"Render more service than that for which you are paid and you will soon be paid for more than you render"
This final Chapter will conclude the study of Trusts, and will offer several time-tested estate planning conclusions.
The remaining Trust discussions will divide Trusts into charitable Trusts, and other Trusts for estate planning purposes.:
1. Charitable remainder Trust.
2. Charitable lead Trust.
3. Charitable gift annuity.
NOTE: Please refer to SUPPLEMENT section in back of this text for details on application of Charitable Trusts in respect to 2001 Tax Law
As discussed, there are many advantages for charitable planning during a lifetime. Most notably, an individual may secure a lifetime income, save on income and estate taxes, enjoy the satisfaction of making a gift and, if one wishes, receive public recognition. Because the organization knows it will receive the gift at some point in the future, it can plan future projects and programs now, and benefit even before it receives the gift. One of the most commonly used forms of charitable tax planning is called the charitable remainder Trust. It is a way a client can convert a highly appreciated asset (such as real estate or stocks) into lifetime income without having to pay capital gains on the sale or estate taxes upon death. At the same time a client can benefit one or more charities or organizations that have special meaning. Anyone who is 50 or older, owns a highly appreciated asset, who is in a high income bracket and would like to enjoy profits now but want to avoid capital gains and estate taxes, should give this Trust every consideration.
An individual places a highly appreciated asset into an irrevocable Trust, naming one or more qualified charities as beneficiary. The Trustee then sells the asset at full market value, paying no taxes on the capital gain, and reinvest the proceeds in income-producing assets, which will grow tax-free. For the rest of the one's life, the Trust will pay an income when the individual dies, the remainder of the Trust assets (the principal) will go to the charity. If an individual just decides to sell the property themselves and reinvest the proceeds then they would pay more in income and estate taxes and have less left for the beneficiaries.
CONSUMER APPLICATION
Twenty years ago Percy purchased a piece of real estate for $100,000. He had is appraised recently and discovered that is now worth $500,000. However, now that Percy is 55 years old and looking forward to retirement, he feels that he would rather have the money in Mutual Funds or other investments, and not have to worry about the real estate. If Percy sells the property, he would have a capital gain of $400,000, which is taxable as ordinary income in the year that the asset is sold. Therefore, Percy would have to pay approximately $113,000 in federal income taxes which leaves only $387,000 to invest.
Percy realizes that if he should die, estate taxes will also have to be paid. If the property value had increased to $1,400,000 at the time of his death, his estate would be in the 40% estate tax bracket. Percy’s estate would lose another $154,800 from the property in estate taxes. That makes a total of $267,800 in income and estate taxes, leaving only $1,232,200 for the beneficiaries.
Percy’s estate planner suggests that he put his funds into a charitable remainder Trust. The income taxes on the capital gain and estate taxes are eliminated, plus, in the year the property is placed into the Trust, the individual can take an immediate charitable tax deduction, reducing current income taxes. The Trustee sells the property for the full market value and because there are no capital gains taxes on the sale, reinvests the full $500,000 in a balanced portfolio (like stocks and bonds) to provide the individual with a lifetime taxable income. Now the entire $500,000 is working instead of only $387,000.
The amount of income received from the Trust is flexible, and will depend upon how much income is needed, the value of the property, age, life expectancy, etc., of the client. For example, if Percy elects to receive an annual income from the Trust equal to 8% of the Trust's assets, for the first year, then Percy will receive $40,000 in income (8% of $500,000). If the Trust is well managed, it will grow quickly because whatever the Trustee earns over 8% will be added to the Trust assets and reinvested tax-free. The Trust is revalued each year to determine the dollar amount of income to be received. As the Trust grows, income will grow also as Percy would be receiving 8% of a larger amount.
The Charitable Remainder Trust (CRT) is one of the most flexible instruments in estate planning. Since at the end of the donor’s life, the charity(s) receive the remainder after the lifetime income of the donor has been subtracted, this is called as a “Split Interest” trust. There are two interests: the income interest and the charitable interest, and when the trust is property drawn up, the CRT can benefit both interests.
There are two basic kinds of CRT’s. One kind pays a fixed income to the income beneficiaries while the other pays a variable income. When it pays a fixed income, it is called a Charitable Remainder Annuity Trust (CRAT). When designed to pay a variable income, the CRT is called a Charitable Remainder Uni-trust, as discussed in the next section. To differentiate, the CRAT is fixed income, and CRUT is variable income. (Again, acronyms – one has to think of a convention of estate planners, discussing the merits of “Cruts” and “Crats”…)
Generally, the CRAT is used for older income beneficiaries who want to be able to plan on a fixed amount of income each year for the rest of their lives. On the other hand, the CRUT is usually younger donors who are afraid that inflation could erode the value of a fixed dollar amount.
(Please note the SUPPLEMENT section at the back of this text for example of how this trust can be used with 2001 Tax Law.)
Using the above Consumer Application as an example, the Trust can include a “make-up” provision, so if the Trust does not earn enough to pay 8% one year, it will make up the difference in a better year. Since a percentage of the value of the Trust assets are being paid, this is referred to as a charitable remainder Uni-trust. If the individual elects instead to receive a fixed amount of income each year, this would be called a Charitable Remainder Annuity Trust.
This means that the amount of income received is guaranteed, it will not go down if the Trust has an "off" investment year. But it also will not increase if the Trust does well, because they want protection against inflation, many people prefer to receive a percentage of the Trust's assets as income (the Uni-Trust).
The charitable income tax deduction is based on the amount of income the taxpayer receives, the size of the gift and the age. (Basically the more elected to receive in income, the less the deduction will be.) It is limited to either 30% or 50% of the adjusted gross income, depending on how the IRS defines the charity and the type of asset involved. If the entire deductions are not used in the first year, it can be carried forward for up to five years.
The best assets for a charitable remainder Trust are those that have greatly appreciated in value since purchased, including real estate, a closely held company and publicly traded securities.
Although the client can be the Trustee of his/her charitable remainder Trust, it's usually not a good idea because of the lost tax advantage if the Trust is not administered correctly. Anyone can be named but because of the investment and administrative experience required, many clients choose a corporate Trustee. Some charities also like to be the Trustees, and frequently the charity will pay for the cost of setting up the Trust in return for being named the Trustee in addition to beneficiary. Keep in mind that, if an individual elects to receive a percentage of the Trust value (the Uni-Trust), they are depending on the Trustee's investment performance for their income. It will be important to be sure the Trustee has a good past performance record as an investor!
Most people will not be their own Trustees, however they still have some control. Until they die, the Trust controls the assets transferred to the Trust - not the charity that will eventually receive them. The Trustee selected must follow the instructions in the Trust. Also, an individual can retain the right to change the Trustee at any time. It is also possible to change the beneficiary of the Trust, but only to another qualified charity. Otherwise the tax advantages are lost. Generally, once an irrevocable Trust is signed, no changes may be made.
In this example, the Trust was set up to pay a lifetime income to the creator, but there is quite a bit of flexibility. If one is married, the Trust can pay an income for as long as either of the married couple is alive. The Trust could also be set up to last for the combined lives of the children. The person who receives the income doesn't even have to be related to the creator, or even be a person. Also, instead of lasting for someone's lifetime, the Trust can be set up to last for a set number of years , up to 20. One can also defer the income until later. For example, one may want to sell the property now to be free from management headaches, but aren't yet ready to retire and do not need the income. One can set up the Trust, taking the income tax deduction in that year, and the Trustee will invest the Trust assets. By the time the individual is ready to receive an income, the Trust, with good management, will be substantially greater in value, resulting in a higher income.
These types of Trusts are popular with those individuals with no children or whose estates are quite sizable, (the property placed in a charitable remainder Trust may only be a small percentage of total assets). The question remains, what if this asset is a large part of the estate? Obviously, the children will not be very happy about losing such a large inheritance. There is a easy way to replace the value of the asset so everyone wins.
By using the income tax savings and part of the income received from the charitable remainder Trust, a person can fund an irrevocable life insurance Trust. Each year the person can "give" money to his/her life insurance Trust, and the Trustee can then purchase enough life insurance to replace the value of the property. When the person dies, the children will receive the full proceeds from the insurance Trust without Probate, and free from income and estate taxes.
Life insurance is the fastest and most inexpensive way to replace the property. This combination of the charitable remainder Trust and irrevocable life insurance Trust should keep everyone satisfied.
The Tax Reform Act of 1997 (TRA 97) provided some limitations to Charitable Remainder Trusts.
Some taxpayers found that Charitable Remainder Trusts could be used as a method to avid payment of capital gains tax on assets that were highly appreciated, instead of using it as a bona fide deferred charitable giving mechanism. These taxpayers could set up short-term, high-payout Trusts to avoid most of the capital gains tax upon the sale of the appreciated assets.
So as to eliminate this practice, the TRA 97 imposes a limitation: The Trust will not qualify as a Charitable Remainder Trust if the annual payment from the Trust is more than 50% of the initial fair market value of the Trust assets (for Charitable Remainder Trusts); and 50% of the annual value of the trust assets (for Charitable Remainder Uni-trust).
The second limitation imposed by TRA 97 is that the value of the remainder interest for charity in a Charitable Remainder Trust, must be at last 10% of the net fair market value of property as of the date the property is contributed to the Trust. This limitation can be quite significant, as it limits a taxpayer’s ability to establish a Trust with successive lifetime interests prior to ultimate payment to the charity.
Basically, a charitable lead Trust is just the opposite of a charitable remainder Trust. With a charitable lead Trust, the charity receives the income from the Trust now and the beneficiaries will eventually receive the principal (the charity “leads”, i.e., participates prior to the other beneficiaries in receiving benefits of the Trust).
A charitable lead Trust can also reduce income taxes, reduce or eliminate estate taxes, and allow the individual to make a contribution to one or more qualified charities. Unlike a remainder Trust, however, one would be interested in lead Trust if one does not need income and wants a beneficiary other than the charity (usually the spouse and/or children) to eventually receive the Trust assets.
If the annual income paid to the charity is a percentage, and the amount fluctuates, depending on investment performance, it is called a Charitable Lead Uni-Trust. If the income is a fixed amount (the same dollar amount paid every year), it is called a Charitable Lead Annuity Trust.
With a gift annuity an individual (or whoever is named as beneficiary) will receive a guaranteed income for life in exchange for making a direct gift to a charity (in cash, real estate, or another asset). The income will be paid in the form of an annuity, which means each payment received will be for the same dollar amount. Part of each payment is a return to the individual of your gift (the principal). Soon only a portion is taxable as ordinary income. One can begin receiving the income immediately when the gift is made or the income can be delayed until a later date (usually at retirement, when income -and tax bracket- is lower). If the income is delayed, this is called a deferred gift annuity. Under this option, the income will be higher because the original investment will have time to grow. Regardless of when the income begins, one can take a charitable income tax deduction in the year the gift was made. Upon death (or the death of the last beneficiary) the charity will keep the remaining principal and any undisturbed income.
If an individual does not have significant assets to contribute to a charitable reminder or lead Trust, or if the person prefers to make smaller contributions over a period of time this fund should be considered. The individual would make these contributions directly to the charity and the charity will "pool" the contributions with others and invest them together. The contributions then become "shares" of the fund (similar to a mutual fund). The individual (or a designated beneficiary) will receive a lifetime income from the fund. When the last beneficiary dies, the share will transfer to the charity. The gifts can be made in cash, stocks, or bonds, and the individual receives an income tax deduction in each year he/she makes a contribution.
This is an arrangement through which one can give a portion or all of their home, vacation home or farm to the charity of choice while they are still living. Until death, the individual would continue to enjoy the property as if it is still owned. One can live in it, take care of it, and keep any income it may generate. This option is usually considered when an individual is planning to give the property to charity after death anyway, but wanted to take the charitable income tax deduction while still alive. One will also save on estate taxes by removing the property from the value of the estate.
An individual may give a charity the right to use a piece of property for a certain number of years as a public park, a wildlife refuge, an historic landmark, etc. or, one could give away just the mineral rights to a piece of real estate and keep the land in the family.
The tax advantages of this type of gift are generally less than others mentioned.
One may have certain investment or valuables (for example art, musical instruments, books, etc) that could be given to a charity, not to have them sold and proceeds reinvested, but rather to have them to be enjoyed.
For an individual to receive a charitable income tax deduction, the gift must be related to the charity's tax-exempt purpose. For example, gifting artwork, antiques or jewelry to a museum, books to a university or library, musical instruments to a symphony, etc.
This is often overlooked as a gift. An individual can give an old policy to a charity, making it both the owner and the beneficiary or the individual can work with a charity and have it purchase a new policy on his/her life (the charity should be the applicant, owner and beneficiary). In either case a charitable income tax deduction is available.
Note: As this section which is devoted to Trusts, ways to reduce/eliminate estate taxes and more through the utilization of three Trusts are discussed. The "A,” "B,” "C" Trusts and the qualified terminable interest property Trust-Q-TIP Trust provide valuable tax planning benefits and other advantages, such as how an individual can provide for a surviving spouse yet keep control of certain assets, and how one can protect assets in the event either husband or wife suffer a catastrophic illness or injury.
To avoid any confusion it is important to explain the two kinds of taxes that must be paid when a client dies, income taxes and estate taxes.
Regardless of Trust status, an estate must file a final federal income tax return just as is done every year. (Depending on the state residence there could be a state income tax return required also). Any income received in the year must be reported and any taxes due on that income must be paid. A Trust has no effect whatsoever on income taxes.
As been discussed before the federal estate tax (also called a death tax) will also have to be addressed. If the net value of the estate is more than $650,000 upon death federal estate taxes must be paid from the estate before it is distributed to any beneficiaries beginning at a tax rate of 37%. This is, in effect a "double" tax. Over the years, one has already paid income taxes on the money and assets that now make up their estates. And unless we can plan ahead, the estate may have to pay taxes on these assets again. But with proper planning, a Trust can reduce or eliminate these estate taxes.
Fortunately, as discussed before, Uncle Sam has a plan to reduce estate taxes for the first to die. To recap the mechanism of the marital deduction, when an individual dies, he/she can leave any amount of assets to their spouse and it will not be taxed at the death of that individual. There is no limit on the value of assets one spouse can leave to the other tax-free. So far so good!!
But when the surviving spouse dies, the full amount of the estate (what the spouse owns plus what was left by the first to die) will be taxed before it can go to any of the beneficiaries. And, depending on how much longer the spouse live, it could be worth substantially more than when the first person died. The estate is entitled to claim a tax exemption. Currently, the amount is equal to $650,000, so the first $650,000 of the estate can go to the heirs tax-free.
This is the problem: Both individuals (husband/wife) were entitled to a $650,000 exemption if they had planned ahead. Husband and wife could have passed on up to $1.3 million to their beneficiaries tax-free, but now the estate is only entitled to one $650,000 (your surviving spouse's exemption). Uncle Sam is very patient (and smart) and he will wait until the surviving spouse dies and gambles that the government will collect more taxes on a much larger estate.
Many of your clients do not think their estates are anything close to $650,000 so they don't worry about tax planning. But keep in mind, people are living longer (particularly women, who often outlive their husband by many years) and even a small estate can increase tremendously in value over time especially if one owns a home or other real estate if he/she own substantial life insurance.
At this point in this discussion, the Personal Residence Trust must be mentioned. Earlier in the text, there was a discussion of passing real estate, and more specifically, the family home or farm, by using Deed designations. A Trust can also be used to accomplish the same purposes by using the Personal Residence Trust, or also known as the “Grantor Retained Income Trust” (or GRIT - now we have GRIT, CRAT and CRUT !)
When using this trust the grantor transfers the home to the trust, lives in the home, and the value of the home for estate tax purposes has been frozen. However, if this is used, the property owner no longer owns the resident and at some future time (usually at death) the property will completely pass to offspring. Actually, according to those planners who advocate the use of this trust, the individual will pay rent to the child once the ownership of the residence has passed to the child. Some planners object to this vehicle because they do not want to see the parent without ownership of his/her personal residence.
Some planners fear that a lawsuit against the child who becomes the owner, could cause the parent to lose their home. This is a legitimate concern and is the reason that it is not used more often. Our society is particularly litigious and these situations do arise.
However, for a single parent with only one child who is not in a highly litigious profession, this plan may work well. As the purpose is to save estate taxes, it should be used, of course, only by families that have a highly taxable estate.
The liquidity problems of family farmers originally persuaded Congress to take some action, leading to Section 2032A which applies to the valuation of real estate used in a farm or closely held business. The executors of deceased farmers had been forced to sell the farm just to pay estate taxes on the value of the farm.
Usually, the “fair market value” of real estate for the purpose of estate taxation is based on the highest and “best use” of the property. The use of real estate for farming may not be the highest value activity for a farm, e.g. farms located near rapidly – expanding urban areas wherein the farm could be used for development. This Section 2032A is designed to value the property at its current use, when certain conditions are met. This can reduce the value of the gross estate by up to $750,000, reducing taxes and ease the liquidity needs of the estate.
To qualify for this valuation, the following requirements must be used.
If the “qualified heir” (see above) disposes of the property within 10 years after the decedent’s date of death, 100% of the estate tax savings resulting from this 2032A valuation is recaptured. However, the recapture tax is phased out between the 10th and 15th years following the decedent’s death.
As with the discussion of Recapitalization and Estate Freezes immediately following, this is not technically a discussion of “Trusts” but illustrates and demonstrates a tax provision that can be used in certain situations, usually when planning and the estate is large enough for the consideration of trust(s).
The Section 303 redemption affects corporate stockholders by providing some degree of tax and liquidity relief. When a shareholder receives a stock distribution from a corporation, it is treated as a dividend to the shareholder, unless it meets the following three considerations.
Because of these rules, the shareholder faces difficult in trying to treat a partial redemption as a sale that qualifies for capital gains, rather than a dividend treatment. Although capital gains are taxed as ordinary income, the shareholder’s basis can offset a capital gain but not a dividend.
Section 303 permits a partial redemption to be treated as a sale when the following requirements are met:
The maximum amount of stock that can be redeemed under this section equals the sum of (1) the Federal and state death taxes, and (2) funeral and administration expenses. Therefore, an heir or the Executor can swap the illiquid stock for cash from the corporation. Life insurance on the shareholder is often used to provide the corporation with the cash to carry out the redemption.
In the normal and typical 303 redemption, because of the stepped‑up basis at death, very little capital gain is recognized, unless the stock appreciates after the shareholder's death. Therefore, Section 303 takes what would otherwise be dividend income and, in most situations, converts it into a nontaxable form of income.
The cash that the executor or heir gets from the redemption does not have to be used to pay death taxes and estate expenses. There is no liquidity test here, as even an estate that is already liquid can utilize Section 303.
Section 303 provides a significant advantage in keeping a family corporation in friendly hands. A redemption keeps control of the corporation in the hands of the surviving shareholders, and this can avoid a forced sale of a decedent's stock to someone outside of the family.
While this is not a “Trust” it is discussed in this section as it is a particular and peculiar situation that can be treated by proper estate planning and may arise during discussions of Trusts and assets to be included, etc.
Before 1987, as an owner of a family corporation faced retirement or the problems of leaving a business to heirs, these owners often recapitalized their business by exchanging their common stock to Preferred Stock. The Preferred Stock had a value then that remained fixed, regardless, and particularly, if the corporation increased in value. The common stock was then reissued to the next generation and carried with it both the current value and future appreciation of the business. This way, the owner “leveled off” the amount subject to estate tax at his/her death at a little or no cost in gift taxes.
The 1987 tax law made the appreciation in the value of the common stock to be included in the gross estate of the aging owner at death. In 1990, the tax laws changes and the pre-1987 law was reinstated with some qualifications:
In today’s society, there are many people who have trouble taking care of their resources, particularly the cash resources. In addition to those who carry huge credit-card debts, and those who have “holes in their pockets”, there are those who are addicted to drugs and alcohol. If any family member belongs to this category, it is unwise to leave them substantial amounts of money in a lump sum. Obviously, it is wiser to leave them a stream of income instead.
Of all of the options that can be used for this situation, the most useful one is the “Spendthrift Trust.”
To create such a trust, the first logical step is for the individual to discuss with his attorney, the criteria that would best fit the situation. For instance, one might pick a bank or other trust department as trustee, and instruct the trustee to benefit the children (or grandchildren, or both) by
By so stipulating, the corpus of the money has been protected against waste and the values of the individual setting up the trust guides the disbursement of the estate. Note that the estate beneficiaries are protected also from poor health and encourages education.
Some, if not many, individuals who create such a trust, carry it on for many years, and then at the end of the trust period, they give some or all of the assets to the heirs – some leave part or all to a Charity
A discussion of Trusts would not be complete without the inclusion of a Living Revocable Trust. Actually, any trust that becomes effective during the life of the grantor is a living trust. If the Trust contains words, such as “I reserve the right at any time to revoke this Trust in whole or in part”, it is a revocable Trust
The primary purpose of the Living Revocable Trust (LRT) is to avoid probate. The LRT does not in itself, save taxes, but it is used in more sophisticated estate plans and when used with a By-pass Trust, does save taxes.
A Living Trust has three primary “offices”: (1) Trustor (creator of the trust), (2) Trustee (who administers the Trust and makes sure the provisions are carried out) and the (3) Beneficiary (the receiver of the benefits of the trust, whether money, property, valuable instruments, etc.). In most states, it is possible for an individual to fill all three offices.
If a LRT is used, a Standby Trustee should be appointed in case of the death or disability of the Trustee, usually a bank or stockbrokerage trust department is used. A Standby Beneficiary should also be appointed, who generally does not benefit until the end of the Trustor’s life and can be a person, another Trust, or an institution.
To make an LRT effective, it must be funded by having assets placed in it, otherwise it is an “empty trust” and of no value.
To leave assets to a Charitable institution, for instance, the trust may say, “At death of Trustor, the Standby Trustee is to give X% of the Trust assets to the (name of charity).
Husband and wife can set up one common Living Trust of which each owns half. When one dies, this Trust will automatically split into two separate Trusts. This is called an "A - B Living Trust" because the two separate Trusts are typically referred to as Trust A (for the surviving spouse) and Trust B (for the deceased).
If the value of the common Trust is not more than $1.3 million, half of the value of the assets are placed in Trust A and half in Trust B. Each Trust will be entitled to a $650,000 exemption. Trust B uses the deceased's exemption and Trust A will use the surviving spouses’ exemption later when he/she dies and the assets in both Trust are distributed to the beneficiaries. So assuming Trust A does not grow too more than $650,000 by that time, the entire estate will be exempt from estate taxes. If the Trust is more than $1.3 million, usually only $650,000 of the deceased's half is placed in Trust B, since this is the amount of the estate tax exemption. The rest is added to Trust A (the surviving spouse's Trust). There are no estate taxes on Trust B because it does not exceed the $650,000 exemption. And there are none due now on the rest of the deceased's estate because it is transferred to Trust A using the marital deduction. Later when the surviving spouse dies, his/her exemption is used, so another $650,000 is exempt from estate taxes.
By using an A-B Trust, husband and wife can leave up to $1.3 million estate tax free to beneficiaries and with no Probate costs. If clients are using a simple Will (as many couples do) or have no estate plan, and rely on just the marital deduction for tax planning, they would not only be able to use one $650,000 exemption, and, under current law, approximately $325,000 in federal estate taxes would have to be paid on the $1.3 million estate, plus thousands of dollars in Probate fees.
This is not a tax shelter or some devious way to avoid paying taxes. The estate is being taxed when both spouses die. But they are simply using the exemptions to which they are entitled.
If the total estate is over $ 1.2 million, the Trustee will need to decide which of the deceased's assets will be placed in Trust B and which ones will be transfer to Trust A through the marital deduction. It would be wise to place into Trust B assets that will appreciate the most in value over the next few years. That is because the assets in Trust B are only valued and taxed when the first spouse dies. They are not revalued later when the second spouse dies, and may be worth much more.
(Please note example of Q-TIP Trust with 2001 Tax Law) in
SUPPLEMENT section in back of this text.
The Qualified Terminable Interest Property Trust (Q-TIP) is designed to be used by married couples whose combined net estate is more than $1.3 million. This Trust is often referred to as the "C" Trust. In short, the surviving spouse must receive the income from Trust C and may have access to the principal under certain conditions in his/her "qualified interest" in the property. It is "Terminable" because this "interest" ends when the surviving spouse dies.
This Trust is used by married people to guarantee that the first decedent’s assets benefit the spouse for his or her life, and then to guarantee that the first decedent’s heirs or causes receive the benefits.
The Q-Tip Trust is not created when the estate plan is first drawn up, but it is authorized at that time. In the Will, or in Living Revocable Trust (LRT), the Trustor authorizes the Executor or Trustee to create the Q-Tip Trust at his/her death. Each spouse needs to authorize the Q-Tip Trust in his or her Will or LRT.
The LRT might state words to this effect: “If I die first, put the first $650,000 into my By-Pass Trust, and remainder into my Qualified Terminable Interest Trust.
The Q-Tip Trust and the By-Pass Trust are designed to benefit the spouse for his/her life by giving the surviving spouse either all income; (such as) 5% or $5,000 – whichever is greater – annually; or anything needed for the spouse’s Health, Education, Maintenance and Support. At the end of the second spouse’s life, both the By-Pass Trust and the Q-Tip Trust can go to the persons, institutions or Trusts that were originally named by the first decedent.
The Q-Tip Trust can benefit both spouses (as life beneficiary) and other persons or causes (as the ultimate beneficiary). Therefore, there is no need to have a choice between a spouse and others.
The By-Pass Trust is used by married people to guarantee that the two lifetime exemptions are properly used. Under current law, it can save as much as $235,000 in federal estate taxes.
The By-Pass Trust is not created when the estate is devised, but is authorized (very similar to Q-Tip Trust) by authorizing the Executor or Trustee to create the By-Pass Trust at the death of the Trustor, and certain criteria concerning the By-Pass Trust can be specified.
Each spouse must authorized the By-Pass Trust in her or her Will, or LRT (Living Revocable Trust). Wording in the LRT may state in essence, “If I am the first to die, pay all the tax that will ever be due on my estate.” If the half of the estate is $650,000 or more, there will be no tax due. But, the Trustor will have paid “all that is due” and the By-Pass Trust can never be taxed again.
The By-Pass Trust is designed to benefit the spouse for his or her life and can be designed to give the spouse all income; a percentage or amount; or anything needed for the spouse’s Health, Education, Maintenance and Support. At the end of the second spouse’s life, the By-Pass can go to the persons or trusts that we originally named by the first spouse to die.
The advantage of the By-Pass Trust is that it can benefit both spouse (as life beneficiary) and other persons or causes (as ultimate beneficiaries). Again, note the similarities between the Q-Tip Trust and the By-Pass Trust.
CONSUMER APPLICATION
Doctor Ronald Weiss and his wife, Dr. Mary Weiss, had an estate of about $2 million. Most of it was in joint ownership. Ronald owned only about $300,000 in his name. Therefore they could only get the $300,000 into the By-Pass Trust instead of the $650,000 (at the time of her husband’s death) that they would liked to have moved into it.
They lost the tax on $300,000, or actually over $100,000.
If each had a separate estate of $650,000, the By-Pass Trust could save as much as $235,000 in federal estate taxes. However, in this case, the couple saved about $100,000, and left $135,000 that they could not use.
This is not a way to avoid paying estate taxes if an estate is more than $1.3 million. The portion of the estate placed in Trust C is not exempt from estate taxes. However, payment of estate taxes on this part of the estate will be delayed until the second spouse dies. The chief advantage is that this leaves the estate intact. Since the estate has not been reduced by an estate taxes, a larger amount is available to invest and provide income to the surviving spouse. In addition, the individual is keeping more money available in case the spouse needs it, and, if the spouse does need part of the principal from Trust C, the estate may be worth less by the time the spouse dies. So the estate could end up paying less in estate taxes.
A-B-C provides additional control. This arrangement will let couples keep control over who will receive more of the estate than an A-B Trust would.
If an individual uses an A-B Living Trust and that person dies first, only the $650,000 of the estate will be controlled by the survivor. Since that is the amount of estate tax exemption, usually that is all that is placed in Trust B. The rest usually goes to the surviving Trust through the marital deduction to avoid paying any estate taxes at the time.
If an A-B-C Living Trust is used, one can be sure to keep control of half the estate, even at the death of the first spouse. The surviving spouse has complete control over Trust A, can receive income from Trust B, and can also receive principal from Trust B, if needed, for health, education, maintenance and support. In addition, the surviving spouse will receive all the income from Trust C and can also receive its principal, if needed, for these living expenses. When the surviving spouse dies, the assets both Trust B and Trust C (50% of the estate at the time of the first death) will be distributed to the beneficiaries the first spouse specifies.
This section discusses three estate planning strategies frequently used or discussed by planners when advising clients. Many couples are extremely concerned when planning for their children and they want to be confident that the property is transferred according to plan.
The responsibility that a professional estate planner has in assisting parents in planning for their children in the event of the client’s death is serious and may seem overwhelming. Every bit of professional knowledge the planner has or is available must be used. After a parent has died, there is no place for a “Whoops” factor.
The aftermath of planning in this area involves far more than mere economics. Planning for children involves creating an environment that will allow underage loved ones to experience both love and the care that goes with it and the economic security that will provide more than the necessities of life as they grow to adulthood. In this section we will discuss the techniques that one can use to provide a substitute lifestyle for a loved one should a catastrophe occur.
It is mandatory that client takes the time to select and name the person or persons whom they wish to raise their children in the parents absence; these persons are called "guardians.” These guardians should be named in any Will or Trust that the client has prepared. Clients must understand that if they don't name a guardian the choice will fall to the Probate Judge. When selecting a guardian there are five things to consider:
In most states, the guardians who are selected and named in a Will do not serve automatically. The Probate court Judge must, after independent inquiry approve and name the guardian who will ultimately serve. In some states, the parent's choice is presumptive; in others, it is not. Regardless of the laws of the state in which one resides, the choices made in a Will must be manifested and be designed to give the Probate Judge some guidance as to the decedent’s desires.
As discussed in the following topic, property or insurance proceeds should not be left directly to minor children. It is best to always use a Trust vehicle. By using a Trust, one can spell out in great detail precisely how the children are to be taken care of and when they should receive the balance of the property. The individuals or institutions they would like to manage the property for the benefit of the children can be specifically named.
The property division is, of course, will be at the direction of the individual establishing the Trust. It may be suggested that they leave all property in a common Trust for the benefit of all the children for their health, support, maintenance, education, and general welfare. Once all the children become adults, whatever is left can be divided equally among them and given to them or placed in a separate Trust for each child to be distributed in accordance with the parent's wishes. The most important consideration in an estate plan is to be sure all the children are provided for while they are minors and that they are provided for from all resources.
Whether or not a young adult will exercise good judgement with regard to inherited property is always in doubt, however, there can be little doubt that most young adults do not have the experience or maturity to handle what are to them large sums of money. Parents who are concerned about when their children will receive their funds usually provide for a pattern of distribution in their Trust documents. Regardless of the ages, the concept is to ease the child into the money, to provide that if a mistake is made with the first distribution, time and experience will be on the child’s side when the subsequent distributions are made. Thus the child will be able to learn from previous mistakes. The key element is that parents can control how they wish their property to pass to children.
In summary, planning for children is an extremely important issue. By helping the client select a guardian; by leaving property in a Trust for the children and making several distributions to children, the planner is creating a solid foundation of estate planning.
There can be many problems in simply getting property to children. Under our system of laws, getting property to minors is not very easy. Most states define minors as persons who have not attained the age of 21 years.
Can one make an outright gift of property to a minor child? The answer is yes and no. “Yes” in that you can do anything you want; “No” unless you follow the legal formalities that are associated under state law with the making of that gift. Under most state's law, in order to make a gift of more than nominal amount to a minor, you must do the following:
In summary, leaving property directly to minors on death involves a considerable amount of red tape. All-in-all, the best way to accomplish this is to create a Trust with broad powers of instruction for the parents.
This section could be entitled “How to disinherit your son-in-law” as a this type of Trust (PAKT) is designed to make sure that Trust benefits go only to the donor’s own heirs. (This is actually a form of Spendthrift Trust) Assets are often scattered among direct descendants and in-laws, and can end up outside of the family because of divorce or an untimely death.
A person can create this trust and direct that it is to benefit “only my issue.” By using this phrase and directing the trustee to pay out only certain benefits to the heirs, while retaining the corpus or body of money.
A person can then list the kinds of benefits that they want their heirs to receive, which could include health, education, disability protection, education, travel, etc.
The trust can be funded by lifetime gifts and by a final gift from a Will or Living Trust at death.
CONSUMER APPLICATION
Rodney and Sandra have an estate worth $400,000. Their family consists of 4 children, all married. Two of the children had children. The other two had no children of their own, but they both have step-children.
Rodney and Sandra want only their issue to benefit from their estate, i.e. they do not want to leave anything to their step-grandchildren. They wanted the estate to go to their 4 children with right of survivorship prior to the remainder going to the grandchildren.
In this case, the PAKT Trust was suggested. The parents would place their assets into a Living Revocable Trust which would become, at the death of the last parent, the PAKT.
Instead of benefiting the children directly, they would create a generation-skip and make the trust for the eventual benefit of the grandchildren. However, during the lives of the children, income will go to the children with right of survivorship.
Therefore, the grandchildren would not benefit until all of the children had died. When all of the children (children of the original parents) were alive, they would all receive income. When one died, then three would receive income, etc.
Until the last of the above children (the second generation) died, the grandchildren would receive nothing. No step-grandchildren or spouse (in the second or third generation) would benefit.
An affiliated problem that can arise, is where assets can leave a family because of a divorce. For example, if a daughter is left $100,000 and she uses that money as a down payment on a home, and she and her husband take title jointly. In case of a divorce half of the house belongs to the husband and it has lost its inherited characteristic.
To avoid losing assets to an heir’s subsequent divorce, an irrevocable trust can be used into which the assets are placed. If a bank or stockbrokerage trust department is named as Trustee, and if it is stated in the trust that certain benefits can only to people who are “your issue”, the inheritance has been divorce-proofed.
The “only my issue” statement can also prevent adopted children from receiving assets, so it should therefore state: “Only my issue, or legally adopted children of myself and my issue…”
There is no average or representative estate. Planning situations that could be used as an example or illustration to summarize all the estate planning principles and techniques that have been discussed cannot be done. People have individual estates that require individual planning techniques. There are, however, certain basics or "universals" common to the estate planning process that are addressed to those who are, or plan to be, involved in estate planning.
$650,000. (Supp.)Spouses in all states can give or leave an unlimited amount of property to their U. S. citizen spouses tax free. The only requirement associated with the unlimited marital deduction is that the surviving spouses receive all of the income from the property during their lifetimes.
20. Trustees are compensated, Institutional Trustees publish fee schedules. Individual Trustees usually negotiate their fees within parameters set by local state statutes or court rules.
21. Getting property to a minor can be difficult, under the laws of most states, in order to make a gift to a minor, you must set up a uniform gifts to minors act trust, establish a Totten Trust, or fund a Living Trust created for the minor's benefit.
22. Property left directly to a minor will be stalled in a court imposed custodianship until the minor reaches legal age. Leaving property directly to a minor involves a great deal of red tape.
23. When planning for children, you should provide for a succession of guardians and discuss your situation with the guardians you choose.
24. How you divide and distribute your property among your loved ones is very important. Some general rules would be: Do not divide your property among your children until the youngest of your children is an adult. Once your property is divided, you can provide for different distribution dates for each child to allow for specific thoughts you have with regard to each. It is important to recognize that you can control how you wish your property to pass to your children. If you wish to bypass your children in favor of your grandchildren you must take into account the generation-skipping federal estate tax rules.
25. When planning for your spouse, you must consider your own state's law and the rights it gives your spouse to your property. You may, however, avail yourself of two planning techniques, either a pre-marriage (pre-nuptial) or an after marriage contract. Given a choice of two, you should always opt for the former; they are valid and binding if fair and have always been favored under the law of most states.
26. Today the number of planning possibilities available when planning for a spouse is staggering. Great care must be taken to analyze all the espousal planning possibilities before selecting the best personal choice.
27. A life insurance program should be coordinated with, and become an integral part of the total estate plan. Life insurance that is owned on your life will be federal estate taxable on your death and may be taxed by your state. It is important to properly record both primary and contingent beneficiary designations with your agent. Never make your estate or minors the direct beneficiary of the insurance proceeds.
28. Always re-examine your life insurance portfolio. Insuring the life of the younger spouse makes excellent sense in light of the federal estate tax rules.
29. Life insurance can be purchased and structured to totally avoid federal estate tax. In general this is best accomplished through the use of an irrevocable life insurance Trust. It can be structured by estate planning specialists to accommodate almost any type of insurance owned.
30. If you desire to make contributions of cash, or assets, other than cash, to qualified charities, either currently or on death, you may receive tax benefits for your good works.
31. Estate planning is no place for loners. Professional advisers should be selected for the knowledge they possess within their particular disciplines. All advisers should participate in the estate planning process and should work well, not only with you, but with each other.
CHAPTER 10 – STUDY QUESTIONS
1. If an individual owns a highly appreciated asset, such as an apartment house and wishes to make a charitable contribution he/she should consider
A. an outright gift to the charity.
B. selling the apartment house and donating the cash.
C. a charitable remainder trust.
2. If a charitable remainder trusts is established the assets transferred into the trust
A. grow tax free.
B. should be non appreciated assets.
C. belong to the charity immediately.
3. Generally an individual using a charitable remainder annuity trust
A. is a younger donor.
B. is an older donor.
C. can only make the donation to one charity.
4. In an irrevocable charitable remainder trust
A. the trustee controls the assets.
B. the grantor may charge the beneficiary at any time.
C. the trustee must be a corporate trustee.
5. The benefit of a charitable remainder trust is
A. only the charity.
B. the charity and the donor.
C. is subject to gift tax.
6. With a charitable lead trust
A. the charity receives the trust property after the beneficiaries receive the income from the property.
B. you do not need a trustee.
C. you can reduce income taxes.
7. When a surviving spouse dies
A. his/her estate will be taxed at 100% of value.
B. the unlimited marital deduction eliminates any estate tax.
C. his/her estate will be taxed based on 50% of the value of the assets.
8. A living revocable trust
A. avoids taxation of the grantor’s estate.
B. avoids probate.
C. requires the trustee to be someone other than the grantor.
9. A spendthrift trust
A. enables a trustee to distribute income as needed, without evading the trust corpus.
B. requires the trustee to distribute the income and corpus of the trust in a lump sum.
C. limits the grantor’s ability to drain the trust assets.
10. A living revocable trust
A. becomes effective at the death of the grantor.
B. to be effective must be funded by having assets placed in it.
C. cannot be amended or changed.
Answers to Chapter 10 Quiz: 1C, 2A, 3B, 4A, 5B, 6C, 7A, 8B, 9A, 10 B