Why a Trust, and What about a Will?

Most people believe that, when they die, the way to pass their assets to their beneficiaries is via a will.  That is not wrong.  But there are downsides to a will.  And there is a better way: via a trust.

In order for assets to pass on to your heirs via a will, the will has to be filed in court in a process called “probate”.  This means that your will is submitted to a court of law.  That makes your will a public document.  Anyone can read your will, see what assets you owned, make a claim to your assets, and challenge the validity of your will in court.  Since the will names your heirs, and the assets to be dispersed to your heirs, this public information now also provides a roadmap to your heirs and their new wealth.  If you leave behind property in multiple states, there may be multiple probate court proceedings.

Moreover, in order to maneuver through this probate court process, and whether or not there is a will contest or outside claims to assets, your heirs will need to hire a lawyer.  The court will make sure that your assets are distributed the way you directed in your will.  And courts work very slowly, which means that those assets may not pass on to your heirs for another year or two, or much longer if there is a court issue, will contest or other probate problem.  In short, if you rely on a will to distribute your assets, you automatically involve the state, which has monetary costs, lack of privacy and delays.

A better mechanism for passing your assets to your heirs is via a trust.  A trust is an entity created to manage assets.  The trust is controlled by a trustee, who manages the property within the trust.  Subject to the terms of the trust, a trustee can invest, sell, buy, lease, mortgage, lend, collateralize, etc., whatever has been placed in the trust, e.g., cash, securities, shares of stock or LLC interests, art, real estate, patents, trademarks, anything of value.  If you establish a trust, and contribute assets to this trust, you may be the trustee over this trust and thus continue to control the assets in the trust while you are alive.  You would also chose a successor trustee.  Because the trust continues to exist after your death, the role of the successor trustee is to control the trust after you die.  The successor trustee, who could be your surviving spouse, relative or trusted friend, would be obligated to follow the instructions you set forth in the trust document, called a trust deed of settlement.  This document will also set forth who inherits your assets upon your death, much like a will directs where your assets are to be distributed at your death.  The people who inherit your assets are called “beneficiaries”.  The trustee has a fiduciary obligation to act in the best interests of the beneficiaries.

However, whereas a will has to go through the probate court process, a trust does not.  At your death, the successor trustee (who you’ve appointed when you created the trust), follows the directives of the trust (which you’ve set forth when you created the trust), including distribution of trust assets to the beneficiaries who you’ve named when you created the trust.  The beneficiaries can be your children, other family members, your alma mater, charities, etc.  Distributing your assets under the terms you’ve set forth could be accomplished by a will through the public probate process, or instead, the very same terms could be satisfied by a trust, privately, without involving the state, without a probate court, without lawyers, and with less of an opportunity for others to challenge the validity of the inheritance terms that you’ve set.

Moreover, because a trust avoids probate and the delays of probate, the successor trustee can step in immediately and administer the trust assets.  The successor trustee can communicate with banks and brokerage firms without a need for court appointment, and can begin to settle the estate and make distributions much faster than if a probate court were involved.  In addition, because banks, brokerage firms and other custodians will freeze an individual account at death, thus complicating the account and delaying distributions and payments, a trust account may continue seamlessly with the successor trustee.  Finally, illiquid assets (e.g., real estate, private investments, private equity, limited partnership interests) that may be complicated by the probate process and require re-titling of the assets after death, can instead continue smoothly in the name of the trust.

The trust is a “revocable” trust, meaning that you have the ability to revoke, or cancel it.  You also have the ability to modify it.  For instance, you can change your beneficiaries or change the trustee.  Because the trust is revocable, the IRS doesn’t consider it to be an independent taxpayer and the trust will not get its own taxpayer ID number.  However, when you die, the trust becomes irrevocable.  At that point, the successor trustee (who you’ve already chosen), steps in and is obligated to follow the terms of the trust that you’ve set forth.

It is more difficult to contest the terms of a trust than the terms of a will.  This is because whereas the will is admitted to a probate court for all to see, nowhere is the trust publicly recorded.  A probate court automatically provides a venue and a mechanism for challenging a will.  Yet, trusts are not public documents and trusts avoid the probate process.

This allows you a greater opportunity to control the terms of distribution, knowing that it will be more difficult for others to challenge those terms.  For instance, you might direct the successor trustee to pursue a certain investment at the exclusion of another.  You might also, for example, set forth pre-conditions for inheritance, such as completing college or graduate school.  If you leave behind a child who is a minor, you can create a sub-trust for that minor, funded with life insurance, IRA proceeds or other accounts payable on your death, and set the terms of that sub-trust, such as delayed distributions at certain ages or periodic support payments over the life of a beneficiary.

An additional important benefit to a trust is that the assets held in trust may be protected from lawsuits, including divorces, and the claims of creditors.  On the other hand, after distribution from a will to a beneficiary, the inheritance is vulnerable to creditors of the beneficiary, including a spouse.

Your will still does have a role in estate planning, even though distribution of your assets is controlled by a trust.  In your will, you set forth your personal representative, who is the person you empower to take care of your funeral arrangements, final personal debts and your last tax return.  This person can be the same as your successor trustee.  If you have children who are minors, the will is also the document to name their guardians in the event both parents pass away before the children reach adulthood.  Finally, the will also should include a provision that any property that you did not address in your trust should now “pour over” into the trust and be subject to the terms of your trust.

Another benefit to a trust is that, if you are married, it preserves both spouses’ exemptions from the estate tax.  Each person currently is allowed an exemption from federal estate tax for the first $5.45 million worth of assets.  In other words, if one’s estate is valued at less than $5.45 million, there is no federal estate tax.  (State estate tax may apply, however, and there is great disparity among exemptions and estate tax rates across all the states.)  That exemption of $5.45 million is now “portable”, meaning that if one spouse did not use up the exemption at death, the unused amount can be transferred to the second spouse and added on to the exemption of that second spouse.  The net effect is a combined federal exemption of $10.9 million for the couple.  On the state level, however, there may not be portability and the exemptions may be much smaller in your state.  Through the use of a revocable family trust, both spouse’s exemptions on the state level could be preserved.  Notably, portability cannot be accomplished via a will.

Thus, while a will has traditionally been thought of as the way to pass on one’s assets at death, wills have significant drawbacks including the probate court process, delays and lack of privacy.  A trust is a better way to accomplish the same inheritance planning, privately, more efficiently, without involving courts or lawyers, with greater control over inheritance terms, and with lower estate taxes.

For information about your estate planning needs, contact Rubinstein & Rubinstein today.

How to Lower Your Estate Tax Liability on the Federal and State Levels

In early 2013, Congress clarified the estate tax landscape and made permanent certain provisions of estate tax law, such as the exemption from estate tax for the first $5.45 million of one’s estate, indexed annually for inflation. There has been no such clarity on the state levels, which remain a patchwork of different estate tax laws.

On the federal level, in addition to the exemption of $5.45 million each year indexed for inflation, the 40% estate tax rate is, for now, standard.  In addition, portability between spouses of an unused exemption is also now allowed.  Congress can change these laws in the future, as it has in the past.  In addition, in this election year, estate tax rates and exemptions are campaign topics and are subject to revision by a new administration.  However, at least for now, the federal estate tax regime is clear and as a result, we as tax practitioners have a better ability to plan for clients when the law is clear.

However, estate taxes on the state level are much more variable.  In New Jersey, the threshold for estate tax is only $675,000, the lowest in the U.S., and at a huge variance from the $5.45 million federal exemption.  The threshold in Connecticut is $2 million, cut from $3.5 million in 2011.  The threshold in New York is currently $3.125 million, will rise to $4.18 million on April 1, 2016 and to $5.25 million in 2017.  Ultimately, the NYS exemption will be at parity with the federal exemption amount in 2019.  In a significant quirk, a New York tax law anomaly known as “the cliff” sets the estate threshold to zero (i.e., no exemption from estate tax at all) if one’s estate is valued at $3,281,250 or more.  In other words, in New York, there is no estate tax for estates lower than $3.125 million and complete estate tax on the entirety of the estate, with no threshold and no exemption, for any New York estate valued in excess of $3,281,120.

Thus, depending on the value of one’s estate, and one’s residence, one’s estate may owe considerable state estate tax even if it is exempt from federal estate tax.

Some states have no estate tax and no income tax.  For this and other reasons (sunshine?) such states, which include Florida and Nevada, attract migration from high-tax states such as New York, New Jersey and Connecticut.

There are various strategies that one may utilize to lower one’s taxable estate on both federal and state levels.  Some of the strategies proven to reduce estate taxes are:

GRAT – If you contribute assets into a Grantor Retained Annuity Trust, you could receive a regular payment akin to an annuity over many years, and then when the trust term ends, the appreciated assets pass to your heirs, are not considered part of your estate and will not be subject to estate taxes.

QPRT – If you contribute your personal residence into a Qualified Personal Residence Trust, you may still live in the residence for a term of years, and when the trust term ends, the home is removed from your estate while passing to your heirs and will not be subject to estate taxes.

FLP – After contributing your assets into a Family Limited Partnership in return for general and limited partnership interests, you may then, over time, gift your limited partnership interests to your heirs while retaining the general partnership interest (thereby continuing to control the FLP), and thus remove the value of the limited partnership interests from your estate.  FLPs also provide the additional bonus of excellent asset protection.

CRUT – By contributing appreciated assets to a Charitable Remainder Unitrust, you are entitled to a charitable deduction, regular payments from the trust back to you during the trust term, and at the end of the term the assets pass to the charity, are not subject to income tax and are removed from your estate.

ILIT – If you own or control life insurance policies, the IRS deems their death benefit to be in your estate and subject to estate tax, even though you will never receive the death benefit during your life.  If you contribute these life insurance policies to an Irrevocable Life Insurance Trust, you may remove the insurance policies from your estate.  Your family members may receive the death benefit from the trust, free of any estate tax.

Dynasty Trust – Such a trust allows the preservation of assets for one’s immediate and remote descendants, along with offering asset protection from creditors, as well as delay of the estate tax bite for many generations.  The trust can distribute income to beneficiaries, but principal is preserved, asset-protected and grows tax-free.

These strategies are not only for the mega-wealthy.  We have successfully utilized these strategies for clients of means at various levels who are concerned with leaving as much of their hard-earned assets for their heirs with as little as possible going to the IRS and state tax authorities.  These are equally attainable goals with a $5 million estate as they are at $50 million.

Moreover, these strategies are affordable, especially considering the amount of tax savings they offer.

Of course, if you want to move to Florida or Nevada, go for it.  But if you’re considering a move for estate tax reasons, first consider these various strategies to lower your estate tax liability without having to relocate.

THE EFFECT OF RISING INTEREST RATES ON ESTATE PLANNING STRATEGIES

This article’s author is Kenneth Rubinstein

The Federal Reserve Board raised interest rates at the end of 2015 and predicted that it will continue to raise rates several times in 2016.  Affluent taxpayers need to review their estate planning strategies to determine what strategies should be implemented before interest rates rise and what strategies will be most advantageous after interest rates rise.

Before Interest Rates Rise:

The most advantageous estate planning strategy to consider during a low interest rate regime is the use of intra-family loans.  Parents may lend investment funds to children or grandchildren and they may also sell assets (e.g., equity in private businesses, real estate) to children or to trusts for the benefit of children (e.g., Intentionally Defective Grantor Trusts), taking back promissory notes that will be repaid over time.  Future appreciation of the assets will inure to the children/borrowers while the repayment installments will provide a stream of income to the parents/lenders.  These strategies depend upon the assets earning sufficient income to support the repayment installments plus the interest.  Interest must be charged (and paid) to avoid an IRS claim that the loan is nothing more than a disguised gift, subject to gift tax.  The minimum interest rate that will avoid such an IRS claim depends upon the interest rate paid by the government on mid-term federal notes.  Obviously, the lower the interest rate, the easier for this strategy to succeed.  Taxpayers should therefore consider implementing such loan strategies now, before interest rates rise.

After Interest Rates Rise:

Strategies that provide a stream of annuity payments to a grantor will benefit most from a rising interest rate environment.  The two most common strategies are Grantor Retained Annuity Trusts (“GRAT”s) and Charitable Remainder Trusts (“CRT”s).

In a GRAT an asset that is expected to appreciate significantly is contributed to a trust for a term of (at least two) years. The grantor receives a stream of annuity payments for the term.  The annuity payments equal the value of the asset contributed to the GRAT plus a market based interest rate.  At the end of the term the asset (which has presumably appreciated) plus any income retained in the GRAT (i.e., income earned in excess of the annuity payments) go to the beneficiaries/heirs tax free.  Obviously, the higher the interest rate, the higher the annuity payments to the grantor and the lower the initial value of the asset contributed to the GRAT may be.

A CRT is a trust that is exempt from tax on income that it earns because it provides for a final remainder distribution to charity.  The grantor contributes an asset to the CRT (usually a highly appreciated asset) which the CRT may sell free of tax.  During the term of the CRT (which may be up to twenty years or for the lifetime of the grantor and/or his/her family members) the trust must make annual distributions to the term beneficiary (usually the grantor and/or his/her family members).  The idea is to structure the size of those distributions so that over the term of the CRT, 90% of the initial asset contribution plus its assumed appreciation is distributed to the term beneficiary and 10% of the initial contribution (the remainder) is left for charity.  The higher the prevailing interest rate is at the creation of the CRT, the higher the annual distributions will be to the term beneficiary.

Various combinations and permutations of the above strategies (GRATs, GRUTs, CRATs, CRUTs, SCINs, etc.) are available in order to maximize their effectiveness depending upon a particular taxpayer’s situation.  The above descriptions have been significantly simplified to provide general information about the strategies that are available. These strategies should be discussed and implemented with qualified tax counsel.

FBAR Reporting for Foreign Annuities, Life Insurance and Trusts

We remind readers that FinCEN Form 114 (formerly TD 90-22.1), the Report of Foreign Bank and Financial Accounts (the “FBAR”), for calendar year 2013, is due by June 30, 2014.  The FBAR must be filed electronically.

As we advised previously, in 2011, the U.S. Treasury Department issued revised regulations regarding the FBAR.  The FBAR filing now applies to foreign annuity policies and foreign life insurance policies that are owned by U.S. taxpayers, and to some beneficiaries of foreign trusts.  If you are subject to the FBAR filing requirement, the 2013 FBAR is due by June 30, 2014.

The FBAR is required to be filed by a U.S. person who has a financial interest in, or signature or other authority over, any foreign financial account (including bank, securities or other types of financial accounts), if the aggregate value of the financial account(s) exceeds $10,000 at any time during the calendar year.

1. Foreign Annuity Policies

The 2011 FBAR regulations extend the FBAR requirement to foreign annuity policies that have a cash surrender value and are owned by U.S. persons.  Under the new regulations, such annuity policies are considered a “foreign financial account”, reportable via the FBAR by the policy owner, which is usually the U.S. client. Such annuities are reportable even if they are deferred annuities and there are no present annuity payments.

2. Foreign Life Insurance

A foreign life insurance policy is now reportable as a “foreign financial account” if the insurance policy is owned by a U.S. person and the policy has a cash surrender value.  The reporting requirement applies to the policy owner, if he/she is a U.S. person.  It does not apply if the policy is owned by a foreign trust rather than a U.S. client. (Note, however, that a client who is a beneficiary of a foreign trust may still be subject to the FBAR, see 3 below.)

3. Foreign Trusts

The 2011 FBAR regulations extend the FBAR requirement to some U.S. beneficiaries of foreign trusts, such as foreign insurance trusts.  The new regulations apply to U.S. beneficiaries of a foreign trust who have a reportable financial interest in the trust.  A U.S. person has a reportable financial interest if the U.S. person had more than a fifty percent (50%) present beneficial interest in a trust’s assets or if the U.S. person received more than fifty percent of the current income of the trust.  The beneficial interest in the assets of the trust must be a “present” beneficial interest for the FBAR to apply.  A beneficiary of a purely discretionary trust, i.e., where trust distributions are made solely in the discretion of a trustee does not have a “present” interest.  However, with respect to the trust income, a beneficiary who receives more than fifty percent of trust’s “current” (i.e., annual) income has a financial interest that is reportable on the FBAR.

Under prior FBAR regulations, there was ambiguity as to whether a discretionary trust beneficiary was subject to the FBAR.  Beneficiaries of a foreign discretionary trust may only receive distributions at the discretion of the foreign trustee.  The new rules clarify that only a present beneficial interest gives rise to the FBAR and only beneficiaries who receive more than fifty percent of a trust’s current income are subject to the FBAR.

4. Additional Important Points

• Even if the annuity policy or insurance policy was cancelled in 2013, and the trust account closed during 2013, if they existed at any point during 2013, an FBAR is required.

• The requirement to file the FBAR exists irrespective of whether you filed IRS Form 8938, Statement of Specified Foreign Financial Assets.  This is yet another IRS form to report foreign assets, including foreign annuity policies, foreign life insurance policies, and interests in foreign trust.  We’ve written about IRS Form 8938, here.  Form 8938 is due with your annual tax return.

•  The June 30, 2014 deadline is the deadline for receipt of the FBAR by the Treasury Department.

•  Even if you have an extension for filing your tax returns, the 2013 FBAR is still due by June 30, 2014.  There are no extensions for the FBAR deadline.

•  The FBAR is now required to be filed electronically.

It is crucial to preserve the integrity of your offshore planning and to maintain its tax compliance by abiding by all IRS rules and regulations.  Please contact us for more information.

 

Offshore Asset Protection Trusts and FBAR Reporting

We again remind readers that FinCEN Form 114 (formerly TD 90-22.1), the Report of Foreign Bank and Financial Accounts (the “FBAR”), for calendar year 2013, is due by June 30, 2014.   The FBAR must be filed electronically.

As we wrote previously, in 2011, the U.S. Treasury Department changed the FBAR filing requirements to now apply to U.S. grantors of foreign trusts, and in some cases their U.S. beneficiaries.

The FBAR is required to be filed by a U.S. person who has a financial interest in, or signature or other authority over, any foreign financial account (including bank, securities or other types of financial accounts), if the aggregate value of the financial account(s) exceeds $10,000 at any time during the calendar year.  If you are subject to the FBAR filing requirement, the 2013 FBAR is due by June 30, 2014.

U.S. grantors (also known as settlors) of foreign asset protection trusts are deemed to be the owners of all trust assets for tax purposes.  Thus, the FBAR filing requirement applies to such grantors, whether or not they actually control trust assets and whether or not they receive distributions from the trust.

The 2011 revised regulations now extend the FBAR requirement to some U.S. beneficiaries of foreign trusts, including foreign asset protection trusts.  The new regulations apply to U.S. beneficiaries of a foreign trust who have a reportable financial interest in the trust.  A U.S. person has a reportable financial interest if the U.S. person had more than a fifty percent (50%) present beneficial interest in the assets of a trust or if the U.S. person received more than fifty percent of the income of the trust.  The beneficial interest in the assets of the trust must be a “present” beneficial interest for the FBAR to apply.  A beneficiary of a purely discretionary trust, i.e., where trust distributions are made solely in the discretion of a trustee (asset protection trusts created by this firm are purely discretionary trusts) does not have a “present” interest.  However, with respect to the trust income, a beneficiary who receives more than fifty percent of trust’s “current” (i.e., annual) income has a financial interest that is reportable on the FBAR.

Under prior FBAR regulations, there was ambiguity as to whether a discretionary trust beneficiary was subject to the FBAR.  Usually, beneficiaries of a foreign asset protection trust receive distributions at the discretion of the foreign trustee.  The new rules clarify that only a present beneficial interest gives rise to the FBAR and only beneficiaries who receive more than fifty percent of a trust’s current income are subject to the FBAR.

Please also note the following with respect to the FBAR requirement:

  • Even if the trust account was closed during 2013, if the account existed at any point during 2013, an FBAR is required.
  • The requirement to file the FBAR exists irrespective of whether you filed new IRS Form 8938, Statement of Specified Foreign Financial Assets.  Please contact us for a copy of our memorandum regarding new Form 8938.
  • The June 30, 2014 deadline is the deadline for receipt of the FBAR by the Treasury Department.
  • Even if you have an extension for filing your tax returns, the 2013 FBAR is still due by June 30, 2014.  There are no extensions for the FBAR deadline.
  • The FBAR is now required to be filed electronically.

 We also take this opportunity to remind you again that foreign asset protection trusts also give rise to filing IRS Forms 3520 and 3520-A, as well as Form 8938.

 Having established an offshore asset protection trust to safeguard your assets from attack by creditors and litigants, it is crucial to preserve the integrity of the trust and to be in compliance with all IRS requirements.  Please contact us with any questions.

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