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Recent Articles Book Chapters These chapters were written by Edwin P. Morrow, III and will appear in a book titled "Financial Planning for Business" to be published in the Fall of 2002 by Aspen Publishers. Once available we will provide purchasing information for this book.
Written by: Edwin P. Morrow and Edwin P. Morrow, III Reprinted with permission and courtesy of CCH INCORPORATED, published in their Journal of Practical Estate Planning bimonthly publication, October-November 2002 issue. Click here to view article - A Trust is Not Enough! - in PDF format.
Flexibility in Funding and Accessing Cash Values in Insurance Trusts Written by: Edwin P. Morrow, III, J.D., LL.M. Reprinted with permission and courtesy of Society of Financial Service Professionals, published in their Estate Planning newsletter, September 2002, Volume 4, Number 2, article located on Page 4.
Estate
Planning After the 2001 Tax Act
Written by: Edwin P. Morrow, III, J.D., LL.M. Published in The Register (Registered Financial Consultant publication) July 2001 Issue On June 7, 2001, President Bush signed
the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Act). This broad sweeping Act gradually cuts income tax rates and
reduces limitations on itemized deductions and personal exemptions (Title I),
addresses the marriage penalty (Title III), gives more child care tax relief
(Title II) and education breaks (Title IV), increases retirement plan limits
(Title VI) and eliminates the estate and generation skipping transfer (GST)
taxes (Title V). Common wisdom tells us that these
radical changes greatly simplify estate planning for US taxpayers.
Or does it? In this article
we will consider how the Act affects the transfer tax system, which includes
estate, gift and GST taxes; and we will debunk the repeal and simplicity myths.
Finally, we will review how the new law will impact common planning
techniques. The death of the “death tax” has
been greatly exaggerated. There is
understandable confusion about the future of the transfer tax system.
The uncertainty is a result of the so-called “Sunset” provision.
Congress, to comply with the Congressional Budget Act, buried this
provision at the end of the Act. To
summarize, the Sunset provision simply voids the law starting in 2011 after
which the law reverts to as it was prior to the Act.
This is not retroactive, so this will affect neither those who increase
their IRA contributions nor those who inherit an estate that escapes taxation
due to increased exemption or repeal.
Congress could, of course, repeal the
repeal of the repeal; but then, they could do this at any time.
It all comes down to who has enough votes. As the recent Jeffords defection made clear, Republican
control is not exactly assured; another Congress or President is likely to
change the agenda again. It is an
ill-conceived mess. In light of
such uncertainty, how do we advise our clients? The table below shows how the
exemption gradually increases and how the transfer taxes gradually decrease.
The increased exemption for estate and GST taxes is straightforward and
relatively easy to understand, at least until the repeal of the repeal.
The decrease in taxable rates is
deceptive, however. Over the next
four years the Act will phase out the state death tax credit while
simultaneously “cutting” the federal rates.
A deduction will replace the credit, but this will not help the majority
of taxpayers, who live in states with “pick-up” or “sponge” estate
taxes. In effect, Congress is
cutting the states share of the tax revenue, a clever way to lower taxes and
still collect more money – funds that would have gone to the states!
Many states will lose substantial revenue as a result of this provision.
Expect to see many states increase their estate taxes in the next decade
to make up for the shortfall.
The gift tax, however, remains in
place and continues even after the potential repeal.
This provides an odd disincentive in the tax code to business owners
wishing to pass on ownership of the family business to a new generation.
Hold on ‘til death and perhaps escape the estate tax, or transfer the
business now and be taxed. A cynic
might say that Congress, anticipating the repeal would not last, retained the
gift tax system to discourage people from gifting all their funds into dynastic
trusts, which are forever exempt from transfer taxes.
More likely, however, Congress retained the gift tax as a back up to the
income tax, to discourage taxpayers who might transfer assets to lower bracket
or offshore relatives in order to escape federal or state income taxes.
A great disparity in taxation results
depending on the year involved and the vagaries of Congress, compelling both the
planner and the client to play the role of Nostradamus.
“Tell me which party will be in power, how the economy will do,
describe the future political situation, and when you and your spouse will die,
and I’ll gladly tell you how to plan.”
Needless to say, clients do not appreciate such uncertainty. So, considering all these changes, how
do we create a flexible estate plan? First
of all, much of estate planning is not tax driven at all. People will still need our guidance. Consider the following challenges and client objectives:
Take the typical AB trust.
How should we change this trust to account for the new law?
Should we change it at all? This
depends on the family situation. For
instance, a husband may leave $1,000,000 in a bypass trust for his wife, who
will receive all the income and has very liberal access to principal.
Why change this? Especially
if the wife is the trustee? Even if
the tax is repealed, the bypass trust protects the assets from lawsuits, from
creditors and from a future spouse in event of remarriage.
True, this will involve a separate tax return every year – an
administrative hassle, and the bypass trust could conceivably lose a step up in
cost basis at the second death; but the spousal trust may still be worth it.
This is especially true if there are
children from a prior marriage or if the husband and wife’s estate plans
differ. If the children are from
the same marriage, you can establish a trust protector provision or power of
appointment - allowing an outside
party or independent trustee to cancel the spousal trust if it is no longer
warranted (perhaps with the permission of the children).
Some attorneys have suggested amending wills and trusts to insert a
contingency clause that would make an outright disposition to a spouse if the
tax is repealed. Yet such a provision is fraught with
serious problems. What constitutes
“repeal”? What if the husband
dies in 2010 when the tax is “repealed” and such a contingency provision
leaves $3 million outright to his wife, who dies the following year with a $4
million estate? Her death would be
after the Sunset provision repeals the repeal.
Such a provision that allegedly “simplifies” the estate planning just
increased the family’s estate tax burden by roughly $1,500,000!
A flexible bypass trust could have avoided this pain altogether. Under the new law, substantial
problems may result if the provisions in the bypass trust differ from those of
the marital trust. For example, a
husband may have a $3 million estate, and currently leaves the exemption amount
to children from his first marriage, and the remainder to a marital trust for
his wife. The wife receives either
a substantial amount ($2.325M, $2M, $1.5M, $1M, depending on the year) in trust,
or nothing at all, depending on when her husband dies. We are bound to see substantial
litigation from these types of estate plans in the coming years.
Unlike the first situation with children from the same marriage where the
family may very well agree to allow termination of the trust should
circumstances later merit, having trust protector and early termination
provisions does not help much in a second marriage type situation, because an
outside party is unlikely to change the distribution scheme without incurring a
lawsuit from the other side. People
in this situation will simply have to amend their will or trust to accommodate
the new law. What about other planning techniques?
Family Limited Partnerships and Limited Liability Companies will still be
used to protect and manage wealth, plan for business succession and to retain
flexibility and control over family assets.
These may be used less and less for fractional interest discounts as the
exemption increases. Irrevocable Insurance Trusts will
continue to be used, but less so. Those
who use this technique will likely insist on greater flexibility, such as powers
of appointment, trust protector provisions and the ability to access cash
values. Although the need for
insurance to pay estate taxes and to provide liquidity will gradually diminish,
its use for long term income tax avoidance may actually increase, due to the
repeal of the step up in basis on other investment assets. We are sure to see less of other
arrangements that are largely estate tax driven, such as Qualified Personal
Residence Trusts (QPRTs), Grantor Retained Annuity or Unitrusts (GRATs and GRUTs),
and some charitable vehicles, such as Charitable Lead Trusts.
Some clients may trust the government and assume the tax will stay repealed. More savvy taxpayers recognize that the estate tax will probably not go away in their lifetimes. The only question is how much of the estate is exempted and what the rates will be. Sophisticated advisors will continue to use many of the standard tax avoidance techniques, unless actual gift tax would be owed as a result. Don’t be fooled into thinking that estate planning can be avoided because of the new Act. On the contrary, the new law just makes it more important than ever for advisors to review each client’s current plan.
Trust Protectors – Written by: Edwin P. Morrow, III, J.D., LL.M. Published in Financial Services Advisor July/August 2001 Issue and also in The Register (Registered Financial Consultant publication) April 2001 Issue Many advisors and sophisticated clients have heard of the term "trust protector", but very few know exactly what such a person or entity does or why they should have one in their trust. This article will help define what a trust protector is, outline the uses (and abuses) of naming a trust protector, and provide a general guideline for using them, focusing on standard domestic trusts. It is difficult to precisely define the position of a trust protector. Black’s Law Dictionary does not have a definition for a trust protector. Neither do many treatises on trusts. The concept is certainly well-known, though, if not well defined - especially in the foreign trust arena, where the trust protector is essential to Foreign Asset Protection Trusts. Tax Management Portfolio describes the trust protector as a third party vested with powers to modify a trust that the grantor is unable or unwilling to retain personally, which may include the ability to change trustees, regulate trust investments, amend the trust, change beneficiaries, change situs or revoke the trust and cause funds to revert to the grantor. A trust protector is generally someone with a special power over the trust or over the trustee, but with no day-to-day fiduciary responsibilities. The trust protector may also be a committee of several people with such power and may effectively serve as a kind of board of directors overseeing the management of the trust. A trust protector can add flexibility to the trust and serve as a check and balance to trustee abuse. Some trusts may have such a provision, but reference it as a "special trustee" or "independent trustee." Using a trust protector provision may be limited and relatively conservative, or it may be closer to a "bleeding edge" technique. You need to recognize the difference. First, why do people consider having such a person or power? In three words: control, flexibility and security. People who transfer their hard-earned dollars to a trust for their family often want as much flexibility for the trust as possible - without adverse tax or asset protection consequences. Those who execute trusts (a.k.a. settlors, grantors or trustors) cannot generally be trustees or keep the right to amend the trust without adverse estate tax or asset protection consequences, but want the trust operation to accommodate future circumstances and protect their original intentions. Foreign Asset Protection Trusts have long used trust protector provisions because people are naturally reticent about naming a foreign trustee and prefer provisions to enable changing the trustee and changing jurisdiction to a country more favorable to debtors/defendants. This article will not focus on foreign trusts, but remember that generally you cannot be trust protector of your own trust and still have any asset protection benefits, despite what many offshore "experts" claim. If the courts find that you keep unlimited power over the trust or trustee, they will naturally consider the funds to be under your control. Recent fraud cases dealing with offshore entities highlight this point (e.g., FTC v. Affordable Media LLC). In domestic trusts, the trust protector may still have the ability to change the trust situs, but the issues primarily have to do with the transfer tax system. The typical trust protector provision may cause the IRS to construe the trust protector as having the de facto powers of the trustee. If the grantor of a trust also serves as a trust protector, IRC sections 2036 and 2038 may be broad enough to cover any such retained interest or control and may cause the trust to be included in the grantor’s estate. Just as in the asset protection area, the grantor should not be a trust protector for transfer tax (estate, gift and generation skipping transfer tax) reasons. However, as long as the trust protector is not disqualified from serving as trustee initially, being considered as a de facto trustee does not produce a negative result for transfer tax. For instance, if you can appoint your spouse, brother, children, accountant or attorney as trustee, they might also safely serve as a trust protector. Take the standard irrevocable life insurance trust holding a survivorship policy. The grantor/insureds must name another party as trustee to avoid Code Sections 2036/2042. These sections do not prohibit a grantor from naming a competent child, family member or other beneficiary as trustee. For many reasons, however, a grantor may not want to initially name a family member: the children may be young, irresponsible or spendthrifts; they may have a manipulative spouse (or the parents fear it); the trust may have substantial discretion better exercised by an independent trustee; or maybe the parents simply do not want them to know much about their finances. In addition, many asset protection experts believe that spendthrift provisions give more effective protection when a beneficiary is not also the sole trustee. Thus, the insureds prefer to name a trust company, attorney, accountant or other professional. A recent revenue ruling (Rev. Rul. 95-58) allows grantors to retain the right to change one trustee for another trustee only if the replacement is a sufficiently independent trustee who is neither related nor subordinate to the grantor. This cuts out the possibility of later naming family members, however, and it may be appropriate to later appoint family members as trustee once they reach a certain level of maturity. The parents could use Uncle Bob, for instance, as a trust protector who could fire the trustee and name anyone but the grantors, including the children. Uncle Bob could also have the right to demand an accounting from the trustee, require a bond to be posted, remove a Trust Financial or Investment Advisor (who may be different than the trustee), approve any changes in trustee compensation, approve any self-dealing with the trustee, change the trust situs to achieve better state income tax or asset protection treatment, amend the trust for the benefit of the beneficiaries or merge the trust with any other trust with substantially identical terms. If a beneficiary is also a trustee or co-trustee, the trust protector might also have the power to approve distributions to a trustee/beneficiary not bound by an ascertainable standard, or execute incidents of ownership over an insurance policy insuring a trustee/beneficiary, in effect, acting as a limited co-trustee. These powers help to prohibit IRC Sections 2041 and 2042 from causing the trust corpus or policies to be added to a trustee/beneficiary’s estate and is important for dynasty-style trusts that do not immediately distribute funds on the death of the grantor. Some instruments even give a trust protector the right to add or delete beneficiaries, but this may push the edge of such flexibility and would not normally be recommended. Just as one should be careful with giving the trustee too much power, one should think twice about giving a trust protector too much power. With careful drafting, however, a trust protector can provide substantial oversight and flexibility without any adverse tax consequences. The limits of such flexibility largely are set by the limits of giving a third party an inter vivos limited power of appointment over the trust assets, which is a well established trust and tax law concept. What are the "outer limits" of such flexibility? For instance, Uncle Bob as trust protector might be given the power to appoint the assets to a new trust or even terminate the trust and distribute the assets directly to the beneficiaries. Care must be exercised to avoid giving the trust protector in such case a general power of appointment and any such ability to amend or appoint must be limited to exclude the trust protector, their estate, or creditors of either from benefiting from such a power. A general power of appointment causes any funds subject to that power to be included in the power holder’s estate and perhaps also be subject to creditor attack. IRC 2041. It may also cause gift tax consequences. IRC 2514. Limiting the permissible beneficiaries of this power prevents a general power of appointment from being created and these sections from applying. Usually any limited power of appointment would only be permitted to benefit the descendants of the grantor (or perhaps include spouses, charities or other specific beneficiaries). However, the grantors could give Uncle Bob the limited power to appoint the trust assets back to any family member of the grantors, including themselves. This maximum flexibility definitely pushes the envelope, and certainly goes much further than a simple oversight power. However, absent the Service proving some kind of pre-planned collusion, there is no tax law or regulation that would cause this limited power of appointment to cause estate tax inclusion in the grantor or trust protector, since there is no retained benefit, control or incident of ownership, and such a power would not come under IRC 2041 or 2514. There are various advantages to having a trust protector be able to appoint/amend the trust or change trustees for the benefit of the beneficiaries. It can be difficult and expensive to remove a trustee for cause through the court process. It can also be costly and difficult (if not impossible) to approve even minor administrative changes to typical irrevocable trust documents. A trust protector provides an easier and cheaper mechanism for this. Of course, care should also be taken to prohibit changes that would, for instance, disqualify a marital or QTIP trust from the marital deduction, or disqualify Crummey gifts from the annual exclusion. Care should also be taken to recognize that if a vested beneficiary executes a limited power of appointment (or substantial amendment), they may be considered to have made a gift of their share of the trust. Thus, if Uncle Bob were a vested beneficiary of the trust, he would be making a taxable gift by appointing his share to another party. This issue most often comes up when a spouse is given a limited power of appointment over a credit shelter trust and wants to then give away his or her share while still living. Thus, a trust protector should ideally be an independent party who is not a beneficiary. A trust protector may serve without fee, as is typical with a family member. Professionals may charge a modest annual fee, or more typically charge an hourly fee based on the time actually spent. Usually provisions do not call for extensive annual reviews of trustee performance, but the rather for review only under extraordinary circumstances. Depending on the client, such flexibility may be worth the extra cost and care, but adding trust protector provisions undoubtedly adds more complexity and considerations to the planning. By having a trust protector (and, of course, provisions for successor protectors) named in a trust, many people may feel more comfortable in creating an irrevocable trust or establishing one that may become irrevocable at death. This is especially true for the increasing use of dynasty trusts. The trust protector offers a powerful tool in the estate planning arsenal and may offer greater assurance that the original intentions of the client will be carried out – no matter what events transpire in the future.
Flexibility in Insurance Trusts with Survivorship Life Written by: Edwin P. Morrow, III, J.D., LL.M. Published in The Register (Registered Financial Consultant publication) December 2000 Issue More and more wealthy and middle class Americans want to move not only to tax deferred investments, but tax free investment vehicles. Variable life insurance offers many investors a way to get equity investment returns on a tax-free basis. However, the drawback to any substantial investment in such policies is that the death proceeds can potentially cause a massive estate tax problem. Savvy financial and estate planners know that the usual way around this problem is to have the owner and beneficiary of a policy be an irrevocable life insurance trust (ILIT). Death benefits owned and payable to a properly structured ILIT should not be considered part of an insured’s estate. This article will discuss the key concern of middle-class clients, which is how to keep some access to the cash values of an insurance policy in case they later need it, while keeping the death proceeds out of their estates for estate tax purposes. There are two principal sections of the Internal Revenue Code, IRC 2036 and IRC 2042, that control the estate taxation of ILITs. Section 2036 prohibits "transfers with retained life estates". It essentially says that if you give money to a trust but still keep benefit or control, that portion is in your estate for tax purposes. Thus, you cannot generally be a beneficiary or trustee of a trust you give money to without adverse tax consequences. However, one loophole in the law is the fact that someone can give money to a trust and have a spouse be a trustee or beneficiary without Section 2036 applying. Section 2042 essentially says that if you own any "incidents of ownership" over an insurance policy on your own life, any death benefit is taxed in your estate. Regulations specifically state that being a trustee of a trust owning a policy on your own life is like ownership because you can control the policy as trustee. Thus, an insured cannot be a trustee of a trust holding a policy on themselves without adverse tax consequences. What is debated is whether being a beneficiary of a trust constitutes an "incident of ownership" regarding the policy. Again though, a spouse can be a trustee and beneficiary (assuming the trust is drafted properly to limit the spouse’s control over the trust distributions to "ascertainable standards"). Thus, in a single life policy, while the insured gives up some control, the insured is comforted by having the spouse retain access to the policy cash values in the trust. However, how does a couple retain access when both husband and wife are insureds, as in a survivorship policy? Regulations under Section 2042 would not permit either to be trustee, but can one spouse still be a beneficiary? After a recent IRS Private Letter Ruling (PLR), naming one spouse as beneficiary is becoming much more common, but is not yet widespread. This ruling discusses what some call a Survivorship Access Trust. PLR 9748029 permitted one spouse to be a beneficiary of an ILIT holding a survivorship policy on both spouses, provided that neither spouse be trustee, and only the non-beneficiary spouse contribute all the funds for the trust. A Private Letter Ruling is different than a statute, official regulation or revenue ruling in that the IRS will not promise to follow it later on, and taxpayers cannot rely on it for guidance or authority in tax court. Although it is uncommon for the IRS to go against its own rulings, it does happen. Unless you pay thousands to the IRS and your attorney to get an advance ruling, you cannot have 100% assurance. To avoid any adverse tax consequence the following guidelines should be followed when naming a spouse as beneficiary of a trust holding survivorship life: 1) Make another party trustee. Neither spouse may be trustee; 2) The spouse most likely to survive should be the beneficiary under the trust, but not contribute money to the trust. Sometimes other concerns may change this, such as the goal of drawing down the richer spouse’s estate; 3) The spouse least likely to survive the other should be the grantor (person executing the trust), but not a beneficiary. 4) The trustee(s) would be able to borrow from the cash value of the policy and make discretionary distributions from the trust to the beneficiary-spouse. The trustee may make loans (with adequate security and interest) to the grantor-spouse. 5) Funds gifted to the trust should come only from a bank or money market account in the name of the grantor-spouse, not the beneficiary-spouse or joint or community property account. It may be necessary to sever a joint bank account to title an account solely in the grantor-spouse’s name if you do not have such an account already. If funds are "community property", then a separate property agreement may be required. "Gift-Splitting" under Code Section 2513 does not affect this concern; 6) To avoid the consequence of the possibility of the grantor-spouse dying before the insurance is fully funded, a minimal short-term rider insuring the grantor-spouse, or some other source should considered to pay any remaining premiums after the death of the grantor-spouse. Remember, the beneficiary-spouse should not contribute funds to a trust that names them as a beneficiary to avoid Section 2036 of the Tax Code. Thus, there should be a plan that provides payment of premium from some other source than the beneficiary-spouse. Another solution might be to make the ILIT a possible beneficiary under any Credit Shelter Trust created by the grantor-spouse. This would allow the premiums to continue to be paid without the beneficiary-spouse having to contribute their own funds to the ILIT. Some advisors still recommend the more conservative route of naming neither spouse as a beneficiary of such a trust, even after the recent IRS ruling. Although the likelihood of incurring tax is low based on the law and recent ruling, the ramifications of an adverse determination should it occur are very serious (37%-55% of possibly millions). If the insureds do not foresee a need to access the cash value from the policy held by an ILIT, such a provision in the trust should not be included, because even a small chance of incurring hundreds of thousands (if not more) of dollars of tax should be avoided if there is no great need for the provision. If the insured’s primary concern is accessing the cash value for possible retirement or other needs, and potential estate tax avoidance is only secondary, then they should seriously consider drafting an ILIT in this manner because of the greater access it affords. In essence, such flexible provisions allow a client to have their cake and eat it too . . . tax free growth and accumulation while alive, with tax-free withdrawals and loans of up to most of the cash value, plus the proceeds pay out to the family free of state and federal income tax or probate costs, and without any state or federal estate tax. With dynasty provisions (depending on the state), the trust proceeds can continue estate tax free forever for future generations. While there remains a slight chance the IRS could attack the trust, even in the worst-case scenario you would be no worse tax wise than had you never established the trust.
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