Free Your Clients From Old, Obsolete Trusts
The Perils of Outdated Plans and How to Overcome Them
by: Christopher Klug – Trust Administration Attorney, Washington DC
Estate planning needs evolve. An old, obsolete estate plan often fails to achieve client goals, resulting in dissatisfaction, unnecessary taxes or probate costs, and a greater likelihood of lost assets under management. Fortunately, we can help your clients revitalize the obsolete aspects of their plans and get them back on track for the future, making you the hero and enhancing your relationship as a trusted advisor.
How to spot an outdated trust or will
There are two types of outdated trusts and wills: (1) documents your clients have created and (2) documents created by deceased loved ones of your clients where your clients are beneficiaries.
The fastest way to determine whether documents your clients have created are outdated is to look at the signature pages. If the documents were signed during or before 2012, your clients need an immediate estate plan review. Of course, if there are no signatures (a not unheard of situation), then we absolutely need to speak with your clients since their wishes are likely not legally valid.
For trusts and wills signed in 2013 and afterward, it’s a good idea for us to sit down with your clients to make sure the plan still meets all of their needs and avoids confusion, complexity, and needless cost due to obsolete tax planning.
As mentioned earlier, clients may be the beneficiary of a deceased loved one’s trust or estate. You can usually spot this when a trust or account bears someone else’s name with language like “FBO” or “for the benefit of” at the end. For example, the Susie Smith Article 6 Trust FBO Adam Smith. These trusts can sometimes be decades old and almost certainly have obsolete language. It is almost always worth examining these documents to ascertain opportunities for tax and administrative improvement.
Many individuals take a set-it-and-forget-it approach to their estate plans or feel like they cannot modernize an old trust they’ve inherited. Like investment or financial planning, tax planning, health and fitness, and so many other aspects of life, proper estate planning is an ongoing process that clients must revisit regularly.
We routinely monitor the latest developments in legislation and know how to modernize clients’ plans. If outdated plans go unchecked, negative consequences can occur. Let’s look at some potentially obsolete estate planning techniques that are worth a second look.
Be wary of the alphabet soup from yesteryear
FLPs, ILITs, AB trusts, and other convoluted acronyms can be indicative of trusts or planning strategies that have outlived their usefulness to your clients. Admittedly, these strategies can still be a great fit for the right client, but Family Limited Partnerships and other discounting-driven planning tools may produce a worse result now for some clients, as they can increase capital gains taxes. These discounting-driven plans were originally designed to reduce estate and gift taxes, which were a substantial issue at the time that these plans became popular. At the time, these were good strategies to implement, but changes in tax laws make them contraindicated (or even downright harmful) for many clients now.
The current $5.49 million exemption for the estate tax ($10.98 million for married couples) means that the overwhelming majority of clients do not have to worry about paying estate tax and can still take advantage of an income-tax-saving basis step-up on all of their assets.
While estate taxes have become less of an issue, federal capital gains tax rates have been rising and are now up to essentially a 20 percent base rate. For some clients, the net investment income tax (often referred to as the NIIT) tacks on 3.8 percent more. Add on state income taxes (ranging from 5-13.3%), and an obsolete discounting-driven plan could “save” a client on a non-existent estate tax bill while creating a built-in capital gain that could be taxed as high as 37.1 percent. This happens because discount-driven planning strategies, such as FLPs, do not obtain a full basis step-up at the death of a client, which can create unnecessary capital gains taxes. Any plan that saves non-existent estate tax while creating a capital gains tax bill should be reviewed and likely reworked. Any clients with estates less than the exemption of $5.49 million ($10.98 for married couples) that have used these strategies in the past should take a second look.
Clients are not trapped with old plans (even if those plans are “irrevocable”)
Old, obsolete plans can be updated. Just as there are many ways to remodel a home, there are many strategies and legal tools that can be used to modernize obsolete estate plans.
- Updating an old trust
Once you are aware of an outdated trust posing a potential risk to a client, advise the client to see us so we can help them craft a restatement or amendment. This is a straightforward solution that can update and modernize revocable trusts created by your clients. This makes their plan ready for the realities of the legal and financial landscape we live in today.
A client may have an irrevocable trust, perhaps an inheritance from a parent or grandparent or a trust created by the client for tax reasons that no longer make sense. There are several options to modernize these trusts, including decanting, trust protector restatement, judicial modification, and non-judicial settlement, depending on the circumstances, the clients’ needs, and the laws of the state. There are no one-size-fits-all solutions, but the best place to start is with a discussion about your clients’ circumstances, needs, and goals.
- Untangling an obsolete plan
Tax-driven planning often utilizes more than a single document. For example, a discount-driven plan often involves a family partnership or family LLC agreement, one or more trusts, promissory notes, appraisals, and a gifting strategy. Similar to the solutions to old trusts described above, there are many tools and strategies available to unwind these plans when they have outlived their usefulness. Since each client and plan is unique, the way to unwind it will be as well. Coming up with the most effective strategy requires delicate consideration of the client’s current goals and needs, as well as tolerance for risk.
Planning for International Families
Our office has extensive experience working with families where one spouse is a US citizen and the other is a nonresident of the US. This significantly complicates the planning as there will be two separate set of rules that will apply. By knowing the rules, there are also significant planning opportunities.
As discussed above, the US citizen spouse will have a $5.49 million gift and estate tax exclusion. Transfers from the nonresident spouse to the US citizen spouse would not incur any gift or estate tax as transfers to the US citizen spouse qualify for the marital deduction.
The nonresident spouse is subject to US estate tax on US situs assets and they will have a $60,000 estate tax exemption. The nonresident spouse is subject to gift taxation on lifetime transfers of real and tangible personal property and they do not have a gift tax exemption. The marital deduction is not allowed on the transfer of assets to a nonresident spouse. There is an enhanced annual exclusion of $149,000 on transfers to the nonresident spouse.
The starting point for these international families is to have a detailed list of their assets and where they are located. Transfer of ownership of assets can be a significant opportunity for the citizen spouse and nonresident spouse to minimize US income taxation and at the same time reduce or eliminate any US gift and estate tax exposure, even for families with significant net worth.
For example, Susie Smith is a US citizen and her husband Adam Smith is a citizen of Australia. Adam is neither a resident of the US for purposes of income taxation or estate and gift taxation. Susie and Adam are currently residing in Australia. Adam owns a successful business in Australia estimated to be worth $30 million, has investments in Australia of about $15 million, house in Australia with an estimated value of $2.5 million, and $5 million in US real estate investments. Susie has investments outside of the US of about $10 million. Adam and Susie’s succession plan is to have their estate go to the surviving spouse at their death with the remainder equally to their two children, one who is a US citizen and the other who is nonresident of the US.
If there was no planning or the assets remained titled as they are and presuming Adam were to die first, at his death there would be a US estate tax of $1,976,000 on his US real estate. Since all of the assets would then transfer to Susie, at her death there would be an additional US estate tax of $22,804,000. Through poor planning there would be total US estate tax of $24,780,000.
The issue for Adam is the US real estate. Adam should either transfer the US real estate into a structure where what he owns at death is not US real estate, but an interest in a foreign corporation that owns directly or indirectly the interest in the US real estate. Adam could also transfer or sell the US real estate to this wife. This would remove any estate tax issue at his death, assuming that if he transfers the US real estate to Susie, that Susie’s estate plan does not transfer the US real estate directly back to Adam should Susie predecease Adam.
Also key in the estate planning for Adam, is to ensure that at his death he does not leave his $52.5 million estate outright to Susie. Typically, clients accomplish this result by leaving the assets in trust for the surviving spouse where the spouse can be both trustee and primary beneficiary and the trust is asset protected, while assets held in the trust are excluded from Susie’s estate at her death.
When Susie dies she will have a US taxable estate of $10 million which will incur US estate tax of $1,804,000, if no additional planning is completed. Susie has many planning alternatives to reduce her remaining US estate tax liability.
As important to the planning is considering how to succeed wealth to the children, one who is a US citizen and the other who is a nonresident of the US. As with Adam and Susie, their children will be subject to a separate set of US gift and estate tax rules based on their status. It is important to take this into consideration in providing a comprehensive estate plan for Adam and Susie.
Even though there is no way to know for sure what to do until some analysis is completed, it’s better to have an informed choice rather than acting upon the assumption that the plan is going to work for the best interests of the client or that the plan cannot be changed. These are complex legal processes, and there is no one-size-fits-all answer. But no matter how tangled the threads of your clients’ old trusts or plan seem to be, we can ascertain the right way to smooth things out.
Consult with us and let’s see how we can achieve your clients’ goals.
Get in touch today for a fast-track solution to your clients’ outdated trusts and obsolete plans.
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