When Death Do Us Part

This one is for married folks (or those who may be married, or re-married, some day). It’s a topic that comes up every time we prepare an estate plan for a married couple. For some people, it’s the main reason they have sought out an estate planner; for many, it’s something they didn’t even think about until we brought it up during the planning session. But for ALL married couples, it’s something (and often, the most difficult thing) that must be decided as part of crafting the estate plan.

What happens when ONE spouse dies, and the other survives? And particularly, how much control should the surviving spouse have over the couple’s assets – particularly the jointly built and preserved assets, but also any assets that the deceased spouse may consider his or her “own” or “separate” property (for example, things that the deceased spouse brought to the marriage, or inherited from his or her family members) – after the other spouse has died? Do you think the surviving spouse should have COMPLETE control over all assets remaining in your combined “estate” (and by this, I mean everything that both or either of you own), or do you want the survivor to be constrained in some way(s) regarding the use or disposition of those assets?

Many people’s initial response is,

Should I Have a Trust?

This has to be one of the most common questions posed to me. And the answer is not necessarily simple, but there are definitely some guidelines that I use to determine whether I should recommend trust-based planning. We’ll start with the revocable living trust, the most common type of trust – this is the trust that is basically used to avoid probate; the trustmakers can revoke or change its terms at any time, they generally remain the trustees and in full control of the trust assets for as long as they are alive and competent. My guess would be that 99% of the trusts in existence in the U. S. are (or were, before the trustmaker(s) died) this kind of trust.

First, a caveat. Although one of the main reasons that people create trusts is to avoid probate, in at least half of the cases that I have been called upon to help settle a trust after someone has died, a probate was necessary even though there was a trust! Why is this? Usually, because the deceased person had some substantial assets that they hadn’t put into their trust (this is called “funding” the trust). This can happen for many reasons. Sometimes people just forget, or don’t want to go to the trouble of transferring an asset. Sometimes people inherit assets and die before they can receive the asset and transfer it to their trust. Sometimes people are involved in litigation when they die, and don’t receive a settlement or award until after death.  Trusts can be useful even if not funded, but obviously if the purpose is to avoid probate, having substantial assets (including ANY real estate, even a timeshare) that is not in the trust will frustrate this purpose. I have put a purple “F” by each reason that requires that the trust be fully funded in order to meet the specified objective. If there is no “F”, the objective may be met by creating a trust that is funded only through a will, which would need to go through probate in order to get the assets into the trust.

So, when should you definitely consider creating, and funding, a revocable living trust?

The A/B Tax Trap (Basis Step-Up, Part II)

Welcome back! So last week we reviewed the basics of basis. This week, I’ll explain how your fancy trust, well-crafted to save you lots of estate tax back in the 1990s or 2000s, could actually end up costing your heirs money, due to changes in the law over the past few years. It all comes down to basis (which is why we went over how that works, in the last post.)

You see, a few years back, the federal Estate Tax ‘kicked in’ when someone died leaving a relatively modest estate (in 2001, $675,000; even less before that).  The amount that each person could pass at death without paying tax (what we call the “Exemption Amount”) increased a few times from 2001-2008 (when it was $2 million), but of course real estate values also increased dramatically over that time period, and many people built up substantial retirement accounts such as 401(k)s and IRAs.  Remember, too, that for estate tax purposes, we count not only your real estate and investments, but also any retirement accounts and the proceeds of life insurance payable on your death.  While there was (and still is) usually no tax on assets passed to a surviving spouse,* if all of the dying spouse’s assets (and the dying spouse’s half of joint assets) go to the surviving spouse, then when that survivor dies, his or her estate will include ALL of the couple’s assets.  This could easily cause the survivor’s estate to exceed the lower tax thresholds in effect in the 1990s and early 2000s. And the tax – with a maximum rate of 55% in 2001, declining to 45% in 2009 – was nothing to sneeze at!

So to be sure to minimize these taxes for couples who might be subject to them, estate planners came up with something called an “A/B Trust Plan,” which works like this: When the first spouse dies, instead of their entire estate passing to their surviving spouse, a portion of the estate equal to the Exemption Amount in effect in that year (for example, $675,000 if they died in 2001) is placed into a “B” (or “Bypass” or “Credit Shelter”) Trust, and the rest passes to the surviving spouse (or into an “A” or “Marital” Trust, hence the “A/B” designation). The “A” property would be included in the surviving spouse’s estate (this is necessary to avoid paying tax on it at the first spouse’s death), but the property in the “B” trust, though available for the surviving spouse to use, is NOT included in his or her estate at death (this is accomplished by the design of the “B” trust). This helped to keep the survivor’s estate below the Exemption Amount (or if that’s not possible, as low as possible), by having some of the assets of the first dying spouse “bypass” the estate of the second spouse to die.

Now, however, with the “Exemption Amount” much higher – for 2014, it’s $5.34 million per person – and the ability to increase it further, even DOUBLE it, for a surviving spouse using something called “portability,” the “bypass” procedure is almost always unnecessary, since there will be no estate tax on the second spouse’s death even without it.  But, you may ask yourself, if the assets are simply taken out of the surviving spouse’s estate for tax purposes, then what’s the harm? Why do we have to mess with it?

Well, consider this: anything that is NOT in the surviving spouse’s estate when he or she dies (which, for most couples today with an A/B Trust Plan, will be one-half of their joint assets – perhaps more if the spouse who owned the bulk of the property died first), does NOT get a ‘step-up’ in tax basis at the surviving spouse’s death!  So if the couple had a home, or other assets, that have appreciated in value, and are likely to continue to appreciate in value after the first death, and half of those assets are owned by each spouse, then on the first spouse’s death, his or her half of the assets will go into the “B” Trust. If the surviving spouse then lives for 10 or 20 more years, when he or she eventually dies, the children or other beneficiaries will get a ‘step-up’ in basis on only HALF of the couple’s assets – the half that was in the “B” trust will get no step up. Since it is often more likely that the family home will be sold by the children (or other recipients) after BOTH spouses have died – and also that the children will not have lived in the home for a sufficient time to be able to exclude gain using the ‘primary residence’ exclusion – this could result in a large capital gains tax bill for the children, when the home is sold after both parents have died.

Bottom line: in many cases, the sole reason for using an “A/B” trust plan, back in the 1990s and early 2000s, was to avoid estate taxes at the second spouse’s death. Now, due to changes in the tax laws and increases in the exemption amount, the “A/B” split is often not needed to avoid estate taxes, and it can actually cause a substantial increase in income taxes for the beneficiaries after the second spouse’s death. (It can also create unnecessary administrative complexity for the surviving spouse; however, an A/B Plan can nevertheless be warranted if the estate is fairly large, and/or for certain non-tax reasons.) So if you have an old trust plan (whether a single, joint trust, or two separate, individual trusts), you should have it reviewed TODAY to see if a change could save your beneficiaries a LOT of money!

* If the survivor is a U.S. citizen; different rules apply to non-citizen spouses.

A Trap for the Unwary

A tax trap, that is. If you (1) are married, (2) have a small or moderate-sized estate (under $10 million), and (3) created a trust-based estate plan at any time in the past several decades, chances are that plan could end up costing your children or other beneficiaries a LOT in unnecessary taxes after you die.  Now, this probably does not apply to you if you live in one of a handful of states that imposes a state estate tax with a low exemption amount (CT, DC, ME, MD, MA, MN, NJ, NY, OR, RI, and TN all have exemption amounts for 2013 that are $2 million or less), in which case your planning has probably been designed to minimize those taxes, as well as the Federal estate taxes, and that may save you more in the long run.  But if you live in one of the many states that has no state estate tax (a list of states with an estate tax can be found here), or has an exemption greater than the value of your estate, keep reading to find out why your plan may be in need of a critical update.

Five Things to Consider Now

The end of the year approaches, and pretty soon we’ll all be busy with entertaining, shopping, and other holiday pursuits. So now’s the time to think about things that you might want to set in motion to provide a little fiscal relief for the rest of 2012 and 2013.

1. Look at your income for 2012. Is this a slow year? If so, think about things that you might have been putting off or avoiding because of their negative tax consequences. If your income is low this year, or you have a lot of deductions, maybe now is the time to take the tax hit from converting some IRA funds to Roth-IRA status, or withdrawing them entirely (if  you would be needing those funds in the near future anyway). If your income is looking low for 2012, consider shifting some deductions into 2013, by putting off expenditures until after the first of the year. Conversely, if it’s looking high for the year, think about additional deductions you might be able to squeeze into 2012, by purchasing items or pre-paying for rent or services in November or December.

2. Consider using the huge estate and gift unified tax exemption that is going to expire at the end of this year. If your estate is over $5 million, or likely to be that large when you die, then now is the time to shift some of those funds out of your estate to your children or other beneficiaries. You don’t have to give them a big check – you can place the funds into irrevocable trusts, that will protect the assets and allow them to be prudently managed, with not only their current value but all future appreciation out of your estate permanently.

3. Update your estate plan, if it hasn’t been done lately. With the extreme uncertainty over what the estate and gift tax laws will look like for 2013, you want to be sure that your planning is flexible enough to adapt to changing laws and rules, and still provide the best results for you and your family.

4. Plan to have a ‘heart-to-heart’ with your family. Why not take time over the holidays, when everyone is together and in a relaxed frame of mind, to discuss your estate planning with family members? It can be a difficult subject to broach, but a pleasant family gathering can be the perfect time to spend a little time explaining to your children the steps you’ve taken to ensure that things go smoothly if something should happen to you. Everyone’s catching up, so make sure they’re caught up on this aspect of your life too. (One way to bring up the subject is to tell your adult children that you’ve made plans for them, and ask if they’ve done the same for their families. Children can use this approach with their parents as well.)

5. Read up on the new 3.8% ‘surtax’ on certain kinds of investment income, and determine the effect it will have on your overall tax bill. Consider whether shifting some of your assets to a different investment vehicle, or converting some assets to a Roth IRA, might eliminate or reduce the ‘bite’ of that extra tax. Here’s one article that provides some ideas, to get you started.

Zombie Tax – Update

Good news on the “Zombie Tax” front. This summer, the Legislature passed a new law changing the Hawaii death tax laws. Honestly, I haven’t read the law in its entirety (watch this space for a more in-depth update), but basically it changed the amount that can be passed free of Hawaii state estate tax from a fixed, $3.5 million, to a figure that tracks the Federal exemption (which is now $5.12 million, set to return to $1 million on January 1, 2013). So while the Zombie Tax is still (un)dead, at least it is a little easier to figure out, and plan for – you will either have a taxable estate (under both Federal and State law) or you won’t.

Unless you are in a civil union, of course – in which case you can’t claim the unlimited Federal marital deduction, but can claim an unlimited marital deduction for the purpose of calculating the Hawaii estate tax. Hopefully they’ll fix that soon, too – I heard that DOMA was just declared unconstitutional by the Second Circuit, looks like it’s headed to SCOTUS.

The Best of Both Worlds

When setting up a trust-based estate plan, married couples* in Hawaii have always had to decide what to do about their real property that was held in the special tenancy known as “Tenancy by the Entirety,” or “T-by-E” for short. That was because T-by-E property enjoys special protections, including protection from either spouse’s individual creditors. So if a couple owns property in this manner, and just one of them gets sued or incurs a debt, the creditor cannot place a lien on the T-by-E property, or force it to be sold to pay the debt. There are other special properties of T-by-E ownership as well, and together these properties generally make T-by-E the preferred form of property ownership for most married (or civil union) couples. In fact, in Hawaii, ALL kinds of property – even personal property – can be held as a Tenancy by the Entirety.

But in order to put such property into a trust, and gain all of the benefits that trust planning provides (avoidance of probate, privacy, planning to use both spouse’s tax exemptions fully, providing a smooth transition in the event of death or incapacity), the owners had to give up the benefits conferred by the “T-by-E” tenancy. So couples owning T-by-E property have always had to choose between keeping their property in T-by-E (and risking a probate if they should die at the same time, or if the survivor should die before transferring the property into his or her trust, or creating a ‘Transfer on Death Deed’), and putting it into their trust(s) and losing the special benefits of T-by-E ownership.

But now they no longer have to make such a choice. And if you are in this situation, and previously set up a trust but elected not to put your home or other T-by-E property into your trust (or separate trusts), it’s time to reconsider that choice.

Why the change? Because this summer, our State Legislature passed a new law, which allows T-by-E property to be placed into the owners’ joint revocable trust (or, if they have separate trusts, 50% into each spouse’s or parther’s trust), and KEEP all of the protections afforded by the T-by-E form of ownership. To get the benefit of this new law, certain formalities must be complied with. If you put your property into a trust before July 2012, then you will have to transfer it BACK to your names as a “Tenancy by the Entirety,” and then put it back into the trust, to regain the protections of T-by-E. (But that’s not difficult; both deeds can  be prepared at the same time.) It may be necessary to change the name of your trust, and there is certain language that must be included in the deed in order for the new law to apply.

So, if you have a trust, or have been thinking about getting one, and also own real property here in Hawaii (or in one of the other states that recognizes the T-by-E form of ownership), it is definitely worth looking into this new law that allows you to now have “the best of both worlds.”

*This article also applies to civil union partners (who enjoy all of the legal rights of married couples in Hawaii), and those in “reciprocal beneficiary” relationships.

The Zombie Tax

Years ago, Hawaii had an estate tax, but it was a “pickup” tax – the amount of the tax was offset by an equal credit against Federal tax, so it was not “felt” by the heirs as a separate tax. Then, the credit was eliminated, and the tax went with it.  But in 2010, it rose from the dead, like a zombie, and while it’s not hungry for brains, it IS hungry for a nice, juicy piece of the estate you were hoping to leave to your kids and other beneficiaries.  Here are a few tidbits about this ‘zombie tax’:

– The tax ‘kicks in’ when your total estate (which includes all of the property and assets you leave behind, including your retirement accounts and often the full proceeds of life insurance payable on your death) is valued at $3.5 million or more.

– Although Hawaii has no gift tax, due to a quirk in the way the law is written, your heirs may still end up paying Hawaii estate tax on your lifetime gifts, after you die. So you may have to include those gifts when determining whether the tax will apply to your estate.

– The Federal estate tax now has an exemption of $5 million per person (until 12/31/2012).So, you may not have an estate that is taxable by the IRS, but it may still be taxed by the state of Hawaii.

– Although (until 12/31/2012, if not extended) you may be able to use your deceased spouse’s unused FEDERAL exemption (that is, if he or she used less than the full $5 million exemption when he or she died, before you), there is no such “portability” of the Hawaii exemption. So if a couple does not plan properly, some of their total $7 million Hawaii exemption ($3.5 mil/spouse) could be wasted, and tax paid unnecessarily.

– If you (and your spouse together, if you’re married) have property worth more than $3.5 million, and you have will(s) or trust(s) that were prepared before 2010, your heirs may end up having to pay a hefty Hawaii estate tax if you don’t have your documents REVIEWED and UPDATED to plan for this ‘zombie’ tax.

– Properly drafted documents can help you to avoid any tax (even the zombie tax) when the first spouse dies, and to use both exemptions fully, to avoid paying any unnecessary tax.

– There are ways to avoid or minimize the taxes paid (both Federal and State), even you have a very large estate.

So, if you have not had your documents reviewed by an experienced estate planner in the past two years, you should do it now – or the Zombie Tax may devour your estate!

Hawaii Asset-Protection Trusts, Rev. 2.0

Well, despite having royally screwed it up the first time, it seems the state legislature has finally put together asset-protection trust legislation for Hawaii that is not altogether horrible. Although not quite in the league of Nevada, Alaska or South Dakota, Hawaii’s new domestic asset protection trust will no doubt be appealing to many who would like to have some home-grown protection for their local real property, and perhaps for other assets as well.

The new, improved “Permitted Transfers in Trust Act,” effective July 1, 2011, provides a welcome alternative for Hawaii residents, and non-resident owners of Hawaii real property, who are looking to shelter some of their assets from future creditors. Unlike the prior version of the law (which had much in common with many “1.0” versions of software, i.e., lots of bugs), the new law allows real estate to be put into a Hawaii asset-protection trust; eliminates the requirement that the trust property comprise no more than 25% of the settlor’s net worth; and – most significantly – repeals the 1% tax imposed on transfers into these trusts, which had rendered the prior law “dead on arrival”.

The new law allows the creation of an irrevocable trust, the corpus of which will, after two years, be protected from all new claims against the settlor except for  specified exceptions: alimony or child support; property division on divorce, IF the transfer into trust was made during the marriage or in some cases, within 30 days prior to it; personal injury or property damage claims arising from acts that occurred before the transfer into trust; debts secured (expressly or impliedly, not exactly sure how that will be interpreted) by trust property; and tax liabilities.

The settlor may retain significant powers and rights, including the power to veto distributions, to serve as investment advisor, to replace a trustee or advisor, a testamentary limited power of appointment, the right to all income (or to a unitrust amount not to exceed 5% annually), and the right to distributions in the discretion of the trustee, without losing the desired creditor protection.

Even if creditor protection is not required or desired, a trust that conforms to the statute may be of perpetual duration – thus, obtaining all of the benefits of a trust structure for multiple generations (i.e., a dynasty trust).  Specific allowance is made for the necessary provisions of a QPRT or GRAT, so that those types of trusts can also take advantage of the benefits conferred by the new statute. And, property held by a married couple as ‘tenants by the entirety’ will not lose the benefits of that tenancy when it is put into one of these trusts.

If you are concerned about the vulnerability of your property – including what we all hold so dear, that “little piece of Hawaii” that is our home or our living, in the form of business or rental property – to potential, future claims of creditors, OR if you would like to create a permanent legacy for your family in the form of a dynasty trust, that can carry the benefits of your hard work or good fortune through many generations, you might want to consider setting up a Hawaii asset-protection trust.   It is never too soon to get that two-year ‘statute of limitations’ running!

Is the IRS your favorite charity?

(… or, How to save some of those pesky taxes on IRA conversions, while also benefiting the charities of your choice.)

If you converted some or all of your IRA accounts to Roth IRAs in 2010, or plan to do so this year or in the future, you will be looking at a hefty add-on to your income tax bill in the near future. If you converted in 2010, and accepted the default of deferring the income recognition to 2011 and 2012, you may not have been thinking about those checks you will have to write to the IRS in 2012 and 2013.  But alas, time marches ceaselessly forward, and you’ll soon be feeling that deferred pain.

So, what if I told you that instead of paying all that cash over to the IRS, you could donate a chunk of it to your favorite charity instead?  That you could send it to the Red Cross to help with the Japan relief efforts, to the SPCA to save little puppies and kittens, to an organization that fights cancer, AIDS, or another nasty disease? Now maybe with our deficit being what it is, you might feel OK about sending your check to the IRS. But if you’d rather support your church, school or another tax-exempt charity over the next several years, while getting a hefty income tax deduction now to offset that pesky Roth income, read on.