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Advanced Planning

CHARITABLE REMAINDER TRUST

A Charitable Remainder Trust (CRT) can let you sell highly appreciated assets without having to pay any capital gains tax, provide you with a higher lifetime income than you otherwise would have and help you avoid estate tax after your death. The CRT works as follows: You transfer highly appreciated assets into an irrevocable trust, thus removing the assets from your estate. At the time of transfer, you would be allowed to take a charitable deduction, which reduces your income taxes. The trustee of the CRT later sells the assets, but avoids a capital gains tax because the CRT is exempt from capital gains tax. The proceeds from the sale of the assets are reinvested by the trustee to provide a lifetime income for your benefit. At your death, the assets are transferred to the charity that you designate in your trust. You get the benefit of receiving a higher income during your lifetime as a result of investing assets not reduced by a capital gains tax. You also avoid estate taxes since assets are transferred out of your estate.

The income earned by the CRT can be distributed in the form of a percentage (called a Charitable Unitrust) or in the form of a fixed income stream (called a Charitable Annuity Trust). The income can be postponed until a future date to allow the assets in the trust to grow. The income can be paid either to you and your spouse during your lifetimes or to your children during their lifetime. However, income paid to children will be subject to estate and gift tax restrictions (i.e. income taxed to the extent it exceeds the lifetime or annual exemptions). Alternatively, the income can be paid for a fixed period (i.e. 10 years). Distribution of income can also be delayed in order to allow growth of the trust assets.

You can act as the trustee of the trust or you can choose a corporate trustee (i.e. a bank or trust company).

Although the trustee retains control of the assets during your lifetime, you can retain the right to replace the trustee as you see fit. The trustee is required to manage the assets according to the terms of the trust, which are determined by you. You can change the charity at any time without suffering adverse tax consequences.

Another estate planning strategy that works well is to combine a CRT with an irrevocable life insurance trust (ILIT DISCUSSED BELOW) to provide for your children. With a CRT, a significant portion of a couple’s estate may have been transferred to charity, at the expense of the children. With proper planning, the couple can use the income tax savings from the charitable deduction and estate tax savings with the increased lifetime income from the CRT to purchase a life insurance policy through an ILIT (See Article on ILIT). The children can be named the beneficiaries of the ILIT. If enough insurance is purchased, the proceeds from the life insurance can make up the difference that the children would otherwise receive from the assets transferred to the CRT, but at substantial estate tax savings. As a result of planning with a CRT and ILIT, the couple will have been able to convert highly appreciated assets into a lifetime income without paying capital gains tax. The assets would no longer exist in the couple’s estate, thus eliminating or minimizing estate taxes at death. The couple receives a charitable income tax deduction in the year the asset is transferred to the trust, reducing income taxes. The ILIT replaces the full value of the assets for the benefit of the couple’s children. The life insurance proceeds are free from income and estate taxes, and probate. Finally, the couple will have made a substantial gift to their favorite charity.

THE IRREVOCABLE LIFE INSURANCE TRUST

An irrevocable life insurance trust allows you to reduce or eliminate estate taxes so that you can pass more of your estate to loved ones. For a single individual whose net estate, including life insurance, exceeds the estate tax exemption ($1,000,000 for MA and $5,340,000 for Fed) and a married couple whose net estate exceeds both spouse’s exemptions ($2,000,000 for MA and $10,680,000 for Fed), an irrevocable life insurance trust should be considered. For a single person's estate valued at $1,500,000 (of which $500,000 is life insurance) if the life insurance is owned by the deceased person, it would be included in the their estate and would be subject to estate taxes.  In 2014, the MA estate taxes would be approximately $60,000. If instead the single person utilized an irrevocable life insurance trust to own the policy, the life insurance proceeds would be removed from the deceased person's estate and avoid estate taxes. Very simply, an irrevocable life insurance trust owns a person’s insurance policy for him or her. As a result, the policy will not be included in the person’s taxable estate at death. This means the estate will pay less in estate taxes, and family will benefit from wealth preservation.

If a couple’s estate is much larger than the foregoing example, they can purchase additional life insurance to reduce estate taxes. The benefits of additional life insurance include the exclusion of the policies from the deceased person’s estate at death, the availability of proceeds immediately after death, and the avoidance of having to liquidate assets to pay estate taxes (estate taxes are due 9 months after the date of death and must be paid in cash). Additionally, life insurance is inexpensive relative to the cost of having to pay estate taxes.

The irrevocable life insurance trust works as follows:

You set up an irrevocable life insurance trust and name a trustee other than yourself (i.e., bank, corporate trustee, adult children). The trustee purchases a life insurance policy in the name of the trust with you as the named insured. You name your revocable living trust as the beneficiary of the policy. When you pass on, the life insurance proceeds are paid to the trustee, who then uses it to pay estate taxes and/or other expenses (including debts, legal fees, probate costs, and income taxes that may be due on IRAs and other retirement benefits). The proceeds are then distributed by the trustee to the beneficiaries named in your trust. As mentioned, the proceeds will not be included in your estate when calculating estate taxes that may become due because the policy is owned by the trust and not by you. The irrevocable life insurance trust gives you control over how the proceeds are to be used since the trustee that you name will distribute the proceeds according to the instructions set forth by you in the irrevocable life insurance trust.

You may be asking whether the same objective can be accomplished by naming a child or spouse as the owner of the policy. You can. However, the problem with doing so is that your spouse or child will have control over how the life insurance proceeds are spent. With a revocable living trust, you determine how the proceeds are spent. For example, you could instruct the trustee to keep the proceeds in the trust while making periodic distributions to your spouse or child during their lifetimes.

You will also note that the above example recommends that your revocable living trust be named as the beneficiary of life insurance policy. There is good reason for this. If you name a child or spouse as the beneficiary and either your child or spouse predecease you, the insurance proceeds would be payable to either your child’s or spouse’s estate, which would be subject to probate before distribution could occur. In such instance, you would also lose control over how the proceeds are to be spent.

The trustee of the irrevocable life insurance trust must be careful when purchasing the insurance policy so as not to incur a gift tax. Making use of the annual gift tax exemption of $14,000 (2014) ($28,000 for a married couple) to one or more beneficiaries of the irrevocable trust can accomplish this. How it works is you pay to the trustee for the benefit of each beneficiary of the trust up to $13,000 ($26,000 for married couples). The trustee advises the beneficiaries (your children) in writing that you (and your spouse) have made a gift to them. This written letter is known as a “crummy” letter. Legally, the beneficiaries can withdraw their share and use the funds for whatever they desire. However, it is in their best interest not to do so. The trustee then reinvests the gifted funds to pay for the insurance premiums.

You can also transfer existing life insurance policies into an irrevocable life insurance trust, but if you die within three years of the date of the transfer, the life insurance proceeds will be taxed as part of your estate. The transfer may also subject you to a gift tax since the beneficiaries of the trust would be receiving policies with a value in excess of the annual gift tax exemption.
FAMILY LIMITED PARTNERSHIPS

The Family Limited Partnership (FLP), when used properly, can be an extremely valuable tool for preserving wealth, protecting assets from frivolous lawsuits and creditors claims and allowing married couples to maintain control over their estate while reducing or eliminating estate taxes. It is especially useful where a family business or real estate is involved.

A married couple sets up a FLP by transferring all of their assets into the FLP in exchange for shares in the FLP. The parents become the general partners, with absolute decision-making authority and control over the assets of the FLP. Each of the children become limited partners in the FLP, having an ownership interest in the assets, but not having any decision-making authority with respect to distribution and control. The parents use their lifetime federal estate and gift tax exemptions ($7,000,000 for a married couple in 2009) to transfer their assets into the FLP. For example, in a $7,800,000 estate, the couple would transfer $7,000,000 into the FLP so that the transfer would be tax-free. They would retain the remaining $800,000 for the time being. Assuming they have four children, each child would be given an interest as a limited partner. In our example, each child’s interest in the FLP would be $1,750,000. Since the couple used their $7,000,000 lifetime exemption to make the transfer, there would be no gift or estate tax on the transferred interests. The couple would then use their annual gift tax exemption to transfer $28,000 ($14,000 each for husband and wife in 2014) per year to each child tax-free. Since there are four children, the couple would be able to reduce their estate by $104,000 per year. In about eight years, the couple would be able to transfer their entire estate tax-free to their children. The couple, as general partners, would have to retain 1% of the assets if they want to retain control of the FLP. When the couple passes on, their estate has effectively been transferred to their children tax-free.

The FLP allows the couple to retain absolute control. They determine how the assets are managed, when income is to be distributed and how the partnership is run. The children have no say in how the FLP is managed since they are limited partners. Losses and profits are allocated among the partners, but no income is distributed unless the general partners decide to do so. The general partners may also execute a written agreement that restricts sale or transfer of the shares without their approval.

When the assets are transferred to the children, the limited partnership shares are highly discounted, since they are minority shares without a ready market. As a result, the value of the estate and, thus, estate taxes are further reduced.

Finally, the assets are protected from creditors. A judgment creditor does not have any rights in the partnership assets since the assets are owned by the FLP. A creditor can only make a claim against distributed income. However, there is no requirement for a limited partnership to ever distribute income. The general partners (parents) have the absolute discretion to determine when and if income is to be distributed. A judgment creditor has no more rights than a limited partner. However, if such creditor seeks to collect on a judgment and is given a charging order against the FLP, he or she is required to pay income taxes on their proportionate share of the income even though no distribution has occurred. It is obvious that this discourages creditors from waiting until the general partners pay a distribution. As a result, lawsuits are often settled for much less than their judgment amount.

QUALIFIED PERSONAL RESIDENCE TRUST

The Qualified Personal Residence Trust ("QPRT") is special kind of irrevocable Trust which can be used to transfer a person's residence to his children (or any other beneficiaries) at a significantly reduced gift tax cost and with no estate tax, yet allow him to continue to live in the residence for as long as he wishes. Here's how the QPRT works. Assume both Dad and Mom are alive.

During Mom and Dad's lifetime, they transfer their residence to the Trustee of the QPRT. They can be the Trustees of the QPRT. They will be allowed to continue to use the residence rent-free for a fixed number of years specified in the Trust instrument (the "fixed term"), which should be a term they are likely to survive. During the fixed term, they will continue to pay mortgage expenses, real estate taxes, insurance, and expenses for maintenance and repairs, and will continue to deduct mortgage interest and real estate taxes on their individual income tax return. When the fixed term ends, the residence will be distributed to their children, or will remain in further trust for them.

Even after the fixed term ends, they can continue to use the residence in one of two ways. First, the residence can be retained in trust for their lifetime, thus assuring that the entire residence is available to them, before it will be distributed to the children. Second, they can enter into a lease with their children which will allow them to live in the residence for as long as they wish. If they do this, however, they must pay fair market value rent to their children after the fixed term ends in order to keep the residence from being subject to estate tax on their deaths. Although their transfer of the residence to the QPRT is a taxable gift, they are allowed to subtract, from the fair market value of the residence, the value of their right to live rent-free in the residence for the fixed term. Thus, the amount of the taxable gift will usually be substantially less than the fair market value of the residence. If the amount of the gift is less than their available applicable exclusion amount from the federal gift and estate tax ($10,680,000 in 2014 and beyond), no gift tax will be due as a result of his gift to the QPRT.

If they survive the fixed term of the QPRT, the value of the residence will not be included in their estate for estate tax purposes. Even if they do not survive the fixed term, the estate tax consequences will be no worse than they would have been if they had not created the QPRT in the first place. In other words, from an estate tax point of view, there's no potential downside to a QPRT. A QPRT is an extremely effective way to remove a residence's value from one's estate at a greatly reduced gift tax cost.

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