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Friday, December 5, 2014

Dynasty Trusts Explained

I am frequently asked about the best way to transfer wealth to younger generations.  Sometimes people feel that absent having a minor child, a problem child or a special needs child, there is no reason to set up a trust.  Often times they are correct and there is no reason create a trust because the client has very responsible children.

Sometimes though, even if the children are quite responsible, if the client has a lot of money, it may be worthwhile to set up a dynasty trust.  Most trusts are designed so that the trust assets will be distributed to the beneficiaries at staggered ages (e.g., one-half at age 25 and the balance at age 30). On the other hand, a dynasty trust is a trust designed to hold assets for many generations usually without any requirement that the principal ever be distributed. 

Keeping assets in trust has many benefits.  If money is in trust it can be protected from creditors, including an ex-wife or an ex-husband.  Additionally, keeping assets in trust will protect it from estate taxes.  (If you give money to a child upon death, it is taxed, when they die, it is taxed again, and so forth...)  

The grantors of the trust can also control the flow of money out of the trust.  For example, they can allow for an income stream, they can allow for small percentage distributions when their heirs reach certain ages or graduate from college, they can allow invasion for certain expenses or they can simply let the trustee decide when and how to give their heirs money based upon whatever criteria they think is important.  The most common standard is for the health, education, maintenance and support of their heirs.

Another beneficial feature of a dynasty trust is that it can be located anywhere.  Typically, wealthy parents have provided for their children and already have good careers and plenty of their own assets.  If parents simply give more money to their children outright, it will be taxed in the jurisdiction where the children live.  If that state has a high income tax, it could be a drain on the funds.  If trust were created in a place that doesn't have a state income tax, that can save significant assets for future generations.

Almost anyone can be trustee of the dynasty trust other than the Grantor.  The Trustee is the party that manages the money and makes distribution from the trust.  Common choices of trustee include the heirs of the Grantor, a friend or an attorney or a corporate trustee.  If the Trustee is also a beneficiary of the trust, there will have to be restrictions on what the Trustee gives himself (otherwise you lose the tax and asset protection benefits).  Often times a trust is created with substantial flexibility so that an heir can act as trustee with limited invasion, but that heir also can be given the power to hire and fire additional trustees who have much broader discretion to distribute funds.  

A dynasty trust can go on for as long as the Grantor has heirs.  In case something happens to the entire family, most people usually name a charitable remainder beneficiary.  Other features that most good dynasty trusts include are the ability to relocate the trust to another jurisdiction (usually to obtain a more favorable tax rate), the ability to have a separate investment advisor, and the creation of a trust protector to modify terms of the trust in the events facts or circumstances change. 

A dynasty trust can be created during the lifetime of the Grantor (an intervivos trust) or upon his death (as a testamentary trust).  Usually it is better to create the trust during the lifetime of the Grantor because it will offer more flexibility in terms of jurisdiction (where the trust is located).  Jurisdiction is important because some states do not allow a perpetual trust, there is a state income tax in some states, and some states offer better creditor protection than others.  Another benefit to creating a dynasty trust during the lifetime of the Grantor is because the trust can be set up as an Intentionally Defective Grantor Trust (IDGT).

An IDGT is an irrevocable trust created during the Grantor's life that is not includible in the gross estate of the Grantor at the time of his death, but while the Grantor is alive, the income is taxable to the Grantor.  The benefit to this is that the Grantor can pay the taxes on the trust with his own money, allowing the trust to grow at a faster rate.  Essentially, it is like making a tax free gift to the trust in the amount of the tax.

Even if a trust is created during a Grantor's lifetime, it does not have to be funded until the Grantor passes away.  Sometimes a Grantor will want to or need to maintain control over certain assets.  Often, it is best to partially fund the dynasty trust with assets that the Grantor thinks will appreciate substantially in the future and transfer low basis assets that have already highly appreciated to the dynasty trust on death.

Because of the potential that these trusts can go on forever, it should not be set up unless the individuals involved have a fair amount of assets.  Normally I would not recommend it unless the Grantor is planning to fund it with several million dollars.  However, each client's situation is unique. Please contact our attorneys if you think a dynasty trust might be right for you.

Monday, December 1, 2014

Update to Executor's Commissions in NJ

Back in March of 2014, I wrote a lengthy post about how to Calculate an Executor's Commissions in New Jersey.  Frankly, most of the executors I work with don't want a commission.  However, I recently came across an interesting situation where an executor wanted a commission and the decedent had substantial joint survivorship accounts with the executor.

Normally, a survivorship account is not subject to an executor's commission on the theory that the executor doesn't have to do any work with respect to those accounts.  In this situation though, the survivorship accounts were actually convenience accounts.  A convenience account is a type of account that goes to the surviving account holder, primarily to pay bills, but based upon the intent of those involved, the balance of the funds will be disposed of with the rest of the Decedent's estate.  In other words, the money does not legally belong to the surviving joint account holder, it belongs to the estate of the Decedent.

In my situation, even though the money passed to the executor, in his individual capacity, on the death of the decedent, the money will ultimately be processed through the estate's accounts and go to the beneficiaries under the Decedent's Will. Accordingly, the executor CAN take a commission on these joint accounts.  More importantly, this commission is tax deductible for purposes of calculating the New Jersey estate tax.

I had trouble finding legal authority for this position, so I called up the New Jersey Division of Tax, Estate and Inheritance Department, and they confirmed this result.

Monday, November 17, 2014

2015 Update to Federal Estate Tax Exemption

Starting January 1, 2015, the federal estate and gift tax exemption will increase from $5,340,000 per person to $5,430,000.  That is an increase of $90,000.  If you are married, that amount will be doubled.

In addition to the lifetime estate and gift amounts, a person can also give away up to $14,000 per year.  This amount will not change for 2015.

Tuesday, September 30, 2014

Non Residents of Pennsylvania Can Be Subject to Pennsylvania Inheritance Tax

I frequently get calls from individuals who had a relative pass away with property located in Pennsylvania. Even though the decedent lived somewhere besides Pennsylvania, you should be aware that Pennsylvania reserves the right to tax this property on the death of the owner via an inheritance tax.

This tax will apply whether the decedent owned the property outright or in a revocable trust. Moreover, it does not matter where the beneficiaries live.  However, the tax rate for the PA inheritance tax is based upon who receives the property.  So, there will not be a tax if the property is left to a surviving spouse or a charity, but there will be a 4.5% tax if it is left to children.

There are ways to minimize or avoid this tax completely, but often it can come at the cost of paying more in capital gains tax.  If you are a non-resident owner of Pennsylvania real estate, I strongly suggest you meet with an estate planning attorney on how to minimize the taxes on your death.

Monday, August 11, 2014

Non-residents Non-citizens of the US Should Be Careful of How they Invest in American Assets

Many individuals who live outside of America like to purchase real estate in America or invest in the U.S. Stock Market.  It can be much safer than in investing in other parts of the world and often times the individual has children who have moved to America to live or study.

Florida and New York are particularly attractive locations for foreigners to buy vacation homes or rental properties, so I will focus on those jurisdictions a bit.

From a tax perspective, Florida is relatively easy to deal with as there is no estate tax. The transfer taxes are small and the process is pretty quick if you need to transfer the property during your lifetime. New York recently changed its estate tax laws, so that individuals can soon transfer over $5,000,000 before there is a state estate tax.  Transfer taxes are a bit higher and the process is a bit slower, but it is not terrible.

On death, it is a different story, both Florida and New York can be a royal nightmare and you should avoid probate.  Probate is the process of transferring assets on death and is typically quite expensive. It is also very easy to avoid by setting up a simple trust that is invisible for taxing purposes. A trust can also be set up to avoid the US federal estate tax, and I strongly recommend this.

With respect to the US taxes, a foreign investor must worry about both income taxes AND estate taxes.  While owning stock or real estate outright may be easiest and perhaps even best to minimize income taxes, it can be the worst thing to do for estate taxes.

The United States is not very friendly when it comes to foreign individuals who wish to transfer property in America. While a US citizen or resident alien may transfer $5,340,000 before there is a gift or estate tax, the threshold for non-resident is $14,000 for gifts (per person per year) and only $60,000 (total) on death.  A person may gift $145,000 (annually indexed for inflation) to a non-citizen spouse before there is a US gift tax.

For transfers in excess of the limits above, there is an 18%-40% tax depending upon the amount of the transfer.  You can defer the tax on a transfers to a spouse by setting up a Qualified Domestic Trust (QDOT).

Additionally, the rules are very complicated because some assets are taxed on death or gift and some assets are not.  The general rule is that if something can be considered a U.S. Situs asset, it is subject to the US Federal Estate Tax when the owner dies.  Examples of U.S. Situs assets include: real estate located in the U.S., cash or jewelry in the U.S., ownership in a US based REIT, and ownership of a US based Annuity.  Examples of Non-U.S. Situs assets include: real estate in foreign countries and stock in foreign corporations.  Less obviously, this also includes life insurance and debt obligations (such as bonds).

This is further confused by the fact that some assets considered non-U.S. situs for gift tax purposes differ from the assets that are non-U.S. situs for estate tax purposes.  Specifically, intangible property such as stock in a U.S. corporation or an interest in a US partnership or limited liability company are considered U.S. Situs assets for the estate tax, but not the gift tax. Additionally, cash on deposit in a checking or savings account at a U.S. Banking institution is a U.S. situs asset for gift tax purposes, but not for estate tax purposes.

To restate this another way, a gift in excess of $14,000 of cash on deposit in a U.S. bank is subject to a gift tax.   However, regardless how much cash is there when you pass away, it is not subject to the U.S. Estate tax.  Conversely, a gift of U.S. stock (regardless of how much), is not subject to the U.S. Gift Tax, but if you die owning the stock, anything in excess of $60,000 is subject to the estate tax.

(NOTE: a person must be really careful of that cash in a money market account is treated as an intangible asset so it is considered a U.S. Situs asset for estate tax purposes, but not gift tax purposes.) Please see this link to the IRS website which details assets that are subject to the US estate tax and those which are exempt.

If you are a non-resident, non US citizen who owns stock and real estate in the United States, your options include:
1) Paying the estate tax on your death;
2) Setting up a foreign corporation to own a local business entity (this will cause more income taxes now though, but save money on estate/gift taxes);
3) Sell the stock and property before you die and put the money into non-US situs assets until afterwards (this can be tough to time though).
4) Transfer the house to an LLC and then transfer the stock and the LLC to your children or to a trust for your children. As long as you survive for 3 years after the transfer, this should not be an issue for estate tax purposes.
5) Sell the assets and invest the money inside of a life insurance policy. That will be free of income tax and estate tax. The question is whether you can find someone to write the policy on a non-resident.

I generally recommend that if a person can afford it, you establish a US based trust in a state that doesn't have an income tax (like Florida) to own assets. Ideally you should transfer money into the trust from a non-US bank account. If you do not need the income from the trust, you can make the trust strictly for the benefit of your heirs. This will avoid an estate tax on the assets owned by the trust REGARDLESS OF WHAT ASSETS ARE NOW IN THE TRUST. This is how you can invest in the market or in real estate without worrying about an estate tax. As mentioned above trust will also help with administration and managing the funds by avoiding probate.

Remember a gift or transfer of assets may require the need to file an informational return with the IRS.  Also, the United States has tax treaties with several countries which may affect your need to do planning, so please confer with a competent international estate planning attorney before buying any assets in America.

Friday, August 8, 2014

Japanese Inheritance Tax vs. US Estate Tax (2014 Update)

(2014 Update)

I. Estate Taxes
A. America
1. If the Decedent is a Citizen or Permanent Resident
a. Tax on Worldwide property (credit for taxes paid to foreign countries)
b. Exemption of $5,340,000 in 2014 (indexed for inflation). For married couples, the exemption amount is $10,680,000 as a result of portability.
c. Federal Estate Tax of 40% on amount over $5,340,000
d. Unlimited Marital Deduction for Surviving Spouse if Surviving Spouse is a citizen
2. If the Decedent is a Non-Citizen/Non-Permanent Resident
a. Tax only on Real Property and business interests in the United States (Cash in foreign banks and foreign stocks are not taxed)
b. Exemption of $60,000 for US based Assets
c. Tax of between 18%-40% on amount over $60,000
d. Unlimited Marital deduction if Surviving Spouse a citizen
e. Tax on bequest to surviving spouse can be delayed by creating a Qualified Domestic Trust
3. If the Decedent is not a United States Citizen or permanent resident alien, assets outside of the US can pass to a US person with no US estate tax.
B. Japan (Actually an Inheritance tax, not an estate tax)
1. Japanese Citizens and Permanent Residents
a. Tax on Worldwide property (credit for taxes paid to foreign countries) - [NOTE - this is new for 2013, previously Japan did not tax worldwide assets] 
b.  Exemption of ¥30,000,000 + (¥6,000,000 for each statutory heir); Possible additional exemption for insurance money, retirement savings, and money left to handicapped individuals [NOTE - this is a reduction from the previous exemption of ¥50,000,000 and ¥10,000,000 per statutory heir.]
c. Additional exemption for life insurance received of ¥5,000,000 multiplied by the number of statutory heirs
c. Until December 31, the highest tax rate is 50%.  Effective January 1, 2015, tax between 10%-55% for statutory heirs (spouse, children and parents) after you go over the exemption amount;
  • Up to ¥10 million 10%
  • Above ¥10 million up to ¥30 million 15%
  • Above ¥30 million up to ¥50 million 20%
  • Above ¥50 million up to ¥100 million 30%
  • Above ¥100 million up to ¥200 million 40%
  • Above ¥200 million up to ¥300 million 45%
  • Above ¥300 million up to ¥600 million 50%
  • Over ¥600 million 55% 
d. An additional 20% surcharge for everyone other else other than charities (this does include a surcharge on gifts to grandchildren);
e. For property outside of Japan, a beneficiary that acquires property will be subject to Japanese inheritance tax. (THIS IS A MAJOR CHANGE, prior to April 1, 2013, Japan did not tax gifts or inheritance of property outside of Japan received by non-Japanese nationals.)
f. A surviving spouse is entitled to a tax deduction. This is a complex formula based upon who is living at the time of the Decedent's death and where the money goes. Generally, a surviving spouse can deduct about 1/2 to 2/3 of the tax.
2. Non-Citizens/Non-Permanent Residents
a. If beneficiary is not Japanese and not living in Japan and property is not in Japan, appears Country where property located will tax such property.
b. I'm currently double checking to see if the Beneficiary is a Japanese Domiciliary whether Japan CAN tax inheritance regardless of where Decedent lived and regardless of where assets are located (subject to tax treaties)
c. If there is a tax, it appears a surviving spouse is entitled to the same marital tax deduction as for Japanese citizens.
3. Real estate acquisition tax is exempt if passing by bequest.  There is a registration and license tax at the rate of 0.4% of the assessed value of the land and building. (currently reduced?)

II. Gift Taxes
A. America
1. Citizens and Permanent Residents
a. Tax on all gift transfers of Worldwide property
b. Annual exemption of $14,000 per person/per donee (unlimited gifts for donees if different donors)
c. An annual gift to a non-citizen, permanent resident spouse, of $145,000 is available.
d. Lifetime exemption of $5,340,000
e. Gifts may be split with spouse
f. Tax rate of 40% if lifetime gifts exceed $5,340,000
2. Non-Citizens/Non-Permanent Residents
a. Tax on all gift transfers of US Property (including real estate and Stocks in US companies)
b. Annual exemption of $14,000 per person/per donee (unlimited gifts for donees if different donors)
c. Annual gift tax exemption if gift to a spouse of $145,000 (Note that a person can gift more to a spouse than they can bequest to a spouse)
c. No Lifetime exemption
d. Gifts may not be split with spouse
e. Tax rate of 18%-40% if gifts exceed $14,000
B. Japan (Rates between 10%-55%)
1. Citizens and Permanent Residents of Japan
a. Tax on gifts of property Worldwide (credit for taxes paid to foreign countries) - [NOTE - this is new for 2013, previously Japan did not tax gifts worldwide assets to certain people] 
a. Annual exemption of ¥1,100,000 for each beneficiary (beneficiary taxed after this)
b. One time spouse exemption of ¥20,000,000
c. Effective January 1, 2015, tax between 10%-55% for statutory heirs (spouse, children and parents) after you go over the exemption amount;
  • Up to ¥2 million 10%
  • Above ¥2 million up to ¥4 million 15%
  • Above ¥4 million up to ¥6 million 20%
  • Above ¥6 million up to ¥10 million 30%
  • Above ¥10 million up to ¥15 million 40%
  • Above ¥15 million up to ¥30 million 45%
  • Above ¥30 million up to ¥45 million 50%
  • Over ¥45 million 55% 
  • The threshold is lower for gifts to other individuals.
d. For property outside of Japan, a donee that acquires property will be subject to Japanese gift tax.  (THIS IS A MAJOR CHANGE, prior to April 1, 2013, Japan did not tax gifts or inheritance of property outside of Japan received by non-Japanese national.)
2. Non-Citizens/Non-Permanent Residents
a. Annual exemption of ¥1,100,000 for each beneficiary(unclear – enforcement is almost impossible)
b. Japan will tax donees who live in Japan.
3. Special real estate acquisition tax of 4% (currently reduced?) in addition to a registration and license tax at the rate of 2% of the assessed value of the land and building.

III. Generation Skipping Taxes (Taxes on gifts or bequests to grandchildren or lower generations)
A. America
1. Exemption of $5,340,000 (indexed for inflation)
2. Tax of 40% on rest
B. Japan
1. None

Remember, there is an estate and inheritance treaty between the United States and Japan to minimize double taxation of assets on death if you own assets in both countries or are a resident of one living in the other country

For more information on Japanese taxes, the Japanese government has a website in English with some helpful facts, but it is now very outdated. 

I am not licensed to practice in Japan, this is just my understanding of Japanese gift and inheritance tax law that I can gather from sources which are written in English.

NOTE- Major rewrite on 9/12/14 to address changes in rates and fact that assets outside of Japan are now subject to Japanese inheritance and gift tax.

Wednesday, July 16, 2014

Duty of Executor to Defend a Will Against a Will Contest in Pennsylvania

In most states, when a person is named as an executor in the Will, the executor has an affirmative duty to defend the Will from Will contests.  For example, if mom dies testate leaving her entire estate to child one, cutting out child number two, and child number two sues to say the Will is result of undue influence, the executor would be obligated to defend the validity of the Will and could hire an attorney using estate assets to aid in the defense.  Unless the executor caused the undue influence, he would not be personally liable to the estate for the cost in defending the validity of the Will.

Pennsylvania law is quite different from most other states in that while an executor is a necessary party to a contest involving the Will, the executor is generally not a party in interest who has standing to instigate a contest or to appeal a decree of distribution. (In re Estate of Fleigle, 664 A.2d 612, 444 Pa Super. 632 (1995))  An executor who has not been surcharged or is not required to distribute an amount larger than the total assets of the estate has no standing to except to an adjudication of the auditing judge regarding payment of claims against an estate unless the executor is also a residuary beneficiary of the estate.  (Appeal of Gannon, 428 Pa. Super. 349, 360-61, 631 A. 2d 176, 181 (1993))  The executor is entitled to notice and may then elect whether to become a party (Royer’s Ap. 13 Pa. 569; Yardley v. Cuthbertson, 108 Pa. 395, 445-448), although if he does become a party his costs and counsel fees must be paid by him or those who authorize him, not by the estate.  (Faust Estate, 364 Pa. 529 (1950))

The Faust case is extremely important because it shifts the burden for payment of legal fees from the estate to the executor personally if the executor decides to insert himself or herself into a Will contest.  Additionally, if executors engage in an act that is beyond their scope as representatives of an estate, they risk losing their executor's commission.

Pennsylvania law does have a few exceptions for when an executor can get involved in a Will contest.  An exception exists where a testator directs or imposes a duty on the executor to defend the Will against contests.  (Bennett Estate, 366 Pa. 232 (1951); See also:  Tutelea Estate, 4 Pa. D. & C. 3d 199 (1974))  Another exception to the Pennsylvania rule is where the executor is also a trustee and is required to defend the trust.  (Fetter's Est., 151 Pa.Super. 32, 29 A.2d 361 (1942)).

We also need to differentiate cases where an executor is being sued for his services as executor.  (Browarsky Estate, 437 Pa. 282 (1970))  Because the executor is placed in the position to be sued because of duties he had performs for the estate, it would be unjust to require him personally to bear the reasonable costs of the defense of suits brought against them solely by reason of their positions as executors. "It is well established that whenever there is an unsuccessful attempt by a beneficiary to surcharge a fiduciary, the latter is entitled to an allowance out of the estate to pay for counsel fees and necessary expenditures in defending himself against the attack [citing cases]." Wormley Estate, 359 Pa. 295, 300-01, 59 A.2d 98, 100 (1948). Accord: Coulter Estate, 379 Pa. 209, 108 A.2d 681 (1954).

Finally, there is very old case that stands for the proposition that: “The executor propounding a Will for probate, acting in good faith, is entitled to costs out of the estate, whether probate is granted or refused.”  (Ammon’s Appeal, 31 Pa. 311).  I note that I can’t find the case, only a cite in a treatise, but I believe this to still be good law if the executor does not get involved in a Will contest.

If an executor uses estate assets to pay for legal fees related to a lawsuit against himself or because the executor impermissibly got himself involved in a Will contest, a judge can surcharge counsel of an estate or counsel for an executor. (Faust)

The rationale behind the Pennsylvania case law is that a Will contest is between the testamentary beneficiary and the heirs or next of kin, therefore the executor should not waste estate assets on their dispute.  The rationale behind the rules in most other states presumes that the testator wrote the Will the way he or she wanted it and the executor should try to uphold the testator's intent.

From a practical point of view of estate administration attorneys, we need to consider three things.  One, we need to understand the source of the money from which we are getting paid and keep track of it. If we are paid from the estate for a Will contest or for an objection to an accounting, we may be required to give the money back to the estate.  Personally, we always ask for a retainer from a proposed executor before they have qualified executor.  Accordingly, they are paying me with their own money and getting reimbursed from the estate later.  Also, attorneys should put language in their retainer agreements stating that the proposed executor is personally liable for the legal work if he cannot qualify as executor or if we wind up doing work for the executor in an individual capacity.

Second, in the event of a Will contest or an objection to an accounting, attorneys should track their time separately.  Time spent on the Will contest or an objection to an accounting should be differentiated from time spent administering the estate.

Finally, attorneys should consider whether they want to draft their estate planning documents in a way to change the default rules regarding an executor's duty to defend the Will.  Personally, I think that it makes more sense for an executor to use estate assets to defend the integrity of a Will and that the executor shouldn't be personally liable absent gross negligence, willful misconduct or bad faith. After all, some beneficiaries might not have the resources or the mental capacity to act in their own best interests.
Thanks to Pierson W. Backes, Esq. for his help with this article.