Spring 2013 Newsletter
Trust Planning: Still Relevant Despite Higher Estate Tax Exemptions and Portability
By Kathi L. Ayers
Now that Congress has made permanent the elevated federal estate tax exemption (currently $5.25 million, to be further indexed for inflation) and given the portability of estate tax exemptions, many planners wonder whether trust planning still makes sense for clients with more modest estates. This article will discuss the reasons why trusts remain not only relevant but crucial in many clients’ estate plans, even when minimizing estate tax liability is not the primary goal. These reasons include avoiding the probate court system, streamlining the administration of estates, planning for minor children or special needs beneficiaries, planning for spouses with different ultimate beneficiaries, and preserving the benefits associated with the use of traditional bypass trusts.
I. Avoiding Probate and Streamlining Administration
One important goal of estate planning is to streamline the settlement of one’s affairs after death in a way that minimizes court involvement. Even for clients not primarily concerned with estate tax minimization, avoiding the probate process is often a significant motivation for using a revocable trust. Not only is the probate process time-consuming and expensive, it can be overwhelming for family members who are thrust into the position of serving as executors of an estate. Probate involves qualifying as a fiduciary, preparing various notices and affidavits, filing accountings with the Court, and in many cases, hiring an attorney to help navigate this process. When assets are titled in the name of a revocable trust, many of these steps can be avoided. Additionally, probate requires the payment of probate taxes and fees. While a revocable trust typically costs more to establish than a simple will, it is usually the least expensive option in the long run.
When a client relies on a will and beneficiary designations to pass assets to beneficiaries after death, the distribution plan is fragmented. Some assets will go to named beneficiaries (typically life insurance and retirement account assets). Other assets will go through the probate process to beneficiaries in the will. In some cases, assets passing outside the will are the majority of the decedent’s assets, leaving the estate without sufficient funds to pay the decedent’s debts, expenses, and taxes. In that case, beneficiaries have to reimburse the estate for expenses from their inherited portion. The results can be disastrous, especially when the family is grieving the loss of their loved one or when family members are at odds with one another. In contrast, a revocable trust creates a central destination for assets after death. The Trustee first pays all of the decedent’s debts, expenses, and taxes and handles all administration matters. The Trustee then distributes the remaining trust assets to the beneficiaries. With a trust, there is no need for beneficiaries to reimburse the Trustee for expenses because they will have been paid prior to distribution to beneficiaries. The revocable trust makes for a cleaner, more organized administration by creating a more centralized system for distribution of assets after death.
II. Incorporating Continuing Trusts
Another important goal of estate planning is to provide for beneficiaries in such a way that maximizes control over the “who,” “what,” and “when” of the management and distribution of assets after death. Continuing trusts contribute toward this goal by allowing clients the flexibility to take into account the particular circumstances of their beneficiaries and to structure distributions to them in a way that accommodates these circumstances. It is important to note that while continuing trusts can be set up under a will with the same provisions, assets would be under court supervision and subject to the requirement to file annual accountings, unless waived.1 If set up under a revocable trust, clients can create accountability outside the court system under the trust’s terms and preserve privacy. This section will examine situations in which a continuing trust is essential to a client’s estate plan.
A. Preventing Court Involvement for Minor Beneficiaries
When minor children are named as beneficiaries of assets (e.g., life insurance policies or retirement accounts) or they inherit property directly in a will without designation of a custodian under the Virginia Uniform Transfers to Minors Act, it will be necessary for the court to appoint a guardian of the “estate” (property) of the minor.2 In most cases, a payor of benefits or assets will distribute the benefits or assets only to a court-appointed guardian even if the child has a surviving natural parent.3
A guardian of the estate of a minor appointed by the court must give bond in the amount equal to the value of the minor’s estate and provide surety on that bond, unless surety is waived by statute or by will. The guardian must also file an inventory with the Commissioner of Accounts detailing the minor’s assets within four months of being appointed guardian. The guardian must then file a first accounting with the Commissioner of Accounts within six months, and subsequently on an annual basis, until all assets are distributed or the child turns 18.4 The expenses of preparing and filing these accountings will erode the value of the assets being held for the minor over time. The fees associated with filing accountings with the Commissioner of Accounts under the State of Virginia voluntary fee guidelines range from $100 to a maximum of $5,000 per year and are based on the value of the minor’s estate, plus a $16 recording fee.5
The court-appointed guardian is limited in his or her ability to make distributions from the minor’s estate for the support of the minor when the child has a living parent.6 This is because a parent has a legal obligation to support his or her minor child.7 Under Virginia law, the guardian of the estate can make a distribution to a minor with a living parent only if (a) the parent is unable to fulfill that duty of support, (b) the parent is not required to provide the support, or (c) the distribution is beyond the scope of the parental duty.8 Even if a request for a distribution meets these guidelines, the guardian must first seek Court authorization before any distribution can be made.9 The only exception to this rule is that distributions of up to $3,000 per year will be allowed without court approval provided the distributions meet the same criteria for Court authorization and the Commissioner of Accounts approves the distribution. 10 Thus, naming a minor child as the beneficiary of an asset can severely limit the guardian’s ability to use such funds for the child when the child has a living parent, and such a result could completely frustrate the decedent’s intent for naming the minor child as the beneficiary. The following example illustrates a worstcase scenario.
Case Study: Peter is married to Jane, and has adult children from his first marriage. Peter and Jane have a daughter, Mary, who is an infant. Peter names his children (including his infant daughter) as beneficiaries of a life insurance policy. Unfortunately, Peter is killed in an accident. The life insurance company will not pay Mary’s share of the death benefit to Jane, but requires that she be appointed as guardian of Mary’s estate. Since Jane is Mary’s mother (and owes a duty of support to Mary), she cannot use the life insurance proceeds for Mary’s basic needs unless she proves that she cannot fulfill that duty. Jane files an accounting each year and pays court fees, commissioners fees and attorneys’ fees. As the years go on, Jane falls on hard financial times, and faces a foreclosure on her house. Jane liquidates all of her assets in an attempt to save her house from foreclosure. This is not enough, so Jane then liquidates the assets in Mary’s account with the intention of paying them back later. Because these transactions were not authorized by the Court, Jane is now required to justify the withdrawals to the Court and possibly pay penalties for her actions.
Much of this court involvement could have been avoided if Peter had named Jane as a custodian for Mary’s share under the Uniform Transfers to Minors Act (“UTMA”) (which allows property to be transferred to a custodian who holds and administers the property for the benefit of a minor until age 18 or 21)11 or if he had established a trust for Mary’s benefit with her share. While Jane could not use funds held for Mary under an UTMA account for her own expenses, Jane could expend as much of the account that she deemed necessary to provide for Mary’s needs, without regard to her own duty of support as Mary’s mother.12
B. Asset Management & Protection
Many clients are uncomfortable with a child receiving inherited assets outright at age 18 or 21. They are justifiably concerned about improvident uses of the assets and desire to prevent the assets from being wasted, preserve the ambition of the beneficiary, and protect against creditors and predators. Most 18-or 21-year olds do not have the maturity to handle large sums of money. Even if a particular beneficiary is mature and responsible, his or her “friends” may not be. In order to maintain control, clients may establish a continuing trust (preferably under a revocable trust) which takes effect at the client’s death and which can include restrictions on distributions until the beneficiary reaches ages specified by the grantor. While the money is in trust, it can be structured to be protected from creditors and predators of the beneficiary, as well as from a spouse in a beneficiary’s divorce settlement. In some cases, clients may designate the ages for distribution as high as the 50s or 60s in order to create a supplemental source of retirement income for the beneficiary. Additionally, if the beneficiary has a known problem, such as poor financial management skills or addiction issues, a continuing trust can be designed to provide for the beneficiary’s benefit for life, rather than distributing assets to the beneficiary outright.
Protecting assets of elderly clients from predators is another frequent concern. If a client’s assets are in a revocable trust, and there is a co-Trustee, then the co-Trustee can help manage the assets. Additionally, if a client becomes incapacitated, then a co-Trustee or a successor Trustee can step in and assist the client with managing trust assets.
C. Providing for Special Needs Beneficiaries
When beneficiaries have special needs, it is important to structure any distribution to them in such a way that does not disqualify the beneficiary from receiving government benefits to which he or she may be entitled. This requires the use of a special needs trust, sometimes referred to as a “supplemental needs trust,” which can be incorporated as a component of the clients’ revocable trust or can be a standalone document.
D. Allowing for Distribution to Spouses’ Separate Beneficiaries
Where one or both spouses have children from a previous marriage, separate revocable trusts are crucial to ensuring that each spouse’s assets will ultimately reach his or her own children.
Case Study: Carl and Andrea each have two adult children from a prior marriage. Carl and Andrea own all assets jointly, and their wills leave everything to each other. They plan to rely on the surviving spouse to provide for the children of the first spouse to die. Carl passes away, leaving all of his assets to Andrea. At first, Andrea remains close to Carl’s children, but after a few years, their relationship becomes distant. Andrea updates her estate planning arrangements to provide solely for her own children. Upon her death, Carl’s children are left out, and there is nothing they can do about it.
To more effectively reach their goal of providing for their own children, Carl and Andrea can establish separate revocable trusts that leave the deceased spouse’s trust assets in a continuing trust for the benefit of the surviving spouse for his or her life. Upon the surviving spouse’s death, the assets in Carl’s trust will go to his beneficiaries, and the assets in Andrea’s trust will go to her beneficiaries.
III. Do Traditional Bypass Trusts Make Sense in Light of Portability?
Portability allows a surviving spouse to elect to use his or her deceased spouse’s unused estate tax exemption so that the surviving spouse effectively has two exemptions available to protect the estate without the use of a formal bypass trust structure. There are several reasons why clients who might otherwise be inclined to rely on portability should still consider the use of bypass trusts.
First, while portability has been made permanent under the American Taxpayer Relief Tax Act of 2012, it could be repealed at a later date.
Second, portability allows a surviving spouse the protection of assets from estate taxes up to the amount of his or her exemption and the deceased spouse’s unused exemption. If one spouse dies and his or her unused estate tax exemption is transferred to the surviving spouse, any growth on the deceased spouse’s assets will be included in the taxable estate of the surviving spouse and could potentially be exposed to estate taxes on the second death, depending on the size of the surviving spouse’s estate. However, a bypass trust can provide additional protection by also protecting from estate taxes the growth of the bypass trust assets during the surviving spouse’s lifetime.
Third, there is a requirement for the surviving spouse to make a portability election within nine months of date of death (or fifteen months, with an extension from the IRS)13 on the decedent’s federal estate tax return. A surviving spouse may not act quickly enough to make the election, or may choose not to do so, to save the legal or accounting fees associated with preparing the estate tax return.
Fourth, there is no portability of the generation skipping tax (GST) exemption. Clients who want to incorporate generation-skipping planning into their documents cannot rely on portability and must create separate trusts for spouses to take advantage of both spouses’ GST exemptions. Additionally, there is no portability of the state estate tax exemption in the 14 states (and the District of Columbia) that impose state estate taxes.14 This means that clients who rely on portability may waste one spouse’s state estate tax exemption, resulting in the imposition of state estate taxes.
Fifth, a surviving spouse may only carryover the unused portion of his or her most recent deceased spouse’s estate tax exemption. If a couple decides to rely on portability, and the surviving spouse later remarries (and does not use the first deceased spouse’s unused exemption to make lifetime gifts) then outlives the second spouse, the first spouse’s remaining exemption is lost since only the second spouse’s unused exemption is portable. Depending on the circumstances, some clients may need to avoid remarriage in order to minimize estate taxes!
Finally, portability does not protect assets from potential creditors and predators of the surviving spouse. A bypass trust can afford such protection.
Even in the face of high estate tax exemptions and the option of portability, trust planning remains extremely useful. Trusts can be set up to minimize court involvement after death, maximize the management and distribution of assets to beneficiaries, and provide the flexibility to address a multitude of family situations.
Kathi L. Ayers is a principal with the firm of Vaughan, Fincher & Sotelo, PC, in Vienna, Virginia. Ms. Ayers assists clients with the planning and preparation of estate planning documents, including trusts, wills, powers of attorney and advance medical directives. She is a member of the Virginia State Bar, the District of Columbia Bar, the Wills, Trusts and Estates section of the Fairfax County Bar Association and the Northern Virginia Estate Planning Council.
1. Even if waived, however, the accounting obligation can be resurrected at any time upon a testamentary trust beneficiary’s request. See Va. Code § 64.2-1307(D).
2. Va. Code § 64.2-1702.
3. Marie McKenney Tavernini et al., Estate Planning in Virginia ¶ 8.202(C)(1) (3d ed. & Supp. 2009).
4. Va. Code §§ 64.2-1300(B), 64.2-1305(A)–(B).
5. See Uniform Fee Schedule Guideline for Commissioners of Accounts (as approved by the Va. Supreme Court effective July 1, 2008), available online at http://www.courts.state.va.us/ courts/circuit/resources/coa_fee_schedule.pdf.
6. Va. Code § 64.2-1801(A).
10. Id. § 64.2-1802.
11. Id. §§ 64.2-1901, 64.2-1908(D).
12. See id. § 64.2-1913(A).
13. A six-month extension is obtained by filing Form 4768 with the IRS.
14. See Joel Michael, “Survey of State Estate, Inheritance, and Gift Taxes,” available at http://www.house.leg.state.mn.us/hrd/ pubs/estatesurv.pdf.