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Occasionally, those who aren’t Estate Planning attorneys will attempt to do their own Estate Planning. They think they can find a document online or use a friend’s document and can figure it out. Unfortunately, there are many pitfalls one could run across.

Let’s look at three of these pitfalls which one must sidestep.

Bill and Mary had a house worth $500,000, an IRA worth $500,000, and investments of $500,000. They have three children, Aaron, Betty, and Charlie. At the death of the survivor of Bill and Mary, they want to leave the house to Aaron, the retirement plan to Betty, and the investments to Charlie.

The first problem with this plan, even assuming they draw up documents which accomplish this distribution pattern, they may not have considered the downsides. Bill and Mary’s plan didn’t anticipate that they might sell the house, which they did. The specific bequest of the house to Aaron lapsed. They added the proceeds from the house to the investment account. Since their plan left the investment account to Charlie, those assets went to him instead of Aaron.

There’s a second problem with this plan, even assuming they draw up documents which accomplish the plan. They’ve not considered the income tax implications. While the three assets are the same value currently, the house and the investments get a step-up in basis at death. In other words, when the beneficiary receives the assets, they won’t owe income tax on them. However, the IRA is “Income in Respect of a Decedent” or “IRD,” which is an exception to the step-up rules. Assuming Betty has a marginal state and federal income tax rate of 40%, $200,000 of the IRA would be lost to income taxes. It might have been better to leave the IRA to Charlie who is in a lower tax bracket or spread the tax consequences over all three of them. After taxes, Betty would end up with $300,000, while each of her brothers would end up with $500,000.

There’s a third problem with this plan, even assuming they draw up documents which accomplish it. They’ve not considered fluctuations in the values of the various assets. Let’s say they die ten years after they draft the plan and the assets are then worth $3 million. But, their children won’t each get $1 million. In fact, one of the children might get far less than the others. How is that possible? The house bequeathed to Aaron could be in a neighborhood of decreasing property values. Its value declined to $100,000. Bill and Mary continued to contribute to the IRA designated to Betty and it was worth $1 million at the death of the survivor of Bill and Mary. The investments bequeathed to Charlie did quite well and were worth $1.9 million by the death of the survivor. Thus, Aaron would get the house worth $100,000. Betty would get the IRA worth $1 million (but subject to income taxation of $400,000). Charlie would get the investments worth $1.9 million. Thus, Charlie would get more than triple the after-tax value of his sister and 19 times the value of the bequest to his brother.

Estate Planning is about far more than documents. It’s also about the knowledge and experience of the attorney who drafts the plan.

Often, there is confusion regarding how a trust or a subtrust may report income and the TIN which should be used. Treasury regulations spell this out quite clearly. Treasury Regulation 1.671-4 is the relevant section.

A “nongrantor” trust is a trust which is not substantially owned by anyone pursuant to the provisions of section 671 and following. A nongrantor trust should obtain and use its own TIN. The trustee of the trust should provide the TIN of the trust and the address of the trust to banks and other institutions at which it has assets.

The income of the trust gets reported on the trust’s own tax return, Form 1041. The trust would receive a distribution deduction for distributions which carry out Distributable Net Income (“DNI”). These distributions to the beneficiary which carry out DNI then get taxed on the beneficiary’s tax return. The trustee would provide a Form K-1 to the beneficiary advising the beneficiary of the amount of income which the beneficiary must report on their tax return.

Let’s look at a quick example.

Mary set up an irrevocable trust. The trust contains nothing that would deem Mary or any other person as the substantial owner under Sections 671 and following. In other words, the trust is a nongrantor trust. The trust had $50,000 of income in the year. The trust made $20,000 of distributions to the beneficiary of the trust, Ben (Mary’s son). Those distributions were of cash and carry out DNI. Mary’s sister, Alice, is the trustee of the nongrantor trust. Alice will file a Form 1041 for the trust and report the $50,000 of income and a distribution deduction of $20,000. She’ll also provide Ben with a K-1 for the distribution of $20,000 to him. Ben will include the $20,000 of income from the K-1 on his tax return for the year.

Grantor trusts and nongrantor trusts each have their place in Estate Planning. Remember, whether a trust is a grantor trust or a nongrantor is not indicative of whether it is included in the taxable estate of the grantor for estate tax purposes, only income tax purposes.

Often, there is confusion regarding how a trust or a subtrust may report income and the TIN which should be used. Treasury regulations spell this out quite clearly. Treasury Regulation 1.671-4 is the relevant section.

Section 1.671-4(b)(2) provides that if a trust is treated as owned by one grantor or one other person, the trustee must either A) Furnish the name and TIN of the grantor or other person treated as the owner of the trust and the address of the trust to all payors for the taxable year, or B) Furnish the TIN of the trust and address of the trust. Of course, the latter method would also be used if the trust is a nongrantor trust.

A grantor of a trust is spelled out in Sections 671 to 677. For example, the power to revoke is listed as a power making a trust owned by the grantor under section 676. Under Section 678 someone other than the grantor may be treated as the owner of the trust for income tax purposes. Under Section 678, someone other than the grantor would be treated as the owner of the trust if they had the power to vest the corpus or income of the trust in themselves (i.e. a general power of appointment), or if they previously had such a power and they retained other powers under sections 671 to 677. There is an exception if the original grantor still is considered the owner of the trust. (Of course, upon the grantor’s death, the grantor is no longer considered the owner of the trust.)

Let’s look at two quick examples.

Example 1: Mary has a revocable trust. The trustee of Mary’s trust (who might be her or might be someone else) wants to use Mary’s TIN (which is her social security number). This is appropriate because Mary has the power to revoke the trust and is the owner pursuant to section 676. If the trustee preferred, they could choose to use a separate TIN for the trust.

Example 2: Upon Mary’s death, her trust sets up a subtrust for John. Under the subtrust, John has a right to withdraw the assets and income from the trust. This type of trust is commonly referred to as an “Access Trust” or a “Divorce Protection Trust.” Since John has a right of withdrawal and Mary is dead, John is considered the owner pursuant to Section 678 of the Code. The trustee of John’s subtrust may use John’s TIN (which is his social security number) as the TIN for the trust. If the trustee preferred, they could use a separate TIN for the trust.

If the trustee chooses to use the substantial owner’s TIN, the income would go directly to the substantial owner’s tax return and there’d be no need for a separate tax return for the trust. If the substantial owner isn’t the trustee, the trustee would need to provide the substantial owner a statement showing all items of income and deduction and other information which might be necessary for the substantial owner to take into account in computing their taxable income.

A grantor trust is “substantially owned” by someone under Code Sections 671 and following a common power which causes a trust to be a grantor trust is the retention of the power to revoke the trust under Section 676. A revocable trust is income taxed to the grantor and it’s also included in the estate of the grantor for estate tax purposes. However, a trust need not be included in the taxable estate of the grantor to be a grantor trust. A trust could be called what is known commonly, though confusingly, as an “intentionally defective” grantor trust. In reality, there’s nothing at all “defective” about such a trust. It’s excluded from the estate for estate tax purposes, but, taxed to the grantor for income tax purposes.

For example, if the grantor retains the power to substitute other assets of an equivalent value for the assets of a trust, it’s a grantor trust, pursuant to Section 675(4)(C).

A grantor trust can offer many advantages. First among those is simplicity from an income tax perspective. A grantor trust does not need to file its own income tax return but can report the income on the grantor’s taxpayer identification number. Second, the income from the trust is taxed to the grantor, whether or not it is distributed to the grantor. This may sound like a flaw, but it’s a huge advantage if the grantor is trying to remove value from their taxable estate. It allows the assets in the trust to grow tax-free because the grantor is paying the taxes on the income of the trust. It’s important to note that the payment of taxes by the grantor is not considered a gift by the grantor, but rather the grantor’s own legal obligation.

Let’s look at a quick example. Mary set up a trust and contributed $1,000,000 to the trust. The trust has $50,000 in taxable income and no distributions in the year. The $50,000 of taxable income is taxed on Mary’s income tax return. Mary pays the tax which she owes on the $50,000 of income, which comes to $20,000. Mary pays the taxing authorities the $20,000 from her own funds, not diminishing the trust’s assets. When Mary pays the $20,000, she is not making an additional gift to the trust.

A grantor trust allows assets to grow tax-free, much like a Roth IRA. This increased compounding power is a very powerful advantage for a grantor trust. The next article in the series will examine the tax reporting of trusts. In other words, what tax identification number and address does the trustee provide to the bank or brokerage company?

The first advanced planning strategy is to use a Roth IRA to maximize the deferral on an inherited IRA. Prior to the SECURE Act, beneficiaries could take distributions over their life expectancy. For those dying after 2019 with IRAs, the SECURE Act applies. Under the Act, most beneficiaries must withdraw the assets from an inherited IRA by the end of the period ending at the end of the year that includes the 10^th anniversary of the IRA participant’s death, i.e., the so-called “10-year rule.” With a traditional IRA, the problem is that if the beneficiary waits until the last year for maximum deferral, they’d have a large bump in income which would push them into higher tax brackets. For example, let’s say Mary inherits a traditional IRA with $1 million. If she waits until the last year, most of the IRA would be taxed at the highest marginal income tax rate. Conversely, if Mary inherits a Roth IRA, she could allow it to grow tax-free until the end of the “10-year rule.” Mary could withdraw the entire IRA in the last month of the period because distributions from a Roth IRA are not included in taxable income.

The other advanced planning strategy is to use a Roth IRA to reduce estate taxation. The value of an IRA is included in the taxable estate of the IRA owner. However, with a traditional IRA, income taxes would be owed on the balance upon withdrawal. But this does not reduce the value for estate tax purposes.

Let’s look at an example: Tom Taxpayer is in the maximum income tax bracket of 37% and lives in a state without a state income tax. Tom has a taxable estate and has an IRA of $1 million. If Tom converts the $1 million IRA to a Roth IRA, he’d pay $370,000 in income taxes, thus reducing his taxable estate by that amount. That reduction in his taxable estate would save him the estate tax on the $370,000 income tax paid upon conversion, or $148,000 with an estate tax of 40%. Of course, the payment of the income tax upon the conversion to a Roth IRA also would mean that the beneficiary who receives the IRA won’t have to pay income tax upon withdrawal.

Thus, the conversion to a Roth IRA can allow a full utilization of the 10-year rule and can act to reduce the taxable estate while providing an income tax benefit to the recipient.

An Individual Retirement Account (IRA) is a savings vehicle in which a deduction may be taken upon contribution (with limitations). The maximum contribution in 2021 is $6,000, and those age 50 and over may contribute an additional $1,000. While the assets are in the IRA, the income is not taxable. However, when distributions are taken in retirement, those distributions are included in taxable income.

A Roth IRA is almost the reverse of a traditional IRA. A taxpayer contributing to a Roth IRA does not get a deduction for the contribution. The earnings grow tax-free. And when the distributions come out, they are generally not taxable.

A taxpayer only qualifies to contribute to a Roth IRA if their taxable income is within certain limits. Married taxpayers filing a joint return may contribute the full amount if their income is below $198,000 in 2021. There is a phaseout and then the taxpayer cannot contribute anything if their income is $208,000 or higher. For an unmarried taxpayer, they may make a full Roth IRA contribution if their income is below $125,000 in 2021. There is a phaseout up to $140,000 and then no contribution is allowed.

While eligibility to contribute to a Roth IRA depends upon the taxpayer’s taxable income, anyone may convert their IRA to a Roth IRA. When they do a conversion, the amount of the traditional IRA is income taxable.

Let’s look at a quick example: John normally has income of $300,000 per year. He was furloughed until 2022 due to the pandemic. He has no income in 2021. He has a traditional IRA of $50,000. He could convert his traditional IRA to a Roth IRA and would pay tax at relatively low rates since his income is lower in 2021.

If a taxpayer doesn’t qualify to contribute to a Roth IRA, they may be able to contribute to a traditional IRA (deductible or nondeductible) and then convert that IRA to a Roth IRA.

One of the key factors in converting (or contributing) to a Roth IRA is whether the tax rate at the time of conversion (or contribution) will be lower than the expected tax rate at the time of distribution.

An Estate Plan includes various different moving parts. The Revocable Trust may be the keystone of the plan, but it’s important to consider how the other parts of the plan will work with…or against…the plan.

Let’s look at a simple example. John had three children and he wished to leave his assets to them equally. He had $6 million in various assets. John hired an attorney to help him with a Revocable Trust leaving everything equally to his three children. The Trust was wonderfully drafted. He had a Pourover Will which poured into the Trust. Would this achieve his goal?

Not necessarily. Some of John’s $6 million in assets might not be controlled by either the Trust or the Pourover Will. Let’s say John had an IRA. The IRA beneficiary designation would control who would receive that asset. If the IRA beneficiary designation were to John’s Trust, the IRA would pass according to the terms of John’s Trust. All too often, retirement accounts and other assets have beneficiary designations which predate the Trust and haven’t been updated. Often when the IRA is established, it has only a small amount. In John’s case, he opened the IRA with $5,000. He named the person he was dating at the time, Betty. He never changed that beneficiary designation. He never even thought about it years later when his spouse died and he did a spousal rollover of her retirement plan into his own IRA. Nor did he think about it when he left his job and rolled his 401k into his IRA. Now he has $3 million in his IRA. At his death, that asset would pass according to the beneficiary designation, to Betty.

Betty could take the $3 million and not look back. She’d be under no legal obligation to give it to John’s children. In that case, John’s children would be out half their inheritance. If Betty is cooperative, she might disclaim the $3 million IRA and it would pass to the contingent beneficiary. In John’s case, he didn’t name a contingent beneficiary. So, we’d look to the custodial agreement. In John’s case, the agreement provides, if the primary beneficiary isn’t there, and there’s no contingent beneficiary, the assets would go to his estate.

Passing through the probate process, the assets would pass pursuant to John’s Pour Over Will to his Trust. This would get the assets to John’s three children. However, the IRA would have been unnecessarily diminished by the expenses of the probate process.

This turmoil could have been avoided if John had coordinated the Estate Plan. John could have changed the beneficiary designation on his IRA. He could have named his children outright, if appropriate, or he could have named his Revocable Trust. Without coordinating the Estate Plan, a large portion of the assets could go in unintended ways, just like in this example.

Trust distribution standards may be very broad. In fact, the trustee could be given the authority to distribute to the beneficiary in the trustee’s sole discretion. This type of discretionary trust can provide asset protection if the trustee isn’t the beneficiary. However, if the beneficiary is the trustee, it would subject the trust assets to the beneficiary/trustee’s creditors (at least in most states). It would also cause inclusion in the beneficiary/trustee’s taxable estate. After all, the trustee would have a “general power of appointment” under Section 2041 of the IRC because the trustee could appoint the assets to themself as beneficiary. Conversely, if the beneficiary isn’t the trustee, they’d have no way to force any distributions by the trustee, which is why such a trust typically provides asset protection. Typically, a creditor stands in the shoes of the debtor.

However, the regulations to Section 2041 carve out an exception when the trustee is acting under an “ascertainable standard.” Certainly, if the trust mandated the trustee to distribute $1,000 per month to themself as beneficiary, that would not be a general power of appointment because it would be “ascertainable.” However, the limits of ascertainability are far broader.

Treas. Reg. 20.2041-1(c)(2) provides “a power is limited by [an ascertainable] standard if the extent of the holder’s duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health, education, or support (or any combination of them).” The regulation goes on to provide that the terms “support” and “maintenance” are synonymous. Many trusts are drafted with this “safe harbor” language from the regulations, “health, education, maintenance and support,” sometimes referred to as the “HEMS” standard. While the HEMS standard is an ascertainable standard according to tax law, it’s still very flexible and it’s difficult to say exactly what is required. But, it would allow a beneficiary to go to court to enforce the standard.

Let’s look at a typical example of the difference between a fully discretionary standard and a HEMS standard. Mary is the trustee of a trust and John is the beneficiary. If the trust provides for Mary to make distributions to John in her sole discretion, she would not be required to distribute anything to John. On the other hand, if the trust provides a HEMS standard, then Mary would need to make distributions to or for John’s benefit at least for a minimum level. But, Mary could decide to provide that minimum or more. For example, Mary could determine that John only needs a studio apartment in a working-class neighborhood. Conversely, she could determine John needs a larger home in a nicer neighborhood. Mary would have a similar level of discretion in other areas, as well. She could distribute enough for John to scrape by or enough for him to live more comfortably.

A HEMS standard, while ascertainable, isn’t specific. It provides a range in which the trustee may operate. If a dispute arose over the limits of that range, the court would be the final arbiter.

More to follow . . .

A revocable trust is usually treated the same as the individual who created the trust. For federal income tax purposes, a revocable trust is a “grantor trust” under section 676 of the Code. Therefore, all items of income and expense of the trust flow through to the grantor.

However, for some purposes, a revocable trust may not be treated the same as the grantor. Here are two examples.

First, let’s say John has an IRA and he makes it payable to his friend, Carlos. At John’s death (on or after January 1, 2020), Carlos would ordinarily have to take all the assets out of the IRA by the end of the year that includes the 10^th anniversary of John’s death, the so-called “10-year rule.” If John named Carlos’ revocable trust, the result would be different. In that case, assuming Carlos were still alive at John’s death, Carlos’ trust would not qualify as a “look through” trust because it would not have been irrevocable by the date of John’s death. As a result, the IRA would need to pay out under the “5-year rule” applicable when a non-individual is the beneficiary.

Here’s another example of how a revocable trust and the individual may not be treated the same. Under Missouri law, a purchaser owes sales tax on a vehicle upon purchase. If that vehicle is stolen or destroyed and there are insurance proceeds, those offset the price of the replacement vehicle purchased and thereby reduce the sales tax. In a recent case, the Missouri Supreme Court held that a revocable trust wasn’t the same as an individual for purposes of the Missouri sales and use tax. In Collison, a couple (in their individual names) owned a vehicle and purchased a replacement vehicle in their trust. The Court didn’t allow the insurance proceeds the couple received from their first vehicle to be applied against the price the trust paid for the replacement vehicle.

While revocable trusts are treated the same as the grantor for federal income tax purposes, they may not be treated as the same for other purposes.

The Achieving a Better Life Experience (ABLE) Act allowed accounts to help people with disabilities (and their families) save and pay for disability-related expenses. ABLE allows states to create tax-advantaged savings programs for eligible people with disabilities. Distributions from ABLE accounts are tax-free if used for qualifying disability expenses.

ABLE accounts may be used by those who were disabled before age 26. Regulations issued in 2020 allow such individuals to roll money from qualified tuition programs — 529 plans — into ABLE accounts.

Contributions aren’t federally tax-deductible. However, distributions and earnings are tax-free to the beneficiary if they are used to pay such qualifying disability expenses as:

• Housing
• Education
• Transportation
• Health
• Employment training and support
• Assistive technology
• Personal support services.

In addition to the annual contribution limit of $15,000, a designated beneficiary who works also may contribute his or her compensation up to the federal poverty level for a one-person household (but not if his or her employer contributed to a 401(a) defined contribution plan, 403(b) annuity contract, or 457(b) eligible deferred compensation plan). In 2021that’s $12,880 (except for Alaska and Hawaii).

Amounts in ABLE accounts aren’t considered “available resources” for Medicaid purposes. Further, amounts up to $100,000 are ignored for purposes of Supplemental Security Income (SSI). This is critically important. It allows the disabled beneficiary to have some resources without jeopardizing their benefits. Can you imagine if you could only have $2,000 to your name without being penalized? Without an ABLE account, that would be the terrible position such individuals would be in.

An ABLE account allows for dignity for the disabled beneficiary, in addition to the many other benefits available. The question isn’t whether a disabled beneficiary should have a SNT for their benefit or whether they should have an ABLE account. The question is why shouldn’t they have both? An ABLE account is a nice supplement to a SNT.