Reviewing Estate Planning Documents

Take-Away: When you meet with your clients this year for their annual review, it is wise to strongly suggest to them that they have their estate planning documents reviewed by their attorney. Not only many the changes brought about by the 2017 Tax Act impact their existing instruments, several reported cases during the past year may also have an impact on their existing estate planning documents.

Context: Lauree and I were talking yesterday about a trustee’s periodic review of his or her client’s estate planning documents, particularly in light of the impact of the recent 2017 Tax Act. Her question is what should she be ‘issue spotting’ that she can mention to the Greenleaf Trust clients when she meets with them for their annual review, to encourage them to have their instruments reviewed by their legal counsel. Some trust and will provisions or topical issues that warrant a quick review with the client include the following.

1. Revisit Formula Trust Funding Provisions: Many trusts include formulas based on a deceased individual’s available estate tax exemption amount. Example: “From my estate I leave the largest amount to the family trust without incurring a federal estate tax, with the excess, if any,  passing to the marital trust.” Under this formula the first $11.2 million would pass to the family trust, and only the excess above that amount would pass to the marital trust. Problem is that there is, generally, no basis step-up on the assets held in the family trust on the survivor’s death. So relying on a formula to fund trusts may not be the most tax efficient approach to take in a will or trust, when income taxes are factored in to the decision.
2. 5+5 Power Expanded: Many family trusts give to the surviving spouse the right to withdraw the larger of $5,000 or 5% of the family trust assets each year. This withdrawal right is a general power of appointment held by the surviving spouse beneficiary. Most of these 5+5 power provisions are restricted to only be exercised in a very narrow period of time, e.g. the last two weeks of the calendar year. This restriction was normally imposed because the assets subject to the power of appointment are taxed in the estate of the beneficiary spouse, so that if the spouse dies at any time during the year other than the withdrawal ‘window period’ the value of those assets will not be subject to federal estate taxation on the surviving spouse-beneficiary’s death. But with the dramatic increase in the federal estate tax exemption, we may now want to expose those trust assets subject to beneficiary’s withdrawal as a general power of appointment, since the value of  those assets, whether withdrawn or not, will receive an income tax basis adjustment. In short, the client may now want to ‘widen the window of withdrawal’ period so that trust assets  are more likely to be subject to an exercisable withdrawal power to expose those assets to an income tax basis adjustment.
3. Portability Election: Many estate planning documents, including prenuptial agreements, were executed prior to the concept of portability, which became permanent in 2012. Portability enables a surviving spouse to claim and use the deceased spouse’s unused federal estate and gift tax exemption amount. Only a surviving spouse can benefit from a portability This became a hot topic in an Oklahoma Supreme Court decision (Vose) this past year. Spouses had signed a prenuptial agreement waiving all claims in their spouse’s estate. Wife died. Wife’s son from her first marriage, as personal representative,  refused to elect portability on his mother’s estate tax return. Second husband wanted the portability election made. Court decided in husband’s favor, ordering son who was mother’s personal representative to file an estate tax return on which portability was to be elected, but with the condition that his step-father pay for the preparation and filing of the estate tax return. The Court came close to saying that portability is an ‘asset’ that only the surviving spouse can inherit. The point is that in second marriages, and with the increase in a decedent’s exemption amount now being close to $11.2 million, there may be no need to file a federal estate tax return, yet that is the only way a portability election can be made to benefit the surviving spouse, and indirectly his or her heirs. This ends up pitting the children of the deceased spouse with their step-parent. Will and trust provisions should be amended to direct the filing of a federal estate tax return on which portability can be elected, with the caveat that the cost to prepare and file the estate tax return be borne by the surviving spouse who benefits from that election, even when he/she may not be a beneficiary of the decedent’s estate.
4. Dynasty Trusts and GST Election: With the increase in a decedent’s federal estate and gift tax exemption, there might be renewed interest in a client funding a dynasty trust for the benefit of their children and grandchildren, particularly when the law drops the exemption amount back to about $5.0 million in 2026. Thus, the impetus may be to make use of the larger exemption amount now, to fund a dynasty trust for family members. While that is a sound strategy it is important to remember that while a deceased spouse’s unused estate tax exemption can be used by the surviving spouse with a timely portability election, the deceased spouse’s unused generation skipping transfer tax exemption (also now about $11.2 million) is not subject to a portability election. Consequently if the surviving spouse plans to fund a dynasty-type of trust, only the surviving spouse’s GST exemption will be available to protect the dynasty trust’s assets from future GST taxation on distributions or its termination. One technical way to circumvent this limitation on portability is for the first spouse to die to create a QTIP trust for the survivor. The deceased spouse’s estate representative can then make what is called a ‘reverse-QTIP election’, which has the effect of cloaking the QTIP trust with the deceased spouse’s unused GST exemption. That QTIP trust, so protected from future GST taxes by virtue of the ‘reverse QTIP election’ can then flow into a dynasty trust on the surviving spouse’s death, the result of which is that all of the assets held in the dynasty trust will be protected from future GST taxes. In sum, dynasty trusts, whether lifetime or created on the death of the surviving spouse, need to plan for the use of both spouse’s GST exemptions, and assuming that a portability election on the death of the first spouse to die gives to the surviving spouse a GST exemption of close to $22.2 million is incorrect.
5. Tax Exemption Cliff: Probably most trusts will have to be drafted in anticipation of the available exemption amount dropping back to 50% of the earlier exemption amount in 2026 (if not earlier if a new administration revisits tax reform.) Thus, more ‘word’ formulas will have to be used to deal with ‘when’ death arises and what exemption will be available at that time of death. In short, forewarn clients that their estate planning documents will become even more complex in order to deal with the ‘what if..?’ issues associated with an ever-shifting estate tax exemption amount.
6. 529 Accounts: Many grandparents direct in their trusts the funding of 529 accounts on their death for the benefit of their grandchildren. Their intent is to help fund the college education of their grandchild. The 2017 Tax Act expands the use of a 529 account to include K though 12 education expenses. That may not be what the grandparent wanted the 529 funds to be used for by the grandchildren. If their intent is to limit the use of the 529 account solely to college education expenses, then they need to provide that limitation, and perhaps direct that the trustee maintain the 529 account rather than the grandchild’s parent, to keep that restriction in mind.
7. Decanting: A small matter, but still important. Michigan has two decanting statutes that enable the trustee of an irrevocable trust that possesses current discretionary distribution powers to decant the trust assets to a new trust and thus make changes to the trust instrument. Some clients may not want to give to the trustee the power to decant their continuing trust for the benefit of their children and grandchildren. The decanting power will be possessed by the trustee unless the trust instrument clearly directs the trustee that’ it shall have no power to decant this trust’, or the power to decant is permitted only after the passage of a specified number of years the trust has continued in existence. Alternatively, both Michigan decanting powers have limits on when the trust can be decanted and in what manner it can be changed. If the settlor wishes to give close to carte blanche to the trustee to modify the trust to respond to changes in the law or the beneficiary’s needs, the settlor may  want to give the trustee a broad power of decanting without abiding by the statutory  limitations, e.g. ‘the trustee shall have a broad power to decant this trust without having to comply with any Michigan statute that imposes conditions or limitations on the trustee’s power to decant.’
8. Settlor’s Creditors: If the client is concerned about potential future creditors it would be wise to at least mention that Michigan now permits the client to create a self-settled asset protection trust, aka the Qualified Dispositions in Trust Act trust.
9. Beneficiary’s Creditors: If the client is worried about their child losing his or her inheritance to creditors or to a spouse in a future divorce, then attention needs to be paid to the type of trust that is established for that child. In a discretionary trust under the Michigan Trust Code, most creditors, including former spouses, cannot reach the assets held in the trust. If a child holds a withdrawal right over the trust assets or a portion of them, then the assets subject to the withdrawal right can be taken by a judgment creditor, since the trust beneficiary is treated as holding a property right in the trust assets that can be withdrawn (it is a general power of appointment.) Similarly, if the beneficiary possesses a general power of appointment over the trust assets, again the presence of that general power of appointment will be exposed to creditor claims, so the client needs to be aware of the consequences of giving a trust beneficiary a general power of appointment. If creditor concerns are expressed by the client make sure that there is a spendthrift provision in the trust which will protect, to some degree, the assets held in the trust, or limit when the beneficiary’s creditor can access the trust assets, i.e. ‘only upon distribution from the trust to the beneficiary, but not before.’
10. Review Trust Protector Powers: A close look needs to be made of the powers that are conferred on a trust protector, vis-à-vis the powers of the trustee. If the trust protector is given the power to direct the trustee, then the trustee should be exonerated if problems later arise for following the trust protector’s directions, including the right to hire an attorney to defend the trustee using trust assets. Equally important is the need for the trustee and the trust protector to communicate with each other, including  timely sharing information and records, and accountings, so that each understands what the other is doing, or not doing, as the case may be. All too often trust protector provisions are simply tacked onto a trust without any or much thought to how those powers interact with, or conflict with, the powers of the trustee. In short, more thought should go into when a trust protector is added to a trust and when they are to become involved in the administration of a trust. Consider using a springing trust protector who comes into the administration of the trust only when formally asked to participate,  as opposed to a trust protector who immediately has a role to play just as soon as the trust becomes irrevocable. In short, a careful balance between the two fiduciaries needs to be considered.
11. Anticipate ‘Free-Basing:’ Many assets held in an irrevocable trust, e.g. a credit shelter or family trust, will not receive an income tax basis adjustment (hopefully upward) on the death of the lifetime beneficiary of the trust. Conversely, if the trust beneficiary held a general power of appointment over the trust assets, then all of the assets held in the trust would receive a basis adjustment on the lifetime beneficiary’s death, whether or not the general power of appointment was exercised by the beneficiary. While the trust might start out with the lifetime beneficiary not holding a general power of appointment, a trust protector could be given the power to amend the trust to give to the trust beneficiary a general power of appointment which would presumably be added to the trust on the beneficiary’s deathbed. Then the assets would receive a basis ‘step-up’ on the beneficiary’s death and the remainder beneficiaries of the trust could sell the distributed assets without incurring any capital gain. Note that the trust protector could ‘cherry pick’ which assets the lifetime beneficiary had a power to appoint, and only those ‘cherry picked’ assets (presumably with a low tax basis) would be exposed to the basis adjustment on the beneficiary’s death. Note too, that the power of appointment that is conferred could be narrowed to prevent against the beneficiary ‘going rogue’ in the exercise of the general  power of appointment. Example: the trust protector could amend the trust to give to the trust beneficiary a ‘testamentary general power of appointment to appoint trust assets to the creditors of the beneficiary’s estate.’ If the beneficiary had no creditors, then the power of appointment could not benefit them, but the mere fact that the trust beneficiary could benefit the creditors on his/her death exercising the testamentary general power of appointment is sufficient to cause the trust assets subject to the testamentary power of appointment to cause estate inclusion, and thus an income tax basis ‘step-up’.
12. Revisit Durable Powers of Attorney: A couple of points here. First, a durable power of attorney should be reviewed to see if the agent possesses the power to exercise a power of appointment that may be held by the principal over a trust. Some courts are reluctant to find an implied power given to the agent to exercise a power of appointment. Second, pay close attention to the agent’s power to make gifts. This was important in a recent Tax Court case (Powell) where the agent acting under his mother’s durable power of attorney [she was on her deathbed] used it to fund a charitable lead annuity trust (CLAT). The Tax Court looked at the durable power of attorney that was given to the son and noted that the durable power given to the son was only to ‘make annual exclusion gifts.’ The delegated power did not include the power to make charitable gifts or to fund an irrevocable trust. As a result the attempt to transfer assets to the CLAT by the son prior to his mother’s death was deemed voidable which meant that roughly $10 million in assets were brought back into the mother’s taxable estate. Thus, if the goal is to give the agent plenty of authority to make last-minute moves to reduce federal estate or gift taxes, then there should be expanded authority under the durable power of attorney to do so by the agent.
13. Exploit CRTs: We just enjoyed a remarkable run up in the stock market in 2017. Probably a lot of clients are sitting on an appreciated stock portfolio. They may want to diversify that portfolio, but in doing so they will recognized lots of capital gains.  They may want to consider funding a charitable remainder trust (CRT) with those appreciated securities. Why? A couple of reasons.  First, if they fund the CRT with appreciated securities, they will gain a large charitable income tax deduction. With the recent ‘doubling’ of a taxpayer’s standard deduction, charitable gifts will not produce much of an income tax relief for many taxpayers. By ‘bunching’ the charitable gift into a single calendar year, they taxpayer may end up with a larger income tax charitable deduction than their standard deduction, meaning that the charitable deduction can actually be used; the value of the gift of the remainder interest in the CRT to a charity or charities generates that larger ‘bunched’ charitable gift in a single tax year. Second, when the CRT sells the appreciated securities transferred to it, it does not pay a capital gain as the trust is tax exempt. Instead, that gain is recognized over the lifetime of the CRT beneficiary as distributions are made from the CRT to the beneficiary. Thus, rather than selling the appreciated securities as part of a wealth diversification strategy, but then paying perhaps 28% in combined federal and state income and NIIT taxes, and reinvesting the net balance, all 100% of the securities sales proceeds can be reinvested by the CRT trustee and thus used to pay the lifetime beneficiary an annuity or a unitrust amount.
14. Discuss Qualified Charitable Distributions: Many of our clients have large IRAs. If the client is over age 70.5 and charitably inclined, remind them of this opportunity to use their IRA to make charitable gifts. These are distributions made directly from the IRA custodian to designated charities (but not donor advised funds.) The distribution is not included in the IRA owner’s income, so the distribution provides the same net benefit of a taxable distribution that is used for a gift and then deducted. A qualified distribution has the extra advantage of not increasing the owner’s adjusted gross income that a taxable IRA distribution would cause. By increasing the owner’s adjusted gross income increases the income tax on Social Security benefits and the cost of Medicare premiums, and also it can reduce the medical expense deduction (which expense deductions are allowed only to the extent they exceed 7.5% of adjusted gross income.) The qualified distribution also can satisfy the owner’s annual required minimum distribution requirement, up to $100,000 for the year.
15. Check Beneficiary Designations: Probably all beneficiary designations for IRAs and TOD and POD arrangements need to be checked. Many of them refer to the federal estate tax exemption amount, which since it has been changed, may make those beneficiary designations no longer reflective of the owner’s testamentary wishes.
16. Lifetime Gifts: With the increase in a client’s available federal gift tax exemption, we might see more lifetime gifts to exploit that temporary enlarged tax exemption, particularly when the client realizes that the exemption disappears beginning in 2026. If a hard-to-value asset is the subject of the gift, e.g. a closely held business interest or an LLC that holds marketable securities, there always lurks the risk of an IRS audit on the valuation of the gifted interest. A couple of strategies might be employed to reduce the risk of an IRS audit. The first is to use a defined value formula clause to make the gift. For example I could either gift to my child ‘100 shares of stock in ABC corporation worth $5.0 million’ or I could gift to my child ‘that amount of stock in ABC corporation that is worth $5.0 million.’ In the later, the maximum amount I am gifting, regardless of what value is finally assigned to the shares in an IRS valuation audit, is $5.0 million. In the former, I am giving a specific number of shares in ABC, and thus I run the risk that the final value for the 100 shares is worth more than $5.0 million. Additionally, if the subject of the gift his highly liquid in the hands of the donee, consider using a ‘net gift’ approach, where the donee agrees to pay any gift tax assessed on the gift. That might not be all that relevant if the donor has plenty of gift tax exemption available to use against the gift, i.e. with the tax law change each donor now has roughly $11.18 million in exemption. If some of that gift tax exemption was previously used by the donor, a net gift requires the donee to pay the gift tax liability. This results in a ‘smaller’ gift [the gift tax liability is subtracted from the value of the gift] which in turn reduces the gift tax liability that is owed (a smaller value produces a smaller gift tax to be paid.)
17. Foreign Trustee: If an irrevocable trust is classified as a foreign trust, a whole new set of laws and taxes apply that are exceedingly complex and expensive. A foreign trust can arise if a non-resident alien becomes a trustee of the trust. It is usually best when giving a trust protector or a trustee the power to remove and replace an acting trustee to prohibit the appointment of a non-resident alien as the successor trustee. Thus there is often added to a trust instrument a prohibition against aliens being named trustee. Example: ‘The trust beneficiary may at any time remove the trustee and replace the trustee with a new trustee. However, the new trustee may neither be related nor subordinated to the trust beneficiary as that term is described in IRC 672(c) nor may the new trustee be a person who would otherwise cause this trust to be classified and taxed as a foreign trust.’