QTIP Trusts and California’s Total Return Trust
A qualified terminable interest property trust (QTIP) is often included as a subtrust for a married couple. When combined with bypass subtrust that captures the amount of the first deceased spouse’s lifetime exemption, the QTIP allows the assets be used for the income benefit of the surviving spouse while preserving the principal for the remainder beneficiaries, usually the couple’s children.
For example, John and Mary have two children named Bob and Joe. When John passes away, their estate is worth $5 million. The current lifetime exemption for estate taxes is $3 million, so the first $3 million is placed by their joint trust into a bypass trust, with the other $2 million placed in the QTIP trust. The bypass trust pays out income to Mary and the principal can also be used for limited purposes such as maintenance and health. The QTIP trust terms require the income to be distributed to the spouse and the principal left for the children in order to qualify for the marital exemption from estate taxes.
But here’s the problem: does the trustee manage the assets in the QTIP trust for income or growth in principal? The trustee is required by law to treat all beneficiaries equally, and so cannot favor one or the other with the investment decisions. But the original intent may have been to prioritize income over growth to provide for the surviving spouse. Prudent investing guidelines require diversification, also creating conflict for the trustee. California resolved this problem in 2005 with the creation of a trust called a ‘total return trust’.
In this special type of trust, the current beneficiary (Mary, the surviving spouse in our example) receives a specific percentage of the trust’s total assets every year. The amount must be from 3% to 5% of the total assets to qualify, and can include distribution of principal assets.
Now Bob and Joe (the children) are happy - the assets can be invested to maximize total return. And Mary the surviving spouse is happy, as the trust’s assets grow her distributions increase because they are tied to a percentage of the total value. And the trustee is no longer caught in the middle.
Common Types of Trusts
Trusts fall into two categories; revocable and irrevocable. Revocable trusts are often called living trusts, and they can be canceled or revoked at any time. Irrevocable trusts are permanent, once created and funded they cannot be canceled or modified.
Revocable Living Trusts
These common trusts are normally used to avoid probate. The grantor, trustee and beneficiary (the person giving the assets to the trust and the person controlling those assets once they are in the name of the trust, and the person getting the benefits of those assets) can be the same person. Revocable living trusts retain the estate tax exemption on assets owned individually, so there is little downside to forming this type of trust. Assets must be retitled (your home, car, etc) into the name of the trust in order for this strategy to work, and this retitling often falls short, especially as time passes. These trusts also usually contain a ‘pour over’ provision or are accompanied by a pour over will so that assets not retitled can still pass into the trust at the time of the trustee’s death, but this often triggers probate anyway. If you or a loved one has a revocable living trust it should be reviewed routinely by an estate attorney to keep it up to date.
Irrevocable Trusts
These trusts are permanent - they cannot be changed or canceled. And one person cannot be grantor, trustee and beneficiary.
Irrevocable Income Only Trusts
These trusts transfer assets away from the grantor while preserving the proceeds. This is sometimes helpful for shielding assets for Medicare eligibility rules, protection from creditors, or providing an income stream for disabled dependents. Once placed in the trust assets are no longer available to the grantor, only the income generated remains accessible. At the death of the grantor the assets are inherited by the grantor’s beneficiaries.
Irrevocable Life Insurance Trusts
This trust holds a life insurance policy for the grantor. The payout of the insurance goes to the trust, not the estate and so is not subject to estate tax. This type of trust is also used to replace the value of assets given to charity or used in an Income Only Trust. Because it’s irrevocable you cannot change the beneficiaries of the life insurance once the trust is set up. Another challenge with this type of trust is that the premiums are often considered a taxable gift to the trust. Transferring an existing policy into the trust has a similar problem of tax, based on the cash value of the policy at time of transfer, and if the grantor dies within 3 years the trust is not eligible to receive the payout, it is considered paid to the estate. Some people get around these gift tax problems with a Crummey Trust, named after the Crummey family who successfully defended a provision against gift taxes. The IRS considers gifts to a trust as taxable, because it holds that the beneficiaries (usually the children of the grantor) do not have a present interest in the gift. The Crummey provision allows the children to withdraw the gift anytime within thirty days of the gift. After thirty days, the trust holds the gift and can use it to pay premiums, schedule payouts over time, or whatever. This provision means that gifts to the trust are subject to the gift tax exclusion, currently $12,000 per year.
Irrevocable Generation Skipping Trusts
This trust holds the assets after the grantor dies, and the immediate beneficiaries receive only the income from the assets. After the immediate beneficiaries die the assets are inherited from the trust by their children, the original grantor’s grandchildren. This arrangement allows the assets to grow for a generation without the impact of estate taxes.
Trustees
The irrevocable trusts generally require a third party trustee to manage the assets of the trust. This is a service offered by banks and financial institutions that varies in cost. For example, a life insurance trust requires no decisions and so typically has lower trustee fees associated.
These are just some of the many trust types out there, all designed to help you protect your assets from taxation and waste. Seek the help of a specialist attorney when arranging trusts: good advice can often save a fortune, whereas bad advice can lose one.
Estate Planning for the Chronically Ill
A recent Wall Street Journal article (4/5/2009) cited some prudent extra steps and some good ideas for individuals with chronic illness when they prepare their estates. Here is a quick summary:
1. Power of Attorney
This document allows others to act on your behalf - paying bills, filing taxes, etc. A ‘durable power of attorney’ can define the limits of authority, perhaps limiting the power to disallow selling assets over a certain value or changing beneficiaries. Some powers of attorney are ’springing’, meaning they do not go into effect until you are incapacitated, but the Journal makes the point that these are often not fast enough, that your designated individual may have to go to court and have you declared disabled before they could act on your behalf. They credit attorney Martin M. Shenkman of Paramus N.J. with the idea of two documents, one of limited power that is immediate and durable, and one with more sweeping power that is ’springing’ to handle your affairs should you be incapacitated for a long time.
2. Health Care Proxy
A normal power of attorney does not allow someone to make health care decisions for you. To do this, you need a health care proxy. Combined with a living will a health care proxy enables a trusted friend or family member to make sure your wishes are followed. In a chronic illness situation, knowing how your family and friends individually react to your illness can help in selecting the right person. The Journal quotes an individual who does not want feeding tubes to extend her life, and her brother disagreed with her decision, yet he still agreed to be her proxy, and to carry out her wishes. A health care proxy is legally bound to follow your instructions, so they should be complete and comprehensive. Depending on your ailment it might make sense for your physician to review the documents beforehand, for their knowledge of the progression of your ailment might point out some special considerations or perhaps pointing out that a hereditary disease might impact some of your family members. In cases where your illness could drag on it is important to name successive proxies, in case your first choice is no longer able to carry out the duties. One more great suggestion: carry a card in your wallet with information about your living will and health care proxy, and emergency contact names and numbers.
3. Trusts
A revocable living trust makes it much easier for someone else to manage your finances, and avoids many of the problems of probate. One option for chronically ill patients is a co-trustee, so that during occasional bouts of incapacitation your co-trustee can make decisions. These decisions can be limited by the trust, just as they can in a power of attorney.
Planning your health and end of life decisions in advance allows you to keep control, even if you can’t communicate. But you have to choose carefully - will the individual you name as proxy be able to withhold nutrition or hydration if that is your wish, or will their religious or ethical beliefs create a strong conflict? Some people name institutional trustees for their finances, since caring for a chronically ill family member is often a large burden, and having a professional handle the money matters takes off some of the burden. According to the Journal, this only makes sense if your estate is worth more than $500,000. Whatever your situation, make sure you consider your needs and the needs of your loved ones before making these critical choices, and spend the time to go over your plans in detail with your designated helpers.
Inheriting Debt
Can you inherit your parent’s bills when they pass away? Generally not. Careful planning can make sure you don’t fall prey to “Negative Inheritance”.
Normal secured debt (like car loans and mortgages) are backed by the asset, and by the people who signed or co-signed the loan documents. If you didn’t sign the loan documents on your parents secured debt, you don’t inherit the obligation. The creditor can repossess the assets - so after your parents pass away it pays to keep up the payments while planning your next steps.
Unsecured debt (like credit cards and medical bills) are likewise the obligations of the people who backed the debt. If your elderly parents want you to be able to use their credit cards, make sure that you are set up as an authorized signer, not as a joint account holder. By limiting your involvement you avoid inadvertently inheriting the debt.
Of course when a person passes away, their debts are paid ahead of any inheritance. So when the estate has a positive net worth the debt is inherited - by reducing the amount that is distributed to heirs. First the secured debt is paid, then unsecured debt, then what is left over (if any) is paid to heirs.
Sometimes assets are disposed of prior to death in an attempt to avoid paying off the bills. This possibility has created special powers for holders of debt - they can and do go to court to get the disposed assets back into the estate, even if they were gifted prior to death. So ‘gifting’ of cash and other assets prior to death in order to avoid paying debts doesn’t work.
Another way to accidentally trigger debt inheritance is to pay your parents bills directly from your checking account. Let’s say your elderly parent needs help in paying for rent, medicine, or medical services. If you want to help, give money to your parent and make sure the bills are paid from their account. Otherwise the creditor can make the case that you assumed responsibility for the debt, and collect from you after your parent has passed away.
Aging baby boomers are facing another challenge - expensive end of life care for their parents. Although the majority of boomers are happy to help their parents, the result is sometimes a serious financial burden. Paying for long term nursing care, moving in with parents, or quitting a job to care for them wreaks havoc with your own financial health. This negative impact can be avoided by talking through the possibilities with your parents and obtaining long term care insurance in advance of need. Avoiding this all too common form of negative inheritance should be a key part of any solid financial plan.
Irrevocable Life Insurance Trusts - 5 Reasons
First - what is an Irrevocable Life Insurance Trust (ILIT)? This special type of trust is set up to keep life insurance proceeds out of the estate. But there are other benefits; a recent article on JD Supra by the attorney John C. Martin covered ILITs (Irrevocable Life Insurance Trusts) and described key benefits. Here are some excerpts:
First Reason: No Loss of Control over Income-Producing Assets
First, an ILIT is an attractive alternative to other estate planning strategies that involve transferring substantial amounts of assets out of one’s estate. Grantor Retained Annuity Trusts (GRATs), Charitable Lead Trusts (CLTs), and other trust arrangements may involve the transfer of valuable income producing or business assets that most if not all would be hesitant to transfer out of their control (not to mention that the ILIT usually costs less). Yet, transferring a life insurance policy comes more easily: While premiums must be paid, the proceeds are only payable to beneficiaries upon death. Thus, there is not a great fear that transferring the policy would deprive the owner of its benefit.
Keep in mind that this benefit is psychological. The person setting up the trust is paying premiums, so there is a cash flow impact. And if your circumstance doesn’t have a high cost associated with other trust options surrounding ‘loss of control’ this benefit may not make sense.
Second Reason: Liquidity Creation
Second, and most importantly, an ILIT that is structured properly provides liquidity. In an estate laden with illiquid real estate assets, an ILIT can be essential in order to pay a large estate tax bill without selling off assets. Consider the example of Robert and Sally Colmery. Over their lifetimes, Robert and Sally accumulated a small real estate empire throughout California, including a Palo Alto home ($3,000,000), a vacation home in Tahoe ($1,000,000) and three rentals in San Mateo (together worth $2,500,000). Robert’s liquid assets were mostly spent by the end of his life, amounting to $150,000. At the end of his and Sally’s life, $3,150,000 of the estate will be subject to the federal estate tax at a rate of 45%, and Robert’s and Sally’s children, Peter and Ruth, will not have sufficient cash to cover the bill unless they sell off some of the properties.
Now let’s assume that Robert establishes a qualifying ILIT with a second-to-die insurance policy naming his children, Peter and Ruth, as remainder beneficiaries, and pays the premiums by using his $13,000 annual gift tax exclusion. Robert structures the payment of premiums with the help of an attorney so that they do not trigger any gift tax by using something called a “Crummy” power. At the time of the second spouse’s death, the proceeds of the life insurance policy will pass estate tax-free. As a result, Peter and Ruth are not forced to sell off the real estate when they inherit.
“Crummy” refers to a clause embedded in the irrevocable trust, which uses the gift tax annual exclusion to keep the proceeds of the trust from being taxed. Crummy provisions are complicated and should be set up by a skilled attorney
Third Reason: Leveraging the Generation-Skipping Transfer Tax Exemption
Third, an ILIT can be used to leverage the insured’s GSTT exemption. Whenever we would like to give to our grandchildren or to individuals removed by 2 or more generations, the IRS imposes a second layer of tax called the GST tax. However, a $1 million exemption exists to which transfers to a trust can be allocated at the time of such transfer. If the amounts transferred to a trust appreciate, the ratio of assets exempt from GSTT to non-exempt assets will remain constant. As a result, if the entire transfer to the ILIT is allocated to the GSTT exemption (an inclusion ratio of zero), all GST tax can be eliminated at the final distribution, even if the trust enjoys considerable income over the years.
remember Robert in the example above? Here he sets up a ILIT that benefits not only his children Peter and Ruth, but also their descendants.
For instance, let’s say that Robert sets up a generation-skipping ILIT. The ILIT directs the proceeds from the life insurance to be invested in securities. All net income is payable to Peter and Ruth over their lifetime, with a remainder interest to Peter and Ruth’s children. Normally, Peter and Ruth’s children would be liable for GST tax at the maximum applicable federal rate when they take. However, if the ILIT is set up so that the inclusion ratio of assets subject to GSTT is zero, Peter and Ruth’s grandchildren will pay no GST tax. If ILIT assets grow at a modest rate, the grandchildren would take potentially significant amounts without incurring any additional GST or estate tax liability.
Fourth Reason: Protecting Beneficiaries from Creditors
Fourth, Robert can also protect his children and grandchildren from future creditors by including a spendthrift provision in the trust document and granting discretion to the trustee in giving distributions to the beneficiaries. If the ILIT is set up with investments or cash that Robert doesn’t need to access, the amounts can be shielded from Peter’s and Ruth’s creditors.
Many advisors caution you to think carefully when putting restrictions on trust proceeds. Benefit number 4 and 5 are both founded on these restrictions, and apply to more trust types than just ILITs. See my post Inheritance with Strings Attached.
Fifth Reason: Encouraging Responsibility
Fifth, while the ILIT is non-amendable, it can be structured so that beneficiaries are incentivized to engage in positive behavior. The trustee may be given directions to not make distributions until the beneficiaries reach a certain age, or unless they have demonstrated positive behavior. For instance, they can be directed to withhold funds that would pay for a drug addiction, gambling, or otherwise. The trustee can be directed to pay for the education, business planning, or other positive expenditures that the beneficiaries may require.
Practicing attorney John C. Martin’s article first appeared on the JDSupra website dated April 20, 2009
One more holiday chore
Yes, there is a lot to do in December. Don’t leave gifting to the last minute - get it done now to insure your gift happens in this calendar year.
If you are gifting cash, remember the $12,000 exclusion limit. You can gift more than $12,000 but must fill out a gift tax form on your taxes. Gifts in excess of $12,000 this year can be tax free as part of the $1 million dollar lifetime exclusion, but you still have to file the gift on your return. Next year (2009) the gift exclusion rises to $13,000.
If you are gifting stock to take advantage of the depressed valuations, take action earlier rather than later. Brokers are very busy at the end of the year, and this year is no exception. Gifting stock is not simple and straightforward and requires assistance - so be mindful of possible delays and get your gifts in now. If your gift is not completed by December 31st it won’t count in 2008, so get ahead of any problems and take action early this month.
Immediately After Death - What to do
This post is written for the person on the hot seat - present and responsible for the actions required in the hours and days after a loved one passes away.
If the death occurred in a hospital or hospice, the staff will be very helpful. They will pronounce the patient dead, and will allow you space and time to experience initial grief. If the death occurred at home, call the treating physician who will come and pronounce death and help you through the next steps. Of course if there is any doubt that the patient might still be alive call an ambulance first. If the death was unexpected, call the police who will send an office and a local coroner or medical examiner. But don’t call the police if the death was expected, they will need to respond with an investigation if you call them to report the death.
As soon as you can, you should call family members. Don’t worry about waking them, if you don’t call they’ll feel left out. The process of making the calls is in itself therapeutic - saying the words out loud confirms the death in your mind and is an important step in the grieving process. They may want to help make calls, and you should let them. Distant relatives and friends would welcome a call from the deceased’s family, and everyone benefits from the process.
The funeral home or cremation service will come and remove the body - hospital or hospice workers will need the name and number of the company you have selected. If the death occurred at home, you will need to call the company yourself after the patient has been pronounced dead. If there is a coroner or medical examiner involved they will usually remove the body for a possible autopsy (usually at no cost to you) and you should instruct them which funeral home or cremation service will collect the body after their examination.
Families often come together immediately after the death of a loved one. Preparing the home for visitors is a good idea - basic food and beverages can be made ready, even though many people will bring food it’s best not to rely on this. When everyone is together you will naturally share memories, but also take a few minutes for planning the memorial service - immediate or delayed, where it will be held, etc.
This is also a good time to write the obituary notice. Most newspapers have online obituary submissions and publication these days, so you can read a few to get an idea of the range of styles. Write a rough draft and share it with family, they will have comments and suggestions that will not only improve the final obit, but also help the healing process and bring the family together. When it is ready to post, remember to post it in the local paper and any home town paper where distant friends will be able to read it. There is a fee for posting, and this is one of the first expenses for the estate - start keeping good records right away.
Someone needs to be responsible for the funeral home or cremation service - this is a good task to delegate. This person should contact the company, make sure the body is being prepared, get copies of the necessary forms and fill them out for the signature of the executor. This is the time to order death certificates, and you should order at least 10 right away as part of the funeral/cremation process. If you already have a list of assets of the estate, you should order about 10 death certificates for general use, plus one for every investment held by the estate. Having someone else handle the forms and speaking with the company allows you to spend more time with family during this critical time.
All through this difficult process remember to sleep, take care of your needs, and experience the loss. Human life is amazing, and during this moment of loss the magnitude of life seems larger and more poignant. The loss of a loved one is a strong human experience that most of us share, and the more loved a person is, the more intense the loss when they pass.
Your parent is dying, you are the executor - now what?
This is a difficult time. On top of the emotions you have responsibilities and decisions to make. This post hopes to outline some priorities and helps you create a to do list.
With your parent
If you haven’t already, now is the time to discover your parent’s wishes regarding end of life medical care. Also confirm their preferences for burial/cremation and memorial services. And stay present - spending time together in their final days should be priority number one. If they are in a hospital or hospice, you should think of yourself as an extension of the facility’s staff. You know when your parent is uncomfortable - what they need, and it’s your job to keep the staff informed.
With your family and friends
Communicate with your family: siblings, spouses, children. Let them know what’s happening, and what to expect in the days ahead. Making decisions as a group and in the open is an excellent way to avoid problems later.
Spouses and family friends often want to help, and you should let them. Someone needs to manage or create a call list, keep everyone up to speed with developments, communicate last wishes with the hospital or hospice staff - and if these tasks can be handed off to trusted people one step removed that can allow you to spend more time with your parent.
Memorial service planning
Sometimes there are very specific instructions from your dying parent, sometimes not. If your parent is religious someone should be making plans with the church (another great spouse or friend task). If a funeral home was selected by your parent, keep in touch with them. If the parent leaves it up to the survivors, consider all your options. Services can be held in a funeral home, in a church’s community center, in a restaurant’s back room, a rented hall, or even outdoors in a park or natural setting. The memorial service can be immediate or anytime within the next few months. Consider travel plans for those who will want to attend when deciding on a date for the services. You will need to reach a consensus decision on the date and location rather quickly, since the memorial information is normally including with death notification phone calls, and in the obituaries. Once the general timeline is known the chore of calling the prospective venues for availability and pricing is another great task to delegate.
Cremation
If your parent has elected cremation, you should know there is a wide variance in price from one funeral home to the next, with little difference in service. In a recent death I had the unfortunate task delegated to me to make the calls to vendors for cremation. I found prices ranged from $500 to $2500 for exactly the same service - so it pays to have someone shop around.
Your parent’s home
Two pieces of advice for immediate action in their home as they pass away: 1. don’t let anyone take anything or claim anything no matter how trivial it seems until the entire family has had a chance to grieve and get back together to discuss the process of splitting up personal possessions. I am amazed that this advice is needed, but there is always someone around looking to get something. 2. someone trusted should visit their home to make it ready for family and friends to congregate after they pass (put valuables and breakables away, clean up any lived-in messiness) and to do a quick sort at their desk looking for a personal phone/address book for notifications and to collect paperwork on assets.
Gifting and the IRS - Misconceptions
After years of incorrect understanding of gift taxes, today I did some research online and found a few interesting misconceptions and their correction. The definitive source online is the IRS site, with the relevant page located at:
IRS Gift and Estate Tax Overview
Misconception #1: The recipient of gifts over the exclusion limit ($12,000 per person in 2008) is taxed. This is not true, the only possible tax on gifts is born by the person giving the gift.
Misconception #2: All gifts are subject to the exclusion and possible taxes. Not true - gifts of tuition or medical expenses are excluded regardless of the dollar amount. Gifts to your spouse are also excluded.
Misconception #3: All gifts over the exclusion limit are taxed. This is not technically true, because of the Unified Credit in the tax code. This provision allows you to use some of the inheritance exemption while you are alive to avoid paying taxes on gifts that exceed the exclusion limit. You still have to fill out the gift tax form in your tax return, but you can use some of the Unified Credit to avoid paying taxes.
The Unified Credit is interesting. This allows you to time your inheritance to minimize the value of assets when transferred. Non-cash assets can be transferred anytime prior to death and still be part of the estate tax inclusion. Stocks, real estate, and other non-cash assets can be gifted when the market is down, reducing the overall size of the estate. By exceeding the $12,000 limit ($24,000 for married couples) you may have to fill out an extra form, but you do not necessarily trigger taxes. Instead, you might just lower the overall tax bill for your heirs.
Assets Values Depressed? Good News for Gifting.
Right now a lot of us are depressed, or at least our portfolios are. That’s not all bad news. Because some of our assets are reduced in value, we can gift more to our heirs this year without penalty. This is a great time to gift stocks to your heirs, removing them from your estate and possibly eliminating a considerable tax burden.
The maximum gift allowed by the IRS without filing requirements and possible taxes is $12,000 per year per person. If you are married, you and your spouse can combine your gift exclusion and give up to $24,000 to any individual.
With today’s stock prices, consider gifting stock now. You can transfer more shares at today’s low prices than you could a year ago. And if the stock market values return (hope and pray) then the value received by your heirs will be worth more than the exclusion.