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Monday, September 10, 2007

Follow up to Pet Trusts

Following Leona Helmsley's bequest of $12,000,000 to her dog, the USAToday published a nice article about the importance of setting up a pet trust for your beloved animals. I note that the article contains a nice chart detailing which states allow for the creation of a pet trusts.

Friday, August 3, 2007

Business Succession Planning

Some of you may have seen these scary statistics:

According to the U.S. Small Business Administration, 90 percent of the 21 million small businesses in the U.S. are family-owned, but less than one-third of family-run companies succeed into the second generation, while only half of that make it to the third. Most often, the lack of a proper succession planning is to blame.

Proper business succession planning is particularly vital in the Northeast where taxes are so high.

Let's assume that an unmarried NJ decedent (Jane) has a company worth $5,000,000 at the time of her death. Without looking at Jane's other assets, I can tell you that her heirs have a potential federal estate tax liability of close to $1,350,000 plus a NJ Estate Tax liability of almost $400,000 for a total tax liability of close to $1,750,000. If she had no issue or parents living, this would also be subject to a $750,000 New Jersey inheritance tax. These taxes could decimate a small company at a time when the key person involved is not around.

The benefits of proper planning are countless.At a minimum, proper strategy will help you minimize taxes, maximize control and provide a clear path for continuity of the business. Planning an exit strategy is important as soon as you go into a business. This includes planning for death, divorce or a sale upon retirement.

Some popular planning techniques include:
  1. Setting up an entity structure (LLC, C Corporation, S Corporation, Partnerships, etc.);
  2. Purchasing Life Insurance (combined with Buy-Sell Agreements);
  3. Creating agreements limiting control of potential takers to the business;
  4. The use of promissory notes;
  5. Selling or gifting ownership in the business to family members; and
  6. Selling or gifting ownership in the business to other entities or trusts that will benefit family members.
Valuation Discounts

One of the most important aspects of proper planning is gaining the ability to maximize the amount that you can pass down to your heirs through the use of Valuation Discounts.

When a person has a small business, it is often difficult to sell. The IRS recognizes this lack of marketability. Additionally, as many small business owners get on in years, they are not as involved in running the business. The IRS also recognizes this lack of control.

It is not uncommon to have restrictive agreements in place that will allow an owner to pass on his or her interest with a one-third discount for lack of marketability PLUS another one-third discount for lack of control. Discounts are very specific to each business and a proper appraisal is a MUST.

So how does it work?

Let's go back to our example above. Let's assume that Jane has one child, Dave, who is 35 years old and has shown some interest in the business. Ten years ago, Jane sets up an entity, let's say an LLC, with a restrictive operating agreement. As a result, the appraisal comes back and states that there is a 1/3 discount for lack of marketability. Jane can transfer Dave $1,012,000 of this company without any out of pocket gift tax consequences. Without the appraisal, this would result in a transfer of 20% of the company. With the appraisal, Jane could transfer as much as $1,518,000 of the LLC (a little over 30%) without gift taxes. Additionally, Dave could buy another 20% of the company with a promissory note at the lowest rate available for tax purposes. Let's say a ten year note of $666,666 at 6% interest. Finally, Jane is in good health, so for the next 10 years she uses her annual exclusion amount to gift Dave another $12,000 worth of the company annually. (Since annual appraisals would be expensive, let's assume we don't discount this.)

The result is that upon Jane's death 10 years later, her 100% interest in the company, which started at $5,000,000 company, has been reduced as follows:
1) Through the lifetime gift to Dave, her interest is reduced to a 70% interest, worth $3,500,000;
2) Through the promissory note, her interest is reduced just under 50%, with a value of just under $2,500,000.
3) Through the annual gifting, her interest in the business is reduced to $2,380,000.

Upon Jane's death her $2,380,000 interest will receive a 1/3 discount for lack of marketability and another 1/3 discount for lack of control. This will result in a tax valuation of approximately $1,060,000. After we add back in the $666,666 that she received for the 20 interest plus another $220,000 for interest payments, she will pass with a taxable estate of about $1,950,000.

Accordingly, upon Jane's death, her estate will not be subject to any federal estate tax liability. Additionally, the NJ Estate tax liability will be reduced to $96,000. This is a tax savings of over $1,600,000 - which far outweighs the costs involved in such preparation.

Obviously, there are many different ways to structure this type of transaction, but they are usually based upon the same methodology. The numbers and techniques involved will depend upon the individual needs of the client. For example, if Dave were not responsible or had no interest in running the business, Jane could give him his shares in trust. If Jane had a business partner, this structure could be done for each partner and combined with a buy-sell agreement funded by life insurance.

Tuesday, May 22, 2007

IRA Stretch Trusts

What is a Stretch IRA Trust?

Trusts in General - A trust is a legal relationship that exists when one person or an entity (the Trustee) holds title to money or property for the benefit of one or more people (the Beneficiaries). The terms of the relationship are decided by the person providing money to the trust (the Grantor), and are usually in writing.

Stretch IRA – The term Stretch IRA refers to a plan, following the death of the IRA holder, to withdraw only the minimum amount allowed by law. This amount is known as the required minimum distribution. The resulting benefit of this plan is that the assets inside the IRA can continue to grow tax-deferred over the lifetime of the named beneficiaries. Either a traditional IRA or a ROTH IRA may be stretched.

Design of a “Stretch IRA Trust” - A “Stretch IRA Trust” is a flow-through trust designed to guarantee the extension of payouts of your IRA for as long as possible after your death. This is accomplished by allowing the trustee of the Stretch IRA Trust to take out the required minimum distribution, absent emergency. The trust is specially created for the sole purpose of being named as the Designated Beneficiary of an IRA. The reason a special trust is needed is because the provisions of most trusts will not qualify as a flow-through trust. In contrast, should a non-qualified trust be named as the Designated Beneficiary, all the income tax would be due in year one and there would be no further opportunity for tax deferred growth – the worst outcome possible.

What are the Benefits of a Stretch IRA Trust?

Guarantees Deferred Payout of IRA – A plan to stretch out an IRA is merely a plan until the person you name as your beneficiary decides to withdraw the entire amount, creating a huge income tax. Naming a Stretch IRA Trust as the beneficiary of your IRA will ensure that your loved ones defer the built in tax for as long as possible. This is especially useful for young or irresponsible children/grandchildren.

Allows for Control of Assets After You Die – You can set the terms of an IRA Stretch Trust so that your heirs receive money over time, rather than in a lump sum. You can also control where the money goes at the death of the beneficiary if the beneficiary should die before all the money is distributed.

Asset Protection - A trust can protect your money from creditors and make it less likely your heirs will fritter away their inheritance.

Allows for Post-mortem Planning – It is difficult to do much planning with IRAs, but in the event your children do not need the money, creating a trust structure will permit your children to transfer the IRA to their heirs, via disclaimer, without fear that the money will be squandered.

Avoids Over-funding of Spouse for Estate Tax Purposes - A trust structure can both provide income for a surviving spouse and allow both spouses to make proper use of their tax exemptions, thereby minimizing federal and state estate taxes upon the second to die.

Who Should Consider an IRA Stretch Trust?

Individuals with Significant IRAs or ROTH IRAs - Individuals with substantial wealth trapped in their IRA or ROTH IRA may benefit from a Stretch IRA Trust as a way to guarantee that income taxes are reduced, the assets continue to grow on a tax deferred basis, the assets are protected from creditors, and your wealth is preserved. This is particularly helpful for individuals who have young or irresponsible children/grandchildren.

Couples in a Second Marriage – An IRA which names a second spouse as a beneficiary, rather than children of the first marriage, can frequently lead to unintended results - like the money going to the children of your spouse rather than to your children! Giving the money to your spouse in trust will ensure that the money is available for spouse, but also provide for any remainder to go to the people you truly wish to benefit.

What Is Involved In Creating an IRA Stretch Trust?

Hiring an Attorney – When choosing an attorney to prepare your IRA Stretch Trust, you should choose an attorney who is knowledgeable in estate planning, retirement planning, current tax law and asset protection law.

Choosing a Trustee – You can hire either a corporate trustee or an individual trustee. Many people simply have their spouse or a relative act as trustee. You may also have a corporate fiduciary and another person act as co-trustees.

Cost - The cost of an IRA Stretch Trust varies from practitioner to practitioner as well as each client’s needs. How complicated you wish to make the trust and how many beneficiaries you wish to name may also be a factor in the cost. Nevertheless the cost will almost always be far less than the anticipated savings.

Beneficiary Designation Forms – Whether you create an IRA Stretch Trust or plan to stretch an IRA without a trust, it is imperative that you correctly fill out the beneficiary designation forms associated with your IRA to avoid one or more of your loved ones from being inadvertently left out or to avoid paying unnecessary taxes.

Maintenance – An IRA Stretch Trust generally requires no maintenance until after the death of the IRA holder.

Thursday, March 29, 2007

Animal/Pet Trusts

New Jersey passed legislation a short while ago permitting the creation of a Pet Trust under: N.J. Stat. Ann. § 3B:11-38.

1. The new law states:

a. A trust for the care of a domesticated animal is valid. The intended use of the principal or income may be enforced by a person designated for that purpose in the trust instrument, a person appointed by the court, or a trustee. The trust shall terminate when no living animal is covered by the trust, or at the end of 21 years, whichever occurs earlier.

b. Except as expressly provided otherwise in the trust instrument, no portion of the trust's principal or income may be converted to the use of the trustee or to any use other than for the benefit of the animal designated in the trust.

c. Upon termination of the trust, the trustee shall transfer the unexpended trust property as directed in the trust instrument. If no directions for such transfer exist, the property shall pass to the estate of the creator of the trust.

d. The court may reduce the amount of the property transferred if it determines that the amount substantially exceeds the amount required for the intended use. The amount of any reduction shall be transferred as directed in the trust instrument or, if no such directions are contained in the trust instrument, to the estate of the creator of the trust.

e. If no trustee is designated or if no designated trustee is willing or able to serve, a court shall appoint a trustee and may make such other orders and determinations as are advisable to carry out the intent of the creator of the trust and the purpose of this act.

2. Prior Law - Previously, an animal trust existed as an honorary trust (i.e. there was no judicial enforcement).

3. Planning Points

a. Unlike most other trusts, the beneficiaries of an animal trust literally cannot talk for themselves, so the Grantor/Pet Owner must clearly indicate what level of care should be given to the surviving pet. The document should also clarify what payments may be made to the pet’s caretaker.

b. A remainder beneficiary should always be considered (and it is usually inadvisable to make the caretaker the remainderman).

c. Many animals live longer than 21 years, so a truly trusted caretaker and trustee should be considered. Any animal trust that is in excess of 21 years likely continues as an honorary trust.

d. The animal should be clearly identified to prevent fraud.

4. Tax Aspects

a. A Pet Trust is taxed as a complex trust that has not made any distributions. Revenue Ruling 76-4876.

b. In general, a trust's income is subject to graduated income taxation at the same rates as individuals with the highest marginal rate of 35% taking effect after only $10,050 (for 2006) of income, a significant detrimental income tax effect. Some commentators have reported that the IRS will tax these trusts at a marginal rate that is lower than that of the average trust.

Wednesday, March 21, 2007


Qualified Domestic Trust (QDOT) – A QDOT is a statutorily created trust designed to allow a non-citizen widow or widower qualify for the unlimited marital deduction. See I.R.C. §2056A.

1. Other than the citizenship requirements:
a. A QDOT must qualify for the marital deduction as provided for in §2056.
1) Although I.R.C. §2056A does not expressly mandate the distribution of trust income to the spouse, the IRS has stated in letter rulings that a QDOT must also meet the general marital deduction requirements of Sec. 2056. Accordingly, a QDOT should provide that all income is distributable to the surviving non-citizen spouse.
b. The trustee of the QDOT must be a citizen of the United States and possibly even a corporate trustee depending upon the size and types of assets involved.
1) A “large QDOT” is a QDOT with assets in excess of $2,000,000.
i At least one of the trustees must be a U.S. bank or a trust company; or
ii The U.S. trustee (an individual trustee) must furnish a bond or letter of credit equal to 65 percent of the fair market value of the assets in the trust.
2) A “small QDOT” is a QDOT with assets less than $2,000,000.
i There must be either a U.S. bank or a trust company as the trustee; or
ii No more than 35 percent of the trust assets can be real property located outside the United States.
c. As funds are paid out from the trust, the estate tax must be paid on each distribution and the trustee must have the right to withhold the taxable amount.
1) Income distributions from a QDOT are not subject to the estate tax;
2) A surviving non-citizen spouse may also be eligible for a hardship exemption.

2. Planning Considerations
a. To avoid the difficulties associated with QDOTs, it is advisable for clients to make use of the $100,000 gift tax exemption (indexed for inflation, making it over $134,000 in 2010) available for transfers to a non-citizen spouse. Other planning tools such as ILITs should be considered.
b. A QDOT need not be created in the decedent’s Will (or in a revocable living trust); it may be created by the surviving non-citizen spouse provided it is funded prior to the due date for the federal estate tax return.
c. Citizenship – It is imperative to learn of the client’s citizenship and status to accurately plan and determine if any treaties apply.
1) If the surviving non-citizen spouse becomes a citizen prior to the filing of the estate tax return, there will be no need for a QDOT.
2) If the surviving spouse becomes a citizen after the assets are transferred to the QDOT, distribution of property from the QDOT will not be taxed if:
i the surviving spouse either was a U.S. resident from the date of death of the decedent or no taxable distributions were made from the QDOT prior to the surviving spouse becoming a citizen; and
ii the United States trustee notifies the IRS that the surviving spouse has become a U.S. citizen.
iii Note: Special rules apply if the QDOT had already made taxable distributions. See Treas. Reg. § 20.2056A-10
d. A QDOT Rollover IRA should be considered for the decedent’s IRA and 401(k) assets to avoid an immediate income tax and estate tax. See also Treas. Reg. §20.2056A-4(c) for alternatives on handling non-assignable annuities and other such assets.
e. Joint property owned by the decedent and the non-citizen spouse will follow the rules established under I.R.C. §2040(a), which basically states that the asset will be includible in the gross estate of the person who paid for the asset. I.R.C. §2040(b), which provides an exception to married couples, does not apply.
f. The QDOT should only be funded with assets in excess of the federal estate tax limit, not in excess of the New Jersey estate tax limit (unless the spouse decides to become a citizen before any distributions are made from the trust).

3. Tax Consequences
a. The QDOT should be taxed as a simple trust for income tax purposes.
b. The assets transferred into the QDOT are eligible for the unlimited marital deduction.
c. Each distribution from the QDOT triggers the federal estate tax.
d. Form 706-QDT must be filed annually to report the amount in the trust as well as the distributions made from the trust.
e. A non-citizen spouse cannot use the applicable exclusion amount to shelter any distributions of principal from a QDOT, because QDOT assets are never considered part of the non-citizen spouse's gross estate; they are part of the deceased spouse's estate for estate tax purposes.
f. A non-citizen spouse cannot use the applicable exclusion amount to shelter assets in a QDOT from estate taxes upon his or her death. However, the surviving non-citizen spouse may use the applicable exclusion amount ($2 million in 2006) to shelter his or her own assets from federal estate taxes.
f. The 2001 tax act (known as "EGTRRA") now provides that even though the Federal Estate Tax may be abolished, if assets pass to a QDOT as a result of a death before the phase-out is complete, the assets in the QDOT will be taxable upon withdrawal until December 31, 2020.

Minor updates made on December 14, 2010.

Friday, March 9, 2007

Contribution Notice - Who Signs for a Minor?

Many people create irrevocable life insurance trusts (ILIT) for the benefit of minor children. The common scenario is that the grantor will create an ILIT and his or her spouse will act as trustee of such trust.

Because ILITs are established as Crummey trusts, a contribution notice should be sent out to the beneficiaries whenever a contribution is made to the trust. When the children are minors - who signs off on the notice, the Grantor or the Trustee?

General consensus amongst practitioners is that the Trustee parent should sign the notice under the theory that if the Grantor parent acts as if he or she has a withdrawal power, then he or she is maintaining an impermissible incident of ownership in the trust. Such retention of power might cause the trust to be includible in the Grantor's estate for estate tax purpose, thereby nullifying the reason the trust was probably created in the first place.

For second to die life insurance trusts, neither parent should act as signer for a minor child. Accordingly, to be very safe, a guardian ad litem should be appointed, in a limited capacity, to sign the contribution notices. Practitioners should try to avoid creating second to die life insurance trusts until the designated beneficiaries of the trust have reached the age of majority.

Nuts and Bolts of Life Insurance Trusts

Life Insurance Trusts – The most common form of inter vivos irrevocable trust is the Life Insurance Trust (ILIT). Since the grantor of the trust has no desire to use the proceeds of this trust during his life, and because the value of the insurance at the time of the grantor’s death can be quite high, it is a very popular mechanism for reducing or avoiding a grantor’s estate tax liability.

a. When creating a life insurance trust, it is important to know whether the client will be buying the insurance through the insurance trust or if they will be transferring in an existing insurance policy.

1) If at all possible, the client should always have the trust buy the insurance because:

i It avoids I.R.C. §2035 which states that a person’s gross estate for estate tax purposes includes certain assets that have been transferred out of the person’s estate within three years of death. Accordingly, if a person transfers an insurance policy to an insurance trust and dies within three years of when the gift to the trust was made, the full amount of the proceeds will be subject to both the Federal and New Jersey Estate Taxes.

ii It avoids having to determine the value of the existing policy at the time of the transfer. This value is known as the interpolated terminal reserve.

iii We are sure the insurance actually gets into the trust. All too often a planner creates the insurance trust and then it never gets funded, exposing the practitioner to unnecessary liability.

2) If the client will be contributing existing insurance to a trust:

i The value of the insurance at the time of the transfer is a gift to the Crummey beneficiaries of the trust.

ii Care must be taken when selecting the beneficiaries of the trust to ensure that there are enough beneficiaries to shelter the value of the gift.

iii The trust must be funded with enough liquid assets in the event someone does wish to exercise their withdrawal rights.

b. The trust should be established as a Crummey Trust.

1) A Crummey Trust is named after Clifford Crummey, the first taxpayer to use this type of trust successfully.

2) A Crummey trust is designed to provided a limited withdrawal right to certain beneficiaries in an irrevocable trust so that transfers to the trust are eligible for the annual gift tax exclusion.

3) The more Crummey beneficiaries there are, the greater the gift that may be made to the trust without having to pay a gift tax. Crummey beneficiaries may not just be named at random, because they do have a real right to withdraw the money that is put into the trust.

4) Generally, a 30 day withdrawal right is considered adequate, but there is no clear minimum.

5) Particular care must be taken when drafting the Crummey power to ensure that the power lapses only the extent of the greater of $5000 or 5%. Any greater lapse will be considered a gift by that withdrawal beneficiary to the other beneficiaries of the trust.

6) The trustee should have broad powers to satisfy any withdrawal rights. All Crummey withdrawal rights should be satisfied either against the contribution or the property of the trust, including any insurance policy or fractional interests in the insurance policy. This will provide substance to a Crummey withdrawal right.

c. Tax aspects

1) The trust should generally be created as an Intentionally Defective Grantor trust, I.R.C. §677, so that although the assets of the trust are out of the grantor’s estate, during the life of the Grantor any income received by the trust is taxed to the Grantor rather than being taxed to the trust. This avoids having to file a Form 1041 income tax return for the trust and it provides an additional gift to the beneficiaries in an amount equal to the income taxes actually paid. Frequently this is done with a power to substitute trust assets, other than the insurance, with assets of an equivalent value to the trust in a non fiduciary manner I.R.C. § 675(4).

2) Upon the death of the grantor, the trust will either be taxed as a simple or complex trust depending upon the terms of the trust.

3) The practitioner must consider whether the Grantor’s Generation Skipping Tax Exemption should be allocated to the ILIT. The Code was revised under EGTRRA to provide an automatic allocation of the Grantor’s GST exemption in many cases and this is not always the most desirable result. A grantor may opt in or opt out of having the automatic allocation on a timely filed gift tax return.

d. Planning Considerations

1) The Grantor should NEVER be trustee of his or her own ILIT.

2) It may sound obvious, but it is important to counsel clients that once money goes into an irrevocable trust, the money no longer belongs to them and they will have difficulty getting the money back.

3) If the Trustee is the Grantor’s spouse, care must be taken when making contributions to the trust to ensure that the Trustee spouse is not making any contributions. (i.e. Never contribute joint or community property to the trust or write a check to the trust from a joint account or a business account).

4) ILITs are somewhat expense to establish and maintain for many clients, particularly those who have large estates due strictly to the amount of insurance they buy. Consideration should be given to naming a child as the owner and beneficiary of the policy as a means to save money for the client while receiving many of the same tax benefits.

5) The client should make sure that the insurance premiums are paid on an annual basis to minimize the maintenance fees. If multiple insurance policies are in one trust, try to convince the insurance carriers to have the same due date for the premiums.

6) The life insurance trusts is a particularly useful planning tool for same sex couples and unmarried couples because it provides a means to give the decedent’s significant other a large sum of money tax free, yet control the money’s ultimate destination.

e. Types of Life Insurance - Regardless of whether a client owns a term, whole life, or variable life insurance policy, if the value of the policy and the client’s other assets are in excess of the New Jersey Estate Tax threshold, it is advisable to discuss the benefits of the ILIT.

1) Term Life Insurance – These policies by their nature are designed to last for short period of time to cover a particular type of risk. The premiums on these policies are typically low, and a contribution of an existing policy to an insurance trust is relatively easy because of the low value of the policy.

2) Whole Life Insurance – These policies are designed to build up a cash value to produce a guaranteed return that will ultimately pay for the insurance premium. The premiums can be quite substantial, which is important to know when calculating the number of Crummey beneficiaries that must be named. A contribution of a large whole life policy to an ILIT may result in a gift tax no matter how comprehensive the planning because of the size of the insurance.

3) Variable Life Insurance – This type of policy is similar to the whole life insurance except that instead of having a guaranteed return, the rate is variable. Since most people are not good investors, be wary of advising this product.

4) Second to Die Insurance - A Second to Die Insurance Trust is different from a typical ILIT in one substantial and obvious way - the insurance benefits are not paid until the second to die.

i Practitioners should ensure that neither spouse is ever eligible to serve as trustee nor made a Crummey beneficiary.

ii Since this trust is not for the benefit of the surviving spouse, the clients should be sure that the surviving spouse has enough funds to live on absent the trust funds.

iii These trusts are particularly beneficial for clients interested in dynasty trusts as more insurance can purchased for a lower premium amount.

f. Insurance Trusts Established Pursuant to Divorce or Separation– Frequently Divorce attorneys draft provisions in a separation agreement or a divorce decree that call for an insurance trust to be created for the benefit of the children of the marriage. Terms of the trust are rarely spelled out with any specificity.

1) In the event that the person who is required to be insured passes prior to the creation of an ILIT, the courts can impose a constructive trust for the benefit of the children. (A constructive trust is an implied trust established by operation of law.) The terms of the trust are in the judge’s discretion, rather than in either the form that the decedent, or surviving parent, would want.

2) Planning Considerations

i Frequently a divorce or separation agreement will say what amount of insurance a person should have without any consideration for who should be trustee, the tax consequences or the ages at which the children should have access to the money. Occasionally, inappropriate provisions are included. Thought must be given how to address these concerns, particularly in light of the fact that these two individuals may not be on good terms.

ii Payment for the trust. I have yet to see a divorce decree or separation agreement that contemplates who will actually pay for the insurance trust. This is often a sticking point for many clients.

iii Compliance. Working with an unfriendly trustee or grantor can severely complicate compliance with both the tax laws and properly funding the trust.

g. Management of Insurance Trusts

1) The management of an insurance trust from an investment standpoint is quite simple. Most insurance trusts do not have assets other than the insurance itself.

2) The complexity comes when trying to explain the maintenance and funding requirements of the trust to clients. Further complicating matters, often clients will try to manage the trust completely on their own to save on costs. The practitioner must take extreme care when allowing this to happen because the practitioner will still be potentially liable.

3) Funding the Trust

i Checking accounts must be created in the name of the trust (and if the Grantor does not have an individual checking account, the Grantor may also have to create a checking account to fund the trust). Many practitioners like to get a separate tax identification number for the ILIT. If the trust is an Intentionally Defective Grantor Trust (IDGT), it is not necessary, but it is still a good idea in the event a creditor does an asset search using the Grantor’s Social Security Number.

ii Insurance must either be purchased by the trust or transferred into the trust. This requires completing insurance forms that designate the trust as the owner and beneficiary of the policy.

4) Sending the annual Crummey letter. As soon as practical after the trust is funded, a letter must be sent to the designated Crummey beneficiaries to advise them of their withdrawal rights. These letters should be acknowledged by the beneficiaries (or their guardians) and maintained by the attorney (or trustee).

i After 30 days (or whatever the relevant Crummey time period is) the Trustee may use the gift from the Grantor to pay the insurance proceeds.

5) To avoid problems with I.R.C. §2035 and §2036 (which would bring the insurance back into the gross estate of the Grantor), it is important that the Grantor contains no impermissible control over the trust and should never be the trustee. The Grantor may be given limited ability to hire and fire Trustees.

Friday, February 9, 2007

Asset Protect Trusts vs. Family Limited Liability Companies

Occasionally, people who are interested in asset protection ask me what is more appropriate, a trust or some sort of FLC or FLP. Here is my response:

An asset protection trust is more secure than an FLC, but it is also more costly to maintain (high annual fees for an independent trustee) and you give up more control. The more money you have and the more at risk you are for a lawsuit, the more you want to set up a trust. For asset protection trusts to work properly, you must give up almost all decision making power over the assets (to a trusted advisor), and you will become, at best, a discretionary beneficiary of such trust.

A single person FLC does not offer much protection, but certainly some. A two person FLC without an operating agreement offers decent protection from any lawsuit arising out of assets in the FLC, but little protection for misdeeds done outside the FLC. With an operating agreement limiting distributions, you get much more protection and that is why there is more of a setup cost. This structure is good for people who really don’t want to part with their assets and/or think they will need it in the future. These receive more protection over time as the Grantor transfers shares of this down to issue (usually at a discount) because of the lack of marketability and lack of control.

There are many types of Asset Protection Trusts. Inter vivos ones (trusts set up during the Grantor’s life) are invariably more costly than one’s set up on death. Something as simple as a traditional ILIT can make a great Asset Protection Trust, especially if funded with Whole Life Insurance. Self Settled Asset Protection Trusts (where the Grantor is also a beneficiary) are available in a few jurisdictions such as Delaware, Alaska, Nevada and New Hampshire. These are high end domestic asset protection trusts. For even greater protection, we can go offshore.

So, basically, it comes back to what you, the client, is trying to accomplish.

Tuesday, February 6, 2007

Estate Planning When Contemplating Divorce

Once a divorce is final, your former spouse, and relatives of your former spouse, are generally not entitled to inherit any money from you upon your death. But what should you do during the lengthy time of your separation leading up to your divorce?

Ripping up a Will that gave everything to your surviving spouse does not solve your problems. New Jersey’s newest probate law (N.J.S.A. 3B:5-3), enacted in 2005, states that you are married and die without a Will a large portion of your assets, possibly all your assets, will pass to your surviving spouse. Accordingly, if you die before your divorce is final, your surviving spouse may still be entitled to all your assets (marital and non-marital). Additionally, your surviving spouse will be entitled to be the Administrator of your estate. This may be completely contrary to your real wishes.

If you do not want the person you are divorcing to receive all your assets, creating a new Will gives you greater control over where your assets go and allows you to pick your own Executor.

When drafting a new Will, keep in mind that any persons that you name under your Will to act as trustee or guardian for your children might be affected by your divorce. Accordingly, if you name a relative of your former spouse as a trustee, he or she may be ineligible to serve as a trustee of any trusts for your children unless clear instructions are given. You should also revisit your guardianship designations to make sure they are still appropriate given your current circumstances.

However, even with a new Will, you usually cannot completely cut out your spouse. Depending upon how far along you are in the process of your divorce, New Jersey’s Elective Share Statute may allow your surviving spouse to claim up to 1/3 of your estate. However, even if your surviving spouse is unable to collect his or her elective share, the Court may intervene if it thinks it would be inequitable to completely cut out your surviving spouse. In 1990, the New Jersey Supreme Court utilized its equitable powers to grant a surviving spouse an equitable share of the marital assets.

In addition to writing a new Will, to further protect yourself, your divorce attorney should consider provisions in your separation agreement whereby you and your spouse waive your right to claim the elective share of your spouse. Your divorce attorney may also wish to consider submitting a motion to the Court to prevent your spouse from making beneficiary changes to his or her life insurance, retirement plans and educational savings accounts.

Finally, do not forget to speak with your parents and siblings about their estate planning documents. If they have money passing to your spouse under the terms of their Wills, or if you or your spouse is named as a guardian, they may wish to update their Wills as well.

Monday, February 5, 2007

Irrevocable Trusts

There are many different types of irrevocable trusts. The most popular irrevocable trusts include:
  1. life insurance trusts;
  2. asset protection trusts;
  3. charitable trusts;
  4. trusts created upon death (such as QTIP trusts and bypass trusts); and
  5. special needs trusts.
Generally, an irrevocable trust is designed to prevent its terms from being modified in the future. As a practical matter, what this means is that a person (the Grantor) creates a document (the Irrevocable Trust) outlining how his or her beneficiaries should receive any assets that are placed into the trust.

The Irrevocable Trust document itself has provisions which state that the Grantor may not make changes or modifications to the trust. Unlike a Revocable Trust, the Grantor of an Irrevocable Trust gives up all control once the trust is created. There are times when such trusts can be later modified, whether by court or by consent of all the beneficiaries, but never by the grantor alone.

Frequently people also create an Irrevocable Trust because once assets are transferred to such trust they will receive favorable estate and inheritance tax treatment. Assets in Irrevocable Trusts receive favorable tax treatment because they are excluded from the gross estate of the grantor at the time of the grantor’s death.

Another reason people also create irrevocable trusts is to provide as a means of protecting the assets in the trusts. By giving up control of the assets (in a non fraudulent way), a potential creditor may not sue the Grantor and try to claim against the assets in the trust.

In most states, including New Jersey, a Grantor may not be a beneficiary of an asset protection trust. However, a few states do allow self settled spendthrift trusts.

Friday, February 2, 2007

Revocable Inter Vivos Trust (a/k/a the Grantor Trust)

The Revocable Grantor Trust is a favorite of practitioners who wish to help their clients avoid probate. The other advantage to the trust is that for individuals who wish to keep their family secrets out of the public domain, it provides a means to keep their estate planning wishes private.
1. The major benefit of the Grantor Trust is that it provides a method for managing the Grantor’s assets, which is particularly useful in the event of incapacity.
2. It is valuable for clients who are not sure if they plan to stay domiciled in New Jersey and may move to a part of the country where avoiding probate is of utmost importance.
3. Planning considerations
a. When transferring real property into any trust, there is a cost associated with the transfer. Additionally, there may be real estate transfer fees and if there is a mortgage on the property, the mortgage company may have an issue with the transfer.
b. Under Revenue Ruling 85-45, the sale of a person’s principal residence held in trust qualified for the I.R.C. §121 capital gains tax exclusion provided the person and trust otherwise qualified for the exclusion.
c. Probate of property in New Jersey is not as expensive or time consuming as in other jurisdictions, so the cost of establishing the trust may not always be justified.
4. Tax aspects
a. While the Grantor is alive, this trust will be ignored for tax purposes and taxed to the Grantor. The trust may also use the Grantor’s social security number until this time.
b. Upon the death of the Grantor, the taxation of the trust will be dependent upon the terms of the trust. A new tax ID number will usually be appropriate.
5. Administration
a. During the life of the Grantor.
1) The administration of Grantor trusts is quite simple while the Grantor is alive as the Grantor who acts as his own Trustee generally has complete control over all the assets as if he owned the assets outright.
2) At any time a Grantor may terminate (or revoke) the trust and receive all of his assets back. This may be especially useful if there is a third party Trustee who is not doing what the Grantor wants.
3) All bank accounts and titling of assets should be made as follows: “[Trustee Name], as Trustee of the [Trust Name]”.
4) To avoid confusion, a Trustee should always indicate when he or she is acting on behalf of the trust rather than in an individual capacity. Accordingly, checks, letters and any other documents should be signed as Trustee.
b. Upon the death of the grantor, the trust turns into an irrevocable trust. The administration will be dependent upon the actual terms of the trust instrument.
1) Unlike trusts created under a Will, the Trustee does not need to acquire Letters of Trusteeship from the Surrogate. This is both a time saver and a small cost saver.
2) Summaries of various common irrevocable trusts to be discussed later.

Thursday, February 1, 2007

Japanese Inheritance Tax vs. US Estate Tax

NOTE: This information has been updated. The new post can be found at: http://willstrustsestates.blogspot.com/2014/08/japanese-inheritance-tax-vs-us-estate.html

I. Estate Taxes
A. America
1. Citizens and Permanent Residents
a. Tax on Worldwide property (credit for taxes paid to foreign countries)
b. Exemption of $2,000,000 in 2006; $3,500,000 in 2009; unlimited in 2010; and back to $1,000,000 in 2011)
c. Tax between 18%-46%
d. Unlimited Marital Deduction for Surviving Spouse if a citizen
2. Non-Citizens/Non-Permanent Residents
a. Tax only on Property in the United States (Cash in foreign banks and foreign stocks are not taxed)
b. Exemption of $13,000
c. Tax of between 18%-49% on rest
d. Unlimited Marital deduction if Surviving Spouse a citizen
B. Japan (Actually an Inheritance tax, not an estate tax)
1. Japanese Citizens and Permanent Residents
a. Exemption of ¥50,000,000 + (¥10,000,000 for each statutory heir); Possible additional exemption for insurance money, retirement savings, and money left to handicapped individuals
b. Tax between (10%-50%)
c. For property outside of Japan, a beneficiary that acquires property will be subject to Japanese inheritance tax if the beneficiary is a Japanese national and the beneficiary was domiciled in Japan at any time during the five years preceding the receipt of the inheritance.
d. 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. If there is a tax, it appears a surviving spouse is entitled to the same marital tax deduction as for Japanese citizens.

II. Gift Taxes
A. America (18%-46%)
1. Citizens and Permanent Residents
a. Tax on all gift transfers of Worldwide property
b. Annual exemption of $12,000 per person/per donee (unlimited gifts for donees if different donors)
c. An annual gift to a non-citizen, permanent resident spouse, of $120,000 is available.
d. Lifetime exemption of $1,000,000
e. Gifts may be split with spouse
2. Non-Citizens/Non-Permanent Residents
a. Tax on all gift transfers of US Property (including Cash and Stocks in US companies)
b. Annual exemption of $12,000 per person/per donee (unlimited gifts for donees if different donors)
c. No Lifetime exemption
d. Gifts may be split with spouse
B. Japan (10%-50%)
1. Citizens and Permanent Residents
a. Annual exemption of ¥1,100,000 for each beneficiary (beneficiary taxed after this)
b. One time spouse exemption of ¥20,000,000
c. For property outside of Japan, a donee that acquires property will be subject to Japanese gift tax if the donee is a Japanese national and the donee was domiciled in Japan at any time during the five years preceding the receipt of the gift.
2. Non-Citizens/Non-Permanent Residents
a. Annual exemption of ¥1,100,000 for each beneficiary(unclear – enforcement is almost impossible)

III. Generation Skipping Taxes (Taxes on gifts or bequests to grandchildren)
A. America
1. Approximately $2,000,000 in 2006 is exempt; $3,500,000 in 2009 is exempt; there is no GST tax in 2010; $1,000,000 exemption in 2011 (but indexed for inflation)
2. Tax of 55% on rest
B. Japan
1. None

For more information on Japanese taxes, the Japanese government has a nice website in English with some helpful facts. This is a link directly to the inheritance tax information: http://www.mof.go.jp/english/tax/taxes2006e_d.pdf

(Revised on 2/2/09 to correct Japanese tax rates)

Monday, January 29, 2007

SEP IRA is a protected asset in NJ

I was asked earlier today whether a SEP IRA is protected against creditor lawsuits. Without doing a lot of in depth research, I have found that the answer is generally yes. The answer is not the same in all states as it is dependent upon state statute.

New Jersey exempts the claims of creditors from qualifying trusts. See N.J.
STAT. ANN. § 25:2-1. Qualifying trusts include trusts created or qualifying under the Internal Revenue Code §§ 401, 408. (i.e. IRAs, SEP IRAs and 401(k) plans)

Additionally, there is a New Jersey bankruptcy case on point. See In re Lamb, where the court held that 25:2-1 exempts IRAs. See In re Lamb, 179 B.R. 419, 427 (Bankr. N.J. 1994).

Since SEPs are a type of IRA, all of the IRA requirements and benefits, other than the contribution limits, apply to SEP-IRA accounts as well.

The protection is limited by The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which does not protect IRAs in excess of $1,000,000.

I also found this interesting site which appears to have a lot of information on the topic: http://www.aicpa.org/pubs/jofa/jan2006/altieri.htm

As always - if a transfer of assets is made prior to a lawsuit, it's good planning. If you do it afterwards, its FRAUD.

Friday, January 26, 2007

Tax Filing Deadline

Just an FYI in case you weren't aware:

The tax filing deadline is Tuesday, April 17th this year due to the 15th falling on a Sunday and a major holiday, Emancipation Day, falling on th the 16th.

This means you will have an extra couple of days not only to file your returns, but to contribute any amounts you might want to contribute to your ROTH or traditional IRA.

Thursday, January 25, 2007

Fake Will - Just so you see what you are really doing if you don't have a Will


I, "WILL" LESS, do hereby forfeit my right to make, publish, and declare a Last Will and Testament.

A. If my spouse survives me and my parents are deceased, then my spouse shall receive my entire estate, and nothing shall go to my descendents (children or grandchildren) unless they are not my spouse’s children also. My spouse shall receive the entire amount even if we are in the process of getting a divorce and the divorce is not yet final.
B. If, however, I have descendents that are not descendents of my spouse and my spouse survives me, then I leave to my spouse 25% of my estate, but not less than $50,000.00 nor more than $200,000.00, plus one-half of any balance of my estate, the other one-half shall go equally to such surviving descendents who are not related to my spouse.
C. If, however, I do not have any descendents and my spouse survives me and at least one of my parents also survives me, then I leave to my spouse 25% of my estate, but not less than $50,000.00 nor more than $200,000.00, plus three-fourths of any balance of my estate, the other one-fourth shall go to my parents, not to my spouse.

A. My spouse will be appointed the guardian of my children, but shall be required to report to the Probate Court, at such intervals as the court requires, to render an accounting of how, why, and where she spent the children's money if the annual income for each child is greater than $5,000.
B. When a child of mine shall reach the age of 18 years, such child shall have the right to demand of my spouse, his/her mother or father, a complete accounting of all financial transactions pertaining to his/her money.

A. Whatever poor soul decides to figure out my estate and pay my bills shall be required to purchase, at the expense of my estate, and produce to the Probate Court a Performance Bond to guarantee that she will exercise proper judgment in handling, investing, and spending the children's money. This Bond shall remain in force until the youngest of my children reaches the age of 18 years.

A. When one of my issue shall reach the age of 18 years, he shall have an unfettered right to withdraw and to spend his share of my estate. No person or court may question the beneficiary's readiness to manage large sums of cash and other property.

A. I forfeit my right to nominate the guardian of my children in case my spouse should predecease me or die while any of my children are minors.
B. Instead of my having nominated a guardian of my choice, my friends and relatives shall be permitted to select a guardian by mutual agreement, if same be possible.
C. In the event that they fail to agree, the Probate Court shall select the guardian of my children. The person selected may be a total stranger to me, or worse, someone I would not have chosen.

A. I give, devise, and bequeath to Uncle Sam and to the Governor of New Jersey the maximum amount of federal and state death taxes payable as the result of my death.

IN WITNESS WHEREOF, I have set my hand and seal to this, my Last Will and Testament, on this _____ day of ____________________, 20__.


Wednesday, January 24, 2007

Benefits of a Life Insurance Trust

I. What is a Life Insurance Trust?
A. Legal Relationship - A trust is a relationship that exists when one person or an entity (the Trustee) holds legal title to money or property for the benefit of one or more individuals or organizations (the Beneficiaries). The terms of the relationship are decided by the person providing money for the trust (the Grantor), and are usually evidenced in writing.
1. Grantor/Settlor - The Grantor or Settlor is the person or entity that creates the trust by providing the money or insurance to fund it.

2. Trustee - The Trustee is the person or entity that manages the trust assets for the benefit of the beneficiaries of the trust. The trustee is bound by a fiduciary duty to act in the best interests of trust, as directed by the Grantor or Settlor.

3. Beneficiary - A Beneficiary of a trust is a person or entity that is entitled to receive money from the trust. The manner in which a person receives such money varies from trust to trust, and generally a Grantor may put in a range of provisions to restrict a Beneficiary’s access to the money.
B. Design - A life insurance trust is specifically designed to hold life insurance.
1. Irrevocable – Once created, a life insurance trust is almost impossible to change.

2. Loss of Control - Generally, the insured must give up all rights to control the trust and the life insurance policy in favor of a trusted advisor. The Grantor should decide the terms of the trust upfront so that the Trustee may carry out the Grantor’s wishes.

3. Tax - A life insurance trust is typically designed to save money on estate and inheritance taxes. It should also allow the Grantor to use his or her annual gift tax exclusion so that the premium payments are not treated as a taxable gift.

II. What are the benefits of an insurance trust?
A. Reduces estate and inheritance taxes - If life insurance is owned by a trust, and the trust is structured properly, the proceeds from the life insurance will NOT be includible in the taxable estate of the Grantor. Note: A trust must purchase the life insurance, otherwise there is a three year look-back period.

B. Allows for control of assets after you die – Despite the fact that the trust is irrevocable and you lose control once it is established, with proper planning, the trust can allow a Grantor to decide when and how his or her heirs should get the proceeds of the life insurance.

C. Asset protection – By giving money to your heirs in trust, it ensures that your heirs are less likely to squander their inheritance. It also protects it from creditors.

III. Who should consider an insurance trust?
A. Recent Divorcees – Many divorce decrees call for an insurance trust to be established. It benefits the custodial parents by giving them assurance of the existence of the policy. It benefits the non-custodial parent by giving them a voice in when the child gets the money and ensuring that they money benefits the children, and not the person they just divorced.

B. Individuals with Significant Assets – Individuals with substantial wealth may benefit from a life insurance trust as a way to reduce taxes or to create liquidity for an estate that may have other tax or cash flow issues.

C. Individuals with Large Insurance Policies – By itself, a large policy can create estate tax issues, so even if a person is not otherwise wealthy, it makes sense to transfer the wealth you do have with minimum tax consequences.

D. Same Sex Couples – Despite the recent changes in some states, including New Jersey, that benefit same sex couples, many states and the federal government still treat same sex couples as nothing more than friends for tax purposes. Accordingly, a life insurance trust will ensure that your loved one benefits upon your death without a large tax bite.

E. Individuals married to Non-Citizen Spouses – A non citizen spouse is not entitled to the unlimited marital deduction for estate and gift tax purposes. Accordingly, if you are married to a non-citizen spouse, the best way to avoid a large estate tax upon your death is to create a life insurance trust.

Tuesday, January 23, 2007

Reasons for a Will

  1. General Benefits
    a) Ensures a clear WRITTEN clear plan for the distribution of assets after your death
    i. Provides proof of plan
    ii. You get to choose who serves as executor, trustee and guardian
    iii. A clear plan can help avoid infighting amongst surviving family members
    b) Important means of ensuring that money will go to whom you wish it to go rather than according to state law
    c) Eliminates need for Insurance bond for Trustees and Guardians (Savings of approximately $500 for every $100,000 that the estate is valued at)

  2. Establish trusts for your children/grandchildren
    a) Minors – allows for both discretion over distribution and control over timing of distributions
    i. Tiered distribution – traditional means of giving money to children (age 21, 25, 30)
    ii. Dynasty trusts – stays in family blood forever if funded with enough money.
    b) Problem children – can give trustee discretion as to when to distribute money out

  3. Flexibility
    a) A Modern Will should allow for a great deal of flexibility because of the ever-changing tax laws.
    i. Regardless of whether a Testator’s estate goes up or down, the will should contain formulas to take into account the current state of the tax laws and future anticipated changes.
    ii. Ability to take into account State Tax laws in conjunction with Federal Tax Laws
    b) Trustee provisions - Many problems occur when beneficiaries are stuck with trustees whom they cannot remove. A modern Will should have the ability for trusted beneficiaries to replace trustees and appoint independent trustees to allow for invasion of principal to beneficiaries in a way that will not produce adverse tax consequences.
    c) Post mortem planning - A will should allow for the surviving spouse or an independent executor to do planning after the death of the testator including tax planning.
    i. Disclaimers
    ii. Limited Powers of Appointment – You can allow the surviving spouse to appoint the balance of a trust among your children as he or she sees fit. (This is especially useful when children have varied income levels.)
    iii. Granting of a General Power of Appointment for tax purposes.
    d) Side letters – Under New Jersey law, a testator may revise the provisions regarding disposition of tangible personal properties without redoing the entire will. (E.g. You can easily change your mind about who you want to leave your golf clubs to without redoing your Will.)
    e) Combining trusts – A well drafted will (and trust) should allow you to combine two or more trusts with similar terms to save time and money.

  4. Minimization of Tax consequences
    a) Establishing trusts allows couples to make full use of both spouses’ tax exemptions.
    b) Anyone who plans to distribute to non-lineal descendents, up or down, must plan to minimize inheritance taxes
    c) Establishment of multiple trusts for minimization of Generation Skipping Transfer Tax (GST tax)

The Pension Protection Act



In addition to requiring corporations to more fully fund their pension plans, the Pension Protection Act (“PPA”), which was passed on August 17, 2006, provides or extends numerous tax benefits that could affect you or your employer. The PPA recognizes the reality that the government and many companies are pushing the responsibility of saving for retirement on to individuals. To help us take on that responsibility, the PPA provides greater tax deferred savings opportunities for all and offers favorable tax treatment for certain beneficiaries named under a Retirement Savings Account.

Estate Planning – Additional Opportunities for Your Loved Ones to Stretch Your Retirement Savings after your Death

From a planning perspective, perhaps the most important new provision of the PPA is to allow non-spousal beneficiaries to “roll over” assets inherited from a qualified retirement plan into an IRA. The beneficiary will avoid tax on the rollover, and will be taxed only when the assets are withdrawn. Previously, this tax treatment was available only for people who inherited retirement assets from a deceased spouse. The new law extends treatment that already exists for IRAs and will primarily benefit children, grandchildren domestic partners and non-traditional couples.

Specifically, the surviving beneficiary will now be able to “roll over” the decedent’s retirement funds into an Individual Retirement Account (IRA) and either draw down the benefits over a five-year period or over such beneficiary’s own life expectancy. Since the terminology in this particular field is imprecise and confusing, it must be clearly stated that the term “roll over” as used here does NOT allow a non-spousal beneficiary to merge the decedent’s qualified retirement plan with their own. It merely allows the beneficiary to take withdrawals over the beneficiary’s life expectancy rather than being forced to withdraw the entire amount as a lump sum and incur immediate tax charges. This particularly important because this forced withdrawal often bumped the survivor into a higher tax bracket as the withdrawal is counted as taxable income to the beneficiary.

In order for your loved ones to benefit from this new law, you MUST properly designate a beneficiary under your retirement account. If you have not done so, contact your employer’s benefits coordinator and fill out a beneficiary designation form, otherwise they will not receive the benefit of this new law. Unfortunately, the pension plan that your employer uses still determines who you can name as beneficiary. If the pension plan currently does not allow distributions to anyone other than to a spouse, this provision in the PPA will not help you.

The amendments made by this section of the PPA shall apply to distributions after December 31, 2006

Note: The transfer to the beneficiary must be done as a direct rollover, also known as a Trustee to Trustee transfer, otherwise the tax benefits of this rollover will be lost! The direct transfer must go to a properly titled inherited IRA, which means the inherited IRA must be maintained in the named of the deceased plan participant. For example, “Grandpa’s IRA (Deceased March 1, 2007) FBO grandson”.

Retirement Planning Opportunities

The new law extends a number of retirement benefits. The contribution limit for IRAs will be $4,000 in 2006 and 2007, $5,000 in 2008, and adjusted for inflation after 2008. Catch-up contributions for individuals age 50 or older will be $1,000 for IRAs, $2,500 for SIMPLE-IRAs, and $5,000 for 401k plans. IRA catch-up contribution limits, however, will not be adjusted for inflation. SIMPLE and 401k catch-up contributions will be adjusted in $500 increments based on inflation.

The new law permanently allows for Roth 401k and Roth 403b plans. Under the sunset provisions of the previous tax law, Roth-type 401k and 403b plans were not allowed after 2010. The new law removes this sunset provision. Like a Roth IRA, an individual makes post-tax contributions to a Roth 401k or Roth 403b plan, up to the plan limits. The assets grow tax-deferred and may be withdrawn tax-free in retirement.

If you are in a low income tax bracket, you may wish to take advantage of a provision in the PPA that allows a direct rollover from a 401k to a Roth IRA, with the rollover treated as a Roth conversion.

The new law also permanently allows the Retirement Savings Tax Credit, which would have expired at the end of 2006.

How the PPA may affect an Employer

Employers may now automatically enroll their employees into a 401(k) retirement plan using default contribution levels. Employees will need to opt-out of the 401(k) if they don't want to utilize the 401k plan.

Military Personnel

Military personnel who are called to active duty between September 11, 2001 and December 31, 2007, may now take a penalty-free withdrawal from their 401(k) or IRA. However, these individuals must re-deposit the withdrawal within two years from time their active duty ends in order to avoid paying income tax on the withdrawal.

Hardship Withdrawals

The PPA makes it much easier to make hardship withdrawals from 401k plans including allowing hardship withdrawals "with respect to any person listed as a beneficiary under the 401(k) plan." Beneficiaries such as siblings, parents, same sex couples, and children may now draw on a retirement fund in the case of a qualifying medical or financial emergency. In the past, the federal law covered only the spouses or dependents of employees when it came to accessing retirement funds during an emergency.

Stricter Rules for Charitable Donations

Under the new law, taxpayers must keep records of all cash donations to charity. Individuals must show a receipt from the charity, a canceled check, or credit card statement to prove their donation. No charitable tax deduction will be allowed if the taxpayer cannot provide any supporting documentation. Taxpayers will not need to mail in the receipts with their tax return. Instead, taxpayers will need to keep receipts and other documentation with their copy of the return in the event of an IRS audit. The Law Office of Kevin A. Pollock LLC strongly recommends that you maintain all such records for a minimum of seven years.

The new law also toughens the rules for non-cash donations. Donated items, such as clothing, cars, and household goods, must be in good condition. Unfortunately, the new law does not offer any guidance as to what “good condition” means.

Charitable IRA Donations

The Pension Protection Act allows taxpayers to donate up to $100,000 to charity directly from their IRA account in 2006 and 2007. The distributions will be tax-free and avoid the penalty on early withdrawals. Taxpayers are allowed to donate up to $100,000 per year from their IRA. Since the distribution will not be included in taxable income, individuals will not be able to claim a tax deduction for the charitable contribution.

Qualified Charitable Distributions from IRAs Allowed

· Under pre-Act law, there was no provision permitting the tax-free distribution from an IRA where the distribution was to be donated to a charity. The Act provides a favorable new rule that permits an exclusion from gross income, not to exceed $100,000 per year for otherwise taxable distributions from a traditional IRA or a Roth IRA that are made:

o directly by the IRA trustee to qualified public charities and certain private foundations (but not to most private foundations, supporting organizations and donor advised funds);

o on or after the date the IRA owner attains age 70½; and

o only for distributions made in 2006 and 2007, without carryover to any subsequent year.

· Distributions that are excluded from gross income are not taken into account in determining the IRA owner’s deduction for contributions to charity, but are counted as part of the IRA owner’s required minimum distribution for that year.

· The benefit arises from not including the IRA distribution in adjusted gross income, those affected by limitations on itemized charitable donation deductions, and for taxpayers who do not itemize their deductions.

Section 529 College Education Plans Made Permanent

· Withdrawals from Section 529 Plans for qualified college expenses have been completely exempt from Federal income taxes since 2002. However, this valuable tax benefit was set to expire in 2011. The new Act makes permanent the tax benefits of Section 529. Distributions for qualified educational expenses (including special needs services) and certain rollovers Section 529 plan accounts, will continue to be permitted under the new law. This benefit is particularly welcome for those saving for college in light of recent changes to the “kiddie tax” provisions which were the subject of our June 2006 Alert.

Gifts of Fractional Interests in Tangible Personal Property

· The Pre-Act law allows a charitable deduction for a contribution to charity of a fractional interest in tangible personal property if the contribution satisfies requirements for partial and future interests, and in later years the donor makes additional charitable contribution of interests in the same property. A common use of this provision was to make a gift of a percentage interest in a painting or other artwork to an art museum; in theory, the museum must have use and possession of the art for part of each year commensurate with its percentage interest.

· For contributions, bequests and gifts made after August 17, 2006, the Act limits the charitable deduction for such fractional interest contributions, provides rules for valuing the donor’s additional fractional interest contributions and provides for recapture of the tax benefits under certain circumstances.

· The Act requires that the charitable entity receiving a fractional interest must take complete ownership of the item within 10 years of the gift, or the death of the donor, whichever first occurs. Further, the entity must take possession of the item at least once during the 10-year period as long as the donor is living, and use the item for the entity’s exempt purpose. Failure to comply results in the recapture of all tax benefits plus interest and imposition of a 10% penalty. The more restrictive 10-year rule is likely to deter many younger donors from making fractional interests gifts, since enjoyment during the balance of the donor’s lifetime is no longer possible.

· There are also special rules for deductions of future gifts of partial interests in the same property. In general, for items that are contributed to further a donee’s exempt purposes, the deduction will be equal to the fair market value of the interest. The fair market value of an additional contribution of a partial interest in this case is the lesser of the item’s fair market value at the time of the initial contribution or the fair market value at the time of the current contribution. The additional rules that limit the charitable deduction which apply for income tax purposes, also apply for gift and estate tax purposes. There is a potential gift and estate tax trap when the donor makes a transfer of his remaining interest in the property if the property has appreciated in value from the time of the initial contribution, since the interest that remains in the donor’s estate at the time of his death is valued at its full value, while the estate tax deduction is limited to the value of the property at the time of its contribution.

Tougher Record Keeping Required for Charitable Gifts of Money

· The Act disallows any charitable deduction for contributions of cash, check or other monetary gift made after December 31, 2006, unless the donor maintains a written record of the contribution, regardless of the amount. For a contribution of cash, the donor must maintain one of the following (i) cancelled check, (ii) receipt (or letter or other written documentation) from the entity showing the name of the entity, the date and amount of the contribution or (iii) other reliable written records showing the name of the entity, the date and amount of the contribution. The existing rule for requiring a written receipt from the charity for cash contributions of $250 or more remains in effect.

Limitations for Charitable Gifts of Clothing and Household Items

· The Act restricts the charitable deduction for donations of clothing or household items unless they are in good used or better condition. Thus, effective after August 17, 2006, items donated in poor condition will not result in a charitable deduction.

Tougher Rules for Donated Tangible Personal Property

· For contributions made after September 1, 2006, there is a recapture of the tax benefit for charitable contributions of tangible personal property exceeding $5,000 for which a fair market value deduction is claimed unless the charity uses the property for its exempt charitable purposes. If the charity disposes of the donated property within 3 years from contribution, the donor is subject to an adjustment of the tax benefit arising from the contribution. However, there is no adjustment if the donee entity makes a proper certification to the IRS, a copy of which must be given to the donor.

Conservation Property

· To encourage charitable contributions of real property for qualified conservation, the Act increases the percentage limitation applicable to qualified contributions of real property from 30% to 50% (100% for qualified ranchers and farmers) and increases the carryover period for qualified conservation contributions that exceeded percentage limitation from 5 to 15 years. This provision is effective for contributions in 2006 and 2007.

New Taxes on Prohibited Benefits Received from Donor Advised Funds

· In order to close a perceived loophole under current law, the Act provides that if a distribution from a donor advised fund results in a donor, donor advisor, or a related person receiving, directly or indirectly, more than an incidental benefit as a result of the distribution, then: (i) a tax is imposed on the fund manager equal to 125% of the amount of the benefit is imposed on the advice of any related person to have a sponsoring organization make the distribution and such person who advises that the distribution be made or who receives the benefit pays the tax; (ii) a tax equal to 10% of the amount of the benefit is imposed on the agreement of any fund manager who makes the distribution that confers a benefit up to a maximum of $10,000. This provision is effective for tax years after August 17, 2006.

Benefit to S Corporation Shareholders for Charitable Contributions

· Under the Act for tax years beginning in 2006 and 2007, if an S corporation makes a charitable contribution, its shareholders will now reduce their basis in the stock of the S corporation only by their pro rata share of the adjusted basis of the contributed property. Under the prior law, their stock basis had to be reduced by their pro-rata share of the entire charitable contribution. This provision now treats S corporation shareholders the same as partners in a partnership. For example, if an S corporation having a sole shareholder makes a charitable contribution of stock with a basis of $200 and a fair market value of $500, the shareholder will be treated as having made a $500 charitable contribution and will reduce the basis of his or her stock by $200. This is only a temporary tax incentive to encourage S corporations to make charitable donations of appreciated assets in 2006 and 2007.

Enhanced Taxpayer Penalties for Valuation Misstatements

· For returns filed after August 17, 2006, the Act increases the accuracy-related penalties imposed on taxpayers for income, estate or gift tax understatements of value. Under the Act, a “substantial” estate or gift tax valuation misstatement occurs when the claimed value of the property is 65% (previously 50%) or less of the correct value. A “gross” estate or gift tax valuation misstatement exists when the claimed value is 40% (previously 25%) or less of the correct value.

Filing Requirements for Split-Interest Trusts

· The Act increases the penalty on split-interest-trusts (e.g. charitable remainder annuity and unitrusts and pooled income funds) for failure to file a return and failure to properly report required information. The penalty is $20 for each day the failure continues up to $10,000. For trusts with gross income in excess of $250,000, the penalty is $100 per day up to $50,000. If any officer, director, trustee or other individual under a duty to file or include required information, knowingly fails to file the return or include required information, such person is personally liable for such penalty, in addition to the penalty imposed upon the entity. This provision is effective for taxable years after December 31, 2006.

Use of Educational Savings Accounts in Light of the Revised “Kiddie Tax”


The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) further restricted the ability of parents to shift their income tax burden to their minor children so that such money would be taxed at the child’s lower rates. This shifting tax burden, known as the “Kiddie Tax”, previously only applied to minor children who had not reached the age of 14 by the end of the taxable year. Now, parents of children under the age of 18 will be taxed on the unearned income of their children.

Specific Application

In 2006, the unearned income of a minor, up to $850, is not taxed. Unearned income greater than $850 but less than $1,700 is taxed at the minor’s rate. However, a minor’s unearned income over $1,700 is taxed at the parent’s highest marginal rate, if application of that rate results in a higher tax than the minor would have otherwise paid as a single person. In certain circumstances, a parent may make a “pick up” election to include the minor’s gross income (in excess of $1,700) on the parent’s own return. The threshold of $1,700 will be indexed for inflation. The Kiddie Tax does NOT apply to qualified Disability Trusts.


As a result of this change in the law, parents and grandparents now have one more reason to set up a Coverdell Education Savings Account (CESA) or a Qualified Tuition Program (529 plan) as opposed to a custodial account to save for a child’s college education. Both the CESA and the 529 plan permit tax-free accumulation of the principal contributions and the ability to roll over the accounts to other children. Most importantly, assets transferred to one of these plans will NOT be included in the donor’s estate for estate tax purposes.

Many of you are probably now familiar with a 529 plan, but parents should also consider the use of a CESA. A CESA is available for individuals with an income less than $110,000 married parents with an income below $220,000 (with a phase-out starting at $95,000 and $190,000, respectively) and permits parents to direct the investments in the account. The disadvantage of a CESA is that no more than $2,000 may be contributed per year for each child, regardless of who establishes or contributes to the accounts. A parent or legal guardian of the designated beneficiary of the CESA, may change the designated beneficiary to a family member of the original beneficiary, provided the new beneficiary is under the age of 30. Unfortunately, unlike a 529 Plan, if the money in the CESA are not used for college, they cannot be refunded to you, but will be distributed to the designated beneficiary thirty days after such beneficiary attains age 30, if the account is not rolled over prior to that date.

There are two types of 529 plans, a prepaid plan and a savings plan. A prepaid plan allows the parent to prepay the tuition at an eligible educational institution, thereby guarding against the inevitable tuition increases. A savings plan involves investment in mutual funds that will grow tax free. Anyone may open up and fund a 529 for a child. The account owner retains may change the beneficiary to any other member of the original beneficiary’s family without adverse tax consequences. Further, although there is no annual limit on contributions to a 529 Plan, generally a person will not want to gift more than the annual exclusion amount (currently $12,000) or it will be a taxable gift to that child. A special gift tax election may be made to gift up to 5 years worth of contributions to a 529 plan in the first year, but no other tax free gifts may be made to that child for the next 5 years. It should be noted that if the donor dies prior to the expiration of the 5 year period, a portion of the gift will be added back to the donor’s estate when calculating the estate tax.

Unqualified distributions from either a CESA or a 529 plan will result in a tax on the accumulated income plus a 10% penalty tax.