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Changing circumstances for post-mortem trust planning.

Post-mortem trust planning has changed dramatically as a result of recent changes, such as the increased federal income tax brackets and modifications to New York's estate tax, which have made post-mortem trust planning more challenging than ever before. This article endeavors to identify some of the many different trust circumstances where particular caution must be exercised.

The Role of Trusts

Historically, most trusts--especially testamentary trusts created under a will upon death--have been formed in one's home state. In recent years, it has become more common for inter vivos trusts to be formed in trust-friendly jurisdictions that have laws and tax systems designed to be as favorable as possible. It has become more common for inter vivos trusts to incorporate a bust protector position and to empower this individual to change trustees and other aspects of the trust. For example, it may no longer be that a testamentary trust formed under a New York will has to remain in New York. The governing instrument may provide for a trust protector who can change the New York trustees to ones from a different state, and change the situs and governing law to a different jurisdiction. This could have a positive impact on many bust characteristics, described below.

* State trust accounting rules may impact determination of trust income and deductions. The definition of income for a trust under IRC section 643(b) requires that state law rules applicable to the determination of income be considered in determining a spouse's income interest in a marital trust.

* Trustee commissions determined under state law.

* State Uniform Principal and Income Act (UPIA) provisions differ significantly. For example, unitrust payments under New York statute would be 4% (N.Y. Estates, Powers, and Trusts Law, section 11-2.4). Delaware, in contrast, permits a unitrust payment ranging from 3% to 5% (Del. Code Ann., Title 12, section 3527).

Approximately 20 states now permit the decanting (merger) of an existing trust into a new bust. New York has a robust decanting statute. Decanting may permit the modification of an existing bust, such as a testamentary trust, in order to provide a more favorable result As decanting grows in use, is the fiduciary obliged to change situs and the bust if they are not optimal?

Advisors may no longer be constrained by some of the terms of an existing bust when evaluating planning options.

Investment, Trust Funding, and Related Considerations

Tax and non-tax decisions are now more likely to be intertwined, and asset allocation and location decisions can differ from how they have been previously handled: Historically, assets most likely to appreciate were distributed to trusts that would not be taxed in a surviving spouse's estate (e.g., bypass or credit shelter bust). For many wealthy clients whose estates are under the federal exemption amount, the opposite approach may now be preferable. It might be advantageous to fund a bypass bust with non-appreciating assets (e.g., a portion of a bond portfolio) and fund the marital bust with assets most likely to appreciate, to obtain a step-up in basis upon the death of the second spouse. It may also be feasible to fund the bypass trust with a portion of the portfolio that will be actively traded, so that the magnitude of unrealized appreciation will be minimized.

These funding and investment decisions will also be affected by the rights to distribute appreciated assets back to the surviving spouse out of a bypass bust, by an investment manager's confidence in controlling gains in the bypass bust, and by whether the bypass bust was structured to be a grantor trust as to the surviving spouse to permit swapping appreciated assets.

In summary, the following factors should be considered when making investment allocation decisions:

* An investment analysis that indicates where gains should be recognized

* The needs of beneficiaries (e.g., liquidity, current distributions, asset protection)

* Estate distribution and cash requirements (i.e., to pay debts or other expenses)

* Estate's and beneficiaries' income tax consequences. (These can be daunting to determine.)

Unfunded Bypass Trusts

As a result of the dramatic increase in the inflation adjusted estate tax exemption, many individuals will simply refuse to fund a bypass trust for smaller estates, even though the decedent's will has never been updated to provide for an alternative. Many are simply unwilling to incur the cost or complexity of funding a bypass trust that will provide little or no estate tax benefit, and which may even result in a a potential loss in step-up in basis step-up. What liability will the fiduciaries face if they don't fund a trust and instead distribute assets intended for the bypass trust outright? Who should receive that outright distribution--only the surviving spouse? Or other current and remainder beneficiaries?

How can advisors deal with an unfunded trust? If a CPA prepares and files a Form 706 to secure portability, and the income tax returns report the assets that should have been held in the bypass trust, what responsibility does the preparer have? Merely accommodating client requests might expose the CPA to claims by disgruntled remainder beneficiaries.

In many instances, CPAs will become aware of an unfunded bypass trust after the fact. In order to correct the unfunded bypass trust in those circumstances, one should review with the estate's attorney whether the trustee had an option under the governing instrument (e.g., the decedent's will) to distribute out the entire trust corpus to any one or more of the current beneficiaries under specified conditions. If those criteria were met, all that may be required is appropriate documentation.

State law may assist in some situations. For example, New York has a statute permitting the termination of an uneconomic trust. One should endeavor to identify the assets that should have been used to fund the intended bypass trust and determine how income earned in the intervening period should be allocated among beneficiaries, including the to-be-funded trust. If the failure to fund the bypass trust was inappropriate, discuss with legal counsel the prospect of negotiating a funding agreement with all affected heirs, along with any relevant transfer documents (e.g., an attorney preparing a deed to transfer a house to the bypass trust that might have been inappropriately transferred outright to the surviving spouse), in order to confirm the decisions made to rectify the situation.

The Dangers of a Pecuniary Bequest

A bypass trust, grandchild trust, or other trust may be structured as a pecuniary bequest. This is a bequest of a specific dollar amount rather than a share of the estate. Even if the bequest is determined by a formula, it can still be properly characterized as a pecuniary bequest. Funding such a trust with appreciated assets will trigger a gain [Treasury Regulations, section 1.661 (a)-2(f)( 1)]. With higher income tax rates, this issue can be more costly than in the past.

IRC Section 2519 QTIP Planning

CPAs should be alert to the ways QTIP planning has changed. More specifically, the use of an IRC section 2519 disclaimer should be given greater consideration.

On the first spouse's death, if the deceased spouse has not used all of his estate tax exclusion, the surviving spouse may, under the new portability concept, be permitted to take advantage of that unused exemption. This is the now-familiar Deceased Spouse Unused Exemption (DSUE).

To assure that only the surviving spouse's estate will benefit from one such prior unused exclusion, and to provide clarity as to which exclusion can be utilized, it is the exclusion of the last deceased spouse that governs. If the surviving spouse is planning to remarry, she should consider using the DSUE from the deceased spouse before remarriage; if not, when the new spouse dies, the DSUE from the first deceased spouse will be lost.

How can the surviving spouse ensure the use of the ported exemption before remarriage? The surviving spouse could disclaim her income interest in the QTIP trust created by the first-to-die spouse. If the income interest in a QTIP is disclaimed, it will be treated as if the entire QTIP--principal interests as well as the actually disclaimed income interests--is gifted. This gift could use the DSUE under IRC section 2519.

IRC section 2519 provides that a gift of any part of the qualifying QTIP income interest will be treated as a transfer of the entire QTIP property [Treasury Regulations section 25.2519-1(g)]. In this case, the surviving spouse would be required to sign an appropriate disclaimer document and deliver it to the trustee. Be certain that legal counsel reviews the appropriateness of this technique before proceeding. Many states' laws, and often the terms of the trust itself (e.g., a spendthrift provision), may prohibit the transfer of an interest in the trust.

Why might a surviving spouse be willing to give up the QTIP income interest to accomplish this beneficial tax goal? The QTIP may provide that the surviving spouse is a discretionary principal distribution, so it is possible that the surviving spouse may continue to receive as much cash flow as before the disclaimer.

A recent Private Letter Ruling illustrates the flexibility CPAs can bring to this type of planning (PLR 201426016). In the PLR, the surviving spouse was the beneficiary of single QTIP trust. The QTIP was divided into three trusts:

* Trust 1 had the same terms as the predivision QTIP.

* Trust 2 made an election under state law to adapt a unitrust distribution. For example, the successor QTIP might pay a fixed percentage of principal (e.g., 3-5%) in lieu of income payments. In the current low-interest rate environment, this could be as much as the entire predecessor QTIP paid in terms of income.

* Trust 3 had the same terms as the predivision QTIP, but it would be ended after the division and distributed.

A division was required because IRC section 2519 provides that if any portion of a QTIP transferred during one's lifetime, it is treated as a gift of the entire interest.

There might be a more flexible alternative to the surviving spouse having to disclaim her entire income interest. The spouse could gift a portion of her income interest in the QTIP sufficient to trigger the application of IRC section 2519. This should suffice to capture the DSUE as intended, but leave some of the income interest intact. Upon the death of the surviving spouse, the QTIP will be included in her estate under IRC section 2036 because the surviving spouse retained an income interest. Although the entire QTIP will be included, the DSUE will be recaptured and available to the estate.

Be Wary of Potential Traps

Post-mortem trust planning has become more complex, and it can, in many circumstances, have surprising and different consequences than planning decisions made in the past. CPAs have many new opportunities to advise individuals, but need to be mindful of the potential traps.

Martin M. Shenkman, JD, CPA, MBA, PFS, AEP, is an attorney at Shenkman Law in Paramus, N.J.
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Title Annotation:Finance: estate & retirement planning
Author:Shenkman, Martin M.
Publication:The CPA Journal
Geographic Code:1USA
Date:Apr 1, 2015
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