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Friday, February 13, 2015

Dynasty and Generation Skipping Trusts Can Trigger a Compromise Tax

A number of years ago I wrote about the dangers of accidentally triggering a Compromise Tax in New Jersey and in Pennsylvania.  It occurs to me that most dynasty trusts are set up to go to children, grandchildren and more remote descendants, but there is also boilerplate that says if the Grantor doesn't have any living descendants, it will go to other family members or friends.

This is where the tax gets tricky.  As a refresher, if money goes to a child, in New Jersey there is no inheritance tax and in Pennsylvania there is a 4.5% inheritance tax.  If money goes to other parties, like nieces and nephews, there can be an inheritance tax of 15-16%.   So, when money goes into trust for the life of a child, and then it goes to a niece or nephew after that, the tax must be computed based upon the value of the remainder interest.

Now let's take it a step further, what happens if the trust doesn't say upon the death of  the child that it goes to nieces and nephews, but rather there is a contingency.  The contingency being that it goes to the child's heirs, and if the child doesn't have any heirs, it goes to the nieces and nephews.

In this situation, technically you still have to calculate the actuarial interest of the child's interest, but now you also have to calculate the actuarial interest that the nieces and nephews will receive the remainder interest rather than any descendants of the child. 

If the chance that the nieces and nephews will receive the remainder interest is too remote that there will not be a tax, the question then becomes what is too remote?  In a call to the New Jersey Division of Inheritance Tax, they advised me that there is no bright-line rule.  Each situation is a facts and circumstances test.  

For example, in the situation described above, they might look at the age of the child when the trust is created, whether there are actually any grandchildren alive at that point, the terms of the trust, and many other factors.  So in a situation where the children are older, unmarried and without children of their own, there is a much higher chance that nieces and nephews will wind up with the remainder interest.

So how can you complete the inheritance tax return when there are so many possible contingencies?  The safe route, and the one recommended by the New Jersey Division of Inheritance Tax, is to make a note of the potential tax and explain why you think there should only be a minimal or no tax.  Usually this is the better way to go in New Jersey because if someone is setting up a dynasty trust, they typically are doing it with a fair amount of assets and are going to be paying the New Jersey estate tax anyway.  In Pennsylvania, because there is no estate tax, this may be a tougher negotiation.  

Because of the complexity of these situations, I strongly recommend hiring a competent estate administration attorney to assist.  Failure to deal with this at the time the inheritance tax return is due could lead to substantial interest and penalty costs.

   

Monday, January 5, 2015

Change in Pennsylvania Power of Attorney Law

Happy New Year!  Effective January 1, 2015, under Act 95, Pennsylvania modified Chapter 56 of Title 20 of the Pennsylvania Consolidated Statutes, which deals with Powers of Attorney.  The amendment was made to try to better protect the Grantor of the powers.

Under the new statute, a Pennsylvania Power of Attorney must be witnessed by two witnesses and a notary to be valid.  Also, the warning statement that the Grantor must sign at the beginning of the Power of Attorney was also modified slightly so that the Grantor better acknowledges the power he or she is potentially giving to the Agent.

The new law also creates some mandatory duties on the Agent that the principal cannot waive or modify. These three requirements are that the agent must: (1) act in accordance with the principal’s reasonable expectations to the extent actually known by the agent, and otherwise in the principal’s best interests; (2) act in good faith; and (3) act only within the scope of authority granted in the power of attorney.

Furthermore, under the new law, unless the document says otherwise, an Agent must also:
(1)  Keep his funds separate from the principal’s funds unless: 
    (i)  the funds were not kept separate as of the date of the execution of the power of attorney; or 
    (ii) the principal commingles the funds after the date of the execution of the power of attorney and the agent is the principal’s spouse.
(2)  Act so as not to create a conflict of interest that impairs the agent’s ability to act impartially in the principal’s best interest.
(3)  Act with the care, competence and diligence ordinarily exercised by agents in similar circumstances.
(4)  Keep a record of all receipts, disbursements and transactions made on behalf of the principal.
(5)  Cooperate with a person who has authority to make health care decisions for the principal to carry out the principal’s reasonable expectations to the extent actually known by the agent and, otherwise, act in the principal’s best interest.
(6)  Attempt to preserve the principal’s estate plan, to the extent actually known by the agent, if preserving the plan is consistent with the principal’s best interest based on all relevant factors, including:
    (i)    The value and nature of the principal’s property.
    (ii)   The principal’s foreseeable obligations and need for maintenance.
    (iii)  Minimization of taxes, including income, estate, inheritance, generation-skipping transfer and gift taxes.

Finally, Section 5601.4(a) limits the power of an agent to take certain actions unless the authority is expressly granted in the POA and is not prohibited by another instrument. The major powers and actions that must be specifically authorized are:  
(1)  Create, amend, revoke or terminate an inter vivos trust other than as permitted under section 5602(a)(2), (3) and (7) (relating to form of power of attorney).
(2)  Make a gift.
(3)  Create or change rights of survivorship.
(4)  Create or change a beneficiary designation.
(5)  Delegate authority granted under the power of attorney.
(6)  Waive the principal’s right to be a beneficiary of a joint and survivor annuity, including a survivor benefit under a retirement plan.
(7)  Exercise fiduciary powers that the principal has authority to delegate.
(8)  Disclaim property, including a power of appointment.
Section 5601.4(b) further limits the exercise of hot power authority by agents who are not in certain family relationship with the principal. However, a Power of Attorney can be written to specifically opt out of these limitations.

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.