January 2009

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MONTH YEAR: Lead Article: 1 ¾ pages [2nd page about 45 lines]
Lead Article Title: Insurance Trusts (ILIT) Not So SimpleSummary: Irrevocable life insurance Trusts (“ILITs”) are a common estate planning tool. Having a trust own your insurance can keep the proceeds outside your taxable estate, protect the proceeds for your surviving spouse, partner or children. An ILIT can protect the proceeds from an heir’s divorce or lawsuit. Physicians and others worried about malpractice claims use ILITs to hold permanent insurance to build value in the protective envelope of the trust. But too many people assume insurance trusts are a simple boilerplate form. That assumption is likely to result in a trust document that is inadequate and not tailored to their situation, and lax administration of the trust (after all, it’s simple and standard!).

Start Simple: Who Should be Trustee.
The simplest step for an ILIT is to name the trustee, right? The reality is that administering an ILIT
Isn’t the cake walk most people think. Insurance must be properly purchased, monitored and reviewed. Gifts must be accepted and Crummey notices issued (see below). Financing and other arrangements may have to be monitored. There are a myriad of other technical administrative issues that could affect an ILIT. Uncle Joe might be a nice guy, but you’re always safer naming a professional, such as a trust company, or a long time family CPA, to be certain your ILIT is handled properly. The fees they’ll charge are modest compared to the problems Uncle Joe frequently creates. You can always have the Uncle Joe replace the professional trustee following your death with the ILIT has substantial funds you want him to administer instead of the trust company or CPA. But that too is probably a mistake. Instead, have Uncle Joe serve as a co-trustee so that the professional management of your trust can continue. Be sure your ILIT specifically addresses compensation for professional trustees since most ILITs have no income and many have only nominal asset values (e.g., if they only hold term insurance) so that standard methods of calculation compensation will provide inadequate payment.

Situs-Which State Law Governs.
There are a host of important matters that can be affected by the particular state law that governs your ILIT. Some states have enacted legislation holding trustees harmless for insurance investment decisions by relieving the trustee from the general standard of care applicable to a trustee, such as investing with care and skill, etc. Del. Code Sec. 3302(d). This relieves the trustee of liability for not: determining if an insurance policy is a proper investment, investigating the financial strength of the insurance company, exercising any policy option, etc. If a state other than your state of domicile has statutory protections you want for your ILIT trustee then issues of nexus (connection to that state) must be addressed. The surest way is to name an institutional trustee in that state. Florida law may permit the trustee to delegate insurance management to other persons without the fiduciary duty of care that would otherwise apply. Fla. Statutes Sec. 518.112(2). North Dakota, Pennsylvania, Wyoming also have favorable statutes. Another approach may be to list the indemnifications and exceptions in your ILIT document to minimize the liability your trustee faces (especially if compensation is minimal). But think carefully, do you really want the trustee to avoid these responsibilities?

Reciprocal Trust Doctrine.
If you set up an ILIT with a $1 million 20 year term policy on your life naming your wife as beneficiary and co-trustee, and your wife sets up an identical trust naming you as beneficiary and co-trustee, the two parallel (reciprocal) trusts might be unwound by application of the reciprocal trust doctrine. Whenever you and your spouse, or perhaps another family member, are establishing similar ILITs take care to plan and draft around the reciprocal trust doctrine. See U.S. v. Grace, 395 316 (1969); PLR 9643013; PLR 200426008. Incorporate as many differences between the two trusts as possible. While substantive economic differences are preferred, if not essential, the inclusion of other more administrative differences may still support the independence of the two trusts. The following listing does not weigh the strength of the various factors listed: ■ The parties, e.g. husband and wife, should not be in the same economic position following the establishment of the two trusts. ■ Give one spouse a “5 and 5” power under one trust, but don’t include a “5 and 5” power under the second trust. ■ Include an inter-vivos special power of appointment (“SPA”) under one trust, but not another. Endeavor to make the power meaningful, not just a reallocation of assets between the same group of grandchildren. ■ Include a testamentary special power of appointment under one trust, but not the other. ■ Include a martial savings clause in one trust, but not in the other. ■ Each trust should have different distributions, e.g., one trust could mandate distributions at specified ages and the other trust could be a perpetual dynasty trust. ■ Use different distribution standards in each trust, e.g., one trust could distribute solely based on an ascertainable standard, and the other trust could use a broad discretionary standard with an independent trustee. ■ Add an additional beneficiary, like aunt Jane, to one of the trusts, but not the other. ■ Use different trustees for each trust. If neither spouse is a trustee or co-trustee and you have different trustees for each trust this could be a significant factor. ■ Have the trusts signed at different times. ■ Each trust can hold different assets, e.g., husband’s trust holds universal life, and wife’s only term insurance). Vary the amount of insurance coverage and other assets in each trust. For example the wife’s term policy could be for $5 million while the husband’s trust only holds $2 million of coverage. ■ Have one trust receive a significant initial contribute and the second trust merely a nominal initial contribution.

GST Exempt or Not.
Should the trust be GST exempt or not? Since only about 2% of term insurance policies ever pay-off, evaluate whether your GST exemption should be wasted on an ILIT holding only term coverage. Also, even if your ILIT holds permanent insurance that is almost assuredly going to be maintained in force for the duration, you may have more important uses of your GST exemption. Plan accordingly. So even if making the ILIT GST exempt is reasonable, if you have better uses of your exemption, have the trust drafted in a manner that avoids GST issues. For example, the ILIT could be drafted in a manner that causes it to be included in your children’s estate to avoid the GST tax. If it is intended that you will allocate, on your gift tax return, sufficient generation skipping transfer (“GST”) tax exemption to the trust to keep it free of GST Tax issues (to create a zero inclusion ratio) be certain your accountant addresses this on a gift tax return. See “Potpourri”.

Who is Your Spouse
No, this is not about the ABC show Wifeswap. But if you set up an irrevocable (can’t be changed) insurance trust, you need to plan for lots’ of “what-ifs”. At some future point you may no longer be insurable and you might be divorced, perhaps remarried, perhaps several times. Who should benefit from your ILIT? Should “spouse” be defined as a particular person, or as the person married to you at a specific time (a “floating spouse” clause)?

Divorce.
Under some state’s laws divorce may automatically terminate your ex-spouse’s interests as a beneficiary in insurance on your life (or it may not). Should your ILIT override either type of statute? If you have your spouse automatically terminated as a beneficiary in the event of divorce and you are required to provide life insurance for his or her benefit, but you are rated? Precluding the use of the insurance held in the trust could prove a costly mistake.

Annual Demand (Crummey) Powers.
If you make gifts to an ILIT you will have to qualify those gifts for the annual gift tax exclusion ($13,000 in 2009), use up some of your $1M lifetime gift exclusion, or use alternative financing means to reduce the annual gift impact. To qualify for the annual gift exclusion beneficiaries have to be able to obtain the money given currently (a present interest). This is often accomplished by giving each beneficiary the right to withdraw new gifts during a window of time and giving them notice, which they acknowledge, of that right. This technique is called a “Crummey” power after the court case initially sanctioning it. Consider the number of Crummey power holders, provide flexibility so as irrevocable trust sufficient annual gifts can be made to hold likely future increases in insurance to be added to the trust. Give every power holder sufficient rights under the trust so that they are more than a mere naked Crummey power holder.

Conclusion.

The above discussion only touched upon a few of the scores of issues that should be addressed in even a “simple” insurance trust and plan. If Capital One did insurance trusts as well as credit cards, their slogan would be “What’s in your ILIT?”
Checklist: Second Article 2 lines less than One Page [about 54 lines]:
Checklist Article Title: Art and Collectibles – Part II

Summary: Last month’s checklist addressed record keeping and income tax consideration for your art and collectibles. This month’s column addresses additional issues. The topic is so broad and complicated that the following should be viewed at most as a starting point to make you aware of some of the many issues to consider.

■ Appraisals. Appraisals of art and collectibles is common, and an important component of planning. Most people assume that all appraisals have the goal of determining the value of the art or collectibles being appraised. But “value” is has many definitions depending on the context. You have to clarify the correct definition of “value” to obtain the desired result.
■An appraisal to be certain your art is appropriately insured should be aimed at identifying the “replacement value” of the property. This is the highest price that would be required to replace a property with another of similar age, quality, origin, appearance, provenance and condition. The replacement purchase should be assumed to be consummated within a reasonable length of time, and in an appropriate and relevant market. Similar items are those from comparable manufacturers, craftsmen, artisans, designers, using similar materials, close in size, date, importance, similar aesthetic qualities, and appearance.
■If you’re planning a gift of collectibles to your children or a charity, for tax purposes your appraiser should be directed to determine the “fair market value”, as that term is defined in the tax laws. “Fair market value” is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts. Treas. Reg. Sec. 20.2031-1 (b). The appraisal report should identify, compare and contrast recent sales of comparable items sold in the market where the items are most commonly traded.
■A qualified appraisal must be prepared, signed, and dated by a qualified appraiser. The appraiser should: hold himself out to the public as an appraiser or performs appraisals regularly; be qalified by background, experience, and education to make appraisals of the type of property being valued; not be the donor, donee, or someone employed by the donor or donee, or the dealer who sold the art to you; not charge based on a percentage of the appraised property; understands that an intentionally false or fraudulent overstatement of the value of the property may subject the appraiser to a civil penalty under IRC Sec. 6701; understands that a substantial or gross valuation misstatement resulting from the appraisal used in connection with a tax return may subject the appraiser to the penalty under IRC Sec. 6695A; and is not barred from presenting testimony by the Office of Professional Responsibility, Reg. 1.170A-13(c)(5).

■ Estate Planning.
There are a myriad of estate planning implications and considerations to your holding art and collectibles. The following discusses a few of these.
■ Code Section 2036(a)(1) is a major landmine in estate planning in that it can pull assets back into your taxable estate based on your having retained some inappropriate “strings” to the asset involved. Property transferred by your, during your lifetime, is brought back into your gross estate if you retain the right to receive the income from the property, or if you retained the “possession or enjoyment” of the transferred property, for: (1) life, (2) a period ascertainable only with reference to your death (e.g., monthly, except for the month in which you died), or (3) a period that does not in fact end before your death (e.g., 5 years if you died during this period). So if you give your daughter your Miro, but you retain the right to display the painting in your home for your life, the full value of the Miro is taxable in your estate regardless of the “gift”.
■ Tax allocation clauses in your will are vital to address. Many wills allocate the tax burden in proportion to the value of assets given. However, if one heir receives a bequest of $3 million in securities, and your other heir $3 million in collections, how will the heir with the collections have the cash to pay his share of the estate tax? Think through “standard” clauses to make sure the result is what you actually intend.
■ Another “will” trap for art and collectibles is to be certain that it is clear which provision of your will governs the distributions of your art and collectibles. Most wills contain a general clause governing the distribution of tangible personal property, which will generally cover art and collections. However, if you have important pieces that you want distributed in a specified manner you should have greater clarity then merely a generic clause. You might leave your furniture and certain art with your home that is being bequeathed to your new spouse, but wish your collection of Chinese porcelain vases to be bequeathed to your daughter. Absent specific language, the general bequest of tangible personal property would cover this. If you own a business, and the business actually purchased and displayed many of these vases, the bequest of the stock in the business will include the vases owned by the business unless you take specific action.

Recent Developments Article 1/3 Page [about 18 lines]:
■ Bankruptcy: When you make a mortgage payment, part of each payment is interest, and the balance is principal, reducing the amount you owe the lender, and increasing your equity in the house. The Bankruptcy Code provides that: “…a debtor may not exempt any amount of interest that was acquired by the debtor during the 1215-day period preceding the date of the filing of the petition…” A recent case held that your making regular mortgage payments, including principal payments that build equity in your home, won’t be treated as your acquiring an interest in real property under Section 522(p) of the Bankruptcy Code. In re Burns, 21 Fla. L.L. Weekly Fed. B487 (U.S. Bankruptcy Court, M.D. Fla. August 8, 2008. Exercise caution extrapolating this to making payments larger than your regular monthly payments. The courts might not view that as favorably.
■ S Corporation Tax Basis: Tax basis is important to your being able to deduct losses, and reducing gain on a sale of stock. Your basis in your S corporation stock is increased by your share of income and reduced by your share of loss, etc. Once your tax basis in your S corporation stock is reduced to zero, additional losses will reduce your tax basis in loans to the corporation. IRC Sec. 1367(b)(2)(A). The taxpayers argued that capital contributions should be treated as income restoring tax basis in their loans. The Tax Court held that capital contributions are not income, and the contributions did not increase the taxpayers basis in his loans. The court noted that capital contributions increase a taxpayer’s basis in his stock. Nathel, 131 TC No. 17 (2008).
■ Private Annuity Respected: The Tax Court held that a private annuity transaction should be respected and capital gains tax could be deferred. Katz, TC Memo 2008-269. While this case is somewhat helpful to the use of private annuity transactions, the effective date precedes the proposed Treasury Regulations effective for sales after 10/18/06 requiring the seller of property for a private annuity to recognize all gain in the year of sale, rather then when payments are received (which is why these are often structured as sales to grantor trusts).
Potpourri ½ Page:
■ What’s Scarier then the Crypt Keeper? Not en-crypting your laptop! 10,000 laptops are stolen from airports every week. If you have valuable data on your laptop (or perhaps your accountant or estate planner have your data on their laptop) encrypt it. Don’t stop there. Here’s another Tale from the Crypt — About 40,000 PDAs a year are left in Chicago area taxis! No avoiding Chicago isn’t a solution. What about all those confidential emails you send to your attorney? Password protect your Blackberry (and be sure your lawyer does too).
■ Unintended GST Allocations: So you have an old insurance trust that owns policies on your life. You’re one of three people in the country that heeded their estate planner’s advice and you religiously prepared Crummey powers for each gift to the trust (to make sure the gifts qualify for the annual gift tax exclusion, $13,000 in 2009). Other than that you have the Alfred E. Neuman attitude of “What, Me Worry?” So start worrying. Has your CPA addressed GST allocation to the trust? Might be that the rules the IRS enacted to “simplify” (you know what happens when anyone simplifies the tax laws!) the allocation of GST exemption to trusts, has a nasty surprise for you. These rules were enacted in 2001 as part of the Economic Growth and Tax Relief Reconciliation Act (sorry, Barack, this catchy name is already taken). These automatic GST allocation rules (Code Section 2632) can allocate (waste) your valuable GST exemption by automatically allocating it to your insurance trust when that is really not your intent, or what is optimal for your plan. If your old insurance trust meets the requirements to be classified as a “GST trust” your exemption has been automatically allocated every year you’ve made gifts to your trust unless your CPA filed a return electing not to have the allocation made. What to do? Well meet with your CPA now and get the election made on your 2008 return to avoid further waste of GST exemption. Next, consult with your estate planner about seeking a private letter ruling from the IRS fixing the issue. Before heading down that path, be sure the legal fees will be worth the GST exemption that was wasted (assuming you are in fact successful).

Back Page Announcements:

Free Seminar: ■ “Heckerling Institute of Estate Planning – A Review”, at Marriott Glenpoint 2/3/09, registration/breakfast 7:30, presentation 8:00-11:00 am. 3 CPE/CFP credits. Sponsored by Steven Fishman and Norwood Financial. No charge. Call 201-845-8400 for info.
■ Free Webinar “Operating and Maintaining your Estate Plan.” Practical “how to” seminar for clients as well as professionals. Attend from your home or office. 1 hour overview of steps you should take to keep your plan current and operating properly. Practical checklists and ideas you can use. 2/17/09 12-1 pm. Call 201-845-8400 or email [email protected] to register.