Dedon on Estate Planning

Appointing and Removing Trustees for Irrevocable Life Insurance Trusts

I have written in the past about Irrevocable Life Insurance Trusts and their advantage in removing life insurance from an individual’s taxable estate. The Grantor (person who creates Trust) forfeits flexibility and the ability to make substantial changes when using an Irrevocable Life Insurance Trust in order to obtain this advantage. For example, a Grantor cannot change the Trust beneficiaries.

However, some flexibility can be retained. The Grantor can remove and appoint a new Trustee, provided the new Trustee is an institution or an individual who is not "related or subordinate" to the Grantor within the meaning of Internal Revenue Code Section 672(c). The new Trustee named should not be the Grantor, or the Grantor’s spouse, parents, children, siblings or an employee of the Grantor. (There is an exception to the related or subordinate rule if the party named is an "adverse party" but that is beyond the scope of this Post.)

The relevant authority interpreting Section 672(c) is Wall Estate v. Commissioner, 101 T.C. 300 (1993) and Rev. Rul. 95-58 1995-2 C.B. 191. Although the Grantor’s ability to name a new Trustee does provide some indirect control over the Trust by the Grantor, any Trustee named must abide by its duty of complete loyalty to the Trust beneficiaries. Thus, regardless of who is named, the Grantor does not directly control the Trust or its assets.

Tax Exemption Under Section 501(c)(3)

Internal Revenue Code Section 501(c)(3) affords organizations tax exemption if certain requirements are satisfied.  These organizations must accomplish a charitable purpose. Such purposes include conducting scientific, religious, educational, or literary activities. At least one of these purposes must be set forth in the organization’s Articles of Organization. This post focuses on educational and scientific purposes.

An educational purpose includes not only "instruction or training of individuals for the purpose of improving or developing his capabilities" but also "the instruction of the public on subjects useful to the individual and beneficial to the community." Treas. Reg. Section 1.501(c)(3)-1(d)(3). For example, the IRS has determined that an organization whose purpose was to educate the public about the accuracy and fairness of news coverage was eligible for tax exemption. Rev. Rul. 74-615, 1974-2 C.B. 165.

Fraudulent Conveyances

In the face of an uncertain economy and increased exposure to costly litigation, a growing number of individuals are embracing asset protection mechanisms to insulate their assets and ensure their wealth preservation. Though the benefits of utilizing these structures are extensive, there are both federal and state prohibitions concerning the nature of transfers to an asset protection arrangement which could render the creditor protection provided by these structures ineffective.

Transfers made with the intent to delay, defraud, or hinder creditors or those which cause the debtor to become insolvent are deemed fraudulent conveyances. Most states have implemented either the Uniform Fraudulent Conveyance Act (UFCA) or the Uniform Fraudulent Transfer Act (UFTA) to address fraudulent conveyance issues. Federally, the Bankruptcy Act contains similarly pertinent provisions.

Fraudulent conveyances should be avoided when making asset transfers as they allow creditors to seek, depending on the applicable law, a variety of remedies which would not have been afforded to them otherwise. Under the Bankruptcy Code, Section 550, a creditor may recover from the debtor either the property transferred or the value of the property transferred. While there is a judicial preference to return the actual property, monetary compensation may be awarded when the property’s value has depreciated significantly.

Conflicting Objectives Under Income and Estate Tax Planning

Sometimes income tax planning goals conflict with estate tax planning goals. For example, on the income tax side, taxpayers often want to exchange like kind property under Internal Revenue Code Section 1031 to avoid triggering capital gain. Generally, Section 1031 applies if property "held for productive use in a trade or business or for investment" is exchanged solely for property of a like kind to be "held for productive use in a trade or business or for investment." On the estate side, the planning often involves lifetime transfers to related entities (e.g., an LLC or a Partnership, hereafter I will assume an LLC), and then gifts to family members at discounted values. If the transfers and gifts occur prior to a sale, there is an opportunity to claim market and minority discounts on both the value of the property and the transfer of the LLC interests.

The conflict between the income tax advantages of a Section 1031 exchange and the estate tax advantages of transferring property and then subsequent gifts at discounted values centers on the Section 1031 requirement that the property both exchanged and acquired be held for productive use in a trade or business or for investment. Query, if a taxpayer takes property and transfers it to an LLC, and the LLC then does the exchange, did the LLC hold the property with the requisite intent ("use in a trade or business or for investment"), or would the IRS take the position that the LLC is not the same taxpayer as the owner that transferred the property and deny Section 1031 treatment? Further, is Section 1031 even less certain if the property is transferred into an LLC and then LLC interests are gifted to other family members.

The Future of Estate Planning

After years of campaigning, each Party appears to have chosen their presidential candidate, with the summer conventions a formality to a McCain/Obama match. Whether these two candidates square off, or Clinton somehow captures the Democrat nomination, the election holds special interest for estate planning professionals and their clients.

Currently, Federal estates exceeding $2 million are subject to estate tax. In 2010, the Federal estate tax disappears, but only for one year. Beginning in 2011, the estate tax returns with a vengeance, taxing estates over $1 million dollars at maximum rates of 55 percent. If you are reading this twice thinking it makes no sense, try explaining it to incredulous clients attempting to plan for their families and future generations. Although an educated guess is that the next President and Congress will step in and "permanently" fix the problem in 2009 (when the exemption amount is $3.5 million for one year), the only certainty is that, if they can’t agree, $1 million is the protected amount starting in 2011.

Thus, back to the November election: as we patiently wait to see who is elected, the most significant impact for many voters and their families may not be the election’s effect on Iraq, gas or food prices, or Supreme Court nominations. Rather, it could be whether, upon death, 55 cents of every dollar goes to pay estate tax, or whether the next President and Congress join to provide a sensible solution to the problem they created during President Bush’s first term.

Gifts to Irrevocable Trusts

A previous Post (February 11, 2008) was about using an Irrevocable Trust to remove insurance proceeds from the taxable estate of both a husband and wife even though one or both are the insured's. Because the Irrevocable Trust owns the insurance, and the clients (i.e., the husband and wife in this case) give up control over the policy, the insurance proceeds are not included in their estate. Yet, the surviving spouse and children can still be beneficiaries of the Trust and indirectly the proceeds.

Besides the estate tax advantages of removing the insurance proceeds from the taxable estate, there are also gift tax issues when the premiums are paid. Because the Trust owns the policy, the Trustee must pay the premiums out of funds in a Trust bank account. Thus, the Trustee is receiving the premium payments from the clients. (Note, the Trustee is not typically the clients, but an independent trustee such as a bank or family member.)

The gift issue arises because the clients, when paying the premium to the Trustee, are making gifts to the beneficiaries of the Trust, typically their children. However, the gifts, because they are to a Trust, are not "present interest gifts." Because the gifts are not present interests, the gifts don’t qualify for the annual exclusion, which is currently $12,000 per recipient. As described in the February 11, 2008 Post, that is the purpose of the "Crummey" letter. Without a Crummey letter to qualify the gifts as present interests, the clients are depleting their exemption amount each time a premium is paid.

Have you Talked to Your Parents About Their Planning?

We all know the population is growing older. For children with elderly parents, concerns include taking care of their parents when they no longer can take care of themselves and estate issues upon their parents’ deaths. There are holes in the planning if these issues are not addressed. An obvious problem is that children often do not feel comfortable discussing incapacity, death and finances with their parents. If the parents don’t bring up these issues, they may not be adequately addressed.

For example, what if parents are living, but no longer able to make decisions for themselves? It is necessary to have a Revocable Trust, or at the least, a Power of Attorney, to handle the financial issues. It is also critical to have a Health Care Power of Attorney and a Living Will (if so desired) for health issues. These health documents are sometimes combined in a single document, depending on state law.

Upon death, what is going to happen with the assets? Children should at least be asking their parents:

Taking Advantage of Low Interest Rates and a Declining Market

The January 28, 2008 Post explained why 2-year GRAT’s (Grantor Retained Annuity Trusts) are an essential estate planning tool for affluent taxpayers looking to pass wealth to children and other beneficiaries with little or no gift or estate tax consequences. No other tax strategy is as straight forward, effective and IRS sanctioned.

What was a wonderful idea in January 2008 is even a better idea in Spring 2008 for the following two reasons: First, the interest rate applicable to GRAT’s is now one percent lower than in January: the rate has decreased from 4.4% to 3.4%. Therefore, if assets transferred to a GRAT appreciate at greater than 3.4%, the excess appreciation passes to beneficiaries chosen by the taxpayer estate tax free. Perhaps this interest rate will decline even further in coming months, however, at 3.4% the rate is attractive regardless of future fluctuations. Second, although nobody can time the stock market, many believe it has bottomed out. (Note, GRAT’s also can be used with real estate and closely held businesses, but this Post assumes taxpayers hold marketable securities.)

For example, if in April a taxpayer transferred $1 million to a 2-year GRAT, when the applicable rate is 3.4%, and the assets appreciated at 10% over a 2-year period, approximately $106,000 would pass to beneficiaries tax free. The taxpayer would have received from the GRAT approximately $1,050,000. The taxpayer would then roll the $1,050,000 into the next GRAT.

Supporting Organizations

Supporting Organizations ("SO") are charities created under Section 501(c) (3) of the Internal Revenue Code. Donations are deductible as charitable contributions. SO’s have been utilized by wealthy individuals who otherwise would be limited by creating a private foundation. These well-advised individuals (or their advisors) mastered the arcane and complicated tax provisions authorizing SO’s, and thereby created SO’s to obtain greater tax advantages compared to private foundations. The advantages arise because SO’s are treated as public charities. (The February 25, 2008 Post discussed these advantages.)

As often the case in other areas of the tax law, creative but misguided taxpayers and advisors used SO’s to obtain tax benefits beyond those intended by Congress. Congress pushed back with substantial changes to SO’s. These changes affect primarily "Type III" SO’s, which are the type most often used by individuals seeking the greatest autonomy and control over their charity. In contrast to Type I and Type II SO’s, where the supported public charity effectively controls the SO, Type III SO’s resemble private foundations with greater control for the taxpayer. It is for this reason that Type III SO’s were targeted by Congress as requiring the greatest reform.

Tax Planning: Devil in the Details

The April 1, 2008 Daily Tax Report, which is a publication geared to tax professionals, reported on a study prepared by the accounting firm Deloitte, which concluded that, among 108 companies surveyed, there were 165 tax-related problems. According to the report, most of these problems arose because of "people problems." Specifically, a lack of personnel or untrained personnel, leading to insufficient or inadequate review.

What does this study have to do with estate planning? Nothing, other than the conclusions are instructive. It has been my own experience, supported by the case law and anecdotal evidence, that many estate plans fail because of inadequate follow through. Examples include:

-- Revocable Trusts that are not funded.

-- Family Limited Partnerships, where assets are co-mingled or accounts are not opened.

-- Gift/Sales to Intentionally Defective Trusts, where the ancillary documents are not prepared and respected (e.g., note, security agreement, deeds of gift).