Dedon on Estate Planning

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

A common question is "what do I need to bring with me to our first appointment?" My video, which you can access on YouTube, will provide an overview of the issues we will discuss when we meet.

In addition, 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. Therefore, 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.)

Bad Times Make Good Gifting Opportunities

In my October 13 Post, I discussed how this is an opportune time to make gifts to family members because of reduced stock values. The same could also be said for real estate and perhaps closely held businesses.

Recent articles from two leading newspapers follow these same lines. In an October 18th Wall Street Journal article, captioned "Why Now Is the Time to Help Your Heirs," the Journal mentions several techniques to make generational transfers, including GRATs (which I have written about in the past), gift and sales to Intentionally Defective Trusts, and family loans. These go hand in hand with the Family Partnership concept that I wrote about last week. In the charitable arena, the Journal also mentioned Charitable Lead Annuity Trusts.

The second article was an October 16th New York Times piece by Warren Buffett in which he urged investors to continue to buy American stocks and take advantage of buying opportunities. As Buffett says, "be fearful when others are greedy, and be greedy when others are fearful." As Buffett's October 16th article states: yes the financial world is a mess, but it also presents opportunities in the long term for generational transfers.

Generational Planning: Take Care of Non-Tax Issues First

Business owners are well aware of how federal estate taxes can prevent the family business from passing to the next generation. With a maximum 45 percent tax rate on assets exceeding $2 million, upon death almost half of the company value is owed to the IRS. With a new President and Congress convening in January 2009, an uncertain estate tax environment will become even more uncertain. (Thankfully, Virginia has repealed its estate tax.)

Future posts will focus on methods business owners can employ to reduce or eliminate estate tax, whatever the tax rate and the exemption amount turn out to be. The focus of this post, however, is on the non-tax issues which can torpedo the business owner’s best intentions. As Keith Schiller, an attorney in Northern California has written in a wonderfully entertaining and informative article about Hollywood movies and their depiction of estate planning issues, "…non-tax issues often dwarf all tax considerations. Controversies within families, particularly over the family business, will continue to spawn novels, children’s stories, criminal cases and the news." See Schiller, 33 Tax Mgmt. Est., Gifts and Tr. J. 175, 177 (July/Aug. 2008).

Of course, most families will not suffer the same consequences as the Corleone family upon the "Godfather’s" death, and no business succession plan could have saved Vito’s family business, but for most business owners proactive planning can preserve the business for the next generation. Without claiming to identify all succession planning issues to consider, the following are reoccurring themes I have seen in my practice. Failure to address them can doom the business, with or without estate tax problems.

• If the company is to pass to the children, who will manage it? Will a power struggle arise because the children do not have well defined responsibilities and roles? Will jealousies arise if one child is granted more control than another? These issues can be further exacerbated if son-in-laws and daughter-in-laws are involved in the management. If the children inherit the stock equally, stalemates can arise that effectively shut down the company operations.

Often times the business owner exerts such control during his lifetime that these problems are ignored or bubble below the surface until his death or retirement. Without him, it is too late to remedy the ills that could have been treated with his involvement. The owner should strive during his active involvement in the company to define the children’s roles and foster a management structure that can continue when he is no longer present. It would be helpful to hold quarterly or semi-annual meetings with the owner and next generation present to inculcate the management structure. To formalize the relationships, the children should be parties to the same documents executed by unrelated parties, such as employment contracts and a shareholder agreement. Unfortunately, planning for the future is often easier said than done when a controlling owner lacks the interest to plan for the future.

Perhaps some of the children are not working in the company. In this case, should the company pass equally to all of the children or only to the children-employees? The children in the business do not want to answer to the passive, non-working children. The non-working children may not be pleased with real or perceived excessive salaries or perquisites enjoyed by the working children. There can also be disagreements involving dividend distributions versus reinvesting in the company, and whether or not to sell, borrow, merge and other major decisions. It may be preferable to leave the business to only the children working in it. However, that may not be possible if a goal is to divide all assets equally among the children.

Obtaining an appraisal to value the company and other assets can alert the family to the looming problem. Next, solutions can be discussed, such as life insurance to help allocate the family resources. Also, strategies such as purchasing stock and lifetime gifting can help divide the assets fairly.

What if the business is inherited by the children but they are not capable of operating it? Often times the children are pursuing their own interests. They have no interest or involvement in the business, other than receiving their quarterly distributions. Or, the company may have reached a growth stage where its continuing prosperity is dependent on abilities or experience beyond the children’s capabilities. Only if successful talent is hired and retained can the company continue. In this model, the children are merely shareholders. However, they should also act as the company’s Directors, with enough interest and oversight to provide direction and input. If the children can recognize their limitations, the company can still succeed with unrelated employees and outside counsel.

What if there is a step-parent involved? The recent poster-case for this problem is the relationship – or failed relationship – between Dale Earnhardt, Jr., and his step-mother, Teresa. In 2007, Junior left the company his father had founded in 1998, Dale Earnhardt Inc. Junior and Teresa, DEI’s owner, could no longer peacefully coexist. A May 10, 2007 ESPN article quoted Junior as saying his relationship with Teresa "ain’t a bed of roses." Money was not the issue: at the time of his departure Junior was the highest paid NASCAR driver. But according to the same ESPN article, Junior wanted at least 51% ownership so he could control DEI’s destiny.

These issues can appear overwhelming to the business owner already struggling to manage and operate the company. Finding the time, energy and interest to plan for the future is often put off until tomorrow. There also is no "one size fits all" solution that is easily discernible. Just as there are a myriad of issues to address, there will be a number of possible solutions. The solution reached may even be to sell the company. If so, this realization is healthy in that the decision is made on the owner’s terms, not a forced decision upon his death or retirement.

One thing is certain: the failure to plan will likely lead to the failure of the business’ continuation and the diminution of its value. Whatever may be the appropriate solution, business owners can take comfort in knowing they are not the first ones to face these difficult issues. With proper planning and effort, management and control issues can be identified and solved.