An irrevocable life insurance trust (ILIT) is an estate planning tool generally used to provide liquidity that may be used to pay off estate taxes.  It does this by keeping the proceeds from life insurance policies outside of the insured’s taxable estate.  According to the IRS, if a policy owner can withdraw cash value from a policy, or change the policy beneficiary (among other powers), then the policy owner has “incidents of ownership” over the proceeds.  If this is the case, the policy will be included in the owner’s taxable estate under IRC Section 2042.  In other words, if you own a $1 million life insurance policy, your taxable estate is increased by $1 million, and so will be more vulnerable to estate taxes upon your death.

In order to avoid this, an ILIT can be drafted to hold the policy.  The trust becomes the owner and beneficiary of the insurance policy, thereby removing it from your taxable estate.  When the insured person dies, the money from the policy goes into the trust, to be administered tax-free to the trust’s beneficiaries (different from the policy beneficiary, remember…the policy beneficiary is the trust itself) by the trustee.  If the estate of the insured needs cash to pay the estate tax (or other expenses), non-liquid assets from the estate can be “sold” to the ILIT in exchange for the cash, providing the estate with the needed liquidity.

Policy Premium Payments

Sounds simple, right?  Well, not quite.  Insurance policy premiums payments can cause a glitch.  Usually, the amount of the premium payment is paid to the trust in the form of an annual gift (which the trust then uses to pay the premium on the policy it owns).  The problem is that gifts to a trust don’t normally qualify as “present interest” gifts, and so cannot be considered for the gift tax annual exclusion.  In other words, when you make payments to the trust to cover the insurance premium, you will have to pay the gift tax.

However, if the trust beneficiaries are given “Crummey powers,” this may be avoided as well.  The Crummey power gives the beneficiary the right to withdraw the gift within a certain amount of time; if they do not, the gift remains part of the trust.  The unspoken understanding, of course, is that the beneficiary will not choose to exercise their withdrawal rights.  As long as a notice is sent informing the beneficiary of their withdrawal right, the Crummey power qualifies the gift as a “present interest,” thereby making it subject to the annual gift tax exclusion. 

Note that if the trust has more than one beneficiary (as ILITS usually do), a “hanging” Crummey power should be used.  When a trust has more than one beneficiary, the IRS will consider the lapse of a Crummey power to be a taxable gift to the other beneficiaries of the trust, if the amount that could have been withdrawn exceeds the greater of $5,000 or 5% of the value of the trust (the so-called “five and five” rule).  A hanging Crummey power allows the holder’s withdrawal right to lapse only to the extent of the IRS “five and five” limitation, allowing the remaining amount (the annual exclusion amount minus the five and five amount) to “hang” over into future years, when an additional amount can lapse without taxable transfer.  (For more information about Crummey trusts and Crummey powers, please see related articles.)

Some Additional Remarks

Remember that the ILIT’s trustee should be a third party, not you or your spouse, since this would cause the policy to be included in your estate (defeating the point of the trust).  It is also best if the trust is the original owner of the life insurance policy.  If you as the policy owner transfer your ownership to the trust, the policy proceeds will be included in your estate for estate tax purpose if you die within three years of making the transfer (IRC Section 2035 (a)).  No such waiting period applies if the ILIT is the original owner of the policy. 

Also note that if the spouse of the insured is going to be a beneficiary of the trust, then the spouse must not also be a grantor of the trust, or the policy proceeds will be considered part of their estate.  If community property dollars (in other words, funds or properties acquired during marriage in community property states such as California) are used to fund the trust, then both spouses are considered grantors.  This means that only separate property of the insured should be used to fund the trust, so that the uninsured spouse will not be considered a grantor.  You don’t want the spouse to have any share in the funds or properties used to pay the premiums, or the spouse will be deemed to have “incidents of ownership” in the policy and the proceeds will be included in the spouse’s estate for estate tax purposes on his or her subsequent passing.

By Genevieve Hoffman 7/15/10

A Roth IRA is an individual retirement plan; it can be either an account or an annuity.  A Roth IRA is similar to a traditional IRA, except for the following differences. 

A Roth IRA can be set up and contributed to at any time in the individual’s life, while a traditional IRA can only be contributed to before age 70.5.  The contributions made to a Roth IRA are also not tax deductible.  However, the distributions from the Roth IRA are tax free, as long as the distributions are made at least five years after the first contribution to the Roth IRA was made, and as long as the payment or distribution is made on or after you reach age 59.5.  The distributions may be made at an earlier age if you are disabled; however, the five year waiting period still applies.  The distributions may also be made to a beneficiary or to your estate after your death, although the five year waiting period applies to this as well.  Furthermore, if you are the original owner of the Roth IRA, you are never required to take contributions, unlike a traditional IRA, which requires you to take contributions after you turn 70.5.

Rules for Contributions

Unlike traditional IRAs, contributions made to a Roth IRA are not tax deductible.  However, there is no age limit on making contributions to a Roth IRA; they can be made at any point in the contributor’s lifetime.  For a given year, contributions can be made any time during that year, or by the due date of your tax return for that year, not including extensions.

In order to contribute, you must have taxable compensation (meaning: wages, salaries, tips, professional fees, bonuses, etc.), and a modified adjusted gross income (AGI) of less than:

• $176,000 for married couples filing jointly or a qualifying widower;
• $120,000 for a single head of household;
• or $10,000 for a married couple filing separately. 

If you are only contributing to Roth IRAs, the combined maximum contribution allowed per year is the lesser of either $5,000 ($6,000 if you are age 50 or over), or your taxable compensation.  If you are contributing to Roth IRAs and traditional IRAs, your maximum annual allowed contribution is the same as above, minus all contributions made to a non-Roth IRA.  (So for example, if you are under age 50 and in one year contributed $3,000 to a traditional IRA, you would only be able to contribute $2,000 combined to your Roth IRAs in that same year.)

If you exceed the contribution limit, you must pay a 6% excise tax on all excess contributions.  However, if your contributions for one year are over the limit, you can apply the excess contribution to a later year if the contributions for that year are less than the maximum allowed for that year, and avoid paying the excise tax.

Conversions

It is possible to convert some or all of you assets in a traditional IRA to a Roth IRA.  There are three ways to do this:

• The first is through a rollover: you can receive a distribution from a traditional IRA and contribute it (roll it over) to a Roth IRA within 60 days of the original distribution.
•   The second is through a trustee-to trustee transfer:  you can direct the trustee of the traditional IRA to transfer an amount from the traditional IRA to the trustee of your Roth IRA. 
• The third option is a same trustee transfer: if the same trustee oversees both your Roth and traditional IRAs, you can direct the trustee to transfer an amount from one to the other. 

However, no matter the method used, amounts transferred or converted from a traditional IRA into a Roth IRA must be included in your gross income for the tax year in which the amount is distributed or transferred.  (For example, if you transfer $1,000 from a traditional IRA to a Roth IRA, you still have to include the $1,000 in your income on your tax return for that year.) 

In addition, if you choose to convert only part of your traditional IRA, rather than the entire thing at once, you can’t choose to convert only the nontaxable part of your traditional IRA (which contains both taxable and nontaxable money).  So, if you have a traditional IRA with a balance of $10,000, $6,000 of which is in nondeductible contributions, and you choose to rollover or convert $6,000 of this money to a Roth IRA, you’re required to treat the rollover as coming 60% from the nondeductible contributions, and 40% from the tax deductible contributions.  Thus, 40% of that rollover money will be taxable.

Rollovers

You can also roll over all or part of a distribution you receive from your (or your deceased spouse’s) employer’s qualified pension, profit-sharing or stock bonus plan (including the 401k); an annuity or tax-sheltered annuity plan; or a governmental deferred compensation plan.  However, you must include in your gross income distributions that you would have had to include in your income if you had not rolled them over into a Roth IRA; you don’t have to include a distribution from a retirement plan that is a return of after-tax contributions that were taxable to you when paid.

There are two rollover methods.  One is to receive a distribution from a retirement plan and roll it over to a Roth IRA within 60 days of the distribution.  Since the distribution is paid directly to you, the payer generally has to withhold 20% of it. 

There is also the direct rollover option, where an employer’s retirement plan gives the option to have any part of a distribution paid directly to a Roth IRA.  Since this is paid directly into the IRA, there is generally no withholding.  Rollovers from one Roth IRA to another Roth IRA are completely tax free, if the rollover is made within 60 days.

By Genevieve Hoffman 7/8/10

General Considerations

One of the most important decisions for trust grantors concerns the selection of a trustee.  Bear in mind that being a trustee can be a lot of work, and the work can often be complicated (although you may be able to hire a professional to deal with the more complicated aspects).  Remember that a trustee’s duties continue for as long as the trust exists, and may require expertise in collecting estate assets, investing money, paying bills, and filing accountings and managing money for the beneficiaries.  The trustee generally also has to spend a lot of time consulting with the trust beneficiaries about their needs, so the ideal trustee would be someone with whom the beneficiaries feel comfortable.

The general qualities you want to look for in a trustee are: honesty, organizational skills, and the ability to use good judgement and to exercise it impartially.  If you are looking at choosing a non-professional, such as a relative or friend, a willingness to seek professional advice (and the ability to manage the advisors) isn’t a bad quality either.  (You don’t want someone who insists they will be able to handle every aspect of the trust’s management themselves, because unless they are a lawyer, CPA, and financial advisor all in one, odds are they won’t be able to do so.)  You also want to choose someone who is willing to serve as your trustee.

Keep in mind the location and types of the assets in the trust, and the location of the beneficiaries.  If the trust contains substantial real estate, for example, you might want to consider a potential trustee’s familiarity with the financial and tax implications of the property.  If the trust contains a family business, think about a potential trustee’s familiarity with that business.  And since the trustee may have to consult frequently with the trust beneficiaries, you might consider choosing someone who lives near those beneficiaries, to make communication easier. 

Lastly, consider the intra-family dynamics of the beneficiaries, and the potential trustee’s understanding of those dynamics.  You want someone who will be able to handle familial conflicts that might arise among the beneficiaries.

So, who should serve as your trustee?  A family member?  A close friend?  A financial institution?  The list of potentials, and the requirements they need to fulfill, can be intimidating.  Here are some ideas to keep in mind that may help narrow the list.

Family Members as Trustees

 The benefit of choosing a family member as a trustee is that they (usually) won’t charge a fee, and will have a personal stake in the trust’s success, theoretically making them more likely to manage the trust well.  A family member is more likely to understand (and be responsive to) the needs of the beneficiaries, and will probably also have a better understanding of any peculiar family dynamics that may be involved.

The downside to choosing a family member is that they will often lack financial expertise, and so will have to pay to hire professional help.  Mortality, of course, is also an issue.  Banks don’t die, and so will be able to administer the trust for as long as the trust is in existence, but if a family member is chosen and the trust is intended to last for generations, successor trustees will need to be named.

The biggest issue with choosing a family member, however, is the potential for family conflict.  Depending on their relationship, family members may have problems with what the beneficiary wants or what is best for him or her.  Sibling rivalries may also complicate matters if one sibling serves as trustee for the others.  A professional manager, on the other hand, doesn’t face such pressures.

However, if you have a family member who is competent to handle the financial matters involved, has the time and interest to do so, and if family conflicts are not a problem, then naming a relative as a trustee may be a good idea.  However, you must also consider who the successor trustee will be in the event of the death or incapacity of the initial trustee.

Close Friend as Trustee

The advantages and disadvantages to choosing a close friend to serve as trustee are fairly similar to those of choosing a family member.  A close friend will have a good understanding of what the grantor wishes to accomplish under the trust, and is likely to have a close relationship with the beneficiaries.  Fees are also generally lower than that of a professional trustee.

The disadvantages, of course, are again a potential lack of experience when dealing with financial matters, and the potential for conflict with the beneficiaries.  The beneficiaries may resent having a family friend given the authority to make decisions for family members and family members’ inheritance, which could create conflict.

Institutional Trustees

The benefit of choosing an institutional trustee, such as a bank or trust company, is that the institution will be able to manage your trust for decades, if necessary (see above: banks don’t die), and will have knowledge and experience concerning financial investment and investment options.  Institutions are also by nature objective and regulated by law, so if you are particularly concerned about the honesty and impartiality of family members or friends, this may be the best option.

However, institutions can also be costly; most charge an annual minimum fee that can be around one or two percent of the trust’s assets.  Institutional trustees can also be very impersonal.  The trust beneficiaries won’t necessarily always be dealing with the same person, since personnel move around and the bank itself could change hands.  This means that the actual person the beneficiaries may be dealing with won’t know them as well, and so may not be as well equipped to handle the beneficiaries’ questions, needs, etc.

Private Fiduciaries

A private fiduciary is similar to an institutional trustee, in that they are a hired professional.  The major advantages and disadvantages are fairly similar to that of an institutional trustee as well: a private fiduciary will have experience with financial investment, but probably won’t be well known to the trust beneficiaries.  However, rather than dealing with an entire corporation, you are dealing with an individual professional trustee, which could be an advantage; one person is generally easier to get to know than several. Private fiduciaries also usually charge by the hour for the services they provide, which, depending on the size of the trust, may be more or less than the specific percentage charged by banks acting as trustees.

Co-Trustees (Yes, you can have more than one!)

If the property to be administered is complex, but you still want to maintain a personal touch, there is always the possibility of naming more than one trustee.  This enables you to pick different people (or institutions) with different strengths, and the grantor can decide how the multiple trustees will make decisions.

However, the co-trustee should also be familiar with nuances of your particular trust, and should also be sensitive to present or potential conflicts between family members you’re considering naming as co-trustees.  You must also establish in the trust which co-trustee is going to be responsible for which task, and create a mechanism for resolving disputes among the trustees.  (For this reason, you don’t want to have too many trustees.  The more trustees, the more unlikely it is that they will agree on anything.)

By Genevieve Hoffman 7/20/10

An ethical will is essentially a document that passes on thoughts, feelings, and values to family and friends.  It can be in any form: letter, journal, video tape, recording, manuscript.  Unlike a legal will, an ethical will has no legal purpose, and is not a legally binding document, although legal wills and ethical wills often accompany each other.  The simplest analogy is this: where a legal will bequeaths valuables, an ethical will bequeaths values.

The concept of an ethical will dates back thousands of years, and can be seen across many different cultures.  It has historically been found in oral traditions; community or family elders or leaders offered prayers, blessings and advice to family members and followers.  Over time, the contents have evolved to include the beliefs and values of the writer, or information of a personal or historical nature.

When to Write One

It is often easiest to write an ethical will over time rather than all in one sitting.  It may be something you want to start and then come back to periodically, as you have time or as you come up with new ideas.  It also doesn’t have to be something read only after the death of the author; many people choose to write and share an ethical will at a major turning point in their life: upon marriage, the birth of children, etc., or when an event or situation gives them cause for reflection. 

What to Include

An ethical will can include anything you want!  However, if you find simply sitting and staring at a blank piece of paper or computer screen intimidating (as many of us do), here are some ideas to consider.

You may find it easiest to organize your thoughts around a simple time frame: the past, present, and future, for example.  In the “past” section you could include meaningful personal or family stories, lessons learned from personal or familial experience, or historical or ancestral information that you want to pass on to future generations.  The “present” section might include your own personal values and beliefs, the values and beliefs of your community or religious faith, or expressions of love and gratitude to family members and friends.  The “future” section may include blessings, your hopes and dreams for present and future generations, advice or guidance, requests, or funeral plans.  Alternatively, you might decide to organize your ideas around several themes: values and beliefs, lessons and reflections about life, hopes for the future, etc. 

Getting Started

There are many different approaches to writing an ethical will.  The fastest and easiest, of course, is to start with an outline and a list of things to choose from, and go from there!  Writing exercises help too.  Think about what you wish your parents or grandparents had told you, and write about it.  Write about the activities you have devoted time to, and why.  Write about your favorite sayings or stories and include examples of how they guided you. 

If all this still feels overwhelming, try choosing a topic or exercise, setting a timer for fifteen minutes, and writing down whatever comes to you.  When the timer goes off, put away what you’ve written and come back to it later.  The task may feel less intimidating if you break it down into small bits.  Lastly, keeping a journal may help you to collect ideas for your ethical will by helping you to discover or remember thoughts, feelings, or events that you think are important, or by helping you to gain perspective about a situation, relationship, or experience.

Remember, these are simply ideas and suggestions.  There are no hard and fast rules.  However, try to avoid words that are chastising, negative, or controlling, or that focus on the actions of the reader, rather than on the feelings and experiences of the writer.  Write about what you think is important, or what you want others to know about yourself or your beliefs. 

A few additional thoughts.  First, this isn’t something your attorney can write for you.  This is both good news and bad news.  The good news is that you don’t have to pay for it!  The bad news is that you actually have to sit down and write it.  Hopefully, however, the above suggestions will make that part easier. 

Second, when you finish writing your ethical will, attach a copy to your original legal will, and give a copy to your attorney to be kept with your other estate planning documents.  It is also a good idea to tell your friends or family members that the ethical will exists, and where they can find it, so they know to look for it after you have passed away.  

Reasons to Write an Ethical Will

An ethical will can be used to articulate what you stand for, and to tell stories that illustrate your personal values, so they can be passed on to future generations.  It can fill in knowledge gaps for Will recipients by providing historical or ancestral information that links different generations.  It can be used to convey feelings, thoughts and truths that may be hard to say face-to-face, or it can be used to express regrets and apologies.  Most importantly, it will give family and friends something to look to for memories, guidance, and inspiration.

By Genevieve Hoffman 7/9/10

In addition to the $13,000 annual exclusion amount, unlimited gifts can also be made in the form of tuition or medical expenses, tax free.  The gifts can be made on behalf of anyone you choose (not just family), as long as the payments to be excluded from the tax are paid directly to the health care provider or educational institution (IRC Section 2503(e)).  These payments are then excluded from both the gift tax and the generation skipping transfer tax. 

What can the payments be applied to?

Education

For education, the exclusion is limited to tuition, and cannot be applied to payments for books, supplies, dormitory and boarding fees, or other similar costs not directly related to tuition.  However, the exclusion applies to tuition expenses for full-time or part-time students at any institution that maintains a regular faculty and curriculum and has students in attendance, meaning the exclusion payments can be used for private primary and secondary schools as well, not just higher education. 

The tuition money can also be prepaid.  You could, for example, choose to prepay tuition for your three grandchildren for the next five (or however many) years, and this would still qualify for the exemption as long as the money is paid directly to the institution, is to be used exclusively for tuition, and is non-refundable.  You must also agree to pay any increases in tuition imposed by the school in subsequent years.  Be aware, though, of the potential risk with this idea: the child may not end up attending that particular school, or may decide to transfer to another school, and the prepaid money is generally non-transferable.  However, if this risk seems unlikely (the child already attends the school and loves it!), then this may be a good idea.

Medical

For medical expenses, the exclusion applies to: expenses incurred for the diagnosis, cure, mitigation, treatment or prevention of disease; expenses for transportation essential to medical care; expenses for prescription drugs; and premiums for medical insurance.  Insurance may include regular health insurance and long term-care insurance.  However, medical payments must be for tax-deductible items (cosmetic surgery, for example, is not covered by this and so would not count for the exclusion).  Note: the exclusion only includes the portion of medical expenses not reimbursed to the donee by insurance.   

Benefits

The benefits to this (in addition to the benefits of gift giving in general), are that there is no dollar limitation on this type of excludable gift, and that these gifts can be given to an individual in addition to the annual exclusion amount without reducing the donor’s lifetime exemption.  Additionally, the dollars gifted are immediately outside of the donor’s estate for estate tax purposes, even if made very shortly before the donor’s passing.

By Genevieve Hoffman 7/11/10

Crummey Recap

The purpose of the Crummey trust is to enable people to gift into a trust and receive the annual gift tax exclusion, while still enabling the gifts to be held in trust for the beneficiary rather than being given to them outright.  The trust accomplishes this by giving the recipient a certain amount of time (at least 30 days) to take immediate control of the gift; if the recipient chooses to let this time period lapse, the gift remains in the trust.  Because the recipient had the chance to take control of the gift, the gift qualifies as a present interest, and can therefore qualify as part (or all) of the donor’s annual gift tax exclusion amount.  When the trust has only one beneficiary, this becomes a great way to gift into a trust without having to pay the gift tax or using up any of your $5 million lifetime exemption amount.  However, if the trust has more than one beneficiary, the issue becomes more complicated. 

 The Five and Five Rule

A trust beneficiary’s withdrawal right is considered a power of appointment under the tax code, and thus a “release” of the power of appointment is considered a transfer of property by the person who had the power, if the amount that lapses exceeds the greater of $5,000 or 5% of the aggregate trust assets.  This is known as the “five and five” rule.  So, if a Crummey trust beneficiary chooses not to withdraw the gift (which is the point, after all) the lapse is considered a release of their power of appointment, and therefore a transfer of property from the beneficiary to the trust.  In other words, the beneficiary’s decision not to withdraw the money is considered a gift to the trust equal to the difference between the total gift into the trust minus the value of the five and five power. 

Now, if the trust has only one beneficiary, this isn’t a problem, since you are only gifting the money to yourself.  However, if the trust has multiple beneficiaries, then the IRS considers a lapse in your withdrawal right a gift to the trust’s other beneficiaries.  And once the money reverts to the trust, it is no longer considered a present interest (because it cannot be immediately withdrawn), and so becomes a taxable gift.

Avoiding Gift Tax Liability

This certainly throws a wrench into the works, doesn’t it?  One way to avoid this, of course, is to ensure that the original donor never gifts more than $5,000 (or 5% of the trust’s assets) into the trust in the first place.  However, this solution rather defeats the point of using the annual gift tax exclusion, since the exclusion amount substantially exceeds the $5,000 limit. 

To avoid the “five and five” rule, and to increase the gift per donee to the annual exclusion amount, a “hanging” Crummey power is used.  The holder of the hanging power has the right to withdraw all of the contribution to the trust up to the annual gift tax exclusion amount; however, the withdrawal power (usually extended to the end of the calendar year) only lapses the extent of the five and five limitation.  The withdrawal right over the amount of property in excess of the five and five rule doesn’t lapse, but “hangs” or rolls over into the next (or future) calendar year, when the additional amounts in excess of the five and five rule can lapse without a taxable transfer.

By Genevieve Hoffman 7/13/10

In 1986 Congress passed a tax law which included enactment of the federal generation skipping transfer tax (GST). In a nutshell, the GST only permits an individual to pass a certain amount of money to someone more than one generation removed from him/her without incurring a tax on the transfer. The tax on the transfer is in addition to any estate tax that might have to be paid and is generally at the same rate as the estate tax rate. The purpose of the GST is to prevent individuals with large estates from escaping estate taxes by skipping generations.

The estate tax exemption is the amount that an individual can have in his or her estate at passing without paying federal estate tax. If that individual has used a portion of his or her gift tax exemption during life, then the estate tax exemption is reduced by the amount of the gift tax exemption used during life.

The GST exemption is the amount that can be passed, during life or at death, to a skipped generation without a GST tax. For example, a gift to a skipped generation would use gift tax exemption and GST exemption for the same dollars gifted. Similarly, a bequest to a skipped generation at death would use estate tax exemption and GST exemption on the same dollars bequeathed.

For 2011 and 2012, the estate/gift tax exemption is $5 million per person ($10 million per couple), and the GST exemption is also $5 million per person ($10 million per couple). The gift tax, estate tax, and GST tax rates are 35% on amounts beyond the exemptions.

Planning to use the available GST exemption should always be considered. It offers the opportunity to save significant amounts of estate tax and thus preserve additional wealth within families.

Example: Illustration of Benefit of Using Available GST Exemption

Scenario #1: Parents have an estate of $10 million, with their entire estate after the payment of estate tax passing to Son. Son uses his estate tax exemption with other dollars and passes the inheritance from Parents to his child, Granddaughter.

Scenario #2: Parents have an estate of $10 million, with their entire estate after the payment of estate tax and GST tax passing to Granddaughter directly.

Scenario #2 above assumes that Parents leave their entire estate to Granddaughter and bypass Son altogether. As an alternative, a Dynasty Trust could be used, as discussed below. The inheritance would be held in trust during Son’s lifetime and Son could receive income and principal from the Dynasty Trust as needed without the assets being included in Son’s estate. Granddaughter could then receive the assets of the Dynasty Trust on Son’s passing, or they could continue in trust for her lifetime as well.

Dynasty Trusts

A Dynasty Trust is a multiple generation-skipping transfer (GST) Trust designed to optimize the exemption from the GST tax. A Dynasty Trust holds assets in trust for the lifetimes of multiple generations. The income and principal from the trust can be distributed to members of the various generations. Estate tax or gift tax (or the use of exemptions) occurs at the creation of the Dynasty Trust, but the assets of the Dynasty Trust are not included in the estates of the members of the next generations so there is no estate tax at any of the next generations (until the trust terminates).

The income and principal from the trust can be distributed to the members of the various generations. Usually the assets of the Dynasty Trust are divided into separate shares for each beneficiary, but could also be administered as a single trust with multiple beneficiaries (called a pot trust). Each beneficiary or generation may also have the ability to decide if the Dynasty Trust should continue in the next generation or not, but would not have control to end the Dynasty Trust during his or her lifetime. The trust would terminate when one of the following occurs:

1. There are no more beneficiaries of the trust living (all generations are deceased with no younger generations remaining)
2. One beneficiary of a separate share (or all beneficiaries of a pot trust) elects to end the Dynasty Trust on his or her passing and distribute the assets to his or her children or grandchildren on his or her passing
3. The Rule Against Perpetuities dictates that the trust terminate (In California the rule provides that trusts can last about 100 years before they must terminate. At that point, the assets will be distributed to the beneficiaries at the time of the termination or in some other way specified in the trust)
4. The assets of the trust are exhausted

By John K. Bishop 2/19/11

A private foundation is a charitable organization that is distinct from a public charity.  A private foundation generally has a single funding source, such as an individual, family, or corporation, whereas a public charity usually solicits funds from the public in general.  Both private foundations and public charities have the intent to provide some type of charitable program, service, or activity.

There are two kinds of private foundations.  Most private foundations in the US are non-operating foundations which generally just disburse funds to other charitable organizations.  Conversely, operating foundations generally use their investment income to run charitable activities and work toward achieve their own charitable purposes.

Minimum Payout rate

A private foundation is required each year to make qualifying distributions for charitable purposes equal to or exceeding 5% of the fair market value of its net investment assets. If the foundation exceeds the 5% payout, the excess reduces the required distributions over the next 5 years. Qualifying distributions include grants and expenses related to pursuing the foundation’s mission, but not investment-related expenses.

Excise Tax

            Private foundations are subject to a two percent (2%) excise tax on their net investment income. The tax is one percent (1%) in any year in which the foundation’s percentage of distributions for charitable purposes exceeds the average percentage of its distributions over the five preceding taxable years.  The government imposes the excise tax so that there is little or no out-of-pocket cost to the government to handle the logistics of approving and handling the reporting for these entities.

Self-dealing and Excess benefit

Certain acts between the foundation and an insider, known as a “disqualified person,” are prohibited, such as the sale or lease of property. A disqualified person includes a foundation’s officers, directors, trustees, substantial contributors, family members, and certain entities (e.g., trusts, corporations, partnerships, estates) in which these persons have significant interests. A substantial contributor is one who has contributed more than 2% of all historical contributions made to the foundation since its formation and, in most case, has contributed at least $5,000.

Benefits of private foundations vs. Donor Advised Funds and other Philanthropic Vehicles:

Control

The donors, through a Board of Directors of their choosing, maintain control over their charitable giving and their investment strategy.

Grant making flexibility

Private foundations have several options for making gifts. In addition to gifts to US-based charities, private foundations may make international grants, grants for scholarships and awards and other forms of assistance directly to individuals and families, and grants to non-charitable exempt organizations (e.g., civic associations, business leagues), governmental units (federal, state, county, town), and even for-profit companies provided that the funds are used for a charitable purpose. Foundations may manage direct charitable programs, such as providing books to a school or hiring contractors to conduct research, and they may make charitably motivated loans and equity investments know as Program Related Investments. All of the foregoing are subject to the fulfillment of IRS requirements.

Continuity

By establishing a foundation, the donors’ charitable goals continue beyond his or her lifetime. The donors’ name is associated with the foundation’s charitable purposes in perpetuity.

Investment Strategy

Private foundations can own nearly any type of asset (partnerships, real estate, jewelry, closely held stock, options) and follow any investment strategy provided that they follow the prudent investor rules and avoid what the IRS defines as jeopardizing investments.

Mission Related Investing

A private foundation may invest its endowment in a way that’s aligned with its mission. For example, a foundation that focuses on environmental issues may invest its assets in a company that’s involved in alternative energy.

Expenses

Foundation members can pay for reasonable (non-lavish) and necessary administrative expenses associated with running the foundation, such as for conferences, office supplies, subscriptions, and site visits to charities. As long as these expenses help achieve the foundation’s charitable purpose and are well-documented, they count towards satisfying the foundation’s minimum payout requirement.

Compensation

Foundation may employ staff to run the foundation including family members. Foundation are allowed to pay compensation to family members provided that the individual is qualified for the position and that the compensation is reasonable in relation to what other foundations of a like size would pay a person with like skills, experience, and duties.

Tax Advantages

Private foundations receive favorable tax treatment. Donors receive an income tax deduction for contributions and an unlimited estate tax deduction for bequests at death. In addition, foundation earnings grow virtually tax free (1-2% excise tax).

Reasons Not to Establish a Private Foundation

There are many reasons why a private foundation may not be the best charitable vehicle for some individuals.  Some of the main reasons are as follows:

1. The cost to establish a foundation is significant
2. The annual cost to administer a foundation can also be significant
3. The amount that should be contributed in order for a foundation to make sense is usually in the rage of $1 million and up, with plans for additional contributions in the future

The private foundation requires a succession plan or a plan for termination on the passing of the original creators.

By John K. Bishop  2/19/11

But does this new law make bypass trusts obsolete? There are still many instances when bypass trusts are beneficial despite portability.

Why Were Bypass Trusts Necessary?

When a person dies, he or she can pass all property to a surviving spouse without incurring any estate tax liability. This is called the “unlimited marital deduction.” So if Husband and Wife have a community estate worth $10 million, Husband can pass his half of the community estate to Wife tax free.

However, if those assets are transferred outright to the Wife, the community assets would now be under her complete control. So when she dies, her estate would be worth $10 million. Without portability, Wife could pass up to the exemption amount tax free. But, her estate would be required to pay taxes on the excess.

How Do Bypass Trusts Work?

Bypass trusts work in the following way: Instead of passing all the estate to the surviving spouse, a portion of the estate up to the exemption amount is placed into a trust.

The trust assets can be used to provide the surviving spouse with income for the rest of his or her life as well as principal from the trust for his or her healthcare expenses, education expenses, and costs for his or her support and maintenance. However, the assets placed in the trust would not be treated as being owned by the surviving spouse for tax purposes, and would therefore not be included in his or her estate for purposes of federal estate tax liability. Upon the surviving spouse’s death, the assets could be passed to the trust’s beneficiaries without estate tax.

The New Estate Tax Law

The new federal estate tax rules signed into law by President Obama on December 17, 2010 allows the executor of a deceased spouse’s estate to transfer a deceased spouse’s unused tax exemption to his or her surviving spouse for use in addition to the surviving spouse’s estate tax exemption. This makes it possible for a deceased spouse’s unused estate tax exemption to be stacked on top of the surviving spouse’s exemption without the use of a bypass trust.  This is done by making an election on the deceased spouse’s Estate Tax Return (Form 706) due nine months following his or her passing.

Situations When Bypass Trusts Should Continue to be Used

Despite the fact that a deceased spouse’s exemption is now portable, there are still quite a few reasons why you may want to include a bypass trust in your planning. These include:

1. Protecting the assets you leave from creditors. Assets that are left to your heirs in a trust rather than outright can be sheltered from disgruntled spouses, creditors and others who may sue your heirs.
2. Remarriage of the surviving spouse. A surviving spouse who remarries may forfeit the deceased spouse’s unused exemption amount. Additionally, the bypass trust allows you to control who gets the remaining assets upon the surviving spouse’s death. If you leave your assets outright to your surviving spouse, and he or she remarries and commingles those assets those of the new spouse, your children may not get the inheritance you would have intended.
3. Your assets may appreciate. If your assets are left in trust, any appreciation on those assets will not be included in your surviving spouse’s estate. This reduces the possibility that your spouse’s estate will be worth more than the exemption amount when he or she dies.
4. You have grandchildren (or might someday). Portability does not apply to the $5 million exemption from the generation skipping transfer tax. If you intend to include grandchildren as beneficiaries, you can make lifetime gifts to your grandchildren or apply part of your exemption to the bypass trust and include them as beneficiaries.
5. Your plan already includes a bypass trust. There are many benefits of having a bypass trust, and you shouldn’t automatically change your will if it includes one. However, it is important that you review your will to ensure the amount of assets headed for the trust still reflects your intentions.
6. Avoiding administrative pitfalls. An executor of a deceased spouse’s estate must transfer the unused estate tax exemption to the surviving spouse by filing an estate tax return within 9 months of death, even if no estate tax is due. If the executor fails to do so, the unused exemption is lost.
7. The new estate tax law expires on December 31, 2012. If Congress does not pass new legislation before then, the exemption amount will be $1 million, the tax rate will increase to 55 percent, and portability may be a thing of the past.

Portability allows married couples to transfer up to $10 million to their heirs without the use of a bypass trust. But the use bypass trusts can still be beneficial in many situations.

Potential Drawbacks of Bypass Trusts

Bypass Trusts are not always a good planning tool.  Before planning with a Bypass Trust, a couple should consider the following factors:

1. Creation and Administration Expenses.  Bypass Trusts have a significant cost to create, and an ongoing cost of administration.
2. Separate Trust Income Tax Returns.  Bypass Trusts require separate trust tax returns (Federal Form 1041 and California Form 541) each year of existence.
3. No Basis Step-Up on Survivor’s Passing.  Property held by a Bypass Trust does not receive an income tax basis step-up on the passing of the surviving spouse like assets in the surviving spouse’s estate will.  This could lead to a higher income tax liability to the beneficiaries.
4. Loss of Control if Survivor is Trustee.  The surviving spouse losses some control over the assets in the Bypass Trust.  If he or she is the trustee, then he or she is only able to use the principal of the trust for his or her healthcare expenses, education expenses, and support and maintenance expenses.  This creates a loss of total control.

Loss of Control if Someone Other than Survivor Trustee.  If a person or entity other than the surviving spouse is named as trustee, then the restrictions on distributions are less stringent, but the surviving spouse has to request distributions from the third party, also causing a loss of control.

Originally by Rania Combs, Attorney at Law, http://www.texaswillsandtrustslaw.com/2011/01/17/does-portability-make-bypass-trusts-obsolete/, with permission.

Additions by John K. Bishop  2/15/11

There are several different ways to gift to children. One, of course, is simply to gift the money to the child outright. However, if the idea of gifting $13,000 to a child is an uncomfortable one (as it understandably may be), there are other options that will enable you to maintain more control over the gift.

The UTMA Account

The first option is to establish a custodial account (also known as a UTMA account, after the Uniform Transfers to Minors Act, which makes the account possible). Under this type of account, the donor is able to gift money into the account established in the child’s name. The child is considered the owner of the gifted property, but it is held, managed, and distributed by the custodian named when the account was originally established. When the child reaches the age of majority (age 18 in California), the property passes to the child outright. The distribution can be delayed beyond age 18 to age 21 (up to age 25 in California if established under a will or a trust) by adding the words “until age 21” in the account title. There is no contribution limit for UTMA accounts; however, it is best to keep your annual contribution at or below $13,000 (the annual gift tax exclusion limit), so that the contribution is not subject to gift tax requirements.

When setting these accounts up there are a few things to keep in mind. First, any money in custodial accounts for which you are the custodian are counted as part of your taxable estate if you are the parent or legal guardian of the child, and the child has not yet reached the age of majority or age of distribution. Thus, if you want to establish a UTMA account for your child, name someone else (not your spouse either!) to be the account’s custodian.

Second, since the account is in the name of a single child, the funds are not transferrable to another beneficiary (as they would be with a 529 plan).

Lastly, note that neither the donor nor the custodian can place any restrictions on the use of the money in the account once the minor becomes an adult. At that time, the child can use the money for whatever purpose they please, so there’s no guarantee the child will use the money for education or some other useful purpose. (This is why some parents or grandparents opt to establish a trust instead of a UTMA account, since it gives them greater control.)

The 529 Plan

The second option is to establish a 529 plan, which is basically a state-sponsored college savings plan. The key word here is college savings plan. The money in a 529 account is intended to be used for higher education purposes. While money from the account can be withdrawn and put to other uses, the withdrawn amount (and possibly the rest of the account, depending on the plan) will then be subject to income tax and a ten percent penalty. (In other words, don’t do this.) However, if the money is withdrawn for qualified education expenses (tuition, fees, books, supplies and equipment, room and board, etc.), the account’s earnings are exempt from federal income tax.

Like contributions to a UTMA account, contributions to a 529 plan in excess of $13,000 are considered taxable gifts. However, with a 529 plan, you do have the option of contributing up to five years of gifts at once ($65,000). However, if you do make 5 years of gifts at one, you cannot give that particular person any more gifts within the next five years without dipping in to your $5 million lifetime exemption.

The benefit of a 529 plan is you are the owner of the account; the child is the beneficiary. This means you will maintain control over the funds in the account even after the child reaches the age of majority. Furthermore, although you are the account owner, the 529 plan is considered a gift, so it is not part of your taxable estate (unlike contributions to some trust funds, or a UTMA account, if you are the custodian). The disadvantage, of course, is that a 529 plan can only be used for higher education (unless you really want to pay all those penalty fees). However, the account can be rolled over to another beneficiary as long as that person is considered a “member of the family.” A member of the family includes the spouse or descendants of the original beneficiary, as well as any siblings, first cousins, nieces, or nephews of the original beneficiary or the beneficiary’s spouse. So if, for example, one child receives a scholarship and thus has money left over in the 529 plan, the money can be rolled over into a sibling’s (or other relative’s) 529 plan.

Recap

A UTMA account is a custodial account created in a minor’s name, but administered by a custodian until the minor reaches the age of majority. Once the minor reaches age 18 (unless receipt of the account is delayed to age 21), control of the account passes to them completely, so they are free to use the money however they choose.

A 529 account, on the other hand, is used only for higher education, and is owned and administered by the person who created it; the minor is the beneficiary. This means that control of the funds does not pass to the minor it was created for, even after they have become a legal adult.

By Genevieve Hoffman 7/14/10