Irrevocable Life Insurance Trusts*

An Introduction

This introduction is the first of a multi-part series on an extremely important planning tool -- the Irrevocable Life Insurance Trust (often referred to as an ILIT).  The ILIT is not as simple as it appears at first glance.  It has the potential to blow up if it isn't 1) based on sound counseling, 2) drafted well, and 3) implemented with precision.

In future issues, we'll discuss the procedures that must be followed every time an ILIT is used, what to do with existing policies, the differences between individual and joint ILITs, how ILITs impact annual gifting programs, the famous "5 and 5" limit, the risks when estate taxes are paid from the proceeds of an ILIT, generation skipping, and choosing proper trustees.

The Big Picture

Life insurance is a critical tool in estate planning.  Life insurance proceeds create liquidity at precisely the time it is needed to pay the expenses of a person's final illness and death -- and to pay estate taxes if necessary.

In addition, life insurance provides cash for beneficiaries of estates that are asset-rich, but cash-poor.  A family business owner may use it for beneficiaries who are not involved in the business.  In a second marriage, one spouse may use it to provide for the other, while preserving the bulk of the estate for children.

Life insurance payable to a designated beneficiary avoids probate (unless the estate of the insured person is erroneously named as the beneficiary). If life insurance is not owned correctly, however, or if premiums are not paid in the most tax-efficient manner, gift and estate taxes can reduce the benefits of life insurance policies by approximately half!

Many people believe that life insurance is exempt from all taxes.  This is not true.  They may remember an advisor telling them that they "won't pay taxes" on the life insurance proceeds.  The advisor, of course, had federal income tax in mind.  Income taxation is separate and distinct from estate taxation.  And if you own life insurance, the death proceeds will be subject to federal estate taxation and perhaps state estate taxation, depending on the state in which you live.

As long as the insured person has any rights or powers over the policy (referred to as "incidents of ownership" in the Internal Revenue Code), the proceeds will be included in his or her estate for estate tax purposes.

To avoid this problem, a life insurance policy can be purchased by, or contributed to, an irrevocable trust.  The insured person cannot be a trustee or beneficiary of that trust because both control by a trustee and enjoyment of benefits as a beneficiary would constitute incidents of ownership.  Instead the irrevocable trust (an ILIT) becomes both the owner and the beneficiary of the policy, and the insured person chooses trustees to manage it.

We often think of life insurance in the context of paying estate taxes.  However, even those estates that will never be large enough to be taxable will probably include insurance policies purchased for other reasons.  By having those policies owned in an ILIT, the estate has more room for growth.

More next issue...

*Adapted from the Planning Partners Press.

Will a Trust Really Fail for Lack of Funding?*

In some jurisdictions, lack of any trust corpus (even just a couple of dollars, or some personal property) will cause the trust to be treated as if it were never created to begin with, and attempts to place assets into such a trust in the future cannot salvage or resurrect the defunct trust.  Most trusts that are created have some modicum of a trust corpus to prevent such a disaster.  Therefore, having anything in the trust will prevent it from failing, right???  That depends on your definition of "fail."  In order to answer the question, we must first talk about how funding works in relationship to a trust.

How does a trust work?  Think of a trust as a bucket, or a treasure chest.  One writes instructions on the outside of the bucket about what one wants done with the things that are in the bucket.  The trustmaker then takes the "bucket" and puts it into the hands of someone the trustmaker can rely on--that's the trustee.  The trustee's job is to follow the trustmaker's instructions with regard to the things that are in the bucket.

What will happen if the bucket is empty when the trustee attempts to follow the trustmaker's instructions after the trustmaker has died?  The trustee only has authority over what is in the trust, so if there is nothing in the trust, then there is nothing for the trustee to do.  (And as mentioned previously, if there is really nothing in the trust, then it may be void, depending on the controlling state law.)

Anything left outside the trust is outside of the trustee's control.  That means that the trustmaker's directions will not be followed with regard to those assets that are out of the trust.  Some assets may find their way back into the trust through a pour-over will, but typically this requires the expense, delay and publicity of probate to do so.

The process we call "funding" is the process of titling assets so that they are in the trust "bucket"--controlled by the trustee.  These assets will be controlled by the trustmaker's directions without the need for probate.

So, back to our question:  having anything in the trust will prevent it from failing, right?  If the measure of success is mere legal sufficiency, then that is correct.  However, the true measure of a trust's success is not whether it is "legally sufficient," but whether the trust meets the client's goals.

One common motivation many have for seeking out an attorney to create a trust is so that their family will be able to avoid the cost, delay, and publicity of probate on their death.  Failure to fully and properly fund a trust means that the client's directions will not be followed with regard to those assets not in the trust, or at least that probate will not be avoided.

If a trust fails to do what the client wanted (transfer assets by specific instructions contained in the trust, or avoid probate, for example), then it has failed whether the trust is legally sufficient or not.

Hopefully, when you buys a gallon of milk at the grocery store, it comes in a container.  But what if you pay for a gallon of milk and only get an empty or half-full container?  You would be upset, and rightly so.  However, people buy empty (or, at least, not full) trust buckets frequently, and do not realize the reduced value they are receiving.

Make sure you are getting full value for your estate plan by working with an attorney who will ensure that the trust bucket is full when created, and has a formal process in place to make sure that it stays that way.

*Adapted from the Planning Partners Press.

Forgotten Estate Planning: Disability*

An often-overlooked part of estate planning is planning for mental disability.  Many of us have been in the uncomfortable position of having to take care of a relative or friend who can't handle his or her financial affairs anymore.  It could happen to you one day.

Our clients tell us that, "I want to control my property while I'm alive and well, and plan for me and my loved ones if I become disabled."

There are four basic disability planning choices:  1) No planning; 2) a Power of Attorney; 3) a Standard trust; 4) a Counseling-oriented trust.

The most common planning issues are: a) Who decides when I lose control?  b) Who takes control?  c) Who gives instructions to the person who takes control?

In most states, if you haven't planned for when you are disabled, your loved ones will have to hire an attorney and go to court.  The judge will decide whether you are disabled, who will be your guardian, and what that guardian can do.  Every state's system is a bit different, but they all have one thing in common:  the Judge is in control.

People often use a General Durable Power of Attorney to prevent guardianship proceedings.  A GDPOA appoints someone as your Attorney in Fact, or agent.  GDPOA's are usually effective immediately, have no reporting requirements, no personal instructions, and have extremely broad powers.  If you look up "lack of control" in the dictionary, GDPOA should be the first definition.  The advantage of this approach is that you get to name the person who is in control.

Standard Living Trusts are often little more than word-processing.  There is no attempt to prepare a personalized plan, so they often use a standard definition of disability, usually based on the option of any doctor with no guidance on which doctor to use.  Doctors are often unwilling to declare someone disabled unless that diagnosis is absolutely certain.  As a result, many families with these trusts may have to resort to the Probate Court to determine whether the planner is disabled.  Additionally, these trusts typically have few personal instructions, but they may provide for a private transfer of control to personally selected trustees.

Most Counseling-orients Trusts provide a personalized definition of disability through a disability panel.  When your loved ones start to think that it's time for you to turn control over to somebody else, they can call the disability panel together to decide whether you are disabled.  Who's on it?  How does it operate? You decide.

Then who takes care of you?  The Successor Trustee you chose when you were well.

How do they care for you?  They follow the instructions you've left behind.  I often ask my clients, "When you need someone to take care of you, would you rather be cared for in your own home, in someone else's home, or in a nursing home?  Everyone has an opinion, but most estate plans doesn't address it!  When you family knows your wishes, they are more likely to be followed.

Many Americans will go through a period of disability.  Planning for your own care has become critically important, as families have become more mobile and fragmented.  With proper planning, you can be well cared for in the way that you want, by the people you have chosen, for the rest of your life.

*Adapted from Planning Partners Press.

Back At It!

I'm back in the office after spending a week in Orlando at the National Network of Estate Planning Attorneys fall conference.  I always look forward to these conferences for a number of reasons--catching up with friends and colleagues from around the country, re-engergizing myself for all that comes with being a small firm practitioner, and LEARNING!  Lots and lots of learning!

I'm always amazed at how much there is to know about estate planning--and the field is constantly changing.  One of the things that I love about NNEPA is the collective philosophy regarding the importance of educating clients on the ins and outs of estate planning and the importance of personalized counseling for every client family to make sure that together we design a plan that will truly work for their unique family.

As part of this philosophy, I believe there is much more to estate planning than a client's financial net worth.  Each of us has a legacy that we can pass on to those we love.  We have stories to share that explain how we became who we are; we have our own thoughts and ideas and opinions about money, charity, legacy, family, faith; we have hopes and dreams for those we love.  As an estate planner, I believe it is important to help my clients capture these non-tangible assets because it is all a part of their true wealth.

For clients enrolled in the Empowered Legacy Planning program, as a result of the SunBridge Legacy Builder Retreat I attended while in Orlando, I will soon be offering Priceless Conversations as part of your membership.  To learn more about Priceless Conversations and the SunBridge Legacy Builder Network, please visit www.SunBridgeLegacy.com.

If you are interested in learning more about membership in our Empowered Legacy Planning program, please give us a call at 480.855.8383.

Do I Have to Pay Income Tax on My Trust Distributions?*

That is one of the most common questions about the administration of trusts and estates.  The answer is, "It depends." The beneficiaries, and perhaps the trusts themselves, are subject to the income tax.  Distributions of principal are not subject to income tax.  Distributions of income are subject to income tax.  The trust has to pay income tax on any income that is not distributed.

Some trustmakers have so much control over the trusts they have created that the IRS ignores the trusts completely.  These are called Grantor Trusts and any income earned by the trust is simply part of the trustmaker's personal income tax return.

If a trust or estate has over $600 of income during the year, the trustee (or executor) musts file an income tax form called a Form 1041.  The biggest difference between a 1041 and a 1040 is that trusts gets a bigger deduction for distributions of income to beneficiaries.  This results in ensuring that either the trust or the beneficiary, but not both, pays income tax on every dollar of income.  The trustee files an informational return, a K-1, if there were any distributions.  This lets the beneficiaries know how much of the distributions they received are taxable to them.  If there is any tax due by the trust, the trustee is responsible for making sure the income tax is paid.

A rule that is sometimes hard to grasp is that trust income and the taxable income of trusts are not the same thing!  For example, most states' laws regard capital gains distributions as principal, not income, for trust accounting.  For income tax, these are income.  It is important to keep this in mind while working with trust income.

The income tax on the amount of trust income that is distributed to beneficiaries is paid by the beneficiaries as part of the beneficiaries' tax returns.  The income keeps the same character as it had for the trust; for example, if the trust had long-term capital gains and distributes them, the beneficiary has long-term capital gains.  This amount is a deduction on the trust's income tax return.  So, somebody's going to pay income taxes on any income earned by the trust.  It could be the trustmaker (in a Grantor Trust), the beneficiary (if there were distributions), or the trust itself.  The trustee does not decide which distributions are income and which are principal; we calculate the Distributable Net Income ("DNI") and apply the DNI rules to determine who pays what.  The results are sometimes surprising, especially when the trust receives tax-free income.

Keep in mind that the tax rates for trusts are the same as for individuals, but the brackets are smaller so the trust marginal tax rates are usually higher.  Trusts reach the 35% income tax bracket at the $11,200 of taxable income.

It is important that trustees review their income and distributions with their tax advisors at the end of the year.  Fortunately, the IRS grants trustees (and executors) the option to treat distributions during the first 65 days of a tax year as made in the prior year; so, the trustee and his tax advisors do have a couple of months to get this done.  During that review, they can figure out what the best results would be and structure the distributions to achieve them.

*Adapted from Planning Partners Press

Still Stuck in Estate Tax "Purgatory"!*

Here's an oxymoron for you--as an advisor, I want to be able to share an "update" with my clients and readers regarding the estate tax "repeal" situation, and there's really no solid update to report!  So, instead, I'll share a little bit of what has been going on behind the scenes...

There have at least been some meetings that have taken place.  There have been a number of different bills introduced, but nothing has really gotten very far.  The three most likely scenarios at this point are as follows:

1) A reinstatement of the estate tax with an exemption of $3.5 Million and a tax rate of 45%.

2) A reinstatement of the estate tax with an exemption of $5 Million and a tax rate of 35%.

3) Congress does nothing, and the estate tax comes back with an exemption of $1 Million and a tax rate of 55%.

Generally, Republicans favor the highest exemption and lowest tax rate, while Democrats generally favor reinstatement at the middle numbers (2009 levels).

Two developments have taken place seemingly make it less and less likely that there will be any action taken soon, however.

First, although Democratic leaders seemed willing to agree to Republican demands in recent talks, they still broke down.  It seems that there are many rank and file Democrats who are now willing to let the tax issue take care of itself, preferring to not take the political risk of appearing to pass legislation favoring the richest Americans--especially so soon before the November elections.

The Democratic leadership appears to be unwilling to bring legislation forward that does not have the support of the majority of the party.  One Senator is quoted as saying more than 80% may be opposed to the increased exemption and lower tax rate discussed by party leaders.  Thus, it may be that nothing is addressed prior to November and that any action taken would be rushed, as was the case with the failed effort to address the situation at the end of 2009.

The second issue that originally looked promising in terms of pushing early action was that of retroactive application of any reinstatement.  Retroactive application was "iffy" during the best of times.  Now, it seems like a long shot.

In late March, Texas billionaire Dan Duncan died.  With an estate estimated at $9 Billion dollars, Duncan was listed on Forbes as the world's 74th wealthiest person.  A lawsuit was a certainty if retroactivity was pursued by Congress at any point.  Now there are significant resources that would obviously be available to oppose any attempt to apply taxes retroactively.  Thus, the compelling urgency originally felt by those who want to reinstate the tax retroactively, already losing steam with each passing day, has now been undercut severely--and probably completely.

So, these are just a few key tidbits--I definitely haven't covered everything that's going on right now--but it doesn't appear that we'll be leaving estate tax "purgatory" quite yet.

*Adapted from the Planning Partners Press.

What Do Hurricanes and Estate Planning Have in Common?

Hurricane season officially begins in June.  And despite the best efforts and intentions of meteorologists, the precise path, time of arrival and strength of these potentially devastating storms cannot always be predicted with complete accuracy.  Local governments do their best to convince people residing in or visiting vulnerable areas to prepare for the worst.  Many heed the warnings.  Sadly, others do not, and often suffer tragic consequences.

We think the onset of hurricane season serves as an apt metaphor about the importance of estate planning.  Like meteorologists, whose host of sophisticated scientific tools and resources do not necessarily enable them to predict a hurricane's path and strength, neither we nor you can predict exactly what the future holds.  

Fortunately, like emergency response planners, we can plan for the future's possibilities by helping our clients prepare an estate plan customized to their unique families and goals.  Your plan can protect your financial well-being today and tomorrow, provide for your loved ones after you are gone, and enable you to leave a lasting legacy for family and society alike.  

Your plan can also help prepare you and your spouse or other loved ones for changes to your physical well-being, through incapacity planning, healthcare directives, durable powers of attorney and more.  Access to the DocuBank Healthcare Directives Registry, which we provide to our clients free of charge, can prove invaluable in this regard.  It ensures that your healthcare directives are immediately available to hospitals and family members in the event of an emergency.  It also provides vital information to doctors, such as medical conditions, allergies and emergency contacts, to name a few.  

One aspect of effective estate planning that some families overlook, at their peril, is the importance of keeping their plan up-to-date.  The fact is, an outdated plan can actually be worse than having no plan at all.  We recommend that families review their estate plan at least once every two years, and whenever a significant change has taken place in their situation or that of a family member.  We can also help our clients update their DocuBank account to reflect any changes to their health or wishes concerning whom they would like to make decisions for them, or the care they would like to receive if they cannot speak for themselves.  

By keeping your estate plan up-to-date, you can truly prepare for the unexpected.  And, help ensure that everyone you love, and everything you own, will be protected--today, tomorrow and beyond.