Step-up or Step-down?

When certain “capital assets,” such as real property or securities, are sold, capital gains tax will typically be due on the difference between the “basis” in the property and the sales price. The “basis” in an asset is the original purchase price. With regard to real property, the basis can be adjusted by the cost of improvements on the property (i.e., installing a new roof). The higher the basis, the less the gain, and the less the tax. Conversely, the lower the basis, the higher the gain, and the higher the tax. As a result, taxpayers want the highest basis possible. 

Combined federal and California capital gains tax on the difference between the basis and the sales price ranges between 25% to 33%. If the asset was used as a personal residence by the seller for two of the previous five years, the first $250,000 of gain will likely be exempt from capital gains tax but any additional gain would be subject to the tax. 

For example, assume that you purchased a rental property forty years ago for $200,000. Over the years, you invested a total of $100,000 in improvements to the house. Your basis is currently $300,000. Assume that today, the house is worth $1,000,000. If you were to sell the house, you would recognize a “gain” of $700,000.

If you transfer the property during life, the recipient of your gift will “inherit” your basis of $300,000. If the recipient of your lifetime gift sells the house for $1,000,000, the recipient will also recognize a gain of $700,000.

Upon your death, the basis in your property will be adjusted to the fair market value on the date of your death. For example, assume that the basis in your rental property is $300,000 but it was worth $1,000,000 on the date of your death. The basis in the property for your heir will be readjusted to $1,000,000. If your heir sells the property for $1,000,000, the heir will have no capital gains tax at all. If the heir waits three years to sell the property when it is worth $1,200,000, the heir will only have to recognize a gain of $200,000. 

This basis adjustment to the fair market value as of the date of a property owner’s death is often referred to as a “step-up” in basis. The term assumes that the asset will be worth more upon the death of the property owner than the property owner’s basis. While it is often the case that real property and investments increase in value over time, that is not necessarily the case. If the fair market value of an asset is worth less than the basis as of the date of the property owner’s death, then there will actually be a “step-down” in basis. 

For example, assume that you purchased a rental house at the height of the market for $1,000,000. However, the market declined and today it is worth $800,000. If you were to sell the house for $800,000, you would have a $200,000 loss. But assume that you held it until you died when it was worth $800,000. Your heir’s basis in the property would be $800,000. If the heir sold it a year after your death when it appreciated in value to $900,000, your heir would have to pay capital gains tax on the $100,000 gain, despite the fact that your basis was $1,000,000. 

It is important to understand the other side of the basis adjustment rule: capital assets do not always appreciate in value. While the readjustment in basis to the value of the property as of the property owner’s date of death is an advantage for the heirs when the rule results in a “step-up” in basis, it might be detrimental to the heir if the rule results in a “step-down” in basis. 

KRASA LAW, INC. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205. 

Disclaimer: This article is for general information only. Reading this article does not establish an attorney-client relationship. Before acting on any of the information provided in this article, you should consult a competent attorney who is licensed to practice law in your community. 

Filling a Trustee Vacancy

When establishing a trust, the selection of a trustee is of paramount importance. The trustee manages the assets of the trust for the benefit of the beneficiaries in accordance with the terms of the trust. Without a responsible and effective trustee, the trust will not carry out its objectives. 

In the event that the trustee ever becomes unable or unwilling to continue to act as trustee, often due to disability or death, a trust should name a successor trustee and several alternates to ensure that the trust will always be managed by a trusted individual. There is no legal limit to the number of alternate successor trustees that can be named in a trust and having a “deep bench” is important. 

What happens when all the named alternate successor trustees are unable or unwilling to serve as trustee? A good trust will provide a mechanism for the appointment of a successor trustee to fill a trustee vacancy that avoids the delay and expense of court intervention. A common provision would be to allow a majority of the trust’s beneficiaries to appoint a trustee in the event of a vacancy. Another possibility is to name an independent third party, such as trusted family member, friend, or professional, to have the power to appoint a trustee to fill a vacancy. However, some trusts fail to provide adequate instruction on filling a trustee vacancy. 

In the event that a trust is silent on the issue of filling a trustee vacancy, the California Probate Code provides guidance. California Probate Code Section 15660(c) provides that all adult beneficiaries may agree on appointing a “trust company” to fill the vacancy without any court intervention. California Probate Code Section 83 defines the term, “trust company,” as an “entity that has qualified to engage in and conduct a trust business in this state.” “Trust companies” include certain banks and other financial institutions that have departments that are dedicated to serving as trustees of trusts for a fee. 

If the beneficiaries do not wish to have a “trust company” to fill a trustee vacancy, then the beneficiaries or other “interested parties” may petition the court to appoint an individual to fill the trustee vacancy. Such a petition would be filed in the local probate court pursuant to California Probate Code Section 17200. The petition would describe the trust, describe the problem of the trustee vacancy, describe the proposed successor trustee, and provide any other information that the court might find relevant. A hearing would be set where the judge would either approve or deny the petition. 

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205. 

Disclaimer: This article is for general information only. Reading this article does not establish an attorney/client relationship. Before acting on any of the information contained within this article, it is important to consult a competent attorney who is licensed to practice law in your community. 

Protecting Inheritances Through an Irrevocable Trust

Introduction

Under California law, as in most states, Trust-Makers cannot establish asset protection for themselves by creating their own trusts with their own assets for their own benefit (CA Probate Code §15304). Such a trust is commonly referred to as a “self-settled trust.” However, under California law, as in most states, Trust-Makers are able to establish asset protection for third-parties by creating irrevocable trusts for the benefit of third-parties (CA Probate Code §15303). Such a trust is commonly referred to as a “third-party trust.” 

The concept of the “Beneficiary Controlled Trust” (“BCT”) is to take advantage of the rule permitting the establishment of creditor protection for third-parties by utilizing a third-party trust to transfer either a lifetime gift or a gift upon death to a third-party. The BCT is designed to give the beneficiary complete control over an inheritance or a gift while at the same time providing a degree of asset protection.

A BCT may be established as a stand-alone trust or as a sub-trust that is created under a living trust after the death of the Trust-Maker(s). 

Trustee 

The beneficiary of the BCT will typically serve as Trustee, either immediately at the creation of the trust or upon attaining a specified age of maturity.

Some BCT’s are structured to designate the beneficiary as the sole Trustee. Under such circumstances, tax laws require that the Trustee be given an “ascertainable standard” as guidance for appropriate distributions of trust assets to the beneficiary (i.e. “trust spending”). The most common and most liberal “ascertainable standard” is known as “HEMS”: the Trustee may distribute income and principal to the beneficiary for the beneficiary’s “Health, Education, Maintenance, and Support.” The beneficiary / Trustee has complete discretion to determine whether a particular distribution meets this standard and thus the beneficiary / Trustee is not practically limited in how he/she decides to spend trust assets. 

Although it is convenient for the beneficiary to serve as his/her own Trustee, such a scenario does not provide the strongest degree of asset protection. Because the beneficiary / Trustee has the ability to not only manage the trust assets, but can also control whether or not to spend trust assets, under certain circumstances, a creditor could “step into the shoes” of the beneficiary / Trustee and force a trust distribution to satisfy a claim. To establish a stronger degree of asset protection, a BCT might be structured to bifurcate the role of the Trustee by naming the beneficiary as the “Administrative Trustee” and an independent third-party as a “Distribution Trustee” (also known as a “Spending Trustee”). 

For example, a BCT might name beneficiary Sally as the Administrative Trustee and might require that Sally appoint an independent third-party to serve as the Distribution Trustee. Sally, as Administrative Trustee, would be solely on title to all trust assets and would have complete control investing trust assets. However, before spending any trust assets on herself, the Distribution Trustee would be required to approve or deny trust spending in writing. Records of spending requests and approvals / denials should be kept in the trust binder. By giving an independent third-party the power to approve or deny trust spending, there is less of a chance that a creditor could force trust spending to satisfy a claim. 

Unlike the scenario of a beneficiary serving as sole Trustee, the Distribution Trustee is not limited to a HEMS standard. Instead, the Distribution Trustee is free to approve or deny trust spending for any reason. This coupled with the fact that the beneficiary does not have the power to unilaterally decide how to spend trust assets gives the BCT stronger asset protection. 

Often the beneficiary is given the power to replace the Distribution Trustee at any time for any reason. The Distribution Trustee must not be “related or subordinate” to the beneficiary (i.e., should not be a parent, child, spouse, or sibling of the beneficiary). 

Although a BCT structured with a Distribution Trustee provides stronger asset protection than a BCT that names the beneficiary as a sole Trustee, both structures provide significantly greater asset protection than a gift or an inheritance that is free of trust.  

Flexibility

A BCT is technically an irrevocable trust, meaning that the beneficiary cannot amend or revoke the trust in the same manner that a Trust-Maker can amend or revoke a typical revocable living trust. However, a well-drafted BCT will include many tools that give the beneficiary flexibility in updating the trust in a variety of circumstances. 

A BCT will often allow the beneficiary to appoint successor Trustees in the event that the beneficiary becomes unable or unwilling to serve as Trustee in the future. This is important, especially if the beneficiary becomes mentally disabled or dies. A beneficiary of a BCT should exercise his/her right to appoint successor Trustees and should review successor Trustee appointments on a periodic basis. 

A BCT will often give the beneficiary the power to remove a Trustee for any purpose if the beneficiary is not serving as his/her own Trustee. As mentioned above, if the BCT is structured to include the use of a Distribution Trustee, often the beneficiary is given the power to replace the Distribution Trustee at any time for any reason. 

A BCT names contingent beneficiaries to inherit whatever might be left in the trust after the beneficiary dies. Often a BCT will give the beneficiary a “testamentary power of appointment,” the ability to name alternate contingent beneficiaries to inherit the remaining trust assets upon the beneficiary’s death. A beneficiary of a BCT should exercise his/her right to name alternate contingent beneficiaries of the trust and should review such contingent beneficiary designations on a periodic basis. 

The power of appointment can either be “limited” or “general.” The distinction between the two different types of powers of appointment can have significant tax implications. Often a BCT will be structured to allow a power of appointment to be converted from a “limited” power to a “general” power. Upon the establishment of a BCT, the beneficiary should consult an attorney or CPA to determine the type of power of appointment and whether or not it can and should be modified. 

As circumstances change and as the law changes, it might be necessary to modify the administrative or tax provisions of a trust. Because the BCT is irrevocable, the beneficiary cannot have the power to make such trust modifications directly. However, a BCT is often structured to include provisions for the appointment of a “Trust Protector,” an independent third-party who has the power to make changes to the administrative or tax provisions of the trust. In some circumstances, the Trust Protector will have the power to terminate the trust and transfer the trust’s assets directly to the beneficiary if the BCT is no longer desired. Often, the beneficiary of the trust has the power to appoint an independent third-party as Trust Protector when needed. 

Many years into the future, the BCT might be completely out of date and a new trust might be in order. A BCT can include “trust decanting provisions” which allow an independent third-party Trustee to “decant” the assets of the BCT into a new, updated trust. If the beneficiary is serving as Trustee, the beneficiary should appoint an independent third-party as Trustee before utilizing the trust decanting provisions. 

Retirement Plans

A BCT might be named as the beneficiary of certain retirement plans including IRAs. Trusts and IRAs involve many nuanced rules that must be navigated carefully in order to ensure that the beneficiary can maximize tax benefits. Often a BCT will include “conduit provisions” that mandate that all “Required Minimum Distributions” (“RMDs”) from the IRA be distributed out of the trust to the beneficiary individually. If a BCT is named as a beneficiary of an IRA, the beneficiary should consult with an attorney or CPA about the proper management of RMDs. 

Tax Returns

A BCT is its own taxpayer and must file federal and state income tax returns under its own Taxpayer Identification Number (“TIN”) each year. The Trustee will often have the discretion to either keep the trust’s net income in the trust each year or to distribute the trust’s net income to the beneficiary individually. 

For any income that remains in the trust at the end of the year, income tax will have to be paid by the trust on the trust tax returns. For any income that is distributed to the beneficiary during the tax year, the trust will issue a K-1 to the beneficiary and the beneficiary will pay income tax on the beneficiary’s personal income tax return. 

The trust tax rate is usually significantly higher than the individual tax rate. As a result, in a typical year where there is no threat of a creditor, it is often better for the beneficiary to distribute all of the net income out of the trust and to the beneficiary individually in order to enjoy a lower tax rate. While the income that is distributed will lose asset protection, the principal will remain protected. In a year in which there is threat of a creditor, it might be prudent to keep the income in the trust and pay the higher income tax rate. 

The beneficiary should consult a CPA at the end of each year to determine whether it is advantageous to keep trust income in the trust or to distribute the trust income out to one’s self by the end of each year.

Keep it Separate 

The basis for creditor protection of a BCT is the fact that a third-party created and funded the trust for the benefit of the beneficiary. A trust that is funded with the beneficiary’s own assets does not enjoy asset protection. As a result, a beneficiary should not under any circumstances transfer his/her own assets into the BCT. It is of paramount importance that the inherited or gifted assets of the BCT not be comingled with the beneficiary’s personal assets.

An Artful Respite

Although I grew-up on the Monterey Peninsula, I chose to attend Saint Michael’s College in Vermont, a small liberal arts school located near the shores of Lake Champlain. I sought frigid weather, covered bridges, and green mountains and that’s what I found! I majored in English Literature and I enjoyed reading the works of the 19th Century American Transcendentalists and the 18th and 19th Century British Romantics, especially Ralph Waldo Emerson, Henry David Thoreau, and William Wordsworth. It was special to study their works in the same region of the country where Emerson and Thoreau lived and in a similar setting as Wordsworth’s Lake District. 

As a senior in college, after I had made the decision to attend law school, my advisor suggested that I take an art history class. His daughter was an attorney and he thought that in addition to being able to discuss literature with each other, lawyers should also be able to discuss art. I fell in love with the Hudson River School painters, a group of 19th Century American landscape painters who lived in New York City in the winter but who traveled to the Catskills Mountains of upstate New York and other parts of the Northeast with their easels in tow. I recognized the same themes in the paintings of Thomas Cole, Jerome Thompson, and Asher B. Durand as I had studied in the writings of Emerson, Thoreau, and Wordsworth. 

Interestingly, there is no evidence that the painters and the writers knew of each other’s work even though they were contemporaries and seemed to be communicating the same ideas. If I had to do my senior thesis again, this would certainly be my topic! 

After college, I immediately enrolled at U.C. Davis School of Law. The first year of law school is always the most challenging and I had trouble adjusting. Although college was rigorous, the rigor was tempered by the flowery language and warm ideas of 19th Century writers and poets. The study of law can be much more rigid and technical without any tempering factors.  

One day, when I was feeling particularly overwhelmed with my law school studies, I wandered into the university’s main library. I found myself in the art history section. I pulled a book from the shelf about the Hudson River School painters. As I looked the pictures of the paintings of Cole, Thompson, and Durand, I was immediately transported to the writings of Emerson, Thoreau, and Wordsworth. It was a restorative respite and one I would repeat throughout the rest of my law school career. 

Recently, I purchased reproductions of two of my favorite paintings, The Oxbow by Thomas Cole and Belated Party on Mansfield Mountain by Jerome Thompson, for my office. When I need a brief respite from drafting trusts or answering clients’ questions, I take a moment to look at these paintings, recalling the themes and ideas of my favorite writers, and I become refreshed and ready for my next project. 

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California and Kyle may be reached at 831, 920-0205. 

Disclaimer: This article is for general information only. Reading this article does not establish an attorney-client relationship. Before acting on any of the information presented in this article, you should consult a competent attorney who is licensed to practice law in your community. 

 

The “Back-Pocket” Trust

 

With regard to the distribution of assets upon death, comprehensive estate planning should focus on three key areas: (1) Who should inherit? (2) What should they inherit? And (3) How should they inherit? Most time and energy are spent focusing on the first two elements. However, the third element should not be overlooked as it might be the most important. The manner in which an inheritance is structured can take advantage of key planning opportunities including protecting an inheritance from creditors, predators, and divorce. In the case of a Special Needs beneficiary, the careful structure of an inheritance will ensure the preservation of crucial government benefits. 

Many public benefits such as Medi-Cal and SSI are “means-tested”: an individual is only entitled to such benefits if his/her estate is below a certain asset threshold. It often requires the navigation of nuanced rules and bureaucracy for an individual qualify for such benefits. Once an individual has qualified for such benefits, keeping such benefits is critical. The receipt of an inheritance could place an individual who has means-tested public benefits in jeopardy of suddenly becoming ineligible for continuing to receive those benefits. The most common solution to this problem is a Special Needs Trust.

If a Trust-Maker knows that a beneficiary is receiving means-test public benefits, a comprehensive trust will provide for a Special Needs Trust: a specific type of trust that allows the beneficiary to benefit from the inheritance in a manner that does not jeopardize eligibility for public benefits. Some of the key requirements of a Special Needs Trust are: (1) a third party other than the beneficiary must serve as trustee; (2) the beneficiary must not be able to revoke or modify the trust directly; and (3) the trustee must be careful in making trust distributions for purposes that are supposed to be covered by the public benefits. 

A Special Needs Trust can work very well in order to achieve the dual goals of providing a beneficiary with an inheritance while also preserving the beneficiary’s eligibility to receive means-tested public benefits. However, traditional Special Needs Trusts only work if the Trust-Maker knows that the beneficiary is receiving means-tested public benefits at the time the trust is created. Circumstances can change and the Trust-Maker might not always have an opportunity to amend the trust in the future to account for such changes. Having a standby Special Needs Trust in the “back-pocket” can resolve this problem. 

If at the time of creating a trust, the Trust-Maker is not aware that any beneficiary is receiving means-tested public benefits, the inheritances can be structured without Special Needs Trust provisions. However, a dedicated section of the trust can provide that if at the time a distribution from the trust is about to be made in the future – after the Trust-Maker has died – any beneficiary is receiving means-tested public benefits, the trustee is instructed to distribute that beneficiary’s share to a Special Needs Trust.  The terms of the standby Special Needs Trust can be included in the dedicated section and will only be triggered if and when needed. 

Although it is impossible to predict all possible scenarios in the future, the possibility that a beneficiary might need means-tested public benefits in the future is foreseeable. Including a standby Special Needs Trust in the “back-pocket” is a reasonable measure to ensure that the beneficiary’s inheritance will not become a burden. 

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205,

Disclaimer: This article is for general information only. Reading this article does not establish an attorney/client relationship. Before acting on any of the information contained within this article, you should consult a competent attorney who is licensed to practice law in your community.

Decanting a Trust

A key idea of estate planning is to preserve your wishes. It is important to have confidence that when you make an estate plan, it will be honored by future generations. In order to preserve such wishes, trusts typically become irrevocable upon the trust-maker’s death.  In certain circumstances, a trust might be irrevocable as soon as it is executed.  The irrevocable nature of the trust is intended to create a legally binding agreement that will be enforced in the future, long after you have passed away. 

Although preserving your estate planning wishes is important, it is impossible to foresee all of the situations that could arise in the future. Changes in the law, changes in legal strategies, and changes in beneficiaries’ circumstances could make what was once a sensible plan obsolete. As a result, providing some method for the ability to change an otherwise irrevocable trust is important. 

The law has long recognized the need to be able to modify an outdated trust.  If the trust-maker is still living, upon consent by both the trust-maker and the beneficiaries, an irrevocable trust can be modified without court involvement pursuant to California Probate Code Section 15404.  However, since many trusts only become irrevocable upon the trust-maker’s death, the simple procedure under Section 15404 is often not available.  

If the trust-maker is incapacitated or deceased, then it is still possible to modify an irrevocable trust upon petitioning the court pursuant to either California Probate Code Section 15403 or 15409.  Section 15403 requires all of the beneficiaries to consent whereas Section 15409 requires a demonstration of a change in circumstances that frustrates the trust-maker’s intent. In both situations, the court must balance the reason for the change with the material purpose of the trust.

In an attempt to make modification of irrevocable trusts simpler, the California legislature recently passed a new law that allows for “trust decanting” in certain situations.  Just as old wine is “decanted” by pouring it into a new container and leaving the old sentiment behind, a trust can be “decanted” by “pouring” the trust assets into a new and improved trust, leaving the old and outdated provisions behind. The new California law allows for trust decanting as of January 1, 2019 even if the original trust did not specifically authorize trust decanting.  However, the new statute has several limitations. 

The law makes a distinction between whether the trustee has “expanded” discretion to decide how to distribute the assets to the beneficiaries or whether the trustee has “limited” discretion.  If the trustee has “expanded” discretion, the trustee can make both administrative changes such as changing administrative powers of the trustee or changing the successor trustees, as well as make substantive changes such as eliminating a beneficiary or changing the standard of trust distributions.  “Limited” discretion is defined as the trustee being limited by an “ascertainable standard,” a guideline that governs the trustee’s discretion.  Because most trusts provide an “ascertainable standard,” trust decanting under the new California law is limited. 

The new law does not prohibit a trust from including more expansive trust decanting provisions or from introducing other ways to modify the trust in the future such as giving the beneficiary the power to change the remainder beneficiaries, giving the beneficiary the power to change trustees, and appointing a “trust protector” – an independent party who has certain amendment and administrative powers. However, the more expanded powers must be specifically included in the trust in order for them to be effective.

Most older trusts do not have comprehensive provisions that allow for flexibility in certain situations. As a result, it is generally a good idea that the California legislature included the possibility of trust decanting over a trust that does not specifically authorize the practice.  However, the new trust decanting law is limited in its scope and application.  As a result, if your trust is still revocable, it is a good idea to consider whether it would be prudent for you to include your own trust decanting provisions or other methods to make the trust flexible in a changing world. 

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California and Kyle may be reached at 831-920-0205. 

Disclaimer: This article is for general information only.  Reading this article does not establish an attorney/client relationship.  Before acting on any of the information provided in this article, you should consult a competent attorney who is licensed to practice law in your community. 


Be Careful about Non-U.S. Resident Trustees

My wife grew-up in a relatively small town in Maine. Her aunts, uncles, cousins, and grandparents all lived in the same town.  Her parents’ aunts, uncles, cousins, and grandparents also lived in the same town. However, her generation was the first to “leave town.” I dragged her to California; her brother lives in New Hampshire; and she has cousins who live in Vermont and Illinois. Many families have similar stories as the world is much more global than it used to be. In fact, it is quite common today to have friends and family who live in a different country. While having contacts all over the world can be a benefit, it can also create a potential estate planning trap.

Most comprehensive estate plans are centered around a revocable living trust.  The trust provides that the Grantors (the “Trust Makers”) serve as the initial Trustees (“Trust Managers”) and name other individuals or entities as Successor Trustees in the event of the Grantors’ incapacity or death.  It is common to name family members and friends as Successor Trustees.  However, if a trust names a non-U.S. Citizen or a U.S. Citizen who resides in another country as a Successor Trustee, the trust could be considered a “foreign trust” by the IRS, resulting in adverse tax consequences. 

Adverse tax consequences of a foreign trust can include recognition of capital gains for transferring certain assets to the trust even if they have not been sold; mandatory withholding by the IRS; and certain federal reporting requirements.  These consequences can result in a significant depletion of the trust estate contrary to the Grantor’s intent. To avoid classification as a foreign trust, the trust must meet two tests: the “court test” and the “control test.”

The “court test” is met if a court located within the 50 states or the District of Columbia has primary supervision over the administration of the trust.  As long as the Trust is administered within the United States and does not contain a “migration provision” – a provision that transfers the administration to another country upon the occurrence of an event – then the “court test is satisfied.”  If the Trustee is a resident of another country – even if the Trustee is a U.S. Citizen – there could be questions as to whether the administration of the trust is actually taking place in the United States.  

The “control test” requires that a “U.S. Person,” which could be a non-U.S. Citizen who is a resident of the United States or a U.S. Citizen who is not a resident of the United States, has the authority to control to “all substantial decisions of the trust.”  Naming non-U.S. residents who are not U.S. Citizens as a Trustee can fail this test. 

When establishing a living trust, care should be taken if the trust involves any parties who are either non-U.S. residents or non-U.S. Citizens.  Special language might be required to ensure that the United States courts have jurisdiction over the administration of the trust and that the trust is controlled by a “U.S. person.”  It might also be prudent to avoid naming any non-U.S. resident or non-U.S. Citizen as a Trustee or to hold any other trust position that involves control over the trust.  If you cannot think of any friends or family members who reside in the United States to act in such a role, you might want to consider appointing an American professional private fiduciary or a U.S. corporation to fulfill such roles. 

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205. 

Disclaimer: This article is for general information only. Reading this article does not establish an attorney/client relationship.  Before acting on any of the information presented in this article, you should consult a competent attorney who is licensed to practice law in your community. 

IRA’s and Special Needs Trusts – A Tricky Mix

Inheritances are not always the carefree “jackpots” that people often envision. Sometimes they can create problems if the estate planning instrument is not structured properly. Two areas where inheritances can become especially problematic without careful planning are Individual Retirement Arrangement accounts (“IRA’s”) and Special Needs Trusts for beneficiaries who are reliant upon means-tested public benefits such as Medi-Cal or SSI.  Exceptional care must be taken when both of these areas are combined. 

IRA’s – Preserving “The Stretch”

Traditional IRA’s allow tax deferment in order to encourage saving for retirement.  Each dollar that is saved in an IRA creates a tax deduction. The money saved in the IRA grows in a tax deferred manner and is not taxed until it is withdrawn from the IRA.  The IRA owner is allowed to withdraw funds from the IRA beginning in the year after the owner reaches age 59.5 without any penalty.  However, beginning in the year after the IRA owner reaches age 70.5, the IRA owner is required to make minimum distributions from the IRA and must pay tax on each distribution.  Such distributions are often referred to as “Required Minimum Distributions” or “RMD’s.” 

If an IRA owner dies while still having funds in an IRA, the IRA owner may designate a beneficiary.  If the beneficiary meets certain requirements, the beneficiary is allowed to spread out RMD’s based upon his or her lifetime, thus minimizing the applicable tax on each distribution every year.  The concept of allowing a beneficiary to “stretch out” the RMD’s over his or her lifetime is often referred to as a “stretch IRA.”  Careful estate plans should allow the beneficiary to “stretch” the IRA over the beneficiary’s life expectancy.  Without careful planning, the beneficiary might be forced to withdraw all of the IRA at a much more rapid rate, thus increasing the taxation and depleting the IRA much sooner.

If an IRA designates a trust as a beneficiary, great care must be taken to ensure that the beneficiaries of the trust may “stretch out” distributions based upon their life expectancy.  The trust designated as the beneficiary of an IRA must meet specific requirements.  Furthermore, the IRA must be based upon the oldest trust beneficiary’s life expectancy.  If a charity is named as one of the trust’s beneficiaries, it will usually prevent a “stretch” of the IRA since a charity does not have a life expectancy.  

The question becomes whether contingent trust beneficiaries must be counted in determining the oldest trust beneficiary to figure out whether an IRA “stretch” is possible and to determine whose life expectancy can be used.  For example, if an IRA designates a trust as a beneficiary that names John (age 35) as the 100% lifetime beneficiary but upon John’s death, any remaining balance is to be distributed to Sally (age 45) and Bob (age 55), Bob might be considered the oldest trust beneficiary and John would have to base his RMD’s on Bob’s life expectancy.  If the contingent beneficiaries included a charity, then John might not be able to stretch out the IRA at all since the charity does not have a life expectancy. 

One way around this problem is to include “conduit provisions” into the trust.  “Conduit provisions” provide that all RMD’s must not only be taken out of the IRA, but that the Trustee of the trust must furthermore distribute the RMD’s directly to the primary beneficiary of the trust.  In the example above, if the trust included “conduit provisions” requiring that all of the RMD’s be distributed out of the trust and be given to John, then only John’s life expectancy is considered in determining RMD’s for the trust (Sally, Bob, and the charity do not have to be considered). 

The solution of including “conduit provisions” works in the majority or circumstances.  However, if the trust designated as the beneficiary of the IRA is a Special Needs Trust, “conduit provisions” are not possible and special language must be included in order to preserve the “stretch” of the IRA. 

Special Needs Trusts

If a beneficiary is reliant upon means-tested government benefits such as Medi-Cal or SSI, the beneficiary’s inheritance should be structed as a Special Needs Trust.  A Special Needs Trust is a trust that is designed to allow the beneficiary to use and enjoy the inheritance in such a manner that the inheritance does not interfere with the beneficiary’s eligibility for means-tested public benefits.  The key with a Special Needs Trust is that a third-party Trustee manages the inheritance for the beneficiary and is careful about the amount, timing, and purpose of each trust distribution. 

Because the Trustee of a Special Needs Trust must be careful about the amount, timing and purpose of each trust distribution, “conduit provisions” that require the Trustee to automatically distribute each RMD directly to the trust beneficiary should not be included in a Special Needs Trust.  Without “conduit provisions,” the contingent beneficiaries will have to be considered in determining whether and to what extent an IRA can be “stretched out.”  

A Special Needs Trust that is designated as the beneficiary of an IRA should not name a charity as a contingent beneficiary and should include special language that under no circumstances shall any contingent beneficiary be born before the primary beneficiary.  This often conflicts with the overall intent of the estate plan.  In such a situation, it might be prudent to design one Special Needs Trust for all non-IRA assets that might name older individuals or charities as contingent beneficiaries and a separate Special Needs Trust just for the IRA’s that limit the contingent beneficiaries to younger individuals. 

Conclusion:

IRA’s and Special Needs Trusts both involve careful, nuanced planning that often conflict with each other.  Any time you name a Special Needs Trust as a beneficiary of an IRA, special care must be taken with regard to the contingent beneficiaries to ensure that the trust beneficiary is able to “stretch out” the IRA as long as possible, thus minimizing tax on IRA distributions.  In many cases, a completely separate trust should be established just to be the designated beneficiary of the IRA.

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California and Kyle may be reached at 831-920-0205.

Disclaimer: This article is for general information only.  Reading this article does not establish an attorney-client relationship.  Before acting upon any information contained within this article, you should consult a competent attorney who is licensed to practice law in your community.  

 

 

Making Sense of Legal Jargon

As an English major, I am passionate about vocabulary.  For me, part of the appeal of practicing law is that lawyers have their own dictionaries!  In preparing for law school, I purchased a copy of Black’s Legal Dictionary from Borders in Sand City, California (remember that store?) and learned terms of interest.  Unfortunately, most legal jargon is not readily accessible to the average person.  A lot of the terms are confusingly similar.  In the Estate Planning context, there are several terms that appear to be the same but in fact have very different meanings.  Below is an overview of some of the most common confusingly similar legal terms related to Estate Planning. 

Power of Appointment v. Power of Attorney: 

A “Power of Appointment” is a power granted in either a Will or a Trust that allows the beneficiary to direct the distribution of assets, either during the beneficiary’s life (a “lifetime Power of Appointment”) or upon the beneficiary’s death (a “testamentary power of appointment”).  A “Power of Appointment” can be a very powerful tool to allow a beneficiary to change the disposition of a Will or a Trust as circumstances change.  Furthermore, the creative use of a “Power of Appointment” can effectuate certain estate planning strategies related to taxes, preservation of benefits, and asset protection. 

A “Power of Attorney” is a document that can be used to appoint a third party (an “Agent”) to make decisions on your behalf.  A “Power of Attorney” can be “immediate,” meaning that as soon as you sign the document your Agent has immediate authority to act upon your behalf, or a “Power of Attorney” can be “springing,” meaning that your Agent has no authority unless you lose mental capacity to make decisions on your own.  

General Durable Power of Attorney v. Health Care Power of Attorney:

A “General Durable Power of Attorney” typically will allow your Agent to make financial decisions on your behalf.  Such decisions can include: writing checks, paying bills, opening bank accounts, closing bank accounts, re-financing real property, selling real property, buying real property, signing tax returns, dealing with retirement accounts, and getting your mail. 

A “Health Care Power of Attorney” will allow your Agent to make health care decisions on your behalf.  Such decisions can include: opting in or out of certain medical procedures, choosing your treatment, choosing your medication, choosing your doctor, and deciding whether or not to maintain artificial life support in certain situations. 

Will v. Living Will:

A “Will,” sometimes referred to as a “Last Will and Testament,” is a document that directs the disposition of your assets upon death and also allows you to nominate an Executor who will have the authority and responsibility to carry out your wishes as expressed in your Will.  For most estates, a Will-based estate plan will lead to probate which is why many people prefer to utilize a “Revocable Living Trust” instead of a “Will.” 

A “Living Will” is a document that expresses your wishes as to how health care decisions should be made on your behalf if you are unable to make such decisions directly.  A “Living Will” is essentially a document that gives guidelines to your Health Care Agent about how your Agent should carry out your wishes under the authority of the “Health Care Power of Attorney.”

Advance Health Care Directive: 

An “Advance health Care Directive” combines a “Health Care Power of Attorney” with a “Living Will.”  The first part of the “Advance Health Care Directive” will name your Health Care Agents who will have the authority to make health care decisions on your behalf if you are unable to do so yourself.  The second part of the “Advance Health Care Directive” will give instructions and guidelines to your Health Care Agent about how to exercise his/her authority as your Health Care Agent. 

Testamentary Trust v. Living Trust:

Historically, trusts were created through Wills.  Upon the death of the testator (the “Will-maker”), after the probate settled the estate, instead of distributing the assets directly to the beneficiaries, the Will would create a “Testamentary Trust” that would govern the administration and distribution of the assets for the benefit of the beneficiary.  

As the probate process became more expensive and time-consuming, Estate Planning attorneys realized that the entire probate process could be avoided by creating Trusts while the testators were still living rather than waiting until the testators died.  Thus a “Living Trust” is a trust that is created during the Trust-Maker’s lifetime rather than upon death.  In addition to avoiding the additional expense and delay of probate, “Living Trusts” provide more privacy.  

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205.

Disclaimer: This article is for general information only.  Reading this article does not establish an attorney-client relationship.  Before acting on any of the information contained in this article, you should consult a competent attorney who is licensed to practice law in your community. 

Advanced Trust Planning

Traditionally, basic estate planning focuses on avoiding the unnecessary delay and expense of a court-supervised conservatorship in the event of mental incapacity, avoiding the unnecessary delay and expense of a court-supervised probate in the event of death, and minimizing estate tax.  A basic revocable living trust is usually the best vehicle for addressing all of these concerns.  

While it is important to avoid conservatorship, avoid probate, and minimize tax, an advanced trust can take advantage of many more planning opportunities.  Below is a description of some of the additional planning opportunities that a more comprehensive trust can provide.

Preserving a Beneficiary’s Eligibility for Public Benefits:

Many public benefits, such as Medi-Cal and SSI, are “means-tested,” meaning that a recipient of such benefits must be below a certain asset threshold. There are two key concerns with respect to “means-tested” public benefits: (1) qualifying for benefits; and (2) preserving benefits that one already has.

In qualifying for public benefits, there is often certain planning that can be done to qualify for public benefits, including rearranging and gifting assets.  In the event that the person who needs public benefits no longer has the capacity to make financial decisions, an advanced trust can include provisions that specifically authorize the successor trustees to engage in this kind of strategic planning on the person’s behalf.  Most basic trusts do not include such provisions which would often require court-intervention in order to allow for such planning.

Once a person has public benefits, preservation of those benefits is paramount.  The benefits recipient must make sure that his/her assets are below a certain threshold at all times.  Receiving a direct inheritance can instantly eliminate the recipient’s eligibility for public benefits.  An advanced trust can include a “standby Special Needs Trust” that will be used to hold the beneficiary’s inheritance if the beneficiary is receiving means-tested public benefits.  The Special Needs Trust can be drafted in such a way as to allow the beneficiary to use and enjoy the inheritance without interfering with the beneficiary’s eligibility for the public benefits.  

Provide a Degree of Asset Protection:

Basic trusts often provide for “outright distributions” after the Trust-Makers pass away provided that the beneficiaries are responsible adults.  Once the beneficiaries receive their inheritances, their inheritances are vulnerable if the beneficiaries develop creditor problems in the future.  For example, a beneficiary could receive a health care bill that exceeds insurance coverage or become involved in an automobile accident and be sued.  

An advanced trust can provide that the inheritance will be kept in trust for the beneficiary for his or her lifetime and can be structured in a way to provide the beneficiary with a strong degree of control as well as a strong degree of asset protection.  

Provide a Degree of Divorce Protection:

A beneficiary’s inheritance is separate property.  However, when a beneficiary receives an inheritance “outright and free of trust,” the beneficiary often will co-mingle the inheritance with the beneficiary’s spouse.  If they subsequently divorce, half of the inheritance can be lost to the divorcing spouse.  

An advanced trust that provides for the inheritance to be kept in trust for the lifetime of the beneficiary can make it less likely that the inheritance will be co-mingled with the beneficiary’s spouse and therefore making it less likely that any portion of the inheritance will be lost in the event of a subsequent divorce. 

Maintain Flexibility Without Court Intervention:

Often, the original Trust-Makers are the only parties who have the power to modify the trust.  In the event of incapacity and after death, the terms of the trust are frozen.  While this is typically desirable with regard to substantive provisions such as how the trust is to be divided upon the death of the Trust-Makers and the identity of the trustees, this can be a problem with regard to the tax and administrative provisions of the trust as the law can change and the beneficiaries’ circumstances can change.  Basic trusts typically do not allow for the modification of a trust once the original Trust-Makers have lost mental capacity or have died.  In such circumstances, a court-petition might be necessary in order to keep the trust current.  

An advanced trust can include “Trust Protector” provisions that allow for the appointment of an independent third party who would have limited authority to make modifications to the tax and administrative provisions of the trust without court involvement, saving considerable time and expense. 

Conclusion:

Trusts can be very powerful vehicles for the efficient management and distribution of assets in the event of incapacity and upon death.  However, most trusts only focus upon a limited number of planning opportunities.  An advanced trust can provide much more flexibility and protection for the Trust-Makers as well as the beneficiaries.  It is worth exploring these additional planning opportunities as they can provide a much more comprehensive plan for the beneficiaries.  

KRASA LAW, Inc. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205.

Disclaimer: This article is for general information only.  Reading this article does not establish an attorney-client relationship.  Before acting on any of the information presented in this article, you should consult a competent attorney who is licensed to practice law in your community.