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Estate Tax Update: Initial Thoughts

The Tax Cuts and Jobs Act of 2017 was signed into law on December 22, 2017, and became effective January 1, 2018 (the “Act”). While most of the Act is made up of provisions that change individual and business income taxes, there were some significant changes to the Estate Tax laws.

We are still awaiting guidance from the IRS with respect to some of the provisions; however, this post will inform you with respect to some of the major changes in the Estate Tax laws and my initial thoughts on some planning opportunities. Note that as these new laws are analyzed and examined, it is anticipated that more planning opportunities will develop and I will update this blog as to such opportunities once further developed. The main purpose of this post is to advise you of the changes made and to give you a starting point when considering your own individual planning.

The Estate Tax is the tax that is assessed against an individual’s total estate and all assets included in such estate when that individual passes away. The Estate Tax rate of 40% did not change. However, the most significant change was the Estate Tax exemption amount doubled. Under the old law, the exemption amount was set to increase to $5,490,000 per individual and $11,180,000 per married couple in 2018; instead, the Act increased this exemption amount to $11,180,000 per individual and $22,360,000 for married couples. Therefore, if an individual passes away with total estate assets valued at less than that exemption amount (including all lifetime gifts), no Estate Tax would apply on such individual’s estate.

This significant increase in the Estate Tax exemption amount presents a number of planning considerations:

If an individual already used part or all of their Estate Tax exemption as part of their planning under the old law, that individual now has at least an additional $5,000,000 in exemption that they could now use in their planning.
Whether or not an individual has used any of their Estate Tax exemption amount already, much consideration should be given as to whether to use some or all of the exemption now. This is because one major piece of this new Act is that it sunsets in year 2026. This means that if no action is taken by Congress before 2026, the Estate Tax exemption amount will go back down to the old law exemption amounts (which would be approximately $6,000,000 per individual in 2026 with inflation adjustments). Thus, it is important to at least consider taking advantage of this increased exemption now. However, the question then becomes, if this new increased exemption amount does sunset in 2026, what will Congress do about individuals who have used more than that new lower exemption amount (i.e., the $6,000,000 exemption)? Will they be grandfathered in and those assets above that amount still not be subject to Estate Tax? Will the amount above the new lower exemption amount be brought back into their estate when they pass away and thus be subject to Estate Tax? These are some of the questions we are still looking to the IRS for guidance on.
This new Act retains the right of the surviving spouse to “port” over the deceased spouse’s unused exemption amount. What this means is if one spouse passes away without using their $11,180,000 exemption, the surviving spouse can elect to “port” over that $11,180,000 exemption in order to retain the benefit of that exemption when that surviving spouse later passes away. This can be extremely beneficial and must be considered as part of every estate plan and when a spouse passes away. Our thought is that even if the exemption amount sunsets in 2026, that this “ported” amount would still be allowed (if a spouse passed away between 2018 and 2026), even at the higher exemption amount. However, there has not been any IRS guidance on this yet. Furthermore, portability should also be used in conjunction with an exemption trust to allow the surviving spouse maximum flexibility.
All of the planning tools that were at our exposure before are still available; the impact of such planning may have changed though. Very briefly and generally, the benefits and risks of Estate Tax planning at this conjuncture are as follows:

Benefits of Estate Tax Planning

Using the Estate Tax exemption while it is available at this increased amount and before it goes away (possibly in 2026 or even sooner if other political changes occur) can be a substantial benefit to transfer more out of your estate tax-free.
Any appreciation on such assets after being transferred will also be out of your estate, providing even more Estate Tax savings.
Not only does it lower the Estate Tax at death, it can also lower your income taxes if you are no longer receiving the income from those assets after you gift them away.

Risks of Estate Tax Planning

We don’t know what will happen when the new Act sunsets in 2026, if that happens. Will the IRS conclude that any amount in excess of the lower exemption amount comes back into your estate? If that happens, will your estate have enough left to even pay the Estate Tax due?
If planning is done, what exemption does it use if you give away less than the future sunset exemption amount (which we believe will be approximately $6,000,000)? For example, if you give away $4,000,000 when the exemption amount is the current $11,180,000 and then later the exemption goes down to $6,000,000, do you only have $2,000,000 of exemption left ($6,000,000 new exemption minus $4,000,000 gifted) or $6,000,000 ($11,180,000 old exemption minus $4,000,000 gifted, but since over the current $6,000,000, capped at $6,000,000)?
For any assets in your estate at your passing, such assets receive a step-up in basis, which means your beneficiaries will not pay capital gain tax on any appreciation up until the date of death. However, for any assets transferred out of your estate, your beneficiaries lose the benefit of the step-up in basis on such assets (i.e., if the asset is sold, the beneficiary will pay capital gain tax on all appreciation). Thus, this loss of the step-up in basis and the assessment of the capital gains tax needs to be weighed against the Estate Tax.
What does the future hold? What will the value of the assets in your estate be when you pass away? Markets can change. What will the Estate Tax law in effect be when you pass away? Political turbulence and changes have this Estate Tax law in a constant flux.

My hope is that this information is helpful and gives you some ideas to consider.

-Matt

The Monthly 5 and 5: Trusts as IRA Beneficiaries – Part 2

Last week in Part 1 of this month’s installment of The Monthly 5 and 5, I discussed five advantages of designating a trust as an IRA beneficiary. In Part 2 below, I will discuss five disadvantages. While this post will focus on IRAs, much of it may also apply to designating a trust as a beneficiary of other kinds of retirement assets. As you read in Part 1, designating a trust as an IRA beneficiary may allow you to achieve many of your estate planning goals; but, there are disadvantages that must be considered. Some of these disadvantages are caused by poor trust drafting and are avoidable, while others you are stuck with. Again, it should be noted that the discussion below is very summarized and only covers general rules; an experienced professional should be contacted before designating a trust as a beneficiary of your IRA (or other retirement asset).

Five disadvantages to designating a trust as an IRA beneficiary:

1. Stretch-Out of IRA Balance

Recall in Part 1 that if a trust is properly drafted and designated as in IRA beneficiary, the IRC allows you to “look through” the trust and “stretch out” the IRA balance over the trust beneficiary’s life expectancy. This allows the IRA balance to be protected and grow over a longer period of time; thus, creating more wealth to be transferred to the beneficiary. However, if the trust is not properly drafted, two things could happen: First, if the trust does not qualify under the IRC as a “look through” trust, then the trust will not be considered a qualified beneficiary of the IRA. Depending on the circumstances, this means that the entire IRA balance will have to be withdrawn within five years of the deceased owner’s death or the annual required minimum distributions will have to be taken over the deceased owner’s life expectancy instead of the trust beneficiary’s life expectancy. In most cases, this will result in a loss of any growth the IRA balance may have accrued over the beneficiary’s longer life expectancy and, most importantly, the beneficiary will have unfettered access to the entire IRA balance much sooner than you may have wished.

The second thing that could happen is: even if the trust does qualify under the IRC as a “look through” trust, and thus, considered a qualified beneficiary of the IRA, the trust may still be drafted poorly when considering the trust beneficiaries’ respective life expectancies. When determining which beneficiaries’ life expectancy to use to stretch out the IRA balance and calculate the annual required minimum distributions, the IRC requires you to use the life expectancy of the oldest beneficiary of the trust. Therefore, if the beneficiaries of the trust include both your 15 year old child and your 85 year old brother, the 85 year old brother’s life expectancy is what the annual required minimum distribution is going to be calculated with. This results in a much, much shorter stretch out than you may have wanted; again, causing loss in growth and protection of the IRA balance. If the trust and beneficiary designation had been drafted properly, both of the disadvantages above could have been avoided.

2. Taxes

Furthermore, recall from Part 1 the added tax advantages of stretching out the IRA balance over the trust beneficiary’s longer life expectancy. If the trust is drafted improperly like discussed above (i.e., the trust is a nonqualified beneficiary or the trust has an older beneficiary), then the tax advantages of stretching out the IRA balance are quickly lost. If the trust is a nonqualified beneficiary, then the IRA funds will have to be withdrawn within five years of the deceased owner’s death or over his/her shorter life expectancy, not allowing the beneficiary to reap the benefits of longer tax deferral as discussed in Part 1. The same is true if there is an older trust beneficiary that causes the annual required minimum distributions to be withdrawn over a much shorter life expectancy than otherwise could have been achieved.

Additionally, because the entire IRA balance will have to be withdrawn over a much shorter period of time (whether the trust is a nonqualified beneficiary or has an older beneficiary), this will generate more taxable income to the trust and/or trust beneficiary each year. This may result in the trust and/or trust beneficiary jumping into a higher tax bracket and thus, paying more in taxes on the IRA income than they would have had to if it had been stretched out over a longer period of time. Again, with proper drafting the above tax consequences could have been avoided.

Also note that the income tax brackets for a trust are much more condensed than individual income tax brackets; thus, if the annual required minimum distribution from the IRA is held and accumulated in the trust instead of distributed out to the beneficiary each year, this may result in higher income taxes.

3. Complicated & Costly

Designating a trust as an IRA beneficiary is both complicated and costly. It is complicated because the rules governing trusts as IRA beneficiaries are extremely complex and convoluted. There is no easy way about it. Both the trust document and the IRA beneficiary designation form must be completed correctly, considering a mess of rules, to ensure that your wishes are carried out the way you intended. There are many rules and options for the IRA owner to consider and that is why you need to work with a professional to ensure it is done correctly.

Because professional advice and drafting must be sought to designate a trust as an IRA beneficiary, it can be costly upfront. Drafting a trust is not cheap, and most experts would agree that because of all of the complicated rules, a separate trust should be created for your IRA; you should not use your everyday ordinary revocable living trust. And, not only may it be expensive upfront, but once the trust becomes the IRA beneficiary after the deceased owner’s death, there will be ongoing administration costs. The trust will most likely have to be professionally managed by a trustee to ensure it continues to comply with the IRC rules governing IRAs and the trust will have to file its own income tax returns each year. While these added costs may be justifiable in some circumstances, they may not be in others.

4. Spouse Loses Rollover Option

There may be reasons why an IRA owner may want to designate a trust for the benefit of his/her spouse as the IRA beneficiary instead of his/her spouse personally (e.g., in second marriage situations). However, those reasons must be weighed against the disadvantages of that designation. If the spouse is personally named as beneficiary of the IRA, he/she has the option of inheriting the IRA or rolling over the IRA into his/her own name. While there may not seem like much of a difference there, there can be many added advantages to rolling the IRA over into the spouse’s own name instead of the spouse inheriting the IRA (e.g., tax benefits, including greater tax deferral and Roth conversions). If the trust for the benefit of the spouse is instead named as the IRA beneficiary, the spouse can only inherit the IRA, and may not roll it over into his/her own name; thus, losing some of the added benefits to doing so.

5. Heirs Lose Flexibility

Individuals (a/k/a grantors) set up trusts for beneficiaries to restrict and control distributions. A trustee of a trust ensures that the beneficiaries only receive and spend the trust funds according to the deceased grantor’s wishes. A beneficiary does not have unlimited and unfettered access to the funds held in the trust. This is the way the grantor wanted it. However, if the grantor really has no reason to put restrictions on how the IRA funds are used, or is not worried about their heirs being spendthrifts or subject to creditor claims, or has no minor or disabled heirs, then why name a trust as an IRA beneficiary? Just name your heirs as the individual beneficiaries personally. They are afforded much more flexibility in stretching out the IRA balance or cashing it in to pursue other investments. Additionally, it is much less complicated and costly. While a trust as an IRA beneficiary gives the IRA owner the greatest flexibility in controlling those IRA funds beyond the grave, it leaves the beneficiary with the least amount of flexibility in later controlling and using those funds.

As you previously read in Part 1 and above in Part 2, the advantages and disadvantages of designating a trust as an IRA beneficiary can be great. The advantages can really help you accomplish your estate planning goals; but, on the flip side, the disadvantages need to be weighed against those advantages. While some of the disadvantages discussed above are unavoidable, others are caused by poor drafting and are avoidable. Designating a trust as an IRA beneficiary should never be done on the whim; but, with proper professional advice and drafting, and after fully considering the advantages and disadvantages associated with designating a trust as an IRA beneficiary, you can make an informed decision. It certainly is not for everyone, but for some it is certainly necessary.

– Attorney Matthew D. Brehmer

The Monthly 5 and 5: Trusts as IRA Beneficiaries – Part 1

In this month’s installment of The Monthly 5 and 5, I will be discussing five advantages and five disadvantages of designating a trust as an IRA beneficiary. In part one below, I will discuss five advantages; I will post part two discussing five disadvantages next week. While this post will focus on IRAs, much of it may also apply to designating a trust as a beneficiary of other kinds of retirement assets. As you will read below, designating a trust as an IRA beneficiary may allow you to achieve many of your estate planning goals; but, if the trust is drafted improperly, the results could have a substantial unintended impact on your estate plan. It should be noted that the discussion below is very summarized and only covers general rules; an experienced professional should be contacted before designating a trust as a beneficiary of your IRA (or other retirement asset).

Five advantages to designating a trust as an IRA beneficiary:

1. Stretch-Out the IRA Balance

When an individual is designated as a beneficiary of an IRA and the owner of that IRA passes away, the beneficiary becomes the owner of an “inherited IRA.” With an inherited IRA, the IRC allows the beneficiary to “stretch out” the IRA balance over their life expectancy instead of being required to either withdraw all of the IRA funds within five years of the deceased owner’s death or take required minimum distributions over the deceased owner’s life expectancy (which may be much shorter if the beneficiary is much younger, i.e., the beneficiary is the owner’s kid). If only the required minimum distribution based on their own life expectancy is withdrawn every year, the balance is left to grow, thus creating more wealth to be transferred to the beneficiary.

Likewise, if a trust is set up properly and designated as a beneficiary of an IRA, this same stretch-out is allowed. The IRC allows you to “look through” the trust and base the required minimum distribution on the trust beneficiary’s life expectancy. Thus, the trust can achieve the same stretch-out discussed above as if the individual was named personally. The added bonus that the trust provides is that the beneficiary cannot cash in the entire IRA balance immediately after the death of the IRA owner; like they could if they were named personally. The IRA balance is protected by the trust and only the trustee of such trust would be allowed to cash it in or take distributions greater than those required each year. This protects the beneficiary from squandering all of the money immediately after the owner’s death on something that may not be as advantageous as saving the money for the future, which may be what the deceased owner would have wanted.

2. Defer Taxes

Another benefit of stretching out the inherited IRA over the beneficiary’s life expectancy is greater tax deferral. Since taxes on the funds in the IRA will not be paid until they are withdrawn from the IRA, that leaves more in the IRA to grow and compound, thus creating more wealth to be transferred to the beneficiary. By designating a trust as an IRA beneficiary instead of the individual personally, the trust can ensure that the beneficiary takes advantage of this tax deferral by not allowing the beneficiary to cash in the IRA immediately after the owner’s death, which the beneficiary could do if they were personally designated as the IRA beneficiary.

Additionally, suppose that the beneficiary is personally designated as the IRA beneficiary and does cash in the entire IRA immediately after the owner’s death. This may cause the beneficiary’s total income for that year to jump up into a higher tax bracket. The result: the beneficiary ends up paying more in taxes on that IRA balance than they would have had they spread it out and withdrawn it over their life expectancy instead. Again, the trust can ensure that the beneficiary does not immediately cash in the IRA and increase the overall tax liability on the IRA funds.

3. Asset Protection

If a trust is designated as beneficiary of an IRA, all of the traditional trust asset protections could apply to that IRA. This means that if the trust is properly drafted, the IRA balance may be protected from creditors, bankruptcy, and/or a divorcing spouse. While an IRA is typically afforded bankruptcy protection if the original owner of the IRA files bankruptcy, it is not afforded that same protection if a beneficiary later inherits the IRA personally and files for bankruptcy (see the U.S. Supreme Court’s 2014 decision in Clark v. Rameker). However, by properly drafting a trust and designating it as the beneficiary instead of the individual personally, the IRA could be afforded bankruptcy protection.

4. Protect Minor and/or Disabled Heirs

Another reason why individuals set up trusts is to protect and provide for their minor and/or disabled heirs. If the trust is properly drafted, it can be designated as the IRA beneficiary and those IRA funds can be protected and used accordingly to provide for any minor and/or disabled heirs. If instead the minor and/or disabled heirs are personally named as the IRA beneficiary, the IRA funds may not be managed and controlled like they would be in a trust for the minor and/or disabled heirs. Additionally, if they are designated personally as an IRA beneficiary instead of a trust, the minor heirs could get outright access to the funds at age 18 (or age 21 in some states) and the disabled heirs may lose their public benefits until they spend down the IRA funds.

5. Control Distributions

Furthermore, individuals will typically include trusts in their estate plan if they would like to have some say in, limit or completely control distributions to the beneficiaries. If properly drafted, the same can hold true for a trust that is a beneficiary of an IRA. The IRA owner may designate a trust as the IRA beneficiary because the owner wishes to control when or how the beneficiary receives the IRA distributions. This can be for a variety of reasons: to provide spendthrift protection, to transfer some of the wealth to future generations, etc. The same would not hold true if the beneficiary was personally designated as the IRA beneficiary instead of the trust.

As you read above, the advantages to designating a trust as an IRA beneficiary can be great. It can really help you accomplish your estate planning goals. However, as you will read in the second part of this post next week, there are disadvantages that need to be considered. Some of these disadvantages are caused by poor trust drafting and are avoidable, while others you are stuck with. Designating a trust as an IRA beneficiary should never be done on the whim; but, with proper professional advice and drafting, and after fully considering the advantages and disadvantages associated with designating a trust as an IRA beneficiary, you can make an informed decision. It certainly is not for everyone, but for some it is certainly necessary.

– Attorney Matthew D. Brehmer

The Monthly 5 and 5: The 5 or 5 Power

Each month I will be publishing a post discussing five advantages and five disadvantages of a particular estate planning technique – the post will be called The Monthly 5 and 5. In this first installment of The Monthly 5 and 5, I will be discussing the “5 or 5 power.” Notice the similarity? Yes, that’s right, the “5 or 5 power” was inspiration for The Monthly 5 and 5.

The “5 or 5 power” gives a beneficiary of a trust the power in any calendar year to withdraw the greater of $5,000 or 5% of the trust’s assets. This means that for any trust with assets of less than $100,000, the beneficiary will have the power to withdraw up to $5,000 each year; and, for any trust with assets of more than $100,000, the beneficiary will have the power to withdraw up to 5% of the value of the trust’s assets each year (i.e., because 5% of $100,000 is $5,000).

You may be asking yourself: Why $5,000 or 5%? What’s so magical about those numbers? Well, put most simplistically, because that is what the Internal Revenue Code (IRC) says. In order to avoid certain consequences, this annual withdrawal power is limited to $5,000 or 5% of the trust’s assets under the IRC. Why is it important to abide by the IRC? Well, for instance, if instead, you gave the beneficiary more than a $5,000 or 5% annual power to withdraw, the beneficiary’s withdrawal power could be deemed a general power of appointment over the trust and some or all the assets in the trust could be included in the beneficiary’s estate for estate tax purposes. This could create devastating tax consequences for the beneficiary.

Below are five reasons (each with an advantage and disadvantage) why the “5 or 5 power” can be a useful estate planning tool:

Reason 1: Minimum Distribution

Let’s say that the trust allows the trustee to only distribute the income of the trust (and not any of the trust principal) to the beneficiary each year for the beneficiary’s support. If in a particular year the trust generates very little income, the 5 or 5 power allows the beneficiary the power to withdraw up to $5,000 or 5% of the trust’s assets that year regardless of the amount of trust income.

Advantage: At a minimum, the beneficiary will be able to receive at least $5,000 per year for support.

Disadvantage: The amount subject to the beneficiary’s 5 or 5 power may not be protected from the beneficiary and/or creditors of the beneficiary.

Reason 2: Strict Trustee

Let’s say that the trust allows the trustee to distribute income and/or principal only for the health, education and support of the beneficiary. If a trustee is particularly strict when following this standard and distributes very little to the beneficiary, the 5 or 5 power allows the beneficiary the power to withdraw up to $5,000 or 5% of the trust’s assets each year even if it is not for the health, education and support of the beneficiary.

Advantage: The beneficiary will be able to withdraw at least up to $5,000 per year without having to satisfy the trustee that it is being used for health, education and support.

Disadvantage: The beneficiary could exhaust the trust more rapidly than intended over time, whether the trust is small (i.e., $5,000 withdrawn each year) or large (5% of trust assets are withdrawn each year), when the main purpose of the trust may have been to transfer wealth to future generations.

Reason 3: Benefit Without Estate Inclusion

Let’s say that both the trust grantor and his wife are near their lifetime exemption amounts for estate taxes (i.e., if they go over their exemption amount, part of their estate will be subject to estate taxes). The trust grantor sets up a trust for the benefit of his spouse during her lifetime with the remainder going to his children at his wife’s death. Here, the 5 or 5 power allows the wife to use the trust as another source of support and income during her lifetime (limited to $5,000 or 5%) but does not substantially increase her estate for estate tax purposes at her death.

Advantage: The amount of trust assets not subject to the 5 or 5 power are not included in the wife’s estate at her death; and, thus, not subject to estate taxes at her death.

Disadvantage: The amount of trust assets subject to the 5 or 5 power (i.e., the greater of $5,000 or 5% of the trust’s assets) will be included in the wife’s estate at her death; and, thus, if including this amount in her estate causes her total estate to exceed her lifetime exemption amount, the amount that exceeds the lifetime exemption amount will be subject to estate taxes at her death.

Reason 4: Crummey Trusts

Let’s say that the trust grantor set up a Crummey Trust for his two children. Each year his two children allow their right to withdraw the amount of the annual gift to lapse. When a beneficiary allows their withdrawal right to lapse, it is considered a deemed gift to the other beneficiaries of the trust. However, by adding the 5 or 5 power to the Crummey Trust, the lapsing of the withdrawal right is only considered a deemed gift to the other beneficiaries so much as it exceeds $5,000 or 5% of the trust’s assets.

Advantage: If the amount of the annual gift to the Crummey Trust is less than or equal to $5,000 or 5% of the trust’s assets, there will be no deemed gifts to the other beneficiaries by allowing the withdrawal right to lapse.

Disadvantage: While the main purpose of a Crummey Trust is to protect the trust assets from the beneficiaries until you see fit (as spelled out in the trust document), the 5 or 5 power gives the beneficiaries unfettered rights to withdraw up to $5,000 or 5% of the trust’s assets each year, regardless of the amount of the current year’s gift.

Reason 5: Hanging Crummey Trusts

Let’s use the same scenario as in Reason 4 except that the amount of the annual gift exceeds $5,000 or 5% of the trust’s assets. If the amount of the gift exceeds $5,000 or 5% of the trust’s assets, it is considered a deemed gift to the other beneficiaries of the amount in excess of the 5 or 5 power; and, thus, possibly causing gift tax consequences for the beneficiaries in the future. However, by adding a “hanging Crummey” provision, the amount of this deemed gift can be eliminated over time (I will explain this further in another post).

Advantage: Over time, the amount of any deemed gift to the other beneficiaries caused by allowing the withdrawal right to lapse will be eliminated; thus, not creating gift tax consequences for the beneficiaries in the future.

Disadvantage: The “hanging Crummey” provision allows the beneficiary to have continued withdrawal rights over the accumulated amount of gifts that have not yet been offset by the 5 or 5 power; thus, allowing such withdrawal rights to possibly substantially increase over time, contrary to what the trust grantor may have intended.

As you can see above, adding a “5 or 5 power” to a trust document may be done for a number of reasons and it does have some really important advantages. But, like most things in life, the advantages must be weighed against the disadvantages. As always, if a “5 or 5 power” is something you are considering, you should consult an experienced estate planning attorney. It will be each individual’s personal situation and wishes that will control whether or not the advantages outweigh the disadvantages of utilizing a “5 or 5 power” in their estate planning.

– Attorney Matthew D. Brehmer

Crummey Estate Plan

All Things Estate Planning – Putting You "In the Know"

advantages

Estate Tax Update: Initial Thoughts

The Monthly 5 and 5: Trusts as IRA Beneficiaries – Part 2

The Monthly 5 and 5: Trusts as IRA Beneficiaries – Part 1

The Monthly 5 and 5: The 5 or 5 Power