 SECTION 2038 REVOCABLE TRANSFER Section 2038 relates to the power to alter, amend, revoke or terminate or to affect beneficial enjoyment. If any of these powers exist at death, the value of the property subject to the power is includible in the decedent's gross estate. A. This is true whether the power is exercisable by the decedent alone or with someone else. B. Types of powers covered under this section include the power to change beneficiaries, hasten the time that the beneficiary can receive the property and increase or decrease the amount of property allocated to any beneficiary. Two exceptions to this rule are: 1. If the decedent's power can only be exercised with the consent of all parties having an interest in the property. 2. If the power added nothing to the parties rights under local law. Other considerations of Section 2038 includes power to: A. Revoke or terminate a trust to which property is transferred. B. Control and manage trust property except as limited to mechanical or administrative duties only. C. Change beneficiaries or vary amounts distributed. D. Appoint by Will or change beneficiaries’ shares by Will. E. Revoke. F. Invade a trust created by another for whose benefit the decedent created a reciprocal trust. Section 2038 does not cover powers that (1) is contingent on the happening of some event, (2) allows addition to the corpus, and (3) are created by others with funds not derived from the decedent and not supported by similar trusts created by others. SECTION 2039 ANNUITIES. Annuities are periodic payments over a set time. The decedent's gross estate will include the present value of an annuity receivable by a beneficiary as a result of surviving the decedent. An annuity is included in the gross estate when payable to the decedent: 1. For life, then payable to beneficiary. 2. For a period that did not end before death. 3. For a period ascertainable only with reference to date of death. If the annuity ends at the decedent's death, the annuity is not includible in the gross estate if payments to a beneficiary are not provided for afterward. 108 Key factor: Whether or not the decedent had an enforceable right to receive payments from the plan during lifetime. Five annuities includible in gross estate: 1. Contracts under which the decedent received or was entitled to receive an annuity or other payment immediately before death and for the duration of life with stipulation that payments continue to beneficiary under decedents’ death. 2. Contract under which decedent received payments prior to death together with another person for joint lives with the stipulation that payments continue to survivor after death of any other individual (joint and survivor annuity). 3. Contract between decedent and employer under which decedent received or was entitled to receive annuity or other payment after retirement for life with payments to beneficiary upon death. 4. Contract between decedent and employer that provided for annuity or other payments to surviving beneficiary if decedent died prior to retirement or before expiration of a certain time. 5. Contract under which decedent was receiving or was entitled to receive an annuity or other payment for a specified time period immediately before death with payments to continue to named beneficiary if decedent died before time expiration. Key Factor: Basically, if the beneficiary receives any benefits under an annuity or annuitylike arrangement, these payments are included in the gross estate. AMOUNT INCLUDIBLE. A. Survivorship: An annuity is included in the gross estate to the extent that decedent paid the purchase price. If the decedent paid the total price, the whole survivorship interest (joint and survivor annuity) enters the estate. If decedent paid 30% of the annuity and spouse (survivor) paid for 70% of the annuity, only 30% of the value of the survivor's income interest is included in the estate. B. Excluded under Section 2039. All amounts are paid as insurance on decedent’s life. Life insurance proceeds are covered under I.R.S. Section 2042. C. Non-qualified retirement income. If employee dies before retirement age, the death benefit is treated under general annuity rules, which means it is included in gross estate. D. Valuation of an annuity: 1. Commercial annuity contracts (sold by company in the business of doing so): valued in comparison to similar contracts being sold by the company on the date of decedents’ death. 2. Annuity benefits are valued as of date of death of a primary annuitant. No alternate valuation date is possible because an annuity reduces in value by mere lapse of time. 3. Lump sum payments are included in gross estate. 4. Payment in form of annuity may be excluded from gross estate if payable to someone other than Executor or estate (e.g., Keogh Plans, US Civil Service Re109 5. tirement Plans). Constructive receipt. Annuities are included in the gross estate if the decedent had a right to have the plan proceeds distributed to decedent while alive. ESTATE TAXATION OF ANNUITIES. A. A life annuity with no certain period does not enter gross estate. B. Life annuity with certain period. If death is before end of period, present value of remaining payments enter gross estate. C. Joint and survivorship life annuity enters estate of first to die in proportion to total premium paid. SECTION 2040 JOINTLY HELD PROPERTY WITH RIGHT OF SURVIVORSHIP BETWEEN SPOUSES. Where property is held jointly with right of survivorship between spouses the estate of the first spouse to die will include one-half of the value of the property regardless of which spouse furnished the money to purchase the property. Three rules dictate this type of ownership: 1. It is mandatory for jointly held property between spouses. 2. When the surviving spouse dies 100% of the property will be included in the surviving spouse's estate. 3. When an individual dies, only one half of the property was included in the gross estate, therefore, only that one-half will receive a stepped-up basis if the surviving spouse sells the property. Creation of a joint interest in property between spouses is no longer considered a gift. Present-interest gifts between spouses qualify for the unlimited gift tax marital deduction. In 1965, Bartle and Mabel, husband and wife, bought Whiterapids as joint tenants with a right of survivorship. They paid $46,000 cash for the property consisting of 24 acres of unimproved real estate. When Bartle died April 15, 1985, Whiterapids was valued at $500,000. 1. Assume that Bartle has furnished all of the $46,000 purchase price. At his death, one-half the value of Whiterapids would be included in his gross estate. 2. Assume that Mabel had furnished all of the $46,000 purchase price and that Bartle had died. One-half of the value of Whiterapids would still be included in Bartle's estate. 3. In 1988, Mabel dies. The value of Whiterapids is now valued at $585,000. 100% of the value is included in Mabel's estate. (Continued next page) Bartle dies in April 1985. One-half of the value of Whiterapids ($250,000) will be included in his gross estate regardless of how much money he furnished to by the property! In 1986, Mabel 110 sells Whiterapids for $550,000. One-half of the amount included in Bartle's estate receives a stepped-up basis to $ 250,000. The other one-half belonging to Mabel will be valued at the original cost basis of $ 23,000 (½ of $46,000). Total basis Mabel has would be: Sales price = $550,000 Less basis 23,000 250,000 = (273,000) Total gains $277,000 The "consideration furnished rule" (better known as the Percentage-Of-Contribution Rule) requires inclusion of the full value of jointly owned property, except to the extent that the survivor can prove funds used to acquire the property. The test is what was paid for the asset, not who owned the asset? If one person gives funds to the other with less than the full and adequate consideration, the "gift" does not switch ownership. This rule applies to all joint tenancies with right of survivorship other than those held between spouses. Tracing the contributions of joint owners (other than between husband and wife): 1. Contribution of the survivor must not be traceable back to the decedent. Joyce cannot receive a gift of $ 25,000 from her brother, invest the $ 25,000 in property with him and then claim that the contribution was hers. 2. Contributions that come from income of gift property are not charged back to the donor. Note: If property was acquired by gift/bequest/inheritance by a non-spouse joint owner, only the value of the fractional interest of the first tenant to die enters the gross estate. ADVANTAGES OF JOINT TENANCIES: 1. 2. 3. 4. 5. Free from claims of creditors of the deceased owner. May save state inheritance taxes. Avoids Probate delays (and costs) and property passes directly to the survivor. Enhances family solidarity. Unlike a Will, a joint tenancy is not open for public scrutiny and cannot be "broken" MAJOR DISADVANTAGES OF JOINT TENANCIES: 1. Decedent can provide no restriction or management advice as can be done through a Will and trust. (An alternative would involve keeping the property in sole ownership). A Stepped-up basis is only available on one-half of the property. This means that tax 111 savings may not be worth as much as the potential capital gain tax and fully stepped-up basis. 2. Establishing the value of the joint tenant's interest. The rule dealing with valuation of jointly held property between spouses when the property was a closely-held business has been repealed by the automatic 50-50 division instituted by the Economic Recovery Tax Act. 3. Property held by Spouses as tenants by the entirety automatically enters the estate of the first spouse to die. Jointly owned property to the extent included in the gross taxable estate that passes to the spouse will qualify for the marital deduction. Under ERTA the maximum marital deduction has been increased to 100% of the property transferred from one spouse to the other, either by gift or at the first spouse's death. An unlimited amount of property can be passed between spouses without any estate or gift tax. SECTION 2040 JOINT INTERESTS The value of the gross estate shall include the value of all property to the extent of the interest therein held as joint tenants with right of survivorship by the decedent and any other person, or as tenants by the entirety by the decedent and spouse, or deposited, with any person carrying on the banking business, in their joint names and payable to either or the survivor, except such part thereof as may be shown to have originally belonged to such other person and never to have been received or acquired by the latter from the decedent for less than an adequate and full consideration in money or money's worth: Provided, That where such property or any part thereof, or part of the consideration with which such property was acquired, is shown to have been at any time acquired by such other person from the decedent for less than an adequate and full consideration in money or money's worth, there shall be excepted only such part of the value of such property as is proportionate to the consideration furnished by such other person: Provided further, That where any property has been acquired by gift, bequest, devise, or inheritance, as a tenancy by the entirety by the decedent and spouse, then to the extent of one-half of the value thereof, or, where so acquired by the decedent and any other person as joint tenants with right of survivorship and their interests are not otherwise specified or fixed by law, then to the extent of the value of a fractional part to be determined by dividing the value of the property by the number of joint tenants with right of survivorship. (b) Certain joint interests of husband and wife (1) Interests of spouse excluded from gross estate. Notwithstanding (above), in the case of any qualified joint interest, the value included in the gross estate with respect to such interest by reason of this section is one-half of the value of such qualified joint interest. (2) Qualified joint interest defined The term ''qualified joint interest'' means any interest in property held by the decedent and the decedent's spouse as (A) tenants by the entirety, or 112 (B) joint tenants with right of survivorship, but only if the decedent and the spouse of the decedent are the only joint tenants. SECTION 2041 POWERS OF APPOINTMENT General power of appointment means a power over property. This power is so broad that the power approaches actual ownership or control of the property. An estate owner may reserve a power by which one can appoint property to anyone without limitation including themselves or estate. There are six elements of the power of appointment: 1. Creator (Donor): The owner of property who directs that the property will be transferred subject to a power of appointment. This is generally done in the Will, but can be done during life by including the power in his deed. 2. Recipient (Donee): Takes the power given to donee by the donor. 3. Subject Matter (Property, either real or personal property): Property over which the donee will exercise the power of appointment. 4. The power which is transferred: This can be either a General Power or a Special (Limited) Power. 5. Objects of the Power: The donee may appoint the property to any number of entities, other individuals, charities or corporations. 6. Appointees of the Power: The ultimate beneficiaries of the exercise of the power; property is received by the appointees. KEY POINTS: Property over which an individual has a General Power of Appointment is included in the estate for estate tax purposes whether the power is exercised or not and whether the person is competent to exercise the power or not. 1. If the general power is exercised or completely released during life, a gift tax will be triggered. The decedent, who was a surviving spouse, had been given income from the property for life with the right to appoint or dispose of the property at death to the decedent's estate, creditors or beneficiaries by Will. Although the decedent did not have the power to transfer the property dur113 ing the decedent's lifetime, the value of the property subject to the power will be included in the decedent's estate. 2. Property subject to power will not be includible in holders’ gross estate if consent is required from the donor, person having a substantial adverse interest to the donee or a person in whose favor power may be exercised. If the decedent was given the power to appoint the trust principal to any of three beneficiaries, not including the decedent, this would not be a general power of appointment. But, if the decedent had the power to invade the corpus for decedent's own benefit without limitation, this would be a general power of appointment. 3. If the donee of a power does not want the property included in donee's estate, the donee must release or exercise the power during the donee's lifetime. A release must occur more than three years prior to death or the property will still be included in the donee's gross estate. 1. Disclaimer: If the decedent refused to accept power of an appointment; nothing is included in the disclaimer's estate. 2. A Qualified disclaimer is not a taxable gift. 3. To be qualified, a disclaimer must be received in writing by the transferring person or the representative within nine months of transfer or by disclaiming prior to the disclaimer’s 21st birthday. The person disclaiming must not direct to whom the power of appointment passes. 1. The decedent's power to invade is limited and is to be used only for reasons of health, education, support or maintenance. 2. The power can be used only with the consent of creator of power or person with adverse interest in the property (stands to gain). Created after 10/21/42. 3. If a power is created before October 21, 1942, exercisable only in conjunction with another person, is not a general power. 4. When a person is given a power that can only be exercised in conjunction with others in whose favor the power could be exercised, a fractional portion of the property will be includible in the donee's estate. A fractional portion is determined by dividing the value of the property by the number of persons in whose favor the power could be exercised. Manny grants Moe, Jack and Joe the unrestricted right to appoint property to either of the three (with the consent of the others) during each person's lifetime. In default of the appointment, the 114 property will go to Agnes. At Moe's death, only one-third of the value of the property would be includible in his gross estate. Time of creation: A power created by Will is considered to be created on the date of the testator's death. A power created by deed/other instrument during creators’ lifetime is created on the date the power becomes effective. 5. Special Power of Appointment: Refers to any power that is not a General Power. The holder of power may exercise power only in favor of someone other than holder or in favor of a limited class of persons. These may be freely retained and freely exercised without tax consequences. A fairly broad (e.g., retained, exercised, released, allowed to lapse) power may be given to another person without adverse tax consequences, but a power reserved by the grantor, even though limited, will likely result in tax problems. POWER OF APPOINTMENT AS USED IN ESTATE PLANNING 1. Flexibility. The following powers may be given without tax consequences: Beneficiary can withdraw $ 5,000 or 5% of the value of the corpus each year, whichever is greater. Beneficiary can be given right to withdraw in excess of the five and five rule in order to maintain a standard of living or for medical expenses. Trustee may be given power to distribute principal to beneficiary at own discretion. Beneficiary can be given special power by deed to appoint corpus to a limited class (e.g., to spouse or to children). 2. Estate Tax Savings: Property left to wife as life tenant with remainder to son escapes estate tax at wife’s death; property can be left to wife outright who can give son a life estate with remainder to grandchildren. 3. General purpose of donor: can be specified and details left upon to donee. SECTION 2042 LIFE INSURANCE Life insurance proceeds are included in the estate for tax purposes if: 1. Decedent had incidents of ownership in policy. These incidents of ownership include the right to: A. Name/change beneficiaries. B. Assign the policy. C. Revoke an assignment. D. Surrender/cancel policy. E. Pledge policy for a loan. F. Take loan or surrender value of policy. 115 G. H. I. J. K. L. Change beneficiary on a policy owned by closely-held corporation. Purchase policy originally purchased by employer. Change ownership, benefits, proceeds in policy owned by a trust. Deal with policy even after policy is physically transferred. Control policy owner Reversionary interest worth more than 5% of policy value. GROUP LIFE INSURANCE Group Life Insurance proceeds are included in the decedent's estate if decedent had the right to: 1. Change beneficiaries. 2. Terminate policy. 3. Prevent cancellation of contract by purchasing policy. Group Insurance is not included if: 1. Power to terminate policy is limited to termination of employment. 2. Right to convert group policy to individual policy at end of employment is assigned to another. MARITAL DEDUCTION AND LIFE INSURANCE NOT IN DECEDENTS GROSS ESTATE Life insurance proceeds do not qualify for the marital deduction if the life insurance is payable to a surviving spouse but is not in decedents’ gross estate (no incidents of ownership). Ralph is employed by Sandler Co. and participates in a pension plan that is entirely paid for by Sandler Co. The pension plan has a death benefit that would pay $50,000 at his death, to his beneficiary, his wife. If Ralph dies and his wife elects to receive the $50,000 in a lump sum, she would have to pay income tax on the proceeds. TRANSFERS OF LIFE INSURANCE Transfers of Life Insurance within three years of death are included in gross estate as gratuitous transfer. Inclusions of gross income are quite extensive. A detailed discussion of life insurance transfers would be voluminous, so salient points only are included in this text. The federal estate tax (FET) is a tax on the right to transfer property when a person dies and is paid by the estate. The federal estate tax is measured at death or the alternate valuation date or during life when the decedent retained specific powers or controls. States levy inheritance taxes which are taxes on the right to receive property and are paid by the recipients. An estate tax return must be filed by the Personal Representative of the estate if the gross estate is above the filing requirement. The filing requirement is the value of gross estate, plus adjusted taxable gifts on the date of death and must exceed $ 650,000. 116 SECTION 6166A DEFERMENT FOR CLOSELY HELD BUSINESS Prior to the TRA 97, this Section 6166A permitted an estate to elect to defer payment of estate taxes attributable to a closely-held business, for a period not to exceed 14 years. If this election were made, the interest charged on the first $1,000,000 of value, including the unified credit amount, was 4% per year, with the interest on additional sums due at the standard rate applicable to underpayment of taxes. Under TRA 97, the 4% rate has been reduced to 2%, and interest on value in excess of $1,000,000 is now at 45% of the underpayment of tax rate. The value upon which the 2% interest is due has also been increased to $1,000,000 over the unified credit amount. However, with these more liberal provisions, it must be noted that the interest is not deductible for estate and income tax purposes. SUMMARY The gross estate is the total value of a person's property at the time of death. The items included in the gross estate and their basic concepts are summarized: SECTION 2033 - the gross estate includes the value of all property interests, real or personal, tangible or intangible, of an individual on the date of death to the extent of the individual's interest in the property. SECTION 2033A - addresses family-owned businesses and the exclusion from the decedent’s gross estate to where the exclusion plus the unified credit does not exceed $1,300,000. SECTION 2034 - states that the amount of an includible property interest in a gross estate is not lowered by the existence of dower or courtesy right. SECTION 2035 - states that gifts made within three years of death are not included in the gross estate of decedents dying after December 31, 1981 except for five exceptions. SECTION 2036 - provides that the gross estate includes all property transferred gratuitously by the decedent during the decedent's lifetime in which the decedent retained or reserved the right to either use, possess or enjoy the property or to receive the property's income or the right to designate the persons who should possess or enjoy the property 's income. SECTION 2037 - covers transfers taking effect at death and provides that the gross estate includes the value of property transferred by the decedent for less than full and adequate consideration if the possession or enjoyment of the property can be obtained 117 by surviving the decedent and if the decedent retained a reversionary interest worth more than 5% of the transferred property value before death. SECTION 2038 - provides that if any of the powers to alter, amend, revoke or terminate or to affect beneficial enjoyment exists at death, the value of the property subject to the power is includible in the decedent's gross estate. SECTION 2039 - Annuities. An annuity is included in the gross estate when payable to decedent for life, for a period that did not end before death or for a period ascertainable only with reference to date of death. The key to whether or not an annuity is included in the gross estate is whether or not the decedent had an enforceable right to receive payments. SECTION 2040 - Joint property, jointly held property between spouses is no longer considered a gift. Present-interest gifts between spouses qualify for the unlimited gift tax marital deduction. Jointly held property with right of survivorship between spouses the estate of the first spouse to die will include one-half of the value of the property. When the surviving spouse dies, 100% of the property will be included in the estate. SECTION 2041 - Power of Appointment. General Powers of Appointment are powers over property that are so broad that the power approaches actual ownership or control of the property. SECTION 2042 - Life Insurance. Life Insurance Proceeds are included in the estate if: The decedent had any incident of ownership in the policy and if the proceeds are paid to the estate. Also, if the proceeds are received by another for benefit of the estate. Life Insurance proceeds do not qualify for the marital deduction if life insurance is paid to the surviving spouse but is not in decedents’ gross estate (i.e., no incidents of ownership). Proceeds will qualify for the marital deduction if proceeds are left at the interest option for life of the surviving spouse and if payable to spouse’s estate or persons appointed by spouse. SECTION 6166A – lowers the interest rate on estate tax deferments from 4% to 2% Following is a letter ruling sent to an inquirer in respect to gift and estate taxes as discussed above, on Dec. 12, 2010. This “Information Letter Ruling” applies only to the situation as presented in the letter, however, it serves as a notice as to any future decision where the situations are the same (or similar) and the inquiry applies to the same (or similar) situation as set forth in the letter. Internal Revenue Service Washington, DC 20224 Department of the Treasury Number: 201116006 Release Date: 4/22/2011 118 Dear : This letter responds to your letter dated July 13, 2010, requesting gift and estate tax rulings with respect to Decedent and Decedent's estate. On Date 1, Court entered the Final Judgment of Divorce (Judgment) which dissolved the marriage between Decedent and Spouse and settled all marital and property rights among the parties. In addition to awarding certain property to Decedent and ordering Spouse to make monthly alimony payments to Decedent, the Court ordered Spouse to establish an irrevoc able trust, Trust, with a cash property settlement for Decedent's lifetime benefit. The Trust was in partial settlement of Spouse's support obligation to Decedent and was incorporated into Judgment. On Date 2, Spouse established and funded Trust with $x. Pursuant to Judgment, Spouse subsequently transferred $y and $z to Trust. Pursuant to Judgment, Court appointed an independent person to serve as the trustee of Trust. Under the terms of Trust, Decedent would receive all the net income of the trust during her lifetime. The independent trustee had the discretion to distribute principal to Decedent, or apply principal for her benefit, during her lifetime. Upon Decedent's death, Trust would terminate and Decedent possessed a testamentary limited power of appointment to appoint the trust assets to her surviving issue. If Decedent failed to appoint the trust assets, then the trustee would distribute the trust assets to Decedent's surviving issue, per stirpes. The trust instrument did not grant Decedent any power to alter, amend, revoke, or terminate Trust or any right to remove, discharge, or appoint the trustee of Trust. Decedent died Date 3, survived by her daughter. Decedent did not exercise her test amentary limited power of appointment. You have requested the following rulings: 1. Decedent was not the transferor, donor, or settler of the Trust assets for purposes of §§ 2501, 2502, 2503, 2511, or 2702. 2. The value of the Trust assets is not included in Decedent's gross estate under §§ 2031, 2033, 2036, 2038, 2039, or 2041. Ruling Request 1 Section 2501 (a) of the Internal Revenue Code imposes a gift tax, computed under § 2502, for each calendar year on the transfer of property by gift during the year by an individual. Section 2502(c) provides that the tax imposed by § 2501 shall be paid by the donor. Section 2503(a) provides that the term "taxable gifts" means the total amount of gifts made during the calendar year, less the deductions provided in subchapter C (§ 2522 and following). Section 2511 (a) provides that the gift tax shall apply whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. Section 2512(b) provides that where property is transferred for less than an adequate and full consideration in money or money's worth, the amount by which the value of the property exceeded the value of the consideration shall be deemed a gift. Section 2516 provides that where husband and wife enter into a written agreement relative to their marital and property rights and divorce occurs within the 3-year period beginning on the date 1 year before such agreement is entered into (whether or not such agreement is approved by the divorce decree), any transfers of property or interests in property made pursuant to such agreement (1) to either spouse in settlement of his or her marital or property rights, or (2) to provide a reasonable allowance for the support of issue of the marriage during minority, shall be deemed to be transfers made for a full and adequate consideration in money or money's worth. 119 Section 2702(a)(1) provides, in general, that solely for purposes of dete rmining whether a transfer in trust to (or for the benefit of) a member of the transferor's family is a gift (and the value of such transfer), the value of any interest in such trust retained by the transferor or by any applicable member of the transferor's family (as defined in § 2701 (e)(2)) shall be determined as provided in paragraph (2). In this case, the transfer was pursuant to Judgment which dissolved the marriage of Spouse and Decedent and settled the parties' marital and property rights. The divorce and the settlement of the parties' marital and property rights, including the Court order to establish Trust in partial satisfaction of Spouse's support obligation to Decedent, were entered into on the same date, Date 1. Accordingly, the transfer of the cash property to Trust constitutes a transfer for full and adequate consideration under § 2516. The only taxable gift is the gift of the trust remainder to Decedent's surviving issue. For gift tax purposes, Spouse, not Decedent, is the transferor of the gift of the remainder. Therefore, based upon the facts and representations made, we conclude that Decedent was not the transferor, donor, or settlor of Trust for purposes of §§ 2501, 2502, 2503, 2511, or 2702. See Rev. Rul. 75-73, 1975-1 C.B. 313. Ruling Request 2 Section 2031 (a) provides that the value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated. Section 2033 provides that the value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death. Section 2036(a) provides that the value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in a case of a bona fide sale for adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any p eriod not ascertainable without reference to his death or for any period that does not in fact end before his death (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income there from. Section 2038(a)(1) provides that the value of the gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for adequate and full consideration in money or money's worth), by trust or otherwise, where the enjoyment thereof was subject at the date of death to any change through the exercise of a power by the decedent to alter, amend, revoke, or terminate the interest in the property or where the decedent relinquished such power within the three-year period ending on the date of the decedent's death. Section 2039(a) provides that the gross estate shall include the value of an annuity payment or other payment receivable by any beneficiary by reason of surviving the decedent under any form of contract or agreement entered into after March 1, 1931 (other than as insurance under policies of the life of the decedent), if, under such contract or agre ement, an annuity or other payment was payable to the decedent, or the decedent possessed the right to receive such annuity or payment, either alone or in conjunction with another for his or her life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death. Section 2041 (a)(2) provides that the value of the gross estate shall include the value of all property to the extent of any property with respect to which the decedent has at the time of his death a general power of appointment created after October 21, 1942, or with respect to which the decedent has at any time exercised or released such a power of appointment by a disposition which is of such nature that if it were a transfer of property owned by the dec edent, such property would be includible in the decedent's gross estate under §§ 2035 to 2038, inclusive. For purposes of § 2041 (a)(2), the power of appointment shall be considered 120 to exist on the date of the decedent's death even though the exercise of the power is su bject to a precedent giving of notice or even though the exercise of the power takes effect only on the expiration of a stated period after its exercise, whether or not on or before the date of the decedent's death notice has been given or the power has been exercised. In this case, Spouse transferred cash property to Trust in partial satisfaction of his spousal support obligation. Accordingly, Decedent is not a transferor for pu rposes §§ 2036 and 2038. Under the terms of Trust, Decedent would receive all the net income of the trust during her lifetime. The independent trustee had the discretion to distribute principal to D ecedent, or apply principal for her benefit, during her lifetime. Decedent possessed a testamentary limited power of appointment to appoint the trust assets to her surviving issue. The trust instrument did not grant Decedent any power to alter, amend, revoke, or terminate Trust or any right to remove, discharge, or appoint the trustee of Trust. Accordingly, based on the facts submitted and representations made, we conclude that the value of the Trust assets are not includible in Decedent's gross estate under §§ 2031, 2033, 2036, 2038, 2039, or 2041. In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representative. The rulings contained in this letter are based upon information and representations submitted by the taxpayer and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination. Except as specifically ruled herein, we express no opinion on the federal tax consequences of the transaction under the cited provisions or under any other provisions of the Code. The rulings in this letter pertaining to the federal estate and/or generation-skipping transfer tax apply only to the extent that the relevant sections of the Internal Revenue Code are in effect during the period at issue. This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) provides that it may not be used or cited as precedent. 121 CHAPTER 6 STUDY QUESTIONS 1. The purpose of Federal Estate Taxes is to A. prevent the transmission of large estates without being taxed. B. tax the estate and have the tax payable over a period of years. C. Transfer large estates without being taxed. D. 2. Dower rights in property set aside property for A. children. B. widows. C. husbands. 3. An estate owner reserves a power by which he/she can appoint an interest in property to anyone without limitation, it is, A. a power of appointment. B. included in the owner’s estate even if the owner releases the power. C. not a gift. Chapter 6 Study Question – Answers & Sections 1 A – page 89 – Estate Taxes 2 B – page 113 – Dower or Courtesy Interest 3 A – page 128 – Power of Appointment 122 CHAPTER SEVEN - COMPUTATION OF THE ESTATE TAX "Do not follow where the path may lead. Go instead where there is no path and leave a trail" INTRODUCTION BACKGROUND OF THE MARITAL DEDUCTION In the past the community property states only called for one-half of the community held property to be included in the estate of the spouse who died first. Residents of the common law states were envious of this preferential tax treatment so Congress gave a federal estate tax marital deduction to married residents in the common law states. The Economic Recovery Tax Act achieved tax parity by allowing an unlimited deduction for assets passing from one spouse to another, either during lifetime or at death. The Unlimited Marital Deduction applies in both Community and common law states. Please remember that the marital deduction is not a device to avoid taxation but defers taxation until the death of the second spouse. As stated before, Congress's goal was to treat spouses as one unit for transfer tax purpose and only tax one estate. Presumably, without proper planning, the second estate will be much larger than the first estate thus rendering more estate taxes. MARITAL DEDUCTION BASIC RULES As may be expected there are numerous roles that govern the use of the marital deduction, with some exceptions. The seven basic rules are: GENERAL RULE: The estate tax marital deduction is given on the full net value of a qualifying interest passing to a decedent's surviving spouse but will be reduced by any taxes that are payable out of the marital share of the estate. NET VALUE OF GROSS ESTATE: Net value is the gross estate tax value of property interest at date of death (or at alternate - valuation date) less any charges against the property interest. Three charges against property interest could be: a. Mortgage/Liens against the interest. b. Administrative expenses payable out of the interest. 123 c. Taxes payable out of the interest (Federal Estate Tax, state death tax). Special Note: These charges can be avoided if the decedent's Will requires taxes/expenses debts to be paid out of the portion of the estate passing to beneficiaries other than the spouse. PROPERTY PASSAGE: Property must pass or have passed to the surviving spouse. A property interest owned by the decedent must pass from decedent to the surviving spouse and the surviving spouse must receive that interest as the beneficial owner (not as a trustee or as someone's agent). Property may "pass" from the decedent to the surviving spouse in many different ways, and still qualify for the marital deduction. Some of these ways are: 1. Life insurance proceeds. 2. Under the intestacy laws. 3. Under the decedent's Will. 4. Joint tenancy property, by right of survivorship. 5. Tenancy by the entirety property, by right of survivorship. 6. Under a General Power of Appointment. 7. Under the spouse's right to elect against the Will. 8. Under a dower or courtesy interest. 9. As lifetime gift to the spouse that is brought back into the decedents gross estate. 10. As "Qualified Terminable Interest Property” (Q-TIP). Note: To qualify for the Marital Deduction the property that passes to the spouse cannot be a "Terminable Interest". This is a property interest that will fail to terminate because of the passage of a time period and the occurrence of some event or contingency or because of failure of an event or contingency to occur. RESIDENCE OR CITIZENSHIP REQUIREMENT: The deceased spouse must have been a citizen or resident of the United States to qualify for the Marital Deduction and transfer must be made by a decedent who was at the date of death a U. S. citizen/resident. In general, a marital deduction is not available if the surviving spouse is not a U.S. citizen unless property passes to the surviving spouse in a qualified domestic trust. 124 INCLUSION OF PROPERTY REQUIREMENT: To be eligible for the marital deduction, the property must meet all requirements for being included in the gross estate. Marie purchased a $500,000 life insurance single premium policy on her husband, Steve, when she received an inheritance from her aunt. If Steve should die and Marie would receive the face value of the policy ($500,000), the proceeds of life insurance policy bought by a wife on her husband's life with her own funds in which she is owner and beneficiary will not qualify. MARITAL STATUS REQUIREMENT: Spouses must be married, not divorced. A legal separation does not change the surviving spouse's status (the marriage was not legally terminated by the date of death). In case of a common disaster there are two methods of determining who died first (who was the surviving spouse): 1. A presumption - of - survivorship clause may be used in the Will/life insurance settlement option (e.g., husband declares that if there is no evidence to determine who died first, "my wife shall be deemed to have survived me"). 2. Uniform Simultaneous Death Act which states if there is no presumption-ofsurvivorship clause, each decedent's estate will be distributed as if decedent were the survivor (husband's Will is Probated as if he survives his wife and wife's Will is Probated as if she survives her husband). This results in the loss of marital deduction. TERMINABLE INTEREST RULE: A marital deduction is allowed only when the interest passed to the surviving spouse is one that, if kept until that spouse's death, will be taxed to the surviving spouse's estate. DISQUALIFICATION RULES A terminable interest may be disqualified if all three of the following conditions exist: 1. The other person (or heirs) could possess/enjoy any part of the property at termination of the surviving spouse's interest. 2. The interest passed to the other person for less than adequate and full consideration in money or money's worth. 3. Another interest in the same property passed to someone other than the surviving spouse. 125 Note: If the decedent in the Will directs the Executor to use assets supposedly available to the surviving spouse for the purpose of terminable interest, then the marital deduction would not apply. If Andrew specifically bequeaths $150,000 to his wife but since Andrew had little faith in his wife’s ability to manage money, he directed his Executor to use that money to buy a life annuity for her. By doing so, however, the bequest will not qualify for the marital deduction. EXAMPLES OF TERMINABLE INTERESTS: 1. 2. 3. 4. 5. Patents and Copyrights. Life Estate and Annuities. "To wife during widowhood." "To my wife for life. Remainder to our children." "To my wife for Life." Special note: To avoid any problems under the terminable interest classification, the property must be vested in the surviving spouse and no other person may have any interest which may follow that of the spouse's. Exceptions to the Terminable Interest Rule 1. A qualified terminable interest property election qualifies. 2. A life insurance policy payable to the surviving spouse in which that spouse has a General Power of Appointment over the proceeds qualifies. 3. A bequest for a life estate paired with a General Power of Appointment ("Power of Appointment Trust") qualifies. This is the most common methods of qualifying property in trust for the marital deduction. The power of Appointment Trust is designed to hold assets for the surviving spouse and to provide that spouse with a General Power of Appointment over the principal. Five requirements are needed to qualify: 1. Surviving spouse has claim to entire income from trust. 2. Income is paid at least once a year. 3. Spouse can exercise the power to appoint corpus to self. 4. Power must be exercisable only by the surviving spouse. 5. Only the surviving spouse has power to appoint any part of corpus to anyone other than the surviving spouse. 126 Final exception to the terminable interest rule: an interest will still qualify for the marital deduction if the bequest to the surviving spouse was conditioned upon the spouse surviving for up to six months after the decedent's death and spouse does survive. TRUSTS AND THE MARITAL DEDUCTION Chapter 9 is devoted to trusts, but a discussion of three popular marital deduction trusts should be discussed in this section. In the previous section, the Power of Appointment Trust was discussed. This section will discuss the Estate Trust and Qualifying Terminable Interest Property Trust in this section. A marital trust is a spouses’ trust. It is designed to hold assets that would qualify for the marital deduction. These trusts would include the General Power to Appoint and would obligate that the property in the trust would be income producing. A non-marital trust is commonly a family trust, which provides management for assets which would be taxable at testator's death. ESTATE TRUST As an alternative to the Power of Appointment Trust, the Estate Trust gives the surviving spouse an interest for life, with the remainder payable to the spouse's estate. 1. 2. 3. 4. 5. ADVANTAGES OF ESTATE TRUST Trustee can accumulate income within the trust. All income does not have to be paid annually to surviving spouse. Trustee can invest in unproductive property/retain unproductive asset. Protection against a spendthrift spouse. Income tax savings. Assets available to surviving spouse's Executor at death. Lifetime assignments of trust property may not be made by surviving spouse. DISADVANTAGES 1. 2. 3. 4. 5. Increased administration costs. Liable to claims of creditors. Subject to state inheritance taxes. Restriction on disposal of trust property by surviving spouse during lifetime No freedom of surviving spouse to use/manage trust assets. 127 FORMS OF MARITAL BEQUESTS OUTRIGHT BEQUEST An outright bequest is a direct transfer of property to the surviving spouse through life insurance proceeds or in a Will. In a Will a clause could be inserted that gives a formula for determining the shape of the asset that will make the most efficient use of the estate owner's unified credit. (more on this in Chapter 10). There are two types of Formula Bequests. A. PECUNIARY (DOLLAR) AMOUNT BEQUEST The survivor will receive a fixed dollar amount (would take into consideration all property qualifying for the marital deduction). B. FRACTIONAL SHARE BEQUEST The survivor will receive a fractional share of each asset in the estate, after specific bequests have been made. ADVANTAGES OF MARITAL BEQUESTS 1. 2. 3. 4. 5. Spouse may use/manage assets at spouse's discretion. Discourages spouse from electing against the Will. Non income-producing assets may be transferred. Trustee's fee/court accounting eliminates. Assets received by spouse are available to spouse's Executor to satisfy liquidity needs. DISADVANTAGES 1. 2. 3. 4. 5. Surviving spouse can exclude children and favor a second spouse in disposing of bequest. Spendthrift spouse may consume assets. Creditors can attach the bequest. Assets not consumed/given away will be included in surviving spouse's Probate estate. No management. As discussed in the text on the marital deduction, the gift tax marital deduction is allowed for gifts of interest in property (including cash) between spouses in an amount equal to the value of such gifts made after 1981. Outright gifts to the spouse qualify for this deduction. However, the marital deduction cannot be taken if the gift is of a life estate or other terminable interests unless it meets certain statutory requirements for qualification. These are the same requirements necessary to qualify a terminable 128 interest for the estate tax marital deduction. The marital deduction will also apply to the value of a donee spouse's income interest in a qualified remainder trust created by the donor spouse if the donee spouse is the only non-charitable beneficiary of the trust. If the spouse of the donor is not a United States citizen, the marital deduction is not available for a transfer to such spouse. However, in this situation, the annual exclusion for the transfer from the donor spouse to the non-citizen spouse is increased from $90,000 to $100,000 (provided the transfer would otherwise qualify for the marital deduction if the donee spouse were a U.S. citizen). CHARACTERISTICS OF CHARITABLE DEDUCTIONS Individuals also may make estate tax charitable deductions for qualified charities. There are four qualified charities: 1. Corporations that are operated solely for religious, charitable, literary and educational purposes. 2. Fraternal societies/orders that use charitable contributions solely for charitable purposes. 3. United States/District of Columbia/State/ Political subdivision that use contributions solely for public purposes. 4. Veterans organizations incorporated by Act of Congress or such organizations— Departments/posts or local chapters. CHARITABLE DEDUCTION DENIALS A charitable deduction will be denied if (1) the charitable beneficiary uses contributions for non-charitable purposes, (2) if the gift is contingent upon occurrence of some events (unless the change of the events actual occurrence is nil), (3) the organization participates in political campaigns or other prohibited transactions, (4) any net earnings of the organization benefit an individual or private stock holder, or (5) the organization's chief activity is influencing legislation. TYPES OF CHARITABLE BEQUESTS There are nine types of charitable bequests which may be made by Will to transfer gifts: 1. Split gifts are made between a spouse and charity. The donor-decedent can create a charitable remainder trust and receive both the charitable deduction (for the charitable bequest) and the marital deduction (for non-charitable bequest to spouse). 2. Gift of art without copyright. A charitable deduction is allowed for transfer of artwork to charity even though the copyright covering artwork is not transferred. 3. Power of Appointment. A charitable deduction is given for property included in the decedent's gross estate due to a General Power of Appointment decedent had over the property that passes to a charity because of an exercise/lapse/release of that power. 4. Partial Interests: Charitable deduction is given for fractional interests that pass to a charity. There are the following types of partial interests: 129 A. Testamentary gift of an undivided share of the decedent's entire interest in property not held in trust. B. Remainder interest in a personal residence/farm transferred by decedent at death. C. Remainder interest in a trust to charitable remainder trusts and pooled income funds. D. Transfer of a fractional interest in property to a charity solely for conservation purposes. 5. Charitable Remainder Trusts. For charitable deduction to be allowed, decedent's transfer of a remainder interest in property to a charity in trust must be made in one of the following three forms (See later discussion on CHARITABLE REMAINDER TRUSTS in the “TRUSTS” (Chapter 10) (1st) Charitable Remainder Uni-Trust. (2nd) Annuity Trust. (3rd) Pooled Income Fund. Note: Payments of Uni-trust/Annuity amounts must start as of the date if the charitable deduction is to be allowed. A remainder trust may be used with a Q-TIP trust to avoid Federal Estate Tax entirely. 6. Charitable remainder. Uni-trust pays a set percentage worth not less than 50% of the net fair market value of the trust assets as annually revalued. Compare with Annuity Trust. •Both require annual payments to non-charitable beneficiaries with the eventual transfer of remainder interest to a qualified charity. •Both may be created by Will or during lifetime. •In an Annuity Trust, if trust income is inadequate to cover the annual payment, the beneficiary must be paid out of principal; in a Uni-trust, payments can be made from income only. •In an Annuity Trust, no additional contributions can be made to the trust after the initial payment; in a Uni-trust, further contributions are allowed. •Annuity Trust pays a set annuity worth not less than 5% of the original net fair market value of the property paid in trust. Payment must be made at least annually to one or more non-charitable beneficiaries who are alive at time trust was created. When the last income beneficiary dies (or after a set number of years, not to exceed 20 years), remainder interest must go to a qualified charity. 7. Pooled Income Funds. Similar to a Mutual Fund which is established for the qualified charity. 8. Guaranteed annuity interest (charitable lead trust). Right to receive determina130 ble amount at least annually for a fixed term. Income interest in property is transferred by decedent to a charity; remainder would go to a non-charitable beneficiary. A charitable deduction is allowed if the income interest is in the form of a Uni-trust interest/guaranteed Annuity Interest. VALUATION OF CHARITABLE GIFTS Partial interest is valued at fair market value of the interest on the appropriate valuation date (date of gift/date of death). Remainder interests in charitable remainder Annuity Trust/Uni-trusts/Pooled Income Funds. Value determined by I.R.S. regulation. Guaranteed annuity interests. Value determined by estate tax regulation. Uni-trust interests. Fair market value of the transferred property minus present value of all interest in that property (other than the Uni-trust interest). ADJUSTABLE TAXABLE GIFTS The Taxable Estate is the Adjusted Gross Estate, less the Marital and Charitable deduction. Before the Federal Estate Tax can be determined, one more adjustment must be made. Adjusted taxable gifts are those gifts made during life after 1976 on which a gift tax was paid and must be added back in the estate ($13,000 2011). Keep in mind that completed gifts made within three years of death will not be included in the decedent's gross estate. Any taxable gift made after 1976 will be brought back into the estate tax calculations as an adjusted taxable gift. EXCLUSIONS There are four exclusions from treatment as adjusted taxable gifts: 1. Post 1976 gifts within the amount of the annual exclusion. 2. Gifts made to a spouse that qualified for the gift tax marital deduction. 3. Gifts that qualified for the gift tax charitable deduction. 4. Gifts that have already been included in the decedent's gross estate. TENTATIVE TAX BASE Once the adjusted gifts are added to the taxable estate, the last step before calculating a tentative tax base is to subtract any charitable gifts made, including those that will take place upon death through trusts or provisions in the Will. Gift taxes on post-1976 gifts in excess of the unified credit are subtracted, which results in estate tax payable before the credits. The four steps to remember in this reduction would be: 131 1. the total of all post - 1976 taxable gifts. 2. to compute the gift tax payable by applying the unified rate schedule in effect a decedent's death to the total taxable gifts. (see chart). 3. reduce gift tax by allowable unified credit. 4. if the gift tax payable exceeds allowable unified credit, subtract the excess from the tentative tax. FEDERAL ESTATE TAX CREDITS There are five tax credits available to a decedent. The federal estate tax credit is a dollar-fordollar reduction of the tax after the unified rates have been applied to the sum of the taxable estate plus adjusted taxable post-1976 gifts 1. PRIOR TRANSFER TAX Where a person transferred property that was taxed at death to the current decedent and the property is included in the gross estate, a credit will be allowed for all or part of the estate tax paid by the first decedent. This will prevent double taxation on the property. This credit reduces every two years; at the end of ten years after death of the first person no credit is allowed. There are two requirements: (1) Property must have been included in the first person estate and must have transferred to the current decedent. (2) Transfer can be of any type (e.g., gift, by Will, life insurance proceeds). 2. FOREIGN DEATH TAXES For property that is included in the decedent's gross estate and situated in a foreign country or a United States Possession, a credit is allowed for death taxes paid. The purpose is to prevent double taxation. Credit is allowable only to the estate of a decedent who was either a U.S. citizen or a resident who was a citizen at the time of death. 3. GIFT TAX PAID ON PRE-1977 GIFTS Gift tax payable on post-1976 gifts becomes part of the computation for determining tax liability under the unified gift and estate tax system so a separate credit is not allowed for taxes attributable to these gifts. A credit still exists for federal gift tax paid by a decedent on taxable gifts made before 1977 if the property is included in the gross estate. 132 John established a trust in 1973 for the benefit of his son, Jason. John reserved the right to all income from the trust during his lifetime. The gift of the remainder interest was a taxable gift on which gift was paid. John died in 1985 and the trust property was includible in his gross estate because of the retained life interest. A credit will be allowable for the gift tax attributable to the gift. 4. STATE DEATH TAXES All state's death-tax laws fall into one of three general death tax categories. (1) States which collect their taxes directly from the Federal Government (GAP-Tax States); (2) States which tax the estates of their citizens much like the Federal Government does (estate-tax states); and (3) States that base their death taxes on the value of the property that passes to certain defined beneficiaries (inheritance-tax states. With the federal exemption increasing many families now worry more about state than federal estate taxes. Despite the new and generous federal estate tax exemption of $5 million per estate and $10 million per couple, many less wealthy families still have to plan for estate taxes—(i.e. state estate taxes). "The $10 million exemption makes state death tax planning all the more important," says Charles "Skip" Fox, an estate lawyer with McGuire Woods in Charlottesville, Va. "You'll pay more if you're in a state that has its own death tax," he adds. Note following summary of state death taxes. 133 STATE DEATH TAX REQUIREMENTS SUMMARY The following states (appropriate state statutes as indicated) are those where death tax is tied to the federal state death tax credit: Alabama AL ST §40-15-2 Alaska AK St §43.31.011 Arizona AZ St §§42-4051; 42-4001(2), 912) (State Estate Tax) Arkansas AR St §26-59-103; 26-59-106; 26-59-109 California CA Rev Tax §§ 13302; 13411 Colorado CO St §§ 39-23.5; 39-23.6-102 Florida FL St §198.02 FL Constitution Art VII Sec 5 Georgia GA St §48-12-2 Idaho ID St §§14-403; 14-402; 63-3004 Louisiana LA R.S. §§47:2431; 47:2432; 47:2434 Michigan MI St §§ 205.232; 205.256 Mississippi MS St § 27-9-5 Missouri MO St §§ 145.011;145.091 Montana MT St § 72-16; 72-16-905 Nevada NV St 32 §§ 375A.025; 375A.100 New Hampshire NH St §§ 87:1; 87:7 New Mexico NM St §§ 7-7-2;7-7-3 North Dakota ND St § 57-37.1-04 Oklahoma OK St Title 68 § 804 (Separate estate tax phased out 01/01/10) South Carolina SC St §§ 12-16-510; 12-16-29; 12-06-40 South Dakota SD St §§ 10-40A-3; 10-40A-1 134 Texas TX TAX §§ 211.001; 211.03; 211.051 Utah UT St § 59-11-102; 59-11-103 Virginia VA St §§ 58.1-901; 58.1-902 West Virginia WV § 11-11-3 Wisconsin exclusion amount. Wyoming WI St § 72.1 (tax only estate exceeding EGTRRA federal applicable WY St §§ 39-19-103; 39-19-104 Other states that have estate tax or similar death tax: Connecticut As of 2009 for decedents dying on or after Jan 1, 2010, tax rates 7.2% to 12% , threshold reduced to $2 million eff. Jan 1, 2011. CRT St § 12-391 (Separate death tax) Delaware Pick-up only. Decedents dying after June 30, 2009, until July 1, 2013, tax tied to federal state death tax credit. Federal death taxes not taken into consideration when calculating the state tax. DE St TI 30 §§ 1502(c)(2) Hawaii Pick-up tax. $3.5 million exemption applies only when estate reaches $3.6 million. Effective May 1, 2010. HI St §§ 236D-3; 236D-2; 236D-B Illinois Pick-up. As of 1-1-12, increase exemption to $3,5 million for 2012 and $4 million for 2013 and later. Permits separate state QTIP election eff. 2009. 35 ILCS 405/22(b-10 Indiana Inheritance tax. Pick-up tied to federal state death tax credit. Has not decoupled but separate inheritance tax. IN St § 6-4.1-2-1. Separate state QTIP election, subject to administrative pronouncement. Iowa Inheritance tax. Pick-up tied to federal state death tax credit. IA St § 451.2; 451.13 Kansas Separate stand-alone estate tax. KS St § 79-15-203 Kentucky §140.130. Inheritance tax. Pick-up tied to federal state death tax credit. KT St 135 Permits separate QTIP election. Subject to administrative pronouncement. Maine ` Pick-up only. 2010 Tax Alert Maine, limits amount of state QTIP threshold to $2,500,000 (difference between Maine’s $1 million threshold and $3,500,000 federal exemption, future regulations not decided at this time. Maine has estate tax exemption of $2 million in 2012. For 2013, up to $2 million, 8% for difference $2 million and $5 million. 10% for estates between $5 million and $8 million, and 12% for excess. Also subjects real or tangible property in Maine that is transferred to a trust, limited liability company, or other pass-through entity to tax in a non-resident’s estate. Maryland Pick-up and inheritance tax. Federal estate tax ignored in computing Maryland Estate taxes. Limits federal credit amount used to calculate state estate tax to 160% of the amount which exceeds $2 million, unless Section 2011 federal state death tax is then in effect. Also allows state QTIP election. MD TAX GENERAL § 7-309. Massachusetts Pick-up tax tied to federal estate tax. MA St 65C §§ 2A. Pick-up tax frozen at Federal state death tax credit in effect on 12-31-2000. QTIP election can be made when applying for states estate tax based on EGTRRA federal state death tax credit. 2012 State Death Tax Threshold $1,000,000. Minnesota Pick-up only. Tax on estates exceeding federal applicable exclusion in effect on Dec, 31, 2000 even if amount is less than EGTRRA law. MN St §§ 291.003. No separate QTIP election permitted. 2012 State Death Tax Threshold $1,000,000. Nebraska County Inheritance Tax. Pick-up tax at state level. Counties impose and collect a separate inheritance tax. NEB REV ST § 77-2101.01910 New Jersey Pick-up tax, Inheritance tax. Pick-up tax on estate with federal applicable exclusion as of 12-31-2991 ($675,000). Executor has option of paying pick-up tax or similar tax. (Note court cases 2008 where different amount of state taxes were determined. Legal counsel is strongly recommended in New Jersey. NJ Dir. Of Div. of Tax, NJ St § 54a:38-1. QTIP election only allowed to extent permitted to reduce federal estate tax.2012 State Death Tax Threshold $675,000. New York Tax frozen at federal state death tax credit eff. 1998. NY TAX § 951 2012 State Death Tax Threshold $1,000,000. NY St. § 6060 (2004) NY estate tax on a pro rata basis to non-resident decedents with property subject to NY Estate Tax. March 2010, notice issued permitting separate state QTIP election when no federal estate tax return is required to be filed or when value of gross estate is lower than required amount for filing federal return. 136 State court maintained (2008) interest in S Corp. owned by non-resident and containing a condo in New York is an intangible asset if the S Corp has no business purpose, then subject to estate tax. State will look to ownership of condo and if no business reason for forming S Corp, then considered intangible asset for estate tax purposes. Important to have legal opinions when proper owner is non-resident, in particular. North Carolina Pick-up only. 20120 State Death Tax Threshold $5,120,000. Amount of tax tied to federal state death tax credit in effect 12-31-01. NC S§§ 105-32.2 No separate state QTIP election allowed. Ohio Separate Tax State. Effective Jan, 1, 2013, state estate tax is repealed, separate state estate tax rates @ OH St § 5731.02. 2012 State Death Tax Threshold $338,333. Allows separate QTIP for state Tax OH St. § 5731.15(B) Oregon Tax tied to federal estate death tax credit. OR St § 118.010 2012 State Death Tax Threshold $1,000,000. Effective 1-1-12, new tax has $1 million threshold with rates increasing from 10% to 16% for amounts $1 - $9.5 million. Estate value for estate purposes based on federal taxable estate with adjustments. Oregon allows separate state marital election for a trust where surviving spouse is sole discretionary beneficiary (considered “special marital property”) OR St §§ 118.005 to 118.840 Pennsylvania Inheritance tax. Tax tied to federal state death tax credit to extent that federal state death tax credits exceeds state inheritance tax. PA St T 72 P.S. § 9117 Recognizes QTIP election. Rhode Island Pick-up only. Tax frozen at federal state death tax credit in effect 1-1-01. RI recognizes separate state QTIP election in state Tax Div. Ruling 2003-03. 2012 State Death Tax Threshold $892,865 Tennessee Inheritance tax tied to federal state death tax credit TN St §§ 67-8-202; 67-8203. While not decoupled, Tenn. has separate inheritance tax recognized by separate QTIP election. Vermont Modified pick-up. 2012 State Death Tax Threshold $2,750,000 decedents as of 1-1-01, after 1-1-12 exclusion will equal federal estate tax applicable exclusion where exclusion is not more than $3,500,000. VT St T. § 4442 No separate QTIP election permitted. Washington Separate Estate Tax. For years 2005-2010, death tax determined unconstitutional. For 2005 and later, state estate tax ranges from 10% to 19%. A $1.5 million exemption in 137 2005 and $2 million thereafter. Deduction for farms. WA St §§ 83.100.040; 83.100.020. Referendum to repeal state estate tax defeated in 2006 elections. Washington permits a separate state QTIP election. A “Pick-up” tax law whereby a state can enjoy participation in the federal estate tax is indicated in the above state listing. Using this tax, states can take part of the federal tax levy, so while they have “no inheritance tax law,” it means that they take part of the amount that is calculated as federal estate tax. CHAPTER 7 STUDY QUESTIONS 1. The estate tax marital deduction is given on the full net value of a qualifying interest passing to a decedent's surviving spouse but A. will be reduced by any taxes that are payable out of the marital share of the estate. B. only 50% of the gross estate is affected. C. will be considered as a “pick-up” situation applicable only in about 3 states. 2. For the Q-TIP Trust to qualify for a Marital Deduction Trust, A. there can be no designated property. B. all contributions to the trust must come from charitable sources. C. decedent spouse/donor must make a transfer of property. 3. All state's death-tax laws fall into one of three general death tax categories, including A. Section 36B taxes. B. states that have no estate taxes. C. States which collect their taxes directly from the Federal Government. Chapter 7 Study Question – Answers & Sections 1 A – page 123 – General Rule 2 C – page 124 – Property Passage 3 C – page 133 – State Death Taxes 138 CHAPTER EIGHT – AVOIDING ESTATE SHRINKAGE & LIFE INSURANCE "Ability without ambition is like a car without a motor" INTRODUCTION As earlier discussed, the estate will need cash immediately to pay expenses and estate taxes. In this Chapter, shrinkage problems facing an estate, such as the need for liquidity in the estate; the method of taxation on life insurance and various ways to utilize life insurance so as to minimize depletion in the estate. ESTATE SHRINKAGE Some shrinkage is unavoidable but the amount of shrinkage depends on six factors: 1. Size of the estate. 2. Nature of the estate assets. 3. Debts left by the decedent. 4. Complexity of the estate. 5. Degree of Probate used. 6. Amount of taxed to be paid. As discussed in earlier, just about everything owned by a decedent of any value will be included in his/her estate. Assets are usually divided into four categories, (1) Personal Assets; (2) Business Assets; (3) Life Insurance, and (4) Government Programs. All such assets must pass through the "funnel" before family members receive the remaining assets. SIZE OF THE ESTATE As discussed in previous Chapters, the size of an estate is crucial in determining federal estate taxes. With the marital deduction and the unified credit the impact of such taxes has been minimized for the first to die in a marriage. However it is important to remember that many single individuals must prepare their estates carefully and those widow/widowers must take extra care with their estates. 139 NATURE OF THE ESTATE ASSETS The nature of the assets in an estate determines the manner in which property will influence the inclusion of assets in an estate. With the popularity of trusts and estate planning as a profession more and more people are beginning to examine the nature of such assets in order to help them avoid unnecessary estate shrinkage. DEBTS LEFT BY THE DECEDENT Statistics show that debts left by decedents usually average between 5-6% of the total estate. Automobile loan balances, credit card balances and other installment credit are all debts in this category. The largest debt is usually a mortgage balance which many times may be eliminated totally, provided that the estate has enough assets to retire it. A. Funeral and Burial expenses are among those debts most commonly considered as a drain on estate assets. Costs for burial plots, tombstones, florists, etc. are subtracted from the value of the estate. B. Last illness expenses. For a prolonged illness this type of debt may be of critical importance. Medications, doctors’ fees and miscellaneous expenses could all be major expenses of the estate. C. Unpaid taxes come in the form of federal, state and local income taxes on the final year's income of the decedent. Do not forget real and personal property taxes. D. Death taxes. Federal and state taxes are a major reason for depletion as discussed earlier The planner may recognize a distinct problem as the estate might not be able to produce the cash to pay the taxes. Fortunately, there are techniques that can be utilized to reduce the federal estate liability. One technique frequently used is the unlimited marital deduction (discussed in the previous Chapter) which permits any amount of property to be transferred to a surviving spouse at death, free of the federal estate tax. Numerous other tax saving techniques will be discussed in the following two Chapters). E. Estate administration expenses. Estate Administration is the process of settling a deceased's estate, paying claims and closing the estate by making distributions of property and cash to beneficiaries. Paying an Executor or attorney to legally comply with estate settlement is a major expense. The need for specialists for advice such as accountants and property appraisers, could be another expense. Other administration costs would be court costs if the Will is contested, costs of insuring estate property while the estate is open, the maintenance or repair of estate property, especially if it is to be sold; and the cost of brokerage fees or sale commissions on the sale of property. Of course the expenses will vary with each estate but the IRS studies have indicated that average estate administration expenses are 4 to 5% of estate assets. 140 COMPLEXITY OF THE ESTATE The complexity of the estate will dictate as to the number of specialists need to open, settle and close an estate. The more complex an estate the more the expenses tend to be. DEGREE OF PROBATE USED This is a constant concern for planners. As discussed in earlier Chapters, Probate will slow the settlement of an estate and with corresponding time delay, there will be estate shrinkage due to lost revenues, therefore the various options available to estate owner in order to neutralize this problem will be discussed. In addition, the planner must be aware that there could be many hidden sources of shrinkage as well. "Fire" sale of assets which are needed to pay for expenses could render the Executor without any bargaining power. Many arts, antique, real estate and other dealers specialize in estate sales because of the bargains that can be obtained. The difference between the market value of assets and the selling price of the assets—is commonly known as liquidation prices. In actuality, the decedent's estate (heirs and beneficiaries) are the ones paying the price! Other hidden factors that cause estate shrinkage would be inflation and outdated Wills. Poor timing; investment prices are down when a decedent who owned many securities dies, and the selling of the securities could be devastating on the estate. The improper arrangement of life insurance ownership, beneficiary and settlement options could all affect the estate. The death of an artist or author could actually increase the value of his/her works while the death of a business owner will often see values drop, as the expertise that the business owner brought to the business is now gone. The planner must look at all the facts and keep in mind that liquidity could be a cure-all for estate problems. Estate debts, expenses and taxes must be paid in cash within a few months following death. Where is this cash going to come from? Obviously, this cash must be raised quickly following death. If the estate owner has not planned for this cash need, the Executor now must borrow, or have a "fire" sale. There is a better method. Generating liquidity in an estate may be accomplished in two ways: 1. Create additional liquidity at death. 2. Minimize the need for cash at the time of death. Most estate owners can achieve #2 by paying for funeral arrangements, etc., in advance. Many people purchase burial plans from a funeral home that provides complete funeral services and may even include the burial plot. The estate can also be planned, through the various strategies previously discussed, so that federal estate taxes are minimized. Since it is not possible to eliminate all shrinkage, the estate owner can see that enough liquidity is provided at death. The best way to accomplish this goal is to purchase life insurance. ESTATE LIQUIDITY LIFE INSURANCE There are many reasons for an estate owner to consider using life insurance in a estate planning. Unfortunately many estate owners are convinced that their estates are liquid, i.e., easily con141 verted to cash. Estate liquidity simply means the ability of an estate to pay death costs from cash and cash equivalents following the decedent's death, when in effect, the estate contains many assets that are not liquid because of the nature of the assets, the prevailing interest rates, the liquidation price of a stock portfolio, etc. An estate can have substantial value but the biggest obstacle the estate owner faces is converting non - liquid property to a liquid asset. In reality, although the estate does have substantial assets, there may not be enough cash to pay obligations, taxes, debts and income to surviving spouses or dependents. The only solution to cover this need is to purchase a life insurance policy. In the past life insurance has been used to cover mortgages, provide needed funds in case of premature death, as a clean-up fund to pay final bills for the deceased, as a retirement fund and as a way to fund buy-sell agreements for existing businesses. The most practical reason that life insurance should be purchased by an estate owner is that life insurance offers the best solution to a critical problem and will deliver needed funds in the most economical manner. An Executor is faced with several costs upon the death of the decedent, as discussed earlier, but to reiterate: Debts of decedents. Fees: real estate, appraiser, legal accounting. Executor fee. Funeral expenses. Last illness expenses. Death taxes. Probate costs. LIQUIDITY SOURCES Estate liquidity may come from various sources, savings and checking accounts, cashing in of securities (bad timing will affect this source), loans from friends or heirs of the estate ownerdecedent. The only source of immediate liquidity that will be relied on to deliver when it is needed most would be life insurance. Life insurance is not subject to market conditions and instabilities. Saving accounts are quite useful as saving vehicles but the total funds available in these accounts probably will not be up to needed levels. Stock accounts historically have performed quite well but have had down cycles. Neither one can match the reliability that life insurance offers to the estate owner. The planner should also emphasize that life insurance is the most economical way to provide dollars in the future whenever they are needed the most. Premiums can be budgeted but the mere fact that, over the long haul, the cost of providing necessary funds will always be less than it would be to fund another investment into which money is periodically paid in order to arrive at the same dollar amount. Liquidity is the most urgent need for all estate owners. It makes it possible for most, if not all, of a deceased's wishes to be carried out. Most often an estate owner's estate will be tied up in a home, business interests, or other property - all considered illiquid assets, without the cash need142 ed, the property and business interest will be needed to be sold of quickly to generate the cash for estate taxes. This is the worst possible scenario as the Executor is forced to revert to a fire sale. As we look at the various advantages of life insurance, the planner should recognize an estate planning pattern that has developed with the advent of the unified credit. As previously discussed, the maximum unified tax credit ($192,800) effectively exempts $600,000 of estate assets from estate tax. Couple this benefit with the unlimited marital deduction, and the federal estate tax becomes of no concern for most people. However, there are still problems to be solved and there are a large, ever-increasing, number of people that have estate problems. Admittedly, the first to die transfers assets to the surviving spouse and there probably will not be a taxable event to cause problems for the surviving spouse. The problem would then arise— more so because of the original estate has probably grown—when the surviving spouse dies. Strategies are discussed later, but it is important that the estate owner realizes that the problem has not been eliminated but rather delayed and thus, higher taxes will be payable upon the death of the surviving spouse. ADVANTAGES OF LIFE INSURANCE FOR LIQUIDITY There are many reasons estate owners should include life insurance in estate planning; including the following seven reasons: 1. While death is obviously uncertain, life insurance is certain. The estate owner can be assured that his/her survivors will not be faced with liquidity problems despite death's uncertainty. 2. The age-old argument still is indisputable - life insurance is discounted dollars. The estate owner buys liquidity at a "bargain.” While the estate owner pays a fraction of the policy's face amount when premiums are paid, 100% of the face value is available at death. 3. Allows early payment of state death taxes. Several states allow a discount for the early payment of death taxes. The tax discounts are usually quite significant. Life insurance will provide the instant cash to be able to pay these taxes. Unfortunately there is no discount for the early payment of federal estate taxes but there is a penalty for paying late! 4. Life insurance makes settling an estate much more prompt. By generating instant cash for the estate, the possibility of long delays for estate settlement is minimized thus preventing unnecessary estate administration expenses. Also, estate beneficiaries receive their shares in a timely manner. 5. With the proceeds from a Life Insurance Policy, the need for borrowing is avoided. This saves the Executor from spending time trying to arrange borrowing sources. Since the decedent would no longer have credit the Executor would probably have to put up assets in the estate as collateral. Loans must be repaid with interest so all a loan performs is "buying time.” 6. Forced liquidations are prevented. Forced liquidations result when estate assets need to be sold under "forced conditions" in order to pay estate obligations. Buyers are aware of the estate problems and can make purchases at drastically reduced prices. Obviously this will 143 affect the total new distribution of the estate. 7. There would be no need for a “sinking fund.” Sinking funds are created over a period of time and are deposit accounts for estate owners anticipating a need for more estate liquidity. The problem exists that death may arrive at any time thus spoiling efforts of funding for these specific needs. Another problem with the sinking fund is the discipline needed to fund it in a periodic fashion. Life insurance is much more adaptable than a sinking fund with its self-competing characteristics at the time it is needed most - at death. The following is an example from the files of an Estate Planner, who recognized it as the poorest example of “Estate Planning” they had ever seen! Margaret is an heir to a large fortune and has an assessed net worth of over $25 million. She informed her estate planner that the I.R.S. would probably say that the estate was worth double that amount. However, she had purchased sufficient life insurance so that her children would have enough money and the government would not get all of her money. However, she informed the Planner that she had instructed the children to keep the insurance money and let the government have the property. Upon her death her property was worth $40 million. Her life insurance policies paid $20 million to her heirs outside of the taxable estate. Her children do as she asked and took the $20 million, and gave the rest to the I.R.S. to satisfy the taxes. The I.R.S., as is its practice, auctioned off the property to the highest bidder, and received only $10 million from the property. They would come to the heirs for the other $10 million. OWNERSHIP AND BENEFICIARIES OF ESTATE LIQUIDITY Since concerns of property distribution and the taxation of life insurance in an estate plan is of utmost concern we have devoted a section to this topic. We would like now to show how the ownership and beneficiary designations impact the role of life insurance liquidity in the estate plan. Properly designated life insurance will do wonders for an estate plan. It will enable the Executor to sell any property or business interests in a timely fashion and prevent forced sales. It will save the burden of a long settlement period and reduce the overall shrinkage of an estate. Life insurance will provide two clear advantages. 1. It will provide cash for the decedent's estate when needed the most. 2. Will provide a way to retain the full value of assets in an estate. The important aspect of life insurance is: who is the owner and who will receive the proceeds (beneficiary). There are five rules to follow when the planner is advising the client as to the owner-beneficiary designations: 1) If a third party is to own the policy any assignment should be absolute in order that the insured holds no incidents of ownership. 2) Proceeds from a life insurance policy should be paid in a lump sum. 144 3) The planner should emphasize the importance of communication between the insured and beneficiary while the insured is alive. 4) Steps should be taken to be sure the annual gift tax exclusion is taken for the policy assignment and subsequent premium gifts. 5) The policy should not return to the insured if the named beneficiary predecease the insured. OWNERSHIP The planner should present different situations when discussing the ownership question with clients. There is no defined rule. Every client is different and each client's objectives will vary also. The planner’s responsibility is to listen to the client's concerns and then make recommendations. All decisions should be based on the facts surrounding each particular situation. As we break down each situation, it is important that the planner understand the ramifications of each in order to advise a client as to the advantages/disadvantages of the client's specific objections. BENEFICIARY CONCERNS The primary question will be "who should handle the proceeds at the client's death?” Putting such proceeds into the hands of someone who is trustworthy and competent will go a long way to having liquidity achieved in the estate. BENEFICIARY DESIGNATIONS Basically there are three designations seen during the course of estate planning. The impact of gifting life insurance and the assignment of a group life policy will also be discussed. 1. ESTATE BENEFICIARY: Small Estates. In a small estate naming the estate as beneficiary should not have any potential tax problems at death. If a married couple is involved, the unlimited marital deduction will further help reduce or negate entirely the estate tax consequences. Larger Estates. By naming the estate as beneficiary could have severe repercussions - just the opposite of the intended objective. By including the proceeds in the deceased's estate more taxes would be paid and thus subject to Probate and to the claims of creditors. Thus, instead of reducing costs, life insurance, in this instance, could result in increased costs and liabilities. 2. INDIVIDUAL BENEFICIARY: Usually in this situation a spouse is named as the beneficiary. This arrangement does have some advantages and, of course, some disadvantages. Proceeds would avoid Probate and usually are not subject to the claims of creditors. Many states exempt death proceeds payable to a surviving spouse from the state death tax. Consideration must be made before using this designation would be: • Insured must not put the proceeds under a particular settlement option. • A contingent beneficiary should always be named. This could be a trust or adult child. 145 Remember that the purpose of this life insurance is to provide liquidity for the estate. • By owning the policy the insured can change the beneficiary designations at life event changes (divorce, death of a spouse, etc.). • The beneficiary should be informed of the Policy's existence, location and objective. DISADVANTAGES: When the spouse is named, it is assumed that the proceeds will be used for their intended purpose, estate liquidity. However, the spouse is not legally obligated to use the proceeds in this way. The spouse could have other ideas on how to use the proceeds thus eliminating the primary purpose of the proceeds. The one way to prevent this situation is to have the policy require the spouse to use the proceeds for the estate's liquidity needs, and the proceeds will be considered "payable for the benefit of the estate.” 3. TRUST AS BENEFICIARY: Usually seen in larger estates a trustee arrangement offers distinct advantages. The trustee will carry out the purpose of the policy-providing liquidity for the estate. The trust agreement (discussed extensively in Chapter 9) will authorize the trustee to make loans to the estate and to purchase assets from the estate if the need arises. The Will of the insured should stipulate the relationship of the trustee and Executor. The trust probably would be established during a lifetime. If the trust is irrevocable and owns the policy then the proceeds will escape inclusion in the insured's estate. The disadvantage to the insured is that there are fees involved. THE LIFE INSURANCE TRUST Each life insurance policy has three “offices”: The insured, the owner and the beneficiary. Generally, but not always, the owner and the insured are the same. If life insurance is owned by the decedent, the life insurance proceeds are in the taxable estate, therefore a tax may be due. When people who have a large taxable estate purchase life insurance to pay the tax, they often make the mistake of adding to their taxable estate by the purchase of life insurance. Steve is widowed and has an estate valued at $10,000,000. Because he knows that the federal estate taxes could equal at least half of his estate, he purchases a $5,000,000 life insurance policy.. If Steve takes ownership of the policy (i.e. he is both insured and owner), his taxable estate has grown to $15,000,000 – with a resultant tax of $8,000,000. But, if he creates a life insurance trust, gives the trust money, and lets the trust buy the life insurance policy, the trust is the owner, with the result now that substantial amounts of federal estate tax are saved. Why? Because the Trust is the owner, and the owner, therefore, does not die. 146 ASSIGNMENT OF GROUP INSURANCE Most clients will want to use their group life proceeds to create estate liquidity. The courts have allowed clients to absolutely assign all ownership rights to the group ownership out of their estates. This helps the estate as the proceeds are excluded from the insured's gross estate thus preventing more estate taxes! Note: An employee will be taxed on the cost of coverage in excess of $50,000 as provided in IRS regulation under Section 79. Absolute assignment does not help in this situation. THE BASICS OF LIFE INSURANCE AND ANNUITIES IN ESTATE PLANNING As an estate planner, one must consider the various uses of life insurance as a liquidity tool. As we have seen, life insurance is a unique product which offers many advantages. This section will discuss the various settlement options available and the estate and income taxation of life insurance and annuities. SETTLEMENT OPTIONS When the insured dies, the proceeds payable by the insurance company can come in five ways to the beneficiary. The beneficiary may receive benefits by the election of the following options: The five settlement options are: 1. Lump sum option. 2. Fixed years option. 3. Fixed amount option. 4. Interest option. 5. Life income option. 1. LUMP SUM OPTION If the beneficiary decides to forego the other four options and take a lump sum at death, the entire amount of such a sum would be received income tax free. It would make no difference if the benefit included double indemnity. The entire amount passes income tax free. 147 2. FIXED YEARS INSTALLMENT OPTION A Fixed Years Installment Option is when the beneficiary receives equal monthly installments for a fixed number of years. These proceeds would also pass income tax - free. Keep in mind that only the interest element of each payment would be taxable to the beneficiary. 3. INTEREST OPTION The beneficiary leaves the principal with the insurer and receives a minimum rate of interest. The entire amount of the annual interest is taxed to the beneficiary as ordinary income and the principal would be tax free. 4. LIFE INCOME OPTION The beneficiary receives equal monthly installments for life. Pure life income payments stop at the annuitant’s death but with Life Income Certain the annuitant is guaranteed payments for a set period of time. On a Fixed Years Installment/Life Income payments, the proceeds that are part of each monthly payment is deemed a tax free return of capital while the balance (interest portion) is taxed as ordinary income. Joint Life Income would pay equal monthly installments on the lives of two beneficiaries. The survivor continues to receive payments for life after the first death. 5. FIXED AMOUNT INSTALLMENT OPTION The insurer keeps the principal, which earns interest at a guaranteed rate. Fixed amounts are paid to the beneficiary in monthly installments until the fund is exhausted. Special note: Several categories of transferred assets are not included in this exempt group which includes the spouse of the insured; e.g., a corporation in which the insured is an employee or director but not a shareholder or an office, and a co-share holder of the insured. ESTATE TAXATION OF LIFE INSURANCE A life insurance policy is included in the insured's estate for federal estate taxation purposes if the insured had an incident of ownership in the policy at the time of the insured's death. Incidents of ownership include the following: 1. The right to change the beneficiary. 2. The right to borrow on the policy. 3. The right to assign the policy. 4. The right to surrender the policy. 5. The right to exercise any basic contractual right. If the deceased possessed any of the above rights, the proceeds will be includible in the deceased gross estate. It does not matter whether the incidents were ever exercised or not! 148 In respect to life insurance transferred to a third party within three years of an insured's death, the general rule is that the transfer is automatically includible in the insured's estate. POLICIES ON OTHER LIVES If an individual owns a policy on the life of someone else and if the owner dies before the insured, the value of the policy must be included in the owner's gross estate. The value of such a policy is the replacement cost. PROCEEDS PAYABLE TO AN ESTATE Proceeds would be included in the gross estate if the policy proceeds on the life of the deceased are paid to or used by the Executor or the Administrator of the estate. If the estate or the estate's Executor is the designated beneficiary of the proceeds, the proceeds are included in the deceased's gross estate, regardless of when the policy was taken out, or who paid the premiums, or who owned it. PROCEEDS PAID TO A TRUST If the proceeds are paid to an individual or a trust that is legally obligated to pay taxes, debts or other estate obligations, the proceeds will also be includible. At times the trustee of a living trust is only empowered to use trust assets to pay estate obligations not required to do so. In this situation, death proceeds of life insurance paid into the trust would only be includible in the gross estate to the extent the trustee exercised the power to pay estate obligations. ESTATE TAXATION OF ANNUITIES Annuities are a popular retirement planning tools and can be used for estate planning because they provide a steady stream of income when one retires. Simply put, one gives an insurance company money—either a single premium (lump sum), or periodical payments as with any other insurance product—for future payments, either periodically (such as monthly) or in a lump sum.. The annuity payments are either a fixed or variable amount, depending upon the type of annuity that is chosen. There a variety of annuities sold, and for estate planning purposes the option available the annuitant may leave part of an annuity to the designated heirs—however, there may be a reduced payout if this option is exercised. One can name a successor beneficiary to the annuity after the annuitant (or annuity owner) dies. A “joint and last survivor” annuity continues to pay an obligated amount as long as either the annuitant or spouse is alive. Further, one can guarantee that children received part of the remaining annuity principal if the annuitant dies before a certain date. In any event, the annuity owner should be aware that there may be income taxes on the annuity (depending upon the type of contract). Even though the annuities are tax-deferred to the owner, the heirs may not be eligible for this provision. Because of IRS tax rules, it is possible that the 149 heirs end up with significant income tax obligations. Also, if the owner owns the contract directly, it may be considered as part of the estate. TYPES OF ANNUITIES USED IN ESTATE PLANNING Depending on the type of annuity, there could be a taxable event when an annuity is used in estate planning. If the annuity is a straight life annuity with no survivor benefits then nothing is included in the deceased annuitant’s gross estate. Since the monthly payment from the insurance company ceases at death there is no value of the annuity to be included in the estate. For Refund or Period Certain annuities that do provide some type of survivor benefits after the first annuitants death, the amount included is the amount refundable or the cost of a comparable contract that would provide the remaining annuity payment. Keep in mind if the decedent only paid a portion of the premiums, then only that portion of the annuities value that is attributable to the deceased's contribution is included in the gross estate. Wilfred purchased an refund annuity with his estate as beneficiary in case of his death. Wilfred dies and leaves his estate annuity proceeds that actuarially could be purchased for $70,000 (Present Value). Wilfred had paid premiums of $42,000 (60%) for this annuity. Therefore, only $42,000 is included in Wilfred’s gross estate. STRATEGIES FOR USING LIFE INSURANCE IN THE ESTATE Life insurance and estate planning go hand-in-hand. It is a major building block in the estate planning process and has often been referred as "Estate Planning Fuel.” The following section has been divided into three parts: 1. The basis with regard to the role of life insurance plays in the estate planning process. 2. Life insurance under Economic Recovery Tax Act. 3. Keeping life insurance proceeds free of federal estate tax. THE BASICS Within the estate planning process, life insurance should be purchased for two reasons, (1) to create an estate that does not exist; (2) protect an existing estate from losses that will be sustained through death taxes and the Probate process. Life insurance purchased to create an estate should be looked upon as casualty insurance. Insurance purchased to replace economic loss resulting from the death of the family-bread-earner. The problem resulting from bread-earner's death is the replacement of lost income over a period of years. The solution that life insurance provides is to create a fund of dollars that can be used to 150 sustain family members who do not have an alternative source of income for a projected period of time. The amount of life insurance purchased should be tailored to the family's lifestyle as it existed before the bread-earner's death. Most individuals today just do not buy life insurance up to their family's needed amount. Good estate planning dictates that all reasonably foreseeable needs must be anticipated and planned-for on a current basis. Maximizing life insurance coverage should be the goal of clients who need estate-creating life insurance. TYPES OF LIFE INSURANCE When discussing life insurance, basically, there are three types of life insurance, “Permanent,” and “Cash Value” and Term” insurance. TERM LIFE INSURANCE While term insurance is the least expensive type of life insurance, the lower price reflects its primary problem for long-range planning. Term insurance is used for the short periods, such as during the educational stage of children. Usually, the term insurance would be for a set term, usually in ten-year increments, and it is usually appropriate for those who want life insurance coverage for a limited amount of time, such as during educational years of children, or until retirement age. It is the least expensive when it is purchased for a set term of years. Term insurance may have premiums that increase with age, and which would be the least expensive plan. Leven term insurance policies may have level premiums also, which makes it the cheapest way to have insurance for a set period of time, primarily because it does not develop cash values and premiums increase if the policy is renewed. In any event, term insurance provides protection while the owner is in good health and working. PERMANENT (CASH VALUE) INSURANCE “Permanent” insurance reflects the fact that it can be purchased for a set premium and provide coverage while it is increasing its Cash Value. Cash Value insurance has an accumulation which accumulates tax-free within the policy. This accumulation—the Cash Value—builds up in an investment account. These funds can be eventually used to pay the policy’s premiums and a place to borrow cash if some extra cash is needed. There are also policies where the tax-free investment benefits of a cash-value policy grows inside the policy , but the policy owner can withdraw premiums paid in without being taxed. This means that beneficiaries do not have to pay income tax when they receive the death benefit on the policy to the heirs. That can be compared to an IRA where the heirs would have to pay income tax on the distribution. A cash-value policy also may make sense if the owner has already contributed the maximum amount to other tax-deferred accounts. Conversely, the higher premiums and higher commissions and restricted investment choices make not make it worthwhile. A buy-term and invest the difference may accomplish what the principal wants, a low-cost insurance policy in case of early death, and a mutual fund or other in151 vestment paid by the difference in cost. There are several types of cash-value policies available, including “Universal Life” which is very flexible and can be invested in funds that create more investment funds. “Variable Life” is another policy that is actually an investment which allows one to invest in, for instance, hedge funds tax-free within the insurance policy. There are “Second to Die” policies (aka “Survivorship policies”) which pays to the beneficiaries, usually children after both parents die. They are often used when one spouse is healthy but the other spouse is not. POLICY OWNER AND LIFE INSURANCE TRUSTS With most insurance policies on a person’s or spouse’s lives, the owners have total control as to beneficiaries, etc., and they can cancel it at any time. But, when the owner of the policy dies, the death benefit is considered as part of the estate. A possible solution is to have the children be the owner and beneficiary of a policy on the parent’s life—it would then be out of the estate. However, by giving up the policy ownership it means that they also lose policy rights, such as naming beneficiaries. Plus, there is also the possibility of a large sum of money going to a young child, if they have problems managing money and/or creditors. It may be beneficial to make outright gifts of cash to the kids so that they can afford the premiums on the policy. LIFE SETTLEMENTS Financial needs change and in estate planning, there should be some anticipation of changes. It is possible that one can be the beneficiary of Aunt Jane’s estate and inherit a fortune. Of course, there is always the lottery. Perhaps Junior develops some internet something-or-other that the parent does not understand but which makes the child financially independent. On the other hand, a spouse or child may die prematurely. Basically, the problem can be the changes of finances and perhaps there is really no need for life insurance. At that point, most people just stop paying premiums, terminate their insurance coverage, and take out their cash value that has accumulated in the policy. But there is a recent alternative, called a “life settlement” which occurs when a policy is sold by the owner to another—individual or firm—who will get the life benefit when the insured dies. For those not familiar with this rather-recent concept, it may seem macabre but it is rather popular lately, particularly when one loses his job and cannot pay the premium, or has a need for an infusion of cash and has a policy with cash value available. Why would one want to do this? Basically, the insured can get more than what they would receive from the insurer if they surrendered the policy. For example, if the insured has a $1 million death benefit, the insurance company may offer $50,000 to buy it back (and get the liability off the books), whereas a life settlement company might pay $200,000 (then when the previous-owner 152 dies, they get a million dollars. This is one way that one might free up needed cash and if they need long-term care, for instance, that may solve that problem. Sometimes, an insured may need a quick financial “fix” for business purposes, for unexpected construction cost, of Junior may have been accepted at Yale. There can be tax consequences because if the policy is sold, usually there are taxes on the money received in the life settlement. And practically, heirs may get into an uproar if they discover that “Dear old Dad” had a million bucks in life insurance, but when he died, some outfit they didn’t even know— got the benefits. PRESENT STATE OF LIFE SETTLEMENTS USED IN ILIT’S With increasing frequency, trustees of irrevocable life insurance trusts (ILITs) are facing the problem of paying life insurance premiums that exceed annual gifts to the trust. One solution is the use of a life settlement which usually is the sale of all or a portion of-a life insurance policy, generally on an insured over age 65 (typically to an institutional investment firm), for an amount exceeding the policy's cash surrender value. When used correctly, a life settlement can used to help maximize the value of a troubled ILIT. When gifts fail to meet premium requirements it could be wise to determine if this was because of changes in objectives or financial status of the grantor. Primarily it is because of the persistent low interest rate environment and, in the case of variable policies, the disappointing performance of the stock market in recent years. What this can mean is the policyholder could pay higher premiums and/or for a longer period of time and or higher premiums—or even all three situations. The problem arises when grantors are unwilling or unable to meet the new premium requirements, usually because they cannot afford the new premiums or they exceed the available annual gift tax exclusions. Trustees have the job, then, of finding an approach that best protects the interests of the beneficiaries while attempting to satisfy the needs and objectives of the grantor. Initially, a simple solution might be to find new coverage that falls within the premium budget, keeping in mind that a new policy will probably be underwritten and if the grantor is at an advanced age, he may not be acceptable. When that happens, even if acceptable, there are new acquisition costs and with the lousy interest rate environment it is doubtful if this would suit the majority of grantors. If a new policy is not available or is a viable option, the trustee could immediately surrender the existing policy to save whatever cash value is available. But if it is necessary to maintain the policy, policy loans, surrendering dividends, decreasing the policy amount or elect a nonforfeiture option such as reduced paid-up or extended term, if available. A trustee faced with these problems, may find that the life settlement alternative should be explored as part of the decision making process. The best situation would be where the decision to surrender the policy has been made because with a life settlement, generally this provides more funds than a simple surrender. Life settlement may be an excellent solution if the trustee would like to keep the existing poli153 cy in force. Consider the case of an ILIT-owned $4 million universal life policy with negligible cash surrender value. As an example, when the trustee finds that keeping the policy in force would mean doubling the premium, formerly $60,000 and now $120,000 and the grantor won’t or can’t increase gifts by that amount. The first solution that came to mind was to reduce the premium to the original $60,000, but that meant that the death benefit was now only$2 million. In this example, with the cooperation of the insurer, the policy became a Universal Life policy and split 50/50—one with a $3 million face amount, and the other with a balance of $1 million. The $1 million policy was sold in a life settlement transaction for $250,000, and the proceeds from the life settlement provided a large enough cash into the remaining $3 million policy so that the trustee was able to maintain it going forward with the originally scheduled premium of $60,000. The result of using a life settlement meant that the trustee was able to keep $1 million more death benefit in-force than would have been possible with just a partial surrender of the policy to $2 million. Using the same example, had the actual insurance need been reduced to $2 million, the trust would still have been better off selling half the policy in a life settlement transaction as it would increase the cash to $500,000. In addition, if there were no further need for insurance, instead of just surrendering the policy, a life settlement could have provided $1 million in cash. Still, if the $4 million of coverage is actually still needed, a life settlement may still be a creative solution if the estate plan could be served by a survivorship policy instead of a single life policy whereby the proceeds of the sale of the individual policy in a life settlement could facilitate the purchase of a new survivorship policy for the desired amount of death benefit, $4 million. The annual premium gift requirement on the survivorship policy could be kept to $60,000 by using the proceeds of the life settlement for a larger initial premium and/or as a fund within the trust to reduce future premium cash flows to $60,000. All is not coming up roses, however, because there may be tax consequences for the life settlement sale because if proceeds exceed the basis in the policy the net policy proceeds should be calculated accordingly, but as long as the tax rate is less than 100%, a life settlement should provide additional value for the trust. There is a common perception that a life settlement is fundamentally a tool to salvage the most from a policy about to be lapsed or surrendered, which may actually be the case. However, a life settlement is, in effect, a detriment to the heirs who would stand to gain much more if the policy were left intact. This is true in many life settlements because the policy owners decide they need the money for themselves now, rather than for their heirs sometime in the future. In the case of a troubled life insurance trust, however, just the opposite can be true. A life settlement can provide a valuable solution to preserving and maximizing the value of a life insurance trust for its beneficiaries. 154 VIATICALS VS. LIFE SETTLEMENTS There are differences between life insurance settlements and viaticals, which are of interest because of recent regulations in respect to viaticals. Both Settlements and Viaticals are almost identical in practice, as both involved a policy and a funding company transferring ownership of a life insurance policy in exchange for a sum of money. The basic difference between the two is the expected life span of the insured. If the expected life span is short, generally less than two years, the service is deemed a “viatical.” If the insured is in reasonable health and has a life expectancy of 2-15 years, the service is normally deemed to be a “life insurance settlement. There have been problems with viatical policies, but very few policy surrenders with life settlements. The differences are not well known, particularly since they are both involved in moving the ownership of a life insurance policy. Therefore, a trustee should know the difference, particularly since viatical policies have received so much adverse publicity which led to volumes of state regulations targeted at the viatical field. Both types involve an owner of a life insurance selling their unwanted or unneeded life insurance policy. A funding company pays the owner for the policy, typically between 30% to 80% of the face amount of the policy and they pay it in a lump sum. At that point, the consumer is finished with the transaction; in effect they can take their money and run (or take a taxi…). The funding company maintains the policy until the death of the insured, at which time they receive the face amount of the policy. The funding company receives the face amount quickly as they do not want to continue to paying premiums. They, therefore, pay the policyowner with something less than the full amount of the policy immediately. The difference is considered as the funding company’s allowance for expenses and profit for the risk. The primary difference between life settlements and viatical is the expected span of the insured. The catalyst for the viatical was born when AIDs was first introduced into the country. Some AIDs victims were facing extensive health insurance costs with little chance of cure, but they held life insurance policies. They were uninsurable and many times the only property they owned was an existing policy and the cash values which had grown at a low rate (often only 3%) were not sufficient for their needs. The funding (viatical) companies pressed hard to purchase the policies at a lower cost and while that appears to have been a worthwhile situation, some viatical companies were paying very little for the policies as they impressed upon the policyowners that with AIDs (in particular) they would die within a short period of time so they would not pay much for the policies. Obviously, this really “opened a can of worms” with the consequence this is a heavily regulated industry. It is strongly suggested that if this is to be used for estate planning, the policyowner obtain several competitive bids. Legal advice is valuable here. 155 PROTECTING AN ESTATE WITH LIFE INSURANCE As discussed before, this is a critical need especially for larger estates. This type of insurance situation will require the calculation of death taxes and the calculation of projected costs that are essential to the estate planning process. Any person, whose motivation in purchasing life insurance is to protect the estate, should first plan that estate to reduce or avoid every cost possible. After the projected costs have been reduced to the lowest dollar possible, life insurance should then be purchased to cover the remaining costs. The estate planning process creates the car, gas tank, and gasoline gauge. While the life insurance is the gasoline, in the right amount and in the right octane, the amount and type of life insurance must meet the designer's specifications. Prudent estate owners should always plan to pay their estates debts with cash. If Estate property is to be sold then it should be sold at the highest possible price and should not be time constrained. Life insurance should be used to create instant estate cash. The more non-liquid the estate, the greater the potential need for life insurance. In summary there are twelve key points to consider when discussing life insurance in the estate plan: Life insurance is a third party beneficiary contract. Leaving proceeds to third parties, whether directly or in trust, removes the proceeds from the Probate process. Life insurance owned by the insured is subject to federal estate taxation on the ownerinsured's death. The owner of a policy does not have to be insured, and as a matter-of-fact, the owner should not be the insured if insurance proceeds are designed to avoid death taxes. Most state death taxes tax life insurance after certain dollar deductibles have been meet. Some states may not tax life insurance proceeds.(See State Death Taxes, Chapter Seven) Precisely written beneficiary designations are of critical importance. Contingent beneficiary designations should always be made. The estate of the insured should never be named as beneficiary: to do so is to subject the life insurance proceeds to the Probate process. Minors should never be named as primary or contingent beneficiaries because they cannot receive the proceeds without court supervision until they are adults. Insurance proceeds intended to benefit minors should be left to a trust created for their benefit. Life insurance proceeds left to beneficiaries other than the estate of the insured owner are generally not subject to the claims of creditors. This is true with regard to creditors of the deceased, of the estate itself, and of the beneficiaries. 156 A life insurance program should always be coordinated with and became an integral part of the total estate plan. Life insurance recommendations should be discussed with and reviewed by other members of the estate-planning team. SECTION 1035 (LIFE INSURANCE POLICY EXCHANGES) With the introduction of “interest-sensitive” and Universal Life policies which allow the Cash Values to grow at a rate based upon the level of interest paid on investments or cost-of-living indices, the exchange of older fixed-interest whole life policies for the “newer” generation of policies, has become very popular. It is important that such exchange falls under the IRS Code Section 1035, which allows for a tax-free exchange. The IRS establishes certain criteria for a policy exchange to fall within Section 1035 and if the exchange does not meet the requirements, the gain is treated as ordinary income and is taxed. 1. It is an exchange of a life insurance contract for either another life insurance contract, an endowment contract, or an annuity contract, or 2. It is an exchange of an annuity for another annuity contract, or 3. It is an exchange of an endowment contract for either another endowment contract (provided the endowment date isn’t postpones) or for an annuity contract. If there is a loan against the policy, this is a routine exchange. However, if there is a loan against a policy, there are no complications if the new policy has an equivalent loan against it. However, it usually is the case that the new policy does not have a loan against it. In that case, the IRS may determine that that is a taxable gain and subject to income taxes. LIFE INSURANCE PROCEEDS When using life insurance in Estate Planning, the taxation of proceeds is important to recognize. Simply put, life insurance proceeds paid to an individual because of the death of the insured person are not taxable unless the policy was turned over to another (beneficiary, for instance) for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. Interest income, on the other hand, received as a result of life insurance proceeds may be taxable. PROCEEDS NOT RECEIVED IN INSTALLMENTS If death benefits are paid to a person in a lump sum or other than at regular intervals, only the benefits that are more than the amount payable to the receiver of the installments must be shown on the tax form. If the benefits payable at death is not specified, the individual must include this in their income, the benefits that are more than the present value of the payments at the time of death. 157 PROCEEDS RECEIVED IN INSTALLMENTS If life insurance proceeds are received in installments, part of each installment can be excluded from income. In order to determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Anything over this excluded part of the income is to be shown as interest. SURVIVING SPOUSE If the spouse died before Oct. 23, 1986, and insurance proceeds are paid to the individual because of the death of the spouse, up to $1,000 a year of the interest is included in the installments. Remarriage does not affect the exclusion. If an insurance company pays only the interest on proceeds from life insurance left with the insurer, the interest the individual paid is taxable. SURRENDER OF POLICY FOR CASH If a life insurance policy is surrendered for cash, the amount received must be reported any proceeds that are more than the cost of the life insurance policy. The cost—or investment in the contract—is the total of premiums that was paid for the life insurance policy, less any refunded premiums, rebates, dividends, or unpaid loans that were not included in income. One should keep in mind that if one policy is exchanged for another, this may be considered a 1035 exchange and there would be no taxes due. Consult tax accountant or attorney. (Exchanges are discussed elsewhere in this text.) ENDOWMENT CONTRACT PROCEEDS An endowment policy is a policy under which the insured is paid a specified amount of money on a certain date unless the insured dies before that date, in which case the money is paid to the designated beneficiary. Endowment proceeds paid in a lump sum at maturity are taxable only if the proceeds are more than the cost of the policy. To determine the cost, subtract any amount previously received under the contract and excluded from income for the total premiums (or other consideration) paid for the contract. The part of the lump sum payment that is more than the cost is included as income. ACCELERATED DEATH BENEFITS Certain amounts paid as accelerated death benefits under a life insurance contract or Viatical settlement before the insured’s death are excluded from income if the insurance is terminally or chronically ill. 158 LIFE INSURANCE SINCE THE ECONOMIC RECOVERY TAX ACT This section will discuss Economic Recovery Tax Act (ERTA) as it applies to life insurance purchased to protect an estate that has already been built. Under the Economic Recovery Tax Act, people can leave their entire estate tax free to their spouses and can leave all or part of their exemption ($650,000) to non-spouses. Now, most planning for U. S. citizens surviving spouses and other family members results in no tax liability on the death of the first spouse. This is true regardless of the size of the estate. The tax bite may be deferred to the second spouses’ death. A problem does exist. Most existing life insurance policies purchased prior to the Economic Recovery Tax Act (1986) with federal estate taxes in mind insure the life of the bread-earner spouse - usually the husband. If the husband does die first - the purpose for which the insurance was purchased may not materialize. There should be no federal estate tax on his death. A better idea would be to insure the younger of the two spouses. Premiums can be saved and regardless of whose life is insured, the proceeds can be available to pay the taxes resulting from the death of the surviving spouse. This is of massive importance where significant insurance programs are in place. Many insurance companies provide a unique product called a Joint and Last Survivor Policy. This type of policy insures two lives and pays out death proceeds only on the death of the last of the two insured to die. As a method for only insuring the payment of death taxes, joint and last survivor policies have merit. However, if life insurance proceeds are needed for any purpose, insuring the younger spouse may be the alternative. The decision whether to insure the younger of the two spouses to purchase a Joint and Last Survivor Policy can generally be reduced to an economic decision based on the premium costs of each product. The planner must "price compare" for his/her clients as different companies have different premium structures for each of their insurance products. The decision between these two products may not entirely hinge on economics. There may be spouses who will elect to insure their young spouses rather than elect the joint and survivor policy. If the younger spouses do die first, then the other spouse will have the insurance proceeds to use and invest. Since the planner could be charged with improper policy comparisons, he/she should be particularly diligent while doing such comparisons. A complete analysis should be made of the relative costs between existing policies and new policies. Also if the new policy is less expensive truly less expensive on an apples-to-apple basis - old policies should still not be canceled until the new policies are in force. The planner must be very careful to suggest to clients that they should drop an old policy, as the client could be uninsurable or very highly rated due to health problems. THE IRREVOCABLE LIFE INSURANCE TRUST As life insurance proceeds provide the fuel that powers many an estate planning "car,” most of the time the fuel mixture is taxed at the "pump" before it finds its way into the estate planning 159 "vehicle.” A disadvantage associated with the purchase of life insurance is that the life insurance proceeds usually increases the taxable estate of the policy owner. Upon the death of the insured owner, the life insurance proceeds will be included in the insured owner's estate for federal estate tax purposes. If the insured owns a life insurance policy on his/her life, all the life insurance proceeds will be included in his/her estate for a federal estate-tax purpose. In order to avoid federal estate tax many clients have the life insurance on their lives owned by their spouses or others; then upon the death of the insured, the policy proceeds will be paid to the owner's beneficiary federal estate-tax free. There are problems with this cross-ownership technique: 1. The insured loses control of the life insurance policies. 2. Proceeds are usually taxed on the death of the policy owner if he/she is the beneficiary and dies before the insured. 3. Few people can plan for the contingency that the owner/beneficiary may die first. 4. If the proceeds are payable to other than the insured or the owner, there is a gift of the entire insurance proceeds to the beneficiary from the policy owner. The goal sought by insurance policy cross-ownership - to avoid federal estate tax on Life Insurance Proceeds - is a good one. But there is a better way to accomplish this goal. The planner can recommend the use of an irrevocable life insurance trust (ILIT) to own Life Insurance policies that insure an individual life. By using the ILIT, the insurance proceeds will be federal-estate-taxfree upon death. Also, if the client plans for the spouse, the ILIT will keep the proceeds out of the spouse's estate as well. The ILIT is used to own an insurance policy whether it is purchased by the ILIT or given to it. The ILIT must be irrevocable. Once the trust is drafted and signed, it can never be changed. If the ILIT is not totally irrevocable or if the maker retains direct control over it, the insurance proceeds will not be federal estate tax free. By using an ILIT, three estate planning objectives are achieved: 1. Insurance Proceeds can be kept federal estate-tax-free upon the death of both spouses. 2. Because of the terms provided in the trust document, the trust maker can control the insurance proceeds received by the ILIT to care for the maker's beneficiaries. 3. The Life Insurance Proceeds received by an ILIT can be used to pay the death expenses, including taxes on both the maker and the maker's spouse. In summary please note that ILIT drafting is not for rookies and should be implemented by an Estate Planning Professional. One small mistake in an ILIT, and all the tax benefits can be lost. Remember, irrevocable means irrevocable!! 160 CHAPTER 8 STUDY QUESTIONS 1. A Life Insurance policy A. owned by the decedent insured will not be taxed. B. will provide cash for the decedent’s estate when it is needed the most. C. Proceeds are tax free if the estate is the beneficiary. 2. Life insurance proceeds payable to an estate upon the death of the insured A. are tax free. B. must be paid in a lump sum. C. are part of the estate and therefore are taxed. 3. If an individual owns a policy on the life of someone else A. and the owner dies before the insured, the value of the policy must be included in the owner’s gross estate. B. the proceeds payable when the insured dies are tax free. C. the insured can designate the beneficiary. Chapter 8 Chapter Question – Answers & Sections 1 B – page 144 – Ownership and Beneficiaries of Estate Liquidity 2 C – page 157 – Life Insurance Proceeds 3 A – page 149 – Policies on Other Lives 161 CHAPTER NINE - TRUSTS "Put not your trust in money, but put your money in trust" Oliver Wendell Holmes INTRODUCTION A great number of estate planners implement trusts. There are trusts designed to accomplish a host of planning alternatives. Most planners use a variety of trust documents in accomplishing the objectives of their clients. An estate planner uses trusts like a professional golfer uses clubs. However, very few clients will initially understand what trusts can do, what they involve, and how they are structured. Before explaining what trusts are, how they work, and what they may accomplish a brief history is in order. HISTORY Trusts have been used successfully, in one form or another, for hundreds of years and, in fact, go back at least to the Middle Ages. The concept was used by knights who received land in exchange for providing services to the king. (This usually meant going off to fight wars). To keep the land, the knight had to keep providing his services. After years of fighting the king's wars (and with the increasing availability of money taking the place of the barter system), the weary knight started paying the king a fee instead, and the king would then hire a mercenary to fight in the knight's place. Eventually the knights wised up and concluded that they could transfer the title of their land to the church (which was exempt from paying fees to the king), but retain the use of the land for their lifetimes or for several generations to come. This became known as a “trust”, because the knight trusted the church to allow him to continue using the land. So the knight kept the use of his land, the church got title to it, and the king didn't get his fees. This was the beginning of the living trust concept as we know it today. In the United States trusts became associated with greed. Toward the end of the 19th century John D. Rockefeller Jr. was engaged in the capitalistic pursuit of controlling the petroleum marketplace. Mr. Rockefeller did a pretty good job of it. One of the problems he faced, however, was that different states had different laws; and these legal impediments threatened to curtail his interstate growth. With the help of his chief legal mogul, Mr. Dodd, Mr. Rockefeller signed a document called the "Standard Oil Trust.” He transferred all his Standard Oil stock to his trust, and he then named trustees to run that trust. Using a bold common-law form of title holding, Mr. Rockefeller set the world of finance on its ear. Through the use of the Standard Oil Trust, Mr. Rockefeller crossed state lines and an empire was established. Monopoly resulted from this Standard Oil Trust because Mr. Rockefeller indeed controlled the petroleum marketplace. The government stepped in and passed antitrust laws. These laws were passed to curtail and regulate Mr. Rockefeller's monopolies and other monopo162 lies throughout the American marketplace. These laws were antimonopoly laws, not really antitrust laws; but because of Mr. Rockefeller's legal genius, Mr. Dodd, chose to use the old form of ownership to effectuate his client's industrial dominance, trusts became synonymous with and a symbol of monopoly. Thus the nebulous reputation of trusts in the United States—but times are changing. TRUST BASICS In estate planning, trusts enable people to pass title to their property to others either during lifetime or at death. When a person creates a trust and places property in a trust, the trust maker, in effect, makes a gift. Trusts enable their makers to make gifts to their beneficiaries and allow the trust maker to exercise significant control, on a prearranged basis, over the disposition of the trust property. In effect, trusts allow property to pass with "strings" attached. DEFINITION A trust is defined as a legal entity, with all the rights and obligations of an individual and that is used primarily as a property management device. The trust’s primary use is to manage and distribute the property granted to the trust by one party, (called the grantor) for the benefit of another party (the beneficiary). Legal title is transferred to the trustee, usually a third party responsible for the trust assets and their management. The beneficiary, who is not a party to the agreement, holds equitable title to the property since the trust exists for his/her benefit. A trust exists whenever legal title to property has been transferred by one party (grantor) to another (trustee) for the benefit of a third party (beneficiary). In a trust, the legal ownership and the beneficial ownership are separated. The trustee is subject to the terms and restrictions placed on the trustee by the trust agreement at the request of the grantor. The trustee does not need not be a corporate or business "person,” often, the trustee is an individual. PURPOSE OF A TRUST A trust looks a lot like a Will. In fact, it actually does what a Will does. It lets property be distributed to the people or organization specified, but it does not go through Probate. Basically a purpose is used for six reasons: 1. Protect assets from creditors. 2. Income tax savings. 3. Manage trust property. 4. After death management. 5. Utilize the skills of qualified individuals. 6. Secure property for beneficiary. 163 ELEMENTS OF A TRUST There are seven elements in a well designated trust: 1. GRANTOR (CREATOR OR SETTLOR) Intentionally sets up the trust. Only a natural person can create a trust under Will, but a business firm (or anyone else) can create a living trust. The grantor must have the legal capacity to transfer title to property. All states have laws specifying the minimum age at which a person may make a valid, enforceable contract. A trust is a contract. 2. TRUSTEE Holds and manages property for the beneficiary. Trustee and beneficiary have a fiduciary relationship (i.e., the trustee must honestly and loyally act for the beneficiary's good). The trustee manages all assets in the trust. The trustee can be the grantor but this could have adverse income and estate tax implications for the creator. If married, both spouses can be cotrustees. This way either party can act for the other. With a living trust, technically neither party owns the property. The trust owns the property. 3. BENEFICIARY Person(s) for whom the trust exists is the beneficiary who does not have to be a natural person (e.g., a business entity). Beneficiaries must be identifiable, individually or as class. There should be no question as to the identity of beneficiaries. 4. CORPUS A trust is not valid unless there is property to be placed in trust. It must exist at the time the trust is established. Trust property or principal is referred to as corpus of the trust. Almost any kind of property can be held in trust, unless the trust instrument itself places restriction on the type of property that may be held. 5. TRUST INCOME If the corpus consists of income producing property, then the trust agreement must specify what is to happen to this income. A trust that pays out all income it is a "simple trust.” Trusts that accumulate some or all of their income are "Complex Trusts.” When the trustee has discretion over distributions, the trust is referred to as a Discretionary Trust. When the grantor retains sufficient powers over or rights to trust income that he/she is treated as the owner of the trust for income tax purposes, the trust is called a Grantor Trust. 6. LAWFUL PURPOSE The trust must exist for lawful purposes. Obviously the trust cannot involve the commission of a crime to meet its objective nor can it generally deny the basic constitutional rights of individuals. 7. TERMS The terms of a trust must be stated fully and clearly and should be in writing. Some states allow parol (oral) trusts but written trusts remove any doubt as to existence and terms. 164 SELECTION OF TRUSTEE Trustees may be individuals or entities (Bank and Trust Companies). Many people prefer to name as a trustee a relative, friend, financial adviser or other individual close to the family. If any individual is named, it is important to be sure that the person chosen has the honesty and basic financial know-how to serve competently. A trustee should know what needs to be done, and know how to get advice from people who know of such matters. There are decisions to be made if a client is considering an institution as opposed to an individual as a trustee. 1. Consider the costs. Bank Trust Departments charge an annual fee that often is in the neighborhood of 1% of assets under management depending on the size of the estate. 2. Look for a corporate trustee who has a record of experience and stability. If the trust will include a family business, real estate or other non-financial assets be sure to check these areas of experience. 3. Request a meeting with some of the Trust Department staff. Always ask about employee turnover and any pending mergers that might affect the institution's trust business. 4. Check the track record of investment results within the Trust Department. Because of concerns about investment performance consider designating a family member or other individual as co-trustee with an institution. Under an arrangement, if the institution fails to meet expectations, the individual can replace it. This could be one way to keep the Bank "on its toes.” 5. Trust Protector. This person would act as a watch dog and place limits on an institution's authority. Such an individual could be given authority to remove a corporate trustee. Since trust protectors are neither co-trustees nor beneficiaries, they would avoid some of the problems that may complicate other power sharing arrangements. DUTIES OF TRUSTEES Generally, a trustee's duties are four fold: • Dealing prudently, as though with the trustee's own property. • Performing the needed acts required and not delegating such acts to others especially if the trustee is capable of performing such acts. • Keeping good records in all trustee activities. • Representing the beneficiaries of the trust in accordance with the creator’s wishes. POWERS OF TRUSTEES The powers of trustees, either individual or institutionally, come from two sources; the law, and the terms of the trust itself. Some of the powers of a trustee would be: 1. A trustee may incur reasonable expenses necessary to perform their duties. Reasonable 165 expenses will be reimbursed from trust income and corpus. 2. A trustee can lease trust property unless the trust agreement prevents it. 3. The trustee cannot continue a business. The trustee must sell the business interests and invest the sale proceeds in permissible trust investments. If the creator would want his/her business to continue then it should be so defined in the trust agreement. LIABILITIES OF TRUSTEE Acting as a trustee involves a series of duties and responsibilities that accompany such powers, commonly known as fiduciary responsibility. Such duties include individuals or trustees that are acting for another's benefit. When acting as a trustee, fiduciary responsibility is only concerned about the property in the trust. As a fiduciary of a trust the individual is under a legal duty to fulfill all obligations inherent in the relationship until relieved of such duties. The duration of such duties can be from one year to 30 years. It will vary depending on the completion of the administration of the trust. There are four basic duties to all fiduciary relationships: 1 The trustee should not delegate his/her responsibilities. 2. The trustee should not profit at a beneficiary's expense (no conflict of interest). 3. The trustee must make full disclosure of all activities in the account. 4. The trustee must act for the beneficiary's benefit. Special note: An individual is held to a lesser standard than an institution. An individual must act according to the prudent-man rule. This means that an individual must exercise judgment and care which can reasonably be expected of prudent people. THE TRUST AGREEMENT The trustee's power comes from the trust instrument and only last as long as the trust is in effect. The trustee generally has the power to: 1. Compromise claims. 2. Distribute property in cash or kind or both. 3. Retain or sell investments, mortgage property, borrow money. 4. Invest and reinvest in common trust. 5. Hire attorneys, investment advisor, accountants, etc. A planner should recommend five considerations for a client before selecting a trustee: 1. Complications could occur when a beneficiary is a trustee (can't participate in decisions). 2. Elderly trustees may be able to provide only temporary services. 3. Trustees who are family members have difficult (uncomfortable) positions. 166 4. Individual trustees are not scrutinized the way corporate trustees are. 5. Due to the changing law and responsibilities, a trustee position is very difficult. COMMON PROBLEM AREAS Two common problem areas of breach of duty occur when a trustee (1) "borrows" and never returns trust assets (This is a civil and criminal breach); or when the trustee invests trust funds at lowest return rate possible when higher return rate investments would not overly risk funds (breach of duty). ILLEGAL TRUSTEE ACTIVITIES Some actions that a trustee must not engage in are: 1. Compete for investments for business purposes. 2. Profit personally from dealings involving trust property. 3. Invest trust fund in the stock of the corporation (a Bank as trustee may not invest trust funds in the Bank's stock, and in some states, the trustee bank may not deposit trust funds in trustee's own bank). 4. Purchase property from a third party in which the trustee account has an interest. 5. Favor one trust account over another. 6. Use trustee property for personal use. 7. Sell to self as a trustee any property owned personally (unless authorized by the Will or trust agreement). INVESTMENTS BY TRUSTEES Investments by trustees must follow one or two rules: the Prudent-man rule or the use of prescribed list of investments (known as "legal investments"). This list will include: U.S. Government Securities, state and municipal bonds, public utility bonds, first mortgages on real estate and mortgage participation certificates. Often times the trust agreement will allow the trustee to invest in common stocks. TYPES OF TRUSTS For the purpose of estate planning, there are five basic types of trusts: 1. Funded (Income-Producing Property in Trust or Unfunded (only nominal assets). 2. Living Trusts: Created while the grantor is alive and the trust becomes active during grantor's life. (Also known as the Inter-vivo Trust which will be discussed in detail later in the text) 3. Testamentary Trust. Created through a Will and becomes effective at grantors’ death, at which time the trust becomes irrevocable. 167 4. Revocable or Irrevocable Trusts during the grantor's lifetime: Such provisions must be stipulated in the trust agreement. Revocable trusts may be altered, amended, revoked or terminated. In an irrevocable trust however, the grantor retains no rights whatsoever with respect to altering, amending, revoking or terminating the agreement. These types of provisions are seen in Testamentary trusts. These trusts are never created to benefit the creator. Death trusts have no life until the death of the maker. Testamentary trusts are included in the Probate process and are subject to the local Probate court's direction and control. 5. Insurance Trusts are intended to hold, invest in or administer a life insurance policy or proceeds for personal or business use. Almost any type of trust may be a life insurance trust. The advantages of living trusts will be explored in detail, however prior to such a discussion, the planner should have a general knowledge of the advantages of any trust. ADVANTAGES OF TRUSTS There are numerous advantages in establishing a trust. Most of these advantages have become popular since Mr. Dacy’s Book "How to Avoid Probate." As mentioned in the History Section of this Chapter in the past there has been confusion as to the basic nature of "trusts,” with clients becoming more sophisticated and aware of the need for planning the utilization of trust. There are 11 distinct advantages of establishing trusts: 1. Trusts avoid Probate and helps clients save money. 2. Keeping control. The trust document outlines instructions of the creator on how to manage assets and distributing such assets after death. A client can be sure that assets are handled the way he wants. 3. Takes less time to distribute property. Instead of a long drawn out Probate procedure, distribution could take but a few weeks. 4. A trust is private. There is no announcements have to be placed in the paper upon death. The deceased is not part of the public record. No information about a client's assets, beneficiaries or trustee will ever be made public. 5. Minimize emotional stress. Since all affairs are handled quickly and easily, families are able to continue their normal day-to-day routines. There are no prolonged court proceedings. 6. Easy to establish. Although the cost of establishing a trust will be more expensive than writing a Will. Remember, the true cost of a Will also include the cost of Probate in the long run, a trust arrangement will probably save clients’ money. 7. No special government forms are required. If the client is the trustee or co-trustee a separate Tax identification Number is not needed. 8. Low maintenance - Easy to change. Usually setting up a trust is one-time charge. If changes are needed, an attorney can prepare an amendment for a nominal cost. There is no 168 need to have the whole trust redone. 9. Ease of making special gifts. If the client wants to give certain items to specific people and or organizations all that would be required is the preparation of a single sheet of paper, (have it notarized) and place it with the trust document. The notarized list is a legally recognized amendment to the trust document. 10. Effective pre-nuptial protection. This is popular because your client can place any property into the trust before he/she marries and the property of that trust stays separate from property accumulated during the marriage. 11. Reduce or eliminate estate taxes. A trust can also reduce or even eliminate estate taxes. (We will look more closely at this in the next section). DISADVANTAGES OF A TRUST 1. As noted, a Trust arrangement is more expensive than a Will. 2. It will take time to change titles and beneficiary designations. Depending on the number of assets a client might possess the time element will vary. 3. Loss of bankruptcy protection—in some states, a portion or all of the home is automatically protected from creditors if one is filing for bankruptcy. When a client places his home in a Trust, this protection might be lost. But the amount of protection forfeited will depend on the state. There are many specific Trusts from revocable Living Trusts to generation-skipping Trusts. BASIC TRUSTS There are other trusts discussed in this text, such as Crummey Trusts, and Protect Assets for Kids Trust, but these are Trusts that are used more for specific purposes and are not used as frequently as the ones above. INTEREST RATES AND TRUSTS Many trusts are required by tax law to use a special interest rate—issued by the IRS each month. Many popular trusts, such as Grantor Retained Annuity Trusts (GRATS), Qualified Personal Residence Trusts and charitable trusts, are all susceptible to interest rate fluctuations as the success of the trusts changes with changes in rate occur. The rate assigned by the IRS is primarily how much the IRS estimates a trust will earn for tax purposes, irrespective of how much the assets actually appreciate; actually it is just an assumed rate of return. Said rate is known as the “7520 rate” or “hurdle rate” and it is linked to Treasury bond yields and is used to determine the possible tax bill when setting up a trust. GRATS and Charitable lead annuity trusts work best when rates are low, but conversely, QPRTS and Charitable Remainder Trusts do better when interest rates are high. 169 When considering a trust, it is important for the owner to discuss with an attorney and accountant as to present interest rates and whether the rates are projected to move higher or lower in the future. This may indicate waiting for a short period of time in order to take advantage of rate fluctuation. TRUST LOCATION An irrevocable trust does not have to be located where one lives, as evidenced by a spate of new laws making these places attractive for setting up a trust—states such as Delaware, South Dakota, Alaska, Nevada, Florida Wyoming and New Hampshire. The location does not make much difference for smaller trusts, or especially for living trusts as there are no special tax breaks. There are people that have actually moved to one of these states because of trust laws, but in any event, the trustee usually must be located in that state (such as a trust company, lawyer, and family member). Generally a trust company, a lawyer, or friend can recommend a trustee. The advantage of going outside of the state can be the avoidance of state income taxes— Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming do not have such taxes. Delaware and New Hampshire usually do not impose a tax on trust assets if the beneficiaries live outside the state. FLEXIBILITY IN BENEFICIARIES Usually trusts have two beneficiaries—current and future. A “current beneficiary” usually is a surviving spouse who receives income distribution. Future beneficiaries are usually children or grandchildren with assets placed in trust. This has led to inter-family riffs, to say the least, as their demands normally differ—a spouse wants to invest safely, such as in bonds, to maximize her income. Children many times want an active aggressive portfolio to increase the principal. More than 40 states have created a “power to adjust” which gives trustees flexibility to make contribution, even if that means tapping into the principal. Five states (AL, CAL, FL, IL, and PA.) have laws allowing trusts to pay current beneficiaries a fixed percentage of trust assets (usually 3% or 5%) instead of just paying out the income generated by the trust. TRUST INTEREST RATES Many trusts must use a special interest rate required by the IRS who issues such rate on a monthly basis. The effect is that many of the more popular trusts —such as GRATs, QPRTs and charitable trusts—are sensitive to interest rates. This means that the success of the purpose of the trust varies when interest rates go up or down. The rate is determined by the IRS and how much they estimate the trust will earn for tax purposes—regardless of how much it actually increases or decreases. This rate, known as the 520” rate, or “hurdle rate,” is linked to Treasury bond yields, and such is used when establishing a trust. The effects on the trusts vary. For instance, GRATs and Charitable Lead Annuity Trusts 170 (CLATS) are more useful when rates are low; conversely, trusts such as QPRTs and CRATs work better in a higher interest rate environment. Obviously, when considering using a trust, the current interest rates and projected interest rates must be discussed with one’s lawyer or accountant. Sometimes, just waiting a month could make a substantial difference at a later date. QUALIFYING TERMINABLE INTEREST PROPERTY TRUST (Q-TIP) Four requirements must be met for the Q-TIP Trust to qualify for a Marital Deduction Trust: 1. Decedent spouse/donor must make a transfer of property. 2. Surviving spouse/donee must be entitled to all the income for life; the income must be payable at least annually. 3. No one can be given the right to direct that the property will go to anyone (other than the surviving spouse) as long as the spouse is alive. 4. The Executor appointed by the first decedent spouse must make an irrevocable election on the decedent's Federal Estate Tax return, providing that the value of whatever Q-TIP property is left at the death of the surviving spouse will be included in the estate (i.e., the remaining property's value at surviving spouse's date of death). ADVANTAGES OF Q-TIP TRUST 1. 2. 3. 4. 5. Protection against creditors. Avoidance of Probate of trust principal at death of the surviving spouse. No power for surviving spouse to dispose of the property. Grantor assured that trust assets will go to those the grantor selects. A spendthrift spouse cannot consume assets. DISADVANTAGES 1. False sense of security that estate owner's objectives will be realized. 2. Assets use restricted. 3. Non-income producing property can only be used to fund the trust if the surviving spouse is granted power to demand that the assets be made productive. QTIP TRUSTS – FOR SPOUSES This is simply a way for making sure that the money goes where the one wants it to go, such as a new spouse or a brother-in-law or stepchildren. The trusts allow one to leave the surviving spouse with money from the trust to spend for the remainder of their life, but upon the spouse’s death, the leftover QTIP trust assets pass as indicated in the trust, rather than how the surviving 171 spouse chooses. Many “blended” families use QTIP trusts to make sure that children from a previous marriage get any remaining assets from the trust once the spouse is gone. Another advantage is that with a QTIP trust that benefits the surviving spouse, no estate taxes are due upon the death of the settlor (the one creating the trust). However, there are some tax laws that say that when the spouse dies, whatever is left in the trust may be subject to estate taxes if the estate is big enough. Basically, one could say that if the estate is large, the QTIP trust defers estate taxes, rather than eliminating them completely, but it allows the trust creator (settlor) more control of where the money eventually ends up. For very wealthy families, QTIP trusts are often used combination with credit shelter trusts. They place the maximum amount that can be sheltered from the estate taxes in credit shelter trust to ensure more control over death. QTIP trusts are regulated by states and are not authorized in a few states. Note the STATE TAXATION section for states in respect to QTIP trusts. CONSUMER APPLICATION When planning for the future, sometimes there are questions best left unasked: When planning for formal estate planning, Jill has a thought and asks her husband, Bill, “If I die first, will you remarry?” Bill says, “Probably— because our children may need someone to be a “mother” to them and it would be better than simply getting a Nanny and there are a lot of financial advantages such as the large equity we have in our home.” Jill thinks about it, and then asks, “If you remarry would she get my mink coat?” “Yep,” Bill responds. “How about my jewelry?” “Yep.” “Would she get my car and my art collection?” “Yep” “Okay, how about my golf clubs you bought me when we got married?” “Nope!” Jill says, “How come she would get my coat, and my jewelry and my car and my art collection, but not my golf clubs?” Bill replies, “Because she is left-handed.” QPERT TRUSTS FOR REAL ESTATE Homes are often the most valuable asset in many estates. A “Qualified Personal Residence Trust (QPERT) - (You can pronounce it Kew-Pert” if you want). This allows families to pass on future appreciation of a house’s value to heirs, free of estate tax. This trust is best if it is expected that the house will appreciate (as it die in previous years). There could be a gift tax, however, because you are basically making a discounted gift of the house to the children. Simply put, the parent transfers deed of the house into a trust and are entitled to life in that house for the length of the trust which can vary, often ten years. For example when the trust was established, the house was worth $1 million, but ten years later, the house is worth $5 million. When the trust ends, regardless of its appreciated value, it passes to the children and out of the 172 estate, estate tax free. There might be gift tax with a QPRT, as there are special IRS formulae to determine the value of the gift to the children, based upon various factors, such as the value of the house when it was put into the trust, the length of the trust, and a special rate determined by the government each month. It usually works out that the longer the length of the trust, and the higher the interest rate, the small the potential gift tax amount owed. DANGER: Not really a catastrophe, but if the parent dies before the end of the trust, the property goes right back into the estate which is valued at time of death. So, this works best if the settlor lives for more than ten years. But, if the person outlives the trust, the heirs could face considerable capital gain taxes if they should try to sell the house because with this QPRT, the heirs do not get a step-up in cost basis. It is smart to consult with an attorney as there are lots of tricky tax rules that must be considered. But what if one outlives the trust and do not want to move out of their house. The settlor can continue to live in the house by paying rent to the children (at fair market value). Sounds odd to have your children be your landlord(s) but practically, it is another way to transfer more wealth to them without incurring any estate taxes. Children would appreciate the fact that this is just a way of their getting more money from the estate when their parent(s) die. “GRAT”-TRUSTS FOR APPRECIATED ASSETS Another trust that helps remove assets from your estate quicker and helps to avoid taxes on future appreciation is the Grantor Retained Annuity Trust (GRAT). These trusts can have a short life span—as short as two years—are used primarily for those who have assets that are expected to increase in value, such as depressed stock or shares in a private company that is expected to go public. If the assets do well, a large part of the appreciation in the trust can pass tax-free to the heirs at the end of the trust period. Typically, a parent transfers assets to a trust and received fixed annuity payment for a specific period of time (just like an annuity). The interest is permanently applied and set up at the trust creation and with a GRAT, the lower the rate, the greater the chances of passing more money to the beneficiaries. If the trust is established correctly, the parent will eventually get back the principal placed in the trust, plus interest as set according to the Trust. The excess goes to the children— tax free— when the trust ends. HOWEVER, if the parent dies before the end of the trust’s term, the assets of the trust could be taxed as part of the estate, which would mean that there is no purpose for the trust. However, estate advisors maintain that there is little tax risk, although a fee for setting up such a trust could range from $2,000 to as high as $10,000, and often last just a couple of years. That way, one is not tying up his money for a long time if situations change drastically. 173 DYNASTY TRUST There has been an old “rule against perpetuities” law that placed time limits on trusts – usually 90 – 120 years. Now states are allowing dynasty trusts that can last for hundreds of years—or even into perpetuity. The idea is that as long as money is held and invested by a trust, it can pass among generations without additional estate taxes. If a trust was funded with $1 million, and after a hundred years, it would grow to $867.7 million @ 7% annual growth rate. A dynasty trust can be funded several ways, including life insurance or selling interest in a business to the trust. A simple (and more feasible) way is to make annual exclusions gifts so the money is not subject to gift taxes ($13,000 currently). A true value of this kind of trust is that assets that the family has worked hard to assemble can be retained without being confiscated in a couple of generations. ASSET PROTECTION An asset protection trust is of interest lately to doctors, business executives and other professionals. The assets are transferred into a trust that is managed by an independent trustee, who has discretion over the trust but who can provide out distributions when needed. The purpose is usually to keep the assets out of the reach of creditors in legal judgments. Others have widely used offshore trusts, such as in the Cook Islands and Nevis, plus several states (including Alaska, Delaware, Rhode Island, Nevada and South Dakota) allow these trusts. It should be noted that asset protection trusts set up in the US have not been adequately tested in the courts, leaving experts to wonder how well they will hold up if tested. CHARITABLE REMAINDER TRUST As discussed, there are many advantages for charitable planning during a lifetime. Most notably, an individual may secure a lifetime income, save on income and estate taxes, enjoy the satisfaction of making a gift and, if one wishes, receive public recognition. Because the organization knows it will receive the gift at some point in the future, it can plan future projects and programs now, and benefit even before it receives the gift. One of the most commonly used forms of charitable tax planning is called the charitable remainder Trust. It is a way a client can convert a highly appreciated asset (such as real estate or stocks) into lifetime income without having to pay capital gains on the sale or estate taxes upon death. At the same time a client can benefit one or more charities or organizations that have special meaning. Anyone who is 50 or older, owns a highly appreciated asset, who is in a high income bracket and would like to enjoy profits now but want to avoid capital gains and estate taxes, should give this Trust every consideration. HOW THE TRUST WORKS An individual places a highly appreciated asset into an irrevocable Trust, naming one or more qualified charities as beneficiary. The Trustee then sells the asset at full market value, paying no 174 taxes on the capital gain, and reinvests the proceeds in income-producing assets, which will grow tax-free. For the rest of the one's life, the Trust will pay an income when the individual dies, the remainder of the Trust assets (the principal) will go to the charity. If an individual just decides to sell the property themselves and reinvest the proceeds then they would pay more in income and estate taxes and have less left for the beneficiaries. Twenty years ago Percy purchased a piece of real estate for $100,000. He had is appraised recently and discovered that is now worth $500,000. However, now that Percy is 55 years old and looking forward to retirement, he feels that he would rather have the money in Mutual Funds or other investments, and not have to worry about the real estate. If Percy sells the property, he would have a capital gain of $400,000, which is taxable as ordinary income in the year that the asset is sold. Therefore, Percy would have to pay approximately $113,000 in federal income taxes which leaves only $387,000 to invest. Percy realizes that if he should die, estate taxes will also have to be paid. If the property value had increased to $1,400,000 at the time of his death, his estate would be in the 40% estate tax bracket. Percy’s estate would lose another $154,800 from the property in estate taxes. That makes a total of $267,800 in income and estate taxes, leaving only $1,232,200 for the beneficiaries. Percy’s estate planner suggests that he put his funds into a charitable remainder Trust. The income taxes on the capital gain and estate taxes are eliminated, plus, in the year the property is placed into the Trust, the individual can take an immediate charitable tax deduction, reducing current income taxes. The Trustee sells the property for the full market value and because there are no capital gains taxes on the sale, reinvests the full $500,000 in a balanced portfolio (like stocks and bonds) to provide the individual with a lifetime taxable income. Now the entire $500,000 is working instead of only $387,000. The amount of income received from the Trust is flexible, and will depend upon how much income is needed, the value of the property, age, life expectancy, etc., of the client. For example, if Percy elects to receive an annual income from the Trust equal to 8% of the Trust's assets, for the first year, then Percy will receive $40,000 in income (8% of $500,000). If the Trust is well managed, it will grow quickly because whatever the Trustee earns over 8% will be added to the Trust assets and reinvested tax-free. The Trust is revalued each year to determine the dollar amount of income to be received. As the Trust grows, income will grow also as Percy would be receiving 8% of a larger amount. TYPES OF CHARITABLE REMAINDER TRUSTS The Charitable Remainder Trust (CRT) is one of the most flexible instruments in estate planning. Since at the end of the donor’s life, the charity(s) receive the remainder after the lifetime income of the donor has been subtracted, this is called as a “Split Interest” trust. There are two interests: the income interest and the charitable interest, and when the trust is property drawn up, the CRT can benefit both interests. 175 There are two basic kinds of CRT’s. One kind pays a fixed income to the income beneficiaries while the other pays a variable income. When it pays a fixed income, it is called a Charitable Remainder Annuity Trust (CRAT). When designed to pay a variable income, the CRT is called a Charitable Remainder Uni-trust, as discussed in the next section. To differentiate, the CRAT is fixed income, and CRUT is variable income. (Again, acronyms – one has to think of a convention of estate planners, discussing the merits of “CRUTs” and “CRATs,” etc…) Generally, the CRAT is used for older income beneficiaries who want to be able to plan on a fixed amount of income each year for the rest of their lives. On the other hand, the CRUT is usually younger donors who are afraid that inflation could erode the value of a fixed dollar amount. UNI-TRUST The Trust can include a “make-up” provision, so if the Trust does not earn enough to pay 8% (for example) one year, it will make up the difference in a better year. Since a percentage of the value of the Trust assets are being paid, this is referred to as a Charitable Remainder Uni-trust. If the individual elects instead to receive a fixed amount of income each year, this would be called a Charitable Remainder Annuity Trust. This means that the amount of income received is guaranteed, it will not go down if the Trust has an "off" investment year. But it also will not increase if the Trust does well, because they want protection against inflation, many people prefer to receive a percentage of the Trust's assets as income (the Uni-Trust). The charitable income tax deduction is based on the amount of income the taxpayer receives, the size of the gift and the age. (Basically the more elected to receive in income, the less the deduction will be.) It is limited to either 30% or 50% of the adjusted gross income, depending upon how the IRS defines the charity and the type of asset involved. If the entire deductions are not used in the first year, it can be carried forward for up to five years. TYPES OF ASSETS SUITABLE FOR THE TRUST The best assets for a Charitable Remainder Trust are those that have greatly appreciated in value since purchased, including real estate, a closely held company and publicly traded securities. SELECTING A TRUSTEE Although the client can be the Trustee of his/her charitable remainder Trust, it's usually not a good idea because of the lost tax advantage if the Trust is not administered correctly. Anyone can be named but because of the investment and administrative experience required, many clients choose a corporate Trustee. Some charities also like to be the Trustees, and frequently the charity will pay for the cost of setting up the Trust in return for being named the Trustee in addition to beneficiary. Keep in mind that, if an individual elects to receive a percentage of the Trust value (the Uni-Trust), they are depending on the Trustee's investment performance for their income. It will be important to be sure the Trustee has a good past performance record as an investor! Most people will not be their own Trustee, however they still have some control. Until they die, the Trust controls the assets transferred to the Trust - not the charity that will eventually re176 ceive them. The Trustee selected must follow the instructions in the Trust. Also, an individual can retain the right to change the Trustee at any time. It is also possible to change the beneficiary of the Trust, but only to another qualified charity. Otherwise the tax advantages are lost. Generally, once an irrevocable Trust is signed, no changes may be made. WHO CAN RECEIVE INCOME FROM THE TRUST In this example, the Trust was set up to pay a lifetime income to the creator, but there is quite a bit of flexibility. If one is married, the Trust can pay an income for as long as either of the married couple is alive. The Trust could also be set up to last for the combined lives of the children. The person who receives the income doesn't even have to be related to the creator, or even be a person. Also, instead of lasting for someone's lifetime, the Trust can be set up to last for a set number of years up to 20. One can also defer the income until later. For example, one may want to sell the property now to be free from management headaches, but aren't yet ready to retire and do not need the income. One can set up the Trust, taking the income tax deduction in that year, and the Trustee will invest the Trust assets. By the time the individual is ready to receive an income, the Trust, with good management, will be substantially greater in value, resulting in a higher income. CHARITABLE REMAINDER UNITRUST A charitable remainder uni-trust is an irrevocable trust created under the authority of Internal Revenue Code § 664 ("Code"). This special, irrevocable trust (known as a "CRUT") has two primary characteristics: (1) Once established, the CRUT distributes a fixed percentage of the value of its assets (on an annual or more frequent basis) to a non-charitable beneficiary (which is considered the settlor of the trust); and (2) At the expiration of a specified time (usually the death of the settlor), the remaining balance of the CRUTs assets are distributed to charity. The trustee determines the fair market value of the CRUT's assets at the time of contribution, and thereafter on the applicable valuation date. The fixed annuity percentage must be at least 5% and no more than 50% of the fair market value of the assets in the corpus. The remainder (the amount expected to go to charity) must be at least 10% of the fair market value of the assets contributed to the CRUT. Code Section 664(d)(1) sets the federal income tax requirements for a charitable remainder unitrust. Example: Assume an individual, Mr. Smith, has $1 million of publicly traded stock and would like to establish a CRUT. Assume the CRUT is set up to pay the annuity to Mr. Smith over his lifetime. Mr. Smith selects a 10% CRUT. The CRUT will pay Mr. Smith 10% of its assets (initially $100,000) per year until Mr. Smith passes away. At that time, any balance remaining in the CRUT will be distributed to charity. The term "uni-trust" means the annuity percentage is fixed; the 177 CRUT will distribute 10% of the value of the CRUT's assets each year, which may increase or decrease over time. REQUIREMENTS A charitable remainder uni-trust is a trust that which meets both: (1) The applicable rules under state law for a valid Charitable Trust; and (2) the requirements set forth in Code Section 664(d)(2). STATE LAW REQUIREMENTS First, a CRUT is formed like any other kind of trust, and must be valid under state law. Most states require CRUTs to be registered with the state. For example, California requires charitable trusts to be registered by filing a form ( CT-1) with the state attorney general. This is because the state attorney general represents the charitable interests involved with CRUT. INCOME TAX REQUIREMENTS Code Section 664 imposes the following requirements on CRUTs: FIXED PERCENTAGE PAYMENT The CRUT must distribute a fixed percentage annuity to the non-charitable beneficiary. This percentage may not be less than 5 percent or more than 50 percent of the net fair market value of the CRUT's assets. The CRUT's assets are valued annually, and the annuity amount is determined at that time. As may be seen, the amount of the annuity might vary from year to year, but the percentage always stays the same. For example, assume a 10% CRUT is established, and assume the value of its portfolio holdings in year 1 is $1 million. The annuity that year is $100,000. Assume the portfolio drops in value, and in year 2 is worth $900,000. The annuity in year 2 will be reduced to $90,000 (10% of the value of the CRUT's assets). The annuity must be distributed not less often than annually to one or more persons. The "person" may be an organization, however, it may not be a charity described in IRS regulations. The CRUT is usually set up so that annuity is paid to the settlor of the trust. In the case of natural persons, payments may be made only to those who are living at the time of the creation of the trust. The annuity is paid to that non-charitable beneficiary for his or her lifetime, or for a fixed term of years (not to exceed 20 years). NO OTHER PAYMENTS The CRUT may not distribute any of its assets to anyone other than the annuity recipient or the qualified charity beneficiary. The CRUT may not let any of its assets be used for the benefit of anyone other than the annuity recipient or the qualified charitable beneficiary. 178 TRANSFER REMAINDER INTEREST WHEN TERMINATION OF PAYMENTS Once the annuity period is over (i.e., at the death of the non-charitable beneficiary, or at the expiration of the term of years), the remainder of the CRUT principal is distributed to charity. The charity must be an organization described in these regulations. PORTION OF REMAINDER INTEREST IN CONTRIBUTIONS TO TRUSTS At least 10% of the statistical fair market value of each contribution of property to the trust, must be a part of the remainder interest that will pass to charity once the annuity term expires. Treasury Regulations have imposed several other conditions relating to CRUTs: NICRUTS & NIMCRUTS Treas. Reg. §1.664-3 authorizes CRUTs to be drafted so that the annuity can be the lesser of the annuity percentage, multiplied by the fair market value of the CRUT's assets (i.e., the normal annuity amount); or the amount of the CRUT's "trust income" for the year. This is known as a "net income CRUT", or NICRUT. For example, assume a 10% CRUT holds $1 million in assets. Assume the CRUT has only $70,000 of income that year. A NICRUT would distribute $70,000, because that is lesser than the ordinary $100,000 annuity. Furthermore, Treas. Reg. §1.664-3(a)(1)(i)(b)(2) allows the CRUT to pay a "makeup amount", which means if the trust income is lower than the selected fixed percentage, the trustee can distribute a "make up amount" from the trust's income in subsequent years. This is known as a "net income/makeup CRUT", or "NIMCRUT". For example, assume the NICRUT above distributed $70,000, and had $130,000 of trust income the following year. Assume the NICRUT included the makeup provision (making it a NIMCRUT – really! Can’t make these names up.). The NIMCRUT would distribute the $130,000 to the annuity beneficiary. GRANTOR-RETAINED ANNUITY TRUST (GRAT) There are trusts that help remove assets from an estate quicker than normal to help avoid taxes on appreciation. An example would be where one purchased stock at a very low price so one would want to get those shares out of the estate early as if they suddenly grow in value, the appreciated value is not subject to estate taxes. This is where the GRAT comes in as their life span can be as short as two years , making them popular with families who have assets that are expected to increase in value (stock in a private company that is going public is an example). If the trust assets perform as expected, much of the appreciation can pass tax-free to heirs when the trust ends. Typically, a parent will transfer assets to a trust and receive fixed annuity payment from the trust for a specified period of time. A GRAT is subject to a special interest rate (set by the gov179 ernment) and locked in when the trust is created. The lower the rate, the greater the chance is of passing more money to beneficiaries. It is important to make sure that trust is structured properly so that the lower the rate, the greater the chance of the beneficiaries receiving more money. HOWEVER, if the owner dies during the term of the trust, trust assets could be taxed as part of the estate, which would, obviously, defeat the purpose of the trust. But, even though the setup fees can range from $2,000 to $10,000, they are short-term and often last only a couple of years. Therefore, one does not tie up money for a long period of time is the financial situation changes dramatically. THE CRUMMEY TRUST A Crummy trust allows one to transfer property and have the gift qualify for the annual gift tax exclusion. The primary physiognomies of a Crummey trust (named after a court case) is that it gives the beneficiary may demand distributions from the trust equal to the lesser of the amount of the contributions to the trust during the year or some specified amount (e.g., $5,000 or 5% of the trust's value) and to provide such on an annual basis. The beneficiary (or legal guardian) must be notified of the power to withdraw from the trust, even though such power may lapse or terminate after a short period of time (e.g. 30 days). If the beneficiary fails to make a demand during the specified period of time, and after being notified that a contribution was made, the right lapses for that year's contributions. To the extent the beneficiary (or legal guardian) has the right to demand distribution of the year's contribution, legally such contribution would be considered as a "present interest" and thereby allowing it to therefore, qualify for the annual gift tax exclusion. Flexibility of a Crummey trust makes it advantageous in many cases. The trustee can be required to accumulate income until the child reaches a specified age above age 21. The trustee also can be restricted to using trust assets and income for specific purposes (e.g., college expenses)— another way of providing educational funds. The trust is useful as a vehicle for permanently removing assets from the parents' gross estates. SPRINKLING POWERS Using “sprinkling powers” (or “spraying powers” ) when designing a Trust for children or grandchildren can help to “even out” the benefits when one family member may need more help from the Trust than others. An example is where one child marries a very wealthy person and will not need as much financial assistance for either themselves or their children, as other family members. Bob and Marie have two children, Sue and Bill. Sue marries the son of a very wealthy individual who is also the sole heir to a fortune. Sue and her 2 children will probably never need financial support, however the situation could change in case of a divorce. (Continued next page) 180 Bill has always had a hard time of it, barely getting through High School and flunking out of college. He joined the Army as a career, is married and has 3 children. He probably will stay in the Army and retire as an enlisted man. One of his children has evidenced symptoms of a learning disability. Bob and Marie create a Trust by Will, which will produce an annual income, and the income will go to the five grandchildren as heirs. The length of the Trust is until the youngest heir turns 60 years of age. The Trust will be spread by 20% to each of the heirs. BUT, the Trust contains the following wording: “The Trustee is hereby ordered to produce all of the income that a prudent man can generate under the economic conditions of the time and to distribute all such income to the named beneficiaries every year, using the percentage amounts mentioned above for guidance purposes only. The Trustees are given complete Sprinkling Powers. If one of the heirs should experience a health problem or a serious financial problem, the Trustee is ordered to use the Trustee’s personal judgment as to the distribution of the income to that heir that year. The income may be sprinkled among the named beneficiaries in any proportion the Trustee deems in the best interest of the heirs.” POUR-OVER TRUSTS The grantor's Will instructs the Executor to collect all assets that are subject to court jurisdiction and to pay all of the estate liabilities with the remaining assets into a single Trust which is set up during the testator's life - the “Pour-Over. The Trustee becomes responsible for the management and disposition of the estate's assets. ADVANTAGES: 1. Consolidated property management into one instrument is efficient for lower fees. Since most Trustees’ fees are a declining percentage of the amount of property being managed, as the total amount of property increases, the Trustee’s fee diminishes proportionately. 2. Such consolidation makes it easier to administer the property. This ultimately will assure that the grantor's wishes are being carried out. TESTAMENTARY TRUSTS To review Testamentary Trusts, these Trusts are written in the Will and do not occur until death. Property that is destined for the Testamentary Trust must first pass through Probate. If the Will is held to be invalid, the Testamentary Trust will never come into existence. SUPPORT TRUSTS Often used in estate planning these are Trusts that are designed to provide financial support for the Trust beneficiary. 181 ESPOUSAL REMAINDER TRUSTS Often used in the past as a device to shift income but was halted by the Tax Reform Act of 1986. The spouse was given a remainder interest to take effect, say, six years rather than the grantor retaining a reversionary interest to take effect in ten years. The planner should be aware generally of such arrangement in order to advise clients of the need to change Trust arrangements since this Trust is no longer accepted by the IRS. SECTION 2503C. TRUSTS A popular planning tool used in making gifts, usually in Trust, to a minor is the Section 2503C Trust. This Trust secures the $13,000 (2011) annual exclusion. An outright gift of a present interest will qualify for the annual $13,000 exclusion, but the gift of "future" interest will not. As you may recall, a "future" interest is a right to use property only in the future. Ordinarily, the future interest question arises in connection with gifts in Trust. The income beneficiary usually has a present interest, and the remainder man a future interest. However, if the income is to be accumulated, everyone has a future interest, except where a Trust for a minor meets the following requirements: 1. The property given may be expended by, or for the benefit of, before age 21. 2. The property will pass to the donee on the minor's attaining age 21. 3. If the minor dies before age 21, the property will be payable to the minor's estate or to a beneficiary appointed by the donee under a General Power of Appointment. A practical consideration for many parents and grandparents is whether a 21-year old can, in fact, manage a financial nest-egg. If a client raises this concern, then another alternative plan should be devised which would restrict full enjoyment of any Trustee property until a later age. MARITAL TRUST This Trust is a device to receive and manage a creator's property for the surviving spouse while allowing the survivor some control over the property to qualify for the marital deduction. The one big advantage of this type of Trust is that the surviving spouses do not have to burden themselves with various financial and property management decisions. The chances of property being squandered would be minimal since the beneficiary would need to invade the Trust to attempt to change the Trust agreement. Most of the time the planner will discover that the surviving spouse will not have a great deal of experience in financial matters which would help to make the marital Trust a viable option. Property that makes up a marital Trust should be advised by an attorney. The attorney will probably be the best situation to determine the proper use of property upon a client's death. 182 NON-MARITAL TRUST The Trust is a device designed to allow the surviving spouse lifetime enjoyment of the Trust's income but also keep the property out of the survivors estate at his/her death. This type of Trust is advantageous in those estates where it is desired to keep the combined estate taxes of both to a minimum while allowing flexibility in providing for the needs of the surviving spouse while alive. The marital deduction simply postpones taxation until the death of the surviving spouse. If the surviving spouse controls all of the property, it will eventually all be taxed at the second death. Even when this is used, the property will be taxed. It is just postponed for the first death. When a marital deduction is used in conjunction with a non-marital Trust that is funded by an amount that is the exemption equivalent to the unified credit, some tax avoidance can be accomplished because the non-marital portion would escape estate taxation at the second death. It may be desirable to limit overall estate taxation in order to equalize both taxable estates. With the existence of the unlimited marital deduction many options are available for the nonmarital and marital Trusts. GENERATION-SKIPPING TRUSTS If clients are planning to leave assets to grandchildren, they should be aware of the Generation Skipping Transfer Tax. This tax applies if the inheritance skips a generation. For example, if a person omits his/her children as beneficiaries and leaves the inheritance directly to his/her grandchildren and younger generations. In the past, Generation Skipping Trusts were common, especially among the wealthy. The grandfather would set up a Trust that distributed only income from the Trust (no principal) to his children. The Trust principal would be distributed later to the grandchildren and future generations. This allowed the Trust to grow tax-free and appreciate in value, and it avoided the heavy taxation that would have occurred if each generation had been taxed on the full inheritance. One can understand how this Trust was used to build wealth for several generations. Eventually (1986) Uncle Sam decided he wanted his share of taxes, just as if each generation had received its inheritance and paid taxes on it. So, if a person now leaves substantial assets to their grandchildren and future generations, bypassing their children's generation, these assets may be subject to the generation skipping transfer tax. The GST tax is a very expensive tax, a flat rate of 55%. Keep in mind that this tax is in addition to estate taxes, so if, for example, a $10 million of a $15 million estate was left directly to the grandchildren with no estate planning, $5.5 million would be paid in estate taxes and another $2,475,000 would be paid in GST taxes, leaving only $2,025,000 for the beneficiaries. The good news is that everyone has a $1 million exemption from this tax. So, husband and wife together can leave up to two million to their grandchildren and future generations free of this generation tax. 183 In summary the Generation-Skipping Tax is aimed at the wealthy individuals who want to pass a substantial amount of property to younger family members without paying federal estate tax when intervening generations of family members die. For most of us, generation skipping will never play a role in our estate plans. Bruce is a retired successful architect who has amassed about $3 million. All of the property and money is in his name, and not his wife’s as she has never had any interest in financial matters. Both of their children have married wealthy and appear not to need any money, so he wants to leave everything to his grandchildren. The Estate Planner pointed out that the Generation Skipping Transfer Tax which is imposed on all gifts and legacies that go beyond the immediately succeeding generation, in effect targeting grandchildren and great-grandchildren. In the situation of Bruce, the tax would be nearly $2.8 million – almost exceeding the value of the estate. The solution was basically his giving his wife $1 million, and she and he would each transfer $1 to the grandchildren, thereby taking the Generation Skipping Transfer Tax exemption. This would exempt $2 million from this tax. Then, through Trusts and gifts, there were other means to give to his children and letting them, at their option, give to the grandchildren. CONCLUSION The planners’ role in Trust planning is to suggest appropriate situations in which Trust planning could be helpful. By enlisting the help of a qualified Trust-oriented attorney, the planner can render a tremendous service to clients. The planner should realize that every client’s needs are unique and should be uncovered and the discussed. Many clients are unaware of the Probate proceeds and need to be informed of the many pitfalls that may be created by not exploring the advantages of Trusts. Clients that make the effort to plan and prepare Wills are sometimes the most surprised of all clients as to "other options.” A planner’s responsibility is not to get caught up in the "emotionalism" of the newest marketing techniques to help clients avoid federal estate and gift taxes. Rather, your duties are to make recommendations for each client depending on that family's situation. 184 CHAPTER 9 STUDY QUESTIONS 1. A trust A. is used to establish a monopoly. B. enables an individual to pass title to their property to others either during lifetime or at death. C. transfers legal title to property to the beneficiary. 2. The corpus of a trust A. is not necessary for a trust to be valid. B. can only be personal property. C. is also referred to as trust property. 3. A pour-over trust A. allows assets to pour-over into a testamentary trust. B. is used to take advantage of the unlimited marital deduction. C. requires the trustee to manage and dispose of the estate’s net assets. Chapter 3 Study Question – Answers & Sections 1 B – page 163 – Trust Basics 2 C – page 164 – Beneficiary 3 C – page 181 – Pour-Over Trust 185 CHAPTER TEN - ESTATE PLANNING STRATEGIES "Render more service than that for which you are paid and you will soon be paid for more than you render" INCOME, GIFT, AND ESTATE TAX CONSEQUENCES CHARITABLE DEDUCTIONS A donor is entitled to a Charitable Deduction based on the present value of the remainder interest in a CRUT. The method of determining the charitable deduction is complicated, and is generally stated in regulations (Treas. Regs. § 1.664-4(e)(3) and (4)). Various factors are taken into consideration, including the adjusted payout rate, the value of the remainder interest, the age of the measuring life (the annuitant), the term of the CRUT, the date of trust creation, and federal interest rates. GIFT TAX IMPLICATIONS The grantor/donor does not make a taxable gift if he or she is the recipient of the CRUT income for life or term of years. However, the creation of a CRUT will have a gift tax consequence if an individual other than the grantor/donor (or his or her spouse) is the designated beneficiary of the CRUT income. ESTATE TAX Regulations (26 U.S.C. § 2055(a)) provide for a deduction from the value of the gross estate of bequest for public, charitable, and religious purposes. Therefore, the amount of principal contributed to a CRUT is not considered for estate tax purposes. Furthermore, the corpus is not subject to probate. UNRELATED BUSINESS TAXABLE INCOME If a CRUT has any unrelated business taxable income (UBTI), the trust becomes a taxable entity subject to a 100% excise tax. UBTI is generally income earned from an active business. Accordingly, it loses its status as a CRUT. 186 WIFO The annuity paid from the CRUT is taxable to the person receiving the payment. The annuity is taxed in the so-called "Worst-In, First-Out" (WIFO) method. Roughly, the annuity is taxed in the following order of the CRUTs income: ordinary income, capital gain, other income, and trust corpus. The trust's income, for the year it is required to be taken into account by the trust, is assigned to one of three categories: the ordinary income, the capital gains category, or the other income. TAX PLANNING CRUTs are used for a variety of reasons. Often, CRUTs can be used to save income, gift, and/or estate tax. Because the CRUT is a tax-exempt entity a CRUT can be used to sell highly appreciated assets at greatly reduced tax consequences. For example, assume an individual purchases publicly traded stock for $50,000.00. Assume that, over time, the stock appreciates in value to $1 million. If this individual taxpayer were to sell the stock, the taxpayer would have a $950,000.00 capital gain for income tax purposes, and would be subject to a substantial capital gains tax (this example will assume a combined federal and state capital gains tax rate of 20%, or $190,000.00 of capital gains tax). One tax planning idea would be for this individual to contribute the stock to a CRUT prior to the sale of the stock. The CRUT would then sell the stock. Assuming no other activity in the CRUT account, the $190,000.00 capital gains tax on the $950,000.00 gain would be paid over the lifetime of the taxpayer (without the CRUT, the taxpayer would have to pay the $190,000.00 all at once). The taxpayer would receive an annuity from the CRUT based on the full $1 million dollars of sales proceeds, rather than an annuity (or income stream) based on the $810,000.00 after-tax proceeds. One possible concern for the taxpayer in the above situation is the risk of death shortly after setting up the CRUT. In such instance, the CRUT proceeds would pay to charity before the taxpayer has received much benefit from the annuity. In addition, at the taxpayer’s death, charity receives the assets that might have otherwise passed to children or other heirs. Because of this, tax planners often suggest that their clients purchase life insurance, to be held separately from the CRUT. Using life insurance mitigates the risk of an early death. Another example: Assume the same taxpayer above were to set up a CRUT and were to die quickly. In such instance, the balance of the CRUT would pay to charity. If this taxpayer purchased a $1 million dollar life insurance policy, in the event of the taxpayer’s premature death, the taxpayer’s family would receive the $1 million dollar life insurance proceeds and charity would receive the balance of the CRUT. With proper planning, the life insurance proceeds received by the family would be free from all income tax and estate tax 187 REPLACING THE ASSET The second limitation imposed by TRA 97 is that the value of the remainder interest for charity in a Charitable Remainder Trust, must be at least 10% of the net fair market value of property as of the date the property is contributed to the Trust. This limitation can be quite significant, as it limits a taxpayer’s ability to establish a Trust with successive lifetime interests prior to ultimate payment to the charity. To avoid any confusion it is important to explain the two kinds of taxes that must be paid when a client dies, income taxes and estate taxes. INCOME TAXES Regardless of Trust status, an estate must file a final federal income tax return just as is done every year. (Depending on the state residence there could be a state income tax return required also). Any income received in the year must be reported and any taxes due on that income must be paid. A Trust has no effect whatsoever on income taxes. ESTATE TAXES As been discussed before the federal estate tax (also called a death tax) will also have to be addressed. If the net value of the estate is more than $1,000,000 (2012) upon death federal estate taxes must be paid from the estate before it is distributed to any beneficiaries. This is, in effect a "double" tax. Over the years, one has already paid income taxes on the money and assets that now make up their estates. And unless we can plan ahead, the estate may have to pay taxes on these assets again. But with proper planning, a Trust can reduce or eliminate these estate taxes. THE MARITAL DEDUCTION Fortunately, as discussed before, Uncle Sam has a plan to reduce estate taxes for the first to die. To recap the mechanism of the marital deduction, when an individual dies, he/she can leave any amount of assets to their spouse and it will not be taxed at the death of that individual. There is no limit on the value of assets one spouse can leave to the other tax-free. So far so good!! But…. the estate is entitled to claim a tax exemption. Currently, the amount is equal to $1,000,000, so when the surviving spouse dies, the full amount of the estate (what the spouse owns plus what was left by the first to die) will be taxed before it can go to any of the beneficiaries. And, depending on how much longer the spouse lives, it could be worth substantially more than when the first person died the first $1,000,000 of the estate can go to the heirs tax-free. This is the problem: Both individuals (husband/wife) were entitled to a million dollar exemption if they had planned ahead. Husband and wife could have passed on up to $2 million to their beneficiaries tax-free, but now the estate is only entitled to one million dollars (your surviv188 ing spouse's exemption). Uncle Sam is very patient (and smart) and he will wait until the surviving spouse dies and gambles that the government will collect more taxes on a much larger estate. QPRT – QUALIFIED PERSONAL RESIDENCE TRUST At this point in this discussion, the Personal Residence Trust must be mentioned. Earlier in the text, there was a discussion of passing real estate, and more specifically, the family home or farm, by using Deed designations. A Trust can also be used to accomplish the same purposes by using the Personal Residence Trust, or QPRT. This trust allows families to pass on the future appreciation of a house’s value to the heirs, free of estate tax This works best if there is expectation that the house will appreciate in worth and essentially, the house appreciation is being removed from the estate. However, there may be a gift tax when use the QPRT because the owner is actually making a gift of the house (usually to the kids). The methodology is rather simple: The parent transfers the deed of the house into a trust which allows the parent to live in that house for the length of the trust (determined by the trust). As an example, assume that it is set up for ten years and the house was worth $1,000,000. Further assume that ten years later the house is now worth $6 million (further assuming something happens to the real estate market, but that is beside the point here). When the trust ends, regardless of its appreciated value, the house passes to the children and out of the estate, free of estate tax. Okay, how about gift tax? The answer is that “it depends” because with this type of trust the IRS has special formulas to determine the value of the gift, based upon several things (it’s government, what would you expect?) such as the value of the gift when it was put into a trust, the length of the trust, and a special interest rate set by the government each month (discussed later). Generally, the longer the length of the trust and the higher the interest rate, the smaller the gift tax at time of death. So, if one plans on living for ten years or more, but even if one outlives the trust, the heirs could consider capital gains taxes if they sell the house. (Note: Capital gains tax has been the subject of much discussion in Washington, no telling where it will end up…) WHATEVER THE PROPERTY OWNER DOES IN SETTING UP A TRUST IT IS IMPORTANT THAT AN ATTORNEY BECOME INVOLVED—THERE IS A LOT OF COMPLICATED, PROBLEMATIC AND DELICATE TAX RULES TO BE CONSIDERED. If the parent outlives the kids, for instance, they can still live in the house by paying fair rent to the kids. Some planners fear that a lawsuit against the child who becomes the owner, could cause the parent to lose their home. This is a legitimate concern and is the reason that it is not used more often. Our society is particularly litigious and these situations do arise. GRANTOR RETAINED INCOME TRUST (GRIT) When using this trust the grantor transfers the home to the trust, lives in the home, and the 189 value of the home for estate tax purposes has been frozen. However, if this is used, the property owner no longer owns the resident and at some future time (usually at death) the property will completely pass to offspring. Actually, according to those planners who advocate the use of this trust, the individual will pay rent to the child once the ownership of the residence has passed to the child. Some planners object to this vehicle because they do not want to see the parent without ownership of his/her personal residence. Some planners fear that a lawsuit against a child who becomes an owner, could cause the parent to lose their home. This is a legitimate concern and is the reason that it is not used more often. Our society is particularly litigious and these situations do arise. However, for a single parent with only one child who is not in a highly litigious profession, this plan may work well. As the purpose is to save estate taxes, it should be used, of course, only by families that have a highly taxable estate. SECTION 2032A The liquidity problems of family farmers originally persuaded Congress to take some action, leading to Section 2032A which applies to the valuation of real estate used in a farm or closely held business. The executors of deceased farmers had been forced to sell the farm just to pay estate taxes on the value of the farm. Usually, the “fair market value” of real estate for the purpose of estate taxation is based on the highest and “best use” of the property. The use of real estate for farming may not be the highest value activity for a farm, e.g. farms located near rapidly – expanding urban areas wherein the farm could be used for development. This Section 2032A is designed to value the property at its current use, when certain conditions are met. This can reduce the value of the gross estate by up to $750,000, reducing taxes and ease the liquidity needs of the estate. To qualify for this valuation, the following requirements must be used. 1. The adjusted – reduced by debts against the property - value of the real and personal farm (or business) property must be at least 50% of the adjusted value of the gross estate. 2. The adjusted value of the real property by itself, must be at least 25% of the adjusted value of the gross estate. 3. The property must have been used in at least five of the last eight years for farm (or business) purposes. 4. The property must pass to a qualified heir, defined as spouse, ancestors, lineal descendants, siblings, or lineal descendants of the decedent’s parents. 5. The decedent must have “materially participated” in the farm or business. If the “qualified heir” (see above) disposes of the property within 10 years after the decedent’s date of death, 100% of the estate tax savings resulting from this 2032A valuation is recaptured. However, the recapture tax is phased out between the 10th and 15th years following the decedent’s death. 190 SECTION 303 REDEMPTIONS While a Section 303 Redemption is not technically a Trust, but it fits because illustrates and demonstrates a tax provision that can be used in certain situations, usually when planning and the estate is large enough for the consideration of trust(s). Section 303 of the IRS Code gives a close corporation shareholder’s estate or heirs a tax-advantaged way to generate funds to pay for estate settlement when the owner of the estate dies. The Section 303 redemption affects corporate stockholders by providing some degree of tax and liquidity relief. When a shareholder receives a stock distribution from a corporation, it is treated as a dividend to the shareholder, unless it meets the following three considerations. (1) the shareholder's entire stockholding was redeemed, (2) the redemption was "substantially disproportionate," or (3) the redemption was "not essentially equivalent” to a dividend. Because of these rules, the shareholder faces difficult in trying to treat a partial redemption as a sale that qualifies for capital gains, rather than a dividend treatment. Although capital gains are taxed as ordinary income, the shareholder’s basis can offset a capital gain but not a dividend. Section 303 permits a partial redemption to be treated as a sale when the following requirements are met: (1) the stock redeemed is included in the decedent's gross estate; (2) the stock's value exceeds 35% of the adjusted gross estate; (3) the stock is liable for the payment of estate expenses and taxes; and (4) the redemption occurs within four years of the decedent's death. The maximum amount of stock that can be redeemed under this section equals the sum of (1) the Federal and state death taxes, and (2) funeral and administration expenses. Therefore, an heir or the Executor can swap the illiquid stock for cash from the corporation. If more than one heir wants to redeem stock, a “first-come, first-served” rule applies. Once the maximum is reached, Section 303 is no longer available to the decedent’s estate or any heir. Life insurance on the shareholder is often used to provide the corporation with the cash to carry out the redemption. While life insurance death proceeds are usually federal income tax-free, if the notice and consent requirements have been met, a policy owned by a C Corporation may cause the proceeds to be subject to the corporate alternative minimum tax unless the business qualifies for an exemption. In the normal and typical 303 redemption, because of the stepped-up basis at death, very little capital gain is recognized, unless the stock appreciates after the shareholder's death. Therefore, Section 303 takes what would otherwise be dividend income and, in most situations, converts it into a nontaxable form of income. The cash that the executor or heir obtains from the redemption does not have to be used to pay death taxes and estate expenses. There is no liquidity test here, as even an estate that is already 191 liquid can utilize Section 303. Section 303 provides a significant advantage in keeping a family corporation in friendly hands. A redemption keeps control of the corporation in the hands of the surviving shareholders, and this can avoid a forced sale of a decedent's stock to someone outside of the family. Heirs are assured of having funds to help pay estate settlement costs. Corporate dollars can be used to make a tax-favored partial redemption. Also, a Section 303 redemption can be used only if the estate needs cash to pay death costs, even if other cash is available. If this is used, it must be kept in mind that such redemption alters the surviving shareholders’ ownership percentages. As an example, Jim and Bob each own 40% of the stock of Apex, Bill owns 20%. Bob dies and half of his stock (20%) is redeemed. The ownership percentages now goes to 50% for Tom (10% increase); 25% for Bill and 25% for Bob’s heirs (a 5% increase added to their remaining 20%. Corporate wise, whereas Bill’s interest was twice as much as much as bill’s, the redemption of half of Bob’s stock means that Bill’s interest now equals the interest of Bob’s heirs. RECAPITALIZATIONS AND ESTATE FREEZES While this is not a “Trust” it is discussed in this section as it is a particular and peculiar situation that can be treated by proper estate planning and may arise during discussions of Trusts and assets to be included, etc. Before 1987, as an owner of a family corporation faced retirement or the problems of leaving a business to heirs, these owners often recapitalized their business by exchanging their common stock to Preferred Stock. The Preferred Stock had a value then that remained fixed, regardless, and particularly, if the corporation increased in value. The common stock was then reissued to the next generation and carried with it both the current value and future appreciation of the business. This way, the owner “leveled off” the amount subject to estate tax at his/her death at a little or no cost in gift taxes. The 1987 tax law made the appreciation in the value of the common stock to be included in the gross estate of the aging owner at death. In 1990, the tax laws changes and the pre-1987 law was reinstated with some qualifications: 1.The common stock must be valued correctly (actual worth) at the time is transferred to the “next generation.” 2.The value of the stock cannot be established at an artificially or unreasonably low level so as to minimize the taxable gift to the next generation. 3.The Preferred Stock must pay dividends to the original (aging) owner. 4.The aging owner will not have to sever ties with the corporation in order to freeze their corporate interest as was required in the 1987 law. Present (2011) laws state that the “distribution of stock dividends and stock rights (aka stock options) are taxable to you if (5) the distribution is on preferred stock. (The distribution, however, is not taxable if it an increase in the conversion ratio of convertible preferred stock made solely to 192 take into account a stock dividend, stock split, or similar event that would otherwise results in reducing the conversion right.” Any transaction having the effect of increasing ones proportionate interest in a corporation’s assets or earnings and profits may be taxable to you, even though no stock or stock rights are actually distributed. If a person receives taxable stock dividends or stock rights, the fair market value must be included at the time of distribution. THE SPENDTHRIFT TRUST In today’s society, there are many people who have trouble taking care of their resources, particularly the cash resources. In addition to those who carry huge credit-card debts, and those who have “holes in their pockets”, there are those who are addicted to drugs and alcohol. If any family member belongs to this category, it is unwise to leave them substantial amounts of money in a lump sum. Obviously, it is wiser to leave them a stream of income instead. Of all of the options that can be used for this situation, the most useful one is the “Spendthrift Trust.” To create such a trust, the first logical step is for the individual to discuss with his attorney, the criteria that would best fit the situation. For instance, one might pick a bank or other trust department as trustee, and instruct the trustee to benefit the children (or grandchildren, or both) by 1. paying their health insurance premiums. 2. paying their disability insurance premiums. 3. Paying any legitimate educational costs. 4. gives them all (or part) of the income generated. By so stipulating, the corpus of the money has been protected against waste and the values of the individual setting up the trust guides the disbursement of the estate. Note that the estate beneficiaries are protected also from poor health and encourages education. Some, if not many, individuals who create such a trust, carry it on for many years, and then at the end of the trust period, they give some or all of the assets to the heirs – some leave part or all to a Charity. THE LIVING REVOCABLE TRUST A discussion of Trusts would not be complete without the inclusion of a Living Revocable Trust. Actually, any trust that becomes effective during the life of the grantor is a living trust. If the Trust contains words, such as “I reserve the right at any time to revoke this Trust in whole or in part”, it is a revocable Trust The primary purpose of the Living Revocable Trust (LRT) is to avoid probate. The LRT does not in itself, save taxes, but it is used in more sophisticated estate plans and when used with a Bypass Trust, does save taxes. 193 A Living Trust has three primary “offices”: (1) Trustor (creator of the trust), (2) Trustee (who administers the Trust and makes sure the provisions are carried out) and the (3) Beneficiary (the receiver of the benefits of the trust, whether money, property, valuable instruments, etc.). In most states, it is possible for an individual to fill all three offices. If a LRT is used, a Standby Trustee should be appointed in case of the death or disability of the Trustee, usually a bank or stockbrokerage trust department is used. A Standby Beneficiary should also be appointed who generally does not benefit until the end of the Trustor’s life and can be a person, another Trust, or an institution. To make an LRT effective, it must be funded by having assets placed in it, otherwise it is an “empty trust” and of no value. To leave assets to a Charitable institution, for instance, the trust may say, “At death of Trustor, the Standby Trustee is to give X% of the Trust assets to the (name of charity). The trust is created during a person’s lifetime and who may amend or revoke it at any time. It stipulates how the assets held by the trust are to be managed during their lifetime. Basically, it operates much like a will inasmuch as the trust instrument can include instructions about how the assets in the trust should be distributed after the death of the settlor (the one funding the trust, etc.). What distinguishes a revocable trust from other kinds of trust arrangements is that the settlor keeps the power to reclaim the trust assets or contribute additional property to the trust at any time and for any reason. Therefore, if a revocable trust is established, the settlor has really not committed themselves to anything during lifetime, but at death, the trust becomes irrevocable. In essence, the settlor continues to own the trust property but the trust merely gets legal title. Since the settlor maintains complete control over the trust and its assets, the property that is held in the trust will be included in the settlor’s gross estate for estate tax purposes. All income and deductions attributable to the property in the trust will be included on their income tax return. Conversely, the settlor will not be liable for any gift tax when they contribute assets to the trust, even though the trust names the beneficiaries who will inherit the property upon their death. Be aware that if the settlor gives up their power to revoke or amend the trust, or if the income or principal is paid to someone else, the power to amend or revoke the trust is lost. While there are no tax advantages gained by establishing a revocable trust, a trust can provide other financial and administrative advantages. THE SOLUTION: "A-B LIVING TRUSTS" ADVANTAGES Husband and wife can set up one common Living Trust of which each owns half. When one dies, this Trust will automatically split into two separate Trusts. This is called an "A - B Living Trust" because the two separate Trusts are typically referred to as Trust A (for the surviving spouse) and Trust B (for the deceased). 194 If the value of the common Trust is not more than $1.3 million, half of the value of the assets is placed in Trust A and half in Trust B. Each Trust will be entitled to a $650,000 exemption. Trust B uses the deceased's exemption and Trust A will use the surviving spouses’ exemption later when he/she dies and the assets in both Trust are distributed to the beneficiaries. So assuming Trust A does not grow too more than $650,000 by that time, the entire estate will be exempt from estate taxes. If the Trust is more than $1.3 million, usually only $650,000 of the deceased's half is placed in Trust B, since this is the amount of the estate tax exemption. The rest is added to Trust A (the surviving spouse's Trust). There are no estate taxes on Trust B because it does not exceed the $650,000 exemption. And there are none due now on the rest of the deceased's estate because it is transferred to Trust A using the marital deduction. Later when the surviving spouse dies, his/her exemption is used, so another $650,000 is exempt from estate taxes. By using an A-B Trust, husband and wife can leave up to $1.3 million estate tax free to beneficiaries and with no Probate costs. If clients are using a simple Will (as many couples do) or have no estate plan, and rely on just the marital deduction for tax planning, they would not only be able to use one $650,000 exemption, and, under current law, approximately $325,000 in federal estate taxes would have to be paid on the $1.3 million estate, plus thousands of dollars in Probate fees. This is not a tax shelter or some devious way to avoid paying taxes. The estate is being taxed when both spouses die. But they are simply using the exemptions to which they are entitled. DIVIDING ASSETS BETWEEN TRUST A AND TRUST B If the total estate is over $ 1.2 million, the Trustee will need to decide which of the deceased's assets will be placed in Trust B and which ones will be transfer to Trust A through the marital deduction. It would be wise to place into Trust B assets that will appreciate the most in value over the next few years. That is because the assets in Trust B are only valued and taxed when the first spouse dies. They are not revalued later when the second spouse dies, and may be worth much more. ADVANTAGES OF THE A-B LIVING TRUST REDUCE/ELIMINATE ESTATE TAXES: With an A-B Living Trust, husband and wife can each use their $1,000,000 federal estate tax exemption. This allows the couple to pass on to their beneficiaries up to $2 million estate tax-free and with no Probate, saving federal estate taxes, plus Probate costs. PROVIDE FOR SURVIVING SPOUSE: The surviving spouse has complete control over Trust A. In addition, he/she can receive the income (and principal, if needed for certain living expenses) from Trust B. 195 CONTROL FOR FIRST TO DIE: After the first spouse dies and the common Trust has been divided into Trust A and B, no changes can be made to the provisions of Trust B, giving the first spouse to die complete control over who will eventually receive the assets in Trust B. ESTATE TAX-FREE APPRECIATION OF TRUST B: The assets placed in Trust B are valued and taxed only when the first spouse dies. There will be no revaluation or estate taxes paid on any appreciation of these assets later when the surviving spouse dies and the assets in Trust B are distributed to the beneficiaries. PROTECTION OF ASSETS IF CATASTROPHIC ILLNESS STRIKES: In the event of catastrophic illness or injury of the surviving spouse, the Trust can be written to protect the assets in Trust B so only the assets in Trust A will need to be "spent down" to qualify for valuable government assistance. QUALIFIED TERMINABLE INTEREST PROPERTY TRUST (Q-TIP) The Qualified Terminable Interest Property Trust (Q-TIP) is designed to be used by married couples whose combined net estate is more than $1.3 million. This Trust is often referred to as the "C" Trust. In short, the surviving spouse must receive the income from Trust C and may have access to the principal under certain conditions in his/her "qualified interest" in the property. It is "Terminable" because this "interest" ends when the surviving spouse dies. This Trust is used by married people to guarantee that the first decedent’s assets benefit the spouse for his or her life, and then to guarantee that the first decedent’s heirs or causes receive the benefits. The Q-Tip Trust is not created when the estate plan is first drawn up, but it is authorized at that time. In the Will, or in Living Revocable Trust (LRT), the Trustor authorizes the Executor or Trustee to create the Q-Tip Trust at his/her death. Each spouse needs to authorize the Q-Tip Trust in his or her Will or LRT. The LRT might state words to this effect: “If I die first, put the first $650,000 into my ByPass Trust, and remainder into my Qualified Terminable Interest Trust. The Q-Tip Trust and the By-Pass Trust are designed to benefit the spouse for his/her life by giving the surviving spouse either all income; (such as) 5% or $5,000 – whichever is greater – annually; or anything needed for the spouse’s Health, Education, Maintenance and Support. At the end of the second spouse’s life, both the By-Pass Trust and the Q-Tip Trust can go to the persons, institutions or Trusts that were originally named by the first decedent. The Q-Tip Trust can benefit both spouses (as life beneficiary) and other persons or causes (as the ultimate beneficiary). Therefore, there is no need to have a choice between a spouse and others. 196 THE BY-PASS TRUST The By-Pass Trust is used by married people to guarantee that the two lifetime exemptions are properly used. Under current law, it can save as much as $235,000 in federal estate taxes. The By-Pass Trust is not created when the estate is devised, but is authorized (very similar to Q-Tip Trust) by authorizing the Executor or Trustee to create the By-Pass Trust at the death of the Trustor, and certain criteria concerning the By-Pass Trust can be specified. Each spouse must authorize the By-Pass Trust in her or her Will, or LRT (Living Revocable Trust). Wording in the LRT may state in essence, “If I am the first to die, pay all the tax that will ever be due on my estate.” If the half of the estate is $650,000 or more, there will be no tax due. But, the Trustor will have paid “all that is due” and the By-Pass Trust can never be taxed again. The By-Pass Trust is designed to benefit the spouse for his or her life and can be designed to give the spouse all income; a percentage or amount; or anything needed for the spouse’s Health, Education, Maintenance and Support. At the end of the second spouse’s life, the By-Pass can go to the persons or trusts that we originally named by the first spouse to die. The advantage of the By-Pass Trust is that it can benefit both spouse (as life beneficiary) and other persons or causes (as ultimate beneficiaries). Again, note the similarities between the Q-Tip Trust and the By-Pass Trust. Doctor Ronald Weiss and his wife, Dr. Mary Weiss, had an estate of about $2 million. Most of it was in joint ownership. Ronald owned only about $300,000 in his name. Therefore they could only get the $300,000 into the By-Pass Trust instead of the $650,000 (at the time of her husband’s death) that they would like to have moved into it. They lost the tax on $300,000, or actually over $100,000. If each had a separate estate of $650,000, the By-Pass Trust could save as much as $235,000 in federal estate taxes. However, in this case, the couple saved about $100,000, and left $135,000 that they could not use. DELAYING ESTATE TAXES USING AN A-B-C TRUST This is not a way to avoid paying estate taxes if an estate is more than $1.3 million. The portion of the estate placed in Trust C is not exempt from estate taxes. However, payment of estate taxes on this part of the estate will be delayed until the second spouse dies. The chief advantage is that this leaves the estate intact. Since the estate has not been reduced by estate taxes, a larger 197 amount is available to invest and provide income to the surviving spouse. In addition, the individual is keeping more money available in case the spouse needs it, and, if the spouse does need part of the principal from Trust C, the estate may be worth less by the time the spouse dies. So the estate could end up paying less in estate taxes. A-B-C provides additional control. This arrangement will let couples keep control over who will receive more of the estate than an A-B Trust would. If an individual uses an A-B Living Trust and that person dies first, only the $1,000,000 of the estate will be controlled by the survivor. Since that is the amount of estate tax exemption, usually that is all that is placed in Trust B. The rest usually goes to the surviving Trust through the marital deduction to avoid paying any estate taxes at the time. If an A-B-C Living Trust is used, one can be sure to keep control of half the estate, even at the death of the first spouse. The surviving spouse has complete control over Trust A, can receive income from Trust B, and can also receive principal from Trust B, if needed, for health, education, maintenance and support. In addition, the surviving spouse will receive all the income from Trust C and can also receive its principal, if needed, for these living expenses. When the surviving spouse dies, the assets both Trust B and Trust C (50% of the estate at the time of the first death) will be distributed to the beneficiaries the first spouse specifies. ADVANTAGES Reduce/Eliminate Estate Taxes. With an A-B-C Living Trust, a husband and wife can each use their federal estate tax exemption. This allows both husband/wife to pass onto the beneficiaries up to $1.3 million estate tax free with no Probate. Provide for surviving spouse. The surviving spouse has complete control over Trust A and receives all income from Trust C. In addition, he/she can receive the income from Trust B and can have access to the principal of Trust B and Trust C, if needed, for certain living expenses. Control for first to die. When the first spouse dies and the common estate is divided among Trusts A, B and C, no changes can be made to the provisions of Trust B and Trust C, giving the first spouse to die complete control over who will eventually receive the assets in Trust B and Trust C (half of the common estate). Estate tax free appreciation of Trust B. The value of the assets in Trust B are valued and taxed only when the first spouse dies. There will be no revaluation or estate taxes paid on any appreciation when the surviving spouse dies and assets in Trust B are distributed. Estate taxes delayed on Trust C. Assets placed in Trust C are taxed only when the surviving spouse dies. This leaves the estate intact until then, so a larger amount is available to provide income to the surviving spouse during his/her lifetime. Protection of assets if catastrophic illness strikes. In the event of catastrophic illness or injury of the surviving spouse, the Trust can be written to protect the assets in Trust B and Trust C. So, only the assets in Trust A will need to be "spent down" to qualify for valua198 ble government assistance. However, the income from Trust C will be included in the spouse's assets when application for benefits is made. ESTATE PLANNING STRATEGIES This section discusses three estate planning strategies frequently used or discussed by planners when advising clients. Many couples are extremely concerned when planning for their children and they want to be confident that the property is transferred according to plan. PLANNING FOR CHILDREN The responsibility that a professional estate planner has in assisting parents in planning for their children in the event of the client’s death is serious and may seem overwhelming. Every bit of professional knowledge the planner has or is available must be used. After a parent has died, there is no place for a “Whoops” factor. The aftermath of planning in this area involves far more than mere economics. Planning for children involves creating an environment that will allow underage loved ones to experience both love and the care that goes with it and the economic security that will provide more than the necessities of life as they grow to adulthood. In this section we will discuss the techniques that one can use to provide a substitute lifestyle for a loved one should a catastrophe occur. SELECTING THE GUARDIAN It is mandatory that client takes the time to select and name the person or persons whom they wish to raise their children in the parent’s absence; these persons are called "guardians.” These guardians should be named in any Will or Trust that the client has prepared. Clients must understand that if they don't name a guardian the choice will fall to the Probate Judge. When selecting a guardian there are five things to consider: 1. Provide for a succession of guardians in the Will or Trust. There is not guarantee that any guardian will be alive when needed or that your chosen guardian will agree to serve. Always spell out your first, second and third choices. 2. Always discuss the situation with the guardians you would like to name before you name them. Get their permission first!! 3. Share your estate plan with the guardians you have named so that they will understand what they may be getting into. 4. Select your guardians on the basis of their beliefs, morality, and lifestyle, not necessarily on their ability to manage a financial portfolio. Management of the children's funds will not necessarily be the responsibility of the guardian, others can be name to manage the children's property as Trustees. 5. If you elect to name a married couple as guardians, use both their full names in describing 199 them in your Will or Trust. If you use a "Mr. and Mrs." designation, there could be a different "Mrs." at the time they are needed. In most states, the guardians who are selected and named in a Will do not serve automatically. The Probate court Judge must, after independent inquiry approve and name the guardian who will ultimately serve. In some states, the parent's choice is presumptive; in others, it is not. Regardless of the laws of the state in which one resides, the choices made in a Will must be manifested and be designed to give the Probate Judge some guidance as to the decedent’s desires. LEAVING PROPERTY TO CHILDREN As discussed in the following topic, property or insurance proceeds should not be left directly to minor children. It is best to always use a Trust vehicle. By using a Trust, one can spell out in great detail precisely how the children are to be taken care of and when they should receive the balance of the property. The individuals or institutions they would like to manage the property for the benefit of the children can be specifically named. WHEN SHOULD PROPERTY BE DIVIDED AMONG CHILDREN The property division is, of course, will be at the direction of the individual establishing the Trust. It may be suggested that they leave all property in a common Trust for the benefit of all the children for their health, support, maintenance, education, and general welfare. Once all the children become adults, whatever is left can be divided equally among them and given to them or placed in a separate Trust for each child to be distributed in accordance with the parent's wishes. The most important consideration in an estate plan is to be sure all the children are provided for while they are minors and that they are provided for from all resources. WHEN SHOULD PROPERTY BE DISTRIBUTED TO CHILDREN Whether or not a young adult will exercise good judgment with regard to inherited property is always in doubt, however, there can be little doubt that most young adults do not have the experience or maturity to handle what are to them large sums of money. Parents who are concerned about when their children will receive their funds usually provide for a pattern of distribution in their Trust documents. Regardless of the ages, the concept is to ease the child into the money, to provide that if a mistake is made with the first distribution, time and experience will be on the child’s side when the subsequent distributions are made. Thus the child will be able to learn from previous mistakes. The key element is that parents can control how they wish their property to pass to children. In summary, planning for children is an extremely important issue. By helping the client select a guardian; by leaving property in a Trust for the children and making several distributions to children, the planner is creating a solid foundation of estate planning. 200 GETTING PROPERTY TO MINORS There can be many problems in simply getting property to children. Under our system of laws, getting property to minors is not very easy. Most states define minors as persons who have not attained the age of 21 years. Can one make an outright gift of property to a minor child? The answer is yes and no. “Yes” in that you can do anything you want— “No” unless you follow the legal formalities that are associated under state law with the making of that gift. Under most state's law, in order to make a gift of more than nominal amount to a minor, you must do the following: A. Set up uniform gifts to minor act account. These accounts are generally used in order to make a gift of stock, but in many states, they can be used for gifts of cash, other securities, and annuity contracts. An adult custodian must be named on the account with the minor. The custodian manages the account until the minor becomes an adult. B. Create a savings account Trust. These accounts can be established in the name of a minor, and the minor is entitled to make deposits or withdrawals in the same manner as an adult without any liability to the bank. C. Establish a Totten Trust. Establish with a commercial bank or saving and loan association. A Totten Trust is created by registering the account in a form such as "John Jones" in Trust for "Mary Jones.” In those states that recognize this technique, it is usually presumed that the account belongs to the adult person named as Trustee unless it can be shown that the Trust was intended to be irrevocable. On the death of the adult Trustee, the account proceeds would belong to the minor beneficiaries but would be controlled by the local Probate court on behalf of the minor until she or he reached adulthood. Where this is used, it is not considered a separate entity for tax purposes because the donor retains complete control over any property in the trust. Accordingly, the donor will be taxed on the income as if the trust were not in existence. Assets in the trust account are included in the donor’s estate. D. Fund a Living Trust created for the benefit of the minor beneficiary. A Living Trust that is used to give property to minors is called a 2503(C) Trust (which has already been covered). In summary, leaving property directly to minors on death involves a considerable amount of red tape. All-in-all, the best way to accomplish this is to create a Trust with broad powers of instruction for the parents. PROTECT ASSETS FOR KIDS TRUST This section could be entitled “How to disinherit your son-in-law” as this type of Trust (PAKT) is designed to make sure that Trust benefits go only to the donor’s own heirs. (This is actually a form of Spendthrift Trust) Assets are often scattered among direct descendants and inlaws, and can end up outside of the family because of divorce or an untimely death. A person can create this trust and direct that it is to benefit “only my issue.” By using this phrase and directing the trustee to pay out only certain benefits to the heirs, while retaining the 201 corpus or body of money. A person can then list the kinds of benefits that they want their heirs to receive, which could include health, education, disability protection, education, travel, etc. The trust can be funded by lifetime gifts and by a final gift from a Will or Living Trust at death. Rodney and Sandra have an estate worth $400,000. Their family consists of 4 children, all married. Two of the children had children. The other two had no children of their own, but they both have step-children. Rodney and Sandra want only their issue to benefit from their estate, i.e. they do not want to leave anything to their step-grandchildren. They wanted the estate to go to their 4 children with right of survivorship prior to the remainder going to the grandchildren. In this case, the PAKT Trust was suggested. The parents would place their assets into a Living Revocable Trust which would become, at the death of the last parent, the PAKT. Instead of benefiting the children directly, they would create a generation-skip and make the trust for the eventual benefit of the grandchildren. However, during the lives of the children, income will go to the children with right of survivorship. Therefore, the grandchildren would not benefit until all of the children had died. When all of the children (children of the original parents) were alive, they would all receive income. When one died, then three would receive income, etc. Until the last of the above children (the second generation) died, the grandchildren would receive nothing. No step-grandchildren or spouse (in the second or third generation) would benefit. DIVORCE-PROOFING AN ESTATE An affiliated problem may arise if assets can leave a family because of a divorce. For example, if a daughter is left $100,000 and she uses that money as a down payment on a home, and she and her husband take title jointly. In case of a divorce half of the house belongs to the husband and it has lost its inherited characteristic. To avoid losing assets to an heir’s subsequent divorce, an irrevocable trust can be used into which the assets are placed. If a bank or stockbrokerage trust department is named as Trustee, and if it is stated in the trust that certain benefits can only to people who are “your issue”, the inheritance has been divorce-proofed. The “only my issue” statement can also prevent adopted children from receiving assets, so it should therefore state: “Only my issue, or legally adopted children of myself and my issue…” 202 ESTATE PLANNING SUMMARY CAPSULES There is no average or representative estate. Planning situations that could be used as an example or illustration to summarize all the estate planning principles and techniques that have been discussed cannot be done. People have individual estates that require individual planning techniques. There are, however, certain basics or "universals" common to the estate planning process that are addressed to those who are, or plan to be involved in estate planning. (For summary purposes, the estate owner is referred to as “you.”) 1. Inventory the assets that you own. 2. Know where all your title papers are, locate and understand how you have taken title. 3. If title is in your name alone, you own the property in fee simple and can give it away, sell it, or leave it to whomever you please. If you own it in tenancy in common, you only own part of it and can only give, sell, or leave your part. If you own property in joint tenancy, you own all of it with someone else. You may give your interest away or even sell it, but you cannot dispose of it on death. 4. The laws of the state of your domicile will provide an estate plan for you if you do not provide your own. 5. If you choose to accomplish your planning by using a Will, you should remember that Wills are only effective on death and require a public Probate process. In addition, your Will may not control the passage of all your property. If you move to another state, you should have your Will reviewed. Each state's laws are different, and it may have to be re-written. 6. Probate involves unnecessary red tape and expense; it puts the real control in the judge's chambers. Probate can and should be avoided. 7. Federal estate taxes are imposed on your right to transfer almost all your property interest on death. It is a tax, which is levied on the fair market value of your property and is generally paid within nine months of death; it is paid before your beneficiaries receive their inheritance. 8. The federal estate tax rules generally only apply to estates greater than $1,000,000. Spouses in all states can give or leave an unlimited amount of property to their spouses that are US citizens, tax free. The only requirement associated with the unlimited marital deduction is that the surviving spouses receive all of the income from the property during their lifetimes. 9. The federal estate and gift tax systems have been unified for some time. The $1,000,000 exemption and the unlimited marital deduction apply to gifts made during life as well as on death. 10. The law allows you to make gifts to anyone of up to $13,000 (the annual exclusion) without the requirement of filing a federal gift tax return. If your spouse chooses to "split" the gift with you, the amount goes up to $26,000. 11. If you make a gift to your non U. S. citizen spouse, the annual exclusion is $136,000 (in 2011 as it is adjusted for inflation) because the unlimited marital deduction only applies to U. S. citizen spouses. 12. Most states have their own death and gift taxes. 203 13. Your property interests receive step-up in basis at your death. 14. Trusts are truly the estate planner's best tools because they can accomplish just about any of your objectives. Any number of separate Trusts can be created in a simple Trust document. A death Trust is called a Testamentary Trust and can only be created in your Will. A Living Trust is always created during your lifetime. A Living Trust that allows you the right to change your mind and thereby change the Trust is called a revocable Living Trust, one that cannot be changed is called an irrevocable Living Trust. 15. An irrevocable Living Trust commonly used to give property to minors is the 2503(C) Trust. 16. A revocable Living Trust can provide for the control, coordination, and distribution of your property while you are alive as well as on your death. It can also provide for your care and needs as well as those of your beneficiaries. Revocable Living Trusts are not public and are good in all states. They are extremely difficult for disgruntled heirs to attack. 17. A revocable Living Trust can be unfunded, partially funded, or totally funded during your lifetime. It can also be funded subsequent to your death. A properly funded revocable Living Trust avoids the Probate process. 18. Your Trust planning will only be as good as the performance of your Trustees. Trustees are totally responsible for expert performance and judgment while following the written instructions provided in your Trust document. Trustees have power, accountability, and liability. 19. Both individual and institutional Trustees have their strengths and weaknesses. You should select the type of Trustees that best serve your planning purposes. 20. Trustees are compensated; Institutional Trustees publish fee schedules. Individual Trustees usually negotiate their fees within parameters set by local state statutes or court rules. 21. Getting property to a minor can be difficult, under the laws of most states, in order to make a gift to a minor, you must set up a uniform gifts to minors act trust, establish a Totten Trust, or fund a Living Trust created for the minor's benefit. 22. Property left directly to a minor will be stalled in a court imposed custodianship until the minor reaches legal age. Leaving property directly to a minor involves a great deal of red tape. 23. When planning for children, you should provide for a succession of guardians and discuss your situation with the guardians you choose. 24. How you divide and distribute your property among your loved ones is very important. Some general rules would be: Do not divide your property among your children until the youngest of your children is an adult. Once your property is divided, you can provide for different distribution dates for each child to allow for specific thoughts you have with regard to each. It is important to recognize that you can control how you wish your property to pass to your children. If you wish to bypass your children in favor of your grandchildren you must take into account the generation-skipping federal estate tax rules. 25. When planning for your spouse, you must consider your own state's law and the rights it gives your spouse to your property. You may, however, avail yourself of two planning techniques, 204 either a pre-marriage (pre-nuptial) or an after marriage contract. Given a choice of two, you should always opt for the former; they are valid and binding (if fair) and have always been favored under the laws of most states. 26. Today the number of planning possibilities available when planning for a spouse is staggering. Great care must be taken to analyze all the espousal planning possibilities before selecting the best personal choice. 27. A life insurance program should be coordinated with, and become an integral part of the total estate plan. Life insurance that is owned on your life will be federal estate taxable on your death and may be taxed by your state. It is important to properly record both primary and contingent beneficiary designations with your agent. Never make your estate or minors the direct beneficiary of the insurance proceeds. 28. Always re-examine your life insurance portfolio. Insuring the life of the younger spouse makes excellent sense in light of the federal estate tax rules. 29. Life insurance can be purchased and structured to totally avoid federal estate tax. In general this is best accomplished through the use of an irrevocable life insurance Trust. It can be structured by estate planning specialists to accommodate almost any type of insurance owned. 30. If you desire to make contributions of cash, or assets, other than cash, to qualified charities, either currently or on death, you may receive tax benefits for your good works. 31. Estate planning is no place for loners. Professional advisers should be selected for the knowledge they possess within their particular disciplines. All advisers should participate in the estate planning process and should work well, not only with you, but with each other. CHAPTER 10 STUDY QUESTIONS 1. A donor is entitled to a Charitable Deduction based on the A. present value of the remainder interest in a CRUT. B. past value of the reminder interest in a CRUT. C. future value of the reminder interest in a CRUT. 2. A living revocable trust A. avoids taxation of the grantor’s estate. 205 B. avoids probate. C. requires the trustee to be someone other than the grantor. 3. The By-Pass Trust is used by A. married people to guarantee the two lifetime exemptions are properly used. B. single people to guarantee the two lifetime exemptions are properly used. C. married people to guarantee the one lifetime exemptions are properly used. Chapter 10 Study Question – Answers & Sections 1 C – page 186 – Charitable Deductions 2 B – page 193 – The Living Revocable Trust 3 A – page 197 – The By-Pass Trust SYNOPSIS The information discussed herein is, basically, an update using recently enacted laws regarding new gift and estate tax laws. These objectives have been detailed in this text so that changes are explained and the usage thereof more definitively discussed. These are presented here as if these gift and estate tax laws were being discussed with a potential estate planning client. Giving assets can be quite satisfying, particular if these assets are going to be used for starting a business, purchasing a home or educating a grandchild. Besides the personal satisfaction of “giving,” when an asset is given is an asset removed from the estate and estate taxes. At the present time, estate taxes have been changed but still you have to be aware of changes that could occur in the future. To start, one should know that a married couple, who give $28,000 annually to each of their three children, will have given away $2,340,000. At today’s estate tax rate of 35%, that is actually a tax savings of $819,000. If most of the assets in the estate are in stock or real estate, it is possible that you could experience a substantial appreciation in value over a lifetime. If you have, for instance, a $5 million investment(s) appreciating at a hypothetical rate of 5% annually, you would have $13 million in 20 years. Using today’s tax rate of 35%, your estate tax liability would be more than $4.5 million. There are gifting strategies that could remove both assets, plus any potential appreciation, from the estate. It is possible to freeze the value of the current estate and then transfer potential appre206 ciation to your heirs. If the estate is hit with a large and unexpected estate tax bill, the family members may be forced to sell real estate and/or other valuable assets that otherwise they would try desperately to keep. A well-conceived gifting strategy can provide the funds to meet the estate tax liability and keep the assets where they belong—in the hands of loved ones. If a family business is involved and doing well financially, you can gift stock or ownership interest in the business by using a gifting strategy that can remove substantial assets from your estate. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 create an opportunity to remove assets from your estate that can reduce estate taxes and leave your family with a more substantial legacy. This legislation increased the lifetime gift from $1 million to $5 million and also allows you to continue to make annual gifts of up to $13,000 a year to each of your children, grandchildren—or anybody else that you wish—without incurring a gift tax. As stated herein, this opportunity may only be temporary as this tax legislation expires on December 31, 2012, because Congress may keep exclusion and exemption limits where they are, or they could raise them, lower them or just do away with them. It all depends upon 2012 election results. There is the possibility that this text may have to be changed again to reflect new tax-law changes. 207
