Benefits of a Second to Die Life Insurance Trust

I. General Benefits

A. Tax savings
B. Control of assets after death
C. Second to die policies typically provide guaranteed money for your heirs which is cheaper to obtain than single life premium policies.

II. Reasons to establish a Second to Die Life Insurance Trust

A. Pay taxes upon death for assets outside of trust
B. Provide guaranteed funding for disabled child
C. Guarantee liquidity (so sentimental assets are not forced to be sold in a fire-sale)

III. How does a Second to Die Life Insurance Trust Work?

A. The trust should be created prior to the purchase of the policy (otherwise there is a 3 year lookback for tax purposes).
B. The trustee of the trust then purchases the life insurance on the joint life expectancy of you and your spouse.
C. A bank account must be set up for the trust.
D. The premium should be paid into the trust’s bank account at least 45 days prior to the premium due date.
E. Immediately after the trust’s bank account is funded, a beneficiary designation notice must be sent out. (In order to make gifts to the trust tax free, the beneficiaries of the trust must be allowed a window in which to withdraw the money. This is known as a Crummey trust.)
F. Thirty days later (this time frame various depending upon the trust document), the trustee can pay the premium.
G. Upon the death of the survivor of you and your spouse, the insurance is paid to the trust.
H. The trustee then pays out the money according to the terms of the trust.

IV. Putting the Tax Savings into Real Dollars

A. Let’s assume Harry and Winny have $7,000,000 in assets. They have two kids, one of whom has autism and needs permanent care. Even with proper planning, if Harry & Winny passed now, they would have a potential tax liability of about $1,500,000.
B. By setting up a life insurance trust, 100% of the money in trust can pass free of federal estate taxes as well as state estate and inheritance taxes. Additionally, the trust can be established to benefit Harry & Winny’s autistic child in a way that he remains eligible for government benefits.
C. To revise the example above, if we properly move $1,000,000 of assets into this life insurance trust, leaving a taxable estate of $6,000,000, the potential tax liability is reduced to about $1,000,000. This a savings of about $500,000.

Taxing Politics

The 2008 political season officially began last night in Iowa. Accordingly, I thought it would be helpful to look at each candidate's tax policies, especially their estate tax policies. I've listed only those who I consider to be the viable candidates. For fun, I put them in order of how they finished in the Iowa caucuses.

The Democratic Candidates

1. Barack Obama
   Income Taxes
   --> Senator Obama appears to favor a reduction in income taxes for individuals making less than $50,000. This appears to be balanced by an increase on those whose income puts them in the top 1% of the country. He voted against a repeal of the alternative minimum tax.
   Estate Taxes
   --> It is clear that Senator Obama is in favor of keeping a federal estate tax, but it is unclear at what level. He voted againt raising the threshold to $5,000,000 per person.
   Other Tax and Probate Related Issues
   --> Senator Obama is in favor of closing tax loopholes for companies that move jobs abroad and in favor of rewarding companies that create jobs in America.
2. John Edwards
   Income Taxes
   --> Senator Edwards appears to favor using a combination of credits to reduce the taxes of those earning less than $75,000. The most notable credit is a large increase for Child Care. He voted against a repeal of the alternative minimum tax. He wants an increase in the capital gains tax rate to 28% for those earning over $250,000.
   Estate Taxes
   --> Senator Edwards is in favor of keeping the federal estate tax at the same levels as are currently in place, $2,000,000 per person.
   Other Tax and Probate Related Issues
   --> Senator Edwards is in favor of closing tax loopholes for hedge fund and private equity managers (meaning that they would be taxed at income tax rates, not capital gains tax rates). He also had a very interesting proposal that would require the IRS to prepare tax returns for those people who are simply W-2 workers or receive all income from 1099's.
3. Hillary Clinton (No real public plan yet)
   Income Taxes
   --> Senator Clinton wants to keep the AMT, but it is unclear at what level.
   Estate Taxes
   --> Senator Clinton is in favor of keeping the federal estate tax at the same levels that will be in place starting in 2009, $3,500,000 per person.
   Other Tax and Probate Related Issues
   --> Senator Clinton proposes increasing or removing the $95,000 cap from the payroll tax. Currently, only the first $95,000 of income is subject to payroll tax. Payroll taxes are for such things as Social Security, Medicaid and Medicare.

The Republican Candidates

1. Mike Huckabee
   Governor Huckabee wants to eliminate ALL income, payaroll, gift, estate, capital gains, alternative minimum, Social Security, Medicare and self employment taxes. He wants to replace these with a consumption tax (i.e. a tax on what we buy - similar to a sales tax). The consumption tax rate would be about 23% inclusive (or about 30-34% exclusive). For a view of the plan known as FairTax given by supporters, click here. For an opposing view, click here. The consumption tax would theoretically be on EVERYTHING, including new home purchases, rent, doctor's bills, and worst of all - LEGAL FEES. It would however exclude used items. (Hmm... I wonder if you can have used legal services...)
   Income Taxes
   --> See above
   Estate Taxes
   --> See above
   Other Tax and Probate Related Issues
   --> See above
2. W. Mitt Romney
   Income Taxes
   --> Governor Romney generally wants to lower tax rates for everyone.
   Estate Taxes
   --> Governor Romney is in favor of permanently repealing the estate tax. It is unclear if he wishes to repeal the gift tax.
   Other Tax and Probate Related Issues
   --> Governor Romney wants to get rid of taxes on interest, dividends and capital gains for those with an adjusted gross income under $200,000.
3. Fred Thompson
   Income Taxes
   --> Former Senator Thompson plans to index the AMT for now and repeal it eventually. He believes in instituting a flat tax which would give much larger personal exemptions, but get rid of all deductions.
   Estate Taxes
   --> Former Senator Thompson wants to elimate the estate tax. It is unclear if he wishes to repeal the gift tax.
   Other Tax and Probate Related Issues
   --> He has an interesting proposal to let tax payers choose the current tax forms or a flat rate form with only 2 exemptions.
4. John McCain
   Income Taxes
   --> Senator McCain is in favor of permanently repealing the AMT. He would make the currently scheduled tax levels permanent.
   Estate Taxes
   --> It appears Senator McCain wants to elimate the estate tax. It is unclear if he wishes to repeal the gift tax.
   Other Tax and Probate Related Issues
   --> Would ban taxes on cell phone messages. (I don't think that there is one...)
5. Ron Paul
   Congressman Paul wants to get rid of the income tax completely (which would require severe spending cuts).
   Income Taxes
   --> See above
   Estate Taxes
   --> It appears that Congressman Paul wants to eliminate the gift, estate and GST tax.
   Other Tax and Probate Related Issues
   --> It appears he wants to fund the goverment with fees such as: tariffs, excise taxes, user fees and highway fees.
6. Rudy Giuliani
   Income Taxes
   --> Former Mayor Giuliani intends to permanently lower the marginal rates to what they will be under the Bush tax act, or lower. He intends to tie the AMT to inflation. He also proposes an income exclusion up to $15,000 for families without employer based health care.
   Estate Taxes
   --> Former Mayor Giuliani wants to eliminate the estate tax. It is unclear if he wishes to repeal the gift tax.
   Other Tax and Probate Related Issues
   --> He wants to drop the corporate tax rate from 35% to 25%.

Sources include: www.ontheissues.org, the candidate's websites, and various news articles.

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.

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.

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.

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.

QDOTs

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.

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Minor updates made on December 14, 2010.