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.

 


© 2020 Bilzin Sumberg Baena Price & Axelrod LLP

More tax guidance on the National Law Review Tax Law page.

Letters of Wishes: An Administrative and Moral Headache in Disguise?

1. LETTERS OF WISHES ARE THEORETICALLY SOUND

Trustees may have difficulties determining whether to make distributions when the grantor’s intentions are unclear. Consider a trust provision that provides for a beneficiary’s support in the form of reasonable medical expenses. The trust’s sole beneficiary approaches the trustee requesting a distribution for a gastric bypass surgery. The surgery can cost upwards of $45,000 and is the preferred method of achieving seventy-five pounds of weight loss. However, the surgery may be unsuccessful, and may result in post-operation complications and side effects that could impact the beneficiary’s health and require further distributions. Is the surgery a reasonable medical expense? Should the trustee make the distribution for the surgery?

Depending on the trustee, and his or her relationship to the grantor, the answer to the above questions is likely different. Scholars suggest that trustees should administer a trust “in [the] state of mind in which it was contemplated by the settlor that [the trustee] would act.”[1] If a spouse is serving as a trustee, he or she seemingly has ample opportunity to determine the grantor’s intent. If the drafting attorney is the trustee, the trustee may have gathered insight into the grantor’s mindset and goals while drafting the trust that could be applied to administration. Consider next a corporate trustee who enters the picture well after the grantor’s death. These trustees may have never met the grantor and are unlikely to have anything more than the trust instrument to guide administration. When contemplating a distribution to a beneficiary, each trustee should rely on the terms of the trust to determine whether the distribution should be made, although it is likely that each trustee’s perspective and relationship with the grantor will impact his or her decision.

A significant challenge many trustees face is that terms like health, education, maintenance, support, and best interests are as common in trust instruments as they are interpretive. Because these terms are interpretive, their application can be challenging even for the most diligent trustee; the interplay between these interpretive words/phrases and social, economic, and legal changes that occur during the administration of a trust can prove difficult to manage. In determining whether to make a discretionary distribution what must, or may the trustee rely on? Just the trust instrument? Extrinsic evidence? Personal opinion?

A. Enter the Letter of Wishes

A letter of wishes is a document that allows a grantor to express his or her goals for the trust. Information included can vary, but they offer information about how the grantor wants the trust to be administered by giving insight into the grantor’s state of mind, opinions on distributions, and issues that may arise with the trust’s beneficiaries.[2] These letters can serve two separate but equally important purposes. First, a letter of wishes can give the grantor the sense that the trustee fully understands their goals for the trust and can administer it in accordance with those goals. Second, letters of wishes can give a trustee something to proverbially hang their hat on when looking for guidance as to whether to make a distribution as the letter can clarify a trust instrument’s general terms.

In the example above, a letter explaining the trustee’s hesitance toward making distributions for cosmetic medical procedures would be valuable. Instead of guesswork, a letter outlining the grantor’s interpretation of the trust’s terms can assist a trustee in choosing to make distributions with greater confidence and flexibility.[3] This is the crux of the argument for many proponents of letters of wishes.[4]

2. LOGISTICS OF INCORPORATING A LETTER OF WISHES INTO AN ESTATE PLAN

Though letters of wishes are thought of as an informal tool[5] drafted by the grantor for the trustee’s benefit, the timing and method of drafting should be considered in relation to state trust laws by any practitioner who recommends its use to a client. Consideration should also be given to whether the letter should be incorporated into the trust as an exhibit or whether the letter should bind the trustee.

A. What is the Ideal Time to Draft a Letter of Wishes?

Practitioners should consider advising clients to draft letters of wishes close to the time the trust is settled in order to avoid disputes over whether the letter is representative of the grantor’s intent.[6] The following is illustrative: in 2017, immediately after selling his business, at his attorney’s advice, Grantor executes a discretionary trust for Grantor’s grandchildren to provide for their college educations. In 2022, the Grantor is now retired and has time to finally read the education trust that his attorney prepared for him.  At that time, the Grantor writes a letter of wishes explaining the grantor’s preference for distributions from the trust that further the pursuit of a STEM college education by Grantor’s grandchildren.  Shortly thereafter, all but one of Grantor’s grandchildren enroll in college to pursue liberal arts degrees.  The golden grandchild enrolls in a STEM program at his grandfather’s alma mater. The letter of wishes, drafted well after a significant passage of time, reflects that perhaps the Grantor’s opinions and relationships with his grandchildren may have changed. The trust does not have sufficient funds to cover the college tuition for all of the grandchildren and so the trustee must determine whether or not to make tuition payments for each grandchild or only certain grandchildren.  What is the trustee to do – follow the terms of the trust or follow the current wishes of the grantor?  Because of the timing as to the execution of the letter of wishes – there is an argument that the letter of wishes should be ignored.

Hugh v. Amalgamated Tr. & Sav. Bank[7] illustrates how timing can impact the effectiveness of a grantor’s extrinsic letters.[8] In Hugh, the Illinois Court of Appeals determined that the grantor did not gift land to a trust for the benefit of his grandchildren in part because letters expressing the grantor’s desire that the land be gifted to the grandchildren’s trust were delivered to the trustee several years after the trust was settled.[9] The court noted that the grantor’s exercise of dominion and control over the land in the time between when the grantor settled the trust and drafted the letters and when the letters were actually delivered to the trustee indicated that the grantor’s intent was to retain the property and not to make a gift.[10] Therefore, given the complications that may arise, the timing of the letter is very important.

B. How Involved Should an Estate Planning Attorney be in Drafting a Letter of Wishes?

Practitioners should consider their own involvement in drafting a letter of wishes and how differing degrees of involvement can impact the trust. Letters of wishes are often personal documents that allow a grantor to express his or her feelings about beneficiaries, philosophy on distributions, and goals for how the grantor’s legacy should be maintained.[11] Though the letter may be of great importance to the grantor, significant attorney involvement can complicate the trust drafting process by risking inclusion of precatory language in the trust instrument and presenting an opportunity for a grantor to incur significant legal fees for something of questionable utility. Executing a letter of wishes in conjunction with a trust instrument may cause a grantor to request that language from the letter be incorporated into the trust. Though many estate planning clients are sophisticated, the risk of creating ambiguity in the trust with emotional, personal, and imprecise language may be lost on them.[12] This risk should not be lost on their attorney. Time constraints and workload may cause estate planning attorneys to devote little thought to the letter of wishes, even though the letter may be important to the client and may risk insertion of precatory language into the trust document.

C. To be Effective, Must a Letter of Wishes be Incorporated into the Trust?

As letters of wishes are not legally binding on the trustee in and of themselves,[13] grantors must rely on a trustee feeling morally and ethically obligated to administer the trust in accordance with the letter. A solution to this problem may be to incorporate the letter of wishes into the trust as an exhibit. Matter of Estate of Kirk suggests that this option may be feasible as the court found a handwritten note attached to a formal trust amendment to be part of the amendment for purposes of administering the trust.[14] However, some scholars counsel against this, as attaching the letter as an exhibit would make the letter discoverable by beneficiaries, who may use the letter as an opportunity to increase the likelihood of getting a distribution or may find the letter hurtful.[15] Practitioners should counsel clients using this option to be sure that the letter does not contradict the trust instrument’s terms. Contradictions of this sort could be used as evidence of ambiguity, subjecting the trust to attacks from dissatisfied beneficiaries.

D. Should the Letter be Binding on the Trustee?

Scholars agree that letters of wishes should be made explicitly non-binding on the trustee, arguing that binding letters would interfere with the trustee’s discretion and hinder administration.[16] This argument is bolstered by the fact that the purpose of using more general language in a trust instrument is to provide the trustee with flexibility so that the trust can adapt to social, legal, and economic changes that impact administration.[17] Although the lack of litigation over letters of wishes may indicate that letters of wishes are often taken into account and used in administering the trust,[18] grantors should understand that the letters are deliberately non-binding in order to reap the benefits of adaptability. Grantors and their counsel should evaluate the risks of making a letter of wishes binding, and consider the benefits of a non-binding instrument.

3. DIGGING DEEPER: ARE LETTERS OF WISHES TRULY A POSITIVE ADDITION TO AN ESTATE PLAN?

Fast forward 10 years in the hypothetical posed in Part 1. Suppose you are approached by the trustee who has just found the letter expressing the grantor’s distaste for cosmetic procedures. Also assume that the trustee just received the gastric bypass distribution request. The trustee asks the attorney whether he or she must rely on the letter, what do you tell them? What if they ask whether they can exercise their discretion? Or what the trustee’s moral obligations are? Could the letter be deemed an amendment? The answers are unclear, but the following section applies scholarly opinion, statutory authority, and case law to explain how these issues can be addressed by practitioners.

A. Does the Trustee Have to Rely on the Letter?

While scholarly opinion is generally favorable toward letters of wishes, issues can complicate the positive purpose for which these letters are drafted. The first issue is whether the trustee has any obligation to rely on a letter of wishes. While trustees have historically abided by letters of wishes,[19] the letters are usually non-binding and often do not need to be disclosed to beneficiaries.[20] This means that the trustee has no legal obligation to make or forego making distributions in accordance with a letter of wishes.[21] Further, as noted by the restatement, letters of wishes are generally considered private correspondence between the grantor and trustee that offer guidance to the trustee, suggesting that the trustee has no duty to consider or abide by the letter in making a discretionary distribution.[22] Practitioners should be sure to discuss this with clients when deciding who to name as trustee to ensure that the client picks a trustee who is capable of managing the trust financially and effectuating the grantor’s intent to the full extent allowed by the law.

B. If the Trustee Wants to Consider a Grantor’s Letter of Wishes, Can They?

Further, a trustee may not be able to consider a grantor’s letter of wishes even if they want to. For example, Illinois common law provides that the general goal in construing a trust is to determine the grantor’s intent and to give effect to that intent if it is not contrary to law or public policy.[23] The grantor’s intent is to be determined solely by reference to the plain language of the trust itself.[24] Extrinsic evidence is only appropriate if the trust is ambiguous and the grantor’s intent cannot be ascertained.[25] When the language of a document is clear and unambiguous, a court should not modify or create new terms.[26] While Illinois courts have not addressed how a letter of wishes should be treated in relation to these rules of interpretation, Illinois’ Court of Appeals in In re Estate of Crooks noted that a decedent’s letter directing parcels of land to be transferred to him individually—which contradicted his previously executed will, trust, and quitclaim deeds directing the parcels to be transferred to a revocable trust—could not be used by a disgruntled heir to create an ambiguity in the decedent’s will, trust, or quitclaim deeds.[27] This suggests that a letter of wishes would be treated similarly unless there was an ambiguity in the four corners of the trust.

Practitioners should ensure that they are familiar with the statutes and common law governing trust interpretation for the state that governs the trusts they administer. While Illinois is fairly restrictive as far as what the trustee can rely on in administering the trust, Florida is more liberal.[28] In Kritchman v. Wolk, Florida’s Court of Appeals found that co-trustees of a revocable trust breached their duties of prudent administration and impartiality by failing to pay a beneficiary’s education expenses as requested in a letter from the grantor to the co-trustees prior to her death.[29] As such, the state where a letter of wishes is executed could impact whether a trustee may refer to it in administering the trust.[30] Further, the trust’s terms should be considered carefully to determine whether a letter of wishes or other written directive from the grantor should have any impact on administering the trust.

C. Moral and Ethical Obligations

While a trustee is unlikely to be required by law to consider a letter of wishes when administering a trust—and may, in fact, be prohibited from considering such a letter—they may feel a moral or ethical obligation to consider the grantor’s wishes when making discretionary distributions. Scholars suggest that trustees should administer trusts “in the state of mind contemplated by the settlor.”[31] Scholars also note that letters of wishes are “[m]oral and emotional accompaniments to a formal distribution scheme, [which]. . . have an important role to play in the planning process.”[32] This suggests that trustees may feel obligated to administer a trust consistently with a grantor’s letter of wishes. However, as shown by Kritchman, trustees without a personal connection to the grantor may feel no obligation to administer trusts in accordance with a grantor’s letter of wishes and may instead rely solely on the terms of the trust.[33] grantors and attorney’s should consider a potential trustee’s moral or ethical disposition towards a letter of wishes because this sense of obligation may depend on the trustee’s relationship with the grantor.[34]

D. Is the Letter an Amendment?

Depending on the circumstances under which a letter is drafted and signed, in addition to the letter’s content, some could argue that a letter of wishes is an amendment to a trust. Though many trust statutes require amendments to be made in accordance with the trust’s terms, a significant number of states allow a trust to be amended “by any other method manifesting clear and convincing evidence of the settlor’s intent.”[35] Arguably, a letter of wishes expressing a grantor’s specific desire as to what distributions should and should not be made could function as an amendment. However, no United States federal or state court has addressed the issue.

In Illinois, a trust can be amended by reserving the right to amend in the trust instrument.[36] If the trust instrument specifically describes the method for amendment then that method alone must be used to amend the trust.[37] Scholars suggest that Illinois trusts should be drafted in such a way that all amendments must be prepared by a lawyer familiar with the trust instrument.[38] Despite this guidance, the status of a letter of wishes as an amendment to an Illinois trust uncertain. While it is possible that a letter of wishes could be drafted in such a way that it meets the trust’s requirements, it is dependent on the trust instrument’s amendment provision(s). If the grantor wants their letter to function as an amendment, the trust instrument would need to be drafted to ensure that the letter meets the trust instrument’s formal requirements. Drafting a trust instrument in this way may not be advisable because of the potential for introducing precatory language and ambiguity into the trust.

An example serves to further illustrate this issue. Consider a marital trust instrument that allows discretionary distributions for either the beneficiary-spouse’s support or best interests. Assume that both terms are defined with substantive differences. Suppose the grantor drafts a subsequent letter of wishes explaining how the grantor would determine what is in his or her spouse’s best interest, but uses language that mirrors the trust instrument’s definition of support. Should the trust be considered amended to reflect a support standard for all discretionary distributions? The answer depends on the letter’s wording, governing state law, and the trust’s terms. In Illinois, such a letter would be unlikely to amend the trust unless the trust instrument’s amendment provision was drafted to allow for such a letter to function as an amendment.[39] However, a letter of wishes may be more likely to amend a trust in states like Wisconsin[40] and Kentucky[41] that follow the UTC’s more lenient provision.[42]

4. CONCLUSION

While letters of wishes may aid a trustee in administering a discretionary trust and provide the grantor with peace of mind, grantors and their counsel should think carefully about whether a letter of wishes is appropriate for the grantor’s situation. The uncertain state of the law as to the effect that a letter of wishes has on trust administration suggests there is more to letters of wishes than meets the eye. Though scholars generally praise letters of wishes as a means for a grantor to “communicate their cultural beliefs, values, and practices”[43] or as “helpful to a trustee in ascertaining the settlor’s state of mind, objectives, and purposes in establishing [a] discretionary trust,”[44] counsel should be aware that a letter may cause problems in administering the trust instead of solving them.[45] Practitioners who recommend a letter of wishes and/or whose clients choose to include them in their estate plan should advise clients as to the uncertain status of letters of wishes as a viable estate planning tool. Further, any decision to include a letter of wishes in an estate plan should only be made with an understanding of state trust statutes and case law and careful consideration of who to name as trustee.


[1] Austin Wakeman Scott & William Franklin Fratcher, The Law of Trusts § 187 (2006).
[2] See Alexander A. Bove, Jr., The Letter of Wishes: Can We Influence Discretion in Discretionary Trusts?, 35 ACTEC J. 38, 39 (2009).
[3] Id.; Edward C. Halbach, Problems of Discretion in Discretionary Trusts, 61 Colum. L. Rev. 1425 (1961) (arguing that the trustee should be given notice of the trust’s purpose and the grantor’s goals and beliefs to administer the trust in the way the grantor intended).
[4] See e.g., Bove, supra note 2, at 43; Henry Christensen III, 100 Years is a Long Time – New Concepts and Practical Planning Ideas, SN025 ALI-ABA 149, 183–84 (2007) (“[A letter of wishes] permits much more flexibility to. . . the trustee, who has more flexibility built into the trust instrument to exercise powers consistently with the intent of the settlor, rather than at the precise direction of the settlor, which was usually expressed in the vacuum of unknown and unanticipated events.”).
[5] Christensen, supra note 4, at 185.
[6] See Wakeman & Fratcher, supra note 1.
[7] 602 N.E.2d 33 (Ill. Ct. App. 1992).
[8] Note that the Hugh court referred to the grantor’s letters as “letters of direction” as opposed to “letters of wishes.” That said, the grantor’s “letter of direction” served essentially the same purpose that a letter of wishes would have.
[9] Id. at 35.
[10] Id. at 35–37.
[11] Bove, supra note 2 at 40; Deborah S. Gordon, Letters Non-Testamentary, 62 U. Kan. L. Rev. 585, 589 (2014).
[12] Both precatory language and ambiguity should be avoided in trust instruments. Trusts with patent or latent ambiguities are subject to having extrinsic evidence used in interpretation. See Koulogeorge v. Campbell, 983 N.E.2d 1066, 1073 (Ill. App. Ct. 2012). Further, including precatory language in a trust runs the risk that the preacatory terms will not be binding on the trustee. See Duvall v. LaSalle Nat. Bank, 523 N.E.2d 974 (Ill. Ct. App. 1988).
[13] See infra § 3(a).
[14] 907 P.2d 794 (Idaho 1995).
[15] See Bove, supra note 2, at 43.
[16] Id. at 43–44 (“Binding instructions on the trustee can interfere with the concept of full discretion and undermine or diminish the opportunity of exercising that judgment. If such instructions are that important and inflexible, they should be included in the body of the trust. . .”); Christensen, supra note 4, at 183–84.
[17] Gordon, supra note 10, at 616.
[18] Christensen, supra note 4, at 183–84. This lack of case law may also be explained by the fact that letters of wishes are likely to be considered non-discoverable trust documents. As such, beneficiaries are unlikely to see letters of wishes unless the trustee voluntarily discloses them.
[19] Id. at 184 (describing how letters of wishes are widely used and that trustees often fulfill their duties as outlined in letters of wishes).
[20] Restatement (Third) of Trusts § 87 cmt. 3 (2007); Bove, supra note 2, at 43–44; Christensen, supra note 4, at 184; Steven M. Fast and Steven G. Margolin, Whose Trust is it Anyway?, SM001 ALI-ABA 187, 199-200 (2006).
[21] Note that some foreign jurisdictions legally require a trustee to consider a letter of wishes in making trust distributions. That said, these jurisdictions do not require the trustee to make discretionary distributions in accordance with the letters nor do the letters create any additional duty for the trustee. Bove, supra note 2, at 41; see also, Anguilla Trusts Ordinance 1994 §13(4); Belize Trusts Act 1992 §13(4); and Niue Trusts Act 1994, §14(4).
[22] Restatement (Third) of Trusts § 87 cmt. 3 (2007); see also Bove, supra note 2 at 42.
[23] Citizens Nat. Bank of Paris v. Kids Hope United, Inc. 922 N.E.2d 1093 (Ill. 2009).
[24] Koulogeorge v. Campbell, 983 N.E.2d 1066 (Ill. App. Ct. 2012).
[25] Stein v. Scott, 625 N.E.2d 713 (Ill. App. Ct. 1993).
[26] Ruby v. Ruby, 973 N.E.2d 36 (Ill. App. Ct. 2012).
[27] 638 N.E.2d 729 (Ill. App. Ct. 1994). However, the court suggested that if the letter, will, trust, and quitclaim deeds had been executed simultaneously, the letter could indicate an ambiguity for which extrinsic evidence could be admitted to determine the decedent’s intent. The Idaho Supreme Court dealt with a similar issue, but decided differently in Matter of Estate of Kirk. 907 P.2d 794 (Idaho 1995). In Kirk, the court allowed a settlor’s handwritten note to be considered for purposes of construing her previously executed trust agreement. Id.
[28] See Fla. Stat. Ann. § 736.0804 (2017) (requiring a trustee to “administer the trust as a prudent person would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.”) (emphasis added).
[29] 152 So.3d 628, 631–32 (Fla. Dist. Ct. App. 2014). Note, however, that the grantor’s letter differed from a standard letter of wishes as it was delivered to the trustee during the grantor’s lifetime pursuant to the trust instrument’s provision allowing her to direct the trust to make payments as requested. Id. at 629–30.
[30] See e.g., Baker v. Wilburn, 456 N.W.2d 304, 306 (S.D.1990) (“[W]hen two or more instruments are executed at the same time by the same parties, for the same purpose and as part of the same transaction, the court must consider and construe the instruments as one contract.”).
[31] Wakeman & Fratcher, supra note 1; Bove, supra note 2, at 38.
[32] Gordon, supra note 10, at 617.
[33] Kritchman v. Wolk, 152 So.3d 628, 630–31 (Fla. Dist. Ct. App. 2014) (describing trustee/defendant’s position that the terms of the trust nullified all of the grantor’s written directives).
[34] See id. at 615 (“These letters, which in general avoid theatricality for simplicity and performance for connection, reinforce the social relationship between writer and recipient without disrupting the estate plan or manipulating the beneficiaries.”).
[35] Unif. Trust Code § 602; see also, Colo. Rev. Stat. Ann. § 15-16-702; Fla. Stat. Ann. § 736.0602(3)(b)(2); Mich. Comp. Laws Ann. § 700.7602; Mont. Code Ann. § 72-38-602; ; N.H. Rev. Stat. § 564-B:6-602;  Ohio Rev. Code Ann. § 5806.02; S.C. Code Ann § 62-7-602; Wyo. Stat. Ann. § 4-10-602.
[36] Parish v. Parish, 193 N.E.2d 761, 766 (Ill. 1963).
[37] Id.; Northwestern University v. McLoraine, 438 N.E.2d 1369 (Ill. App. Ct. 1982).
[38] Robert S. Hunter, § 213:23. Amending the trust agreement, 19 Ill. Prac., Estate Planning & Admin (4th ed. 2016).
[39] Supra § 3(d).
[40] Wis. Stat. Ann. § 701.0602 (2017).
[41] Ky. Rev. Stat. Ann. § 386A.2-020 (2017).
[42] Unif. Trust Code § 602.
[43] Gordon, supra note 17, at 617.
[44] Bove, supra note 2, at 39.
[45] See e.g., Matter of Estate of Kirk, 907 P.2d 794 (Idaho 1995) (describing a conflict between potential beneficiaries over changes in their interests in the decedent’s trust caused by decedent’s handwritten letter attached to a trust amendment).


© Horwood Marcus & Berk Chartered 2020. All Rights Reserved.

For more on Trusts, Grantors and Beneficiaries, see the National Law Review Estates & Trust law section.

2020 Inflation Adjustments Impacting Individual Taxpayers

Last month, the IRS released the 2020 inflation adjustments for several tax provisions in Rev. Proc. 2019-44. The adjustments apply to tax years beginning in 2020 and transactions or events occurring during the 2020 calendar year.  A select group of key provisions relative to trusts and estates are identified below.

Income Tax of Trusts and Estates

The taxable income thresholds on trusts and estates under Section 1(e) are:

If Taxable Income is: The Tax is:
Not over $2,600 10% of the taxable income
Over $2,600 but not over $9,450 $260 plus 24% of excess over $2,600
Over $9,450 but not over $12,950 $1,904 plus 35% of excess over $9,450
Over $12,950 $3,129 plus 37% of excess over $12,950

The alternative minimum tax exemption amount for estates and trusts under Section 55(d)(1)(D) is:

Filing Status Exemption Amount
Estates and Trusts ((§55(d)(1)(D)) $25,400

The phase-out amounts of alternative minimum tax for estates and trusts under Section 55(d)(3)(C) are:

Filing Status Threshold Phase-out
Estates and Trusts ((§55(d)(3)(C)) $84,800

Estate and Gift Tax

For an estate of a decedent dying in 2020, the basic exclusion amount, for purposes of determining the Section 2010 credit against estate tax, is $11,580,000.

The Section 2503(b) annual gift tax exclusion for gifts made in 2020 is $15,000 per donee.

For an estate of a decedent dying in 2020 that elected to use the Section 2032A special valuation method for qualified property, the aggregate decrease in value must not exceed $1,180,000.

For gifts made to a non-citizen spouse in 2020, the annual gift tax exclusion under Section 2523(i)(2) is $157,000.

Additionally, recipients of gifts from certain foreign persons may be required to report these gifts under Section 6039F if the aggregate value of the gifts received in 2020 exceeds $16,649.

For an estate of a decedent dying in 2020 that elect to extend the payment of estate tax under Section 6166, the 2% portion for determining the interest rate under Section 6601(j) is $1,570,000.

2020 Penalty Amounts

In the case of failure to file a return, the addition to tax under Section 6651(a)(1) is not less than the lesser of $215 or 100% of the amount required to be shown on the return.

The penalties under Section 6652(c) for certain exempt organizations and trusts failing to file returns, disclosures, etc., which are required to be filed in calendar year 2020, are:

Returns Under §6033(a)(1) (Exempt Organizations) or §6012(a)(6) (Political Organizations)
Scenario Daily Penalty Maximum Penalty
Penalty on Organization (§6652(c)(1)(A))  $20 Lesser of (i) $10,500 or (ii) 5% of gross receipts for year
Penalty on Organization with Gross Receipts Greater than $1,049,000(§6652(c)(1)(A))  $105 $54,000
Penalty on Managers (§6652(c)(1)(B)(ii))  $10 $5,000
Public Inspection of Annual Returns and Reports (§6652(c)(1)(C))  $20 $10,500
Public Inspection of Applications for Exemption and Notice of Status (§6652(c)(1)(D))  $20 No limits

Returns Under §6034 (Certain Trust) or §6043(b) (Terminations, etc., of exempt organizations)
Scenario Daily Penalty Maximum Penalty
Penalty on Organization or Trust (§6652(c)(1)(A)) $10 $5,000
Penalty on Managers (§6652(c)(2)(B)) $10 $5,000
Penalty on Split Interest Trust (§6652(c)(2)(C)) $20 $10,500
Split Interest Trust with Gross Income Greater than $262,000 (§6652(c)(2)(C)(ii)) $105 $54,000

Disclosure Under §6033(a)(2)
Scenario Daily Penalty Maximum Penalty
Penalty on Tax-Exempt Entity (§6652(c)(3)(A)) $105 $54,000
Failure to Comply with Demand (6652(c)(3)(B)(ii)) $105 $10,500

 


© 2020 Davis|Kuelthau, s.c. All Rights Reserved

For more IRS Guidance & Regulatory Updates, see the National Law Review Tax Law section.

2019 Year-End Estate Planning: The Question Is Not Whether to Gift, But How to Gift

Federal and Illinois tax laws continue to provide opportunities to transfer significant amounts of wealth free of any federal gift, estate and generation-skipping transfer (GST) taxes. However, because certain beneficial provisions “sunset” on January 1, 2026, now is an ideal time to revisit estate plans to ensure you make full use of this opportunity.

Current Exemption Levels

The federal gift, estate and GST exemptions (i.e., the amount an individual can transfer free of any of these taxes) are currently $11,400,000 for each individual, increasing to $11,580,000 in 2020. For married couples, the exemptions are currently $22,800,000, increasing to $23,160,000 in 2020. However, on January 1, 2026, the federal gift, estate and GST exemptions will be cut in half.

Federal and Illinois estate tax laws allow for a marital deduction for assets passing outright to a spouse or to qualifying trusts for the benefit of a surviving spouse. Thereafter, the federal estate tax rate is 40 percent. Illinois imposes a state estate tax based on a $4,000,000 threshold, which is not adjusted for inflation, at effective rates ranging from 8 percent to approximately 29 percent. (The Illinois estate tax paid is allowable as a deduction for federal estate tax purposes.) The only way to take advantage of the increased federal exemptions is to utilize planning strategies such as gifting in advance of the sunset date.

Gifting Options

Lifetime utilization of transfer tax exemption. A simple and effective planning opportunity involves early and full use of the high exemptions. Lifetime gifts utilizing the exemption amounts will almost always result in overall transfer tax savings, unless the assets that have been transferred decline in value. As with any gifting strategy, all income and future appreciation attributable to the gifted assets escapes future gift and estate taxation.

Assuming that assets appreciate, the sooner a planning strategy is implemented, the greater the estate tax savings will be. On November 22, 2019, the IRS issued final “anti-clawback” regulations expressly acknowledging that, when the exemptions are decreased, gifts made using the current high exemption amounts and which are in excess of the future reduced exemption amounts will not be subject to any additional gift or estate taxation. Thus, now is clearly the time for a “use it or lose it” strategy.

Annual exclusion gifts. Making use of annual exclusion gifts remains one of the most powerful estate planning techniques. The “annual exclusion amount” is the amount that any individual may give to any other individual within a tax year without incurring gift tax consequences. This amount, indexed for inflation, is currently $15,000 per donee.

Married couples can combine their annual exclusion amounts when making gifts, meaning that a married couple can give $30,000 per year to a child without using any transfer tax exemption (although filing a gift tax return may be required in some circumstances). When the spouses of children are included in the annual exclusion gifting, the amount that can be gifted is doubled again, meaning that a married couple can give a total of $60,000 per year to a child and the child’s spouse without using any transfer tax exemption.

Annual exclusion gifts can result in substantial transfer tax savings over time, as they allow the donor to remove the gift amount and any income and growth thereon from the donor’s estate without paying any gift tax or using any transfer tax exemption. Annual exclusion gifts also reduce a family’s overall income tax burden when income-producing property is transferred to family members who are in lower income tax brackets and not subject to the “kiddie tax” or the 3.8 percent net investment income tax.

Tuition and medical gifts. Individuals can make unlimited gifts on behalf of others by paying tuition costs directly to the recipient’s school or paying their medical expenses (including the payment of health insurance premiums) directly to a health care provider.

Gifts to spousal lifetime access trusts. Most people consider $11,400,000 to be a very large gift and either cannot, or do not want to, give away that much, as they may need or want it for themselves. A gift to a properly structured “spousal lifetime access trust” lets an individual make a completed gift now, and use the temporarily increased transfer exemption, but allows the individual’s spouse to be a beneficiary of the trust and have access to trust assets if needed. If the spousal lifetime access trust is implemented properly, the assets of trust (and the growth thereon) will not be subject to estate tax at the death of the grantor or at the death of the grantor’s spouse.

Grantor trusts. When planning with trusts, donors have great flexibility in determining who will be responsible for the payment of income taxes attributable to the assets in a trust. As an enhanced planning technique, trusts can be structured as “grantor trusts,” in which the trust is a disregarded income tax entity and the donor—not the trust or the beneficiaries—is responsible for paying tax on the trust’s income. By structuring a trust as a grantor trust, a donor can make tax-free gifts when paying the tax attributable to the trust’s income. This technique promotes appreciation of the trust assets while simultaneously decreasing the size of the donor’s estate, producing additional estate tax savings.

Combining gifting and selling assets to grantor trusts. Additional estate tax benefits can be obtained by combining gifts to grantor trusts with sales to grantor trusts. Because the grantor is treated as the owner of the trust for income tax purposes, no capital gains tax is imposed on the sale of assets to a grantor trust. The trust can finance the sale with a promissory note payable to the grantor, which provides the grantor with cash flow from the trust. The growth on the assets that are sold would then escape estate taxation at the grantor’s death.

Considerations When Making a Gift

Use of trusts when gifting. As with any gifting strategy, assets may be gifted outright so that the recipient directly controls the assets, thereby exposing the assets to the claims of the beneficiary’s creditors. Alternatively, assets may be gifted in trust, which 1) protects the gifted assets from the beneficiary’s creditors, including the spouses of beneficiaries in the event of divorce, 2) determines the future use and control of the gifted assets, and 3) shelters the gifted assets from future gift, estate and GST taxes through the allocation of the GST exemption.

Valuation discounts and leveraging strategies in the family context. “Minority interest,” “lack of marketability,” “lack of control” and “fractional interest” discounts can still be applied under current law to the valuation of interests in family-controlled entities and of real estate and other assets that are transferred to family members. Such discounting provides for estate and gift tax savings by reducing the value of the transferred interests. Leveraging strategies (e.g., family partnerships, sales to grantor trusts and grantor retained annuity trusts) can also be utilized to advantageously pass tremendous amounts of wealth for the benefit of many generations free of federal and Illinois transfer taxes.

State of Illinois estate tax laws. Illinois continues to tax estates in excess of $4,000,000, which is not adjusted for inflation and not allowed to be “ported” to a surviving spouse. Given the disparity between the $11,400,000 federal estate tax exemption and the $4,000,000 Illinois estate tax exemption, married couples domiciled in Illinois should make certain that their estate plans are structured to take advantage of the Illinois estate tax marital deduction. Otherwise, an estate plan that is designed to fully utilize the federal exemption can inadvertently cause an Illinois estate tax in excess of $1,000,000 upon the death of the first spouse.

The obvious and most direct strategy to address the Illinois estate tax is to simply move to one of the many states that do not currently impose an estate tax. In the event that a change of domicile is not possible or is not desired, all of the traditional planning techniques described above (in addition to others) are available to address this state liability. Because Illinois does not impose a gift tax, enacting gifting strategies will reduce future Illinois estate taxes.

Income tax basis changes. We continue to enjoy an income tax basis adjustment for assets received from a decedent upon his or her death (commonly known as the “step-up in basis,” although if values go down it can also be a “step-down” in basis). With the increase in the federal gift, estate and GST exemptions, and even with Illinois’ $4,000,000 exemption, transfer taxes are no longer a concern in many circumstances, and there is increased emphasis on income tax planning (specifically, planning with the goal of obtaining an income tax basis step-up at death). For many clients, it may be advisable, if possible, to “reverse” prior estate planning techniques, including trusts that were established on the death of a first spouse to die, to allow for a step-up in basis.

Traditional Estate Planning Still Matters

There is no time like the present to make certain that estate planning documents accurately reflect current wishes and make beneficial use of the federal and state transfer tax exemptions (to the extent not utilized during lifetime), federal and/or state marital deductions, and federal GST exemptions. Revisions may also be needed if family circumstances have changed since documents were originally executed.

Your estate planning goals may have changed. Many people no longer have taxable estates for federal estate tax purposes and may be able to adjust their estate plans accordingly, while others have existing plans that automatically adjust to the increased exemptions and do not desire more aggressive planning. Still others may want to take prompt action to aggressively utilize the new exemptions.

The above summary is not intended to enumerate all available estate planning techniques. Non-tax reasons to review and implement estate plans include:

  • Planning for probate avoidance
  • Planning for individuals with special needs (or who otherwise require specialized planning)
  • Implementing advance health care directives (such as living wills and health care powers of attorney)
  • Planning for incapacity
  • Planning for business succession
  • Planning for minor children and designating guardians
  • Planning for charitable giving

New Trust Code for 2020

On January 1, 2020, a new Illinois Trust Code will become effective, making many significant changes with regard to the administration of trusts. Of note:

Notice and designated representatives. Under the new law, for trusts that become irrevocable on or after January 1, 2020 (for example, a revocable trust becomes irrevocable upon a settlor’s death), the trustee is required to provide a copy of the trust agreement to all current and presumptive remainder beneficiaries. However, you can name a designated representative to receive such notice on behalf of any current and remainder beneficiaries.

Accountings. Under current law, a trust can be drafted so that accountings only need to be provided annually to current beneficiaries, not presumptive remainder beneficiaries. Under the new Illinois Trust Code, for trusts that become irrevocable on or after January 1, 2020, a trustee will have to provide annual accountings to current and presumptive remainder beneficiaries.

However, a trust agreement can be drafted to forego the requirement of providing the annual accountings to the remainder beneficiaries or potentially to provide that the accountings be provided to a designated representative for a remainder beneficiary rather than the remainder beneficiary himself or herself (although the remainder beneficiaries will be entitled to accountings when the current beneficiary’s interest terminates). This could mean, for example, that children who are remainder beneficiaries of a marital trust created under their father’s estate plan for their mother’s benefit will receive an annual accounting during their mother’s life unless they waive their right to receive it or the trust provides otherwise.

The Secure Act

Finally, pending in Congress is a bill known as the Secure Act. This legislation, if enacted in its current form, would push back the age of required minimum distributions from 70½ to 72 and eliminate the “stretch IRA.” If the Secure Act becomes law, we will send a supplement to this bulletin.


© 2019 Much Shelist, P.C.

More estate planning considerations on the National Law Review Estates & Trusts law page.

The Natural Segue between Tax Compliance & Estate Planning: Jennifer Tolsky Promoted to Partner at Gould & Ratner

Jennifer Tolsky was recently promoted to partner with the law firm of Gould & Ratner in the Tax & Wealth Transfer Group.  Tolsky is a CPA whose tax knowledge augments her legal practice, giving her a heightened awareness of tax concerns with estate planning, wealth transfer strategies and business succession planning.  Tolsky blends experience in tax compliance with an understanding of the personal nature of estate planning to provide nuanced and well-rounded counsel to clients of Gould & Ratner.

The Importance of Tax Compliance to  Estate Planning

Although “technically” Tolsky received her law degree first, she points out that she began her career as a CPA.  For Tolsky, her work as an attorney is built on a foundation of tax compliance knowledge.  The recession of 2008 influenced her career trajectory, and she says, “My dad, who is also a CPA, urged me to pursue an advanced degree in accounting due to the job shortage.”  This led to work in tax compliance, and she was able to marry the two by becoming an associate at Gould & Ratner.  Tolsky says, “Tax law is ever changing and evolving, and I enjoy the challenges it brings.  My accounting background, and specifically, my tax compliance background, informs my legal practice on a daily basis.”

Tolsky sees her current area of practice in the Tax & Wealth Transfer group as a “natural segue” from her previous experience in tax compliance.  She says, “I always consider how an issue I am reviewing or a provision I am drafting will impact a tax return, as well as how items will be executed once implemented . . . because of my previous role in tax compliance, I was able to see many of the issues I deal with currently manifest themselves in the ‘real world’.”  This practical familiarity is ideal in such a personal area of law such as estate planning, where there is a premium on tax efficiency and clients appreciate an in-depth understanding of the nuances of their individual situations.

With tax laws constantly changing, the challenges confronting estate planning clients continue to evolve.  Tolsky sees her role as an advisory one, helping her clients understand how the changes can impact them on multiple levels.  For example, the increased federal exemption on estate taxes, which has increased steadily since 1997, and according to the Tax Policy Center, the federal estate tax impacted the tax returns of less than 0.1 percent of the 2.7 million people who passed away in 2018.  However, other issues are still in play for clients.  Tolsky says, “Although the increased exemption may allow an individual’s estate to pass estate tax-free, there are other issues, such as probate, creditor protection, and ensuring that your assets pass according to your wishes.”  While the playing field is constantly changing, a strong foundation in tax compliance provides real-world expertise for Tolsky as she guides her clients through these issues.

Value of Relationships with Estate Planning, Wealth Transfer and Business Succession Clients

Estate planning is an area of the law that can get very personal for individuals, and Tolsky knows how important it is that client concerns are addressed with an eye to all the issues in play.  She works to establish trust with her clients by understanding their concerns as well as their goals, and finding solutions that deliver on both as efficiently as possible.  She says, “Due to the individual nature of estate planning, relationships are important, and I believe that’s the best way to invest in building your book of business.” John Mays, the Managing Partner of Gould & Ratner, says, “she [Jennifer Tolsky] brings a wealth of experience to the firm and is a pleasure to work with on matters very personal and thus very important to our clients.”

Copyright ©2019 National Law Forum, LLC.
This post was written by Eilene Spear of the National Law Review.
Read more Business of Law news on our Law Office Management page.

California Estate Tax: Gone Today, Here Tomorrow?

California has no estate tax, but that could change in the near future. California State Senator Scott Wiener recently introduced a bill which would impose gift, estate, and generation-skipping transfer tax on transfers during life and at death after December 31, 2020.

California law requires that any law imposing transfer taxes must be approved by the voters. This means that, if the California Legislature approves the California bill, it will be put before the voters at the November 2020 election.

For a time, California imposed a “pick up tax,” which was equal to the credit for state death taxes allowable under federal law; however, federal tax legislation phased this credit out completely in 2005, effectively phasing out any California estate tax. California has not in recent memory, if ever, had a statewide gift or generation-skipping transfer tax.

Under the proposed California bill, like the federal regime, all California transfer taxes will be imposed at a 40% rate. The good news is that the taxpayer will be granted a credit for all transfer taxes paid to the federal government, so there will be no double taxation. The bad news is that, unlike the federal regime where the basic exclusion amount for each type of transfer is $11,400,000 and is adjusted for inflation, the basic exclusion amount for each type of transfer in California will be $3,500,000 and will not be adjusted for inflation. With the federal exclusion rates rising every year, advanced estate planning techniques to minimize such taxes have become something that fewer and fewer people have had to worry about. If the California bill passes, any person who has assets valued in excess of $3,500,000 could be subject to a 40% California transfer tax during life or at death. Moreover, with a full credit for federal transfer taxes, only estates between $3,500,000 and $11,400,000 will be subject to the California tax. Thus, a California resident with an estate of $100,000,000 would pay the same California estate tax as someone with an estate of $11,400,000.

As drafted, the California bill appears to have no marital deduction; however, this is most likely an oversight and should be corrected in future revisions of the California bill. The goal of the California bill is to impose transfer taxes on wealthy Californians equal to what they would have paid prior to the implementation of the increased exemption rates at the end of 2017.  As the marital deduction existed when exemption rates were lower, eliminating the marital deduction at the first death would not be aligned with the purpose of the California bill.

All transfer taxes, interest, and penalties generated by the California bill would fund the proposed Children’s Wealth and Opportunity Building Fund, a separate fund in the State Treasury, which will fund programs to help address socio-economic inequality.

 

© 2019 Mitchell Silberberg & Knupp LLP
This post was written by Joyce Feuille of Mitchell Silberberg & Knupp LLP.
Read more news on the California Estate Tax on our Estate Planning page.

A Cautionary Fairy-Tale – If Only Cinderella’s Father Had An Estate Plan

Ah, the tale of Cinderella, a classic childhood favorite. We all know it as the story of an orphan who is mistreated by her Evil Stepmother and, with the help of her Fairy Godmother, wins over the heart of Prince Charming.

Often overlooked, however, is how the story began. Cinderella’s Mother died when Cinderella was a child. Cinderella’s Father remarried and shortly after, he also died. Cinderella’s Evil Stepmother then stole Cinderella’s inheritance and enslaved Cinderella in her own home. Surely, Cinderella’s parents never planned on this future for their lovely daughter. But, you see, it was the parents’ failure to plan for the future that put Cinderella in this terrible predicament. With a little planning—estate planning, that is—Cinderella never would have endured such suffering.

Avoid the Stepmother Trap 

There are several ways a skilled estate planning attorney could have helped poor Cinderella, as we analyze author Charles Perrault’s beloved fairytale under modern-day Arizona law.

With no estate planning documents in place, Cinderella’s modern-day predicament would look like this: half of Cinderella’s Father’s estate would be distributed to Evil Stepmother, and half of the estate would be distributed to Cinderella, as a child of the father who was not also a child of Evil Stepmother. Being a minor, Cinderella’s half of the estate would be placed in one of two places.

The first place would be a Uniform Transfers to Minors Act (“UTMA”) account. An UTMA account requires a court-appointed custodian – presumably, Evil Stepmother – who should use those funds for Cinderella’s health, education, maintenance, and support. Unfortunately, with little oversight, we doubt Evil Stepmother would have complied with UTMA. Instead, Evil Stepmother likely would have used Cinderella’s share of the estate to benefit herself and her two biological daughters.

The second place the money might have been placed would be in a trust for the benefit of Cinderella. While the second option is the best option, someone (another family member, on Cinderella’s behalf) would have to petition the court to order that outcome, and it is unlikely that Evil Stepmother would do that for Cinderella.

Why Oh Why Didn’t Cinderella’s Father Create a Trust for His Precious Little Girl? 

What Cinderella’s Father should have done was create a Revocable Living Trust Agreement (the “Trust”). He should have created the Trust after marrying Evil Stepmother to ensure there was no pesky “omitted spouse” claim. The Trust should state that (1) certain assets, as set forth on an attached Schedule A, are the separate property of Cinderella’s Father, (2) certain assets, if any, as set forth on an attached Schedule B, are the separate property of Evil Stepmother, and finally (3) that certain assets, as set forth on an attached Schedule C, are the community property of Cinderella’s Father and Evil Stepmother.

To assist with the trust administration after his death, Cinderella’s Father also should have named a neutral successor trustee, such as a friend, fiduciary, corporate trustee, or perhaps the best choice of all, Fairy Godmother. The Trust should state that, at the death of Cinderella’s Father, the Trust will be divided into two subtrusts, commonly referred to as an A/B split trust.

Trust A (the Survivor’s Trust) would be allocated all of Evil Stepmother’s separate property as well as one-half of the value of the community property assets. Trust B (the Decedent’s Trust) would be allocated all of Cinderella’s Father’s separate property as well as one-half of the value of the community property assets. The Trust could provide that Evil Stepmother would be able to use the Survivor’s Trust assets as she pleases and can only access the Decedent’s Trust assets (other than perhaps receiving income, if so stated in the estate documents) if the assets allocated to the Survivor’s Trust were depleted or illiquid. Having a neutral successor trustee to either work with Evil Stepmother or to oversee only the Decedent’s Trust would ensure that Cinderella’s share was not being improperly raided and depleted. Then, at the death of Evil Stepmother, the assets in the Decedent’s Trust would be distributed to Cinderella.

Creative Considerations for Dear “Cinderelly”

Other provisions can be added to such trusts that ensure Cinderella’s interests are protected. For example, a provision could be added that gives Cinderella the ability to request funds from the Decedent’s Trust, as needed, for health, education, maintenance or support (payable on her behalf, as a minor, and to her, once she is of age). Another provision could allow Cinderella to receive a portion of the Decedent’s Trust at a certain age or upon her marriage to Prince Charming, prior to Evil Stepmother’s death. Finally, another provision could allow the successor trustee to create and fund a 529 college savings account using funds from the Decedent’s Trust.

There are other possibilities if Cinderella’s Father did not want to create a trust as described above because he was so utterly and completely in love with Evil Stepmother and wanted everything to be considered community property. In this case, he could have planned in some untraditional ways to still ensure Cinderella was cared for. For example, Cinderella’s Father could take out a million dollar term life insurance policy after his second marriage, naming Cinderella as the sole beneficiary and directing funds to be distributed to an UTMA account with a neutral custodian or to a support trust with a neutral trustee.

Cinderella Ultimately Inherited Litigation 

In our modern-day analysis, the only inheritance Cinderella’s Father left her was likely litigation. Although not ideal, in circumstances like these, litigation affords the child of a parent with no estate plan, or with a poor estate plan, the opportunity to recover all or some of the property the child is rightfully entitled to receive. Assuming Cinderella’s Father died intestate (without a will), half of his estate should have passed to Evil Stepmother and the other half to Cinderella. Assuming Evil Stepmother either adopted Cinderella or was her court-appointed guardian, conservator or custodian, Evil Stepmother would owe Cinderella a fiduciary duty to protect her share of the inheritance and should have prepared an accounting of the assets that existed at the time of Cinderella’s Father’s death.

Of course, in the original story, Evil Stepmother never protected Cinderella’s interests and instead pillaged all of the assets. Cinderella, therefore, would have had a cause of action against Evil Stepmother for breach of fiduciary duty and conversion, among others. Fortunately, children like Cinderella are not without a remedy. An experienced estate litigation attorney can assess each case and determine what causes of action exist, the expected cost, and the likelihood of recovery.

Your Fairy Godmother Equivalent

Luckily, Cinderella had allies in the form of her Fairy Godmother and her many animal friends. If you have questions about estate planning, trust administration, and estate litigation issues, there are many resources available to you. This includes the most powerful resource of all: calling upon an estate planning attorney to help you – and others – learn from the cautionary fairy-tale that is the Cinderella story.

Copyright © 2019 Ryley Carlock & Applewhite. A Professional Association. All Rights Reserved.

ABLE Accounts: What They Are and What They Mean for Your Family

Individuals with disabilities and their families have many options to set aside funds without jeopardizing eligibility for means-tested government benefits. However, until recently most of the available options require the person with a disability to lose control over his or her own money.  With the 2014 enactment of the Stephen J. Beck Achieving a Better Life Experience (ABLE) Act, people with disabilities can once again control some of their own money and retain a sense of autonomy. While ABLE accounts will not replace other forms of planning that are available to and recommended for people with disabilities, there are definite advantages to adding the ABLE account into an overall plan.

The Basics

ABLE accounts are tax-deferred savings accounts that are closely modeled on 529 education savings plans. While ABLE is a federal program, much like 529 education plans, each state is responsible for crafting and administering its own program. Some states only allow residents to enroll, while others welcome out-of-state residents. It’s important to consider not only whether an ABLE account is appropriate, but also which state’s program best suits your situation.

To be eligible for an ABLE account, a person must be diagnosed, before age 26, with a disability that would entitle him or her “to benefits based on blindness or disability under Title II or XVI of the Social Security Act.” Once eligibility is determined, the individual or a third party (e.g., the disabled individual’s parents, siblings, or friends) can establish and fund an ABLE account.

Contributions and Account Limits

In any given year, the aggregate cash contribution from all donors (including the beneficiary him/herself) cannot exceed the annual gift tax exclusion amount ($15,000 for 2018). ABLE accounts accept cash only. Stocks, bonds, investments, and real estate cannot be contributed.

In addition to the annual contribution limits, as of January 1, 2018, the Tax Cuts and Jobs Act of 2017 authorizes an employed ABLE account beneficiary to contribute an amount up to the lesser of (i) his or her compensation or (ii) the poverty line for a one-person household ($12,140 for 2018). In order to be eligible for this additional contribution the individual cannot also contribute to an employer-sponsored defined contribution plan, such as a 401(k). Since the earned income contribution can be made in addition to the aggregate cash contribution, the total possible contribution for 2018 is $27,140.

Starting this year, a new funding option is available that allows individuals to “roll over” assets from a 529 plan into an ABLE account. While this is certainly a boon for families who initially set aside funds in a 529 account for a beneficiary who cannot use it, the funds rolled over cannot exceed the standard annual ABLE account contribution limit, so depending on the value of the 529 account the rollover could take several years to complete.

One of the biggest differences between the various state programs is the maximum amount that may be held in the account. For New York plans, the limit is $100,000. In other states, the limits are significantly higher and are tied to the limits those states have imposed for 529 education plans. For example, Illinois plans have a limit of $400,000. So for people who plan to accumulate larger sums in an ABLE account, it is wise to shop around to different states.

Although ABLE accounts are generally disregarded as a resource when determining eligibility for means-tested benefits, there is an exception. The first $100,000 of assets held in the ABLE account will not count as a resource when determining Supplemental Security Income (SSI) eligibility. However, once the account balance exceeds $100,000, the individual’s SSI will be suspended until the balance is again below that amount. There is no impact on Medicaid eligibility regardless of how much money is in the account.

Growth and Distributions

Income generated on assets held in an ABLE account are not taxed. Disbursements made for qualified expenses of the disabled individual are also not taxed. If a distribution is made that does not constitute a qualified expense, the beneficiary will be responsible for both ordinary income tax and a 10 percent penalty.

Qualified expenses of the disabled individual that can be paid for from the ABLE account without incurring taxes or penalties include, but are not limited to, education, legal fees, financial management and administrative services, health and wellness, housing, transportation, personal support services, and funeral and burial expenses.

As of January 1, 2018, the designated beneficiary is permitted to claim the saver’s credit for contributions made to his or her ABLE account. The saver’s credit is a nonrefundable tax credit for eligible tax payers who make contributions to retirement savings accounts.  The maximum annual contribution eligible for credit is $2,000 per individual, and the amount of the credit depends on the taxpayer’s adjusted annual income.

Benefits Eligibility Tip: An important benefit of the ABLE account is that, unlike when payments are made from a Special Needs Trust, payments for the beneficiary’s housing and food are not viewed as in-kind maintenance support for the purposes of SSI, and the beneficiary will not suffer the usual reduction for payments made by someone other than the SSI recipient for those purposes.

Words of Caution

Although ABLE accounts can be a valuable tool, there are several pitfalls to consider before opening an ABLE account. As with any decision that may affect government benefits, it is always best practice to discuss the situation and your options with your attorney, as there are many issues to consider before adding an ABLE account to a beneficiary’s plan.

For example, an important thing to consider is whether the beneficiary is capable of managing the ABLE account. Since the beneficiary is allowed to manage the funds in the account, families should carefully consider the risks (e.g., making non-qualified distributions or risking abuse and undue influence by an outside person) of the funds being immediately available. While this risk can be mitigated in several different ways beyond the scope of this article, it is certainly a point worthy of consideration.

Additionally, ABLE accounts are similar to first party Special Needs Trusts in that, to the extent the beneficiary receives medical assistance funded by Medicaid after the account is established, any funds remaining in the ABLE account at his or her death will be used to pay back the state for benefits that are paid for the beneficiary. This is the case regardless of whether the funds originally come from the beneficiary or a third party.

Notwithstanding the limitations, ABLE accounts can still be a valuable addition to a carefully crafted special needs plan.

 

© 2018 Schiff Hardin LLP

Estate Planning for Founders

Founders and entrepreneurs face many pressure points while building their company into their vision. Important decisions must be made relating to the choice of a business entity, how to fund the business, what sort of regulations impact the business, how to protect intellectual property, how to manage employees, and what to do if sued. Most of these points focus on the business.

As Founders are busy building their business and working towards success, they often overlook their personal estate planning. Founders are not alone in avoiding this topic – as few people enjoy considering what happens to their assets upon incapacity or death. Founders have unique needs that necessitate proactive estate planning as early in a company’s existence as possible in order to minimize tax consequences and maximize liquidity options. In order to simplify estate planning and encourage Founders to focus, estate planning for Founders should be broken down into the following segments:

  • Segment I: Core Planning.
  • Segment II: Business Continuity and Liquidity.
  • Segment III: Advanced Wealth and Transfer Strategies.

This article will detail each of the segments that all Founders should consider. Although presented in numerical order, we find that Founders are often driven into a particular segment that meets their personal situation. We note that once a Founder starts a segment, it almost always makes sense to consider the other segments as well.

Segment I: Core Planning

Core estate planning answers the question of what happens to the business and your other assets at death – including who controls those assets (the fiduciaries), who receives the assets (the beneficiaries), and how much tax is paid. Core estate planning involves putting together a well-constructed set of wills and revocable trust agreements that capture the available exemptions from state and federal estate taxes, protect your children’s inheritances from “creditors and predators” and name appropriate individuals or institutions to manage your estate after your death. This phase also includes setting up simple documents that appoint individuals to manage your financial and personal affairs in the event of your incapacity, including a living will and power of attorney.

Under current law, everything you own is subject to federal estate tax, and potentially state estate tax as well. Every person is entitled to an exemption from federal estate tax – that exemption is currently $11,180,000 (note that the exemption increases every year). The federal estate tax rate is currently 40 percent on the assets in excess of the federal exemption (reduced by any taxable gifts made during your life).

Even though the tax exemptions seem large, it is important for Founders to engage in estate planning that minimizes the taxes’ impact, especially since a startup’s value can grow rapidly over a short period of time. A married Founder’s estate plan can be carefully crafted to delay tax until the death of the survivor of the Founder and the Founder’s spouse.

Segment I planning also includes incapacity planning. If you become incapacitated and no planning has been done, your family may be forced to go to court to obtain the appointment of a guardian or conservator to manage your financial and personal affairs. This result can be avoided in almost all cases through power of attorney and health care proxy naming your spouse or other individual to make financial and health care decisions in the event of your incapacity.

Upon completion of Core Planning, a Founder will have created tax efficient wills and revocable trusts, considered asset protection planning for a spouse and children, and appointed fiduciaries to administer your estate and continuing trusts.

To us, Core Planning is the minimum amount of estate planning a Founder should complete. The Core Plan helps educate Founders on the planning, taxes and asset protection. The Core Plan ensures that the Founder is able to select the correct fiduciaries to manage his/her estate upon death and that the intended beneficiaries benefit from the Founder’s success. The Core Plan can, and should, change with time.

Segment II: Business Continuity and Liquidity

While Segment I planning is essential for everyone, Segment II planning addresses the unique needs that Founders have regarding business continuity and liquidity. With regard to continuity, it is often appropriate for Founders to consider a buy-sell agreement, which is a contractual arrangement providing for the mandatory purchase (or right of first refusal) of a shareholder’s interest upon the occurrence of certain events described in the agreement (the so-called “triggering events”). The buy-sell agreement’s primary objective is to provide for the stability and continuity of the startup in a time of transition through the use of ownership transfer restrictions. Typically, such agreements prohibit the transfer of ownership to unwanted third parties by setting forth how, and to whom, shares may be transferred. The agreements also usually provide a mechanism for determining the sale price for the shares and how the purchase will be funded.

Because a startup is built from nothing, it is often important to a Founder to maintain control while providing for a smooth transition to his chosen successors upon his death or disability. Structuring a buy-sell agreement provides a nonthreatening forum for the Founder to begin thinking about who should manage the startup in the future. By specifically carrying out the Founder’s intent, a properly structured buy-sell agreement avoids the inevitable disputes between people with competing interests. If the Founder becomes disabled or retires, a buy-sell can provide him with the security that his case flow won’t disappear, as the agreement can provide for the corporation and/or the other shareholders to purchase the shares, at a predetermined price, either in a lump sum or installments, typically at preferable capital gains rates.

Funding a buy-sell agreement is essential to its success, but that requires liquidity. Life insurance is an extremely common and effective funding choice. Whether owned by the business in a redemption agreement or by the other shareholders in a cross-purchase agreement, it provides the purchasers with the ability to guarantee a certain amount of money will be there when the Founder dies—as long as premiums are paid. The type of life insurance typically purchased in the startup context is some form of permanent insurance (such as whole life, universal life, or variable life) rather than term insurance, which gets more expensive as the insured ages and may not be able to be renewed beyond a certain age (usually between 60 and 70 years of age).

There are downsides in certain circumstances to using life insurance in this manner. As mentioned, if a cross-purchase agreement is chosen and there are more than two shareholders, each shareholder will need to purchase a life insurance policy on every other shareholder (unless a partnership is established to own the insurance). Additionally, life insurance doesn’t solve the funding problem for transfers while the Founder is still alive.

In addition to providing liquidity to the business, liquidity may also be important for the Founder’s beneficiaries. If significant wealth is tied to the business, the Founder’s beneficiaries may have little to no access to liquid funds upon the death of a Founder. The most common strategy to deal with this lack of liquidity is to purchase life insurance. As noted above, there are several types of life insurance available. In addition to the type of insurance, a Founder should consider whether it is recommend to own the life insurance policy inside an irrevocable life insurance trust in order to remove the proceeds of such policy from the Founder’s estate for tax purposes.

Aspects of Business Continuity and Liquidity are often addressed in the business’ governing documents. However, as the business grows, partners enter the business and investors come and go – these documents should be reviewed on a regular basis. The liquidity concerns of the Founder should also be regularly reviewed.

Segment III: Advanced Wealth and Transfer Strategies

Generally, Segment III planning involves the transfer of assets out of your estate to shelter them from estate tax. Although we often encourage clients to at least consider Segment I planning first, often a business is about to “pop” in value – this “pop” offers a great opportunity for tax planning. In those circumstances, Advanced Wealth and Transfer Strategies is often the initial introduction to estate planning.

If an individual attempts to transfer assets during life in order to avoid an estate tax, the transfer will generally instead be subject to a federal gift tax. Since the gift tax and the estate tax apply at the same rates and generally have the same exemptions, there should be no incentive for an individual to transfer wealth during life as opposed to waiting to transfer it at death. In effect, by enacting the gift tax as companion to the estate tax, Congress created an “airtight” transfer tax system. There are, however, leaks in that system. The three primary examples of the leaks in the system are: removing value from the system; freezing value within the system; and discounting values within the system.

Removing value from the transfer tax system is hard to do and takes time. In most cases, if an individual makes a gift during lifetime, that gift is brought back into the taxable estate at death. However, there are two exceptions to this general rule, which are the annual gift tax exclusion and the “med/ed” exclusion. If an individual makes a gift using his or her $15,000 annual gift tax exclusion, the gifted property is entirely removed from the taxable estate. Individuals are also permitted to make gifts of unlimited amounts for tuition and certain medical expenses, as long as the payment is made directly to the provider of services. Such med/ed gifts are entirely excluded from the taxable estate.

Removing value is done over-time and is a consistent theme for Founders in their estate planning. However, the real benefit of a business “popping” in value is in the freeze and
discount strategies. Freezing value within the system usually connotes the individual making a gift using some or all of his or her lifetime exemption from federal gift tax. For example, you might make a gift of $5 million worth of stock to a child. Upon your death, the $5 million gift is actually brought back into your estate for purposes of calculating your estate tax. However, it is only brought back into the estate at its value at the time the gift was made and is sheltered from tax at that time via the use of your $5 million estate tax exemption. Accordingly, if the value of the gifted property increases between the date of the gift and the date of your death, the appreciation avoids transfer tax. In other words, you succeed in “freezing” the value of the gifted property at its date-of-gift value.

A holy grail of estate planners has been to find a way of freezing the value of an asset at some number lower than what it is actually “worth” to the gift-giver’s family, also known as “discounting” values. Suppose an individual owns all of the stock in a business with a total value of $10 million. If the individual gives all of the stock to her child, she will have made a taxable gift of $10 million. On the other hand, suppose that the individual gives 10% of the business to five people. An appraiser is likely to opine that the interests received by the individuals are subject to lack of control and lack of marketability discounts, since none of the recipients can easily control or transfer the entity. If the appraiser applies, say, a 30 percent discount for the lack of marketability and control, the value of the gift would be reduced to $3,500,000.

Accordingly, the Founder succeeds in freezing values at something less than the entity value of the business in the eyes of the family as a whole.

Founders generally use one of two strategies when planning for a “pop” in value – both strategies utilize both the freeze and discounting tactics discussed above – Grantor Retained Annuity Trusts (GRATs) and Sales to Intentionally Defective Grantor Trusts (IDIT Sale).

Grantor Retained Annuity Trust

A GRAT allows an individual to give assets to a trust and retain a set annual payment (an “annuity”) from that property for a set period of years. At the end of that period of years,
ownership of the property passes to the individual’s children or trusts for their benefit. The value of the individual’s taxable gift is the value of the property contributed to the trust minus the value of his right to receive the annuity for the set period of years, which is valued using interest rate assumptions provided by the IRS each month. If the GRAT is structured properly, the value of the individual’s retained annuity interest will be equal or nearly equal to the value of the property contributed to the trust, with the result that his taxable gift to the trust is zero or near zero.

How does this benefit the children? If the assets contributed to the GRAT appreciate and/or produce income at exactly the same rate as that assumed by the IRS in valuing the individual’s retained annuity payment, the children do not benefit, because the property contributed to the trust will be just sufficient to pay the individual his annuity for the set period of years. However, if the assets contributed to the trust appreciate and/or produce income at a rate greater than that assumed by the IRS, there will be property “left over” in the trust at the end of the set period of years, and the children will receive that property–yet the creator of the trust would have paid no gift tax on it. The GRAT is particularly popular for gifts of hard to value assets such as business interests, private equity and hedge fund interests because the risk of an additional taxable gift upon an audit of the gift can be minimized. If the value of the transferred assets is increased on audit, the GRAT can be drafted to provide that the size of the individual’s retained annuity payment is correspondingly increased, with the result that the taxable gift always stays near zero IDIT Sale

A GRAT is often compared with a somewhat similar technique, known as the IDIT Sale. The general IDIT Sale concept is best understood by means of a simple example. An individual makes a gift to an irrevocable trust of, say, $100,000. Sometime later, the individual sells assets to the trust in return for the trust’s promissory note. The note provides for interest only to be paid for a period of, say, 9 years. At the end of the 9th year a balloon payment of principal is due. There is no gift because the transaction is a sale of assets. The interest rate on the note is set at the lowest rate permitted by IRS regulations.

How does this benefit the individual’s children? If the property sold to the trust appreciates and/or produces income at exactly the same rate as the interest rate on the note, the children do not benefit, because the property contributed to the trust will be just sufficient to service the interest and principal payments on the note. However, if the property contributed to the trust appreciates and/or produces income at a rate greater than the interest rate on the note, there will be property left over in the trust at the end of the note, and the children will receive that property, gift tax free.

Economically, the GRAT and IDIT Sale are very similar techniques. In both instances, an individual transfers assets to a trust in return for a stream of payments, hoping that the  income and/or appreciation on the transferred property will outpace the rate of return needed to service the payments returned to the individual. Why, then, do some clients choose GRATs and others choose IDIT Sales?

The GRAT is generally regarded as a more conservative technique than the IDIT Sale. It does not present a risk of a taxable gift in the event the property is revalued on audit. In addition, it is a technique that is specifically sanctioned by the Internal Revenue Code. The IDIT Sale, on the other hand, has no specific statute warranting the safety of the technique. Unlike the GRAT, the IDIT Sale presents a risk of a taxable gift if the property is revalued on audit and there is even a small chance the IRS could successfully assert that the taxable gift is the entire value of the property sold rather than merely the difference between the reported value and the audited value of the transferred property. Moreover, if the trust to which assets are sold in the IDIT Sale does not have sufficient assets of its own, the IRS could argue that all of the trust assets should be brought back into the grantor’s estate at death.

Although the IDIT Sale is generally regarded as posing more valuation and tax risk than the GRAT, the GRAT presents more risk in at least one area in that the grantor must survive the term of the GRAT in order for the GRAT to be successful; this is not true of the IDIT Sale. In addition, the IDIT Sale is a far better technique for clients interested in generation skipping planning. The IDIT trust can be established as a Dynasty Trust that escapes estate and gift tax forever. Although somewhat of an oversimplification, the GRAT generally is not a good vehicle through which to do generation skipping planning.

Spousal Lifetime Access Trust

When using either a GRAT or an IDIT Sale, we encourage our clients to also consider a Spousal Lifetime Access Trust (SLAT). In addition, the SLAT is often the remainder beneficiary of the GRAT or IDIT transaction. A SLAT can remove, freeze, and discount values all in one fell swoop. In a typical SLAT, an individual creates an irrevocable trust, naming her spouse or some other trusted individual or institution as trustee. During the life of the individual and her spouse, the trustee is authorized to sprinkle income and principal among a class consisting of her spouse and descendants. Upon the death of the survivor of the individual and her spouse, the remaining trust assets are divided into shares for descendants and held in further trust. The SLAT provides several benefits. The individual’s gifts can qualify for the gift tax annual exclusion if the trust is designed properly. This removes value from the owner’s estate. If desired, the owner could use the trust as a repository for a larger gift utilizing her lifetime gift tax exemption, thereby freezing values for transfer tax purposes. Moreover, depending on the type of asset gifted to the trust, it may be possible to apply valuation discounts as well.

Beyond being a good vehicle through which to remove, freeze, and/or discount values for tax purposes, the SLAT provides a number of other benefits. The trust includes the grantor’s spouse as a beneficiary. Although the grantor can never have any legal right to the assets held in the SLAT, and neither can there be any prearrangement or understanding between the grantor and her spouse that the grantor can use assets in the trust, if the grantor is in a happy marriage, it nonetheless can be comforting to know that her spouse will have access to the property in the trust even after the gift. As an additional benefit, the SLAT would be established as a “grantor trust” for income tax purposes. This means that the creator of the trust would pay income tax on the income and gains earned by the trust. This depletes the creator’s estate, and enhances the value of the trust, but is not treated as a taxable gift, in effect providing a very powerful additional means of removing value from the transfer tax system. Finally, the SLAT can be structured as a “generation skipping transfer tax exempt trust” (also known as a “Dynasty Trust”), thereby removing the gifted assets from the transfer tax system for multiple generations.

Conclusion.

Although a Founders’ personal and business life can be complicated and stressful, we find that breaking a Founders’ personal estate planning into three key segments allows the Founder to focus on what is important to them and take strong steps towards successful estate planning.

 

© 1998-2018 Wiggin and Dana LLP
This post was written by Erin Nicholls and Michael T. Clear of Wiggin and Dana LLP.