Dedon on Estate Planning

The All Important “Ascertainable Standards”

I have written in the past about designing Trusts for children. Indeed, you can see under the "Most Popular Posts" section of my blog, a post devoted to the subject.

In planning for children, the question always comes up: upon the death of the second parent, how do I protect the children so that they have what they need but not so much it saps the children’s motivation to lead a productive life? As the prior posts describe, most Trusts address this objective with "ascertainable standards." Ascertainable standards provide parameters for Trustees to utilize in deciding what is appropriate for the Trust beneficiaries. When a client names an institutional Trustee or a third party Trustee, these standards protect the independent Trustee so that the beneficiary cannot compel extravagant distributions. At the same time, those standards ensure the beneficiary receives necessary distributions and the Trustee is not acting arbitrarily.

Ascertainable standards are also important for estate tax purposes. Sometimes the client creates a "Dynasty" Trust for the child’s lifetime where the child is the beneficiary and also is named as the sole Trustee. Despite serving in these dual roles, the Trust assets would not be taxed in the child’s estate upon the child’s death if the Trust is governed by ascertainable standards. In other words, provided the client trusts the adult child to spend Trust assets wisely, the child can serve as beneficiary and the sole Trustee and avoid estate tax inclusion at the child’s death. However, if the Trust does not have ascertainable standards, these estate tax advantages are lost. (By the way, these same ascertainable standards allow the client to name a surviving spouse as the beneficiary and Trustee without triggering tax in the surviving spouse’s estate.)

So what are ascertainable standards? As described in prior posts, they are defined as "health, maintenance, support and education." These terms, ostensibly common and innocuous, have deeper meaning in the Trust world. These terms are accepted by the Courts and IRS as providing sufficient guidelines for Trustees in administering Trusts. On the other hand, when drafters stray outside of these four words, the tax advantages may be lost. Such was the case in a recent Tax Court decision, Estate of Chancellor v. Comm’r, T.C. Memo. 2011-172, where the IRS argued that the inclusion of the word "welfare" jeopardized the advantages of the Trust because "welfare" was not an ascertainable standard. Although the IRS ultimately lost and the Tax Court did not subject the Trust assets to estate tax in the beneficiary’s estate, it required a Tax Court case to reach that conclusion. Chancellor teaches us that clients and their attorneys are well advised to stay within the well accepted "health, maintenance, support and education" standards in designing their Trusts.

"No Estate Tax? All the News is Not Good"

Most estate planning advisors believed Congress would enact legislation prior to 2010 to avoid the disappearance of the federal estate tax. Those of us sharing this belief have been proved wrong, as we enter 2010 with no estate tax, at least for this year. In 2011, the estate tax returns with only a $1 million exemption amount and a 55% tax rate.

Besides the prospect of a 2011 meager $1 million exemption amount, the uncertainty and complication of current law balances, in part, the advantages of no estate tax. Right now, the law includes these rules:

• there is no estate or generation skipping tax.

• there is still a $1 million exemption on gifts, however, the gift tax rate is reduced to 35%.

• although there is no estate tax, there is an income tax that can apply on inherited assets because there is no "step-up" in basis, as under prior law. Along with a carryover basis to inherited assets, there is a $1.3 million tax exemption, and a $3 million marital exemption. Thus, assets sold at a gain over these amounts will be taxed at ordinary or capital gain rates.

The sophisticated planning options under the 2010 law are now being analyzed and considered. However, some basic questions, and speculated answers (with the emphasis on speculation) are the following:

1. Will Congress reinstate the estate tax in 2010? Probably. There is too much tax revenue at stake, not to mention the chaos the law is creating. Further, there is a need to address the $1 million exemption amount returning in 2011. This provides an incentive for all members of Congress to compromise on an exemption amount - those members who believe there should not be an estate tax and those members who believe virtually all "wealthy" people should pay some estate tax.

2. Assuming Congress addresses the estate tax in early 2010, which is what is expected, is the exemption amount $3.5 million or as much as $5 million? Again, nobody knows, but these are the range of exemption amounts widely discussed. Assuming there is Congressional action, it is virtually certain the new exemption amount will exceed $1 million.

3. What if you die before the estate tax is reinstated - is it constitutional to apply the tax retroactively? Nobody knows because there is precedent to support that Congress can and cannot enact laws applying taxes retroactively. Assuming there are wealthy people dieing prior to any 2010 legislation, this constitutional issue will likely be answered by the Supreme Court.

4. Is it possible nothing is done all year and the exemption amount is only $1 million in 2011? As suggested above, this is possible but not likely. But then again, not many of us saw this mess continuing into 2010 so who can say.

5. Most importantly, what is a client to do? There obviously is not one answer. Much depends on your existing plan and your objectives. It is likely you will want to consult with your estate planning counsel. For example, consider this scenario:

Dad and Mom have a common estate plan that provides, upon the first death, the surviving spouse receives all assets necessary to eliminate estate tax at the first death. The balance of the assets pass to children. In the past, this clause may leave all but $1 million, or $2 million, or even $3.5 million, to the surviving spouse. Now, under this clause, the surviving spouse would be disinherited. Conversely, Dad and Mom may deliberately leave all assets to the children while there is no estate tax (and future generations because there also is no generation skipping tax) because they are confident the children will take care of the surviving parent. Or, you could leave the surviving spouse a small amount, such as $1 million since you believe the exemption amount will always be at least $1 million, and the balance to a GST Trust for your children and future generation.

Congress has provided us with much to consider.

Estate Tax Legislation?

Is this the week Congress establishes certainty in the estate tax law? Probably not but talks are ongoing.

According to House Ways and Means Committee Chairman Charles Rangel, Committee members this week are continuing to discuss how to avoid the one-year elimination of the estate tax. Under current law, there would be no estate tax in 2010 but in 2011 the estate tax would return and cover estates exceeding $1 million at maximum tax rates of 55%. Currently, there is a $3.5 million exemption amount. For married taxpayers who do the proper planning, they can double the exemption amounts ($2 million in 2011 and $7 million in 2009).

It is difficult to plan not knowing whether the estate tax exemption will be extended at the $3.5 million level; whether it goes away temporarily or permanently; whether the exemption is reduced to $1 million; or an entirely unknown alternative. Rangel was quoted last week by the Publisher, BNA, that he favors a one-year extension of the $3.5 million amount rather than a "permanent" solution. President Obama has said he believes $3.5 million is the appropriate amount. On the other hand, Republicans still believe that a greater exemption amount and a lower estate tax rate is appropriate.

My prediction is that Congress will, as Rangel said, extend the $3.5 million exemption for one year, meaning we will have the same uncertainty for at least one more year. The problem would then again have to be addressed 2010. We will know soon. 

GIFT TAX RULES

When it comes to transferring assets for gift and estate tax purposes, there is much confusion regarding the federal rules. What is an annual exclusion gift? How much can I protect from estate tax when I die? Can I give it away before I die? There are many more questions. Let’s consider these rules: (I am assuming U.S. citizens because the rules may be different for non-citizens.)

1. Upon your death, you can protect $3.5 million from estate tax. Although this amount changes on January 1, 2010, virtually everybody knowledgeable in this area expects Congress and the President to extend the $3.5 million amount (or increase it) into 2010 and beyond.

2. Prior to you death, you can give away $1 million without paying any gift tax. However, if you do give away $1 million during your life, the amount of the gift is deducted from what you can protect at your death (unless it is an annual exclusion gift – see 3).

3. In addition to the $1 million, you can give away $13,000 per year to any beneficiary. This "annual exclusion" amount does not have to be to a family member.

4. You can pay education and medical expenses in addition to the $13,000 and the $1 million exemption amount

5. If you are the beneficiary of an inheritance under 1) above, or a gift under 2), 3) or 4) above, you do not pay federal tax on receipt of the gift. If there is a tax consequence, it applies to the person dieing or making the gift.

How do these rules apply? Here are some examples:

Ex 1: Mom and Dad have three children. They can each give $13,000 ($26,000) to each of the three children ($78,000). Mom and Dad can make these same gifts each year without any income or gift tax consequence.

Ex 2: Two of the children are married. There are 4 grandchildren. Mom and Dad also have a favorite niece. They can gift on an annual basis another $182,000 without any income or gift tax consequence (7 x $26,000).

Under Ex 1 and 2, Mom and Dad gave away $260,000, saving $117,000 in estate tax upon their deaths ($260,000 x 45% estate tax).

Ex 3: Mom and Dad are really wealthy and desire to give away more than the annual exclusion amounts in Examples 1 and 2. Thus, they gift $2 million to their three children. Now upon their deaths, they will only be able to protect $5 million between them ($3.5 million each x 2 = $7 million - $2 million gifts).

Ex 4: For all the gifts above, the assets come from Mom’s separate brokerage account. Notwithstanding, Dad can join in the gifts even thought he does not own the assets because of "gift splitting." The "gift split" would be reflected by Mom and Dad filing a gift tax return each year of the gift, which provides information to the IRS but does not cause any gift tax.

Why gift now? There are several answers to this question. For example, asset values are low, thus allowing you to remove more from your taxable estate. Also, all appreciation in the assets will be removed from your taxable estate. Further, there are various gift strategies that allow you to discount the value of the transferred assets for gift tax purposes. IRS interest rates that may apply to some of these strategies are also low now, allowing for more to be removed from the taxable estate.

Obviously there is more to gift and estate tax planning, but these are a few of the basic rules.

Building Flexibility Into Irrevocable Trusts

Irrevocable Trusts are a common estate planning tool to remove assets from the taxable estate. The "grantor" creates the Irrevocable Trust, transfers assets to the Trust, and after accounting for any gift tax issues, the Trust assets are removed from the grantor’s taxable estate for estate tax purposes. However, to obtain the advantage of estate tax removal, the grantor must give up control over the Trust assets, including the right to change the Trust.

However, often times Trusts need to be, or should be, amended. There may be a change in the law or circumstances that require an amendment. Because Irrevocable Trusts are often designed to last many years – sometimes in perpetuity – there can be a number of reasons why it would need to be amended. For example, there could be ambiguities in the language or a drafting error. Perhaps the Trust should be divided to separate assets or, conversely, perhaps different Trusts should be consolidated.

Herein lies the dilemma: we know the grantor cannot amend the Trust or he would lose the estate tax benefits. A common solution to amend a Trust is to ask a judge to judicially reform the Trust. However, this can be expensive and it may require the consent of the beneficiaries.

A second alternative available in certain states is to take advantage of a "decanting" statute. The decanting statutes allow a Trustee, without court involvement, to essentially prepare a new Trust to address changes in circumstances. (Of course, the assumption is that the Trustee is acting pursuant to the grantor’s wishes during the grantor’s lifetime and after his death.) This flexibility is provided by pouring the assets from the old Trust into the new Trust without court involvement or beneficiary permission. At least seven states allow decanting, including Delaware, New York and Florida. Basic requirements are that the Trustee has the ability to invade Trust principal and the beneficiaries of the new Trust will be identical, or at least similar, to the beneficiaries of the old Trust.

Even states that do not have decanting statutes still allow for some limited Trust amendment without court involvement. For example, a properly drafted Irrevocable Trust will allow for changes of Trustees, the merger of identical trusts, and changes in the Trust situs.

In sum, an "irrevocable" trust will be irrevocable but not necessarily inflexible.

Getting Started

I am often asked, "what should I do before our first appointment and what should I bring?" In order to help you prepare, I recommend you do the following:

• Watch this video I  have createrd to provide an overview of the issues we will discuss when we meet.
  
  
• Print the pre-interview form, complete the first page, and bring it with you.
  
  
• While optional for our first meeting, the second page of the pre-interview form, item two above, is a Financial Statement Summary table. Funding Revocable Trusts for probate avoidance and to balance the assets for estate tax purposes often is an important part of the planning. Although a list of assets is not necessary for our first meeting, ultimately it will be important to review the assets’ value and ownership.
  

Below is an example of how to complete the Financial Statement Summary. Assuming you are married, you may prepare a financial statement listing across the top of the page these three types of ownership:

Mr.                 Mrs.                 Joint

Listed down the page will be the assets by general categories. Almost all clients will have real estate (one or more homes); retirement assets (IRA, 401(k), etc); other liquid assets (stocks, mutual funds, bank accounts) and life insurance. In addition, there may be closely held business interests or investment properties.

Taking Care of Basics: Revocable Trust FAQs

With the end of the year approaching, it is appropriate to revisit a basic but yet important and neglected concept central to estate planning: the need to fund your Revocable Trust to avoid probate and, in the case of a married couple, to balance out the estates for tax purposes. The March 31 Post, reprinted below, discussed this funding in more detail. In addition to the guidance provided in the March 31 Post, set forth are common questions clients ask regarding how to transfer assets into their Trusts.

2009 Annual Exclusion Gift

The IRS has provided an early Christmas present by announcing that the 2009 annual exclusion gift is $13,000. It increases from $12,000, which was the amount in 2008. The annual exclusion gift is the amount that you can give to any recipient of your choice during the calendar year without tax consequence. If the gift is a present interest and qualifies for the annual exclusion, it does not erode the exemption amount available upon death. As has been widely reported, the exemption amount in 2009 increases from $2 million to $3.5 million.

For example, in 2009, if husband and wife have two children, in 2009 they can give $26,000 to each child. Upon their deaths, if they have done the appropriate planning, they could still leave $7 million to their children without any federal estate tax. (State estate tax may differ.) There generally is no reporting regarding the annual exclusion. However, there are exceptions depending on the type of gift and who is making the gift.

Designing Trusts For Children

A critical issue parents wrestle with in designing Trusts for their children upon their deaths is how to balance providing the necessary resources for their children against providing "too much too soon" and thereby undermining each child’s motivation to lead a productive and meaningful life. My July 28th Post, reprinted below for your convenience, describes how "ascertainable standards" are the typical provisions utilized to achieve this balance. The ascertainable standards are "health, maintenance, support and education." These words are well understood in the Trust world and in the eyes of the IRS. They provide guidance to Trustees to accomplish the parents’ objective to protect the child with adequate resources but not sap the child’s incentive.

Some clients go beyond ascertainable standards by providing specific guidance that condition distributions on various targets, such as achieving a level of education or income, or marrying, or pursuing a particular profession. These "Incentive Trusts" strike some as trying to "rule from the grave," while for others they merely provide the necessary structure and guidance to help the child when they no longer are able.

Planned Giving: The 2008 Charitable Remainder Annuity Trust

The November/December issue of Advancing Philanthropy, the bimonthly magazine dedicated to ideas and strategies pertaining to fundraising which is published by the Association of Fundraising Professionals, contains an article I wrote regarding Charitable Remainder Annuity Trusts combined with life insurance. As charities struggle to maintain gift levels, the article illustrates how CRAT's can help charity and the individual. The article contains case studies applying the concept to particular client situations. It is reproduced here.  (It will take a minute to download.)