The Differences Between Revocable and Irrevocable Trusts

(Can You Trust Your Kids With $5.34 Million Dollars?)

 

Prepared by:

 ToddE. Lutsky, Esq., LL.M.

 March, 2014

 Cushing & Dolan, P.C.

Attorneys at Law

 375 Totten Pond Road, Suite 200

Waltham, MA 02451

Tel: 617-523-1555

Fax: 617-523-5653

www.cushingdolan.com

tlutsky@cushingdolan.com

Introduction: 

While we now have a federal estate tax exemption of $5,340,000 and it is indexed for inflation many people think it is time to celebrate but not all as now the bigger question is can the children handle that type of an inheritance? Families must now consider the best way to have children receive the inheritance which is generally not all at one time. The concern is that the children continue to work and be productive members of the society and understand the value of a dollar. Other concerns are protecting these assets from future creditors of the children the most important on many times is divorce. Revocable trusts and irrevocable trusts can both be designed in a way that can accomplish these objectives. While saving taxes is still very important, especially if you live in a state that has an estate tax, remember there is always a family behind every estate plan and how they get your assets maybe more as important if not more important that the taxes you save.

These new tax laws will also allow more people to consider estate and asset protection planning at the same time than could do this in the past. Federal estate tax laws and Medicaid laws do not always mix well together. For example, if your estate was over the 2,000,000 dollar mark then it became more difficult to do both estate and nursing home protection at the same time because of the Medicaid rules conflicting with the federal estate planning rules. However, now with the estate federal estate tax exemption increased to $5,340,000 per person and indexed for inflation, federal estate taxation becomes less important for many people. This allows folks with assets as high as $4-5 million to focus more on the nursing home planning without the worry of conflicting with federal estate tax laws. Now more folks can do both nursing home protection planning while still reducing their state estate tax liability. The bottom line is that now more estate and asset protection planning can be accomplished with less complication and perhaps at a lower cost.

Many people still view estate planning as a mystery and can be overwhelmed with the terminology or simply do not know where to begin and put off the entire planning process. However, estate planning does not need to be so mysterious, and, when broken down into components, may serve as a road map to help people begin the process. These basic estate planning components generally include: avoiding the cost associated with the probate process, reducing and possibly eliminating federal and state estate tax liability, insuring a bloodline distribution of assets to the family members which may include protection from future divorces and creditors of the children, protecting assets from the cost of long-term care and all the while maintaining as much control over your assets as possible during your lives. These estate and asset protection planning objectives may not be the same for everyone and will vary based primarily on the value of an individual’s estate and his/her age. For example, generally the younger a person is, the less likely nursing home protection planning would be a part of his/her current estate plan but just because you are young does not mean you should not do estate planning. Remember, if you have minor children and pass away the children cannot own real estate or really any other asset in their name, however the trust can own such assets for their benefit. Therefore, planning for young couples with minor children is also very important and not just for estate tax reasons.

Valuation

The first step of the estate or asset protection planning process is to determine the value of the assets that make up your estate. The assets that make up your estate should be valued at fair market value as of the date of death and include, but are not limited to, all of your real estate, all retirement accounts including IRA’s, Roth IRA’s, and 401K accounts, investment or brokerage accounts, all bank accounts, annuities, the value of your business if any and most importantly the value of the death benefit on any life insurance policies. Once this valuation is complete, you may then use this information to determine whether one or two trusts are needed, assuming a married couple, and whether an irrevocable or revocable trust is right for you. In this regard, although there is no hard and fast rule, under today’s new estate tax rules if your estate is valued at say, $5 million or more, then your focus maybe more on estate planning and the use of two revocable trusts, again assuming a married couple, in terms of reducing your estate tax exposure, while potentially looking at long term care insurance as a means of protecting your assets from the cost of long term care. Furthermore, if your estate is this large you can also use the insurance to simply help you self insure for Medicaid expenses as the assets maybe invested to generate income needed to pay the nursing home without the need to touch principal. Also, under these new tax rules if you have an estate under $10 million dollars and or one of the assets is a large IRA then you may want to consider using a joint revocable trust so as to take better advantage of the income and estate tax components associated with IRA type assets. A complete discussion of joint trusts is beyond the scope of this article. Joint trusts may also help to reduce the costs of estate planning, for establishing one trust is less costly than establishing two.

If the value of your estate is $4-5 million or less but more than $1 million, and you are 60 years of age or older, then you may wish to pursue a combination of estate and asset protection planning through the implementation of two irrevocable Medicaid income only trusts. Remember, if your estate exceeds even the $1 million Massachusetts exemption, you still need to be concerned about state estate taxes, as everyone dies but not everyone goes to the nursing home. For example the taxes in Massachusetts on an estate worth $1,100,000 is approximately $33,000, why pay taxes if you do not have to. A married couple can shelter up to $2,000,000 in assets from Massachusetts estate taxes through the implementation of these irrevocable or revocable trusts.

Finally, if you are over 60 years of age and your estate is valued at less than $1 million, which is below the current $5,340,000 federal and the current $1 million Massachusetts estate tax exemptions, your focus may primarily be on asset protection planning and the implantation of only one irrevocable trust. The important thing to remember with estates this size is not to make the mistake of thinking that you are not worth enough to do estate planning as nothing could be further from the truth.

Hypothetical Fact Pattern

John and Jane are married and own a home worth approximately $1 million, a vacation home worth approximately $500,000, IRA accounts worth approximately $500,000 and miscellaneous investment accounts worth in total approximately $3 million. Assume that they own all of their assets jointly except for the IRA accounts, which are owned in their respective names. They have three children, three grandchildren, and are both 55 years of age. Many families in this situation have similar objectives, such as avoiding the costs associated with the probate process, reducing and possibly eliminating estate taxes, not giving up control over their assets during their lives, and ensuring the proper blood line disposition of their assets following their deaths as well as protecting these assets from future creditors of the children including divorces.   Asset protection planning for a couple like this may not be a top priority but may be pursued through the use of long term care insurance and proper investing of their assets to generate income to pay for the nursing home, but this is not to say that irrevocable trusts are not an option.

With the passage of the American Taxpayer Relief Act of 2012 there finally seems to be some certainty in the estate planning world. This act has set the federal exemption amount at $5,340,000 indexed for inflation and has made this permanent. Remember however that the Massachusetts exemption amount remains at $1,000,000. This new law will hopefully enable folks to be able to make better estate planning decisions and stop procrastinating as procrastination planning can only benefit the government.

The balance of this article will explore and compare the use of Revocable Trusts vs. Irrevocable Trusts in the estate planning and asset protection planning world. Sometimes simply understanding whether you need a revocable or an irrevocable trust might be all you need to begin the estate and or asset protection planning process.

 

REVOCABLE TRUSTS

Assume John and Jane are not interested in nursing home planning. Their focus will be on estate planning and the use of revocable trusts to accomplish these goals. As mentioned above, John and Jane will establish two revocable trusts as part of their estate plan. While this article discusses the use of two trusts under the new tax rules this couple may want to consider the use of a single Joint Revocable trust.  A revocable trust, sometimes called a living trust or loving trust, is an instrument that John and Jane will establish during their lives into which they will transfer their property prior to death. This is often times referred to as funding the trusts. Please do not make the common mistake of not funding the trusts once it is created. Funding a trust simply means that you re-title your assets to the name of the trust.   For example they would simply change the name on bank and investment accounts so that the statements they receive in the future will show their names as trustee of their trust instead of their names individually. With regard to IRA type accounts it is suggested to make the primary designated beneficiary the spouse but the contingent beneficiary that person’s trust which will provided estate and income tax planning options as of the date of the death of the IRA owner. IRA assets cannot be titled to trusts while the participant is living without causing an adverse income tax consequence. Finally, do not forget about real estate as this can simply be deeded directly into their respective trusts without any tax consequences.

Therefore, Jane will put some assets into her trust and John will put some assets into his trust. It is important to try and balance the assets between the two trusts to more fully utilize the estate tax exemption amounts mentioned above and that will be discussed below in more detail. They each will use their respective social security numbers to establish any such bank or investment accounts inside the trusts. The transfers to these trusts of any such accounts are also non-taxable events. In the event they do not fund the trusts, then upon their death, any assets owned in their own name would go through the probate process while any assets owned by the trust would avoid probate regardless of the amount.   At death, the assets in trust are distributed and/or held in a continuing trust according to their wishes and will accomplish the all important bloodline planning component of the estate plan.

 

THE GENERAL PURPOSE AND USE OF REVOCABLE TRUSTS

The general purpose and use of these family revocable trusts are to help an individual avoid the costs associated with the probate process, reduce and in many cases eliminate federal and state estate taxes as well as ensure the proper disposition and control of their assets to their family members following their death. The donor of the trust is generally the individual who creates the trust. The trustee of the trust is the individual who would control the operations of the trust and the assets transferred to it. For example, in a husband and wife situation and assuming the use of 2 trusts, the husband would be the donor or creator of his trust while the wife would be the donor or creator of her trust and both of them would serve as co-trustees on each of their trusts. Since these trusts are revocable and the husband and wife are the trustees, there is absolutely no loss of control over the assets transferred to the trust during the donor’s life.

In this regard, the trustee of the trust can manage and invest the trust assets in any way they wish. In other words, there is no investment limitations associated with having assets owned inside the trust. Furthermore, the trustees of the trust can sell trust assets including real estate without any increased complexity versus owning them in their own name. The trustee is also free to spend or save the money inside the trust anytime or anyway the trustee wishes. In essence, there is no operational downside to having a revocable trust and placing your assets in them. However, it is important to note that generally assets owned inside a revocable trust do not provide any protection from creditors, nor do they offer any protection from the costs associated with long-term care. In addition, if you are single and using just a revocable trust by itself with no more sophisticated estate planning it will not reduce your estate taxes. There are however other trusts that are specifically designed for creditor protection planning but are beyond the scope of this article. However, we will be addressing trusts that provide protection from the nursing home.

Planning pointer: How to Leave Assets to Children

Since the passage of the new tax laws many folks are now considering the use of trusts not only to reduce the probate costs and reduce state estate taxes but with more assets getting to the next generation they are concerned about how and when the kids get such assets. If children get large sums of money all at once it can cause them to be less productive, wasteful and or simply cause more harm than good. These trusts can be designed in any number of ways to ensure the children do not get them till you feel they are ready to handle the assets.

One example would be to set out ages when they can get assets and generally stagger the ages say they can have one third at age 30, one third at age 35 and the final portion at age 40. The trust would generally allow the trustee prior to distribute assets to the children prior to them reaching these ages for such thins as their health education welfare and support. Also a good idea to provide that if a child died prior to reaching these ages but after the parent then that child’s assets would go to that child’s children your grandchildren rather than to that child’s spouse. This helps to keep the assets in the blood line and prevents the surviving spouse from remarrying and spending your assets on someone else’s family. You can use any age that works for your family and some folks even hold assets in trust till the kids reach retirement age in case they cannot plan for their own retirement.

Another example might be used to protect assets from creditors including future divorces while also taking advantage of generation tax skipping rules. The trust might state that the assets are to be divided into equal shares for each child but then held in trust for their lives with income and principal being paid out to such child in the trustee’s sole discretion. Generally you can have the children serve as trustee but that child cannot exercise discretion over his own share and pay out income or principal to himself, for this he would need one of his sibling’s trustees to do that. This way they can get the money when they need it but if there is a divorce down the road and the other side wants half of the assets in that child’s share they would not be available unless the sibling trustee wanted to make a distribution. The sibling trustee in all likely hood will say I do not wish to make a distribution and because the trust is a third party trust with sole discretion given to the trustee these assets are not available for this divorce creditor or any other creditor. Finally, if the children never actually use up all the trust assets during life then at the child’s death they will pass to that child’s children and avoid estate taxation in that child’s estate thus successfully skipping a generation for tax purposes.

Finally, folks can set up trusts with incentive language so that children have to work to get some of their assets and these are called incentive trusts. Some folks set up trusts to protect against drug addictions and or simply because they know that their children cannot handle money very well. There are also the ability to make gifts to irrevocable trusts for the benefit of the spouse and the children to get assets out of the estate but keep control over them until the surviving spouse dies and beyond. There are an endless number of ways to design the trust to protect assets for the family which again is becoming more important now as there are more assets getting to the children since the estate tax exemptions are so high. Please do not just let the kids have the assets think about how you would like them to get it and when.

 

INCOME AND ESTATE TAX ISSUES WITH REVOCABLE TRUSTS

Insofar as income tax consequences are concerned, John and Jane will continue to pay the income taxes associated with any such trust income at their lower individual rates. These trusts are grantor trusts, and since the donor and the trustee are the same person, no separate fiduciary income tax returns, forms 1041, will be required to be filed. They will continue to receive their income tax reporting information in their own social security numbers as mentioned above, and may simply report the information on their individual tax return, form 1040. Many people believe that with trusts automatically come higher tax bills, but that simply is not always true. It depends on the type of trust involved. Generally, a grantor trust, whether revocable or irrevocable, will cause the trust’s income to be taxed at the individual donor’s tax rate. A complete discussion on taxation of trust income is beyond the scope of this article.

It is important for John and Jane to have two trusts in order for them to more fully take advantage of both their current $5,340,000 federal and $1 million Massachusetts exemption amounts. An exemption amount is the amount of assets an individual can leave to someone other than a spouse without paying any estate taxes. However, keep in mind that one must plan for the future as the federal exemption can change over time but most importantly one should always be ready for their assets to grow over time. In addition, remember the Massachusetts exemption is stuck at $1 million and has been since 2006, so you need to plan to avoid the state estate taxes at a minimum, and in turn you can prepare for any future federal estate tax changes at the same time. In this regard it is always best to leave the surviving spouses estate as low as possible so as to protect against any future estate tax law changes.

It is important to plan prior to the death of the first spouse, because any plan that shifts all the assets to the surviving spouse will result in the loss of one Massachusetts exemption, and the loss of the ability to shelter from future federal estate tax on all the growth of the assets equal to the federal exemption on the date of death of the first spouse to die.  This is what generally happens when people have simple wills or own everything jointly. The federal exemption is currently portable, which means the surviving spouse can use the unused exemption amount of the latest deceased spouse. However, do not fall into the trap of relying on this portability of exemption as it is not indexed for inflation, nor is it not automatic. In order to get portability it requires the spouse to file an estate tax return and make an election in order to get it. It also requires the estate of the first spouse to die to remain open until 9 months following the death of the first spouse to die and subject to audit. Also remember portability does not apply to Massachusetts estate tax exemption so planning is sill very important. Finally and most importantly is that portability doesn’t allow you to shelter assets from future growth following the death of the first spouse to die and prior to the death of the surviving spouse along with a host of other complications. Please do not think that planning is not important just because of this portability of federal exemption.

In our example, prior to planning, John and Jane were set up to leave all assets to each other, which is the government’s trap for the unwary. The government allows for something called the unlimited marital deduction which means you can leave as much as you want to your spouse without paying any estate taxes on the first death.   This format allows the government to collect more in taxes upon the death of the surviving spouse than would otherwise be the case if some advanced planning had been done. In other words, don’t let the government do your estate planning. Essentially, you must use your exemption while living through the use of gifts, or upon your death, as the government does not allow the surviving spouse, with the exception mentioned above, to use any unused exemption equivalent amount remaining after the death of the first spouse. Even with regard to federal estate taxes, the goal should be to use as much of the current $5,340,000 exemption as possible on the first death by sheltering the assets in a revocable trust for the benefit of the surviving spouse so as to allow those assets to grow estate tax free which will certainly reduce the potential estate tax liability for the surviving spouse and even further reduce the risk of any estate taxes in light of any unknown future estate tax law changes.

In order to take advantage of these exemption amounts, the trusts are designed with separate shares built in. These revocable trusts for Massachusetts residents are designed in such a way that upon the death of the first spouse, the trust will break down into three trusts; a general marital share, a special marital share, and a remainder or by pass share. Depending on where you reside, there may or may not be this extra share called the special marital share which would be designed to help reduce any state estate taxes that may be imposed upon the first spouse’s death.   The surviving spouse, as trustee, would be directed to allocate to the general marital share the exact amount of assets necessary to eliminate federal estate taxes. The trustee would also be directed to allocate the special marital share; in the case of a Massachusetts resident, the exact amount of assets needed to eliminate Massachusetts estate taxes. These amounts will depend upon the size of the decedent’s estate and the exemption equivalent amount in effect for the year of death. This formula will allow you to take advantage of whatever the exemption amount is in effect on the date of your death.

These three shares would be administered separately upon the death of the first spouse. The general marital share will provide that all income must be paid to the surviving spouse during life. Additionally, the surviving spouse, as trustee, would be permitted to withdraw principal upon request. The surviving spouse also will be permitted to direct the final disposition of the marital assets upon his or her death. Essentially these assets are left to the surviving spouse free and clear (although technically in trust). Any assets in the marital share will ultimately be taxes in the surviving spouse’s estate, but would escape taxation on the first spouse’s death. If John died first and his trust had one half of the family assets (i.e. $2.5 million) then his marital share would not have any assets in it, as all the trust assets would have funded the special marital and the remainder or by pass share with amounts that would be determined based on the federal and state exemptions in effect on the date of death. The assets of the remainder share would be subject to federal and state estate tax on John’s death, but no federal tax would be due as John would simply utilize a portion of his current $5,340,000 exemption amount upon his death while the assets of the special marital share will only be taxed at the federal level as this share, coupled with the remainder share, will be equal to or less than the federal exemption amount, thus resulting in no federal estate tax due. Remember, the assets of the remainder share alone will never exceed the Massachusetts exemption amount, resulting in no tax due at the state level on the first spouse’s death either. The assets of the special martial share will not be taxed at the state level on the death of the first spouse as a qualified terminable interest property tax election (i.e. QTIP election) will be made at the state level allowing these assets to pass under the unlimited marital deduction to be taxed when the surviving spouse dies.

The remainder and special marital share will also provide that all income must be paid to the surviving spouse for life. Remember, the surviving spouse is the trustee, so a great deal of control is being maintained by the surviving spouse. Additionally, the surviving spouse will be permitted to withdraw principal to the extent necessary to maintain his or her health and support in the standard of living to which they were accustomed as of the date of the death of the first spouse. This small restriction is what enables John and Jane to more fully utilize both their current federal $5,340,000 and Massachusetts $1 million exemption amounts, thereby allowing them to transfer currently $10,680,000 of assets to their family federal estate tax free and $2 million Massachusetts estate tax free. In addition, all the assets of the special marital share and remainder share will grow federal estate tax-free, as such assets will not be included in the surviving spouse’s federal estate regardless of how much they grow between the date of the death of the first spouse and the date of the second spouse’s death. This ability to shelter the growth on assets at the death of the first spouse is the prime reason one should not rely on portability. Note the assets of the special marital share will be subject to Massachusetts estate taxes upon the death of the surviving spouse.

 

REDUCING ESTATE TAXES

Let’s explore how revocable trusts will actually serve to reduce the estate tax exposure for John and Jane. The first step of the estate planning process is for John and Jane to identify and value all assets which would be includible in their estate upon their deaths. As mentioned above, these assets include their cash, marketable securities, residence, vacation home, receivables, any ownership of businesses, qualified plan benefits, IRAs, face amounts of life insurance and any property over which they have a general power of appointment. These assets are valued at the fair market value on the date of their death. What they paid for these assets is irrelevant. Life insurance can be a tricky asset, as many people may have been told that it is tax free. However, life insurance is only income tax-free to the beneficiary. Should if you die owning it in your own name, it is very much estate taxable at its death benefit value and is sometimes that asset that makes the estate taxable when it might have not otherwise been.

Once the value of their assets is determined, the government allows certain deductions and exemptions. The most important deduction, as mentioned above, is the so-called marital deduction. Under existing federal and some state regulations (i.e., Massachusetts), there is an unlimited marital deduction. This means that neither the federal government nor the particular state will impose an estate tax on the death of the first spouse if all assets are left directly to the surviving spouse. Therefore, it sounds like John could die and leave everything to Jane without paying any taxes.

This sounds simple enough, but this kind of erroneous planning will cost the family plenty since estate planning is all about saving estate taxes on the second death. This is because each spouse who dies has the ability to shelter currently $5,340,000 from federal estate taxes and $1,000,000 from Massachusetts estate taxes, but, as mentioned above, the state does not allow the surviving spouse to utilize any exemption which was unused by the first spouse to die, while the federal government allows portability we have learned that this is not always the best thing to rely on when doing estate planning for all the reasons mentioned above.

Consider John and Jane, who together own approximately $5 million of various assets. Each spouse has a simple will which leaves all individually owned assets to the surviving spouse. Any assets which do not pass according to the terms of the will pass to the surviving spouse because of the joint form of ownership and beneficiary designations. Upon the death of John in say, 2010, survived by Jane, no federal estate tax, and in certain states (i.e., Massachusetts) no state estate tax is due because of the unlimited marital deduction.

The tax computation would be as follows:

Gross Estate                                          $2,500,000

Marital Deduction                              $2,500,000

Taxable Estate                                      $0    

Federal Estate Tax                              $0

Massachusetts Estate Tax                $0

Upon Jane’s death, who owned all the estate assets at that time, a substantial Massachusetts estate tax will be due and payable for remember when you go over the exemption in Massachusetts you pay tax on the full amount of the estate and not just the amount over the exemption.

The computation upon Jane’s death as the surviving spouse will be as follows:

                                                                                          Federal                                                              Massachusetts

Gross Estate                                                            $5,000,000                                                            $5,000,000

Marital Deduction                                                $0                                                                               $0

Exemption                                                               $5,000,000                                                            $1,000,000

Taxable Estate                                                        $0                                                                               $5,000,000

Approx. Federal Tax                                            $0                                 Approx. Mass. Tax        $   391,600      

In the event Jane dies after January 1, 2014 under these new tax rules and no planning had been done the federal estate tax picture would still not be horrible. However, federal estate tax planning is still worth keeping an eye on for even with portability in play if Jane did not file an estate tax return and elect portability and her estate were to grow over the next several years prior to her death to say 7.000,000 dollars then there would be a substantial federal estate tax as well as a Massachusetts estate tax. This is why sheltering assets on the first death via planning is generally a better option plus you still need to plan for state estate taxes anyway. Also remember tax laws can always change and having as small an estate as possible for the surviving spouse is generally a good ideal.

Example Assuming no growth on the assets left to Jane upon Jane’s death:

The computation will be as follows:

                                                                                          Federal                                                             Massachusetts

Gross Estate                                                            $5,000,000                                                            $5,000,000

Marital Deduction                                                $0                                                                               $0

Exemption                                                               $5,340,000                                                             $1,000,000*

Taxable Estate                                                        $0                                                                               $5,000,000

Approx. Federal Tax                                            $0                                 Approx. Mass Tax          $   391,600

*NOTE:   In Massachusetts when you exceed the exemption the whole estate is taxed

Example Assuming Jane lives ten years following the death of John and Jane did not file the estate tax return electing portability of exemptions and all the assets left to Jane have grown to $7,000,000 and there was no change to the estate tax exemptions. The computation will be as follows:

                                                                                          Federal                                                             Massachusetts

Gross Estate                                                            $7,000,000                                                            $7,000,000

Marital Deduction                                                $0                                                                               $0

Exemption                                                               $5,340,000                                                            $1,000,000*

Taxable Estate                                                        $1,660,000                                                            $7,000,000

Approx. Federal Tax                                            $   664,000               Approx. Mass Tax          $   638,000

   *NOTE:   In Massachusetts when you exceed the exemption the whole estate is taxed

This so-called second-to-die tax can be minimized, if not “eliminated,” in most cases, as discussed above, with properly drafted wills and trusts. Do not let appreciation on your assets hurt you do your planning before the death of the first spouse.

It is imperative for the first spouse to die to utilize his or her current $5,340,000 federal exemption available on the date of death and the $1 million Massachusetts exemption. This can only be accomplished by passing the first such exemption amounts of that person’s estate to someone other than the surviving spouse. However, since disinheriting the surviving spouse is usually inconsistent with one’s desire to provide for the surviving spouse, this amount is generally placed in a special trust called a by-pass trust, credit shelter trust, or remainder trust, and a special marital share as mentioned above. The trust is set up so that the surviving spouse has access to the money, if needed, but the funds will not be includible in the surviving spouse’s estate as mentioned above. In the event John died prior to January 2014 and Jane died after January 1, 2014, and trust planning had been done which allowed the special martial and the by pass shares in the revocable trusts to use $2.5 million of John’s federal and $1 million of his Massachusetts estate tax exemption thereby leaving only $2.5 million available to be federally taxed and $4 million to be taxed by Massachusetts on the death of Jane, the tax picture would look different as shown below.

Upon the death of Jane, say later in January 2014 following the death of John assuming trust planning mentioned above had been done leaving Jane with a total federal estate of the other have of the assets $2,500,000 and a $4,000,000 Massachusetts estate and further assuming the estate did not grow in value following John’s death, the computation will be as follows:

                                                                                          Federal                                                                       Massachusetts

Gross Estate                                                            $2,500,000                                                            $4,000,000

Marital Deduction                                                $0                                                                               $0

Exemption                                                               $5,340,000                                                             $ 1,000,000*

Taxable Estate                                                        $0                                                                               $ 4,000,000

Approx. Federal Tax                                             $0                                 Approx. Mass. Tax        $   280,400

Planning Note: Even if no other planning was done this represents a Massachusetts tax savings for the family of approximately $111,200. However, with the Jane’s estate lowered to$ 2,500,000 there is plenty of room for it to grow without the worry of exceeding the federal estate tax exemption, and less concern about a future reduction in the federal estate exemption resulting in estate tax since the taxable estate has been reduced in size through the advanced planning. Also in the event portability was not elected on the John’s death there would still be less of a chance of federal estate taxes being due in the future as a result of Jane’s estate starting out at this lower level. While we may not always know the exact amount of estate tax savings it should be clear that planning will result in a smaller estate tax liability at both the federal and state estate tax levels.   Finally, all the trust assets will have avoided probate as well.

As this example shows, federal estate taxes can be significantly reduced and sometime eliminated with proper estate planning. This works because upon John’s death his $2,500,000 of assets in his trust’s remainder and special marital share combined were subject to federal estate taxes. However, the estate did not actually pay any taxes but instead utilized $2,500,000 of his exemption equivalent amount, thereby leaving only Jane’s $2,500,000 of assets, assuming no growth, to be taxed upon her death. Again having as small an estate for Jane on her death always puts her in a better estate tax planning position going forward. Note that through the use of the special marital share, you can also eliminate Massachusetts estate tax on the first death, and possibly on both deaths depending on the size of your estate as the state exemption amounts may differ from the federal amount. For example, the federal and state estate taxes can be completely eliminated through the use of these trusts for estates worth $2,000,000 or less.

As many people know, the estate tax rates and exemption equivalent amounts have changed over the last several years but with the passage of the American Taxpayer Relief Act of 2012 there maybe finally some certainty in the estate planning world. Here is a look at the past and current estate planning exemptions amounts for both federal and Massachusetts.

The exemption amounts are increasing as follows:

                                                      Federal                                             Massachusetts

Year                              Exemption Equivalent                       Exemption Equivalent

2001                                        $   675,000                                            $   675,000       

2002                                        $1,000,000                                          $   700,000

2003                                        $1,000,000                                          $   700,000

2004                                        $1,500,000                                          $   850,000

2005                                        $1,500,000                                          $   950,000

2006                                        $2,000,000                                         $1,000,000

2007                                        $2,000,000                                          $1,000,000

2008                                        $2,000,000                                         $1,000,000

2009                                        $3,500,000                                         $1,000,000

2010*                                      $5,000,000                                            $1,000,000

2011                                        $5,000,000                                          $1,000,000

2012                                        $5,120,000                                          $1,000,000

2013                                        $5,250,000                                          $1,000,000

2014                                        $5,340,000                                          $1,000,000

*There is also an election that can be made for this year to have no estate tax but a carry- over basis

Through the use of family revocable trusts and proper estate planning, John and Jane can actually create certainty in what appears to be a very uncertain estate planning world. These revocable trusts, as described above, have tax funding formulas that allow John and Jane to take advantage of whatever the federal and/or state exemption equivalent amount is in effect on the date of their death as tax laws or these exemption amounts can always change in the future.

However, do not fall into the trap for the unwary, which is simply to assume that you have no need for any planning since your assets are less than the current exemption amounts. However, you may still want to avoid probate, protect your assets from the children’s future creditors including divorces and perhaps protect your assets from the costs associated with long term care. This type of planning is generally referred to as Medicaid Planning or Asset Protection Planning and will be discussed in detail below.

 

ESTATE AND ASSET PROTECTION PLANNING

 Introduction:

Unlike John and Jane, there are many people who have assets of around $3,000,000 or maybe even less than one million and they still maybe interested in either asset protection planning or estate planning or both. Although the rules for asset protection planning differ from pure estate tax planning, it is possible to provide both estate and asset protection planning for people who have assets that are over the current federal and/or state estate tax exemption amounts. As mentioned above, now that the federal exemptions have increased under the new tax laws it is easier for more folks to do both estate tax planning and nursing home protection planning. For people who have assets less than the federal and state estate tax exemption amounts their focus will be primarily on probate avoidance and asset protection planning and will only need one irrevocable trust. However, as mentioned above, the message is for most people some kind of planning is still needed regardless of how much you may be worth. The balance of this chapter will provide a road map through the asset protection planning world and some Medicaid eligibility issues.

The primary tool for protecting assets from the high costs of nursing home care is an irrevocable Medicaid trust. Most people associate the word irrevocable trust with the relinquishment of control, inflexibility and rigidity. However, this article will explore the use of an irrevocable income only trust and show how such a trust will enable an individual to retain a significant degree of control over their assets during their life, while at the same time provide creditor protection as well as estate and income tax planning opportunities. In addition, these trusts will serve to reduce the risks associated with transferring assets outright to children. Finally, this irrevocable income only trust will help to dispel the common asset protection planning myth that one must gift their assets away and give up complete control over them in order to protect them from both the costs associated with long term care and general creditors. Remember, the assets in these irrevocable trusts will be protected from the costs of long term care after five years from the date they are transferred to the trust not only for the children but more importantly for the healthy spouse.

In this regard, as individuals age they begin to become concerned about the potential costs associated with long term care. Their focus may shift to discovering strategies that will protect their assets from both general creditors and the costs of long term care. These assets often consist of their home, vacation home, rental property and/or liquid investments including life insurance and IRAs. However, many individuals are generally reluctant to transfer such assets directly to their children or other family members for fear of relinquishing total control over them. Often, this fear results in procrastination or inaction, thereby leaving the individuals assets at risk for the costs of nursing home care and potentially subject to estate taxes. Instead, an individual may consider transferring such assets to the irrevocable income only trust mentioned above.

 

GENERAL USE AND OPERATION OF IRREVOCABLE MEDICAID TRUST

Let’s take a typical example. Assume Jeff and Julie, a married couple, living in Massachusetts, who are generally healthy, age 75, have two children, own their own home worth approximately $700,000, other liquid investments worth approximately $1,300,000 and are concerned about avoiding the costs associated with the probate process as well as protecting their assets from both the costs associated with long term care and general creditors as well as reducing and possibly eliminating estate federal and state estate taxes. This type of planning is not limited to folks with 2,000,000 dollars of assets.

The solution may be to divide and transfer all or a portion of these assets to two irrevocable Medicaid trust in much the same fashion as discussed above for the revocable trusts. This funding of the trusts is also important

to help reduce the estate taxes as explained with revocable trusts mentioned above and like with the revocable trusts any such transfers are not gift or income taxable events.   The trusts will provide that both Jeff and Julie will be the donors. They could serve as trustees in Massachusetts but the safer approach would be for a child to serve as trustee while the parents retain the right to remove and replace the trustees anytime and for any reason this way they retain a large degree of control over the trusts. In addition, the trustees will retain the ability to make mandatory distributions of the income from the trust to Jeff and Julie during their lives. Furthermore, they would retain a significant degree of control over the assets transferred to the trust including, but not limited to, the ability to determine how such liquid investments should be invested, the ability to sell any such trust assets, specifically including the home, as well as change the dispositive provisions of the trust via a limited power of appointment. There are no limitations on how the assets in these trusts can be invested.

Finally, distributions of principal can be made to a class of people you choose generally, children of all generations or siblings or nieces and nephews etc who in turn can transfer the assets back to you if needed. In the event they do not cooperate then you can exercise the power to change the beneficiaries and threaten to cut that person out. These powers alone generally provide the individual with a much greater sense of independence and control during their life than would otherwise be the case with outright transfers to the children in which no such controls are in place.

If assets are transferred outright to the children, the parents have no control over how they are invested, no right to the income, no ability to decide if an asset like the home can be sold without getting the permission of the children and will have lost control over the proceeds from the sale, and the assets transferred would be all exposed to the kids creditors such as divorce or financial difficulty. In addition, transfers to the kids also results in adverse income gift and estate tax consequences, plus if the house were sold and the kids owned it they would receive and early inheritance. All of this can be avoided by instead transferring the assets to these irrevocable Medicaid income only trusts.

OPERATION AND CONTROL OF IRREVOCABLE MEDICAID TRUSTS AND THE CORRESPONDING INCOME TAX BENEFITS 

To better understand the control and tax benefits associated with these trusts let’s explore how the home as one common asset might be still used after it transferred to the trust. First and foremost, the parents can live there for as long as they wish and pay the bills and sell without adverse tax consequences or permission from the children. In our case, assuming the parents paid $50,000 and put $150,000 into it in the form of capital improvements so the total basis in the property is $200,000 and sold it for $700,000. If this had been given to kids they would have received all the money from the sale and if they do not live there they would have to pay all the capital gains tax on the 500,000 of gain on the sale which at 23.8% federal and 5% state tax would be $144,000. In addition, in order for the kids to give the proceeds back to the Jeff and Julie as they many need it to buy another home, assuming they will cooperate, they would be limited to giving only $14,000 per year per parent as this is the maximum allowed without incurring a gift tax liability. Any assets the kids keep would at risk to their creditors while the assets that do go back to Jeff and Julie will be at risk for the costs of nursing home once again. However, since the home was transferred to the irrevocable Medicaid trust Jeff and Julie, would not need the permission from the kids to sell and the proceeds would not go to the kids but instead would go to the irrevocable trust in which they can still control and use and benefit form and would remain protected from nursing home costs.

For example, they could decide to invest the proceeds right inside the trust and continue to live off the income or to simply buy another home. If they bought another home the sale and purchase of this other home directly into the irrevocable trust does not reset the five year look back clock for Medicaid eligibility purposes. In addition, there would be no adverse income tax consequences like the ones mentioned when the home was transferred to the kids. In this regard, since the trust is a grantor trust, which means the Jeff and Julie are considered the owners for income tax purposes, they would retain the ability to avail themselves of certain capital gains tax exclusions associated with the sale of their primary residence. Therefore, in the event they chose to sell their home during their life, provided they have owned and used such property as their primary residence for two of the last five years, were married on the date of sale, and the resulting gain did not exceed $500,000, there would be no capital gains tax due. That is a savings of $144,000 by doing this type of planning.

Furthermore, since assets of this trust are not accessible to the creditors of their children during their lives, it eliminates the concern of transferring assets outright to a child who may get a divorce, encounter financial difficulties, or be a gambler, drug addict, alcoholic, or spendthrift. Finally, this type of trust will also provide Jeff and Julie some general creditor protection during their lives. Finally, since all the proceeds went back to the trust they remain protected from the nursing home without resetting the Medicaid clock and the children did not get an early inheritance.

Insofar as annual income tax consequences are concerned, in the event the trust has earned income (i.e., interest, dividends, capital gains or rent), a fiduciary income tax return, Form 1041, may be required to be filed. However, since Jeff and Julie are the grantors and retain the ability to appoint the remainder or principal of the trust to a class consisting of their children of all generations in equal or unequal shares, it makes the trust a grantor trust for income tax purposes. This retained power is generally referred to as a limited or special power of appointment. Since it is a grantor trust, it does not pay any income taxes, but instead flows the income through to the grantors (i.e., Jeff and Julie) to be taxed at their lower individual rates, rather than at the higher, more compressed, trust tax rates. In other words, they will continue to pay the income taxes at their lower individual rates just like they use to prior to establishing this trust. This limited power of appointment also prevents the transfers to this irrevocable trust from being treated as gifts, thereby eliminating the concern of any gift tax due upon the funding of this trust with either a valuable home or investment portfolio.

Remember, if investments are in this trust Jeff and Julie will still not pay any higher income tax on the interest and dividends as a result of this grantor trust status, but will also retain the ability to make investment decisions and get all the income just like they did prior to transferring it to the trust. Even if a rental property were to be placed in this trust Jeff and Julie would still be entitled to the income and pay the same tax rate on such income and could decide when such property might be sold or replaced all while paying the same tax rates as they would have had the property not been transferred to the trust.

In addition, this limited power of appointment allows Jeff and Julie to retain control over the trust assets and provides flexibility during life. For example in the event a child does not do what the parent wants or does not cooperate with the terms of the trust then the parent can cut them out as beneficiaries of the trust. In addition, if later in life the parents decide they would like to leave some more assets to the grandchildren or in differing amounts to the kids as life events may dictate, this power allows them to make such a change.

Upon the demise of the survivor between Jeff and Julie, the assets of the trust will be includible in his or her gross estate and not their probate estate. This distinction is important with regard to the state’s ability to recover any medical expenses spent on their nursing home care. Some states define the recoverable estate to include only probate assets, while other states define the recoverable estate to include the broader definition known as the gross estate. Massachusetts currently defines the recoverable estate to include only those assets in the individual’s probate estate.   The probate estate would include any assets owned by an individual in their own name at the time of their death. Assets owned in this irrevocable income only trust are not considered assets owned in ones’ own name, thus are not includible in the probate estate and would not be subject to Medicaid’s estate recovery provisions in those states that define the recoverable estate to only include the probate assets. Therefore, these trust assets will ultimately be protected for the children.

The estate inclusion also provides a significant income tax benefit known as a step-up in basis for capital gains tax purposes, which is not available for those who gifted appreciated assets like the home, rental property or investment portfolios that have increased in value over the years outright to their children. For example, if Jeff and Julie were to gift their highly appreciated home or stock outright to their children in an effort to protect it from the cost of long term care, the children would receive the parents cost basis in such property, which is known as a carry-over basis. In other words, whatever the parents paid for the particular asset will carry over to the children, which means any capital gain that is built into this property will remain there waiting to be recognized whenever the property is sold.

In our example, if Jeff and Julie transferred their home worth approximately $700,000 outright to their children, and had paid only $200,000 for it, the children would receive their $200,000 cost basis in the property. In the event the children decide to sell the house for $700,000 shortly after the parents died, they would realize and recognize a $500,000 long term capital gain, with a corresponding federal and Massachusetts tax liability of approximately $144,000 assuming a 23.8% federal and a 5% Massachusetts tax rate which reflect the new tax rates following the fiscal cliff..

However, if Jeff and Julie instead transferred these highly appreciated assets to these irrevocable income only trusts, such assets would be includible in their gross estate and would receive a step-up in basis. The step-up in basis is equal to the fair market value of the property on the date of death. In our example, if Jeff and Julie had put their home in this irrevocable income only trust, and the fair market value upon their demise was $700,000, the children would receive the home with a basis equal to this $700,000 value. Therefore, if the children were to sell the home shortly after their demise, there would be little or no capital gains tax to be paid and in addition these assets would have also avoided the estate tax side of the equation.

 

ESTATE TAX BENEFITS OF IRREVOCABLE MEDICAID TRUSTS

With regard to couples who have assets that exceed the federal and state exemption equivalents and are thus concerned about both estate and asset protection planning, these irrevocable income only trusts will still offer a viable solution. In this case the technique would require the implementation of two irrevocable trusts instead of just one. The assets would then be split between the two irrevocable trusts much like the revocable trusts mentioned above. This splitting of the assets between the trusts is what enables the couple to more fully utilize each of their current estate tax exemption equivalent amounts, as the assets in the trust of the first spouse to die

will be taxed in the decedent’s estate but will not be taxed in the surviving spouse’s estate. These irrevocable trusts can make use of the Marital share, and the Remainder or By Pass share in a very similar fashion to how they operated for the revocable trusts mentioned above.

For example, if Jeff and Julie had $2,000,000 of total assets and Jeff died in 2010 without planning thereby leaving all assets to Julie and Julie as the surviving spouse died in 2013 the estate tax calculation be would as follows:

 

                                              Federal Estate tax                                   Massachusetts Estate Tax

Gross Estate                        $2,000,000                                                           $2,000,000

Marital deduction             $0                                                                              $0

Exemption                           $5,250,000                                                            $1,000,000

Taxable Estate                    $0                                                                              $2,000,000

Tax due                                 $0                                                                               $99,600

(Remember once you exceed the MA exemption you pay tax on the whole amount)

For example, Assume the same facts as above except that Julie died in 2014.   There would still be no federal estate tax since we know the federal exemption has been reset to $5,340,000 but this change has no impact on Massachusetts estate tax which still requires estate planning prior to the first spouse to die. The calculation would be as follows:

                                            Federal Estate tax                                       Massachusetts Estate Tax

Gross Estate                        $2,000,000                                                            $2,000,000

Marital deduction             $0                                                                               $0

Exemption                           $5,340,000                                                                $1,000,000

Taxable Estate                    $0                                                                               $2,000,000

Tax due                                 $0                                                                                    $99,600

(Remember once you exceed the MA exemption you pay tax on the whole amount)

This shows how if you ignore planning even with a moderate estate could result in a large estate taxes that really could be completely eliminated if advanced planning had been done.

However, if Jeff and Julie had two irrevocable trusts established and funded with each owning approximately one half of the assets, the estate tax would be currently eliminated as some of the assets would be taxed on the first death and some of the assets would be taxed on the second spouses death. However, in either case the amount of assets subject to tax would have been less than the exemption equivalent amounts, in effect thus no actual tax would be paid and the trusts would have still offered all of the probate and nursing home benefits, mentioned above. Let’s assume the full $1,000,000 of assets were in the first spouse trust and thus sheltered for estate taxes leaving only the remaining $1,000,000 left to be taxed on the surviving spouses death and the surviving spouse dies after January 2014. This means that there would only be Julies’ half of the assets subject to estate taxation.

Assuming planning was done prior to Jeff’s death leaving Julie’s estate valued at only one million because the other million was sheltered from taxes in Jeff’s irrevocable trust and assuming no growth prior to Julie’s death, the calculation of tax due on Julie’s death would be as follows:

                                                            Federal Estate tax                           Massachusetts Estate Tax

Gross estate                                          $1,000,000                                          $1,000,000

Marital deduction                              $0                                                             $0

Exemption                                            $5,340,000                                           $1,000,000

Taxable Estate                                     $0                                                              $0

Tax due                                                   $0                                                              $0

This shows that by planning in advance the estate tax can be eliminated for moderate estates. Plus this plan would also have been avoiding probate and protecting assets from the costs of nursing homes giving the clients the best of both worlds.

In conclusion, this irrevocable income only trust allowed Jeff and Julie to transfer assets to a vehicle that will provide protection from their creditors, their children’s creditors, and the cost of long term care, while at the same time allowing them to retain a significant degree of control over such assets during their lives. In addition, this trust provides some estate and income tax planning benefits. Finally, it is important to remember that after the enactment of the American Taxpayer Relief Act of 2012 many more people can do this type of estate and asset protection planning since the federal exemptions have been increased to 5,340,000 effective January 1, 2014. However, please do not forget about planning for state estate taxes as those rates and exemptions have not changed, as well as remember to avoid probate.

This irrevocable trust is about as close as you can get to having your cake and eating it too.

 

Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors. Armstrong Advisory Group, Cushing & Dolan and The Securities America Companies are unaffiliated.  Representatives of Securities America Inc. do not provide legal or tax advice.  The scenarios provided are for illustrative purposes only and not intended to represent client experiences of Armstrong Advisory Group or the Securities America companies.  Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state. 03/2014 – 869918

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