Thursday, September 6, 2012

The Door Is Closing - Unique Gift and Estate Planning Opportunities in 2012

2012 is truly an exceptional year to do estate planning. The estate, gift, income and generation skipping transfer (GST) tax laws are the most favorable to taxpayers since the 1940s, or possibly ever, and are scheduled to become far less favorable in 2013. That gives taxpayers like you just five more months to complete making gifts to save tremendous amounts in taxes.
Unless tax law changes are enacted (which requires the agreement of the House of Representatives, the Senate and the President), at the end of 2012, the uniquely favorable tax laws we have now will be replaced with tax laws that are drastically less favorable for taxpayers. And, if new tax laws are enacted, we may still lose much of what we have for the next five months as lawmakers search for ways to generate more revenue and lower deficits. Even some planning options that professionals have come to rely upon as “standards” may soon be history. It really is a “use it or lose it” time in estate planning.

In this issue of The Wealth Advisor, we will explain some of the wonderful gifting opportunities that are available only for the rest of 2012 and how using these opportunities can help you transfer huge amounts of your wealth tax free to your children and other beneficiaries.

Understanding Estate, Gift and GST Taxes
For you to fully appreciate these opportunities, a brief review of the federal estate, gift, and GST taxes may be helpful.

Estate, gift and GST taxes are excise taxes imposed by the federal government on the value of assets transferred by gift or at death. They are different from and in addition to probate expenses and income taxes. Some states also have estate taxes. They are beyond the scope of this newsletter, which covers only federal taxes.

Gift taxes apply to transfers made by gift. Estate taxes apply to transfers made when someone dies. GST taxes apply to transfers made both by gift and on death to someone who is treated by the law as being more than one generation younger than the transferor.

Estate, gift and GST tax rates historically have been 35-60% of the value of the assets transferred and they must be paid in cash, usually within a short time after the transfer event (9 months for death and up to 15 1/2 months for gifts).

Whether a tax will be due depends on whether an exclusion can be applied to the transfer. For example, transfers to charities are excluded from these taxes. So are payments made to an educational or health care provided for education or health care expenses of another. Transfers between U.S. citizen spouses may also be 100% excluded.

There are also both annual and lifetime exclusions from these taxes that a taxpayer gets.

On an annual basis, each taxpayer can transfer outright by gift up to $13,000 per recipient to as many people as he or she chooses, and all of the transfers will be excluded from the gift and GST tax. Gifts made in trust may also be excluded, but there are rules to which careful adherence is required and the gift and GST tax rules are different.

Each taxpayer also gets a lifetime exclusion from gift, estate and GST taxes.

If a transfer is not covered by a tax exclusion, the tax is due. Even worse, some transfers can be subject both to the gift or estate tax AND the GST tax!

The starting point to determine if your estate will have to pay estate taxes when you die is its net value at that time. To determine the current net value of your estate, add up all of your assets and subtract all of your debts. Include your home, business interests, bank accounts, investments, personal property, IRAs, retirement plans and death benefits from your life insurance policies. Keep in mind that estate taxes are based on the values when you die, and your assets may appreciate between now and then. Then subtract from the net value of your estate your unused lifetime gift tax exemption. If you are planning to die in 2012, that is $5,120,000 minus the sum of gifts you have made during your lifetime that were not subject to a total or annual exclusion. If you are not planning to die in 2012, the safest number to use is what the current law provides: $1,000,000 minus the sum of gifts you have made during your lifetime that were not subject to a total or annual exclusion. The result in both cases is the amount that would be subject to the estate tax.

In 2012, the tax rate is 35%. This means that every dollar that is taxable will be taxed at 35%. Unless the law is changed, starting January 1, 2013, the estate tax rate will begin at more than 40% and the top estate tax rate will be 55%.

Will the estate, gift, and GST laws be changed? Probably. They have been changed many times before and will likely be changed many times in the future. Today’s laws, however, are the most favorable they have been in decades. Also, a deadlock between the President and at least one of the houses of the Congress is a distinct possibility. If that happens, starting on January 1, many more estates of decedents will be subject to estate taxes and those families who failed to plan in 2012 and lose a loved one after December 31, 2012, may also lose huge amounts of their inheritances to taxes.

How to Use Your $5.12 Million Exclusion Without Dying in 2012
There are lots of people who have been lulled into inaction. They may think that because their net estate is below $5.12 million, there is no reason to do any estate planning this year. Or they may think that they can delay the cost and bother of planning because they are very unlikely to die in 2012.

If they have an estate that would be taxed under current law on a 2013 death, they really need to do planning now, while there is still time, because the $5.12 million gift tax exclusion is very likely not to be available after this year. As the saying goes, “use it or lose it.” Then, when the estate tax calculation is made on a death, if the estate tax exclusion is then lower, excluded gifts in excess of that estate tax exclusion will not be considered.

There is also a benefit to being married here. Married taxpayers can elect to have all their gifts split, so one half is counted against each spouse’s exclusions. In other words, if you are married, through the end of December the amount that you and your spouse can give away together during life without paying gift tax is $10.24 million!

To use all or some of that lifetime gift and GST tax exclusion this year, start giving some assets to the people who will eventually inherit from you. With such large gifts, careful planning is necessary. The rest of this newsletter will focus on some ways to do that gifting that will take full advantage of the exceptional exclusions we currently have.

Planning Tip: Never give away more than you can afford to be without. Also, any kind of substantial giving program must be done under careful professional guidance and supervision to be sure everything is done correctly and really will be excluded from taxation.

Use Annual Exclusion Gifts in a Lifetime Giving Program and Avoid the Gift Tax
Only gifts in excess of the annual gift and GST tax exclusions deplete the lifetime GST, gift and estate tax exclusion. Federal law currently lets you give up to $13,000 per year to as many people as you wish without incurring a gift or GST tax. A married couple can give twice this amount, or $26,000 per year per person. (This amount is currently tied to inflation and may increase to $14,000 next year.) Gifts made in trust have special rules that must be carefully followed to be eligible for the annual gift and GST tax exclusions.

With a lifetime giving program, you can transfer $13,000 annually to the individuals of your choice, typically children, grandchildren and other close family members. For example, if you give $13,000 per year to two beneficiaries for five years, you will have removed nearly $150,000 from your estate for estate tax purposes (assuming these assets would have grown by 6%). After 10 years, you will have removed more than $365,000 and $1.5 million after 25 years. The amount removed from your estate is increased significantly with each additional $13,000 annual gift recipient.

Planning Tip: Gifting programs involving gifts to young people need to be carefully planned. Accumulated gifts not made in trust will have to be turned over to the young person at age 18 or 21, depending on the state of their residence. Many are the families who have suffered from the consequences of an irresponsible youth receiving a large sum of money.

Planning Tip: When you give more than the annual tax exclusion amount, the excess will reduce your remaining available lifetime gift, GST and estate tax exclusions.

Planning Tip: Prior to 2011, the lifetime gift and GST tax exclusions were never more than $1 million. For the remainder of 2012, those who have already exhausted their old $1 million gift and GST tax lifetime exclusions are not “tapped out.” During these 5 months, they have an additional $4.12 million of lifetime gift and GST tax exclusion to use. Again, married couples who plan ahead can double those amounts.

Give More Using Structured Assets
The gift, estate and GST taxes are all based on the value of the asset transferred to the recipient. Careful planning may be able to reduce the “value” of gifted assets substantially. Such reductions are popularly called “discounts.” Here’s how it works.

Put yourself in the shoes of a buyer of assets. Would you pay the same thing for, say 100 shares of IBM that you could sell tomorrow for cash that you would for the same 100 shares that someone else had all the power to decide to sell and what to do with the proceeds? Of course not! That is the heart of asset discounting. Make the shares less attractive.

The way discounting is commonly done is to contribute the assets to a family limited partnership (FLP) or family limited liability company (FLLC) that has been formed for valid non-tax reasons. Later, when interests in the FLP or FLLC are given away, the value of the interests given is often found to be significantly (like maybe 40%) less than the value of the assets inside the FLP or FLLC! Such valuation is a matter of expert professional opinion and the FLP or FLLC has to be formed and governed, so there are significant legal and other costs involved in implementing such a gifting program. However, the tax savings for a family with a taxable estate will far outweigh those costs.

Depending on your goals, the FLP or FLLC can be structured so that the recipients of the gifts have absolutely no say in how the investments are used or managed, and so that the gifted interests cannot be easily sold or transferred without your approval.

Here is an example. $216,670 worth of stock is put into an FLLC. Later, a 10% non-voting interest is given away. If the professional valuation expert determines that a 40% asset to market discount is appropriate, the amount of the gift, for gift and GST tax purposes, is $13,000 instead of $21,667. With that level of discounts, a married couple will be able to transfer approximately $43,000 per beneficiary per year, or $430,000 over ten years, excluding growth without using any of their lifetime gift and GST tax exclusions.

Planning Tip: Discounts are one of those widely used and accepted estate planning methods that may not be around much longer. The IRS has made it clear it hates them. With the Congress looking to close tax “loopholes,” we suspect that the days of using discounts are numbered.

Use Annual Exclusion Gifts to Fund an Irrevocable Life Insurance Trust (ILIT)
Life insurance can be used to provide income for a family, to provide the cash needed to pay estate taxes, and as an income tax shelter. If set up properly using an ILIT so that you do not have any incidents of ownership in the policy, the policy death benefits will not be included in your taxable estate, making them free of estate taxes.

The general concept is that the ILIT is the owner and beneficiary of an insurance policy on your life. You make gifts to the trust to cover the insurance premiums, and the trustee makes the premium payments. If you make annual gifts for this, the gifts will be shielded from the gift tax up to the annual exclusion per beneficiary but probably will not be eligible to the annual GST tax exclusion and so will use some of your lifetime GST tax exclusion. For the gifts to be qualified for the annual gift tax exclusion, the beneficiary must have the right to withdraw up to $13,000 of the transferred funds for at least a period of time. However, if that right is not exercised, the gifted funds can be used to pay life insurance premiums or for other investments.

At your death, the death benefit proceeds are paid to the trustee who can use the funds to purchase assets from your estate and provide the liquidity needed to pay estate taxes and other expenses. The trustee can even make discretionary distributions of income and principal during your lifetime to the ILIT’s beneficiaries, which can include your spouse, children and future generations. Assets that remain in the ILIT are not included in its beneficiaries’ estates (exempting them from estate taxes for generations) and are protected from your and the beneficiaries’ creditors. The trust can become a “family bank” for education, business acquisitions, home purchases and other ventures for generations to come.

Planning Tip: You can also use some or all of your $5.12 million lifetime gift and GST tax exclusions to fund an ILIT to purchase substantial amounts of life insurance for which the future required premiums will exceed the annual gift tax exclusions for gifts to the beneficiaries. That money can then be invested by the trustee and the investments liquidated as needed to pay policy premiums.

Dynasty Trusts
Generally, a dynasty trust is one that benefits multiple generations and none of the assets are included in your or your beneficiaries’ taxable estates. Getting this benefit to your grandchildren and beyond requires allocation of GST tax exclusion to the trust. Not being estate taxed at every generation allows the trust assets to grow tremendously over the years.

It used to be, because of a rule of law called “the rule against perpetuities,” that trusts could only last about 120 years. However, many states have eliminated that rule or made it apply only after hundreds of years. As a result, a dynasty trust established in the right jurisdiction can theoretically go on forever, and the trustee (usually a corporate trustee, like a bank or trust company) can make discretionary distributions for the lifetime of each beneficiary in each generation. Assets in the trust are protected against the beneficiaries’ creditors, divorces, estate taxes, and irresponsible spending.

Planning Tip: It is important to establish the trust in a state that has no income tax, good creditor protection and divorce protection, and no rule against perpetuities (or a very long allowance of years). You must allocate enough GST tax exclusion to cover the entire gift so that no distribution from the trust will ever be subject to the GST tax.

Making Gifts Beyond Your Exclusions
If you have a substantial estate and use your entire $5.12 million exclusion in 2012, it might be wise to give away more this year and pay the gift tax at the current 35% gift tax rate. Remember that the estate tax rate is scheduled to increase to a maximum of 55% on January 1, 2013. You can wait until late in 2012 to make your decision; perhaps by then we will know for sure what Congress will or will not do.

Planning Tip: If there is a gift or estate tax to pay, it will cost you less to pay the gift tax. The reason is that the gift tax is paid on the amount of the gift, and the amount an estate beneficiary gets is what is left after the estate tax is applied to the entire bequest. For example, a taxable gift of $1.00 makes you liable for a $.35 gift tax and depletes your estate by a total of $1.35. On the other hand, that same $1.35 in your estate, after being taxed at 35%, nets just $.88 to your heirs.

What to Expect in 2013
The only honest answer is that no one knows. What we do know is that the estate, gift, and GST tax exemptions are set to be reduced dramatically at midnight on December 31, 2012, and at the same instant, interest rates on those and income taxes are scheduled to increase substantially.

Will the President, the House of Representative and the Senate all agree to make the future different? Maybe. They have in the past. Exactly what they might agree to is unknown, but we know of no one who expects the estate, gift and GST tax exclusions to be higher or the rates lower than they are now. Remember, capital gain and dividend rates are also scheduled to increase on January 1, 2013. Plus, there is a new 3.8% investment tax (it is a part of the Patient Protection and Affordable Care Act recently upheld by the Supreme Court) that will go into effect on January 1. While much depends on the election in November, the current and projected future budget deficits do not bode well for deceased tax rates or increased tax exclusions.

In this newsletter we have presented only some of the unique gifting opportunities available in 2012 that we most likely will not have in 2013. There are many more, including giving through charitable and other trusts, that are also very attractive this year due to other reasons.

We can help you evaluate all the opportunities and implement those that will work best for you and your family. The time to plan is now. You and your family do not want to miss out on this historic opportunity. Don’t say you weren’t warned.


1. There are exceptional estate planning opportunities in 2012 that may not last. T F

2. The only way to use your $5.12 million federal unified gift and estate tax
exemption is to die in 2012. T F

3. Annual tax-free gifts can only be made to those in your immediate family. T F

4. A gift tax must be paid immediately on any gifts over the annual tax-free limit. T F

5. Married couples must share one gift/estate tax exemption. T F

6. Gifts for medical care and tuition expenses are unlimited but only for people
who are related to you. T F

7. Discounts can only be applied to annual tax-free gifts. T F

8. Dynasty trusts can only last for 20 years. T F

9. There is no exemption from the generation-skipping transfer tax. T F

10. If Congress does not act before the end of 2012, all of the existing tax laws
will simply remain as they are for another year. T F

Answers: Only #1 is true; the rest are false.


Estate Planning for Business Owners

“Small businesses,” that is, those that have less than 500 employees, comprise 99.9 percent of all businesses in the United States. The owners of these businesses will, someday, exit their businesses due to retirement, incapacity or death. But most are so busy working that they don’t slow down and think about business succession and estate planning issues. That is one of the primary reasons that less than one-third of family businesses survive to the second generation; 65% of those fail to survive the second generation; and 90% of family businesses fail to survive the founder’s grandchildren.

The owners of small businesses often have multiple advisors, but rarely are the advisors consulted as a team with coordinated input. The team approach, however, is what produces the best results.

In this issue of The Wealth Counselor, we will explore the role of advisors in helping business owner clients plan for what is usually their client’s largest asset, their business. This issue will also explain what business succession/exit planning entails and how this planning can be coordinated with a business owner’s personal estate planning.


Too often a business owner is so busy “working the job” that he neglects “building the business.” A business owner may occasionally wonder if he can ever retire, who could possibly take over his business, if he can get retirement income without going out of business, and what would happen to his business (and family) should he prematurely die or become incapacitated. But most do not seriously think about these things until they are ready to retire. That’s when they realize they could have achieved better results if they had only done more to build their business and prepare for its succession.

The advisory team can help the owner change his focus from how much he is making today to the future rewards he can be building for his family and his retirement.

Two Concepts to Start the Process

Quite often, the business accountant or CPA is the advisor most closely involved with the business on a regular basis and can most effectively start the business owner on the path to planning. Two tools that are often not used by business owners can be most helpful:

* The Year-End Review: This lets the business owner see how the business has performed over the last 10-11 months, review business profitability, and see the tax situation for the year. Often a lead-in to a year-end review is considering ways to reduce taxes in the coming year. It also provides an opportunity to discuss future risk mitigation.

* The Legal Audit: This is a review of all legal documents of the business, including organizational documents, employment agreements, leases, loan documents and guarantees, and buy/sell agreements. It provides another opportunity to look for tax savings and a way to identify potential gaps or liabilities.

Providing the data for these two reports and reviewing them with the advisory team will help force the owner to back up to examine business growth and profitability and talk about continuity issues.

Planning Tip: The business accountant/CPA has much to gain by introducing this planning process. Instead of just filing tax returns, the accountant here shows a real interest in helping the owner grow his business. There will also be additional work for the CPA/accountant, such as preparation of financial statements, budgets, projections and valuations, tax planning and business process and efficiency planning. If new business entities are created, additional tax returns will likely be needed, too.

How the Team Approach Can Help

No one professional has all the answers, and diverse skills and talents are necessary for the best results. The team approach also minimizes time and costs. Members of the advisory team may include the accountant/CPA, financial planner, insurance advisor(s) (property, casualty, umbrella and life), investment advisor, business attorney, estate planning attorney, valuation specialist and a business broker if an imminent sale of the business is part of the strategy.

Planning Tip: All members of the advisory team should be involved so the planning can be coordinated.

Planning Tip: Advisory team members should consider keeping their fees for the initial consultation low, or even free, as there likely will be additional paid work for them as the planning progresses.

Step One: Identify Motivation and Goals

As Dr. Laurence J. Peter, the man who established the famous “Peter Principle” said, If you don't know where you're going, you will probably end up somewhere else.” In order for the business owner client to avoid ending up “somewhere else,” he must establish goals for himself and his business.

Learning what motivates the business owner (income, wealth, identity, challenge, stimulation, satisfaction and/or pride) will help the advisory team work better with him. Also, helping the owner verbalize his goals will help him clarify priorities, avoid quick fixes, move forward by identifying a desired outcome, and focus energy on the most urgent concerns.

Typical business owner goals include the following:
* Create and preserve the value of the business
* Exchange that value for money with the least amount in taxes
* Meet personal and family needs by providing security and continuity of the business in case of the owner’s premature departure
* Leave a legacy
* Give money to charity
* Shift wealth to children
* Reward key employees
* Receive full value for the business
* Keep the business (or sell it) at his exit
* Take the business to the next level

Step Two: Value the Business

Most owners have no idea what their business is worth, but the value will be needed for a third party buyer if a sale is anticipated. In the meantime, knowing what the business is worth will help in projecting cash flow, estate and gift tax planning, knowing how much insurance to purchase for buy/sell agreements, compensation planning, knowing available collateral for financing, and retirement planning. It also allows the advisory team and the owner to monitor progress toward the owner’s stated objectives.

Step Three: Plan for Business Continuity

The business owner’s overall planning objective for what will happen when he retires, becomes incapacitated, dies or sells the business most often includes that the business will continue despite such an event. Most commonly, the business owner will want the business to survive with whoever he chooses receiving the value of his ownership interest. Likewise, if one owner “departs,” for whatever reasons, the remaining owner(s) usually will want to retain ownership and control and not to be in business with the departed owner’s creditors, surviving spouse and/or heirs.

Step Four: Plan for Personal Wealth Preservation and Succession (Estate Planning) and Asset Protection

Universal client objectives are to preserve wealth and minimize taxes using both lifetime and death planning tools. Where a family business is involved, this requires integrating lifetime succession and business objectives with the estate plan. Estate planning thus becomes part of business planning.

The advisory team should be aware that a business owner will often want to address the business planning first. (They most commonly suffer under the delusion of immortality.) Once the advisory team has assisted the owner to clarify his goals and developed a plan for his business, however, the business owner will see that his estate plan has already begun to take shape.

Considerations for the business owner’s estate plan include the growth of non-business assets; how to be “fair” to children both inside and outside of the business; minimizing and having the cash to pay estate tax; asset protection during the owner’s life and for his heirs; probate avoidance; planning for long term health care costs; and sometimes special considerations, such as a child or parent with special needs.

Step Five: Grow and Protect Business Value

From the owner’s perspective, growing the business and protecting its value will maximize the amount realized on the sale of the business, protect assets from potential business and personal creditors, create the ability to sell the business, and can motivate and keep key employees and family members in the business.

Promoting its value will include increasing cash flow; developing operating systems (so that the system, not the owner, who will eventually be gone, becomes the solution); documenting sustainability of earnings (if the owner is taking all the cash out of the business, it will be harder to sell); improving company performance as measured by industry metrics; and paying down debt.

To grow the business and protect its value, it may be necessary to restructure the organization, solidify and diversify the customer base, implement strategies to grow the company, develop and protect proprietary technology, build a solid management team, and groom a successor.

It may also be worthwhile to examine and possibly change the corporate structure (S and C corporations, LLCs and partnerships). The advisory team can help the owner consider tax pros and cons, ease of operation and asset protection features of current and potential entities.

Planning Tip: Most business owners don’t think about asset protection until a claim arises. But the best time to plan, of course, is before the protection is needed. Consider discussing asset protection for both business and personal assets early in the planning process.

Planning Tip: An umbrella policy is often overlooked by business owners and is an inexpensive start toward the need for asset protection of both business and personal assets.

Step Six: Ownership Transfer

The ability to sell and the value of the business are both affected by intrinsic factors (e.g., how the business has grown); extrinsic factors (e.g., the local and general state of the economy); and the effectiveness of the sale process.

There are only two basic types of ownership transfers - to those who are in the business and to outsiders. Each has special characteristics.

Sale to Outside Buyers (Third Parties): The benefits to the owner of a sale to an outside buyer can include cash at closing, no owner financing (which eliminates financial risk), no family succession issues and the speed with which the exit can occur. However, everything must come together just right to successfully complete the sale of a small business. Far more often than not (often as a consequence of failure to plan properly), no buyer can be found who is willing to pay the owner’s price. About 20% of businesses are offered for sale, but only one in four of those actually sells. The probability of effecting a successful sale changes with the size of the business. About a third of offered businesses with annual sales of $10 million or less sell while about half of offered businesses with annual sales over $10 million sell.

Planning Tip: It can often take seven to ten years of proactive planning to successfully prepare a business for a sale to an outside party.

Sale to Children or Key Employees
The owner’s succession objective may be selling the business to his children and/or key employees. This can motivate and help retain key employees and family involvement in the business. Money for that kind of sale usually has to come from the ongoing business, so planning is critical to help reduce risk of buyer default and to increase the amount of money received by the owner.


Depending on the health of the business and the objectives of the business owner, it can take several years of planning and action to implement a business succession plan and get the other planning in place. A forward thinking advisory team that initiates the planning process years before an anticipated succession event, monitors the progress, and helps keep the owner on track will provide a great service to the business owner, his family and his business—and a happy client will tell others.

Income Tax Issues When Planning for the Sale of a Closely Held Business

When a closely held business is a significant part of a client’s estate, as is often the case, business succession planning becomes an important part of the client’s estate planning. Estate planning issues include how to turn the business into cash for the owner’s retirement, who will take over or buy the business from the owner (family members, an outside buyer, employees, key employees, other owners), and how the sale should be structured.
During the planning process, the advisors may determine that the current type of business entity may not be the correct or most efficient one. Changing the business entity must be done carefully and with full knowledge of the tax consequences.

In this issue of The Wealth Counselor, as we continue our discussion of business succession planning begun in a previous issue, we will look more closely at the income tax issues that must be considered during discussions of a sale or transfer of a closely held business.

Basic Inquiries
On learning that the client owns an interest in a closely held business, there are four basic things the advisor team has to know before it can give the client advice. They are: first, what kind of business entity is involved; second, how is the entity classified for income tax purposes; third, who are the current owners; and fourth and finally, what would the client like to have happen (a) if the client lives to a normal healthy life expectancy or (b) dies early or becomes incapacitated. How much the client’s interest is worth may also be an inquiry to determine how critical planning for the business is to the prospects for success of the client’s planning.

Business Entity Types
In the U.S., we have only a few kinds of business entity.  They are:
*    Corporations, which includes professional corporations and associations organized to practice a licensed profession (such as law or medicine);
*    General partnerships, which includes unincorporated associations, investment clubs and limited liability partnerships (as distinguished for “limited partnerships” discussed below);
*    Limited partnerships, which includes professional limited liability partnerships;
*    Limited Liability Companies (LLCs), which includes professional LLCs;
*    Sole proprietorships, which really are not separate entities at all, just the owner “doing business as”; and
*    Trusts, which may or may not be treated as separate taxpayers for income tax purposes.

How Is It Classified for Income Tax Purposes?
Knowing the type of business entity involved sometimes does not answer how it is treated for income tax purposes.

Corporations are taxed under Subchapter C of Chapter 1 of the Internal Revenue Code (called “C” corporations) unless they elect to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code (called “S” corporations).

C corporations are tax paying entities, just like individuals. They report their income to the IRS each year and pay tax on the net income after deductions. They do not get to deduct dividends paid to their shareholders, and their shareholders in turn must report and pay income tax on those dividends. This is commonly referred to as “double taxation.” S corporations, on the other hand, are tax reporting entities. They report their income or loss to the IRS and to their owners, and then each owner reports his or her share of the income or loss on the owners’ tax return and pays the resulting tax. This income and loss attribution and tax liability results without regard to whether any cash or property is distributed by the corporation to its owners.

Both general partnerships and limited partnerships are classified for income tax purposes the same way—as partnerships. Like S corporations, partnerships are tax reporting entities. They report their income or loss to the IRS and to their owners, and then each partner reports his or her share of the income or loss on the partners’ tax return and pays the resulting tax. The one exception is that in the nine community property states, if the only partners are a husband and wife who file a joint income tax return, they may choose to treat the partnership like a sole proprietorship and disregard its existence for income tax reporting.

Planning Tip: Although both partnerships and S corporations are tax reporting entities, the rules applicable to them are quire different. For example, an S corporation can have no more than 100 owners, all of whom must be U.S. citizens or residents and cannot have different income distribution rules for different classes of owners. Those restrictions do not apply to partnerships.

Limited Liability Companies (LLCs)
LLCs have flexibility. For many years, the IRS went through a complicated rigmarole to determine whether each LLC was more like a partnership or more like a corporation and assigned its taxpayer classification accordingly. Now, the owners of a newly formed LLC have the freedom to “check the box” and thereby choose whether their LLC will be treated for income tax purposes as a corporation (which means it may be eligible to choose S corporation status) or as a partnership. As with partnerships, an LLC owned entirely by a husband and wife who live in a community property state and file jointly may be disregarded for income tax purposes and treated as a sole proprietorship.

Sole Proprietorships
The sole proprietorship is the most common form of business in the United States. Many businesses started from scratch begin as sole proprietorships. Many of them stay as sole proprietorships unless someone on the advisor team points out to the owner the disadvantages of operating as a sole proprietorship—such as liability exposure and limitations on retirement plans. For income tax purposes, a sole proprietorship is not a separate taxpayer. Its revenues and deductions are reported on Schedule C of the owner’s income tax return.

Sometimes a sole proprietorship business is started in or transferred to a trust. For income tax purposes, trusts come in two classifications—“grantor trusts,” the income and losses of which are treated for income tax purposes as being those of the person who contributed the assets to the trust, and “non-grantor trusts,” which are treated as separate taxpaying entities for income tax purposes. Some grantor trusts choose to file zero income tax returns and others do not, instead counting on the deemed owner to report the income and deductions on his or her personal income tax return.

Planning Tip: Through careful drafting it is possible to create a trust that is disregarded for income tax purposes, but not for gift and estate tax purposes. Such a trust is sometimes referred to as “intentionally defective” or an “intentional grantor” trust. Almost all ILITs are this type of grantor trust.

Who Are the Owners?
Ownership matters because it can limit the tax planning choices. If a corporation or LLC has any owner who is not a U.S. citizen or resident, it cannot be an S corporation. So, too, if some of its owners have one kind of income right that others do not, the S election is not available to the entity. If the entity is owned by all family members, the planning suggested may be entirely different than if the business is owned by a group who came together for business purposes or who share a common licensed profession.

What Are the Client’s Goals?
Surprisingly, while most clients will have no trouble at all answering the other questions, this one often has never been thought about. The typical owner has his focus on his business and has given little or no thought to how, when, or even if he or she wants to have a life after business.

With careful guidance from the advisor team, the client can be encouraged to focus on the more distant future to do what is possible to preserve the legacy that the business represents, rather than simply closing the doors when the owner is not longer able to run the business.

Planning Tip: This is where the client’s spouse and family may have goals of which the client is unaware. Does a son or daughter assume that they will someday be handed the business “on a silver platter”? Does the spouse envision a life of romantic cruises paid for with the proceeds from selling the business?

There are many, many different strategies for exiting a business other than by closing its doors. In the remainder of this issue we will look at a few of them.

Outright Sale of an Ownership Interest
The client’s ownership interest in the business might be simply sold to a new owner or another existing owner. In that event, the gain or loss on the sale of the ownership interest is taxed as a capital gain or loss.

Exiting a Partnership
Is the business owned by a partnership? If so, the client may wish to reduce their percentage interest in the partnership or leave the partnership entirely. The partnership may accomplish such an ownership reduction or exit by means of a liquidating distribution.

Distributions of cash or marketable securities will cause the receiving partner to recognize capital gain to the extent the amount of cash exceeds the receiving partner’s outside basis (what the selling partner paid for their interest or the basis they received from the senior generation in a gift transaction). The basis may be low relative to the value, especially if the partnership has accumulated assets by investment of income.

When a partner recognizes gain on a distribution because it includes marketable securities that are treated as cash, the partner’s basis in the securities is increased by the amount of the gain recognized. (There is the possibility of a deemed cash distribution under Code Section 752.)

What would otherwise be capital gain is ordinary income if the partnership has “unrealized receivables” and/or “substantially appreciated inventory.” This frequently happens in the case of an auto dealer with inventory.

A partner who contributed property worth more than its basis may have to recognize gain if, within seven years of the contribution, the partnership distributes the contributed property to another partner or the partnership distributes other property to the contributing partner. In general, however, when a partnership distributes property to a partner, neither the partnership nor the receiving partner will recognize gain or loss, because a) the built-in gain or loss in the distributed property will be preserved for later recognition when the receiving partner sells the property or b) the basis of the recipient partner’s partnership interest is reduced by the basis (to him or her) of the distributed property.

Sale of an Interest in a C Corporation
The sale of stock in a C Corporation will result in capital gain or loss to the selling shareholder. The buyer’s basis in the stock is the purchase price. Because underlying corporate assets retain their tax basis regardless of the price paid for the stock, the buyer may “inherit” a substantial future tax liability if the corporation holds appreciated assets. Because of this and the risk of acquiring unknown liabilities in a stock purchase, a buyer of an incorporated business will almost always prefer not purchasing the seller’s stock, opting instead to purchase the assets from the corporation.

The sale of business assets by a C Corporation results in a gain to the corporation and, under current law, is taxed at graduated corporate rates up to 35%. (Corporations generally do not get a special rate for long term capital gains.) The buyer gets a full step up in tax basis of the assets equal to the purchase price. If/when the net after-tax proceeds are distributed out to the shareholders of the selling corporation, the shareholders will have capital gain or loss, depending on the basis of their stock if it is a liquidation or will have dividend income. There is thus a potential Federal tax rate of 45% on such a transaction. That is why a seller would prefer a simple sale of shares resulting in long term capital gains taxed at 15%.
With a going concern, there are both tangible and intangible assets involved in a sale. The intangible assets are the business’ good will and trade secrets and contract rights, such as to distribute a manufacturer’s products or operate under a franchise. With an asset sale, these assets, too, will need to be valued and transferred.

C Corporation Liquidation
Liquidating the C corporation by distributing the assets to the shareholders is generally not advised. It will trigger capital gain income on appreciated assets owned by the corporation and the shareholders will recognize gain on the receipt of corporate assets. The tax bills will have to be paid even though no cash is generated by the transaction. Liquidation of the C corporation is a viable solution if the corporation’s assets are not appreciated and/or shareholders have unused capital losses and/or the corporation has unused NOL carryforwards. In general, if the client simply wants to go out of business and owns a C corporation, it is better to do so in a ten-year plan, as explained below.

Step 1: C Corporation to S Corporation
Make the election to be taxed as an S corporation effective for the corporation’s next tax year. This is a long-range (10-year) plan to eventually eliminate the double taxation that results on the liquidation of a C corporation or conversion to a partnership or an entity taxed as a partnership. Any disposition of corporate assets within this 10-year period—whether by sale, distribution or liquidation—will result in some double taxation, but that is better than all double taxation.

Planning Tip: The current environment of depressed values may make this a good time to make the S election.

Step 2: Liquidate the S Corporation or Convert It to an LLC and Elect Partnership Taxation
Once the ten years has passed, the S corporation can be liquidated or converted to a partnership or LLC taxed as a partnership without enduring the double taxation.

If the client owns an S corporation or an LLC taxed as an S corporation, a transfer to a family member on favorable terms may often be effected by starting with recapitalization.

S corporation status is only available to a corporation or LLC that has a single class of ownership. However, for these purposes voting interests are not considered to be a different classification than non-voting interests that have the same income and loss attributes. However, although they are considered to be of the same “class,” they can have vastly different values because the right to control the company’s affairs is associated with voting ownership but denied to non-voting ownership. This ability to transfer ownership without control offers an opportunity to shift value on favorable terms and often appeals to the owner who is reluctant to give up control. It can also be used to separate active owners from passive owners, such as children who will not be involved in running the business.

Minimizing Tax on the Sale of Goodwill
Goodwill is an intangible value associated with the going-concern value of a business.

In an asset sale where goodwill is a major component of a company’s value, the double tax sting of a C corporation can sometimes be minimized or eliminated by distinguishing the goodwill owned by the shareholder-employee (personal goodwill) used in the C corporation’s business from the goodwill of the C corporation itself. In such situations, the selling price of the C corporation assets can be split between the C corporation seller and the shareholder seller.

The existence of personal vs. corporate goodwill depends on the contractual relationship between the shareholder-employee and the corporation. There should be no employment, non-competition or other agreements between the shareholder-employee and the corporation that serve to transfer personal good will to the corporation. The business sale negotiations need to reflect two separate sales—that of corporate assets and that of the shareholder-employee’s personal goodwill. Proper allocation, supported by appraisals, is needed between corporate assets being sold and personal goodwill. Any covenant not to compete with the buyer needs to be between the buyer and the shareholder-employee, not the selling corporation.

Planning Tip: To determine the value of goodwill, allocate the purchase price to tangible assets (cash, accounts receivable, inventory and fixed assets) whose value can be verified and documented. Whatever is left can be assigned to the intangibles, which may include goodwill and intellectual property.

Intentionally Defective Grantor Trust (IDGT) and Life Insurance
For a transfer to family members, the owner can establish an intentionally defective grantor trust (IDGT) and sell business interests to the trust. Cash flow from the business that is not needed to service the purchase note can be used to pay premiums on life insurance on the grantor’s life. On the death of the grantor, the insurance proceeds can be used to pay off any unpaid promissory note balance from the sale to the IDGT. Since the grantor is paying taxes on the company earnings flowing into the trust, the trust is in essence using tax-free income to pay the premiums.

Planning Tip: Today’s extremely low AFRs coupled with the asset to value adjustments associated with minority, non-liquid, non-controlling interests in businesses often produce plenty of income in excess of what is needed to service purchase debt.

Buy-Sell Agreements
For businesses other than those owned by members of a single family, there is perhaps nothing more important (nor more likely not to exist) than a good, current buy-sell agreement among the owners. We therefore include a few thoughts on buy-sell agreements.

Triggering events for a buy-sell should include death, disability, deadlock, retirement, attempted sale to a third party and divorce. Anything that would jeopardize the business should also be included, such as disbarment of a member of a law firm. Types of buy-sell agreements include stock redemption (equity purchase), cross purchase (surviving owners purchase), use of a partnership to hold insurance on the lives of multiple shareholders, and a hybrid or wait-and-see combination to give shareholders the right of first refusal.

There are different ways to determine value for the buy-sell agreement. A fixed price method must be updated annually to be useful, and should be supported by an appraisal to avoid disputes. A formula method can include book value, modified book value, capitalization of earnings and discounted future cash flows. Under the appraisal method, a single appraiser can be used, or the buyer and seller can each have an appraiser with any disputes resolved by a third appraiser. A hybrid would be to use a fixed price that defaults to an appraisal if it is not updated.

Funding methods can include retained earnings, sinking fund, installment purchase, third-party borrowing and life insurance. Life insurance is the easiest, but the others should be considered if the shareholder is uninsurable.

Consideration should be given as to whether a selling shareholder should have any obligation to provide the right to other shareholders to participate in that transfer. This would be an appropriate topic when a sale of the company is involved. It would also benefit the minority interests, particularly when all shareholders are entitled to the same price.

Planning Tip: A divorcing owner should have the first opportunity to purchase (over time with interest) the shares the divorce court has awarded to the former spouse before the business or other owners buy the stock. If the owners’ spouses sign the agreement, they can be thus bound.

Tax Issues of Buy-Sell Agreements
Proceeds of life insurance are received income tax-free in most cases. However, life insurance proceeds may cause AMT issues with a C corporation. Premiums paid on insurance to fund buy-sell agreements are never tax deductible, either by the entity or the owners.

Planning Tip: Consider how to handle any excess life insurance proceeds. For example, if the business is valued at $5 million and there is $8 million in life insurance, what would happen to the extra $3 million? Depending on how the agreement is written, it could go back to the corporation as key man insurance or it could be paid out to the deceased shareholder’s estate or beneficiary. There could be a tax issue depending on whether the business is a C corporation or an S corporation.

Transfer Tax Issues:  Under Code Section 2703, the transfer tax value is determined without regard to any buy-sell agreements among family members unless: a) the buy-sell agreement is a bona fide business arrangement; b) it is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and c) its terms are comparable to similar arrangements entered into by persons in arm’s length transactions. This is a very difficult burden to overcome. As a practical matter, what is paid under almost all buy-sell agreements has no relationship to what the IRS determines to be the value transferred.

S Corporation Issues: The buy-sell agreement among owners of an S corporation needs to contain a number of provisions in order to preserve the S election status of the corporation:
*    Lifetime or testamentary transfers made to trusts for descendants of shareholders or others, only if the trust is either a QSST or an ESBT;
*    Unless elected otherwise, all income and losses for the entire year are allocated on a per day basis.
*    The possibility that a corporate redemption may not qualify for capital gains tax treatment in the hands of the departing shareholder.
*    Prohibit loans, stock options or other transactions which would constitute a second class of stock.
*    Provide that the corporation will make distributions to shareholders at least quarterly to enable payment of estimated income taxes on flow-through income.

It is impossible for one advisor to know everything, which is why the advisory team concept is so important. But the team member who has awareness of the issues associated with a client owning and/or selling a closely held business will be of great value to the team and to the client.

Monday, September 3, 2012

Estate Planning for Disability

Planning for the possibility of disability is probably the most overlooked part of estate planning. While many people will give serious consideration to estate planning for their death, few will seriously consider planning for their disability. Yet disability planning should be the more important part of estate planning from the client’s perspective both because it benefits the client directly, and because, until a person is well past retirement age, the probability of becoming disabled in the next year exceeds the probability of dying in that period.           

The best vehicle for disability planning is a fully funded trust - usually a revocable living trust. Estate planning professionals need to know how to assist their clients in designing their living trusts, both to provide for taking care of the client in the event of the client’s disability and to provide for anyone who is dependent on the client when the disability event occurs.

In this issue of The Wealth Counselor
, we will examine what happens when someone becomes disabled and has not planned for it, and how the right planning can prevent a court from having to step in to protect the client and the client’s assets. Proper planning can allow the advisory team to continue its role in helping manage the client’s assets and provide for the client and the client’s dependents.

The Team Approach to Planning for Disability
Clients are best served when all of their wealth planning professionals are working together on their behalf. Certain legal documents are required for proper disability planning, but even the best legal documents are ineffective unless the client, with their financial advisor’s help, sets up the client’s financial resources to support them. So, too, financial planning for disability is a very good thing, but the best financial planning is ineffective without proper legal planning to empower trustees and agents to act in the place of the client when the client is unable to do so. The advisory team (attorney, CPA, insurance advisors, financial advisors, and sometimes even the client’s doctors) must work together to integrate planning that will be effective should the client suffer a disability event.

Disability Planning Defined
Disability planning is planning for when the client is mentally incapacitated to the degree that the client is not competent to make business or personal care decisions or so physically disabled that the client cannot communicate directions for the management of the client’s affairs.

A person is considered incompetent
when a medical determination has been made that the individual does not have the mental ability to make business or personal care decisions.

A person is incapacitated
when a court has declared the person legally incompetent to make business or personal care decisions. When a person is determined to be incapacitated, the court will take away the person’s right to make personal care and business decisions and may empower someone else to do so under the court’s supervision.

Planning for disability is vitally important because disability can happen to anyone, at any age, and at any time. Many of our clients tend to think of disability as being something that only happens to old people, like when they develop dementia. However, as noted earlier, a person’s probability of dying in the next year is much lower than his or her probability of becoming disabled in the next year unless the person is well past retirement age. With people living longer due to advances in medicine, their lifetime probability of becoming disabled is increasing. Today, the odds are better than 50:50 that any given person in the U.S. will have some period of incapacity.

But younger, healthy people can suddenly become disabled from accidents or illnesses—or even acts of violence. For example, Terry Schiavo was just 29 years old when she suffered a cardiac arrest that resulted in permanent profound brain injury. The consequences of disability without planning can add another level of disaster. That is why all of our clients, regardless of age and wealth, need disability planning—just in case.

What Happens if We Don’t Plan: Life Probate
Most people think of probate as a legal process for changing titles on assets from the name of a deceased person to the name of the deceased person’s beneficiaries or heirs. But there is another probate court process, a “living probate.”

Living probate is what happens when someone is alleged to be incompetent to manage their own affairs. Someone literally sues them in a probate court, asking the judge to take away their right to make their own care and/or business decisions and give that right to someone else. It is an expensive process in which the alleged incompetent person pays the lawyers on both sides. If the person is found to be incompetent to manage their business affairs and there are business affairs to be managed, the court will appoint a guardian or conservator to do so. The court will require that the guardian or conservator post a bond against theft or mismanagement and provide a detailed accounting to the court on a periodic basis for the court to audit. Sometimes the responsibility for the physical care of a disabled person and the responsibility for the management of assets that are titled in the disabled person’s name are given to two different people: a guardian/conservator of the person (for physical care) and a guardian/conservator of the person’s assets (for financial care).

If there are no assets titled in the incapacitated person’s name, such as when the person’s assets have been placed in a trust, the court has no need to appoint a guardian/conservator of the incapacitated person’s assets. This is just like there is no need for post-death probate if there are no assets titled in a deceased person’s name that are not controlled by beneficiary designation.

Because the courts jealously guard everyone’s rights to manage their own personal affairs and property, living probate provides a form of protection that is anything but free. Living probate, especially when there are assets to be managed, is costly, time consuming and cumbersome with annual accountings, bonds, reports, ongoing determinations of incapacity/incompetency, and fees for attorneys, accountants, doctors and guardians. All those costs are paid from the disabled person’s assets, and all living probate proceedings are a public record. Once a guardianship/conservatorship is established, it will go on until the incapacitated person dies or the court determines that he or she is no longer incapacitated. That can be many years.

Another possible problem is that a court cannot allow an incapacitated person’s resources to be used to provide care for anyone who is not the incapacitated person’s legal responsibility. That means that adult children, parents, grandchildren and others for whom the disabled person was providing support will be on their own.

Planning Tip: The probate court will usually require that all assets of an incapacitated person, other than a home occupied by the incapacitated person, be liquidated if they are not already in the form of FDIC insured accounts or U.S. government securities. In many cases, that will mean loss of assets under management and the loss of a client relationship for the person’s financial advisors.

A Fully Funded Revocable Living Trust Avoids Living Probate
When a living trust is fully funded, all titles of assets are changed from the individual’s name to the name of the trustee and new assets acquired are taken in the name of the trust. Then, if the client becomes disabled, there is no reason for a living probate for asset management because the client does not own any assets in his own name that need managing. While a guardian/conservator of the person may still need to be appointed by the court, a fully funded living trust will allow the advisors to continue to be involved with the management of the client’s assets under the direction of the client’s successor trustee.

Living Trust v. Durable Power of Attorney

A durable power of attorney is not a substitute for a fully funded revocable living trust for several reasons. For example:
*    A durable power of attorney will endure the disability, but not the death, of the asset owner (principal). A living trust, on the other hand, is not affected by the trust maker’s death.
*    A holder of trust assets cannot decline to accept the authority of the trustee (or successor trustee). A durable power of attorney, on the other hand, works only if whoever is holding the assets decides to accept it. That can be a real problem. Perhaps whoever is holding the assets will think the power of attorney is not broad enough to be acceptable. Or perhaps that it is too complex to understand without a legal opinion that the asset holder is unwilling to seek. Powers of attorney also may not be accepted if more than a certain number of days or months have elapsed since they were executed. This is a particular problem when the power is given to a spouse. Many institutions will not accept a power of attorney unless it is on their own form. We could go on. With a living trust, the trustee is the owner of the trust assets; institutions and securities transfer agents must honor the trustee’s ownership.
*    Durable powers of attorney will not endure the disability or death of the agent to whom the power is given. If the principal is disabled, a living probate will likely be needed if no successor agent is available and willing to serve. By contrast, a trust will not fail for lack of a trustee. A well-drafted living trust will contain trustee succession provisions, and even if all named successors are unavailable to serve, a professional trustee can be appointed.
*    A living probate will cause all powers of attorney to terminate; the court will simply take over and put a conservator/guardian in charge. As explained earlier, a fully funded living trust will eliminate the need for a guardian/conservator of the estate because there is no estate.
*    If the power of attorney fails to work for any reason at the principal’s disability, a living probate may be the only solution for taking care of the principal. The guardian/conservator of the estate will be someone appointed by the court. If the incapacitated person has not made his or her wishes known by a certain kind of formal document, the court may choose someone who is a professional guardian/conservator but a total stranger to the family. With a living trust, the client handpicks the successor trustees for his/her trust.
*    Federal agencies, such as the IRS and the Social Security Administration will generally not honor powers of attorney; agents cannot cash Social Security checks or sign tax returns. With a living trust, Social Security checks can be set up ahead of time for direct deposit to a living trust account and a trustee will be empowered to deal with the IRS.
*    A power of attorney must contain very specific instructions for running a sole proprietorship or other business entity. If the sole proprietorship or business entity is owned by the living trust, the successor trustee will have no problem stepping in and running the business. The successor trustee can also hire other persons to run the business if the successor trustee does not want to run the business or does not have the proper license to do so. An agent does not have the power to delegate.

Additional Documents for Disability Planning
Durable Power of Attorney

A durable power of attorney can be useful. Often one will be accepted to transfer titled assets to the principal’s revocable living trust, and they are effective in managing assets (like IRAs) that cannot be put into the living trust before a disability event.

Durable Power of Attorney for Health Care

Also called a Health Care Proxy or Medical Power of Attorney, this document lets you legally give someone the authority to make health care decisions (including life and death decisions) for you if you can no longer make them for yourself. Without a designated health care agent, your client could be kept alive by artificial means for an indefinite period of time. (Most clients will remember this happening to Terri Schiavo. Terri’s tragic incapacity saga and information about the Terri Schiavo Foundation can be found at

Living Wills or Directives to Physicians

A living will is different from a living trust. A living trust is a document used in estate planning for control and management of a person’s assets during lifetime and after death, and as explained above, can prevent a living probate at disability because of the way the assets are titled. A living will or directive to physicians is a document that lets a physician know the kind of life support treatment someone would want provided or withheld in case of terminal illness or permanent condition when the affected person cannot make his or her desires known.

Planning Tip: A living will or directive to physician is limited, because it addresses the use of life support only in very specific situations when the person’s condition makes communication about care decisions impossible. (As a practical matter, if a close family member objects, the physician and hospital will not want to be liable for going against their wishes and may disregard the living will.) By contrast, a durable power of attorney for health care is legally binding and enforceable.

HIPPA Authorizations

HIPPA authorizations give written consent for doctors to discuss a client’s medical situation with others the client has designated and to disclose a client’s medical information to them. These documents are vitally important for disability planning because they can allow not only family members to discuss a disabled client’s situation and prognosis with the doctors, but they can also allow the trustee and members of the advisory team to be kept fully informed.

Defining and Providing for Disability in the Revocable Living Trust
A revocable living trust provides the client the opportunity to define disability in a way that will provide for the continuity of trustee services, to make sure the trust maker and loved ones will be taken care of during a disability, and to ensure that debts, liabilities and obligations will continue to be paid. Options to define disability can include:
*    A determination by two physicians that certify that the trust maker is disabled. (HIPPA authority will be necessary to allow the doctors to discuss the client’s condition with the trustee and other advisors.)
*    A determination of incapacity by a living probate court. (The court does not have to appoint a guardian of the estate if all titles are in the name of the trustee.)
*    A determination of disability by a disability panel named in the trust. This option allows the client to pre-select a group of people to determine his/her disability. (An odd number is recommended to prevent deadlocks.)

Planning Tip: If the trust maker should disappear or is being detained against his/her will (kidnapped, held hostage, in jail or prison), he/she can be declared disabled so the trustee can take care of the obligations and people who need to be cared for. (In contrast, years must pass before a missing person can legally be declared dead by a court.)

Designing “Take Care of” Instructions in the Revocable Living Trust
The revocable living trust should include instructions regarding the persons who are to be taken care of in the event of the trust maker’s disability. For example, it could be the trust maker only; or the trust maker and spouse; or trust maker, spouse and legal dependents. The trust maker may also want to include others who are not legal dependents, like parents and adult children who are actually receiving support at the time of the trust maker’s disability. Also, priority must be established for those the trust maker would like to care for, in case there are not enough funds to provide for everyone.

Planning Tip: It’s also important to find out how the trust maker wants to be taken care of and what things are important to him/her. Are there social, recreation and entertainment needs? Are there religious needs? These instructions can be as detailed as they need to be.

Financial Planning Recommendations for Disability Planning
Proper financial planning requires counseling and is not a one-size-fits-all solution. During the discovery process, determine the client’s desires and insurance needs. Pre-planning for healthy individuals can include:
*    Disability income insurance to help replace lost income.
*    Long-term care insurance to help cover the costs of care that are not covered by medical insurance, including Medicare.
*    Life insurance. Waiver of premium provisions have a real cost but, in the event of disability may convert the policy into a paid-up policy. With term policies, check for guaranteed purchase options and conversion of term to permanent life upon disability, but without them, once the term insurance expires, a disabled client would be uninsurable.
*    Business or professional overhead expense insurance. This insurance will provide cash to pay monthly business operating expenses (rent, payroll, etc.) so that personal assets will not have to be used to keep a business going. A typical benefit period would be 18 months, enough time to see if the disabled owner will recover or to make arrangements for the sale or transfer of the business.
*    Buy out insurance for buy-sell agreements upon disability. The benefit options include a lump sum payment or a stream of income payments over a period of, say, five years.

Planning Tip: The healthy spouse usually is the primary caregiver of the disabled spouse. When the disability occurs, it can be wise to secure additional life and disability insurance on the healthy spouse. If the healthy spouse dies or also becomes disabled, additional funds will be needed to take care of the surviving disabled spouse or both disabled spouses.

Planning Tip: It is not unusual for one spouse to be more engaged in the planning process than the other. Because a disability affects the entire family, the advisory team should work together to bring the disinterested spouse into the process. Eighty-five percent of women in the U.S. die single, so wives are typically particularly interested in this planning.

Planning Tip: Life insurance, long-term care insurance and disability insurance all have special disability provisions, as do retirement plans and IRAs. If the client’s living trust is the owner and beneficiary of the policies, the trustee will have full control and will have access to cash values, waiver of premium riders and term insurance conversion riders.

Planning Tip: Unmarried couples (opposite or same sex) need to have a co-habitation agreement that spells out property rights and occupancy rights in the event of death or disability. Each party needs to have a living trust with instructions that take care of each other, and each one needs to have their own health care documents.

Disability before death is usually not expected, but it should be properly planned for. Advisors should put disability planning on the same level as estate planning and impress upon their clients that this planning for life is at least as important as after-death planning. Coordination among all wealth planning professionals remains the best way to plan for clients. Having a good understanding of each other’s roles and a close relationship with the client is important in the planning stages, at the client’s (potential) disability and after the client’s death

Saturday, August 25, 2012

The Debt Ceiling Debate and the Estate Tax, Pets, Guns, and Alimony. . .What Could They Possibly Have in Common?

Actually, they do have something very important in common: your estate plan.

In this issue of The Wealth Advisor, we will look at what the recent debt ceiling debate can tell us about the estate tax. Then we will look at several specialized trusts designed to solve particular estate planning problems, including trusts for pets, registered firearms and alimony.

What the Debt Ceiling Debate Can Tell Us about the Estate Tax
The recent debt ceiling debate showed us a lot about how Congress works. There is public posturing and blaming, to be sure, but there is also negotiation behind closed doors that we do not see. There are a variety of elements that are constantly shifting and being discussed until things finally do come together, but there is not a deal until the last piece falls into place. Usually the end result is not something anyone could have predicted, nor what either side would have wanted from the beginning. And no matter how much time there is to make the deal, it seems to always come down to the last minute.

We have seen the same kind of thing in recent estate tax legislation. Just look at the Economic Growth and Tax Relief Reconciliation Act of 2001. The final result could not have been what anyone wanted: the estate tax exemption increased over several years to $3.5 million, then the estate tax was repealed for only one year in 2010, then in 2011 it was scheduled to revert to a $1 million exemption. The assumption was that, given so much time to work with, Congress would make the repeal of the estate tax permanent before 2010, and most certainly before 2011.

The House did pass a bill in 2005 that would have made the repeal permanent, but a vote in the Senate was postponed due to Hurricane Katrina and no compromise bill came from that attempt. The House passed another bill in December 2009, but the Senate was consumed with passing health care reform. 2010 arrived with the one-year repeal of the estate tax. Promises were made to work on the estate tax law throughout 2010 and make any changes retroactive, creating great uncertainty within both the professional community and the public. In December 2010, just days before the estate tax exemption reverted to the $1 million exemption, President Obama announced a surprise deal: a two-year extension of the federal estate tax with a $5 million exemption and 35% tax rate.

So, here we are again, this time with a two-year deal. If Congress does nothing between now and January 1, 2013, the estate tax exemption is set to return to $1 million with a top tax rate of 45%. What will Congress do and when?

That brings us back to what the recent debt ceiling debate can tell us about the estate tax. There may be a deal, but probably not without a crisis. If there is a deal, it will be at the very last minute, or even past the deadline. There will be surprises. And the uncertainty of it all will be painful for everyone. And it may not be a permanent fix.

We may see something happen on the estate tax this fall when the "super committee" convenes and "gets serious" about taxes and debt. But if not then, then maybe after Labor Day of 2012 (as Congress notices that December 31, 2012, is approaching). Because campaigning will be in high swing then, more likely not until after the November 2012 election. Whether something happens in the "lame duck" session could depend on who won the presidential election and how the balance of power in the Congress will shift. And if not then, then maybe in 2013 and they will talk about making it retroactive. Deadlock still remains a possibility. Does this sound familiar? Yes, unfortunately, it does.

Planning Tip: Take full advantage of the estate and gift tax laws we currently have. With Congress looking to "close loopholes" and find ways to increase revenue without raising tax rates, proven estate planning favorites like discounts, short-term GRATs, and charitable deductions may not be around much longer. The current $5 million gift tax exemption ($10 million if married) allows you to transfer huge amounts out of your estate, but only until December of 2012 at the latest. We do not know what 2013 will bring us or whether the opportunity will even last until then.

Specialized trusts can take advantage of the estate and gift tax laws currently in place. Trusts designed to solve particular estate planning problems include trusts for pets, registered firearms and alimony.

Pet Trusts
Many who have pets have a very real sense of responsibility to care for them, even after their own deaths. Most states have adopted some form of pet trust legislation that lets you be assured your wishes regarding your pets will be carried out.

When setting up a pet trust, you will need to think about your desires, your pet's needs and how best to accomplish your goals. Consider the following:
• Make sure your pet is identified to prevent a different animal from benefiting from the trust. This is especially important if the pet is valuable or a large sum of money is involved. This can be accomplished with photos, veterinary records, a microchip, even DNA testing.
• You may want to name different people as the trustee (to manage the funds) and the caretaker. You can name one person to have both responsibilities, but it can be good to divide them and have one person be accountable to the other.
• You may want to require that the caretaker sign an agreement to provide proper care and relinquish care to a successor if the promised care is not provided.
• Name successors in case your initial choices become unable or unwilling to act. Include a sanctuary or shelter of last resort if none of your chosen caretakers survives the pet or is able to serve.
• The trust should define what proper care is. For example, expenses could include food, housing, veterinary and dental care, toys, exercise routines, grooming, compensation for persons caring for the pet and burial/cremation fees. Farm animals, race horses and other large or valuable animals could require a full-time caretaker.
• Liability insurance should be considered to cover any potential damage caused by the pet to persons and/or property.
• If the caretaker is subject to additional taxes as a result of distributions from the trust, you may want to increase the distributions to offset the additional tax liability.
• Consider carefully how much money will be needed to fund the trust to provide for this care. If you don't have the assets, a life insurance policy on your life may be the way to provide the needed funds.
• Will the trust end when the pet dies, or will it continue for the pet's descendents? In some states, that is not an option. What do you want to happen to any remaining funds? Do you want them to go to family members or to a charity?
Planning Tip: Will the trust end when the pet dies, or will it continue for the pet's descendents? In some states, that is not an option. What do you want to happen to any remaining funds? Do you want them to go to family members or to a charity?

NFA or "Gun" Trusts
There are four million members of the National Rifle Association (NRA) and an estimated 240 million firearms in this country. Many families also have guns and other weapons as heirlooms that they would like to keep in the family and pass down from generation to generation.

But weapons present some unique challenges. The National Firearms Act (NFA) as well as state and local laws strictly regulate possession of certain weapons and may affect the transfer of permissible weapons. For example, convicted felons, those with a history of mental illness, persons convicted of misdemeanor domestic violence offenses, convicted users of illegal drugs, dishonorably discharged veterans, and persons who have renounced their U.S. citizenship are not allowed to own or possess certain weapons.

When an estate includes firearms or other weapons, the executor must be careful to avoid violating these laws. Transferring a weapon to an heir to fulfill a bequest could subject the executor and/or the heir to criminal penalties. Just having a weapon appraised could result in its seizure. An out-of-state heir creates even more problems.

A revocable living trust designed specifically for the ownership, transfer and possession of weapons (commonly known as a gun, NFA or firearm trust) can avoid some of the problems or at least make them manageable. A corporation or LLC can also be used to own weapons, but trusts do not require annual filing fees, public disclosure or a separate tax return. Here are some of the main points:
• The trust is the owner of the weapons.
• The trust document must be carefully written to account for the different types of weapons held and comply with the applicable laws.
• The name of the trust, once established, should not be changed. Because the regulated weapon is registered in the trust's name, a change in the name of the trust would require that it be re-registered and a transfer tax paid.
• The trust can name several trustees, each of whom may lawfully possess the weapon without triggering transfer requirements. (Persons not allowed by law to own or have access to the weapons in the trust are not eligible to be a trustee.)
• Weapons can be purchased by a trustee to avoid having to pay a transfer tax.
• Once a weapon becomes a trust asset, any beneficiary (including a minor child) may use it. However, the trustee is still responsible to determine the capacity of the beneficiary to use it.
• Unlike a traditional revocable living trust which can be revoked at any time by the grantor, the Bureau of Alcohol, Tobacco, Firearms and Explosives (BATFE) must approve the termination of a gun trust and the distribution of its assets to the beneficiaries.
• No regulated weapons held in the trust may be transported across state lines without prior BATFE approval.
• Also, since weapon laws vary from state to state, gun trusts may not be valid from one state to another as a traditional revocable living trust would be.
Alimony Trusts
These trusts are often set up to provide income to an ex-spouse under a written dissolution or separation decree/agreement. Here are some of the key points:
• Assets are transferred to the trust as part of the settlement.
• The trust's income is typically paid to the former spouse for a specified length of time, until a specified amount has been paid, or until the ex-spouse remarries or dies.
• The payee (the ex-spouse receiving the payments) pays income tax on the income received.
• After the former spouse's interest has ended, the trust can continue for the benefit of the children from the marriage or terminate.
• The trustee can be a neutral third party who can act as an intermediary between the former spouses.

Planning Tip: An alimony trust may be useful for a business owner who cannot or does not want to sell an interest in the family business to make payments to his former spouse or if the business lacks the liquidity to redeem the stock of the former spouse. It can also protect the payee (ex-spouse receiving the income) in the event the payor should die or become financially insolvent before all payments have been made. One downside is that the trust can become under- or over-funded, so care should be taken when creating and funding the trust.

These are just a few of the specialty trusts available to us for estate planning. And as you just read, we are living in interesting times. We currently have an exceptional window of opportunities available to us in estate planning, and we can help you make the most of them. Call us and let's get started.

Regardless of what the Congress does or does not do, control and protection of your assets, improving the predictability of the future, and doing good rather than harm with your accumulated assets remain the principal reasons for doing estate planning.

Test Your Knowledge

1. Congress has the habit of working out legislation with plenty of time to spare. True or False

2. We can confidently predict what changes Congress will make in the estate tax law and when any new law will go into effect. True or False

3. If you have pets and die before they do, the city in which you live will provide for them in a loving home for the rest of their lives. True or False

4. Any person you ask to take of your pets will be willing to do so at their own expense for as long as necessary. True or False

5. You should consider naming successor trustees and caretakers in your Pet Trust in case one becomes unable or unwilling to serve. True or False

6. If you own a gun, you can leave it in your will to anyone you wish. True or False

7. Anyone can be a trustee of a gun trust. True or False

8. Just like any revocable living trust, you can cancel a gun trust at any time without having to notify anyone.
True or False

9. Once a gun is in a gun trust, you can take it anywhere you want. True or False

10. In an alimony trust, the ex-spouse who makes the payments (not the ex-spouse who receives them) must pay the income taxes. True or False

Answers: #5 is True; all of the rest are False. To comply with the U.S. Treasury regulations, we must inform you that (i) any U.S. federal tax advice contained in this newsletter was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (ii) each taxpayer should seek advice from their tax advisor based on the taxpayer's particular circumstances.