Tag: estate planning

Confronting Cognitive Abilities in Well-Rounded Estate Planning

Ask anyone how they would define “trusts and estates law” and the odds are the answer will uniformly focus on the act of making the plan as to who will receive a person’s assets when he or she dies.

What happens, however, when the person who makes the so-called plan loses the cognitive ability not only to plan, but further, to carry on with the tasks of ordinary daily living. When that happens, the person we expect to be planning may be taking actions that unbeknownst to him or her are, in fact, jeopardizing the financial well-being of the estate in question and the ultimate inheritance that he or she intends for his or her loved ones to receive upon his or her death.

A recent decision from the Supreme Court, Suffolk County (Acting Justice Chris Ann Kelley), In the Matter of the Application of T.K., 2024 N.Y. Slip Op. 50045 (Suffolk Cnty. Sup. Ct. 2024), illustrates what can happen when the person whom we expect to make the estate plan is no longer competent to protect the very assets contemplated for disposition under that plan.

In T.K., a petition was filed by T.K. (son of K.K.) seeking the appointment of a guardian for his father’s personal needs and property management under Article 81 of the New York Mental Hygiene Law. The basis for the petition was that T.K.’s father was suffering from “severe delusions,” which put his well-being at risk of imminent harm, and which could cause “catastrophic financial loss.”

K.K., the alleged incapacitated person (“AIP”) was an 80-year-old retired advertising executive. He resided with his wife of more than 50 years. T.K. testified that his father had deteriorated mentally over the past 10 years, including more regular consumption of alcohol in large quantities. Of most concern, the AIP had a 15-year business relationship with “Hugh Austin” (“Mr. Austin”), who lived two miles away from the AIP.

T.K. testified that his father had given Mr. Austin approximately $2,500,000 as part of a so-called investment in Mr. Austin’s businesses, which the AIP believed would result in an “imminent return” to the tune of millions of dollars—the AIP never received any money back from Mr. Austin.

Mr. Austin (and his son), meanwhile, was indicted for fraud crimes against 20 victims in excess of $10 million. Yet, the AIP insisted that Mr. Austin “has done nothing wrong.” While Mr. Austin was under house arrest, the AIP continued to meet with him.

The Court Evaluator reported that the AIP had become a “willing participant” in the exploitation perpetrated by Mr. Austin, luring the father into investments coupled with promises of major returns. The evidence also showed that the AIP’s funds were used to pay Mr. Austin’s personal expenses, including trips to Las Vegas. Cash App payments, and various other non-“business-related” charges.

The Court ultimately found that there was a substantial likelihood that the AIP would continue to engage in self-harming activities as a result of years of being psychologically victimized by Mr. Austin. Such victimization caused psychological stress to the AIP, which manifested itself in the forms of “substantial weight loss, excessive consumption of alcohol and diminished abilities to concentrate and communicate.”

In view of the foregoing, the Court appointed a property management guardian to prevent the AIP from self-harm “by reason of his functional limitations and lack of understanding and appreciation of them.”

Many of us have lived the experience of having a parent, or grandparent, lose cognitive functioning to the point where it is inconceivable that such a person could be in any position to properly plan for the disposition of his or her assets.

The T.K. decision presents another reminder as to why a critical element of estate planning is not just the plan to dispose of one’s assets, but also, defining how to implement that plan when the individual himself or herself is no longer able to carry out the directives of that very plan, and to ensure that a plan is in place to address the situation where the individual lacks the necessary capacity to continue to make decisions with respect to his or her own personal affairs.

These are difficult discussions to have, particularly amidst a culture that walks on eggshells when topics such as death and divorce enter the fray. But to ignore these discussions within our own families, and separately, with our trusts and estates counsel, is a mistake; they are elemental to proper estate planning, not to mention the acceptance of reality.

© 2024 Blank Rome LLP
For more news on Estate Planning, visit the NLR Estates & Trusts section.

Probate & Fiduciary Litigation Newsletter – November 2023

Voluntary Personal Representative Is a “Prior Appointment” For Purposes of the Limitation Period for Commencing Formal Probate

In The Matter of the Estate of Patricia Ann Slavin, 492 Mass. 551 (2023)

Does the position of voluntary personal representative under G. L. c. 190B, § 3-1201 constitute a “prior appointment,” which operates to exempt an estate from the requirement contained in G. L. c. 190B, § 3-108 that probate, testacy, and appointment proceedings be filed within three years of a decedent’s death? The Massachusetts Supreme Judicial Court answered this question in the affirmative In The Matter of the Estate of Patricia Ann Slavin, 492 Mass. 551 (2023).

This case arose out of the murder of Patricia Slavin in May 2016 in circumstances allegedly giving rise to claims for wrongful death. A few months after her death, the decedent’s daughter (petitioner) filed a voluntary administration statement in the Probate and Family Court pursuant to § 3-1201 and thereafter became the voluntary personal representative of her mother’s estate. The petitioner’s status as voluntary personal representative allowed her to administer her mother’s small estate without initiating probate proceedings.

More than three years later, the petitioner—having realized her position as voluntary personal representative did not grant her authority to pursue a wrongful death claim—filed a petition for formal probate in the Probate and Family Court seeking court appointment as personal representative. The petitioner argued that the three-year statute of limitations governing probate proceedings was inapplicable because it excepts otherwise untimely filings for estates in which there has been a “prior appointment.” The Probate and Family Court dismissed the petition as untimely, finding that her position as voluntary personal representative did not qualify as a “prior appointment” under the statute. The judge’s decision relied on a procedural guide published by an administrative office of the Probate and Family Court which provided that the authority of a voluntary personal representative does not result in an official appointment by the court.

The SJC granted the petitioner’s application for direct appellate review and held that both the plain language of G. L. c. 190B, §§ 3-108 and 3-1201 and the purpose of the MUPC support the conclusion that the position of voluntary personal representative is indeed a “prior appointment.” The SJC reversed the judgment of dismissal and remanded for further proceedings.

First, the SJC concluded that the plain language of § 3-1201 constitutes an “appointment” given that the register of probate may “issue a certificate of appointment to [a] voluntary personal representative”—language that the SJC refused to consider as mere surplusage. This language plainly contradicted the administrative guide the Probate and Family Court judge relied on. The SJC also considered the plain language of § 3-108, which does not limit the type of “prior appointment” that qualifies for an exception from the statute of limitations.

Second, the SJC held that this conclusion was consistent with the purpose of the ultimate time limit. Section 3-108 is intended to establish a basic limitation period within which it may be determined whether a decedent left a will and to commence administration of an estate. Where a voluntary personal representative has been named, the determination of whether a will exists has been made, and administration of the estate has commenced.

Finally, the SJC held that this interpretation was consistent with the legislature’s goal of “flexible and efficient administration” of estates in that it incentivizes people to continue to utilize voluntary administration for smaller estates without fear that they could not increase their authority beyond three years.

Takeaway: Voluntary administration can be used for administration of smaller estates without risk that the three-year limitation period for commencing formal probate proceedings will bar future probate, testacy, or appointment proceedings, if necessary.

Conformed Copy of Will Not Admitted to Probate

In Matter of Estate of Slezak, 218 A.D.3d 946 (3rd Dep’t July 13, 2023)

Where a conformed copy of a will was located where the decedent said his will could be found, no potential heir contested the validity of the will and testimony established that the will was not revoked, should the conformed copy of the will be admitted to probate? In Matter of Estate of Slezak, 218 A.D.3d 946 (3rd Dep’t July 13, 2023), New York’s Appellate Division, Third Department, answered that question in the negative, indicating how difficult it can be to probate a copy of a will rather than the original

In Slezak, testimony established that the decedent told a witness that his will was in a lockbox under his bed, and that he had left everything to a certain beneficiary. When the lockbox was opened, there was a conformed copy of the will, with the decedent’s and the witnesses’ signatures indicated with “s/[names].” The will left everything to the beneficiary indicated by the testimony. No potential heir contested the validity of the conformed copy. Nonetheless, the Surrogate denied probate and the Appellate Division affirmed.

New York SPCA § 1407 and Third Department case law provide that “A lost or destroyed will may be admitted to probate only if [1] It is established that the will has not been revoked, and [2] Execution of the will is proved in the manner required for the probate of an existing will, and [3] All of the provisions of the will are clearly and distinctly proved by each of at least two credible witnesses or by a copy or draft of the will proved to be true and complete.” The Surrogate found that petitioner had established the first two elements, but had fallen short on the third. The Appellate Division agreed that “petitioner failed to show that the conformed copy of decedent’s will was ‘true and complete,’” stating that “[a]lthough petitioner tendered a conformed copy of decedent’s will, there was no other proof from the hearing confirming that the conformed copy was identical to decedent’s original will.”

Takeaway: Slezak reinforces the importance of being sure that the original version of a will is available. While there appears to have been no contest to the validity of the conformed copy of the will, the courts followed the statute strictly and denied probate when one of the statutory elements for admitting the conformed copy was lacking.

Beneficiary Has a Right to an Accounting Despite the Trustee’s Return of Funds

Kaylie v. Kaylie, 2023 WL 6395345 (1st Dep’t October 3, 2023)

Can the beneficiary of a trust require a trustee to provide an accounting despite the trustee’s return to the trust of the funds said to have been diverted? In Kaylie v. Kaylie, 2023 WL 6395345 (1st Dep’t October 3, 2023), New York’s Appellate Division, First Department, answered that question in the affirmative, reversing the trial court’s determination that no accounting was necessary under the circumstances.

In Kaylie, a beneficiary of a family trust commenced an Article 77 proceeding in Supreme Court upon learning that trust bank accounts unexpectedly had zero balances. In response, the trustee argued, among other things, that the trust “irrefutably has been made whole by the restoration of those funds, thus obviating any purported need on the part of [the beneficiary] for an accounting of those funds.” The trustee also argued that she had been removed as trustee since the dispute arose, limiting her access to the bank records of the trust. The trial court agreed, holding that since the beneficiary had not “show[n] misappropriation of funds” and the trustee no longer held that position, “the intrusion of an [accounting] is not warranted….”

The Appellate Division disagreed and reversed, in a decision reaffirming the principle that a beneficiary “is entitled to a judicial accounting by reason of the fiduciary relationship between” the beneficiary and the trustee. The court stated: “The fact that respondent has returned the trust’s funds with interest does not affect petitioner’s right to an accounting.”

Takeaway: The Kaylie decision confirms the primacy of a beneficiary’s right to an accounting from the trustee of a trust, even where the trustee has a “no harm, no foul” argument based on the return of funds to a trust and the trustee’s departure as trustee.

2023 Goulston & Storrs PC.

By Charles R. Jacob III , Jennifer L. Mikels , Molly Quinn , Gary M. Ronan , Nora A. Saunders of Goulston & Storrs

For more news on Probate & Fiduciary Updates, visit the NLR Estates & Trusts section.

How to Solve Estate Planning Challenges: Q&A with Lindsey Paige Markus of Chuhak & Tecson, P.C.

In recognition of National Estate Planning Awareness Week, we sat down with Lindsey Paige Markus, a principal with Chuhak & Tecson law firm in Chicago to discuss the top estate planning challenges and considerations that her clients face. Markus oversees Chuhak & Tecson’s 24-attorney estate planning and asset protection group, and focuses her practice on counseling business owners and families in planning their estates, minimizing taxation and transferring wealth.

Read on to learn more about Markus’ key tips for successful estate planning, and how clients can tailor their estate plans for any stage of their lives.

The NLR: Estate planning needs can change throughout a person’s lifetime. How do you counsel clients to navigate these changes, whether it be marriage, having children or divorce?

Markus: Over time, assets and relationships may change. You might not have the same relationship with the individuals you selected to act as executor or trustee. You may also disagree on how the couple you identified to care for minor children have parented their own children at the last family gathering. Asset holdings, values and priorities change. When your children were young, you may have been very concerned with there being sufficient resources to provide for their everyday needs and help fund a college education. If they are now successful adults living on their own, you might wish to prioritize leaving a philanthropic legacy to your community. Similarly, laws and tax exemptions change over time. For these reasons, I often recommend that clients revisit their estate plan every three years to confirm that the individuals they have identified to carry out their wishes are still appropriate, in addition to the division of assets.

The following image from my book, “A Gift for the Future – Conversations About Estate Planning,” helps highlight life events impacting estate planning, including the following:

–         Engagement

–         Marriage

–         Buying a home or property

–         Starting and building a family

–         Welcoming grandchildren

–         Starting a business

–         Rapid estate growth

–         Charitable interests grow

–         Divorce

 

The NLR: How can clients prepare to handle probate and guardianship issues?

Markus: Ideally, clients will take the time to get documents in place so that their loved ones can avoid probate and guardianship proceedings. Often a revocable living trust is the most efficient vehicle to ensure that the court system is avoided during one’s life (guardianship proceedings) and upon death (probate). When properly drafted, the trust can also help to leverage estate tax savings, provide asset protection for beneficiaries and ensure that the maximum amount can pass estate-tax free from generation to generation. But it is not enough to simply have an estate plan with a revocable living trust. Rather, clients need to go through the process of funding their trust – retitling assets into the name of the trust, transferring real estate interests, business interests and making certain that beneficiary designations on life insurance and retirement plan assets comport with the overall plan.

The NLR: What do you think are some of the biggest or most common misconceptions people have about estate planning?

 

Markus: People think that “estate planning is for the rich and famous,” or comment, “I will make an estate plan…when I have an estate to plan!” In reality, everyone should have an estate plan in place to document their wishes and make the process more manageable for their loved ones. Estate tax savings are just one aspect. But anyone who has had the displeasure of going through the probate process appreciates the importance of avoiding it. Too often clients are overwhelmed by the process. In reality, like any project, actually engaging in the planning and getting it done is far easier than procrastinating. And once you find an estate planning attorney that you feel comfortable working with, the attorney should be able to help guide you seamlessly through the process. Clients are often surprised by how empowering the estate planning process can be.

The NLR: Estate taxes owed to federal and state governments can be difficult to deal with for many people. How can clients best navigate challenging estate tax situations?

Markus: Estate tax liabilities at the federal and state levels can easily reach a tax rate of 50%. FIFTY PERCENT! As challenging as it is to consider, those with taxable gross estates can’t afford to avoid planning. In contrast, by engaging in thoughtful estate planning, these estate tax liabilities can be minimized and sometimes completely eliminated. The best advice I have for clients is to engage in planning early. Once you see projections of your future net worth based on your life expectancy, you quickly appreciate the size of the potential tax liability. You will need to provide feedback on your goals of planning. And, from there, your estate planning attorney, working in tandem with your wealth advisor and CPA, can help advise you on proactive steps you can take now to help minimize or avoid those tax liabilities. Maybe it is through implementing an annual gifting program where you use the annual gift exclusion of $17,000 per person per year by making a gift outright or to a trust for the benefit of a loved one. Perhaps you are in a position to use your $12.92 million lifetime exemption before it cuts in half in 2026. The real benefit of gifting is that we can move the current value of the gift and all future appreciation outside of your taxable gross estate. Or, some clients elect to engage in life insurance as an estate tax replacement vehicle – they purchase life insurance to provide the family with liquidity to cover the estate tax in the future.

The NLR: What are some of the most common mistakes you see people make when it comes to estate planning, and how can they avoid them?

Markus: Start early! None of us know what the future has in store. Get your plan in place this year – and make modifications in the future. Fund your trust! Don’t just get an estate plan. Make sure you retitle assets into your trust and update beneficiary designations to leverage the benefits of the plan. Don’t forget about charitable intentions! It is so easy to leave a lasting legacy to a cause you are passionate about. In doing so, follow your estate planning attorney’s advice and consider leaving taxable retirement plan assets directly to the charity. That allows the funds to pass estate-tax free and income-tax free, sometimes saving more than 70% in estate and income tax consequences. Revisit your plan every three years. Review the summary of your plan, make certain your assets were properly moved into your trust and follow-up with your attorney to find out if any changes have taken place in the law which would warrant an update.

Article by  Rachel Popa of The National Law Review / The National Law Forum LLC
Copyright ©2023 National Law Forum, LLC
For more articles on estate planning, visit the NLR Estates & Trusts section.

IRS Announces 2023 Increases to Estate and Gift Tax Exclusions

The Internal Revenue Service recently announced the 2023 cost of living adjustments for the estate and gift tax exclusion amounts.

Gift Tax Exclusion Amount:

The annual gift tax exclusion is the amount (“Gift Tax Exclusion Amount”) an individual may gift to any number of persons without incurring a gift tax or reporting obligation. The Gift Tax Exclusion Amount will increase from $16,000 to $17,000 in 2023 (a combined $34,000 for married couples). The Gift Tax Exclusion Amount renews annually, so an individual who gifted $16,000 to someone in 2022 may gift $17,000 to that same person in 2023, without any reporting obligation. However, for any gift above the $17,000 in 2023, the individual making the gift must report it to the IRS.

Example A: A single person gives her two children $17,000 each in 2023. Each gift falls within the Gift Tax Exclusion Amount so the gifting individual will not have to pay any gift tax or notify the IRS. A married couple could give $34,000 to each child, with the same effect.

Example B: Compare a single person who wants to give her only child $20,000 in 2023. The person who gave the gift must notify the IRS of the $3,000 gift because it exceeds the $17,000 Gift Tax Exclusion Amount.

Estate Tax Exclusion Amount:

The estate tax exclusion is the amount (“Estate Tax Exclusion Amount”) an individual can transfer estate tax-free upon his or her death. The Estate Tax Exclusion Amount will increase from $12,060,000 to $12,920,000 in 2023 (a combined $25,840,000 for married couples).

Example A: A single person with two children passes away in 2023 owning $12,920,000 in assets. The deceased person’s two children will inherit the full $12,920,000 as no estate tax is owed.

Example B:  A single person with two children passes away in 2023 owning $20,000,000 in assets. The decedent’s estate will owe tax on the assets owned that exceeded the $12,920,000 Estate Tax Exclusion Amount ($20,000,000 – $12,920,000 = $7,080,000). The current estate tax rate is approximately 40% which means the decedent’s estate will owe estate taxes in the amount of $2,832,000 ($7,080,000 x 40%).

© 2022 Miller, Canfield, Paddock and Stone PLC
For more Tax Law News, click here to visit the National Law Review.

Estate Planning Considerations That Apply to Nearly Everyone

This article contains core information about the vital estate planning measures that almost all North Carolinians should have in place. 

Why You Need an Estate Plan

Estate planning is not just for affluent individuals.  While good estate planning can lead to desirable financial outcomes under the right circumstances, estate planning in its most basic form involves implementing the legal steps and directives that are necessary to ensure that your health and your assets are managed properly in the event of incapacity and death.

Everyone should consider:

  • Do you want to make sure that your family has the legal authority to direct and take part in your medical care if you become ill?
  • Do you care whether your assets will pass to your spouse, children, or other beneficiaries after your death?
  • Do you want to avoid a costly and uncertain court proceeding if you, your spouse, or your adult child becomes mentally incapacitated?
  • Do you have minor children or grandchildren, and specific desires about how they would be cared for in the event of your death?
  • Do you care about your finances and affairs becoming part of the public record when you die?

If your answer to any of the these questions is “yes,” then you likely need an estate plan.

Foundational Estate Planning Documentation

The following documents are the foundation of any good estate plan.

  • Last Will and Testament. A simple Will directs the disposition of a person’s assets and names someone to handle final affairs, in the event of death.  In the absence of a Last Will and Testament, the disposition of your assets may be controlled by state law, and the result may be much different from what you intended.
  • Revocable Trust. A revocable trust can help ensure that the management and disposition of your assets is more private and efficient during your lifetime and at death.
  • Durable Power of Attorney. A durable power of attorney typically names a spouse, adult child, or other individual(s) of your choosing to step in and handle your financial and legal affairs when you are unable due to incapacity or absence.
  • Health Care Power of Attorney. A health care power of attorney is a document that nominates a trusted person (usually a family member) to make health care decisions in the event of your incapacity.  Without this document, decisions about your medical treatment may be made by the attending physician or might involve petitioning the court for a guardianship – an expensive and cumbersome process.
  • Living Will. A living will addresses medical decisions and directives related to end-of-life care.
  • HIPAA Authorization. The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) protects an adult’s private medical information from being released to third parties without the patient’s consent.  Without a valid HIPAA authorization on file, a doctor or medical provider legally cannot, and frequently will not, discuss the patient’s medical information with family members.

Ownership and Beneficiary Designations

An essential component to planning for death involves reviewing the way that your assets and accounts are structured.  Asset ownership and account-specific beneficiary designations can supersede and undermine even the most carefully-drafted estate planning documentation.  Unfortunately, these aspects are often overlooked, and unintended consequences ensue.  Having the advice of an attorney with significant experience in estate planning and administration is the best way to ensure that your assets and your estate plan will work hand in hand.

Changes in Circumstances

If you already have an estate plan in place, that’s great.  But in the vast majority of cases, an estate plan will need to be updated over the course of a person’s life.  If your estate plan no longer addresses your needs or accurately expresses your wishes, it’s time for an update.

The following are common reasons for updating one’s plan:

  • Children grow up and become able to manage a parent’s healthcare and estate matters.
  • Changes in financial circumstances.
  • Relocation to a new state.
  • Separation, divorce, or remarriage.
  • Changes to applicable law.
  • Birth, death, or marriage of a beneficiary.

Article By Peter B. von Stein of Ward and Smith, P.A.

For more estates and trusts legal news, click here to visit the National Law Review.

© 2022 Ward and Smith, P.A.. All Rights Reserved.

Ten Estate Planning Tips as We Emerge from a Pandemic and Head into a Presidential Election

No one can say that 2020 has been an ordinary year – from the outbreak of COVID-19 in the first quarter of 2020 to the death of Supreme Court Justice Ruth Bader Ginsburg to the upcoming Presidential election.

So, amidst such an unusual year, why not think about estate planning? These times provide an exceptional backdrop to engaging in thoughtful consideration about planning, and the economic environment provides unique opportunities.

Here are ten estate planning tips worth considering, right here, right now, during the final three months of 2020:.

Planning with Continued Low Interest Rates.

The Federal Reserve’s decision to keep interest rates historically low, even at the risk of inflation, has created a fertile environment of estate planning freeze strategies which utilize the IRS’s published interest rates. The Grantor Retained Annuity Trust (or “GRAT”) and the Charitable Lead Annuity Trust (or “CLAT”) are two techniques which, when most successfully deployed, allow for the transfer of wealth at a reduced gift tax cost and provide that the future appreciation on the assets transferred passes without exposure to the individual’s estate tax. The GRAT pays a defined sum back to the creator for a fixed number of years, and the remainder passes to family; the CLAT pays a fixed sum to a named charity for a defined number of years, and then the remainder passes to the creator’s family. The current applicable Federal interest rate for determining the gift tax value of these techniques is currently 0.4%, having dropped from 2.2% in February. Normally a GRAT or CLAT is most successful when a client transfers an asset which has significant appreciation potential, such as a closely-held entity where the owner expects a successful sale in the future. However, funding a GRAT with securities (or swapping them into an existing GRAT, as described below), given the relatively depressed and volatile capital markets and the low interest rates, means that more long term growth resulting from the rebounding stock market will be able to be passed to family.

Lower Values in Commercial Real Estate.

If your commercial real estate holdings have recently decreased in value, this could be an ideal time for making a gift of interests in these assets to family. When gifts are made in the form of interests in limited liability companies or limited partnerships, discounts continue to be appropriate for lack of marketability and lack of control even on top of lower real estate appraised values. The result is that owners of commercial real estate may be in a position to move quickly by transferring that property now to family trusts before the value rebounds in coming years. Such transfers may be most effective in the form of an outright gift or a gift to an irrevocable trust which is not considered to be owned by the creator for income-tax purposes or perhaps using promissory notes to family members.

Checking the Existing Basic Estate Plan.

Now is the time to review your will or your revocable living trust agreement (or both) to see if they still accurately reflect your wishes.

Testamentary Provisions.

Reconsider whether inheritances should be outright or placed in trust for the benefit of children and more remote descendants. Parents have a unique ability to provide meaningful asset protection for children by utilizing trusts for their benefit, to shield children from claims in divorce and other predatory maneuvers. Simple wills can overlook nuances that perhaps now during this period have become magnified, particularly in younger families struggling economically and emotionally with the pandemic. Review and reconsider choices for executors, trustees and guardians.

Testamentary Tax Strategies and the 2020 Presidential Election. Tax strategies and language contained in the will need to be reviewed as the Presidential election approaches and in its aftermath. Most sophisticated estate plans are framed around optimizing an individual’s estate tax “applicable exclusion amount” (or “AEA”) using a credit shelter trust, and his or her generation-skipping transfer (“GST”) tax exemption amount using a “dynasty” or descendants’ trust. Attorneys draft for these strategies in wills or living trusts using a formula meant to maximize the allowance. For many wills, after the Tax Cuts and Jobs Act of 2017 that formula was impacted by the increase of the AEA and the GST exemption from $5,000,000 to $10,000,000. (Increased for inflation, that amount is $11,580,000 today.) Barring Congressional action, the AEA and the GST exemption is set to retreat to $5,000,000 (again indexed for inflation) on January 1, 2026.

Clients and their advisors should evaluate these formulas on a case-by-case basis, with an eye towards the 2020 Presidential election. Vice President Biden has spoken of his intention to repeal the 2017 Tax Cuts and Jobs Act, which, presumably, means restoring the AEA and the GST exemption to the $5,000,000 level, as indexed. A long-standing Democratic agenda item has been to restore the AEA to the Clinton-era $3,500,000. Curiously, the Trump campaign lacks a definitive statement either to eliminate the Federal estate tax or even take decisive action to make permanent the exemption increases in the Tax Cuts and Jobs Act. The one secure tax take-away is that there is no telling what Congress and the President will do in 2021 and the years following, and so having the flexibility in a will or living trust to optimize the wealth tax environment, should death occur during this period of uncertainty, is essential.

How is this accomplished? Avoid or revisit formula clauses for credit shelter trusts where a surviving spouse is involved. These clauses might result in an unexpected and disproportionate benefit passing to a trust which is not exclusively for a spouse’s benefit. Better planning suggests drafting to set up a marital trust for the surviving spouse to hold the estate’s financial assets, which, through elections made during the period of administration and the ability to divide it into different shares, can provide the same benefits of planning with the AEA but offer more flexibility to achieve the best tax strategy overall.

Check Advance Directives and Durable Powers of Attorney.

Usually an integral part of the basic estate planning package, advance directives for health care and durable powers of attorney tend to gather dust as years wane. Unlike wills, which only take effect at death, these documents state an individual’s wishes regarding financial decision-making and health care decision-making while he or she is alive but unable to act or express intentions. These documents should be reviewed and refreshed at least every ten years, even if there is no change.

 Advance Directive for Health Care.

Different practitioners may use different forms, but at its core, this documentation sets out wishes about health care decisions and end-of-life views (end-of-life decisions are sometimes set out in a separate document known as a living will), and the appointment of a health care representative to act as the agent to make medical decisions including end-of-life decisions (sometimes set out in a separate document known as a health care proxy or proxy directive).  Are these choices and wishes still accurate? Is the agent’s information up to date?  Have the wishes been discussed with the agent? If the pandemic has taught many families one thing about estate planning, it has stressed the importance of having this document prepared, properly executed, and having the agent informed and ready with decision-making knowledge and resolve.

Durable Power of Attorney.

A durable power of attorney as created by most practitioners immediately grants authority to an agent to conduct business or financial transactions in the name of the individual who executes it. That being said, these documents can often be the most difficult to use. Many banks and financial institutions will insist on their own forms, whenever possible. In view of these hurdles, these documents should be reviewed and updated, if necessary, to avoid a costly confrontation with an uncooperative bank representative should the need arise to have them implemented. Check the names and addresses of the named agent. If there are co-agents, can they act independently or is unanimity required? Is there a power in the agent to make gifts? Is there authority to deal with digital assets? What is the relationship between the agent and the named executor in the client’s will?

Check Existing Estate Planning Strategies.

Individuals should take stock and review their other irrevocable strategies implemented in years past which may be impacted by the current economic and political climate. Existing life insurance trusts, spousal lifetime access trusts (described below), dynasty trusts, GRATs, qualified personal residence trusts, and charitable trusts, to name the most common, all may be accomplishing a desired goal of minimizing a client’s exposure to estate tax, but they need care and feeding, and a proper audit from time to time is essential. For example:

Insurance Trusts. Are Crummey notices being sent faithfully to trust beneficiaries in the case of insurance trusts where transfers are being made to the trust to pay premiums? Are the trust provisions still desirable? Are the successor trustees still acceptable? Are beneficiary designation forms up to date?

GRATs. Is the property in an existing GRAT subject to volatility such that it might be appropriate to freeze the fluctuation by having the creator substitute the property for a less volatile asset class (like cash) having an equivalent value? Have the required GRAT payments been made faithfully as prescribed in the trust agreement? If a GRAT has terminated, has the remaining property been transferred to the beneficiary of the remainder?

Dynasty Trusts and Spousal Lifetime Access Trusts. Are the provisions in the governing instruments regarding trust benefits and distributions and trustees still desirable? How are the assets performing? Is there an opportunity to do income tax planning for an asset otherwise excluded from the creator’s estate by swapping it out, as described above with the GRAT?

In many instances, upon reviewing these existing strategies, clients or their counsel have identified concerns or issues which need immediate attention, either because the provisions are no longer desirable or the technique has lost its purpose relative to size of his or her estate. Many states, including New Jersey, have adopted in one form or another, the Uniform Trust Code, which can help practitioners address changes needed to outdated or out-of-touch trusts. Decanting, combining or merging may also present viable options.

Renegotiate Family Loans.

Intra-family loans can often be a pragmatic solution for individuals looking to transfer wealth using the technique of an estate freeze.  The transfer itself is not a gift, but the value of the transfer is frozen at the time it takes place, meaning that the expected return of the principal amount is fixed by the value of the loan, whereas the asset or funds in the hands of the borrower is allowed to appreciate free of estate tax. For example, assume in 2015 a parent lends $1,000,000 to a child to purchase a home. If the parent had the child sign a promissory note and mortgage with a market rate of interest, no gift occurred. In October 2015, the applicable Federal interest rate (i.e., the minimum rate the parent must charge to avoid characterizing the loan as a gift) was 2.44%. In October 2020, the AFR for the same term loan is 1.12%. By refinancing the indebtedness, the child can lower his/her payments of interest by more than half. And if the parent is forgiving the interest as part of an annual gifting program, the annual gift tax cost has dropped from $24,400 to $11,200. Consideration should be given, however, to determine if refinancing to a lower rate and the benefit which the child realizes is, itself, a taxable gift. This may be avoided if the child pays to the parent the points associated with the adjustment to the lower interest rate at the time of the refinancing.

Using (or Losing) Your AEA before 2021 (or 2026).

As mentioned above, the AEA is currently $11,580,000 per person and, absent any legislative overhaul, will continue to be adjusted for the next five years with inflation and then disappear, reverting to the base amount of $5,000,000. Neither candidate seems to have mentioned gift, estate or GST taxes directly in any public discourse, but the Biden tax platform does include ending the income-tax benefit of the step-up in basis on appreciated property at death. The step-up at death currently allowed under the tax laws offers pragmatic and economic benefits for all taxpayers, regardless of affluence. Although not entirely clear as yet, a Biden administration agenda item appears to suggest that previously-unrealized gains are to be taxed at an individuals death, regardless of whether they are sold. Similarly, if Republicans were to revive their efforts at full-blown estate tax repeal, it is likely that the measure would follow the pattern of the repeal which occurred in 2010, namely that outside of an exemption, most of a decedent’s assets would not be allowed a step-up in basis.

Sunsetting and “Clawback.”

Putting aside these possibilities, the enhanced AEA will, absent any legislative action, sunset on January 1, 2026, thereby eliminating a meaningful amount of tax-free wealth which an individual can pass to family.  Individuals planning for this increasingly-likely situation are being encouraged to make taxable gifts immediately which use their AEA (i.e., gifts of up to $11,580,000 for individuals or $23,160,000 for married couples). In addition, the IRS has confirmed that taxpayers who make such gifts during this period will not be penalized even if the base amount of the AEA reverts to $5,000,000 as a result of the sunset in 2026.  Prior concerns of this “clawback” have discouraged gifts in the past, but with this pronouncement, there is no downside for making the gifts today and, potentially, no time like the present.

Techniques.

While any irrevocable family dynasty trust can be effective to make a lifetime gift of AEA, the most pragmatic technique which keeps the assets within the creator’s reach is the spousal lifetime access trust (or “SLAT”). SLATs are appealing for married individuals because, when properly set up, SLAT property remains accessible to the creator of the trust through their spouse as the beneficiary. However, the growth on the assets in the SLAT not consumed is passed on to the lower generation without further exposure to estate tax. Obtaining a policy of insurance on the life of the beneficiary (in an irrevocable trust) can be a way to insure for the creator that the death of the spouse-beneficiary does not compromise the access to funds otherwise being enjoyed by the couple prior to the creation of the trust. Spouses can set up SLATs for each other, but care must be taken to avoid the IRS’s “reciprocal trust doctrine” and the “step transaction doctrine,” both of which can cause undesirable consequences.  Clients who are considering the technique but not sure if or when they want to pull the trigger should take steps now to prepare for the eventual transfer of assets by making a substantial gift to the spouse who may not have sufficient assets in her or his own name, in order to enable that spouse to create the gift. In this way, there is a meaningful amount of time which has passed and allows the gift to “cure” in the hands of the spouse before being moved into a trust. Just how much should be considered to be placed in the trust? The answer will vary from client to client and will likely depend upon resources outside of the SLAT, but ultra-high net worth couples are advised to take a large bite of their unused exemption, using the SLAT, while it is still available.

Don’t Forget about the GST: Are Existing Trusts Being Optimized?

Many family wealth portfolios already have in existence trusts which provide benefits in the form of income, savings or potential future educational funds for children. Such trusts may have been created by parents or grandparents or even by the clients themselves during the last “fiscal cliff” estate planning crisis of 2012. Many of these trusts present challenges and opportunities for multi-generational wealth planning which, in this dynamic tax environment, require attention. Many individuals are unaware of the impact of the Federal generation-skipping transfer (or “GST”) tax, which, when applicable, creates an additional tax of up to 40% on transfers which land in the laps of beneficiaries who are two or more generations removed from the creator of the trust. In reviewing these trusts clients should be aware of the following:

“Grandfathered Trusts.”

Is the trust even subject to the GST tax? In general, any trust which was already in existence and irrevocable prior to September 25, 1985, enjoys the status of being a so-called “grandfathered trust,” meaning it is not subject to the tax at any point. Trusts of this nature should be carefully administered to avoid potential unintended exposure to the tax resulting from the exercise of certain rights or powers by beneficiaries or the modification of the terms (using certain statutory techniques or judicial actions). Such actions have the potential to cause the trust to be subject to the tax.

“Non-Exempt” Trusts Fully Subject to the Tax.

As wealth from “the greatest generation” passes down to baby boomers, many sophisticated estate plans have irrevocable trusts that are literally GST tax ticking time bombs. These trusts were created with an individual’s wealth which, at the time of transfer, exceeded his or her GST exemption amount available. By definition, these trusts upon termination will suffer the full blow of the 40% GST tax, thereby depleting the wealth otherwise intended to be passed to the family. Trustees have a fiduciary duty to minimize all taxes – including GST taxes – consistent with the intent of the creator. In many cases there are options available which should be considered at this time, particularly in the face of potentially shrinking estate tax exemptions. For example, assume the principal trust beneficiary is a child of the creator who has personal assets which fall below the AEA. Here, a trustee might do well to consider making a large principal distribution to the beneficiary to enable him to create a SLAT or a dynasty trust using the beneficiary’s own AEA so the trust escapes both the GST tax as well as estate tax when the beneficiary dies. Another strategy might include granting the beneficiary a testamentary general power of appointment which changes the impact of the GST tax and causes the trust to be included in the beneficiary’s estate for estate tax purposes.

Capital Gain Taxes and GST-Exempt Trusts.

Apart from the GST tax planning opportunities and obligations, trustees should also consider the fact that many generational trust strategies may be victims of their own success in another way:  appreciated assets – particularly in GST-exempt trusts such as dynasty trusts – may be harboring large unrealized gains. Family members may be pleased to receive appreciated assets free of GST tax, but that good feeling may soon dissipate if the appreciated asset is sold and the individual is subject to income tax on a large, long-term capital gain. Such gains by definition are not stepped up (as they are in the case where the underlying assets are subject to estate tax) because they bypass the beneficiary’s estate. Trustees, therefore, need to consider strategies which might be employed to minimize the potential gain. Unlike the GST strategies above, these income tax-driven techniques are more complex and need to be vetted against the individual variables of a client’s tax picture.

Strategize about Business Succession and Long-Range Planning.

The national lock-down which began in March not only locked down the economy, but it created a unique environment for business owners to stop and reflect about their enterprises and the future. Is this the time to liquidate a business? A division? Sell certain assets to raise cash and redeploy in a different line of products or services? Professional advisors are essential because they can help provide perspective and options. And if a business owner is looking to stay the course and transition the business to the next generation, an important consideration will be the fitness of the family to continue the legacy in the “new normal.” Business succession experts and consultants are well aware of the expression “shirtsleeves to shirtsleeves in three generations,” meaning an entrepreneur’s ability to have a business thrive multi-generationally is a direct function of the ability of the family members in the next generation to work hard, continue to innovate and adapt to new challenges.

Consider State Estate and Income Tax Effects on Your Domicile.

One of the unintended silver linings of the past six months has been the surprising ease with which certain businesses can conduct their operations in a remote capacity. The increased reliance on web-based video conferencing technology has revolutionized the way employees can accomplish tasks. The long-range effect of this shift in employment platforms may be that companies no longer need employees to remain in a centralized locale. Indeed, many individuals fled their homes and urban apartments to take refuge in the Berkshires, the Jersey Shore and Florida, where they continue to work productively. If business in the post-pandemic age permits migration, individuals now have a unique opportunity to re-evaluate their domicile in terms of tax and estate planning. Florida, for example, affords the benefits of no state income or estate tax and a generous homestead exemption. New Jersey has – for the moment – repealed its estate tax but has retained its inheritance tax. Residing in other jurisdictions could have other benefits. This may be the time to consult a tax advisor to determine if shifting domicile creates an overall tax reduction. In so doing, clients need to remember that a residence maintained in a former domicile renders them vulnerable to tax challenges by that jurisdiction. A legal domicile is a factual consideration made up of a series of intent-driven indicators which go beyond an individual’s physical presence in a jurisdiction. Factors include the individual’s driver’s license, voter registration, club and religious affiliations and the like. If social contacts relating to the former domicile become more prevalent, that state might be able to prove that the individual ultimately intended to return to that jurisdiction and negate even a temporary change in domicile. Here again, a legal advisor can assist in advising which steps are best to accomplish the desired result.

Conclusion

Neither the pandemic nor the upcoming Presidential election promises us any certainty anytime soon. In the midst of this climate, it is important to remember that certain opportunities for shifting wealth down to lower generations may be expiring within the next few years. The pandemic and its effect on the economy continue to keep interest rates at historic lows, which make this an ideal environment to engage in all aspects of estate planning, from the simple to the comprehensive. Now is the time to take stock of what is driving your estate planning, to think through existing choices and options with the help of legal and financial advisors, and then decide how best to optimize the strategies going forward.

© Copyright 2020 Sills Cummis & Gross P.C.
For more articles on estate planning, visit the National Law Review Estates & Trusts section.

Register for the 51st Annual PLI Estate Planning Institute

Live Webcast: Sept 14 – 15, 2020, 9 a.m. EDT

Click here to register.

The Tax Cuts and Jobs Act of 2017 (the “2017 Act”), which was enacted on December 22, 2017, included significant changes to the federal transfer tax regime and related income tax provisions.  More recently, the financial and societal impact of the COVID-19 pandemic of 2020 continues to reverberate and create uncertainty in the future.

This program will review the transfer tax and related income tax developments with the 2017 Act as a starting point, and will discuss how such developments impact estate, trust and income tax planning, and the administration of decedents’ estates.  Moreover, the program will review other recent developments regarding estate, trust and transfer tax and income tax planning.  Further, the COVID-19 crisis and the related estate, trust and income tax legislation and rulings promulgated in response to such crisis will be discussed.

What You Will Learn

  • Advising clients in a time of unprecedented uncertainty
  • An update on recent developments in all areas of estate, trust and transfer tax planning including legislation and rulings issued as a result of the COVID-19 crisis
  • A review of the interaction between the federal transfer tax regime and state transfer tax regimes
  • A review of the transfer tax and related income tax provisions of the 2017 Act
  • Income tax planning for estates and trusts
  • Administering estates and trusts during and after the COVID-19 pandemic
  • A review of the SECURE Act of 2019
  • A review of international estate planning and tax changes
  • FATCA and its progeny
  • A discussion of trust planning and divorce
  • Ethical considerations for attorneys
  • Elder law and special needs planning considerations
  • A review of tax issues for art collectors
  • An update on charitable donation planning
  • A review of electronic Wills and modern-day estate planning
  • Asset protection planning in a pandemic world

…and much more!

Special Features

  • Full hour of ethics credit

Who Should Attend

Attorneys and other professionals advising on estate planning and/or transfer tax planning, including accountants, financial planners and anyone else whose practice requires a solid understanding of estate planning.

Program Level: Overview

Prerequisites: Attendees should have a basic understanding of trusts and estates terminology and a foundational background in tax

Intended Audience: Attorneys, accountants, financial planners, and other professionals who specialize in estate planning, life insurance products and/or transfer tax planning

Advanced Preparation: None

See other upcoming events from PLI here.

529 Plans: Estate Planning Magic

The most common way to reduce state and federal estate taxes is to make lifetime gifts to irrevocable trusts. However, in order for an irrevocable trust to escape estate taxation at the grantor’s death, the grantor may not retain the power to “designate the persons who shall possess or enjoy the property or the income therefrom.” (IRC § 2036(a)(2).) In other words, the grantor cannot change the beneficiaries of the trust.

This poses a problem. What if circumstances change? What if a grantor creates a trust for a child, but the child no longer needs the funds? What if the grantor ends up needing the funds themselves? A grantor can build flexibility into irrevocable trusts by granting powers of appointment to the beneficiaries or by appointing a trust protector, but these powers may not be held by the grantor. Thus, reluctance to give up control keeps many clients from making gifts to irrevocable trusts.

The general rule that a grantor must relinquish all control over gifted assets has been seared into the mind of every estate planning professional fearful of accidentally causing estate tax inclusion. But there is one exception: the humble 529 Plan.

Section 529 of the Code contains a shocking statement:

“No amount shall be includible in the gross estate of any individual for purpose of [the estate tax] by reason of an interest in a qualified tuition program.” (IRC § 529(c)(4)(A))

There are, of course, exceptions. 529 plans are (likely) includible in the estate of the beneficiary upon the beneficiary’s death. Also, if the grantor has made the election to “front load” five years of annual exclusion gifts to the 529 Plan (discussed further below) and dies before the five years expires, a portion of the gifted amount will be includible in the grantor’s estate.

Still, 529 Plans offer unparalleled flexibility in estate tax planning. A grantor can remain the “owner” of a 529 Plan and retain the power to change the beneficiary to a qualifying family member (which includes grandchildren, nieces and nephews, and others), while still removing the assets in the 529 Plan from his or her estate. This is in contrast with an irrevocable trust, in which the grantor cannot act as trustee and cannot retain the power to change the beneficiaries.

The other “magic” of 529 Plans is the ability to “front load” annual exclusion gifts. The annual exclusion from gift tax allows a grantor to transfer up to $15,000 per year, per person. But, if a grantor makes the proper election on a gift tax return, he or she can make five years of annual exclusion gifts in a single year and use no transfer tax exemption. If the grantor is married and elects “gift‑splitting,” the couple can transfer $150,000 to a 529 Plan in a single year and use no estate and gift tax exemption.

529 Plans are, of course, designed for education, and are not complete substitutes for irrevocable trusts. The “earnings portion” of non-qualified distributions (i.e., distributions not used for “qualified higher educational expenses”) from a 529 Plan are subject to ordinary income tax at the beneficiary’s tax rate plus a 10% penalty, and for this reason, care should be taken not to “overfund” a 529 Plan. However, 529 Plans can nevertheless serve as effective wealth transfer vehicles because of their income tax benefits and the high probability that a grantor will wish to make significant contributions to the education of at least some members of his or her family. Combined with their unparalleled estate tax features, this makes 529 Plans “estate planning magic.”

© 2020 Much Shelist, P.C.

For more Estate Planning, see the Estates & Trusts section of the National Law Review.

Choosing a Trustee for Your Children – Should Foreign Family Members Apply?

Often the most difficult decision parents need to make when writing a Will is whom to appoint as the trustee for their children. The choice becomes particularly tricky for clients whose families live outside the U.S. since choosing a foreign trustee will cause the children’s trusts to be classified under U.S. income tax laws as “foreign trusts” – with lots of ensuing complications.

Under the Internal Revenue Code, trusts are by default “for­eign trusts” for U.S. income tax reporting purposes unless a U.S. court exercises both primary supervision over the administration of the trust (the “court test”), and one or more U.S. persons have authority to control all substantial decisions of the trust (the “control test”). The choice of a foreign trustee causes the trust to flunk the control test because a non-U.S. person controls substantial decisions of the trust. Being classified as a foreign trust results in some problematic U.S. income tax consequences. For example:

  •  U.S. beneficiaries who receive distributions from the trust will be taxed to the extent that any trust income, including foreign-source income and capital gains, is included in the distribution. Normally, non-U.S. source income and realized capital gains are not deemed to constitute any part of a distribu­tion to a beneficiary unless specifically allo­cated to a beneficiary. The foreign trust rules change this tax treatment such that non-U.S. source income, as well as capital gains, are deemed to be part of any taxable income distributed to a U.S. beneficiary.
  • Trust income not distributed in the year it is earned becomes undistributed net income (UNI). If, in a later year, a trust distribution to a U.S. beneficiary exceeds that year’s trust income, the distribution carries out UNI and is deemed to include the accumulated income and capital gains realized by the foreign trust in prior years. These gains do not retain their character but rather are taxable to the U.S. beneficiary at ordinary income tax rates.
  • Also, to the extent that a distribution to a U.S. beneficiary exceeds the current year’s trust income, a non-deductible interest charge will be assessed on the tax that is due with respect to the accumulated income and capital gains that are now deemed distributed. This charge is based upon the interest rate imposed upon underpayments of federal income tax and is compounded daily.
  • Finally, accumulated income and capi­tal gains are taxable to the U.S. beneficiary at the beneficiary’s ordinary income tax rate for the years during which it was earned under a complex formula designed to capture the U.S. tax that would have been payable if the accumulations had been distributed in the years earned – called the “throwback tax”.

Foreign trusts also trigger additional reporting obligations that carry heavy pen­alties for failure to comply. A U.S. beneficiary who receives a distribution from a foreign trust must file Form 3520 (“Annual Return to Report Transactions with Foreign Trusts”) reporting the distribution and the character of the distribu­tion. The failure-to-file penalty is equal to 35 percent of the gross distribution.

Recognizing, however, that a domestic trust can inadvertently become a foreign trust through changes in the identity of the trust­ee – such as a trustee’s resignation, disability, or death (but not removal) or the trustee ceasing to be a U.S. person (i.e. change of residency or expatriation) – U.S. Treasury Regulations pro­vide for a 12-month period within which to cure the unintentional conversion. The trust can replace the foreign trustee with a U.S. per­son trustee, or the foreign person can become a U.S. person during these 12 months. The foreign per­son can effectuate the cure simply by making the United States his place of residence; he need not become a U.S. citizen.

Rather than rely upon the 12-month cure period, however, a trust agreement should provide for a means to remove a non-U.S. person trustee to assure that the trust qualifies as a domestic trust. Trustee removal and appointment provisions are critical but should be reserved to individuals or entities in the United States. These powers can also create inadvertent gift and estate tax issues, so consulting a qualified trusts and estates lawyer to draft them is critical.

To avoid these problems, it might seem to make sense to allow the for­eign trustee to appoint a U.S. co-trustee or to grant certain reserved powers over the trust to a foreign family member in lieu of naming them as trustee (for example, reserving to them the power to remove and replace the U.S. trustee.) But this will not solve the problem. A trust is defined as foreign unless it satis­fies both the court test and the control test.

  • The safe harbor provisions of the court test require that the trust must “in fact” be administered exclusively within the United States, meaning that the U.S. trustee must maintain the books and records of the trust, file the trust tax returns, manage and invest the trust assets, and determine the amount and timing of trust distributions.
  • The safe harbor provisions of the control test provide that, in addition to making decisions related to distributions, the U.S. trustee must be entirely responsible for a laundry list of decisions including selecting beneficiaries, making investment decisions, deciding whether to allocate receipts to income or principal, deciding to termi­nate the trust, pursue claims of the trust, sue on behalf of or defend suits against the trust, and deciding to remove, add or replace a trustee or name a successor trustee.

And just to be sure, a well-written document should include a backstop provision that requires the trust to always qualify as a U.S. trust for income tax purposes and to have a majority of U.S. trustees. The inclusion of such a provision, at the very least, alerts those administering the trust to consider these issues before making any changes to the trustee or after an inadvertent change in trustees has occurred.

The increase in cross-border families and multinational asset portfolios have added complexities to the financial planning of families. Familiarity with the impact that these rules may have to existing or proposed estate plans is critical when designing a comprehensive plan for clients.

© 1998-2020 Wiggin and Dana LLP

For more on wills and inheritance trusts, see the National Law Review Estates & Trusts law section.

Why is Section 962 Back in the Spotlight? [Podcast]

In this podcast, international tax and estate planning attorneys Megan Ferris and Paul J. D’Alessandro, Jr. provide an overview of how individuals and corporations are taxed under the GILTI regime and discuss why section 962 has come back into the spotlight in a post-2017 Tax Act world.

Transcript:

PAUL D’ ALESSANDRO

Good morning, everybody, and welcome to our first Bilzin Sumberg Tax Talk podcast. My name is Paul D’Alessandro, and I’m a tax associate here with our international private client group. I focus my practice on inbound planning and estate planning for international high net worth individuals. I’m here today with my colleague, Megan Ferris.  How are you doing this morning, Megan?

MEGAN FERRIS

Hi, Paul. My name is Megan Ferris. I am an international tax associate with Bilzin Sumberg in Miami, Florida. I focus primarily on inbound and outbound tax structuring for businesses, typically closely held businesses. Our hope with this podcast is to bring you current issues related to various tax, trust, and estate matters.

PAUL D’ ALESSANDRO

Thanks, Megan, and I think we have a great topic for you this morning. Our first topic to kick off our podcast series. And we’re going to be talking about Section 962 and why it’s come back into the spotlight as of late. So, I think we’re going to hop right into it. And, Megan, I think a good way to start would be, can you give us a quick overview of the way individuals and corporations are taxed under the new GILTI regime in a post-2017 Tax Act world?

MEGAN FERRIS

Sure. Generally speaking, and especially when it comes to CFCs, the Tax Cuts and Jobs Acts of 2017, or the Tax Reform Act, treats U.S. corporations much more favorably than U.S. individual shareholders. First, at a high level, individuals are taxed in the U.S. on their ordinary income at graduated rates up to 37%, plus an extra 3.8% net investment income tax on their passive income. Corporations, on the other hand, are taxed at a flat 21% rate on their net taxable income.  Next, the Tax Reform Act introduced a handful of new across border taxes and anti-deferral measures.  One of these is Section 951A which, is called Global Intangible Low Tax Income, or GILTI, as you referred to it, which basically applies to the active operating-income of the CFC.  Now pre-tax reform, this income would not be taxed to the CFC’s U.S. shareholders until it was distributed, but today that income is taxed annually at the shareholder’s ordinary income rate.  Congress, however, went a step further by introducing Section 250, which gives U.S. corporations, and only U.S. corporations, a 50% deduction on their GILTI income and that essentially results in a 10.5% tax rate.  But wait, there’s more. U.S. corporations can also take a foreign tax credit for up to 80% of the foreign taxes paid by the CFC. So essentially, if the CFC paid at least a 13.2% tax rate, or specifically a 13.125% tax rate in its local country, then a U.S. corporate shareholder can use foreign tax credits to offset its entire U.S. income tax liability for that underlying GILTI income.  And that’s great for corporations.  An individual shareholder, on the other hand, has no Section 250 deduction and no foreign tax credit for taxes paid by the CFC.  The individual pays up to 37% U.S. tax on GILTI, end of story.  So, as you can see, the disparity between individual and corporation taxation can be quite dramatic.  And I guess that brings us back to the theme of today’s podcast, which is how some individual tax payers might use Section 962 to avail themselves of these benefits that are available only to domestic corporations.

PAUL D’ ALESSANDRO

Thanks, Megan. So that was a great overview I think of the general operating rules for the taxation of offshore income in a post-2017 Tax Act world. So as Megan alluded to, and our next question here in our podcast is, what is a 962 election, and how might an individual consider using the 962 election?

MEGAN FERRIS

Right.  So, in short, Section 962 allows individual U.S. shareholders of CFCs to elect to be taxed as domestic corporations. The election is available to direct and indirect shareholders of CFCs, so if an individual owned their interest through a partnership or certain trusts, they would still be able to make the election.  So now I’ll get into the mechanics of the election, but first I think it would help to give some historical context. Section 962 first became effective beginning in the tax year 1963 along with the rest of subpart F. Back then, the top individual tax rate in the U.S. was 91%, and the top corporate rate was 52%. So if you think we have it bad today, just be thankful we’re not in the 1960s.  Anyhow, with the introduction of subpart F and the new concept of taxing the U.S. individual shareholder on a CFCs income that the shareholder didn’t actually receive, Congress decided to give taxpayers a break and the means of reducing that current tax burden to the lower corporate tax rate of then only 52%. In addition, taxpayers were permitted to claim deemed paid tax credits under Section 960 for foreign taxes that were paid by that CFC. Now the legislative history under Section 962 tells us that, and I quote, “The purpose of Section 962 is to avoid what might otherwise be a hardship in taxing a U.S. individual at high bracket rates with respect to earnings in a foreign corporation which he does not receive. Section 962 gives such individuals assurance that their tax burdens with respect to these undistributed foreign earnings will be no heavier than they would have been had they invested in an American corporation doing business abroad.”  So, as far as tax policy goes, that’s a breath of fresh air for the taxpayers. Okay, now the mechanics.  This is how a U.S. individual is taxed under a Section 962 election. First, the individual is taxed on amounts that are included in gross income under Section 951a and now Section 951A, which is GILTI, at a corporate tax rate, which are currently 21%. Second, the individual is entitled to a deemed paid foreign tax credit under Section 960 with respect to the subpart F or GILTI inclusion as if the individual were a domestic corporation. Third, when an actual distribution of earnings is made from amounts that were already included in the U.S. shareholder’s gross income under Sections 951a and Section 951A, and just a reminder Section 951a is subpart F income, 951A is GILTI, those earnings are included in gross income again, but only to the extent that they exceed the amount of U.S. income tax paid at the time of the Section 962 election.  So, if an individual initially used foreign tax credits to offset his or her entire U.S. tax liability related to GILTI income in the year that the income was reported, then when the income is actually distributed, it will be includable again as dividend income. If the underlying CFC is in a treaty jurisdiction, then that individual will benefit from qualified dividend rates, which are currently 20% plus a 3.8% tax on passive income, that brings us to a total U.S. effective tax rate of 23.8%.

PAUL D’ ALESSANDRO

Interesting, Megan. So it seems like there’s definitely some benefits to be gained potentially under Section 962, but how does an individual taxpayer make a Section 962 election?

MEGAN FERRIS

An individual would typically file a Section 962 election with his or her timely filed tax return for the year to which the election relates, although in certain circumstances, case law would permit a retroactive election. The election is made on an annual basis, meaning each year you have the option to make the election or not, and you also have the opportunity to miss it, so be careful about that. Once made, the election applies to all Section 951a and 951A, included to the U.S. shareholder for all CFCs for that year.

PAUL D’ ALESSANDRO

So that’s an interesting point there you made at the end and something our readers — our listener’s rather, might want to pick up on.  The election applies to all CFCs that are owned by the individual.  So keep that in mind when you’re analyzing Section 962 and whether it makes sense to make the election based on your facts and circumstances.  So I think we kind of gave an overview here of Section 962 and why it matters now.  But what we’re going to do now is drill really down into the pros and cons of 962, what are the benefits to be gained, and what are some of the drawbacks as well by making the selection. So, Megan, do you want to start by taking us through the benefits of the 962 election?

MEGAN FERRIS

Sure. If the circumstances are right for the taxpayer, then the benefits should certainly outweigh any drawbacks for making this election. For example, the subpart F inclusions and the GILTI inclusions, and those are under Section 951a, and Section 951A are subject to tax at the lower corporate tax rate, which is now 21%.  There is a 50% deduction available for the GILTI inclusions. With a Section 962 election, an individual can take a credit for up to 80% of the foreign taxes paid by the CFC to offset the tax paid on the subpart F and the GILTI.  But keep in mind that the individual would still be subject to tax on any Section 78 gross-up based on foreign taxes.  With the Section 962 election, there is no corporate restructuring required that would otherwise take time and money to implement.  There’s no impact on the other shareholders of the CFC, whether there’s domestic shareholders or foreign shareholders.  And finally, there’s no double tax on the future sale of the CFC. Now on the downside, when those previously taxed earnings are distributed, they are taxed again to the extent that the distribution exceeds the tax paid on the initial inclusion.  Now, if the CFC is not in a treaty country, then under Smith v. Commissioner, ordinary tax rates would apply because the dividends are treated as coming from the CFC and not from the deemed U.S. corporation.  And lastly, on the downside, any basis increase in CFC stock as a result of the subpart f or GILTI inclusion is limited to the amount of tax paid on the inclusion.  So, I’ll give an example.  We recently did some tax planning for a client, an individual U.S. tax resident who owned an S corporation that, in turn, owned a Mexican CFC.  The CFC operates hotels throughout Mexico and pays a 30% income tax in Mexico on its net income.  From the U.S. federal tax perspective, that CFC’s operating income is all GILTI income to our client.  And so under his existing structure, the GILTI would flow up to him, and he would be subject to 37% tax on that income without any offset for the Mexican taxes paid.  We recommended making a Section 962 election, which he did.  Now, under his current structure, the client is treated, for U.S. federal income tax purposes, as if the GILTI is earned by a domestic corporation.  U.S. tax is fully offset with the foreign tax credits for the next to get income taxes paid.  And when CFC eventually distributes the income, the client is taxed on their distribution.  However, because the U.S. and Mexico have an income tax treaty in effect, the clients benefit from qualified dividend rates, which total 23.8%.  So in effect, we helped our client reduce his effective U.S. federal income tax rate with respect to GILTI from 37% to 23.8%.

PAUL D’ ALESSANDRO

So there you have it; 962 potentially can result in a lower effective tax rate for an individual, you get the benefit of the lower corporate tax rate, the 50% GILTI deduction, the 80% indirect foreign tax credit.  On the downside, you have to watch out for actual distributions because there’s less PTI than there would have been otherwise.  So a little bit of balancing based on the facts and circumstances to see if 962 is going to make sense in your case. I think we’re going to wrap up now.  Megan, you alluded to it earlier, but, you know, why has Section 962 come back into the spotlight this past year or two, and really when might a person consider making a 962 election?

MEGAN FERRIS

That’s a great question, Paul.  Now, in the decade since Section 962 was passed, it was rarely used planning tool unless the CFC was located at a high tax treaty country, like Mexico or France.  But fast forward to February 1, 2018, when tax reform became effective, now everything has changed because the corporate tax rates dropped from 35% to 21%.  And the effective tax rate on GILTI emerged at 10.5% for U.S. corporations.  Now finally, it’s an attractive option because even when you account for the 23.8% shareholder level dividend tax, the effective tax rate is still lower with a Section 962 election than if the CFC shares were treated as owned directly by the individual.  As far as U.S. tax planning goes, the Section 962 election can be an incredibly useful and cost-saving tool for the taxpayer who fits the profile that I alluded to, and that would be a U.S. shareholder of a CFC that generates GILTI or subpart F income where CFC has foreign taxes paid in this local country where the CFC is located in a treaty jurisdiction.  Now these individual U.S. shareholders can take advantage of the lower corporate tax rate, they can take advantage of the 50% deduction for GILTI income, and they can obtain a foreign tax credit for foreign taxes paid by the CFC, all without any restructuring required.  On the other hand, if the CFC is not organized in a treaty jurisdiction, then the election may not result in a net benefit to the taxpayer.  Now, in this case, it might make more sense to forego the Section 962 election in lieu of interposing an actual UFC corporation which would feature the same mechanical benefits of the Section 962 election, but it would also open the door to taking advantage of the dividends received deduction on distributions from the CFC.  Alternatively, the taxpayer might consider setting up a flow-through structure, and that would also permit the use of foreign tax credits to offset the GILTI inclusions, although the GILTI inclusions would generally be subject to the higher individual tax rate.

PAUL D’ ALESSANDRO

So those are some great points you made, Megan, and I’ll just piggyback off a few of them before we wrap up here. Section 962, I think you’re going to want to look at whether your CFC is in a treaty jurisdiction versus a non-treaty jurisdiction, as Megan said.  The 962 election is more beneficial when you’re in a treaty jurisdiction because you can take advantage of the lower qualified dividend income rates of 23.8%.  Like anything else in tax planning, I think you have to do a little bit of modeling when you’re looking at 962, and by that I mean you have to see if you’re in a situation where your client is going to be looking to pull dividends out of his CFC on a regular to semi-regular basis, or whether the income realization event is really going to be had upon exit when an individual is going to sell shares in a CFC. In that case, 962 is going to provide some benefit there simply by providing deferral in the years where you’re not taking distributions.  And I think a final point worth noting, and Megan touched on this; there’s been a lot of talk about simply having an individual drop their CFC shares into a parent USC corporation to achieve a lot of these results that we’ve been talking about.  That sounds great in theory, but it cannot always be done tax-free in the foreign country where the CFC is located.  Many times, contributing those shares to a U.S. corporation is a taxable event in that foreign country, and it could even result in that foreign country’s own CFC laws now applying to the U.S. parent corporation.  So 962, in that case, could also serve a tremendous benefit by avoiding all those foreign taxes and local taxes that would otherwise be triggered by dropping shares into an actual U.S. parent C corporation.  And with that, I think we’ve concluded our first podcast.  I hope you all enjoyed it and found it useful.  We‘re going to be looking to bring everybody more timely tax topics and hopefully more useful planning tips over the next few months and in the next year.  Megan, is there anything you want to say before we sign off?

MEGAN FERRIS

Thanks, Paul. I think you made some great points just to wrap up there.  And again, yeah, I hope everybody enjoyed this. I hope they can take some of these points and integrate them into their practices, and I hope you continue to tune in and listen to us as we bring you more current tax topics that might apply to your own practice.

PAUL D’ ALESSANDRO

Okay.  Very good. And with that, we’re signing off. Happy holidays and a happy new year to everyone, and we’ll see you next time.

 

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