Winter 1998 Newsletter
FUNDING REVOCABLE LIVING TRUSTS FOR MARRIED CLIENTS WITH ESTATE TAX EXPOSURE
By Martha Leary Sotelo, Esq.
Donna Esposito Fincher, Esq.
Patrick J. Vaughan, Esq.
Authors' Note: In the Spring Trusts andEstates Newsletter, we discussed the issues presented in funding revocable living trusts for single clients. In continuation of that theme, we now look at the issues raised when married clients with estate tax exposure fund their revocable living trusts. While some ofthe basic issues for funding married clients' trusts are the same asfunding a single client's trust, special attention must be paid to the division ofassets between the two married clients' trusts to ensure that the clients take full advantage oftheir available estate tax exemptions. Additionally, planningfor married clients with estate tax exposure who have significant assets in either individual retirement accounts (HlRAs'') or other qualified retirement plans presents complicated income and estate tax issues that must be thoroughly analyzed whenfunding their revocable living trusts.
You've been assisting John and Elizabeth Jones, retired married clients ages 68 and 64 respectively, with their estate planning arrangements. John and Elizabeth have three children. They have a combined net worth of $2,000,000. Their primary goals are to minimize estate taxes, avoid probate complications, preserve family privacy and streamline the settlement of their affairs in the event of their incapacity or death. On your advice, they have executed estate planning documents consisting of revocable living trusts (which include credit shelter trusts upon the first death and continuation trusts for the benefit of the children of a deceased child), pour-over wills, durable general powers of attorney and advance medical directives. The revocable living trusts are designed to shelter both of their federal estate tax exemptions (i.e., applicable exclusion amounts). John and Elizabeth have asked for your recommendations on how to retitle their assets to properly fund their revocable living trusts.
To: John and Elizabeth Jones
Now that you have executed your estate planning documents, you should fund your revocable living trusts to maximize their usefulness as a vehicle to minimize estate taxes, manage your assets in the event of your incapacity, avoid probate and preserve your privacy. Since you are each serving as a co trustee of your own trust, the proper employer identification number for John's trust is his social security number, and the proper employer identification number for Elizabeth's trust is her social security number.
As we discussed, you each have an estate tax exemption which in 1998 is equal to $625,000. This amount will increase steadily for the next several years, until the year 2006, at which time the estate tax exemption amount will equal $1,000,000. We recommend that you prepare for the increase in the estate tax exemption by funding each of your trusts as closely as possible to the $1,000,000 level. Not only will this ensure that you have taken full advantage of the estate tax exemption available to each of you in future years, it also allows for the management of your assets by your successor trustees in the event of your incapacity.
Below you will find the following:
I. Schedule of Assets - Before Funding Trusts
II. Retitling Recommendations
III. Schedule of Assets - After Funding Trusts
Assets are titled as follows:
(1) Joint tenants with right of survivorship
(2) Tenants by the entirety with right of survivorship
(3) Primary beneficiary = spouse; alternate beneficiary = children
II. RETITLING RECOMMENDATIONS
JOHN'S IRA (Traditional)
John's traditional IRA equals roughly one third of your combined assets. John will begin taking his required minimum distributions from this account in approximately three years. In determining how John's required minimum distributions will be calculated, John has the option of using his life expectancy and that of a designated beneficiary.
John may name Elizabeth, his revocable living trust1 or your children as the beneficiary of his traditional IRA. If Elizabeth is the beneficiary of John's IRA, she can elect to roll-over the IRA into an IRA in her own name and defer the payment of income taxes.2 When Elizabeth reaches the age when she must receive her required minimum distributions, (i.e., April 1 of the calendar year following the calendar year in which she reaches the age of 70-1/2), she can elect to have the distributions calculated based her life expectancy and the life expectancy of a designated beneficiary (i.e., your oldest child). A designated beneficiary will be treated as no more than ten years younger than Elizabeth.3
If Elizabeth is the beneficiary of John's IRA, however, John's trust may not contain enough assets to use up all of his available estate tax exemption. With Elizabeth's consent, John could name his revocable living trust as the beneficiary. John can still use Elizabeth's life expectancy to calculate his required minimum distribution.4 The trust, however, does not have the right to roll-over the IRA into an IRA in Elizabeth's name. If John dies before the required mandatory distributions have begun, distributions from the IRA will have to be paid within a five-year period after John's death or over Elizabeth's life expectancy.5 If he dies after the required mandatory distributions have begun, the IRA funds must be distributed at least as rapidly as under the method of distribution in effect on the date of John's death.6
Since an individual's income tax rates are generally lower than the estate tax rate, it may make sense to have John's trust pay some income taxes on his IRA rather than have Elizabeth's estate pay estate taxes on any IRA funds rolled over to her. Before reaching this conclusion, however, the potential estate ·tax liability of Elizabeth's estate needs to be determined. Since we cannot predict at this time the size of Elizabeth's estate, or even which spouse will die first, we recommend that John designate Elizabeth as primary beneficiary and John's trust as alternate beneficiary of his IRA. Thus, if Elizabeth survives John, she will have the option of either (i) rolling over the IRA into her own IRA and deferring income taxes; or (ii) disclaiming some or all of the IRA to further fund John's trust and fully utilize his estate tax exemption.
Designating your children as the beneficiaries of John's IRA would enable you to minimize, to the extent possible, the size of the distributions that he will receive from his IRA. John can' have the amount of the required distributions calculated based on his life expectancy and your oldest child's life expectancy (subject to the ten-year rule). Upon John's death, the children could elect to receive distributions based on the oldest child's life expectancy and continue the deferment of the payment of income taxes.7
Naming your children as the beneficiaries of John's IRA; however, will prevent Elizabeth from having access to these funds if she survives John and needs the IRA assets for her support. Additionally, if John dies first and the amount in the IRA exceeds John's estate tax exemption, estate taxes will have to be paid on the excess amount.
You might consider separating the IRA into several IRAs, one for Elizabeth and one for each of the children. You must separate the IRA, however, before John starts receiving his required minimum distributions. This would allow you to place a significant amount of the IRA assets into an IRA with Elizabeth as primary beneficiary and the trust as the alternate beneficiary. - You could then place smaller amounts into IRAs for each of the children. The main benefit of this strategy is that upon John's death, each child could elect to receive distributions based on his or-her-life expectancy.
In February of 1998, you converted some of the assets in John's traditional IRA to his Roth IRA and you are in the process of converting more assets before April 15, 1999. You are planning to pay the income taxes resulting from the conversion over the tax years 1998 through 2001, rather than solely in 1998.
If John dies before all of the taxes have been paid, Elizabeth, as the surviving spouse, may elect to continue the payment of the taxes over the remainder of the four-year period so long as she is the sole beneficiary of all of John's Roth IRA's.8 Otherwise, any portion of the conversion amount for which taxes have not been paid will be included in John's taxable income for the tax year that includes his date of death.9
In order for any distributions from the Roth IRA to be non-taxable, the amounts in the Roth IRA must be held for a period of five years.10 This five-year time period begins to run on the first day of the tax year in which the first contribution is made to the Roth IRA. II Thus, you could contribute funds anytime from January 1, 1998 to April 15, 1999 and the five-year taxable period begins on January 1, 1998.12 Since you made your first contribution in February 1998, your five-year taxable period will end on January 1, 2003. This five-year taxable period applies to any funds you may contribute in later tax years. For example, if you contribute funds in the year 2000, you may also withdraw those funds without tax in the year 2003.13 If John should die before the end of the five-year taxable period and Elizabeth is the beneficiary of the IRA, she will have the right to treat the Roth IRA as her own and the five-year taxable period could continue from the January 1, 1998 date.14
John is not required to take any distributions from his Roth IRA during his lifetime.I5 John's right to defer distributions from the Roth IRA passes to Elizabeth as the surviving spouse if she is the sole beneficiary of "the Roth IRA.16 Thus, if Elizabeth is, the beneficiary, the amount in the IRA can continue to grow income tax-free for the benefit of your children. If any other beneficiary is designated to receive the Roth IRA, the account must be distributed (i) by December 31 of the year containing the fifth year anniversary of John's death, or (ii) over the life expectancy of the designated beneficiary.17 If you name John's trust as the beneficiary, the life expectancy of the trust's oldest beneficiary, most likely Elizabeth, will be used to calculate the distribution.
Until the five-year taxable period ends in the year 2003, Elizabeth should be the primary beneficiary of the Roth IRA with John's trust as the alternate beneficiary. After that time period, you should determine whether the Roth IRA will be needed to fund John's trust to take full advantage of his estate tax exemption. If his trust is not fully funded, you should designate John's trust as the beneficiary of the Roth IRA in order to shield the Roth IRA from estate taxes. Given the significant advantages to designating Elizabeth as the beneficiary of the Roth IRA, you should carefully monitor the assets in John's trust so that if at a later date you no longer need the Roth IRA to fund John's trust for estate tax purposes, you can change the beneficiary designation back to Elizabeth.
Your residence is encumbered by a $100,000 mortgage. It is our understanding that you may want to refinance this mortgage or obtain a home equity loan in the near future. Under federal law, you may retitle your residence to your trusts without any risk that your lender may exercise its option under the due-on-sale clause as long as you remain the beneficiary of the trusts and continue to occupy your residence.18
Since you intend to refinance or obtain a home equity loan on your residence, we recommend that you execute a new deed conveying an undivided one-half interest in your residence to each of you as tenants in common. Lenders are often reluctant and sometimes even refuse to make a loan secured by property which is titled to a trust. Even if the lender does not refuse to make the loan, the lender will impose additional requirements before agreeing to the loan which will complicate settlement. Additionally, some title insurance' companies may deny claims on the basis that the properties were transferred into a revocable living trust.19
Fortunately, Virginia law provides a method of transferring real property upon death which bypasses traditional probate and allows title to vest automatically upon death.20 The filing of the will without the appointment of an executor has the same effect as if a deed were recorded. Therefore, you should not be concerned that the failure to redeed your residence into your trusts will cause unnecessary probate complications upon your death.
Notwithstanding the above, if you decide that you would rather have your residence transferred into your trusts, you should note that the transfer will not trigger any recordation tax in Virginia.21 Also, the transfer of the property to your trusts will have no impact on your ability to take advantage of the $500,000 capital gain exclusion for married persons who have resided in their homes for two out of the last five years.22
North Carolina Beach Condominium
At this time, your beach condominium is free and clear of any mortgage. If you do not intend to mortgage the property in the future, you should execute a new deed transferring an undivided one-half interest in the property to each of your trusts. Unlike Virginia, North Carolina requires probate proceedings to transfer your property upon death. By transferring title to the property to your trusts now, your estate will not have to undergo ancillary probate proceedings in North Carolina with respect to this property.
You should contact an attorney in North Carolina (or if you prefer, we will contact one for you) to assist in the preparation of a new deed. A North Carolina attorney should prepare the new deed to ensure compliance with North Carolina law and to ascertain any tax consequences resulting from the transfer.
If you intend to mortgage your North Carolina beach condominium, we recommend that you do not transfer the property into your trust until after you obtain the mortgage. As mentioned above, lenders are often reluctant and sometimes even refuse to grant a loan against property which is owned by a trust. If you use the beach condominium only for your personal purposes, you can transfer the property to your trust after you obtain the mortgage without requesting the lender's approval.23 If you use the beach condominium as a rental property, you must obtain the lender's approval before retitling the property to your trust. Failing to obtain the lender's approval before retitling rental property to your trusts could result in the lender exercising its option under the due-on-sale clause.
You should also keep in mind the possibility that the transfer of the property to the trusts may result in a denial of coverage by your title insurance company. You should review your policy and contact your insurance provider to determine whether coverage will continue if you transfer the property. If the insurance provider indicates that such coverage will cease then you should inquire about the cost of purchasing an "Additional Insured" endorsement.
Stock and Bonds
Your stocks and bonds should be evenly divided between your two trusts to the extent possible. While you do not have to hold the exact ·same securities in each trust account, you should try to balance the value and type of securities in the accounts. For instance, you do not want to transfer all of the higher risk securities into one of the trust accounts and all of your more conservative investments into the other account because the value of the accounts may increase or decrease disproportionately. Currently, you have a brokerage account which holds the majority of your securities. You also hold a few stock certificates outside of your brokerage account.
With regard to your brokerage account, you should· contact your broker and instruct him or her to establish a new account in the name of each of your trusts. Your broker will probably want to see certain pages of your trusts in order to verify that the trusts are valid, to ascertain the trustees and to determine the extent of the trustees' powers. Your broker will send you whatever paperwork is necessary to establish the new accounts. Your broker will take care of transferring the stocks and bonds from your existing account to the new trust accounts.
You have two options with respect to retitling the stock certificates that are not in the brokerage account. You can contact the transfer agent for each stock to request a new certificate in the name of one of the trusts, or you can transfer these stocks to your broker. to be held in one of the new brokerage accounts and let your broker handle the retitling. If you contact the transfer agent directly, you will bear the responsibility of making sure the new stock certificates are issued properly. Like your broker, the transfer agent will probably want to see certain pages of your trusts in order to verify that the trusts are valid, to ascertain the trustees and to determine the extent of the trustees' powers.
The appropriate wording for retitling your brokerage account and the stock certificates to John's trust is:
John Jones Trust dated October 15, 1998, John Jones and Elizabeth Jones, Trustees, either of whom may act independently.
The appropriate wording for retitling your brokerage account and the stock certificates to Elizabeth's trust is:
Elizabeth Jones Trust dated October 15, 1998, Elizabeth Jones and John Jones, Trustees, either of whom may act independently.
John should be the owner of the life insurance policy insuring his life and: his trust should be designated as the beneficiary of the policy upon his death as follows:
Trustees of John Jones Trust dated October 15, 1998.
If a life insurance company requires you to identify the specific trustees, identify the trustee(s) who will serve following John's death.
Designating John's trust (rather than Elizabeth or your children) as the beneficiary of your life insurance policy win allow John to further fund his trust for estate tax purposes and ensure that, upon the death of the second of you, your children or other beneficiaries will receive the proceeds in accordance with the trust arrangements you have made on their behalf.
You should transfer $175,000 of your mutual funds into Elizabeth's trust and the balance into John's trust. The greater value to Elizabeth's trust will compensate for the $100,000 of life insurance insuring John's life which will fund his trust upon his death. If your mutual funds are held in your brokerage account, you should contact your broker and instruct him or her to transfer your holdings into the new brokerage accounts registered in the names of your trusts. Your broker will send you any paperwork necessary to complete the transfer.
If you deal directly with the transfer agent for your mutual funds, you should request the transfer agent to retitle the mutual funds into the names of your trusts. The transfer agent will probably want to see certain pages of the trusts in order to verify that the trusts are valid, to ascertain the trustees and to determine the extent of the trustees' powers under the trusts.
The appropriate wording for retitling the mutual funds to your trusts is the same as for retitling the stocks and bonds to your trusts.
John owns a fifteen percent (150/0) interest as a limited partner in a limited partnership. You should transfer this interest into John's trust. The partnership .agreement requires the general partner to approve any transfer of your partnership interest. You should contact the general partner of the limited partnership and request his or her assistance in assigning your limited partnership interest to your trust.
The appropriate wording for the assignment of John's partnership interest is:
John Jones Trust established October 15, 1998, John Jones and Elizabeth Jones, Trustees, either of whom may act independently.
Certificates of Deposit
You should fund Elizabeth's trust with the certificates of deposit ("CDs") in order to balance the assets in her trust with John's trust since John's trust is funded with John's interest in the partnership. One . option is to retitle the CDs into Elizabeth's trust by completing new signature cards which change the title to .both of you as trustees of Elizabeth's trust. The appropriate wording for retitling the CDs to Elizabeth's trust is as follows:
Elizabeth Jones Trust dated October 15, 1998, Elizabeth and John Jones, Trustees, either of whom may act independently.
The other option is to designate Elizabeth's trust as the "Pay on Death" or "P.O.D." beneficiary of the CDs. The appropriate wording for designating Elizabeth's trust as the P.O.D. beneficiary of the CDs is as follows:
Trustees of Elizabeth Jones Trust dated October 15, 1998.
Please note that before you change the title to your CDs, you should ask the bank whether the change in title will trigger any forfeiture of interest. If so, you should wait until the CDs mature before retitling them to Elizabeth's trust.
U.S. Savings Bonds
Your savings bonds are titled in both of your names as joint tenants with right of survivorship with one-half of the bonds registered with John's social security number and one-half of the bonds registered with Elizabeth's social security number. Title to the bonds should be changed in order to ensure that they pass into the trusts and do not pass automatically to the surviving spouse. Accordingly, you should remove Elizabeth's name on the bonds which are registered with John's social security number and, likewise, remove John's name on the bonds which are registered with Elizabeth's social security number. The spouse whose name remains on the bond should then designate his or her trust as the P.O.D. beneficiary of the bonds or retitle the bonds into his or her own trust. Retitling the bonds to the trust will not trigger the recognition of deferred income on the bond because the owner of the bonds bas not changed. The spouse whose social security number was originally assigned to on the bond is considered the owner for income tax purposes.24
The appropriate wording for designating John's trust as the P.O.D. beneficiary is as follows:
Trustees of John Jones Trust dated October 15, 1998.
The appropriate wording for designating Elizabeth's trust as the P.O.D. beneficiary is as follows:
Trustees of Elizabeth Jones Trust dated October 15, 1998.
Five years ago, you loaned money to one of your children to establish her own business. She signed a promissory note agreeing to pay the loan back over 15 years. You are both the payees of the note. You should endorse an undivided one-half interest in the installment note to each of your trusts as follows:.
As to an undivided one-half interest, pay to the order of John Jones Trust established October 15, 1998, John Jones and Elizabeth Jones, Trustees, either of whom may act independently
As to an undivided one-half interest, pay to the order of Elizabeth Jones Trust established October 15, 1998, Elizabeth Jones and John Jones, Trustees, either of whom may act independently. After you insert this wording, you should sign and date the endorsement.
You should continue to own your checking account as joint tenants with right of survivorship The relatively small amount of cash that you maintain in this account will not be needed to· fund your trusts for estate tax purposes. Changing the title of your checking account will complicate the direct deposit arrangements you presently have for your pensions and your government benefits. The account will pass by right of survivorship the surviving spouse upon the death of the first spouse to die without any probate complications. The checking account will be a probate asset in the estate of the surviving spouse. Therefore, after the first spouse dies, the surviving spouse should designate his or her trust as the P.O.D. beneficiary of this account to avoid probate upon the death of the surviving spouse.
Tangible Personal Property
In general, it is not necessary to transfer title to your tangible personal property (e.g., clothing, jewelry, household goods, personal effects and automobiles) to your trusts while both of you are living if these assets are not needed to fund your trusts for estate tax purposes. You should write a letter of instructions to your executor indicating how you would like specific items (not otherwise specifically bequeathed) distributed upon your death.25 This letter must describe the items and intended· beneficiaries with reasonable certainty and be signed by you. It is not necessary for your letter to be witnessed or notarized. You may alter or amend this letter of instructions at any time without having to modify your will or trust. When the first spouse dies, we recommend that the surviving spouse assign his or her·interest in the tangible personal property to his or her trust to avoid probate upon the second death. We will be happy to prepare such an assignment for you.
We strongly encourage you to retitle your assets in accordance with the recommendations set forth above, in order to fully maximize the usefulness of the estate planning documents we prepared for you.
1. The Internal Revenue Service recently issued revised Proposed Regulations regarding the criteria for designating a trust as the beneficiary of an IRA. Revised Prop. Treas. Reg. Section 1.401(a)(9)-1. The revised Proposed Regulations modify Section 1.401(a)(9)-1 of the Treasury Regulations to allow the beneficiaries of a revocable living trust to be treated as a designated beneficiary of the IRA if: (i) the trust becomes irrevocable upon the employee's death; (ii) the trust is valid under state law; (iii) the beneficiaries of the trust are identifiable and; (iv) a copy of the trust agreement is provided to the plan administrator or certain trust certification requirements are satisfied.
2. I.R.C. Section 408(d)(3)(C)(ii)(II).
3. If Elizabeth has more than one designated beneficiary, the designated beneficiary with the shortest life expectancy, not to exceed ten years, will be calculated along with her life expectancy. Prop. Treas. Reg. Section 1.401(a)(9)-1(E) Q&A E-5, and Prop. Treas. Reg. Section 1.401(a)(g)-2 Q&A 6. In order to take advantage of each of the children's life expectancy, Elizabeth could separate the IRA into three accounts naming each child as the designated beneficiary of a different account.
4. Rev. Prop. Treas. Reg. Section 1.401(a)(9)-1 Q&AD6.
5. I.R.C. Section 401 (a)(9)(B)(ii) and (iii).
6. I.R.C. Section 401 (a)(9)(B)(i).
7. John's children would need to choose to receive the benefits over the oldest child's life expectancy no late than December 31 st of the calendar year following the calendar year of John's death. I.R.C. Section 401 (a)(9)(B)(iii).
8. I.R.C. Section 408A(d)(3)(E)(ii)(n); Prop. Treas."Reg. Section 1.408A-4 Q&A 11(b).
9. I.R.C. Section 408A(d)(3)(E)(ii)(I).
10. I.R.C. Section 408A(d)(2)(B).
11. Id.; Prop. Treas. Reg. Section 1.408A-6 Q&A2.
12. Prop. Treas. Reg. Section 1.408A-6 Q&A 2.
14. Prop. Treas. Reg. Section 1.408A-6 Q&A 7. Please note that if Elizabeth had her own Roth IRA with a five year taxable period ending earlier then John's, the earlier time period from her own Roth IRA would apply to the Roth IRA she receives from John. Id.
15. I.R.C. Section 408A (c)(5)(A).
16. Tax Planning and Practice Guide: Roth IRAs (after '98 Technical Corrections) Research Institute of America, August 6,1998, Paragraph 311, citing Form 5305-RA, Article V (1/98); Form 5305-R Article V (1/98).
17. I.R.C. 401 (a)(9)(B)(ii) and (iii).
18. Garn-St. Germain Depository Institutions Act of 1982. Pub. L. No. 97-320; 96 Stat. 1469; 12 U.S.C. Section 1701j-3(d)(8); 12 CFR Section 591.5(b)(1 )(vi).
19. See Jonathan Rivin and Thomas J. Stikker; "Title Insurance for Estate Planning Transfers," Probate & Property, May/June 1998. The authors wish to express their thanks to Richard A. Holdennan, Esq. for bringing this article to their attention.
20. Va. Code Ann. Section 64.1-94.
21. Va. Code Ann. Section 58.1-811A(12).
22. See I.R.C. Section 121 ( as amended by 1997 Taxpayer Relief Act) and Priv. Ltr. Rut. 8006056; Priv. Ltr. Rut. 8007050; Priv. Ltr. Rut. 8025027 (interpreting previous Code Sec. 121).
23. Gam-St. Gennain Depository Institutions Act of 1982. Pub. L. No. 97-320; 96 Stat. 1469; 12 U.S.C. Section 1701j-3(dX8); 12 CFR Section 591.5(b)(1)(vi).
24. Rev. Rul. 58-2, 1958-1 CB 236
25. In 1995, Virginia Code Section 64.1-45.1 was enacted to allow a will to incorporate by reference a written statement or list executed before or after the execution of the will which disposes of specific items of trust tangible personal property. In 1997, a similar provision was enacted for trusts. Va. Code Ann. Section 55-7.2.