Who should own your life insurance policy?

If you own life insurance policies at your death, the proceeds will be included in your taxable estate. Ownership is usually determined by several factors, including who has the right to name the beneficiaries of the proceeds. The way around this problem is to not own the policies when you die. However, don’t automatically rule out your ownership either.

And it’s important to keep in mind the current uncertain future of the estate tax. If the estate tax is repealed (or if someone doesn’t have a large enough estate that estate taxes are a concern), then the inclusion of your policy in your estate is a nonissue. However, there may be nontax reasons for not owning the policy yourself.

Plus and minuses of different owners

To choose the best owner, consider why you want the insurance. Do you want to replace income? Provide liquidity? Or transfer wealth to your heirs? And how important are tax implications, flexibility, control, and cost and ease of administration? Let’s take a closer look at four types of owners:

  1. You or your spouse. There are several nontax benefits to your ownership, primarily relating to flexibility and control. The biggest drawback is estate tax risk. Ownership by you or your spouse generally works best when your combined assets, including insurance, won’t place either of your estates into a taxable situation.
  2. Your children. Ownership by your children works best when your primary goal is to pass wealth to them. On the plus side, proceeds aren’t subject to estate tax on your or your spouse’s death, and your children receive all of the proceeds tax-free. On the minus side, policy proceeds are paid to your children outright. This may not be in accordance with your estate plan objectives and may be especially problematic if a child has creditor problems.
  3. Your business. Company ownership or sponsorship of insurance on your life can work well when you have cash flow concerns related to paying premiums. Company sponsorship can allow premiums to be paid in part or in whole by the business under a split-dollar arrangement. But if you’re the controlling shareholder of the company and the proceeds are payable to a beneficiary other than the business, the proceeds could be included in your estate for estate tax purposes.
  4. An ILIT. A properly structured irrevocable life insurance trust (ILIT) could save you estate taxes on any insurance proceeds. The trust owns the policy and pays the premiums. When you die, the proceeds pass into the trust and aren’t included in your estate. The trust can be structured to provide benefits to your surviving spouse and/or other beneficiaries.

Contact us with any questions.

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A Crummey trust can preserve the annual gift tax exclusion

Traditionally, taxpayers have looked for ways to make the most of the $14,000 annual gift tax exclusion, and using a Crummey trust is one way to do that. But with the federal gift and estate tax exemption currently at an inflation-adjusted $5.49 million and the possibility of an estate tax repeal, it may seem that the annual exclusion is less relevant than ever before. Or is it?

Gift and estate tax law uncertainty

Although an estate tax repeal is called for under the “Unified Framework for Fixing Our Broken Tax Code” released by President Trump and congressional Republicans on September 27, there’s no guarantee that legislation including the repeal will be passed. Even if it is, the repeal could be temporary and the estate tax could return in the future. And notably absent from the framework is any mention of a gift tax repeal.

So affluent people whose estates exceed the exemption amount need to continue to seek strategies for minimizing gift and estate taxes. And even those with more modest estates may want to take advantage of the annual exclusion to shelter assets against potential future changes in their wealth and federal estate tax laws. That’s why a Crummey trust may be worth a look.

Convert a future interest into a present interest

The annual exclusion is limited to gifts of a “present interest,” defined by IRS regulations as “an unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.”

But what about gifts to a trust designed to distribute assets to your children or other beneficiaries at a future date? Certain types of trusts satisfy the present interest requirement, but only if the trust distributes all of its income currently or, in the case of a trust set up for a minor, distributes all of the principal and income to the beneficiary at age 21.

A Crummey trust satisfies the present interest requirement by giving beneficiaries the right to withdraw trust contributions for a limited period of time (typically 30 days after the contribution is made). To ensure that these withdrawal rights are treated as present interests, they must be real rights with economic substance, rather than a mere paper formality.

In addition, there can be no agreement with the beneficiaries — express or implied — that they won’t exercise their withdrawal rights.

If you want to make annual exclusion gifts to loved ones but retain some control over when they use the gifted assets, a Crummey trust may be right for you. But before you set one up, be sure you understand the gift, estate and income tax implications. We can help you determine if a Crummey trust is right for your estate plan.

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Tax law uncertainty requires an estate plan that can roll with the changes

Events of the last decade have taught us that tax rates and exemption levels are anything but certain. Case in point: Congress is mulling abolishing gift and estate taxes as part of tax reform. So how can people who hope to still have long lifespans ahead of them plan their estates when the tax landscape may look dramatically different 20, 30 or 40 years from now? The answer is by taking a flexible approach that allows you to hedge your bets.

Conflicting strategies

Many traditional estate planning techniques evolved during a time when the gift and estate tax exemption was relatively low and the top estate tax rate was substantially higher than the top income tax rate. Under those circumstances, it usually made sense to remove assets from the estate early to shield future asset appreciation from estate taxes.

Today, the exemption has climbed to $5.49 million and the top gift and estate tax rate (40%) is roughly the same as the top income tax rate (39.6%). If your estate’s worth is within the exemption amount, estate tax isn’t a concern and there’s no gift and estate tax benefit to making lifetime gifts.

But under current law there’s a big income tax advantage to keeping assets in your estate: The basis of assets transferred at your death is stepped up to their current fair market value, so beneficiaries can turn around and sell them without generating capital gains tax liability. Assets you transfer by gift, however, retain your basis, so beneficiaries who sell appreciated assets face a significant tax bill.

Flexibility is key

A carefully designed trust can make it possible to remove assets from your estate now, while giving the trustee the authority to force the assets back into your estate if that turns out to be the better strategy. This allows you to shield decades of appreciation from estate tax while retaining the option to include the assets in your estate should income tax savings become a priority (assuming the step-up in basis remains, which is also uncertain).

For the technique to work, the trust must be irrevocable, the grantor (you) must retain no control over the trust assets (including the ability to remove and replace the trustee) and the trustee should have absolute discretion over distributions. In the event that estate inclusion becomes desirable, the trustee should have the authority to cause such inclusion by, for example, naming you as successor trustee or giving you a general power of appointment over the trust assets.

In determining whether to exercise this option, the trustee should consider several factors, including potential estate tax liability, if any, the beneficiaries’ potential liability for federal and state capital gains taxes, and whether the beneficiaries plan to sell or hold onto the assets.

Consider the risk

This trust type offers welcome flexibility, but it’s not risk-free. Contact us for additional information.

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ABCs of HSAs: How an HSA can benefit your estate plan

One health care arrangement that has been soaring in popularity in recent years has been the pairing of a high-deductible health plan (HDHP) with a Health Savings Account (HSA). The good news is that not only does an HSA provide a tax-advantaged way to pay for health care costs, but it also can help you achieve your estate planning goals.

How does it work?

An HSA can be offered by an employer, or an individual can set up his or her own account, similar to an IRA. Contributions to an employer-sponsored HSA are pretax and may be made by employers, employees or both. If you set up your own HSA, you can deduct your contributions.

An HSA must, however, be coupled with an HDHP. For 2017, to qualify as an HDHP, a plan must have a minimum deductible of $1,300 ($2,600 for family coverage) and a $6,550 cap on out-of-pocket expenses ($13,100 for family coverage).

Even if you have HDHP coverage, you generally won’t be eligible to contribute to an HSA if you’re also covered by any non-HDHP health insurance (such as a spouse’s plan) or if you’re enrolled in Medicare.

For 2017, the maximum HSA contribution is $3,400 ($6,750 for family coverage). If you’re age 55 or older, you can make additional “catch-up” contributions of up to $1,000.

The HSA funds can bear interest or be invested on a tax-deferred basis. You can make tax-free withdrawals to pay for qualified medical expenses. Unused funds may be carried over from year to year, continuing to grow tax-deferred.

Withdrawals before age 65 not used for medical expenses will be subject to income tax and a 20% penalty. But after age 65, the penalty won’t apply. Essentially, to the extent you don’t need the funds for medical expenses before age 65, an HSA serves as a supplemental IRA.

What are the estate planning benefits?

Like an IRA or a 401(k) plan account, HSAs with unused balances can supplement your retirement income or continue growing on a tax-deferred basis for the future benefit of your family. Unlike most other retirement savings vehicles, however, there are no required minimum distributions from HSAs, potentially allowing you to leverage tax-deferred compounding to build up a larger account for your heirs.

Carefully consider your HSA’s beneficiary designation. When you die, any remaining HSA balance becomes the beneficiary’s property. If the beneficiary is your spouse, your HSA becomes his or her HSA and is taxable only to the extent he or she makes nonqualified withdrawals.

If the beneficiary is someone other than your spouse, however, the account no longer will qualify as an HSA. The beneficiary must include the account’s fair market value in his or her gross income. But if he or she is in a lower income tax bracket than you were, this still may save tax overall for your family.

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Charitable giving pièce de résistance: Artwork donations

Charitable giving is a key part of estate planning for many people. If you’re among them and own valuable works of art, they may be ideal candidates for charitable donations during your life.

Generally, it’s advantageous to donate appreciated property because, in addition to gaining a valuable tax deduction, you can avoid capital gains taxes. Because the top capital gains rate for art and other “collectibles” is 28%, donating art can be particularly effective.

5 tax-saving tips

If you’re considering a donation of art, here are five tips that can help you maximize your tax savings:

  1. Obtain an appraisal. Most art donations require a “qualified appraisal” by a “qualified appraiser.” IRS rules contain detailed requirements about the qualifications an appraiser must possess and the contents of an appraisal. IRS auditors are required to refer all gifts of art valued at $20,000 or more to the IRS Art Advisory Panel. The panel’s findings are the IRS’s official position on the art’s value, so it’s critical to provide a solid appraisal to support your valuation.
  2. Donate to a public charity. To maximize your charitable deduction, donate artwork to a public charity, such as a museum or university with public charity status. These donations generally entitle you to deduct the artwork’s full fair market value (provided the related-use rule is also satisfied). If you donate art to a private foundation, your deduction will be limited to your cost.
  3. Understand the related-use rule. For you to qualify for a full fair-market-value deduction, the charity’s use of the donated artwork must be related to its tax-exempt purpose. So, for example, if you donate a painting to a museum for display or to a university for use in art history research, you’ll satisfy the related-use rule. But if you donate it to, say, an animal shelter to auction off at its fundraising event, you won’t satisfy the rule.
  4. Transfer the copyright. If you own both the work of art and the copyright to the work, you must assign the copyright to the charity to qualify for a charitable deduction.
  5. Consider a fractional donation. If you’re not ready to give up your artwork but are willing to part with it temporarily, consider donating a fractional interest. This allows you to generate tax savings while continuing to enjoy your art for part of the year. For example, if you donate a 25% interest in your art collection to a museum, the museum receives the right to display the collection for three months of each year. You deduct 25% of the collection’s fair market value immediately and continue to display the art in your home for nine months of each year.

Leave it to the professionals

The rules surrounding donations of art are complex. We can help you achieve your charitable goals while maximizing your tax benefits whether you wish to donate artwork or other valuables.

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Tax basis planning worth a look if estate taxes aren’t a threat

For many people today, income tax planning offers far greater tax-saving opportunities than gift and estate tax planning. A record-high gift and estate tax exemption — currently $5.49 million ($10.98 million for married couples) — means that fewer people are subject to those taxes.

If gift and estate taxes aren’t a concern for your family, it can pay to focus your planning efforts on income taxes — in particular, on basis planning.

Benefits of a “stepped-up” basis

Generally, your basis in an asset is its purchase price, reduced by accumulated depreciation deductions and increased to reflect certain investment costs or capital expenditures. Basis is critical because it’s used to calculate the gain or loss when you or a loved one sells an asset.

Under current law, the manner in which you transfer assets to your children or other beneficiaries has a big impact on basis. If you transfer an asset by gift, the recipient takes a “carryover” basis in the asset — that is, he or she inherits your basis. If the asset has appreciated in value, a sale by the recipient could trigger significant capital gains taxes.

On the other hand, if you hold an asset for life and leave it to a beneficiary in your will or revocable trust, the recipient will take a “stepped-up” basis equal to the asset’s date-of-death fair market value. That means the recipient can turn around and sell the asset tax-free.

Undoing previous gifts

What if you transferred assets to an irrevocable trust years or decades ago — when the exemption was low — to shield future appreciation from estate taxes? If estate taxes are no longer a concern, there may be a way to help your beneficiaries avoid a big capital gains tax hit.

Depending on the structure and language of the trust, you may be able to exchange low-basis trust assets for high-basis assets of equal value, or to purchase low-basis assets from the trust using cash or a promissory note. This allows you to bring highly appreciated assets back into your estate, where they’ll enjoy a stepped-up basis when you die. Keep in mind that, for this strategy to work, the trust must be a “grantor trust.” Otherwise, transactions between you and the trust are taxable.

Is your basis covered?

Before making any changes to your estate plan, be aware that, if an estate tax repeal is signed into law, it’s possible the step-up in basis at death could go away, too. We can keep you apprised of the latest developments and help you determine whether your family would benefit from basis planning.

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Estate tax relief for family businesses is available … in the form of a deferral

If a substantial portion of your wealth is tied up in a family or closely held business, you may be concerned that your estate will lack sufficient liquid assets to pay federal estate taxes. If that’s the case, your heirs may be forced to borrow funds or, in a worst-case scenario, sell the business in order to pay the tax.

For many eligible business owners, Internal Revenue Code Section 6166 provides welcome relief. It permits qualifying estates to defer a portion of their estate tax liability for up to 14 years from the date the tax is due (not the date of death). During the first four years of the deferment period, the estate pays interest only, set at only 2%, followed by 10 annual installments of principal and interest.

A deferral isn’t available for the total estate tax liability, unless a qualifying closely held business interest is the only asset in your estate. The benefit is limited to the portion of estate taxes that’s attributable to a closely held business.

Eligibility requirements

Estate tax deferral is available if the value of an “interest in a closely-held business” exceeds 35% of your adjusted gross estate. To determine whether you meet the 35% test, you may only include assets actually used in conducting a trade or business — passive investments don’t count.

Active vs. passive ownership

To qualify for an estate tax deferral, a closely held business must conduct an active trade or business, rather than merely manage investment assets. Unfortunately, it’s not always easy to distinguish between the two, particularly when real estate is involved.

The IRS provided welcome guidance on this subject in a 2006 Revenue Ruling. The ruling confirms that a “passive” owner may qualify for an estate tax deferral, so long as the entity conducts an active trade or business. The ruling also clarifies that using property management companies or other independent contractors to conduct real estate activities doesn’t disqualify a business from “active” status, so long as its activities go beyond merely holding investment assets.

In determining whether a real estate entity is conducting an active trade or business, the IRS considers such factors as the amount of time owners, employees or agents devote to the business, whether the business maintains an office with regular business hours, and the extent to which owners, employees or agents are actively involved in finding tenants and negotiating leases.

Weigh your options

As you plan your estate, consider whether your family will be eligible to defer estate taxes. If you own an interest in a real estate business, you may have an opportunity to qualify it for an estate tax deferral simply by adjusting your level of activity or increasing your ownership in an entity that manages the property. Contact us for additional details.

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Have you properly funded your revocable trust?

If your estate plan includes a revocable trust — also known as a “living” trust  or a “revocable living trust”— it’s critical to ensure that the trust is properly funded. Revocable trusts offer significant benefits, including asset management (in the event you become incapacitated) and probate avoidance. But these benefits aren’t available if you don’t fund the trust.

We consistently see clients who come to our practice with nice, shiny, thick binders containing their revocable living trusts and other estate plannings, and our usual first question is “what do you have titled in the trust?”  The blank stares coming from the clients can be disconcerting.   They have spent considerable time and money developing the documents, yet nothing has been moved into the trusts.  By failing to move assets into the trust, the administration of the estate will be more costly and less time efficient–this is because probate would generally be necessary to transfer title to your assets.

The basics

A revocable trust acts as a will substitute, although you’ll still need to have a short will, often referred to as a “pour over” will. The trust holds assets for your benefit during your lifetime.

You can serve as trustee or select someone else. If you choose to be the trustee, you must name a successor trustee to take over as trustee upon your death, serving in a role similar to that of an executor.  The successor trustee will manage the administration of your estate after your death ensuring that your bills would be paid and your assets are distributed according to the terms of your trust.

Essentially, you retain the same control you had before you established the trust. Whether or not you serve as trustee, you retain the right to revoke the trust and appoint and remove trustees. If you name a professional trustee to manage trust assets, you can require the trustee to consult with you before buying or selling assets.

The trust doesn’t need to file an income tax return until after you die.  Instead, you pay the tax on any income the trust earns as if you had never created the trust.  The trust will use your Social Security Number to set up accounts while you are alive instead of obtaining a separate tax identification number.

Asset ownership transfer

Funding your trust is simply a matter of transferring ownership of assets to the trust. Assets you should transfer include real estate, bank accounts, certificates of deposit, stocks and other investments, partnership and business interests, vehicles, and personal property (such as furniture and collectibles).

Certain assets shouldn’t, however, be transferred to a revocable trust. For example, moving an IRA or qualified retirement plan, such as a 401(k) plan, to a revocable trust can trigger undesirable tax consequences. And it may be advisable to hold a life insurance policy in an irrevocable life insurance trust to shield the proceeds from estate taxes.  This does not mean, however, that sub-trusts under the revocable trust cannot be named as beneficiary of your qualified retirement plans or life insurance proceeds.  To the contrary, such trusts can be named as the beneficiary; note, however, that special language is required in the trust to ensure the most favorable tax treatment when it comes to qualified retirement plans.  A qualified estate planning attorney should generally be engaged to make sure that proper drafting is achieved–most “self help” websites and software will not properly cover this issue.

Don’t forget to transfer new assets to the trust

Most people are diligent about funding a trust at the time they sign the trust documents. But trouble can arise when they acquire new assets after the trust is established. Unless you transfer new assets to your trust, they won’t enjoy the trust’s benefits.

To make the most of a revocable trust, be sure that, each time you acquire a significant asset, you take steps to transfer it to the trust. If you have additional questions regarding your revocable trust, we’d be happy to answer them.

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Don’t overlook tax apportionment when planning your estate

If you expect your estate to have a significant estate tax liability at your death, be sure to include a well-thought-out tax apportionment clause in your will or revocable trust. An apportionment clause specifies how the estate tax burden will be allocated among your beneficiaries. Omission of this clause, or failure to word it carefully, may result in unintended consequences.

Apportionment options

There are many ways to apportion estate taxes. One option is to have all of the taxes paid out of assets passing through your will. Beneficiaries receiving assets outside your will — such as IRAs, retirement plans or life insurance proceeds — won’t bear any of the tax burden.

Another option is to allocate taxes among all beneficiaries, including those who receive assets outside your will. Yet another is to provide for the tax to be paid from your residuary estate — that is, the portion of your estate that remains after all specific gifts or bequests have been made and all expenses and liabilities have been paid.

There’s no one right way to apportion estate taxes. But it’s important to understand how an apportionment clause operates to ensure that your clause is worded in a way that your wealth will be distributed in the manner you intend.

Suppose, for example, that your will leaves real estate valued at $5 million to your son, with your residuary estate — consisting of $5 million in stock and other liquid assets — passing to your daughter. Your intent is to treat your children equally, but your will’s apportionment clause provides for estate taxes to be paid out of the residuary estate. Thus, the entire estate tax burden — including taxes attributable to the real estate — will be borne by your daughter.

One way to avoid this result is to apportion the taxes to both your son and your daughter. But that approach could cause problems for your son, who may lack the funds to pay the tax without selling the property. To avoid this situation while treating your children equally, you might apportion the taxes to your residuary estate but provide life insurance to cover your daughter’s tax liability.

Omission of apportionment clause

What if your will doesn’t have an apportionment clause? In that case, apportionment will be governed by applicable state law (although federal law covers certain situations).

Most states have some form of an “equitable apportionment” scheme. Essentially, this approach requires each beneficiary to pay the estate tax generated by the assets he or she receives. Some states provide for equitable apportionment among all beneficiaries while others limit apportionment to assets that pass through the will or to the residuary estate.

Often, state apportionment laws produce satisfactory results, but in some cases they may be inconsistent with your wishes.

Avoid surprises

If you ignore tax apportionment when planning your estate, your wealth may not be distributed in the manner you intend. We can answer your questions about taxes and estate planning.

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The stretch IRA: A simple yet powerful estate planning tool

The IRA’s value as a retirement planning tool is well known: IRA assets compound on a tax-deferred (or, in the case of a Roth IRA, tax-free) basis, which can help build a more substantial nest egg. But if you don’t need an IRA to fund your retirement, you can use it as an estate planning tool to benefit your children or other beneficiaries on a tax-advantaged basis by turning it into a “stretch” IRA.

Stretching the benefits

Turning an IRA into a stretch IRA is simply a matter of designating a beneficiary who’s significantly younger than you. This could be, for example, your spouse (if there’s a substantial age difference between the two of you), a child or a grandchild.

If you name your spouse as beneficiary, he or she can elect to roll the funds over into his or her own IRA after you die, enabling the funds to continue growing tax-deferred or tax-free until your spouse chooses to begin withdrawing the funds in retirement or must take required minimum distributions (RMDs) starting after age 70½. (Note that RMDs don’t apply to Roth IRAs while the participant is alive.)

If you name someone other than your spouse as beneficiary, he or she generally will have several options:

  • Take a lump-sum distribution of the IRA’s balance.
  • Withdraw the funds by the end of the year of the fifth anniversary of your death (if you die before beginning to take RMDs).
  • Withdraw the funds over your “remaining” life expectancy, calculated under the applicable IRS table as of the year of death (if you die after beginning to take RMDs).
  • Hold the funds in an “inherited IRA,” which allows the beneficiary to spread RMDs over his or her own life expectancy.

Usually the inherited IRA is the best choice because it maximizes the benefits of tax-deferred or tax-free growth.

Naming a trust as beneficiary

A disadvantage of naming your child or grandchild as beneficiary of your IRA is that there’s nothing to prevent him or her from taking a lump-sum distribution, erasing any potential stretch IRA benefits.

To ensure that this doesn’t happen, you can name a trust as beneficiary. In order for a trust to qualify for stretch treatment, it will need to meet certain requirements, such as distributing RMDs received from the IRA to the trust beneficiaries.  You will need to make sure that your estate planning attorney is well versed in the requirements for naming qualified retirement plans as beneficiaries of trusts–the drafting must be precise in order for the trust to be a qualified beneficiary.

Contact us for additional details.

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