Traditionally, due to lower estate tax exemption amounts, many married couples would use bypass trusts or credit shelter trusts as part of a typical estate plan. For example, on the death of the first spouse, assets in that spouse’s revocable trust would be allocated to a bypass trust (frequently referred to in the trust document as a family trust) up to the amount of the deceased spouse’s remaining estate tax exemption, with the balance allocated to a marital trust for the surviving spouse. The bypass trust would not only pass estate tax free at the first spouse’s death, but would also be outside of (i.e., bypass) the surviving spouse’s taxable estate at death. In addition, the bypass trust assets might continue from generation to generation without being subject to any additional “transfer taxes” like the generation-skipping transfer (GST) tax, if GST exemption was allocated to the trust. This type of planning continues to provide a variety of benefits.

With the passage of the 2017 Tax Act, the estate tax exemption amount has increased from $5,490,000 per individual in 2017 to $11,180,000 per individual in 2018, or $22,360,000 per married couple. This generally means that an estate tax will not be levied unless assets are in excess of these amounts. As a result, many couples are finding that their total assets are well below the current estate tax threshold. However, it is important to keep in mind that this increase in exemption is temporary due to a sunset in the Tax Act. Beginning Jan. 1, 2026, the exemption will fall back down to $5 million adjusted for inflation.

While bypass trusts are great for sheltering assets from the estate tax, one income tax drawback is that the assets in a bypass trust generally do not receive a “basis step-up” at the death of the surviving spouse.                          

You may recall that when someone dies holding assets, those assets receive a basis adjustment to fair market value at the time of death. For example, assume that D purchased 1,000 shares of AAPL stock in 2002 for $1,120 at $1.12 a share. These shares are now worth about $200,000, at $200 per share. If D wanted to sell the shares now, the taxable gain would be $198,880 ($200,000 minus the $1,120 cost basis) resulting in a tax of approximately $59,266 (assuming a 20 percent long-term capital gains tax, 3.8 percent net investment income tax and 6 percent state tax). However, D instead designates C as beneficiary of the AAPL stock upon D’s death. D dies and C immediately sells the AAPL stock. How much is C’s tax liability? The answer is zero because instead of having a cost basis of $1,120 or $1.12 per share, the basis was “stepped up” to $200,000 or $200 per share as a result of D’s death.

How does this apply to bypass trusts? Upon the death of the first spouse, the assets going into the trust receive a stepped-up basis. However, the surviving spouse may live for a long time after the first spouse’s death, and the assets held in the bypass trust could significantly appreciate in value. Consider that upon the surviving spouse’s death, the combined value of the surviving spouse’s assets, as well as those assets in the bypass trust, could be less than the estate tax exemption while at the same time being highly appreciated. When the second spouse dies, the assets in the bypass trust will not receive a basis step-up, and, should those assets need to be sold, the next generation of beneficiaries may incur significant income tax liability. Consequently, it may be beneficial to pull the assets in the bypass trust into the surviving spouse’s estate (triggering a basis step-up) to provide the next generation of beneficiaries a significant income tax savings without triggering an estate tax.

For existing bypass or family trusts, there are a variety of methods to pull assets into a surviving spouse’s estate to allow a basis step-up, if appropriate, oftentimes allowing the trust assets to continue in trust without otherwise impacting the distribution scheme or other trust benefits. However, there are a variety of considerations requiring careful analysis, and it may not be appropriate in every circumstance.

If you currently have a bypass trust/marital trust arrangement, there are provisions that may be included in your documents that will make such income tax planning nearly seamless. In fact, more recent plans quite possibly could already have such provisions. However, if your estate planning documents were created a few years ago, you may want to revisit them to make sure that your surviving spouse and other beneficiaries will be afforded the opportunity for income tax savings.  

Similar methods may also be used for other types of irrevocable trusts that otherwise would not be included in a beneficiary’s estate allowing those assets in the trust to receive a basis step-up upon the beneficiary’s death, potentially providing significant income tax savings to the successor beneficiaries. There are also strategies that may be available to implement if the creator of the irrevocable trust, the “grantor,” is still alive to achieve a basis step-up at the grantor’s death.

If you would like to discuss in more detail some of the strategies to reduce the income tax burden in light of this high estate tax exemption environment, please contact an attorney in our Trusts & Estates Department.

Aretha Franklin, the Queen of Soul, died Aug. 16, 2018. Within days, her four sons filed court documents alleging that she died without a will or trust. If the court filing is confirmed and no will or trust is found, her estate will be considered “intestate.” In other words, Franklin gave no indication as to how her assets should be distributed when she died and the matter will need to be resolved under state law.

The value of Franklin’s estate is not known, but it wouldn’t be surprising if it is significant. The legendary singer is believed to have passed away owning the rights to her original compositions, including the classic “Think.” It’s likely we will eventually know her estate’s value since, in most circumstances, the probate of an intestate estate is public.

The intestate estates of some artists and celebrities end up in costly and ongoing litigation, especially when significant assets are up for grabs (read about Prince’s estate here). There is no certainty that Franklin’s estate will go through expensive and protracted litigation, but the possibility is always there when a loved one dies without giving instructions to those who go on living.

If you have a specific idea of how you want your assets distributed and do not want to risk having a state statute or a court decide ˗ and want to reduce the chance of family bickering ˗ consider having a will or trust drafted. If you also want to add the benefit of some privacy, a separate revocable trust may be your best bet. An attorney in our Trusts & Estates department can discuss with you other advantages to formalizing your estate plan.

Many people who create irrevocable trusts are uncomfortable giving up control of their assets to a trustee, especially a corporate trustee. Even if the trustee is a trusted individual, it is increasingly likely that the trust could last for many years. As a result, the trustee may experience changes in the law that could negatively impact carrying out the settlor’s intent. The following Q&A addresses ways to mitigate concern with a long-lasting irrevocable trust by using a trust protector.

What is a trust protector?

A trust protector is a third party who is granted certain powers under a trust instrument to ensure that a settlor’s wishes are effectively carried out. The use of a trust protector may avoid expensive and drawn-out court proceedings.

What powers may be given to a trust protector?

The person who creates the trust is able to select the powers he or she wants a trust protector to hold. These include but are not limited to:

• the power to remove and replace a trustee;
• the power to direct, consent or veto investment decisions;
• the power to modify a trust in response to changes in tax laws or state law;
• the power to modify the trust to change the tax status of the trust;
• the power to modify a trust to change the governing law; and/or
• the power to modify the trust to deal with changes with respect to trust assets.

Who can be a trust protector?

The selection of a trust protector depends on the powers appointed to the role. In some circumstances, a person may wish to select a trust protector with special skills, knowledge or experience. In other circumstances, he or she may wish to select a trust protector who knows the family or the trust’s beneficiaries, such as a trusted advisor or friend. It may also be beneficial to appoint a committee to serve as trust protector. However, to avoid adverse tax consequences, the trust protector should generally not be someone who already has an interest in the trust, including, but not limited to, the settlor, anyone else who may contribute property to the trust, or a beneficiary of the trust.

Are trust protectors subject to fiduciary duties?

State law determines whether a trust protector will be required to act in a fiduciary capacity. Missouri law, by default, generally deems the trust protector to have a fiduciary duty to the trust beneficiaries. However, like many states, Missouri allows a settlor to override the presumption of a fiduciary relationship through the trust instrument.

If you have questions about using a trust protector or adding one to your existing trust, please contact an attorney in our Trusts & Estates Practice Group.

A growing problem in estate planning is how to provide for special needs individuals (those who may be eligible for government benefits and programs due to a disability or otherwise) without disqualifying them from government benefits and programs they may need now or in the future. As most government benefits have a limit on the amount of assets an individual may have to qualify for such benefits, leaving assets to special needs individuals outright or in a standard trust may disqualify them from receiving those benefits.

One way around this issue is to leave assets for a special needs individual in a special needs trust. Assets in these trusts are only used to supplement, but not supplant (or replace), government benefits. As a result, the individual will not be disqualified from government benefits because the assets in the trust are not considered a “countable asset” for purposes of determining qualification.

For a trust to qualify as a special needs trust, there are certain restrictions on the distribution of assets. First, the assets should never be distributed directly to the special needs beneficiary, but instead should be distributed directly to the providers of goods or services. Secondly, the assets should not be used on anything that a government program would pay for, such as food or housing. For example, the trustee of the special needs trust could pay for clothing, cable/phone bills, non-food groceries, furniture, or movie tickets, but not rent, food groceries, or popcorn at the movie; however, the trust could purchase a home that the special needs beneficiary lives in.

There are essentially two types of special needs trusts: the third-party special needs trust and the first-party special needs trust.

The third-party special needs trust is created by anyone other than the special needs individual for the special needs individual’s benefit. It is funded with the assets of anyone other than the special needs individual. At the death of the special needs individual, no assets remaining in the third-party special needs trust need to be repaid to any state for funds spent on the individual’s behalf.

The first-party special needs trust is one that is treated as created by the special needs individual, because it is funded with the special needs individual’s assets. At the special needs individual’s death, any state that provided means-tested government benefits to them is entitled to be paid back from any remaining assets held in a first-party special needs trust, up to the amount of government funds spent on the individual. For this reason, first-party special needs trusts are not as ideal as third-party special needs trusts. First-party special needs trusts are often created when a special needs individual’s relatives have not planned properly by either gifting assets outright to the individual or leaving assets in a trust that does not qualify as a special needs trust. Frequently, a first-party special needs trust is used when a special needs individual receives a settlement in a lawsuit but still needs to qualify for means-tested government benefits.

With proper planning, relatives can provide for a special needs individual without disqualifying them from receiving much-needed government benefits, while at the same time protecting any such assets left in trust for the individual from claims by the state at the individual’s death.

For more information about planning with a special needs trust, please contact one of the attorneys in our Trusts & Estates Practice Group.

The Internal Revenue Service has released the Applicable Federal Rates (AFRs) for June 2018. AFRs are published monthly and represent the minimum interest rates that should be charged for family loans to avoid tax complications.

Here are the rates for June 2018, which show overall increases over the May 2018 rates:

The Section 7520 interest rate for June 2018 has increased to 3.4 percent (from 3.2 percent in May). The Section 7520 interest rate is the interest used in a common estate tax planning technique called a “grantor retained annuity trust” or “GRAT.” In general, the lower the interest rate, the more effective the transaction is for reducing estate taxes.

For more information, see the full listing from the IRS here.

On December 22, 2017, President Trump signed into law what is commonly known as the Tax Cuts and Jobs Act of 2017 (2017 Act). The 2017 Act increased the estate, gift, and generation-skipping (GST) transfer tax exemptions to $10 million, indexed for inflation ($11.18 million for 2018), and retained the estate/gift/GST tax rates of 40 percent. The gift tax exemption is now significantly larger than it has ever been, and larger than it was ever expected to be. Below are 10 things to consider in determining whether to make a gift to take advantage of the existing $11.18 million gift tax exemption. In addition to the tax benefits, making a gift during your lifetime allows your children or other beneficiaries to benefit from the gift, and you will also benefit by seeing them enjoy it.

1. The $11.18 Million Gift Tax Exemption May Disappear. This is the perfect time to make a gift. If you have a large enough estate that you expect to be paying estate tax when you die, then it is more tax efficient to use gift tax exemption while you are alive as opposed to estate tax exemption when you die. Unfortunately, unless Congress acts sooner, the 2017 Act expires at the end of 2025 and will revert to $5.49 million estate, gift, and GST tax exemptions, adjusted for inflation. If you do not use all of your $11.18 million gift tax exemption before 2026, it may disappear forever.
2. Tax Benefits of a Lifetime Gift. The primary estate tax benefit of a lifetime gift is that all of the future income and appreciation on the gifted assets passes estate tax free to the donee. For example, if you gave $11.18 million to a trust for your children in 2018 and lived another 20 years, then the trust would be worth almost $36 million and you would exclude almost $25 million more from estate taxes than if you had waited until your death to use the $11.18 million exemption (assuming 6 percent annual growth and assuming the trust is a grantor trust, as explained below). With a 40 percent estate tax rate, this $25 million excluded from your estate results in tax savings of $10 million. Another tax benefit is that you can currently create trusts with up to $11.18 million of assets that will be exempt from future gift, estate, and GST taxes forever.
3. Cushion Effect. Another reason to make a gift now, while the gift tax exemption is $11.18 million, is to reduce the IRS’s motivation to audit the gift by contesting the discount. If you give significantly less than $11.18 million, then you will have a large cushion available to shield any potential revaluation of the assets from gift taxes. The IRS will have little motivation to argue about the value of discounted assets, such as limited partnership units or shares in a closely held business, if reducing the discount will not cause a gift tax.
4. Supercharging the Gift with Discounted Assets. The best use of gift tax exemption is to gift assets that are subject to a discount. IRS regulations meant to eliminate discount planning were never implemented, so this continues to be an effective planning tool. For example, if you give away a limited partnership interest, the gift will qualify for discounts for lack of control and lack of marketability. In other words, the value of the gift takes into account that a hypothetical third party would not pay full value for a partnership interest that only entitles them to distributions in the discretion of the general partner. Typical discounts are in the 35 percent range, so a gift of an $11.18 million partnership interest could have a gift tax value of only $7,267,000.
5. Best/Worst Assets to Give. The best assets to give are those most likely to appreciate. The primary benefit to the gift is excluding the future income and appreciation from estate tax, so the more the asset appreciates the larger the tax benefit. Unfortunately, no one can predict the future, so choosing the right assets is more of an educated guess than a science. The worst assets to give may be personal use assets. It is usually not a good idea to give real estate or other assets that you may use in the future. If you make a gift of personal use assets, then you will have to pay fair market value rent for your use of the asset to avoid estate taxes at your death.
6. Disadvantages and Risks of a Lifetime Gift. The primary disadvantage of a gift is that you can no longer use the assets gifted. Another downside is that if the assets depreciate in value between the date of gift and your death, then you would have been better off – for gift/estate/GST tax purposes – if you had not made the gift. Another downside of a gift is that your family loses the benefit of the adjustment in basis at your death (that would have been available if you had not made the gift). Under the adjustment in basis rules the beneficiaries of your estate receive an income tax basis on the property they inherit equal to the fair market value of the property at the time of your death. This eliminates any built-in gain on the property that would otherwise be subject to income tax upon the sale of the property. The adjustment in basis only applies to assets that are included in your estate at death. With a gift, the donee receives a basis in the gifted assets equal to your basis in those assets before the gift. This is called “carry-over” basis. In many cases, the reduction in estate taxes outweighs the increased gain when the asset is eventually sold – but this will not always be the case. The potential estate tax benefits of gifting low basis assets should always be measured against the potential increase in income taxes.
7. Treasury Regulations. The 2017 Act directs Treasury to create regulations to address any difference in the exemption amount at the time of a gift and at the time of death. Some refer to this as a “clawback.” For example, if you make an $11.18 million gift in 2018 and die in 2026 when the gift tax exemption is $5.49 million and estate tax rate is 40 percent, could your estate owe more than $2 million in estate taxes at your death due solely to the prior gift? It appears this is not what Congress intended and hopefully the regulations will clarify this soon.
8. A Gift with a Safety Net (SLATs). The safest way to take advantage of the existing $11.18 million gift tax exemption is to only give assets you are positive to never need during the rest of your life. A more aggressive approach is for spouses to each create an irrevocable trust for the other (sometimes called a spousal lifetime access trust, or SLAT). This allows each spouse to retain access to the assets while both are alive. However, a spouse will lose access to the other trust when his or her spouse dies or if there is a divorce.
9. Reasons to Give to a Trust. There are at least five important reasons to make gifts to an irrevocable trust, as opposed to a gift to an individual or a revocable trust. First, you can maintain control over the investment and distribution of the assets until your death by serving as the Trustee. Second, the beneficiaries of a trust enjoy a level of creditor protection not available if they own the assets outright. Third, with careful drafting the trust can be structured to protect the assets from a marital property division if a beneficiary divorces. Fourth, making the gift to a trust allows the assets to escape estate taxes at multiple generations. For example, if you give $11.18 million to a trust for your children, then – if the trust is drafted properly – the $11.18 million (and all income and appreciation on the $11.18 million) will not be subject to estate tax at your death, or the deaths of any of your children, or the deaths of any of your grandchildren, or any of your great grandchildren . . . and on and on forever or until the assets are eventually depleted or distributed out of the trust. Lastly, if you make the gift to a trust, then you get to choose the remainder beneficiaries – and can ensure the remaining assets will stay in your family if your children or grandchildren die without exhausting the trust assets.
10. Using a “Grantor Trust”. If you retain certain specific powers over an irrevocable trust, then the trust will be ignored for income tax purposes and you will continue to report the trust income on your personal income tax return. This type of trust is known as a “grantor trust.” A grantor trust allows you to make gift-tax free transfers for the trust beneficiaries by paying the income taxes for them (essentially, a grantor trust grows income tax-free while you are alive, similar to a 401(k) or IRA). If at some point in the future, you no longer wish to pay the income taxes (you cannot be a beneficiary of the trust, so you are paying the taxes and receiving nothing in return), you can “turn off” the grantor trust feature by renouncing certain powers over the trust.

When planning for 2018, you may also want to consider these other gifting strategies: grantor retained annuity trusts (GRATs), installment sales to a grantor trust, forgiving loans, and qualified personal residence trusts (QPRTs).

If you would like to discuss any of these strategies in more detail, please contact one of the attorneys in our Trusts & Estates Practice Group.