Personal Wealth Law News

The IRS has just issued Revenue Ruling 2008-22. The ruling states that giving a grantor of a trust the authority to substitute property of equal value will not, by itself, cause the trust to be included in the grantor’s estate for federal estate tax purposes. What’s going on here?

Giving a grantor of a trust the power to replace the property in a trust with property of equal value will make the trust a grantor trust for federal income tax purposes. That means that, for income tax purposes, the trust income will be considered the income of the grantor. Here’s what else it means. If a trust owns a life insurance policy on the life of the grantor, which is a common occurrence when large amounts of life insurance are purchased (because holding the insurance in an irrevocable trust can avoid inclusion of the policy proceeds in the estate for federal estate tax purposes), the grantor might decide after a while that he or she does not like the terms of the trust. But if it’s an irrevocable trust, the grantor can’t amend it. What to do?

What to do is to have the trust sell the policy to another irrevocable trust for the fair market value of the policy. The new trust could have the terms the grantor now prefers. But there are rules in the Internal Revenue Code that state that if an insurance policy is transferred for value, the bulk of the proceeds could be subject to federal income tax. That’s not good. But the IRS has ruled that a transfer from one grantor trust to another grantor trust (of the same grantor) will not create a problem under the transfer for value rules, so the insurance proceeds will continue to be exempt from federal income tax in the new trust.

This ruling helps to assure the success of a valuable planning technique. If a grantor has set up an irrevocable life insurance trust but now doesn’t like the dispositive provisions, a way is clear to get the policy into a new trust with the preferred provisions. This is especially helpful where the grantor has become much older since the original purchase of the insurance, or is having health problems, so buying new insurance could either be much more costly or not possible at all.

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For many people, their largest financial asset will be the balance in their retirement plan. The growth in 401(k) plans and the increases in the limits on deductible contributions to retirement plans have resulted in growth of such plans to overall levels of trillions of dollars. This growth has generated a number of issues, but a requirement covering all such plans and raising many issues is the necessity of taking withdrawals from such plans beginning at a specified age and at a specified rate.

Why are there such rules, called minimum distribution rules and imposed by Section 401(a)(9) of the Internal Revenue Code, and a mountain of IRS regulations? The ability to deduct contributions to such plans causes a loss of tax revenue to the Treasury, and they want the money back…eventually. The longer the wait to get the lost tax revenue, the less value it has to the Treasury. So the specified age for beginning distributions is 70.5, and the rate can be over life expectancies or a specified number of years. The failure to comply with these rules can result in a penalty of 50 percent of the amount that should have been taken out but was not. This creates a powerful incentive to take distributions as required by law.

But the rules are complicated, and it’s easy to make mistakes and to forget to take distributions when they are required. This is especially true when the plan owner dies and leaves the remaining benefits to family members. The naming of individuals as beneficiaries, or trusts for a group of beneficiaries, or separate trusts for each beneficiary can lead to different requirements for minimum distributions. Several books have been written on the subject of retirement plan distributions, and even they don’t cover every situation.

In private letter rulings, the IRS responds to inquiries by and on behalf of taxpayers. The responses they give are to the particular taxpayer and fact pattern, and they cannot be relied upon as authority for other transactions. Despite this limitation, they are useful in showing the thinking of the IRS on difficult tax questions. A recent private letter ruling, No. 200811028, illustrates a solution to a problem of late distributions. In this ruling, a decedent’s IRA was left to a beneficiary. The IRA indicated that distributions were to be made to the beneficiary over his life expectancy, unless he elected a faster payout over five years. The beneficiary did not make such an election, but he also forgot to start taking distributions over his life expectancy. Those distributions should have begun a year after the year of death of the IRA owner, and the first few payments were missed. When this error was discovered, the beneficiary caught up on the late payments, and he paid the 50 percent penalty tax on the late payments. The IRS ruled that he could continue payments over his life expectancy, enjoying the stretched-out deferral of tax, despite having missed the first few payments. In effect, the IRS said that the failure to take the necessary payments was not an election of the shorter five-year payout method.

The lesson of this private letter ruling, and many others on the subject of required minimum distributions, is that considerable care is needed in choosing how and when retirement benefits are to be paid, especially to beneficiaries. But if the distribution process gets off to a rocky start, there are some techniques available to preserve the favorable tax treatment for retirement distributions.

Republished with permission of The Legal Intelligencer.

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In 2001, Congress passed, and the President signed, a strange law regarding the federal estate tax. The plan was to gradually reduce the tax rate and gradually increase the exemption from tax. In 2010, the tax was to disappear entirely, but only for people who died in that year. You can imagine the planning that was contemplated. In the following year, 2011, the tax was to be restored to where it was before the change in the law, a much higher rate and a much lower exemption. This couldn’t be right. Everyone who thought about this situation thought that Congress would have to make some change in this scheme of taxation. But, surprisingly, the two political parties couldn’t agree on what the change should be. One party thought the tax should be abolished entirely, because, after all, it was mostly a tax on rich people. The other party thought it should stay as it was, because, after all, it was mostly a tax on rich people.

Now, we’re actually getting close to 2010, and some leaders in both parties have begun talking about a change to make sense of this law. The federal estate tax next year will be at a rate of 45% and the exemption from tax will be $3,500,000 ($7,000,000 for married couples). The proposal is to extend these numbers into the indefinite future. That’s probably not the end of the discussion of the federal estate tax, but it sounds like a sensible place for the tax to be for a while.

The federal estate tax is not, as it has been called, a death tax, nor is it a tax on death. It’s a tax on the accumulation of wealth, as compared with a tax on income, and it’s imposed when a person has died. No tax is imposed on amounts passing to a surviving spouse, nor on amounts given to charity. There are plenty of opportunities to transfer wealth during life at little or no tax cost. In a sense, it’s a tax imposed on those who try to hold on to their wealth, and the control it brings, until death. It shouldn’t be imposed on wealth that people might need to live on in later years, and that’s the point of the exemption from estate tax. It shouldn’t be the cause of destroying family businesses and farms, and there seems to be no evidence that the tax does so. To ensure that neither of those problems arise, the exemption might be a little larger, such as $5,000,000, and it probably should be indexed to inflation.

There is an excellent short book on the subject of the federal estate tax, called “Wealth and Our Commonwealth: Why America Should Tax Accumulated Fortunes” by William H. Gates and Chuck Collins. Mr. Gates’ son knows something about accumulating wealth. The book makes this point, which is worth considering: if people who have accumulated wealth under this country’s favorable economic system had been born elsewhere, they probably would not have acquired that wealth, or at least not as much. So, say the authors, perhaps something is owed to the country for the ability to accumulate and enjoy wealth.

The question of whether we should have a federal estate tax and at what level it should be imposed will remain unsettled for some time, but it’s helpful to see members of Congress talking about a reasonable compromise to avoid the absurd result that would occur under current law.

Republished with permission of The Legal Intelligencer.

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Megatrends is a name given to important changes in the economy or in the behavior of many people. People write books and articles about megatrends, hoping to identify them before others do and to benefit in some way (usually by selling more books). There are several megatrends that have a definite impact on trusts and estates work, and that will be discussed in future blogs:

• People are becoming wealthier, even with the current stock market setbacks. This is a worldwide phenomenon and contributes to the international flavor of much estate planning.
• A large number of people (the always demanding baby boom generation) are getting close to retirement and to a “final” disposition of their assets.
• There is a strong interest in business succession planning, particularly in this part of the country, where there are so many family-owned businesses. To deal with these issues, trusts and estates lawyers often have to act like psychologists, or at least hire them.
• People want to protect their assets against litigation and divorce, among other threats.
• There is and will continue to be a need for increased tax revenues, which leads inevitably to more complex tax laws and the need to plan for them. When Congress talks about tax simplification, tax lawyers go car shopping.

The combination of these megatrends demonstrates the growing importance of the broad practice area of trusts and estates, often referred to by more general names such as personal wealth, private client or wealth transmission, and ensures that this will be an area of growing importance for lawyers, one that focuses not on death but on the enjoyment of life.

In the next blog, we’ll review the campaign to repeal the federal estate tax and the likely future of the tax and the exemption from tax, as well as efforts to repeal the Pa. inheritance tax.

Republished with permission of The Legal Intelligencer.

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An interesting column, dealing with ethics in everyday situations, appears each Sunday in the New York Times magazine. This week’s (November 11, 2007) edition includes a story about two children with different circumstances in life. One has done reasonably well financially, while the other has chosen a career path that has necessitated continuing financial assistance from parents. The more affluent child asks if this should be mentioned to the parents while they do their estate planning, with a view to “evening out” for the financial assistance provided during life. That is, should children be treated equally even if they don’t have equal financial success in life? The suggestion made by the column writer is to mention it, but don’t insist. What parents do with their wealth is their own business. Some choose the path of equality; others take into account different life circumstances of their children. No decision is wrong. It’s important, though, that parents make a decision and then explain it to their children.

 Since this is November 11, it’s important to remember that our ability to enjoy our lives and the opportunities we have to help our children are the result of the sacrifices made by veterans. Thanks to all of them.

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There are many mistakes that people make in plannning their estates, but we have a candidate for the all-time worst mistake. It doesn’t involve federal estate tax planning or the appropriate beneficiaries for retirement benefits. It’s this simple: the failure to decide what to do with your estate and to tell family members what you want. We have seen an increasing number of family disputes that arose because parents left vague instructions as to the disposition of personal property and other assets. Rather than sit down with children and tell them what should happen after they are gone, too many parents say “I’ll be gone; let the kids worry about it.” This is a terrible attitude, because it so frequently leads to squabbles about what parents wanted, and even who was the favorite. Parents would avoid much expense and heartache for their children if they left detailed instructions and then told their children about those instructions, long before the parents became unable, for whatever reason, to express their wishes.

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Each year, at about this time, the Internal Revenue Service and Social Security Administration issue numbers for various transactions and planning for 2008. Here are a handful of those numbers:

Social Security wage base for 2008: $102,000, up from $97,500 in 2007.

Cost of living Social Sceurity benefit increase: 2.3%

Maximum Social Security benefit at full retirement: $2,185 per month, up from $2,116.

Maximum contribution to defined contribution retirement plans: $46,000 per year, up from $45,000.

Maximum 401(k) deferral amount: unchanged at $15,500 per year.

Fringe benefit exclusion for commuting costs: $115; for parking, $220.

Annual gift tax exclusion: unchanged at $12,000.

These and many other numbers will be included in our benefits card, which will be issued shortly. If you would like to receive that card, at no cost, please send an e-mail to rlouis@saul.com.

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For many of us, it’s difficult to imagine that having money is a problem. Most of us work diligently to acquire wealth, and don’t shrink from having more. But the experience of lawyers and other advisers to those who have been successful financially demonstrates that wealth can be both a blessing and a curse to families. A recent talk in Philadelphia by Charles W. Collier, the senior philanthropic advisor at Harvard University, was very enlightening on this subject. Without offering solutions, because no solution can cover every situation, Mr. Collier showed by illustration and interactive discussion how wealth can have a positive effect on families. His book, titled Wealth in Families, repays reading by families who enjoy comfortable financial circumstances. It’s available through Amazon.

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What is a fair rate of tax and exemption for the federal estate tax? It’s a matter of opinion, of course, but, based upon experience with many business owners and others who have accumulated wealth, here’s a suggestion: the tax rate should permit someone who has worked to acquire a substantial level of wealth to have enough to pass on to the next generation, so that they can enjoy some of the fruits of the labor of the older generation, but not so much that their need to have productive lives is taken away. What is that rate of tax? A tax rate ranging from 15% to 35%, after an exemption of $5,000,000, indexed for inflation, would probably cover only a small number of people but still raise the substantial amounts of revenue needed for government functions.  As it happens, those are the numbers now being considered for a resolution of the future of the estate tax, at least among those who have given up the impractical dream of repeal.

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Taxes remind me of the Woody Allen joke about the guy who complains to a friend that his brother thinks he’s a chicken. When asked why he doesn’t take his brother to a psychiatrist, the guy says he would, “but we need the eggs.” Taxes have a negative effect on the growth of the economy, but we need the money to do all the things we expect government to do. Some people complain, and perhaps rightly, that government tries to do too much, but what they really mean is that government tries to do too much for other people. Again, political candidates often discuss the fairness of taxes- a fair tax being one that neither the candidate nor his contributors have to pay. Is the federal estate tax a fair tax? The answer is clearly yes, no or maybe. What does seem clear is that the federal estate tax is a less painful tax than others, being imposed on fairly high levels of wealth. It couldn’t really be argued that it restricts anyone’s basic lifestyle, unless the basics include a home on the Riviera. Again, it sometimes, but not often, taxes again assets that have already been subject to income tax- the dreaded double taxation scenario. But actually, we are already subject to repeated tax on the same income earned: federal, state and local taxes, sales taxes, Social Security taxes, real estate taxes; so that doesn’t make the estate tax unique. If there’s a justification needed for the federal estate tax, it’s this: it produces a large amount of tax revenue, which we need, from people who suffer the least from paying it. But what level of federal estate tax contains both elements of fairness and adequate revenue? See the next post for a suggestion.

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