You have invested time and money in your estate planning documents, but ongoing attention is needed to ensure that it will carry out its objectives.
One of the goals of estate planning is to avoid a court-supervised probate, the primary method being the use of a revocable living trust. Another common way to avoid probate is with the use of beneficiary designations, which have historically controlled the distribution of life insurance and retirement benefits. However, estate planning does not stop once the documents are signed. Assets change, banks change, new accounts are opened, and often a new job means new retirement benefits. Assets that you acquire in the future do not automatically become part of the trust, and sometimes trust assets are transferred from the trust back to you, for example, if you refinance a home.
Likewise, a job change might result in both a new plan and a rollover from a former company 401(k) plan to an IRA. Each time this happens, the old beneficiary designation may no longer be valid and a new one must be completed and submitted. Be vigilant about funding your trust and maintaining current beneficiary designations. Although you have a “small estate” exclusion from probate in California that just increased from $100,000 to $150,000, probate is still an expensive way to transfer assets to your beneficiaries. In addition, the failure to name a proper beneficiary of a retirement plan could result in additional income tax for your heirs.
Current State of the Gift Tax and Planning Opportunities
As estate planners, we help clients gift assets to their children and others. Gifting allows you to shift assets, as well as all attributable income and appreciation, out of your estate to reduce the estate tax due on your death. Of course, we do not recommend lifetime gifting unless you are certain to retain sufficient assets for your own long-term care and comfort.
To prevent you from avoiding estate tax entirely by gifting all of your assets to others, a gift tax is imposed on gifts in excess of a certain exemption amount. From 2002 through 2010, the gift tax exemption was $1,000,000. For 2011 and 2012, the exemption was increased to $5,000,000. (Actually, for 2012, the exemption has been adjusted for inflation to $5, 120,000.) In 2013, the exemption is scheduled to drop back to $1,000,000. Many other income, estate, gift and generation-skipping transfer tax rules are also scheduled to change in 2013.
The current law creates a unique opportunity to shift significant wealth from your estate tax free. If you previously used your $1,000,000 exemption, you can now gift an additional $4,000,000 with no tax cost. Not only is there a limited window to make large, tax-free gifts, but asset values and interest rates are low, creating unprecedented gifting opportunities. Gifting options range from a simple, outright gift to a child, to a complex, leveraged gift to an irrevocable trust for future generations. If you would like to have a portion of the gift returned to you, you can make a very low-interest rate loan to a child (in February 2012, the interest rate on a 3-year loan can be as low as 0.19%), or you can gift an asset while retaining the right to receive an annual annuity payment. If you would like to gift your residence or vacation home, you may do so while retaining the right to live in it for a specified number of years. With almost any type of gift, you can incorporate a charitable component for additional income tax benefits. An explanation of these and other gifting strategies is beyond the scope of this newsletter, but if you are interested in learning more, we would be happy to meet with you to discuss the possibilities. While it is possible that the increased gift tax exemption may be extended beyond 2012, this should not be assumed. If you do not utilize the increased exemption this year, the opportunity may be lost forever.
Planning for Special Needs
Parents are faced with a multitude of concerns when planning the future of their developmentally disabled child. For instance, parents are obviously concerned about the financial aspects of supporting the child and, of course, the personal well-being of the child. These concerns may motivate the parents to include a “special needs trust” as part of their estate plan (and possibly establish a conservatorship for their developmentally disabled child once the child attains age 18).
It is possible for a developmentally disabled child to qualify for certain benefit programs, such as Supplemental Security Income (SSI) and Medi-Cal, and still receive additional funds from a separate, special needs trust (SNT) established for the child. A SNT can be established by a parent during the parent’s lifetime or upon the parent’s death, or by court order as part of a settlement claim (special rules apply). The applicable regulations provide that the assets of a properly-drafted SNT, which grants the trustee broad discretion to make payments from the trust for the benefit of the developmentally disabled child, will not be counted as a resource of the child. Thus, the child could retain eligibility for benefits while he or she is a beneficiary of a SNT.
It is good practice to have the terms of a SNT reviewed periodically. For example, the Social Security Administration has recently revised sections of the “Program Operations Manual System” (POMS) regarding SNTs. Certain SNTs which include a clause allowing the trust to terminate during the beneficiary’s lifetime may need to be revised to comply with the POMS. Otherwise, the assets of the SNT may be considered a resource to the beneficiary and thus render the beneficiary ineligible for benefits. Aside from ensuring compliance with the POMS and other applicable rules, it is recommended that a SNT be reviewed as well to make sure that it reflects the current circumstances of the disabled child.
“Crummey Notice Letters” Really Are Important
Under current law, you may make “annual exclusion” gifts to as many people as you want without reducing your tax exemption amount for estate and gift tax purposes. For 2012, the annual exclusion is $13,000. Over time, systematic annual exclusion gifts can significantly reduce gift and estate taxes. For example, gifts to two children and four grandchildren would transfer $78,000 out of your taxable estate this year and $780,000 over a ten year period. And if you are married, the dollar amounts can be doubled.
An annual exclusion gift must grant a “present interest” to the recipient. A “present interest” is an “unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.” An outright cash gift to an adult child is a present interest. There are many reasons, however, that might prevent you from making an outright cash gift. For example, your child may be young or lack financial responsibility. By making the gift to a so-called Crummey trust for your child, you can defer the child’s possession of the gift while still granting the child a present interest.
A Crummey trust is an irrevocable trust in which the beneficiary has the power to withdraw the gifted asset from the trust for a short period of time after the gift is made. After the withdrawal right lapses, the asset becomes subject to the terms of the trust and the control of the trustee. The courts have found that a gift of an asset subject to a withdrawal right constitutes a present interest and qualifies for the annual exclusion.
However, in order to ensure that the gift meets the “present interest” requirement, the beneficiary must receive notice of the withdrawal right and must have reasonable time to exercise that right. Hence, most trusts that are designed to receive annual exclusion gifts require that a letter be sent to the beneficiary notifying him or her of the gift and the withdrawal right. Although it may seem somewhat superfluous, especially if the beneficiary is a young child, in order to preserve the tax benefits of the trust, it is absolutely necessary that a “Crummey Notice Letter” be sent every time a gift is made. Copies of all notice letters should be kept with the trust records in case the IRS makes an inquiry in connection with the audit of a gift or estate tax return of the person making the gift.
Powers of Attorney for Young Adults
We routinely advise clients to include an Advance Health Care Directive and a Durable Power of Attorney for property and financial assets in their estate planning. The Advance Health Care Directive designates an agent who will have health care decision-making authority and the ability to access medical information that would otherwise be subject to the patient privacy rules. It also sets forth the individual’s requests and directions concerning end-of-life decisions in terminal situations. The Durable Power of Attorney designates an agent who will have the authority to engage in property and financial transactions on behalf of the principal when that might be necessary or convenient–such as when the principal is incapacitated or unavailable.
Recently, we have had several instances in which a client’s adult child had an accident or sudden illness far from home, requiring hospitalization. In one case, the 19-year old son, a college student on the East Coast, fell off his skateboard and sustained a head injury. When our client (his mom) tried calling the hospital to inquire, the hospital, citing privacy rules, refused to provide any information, even a confirmation that he was in the hospital. We now remind clients with young adult children to encourage their children to get this relatively simple document done. And while they are at it, it is a good idea to have the kids sign a Durable Power of Attorney, so that if there is a prolonged period of incapacity from illness or injury, there will be someone with legal authority to take care of financial and tax affairs for them.
Accounting Rules for Trustees
Many of our clients are acting as a trustee of an irrevocable trust for their own children or as a favor to a friend. Very often the source of disputes between beneficiaries of a trust and the trustee arise from the trustee’s failure to account for his or her actions. More often than not, the trustee’s failure to account is unintentional; the trustee simply was not aware of his or her duty to the trust beneficiaries under California law. Unintentional or not, a trustee’s failure to account may be deemed a breach of his or her fiduciary duty to the beneficiaries, creating liability and justifying removal of the trustee.
In general, the trustee of an irrevocable trust must account at least annually, at the termination of a trust, and upon a change of trustee, to each current beneficiary. Certain exceptions to this rule apply to trusts created before July 1, 1987. If the accounting includes certain information specified in the statute, then the beneficiaries will have only three years to make a claim against the trustee with respect to an item disclosed in the accounting.
There are three exceptions to the duty to account. First, the trust instrument may waive the trustee’s duty to account. This waiver, however, is not valid for certain persons serving as trustee, including but not limited to, the person who drafted the trust and a person considered to be a care custodian of the trustor. Second, the beneficiary may waive his or her right to receive an accounting. However, the beneficiary may withdraw the waiver at any time. Third, the trustee is not required to account if the trustee and the beneficiary are the same person. Even if the trust instrument or the beneficiary has waived an accounting, the court may compel an accounting if it is reasonably likely that a material breach of the trust has occurred.
Even if one of the exceptions described above applies, the trustee may elect to account to the beneficiaries in order to start the running of the three year statute of limitations on claims against the trustee. To shorten the three-year claims period, the trustee may elect to submit the accounting to the probate court for approval.
If you are a trustee of an irrevocable trust, you should review the accounting provisions in the trust instrument, if any. Even if you are not required to account because the instrument waives the duty to account, for example, you should keep careful records of the transactions of the trust in case an accounting is required in the future.
This publication is for general information purposes only and is not specific legal advice or a substitute for advice from qualified counsel. Pursuant to requirements related to practice before the Internal Revenue Service, we must inform you that any federal tax advice contained in this communication is not intended to and cannot be used for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing or recommending to another party any transaction or matter addressed herein.