The following, as promised, is Part 2 of the “Clean Out Your Estate Planning Attic” article which is from Forbes, published March 19, 2023 and written by Martin Shenkman. This part covers family trusts, life insurance, size of some trusts and more. The third and final part will be posted next week.
Bypass, Credit Shelter or “Family” Trusts
So, what is a bypass trust and why might it no longer be a winner? Some years ago, if say the husband died if he gave all his assets to his wife, on her death a greater estate tax would be due to the extent the combined estate exceeded the amount the wife could pass on estate tax free (called the estate tax exemption). So, the dilemma was how could husband make sure wife could benefit from his assets but try to avoid an estate tax on her death? The answer was to create a trust that she could benefit from, but which would not be included in or taxed in her estate. In essence the trust would be available to her but would bypass her estate. Hence, the name “bypass trust.” It was also commonly called a “credit shelter trust” since it used the estate tax credit to shelter assets from taxes. Back then the estate tax exemption may have only been $1 million. Today it is $12,920,000. Millions of surviving spouses have in place bypass trusts that remain from that prior law environment.
So, in the current tax environment, there may be no estate tax benefit from keeping a bypass trust. Worse than no estate tax benefits the assets in that trust won’t get the step-up in income tax basis on the wife’s death. Assets in the wife’s estate will get a basis step up on her death. This can be illustrated as follows. Assume wife bought an investment for $300,000 and it is worth $500,000 on her death the tax basis on which capital gains is calculated is adjusted to the $500,000 value. Since assets in the bypass trust are not in her estate they don’t qualify. So, the current reality is that a trust that could have saved a lot of estate tax when it was created now may save no estate tax, lose a valuable income tax benefit, and requires that the surviving wife pay her CPA every year to file an income tax return for the trust. Lousy deal.
What can the wife do? Assuming no risks of lawsuits, a new spouse divorcing her, or Medicaid risk, she might explore with her estate planner terminating the trust and distributing the assets to herself. The ability to do that will depend on the terms of state law, the trust (her late husband’s will), and perhaps the willingness of the heirs to agree to it. But, getting rid of an old trust may be a tax winner, provide cost savings ever year, and eliminate complexity.
Old Irrevocable Life Insurance Trusts (ILITs)
Life insurance trusts are common estate planning tools and often make sense for people who are not even uber-wealthy. The typical life insurance trust owns life insurance policies on your life and its purpose is to protect those funds from taxes, creditors, predators, to benefit your loved ones, e.g., a spouse and children. In many cases even an old life insurance trust might still make sense as the insurance may still be useful and keeping it in trust might still make sense (although a lot of old insurance trusts are not well planned and can and should be improved by merging them into new and improved trusts, but that is a different article).
But many old life insurance trusts might no longer make any sense. For example, you purchased a $500,000 life insurance policy when your 2 kids were infants with the goal of providing financial protection for them if you died prematurely. Now your kids are in their 30’s, have secure jobs and families of their own. You’ve determined that the life insurance policy makes sense to keep, but is the trust worth keeping? It depends. The old trust, as many do, provides that at age 35 any money in the trust is paid out to the kids outright. So, if you die the trust will serve little purpose. Also, when you purchased that $500,000 policy it was a lot of money, but today, for $250,000 per child the figures aren’t that large so that perhaps simplifying everyone’s life by terminating the trust and having the trustee distribute the policy to the two adult children jointly might be a worthwhile simplification.
Survivorship Life Insurance that is Not Needed
Survivorship or last to die insurance is a type of life insurance that pays off when the last of a couple dies. The rationale for this is that for estate tax purposes the estate tax is only due when the second of two spouses die. That is because there is an unlimited marital deduction so that on the death of the first spouse an unlimited amount of wealth can be bequeathed to the survivor. Example, on husband’s death in 2003 he bequeathed $5 million to wife. On wife’s later death, when the estate tax exemption was $1 million as it was in 2003, a substantial estate tax would be due on the $4 million taxable estate. That amount could have been reduced by another $1 million if husband bequeathed $1 million to a credit shelter trust and the balance to wife. In either event, a big estate tax would be due on the second death. So, a common planning technique was to buy life insurance that only paid off when the second spouse died. That was less costly than buying life insurance on one spouse’s life, and it dovetailed perfectly with when the estate tax would be due. That plan may have been sensible when set up but 20 years later the estate tax exemption is close to $13 million and if it is cut in half in 2026 as it is scheduled to be, the estate may still not be taxable. If you have a survivorship life insurance policy that no longer serves an estate tax purpose, unless there is another use for which it makes sense or reason to keep it (e.g., health issues make it impossible to obtain any other insurance and your estate needs the liquidity for non-tax reasons). So, unless there is another reason for maintaining the life insurance, or financially you determine it is worthwhile, perhaps it may make sense to get rid of the policy. Before you do so, however, explore the option of possibly selling the policy into the secondary market.
Getting rid of a policy that doesn’t make sense may facilitate terminating an old insurance trust that will then have no assets (once the proceeds from the policy are distributed), it may avoid the need for annual payments that can be used for better purposes, and it simplifies your finances and eventual estate.
Power of Attorney with Inappropriate Gift Provision
A power of attorney is a legal document in which you name an agent to make tax, legal and financial decisions for you. A key provision in many powers of attorney is one that authorizes the agent to make gifts. Those provisions can be really important and really powerful and should be reviewed periodically. You may have an old power of attorney that authorized the person you designated as agent to make gifts. Some powers of attorney forms do so without limit. That is really a huge right that you might be uncomfortable with. Some limit the right of the agent to make gifts to your remaining estate tax exemption. When the exemption was say $1 million in 2003 and assuming you had already given away $600,000 in gifts, that would have meant that your agent could have given away about $400,000 of your assets. The exemption today is nearly $13 million so that same provision might authorize your agent to gift away more than $12 million. That may really be uncomfortable. So, talking to your estate planning attorney about getting a new power of attorney form that properly limits, or even prohibits, gifts, might make sense. Getting rid of those old documents (and you might not even remember what the gift provision had provided for!) may be important.
Trusts that are Too Small
So, years ago you set up a trust to hold college savings for each of your three children. That was in the day before 529 plans existed so trusts for children and grandchildren to cover college costs were common. Say you put $150,000 in each trust and during college and grad school those trusts were spent down to $20-$30,000 each. That means the trusts served their purpose then. But what about now? Having old trusts languishing with modest funds in them and paying a CPA every year to complete a tax return, etc. is likely not worth the bother. Perhaps, the trusts provided that all the assets had to be distributed outright to the child beneficiary when they reached age 35 and all your kids are in their 50’s now. Payout the money, terminate the trusts, stop paying for income tax returns, and simplify your financial life and estate. If this sounds odd, be assured it happens frequently. So many people get used to having “stuff” in their estate planning attic that no one ever asks, “what purpose does this serve?”
The Trust That Never Was
This one will sound really odd, but for almost no effort you can save a lot of headaches and costs down the road. When you become incapacitated and someone you name takes over your finances, or when you pass and someone has to serve as your executor, they have to get a handle on all of your finances. A common waste of time, effort and legal fees is often on determining what happened to a trust that never was. Say you spoke to your attorney about creating a life insurance trust, but you never signed it, or even if you signed it you erroneously purchased the insurance in your name instead of in the name of the trust. So, you have drafts or even signed copies of an insurance trust that was never funded, never registered with the IRS (i.e., a tax identification number was never obtained), etc. Years or decades from now when someone has to take over your finances during your disability or following your death, they have the responsibility to identify all assets. When they find an unsigned old trust, or even more confusingly a signed trust that may not have been used or was terminated, as discussed above, they’ll want to confirm that the trust was either never implemented, or if implemented was terminated. It is not easy to prove a negative. The time spent calling your prior lawyers, CPAs and wealth advisers to identify the status of that perhaps never used trust is a real waste of time. Create a document with the name of the trust, explain that it was never used, and so forth. Have any relevant people that were named in the trust sign that document (those you can get to). Put that document on top of a copy of the old trust and scan it. That way, if someone looks through your electronic files to determine what happened, if they search the name of the trust the most recent document will be this one that confirms it did not exist. That way, when someone “goes looking” there is something to easily find to confirm what occurred (or in this case what did not occur). If you have an old trust that was formed but either never used or ended, ask your estate planner if something more should be done to formally terminate the trust. If the trust was ever used there may be tax or other filings that are required to formally and properly close up. But cleaning up all these old loose ends can really simplify and clean up your estate planning attic.
If this wealth of information is making you realize you’re overdue for an estate plan update, give me a call. You can reach me at 513-399-7526 or visit my website, www.davidlefton.com, to schedule a consultation directly.
Source: Forbes online 3/19/23 Written by Martin Shenkman