CURRENT AREAS OF IMPORTANCE IN ESTATE PLANNING

Andrew D. Richards
Sharon A. Burgess

The 2000s have brought significant changes in the approach estate planners need to take in planning. Individually, these changes have occurred with legislation and regulations which would not have generally adversely impacted most clients. However, the cumulative impact of those changes means it is time for a review, if not a major overhaul of many clients’ plans.

Changes In The Laws:

The primary changes have come in three areas: (1) The Federal Estate Tax, (2) the treatment of IRA’s and qualified retirement plans, (3) The treatment of assets for purposes of Medicaid and long term care. This will summarize the changes, how they might relate to your plan, and the actions we recommend you take.

Changes in Client Circumstances:

With the changes, has come a “learning curve” for us in terms of new language included in updated documents, and in terms of the habits and practices of our clients. In years past, we have underestimated the number of and rate of change, many clients have experienced. In particular, we have found that clients don’t fully appreciate the need for proper asset ownership and beneficiary designations in their plans, or (as human nature and our hectic times sometimes dictate) are simply too lax about the process.  It is not unusual for a client to “check in” with us after several years and find significant assets which are not accounted for within the plan.

1.  Changes in the Estate Tax and Suggested Client Action

In 1997, the Congress, for the first time since 1981, enacted a change in the exemption amount for federal estate taxes (prior to that time the exemption amount was $600,000 in assets). ¹ Under the 1997 legislation, the exemption equivalent was to be increased (albeit at a glacially slow pace) to an eventual $1 million (it had reached $675,000 before the next change occurred).

In June of 2001, a conservatively dominated Congress again made changes which appear to be favorable to the taxpayer, increasing the equivalent to $1 million. In January of 2004, it again increased to $1.5 million; and in 2006 to $2.0 million. It is scheduled to change in 2009 to $3.5 million, and in 2010, to be repealed. This apparent good news does not come without some “political baggage,” however.  An archaic provision of Senate procedure provides that “finance” bills which do not garner a certain super-majority vote, must have a sunset provision that requires re-passage, changes, or a law to die a natural death after 10 years. Though Congress was conservatively controlled at that time, it was not enough to pass a “permanent” tax bill. So this one sunsets on December 31, 2010.  This means that on January 1, 2011, we will be back under prior law, which theoretically takes the exemption amount back to $1 million. As all this is unfolding, it is clear to some of us that there is a very good chance that there will be additional changes long before we reach 2011.

In April of 2003, the U.S. House of Representatives passed legislation to make these changes permanent, and sent it to the U.S. Senate. In late June, the Senate defeated the measure.

In practical terms, as good as these changes may seem, they have the potential to create an estate planning nightmare (except, of course, for those of us who make our living working with these rules). Indeed passage of the new law has prompted some tongue-in-cheek commentators to suggest that instead of estate planning, we should engage in “death” planning, and that the time to die is sometime during the year 2010, when there is no estate tax. It may also be true that this “moving target” law could be called the “Estate Planners’ Full Employment Act.” While we can make light of it, it does--unfortunately--require some kind of action by clients.

Plan Simplification:  One broad effect of the new law is that the $1 million exemption is likely permanent (as permanent, at least, as Washington gets) and many clients who were on the proverbial “bubble” at $600,000 are completely “out of the woods” at the $1 million mark. These clients may want to look at whether the “two-trust” plans with estate tax planning remain necessary. The two trust plan certainly makes for more complexity in funding the trust and tracking asset ownership.  It may also create undesirable inflexibility on the death of the first spouse. While there would be some cost involved in restating the trust plan, it may be ultimately more palatable to you as the client.

Another option may be to take a wait-and-see approach. Some of our later two-trust plan documents contained a provision which allows the surviving spouse to, “opt out” of the two-trust plan if the total estate is below the exemption amount.  This, in-effect, allows the surviving spouse to do the “simplification” after the first death.

The risk, of course, of “simplifying” now is that after 2011 (or sooner, if Congress makes more changes), you may have to come back again and do the more complex plan.

Larger Estates - The “Moving Target”

For estates clearly above the $1 million mark, the decisions are tougher. Growth always has to be a consideration. But for the foreseeable future, the mark against which that growth needs to be compared will be moving upward. Will the estate grow faster than the changes in the exemption equivalent? Will the changes actually occur (or will Congress change or stop the upward movement)? The answer to these questions will drive whether to create, or continue “two-trust” plans, or wait to see what happens.

• What Clients Need To Do

If you have not recently done so, you need to take an “estate inventory.” It is important to remember that “estate values” are sometimes quite different from “net worth.” For estate planning purposes we count the death benefit payout of life insurance and annuities. Those values alone can make large differences. The value you arrive at then needs to be put into the above context (e.g., is it more or less than $1 million? What do you anticipate as future growth rate of assets?  Will there be a substantial change in your income in the future?).

2.  IRA and Qualified Plan Assets

One of the things the “estate inventory” will tell us is what assets are either IRA’s or tax-qualified plans (note that annuities will sometimes be treated similarly, but there is a lot of confusion about annuities, so we separate them, too).

Plan Documents . In order to properly advise about the correct treatment of qualified plans, we really need to review the plan documents (or in the case of an IRA, the custodial agreement). This is because, in spite of the IRS regulations and rulings, we have learned that many plan documents either do not take full advantage of the available rules, or are simply not in compliance. Generally, though, the plan document will govern in the event of an inconsistency, so we need to see those to advise about your options. The document, for example, may not authorize a particular beneficiary designation, or may require a particular distribution or designation election.

Beneficiary Designation . The primary question is how to treat these assets in the overall estate plan. The rules regarding the proper designation of beneficiaries in qualified plans require an identifiable beneficiary. This generally must be an individual.  No designation+or improper designation+of a beneficiary can have the consequence of requiring an immediate, taxable, lump-sum distribution. One thing is clear+no matter who the beneficiary, as the assets come out of the plan, they are taxable. It is a matter of how much and how fast they are required to be paid out+a concept known as “required minimum distributions” (or RMD).

Trusts As Designated Beneficiary . It is permissible under the regulations to name a trust as beneficiary, and if the trust beneficiaries are individual(s), it will qualify as an identifiable beneficiary. However, there are significant “pitfalls” to doing this. One is the potential that if the trust contains a beneficiary who does not qualify as an individual (e.g., a charity), the entire trust may fail to qualify as an identifiable beneficiary, causing immediate distribution and taxation. Another problem is that if the trust beneficiaries are a group or “class” (e.g., “my children”), the oldest of the class will be the longest “measuring life” permissible, shortening the “stretchout” of tax-deferral for the younger members of the “class.” Unless careful attention is given to the treatment of “principal” and “income,” the trust may not be allowed to “look through” to the beneficiary and pass the “Required Minimum Distributions” to them. This will result in higher taxation because the trust has higher rates. Suffice it to say, this is a complex area.

In the past, we have recommended contingent beneficiary designations to the Trust Agreement. Depending on the age and circumstances of spouses and children, We now look to whether to include the in the Trust Agreement or leave them entirely outside. There are a number of legitimate reasons for using Trusts as beneficiary designations for these plans:

• Lack of Maturity of the Beneficiary
  
• Concerns about Children’s spouse
  
• Incapacity or Special Needs of the Beneficiary
  
• Spouses:  Second Marriages, concerns about financial management ability, etc.
  
• Desire to give one person the ability to allocate among and/or exclude beneficiaries
  
• Accumulation of Income in Trust (in spite of potentially higher taxation rates).

Given the developments in this area, however, it is now, in our judgment, a better approach to designate adult beneficiaries individually, as beneficiaries rather than the trust, unless one of the above goals is compelling. If there are young beneficiaries, or beneficiaries with some other incapacity, it may be necessary to provide specific trust language to protect against some of the pitfalls. A properly drafted trust provision may well preserve the maximum tax deferral and help to manage the above concerns.

• What Clients Need to Do
  
  • Review all beneficiary designations on IRA’s, TSA’s, 401(k) plans, profit sharing plans, and all other “qualified” retirement plan accounts, in light of the above discussion. If any doubt exists, contact us.
    
  • Obtain a copy of the plan document to determine if current beneficiary designations are authorized by the plan and how they will be treated.

3.  Long Term Care Planning

This is a subject which depends, greatly, on the age and health of the client. For some, it is simply a matter of gaining awareness. For others, the time may be at hand to consider significant planning alternatives.

Durable Powers Of Attorney . One of the most powerful estate planning tools is the “Durable Power of Attorney.” So-named because it continues to be effective even after the maker becomes mentally incapacitated (hence, “durability”), it allows us to designate a trusted individual to act for us in the event we are unable to act for ourselves. Because of the significant number of clients with long term care issues, we have revised and enhanced the language in both our general power of attorney and our health care “Designation of Patient Advocate” (a medical power of attorney), to include provisions allowing the holder (agent) of the Power to take steps necessary for asset preservation and medicaid qualification. Many administrative agencies have made it clear that, absent such specifically worded provisions, they will not honor the agent’s transactions for such purposes.

In a similar manner, the IRS has indicated it will not honor agent-transactions for tax purposes (e.g., gifts and qualified retirement plan elections) unless the power contains specifically worded provisions.

Our Health Care Powers of Attorney have been revised to reflect the changes to the Michigan Probate Laws under the new “Estates and Protected Individuals Code” (“EPIC”), and to provide appropriate “release” language for dealing with medical records of the patient under new potentially more stringent federal law.

Planning Options to Consider . A significant number of us will spend time in a long-term care situation (whether nursing home, or one of the newer alternatives, including home-care, assisted-living facilities, etc.). Current Nursing Home costs in mid-Michigan can approach $60,000 a year. The vast majority (contrary, we believe, to popular opinion) of that cost is paid for by private sources (insurance and private assets).

Long Term Care Insurance . One planning alternative is to consider long term care insurance. That is an area that in many cases, the earlier you apply, the better your rates are and the better Chance of Overall Insurability . Long Term Care insurance policies should be carefully reviewed before purchase to apprize clients of all terms and conditions, limitations and actual coverages. That is something we would be glad to assist you with.

Medicaid Qualification.  In order to be eligible for governmental payment (Medicaid), for these expenses, you have to either be “indigent” (defined in terms of dollars as having not more than $2,000 in “cash” type assets), or your assets have to be arranged in such a way as to be legally unavailable to you to cash in and use for your own care. There are a number of planning alternatives, but all of them involve a significant relinquishment of the asset or rights to them. It is also noteworthy that any action taken now may be subject to a 60-month “lookback” period.

A substantial body of law (popularly referred to as “Elder Law”) has developed around such planning and while I most often consider this a “last resort” planning alternative, it may be one which needs to be considered well in advance, in part because of the “lookback” period.

¹ Technically, the actual amount was a deduction from estate taxes, in the amount of just over $192,000, which was the tax on a theoretical $600,000 estate, which means that only estates over $600,000 had to report and possibly pay a tax.  For our purposes, we will refer to the “exemption equivalent” which will always mean the size of the estate you may pass without taxation.

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