IRS Information Letter 2017-0015 below provides a requesting taxpayer guidance on the proper amount of income includible in the taxapyer’s income from a life insurance split dollar arrangement entered into with his/her employer. This is a good reminder to review your split dollar arrangements periodically to make sure they are functioning and taxed as intended by the parties to the contract. If you need help with a split dollar arrangement, we can help. Contact us at 404-255-7400 or email@example.com.
Although “file and suspend” is no longer available as a Social Security planning tool (expired on April 30, 2016), there is one spousal strategy that still exists. A restricted application called “file as a spouse first” can be filed when you reach full retirement age (FRA) if you turned 62 by January 1, 2016 (born in 1953 or earlier).
Donald Trump’s surprise election gives us a tremendous amount of hope that the federal estate tax might finally be repealed. This concept runs in the face of candidate Clinton’s proposal to reduce the estate and gift tax exemption amounts and increase the tax rates from 40% to 65%.
While we do not want to celebrate too early, a critical message is that estate planning should continue with fervor! The Donald Trump phenomenon, which results in a Republican Presidency and a Republican Congress, gives us a great deal of confidence that tax reform will be among the items addressed early in Trump’s administration. Tax reform could and should include the repeal of the federal estate and gift taxes, and the elimination of the generation skipping transfer tax that has been hanging over our heads since 1976.
However, this will take some time, and the reality is that the U.S. still has huge deficits that must be serviced with tax revenue. Granted, the percentage of the federal revenue coming from death taxes is minimal, but there is also the argument that the tax on the transfer of wealth is “fair” in a system that allowed the accumulation of such wealth. This theory is combined with the tempering affect that the death tax has on the growth of family dynasty wealth (taking from the rich to provide for the poor).
It is likely that the current federal estate and gift tax laws will be replaced by a system more popular in other parts of the world, such as the capital gains calculation that takes place in Canada, Great Britain and other western civilizations. In those countries, at death, the difference between the tax basis of property and its fair market value will be subject to a tax similar to the capital gains tax that would have occurred had the decedent sold the appreciated assets. This accomplishes the practical role of allowing tax basis to be stepped up to fair market value at the death of an owner, and replaces the estate and gift tax revenue with a fair method of taxing growth as it is done in the income tax arena. Of course, there will have to be exemptions and exceptions made for family farms and businesses so these types of assets would not have to be leveraged or sold in order to pay Uncle Sam. All of these details, and many more, will have to be worked out by Congress and the U.S. Treasury Department (IRS).
In the meantime, it appears that some of the more popular techniques that we have been implementing over the last 20 or so years will become even more popular. The use of trusts has long been an important aspect of estate planning. Trusts can own property outside of a taxable estate, trusts can allow an orderly transition of control through the naming and choice of trustees, trusts can protect property from creditors and divorce, trusts avoid probate, and trusts provide significant income tax savings flexibility for current and future beneficiaries.
An important trust that we use in estate planning is the Family Trust, where parents set up trusts for their kids while they are alive, as opposed to waiting until both parents are deceased, and begin funding those trusts with assets by way of gift and otherwise, to remove property from the parents’ taxable estates.
One type of Family Trust that we often use is to make the trust a grantor trust for federal income tax purposes. That means for income tax purposes the IRS ignores the existence of the trust and all the taxable income and deductions associated with the Family Trust continue to be reported on the grantor’s individual income tax return. In our practice, we refer to these Family Trusts as “Defective Grantor Trusts”, or DGTs.
One of the features that allows a trust to be a grantor trust during the grantor’s lifetime is the ability to substitute property in the trust with other property from the grantor. This has been a popular benefit of using DGTs because the trust can hold appreciating assets, removing the appreciation from the grantor’s estate, but those appreciated assets can be swapped for cash or other assets, allowing the low-basis, highly-appreciated assets to come back into the grantor’s estate before death, in order to allow a step-up in tax basis at death for income tax purposes. This has always been kind of “have your cake and eat it too”, removing appreciating assets out of your estate, but retaining the ability to get those assets back in order to achieve an increase in tax basis at death. So, one of the things that we have tried to accomplish with our estate planning clients is to assist them in monitoring the assets in their Family Trusts, to determine if and when it would be desirable to substitute those highly appreciated assets for other assets out of our clients’ taxable estates. Of course, timing is everything, and there is always the risk that the substitution might not occur timely, but at least our clients have retained that flexibility.
Now, with the chance of repeal of our federal estate tax, the strategy with these same grantor trusts might change. In other words, since only appreciated assets would be subject to a capital gains tax at death, it may become more important than ever to remove these appreciated assets from the estate, put them in a grantor trust, and leave liquid, high basis assets in the parents’ taxable estates. Then, if the next President and/or Congress were to reinstate a federal estate tax, we can easily shift strategy and look to exercise the substitution power that exists with the DGTs.
Remember that we still have the evil overhang of the proposed 2704 regulations (see prior articles) which will eliminate much of the discounting that we have enjoyed for valuation purposes when gifting or selling hard to value assets to Family Trusts. These proposed rules will become effective, according to the IRS, 30 days after they become final. While we don’t know when these proposed regs will become final, it does take typically 12 to 18 months for these regulation projects to become completed. The regs were proposed in early August, so we are still “under the gun” for those clients who have situations that warrant this type of estate planning.
So, let’s be happy with the potential repeal of the estate tax but be realistic in what that means. If anything, as new rules evolve, we should be focusing on flexible estate planning now, more than ever, as future tax reform will create new tax regimes. For instance, if the new tax rules no longer encompass the concept of a $5,500,000 exemption per person, will all that exemption that was not used before the estate tax is repealed be lost forever? So, while President-Elect Trump goes about changing our tax system to make us more competitive in the world, and he is ”draining the swamp”, let us pay attention to details and reap the benefits of continuous planning.
For more information about this or any other estate planning topic, please contact us directly at 404-255-7400 or email us at firstname.lastname@example.org.
Not only has the IRS threatened to change the rules of valuing gifts, which will have a significant impact on many estate planning techniques used over the last several decades, the presidential elections will have a huge impact over whether the estate and gift tax law survives, or becomes extremely more expensive and complicated.
After an agonizing wait, the IRS issued Proposed Regulations on August 4th that will eliminate many of the valuation discounts applicable for family-owned businesses and wealth in general. These new rules will become effective thirty days after publication of final regulations, which are expected in the next 12 months.
That means gifts prior to the effective date of the regulations may continue taking into account all applicable valuation discounts and used over the last several decades, and those family business owners who postpone these estate planning techniques of transferring wealth to trusts for future generations will be hurt economically under the new rules. While we do not know for sure what the final regulations will say, the question is obvious, is any further postponement worth the risk?
Additionally, there is a substantial difference between the two presidential candidates’ tax policy proposals, particularly relating to the estate and gift tax. Donald Trump proposes to eliminate the estate and gift tax. Mrs. Clinton, however, proposes to reduce the estate tax exemption (which will be $5,490,000 in 2017) to $3,500,000 (per person) with no adjustment for inflation. She proposes to reduce the lifetime gift tax exemption from $5,490,000 (2017) to $1,000,000, with no adjustment for inflation.
This situation is reminiscent of the concern in 2012 when we feared the exemptions may go from $3,500,000 to $1,000,000. Many clients scurried to take advantage of estate and gift tax advantages before year-end. Those clients, by the way, are generally laughing all the way to the bank as not only have they moved significant wealth out of the gift tax system, but the statute of limitations on the IRS’ ability to review the substance of those transactions has just about expired.
Mrs. Clinton is not done there! She proposes to raise the current estate tax rate from a flat 40% to 45% on estates under $10,000,000, 50% for estates from $10,000,000 to $50,000,000, 55% for estates from $50,000,000 to $500,000,000, and 65% for estates for over $500,000,000. While this seems shocking, the maximum estate tax margin rates when I began practicing in 1976 was technically 77%!
Obviously, the double attack from the IRS and the potential Clinton Administration will raise havoc in the estate planning circles. Be ready to react relatively quickly as these proposals threaten to become reality.
For more information regarding this or any other estate planning concern, please contact us at 404-255-7400 or email us at email@example.com.
Last July, I wrote in my column that the IRS made it known that it would issue proposed regulations as early as September (2015) which would severely restrict valuation discounts for transfers among related entities (such as transfers of limited partnership or LLC interests to other family members or trusts). Not surprisingly, here we are in the spring of 2016 and there are no regulations.
Early this month, an IRS representative spoke at the ABA Tax Section meeting and spoke about upcoming IRS guidance. She predicted that in the next couple of months the IRS would issue 5 or 6 new regulations, the first of these being the proposed regulations under Section 2704, which would place further restrictions on valuation discounts. While we don’t know what the scope of these new restrictions will be, we are certain that they will have a significant impact on valuing property transferred between related family entities. As I expressed last year, our concern is exacerbated by the fact that the IRS will likely make these rules effective retroactively to the date of the proposed regulations.
The judicious use of valuation discounts has long been a responsible tenant in estate planning. Whether it’s getting the “biggest bang for the buck” out of annual gift tax exclusions, use of your one-time lifetime applicable exclusion amount (currently $5,450,000 in 2016), or reducing actual estate or gift taxes, applying appropriate discounts has always been pertinent to accurately determine the fair market value of the property being transferred.
For instance, if Father owned a piece of property worth $100 and gifted 50% of that property to Daughter, the valuation of the undivided one-half interest might only be $40, as opposed to the mathematical value of $50. In a similar vein, if gifts of limited partnership interest or non-voting LLC membership interests in family enterprises are gifted, appropriate valuation discounts for things like lack of control and lack of marketability are applicable.
If the new regulations change the rules and re-define how property is valued for gift and estate tax purposes, the impact will be huge.
As one of my colleagues recently wrote, “The first (regulation project issued this spring) will be new proposed regulations under Section 2704, with time estimates of ‘very, very shortly’ and ‘this spring, before summer’.” If you have put off any estate planning concerning freezing or gifting, time is of the essence. If you are planning to include the many benefits of family limited partnerships and family limited liability companies, or merely gifts of fractional interests, as illustrated in the example above, you may want to get with your advisor immediately.
But what if you do not have children? The answer may not be as clear, but it is no less important.
If you do not specify in a proper Will or Trust to whom and how your want your assets disposed of at your death, the State will do so for you. Generally, the State will find your closest heirs and divide your assets among them. Sound ok since that’s where you would send your assets anyway? Then you should know that intestate (without a will) probate proceedings tend to be much more costly and time consuming than proceedings with a properly drafted Will. The urgency is even greater when you do not want your brother and his kids to inherit your assets. To direct otherwise requires an estate plan.
An estate plan is more than just a will though. A Healthcare Directive and a well-drafted Power of Attorney are key components to a basic estate plan. A Healthcare Directive names someone to make medical decisions for you in the event you cannot do so, it grants such person authorization to access your medical records under HIPAA, and it may include preferences for end of life care in the event of a terminal condition. These directives make it much easier on loved ones to properly care for you in the event you can no longer communicate your medical preferences. Anyone over the age of 18 needs a Healthcare Directive. A parent no longer has automatic access to the medical records of their children after age 18, but so often an 18 year old is still under the care (financially, and otherwise) of their parent.
The last leg of the stool is a properly drafted General Power of Attorney. These may be drafted to be “springing”; so that they spring into effect only upon incapacity. Then, in the event of incapacity, you have previously named a trusted individual to manage your financial and personal affairs. Should incapacity occur without a Power of Attorney in place, a court may appoint a Guardian or Conservator after an administrative process.
These Powers of Attorney and Healthcare Directives are essential documents, even for those individuals who do not feel a will is necessary because they have no children. We, of course, still disagree with that notion, and we will be glad to discuss how each of these components of a good estate plan fit your specific needs.
One estate planning nuance is “beneficiary designation assets.” These are assets that are distributed at death to the person named on a beneficiary designation form, and do not follow the direction of the will. These assets may be life insurance, joint or pay-on-death bank accounts, joint or pay-on-death investment accounts and retirement accounts. During the initial meeting, it is important to discuss the client’s assets and these accounts in particular. If family dynamic has changed, be it from a divorce, death in the family or simply the fact that once small children are now adults, these beneficiary designations may need to be updated. These assets pass outside of probate. Essentially when the account holder dies, upon confirmation of death, the entity which holds the account simply distributes the assets to the named beneficiary.
Retirement accounts (IRAs, 401k plans and the like) are special, however, because they typically allow beneficiaries to prolong withdrawal if properly handled. If the plan allows, beneficiaries may elect to use their own life expectancy in calculating the minimum amount of money which must be distributed each year (this is also called “minimum required distributions”). This is beneficial because it allows a beneficiary to prolong to amount of time the money is in the retirement account, allowing additional potentially tax free growth.
While many individuals choose to leave their retirement accounts to an individual beneficiary, i.e. their spouse or children, there may be good reason to leave such assets in trust. Trusts offer many benefits, including asset protection, especially with the recent Supreme Court decision in Clark v. Rameker, 134 S. Ct. 2242 (2014), in which the Court found that a non-spouse beneficiary’s inherited IRA was not exempt from the beneficiary’s creditors in his bankruptcy estate.
In order to fully take advantage of both the protection a trust offers and the beneficiary’s life expectancy, the trust must be carefully drafted. Such trusts are referred to as “see-through” trusts because the language directs the retirement plan to look through the trust at the beneficiary individually to determine life expectancy. If the trust runs afoul of the rules, however, the consequences are harsh. The trust and its beneficiary’s life expectancy are disregarded and the “5-year rule” applies, requiring a full distribution of the retirement plan assets within 5 year.
This is one of the many reasons it is important to have an attorney who is familiar with these rules to assist you with carefully drafting your estate plan. We would be happy to work with you and your family to craft an estate plan which achieves your goals.
Many of our clients wrestle with the decision to purchase term insurance or permanent insurance. The premiums for term insurance are cheap, particularly when you’re young, while permanent insurance generally provides a level premium with more certainty that a death benefit will be paid.
Term insurance seldom pays a death benefit. The reasons for this are simple. Most people live to, or close to their life expectancy. By the time they have reached their life expectancy, the premiums on term insurance have increased to the point where the insurance is dropped, or the individual has reached an age or health condition that is deemed uninsurable by the insurance company.
For this reason, term life insurance is best for temporary needs such as support for a surviving family (particularly when you are young), funding a buy/sell arrangement for a closely held business, providing cash (key man insurance) for transition of business, and for the repayment of debts.
I often tell clients to load up on term insurance when they are young, partly because it’s so cheap, and partly because their financial “security” needs are so great when their families are young. Of course, the premiums for term insurance are lower because it seldom pays a death benefit. The only usual financial “winners” for term insurance are the insurance agent and the insurance company.
As we get older, financial obligations (except retirement) tend to decrease. Many of us begin to look at permanent insurance as a permanent feature or category of assets that we are accumulating during our lifetime. Most of us want to have a certain portion of our insurance that is ongoing. The insurance can provide liquidity to our heirs, cash to pay estate taxes, a fund to provide for the maintenance of a second home, or a mechanism to equalize the estate where certain hard assets (such as farm, business or vacation home) is necessarily directed to one particular heir, while the other child receives cash.
Permanent insurance generally falls into three categories: whole life, universal life (including universal blends and indexed products) and variable life. Whole life is the most expensive, while universal life is generally the most inexpensive permanent insurance policy. Variable life has more stock market investment features inside an insurance policy wrapper.
Universal life is popular among our clients as it provides guaranteed lifetime coverage at the lowest level of permanent insurance premiums, and generally level premiums can be pre-paid or lowered by lump-sum or higher premiums in early years. Generally, with universal life policies, guaranteed cash accumulation for retirement income or other purposes is not a significant objective. The goal is to lock in a death benefit while keeping premiums as low as possible.
By far, our estate planning clients buy mostly universal life products. While there are many varieties, studies show that the internal rate of return on universal life products is generally positive, where as the internal rate return on any term policy, if clients live to or close to their life expectancy, is significantly negative. In other words, with term insurance, we have thrown our money away unless we die prematurely.
Most term insurance lapses before death. This is fine if the reason for the insurance no longer exists. However, many policy owners want to extend the coverage of their insurance while their health is still good, because they know that the risk of their health changing increases with age and health changes can happen suddenly.
Be aware that term policies can carry a conversion right. This is important, even though it might marginally increase the premium cost, because a client might otherwise become higher risk or uninsurable prior to the expiration of the term policy and be unable to get other insurance.
Generally, our clients are rarely content to allow their insurance policies to lapse when they reach the end of the coverage period. The older we get, the more we see the value of “investing” in insurance as one of our many buckets of asset categories that we are accumulating and tending to during life.
In the volatile tax world, there is good news and bad news. The bad news first.
President Obama is proposing to increase the tax on long-term capital gains from 23.8% on wealthy taxpayers to 28%. His proposal would also increase the tax rate on qualified dividends to 28%. There are separate capital gains schedules for precious metals, collectibles and commercial buildings, and details have not been released concerning these special provisions.
In the estate planning area, we currently have a system which increases the income tax basis of an asset owned at death to the asset’s current fair market value. Therefore, heirs can theoretically sell assets soon after inheriting them and pay little, if any, capital gain. The Obama proposal would eliminate this step-up in tax basis. The Administration has termed this tax basis step-up “the single largest capital gains tax loophole”. Capital gains taxes would be owed at death, in the case of married couple, at the death of the surviving spouse. As a “bone”, the first $100,000 ($200,000 in the case of joint filers) would be free from tax. Couples would have an exemption of $500,000 on the “gains” pertaining to their personal residence, and special provisions would prevent taxes due on inherited small-family businesses until those businesses were sold.
The President has also proposed rolling back the tax-free distribution rules on popular 529 college savings plans, which would make distributions from those plans taxable!
The Administration would require every employer with 10 or more employees to enroll workers automatically in an individual retirement account (IRA). Part-time workers would also have to be covered by company retirement plans.
Finally, the President’s proposal would limit contributions and accruals to retirement plans higher than $3,400,000. Remember, Mitt Romney was reported to have an IRA estimated between $20,000,000 and $100,000,000!
If that’s the bad news, what is the good news? Well, the good news is that the President’s proposals have almost no chance of passing. The Republican-controlled Congress generally thinks that the tax code is progressive enough, that is, taxing the wealthy at higher rates and passing those breaks on to the poor and middle class. However, once proposals are made, they tend to be bandied about for many, many years.
On the estate planning side, one of the major focuses at the present time is to maximize the amount of income tax basis assets achieve when they are inherited by surviving spouses and children. This focus is a result of the significant increase in the estate tax exemption amount, which now sits at $5,430,000 per taxpayer. Therefore, a husband and wife could theoretically be able to pass almost $11,000,000 of assets to their children before their estates incur any estate taxes. If those assets are received by the children with the highest possible income tax basis, then subsequent capital gains are minimized, as well.
In particular, we have been focused, quite frankly, on undoing some of the estate planning that was done over the last 20 or 30 years. When the applicable exemption amount was $600,000, then $1,000,000, then continued to creep higher, the fear was avoiding the 55% federal estate tax upon the death of the surviving spouse. A lot of those estates are no longer taxable (with the almost $11,000,000 of estate tax exemption referred to above). Therefore, we are looking at situations where we are getting appreciated assets back into the hands of our clients so that they can be inherited with a stepped-up income tax basis. That means we are unwinding family limited partnerships and limited liability companies, acquiring highly appreciated assets back from grantor trusts, and doing a myriad of other things that did not appear on the radar screen decades ago.
This serves as a reminder that estate planning is an ongoing process, and planning techniques that were put in place years ago should be reviewed to make sure that they still accomplish all of their desired objectives.
Donald Sterling was the controlling owner of the L.A. Clippers who made racially insensitive comments that went viral earlier this year. After a hefty fine from the NBA, a lifetime ban, and a threat to force him to sell his controlling interest, Mr. Sterling, at age 80, still refused to sell his ownership interest in the team. However, it was not the NBA that forced the sale of the team, it was his wife, Rochelle Sterling (“Shelly”), and the interplay of their estate plan that forced the sale and turned this scenario akin to a made-for-TV movie.
The Sterlings, California residents, created a lifetime revocable trust and funded it with all of their assets, including a controlling stake in the Clippers. Both of the Sterlings were Co-Trustees and primary beneficiaries. The revocable trust is the core document of an estate plan in many states, including California. It controls assets during a person’s lifetime and manages the disposition of those assets at death without the need for the probate process. As Co-Trustees, Donald and Shelly made decisions jointly with regard to their assets.
About the same time as the racial comments came to light, Shelly had Donald evaluated by two doctors for a determination of his mental capacity. The doctors concluded Donald indeed suffered from diminished cognitive ability and was exhibiting signs of Alzheimer’s disease. Pursuant to the Sterling’s revocable trust agreement, Donald could no longer serve as Co-Trustee with such diminished capacity, leaving Shelly as the sole Trustee with sole power to administer the trust’s assets.
Shelly negotiated the sale of the Clippers to former Microsoft CEO Steve Ballmer for $2 billion, despite the protests from Donald. Donald sued to enjoin the sale and sought damages from Shelly and the NBA. He argued that he had the proper capacity to remain Trustee, and that Shelly failed to follow the proper protocol in his medical evaluation; therefore, she was not sole Trustee and did not have authority to sell the Clippers
The dispute went to Probate Court in California where the Judge heard arguments as to whether Donald was properly removed as Co-Trustee based on his mental capacity and whether Shelly had authority to sell the Clippers under the terms of the Trust agreement. In late July, the Probate Court Judge ruled entirely in favor of Shelly and held the sale of the Clippers could proceed even if Donald appealed the ruling. The Judge dismissed the claim that the capacity argument was merely a scheme by Shelly to sell the Clippers.
This case received a lot of attention for Donald Sterling’s racially charged comments, but the case also deserves a lot of attention for highlighting the issues of incapacity and estate planning. As the population ages, reports of dementia, Alzheimer’s disease and other forms of diminished mental capacity are on the rise. Planning for someone else to manage your personal and financial affairs in the event of such illnesses or accident is a crucial part of an effective estate plan. Who you choose to act on your behalf and how it is determined that you are “incapacitated” are equally important. Although the events surrounding the sale of the Clippers were not as Donald and Shelly likely anticipated when creating their Revocable Trust, the Trust functioned exactly how it was intended. Upon the death or incapacity of either Donald or Shelly, the survivor or remaining Trustee would serve as sole Trustee and continue to manage their joint assets, no court intervention needed.
A General Durable Power of Attorney and a Healthcare Power of Attorney or Directive are two key documents that plan for incapacity. Without these in place, a time-consuming and costly court action will be required to name a Guardian or Conservator to manage the affairs of someone who is incapacitated.
Talk to your estate planning attorney about getting these documents in place for your family. If you already have Powers of Attorney, give them a quick review, and make sure they still express your wishes and appropriately plan for the determination of incapacity.
In accordance with IRS Circular 230, this article is not to be considered a “covered opinion” or other written tax advice and should not be relied upon for IRS audit, tax dispute, or any other purpose. The information contained herein is provided “as is” for general guidance on matters of interest only. Hoffman & Associates, Attorneys-at-Law, LLC is not herein engaged in rendering legal, accounting, tax, or other professional advice and services. Before making any decision or taking any action, you should consult a competent professional advisor.