How to Use Annuities to Benefit Spouse/Step-Child Relationship within an Estate Plan

The estate planning complexities surrounding second marriages with blended families are largely under-estimated, not only by clients, but by their attorneys. Since second (and even third) marriages are becoming more common, it is not unusual for a married couple to each have adult children from prior marriages. When you link these parties in an estate plan, sometimes things can go terribly wrong.

When completing estate plans in second marriage situations, the challenge includes how to provide for one’s surviving spouse for the rest of her or his life, while at the same time preserving assets and equity for one’s children. The typical response is a “Marital” or “QTIP” trust that pays the surviving spouse income and may also provide for discretionary principal distributions for the spouse’s health, maintenance and support. At the surviving spouse’s death, the remaining assets of the Marital Trust are then distributed to the children.

While such Marital Trusts are useful tools to accomplish these goals, careful and deliberate consideration should be given to a variety of factors that may exist. If, for example, one’s spouse is closer in age to one’s children then oneself, there is the distinct possibility that the spouse survives the children, effectively removing them from the line of inheritance. While grandchildren may reap those benefits, this may not be consistent with the testator’s intent.

Even where the spouse is not close in age to the testator’s children, there are other emotional, familial and financial issues to consider. Marital Trusts, by definition, economically bind the surviving spouse to his or her step-children. The parties may enjoy a superb familial relationship, or they may not. But once the “glue” that holds these parties together has died, the relationship may become a purely economic one.

And whether the parties acknowledge it or not, the economic relationship is adverse. Every dollar that step-parent spends from the Marital Trust will one day result in the children receiving one less dollar (or perhaps even less when one considers the opportunity cost of compounding interest). Whoever the trustee is has a difficult job of balancing investments inside of a Marital Trust. The surviving spouse wants to maximize income while the children call for growth. Difficult decisions confront the trustee when considering whether to distribute additional amounts that the surviving spouse may request when home repairs, new cars or other major expenses loom.

IRAs, 401(k)s, pensions and profit sharing plans (I’ll just blanket all of these types of accounts by calling them IRAs) pose an even greater challenge. Naming a Marital Trust as the beneficiary to IRA accounts may only serve to result in higher income tax costs since the Required Minimum Distributions will eventually exhaust the account over time if the surviving spouse lives long enough. The alternative is to simply name the surviving spouse as the primary beneficiary.

But when the surviving spouse is named as the primary beneficiary, he or she can roll over the IRA into their own IRA. Now the surviving spouse has the ability to name whomever they want as their beneficiary. There is no guarantee that the children of the first deceased spouse will inherit anything from the IRA account at the surviving spouse’s death.

When IRA accounts are a significant portion of one’s estate, one may consider an annuity as an alternative. Annuities, by definition, are “wasting assets” in that their distributions consist not only of earnings (interest and dividends) but of return of capital (principal). As such, the “income stream” distributed by annuities tend to be higher than simply income that may be earned on investments.

Depending upon the situation, one might be able to divide up one’s IRA account into separate accounts to take care of a surviving spouse and children immediately upon death. In other words, one portion may include an annuity inside of the IRA that guarantees an income stream to the surviving spouse. All parties know and recognize that this portion of the IRA will likely be fully consumed and not end up with the children. The advantage to an annuity over simply bequeathing investment assets is that the annuity company guarantees the payout over the surviving spouse’s lifetime, no matter how long he or she lives.

The balance of the divided IRA account can name the children as direct beneficiaries. Using this approach, the children don’t have to wait until their step-parent’s death before receiving at least a portion of their inheritance. The surviving spouse/step-parent, on the other hand, has an income stream that won’t be scrutinized since the children would have no expectations of receiving any amounts from that portion of the estate.

There are many nuances to this approach that need to be carefully considered with legal, tax and financial counsel. Nevertheless, the thought of “unbinding” a surviving spouse to his or her step-children is worth considering, and may result in better familial relationships into the future since the parties are not tied to one another economically as they otherwise would have been.

©2014 Craig R. Hersch

The Challenge of Annuities with Trust Planning

For the past several years, investors have experienced low yields both in bonds and in dividend declaring stocks. For those who mainly rely upon their investment income for retirement needs, it has been a tough environment. Financial firms have responded with a variety of annuity products that are designed to provide much needed income. Some annuities even promise growth features that are either guaranteed or tied to the stock market, or have quasi-insurance like features that pay out a death benefit.

While these annuity products may fit the present needs of their investors, caution is advised when naming trusts as the beneficiary of the annuity following the primary annuitant’s death.

One may want his or her trust to be named as the beneficiary of the annuity for a variety of reasons, including second marriage situations where the investor wants his or her spouse to enjoy the income but eventually want the equity that is left after the spouse dies to their children. Other investors don’t want their children to inherit a fixed sum of money and would rather have them receive it as the same income stream that they had. Sometimes a beneficiary has qualified for Medicaid or another government program so leaving assets to a Special Needs Trust is necessary so as not to disqualify the recipient from that government program.

Annuities, however, have built in income imbedded within them. Like IRAs, 401(k)s, pension and profit sharing plans, when distributions are made from an annuity, some portion of it is usually taxable income. This is not a problem when the annuity is being distributed to an individual.

When an annuity names a trust, however, there may be significant income tax problems upon the death of the original annuitant. Trusts are not considered people and are therefore treated differently under most annuity contracts, even if the trust has individual beneficiaries. Some annuities require all of the remainder of the balance to be distributed outright to a trust upon the death of the original annuitant, for example.

When this happens, the trust recognizes the taxable income. But if the trust calls for its “income” to be distributed to the beneficiary, this does not necessarily mean that all of the taxable income that was distributed to the trust, will “flow through” to the beneficiary of the trust.

This is because the annuity itself is the “corpus” or the “principal” of the trust. So under the trust statutes, the taxable income that is distributed to the trust is considered its corpus and is accumulated. Only the earnings on that corpus is considered the income.

Under the federal tax law, trusts are subject to a compressed income tax rate schedule. In other words, the highest marginal income tax rate (39.6% presently) occurs once the trust accumulates as little as $12,000 of taxable income. Moreover, the Medicare Surtax (aka ObamaCare) applies at another 3.8%. So the accumulated income could be subject to a 43.4% marginal income tax rate on the annuity that terminates to the trust upon the death of the annuitant. If the trust is established in a state that has a state income tax, even more could be lost to taxes.

Moreover, every annuity contract is different. Some annuity contracts will look through the trust to pay out to the trust beneficiary, so long as such a payout complies with the trust terms. Other annuity contracts require a fixed payout over a term certain number of years.

For the reasons that I mention, annuities are known as “wasting assets” under Florida’s principal and income statutes. In other words, they pay out and are diminished over time. They are also called “income with respect to a decedent” (IRD) items under the federal tax law, as they have built in income that is going to be taxed to something (a trust) or someone (a direct beneficiary) upon the death of the original annuitant.

Sometimes annuities are owned inside of an individual’s IRA. When this occurs, the provisions of the annuity contract that apply upon the death of the annuitant are very important to consider.

So when you own annuities, and particularly when annuities make up a significant portion of your net worth, it is important to let your estate planning attorney know if you own significant annuities and ask your financial advisor to provide your estate planning attorney a synopsis of the contractual rights and obligations that your annuities offer and require.

©2014 Craig R. Hersch

The Problem with Successors Named in a Durable Power of Attorney

A Durable Powers of Attorney (DPOA) is an important document that everyone should have as a part of his or her estate planning portfolio. Generally speaking, the grantor of a Durable Power of Attorney names someone who can legally act for the grantor in any number of ways. The person who is granted the power to act is known as the “attorney-in-fact” or “agent”. For simplicity’s sake in this column I’m going to refer to the grantee of the power as the “agent.”

The DPOA may allow the agent to write checks to pay bills, sign deeds, complete beneficiary designations, enter into and/or enforce contracts, open accounts, close accounts, and direct investments among other things.

DPOAs cease upon the grantor’s death. In other words, they are no longer effective. The “Durable” in the name “Durable Power of Attorney” means that the powers survive the grantor’s incapacity. A General Power of Attorney, in contrast, would cease if the grantor should become incapacitated such as through dementia or Alzheimer’s disease. Most estate plans use the DPOA since the thought is that the power holder would only act if the grantor of the power couldn’t.

Under Florida law, one can name an agent under a DPOA, and then if that agent is unable or unwilling to serve, another agent can be named as an alternate. It might look something like this: “I hereby name my wife Patti as my Attorney-in-Fact and if Patti is unable or unwilling to serve then I name my daughter Gabrielle to so serve.”

I almost always try to persuade my clients from naming successor DPOA agents in the same document.

Why? Even though they are legal under the relatively new Florida statute on point, successor DPOAs are very difficult to use from a practical standpoint.

Consider the fact that any bank, financial firm or broker who is acting under a DPOA is suspicious of the document from a liability standpoint. Consider the scenario where my daughter Gabrielle walks into my financial advisor’s office holding the DPOA and says “I need to transfer $20,000 out of my father’s money market account today.”

My financial advisor looks at the DPOA, worried that if it is not authentic he could be liable for following Gabi’s direction. So he asks Gabi “Why are you using the power? Can I call your dad to see if this is okay?”

“Dad’s in the hospital and isn’t able to talk. I need to write some checks to pay a bunch of his bills and that is why I am here.” Gabi answers him.

My financial advisor then reads the DPOA – and points to the first line that says my wife Patti is the first power holder and not Gabi.

“It says here that your mother is the first power holder and that you can only act if she can’t…” he says.

“My mom is out of the country and can’t take care of these things now,” Gabi says.

“I’m sorry,” my financial advisor says, “I have to be very careful as I may have a lot of liability here if for some reason you aren’t supposed to act,” he says. “I’m going to have to give this to my firm’s legal department to sort out.”

Gabi, frustrated and worried that she won’t be able to pay my bills on time is frustrated. “How long will this take?” she asks.

“I don’t know,” my financial advisor replies.

From there the whole thing can become a circus. The attorney for the financial firm may say that they need written proof that Patti can’t act or that she is unwilling to act. It can take days if not weeks to resolve.

So what’s the alternative? What I normally suggest is that each person you wish to name as your agent under a DPOA have a separate DPOA document that just names them individually. While there is a possibility that if you have two different parties acting under a DPOA that they are in conflict with one another, I will tell you anecdotally from personal experience that I haven’t seen much (if any) of that in my practice.

With that said, if you name more than one party as a DPOA in separate documents it is wise to tell the individuals you are naming of the fact that each has a separate power, and that your expectation is for them to work together and to consult one another. Or if you prefer that one only act when the other couldn’t, that would be a verbal arrangement.

Remember that anyone acting as an agent under a DPOA has a fiduciary duty to the grantor of the power. They should only be acting in the grantor’s best interests. If you fear that someone you name won’t do that, or won’t work in conjunction with another as you would request, then I would say that you probably shouldn’t be naming that person in such a powerful document to begin with.

©2014 Craig R. Hersch

Making an Irrevocable Trust More Flexible

No one likes something that can’t change with the times. Especially now. Things change so rapidly that we appear to live in a “throw away” economy. Remember the Sony Walkman? Replaced by the iPod. Even now the iPod is threatened by music streaming services like Pandora and Spotify.

Blockbuster Video stores used to be in nearly every Publix shopping center. They were run out of business by Netflix, Redbox, Hulu and Xfinity On Demand.

When I was a young kid there was really no such thing as mutual funds. Only the wealthy could afford to have financial advisors who helped them build individual stock and bond portfolios. Today, financial service products abound that meet the needs of everyone from the uber-rich to the middle class.

The Brady Bunch was considered such a unique blended family situation back in the 1970s that America tuned in to watch the antics. Today, Brady Bunches are commonplace.

Tax laws change. Trust laws evolve.

So what’s my point?

Irrevocable trusts. They’re a dangerous necessity in some estate planning situations. As opposed to Revocable (or “Living”) Trusts where the grantor can change anything that he or she wants so long as he or she is alive and competent, irrevocable trusts by design cannot be changed by the grantor.

The reason that irrevocable trusts can’t be changed is because they are used to make “completed gifts” to remove assets from an estate, or to protect assets from the reach of creditors or predators like divorcing spouses. Irrevocable trusts are necessary to get charitable income and estate tax deductions as well. If the trust in question were revocable, it could not accomplish any of those benefits.

When implementing an irrevocable trust, one must be very careful. Once you’ve named the trustee, that selection can’t be changed by you as the grantor. So if you named “Friendly Local Bank” as Trustee, and that bank was bought by “Unfriendly International Bank” that charges high fees and provides little service, the beneficiaries could very well be stuck.

Once you’ve determined which beneficiaries get what share, that is written in stone. When you draft a document to conform to today’s investment strategies and tax laws, it might be obsolete in a few years.

Ask a friend or family member who is a beneficiary or a trustee of an inflexible irrevocable trust and you may hear gripes – or worse – horror stories.

So what is one to do? Live with the inflexibility?

No. There are alternatives. The client and attorney can discuss including “escape hatches” to be built into the irrevocable trust that allow for flexibility. Consider how you might include flexibility in a document that irrevocably names a trustee, for example. Let’s say that client wishes to name Trust Company as Trustee. To ensure that Trust Company remains good and vigilant, Client can create a provision inside of the irrevocable trust that names an independent party who can remove and replace the Trust Company with another or with a family member.

The irrevocable trust can grant “powers of appointment” to certain beneficiaries that allow them to change who is entitled to income and principal from their share. This way, if an unexpected death occurs, or a beneficiary experiences a bankruptcy that threatens the inheritance, or if a beneficiary develops drug or alcohol problems, the terms of the trust can be “amended” – not by the grantor – but by a trusted independent individual or beneficiary – as circumstances warrant.

A “Trust Protector” can be named and powers granted to this individual who would have the ability to modify the trust to comply with changing tax laws. Generally speaking, the Trust Protector should not be a trustee or a beneficiary of the trust to prevent unintended tax outcomes.

There are countless other strategies to make irrevocable trusts more flexible. You see my point. Careful thought should be put into the selection of the independent parties named inside of the document, including the powers that one grants to those parties.

There is always the possibility that the parties you select abuse their authority. If they did, then they would have to answer to the beneficiaries. Anyone serving in an independent role would have a fiduciary duty to the trust beneficiaries when acting. In other words, they would have to act in the best interests of those affected. Paragraphs expressing the grantor’s intent go a long way here.

As you can imagine, a well drafted irrevocable trust is anything but “boilerplate”. But it pays to put the thought in before assets are transferred, rather than waiting for problems after.

©2014 Craig R. Hersch

Ruling From the Grave – Or Protecting the Inheritance?

The client sat across from me in the conference room, “I don’t want to rule from the grave,” he began.

“What do you mean by that?” I asked.

“Just what I said,” he replied, “when I’m gone I want the kids to get everything outright with no strings attached.”

“That sounds good,” I said. “When your children die do you care if they leave the inheritance that you left to them to their children or to their spouse?”

“I want them to leave it to their children of course. What if they die first and their spouse remarries? Then the money could end up outside of my family!”

“Yes, true. But if you leave it to your children outright and their will says everything to their spouse, as most wills do, then that’s what’s likely to happen.”

“I never thought about that.” he said.

“And wouldn’t you want to protect the inheritance that you leave your children in case any of them get divorced?” I asked.

“Yes.”

“And if any of your children have any creditor issues, like deficiency judgments from an upside down mortgage that was foreclosed. You wouldn’t want a bank to find out about their inheritance and go after it would you?”

“Obviously not.”

“Didn’t you say that one of your children – your daughter that owns that software business – is actually a lot wealthier than you are?”

“Yes – she has a lot of money.”

“If you left her inheritance outright to her with no strings attached then you might exacerbate her estate tax problem. If you left it in a continuing trust, on the other hand, you could protect it from any creditors and predators as well as divorcing spouses, plus it can be outside of her estate for estate tax purposes.”

“But I don’t want her to have to go to a bank or trust department and beg for her money,” he exclaimed.

“She wouldn’t have to,” I explained. “You could name each of your children to be the trustee of their own continuing trust share. Your children could decide how their share is invested, they can distribute the income to themselves, or to their children or even their grandchildren one day. You could even let them decide who they leave it to in their own will.”

“But what if I want their inheritance to one day go to their own children?”

“Then you can have me draft their trust share provisions so that’s what is supposed to happen. This is all very flexible. You have me build what are called ‘testamentary trusts’ inside of your own revocable living trust. The testamentary trusts do not get funded with your own trust assets until after you pass away. But the whole structure is built inside of your own trust.”

“Are there any tax problems?”

“Not really. IRA and 401(k) assets might pose certain problems that we would need to plan around since those have an income tax element when they are distributed. But all of your other assets would work just fine.”

“What if one of my children wants to withdraw money from their trust share to buy a house or build an office building? Can they withdraw the money to do so?”

“We could put in a trust provision that would allow them to do so, yes,” I answered. “But the better thing for them to do would be to have their trust share buy the house or build the office building. That way the asset remains protected under the trust umbrella.”

“But what if they wanted to later sell the house or building?”

“Your child could do that too,” I said. “Remember that as trustee they control the trust investments and can buy and sell as they please.”

“Frankly it sounds too good to be true,” my client said. “I always thought by creating trusts for my kids in my estate plan that I’d be ruling from the grave.”

“Not really. This isn’t ruling from the grave so much as it’s creating opportunities that otherwise wouldn’t exist. Your children can’t create their own trusts that would have these features in them. Only someone else can create a trust that would have these asset protection and favorable tax elements. And the parent is the logical person to create it in their own estate plan.”

“You learn something new every day

I Love My Son- or Daughter-In-Law, But…

“Henry” recently visited with me. “I love my son-in-law as if he was my own son,” he began, “but my daughter’s marriage to him has been rocky at times, and I’m worried that when I die he’s going to take the inheritance I leave my daughter. What can be done to ensure that what I leave behind benefits her?”

I suggested that Henry consider leaving the amounts to his daughter in further trust as opposed to an outright distribution.

“I don’t want her to beg for her inheritance though. My aunt was left a trust and had to beg the bank every time she needed money and it was HER money,” Henry said.

“That situation might come true if you name a bank or trust company as the only trustee, and give that bank full discretion over when you daughter gets income or other assets from the trust. But what I’m suggesting is to make your daughter her own trustee, or perhaps name a friendly co-trustee with her. While naming a bank or trust company might give your daughter professional management over the trust, I would suggest – if this is what you want – to give your daughter or some other person the ability to remove and replace the bank or trust company. But in any event, you can always name your daughter as the only trustee of his or her share.” I replied.

“But if she’s her own trustee, won’t she have the ability to do whatever my son-in-law asks?” Henry worried. “What if he wants her to invest in the next big internet company and she blows it all?”

“That’s always a possibility if she has full discretion over the trust funds,” I answered. “This goes to how much you trust your daughter. You were going to give her the money outright before anyway. By leaving it to her in a trust that she controls you can protect the inheritance you leave her from creditors, predators and even divorcing spouses.”

“How does that work. If she has control won’t the assets be subject to those dangers?”

“The more control you give her, certainly the more likely creditors will be able to attack the assets. But by taking some preventive measures, such as naming an independent co-trustee, or naming her children (your grandchildren) as co-beneficiaries who may also be entitled to income you can better protect the trust assets. When there are other discretionary beneficiaries, your daughter will, as trustee, have a duty to protect the trust assets for their benefit as well.”

“But even so, my daughter’s rights to the trust will be mandatory, right? In other words, I want all the trust income to be distributed to her.”

“Well, if she is the trustee, she can determine when it’s best to make distributions from the trust. So I might suggest that you make your daughter a discretionary beneficiary as well.”

“If we make her kids a current beneficiary, when they get older can’t they demand trust money from her? I want her to have enough for her retirement and not necessarily give it all to the grandkids.”

“We can build language into the trust that indicates your primary intent is your daughter. You can also give your daughter something known as a ‘power of appointment’ so that she can dictate where the trust assets are distributed when she dies. There are several ways to limit your grandchildren’s ability to make demands on their mother.”

After several more minutes of give and take on this issue, Henry decided to leave his daughter amounts in trust as opposed to an outright distribution. There are other benefits to doing this, as I’ll point out in later columns.

©2009 Craig R. Hersch

Are All of Our Kids Equal?

Any parent of more than one child knows how different our kids are – even if they have the same mother and father and were raised in the same household. One’s an athlete, the other a bookworm. One’s an A+ student while another struggles to get Bs and Cs. One handles stress easily while another melts down at the slightest provocation.

It’s almost mind blowing, until one considers how different one’s own siblings are from oneself.

But then again, most parents won’t admit to loving one of their children more than another. We may love them in different ways, but we love them nonetheless.

But are they equal? And more to the point of this column, should we treat our children equally inside of our estate plans? Is treating our children the same in our will or trust an implicit obligation to demonstrate – through our very last words and actions – that we really did love them all the equally?

There is no right or wrong answer here. Suppose that you have a daughter, “Sandra,” who is a world renowned neurosurgeon. Sandra has speaking engagements in London, lives in a mansion and enjoys the good life. Your son, Thomas, is an eighth grade schoolteacher. He works very hard but struggles to take modest vacations with his family and to save for his children’s college education.

Should you leave more money to Thomas then you leave to Sandra?

John Sheppard, my retired law partner, commonly counseled his clients to treat his children equally when making these types of decisions. He would say that the children made their own choices in building their lives, and that we are all just stewards of everything that we own anyway. It was his thought that when leaving more to one child than to another, one makes an implicit nod favoring that child that can leave a hole in the other child’s heart.

I don’t know if I agree with his philosophy. I can tell you from first-hand experience, when children are treated differently in an estate plan that the one who is treated less favorably will commonly ask if I knew of anything that they may have said or done to upset their parent. Unfortunately, the parent isn’t around any longer (or we wouldn’t be reading his or her will) to provide assurances that their love was just as strong for the one child as the other who was left more assets or money.

But that shouldn’t preclude one from leaving more to one child than another, particularly where there is a real need. Consider the child who has a disability, and because of decreased lifetime earning potential may not be able to accumulate sufficient savings to take care of himself in retirement. Leaving that child a larger chunk of one’s inheritance would certainly be justified.

Or how about another child who needs a little more help to educate her children? Or the other child who experienced unfortunate medical problems?

There are all sorts of reasons for treating our children differently inside of our estate planning documents.

They key to avoiding any emotional trauma that may result from our decision is communication. Whether that communication is through a heart-to-heart with a son or daughter to ensure that they know your estate plan is not representative of your love for him or her, or through a letter that is only to be opened at the time of your death, a few words of explanation can go a long way.

If it were up to me, I would suggest the lifetime heart-to-heart as opposed to the letter to be opened later. A letter doesn’t allow for the give and take that a conversation does. It’s best to look your child in the eyes and tell him or her what you really feel.

What about a punitive situation? You and the child have had a falling out. Or you don’t like his or her spouse and fear that the spouse will squander the inheritance that you leave your child. These situations are much more volatile.

Here I usually suggest that the parent take a few days or even weeks to consider the emotional impact of reducing that child’s inheritance or leaving them out altogether. There’s no moral judgment here, just a pause to make sure that the emotions and thoughts are true and consistent. This is never an easy decision to make.

So in the end there’s a great deal of emotion in our estate plans, whether we are leaving everything equally to our children or not. Whatever you do, make sure that your heart is in sync with your mind, and that you’ve done your best to communicate your intentions where appropriate.

©2014 Craig R. Hersch

Income Statement vs. Balance Sheet

The other day a client asked me, “Will my children be taxed on their inheritance?” This particular client did not have assets in her estate that would be valued at more than $5.34 million, the current federal estate tax exemption. Since she was also a Florida resident, her estate would not be subject to any state inheritance or death taxes.

“No,” I told her, “except the IRA account money will be taxed to them as income when they withdraw it, just as you are taxed as you take distributions from that account.”

“But what about the house?”

“No. Not taxable.”

“The certificates of deposit?”

“No.”

“My regular investment account?”

“No. The distribution of those assets are not taxed as income.”

“Yes, but are they taxed as an inheritance?” she asked.

That’s when the core of her misunderstanding dawned on me. And I believe that many others harbor the same misunderstanding. Most of us deal with the tax on our income every year when we file our Form 1040s. That tax is computed on our net taxable income, which is calculated as the difference between our gross income and our allowable tax deductions and credits.

Gross income includes earnings from employment, profits from our businesses, dividends, interest, traditional IRA and 401(k) distributions and the like. Deductions include payments for our home mortgage interest, charitable contributions and medical expenses, for example. The tax that we pay on our income is therefore a tax on our personal income statements.

Estate and inheritance taxes, in contrast, are a tax on our balance sheet at the time of our deaths. Our balance sheet does not describe our net income – rather it describes our net worth – our assets less our liabilities.

Our net worth is calculated by subtracting our liabilities – mortgages, credit card balances, etc. from the date of death value of our assets, including our homes, real estate, business interests, partnerships, investment and savings accounts, retirement plans, annuities and life insurance.

When determining the estate tax, our net worth – our taxable estate – is first calculated. Our taxable estate equals the difference between our date of death net worth and allowable estate tax deductions. Examples of allowable estate tax deductions include qualifying distributions to our spouse and charities as well as estate administrative expenses such as legal, accounting and trustee fees.

The final amount of our taxable estate is then applied against our available estate tax exemption. The federal estate tax exemption for 2014 is $5.34 million. Any “taxable gifts” that we made during our lifetime (gifts that exceeded the annual exclusion amount – which was $10,000 in prior years but has increased to $14,000) are deducted from our estate tax exemption to arrive at our available exemption at the time of our death.

If our taxable estate does not exceed the estate tax exemption, then no estate tax payment is due. So the distributions of our assets – our balance sheet items – are not taxable as income to our beneficiaries.

Note a couple of complexities I alluded to above. Retirement plans, such as Traditional IRAs, 401(k)s, pensions and profit sharing plans and annuities have a “double whammy” in that they appear both on the income statement, when the beneficiary takes distributions – and is therefore taxed on those distributions – and the balance sheet – as an element of our net worth – therefore making those assets subject to estate tax.

Another is life insurance. Generally speaking, beneficiaries do not pay income tax on the receipt of life insurance death benefits. Without advanced planning, however, the death benefit of our life insurance policies is an asset that appears on our net worth statement, therefore subjecting the death benefits to estate tax.

You might wonder about capital gain taxes. While the distribution of a house, for example, does not create an income tax event, will our beneficiary have to report a capital gain when they sell the home? Here one must understand the “step up in tax cost basis” that our beneficiaries receive when we die.

Because the estate tax is calculated on our “date of death” fair market values of our assets – our beneficiaries receive a new tax cost basis equal to that value. So if the home we leave our beneficiaries is worth $500,000 when we die, but we only paid $200,000 for it, if our beneficiaries sell the home shortly after our death at $500,000 capital gains tax will not apply.

There are exceptions to the “step up in basis” rule as well. Retirement accounts (IRAs, 401(k)s, etc.), annuities and other similar accounts that enjoyed income tax deferral during our lifetime do not enjoy a step-up in basis. Our beneficiaries pay income tax on the distributions.

I hope that this clears everything up for you! Don’t get lost in all of the exceptions when trying to figure out whether your estate will be taxable. Just look at your net worth. Everything else is details that can be worked out with your advisors when you plan your estate.

©2014 Craig R. Hersch

5 Questions When Family Business A Large Portion of Net Worth

What do you do when a significant portion of your net worth is wrapped up in a closely held business interest and one or more of your children are involved in that business? That’s a loaded question that will have a different answer for each family. So I thought that I’d give you the five biggest questions that each family should ask of their attorney and CPA when a family business is part of the estate planning equation.

1. What’s the true value of the business? While many family businesses are portable to either the next generation or as a part of a sale to a third party, some businesses are dependent upon its owner and have little or no value if that owner were to retire or die. Some businesses may have succession value, but that value would be lost entirely unless a succession plan is considered and implemented.

2. How do we leave the business to the next generation? If there are likely candidates to take over the family business, it won’t happen successfully without a plan. Will senior management accept the younger family member as their new boss or leave to work for a competitor or to create one? What incentives can be offered to key employees to keep them as a part of the team? How will the next generation be groomed? For gift tax and estate tax planning purposes, should transfers of business interests occur now or later?

3. Will the current business owners still need income through retirement? This is perhaps one of the stickiest issues to confront. When transferring a family business for gift and estate tax purposes, the retention of an income interest may result in the entire value of the business being included in the transferor’s estate for estate tax purposes, which can be disastrous. There are many avenues around this problem, however. Employment and consulting agreements, sale of business interests with installment notes and Grantor Retained Annuity Trusts are just a few of the methods that can be used to satisfy the need for income.

4. What to do about the children who are not a part of the business? Generally speaking, it is usually not a good idea to leave family business interests to children who are not actually working in the business. This only leads to resentment between the children who are working and those that are expecting dividends for their shares. Consequently, there are two entirely different ways of thinking about leaving a family business to children. The first is that the children who are working the business are inheriting a “job” and therefore should get a share of the non-business assets. The second is that the children who are working the business are receiving the most valuable asset and the non-working children should therefore get a larger share of the non-business assets. There is no right or wrong answer to this dilemma.

5. What legal agreements need to be put into place to secure the future vision? A will is probably not enough when considering all of the elements that need to be put into place to wrap up a family business succession plan into a tidy package. Shareholder or partnership, employment, consulting and trust agreements will likely all need to be considered. Only after the first four questions are answered will the family have a better idea what legal means are necessary to ensure a smooth transition at the lowest possible tax cost.

Each of the above questions will open other, more detailed questions. My thought in today’s column was to give a broad overview. The type of entity involved, such as “S” Corporation, LLC, partnership or the like will also drive what issues need to be resolved to have a successful plan put into place.

Once that plan is agreed upon, it’s wise to review and to update it at least every two years or so. Laws change, goals change, people’s vision of their own future changes. Finally, consider talking to your family about your plans. Parents often assume things that may or may not be true about their children’s hopes, dreams and expectations.

©2014 Craig R. Hersch

What to Bring to Your Attorney When a Loved One Dies

It’s always a difficult time when you lose a loved one. Usually, one of the first places one visits will be the lawyer’s office who drew the will or trust. The will or trust isn’t usually read to a gathering of family “Hollywood style.” Rather, the lawyer discusses the administrative steps that the personal representative (executor of a will) or trustee (of a trust) must take before distributions are made to the beneficiaries.

You don’t want to wait too long before visiting with the attorney, since there are time deadlines, both legal and tax. With that said, visiting the attorney’s office during the immediate days following the passing isn’t usually helpful either, as the shock of the loss numbs senses. My suggestion is to wait a week or more, unless the parties are in town only for a few days and need to initiate the administrative process prior to heading home.

The question therefore arises as to what you need to bring to the attorney’s office when a loved one dies. The following is a laundry list of items that will make that first meeting go more smoothly:

1. Original of the last will, revocable trust, and any codicils or amendments;
2. Certified copy of the death certificate;
3. Copies of most recent bank and brokerage statements;
4. Certificate of Deposit statements;
5. Savings bonds;
6. Copies of deeds to real property;
7. Copies of stock certificates;
8. Most recent Form 1040 Tax Return;
9. Federal Gift Tax Returns Form 709s previously filed;
10. Information related to any unreported taxable gifts;
11. Information regarding loans, notes, mortgages and indebtedness;
12. Most recent credit card statements;
13. Amounts paid or forwarded for burial, clergy, service and reception;
14. Addresses and contact information of family members who may be beneficiaries as well as those serving as co-personal representative and/or trustee;
15. Names and contact information of financial advisors, insurance agents, CPAs, tax return preparers and other such professionals;
16. Copies of ownership interests in closely held businesses and any shareholders or partnership agreements that the deceased may have been a party to;
17. Prenuptial or postnuptial agreements, if any;
18. Copies of trusts and related account statements of which the deceased was a beneficiary at the time of his or her death;
19. Tangible personal property lists signed by the deceased that directed the distribution of such;
20. Automobile titles;
21. Information related to any safety deposit box leased;
22. Life insurance policies and statements including copies of the beneficiary forms;
23. Annuity information, including gift annuities;

Each situation is different, so there may be items that I have not included on this list that are pertinent. Certainly, not everyone will have all of the suggested items, and will almost always take time to marshal all of this information.

The more information that you can quickly provide your attorney, the better.

©2014 Craig R. Hersch