Financial Planning . . . ALERT

The information contained in this ALERT is not intended to constitute legal, or financial advice.  Decisions with regard to these matters should only be made after consultation with a competent professional.

From the mail I receive, the comments I hear during my educational programs, and the articles I see in the financial press, the role of trusts in competent estate planning can be a confusing matter.  Even such basic considerations as what a trust is; when one should be used; what advantages can be gained from a trust . . . et cetera . . . cause problems. 

Apart from legitimate estate and tax planning concerns, there is another reason to look at this area.  Trust ABUSE is a matter of great concern with the Internal Revenue Service, as many of today’s leading tax scams involve trusts.  If someone proposes to you a business or economic activity claiming tax avoidance through the use of a trust, you should be very, very careful.  These programs typically claim to create tax-free income, or to be exempt from income taxes, due to the machinations of the trust arrangement.  Invariably, these scams offer a “packaged” trust; that is, an activity in which all the participants have the same documents.  The programs are frequently trademarked, which while offered as “assurance” that the deal is sound, is often an indication of a fraudulent program.  As I often advise, check out the IRS website at www.irs.gov, and enter “trust scams” in the search box.   You will be amazed at how foolish people can be when it comes to their tax reporting obligations.

A trust is not a commodity.  It is a legal document established to advance the specific purposes of the person setting up the trust.  An attorney familiar with the individual’s circumstances and with trust law should prepare a trust.   There is no “one size fits all” in trust drafting and administration.  The basic trust arrangements with which you need to be familiar in estate planning:

1.  Revocable Trusts.  These are arrangements which you can amend, or terminate, as long as you are alive and competent.  The basic advantage to a trust is that the assets it holds at the time of your death avoid probate.  However, it also provides for the effective management of the assets it holds if you become incompetent.  The person establishing the trust is called a grantor, or trustor, and that person transfers assets into the trust, with the legal ownership vesting in a person called a trustee.  The trustee, pursuant to the law of the jurisdiction in which the trust is located and the specific terms of the trust, holds title to the trust property (the trust corpus) for the benefit of a person called a beneficiary.  While three different parties could fill these three roles, one person can fill all roles; thereby establishing a trust in which he serves as his own trustee, holding property for his own benefit.  That may sound odd, but it is perfectly legal and the arrangement avoids probate upon the individual’s death.  In fact, in modern estate planning, the revocable trust serves as the individual’s primary estate planning document, containing most (if not all) of the wishes of the individual relative to how he would like his property distributed upon his death.

2.  Credit Shelter Trusts.  The estate tax sections of the Internal Revenue Code currently allow individuals dying in 2008 to leave to someone other than a spouse, $2,000,000 without incurring federal estate taxes.  But, because the estate tax sections of the Code also allow for the passage of an unlimited amount to one’s spouse, families often think an estate situation is in order because taxes were not due when the first spouse died.  Unfortunately, not doing some planning while both spouses are alive makes both estates subject to federal estate taxes upon the death of the survivor.  The planning required to prevent that result is the establishment of a credit shelter trust which is funded to a maximum degree with the exemption equivalent.  This trust is included in one’s revocable trust, but it does not become effective until the death of the first spouse.  Typically, the ultimate beneficiaries of the credit shelter trust are the couple’s children, with the trust terms allowing the surviving spouse some access to the funds in the credit shelter trust.  This simple trust arrangement allows the couple to pass out of their joint estate the amount of the exemption equivalent upon the first death, thereby saving whatever estate taxes would be due on that amount (plus any increase in value) upon the death of the survivor.

3.  Irrevocable Life Insurance Trusts (ILITs).  As members of the Doherty Estate and Financial Planning Society know, the most tax efficient way to pass money to heirs and/or charity is through the use of life insurance.  I did not mandate this outcome – the United States Congress did when the favorable tax treatment of life insurance was enacted into law.  Accordingly, if you are not exploring how life insurance could favorably impact your estate planning, you are probably making a mistake.  If you harbor preconceived notions about life insurance, put them aside and investigate what might be available to you and your family.  The economics of life insurance have changed dramatically over the last 25 years (including the ability to affordably insure older individuals) and many people are as unaware of these considerations as they are of the tax advantages of life insurance in general.

Another aspect of life insurance of which I find people unaware, is if one dies owning a policy insuring their life (or possesses even an incident of ownership in such a policy), the entire amount of the death benefit is part of the decedent’s gross estate.  So, one who thinks her estate is $2M, but who also has a $1M life insurance policy on her life, dies with a gross estate of $3M: the $2M she knew about and the $1M life insurance proceeds.  This problem is simply solved by having the policy owned in an irrevocable trust, one designed to hold life insurance as an asset.  The owner of the policy is the trustee of the trust, holding the policy for the benefit of the beneficiaries, presumably the heirs of the decedent.  Because the policy was not owned by the decedent, it is not part of her estate.  And, it gets even better because another provision of the tax law mandatesthatthe receipt of the death benefit proceeds by the trust is not taxable income to it.

If new life insurance is to be acquired for estate planning purposes, the trustee of the irrevocable life insurance trust should generally acquire it.  If life insurance policies exist, one should consider transferring them into an irrevocable life insurance trust.  In the existing policy situation, the insured must live for three years, or the transfer is deemed to be in contemplation of death and the proceeds are brought back into the calculation of the size of his estate.  Nevertheless, that still is the strategy to employ, because if the insured dies owning the policies, the death benefit proceeds are definitely included as part of his estate!

The hiring of a lawyer is an important decision that should not be based solely upon advertising.  Please visit the Doherty Professional Association at www.dohertypa.com today to learn about Mr. Doherty’s credentials and how he might assist you in estate and financial matters.