INTRODUCTION
Several types of estate planning have become "hot
topics" in the estate planning area. Perpetual
trusts are now allowed in Alaska and several other states.
These trusts provide substantial inheritance tax savings,
creditor protection, probate avoidance, and management
benefits. The estate planning field is now emphasizing
planning for distributions from IRAs and qualified plans,
which often form a substantial part of our clients'
assets. These developing topics are explained below.
New
Federal tax legislation was just enacted. Several of
these provisions have significant estate planning relevance.
The
1998 Alaska legislature was very active in the trust
and estates area. A number of these provisions strengthen
the administration of trusts and estates in Alaska.
Other provisions provide additional support for the
Alaska Perpetual Trusts and Asset Protection Trusts
which were enacted in 1997. The legislature again proved
that it was willing to operate on the "edge of
the envelope" and enacted the Alaska Community
Property Act, an elective form of community property
only available in Alaska. Its goal is to provide a significant
income tax benefit which is available to persons living
in community property states, but not those living in
separate property states like Alaska. This new act has
also spawned a new type of Alaska trust: the Alaska
Community Property Trust.
In
this newsletter we will describe, in general terms,
the above-described estate planning and legislative
developments. Our purpose is to provide you with general
information about the changes which are occurring. We
will not try to go into the specifics of these subjects.
As
always, it is important for you to periodically review
your own estate planning situation. You should consider
not only the changes in the law, but also your personal
financial and family situation. Our office, your accountants,
and your other financial advisors are always available
to review the specifics of these changes with you, as
they apply to your personal estate planning.
Now,
let's review these important estate planning developments
and legislative changes which have recently occurred:
I.
PERPETUAL TRUSTS--A POPULAR NEW DISPOSITIVE APPROACH
Most
states have statutes or case law which restrict the
lifetime of a trust. However, in 1997 the Alaska legislature
amended our law to eliminate this restriction. Therefore,
Alaska trusts may now be perpetual. This means that
the trust will be available to provide benefits to
your descendants and their families for as long as
the trust continues to have assets.
Usually
a Perpetual Trust is divided into shares, one for each
of your children. Then the income and principal of the
child's trust will be used for the benefit of the child
(the primary beneficiary) and your child's descendants.
Often the trustee is given complete discretion to make
distributions to them for any purpose, after taking
into consideration their income and other resources,
and the effect that any of these distributions will
have upon them. In addition, the trustee may provide
your beneficiaries with valuable benefits, such as use
of a trust-owned residence, without actually distributing
income or principal to them. After each child's death,
that child's trust is divided among his or her children,
and each of them becomes a primary beneficiary of a
separate trust. These trusts will be administered and
distributed pursuant to the same type of directions
as those which apply to your child's trust. As each
primary beneficiary dies, new trusts will be created
for that deceased primary beneficiary's descendants.
This plan will continue from generation to generation
until the trusts run out of assets. Some clients desire
to also include their children's and descendants' spouses
in the above-described dispositive plan.
Perpetual
Trusts provide the following benefits:
1.
The trust assets are protected from your descendants'
creditors. These creditors can include judgment
creditors from a commercial transaction, professional
negligence, or a personal injury situation. Further,
the assets will be protected from a property division
upon divorce. Your Perpetual Trust also provides protection
against improper influences that may result from a descendant's
inability, immaturity, inexperience, or possible incapacity
to manage assets.
2.
Probate is avoided.
3. The Perpetual Trust provides an "estate plan"
for your descendants which is already in place.
4.
Each descendant is given considerable flexibility to
modify the trust's dispositive plan. A primary beneficiary
is given both a lifetime and a testamentary special
power of appointment. This allows the primary beneficiary
to gift trust assets during the beneficiary's lifetime
and to change the estate plan at the primary beneficiary's
death.
5.
Potential for enormous inheritance tax savings
The
inheritance taxes which we are concerned with are
the Federal Gift Tax, the Federal Estate Tax and the
Federal Generation Skipping Transfer ("GST")
Tax. The Federal Estate Tax applies when a person
transfers assets at death. It has a graduated rate
scale and reaches a maximum rate of 55% when you have
transferred $3,000,000 of assets. If you design a
trust which continues for multiple generations, then
the Federal Estate Tax will apply to the first transfer
to the trust. Generally, the estate tax will not apply
when an older generation ceases to be the beneficiaries
and a younger generation becomes the new beneficiaries.
In 1986, Congress enacted the Federal Generation Skipping
Transfer Tax. This tax is designed to apply to the
transfers from generation to generation, when the
Federal Estate Tax does not apply. The GST tax is
always at a 55% rate. However, Congress provided each
spouse with the ability to protect $1,000,000 from
application of the GST tax. This protection is accomplished
by allocation of the $1,000,000 exemption to gifts
you make or to trusts which you create.
You
may decide to transfer assets to your Perpetual Trust
during your lifetime. These assets will be accounted
for under the Federal Gift Tax. At present, you can
transfer $625,000 gift tax-free, using your applicable
credit (which will increase to $1,000,000 by the year
2006). Alternatively, or in addition, your estate
planning may direct that certain assets be transferred
to your Perpetual Trust at the death of the first
spouse, or at the death of the surviving spouse. These
transfers will be accounted for under the Federal
Estate Tax. Finally, other irrevocable trusts which
you have created may direct that some or all of their
assets be transferred to your Perpetual Trust. These
transfers have probably already been accounted for
under the Federal Gift Tax. When these transfers are
made to your Perpetual Trust, the trustee is directed
to divide the assets into GST exempt trusts and GST
non-exempt trusts. As discussed above, the GST exempt
trusts are those that are protected by allocation
of your and your spouse's $1,000,000 exemptions from
the GST tax. If assets are allocated to the Perpetual
Trust in excess of your available GST exemption amounts,
then the excess assets will be allocated to "non-exempt"
trusts.
The
GST exempt trusts will only be subject to transfer taxes
once, as described above. Thereafter, these assets may
be used for the benefit of your children, grandchildren,
great-grandchildren, and so on, without any further
inheritance taxes. This is an extremely valuable benefit
of the Perpetual Trust. The compounding growth of the
Perpetual Trust's assets is far superior to the growth
of assets subject to the inheritance taxes at each generation.
Consider
the following example. Assume that $1,000,000 is contributed
to a Perpetual Trust, and it grows at 8% per year (that
is, a growth rate of 12% per year, less 33% income taxes).
Assume that every 30 years one generation dies and a
new generation is born. At the end of 30 years, the
assets in the Perpetual Trust would be $10,062,657.
If these assets had instead been subject to a 55% estate
tax at the end of 30 years, the remaining assets would
be $5,031,328. The tax savings grow enormously during
the next generation. At the end of 60 years, the assets
in the Perpetual Trust would be $101,257,064. Compare
this with the $25,314,266 of assets which would be remaining
after payment of a 55% estate tax at the first and second
generations' deaths.
Comments:
Our clients are now using Perpetual Trusts in a variety
of ways.
1.
Some clients are gifting part or all of their applicable
credit amounts to the Perpetual Trust each year, and
allocating GST exemption to these contributions.
2.
Other clients are designing their estate plan so that
the above-described contributions to the Perpetual Trust
are made at the clients' deaths.
3.
Some clients are planning to distribute most or all
of their assets to a Perpetual Trust.
Our
office can provide you with additional memoranda
concerning Perpetual Trusts. Alternatively, call for
an appointment to discuss this popular new trust.
II.
ESTATE PLANNING FOR IRA AND PENSION ACCOUNTS
Many
of our clients have developed substantial accounts
in profit sharing plans, money purchase pension plans,
§401(k) plans, other qualified plans, and IRAs.
As a result of the stock market boom in the last decade,
these qualified plans and IRA accounts have become
very substantial assets. These assets are different
from many of your other assets in that they are governed
by plan documents drafted by your employer or brokerage
firm, and are subject to special federal income tax
rules. From an estate planning perspective, it is
very important to analyze and fit these assets into
your overall estate planning. The goals are usually
to choose an appropriate beneficiary, maximize tax-free
growth, and minimize income and estate taxes.
Let's
consider possible beneficiaries:
1.
Your spouse. Often the first choice of beneficiary
is the client's spouse. The marital deduction will usually
avoid any estate tax. The spouse can roll over the account
to his or her own IRA. Thereafter, the spouse can receive
distributions after age 59, and can name his or her
own beneficiary.
2.
The marital trust. In many second marriage situations,
the client may want to retain control of the remaining
plan assets after the death of the surviving spouse.
Alternatively, a client may conclude that professional
management is necessary for the funds in the account.
A marital trust will again provide an estate tax marital
deduction. The income will be paid to the surviving
spouse, annually. However, the principal portion of
the account will be preserved for discretionary payments
to the surviving spouse, or for other beneficiaries
after the spouse's death. 3.
The
bypass trust. Sometimes a client will not have sufficient
non-pension assets to fully fund a bypass trust at the
client's death. Remember, the purpose of a bypass trust
is to be able to take advantage of the deceased client's
unified credit amount (presently $625,000). Naming the
bypass trust as a beneficiary of a qualified plan or
IRA account allows these funds to be used for full funding
of that trust. Various methods can be used to accomplish
this funding. A special formula beneficiary designation
can be used so that the bypass trust is fully funded,
and the excess of the account goes to another beneficiary.
Alternatively, a special beneficiary designation can
be used which first names the spouse as the beneficiary,
but if the spouse disclaims a portion of the account,
then it will go to the bypass trust.
4.
Your children, or trusts for their benefit. No marital
deduction will be available to avoid estate tax here.
As a result, both estate and income taxes will be incurred
by these accounts. However, if sufficient other funds
are available to pay these taxes, then some clients
desire to take advantage of the tax-free build-up benefit
of a qualified plan or IRA account. The goal then is
to design the beneficiary designations so as to spread
the payments to the children over a period which is
usually the lifetime of the oldest child.5.
Charities. A 100% estate tax charitable deduction is available.
Payments received by the charity will not be subject
to income tax. A charity can be named outright as a
beneficiary. Alternatively, the use of a donor- advised
fund provides the client and his or her family with
the ability to direct the choice of charities and charitable
purposes.
Comments:
Review your qualified plan and IRA planning to make
sure it is properly implemented. Estate planning
for qualified plan and IRA accounts is complex. The
plan or IRA documents must be reviewed. Specific beneficiary
designations may need to be drafted. Some accounts require
a consent of the surviving spouse if another beneficiary
is chosen. Sometimes it is advantageous to roll the
accounts into several IRAs, which then can be used for
different beneficiaries. Much of the planning should
be done prior to the client reaching the age of 70 years.
Like
all of your estate planning, there should be a periodic
review of your planning for your qualified plan and
IRA accounts. Your estate planning attorney should be
consulted not only about your choice of beneficiaries,
but also about the adequacy of your implementation of
these choices..
III.
NEW FEDERAL TAX CHANGES
On
July 22, 1998, the President signed the Internal Revenue
Service Restructuring and Reform Act of 1998. This
Act contains provisions relating to all tax areas.
In addition, a technical corrections portion clarifies
various provisions of last year's tax act. Most of
these provisions are too technical for this newsletter.
However, several are particularly important for estate
planning and for procedure before the IRS:
1.
One-year capital gains holding period. For individuals,
estates, and trusts, assets will only need to be held
for twelve months to qualify for long-term capital gains
2.
Gift tax statute of limitations. The new Act clarifies
that once the three-year gift tax statute of limitations
has expired, the value of such gifts will be finally
determined, even if no gift tax was paid on the gift.
3.
Burden of proof. In Tax Court and federal court
proceedings involving income, estate, gift, and generation-skipping
transfer taxes, the burden of proof shifts to the government
provided that the taxpayer introduces credible evidence,
complies with any substantiation requirements, maintains
required records, and cooperates with the IRS.
4.
Attorney-client privilege. This privilege is now
extended to communications between a taxpayer and any
"federally authorized tax practitioner" with
respect to "tax advice." Therefore, the privilege
will include attorneys, certified public accountants,
enrolled agents and enrolled actuaries.
Comments: Some experts anticipate that the shifting of the burden
of proof to the government will motivate the IRS to
be much more demanding at audit. Extension of privileged
communications to accountants should assist us in comfortably
including CPAs in our estate planning process. Their
contributions are often invaluable.
IV.
THE NEW ALASKA
COMMUNITY PROPERTY ACT (EFFECTIVE MAY 23, 1998)
1.
Alaska, like all separate property states, has suffered
from the lack of equality between separate property
and community property states.
After
the death of the first spouse, residents of community
property states have a distinct income tax advantage
over residents of separate property states. Assume
a couple's property is owned approximately equally between
them. In a separate property state like Alaska, this
ownership could consist of joint ownership in the form
of tenancy in common, joint tenancy with right of survivorship,
or tenancy by the entirety. At the death of the first
spouse to die, the basis of decedant's assets (but not
the decedant's spouse's assets) is adjusted to the fair
market value of such assets at death. In a generally
growing economy, this adjustment is usually upward,
and therefore the term "stepped-up basis,"
at death.
Contrast
the above basis result to the adjustment provided in
community property states. At the death of the first
spouse, both the decedant's one-half share of the community
property and the decedant's spouse's one-half share
of such community property are adjusted as described
above. Therefore, basis is increased to the fair market
value of the entire property, rather than just one half.
This
lack of equality can produce significant income tax
differences if the surviving spouse sells the assets
during the period between the first spouse's death and
the surviving spouse's death. In a separate property
state, one half of the assets sold will produce capital
gain which would have been completely avoided if the
couple had instead lived in a community property state.
Furthermore, the sale of assets during this period of
the surviving spouse's lifetime is likely. The family
business may need to be sold due to the decedant's lack
of participation, or pursuant to an existing buy-sell
agreement. Real property may be considered burdensome
to manage. Market conditions may dictate the sale of
assets before an expected downturn.
2.
A remedy for this unfairness: Alaska's "elect-in"
community property system. The goal of the Alaska
legislature is to allow taxpayers to obtain the above-described
community property full "step-up" in basis,
to the extent they so desire. A married couple may elect
to treat all their property as community property. Alternatively,
they can elect that only certain assets be treated as
community property, leaving the balance of their assets
as separate property. If both spouses are domiciled
in Alaska, the election occurs through the execution
of a community property agreement or community property
trust. If one or both spouses are not domiciled in Alaska,
then this election can be made by the spouses transferring
property to a community property trust.
The
community property agreement and community property
trust have many similar characteristics. They are written
instruments, signed by both spouses. Within an agreement
or trust, the spouses may agree on (i) the rights and
obligations in the property; (ii) management and control;
(iii) the disposition of the property; (iv) choice of
law governing the instrument; and (v) any other matter
that affects the property and does not violate public
policy. If the agreement or trust is silent as to a
subject, the Act contains a number of default rules.
A
community property trust is designed to be used by couples
when one or both spouses are not domiciled in the state
of Alaska. In order to provide a nexis with Alaska,
a number of additional requirements are added. At least
one trustee must be an individual domiciled in Alaska,
or an Alaska trust company or bank. Other co-trustees
may be non-residents, and may include the spouses. The
Alaska trustee's powers must include maintaining records
for the trust, on an exclusive or a non-exclusive basis,
and preparing or arranging for the preparation of, on
an exclusive or a non-exclusive basis, any income tax
returns that must be filed by the trust. The trustee
must maintain records that identify which property held
by the trust is community property.
It
is uncertain how the IRS will respond to this new elective
community property system. This is the only such elect-in
system presently in effect in the United States. Oklahoma
had briefly experimented with a similar system from
1939 through 1945. At that time, the IRS challenged
the effectiveness of an elect-in community property
system which the taxpayers relied upon to split the
income from the property between them so that they could
report it on separate returns. An additional issue exists
for non-residents: will the IRS argue that they should
be treated differently than Alaskans with respect to
such elective community property? Finally, this new
Alaska approach to get a full stepped-up basis may motivate
the Internal Revenue Service to seek federal legislation
changing the rules for such stepped-up basis.
Comments: If you are interested in treating some or all of
your property as community property, we remain available
to confer with you and assist you in this process. Both
Alaska residents and non-residents will need to carefully
evaluate whether "electing-in" to Alaskas
community property system is advantageous. An analysis
concerning the potential income tax benefits in regard
to the couple's specific situation is the first step.
However, of equal importance will be the non-tax consequences
of partially or fully adopting a community property
system. Some couples may be attracted to the equality
and other characteristics of Alaska community property.
Other couples may conclude that the non-tax consequences
of a community property system are not to their liking.
V.
ALASKA ASSET PROTECTION TRUSTS AND PERPETUAL TRUSTS:
1998 LEGISLATIVE AND IRS DEVELOPMENTS
In
1997, the Alaska legislature enacted statutes which
provided that an individual could form a trust, be a
discretionary beneficiary, and still have all of the
trust assets protected from the individual's creditors.
This asset protection for the person who is both the
creator and a beneficiary of the trust was unique to
Alaska. Not only did these new trusts provide for a
new type of arguable asset protection, but this reversal
of public policy created arguments that an individual
could "complete" gifts to such a trust. Similarly,
proponents argue that the trust assets will not be included
in the settlor's estate at death. This contention is
based upon the fact that the independent trustee has
absolute discretion concerning whether to make distributions
to the settlor. Therefore, it will be difficult to argue
that the settlor has made a transfer under which the
settlor has retained for his life the enjoyment of the
property.
The
1998 Alaska legislature has enacted a number of provisions
designed to strengthen the above-described Alaska Asset
Protection Trusts, as well as Alaska Perpetual Trusts.
1.
Changing an existing trust to an Alaska Perpetual Trust. This statute is designed to allow for the conversion
of an existing trust to a trust which takes advantage
of the new Alaska laws. This may be necessary if the
trust does not contain appropriate perpetual trust provisions.
Pursuant to this new statute, such conversion can occur
if the trustee has absolute discretion under the terms
of the trust document to invade the principal of the
trust for the benefit of a beneficiary who is eligible
or entitled to the income of the trust.
Comments: You may have an existent irrevocable trust to which
you have contributed substantial assets. This may be
a trust for the benefit of your spouse, children, and
grandchildren. It may be a life insurance trust. You
may wish to change the trust's dispositive plan to a
Perpetual Trust. If so, we should review its provisions
to see if it is capable of conversion under this new
statute.
2.
Statute of limitations clarified.
3.
Trustee may use trust assets to defend against creditor
attack.
4.
Prohibition against suing trustee and others involved
in preparation of the trust for conspiracy to defraud.
5.
Non-Alaskans may serve as co-trustees.
6.
Change of a trust's situs to Alaska. This provision
is designed to facilitate the change of situs to Alaska
of a trust which was created in another jurisdiction
that does not have law as favorable as Alaska's. Some
or all of the trust assets must be deposited in Alaska,
at least one trustee must be an Alaska trustee, and
the Alaska trustee must register the trust under Alaska
law. Once the situs is changed to Alaska, then proponents
argue Alaska's creditor protection and perpetual trust
provisions will apply.
Comments: You may have accomplished some estate planning while
living in a state other than Alaska. Your relatives
may live outside of Alaska and have accomplished some
estate planning. You or your relatives may desire to
have some of Alaska's new favorable trust provisions
apply to these trusts. If so, we should review the trust
instruments to determine if this can be accomplished
by a change of situs of the trust to Alaska.
7.
IRS has responded to private ruling request. An
Alaska resident created a trust to which she planned
to contribute most of her unified credit amount. She
asked the IRS to rule that the gift to the trust was
complete, and that the trust's assets would not be included
in her gross estate at death. The IRS ruled that the
contribution to the trust is a completed gift for Federal
Gift Tax purposes. However, since the settlor is still
alive, the Service declined to rule on the question
of whether the trust's assets would be included in the
settlor's gross estate at death.
Comments: Asset protection planning will remain a controversial
and "gray" area of estate planning. Further,
the IRS often declines to rule in areas it considers
aggressive. We remain available to discuss these subjects
with you, and the various techniques which are available.
VI.
ADDITIONAL ALASKA ESTATE AND TRUST ADMINISTRATIVE
STATUTES
ENACTED
1.
Non-residents may direct that probate of their wills
occur in Alaska. This provision is designed to
allow someone living in another state to direct that
the probate of his or her will occur in Alaska. The
proponents of this provision suggest several benefits
to non-resident estates. Alaska does not have a state
income tax. Arguably, a non-resident's estate probated
in Alaska would not be subject to state income tax
here or elsewhere. Second, if Alaska substantive law
applies to the will, then arguably a testamentary
trust may be perpetual, if allowed under Alaska law.
Third, an Alaskan may have been chosen as a personal
representative (executor or executrix) under a non-resident
relative's will. This new statute allows the Alaskan
personal representative to move the probate to Alaska
for easier administration. Since Alaska has adopted
the Uniform Probate Code, probates under this code
are informal, simpler, and less expensive to administer.
Comments: Many of us have relatives who live outside of Alaska.
Often they are older, and we may have been designated
as the personal representatives under their wills. This
provision would allow the Alaskan personal representative
to administer the probate here in Alaska.
2.
Uniform Trustees Powers Act. Alaska statutes have
been silent concerning the powers of a trustee if they
are not specified in the trust document. Adoption of
a portion of this Uniform Act now provides such powers,
which may be limited or added to by the terms of the
trust. The Uniform Trustees Powers Act was drafted in
1964, and has been adopted by sixteen other states.
3.
Uniform Trusts Act. This Uniform Act was originally
drafted in 1937 and has been adopted by six states and
one territory. With some changes, Alaska has now adopted
this Act. The Act provides a number of rules relating
to a trustee's obligations and the extent of the trustee's
and trust's liabilities arising out of contract and
tort suits.
4.
Alaska Uniform Prudent Investor Act. Alaska becomes
the seventeenth state to adopt this Uniform Act, which
was drafted in 1994. This Act states that its provisions
will be default rules, which may be changed by the settlor
in the trust instrument. The Act provides that a trustee
shall invest and manage trust assets as a prudent investor
would, by considering the purposes, terms, distribution
requirements, and other circumstances of the trust.
The trustee shall exercise reasonable care, skill, and
caution. The trustee's decisions shall be evaluated
not in isolation but in context of the trust portfolio
as a whole and as part of an overall investment strategy
having risk and return objectives reasonably suited
to the trust. The Act lists a number of circumstances
that a trustee shall consider. Diversification is emphasized.
The Act emphasizes that compliance with its guidelines
is to be determined in light of the facts and circumstances
existing at the time of a trustee's decision or action
and not by hindsight.
5.
Trust incontestability clauses. Many people desire
to put a provision in their will or trust which states
that anyone contesting the decedant's or settlor's plan
will be disinherited. Existing Alaska law limits the
effect of such a provision in a will if the contesting
party had "probable cause" for the challenge.
The new 1998 statute eliminates this exception for trusts
created during lifetime or through a will. Therefore,
if a trust has an incontestability clause in it, any
challenge will result in the challenging party being
disinherited.
Comments:
Most of our trust instruments contain such an incontestability
provision.
Do
you desire any of the above new Alaska legislative changes
to apply to your existing trusts? The effective
date for the above-described new Alaska statutes (see
paragraphs 1 through 5) is September 15, 1998. In general,
these provisions will only apply to trusts created after
that date. However, these new provisions will apply
to both testamentary and lifetime trusts that were created
before that date if the trust is re-registered after
September 15, 1998, and if the new registration states
that the trust will be governed by these new provisions.
Comments: If you desire that any of the above-described provisions
apply to your existing trusts, then we need to re-register
those trusts and state in the registration that the
trusts will be governed by the new law. We will be
happy to help you with this process. However, you need
to notify us in writing, or at a conference, before
we will accomplish this re-registration for you.
We
hope the above summary of estate planning "hot
topics" and federal and Alaska legislation is helpful
to you. If you have any questions, or desire further
information about these or other estate planning matters,
please contact us for an appointment. We remain available
to assist you and your family. |