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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.

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.

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.

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.

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 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.

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.

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.

I build estate plans around trusts. Trusts offer great flexibility both during life, for example during a period of disability, and after the death of the grantor by providing asset protection, remarriage protection, asset management, and other benefits which might not be otherwise available.

The income tax consequences of a trust depend upon whether the trust contains provisions that make it a “grantor” trust or a “nongrantor” trust. Generally, the tax attributes of a grantor trust flow through to the grantor of the trust, pursuant to Sections 671 through 678 of the Internal Revenue Code (the “Code”). Many refer to these Code Sections as the “Grantor Trust Rules” and these sections determine the income tax status of a trust. If the trust qualifies as a grantor trust under the Grantor Trust Rules, then the Internal Revenue Service disregards the trust as a separate tax paying entity.

If the grantor retains the power to revoke the trust, that’s a grantor trust according to Section 676 of the Code. The grantor reports the income from the trust on their United States Individual Income Tax Return (“Form 1040”). The trust typically uses the grantor’s social security number when establishing an account at a bank or other financial institution in the name of the revocable trust. Alternatively, the trust could use a separate taxpayer identification number for the trust. Either way, the income would flow through to the grantor’s tax return. See Treas. Reg. Section 1.671-4. Assuming the trust uses the grantor’s social security number for tax reporting, when the financial institution issues a Form 1099 or any other tax document, it would do so using the grantor’s social security number.

Revocability alone does not determine grantor trust status. In fact, the grantor need not have a direct benefit from the trust and the trust may be classified as a grantor trust. If the grantor creates an irrevocable trust but retains certain benefits or powers under that trust, then the trust may be a grantor trust. In general terms, if the grantor retains a reversionary interest of more than five percent of the value of the trust, controls the beneficial enjoyment of the income or principal of the trust without the consent of an adverse party, retains certain administrative powers, such as the power to substitute property of equivalent value for the property in the trust, or receives income from the trust, then that’s a grantor trust. Grantor trust status may be beneficial because it allows the grantor to benefit another individual, such as a child or grandchild, while maintaining the tax liability without the payment of the tax being considered an additional gift by the grantor.

The Code classifies any trust that is not a grantor trust under the Grantor Trust Rules as a nongrantor trust and considers such trust its own taxpaying entity. The trustee files a separate income tax return detailing the income, deductions, credits, and tax liability for the trust on the United States Income Tax Return for Estates and Trusts (“Form 1041”). The nongrantor trust obtains a taxpayer identification number for use in reporting items of income and filing its tax returns. If the trustee distributes income to beneficiaries, those distributions may carry out the taxable income of the trust. The trustee provides the beneficiaries with a Schedule K-1 detailing the trust income attributable to that beneficiary which the beneficiary includes in income on their Form 1040. The trust receives an offsetting distribution deduction on its Form 1041. The trust pays tax on any income for which it did not have an offsetting distribution deduction.

The trust reaches the top federal tax rate of 37% on income that exceeds $13,450 in 2022. Contrast that with a single individual taxpayer who reaches the top tax rate of 37% on income that exceeds $539,900 in 2022. Clearly, grantor trust status provides, among other things, tax benefits to a grantor by lowering the tax rate for income. Let’s review a quick example that illustrates that difference in real numbers.

Assume that Mila established the Mila Kunis Revocable Trust. During her lifetime, the trust incurs income of $550,000 annually. Mila includes her only source of income, the trust income, on her Form 1040 for the tax year 2022. Mila has $550,000 of taxable income. Her Form 1040 shows a liability of $166,456 after the application of the tax brackets for a single taxpayer in 2022.

Assume instead that Mila establishes the Kunis Family Trust as a nongrantor trust and names her adult children, Wyatt and Dimitri, as beneficiaries of the Trust. The trust again has taxable income of $550,000 for the year 2022. Thus, Form 1041 would show a tax liability of $201,762. This number alone demonstrates the importance of a trust distributing its income and the important distinction between grantor trust and nongrantor trust status. If the trustee distributes all the income to the beneficiaries, who have no other income, then the trust should receive a distribution deduction for the $550,000 distributed. Each of Wyatt and Dimitri would include $275,000 on their individual Forms 1040. If neither receives income from another source, then assuming each files using single taxpayer status for 2022, each child would have a tax liability of $70,021 after application of the applicable tax brackets.

As the examples above demonstrate, grantor trusts provide an opportunity to lower a trust’s total tax liability, a powerful tool in the Estate Planning arsenal. As we approach the deadline for filing our 2021 income tax returns, it’s important to review your estate plan, paying close attention to any trusts that are part of your plan. Remember that grantor trust income flows through to the grantor, whether or not the trust makes distributions to beneficiaries of the trust. Conversely, non-grantor trust income flows out to the beneficiaries, if they received appropriate distributions during the year, and the trust receives a corresponding distribution deduction. If you have questions about the operation of your trusts or the resulting tax consequences, I can guide you through this complex area of the law.

As many of us remember, the Setting Every Community Up for Retirement Enhancement Act of 2019 (“SECURE Act”) sent shockwaves with its significant changes to the rules regarding distributions from Individual Retirement Accounts (“IRAs”). To recap, the SECURE Act repealed the maximum age at which a taxpayer could contribute to their IRA, increased the age at which the taxpayer needs to begin withdrawing funds from the IRA, and eliminated the lifetime stretch benefit for any beneficiary other than the newly created category of beneficiary called the Eligible Designated Beneficiary (“EDB”). EDBs consist of surviving spouses, children who have not yet reached the age of majority, chronically ill or disabled individuals, and any other individual not more than ten years younger than the participant, or appropriately structured trusts for the benefit of those individuals. Any beneficiary other than an EDB was subject to the newly created 10-year rule. The 10-year rule would operate like the 5-year rule that existed prior to the SECURE Act. This meant that the non-EDB need not worry about RMDs and only needed to withdraw all funds by December 31^st of the year of the tenth anniversary of the participant’s death. Sounds simple and easy enough to understand and implement, right?  Not so fast…

The ink was barely dry on the SECURE Act when the Internal Revenue Service (“IRS”) took a position that changed the perceived operation of the 10-year rule. In the 2020 updated version of Publication 590-B, the IRS included an example that required a beneficiary subject to the 10-year rule to take annual withdrawals for nine years and then exhaust the IRA fully by December 31^st of the year of the tenth anniversary of the participant’s death. This pronouncement meant that the 10-year rule operated completely unlike the 5-year rule. Even though we cannot rely upon Publication 590-B as “official IRS guidance,” the inclusion of this example understandably caused concern. Shortly thereafter, the IRS corrected Publication 590-B by removing that example and confirming that no withdrawals were necessary prior to December 31^st of the year of the tenth anniversary of the participant’s death. Considering the proposed Treasury Regulations issued last week, that earlier “mistake” may have been foreshadowing at its finest.

On February 23, the United States Treasury released much-anticipated proposed regulations updating, among other things, the rules regarding RMDs from IRAs. These proposed regulations backtrack on some of the guidance published since the passage of the SECURE Act in 2019. The proposed regulations revert a bit to the incorrect example previously espoused in Publication 590-B and take a nuanced approach to distributions under the 10-year rule. Now, any non-EDB needs to take annual distributions based upon the participant’s life expectancy over the next nine years and exhaust the IRA by December 31^st of the year of the 10^th anniversary of the participant’s death if the participant reached their Required Beginning Date prior to death. This represents a sharp departure from the operation of the 10-year rule and the advice that most professionals have given their clients since the passage of the SECURE Act in 2019.

Instead of simplifying the IRA Rules, this explanation of the 10-year rule adds another layer of complexity to an already confusing area of the law. Earlier this year, the IRS updated the life expectancy tables which requires recalculation of RMDs for anyone taking distributions from an IRA subject to their life expectancy. Prior to these proposed regulations, only participants, EDBs, and designated beneficiaries who inherited IRAs prior to the SECURE Act used the lifetime stretch. Now, by extension, the tables will apply for non-EDBs who will take under the deceased participant’s life expectancy as well. These changes will undoubtedly confuse many taxpayers and many of their advisors. You can best protect yourself from unintended consequences by consulting with me about the impact that these proposed regulations will have on your IRA and your obligation to take RMDs.

While these Treasury Regulations are only proposed regulations, clients have good reason to be concerned. This area continues to grow in complexity with changed positions and conflicting guidance. Beginning in 2022, any non-EDB subject to the 10-year rule needs to take annual distributions. This author suspects that we have more to learn on this topic and recommends that the brave read the 275 pages of these Treasury Regulations at https://aboutbtax.com/1Ml. This article focuses solely on the most drastic change contained in the proposed regulations, although plenty of other changes were made as well. The final Treasury Regulations may revert the 10-year rule to its prior version that existed from 2019 through 2021, and many commentators believe that these regulations improperly interpret provisions of the Internal Revenue Code that set forth the 10-year rule. Until we have final regulations, taxpayers have three options:  follow the Just, file a Form 8275-R noting the contrary position to the regulations or initiate a lawsuit. Stay tuned for additional changes and updates, but in the meantime, follow one of the three options noted herein.