While either federal or state-level estate taxes remain pertinent to some, almost every estate plan should consider income tax and capital gain ramifications.

I have large IRA or 401(k)…

A large portion of my assets are held in individual retirement accounts.

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Don't Name Minor Children as Beneficiaries

A common mistake, particularly with young parents who come into my office, is the naming of minor children as beneficiaries to financial assets such as life insurance, retirement accounts, or beneficiary designations on brokerage accounts. I can best illustrate this by example:

Assume that Joe and Sally Youngparent have two children, Bobby (age 12) and Brenda (age 8). Joe owns a $500,000 life insurance policy on his life, and he has named his wife Sally as the primary beneficiary. He then names Bobby and Brenda as equal contingent beneficiaries. If Joe and Sally were to die together in some sort of an accident, the idea is to provide funds to raise both Bobby and Sally.

Here’s the problem: the life insurance company won’t pay directly to Bobby and Brenda, because they are minors. Until Bobby and Brenda are at least 18 years of age, the life insurance company will insist that a guardianship be established through the court system before paying the death benefits. Then the court appointed guardian would have to manage the funds and provide accountings annually to the court. As you might imagine, this is an expensive process.

Why won’t the life insurance company pay to the guardian established in the estate? This is due to a number of different laws, but the bottom line is that the life insurance company doesn’t want to get sued when the children become adults if the funds weren’t handled properly. The life insurance company therefore uses the legal process to protect itself.

And it isn’t just life insurance companies that have to worry. Retirement account custodians, brokerage and mutual fund companies, banks and other financial institutions all have to do the same thing if a minor is named as a direct beneficiary to an account.

On top of all that, even with the court appointed guardian, in the scenarios I describe the children will have access to their funds upon turning 18 years of age. Would you expect an 18 year old to make wise decisions with a lump sum of cash when their parents weren’t around to guide them?

So how does one avoid this mess? Easy. Establish a Revocable Living Trust. In the trust name a trustee and designate how the children’s funds are to be used for their benefit. Then instead of naming the children directly as beneficiaries, name the trust as the contingent beneficiary. Problems solved.

Of course, consult with your own counsel when establishing any such trust and designating the trust as a beneficiary to any account. There are a variety of legal and tax consequences that should always be addressed in these types of circumstances.

I’m concerned about the estate tax…

I either don’t completely understand or am concerned about my estate being subjected to the federal or state estate tax.

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New Tax Law Provides Estate Planning Opportunities

You may be aware that the Tax Cuts & Jobs Act was enacted at the end of 2017, and that it provided certain income tax cuts to individuals and corporations. It also raised the federal estate tax exemption to more than $11 million per person. What you may not know is that this new law provides huge income tax planning opportunities that you can build into your estate plan, allowing for significant savings during your lifetime.

In order to understand the theory, you need to first understand what the federal estate tax is and how the transfer of assets into partnerships and trusts opens up opportunities for capital gains and income tax savings.

The federal estate tax is a transfer tax on the value of your assets at the time of your death. It is, essentially, a tax on your balance sheet. Your estate tax exemption however, is not just something that is available to your estate after your death. The estate tax exemption is also part of a gift tax exemption.

You can make $15,000 annual tax-free gifts to anyone that you choose. To the extent that you make gifts to anyone in excess of that amount, you must file a Federal Gift Tax Return Form 709 reporting the excess. You don’t actually remit tax to the IRS until you have consumed your $11+ million exemption. The exemption that you have remaining at the time of your death is what you can apply to your estate. If the value of your estate at the time of your death does not exceed the unused exemption amount, then there is no federal estate tax due.

So how does this provide you current income and capital gains tax planning opportunities? Stay with me here.

Because everyone has a large federal estate and gift tax exemption, this opens doors to creating trusts that sprinkle income among beneficiaries, even the grantor himself, without fear of actually having to pay any transfer tax. Suppose, for example, you have a family business and you wish to distribute some of its income to children or grandchildren.  You can create a trust that sprinkles the income amongst those beneficiaries who then pay the income tax at their lower marginal rates. The increase in the transfer tax exemption provides you the means to create trusts that accomplish just that, especially if the value of your estate is below the current federal threshold of $11 million.

Capital gains taxes are yet another consideration under the new law. Generally speaking, when I die, my estate achieves what is known as a “step-up” in tax cost basis equal to the date of death value of assets at the time of my death. The theory behind this is because there is an estate tax on that value then the capital gains should be eliminated.  The step-up doesn’t hold true for qualified retirement accounts, such as IRA, 401(k) and 403(b) accounts.

Because the federal gift/estate tax exemption is so high, taking maximum advantage of this step-up to eliminate capital gains is of paramount importance for our loved ones, especially in estate plans for married couples. Under the federal estate tax law of several years ago, dividing assets and using each spouse’s separate exemption was of primary importance. Now, for many married couples, it might be better to have inclusion of the assets in each spouse’s estate as he or she passes. This way, the family achieves a “double” step-up. As always, individuals should check with a qualified estate planning attorney to determine if their estate plans should be amended to take advantage of the new law.

Partnership tax law can also be used to minimize capital gains. Here, you might create trusts that benefit younger family members and gift low basis assets (those that have not appreciated greatly) to that trust. That trust then contributes those low basis assets to a LLC or to a partnership. You also form another type of trust funded with high basis assets (those that haven’t appreciated much). That trust then contributes those high basis assets into another LLC or partnership. A new general partnership is formed (call it the Parent Partnership) and both of the existing partnerships contribute their underlying assets into the Parent Partnership.

After the tax law’s requisite holding period, the Parent Partnership is dissolved and the assets are distributed to the various trust/partners and ultimately to the beneficiaries, except the low basis assets are distributed in the liquidation to the older generation. When the older generation dies the step-up in tax cost basis is achieved eliminating the capital gains on those assets. This is known as a “swap technique”. The new tax law opens the door to this and similar planning strategies.

These strategies are not without significant risks if improperly established. Failure to comply with the complicated partnership and income tax laws could result in a deemed sale, accelerating the very taxes that one is trying to minimize.

The swap technique is beneficial not only for wealthy retirees, but also for wealthy middle-aged individuals who have a living, cooperative parent. Assuming that parent doesn’t have a taxable estate (one that exceeds $11 million) then one could use that parent’s exemption and subsequent step-up at death advantageously, minimizing capital gains exposure during the lifetime of the middle-aged child.

The Tax Cuts & Jobs Act is scheduled to sunset on January 1, 2026. It may also be likely that Congress passes a Technical Corrections Act of some kind closing loopholes. Consequently, the application of any strategy should be carefully considered with your legal and tax advisors before jumping in.

State Taxation of Irrevocable Trust

States have been increasingly aggressive taxing trust income, as the need for revenue increases. Only seven states do not impose an income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

Even if you are a resident of a state that does not impose an income tax, you should be aware that the creation of a trust that benefits a beneficiary in a state that does impose state income tax will likely result in the payment of state income tax by the trust’s beneficiary.

So if you’re a Florida resident and create an irrevocable trust for your granddaughter in New York, then when trust income is distributed to your granddaughter she will have to remit New York state income tax payments.

But what happens when you create a discretionary trust that does not distribute its income in a given year? By definition, the trustee of a discretionary trust can choose not to distribute income; instead the income would accumulate inside of the trust. Can the state of the beneficiary’s residence impose an income tax on that undistributed income?

In other words, in my example where a Florida resident creates a trust for the benefit of a New York beneficiary, where the income is not actually distributed would the trust still have to pay New York state income tax?

The answer to that question can be found in a 2015 North Carolina case, Kimberley Rice Kaestner Family Trust v. North Carolina Department of Revenue.  In 1992 Joseph Rice created a trust for the benefit of his three children, which in 2002 divided on its terms into separate trust shares. One of the children was a North Carolina resident.

The North Carolina Department of Revenue assessed the taxes in the amount of $1.3 million in three years that the trustee never distributed income to the North Carolina beneficiary. The rationale for the tax was a North Carolina state statute that imposed tax on out of state trusts that benefit North Carolina residents.

The trust paid the tax, and after its request for a refund was denied, petitioned a North Carolina court to seek the return of the tax paid.

During the time in question, the trustee was a Connecticut resident, the trust records were maintained in New York State, and the assets were custodied with a financial firm in Boston. Trust tax returns and accountings were prepared in New York, and trust meetings occurred in New York.

The court granted the trust’s motion for summary judgment (putting an end to the case – a win for the trust) ruling that the statute in question imposing tax based on the residency of beneficiaries alone violates the Due Process Clause of the United States Constitution as well as the North Carolina State Constitution.

The court noted that the trust did not have a physical presence in the state, own real or personal property in the state, or invest directly in state investments. Trust records were maintained out of state, and the principal place of administration was out of state. The trust did not avail itself of the benefits of state law (the trust indicated that New York law applied), and the court found that the trust itself is a separate legal entity from the beneficiaries. The fact that a beneficiary is a North Carolina resident did not persuade the court that undistributed income should be taxed in the state.

What can we learn from this case? It would seem that if a grantor establishes a trust in a state like Florida that does not impose a state income tax, even if a beneficiary resides in a state that does tax income, so long as that income is not distributed to that beneficiary then no state income tax will apply.

If you hope for a similar result in this case, you should work to have a similar fact pattern, leaving no ties to the state that is attempting to impose the state level income tax.

You should be aware, however, that income accumulated inside of a trust is taxed at the federal income tax level regardless, and that tax is calculated on a compressed rate schedule, resulting in the highest marginal federal rate (39.6%) on amounts above $12,300. Unless the beneficiaries are also in the highest marginal income tax rate bracket, accumulating income inside of a trust may, for federal tax purposes, result in higher tax payments.

When you consider state income tax rates, however, then the combined state and federal tax bracket associated with any specific beneficiary could be higher than 39.6%. In such event it might make sense to accumulate income in the trust, as was the likely fact pattern of the Kimberley Rice Kaestner Family Trust case.

I believe these types of cases will become more common in the coming years. When creating trusts for the benefit of loved ones who live in a state that imposes state income tax, it would be wise to discuss these issues with your estate planning counsel.

I may have large unrealized capital gains…

Based on the growth of my assets or how they’re being transferred, I may have unrealized capital gains.

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How a Trust Saves Income Taxes

Can leaving amounts in trust for your loved ones save income taxes? Yes, it can.

Generally, there are two ways that you can leave your inheritance to your loved ones. The most common method is an outright distribution. Your will reads something like this: “Upon my death I leave the remainder of my estate to my son John, outright and free of trust.”

The second method is to create a testamentary (after death) trust for your loved one’s benefit. Here, your will reads something like this: “I leave the remainder of my estate in trust for the benefit of my son, John, subject to the following terms and conditions…”

Many clients are predisposed to leaving amounts outright since it is simple. “I don’t want any complications,” they might say. Another objection is that “I don’t want my son John to go begging to a trustee for his inheritance.” Often this concern is a product of a bad family experience where amounts were left in trust for a bank or brokerage firm to manage.

You do have the ability to leave amounts in trust for your loved ones, and they can serve as their own trustee. “I leave amounts in trust for the benefit of my son John. John shall serve as the trustee of his trust share.”  This is perfectly legal. John won’t have to beg a bank or trust company for distributions since he is in charge and he determines the distributions, even to himself. So how does this save income taxes?

By creating a “sprinkle trust.”

A sprinkle trust is one that benefits more than one beneficiary. The trustee has the power to sprinkle the income by and amongst a group. As an example, assume that your son John has two children, Frank and Linda. You can direct your attorney to create a sprinkle trust that primarily benefits John, as his needs should be first considered, then in the trustee’s sole and absolute discretion income (or principal) can be sprinkled amongst Frank and Linda (or any other descendants of John).

Since John serves as his own trustee, he is the one to decide whether he takes the income for himself, or whether he wants to sprinkle that income to Frank and Linda. Assume that Frank needs $30,000 for a down payment on his first home purchase. If John wanted to gift the money to Frank, which exceeds the $14,000 annual gift tax free exclusion, John would presumably have to file a gift tax return for the excess ($16,000) and reduce his lifetime exemption from gift and estate taxes.

Instead, John could sprinkle $30,000 of the trust income that year to Frank. Since it is a direct distribution of income to Frank, he will pay the income tax associated with that distribution. Assume that Frank is in a lower income tax bracket than John. What’s happened? Well, the income that would have been taxed to John at his higher rate doesn’t happen; instead the income is taxed to Frank at Frank’s lower rate. There is no taxable gift as well. The family has achieved its goals while minimizing income and gift taxes.

The next year John can continue to send to himself all of the income. He can choose who should receive what income distributions annually since John is the trustee. If he wanted to “even things out” and send Linda a corresponding $30,000 of income the next year, he is free to do so.

As far as the “complications” argument, there really aren’t complications. The trust assets are segregated in separate accounts using a separate tax identification number. So long as the trust distributes all of its income annually there will be no tax paid by the trust, rather the income tax is paid by the beneficiary who receives the income. A 1041 must be filed, but in this scenario the return is a rather simple one.

If John had inherited the money as an outright distribution, none of the tax savings would have been possible. This is just one of the many benefits of leaving assets in trust for your loved ones as opposed to outright distributions.

Testamentary trusts can be drafted any number of ways. Further, there are certain words that you would want to include ensuring that the amounts you leave to your loved ones aren’t estate taxed in their estates when they die. So do meet with your estate planning attorney to discuss the details of what you would like to achieve before acting.

Does Generation Skip Mean Your Children Aren't Beneficiaries?

I’m guessing your estate plan eventually leaves all of your hard-earned wealth to your children in one form or another. Unless, of course, you’re someone who drives around with the bumper sticker “I’m out spending all of my children’s inheritance!” There’s nothing wrong with that of course.

When you leave amounts in continuing trusts for your children, whatever is left in those trusts upon your children’s deaths may end up benefiting your grandchildren. In that case, the trusts are usually drafted to consume something known as your “generation skipping transfer tax exemption.” When a trust is generation skipping transfer tax (GSTT) exempt, it will never be estate-taxed again, even if it grows to enormous sums and continues on for generations.

Note that in my example the children weren’t skipped as beneficiaries. The GSTT exemption speaks to a “tax shield” covering the assets in the trust such that as each generation passes away, the federal government cannot impose an estate tax. Think about the Kennedy family compound in Hyannisport or the Bush family compound in Kennebunkport. Both have been with their respective families for generations and likely have great value. The reason those compounds remain within the families is because they are likely held in generation skipping tax exempt trusts.

To understand what the generation skipping tax is, you first have to understand that it is a “transfer tax” like the gift and estate tax. You may be aware of your approximately $11 million federal estate tax exemption. You can leave that large of an estate to anyone of your choosing without the imposition of federal estate tax. That estate tax is a tax on your balance sheet at the time of your death. It is a tax on the net equity that you possess. It has nothing to do with income taxes.

If you make a taxable gift during your lifetime, generally defined as a future interest gift or a present interest gift, in excess of $15,000 to any beneficiary during a calendar year, then you decrease your total transfer (gift and estate) tax exemption from that $11 million amount. So if I make a taxable gift of $100,000 during 2017, then I have $5.39 million of exemption remaining upon my death.

The generation skipping transfer tax is an additional tax imposed on top of the estate tax. It is imposed on either direct skips or skips in trust that either terminate or distribute to a beneficiary more than one generation below you (grandchildren being the most prominent example). Back in 1976, Congress noticed attorneys leaving amounts in continuing trusts for many generations, so they added the GSTT in an effort to limit the amount of assets that could be placed in continuing trusts without those assets ever being subject to estate tax again.

The GSTT is imposed at the highest estate tax rate (currently 40%) after the estate tax has been calculated. The exemption is the same amount as the federal estate tax (currently $5.49 million).

So if I have neither estate tax exemption remaining nor any GSTT exemption remaining at my death, and my estate bequeaths $1 million to my grandchildren, then the first 40% ($400,000.00) pays the estate tax leaving $600,000.00. Since that $600,000 is designated to my grandchildren, assuming that I have already consumed all of my GSTT exemption, then another 40% GSTT is applied ($240,000.00), leaving my estate with a net amount of $360,000.00 of the original $1 million for my grandchildren. So you can see how the GSTT is extremely punitive in nature.

The concluding thoughts about all of this is that you would generally want to leave amounts in continuing GSTT exempt trusts for your children to the extent possible. Those trusts serve to protect the inheritance from creditors, predators and divorcing spouses. They can even be drafted to give the child control as trustee of his or her own trust share.

If you have an estate large enough that would trigger GSTT, if you left it either in trust or otherwise that would eventually distribute to or for the benefit of that next generation below your children’s, then you want to do something to make sure that those non-exempt amounts are included in your children’s estate for estate tax purposes. That way no GSTT would be due to the government.

This can be accomplished any number of ways. One is to have an outright distribution to your children of the amounts that would not be exempt from GSTT. The other is to include the trust amounts in your children’s estates by giving them something known as a “general power of appointment.” There are also “intentionally defective general powers of appointment” that you could use that serve to limit the class of beneficiaries that could end up with the trust funds.

I’m not sure how to escape my former state’s taxing authority…

In considering moving to Florida, or since doing so, I’m having trouble severing ties with my former state.

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Escaping Your Former State’s Taxing Authority

Regular readers of this column know that I like to educate on the importance of distancing oneself from your former state of domicile when declaring Florida residency. A recent State of New York State Tax Appeals ruling in the Matter of Thomas Campaniello highlights the reasons necessary to remove any doubt as to your state of residency for both income and estate tax purposes.

Campaniello had declared Florida residence, maintaining a home in Key Biscayne since 1981. He spent more time in Florida during 2007 than in New York, and had substantial business ties to Florida. He obtained a Florida drivers license and maintained personal items in Florida, including a doctoral diploma, guitar and his Ferrari.

In Campaniello, the New York State Division of Taxation had a substantial financial reason to argue that he had not established Florida as his new state of domicile or given up his ties to the State of New York. In 2007, Campaniello filed a New York state income tax return as a non-resident, which New York’s Division of Taxation audited, assessing state income taxes of $319,000, New York City taxes of $169,772 plus penalties and interest totaling $709,429.

In response to the audit, Campaniello submitted a summary of his trips from December 2006 to January 2008, copy of passport pages evidencing foreign travel during that time period, credit card statements, quarterly bank statements (indicating a New York address), and cellular phone statements, among other things.

The auditor’s review of the evidence determined that Campaniello (i) was present in New York for 169 days during 2007; (ii) had significant weekly travel between New York and Florida; (iii) always returned to his domicile in New York City for a portion of nearly every week in 2007 and (iv) continued utilizing New York medical professionals. As a result, an Administrative Law Judge sided with the New York Division of Taxation. Campaniello appealed.

The Tax Court agreed with the lower court, reaching its determination on litany of factors: (i) continuing ownership and frequent use of his New York apartment that he had owned since 1979; (ii) his presence in New York for 171 days (note this is less than half a year); (iii) maintained personal belongings and clothing in his New York apartment; (iv) continued receipt of mail and bills (cellular phone service and credit cards) at his New York address; (v) his spouse maintained New York residency; (vi) family ties; (vii) substantial business ties to New York; and (viii) operation of his New York and Florida businesses from a New York office.

It should come as no surprise that New York state pursued Mr. Campaniello for this tax revenue. States have been chasing both “former residents” and corporations for years to cover budget shortfalls. As states raise their income and corporate tax rates, individuals and entities leave states for others, like Florida, that do not impose such taxes.

While the warning is important, that doesn’t mean that one should give up and succumb to state taxing authorities. When making the decision whether to become a Florida resident, several factors should be considered, including:

  • Do you intend to spend the requisite amount of time outside of your former state to qualify for non-resident status?
  • Do you continue to earn income in the state?
  • Is your health insurance or other benefits that you may receive non-transferrable to Florida if you should become a resident here?
  • Are you willing to do the things necessary to sever the ties to your former home state in order to escape that state’s taxing authority?

And there may be other questions pertinent to your situation. If you must remain a state resident to retain certain government benefits such as health insurance or Medicaid, and if it would be unlikely to match those benefits in Florida, then it may not be a good idea to change domicile.

One comment, that is not pertinent, and which I hear often is this: “I have lived in that state my whole life and I cannot imagine not being a resident of that state!”

To this I raise my eyebrows with a perplexed look. Just because you are no longer a legal resident of a state does not mean that you cannot travel within its borders, enjoy the company of family and friends who live there or otherwise feel a close association. It just means that you no longer wish to make contributions to its taxing authority on an annual basis.

So the real difficulty for those who maintain residences here and in their former home state, becoming a Florida resident is not meeting Florida residency requirements so much as it entails escaping the clutches of your former state’s taxing authority.