Aging Parents & Estate Planning

The parent-child relationship is pretty well defined. Children generally don’t advise their parents. It’s the other way around. However, this dynamic can shift as parents get older and children become adults. This becomes especially prevalent when considering estate planning and elder law issues.

As parents grow older, adult children may start to have certain questions about the way mom and dad have planned ahead for the eventualities of aging. Being aware of what plans have been made opens the door for a conversation about what planning is left to be considered to make sure their wishes are carried out as they’d like them to be.

What’s Next?

Once an adult child comes to the conclusion that a discussion is needed with aging parents, determining how to proceed can be difficult. It’s not easy to reverse roles and ask parents to provide their children with sensitive financial information. One way for a child to approach the subject would be to explain their own estate planning efforts. By telling parents what you have done and why, you can then ask them what they have done. The question would arise naturally and organically. You have just explained your estate plan to your parents, so they may feel compelled to explain their plan to you.

This interaction is in their best interests, and it’s not just a conversation about the eventual transfer of financial assets. There is the matter of long-term care to take into consideration. Most Americans will need assistance with their day-to-day needs at some point in time. You may in fact notice that your parents are starting to have trouble getting around. This is something that impacts the entire family because most of the living assistance received by senior citizens comes from family members, friends and neighbors. When this is not possible, seniors often enter assisted-living facilities. Medicare does not pay for an extended stay in an assisted-living community or nursing home. These facilities are extremely expensive, and many seniors may not understand the extent of the financial burden.

Sense of Relief

Once you have expressed an interest in the planning efforts of your parents they may actually be quite relieved. You are demonstrating a high level of maturity as you tackle a difficult subject as a caring family member. As you gain an understanding of their existing plan you can make suggestions. Assisting them in finding a qualified estate planning attorney may be an integral part of this process.

When your parents are aware of the fact that you want to be of assistance as they enter into the later stages of their lives, a new type of relationship may develop. They will know they can count on you as their own capabilities wane, and this can strengthen the parent-child bond.

How Do I Title . . . Part I

It’s impossible to fully understand Estate Planning without considering the goals of the clients, along with their underlying assets. After all, many of the more advanced Estate Planning techniques depend upon obtaining discounts for assets and considering which technique to recommend based on a client’s assets. Some clients lack specific knowledge regarding not only the assets that they own but also the title to such assets, both of which shape the Estate Plan. Inexperienced attorneys may fail to use precise words when describing title and refer to property owned with another individual simply as “joint property.” Such individuals may fail to understand the difference between property held as joint tenants with rights of survivorship, tenants by the entirety, or as tenants in common.

If an individual owns the complete undivided interest in the property, that’s separate property, unless the individual resides in a community property state, as explained later. Generally, an individual may dispose of separate property freely. An owner may transfer separate property during life and bestow separate property upon death. Of course, a few exceptions to that general rule exist. For example, separate property states require a spouse to leave a minimum amount called the elective share to their surviving spouse upon death. If the decedent spouse fails to leave the appropriate amount, state statutes contain provisions that allow the surviving spouse to elect against the decedent’s elective estate to prevent the impoverishment of the survivor.

If a property has more than one owner, each of whom can transfer their interest in the property freely, then those individuals own the property as tenants in common. An interest held as a tenant in common works much the same as separate property. The owner has no restrictions on the disposition of the property either during life or at death. Many states use this type of ownership as a default when more than one owner exists on the title to an asset without specific reservation of rights of survivorship.

In contrast to ownership as tenants in common, if the co-owners reserve a right of survivorship in the property, then the owners hold the title as joint tenants with rights of survivorship. Property titled as joint tenants with rights of survivorship passes title to the survivors upon the death of one of the joint tenants automatically by operation of law. The other owners need not do anything to protect their ownership interest, although they may need to produce a death certificate to clear the title. While many individuals attempt to create a property that will pass in this manner, it often fails. To create joint tenants with rights of survivorship, the joint owners need the following unities upon acquisition of the property: interest, possession, time, title, and survivorship. If the owners lack any one of those unities, then the owners have created tenants in common property, rather than joint tenants with rights of survivorship. Every state recognizes this type of property ownership.

Some states recognize a special form of joint tenants with rights of survivorship called tenants by the entireties, available only for spouses. In addition to the unities described above, the parties need to have the additional unity of marriage at the time they acquire title to the property. Interestingly, not all states that recognize joint tenants with rights of survivorship recognize tenants by the entireties as a form of ownership. Even more interesting, in those states that recognize this form of ownership, some states allow it only for real property, while others recognize it for any type of property. The states that recognize the tenants by the entireties form of ownership afford property titled in this manner asset protection, meaning that only a creditor of both spouses can attach the property.

In contrast to property titled as tenants by the entireties, about fourteen states recognize another form of ownership available only to spouses known as community property. Community property means that each spouse owns one-half of any property acquired by either spouse during the marriage with two notable exceptions. First, if one spouse receives an inheritance that will remain the separate property of that spouse. Second, any earnings on separate property remain separate property. Community property provides various benefits, most importantly a step up in basis of the entire community property interest upon the death of one spouse, rather than just the decedent spouse’s portion, as would be the case for property held as tenants by the entirety, joint tenancy, or separate property. Community property states allow each spouse to dispose of their one-half of the community property without restriction. In pure community property states, no elective share rights exist, which allows for more flexibility in estate planning while guaranteeing that one spouse will keep at least their one-half share of the community property upon the death of the first spouse.

Unlike separate property or common law states, how clients hold title to property does not matter in a community property state. In determining whether property qualifies as community property one looks to the domicile at the time of acquisition of the property. Interestingly, California recognizes community property with rights of survivorship. In that situation, the title will pass automatically to the surviving spouse upon the death of the first spouse as it would with property held as joint tenancy or tenants by the entireties but with the added benefit of the double step-up in basis.

What Makes A Will or Trust Invalid?

I often answer questions relating to the validity of Estate Planning documents. Sometimes, the testator or grantor simply wants to ensure that the documents carry out their last wishes. Other times, a beneficiary questions the terms or amount of their inheritance. Finally, loved ones have concerns that the Estate Plan does not accurately reflect the true intent of the testator. Let’s look at what could invalidate a Will or Trust. 

If a beneficiary, loved one, or other trusted source exerts undue influence on the testator, that might invalidate the Will. Simple enough to explain but understanding what constitutes undue influence requires a closer look at the behavior. The American Bar Association indicates that undue influence occurs when an individual in a fiduciary capacity or other confidential relationship substitutes their own desires for that of the influenced person’s desires. Put another way, a person influenced the testator in such a way that convinced the testator to alter their estate plan, usually in favor of the individual exerting the undue influence and to the detriment of the testator’s other beneficiaries. Each state lists certain factors that indicate the presence of undue influence, such as intimidation, physical threat, or coercion. Perpetrators of undue influence use subtle tactics and are often close to the testator. For example, the influencer may stop providing transportation to the testator or otherwise cause the testator to fear for their health and well-being. The emergence of elder abuse and mandatory reporting thereof has helped shine a light on the existence of undue influence and gives families a way to protect against it. 

In addition to undue influence, if the testator lacks capacity at the Will or Trust’s execution, then that invalidates the documents. Lack of capacity means that the testator executed the Will or Trust at a time when such a testator lacked a sound mind. Many a litigant has tried and failed to prove a lack of capacity, even though it’s common. Frighteningly, the Alzheimer’s Association estimates that nearly 6 million individuals have Alzheimer’s disease in the United States. This disease affects the mind at a time when the elderly individual may have other health issues. Most states require the testator to understand the nature and extent of their property, the natural objects of their bounty, the individuals who would naturally benefit from their estate, and finally, the effect of their Estate Plan. If the testator understands those things, then the testator has a sound mind. If the testator lacks that understanding most of the time but executes the Will or Trust at a time of clarity, then the Will or Trust is valid. Most states presume competence to make a Will or Trust and place the burden on the contesting party to prove that the testator or grantor lacked capacity. Note that a court may consider other factors, such as an unnatural distribution, as evidence of lack of capacity. 

Aside from undue influence or lack of capacity, any Will or Trust not executed with the requisite formalities is invalid. Most states require the presence of two witnesses who watch the testator sign, all of whom sign in the presence of a Notary Public. Although Trusts do not always require that level of formality, sometimes the testamentary provisions of a Trust will not work unless they are executed with the same formalities as required for Wills. 

Finally, any Will or Trust resulting from fraud, coercion, or forgery is invalid. If an individual intentionally misrepresents certain facts to the testator who relies upon the facts in making the Will, that’s fraud in the inducement. Common examples of this are when someone tells the testator that a particular beneficiary no longer needs the money because they have enough of their own or advises the testator that a beneficiary is stealing from the testator or speaking ill of them to other family members. If someone were to present a Will to the testator, while telling the testator that they were signing a Deed, that’s fraud in the factum. If someone else signs the testator’s name without their knowledge and without following the state statutes, then the Will is invalid. 

While these examples seem like they are out of a novel or movie, these things happen often. For example, Brooke Astor, a New York City philanthropist was abused and exploited by her only son who isolated and manipulated her to gain control of her assets, including millions of dollars that she wanted to give to charities. Brooke’s physical and cognitive impairment, dependency upon her son, and isolation made her susceptible to undue influence. If you worry that your plan may be invalid, it’s a great time to contact me to review and update the plan, as making sure that your assets get to the intended beneficiaries requires more than just good documents.

Understanding Tax Apportionment Clauses

A cohesive Estate Plan focuses on the distribution of assets and the naming of fiduciaries to carry out the plan upon the death of the Grantor or Testator. I understand that taxes and the payment thereof play an important role as well. Often, even those individuals whose gross estate falls below the Applicable Exclusion Amount ($12.06 million in 2022) need to worry about taxes. In addition to the Federal Estate Tax, clients need to consider the impact of state estate or inheritance taxes, along with local taxes and cash flow to pull it all together. It’s important to understand how taxes will be allocated among your beneficiaries upon your death and to ensure that allocation honors your wishes. I attempt to control the allocation of taxes through the use of an apportionment clause. An apportionment clause specifies who among your beneficiaries will ultimately bear the burden of the taxes. Omission of this clause or inartful drafting may result in unintended consequences, or worse yet, litigation.

Tax apportionment clauses come in many varieties. For example, a Will or Trust may contain language that designates only those assets passing under the Will or Trust are to pay the taxes. Thus, beneficiaries who receive assets that pass outside the Will or Trust, such as beneficiary designated assets like Individual Retirement Accounts, life insurance, or Pay on Death or Transfer on Death Accounts, would not bear the burden of any taxes. That may or may not reflect the Grantor or Testator’s intent. Conversely, the Will or Trust may allocate taxes among all the beneficiaries, including those who receive the assets outside through a beneficiary designation. Alternately, the documents may direct payment of taxes from the residuary estate, after payment of all specific gifts, expenses, and liabilities. Of course, if the residuary lacks liquid assets sufficient to pay the taxes, that poses another problem altogether. Let’s review an example that highlights one of the potential problems with payment from the residue.

Assume that Ned has two children, Rob, and Sansa. Ned wants to leave his home, Winterfell, valued at $10 million to Rob and the other $10 million of his estate consisting of cash and stock to Sansa through his residuary clause. Ned was clear that he intended to leave equal amounts to his children; however, an inexperienced attorney included a tax apportionment clause that directed payment from the residue of Ned’s estate. Ned died in 2022 leaving an approximate estate tax liability of $3.2 million. Because Ned’s Estate Plan directs payment from the residuary estate, the taxes will diminish the residue, which was going solely to Sansa. Thus, after payment of taxes, Sansa will receive a mere $6.8 million, while Rob will receive $10 million. If the tax clause directed apportionment between the beneficiaries proportionately based upon their share of Ned’s estate, then each of Rob and Sansa would bear $1.6 million in taxes. If we assume that Rob had no assets other than Winterfell, then the attorney needs to consider other sources of payment for the tax or structure the plan in another way to prevent a sale of Winterfell to pay the taxes. Perhaps the best plan gives each of Rob and Sansa half of Winterfell and half of the cash and stocks to ensure equal treatment.

Let’s change the facts a bit to mimic those of a recent Nebraska Supreme Court case, Svoboda v. Larson, 311 Neb. 352 (2022). Now assume that Ned lives with Catelyn and has only one child, Jon. Ned and Catelyn have a business and personal relationship but remain unwed. Ned’s estate plan leaves half of Winterfell to each of Catelyn and Jon and half of his sword-making business to each of Catelyn and Jon. Ned gives his livestock along with the residue of his estate containing minimal assets to Catelyn. Ned’s documents directed payment of estate and inheritance taxes through the residuary estate. A state statute imposes inheritance taxes at different rates based upon the beneficiary’s relationship to the decedent. Catelyn’s portion of Ned’s estate produced an inheritance tax liability of approximately $2,000,000, while Jon’s portion of Ned’s estate produced a tax liability of approximately $70,000. Ned’s residuary estate lacked assets sufficient to bear the burden of these taxes. State law indicates that if the direction given in the Will or Trust results in insufficient funds to pay the tax liability, then such direction fails and the burden of payment falls where the law places such burden, unless the testator made contingent plans in the governing documents. In Ned’s case, Catelyn will be responsible for coming up with $2,000,000 resulting from her bequest, while Jon will be responsible for the much smaller amount of $70,000 because of his legal relationship with Ned. Of note, Catelyn and Jon received substantially similar amounts but because of insufficient planning and state statutes ended up with vastly different results.

As the above examples demonstrate, we always need to consider the tax implications of a plan carefully. It’s important that the Will and Trust coordinate to avoid any confusion. In addition, we consider what assets the Personal Representative or Trustee will use to pay the liability and provide for various contingencies, for example, an insufficient residuary. Finally, remember that state laws and a beneficiary’s individual circumstance will also impact the ultimate responsibility for payment of taxes.

The Toll of Serving as Fiduciary

I often guide clients in naming trustees and personal representatives (collectively “fiduciaries”) as part of the Estate Planning process. These conversations cover many topics including the fiduciary’s duties and responsibilities upon taking office. For example, fiduciaries marshal the assets of the estate or trust; make decisions regarding the distribution of assets to the beneficiaries; and potentially undertake litigation. Fiduciaries may have to appear in court, and certainly, they will have to liaise with the attorney handling the estate or trust. Often, the individuals nominated to serve as fiduciaries have limited or no understanding of their duties and responsibilities, one of which includes the filing of all outstanding income, gift, and estate tax returns for the decedent.

Internal Revenue Code (“Code”) Section 6012 imposes a duty on a fiduciary to file outstanding income tax returns. Treasury Regulation Section 25.6019-1(g) imposes a duty on the fiduciary to file any outstanding gift tax returns for a deceased donor. Finally, Code Section 6018 requires the fiduciary to file an estate tax return if the decedent’s estate exceeds the basic exclusion amount. The Code holds the fiduciary responsible for filing all outstanding tax returns. That the fiduciary may have no independent knowledge regarding whether the decedent was diligent in filing their returns does not matter. For this reason, it’s vital for the fiduciary to prioritize filing of the tax returns and as the rest of the article demonstrates, the payment of any tax liabilities.

Code Section 6321 gives the United States Government (U.S.) a general tax lien on all estate and trust property upon assessment of the tax. In addition, Code Section 6324 provides two special liens for estate and gift taxes that arise upon death, or at the date of the gift, as appropriate. In addition, federal priority statutes provide that the fiduciary must use assets in their custody to pay the U.S. before making other distributions, including distributions to beneficiaries. If the fiduciary fails to pay the government first, he or she may end up personally liable to the IRS for amounts paid to the beneficiaries or any other creditors. Three factors in combination trigger personal liability under the federal priority statute: the fiduciary controlled the assets and distributed the assets to others aside from the U.S.; the fiduciary knew that the U.S. had an unpaid claim; and the fiduciary paid others when the estate was insolvent or the payment made the estate insolvent.

Code Section 2202 and Treasury Regulation Section 22.2002-1 require the fiduciary to pay the estate taxes, even if the fiduciary never had control of those assets. This lack of control causes both a liquidity problem and an unsatisfied tax liability which can be a dangerous combination. The duty to pay taxes extends beyond estate taxes to include unpaid gift taxes, even if the gross estate no longer contains those assets. Many tried and true Estate Planning techniques involve the use of lifetime trusts or planned payment of life insurance proceeds to a beneficiary other than the decedent’s estate, for example, a surviving spouse or an Irrevocable Life Insurance Trust. Estate Planning during life could cause both a liquidity problem along with an unpaid tax problem at death, something that clients and attorneys alike should consider.

Of course, the fiduciary does not remain liable forever. The fiduciary may apply for and receive a discharge from personal liability for estate tax by written application and early determination by the IRS of the amount of tax owed. The IRS must determine within the later of nine months after the executor files the return or nine months after the executor makes a written application. Upon determination and payment of the tax, the IRS will discharge the executor. Code Section 2204(a) allows the executor to receive a discharge if such fiduciary furnishes a bond after determination of the tax. The IRS may issue the notice of discharge later, thereby relieving the executor of personal liability.

If the fiduciary knows that the trust or estate has an unpaid tax liability, then the fiduciary should consider the following steps: ask the IRS to enter into an agreement allowing the fiduciary to make distributions without personal liability; make the IRS aware of each proposed distribution and give the IRS opportunity to object or accept said distribution; maintain current records on solvency; if a court controls the assets, then determine whether the custodian will make distributions pursuant to court order; and finally, consider requesting a private letter ruling to determine whether a distribution may be made without personal liability. If you have concerns about any of the parties that you have named in your documents, reach out to me about your concerns and update your documents. If you have been named as a fiduciary and need help understanding your duties, you can always seek my help to guide you through this complicated process.

The Power in Powers of Appointment

To do my best job, I need to understand each client’s family dynamic, identify areas of concern, provide advice regarding the best course of action and consider potential tax ramifications while protecting beneficiaries from themselves. All that occurs before I ever put pen to paper. I need to create documents that accomplish these competing goals while considering facts and circumstances that may impact the effectiveness of the plan in the future. Sounds impossible, right? It’s not. It just takes careful consideration of all the tools I have at my disposal. A power of appointment is one of those tools. In simple terms, an appointment provides flexibility. Powers of appointment allow the holder to direct his or her share of property held in Trust to another individual or entity, either outright, or in continuing trust. Powers of appointment exist in two types, general or limited, sometimes called special.

An individual holding a general power of appointment (“GPOA”) may exercise that power in favor of anyone or any entity including themself, their estate or the creditors of either. The GPOA has no restrictions. If the holder has a GPOA over assets, that causes inclusion of those assets in the holder’s taxable estate. As a result, the assets subject to the power get a step-up (or down) in basis at the death of the holder. Sometimes, I include a GPOA to prevent another result. For example, some documents I prepare include language that permits an Independent Trustee to give a beneficiary a GPOA to avoid the application of undesirable tax consequences. If the Independent Trustee grants this power, then the powerholder’s estate will include the assets subject to the power, even if the powerholder fails to exercise the power. Holding the GPOA causes estate tax inclusion. It matters not whether the powerholder exercises the power.

A beneficiary holding a limited power of appointment (“LPOA”), by contrast, cannot appoint the assets to themself, their estate, or the creditors of either. The donor granting the LPOA may impose additional limits, but usually the beneficiary may exercise the LPOA in favor of a very broad class, including any one of the billions of people on earth. The overarching prohibition exists only as to the beneficiary, the beneficiary’s estate, or the creditors of either. An LPOA does not cause inclusion in the holder’s taxable estate and does not cause a step-up (or down) in basis if the LPOA is not retained by the grantor of the trust. The LPOA gives the beneficiary the opportunity to use the information existing at their death to direct to whom assets will be distributed, without subjecting the assets to estate tax.

Let’s review a quick example that demonstrates the power of an LPOA. Suppose a spouse establishes a trust for their surviving spouse and gives that surviving spouse an LPOA over the trust assets remaining at death to their descendants. If the spouse fails to exercise the power, then the trust assets will pass in equal shares to the couple’s children. If one of those children recently became a multi-millionaire, while another struggles to pay bills, that power allows the surviving spouse to alter the distribution pattern to account for those changes. Perhaps a third child recently had a disabling accident and now receives government benefits. The surviving spouse could use the LPOA to appoint assets for the disabled child to a newly created stand-alone trust.

Powers of appointment provide a great option to add flexibility to an Estate Plan. They give the powerholder the ability to account for changes in circumstances that were not contemplated at the time the plan was created. They allow a beneficiary to adjust a distribution pattern to ensure a more equitable distribution of assets gifted to them but left to their descendants upon their death. The trust or other instrument granting the power may provide requirements for the effective exercise of the power and it’s vital to exercise the power exactly as required.

What an In Terrorem Clause Can Do for You

Individuals undertake Estate Planning not only to ensure the smooth transition of their assets upon their death, but also to prevent certain beneficiaries from inheriting or limiting the gift or bequest to a beneficiary. A trust can limit the amount given to a beneficiary, for example, by providing one child with a smaller portion of the overall estate than another, or can impose restrictions upon the gift or bequest, for example, by imposing a trust for the beneficiary’s life and naming a third party as trustee. The decision about whether to leave a beneficiary any amount requires careful consideration. By leaving a token amount of say $1, the beneficiary has nothing to lose by contesting thereby undercutting the effectiveness of the no contest clause. Leaving the beneficiary a greater amount, say $50,000, rather than the $1 million that they would have received if they were receiving an equal distribution, may fund litigation, but it may also cause the beneficiary to think twice before initiating a lawsuit. In conjunction with the limitations on the gift or bequest, I always include an “in terrorem” or no contest clause to further evidence the testator or grantor’s intent. The use of an in terrorem clause in a Trust protects the intentions of the testator or grantor from attack by the disgruntled beneficiary by completely disinheriting the beneficiary who challenges the terms of a Trust. These clauses do not work the same in every state and some states impose additional requirements before disinheriting the beneficiary.

Importantly, neither Florida nor Indiana recognizes in terrorem clauses, but all other states acknowledge the use of the no contest clause in varying degrees. Most states construe a no contest clause strictly and narrowly and will enforce a no contest clause only when the beneficiary’s conduct falls into a category prohibited by the no contest clause. New Hampshire departs from this general rule and its statute provides expansive construction and interpretation of the no contest clause to ensure fulfillment of the testator’s intent as expressed in the trust.

Most of the states that accept the use of no contest clauses, like Arizona, Colorado, Michigan, Minnesota, and New Jersey, have adopted the Uniform Probate Code rule that enforces the clause unless the contestant had probable cause to initiate the proceeding. Each state sets a different bar for determination of probable cause. Alaska statutes indicate that an in terrorem clause in a Will contest is unenforceable; however, the same cannot be said for an in terrorem clause in a Trust contest. Alaska statutes specifically indicate that the in terrorem clause purporting to penalize a beneficiary by charging such beneficiary’s interest in the trust, or any other way for instituting a proceeding to challenge the acts of a trustee or initiating any other proceedings related to the trust is enforceable even if probable cause exists for instituting the proceedings.

Arkansas and Illinois enforce an in terrorem clause unless the contestant bases the contest on good faith. Other states like Iowa, North Carolina, and Tennessee require both good faith and just cause for the contest otherwise the no contest clause will apply to disinherit the contesting beneficiary. Still other states, like California, Delaware, and New York have more complex and comprehensive rules regarding the enforceability of in terrorem clauses. Most of the states that have adopted the use of in terrorem clauses in for Trusts.

Several other states like Kentucky, Louisiana, Missouri, Ohio, and Virginia enforce the in terrorem cause without regard to probable cause or good faith. Vermont has no applicable statutes on the enforceability of no contest clauses. Alabama courts have not expressly ruled on the enforceability of the clauses, although several cases have recognized the enforceability of such clauses generally while holding that such clauses were unenforceable in the specific circumstances before the court.

The harsh result of forfeiture of the gift or bequest under a Trust chills potential litigants, the intended result. If the beneficiary seeks only to have the court construe the terms or a provision of the document, that alone does not work as a forfeiture. Interestingly, in 2014 Missouri enacted legislation that allowed a potential contestant to “test the water” before moving forward with a lawsuit that would trigger an in terrorem clause. Under the applicable statute, an interested party may petition the court for an interlocutory determination whether the proposed or alternative pleading will trigger a forfeiture. This legislation gave potential litigants a clear path to the courthouse by eliminating the need to plead in the alternative, as they would have had to do before the enactment of the statute. Prior to the statute’s enactment, beneficiaries would ask the court to rule on whether the counts in their proposed pleading would trigger the clause. Once the beneficiary received that ruling, then the beneficiary would ask the court to rule on whether the clause was enforceable. That process required at least two rulings before getting to the substantive claims, the opposite of judicial economy. Missouri appellate courts have addressed the statute a mere five times in the eights years since its passage which underscores the chilling effect of these clauses.

While Missouri clearly leads the way in no contest clause litigation, other states may follow suit. Even in states like Florida and Indiana that do not recognize no contest clauses, use of the clause may chill litigation and ensure that the testator or grantor’s intended plan of distribution stands.

Business Succession Planning May Be Easier than You Think

Business owners have experience running the business and managing their employees, but often seem lost when it comes to creating a plan for what happens to the business upon their incapacity or their inevitable death. Succession planning plays a vital role in continuing a business, which often provides a necessary income stream for the family and, if not properly protected, can result in disastrous consequences. Statistics show that there are over 32.5 million small businesses in the U.S., which account for 99.9% of all U.S. Businesses according to the Small Business Administration.

Individuals create businesses for numerous reasons with many common threads, most significantly, that each needs a succession plan. This article will provide a roadmap for helping clients determine and implement that plan. Family members who act as both managers and owners make succession planning particularly complex. An attorney needs to understand that the family and business interests while often similar, aren’t always the same and need to adjust their advice and approach accordingly. Here’s a step-by-step approach.

Step one:  I encourage the family to have family meetings. Family and business owners need to practice open and honest communication, if they do nothing else, they must do this. Clear communication helps set expectations and guards against future litigation and family discord. Ideally, clients should communicate regarding the family and business goals, both short- and long-term. Having annual family meetings provides the right setting for participation and reminds participants of their familial relationships, even though they have a business together. By reminding clients of the importance of these meetings, attorneys add value for their clients. An attorney’s conference room provides a formal, yet neutral, location.

Step two:  I help the decision-makers identify key relationships. When an entrepreneur begins the business, that individual has multiple relationships with individuals both inside and outside the business and knows every detail of the business. Every decision begins and ends with them. As the business grows, the creator needs to involve others, but often does so when they have little choice either because their health or business has suffered. I encourage them to identify the important relationships and the long-term role that each of those individuals will play once the entrepreneur no longer makes every decision. Inevitably, the entrepreneur will discover what relationships work and what relationships need work. It also allows me to open a conversation about the role other family members have in developing and deepening these relationships which will ease the transition from one generation to the next.

Step three:   We create a plan. The business family needs to create policies and processes to govern the relationships among the owner and business family members. Again, talking through these issues and keeping open lines of communication helps set expectations and guard against disagreements that turn into litigation, or worse, cause irreparable family rifts. The parties need to consider governance, operation, and growth and the business, practical, and educational requirements for the next generation. Individuals should consider the compensation structure, both for outgoing owners and managers and their incoming counterparts. I encourage conferences with other qualified financial and business advisors, accountants, and perhaps, therapists, to guide the family with these decisions. Sometimes the best advice is to find a qualified professional to help.

Step four:  I remind the client of the legacy their business built. Undertaking appropriate business succession planning helps protect and continue a family legacy. The senior generation built the business and by providing the next generation with the tools necessary for success continues to play a vital role in that business. The better prepared the next generation is when the transition occurs, the more successful the transition will be. Demonstrating confidence in the newer members cements the future success of the business by showing outsiders that they, too, should have confidence in the future of the business, regardless of who’s in charge.

To recap, I start by reminding business owners that they need to create a forum for open, honest, and frequent communication about family and business matters, usually by having family meetings. Next, I discuss which relationships work best, which need work, and who will manage those relationships going forward. Third, make introductions to other qualified advisors to help create a succession plan. Finally, I remind entrepreneurs that the next generation’s success depends upon the confidence demonstrated by the prior generation.

Application of the Transfer For Value Rule to the Sale of Life Insurance

Remember that Internal Revenue Code (“Code”) Section 2042 causes inclusion of the proceeds of a policy on the decedent’s life if an estate receives the proceeds or if the decedent retained significant control over the policy, for example, by retaining the right to change beneficiaries of the policy or to pledge the policy. The Code refers to these rights as “incidents of ownership” and includes the policy proceeds in the estate of the decedent if the decedent dies holding any.

Setting up an Irrevocable Life Insurance Trust (“ILIT”) provides an effective way to remove the value of the policy proceeds from the decedent’s estate. By owning the policy in the ILIT and naming the ILIT as the beneficiary of the policy and including restrictions disallowing the insured to serve as or name a trustee, the insured releases all incidents of ownership. Of course, removing the policy proceeds from the insured’s estate requires advance planning and sometimes the insured obtains a policy without consulting an attorney first.

If the insured did not create an ILIT to own the policy prior to purchasing the policy, the insured has two options:  gift the policy to the ILIT or sell the policy to an ILIT. If the insured gifts the policy, then the insured has gifted the current value of the policy, likely far less than the death benefit of the policy. This may not matter to the insured; however, there’s another issue. Code Section 2035 will include the policy proceeds in the decedent’s estate if the decedent dies within three years of the transfer. For some clients the three-year rule poses a significant hurdle to Estate Planning with life insurance.

Selling the policy to an ILIT for fair market value allows the insured to remove the policy proceeds from their estate immediately, without gift tax consequences thereby avoiding the application of the three-year rule. However, the sale to an improperly structured ILIT could cause income tax consequences because of the “Transfer for Value” Rule. Generally, Code section 101(a) excludes the life insurance death benefit from taxable income. If the policy was transferred for valuable consideration, which would be the case if the policy were sold, then the Code includes the policy proceeds in the policy owner’s income, otherwise known as the “Transfer for Value Rule.”  Unless an exception to the Transfer for Value Rule applies, the proceeds are taxable, except to the extent of the amount paid by the purchaser.

The Transfer for Value Rule contains the following safe-harbors:  (1) a transfer in which the transferee derives their basis from the transferor (gift); (2) a transfer to the insured, (3) a transfer to a partner of the insured, (4) a transfer to a partnership in which the insured is a partner, or (5) a transfer to a corporation in which the insured holds office or is a shareholder. Creating a trust that qualifies as a grantor trust as to the insured removes the sale from the application of the Transfer for Value Rule because it’s treated as a transfer to the insured. Let’s review an illustrative example.

Let’s assume that Grace owned a life insurance policy with a $5 million death benefit. On the advice of Ami Tuer Atty, Esq., she sold the policy for $100,000 (its fair market value) to an irrevocable trust that Ami set up for her. Ami made a critical mistake and failed to ensure that the trust was a grantor trust as to Grace. Grace died a month later and the Trustee of such trust received the $5 million death benefit but was shocked to learn that resulted in $4,900,000 in taxable income to the trust. At the trust’s tax rate, that’s over $1.8 million in tax liability leaving only $3 million for distribution to the trust’s beneficiaries.

Now let’s change the facts a bit. Assume that Grace went to Gray T. Atty, Esq., who created a grantor trust as to Grace to purchase the policy. Again, the Trustee sold the policy to the trust for its $100,000 fair market value; however, under this scenario, because Gray structured the trust as a grantor trust as to Grace, the sale fell into the safe-harbor of the Transfer for Value Rule of a transfer to the insured. When Grace died a month later, the receipt of the death benefit was not taxable income and the Trustee was delighted to distribute the entire $5 million death benefit to Grace’s beneficiaries.

The above example demonstrate the complexities that arise when Estate Planning with life insurance. The example makes understanding the resulting consequences easy; however, it’s important to understand the underlying rules and reasons for the structure to properly advise an insured. There are numerous traps out there for the unwary, this is but one.

What Estate of Marion Levine Means for Life Insurance

Life insurance!! Years ago, when the exemption amount was lower, I suggested the purchase of life insurance to provide liquidity for an estate if the individual expected to have an estate tax liability at death. With the current exemption amount of $12.06 million, far fewer individuals need to purchase life insurance solely for this reason. Far more individuals purchase life insurance as an investment and use sophisticated techniques to achieve the desired tax results. A recent Tax Court case that resulted in a huge win for the taxpayer demonstrates the effective use of one of those techniques.

The taxpayer, Marion Levine, used an ILIT to purchase life insurance on her son and daughter-in-law and structured the transaction to avoid estate tax inclusion under Internal Revenue Code (“Code”) Sections 2036 and 2038. The following example contains facts based upon the Estate of Marion Levine v. Commissioner (158 T.C. No. 2). Marion’s attorneys-in-fact created an ILIT to own two life insurance policies. The provisions of the ILIT named a trust company as an independent trustee and named a business associate of Marion’s as the sole member of the investment committee. Of note, the investment committee possessed the power to terminate the arrangement and controlled all investment decisions for the ILIT. The ILIT borrowed $6.5 million from Marion’s revocable trust to pay upfront premiums to purchase the insurance policies insuring Marion’s son and daughter-in-law. The ILIT assigned the policies to the revocable trust as collateral for the amount borrowed and agreed to repay the revocable trust its investment: the greater of the premiums paid or the cash surrender value of the policies either on the death of the insureds or at the date of termination of the policies. The ILIT retained the right to terminate the arrangement and surrender the policies. Upon Marion’s death, her executor was unclear about what to include in Marion’s estate: her revocable trust’s right of repayment in the future valued at $2,282,195 or the cash-surrender value of the life insurance policies at the time Marion died valued at approximately $6,500,000.

The Tax Court determined that the split-dollar arrangement met the requirements set forth in Treasury Regulation Section 1.61-22 and concluded that neither Code Sections 2036(a)(2) or 2038 required inclusion of the cash-surrender value in Marion’s Estate. Marion retained no right to terminate the policies, either alone or in conjunction with someone else. Remember, that right remained with the ILIT alone. Marion’s revocable trust possessed a receivable created by the split-dollar arrangement which was the right to receive the greater of the premiums paid or the cash-surrender value of the policies upon termination and nothing more. Although the Commissioner argued that the transaction was a façade that did not match the reality, the Tax Court disagreed and found that state law imposed fiduciary duties on the sole member of the investment committee with respect to the trust and its beneficiaries, none of whom were Marion. The Tax Court concluded that the only asset from the split-dollar arrangement includible in Marion’s estate was the receivable owned by her revocable trust at death.

While the above example seems straightforward in many ways, the taxpayer scored a huge victory because the estate included only the discounted value ($2,282,195) of what it gave to the ILIT, rather than the full value ($6,500,000) which was a 65% discount. Further, although Marion’s attorneys-in-fact created both the ILIT and the revocable trust, and served as Trustees of the ILIT, the Tax Court did not collapse the transaction. Because the ILIT named an independent trustee and contained instructions that the investment committee direct the Trustee, that preserved the transaction and kept the assets out of Marion’s estate, even though it seemed she stood on both sides of the transaction. As this article demonstrates, understanding life insurance and the use of ILITs presents an opportunity for us to work together and add value by being well-versed in the myriad ways to use and structure life insurance.