IRC

2016 Estate and Gift Tax Update – A Quick Snapshot

Last year it dawned on me that a lot of us out there, including myself, find ourselves constantly “Googleing” different estate and gift tax thresholds throughout the beginning of the year for a quick refresher on the updated thresholds. The purpose of this post is to provide a snapshot of some of the most common 2016 estate and gift tax thresholds, tax rates, exemptions, elections, etc. Feel free to use this how you see fit. Additionally, if you have any other commonly used 2016 estate and/or gift tax updates that I may have left off the list, please feel free to leave them in the comments.

Federal Gift Tax

Lifetime Exemption: $5,450,000
Annual Exclusion: $14,000
Gift-Splitting: Yes, if married and spouse consents (i.e., annual exclusion is $28,000 for married couples)
Rate: 40% on gifts above the lifetime exemption (plus the annual exclusion)

Federal Generation-Skipping Transfer Tax

Exemption: $5,450,000
Portability: No
Rate: 40% on generation-skipping transfers above the exemption

Federal Estate Tax

Exemption: $5,450,000 (exemption is decreased by lifetime gifts)
Portability: Yes (i.e., surviving spouse may elect to use deceased spouse’s unused exemption, in effect, giving married couples an exemption of $10,900,000)
Rate: 40% on the value of the estate above the exemption amount

Federal Income Tax for Trusts and Estates

Tax Brackets: see chart below
Tax Rates: see chart below
Net Investment Income Tax: A 3.8% surcharge tax on net investment income applies to trusts and estates that are above the $12,300 income threshold (i.e., the marginal tax rate on net investment income above that threshold is then 43.4%)
Distributable Net Income: Net income that is distributed to beneficiaries of a trust or estate is taxed at the beneficiaries’ level and not at the trust or estate’s level

Chart: Federal Income Taxation of Trusts and Estates
If Taxable Income is:	The Tax is:
Not over $2,550	15% of the taxable income
Over $2,550 but not over $5,950	$382.50 plus 25% of the excess over $2,550
Over $5,950 but not over $9,050	$1,232.50 plus 28% of the excess over $5,950
Over $9,050 but not over $12,400	$2,100.50 plus 33% of the excess over $9,050
Over $12,400	$3,206 plus 39.6% of the excess over $12,400

State Taxes

Each State has its own set of rules when it comes to estate tax, gift tax, inheritance tax, and income taxation of trusts and estates. Be sure to check with a professional in your State for an update.

For a complete summary of all 2016 Federal tax-related inflation adjustments see Rev. Proc. 2015-53, available here: https://www.irs.gov/pub/irs-drop/rp-15-53.pdf.

I hope this helps!

-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: 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"

IRC

2016 Estate and Gift Tax Update – A Quick Snapshot

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

The Monthly 5 and 5: The 5 or 5 Power