Sorrell Law Blog

Welcome! Attorneys love disclaimers, and here it is:  The information on this page is intended as a general discussion of legal issues and not as legal advice. It is based upon North Carolina law and is correct as of the time it was written.The law is different from state-to-state, and is constantly changing.  It is important to review the particulars of any given set of circumstances as no two situations are identical. There may be particulars in your situation that may make critical differences. We encourage you to contact an attorney to discuss your situation.We would love the opportunity to be of service to you. But no attorney-client relationship is created by use of this material. You have not retained Sorrell Law Firm or any attorney associated with us unless you have an engagement letter signed by Richard Sorrell.

Transferring Real Estate to Heirs, Part 3

One of the more frequent estate planning conversations we hear centers upon the transfer of real estate from a person to his-or-her heirs (usually children). This is the third in a series of posts reviewing some general information on doing that. As we are typically talking about “the house”, this post will refer to “your house”, but everything here applies to any real estate.

In the last post we considered what happens to property that you own outright (as opposed to having a life estate, joint tenancy with survivorship, etc.) at your death. So we talked about leaving property to others through your will (called a “devise”), and we talked about what happens if you have no will.

1. Transfer to/through a Living Trust. You can establish a Revocable Living Trust, and then draft a deed transferring your house (or any other real estate and most other types of assets) to the Trust. Any property owned by the Trust when you pass away avoids probate. The Trust Agreement will then control what happens to the house (or anything else) when you pass away. The options are virtually limitless. You could have the trust distribute the house to one or more persons, or hold it in further trust and allow someone to live in the house. Or it could direct the trustee to sell the house and pay the net proceeds to one or more people/organizations. If the trust is property drafted, it will protect the house from your beneficiary’s creditors and unhappy spouses. (This sort of trust will NOT protect the house from your creditors.) Note: Unlike some other states, it is NOT enough merely to draft a trust agreement that mentions the house or a declaration of trust. In North Carolina, there MUST be an ACTUAL DEED that transfers the house into the Trust.

PROS:
• During your lifetime you are free to do anything you like.
• You decide who gets your house, subject to certain claims of creditors, maybe your spouse, etc.
• Your heirs (beneficiaries) get a step-up in tax basis when they inherit the house.
• If your heirs (beneficiaries) are your spouse or children and there is a mortgage on the house when you die, they don’t have to pay off the mortgage immediately, and they do not have to assume it; but they do have to keep it current.
• The house is protected from most of the creditors of your beneficiaries (if trust agreement is properly drafted).
• The house is protected from the unhappy spouses of your beneficiaries (if trust agreement is properly drafted).
• There is generally almost zero risk of litigation (if trust agreement is properly drafted).
• Very economical and easy after your death.
• It is a private arrangement, as opposed to probate, which is public.
• If there are to be multiple beneficiaries and you anticipate that they may not get along, this allows the Trustee to deal with the property without the necessity of forging agreements.
• Lends itself well to complex arrangements (if such are needed).
• Allows for genuine long-term control of the property after you pass away.
• You can transfer mortgaged property to your Trust without the approval of the mortgage company.
• If you are married, North Carolina law now allows you to maintain the protections of TbyE even though you have transferred the property to your Trust.

CONS:
• Subject to the claims of your creditors.
• The initial cost will be higher than for a will or a deed, though the long-run cost will likely be less than the use of a will.
• If poorly done, it can really make a mess of things.

2. Transfer to/through an Irrevocable Trust. You could establish an Irrevocable Trust, and then draft a deed transferring your house (or any other real estate and most other types of assets) to the Trust. There are many different sorts of Irrevocable Trusts and they vary greatly. But as a general rule, one big “pro” will be added to the list of “pros” for a Living Trust. It is this: that as a general matter the property in the Trust IS protected from your creditors. (There are some important exceptions to this.) But all good things come at a price, and the price here is a big “con” that is added to the list of “cons” for a Living Trust. It is this: loss of control. That is right, once you transfer property to an irrevocable trust there is NO getting it back. And there is a second con: since the ability to modify an irrevocable trust is quite restricted, if it is not done right the first time there may well be no fixing it.

3. Transfer to/through an LLC or Corporation. Many of our clients own rental or business real estate in an LLC or a Corporation. So the name on the deed is not a person, but is the name of an LLC or Corporation. This means that the specific piece of real estate is not an asset to leave to someone, because it is owned by the LLC or Corporation. But your interest in the LLC or Corporation IS AN ASSET that you leave to your heirs. They do get a step-up in basis in the value of the LLC or Corporation upon your passing. If there is concern that the prospective heirs won’t get along, you can make the LLC subject to an Operating Agreement (or the shares in the Corporation subject to a Shareholders’ Agreement) to facilitate the smooth transition. If you have a Trust, and you have transferred ownership (or equitable ownership) to the Trust, and the Trust is properly drafted, this should not be an issue.

On a related note: The setting up of Partnerships to own real estate used to be quite common. (LLC law was relatively undeveloped and many did not think the LLC a credible option. Also, and this may be a surprise to you, but attorneys as a group tend to be creatures of habit and are rather biased against new things.) We still see quite a few Partnerships. Upon a quick glance, Partnerships can look like an LLC (they share the trait that they don’t pay taxes but pass profit and loss directly to the owners to pay the tax). But Partnerships are not the same as LLCs. Partnerships are very prone to big and expensive problems when a partner dies. If you have one in NC, and can’t explain why it should be a Partnership and not an LLC, come talk to us. (Some states do not give LLCs favorable tax treatment, and the level of protection provided by an LLC varies greatly between states. If you are not in NC, talk to someone in your state about your needs.)

As always, this conversation is of a general nature and is NOT A SUBSTITUTE for coming in and discussing YOUR PARTICULAR SITUATION with us. We will offer you coffee, and we rarely bite. Also, this conversation is based on North Carolina law at the time it was written, and assumes that both you and the real estate in question are in North Carolina. Mobile homes can cause additional complications that are not addressed here. Next time, we will discuss life estates. Until then…

Transferring Real Estate to Heirs, Part 2

This is the second of about four blog posts that addresses ways to transfer ownership of real estate to your children. This is one of the more frequent estate planning conversations we engage in. There is a lot of bad information out there on the topic. These posts form a brief primer of the current options in North Carolina.

In the last post we considered giving your property outright to your children now, and transferring a partial interest to them now as joint tenants. Today we look at “devises”. Devise is an old-time legal word for a transfer of real estate at the death of an owner by will or intestacy. There are two ways that devises happen:

1. Transfer by intestacy (a.k.a. do nothing). If you die owning your house ‘in your name alone’ and with no will (called dying “intestate”), North Carolina’s intestacy statute will determine who owns your property after you pass away.

PROS:
• Your heirs get a step-up in tax basis (though there are better ways of doing this).
• If your heirs are your spouse or children and there is a mortgage on the house when you die, they don’t have to pay off the mortgage immediately, and they do not have to assume it, but they do have to keep it current. (Again, there are better ways of accomplishing this.)
• Free today.

CONS:
• May be very expensive tomorrow.
• There may be a substantial risk of challenge, depending upon your personal situation. Specifically, there could be litigation to determine which people qualify as your heirs, and in what percentages.
• The transfer is subject to the claims of creditors (your creditors could force your heirs to sell the house to pay them).
• May require probate administration (to determine heirs or clear creditor claims).
• WILL require some court administration to sell within three years of your death (must run Notice to Creditors).
• Heirs may lose the property to creditors.
• If your house has a mortgage, your heirs get a house with a mortgage.
• Your heirs may not be who you think they are. (Many people assume that their spouse “automatically inherits everything”. This is often not true.)
• If any of your heirs are minors, or incapacitated, the house cannot be sold with a special proceeding being brought in Superior Court.
• If any of your heirs are married, and the spouse(s) of the heir(s) will not cooperate, there could be big (read: expensive) problems.
• If your heirs have judgments against them, the judgments attach to the real estate upon your death.

2. Transfer by will. So instead of dying intestate, you could draft a will. (A person that dies with a valid will is said to die “testate”.) This conversation will presume that the will is properly drafted and executed, and can be admitted to probate.

You can draft a will leaving your house to anyone you wish. However, if you own the house as tenants-by-the-entireties and your spouse outlives you, OR if you own as joint-with-right-of-survivorship (JROS), what your will says does NOT matter—your spouse (or the joint tenant if JROS) get the property (subject to any liens on the house, of course). But Note: Even with a will, if you are survived by your spouse your surviving spouse has claims against your property EVEN IF your will ‘disinherits’ him or her. Obviously this can be a major issue. It stems from the fact that surviving spouses have statutory rights with regard to the estate of their deceased spouse, which the deceased spouse’s will does not change.

Further Note: The fact that your will says that the house is to be sold and the money divided does NOT mean that your Executor can do this. Such a provision requires VERY specific language to be in the will (in North Carolina), and we see MANY wills that have such a provision but do not have the necessary language to make it happen.

PROS:
• You decide who gets your house, subject to certain claims of creditors, your spouse, etc.
• Your heirs get a step-up in tax basis when they inherit the house.
• If your heirs are your spouse or children and there is a mortgage on the house when you die, they don’t have to pay off the mortgage immediately, and they do not have to assume it, but they do have to keep it current.

CONS:
• There is a certain risk of challenge. The degree of that risk depends upon various factors, most of which relate to how well your will is drafted and your personal situation.
• The transfer (called a “devise”) is subject to the claims of creditors (because your creditors could force your heirs to sell the house to pay them). In short, your heirs may lose the property to your creditors.
• Your heirs could lose the house to their creditors.
• May require probate administration.
• WILL require some court administration if your heirs wish to sell the house within three years of your death (must run Notice to Creditors).
• If the heirs won’t get along, or any of them are minors, or incapacitated, or have spouses that may not cooperate, or have judgments entered against them, it is important that the will give someone the power to sell, which requires VERY specific language, otherwise litigation may result.

In the next couple of posts we will consider transferring your house to/with a trust, and various life estate options. Until then…

Transferring Real Estate to Heirs

One of the more frequent estate planning conversations we hear centers upon the transfer of real estate from a person to his-or-her heirs (usually children). There is a lot of bad information out there on the topic. So this is the first of about four blog posts that will address this issue. Together, they form a brief primer based upon the current climate in North Carolina. As we are typically talking about “the house”, this post will refer to “your house”, but everything here applies to any real estate located in North Carolina (unless otherwise noted).

As always, this conversation is of a general nature and is NOT A SUBSTITUTE for coming in and discussing YOUR PARTICULAR SITUATION with us. We will offer you coffee, and we rarely bite. Also, this conversation is based on North Carolina law at the time it was written, and assumes that both you and the real estate in question are in North Carolina. There are options not covered here, these are the most common. Mobile homes can cause additional complications that will be briefly mentioned in one of the later posts.

The first transfers we will consider involve giving a present interest in your house to your children.

1. Outright Transfer to a Child (or Children). Many people decide that they will “go ahead and give our house to our kids” with the idea that this will “protect it from the nursing home”. If you transfer title to your home to a child (or children), the child (or children) owns the property. This is a gift. There will be no probate when you die, of course, because they already own it. And that means that the nursing home won’t get it when you die (assuming you don’t already owe them money), because it is not there to get. Remember that any transfer of real estate that does not clear (pay-off) liens already on the real estate is still subject to those liens, so if there are judgments or mortgages they go with the property.
But the nursing home isn’t as much of an issue as is Medicaid. If you don’t pay the nursing home, they throw you out. So people go on Medicaid, but people who just gave away a house are denied. So there are problems with this approach.
And there is another issue. You need a place to live, and giving your house away (even to your kids) complicates that. Sometimes doing this makes sense (I suppose…), but there are HUGE potential problems that should make you think twice before putting title in the name of your child.

PROS:
• There is no probate when you die.
• The transfer is clear of creditor problems you may develop in the future, but if you are having trouble with creditors when you make the transfer it may not protect the house from them.
• Deeds are cheap.

CONS:
• Your child OWNS your house. He or she can throw you out.
• Your child OWNS your house, so if he or she has creditor problems, the creditors may get your house (and throw you out). If he or she files bankruptcy, the bankruptcy trustee could sell your house (and throw you out). If your child gets divorced, your house could be lost to the now ex-spouse (who could throw you out). If your child does not outlive you, you will have problems. Your child’s heir (or creditors) will own your house (and throw you out). Picking up on a theme?
• If you have a mortgage, they may have to agree to the transfer in writing. They likely will not, but even if they do they will probably charge you a fee.
• If you are in an age-restricted community, the transfer may be prohibited by the covenants.
• If you are presently receiving property tax discounts that are offered to certain elderly or disabled citizens (that fall below certain income levels), you will no longer qualify for these discounts.
• When you give your children your house, you also give them your basis. This means that they are likely to have a capital gains tax bill in their future.
• This is a gift, so you will probably have to file a gift tax return (though this does not necessarily mean tax would be owed).
• This is a gift, so if you (or your spouse) need Medicaid in the following 60 months you will face a penalty in the form of a waiting period during which you are ineligible for benefits.
• Did I mention that if you do this your child owns your house?

2. Create a Joint Tenancy with Survivorship with a Child (or children). If you transfer title to a child (or children), the child (or children) owns the property. So rather than your kids owning the whole house, they have a partial interest (called a “concurrent interest”). You keep your foot in the door. Merely “putting their name on the deed” isn’t enough, as that would create a tenancy-in-common. The deed must clearly create a joint tenancy. And since not all joint tenancies have the right of survivorship, it must specify that as well. Note that if you own your house in a joint tenancy with right of survivorship, the deed—and NOT your will, controls what happens to the house when you die unless you are the last person whose name is on the deed to die.

This could be done as a gift (your child doesn’t pay you for the interest). Or they could pay you for it (which, if done right, will generally maintain your Medicaid eligibility). Either way, there will be no probate when you die (related to the house), of course, because of the survivorship clause in the deed. Any transfer of real estate that does not clear (pay-off) liens already on the real estate is still subject to those liens, so if there are judgments or mortgages they go with the property. Sometimes doing this does make sense, but it should not be done without careful examination of the consequences. In general:

PROS:
• There is no probate (with respect to the property) when you die.
• The transfer will be clear of many of the creditor problems you may develop in the future; but if you are having trouble with creditors when you make the transfer it may not protect the house from them.
• This type of transfer will not disqualify you for Medicaid IF: the deed meets certain technical requirements AND if the child or children actually pays you FMV for their interest in the property (so if you sell your child a 1% interest, he or she must pay you 1% of the value of the property, and you must be able to prove this actually occurred).

CONS:
• Your child OWNS a present interest in your house. He or she can not throw you out, but you cannot throw him or her out, either.
• Your child OWNS a present interest in your house, so if he or she has creditor problems, the creditors may get that portion of your house (and cause your grief). If your child files bankruptcy, the bankruptcy trustee could cause your grief (though they could not take your portion of the house). If your child does not outlive you, it did not work.
• If you have a mortgage, they may have to agree to the transfer in writing. They likely will not, but even if they do they will probably charge you a fee.
• If you are in an age-restricted community, the transfer may be prohibited by the covenants.
• If you are presently receiving property tax discounts that are offered to certain elderly or disabled citizens (that fall below certain income levels), you will probably no longer qualify for these discounts.
• If you GIVE your children a joint interest in your house, the part you gave them comes with your basis. The part they receive when you die gets a step-up in basis. How big a deal this is depends upon the numbers involved.
• If you SELL your children a joint interest in your house, the part you sell them has a basis that is the amount paid that they paid you. The portion of the property they receive when you die gets a step-up in basis. If you sell them an interest for less than FMV, the IRS will call the difference a gift.
• If there is a gift (as defined by the IRS), you will probably have to file a gift tax return (though this does not necessarily mean tax would be owed).
• If there is a gift, and if you (or your spouse) need Medicaid in the following 60 months, you will face a penalty in the form of a waiting period during which you are ineligible for benefits.
• As a practical matter, you cannot sell your house without your child’s consent (signing the deed) AND, if he or she is married, the spouse signing as well.
• As a practical matter, you cannot borrow against your house without your child’s consent (signing the deed of trust and, probably, the note) AND, if he or she is married, the spouse signing as well.

The outright transfer actually gives your whole house to someone else. There are three common form of concurrent interests. One is joint tenancy, discussed above. The second is tenancy-by-the-entireties, which is only available to married couples. It is a really big deal, and we will discuss it in a future post.

The third is the tenancy-in-common (TIC), which is very common. Unlike joint tenancy, a TIC creates an absolute ownership of ‘part’ of the property. It is like the Brady Bunch episode where Peter and Bobby divide their room with tape. Bobby gets half the room, Peter gets the other half. If Peter dies, Bobby still only has half the room—Peter’s heirs (or creditors) now have the other half. So we are not really discussing that form here, because from an estate planning and creditor protection standpoint it only creates more problems.

More in the next post…

2016 Estate Tax and the Presidential Candidates

One of the frequent topics around these parts involves the estate tax. There is nothing new here: taxes on the transfers of wealth date back to ancient Egypt. Pyramids don’t come cheap. And Caesar Augustus taxed transfers on death, though he made an exception for transfers between certain close family members.

These taxes can have odd effects. Similar taxes in the late Middle Ages were one of the forces that resulted in the Church owning a large percentage of the land in Europe by the time of the Reformation. Later in England, when a handful of families controlled most of the land, these taxes had the effect of breaking up these large estates and make what we would recognize as ownership of real estate possible for many more people (and ushering in modernism). In the United States, the similar taxes were among the tools used to break up the monopolies held by people like Carnegie, Rockefeller, and Morgan.

And—oh, yes, it was also a revenue source in all of the above cases… One thing all governments throughout time and space have had in common: a thirst for other-people’s wealth.

The estate tax as we have it dates to 1916. It was substantially reshaped during the 1970s, when exemptions for gift and estate taxes were combined in a 1976 bill that resulted in the unified gift and estate tax system we have today. (Prior to 1976 there were two separate tax-schemes, one gift and one estate, which resulted in numerous loop-holes.) The result of the 1976 bill is a genuine wealth transfer tax: the federal government limits the amount of wealth that you can transfer without being taxed (called the “unified credit”), subject to certain exceptions. It does not matter whether you transfer the wealth during your lifetime (a gift) or when you die (through your estate). Furthermore, if you sell property to a family member for substantially less than fair market value the government will call the difference a gift, and count that against your credit.

So the credit amount becomes a key to proper estate planning (though not the only one). Today, the credit amount (which, again, is the amount you can pass to others without paying the tax) is $5.45M (2016). The two presidential campaigns have different views on this. The Trump campaign wants to eliminate the tax (on the federal level). The Clinton campaign wants to drop the credit to $3.5M, and raise the tax rate from 40% to 45%. Of course neither of them can accomplish this in isolation, tax bills originate in the House of Representatives. But it is an indication of their thinking. And it is an indication of something else—you recall the old saying “Two things are certain: death and taxes.” It was not that long ago that many well-intentioned advisors were telling people that they really need not worry about the estate tax—“look how high the exemption is!”. Well, today. But maybe not tomorrow. And in terms of effect it is really not very high, but that is a different post. The point is that you cannot simply disregard the estate tax. Even if repealed, it could come back with one vote. It has before, it will again. And failure to plan for that reality creates real problems: The tax is a tax on wealth, but it is paid out of income. Depending upon the nature of one’s estate and assets, this can create an insurmountable burden for those you leave behind. Which is why planning is so important…

So the point of this post is not that you should vote for Clinton so that American wealth isn’t locked up in a few families. The point is not that you should vote for Trump because estate taxes have bad effects. The point is not that you shouldn’t vote for either one of them because they are both full of corn flakes. The point is that you should plan for what will happen when you pass away, and then review the plan periodically based upon changes in your life circumstances, the life circumstances of your prospective heirs, and changes in the law. And you should not count on any relevant factor remaining static; things change and estate plans need to be fluid. The only thing that doesn’t change is that things change. So formulate your goals, and then let’s work together to help your family accomplish them.

Lump Sum Vs. Guaranteed Income: Why Make Payments to Beneficiaries?

Often, when establishing a trust, rather than giving them a lump sum, it is desirable to have the trust make payments to one person for a period of time (called a “lifetime beneficiary” or a “payment beneficiary”), setting up a guaranteed income stream, and then after that to give what is left to another person (called a “remainder beneficiary”). Two common examples: make payments to my spouse for the rest of her/his life, then split what is left equally between my kids. Or, make payments to my kids for the rest of their lives and then give the balance to my grandkids or to charity.

Why use a Unitrust?

A Unitrust is one mechanism for doing this, and a good one. But there are others. I wrote recently about the advantages of a Unitrust . Our question here is: Why would you want to do this (make payments to beneficiaries) in the first place?

With a Spouse: When the recipient of the lifetime payments is the spouse, usually the reasoning is fairly straight-forward.
• The spouse may have assets of his-or-her own. Regardless the guarantee of a payment stream, perhaps along with lifetime rights to live in a house, will assure the comfort of the spouse for the rest of her or his life.
• Additionally, the Trustee may well have discretion to make additional payments if needed. But the main corpus of the trust is protected for later beneficiaries (usually children).
i) There is no worry that it will be lost to creditors of the surviving spouse.
ii) There is no worry that if the spouse remarries that the assets, or a portion of them, will be lost.
iii) There is no worry that the assets will be depleted in the event of a major illness.
iv) And, of course, there is no worry that the surviving spouse will ‘rewrite the estate plan’ to leave the assets to others (whether willfully or due to manipulation). This concern is more acute with later-in-life marriages.

With Kids: When the recipients of the lifetime payments are the children, some of the issues are similar but many may be different. They may include:

1. Protect from spouses. By holding the corpus in trust and making payments to your child, you insure that if your child should later divorce that the corpus of the trust will not be available for distribution in the divorce. Your child will still have his or her inheritance.

2. Protect from creditors. The portion of the inheritance still held in trust is generally not available to pay creditors who obtain a judgment against your child.

3. Protect from sickness. If your child should become terribly sick, the corpus of the trust is not vulnerable to costs for care. This allows the use of public benefits to assist with care, and the Trustee can supplement the care from the trust. This will result in a much better overall quality of care than simply depleting the assets and being broke.

4. Protect from heirs themselves—behavior issues. Sadly, some people simply hit rough patches in their lives and get involved in self-destructive patterns. Whether gambling, alcohol, drugs, or something else awful, the last thing you want to do is finance the problem. Not only can the trustee see that this does not happen, but there will be something left for better days.

5. Protect from heirs themselves—spendthrift issues. It is well known that lottery winners file bankruptcy at a greater rate than the general public. Frequently people just don’t deal well with ‘found money’. Many people, upon receiving a (to them) large sum of money, proceed quickly to spend a large sum of money. Sometimes this is nothing more than willful, flagrant spending. Sometimes a more insidious irresponsibility or even naiveté. Whatever the reason(s), the money is quickly gone with little to show for it. Likely not what you worked and saved for.

6. Protect from heirs themselves—incentive to work. Sometimes we will see people respond to an inheritance by taking a little time off. Like a few years. Why work when you can live off of the savings of someone else? Related to the former point, it is important to think about what your child may do if coming into what they may receive, and the effect it will have upon them.

7. Protection of the heirs themselves—guaranteed income for life. Simply put, you can guarantee—as much as anything in this life can be guaranteed—that your child will have income for life. And it may not be enough income to live off of, but that may be a good thing too. How much difference would another $1000.00 a month make to you? How much difference would it have made back when things were tight?

8. Stretch the benefit/value of inheritance. This is more of a big-picture thing. You are looking at the overall family-picture. You are forcing the assets to be saved. They will be (presumably) invested, meaning that they will generate income. So while payments are being made, which deplete trust assets, income is being generated to replace trust assets. The payments are offset, at least to some extent, by growth. So kids can have payments for the rest of their lives, and the balance can go to grandkids, charities, or some combination.

The idea of a trust making payments to a surviving spouse, especially in a second marriage, is really a pretty good idea. The idea of a trust making payments to your children may or may not work well for children and your situation. But it is something to at least consider in determining what is to happen after your passing.

The Advantages of a Unitrust

Often, when establishing a trust, it is desirable to have the trust make payments to one person for a period of time (called a “lifetime beneficiary” or a “payment beneficiary”) and then after that to give what is left to another person (called a “remainder beneficiary”). Two common examples: make payments to my spouse for the rest of her/his life, then split what is left equally between my kids. Or, make payments to my kids for the rest of their lives and then give the balance to my grandkids. There are numerous advantages to such a plan, which are discussed elsewhere. This is about how to do it. And historically, the payment beneficiary would receive “income” from the trust or, if that was thought to not be enough, income plus a certain amount.

But when payments are being made like this, there is an inherent tension between the interests of the current payment beneficiary and the remainder beneficiaries. The payment beneficiary wants aggressive investing, to yield (at least, potentially) the maximum growth and therefore the maximum income. The remainder beneficiary doesn’t get the income, so he or she doesn’t care about growth, safe investing is what counts. This generally provides less income but helps to ensure the maximum corpus being left to them (because significant investment losses are unlikely).

Enter the Unitrust. The Unitrust varies the traditional model by stipulating that, rather than making the payment beneficiary’s payment based upon trust income, the payment beneficiary receives a payment each year that is a set percentage of the trust balance (technically the Net Asset Value (NAV)) on a given day of the year (usually January 1st) Of course, though the payment is calculated on an annual basis, it could be (and usually is) set up to be paid quarterly or monthly.

So, for example: The trust specifies payment to the surviving spouse of 5% of the NAV annually, remainder to the children. The trust has $500,000.00 on January 1st of a given year. The surviving spouse would get a payment of $25,000.00 ($2,083.00 per month) that year, and the trust might well actually grow over the course of the year (if income less expenses is greater than 5%). This means that the spouse would get a greater payment next year. Meanwhile, the trust balance cannot be lost to nursing home care, creditors, changes in estate planning, or anything else, and may actually grow depending upon the payment level chosen by the person forming the Trust and investment choices made by the Trustee.

Now the payment beneficiary and the remainder beneficiary are both benefited, at least to some degree, by trust growth and harmed by trust loss. Both have an incentive to monitor trust investments and the activity of the financial planning of the Trust. There is still a tension between the payment beneficiary and the remainder beneficiary. But the tension is now reduced to the percentage that the payment beneficiary is to receive, and this is set by the person forming the Trust.

So what should the payment be? That will depend upon your circumstances and goals, but a common starting point for the discussion is 6%. That accomplishes a number of objectives:

1. 6% of the NAV will usually, over the course of time, cause costs and payments to the payment beneficiary to match the income generated from a balanced portfolio. (Balanced portfolios are desirable methods of insuring that the trustee is properly discharging its fiduciary duty to both the income and remainder beneficiaries.) Of course, this depends a little on costs (tax prep, paying investment advisors, etc.) and depends upon market conditions (hence, ‘over the course of time’).

2. The trustee is freed from the artificial restraints of having to invest for income or growth and can follow both the “Prudent Investor Rule” and “Modern Portfolio Theory” which means that a diversified portfolio is created based on a predetermined appropriate risk tolerance, which minimizes the risk of losing value to inflation or to market declines, and lessens exposure on the part of the Trustee.

3. Both the lifetime and remainder beneficiaries are hoping for the same result, an increased portfolio value, because the larger the growth, the greater the 6% payout becomes and the greater the remainder becomes.

4. This is a really important concept in those cases where a lifetime beneficiary can be expected to live (and take payments) for several years because over that length of time an interest oriented portfolio would, in times of modest inflation, see the value of the income decline dramatically. But the Unitrust naturally keeps up with inflation with increasing annual payouts while the principal also grows.

Of course, it may be desirable to direct more of the trust balance to the payment beneficiary (at the expense of the remainder beneficiaries) or to preserve more for the remainder beneficiaries (at the expense of the payment beneficiary). An additional consideration is whether or not the Trustee has discretion to make additional payments to the payment beneficiary if the payments are not adequate at some point (often done if the payment beneficiary is a surviving spouse or disabled). So, yet again, the key to estate planning is the planning, but the Unitrust is a very useful (and greatly under-utilized) tool and this a good starting point for the discussion.

Family Members, Loans, and the IRS

Here is my second stock photo attempt, just in time for tax season.  This one didn't require any expensive props either  but I did have to use my son's glue stick to hold the sheets together. Feel free to use this image, just link to www.SeniorLiving.Org

Image Credit Ken Teegardin

We frequently run into situations where someone wants to loan money to a family member (or has already done it). Often, the idea of charging interest is distasteful to them. This is—after all—family. It probably will not surprise you to find out that the IRS has ideas about this, and that they are happy to use those ideas to impose complications on your life.

The Theory: As a very general matter, the IRS imposes tax on income, gain-in-value, and certain transfers of wealth. The ability to use someone else’s money has value. Generally, when we use someone else’s money (to buy a car, for example), we pay them for the use of the money (in the form of interest and other fees). We are paying for value (the use of the money that allows us to have the car now rather than later). If there is no charge for the use of the money, we are getting the same value, but at no cost. The IRS says that looks like income. (There is actually some history here that is really interesting to those of us who are full-fledged members of the Geekdom, but we will save that…)

Now, if you go to the appliance store, and they give you 2 years same-as-cash (i.e., 0% interest) on your new dishwasher that you can control from the moon with your phone, the IRS doesn’t tax that. That is a ‘third-party’ or ‘arms-length’ transaction. The store is not doing it to be nice, they are not really ‘giving’ you anything in the true sense of the idea. It is just part of “the deal”, and they are getting paid—it is just somewhere else in the transaction.

But when the loan is to an “insider” (a family member, business partner, etc.) the IRS sees it differently. They say this may not be ‘part of a bigger transaction’, and so it may be taxable as income. And if you do not charge interest, the IRS may impute interest. (They love to impute things.) This means you may have to follow complicated rules (called ‘below-market interest rules’) to compute imaginary interest on the loan, after which you get to pay real tax on the imaginary interest. As a bonus, the IRS might decide that the imaginary interest is a gift, which can present further complications.

There are numerous exceptions to the below market rules for loans under $100,000.00. Maybe we will cover those someday. But this post is about the get-out-of-jail for free card.

And here it is: Document the loan and charge interest. As an aside, you should document the loan anyway. People’s memory grows foggy with time, and you or your family member may get sick, die, or whatever. Avoid future fights between yourselves and potentially other family members and much bad will — write down what you are doing.

As to the interest: It is not enough just to charge some interest. The IRS publishes an interest rate (actually a series of rates based on the length of the loan and how the interest compounds) called the Applicable Federal Rate (AFR). They are below market and based on the bond market. You can find them published monthly on the IRS website. If you charge at least this rate on a term loan you avoid all of the problems. (A ‘term’ loan has a specific repayment schedule or a specific due date; as opposed to a ‘demand’ loan that is due on demand rather than having a specific due date).

As of the day I am writing this, the current AFRs for term loans are as follows (based on loans made this month that charge interest based on annual compounding):
0.64% for “short-term” loans of up to three years.
1.41% for “mid-term” loans over three years but not over nine years.
2.24% for “long-term” loans over nine years.

For a term loan, the minimum interest rate can in effect on the date of the loan can apply to the entire term of the loan. But be careful: for a demand loan (one where you can demand payment at any time) the rate must ‘float’. For each month a balance remains outstanding, the rate must be at least equal to the AFR for that month. This means you must keep up with it, but it also means that the rate could go up, maybe a lot—it is certainly not likely to go down much.
Now—you must include the interest income on your tax return (no surprise). Your family member cannot deduct the interest unless it would be otherwise deductible (mortgage or certain business loans).

Finally, again, please put the loan in writing to make sure the IRS (and the borrower) will respect the deal as a loan rather than a gift. Also because things happen—it could really help to have the intentions recorded in writing and not dependent of recollection and/or the impressions of people that weren’t a part of the original conversation (like siblings). You should also require at least some payment once per year, even if only the accumulated interest. This will keep the statute of limitations from tolling on the note, which could trigger gift issues again.
Follow these simple precautions, and you can give your family-member borrower some great loan terms, avoid family fights in the future, and keep your friends at the IRS off your back.

Trust Protectors and Popcorn

First some background: All trusts begin with three plates at the table. There is a Trustor (or Grantor), who is the person forming the trust by transferring property to a Trustee (and hopefully signing a well-drafted Trust Agreement). So there is also a Trustee, who is in charge of managing the property and carrying out the Trustor’s directions as set forth in the Trust Agreement. And there is a beneficiary, who is the person who receives some benefit from the trust. Of course, there could be more than one Trustor, more than one Trustee, and frequently there will be more than one beneficiary. Additionally, bear in mind that all trusts are either revocable (meaning that the Trustor can still change the Trust Agreement) or irrevocable (meaning that the Trust Agreement can’t be changed). Revocable Trusts frequently become irrevocable at some point (e.g., when the Trustor dies). Many end quite soon thereafter (when I die take all that I have and divide it equally between my children and give it to them as soon as you can…). But others continue to hold property in trust for quite a while, sometimes for a generation or two (take all that I have and make payments to my kids each year, or hold this property for them to use, etc.). A lot can happen during that time. And many trusts are irrevocable from their very beginning.

With that in mind, it is becoming increasingly common to set another plate at the table, for someone called a Trust Protector. Or maybe it is more appropriate to think of the Trust Protector as being in the next room eating popcorn and watching TV?

The Trust Protector exists to protect the purposes of the Trustor. But unlike the Trustee, who is involved in the day-to-day operations of the Trust and is obligated to act as a fiduciary, the Trust Protector doesn’t ‘do’ anything until someone asks. When someone (usually a beneficiary) gets up from the table and goes into the next room to get the Trust Protector, the Trust Protector may spring into action.

And what can he do should he so choose? The Trust Protector has very limited and specific powers, and these are usually laid out in the Trust Agreement. The most common things that a Trust Protector can do is to remove a trustee and appoint a successor trustee, or to amend the trust to comply with current tax law or otherwise to save on taxes. Sometimes a Trust Protector may be given the power to change a beneficiary’s interest. Generally the Protector’s exercise of these powers will be in response to the request of a Trustee or Beneficiary, not an action that the Protector takes on her or his own initiative. The Trust Protector does not independently monitor things, he is not ‘paying attention’ until someone asks for his help. Hence, we might describe the Protector as not being at the table, but in the next room watching TV. Trust Protectors do not get paid (except for the popcorn they eat).

But even though the Trust Protector’s assistance must be sought by someone, his power(s) can be useful if the Trust is going to be ‘in business’ as an irrevocable trust (which, remember, by definition can’t be amended—at least not in theory) for a long time. And it is useful because it is one way to give the person forming the Trust some guard against unanticipated changes in the future without either necessitating court involvement or the agreement of the beneficiaries. But it can also cause problems, and needs to be well thought-out. Yet another reason why estate plans are not one-size-fits-all packages that can easily be obtained off-the-rack. The key aspect of estate planning is the planning, and it is not a bad idea to revisit your estate plan from time-to-time, and especially in light of major life changes, to make sure it is still the best plan for you.

Why Clark v Rameker Matters To Your Children: Protecting Retirement Funds for your Heirs

Retirement plan assets have become a major factor in the USA, amounting to approximately $23 trillion as of the end of 2013. Many individuals and estate plans use IRA accounts and other retirement funds as an integral part of succession planning. And such a big chunk of funds is always going to be a target.

On June 12, 2014 the U.S. Supreme Court unanimously ruled in Clark v. Rameker that an inherited IRA is not exempt from claims of creditors under the Bankruptcy Code provisions that generally exempt “retirement funds” from claims of creditors. There are numerous creditor-protections that protect retirement funds from creditors. Now, not all retirement funds, not all creditors, not in every circumstance. If you have creditors knocking at your door, you need particular advice for your situation—and you should not waste time getting it. But in general, retirement funds enjoy numerous protections.

The question has been: do inherited retirement accounts enjoy the same protections? Many people have wrongly assumed this to be the case, with the result that they will tell you to go ahead and name your kids as beneficiaries on your retirement accounts…this is the best thing to do…it is perfectly safe. Before the June decision in Clark, whether or not they were right depended in part upon where you were standing in the United States when you asked the question.

But now the United States Supreme Court has spoken, and it turns out these people were wrong all-along. On June 12, 2014 the US Supreme Court shook the financial world with Clark v Rameker.  In Clark the court held 9-0 that inherited retirement accounts are NOT exempt from the claims of the bankruptcy trustee (and other creditors). You can read it here.

Here is the short-version of the story: During her life Ruth Heffron established an IRA and named her daughter Heidi Clark as the beneficiary upon her death. People do this every day. When Ms. Heffron died in 2001, Heidi inherited Mom’s IRA under the beneficiary designation and rolled it into an IRA in Heidi’s name. Happens every day.

Fast-forward to 2010, when Heidi and her husband filed chapter 7 bankruptcy and sought to exempt the roughly $300,000 in the IRA, which Heidi had inherited from her mother’s IRA, under a provision of the bankruptcy code (specifically, 11 USC §522(b)(3)(C)) that affords creditor protection for many (but not all) retirement accounts from most (but, again, not all) creditors. On behalf of the creditors, the Trustee (William Rameker) challenged the exemption.

In the end the bankruptcy court refused to allow the exemption, and the Clarks appealed to District Court…and on it went to the US Supreme Court. In plain, if perhaps slightly oversimplified English, the court held that inherited IRAs are simply not the same as money an individual has set aside for the day that individual stops working, and the owner of inherited IRA can withdraw the money at any time without penalty (though, of course, taxes are due). Apparently, as the court sees it, the creditor-protection exists to prevent late-in-life poverty for that individual, the person inheriting the IRA is not relying on the money the same way.

So what do we do?

What is clear: The court has made it clear that IRAs that name children as beneficiary enjoy almost no protection from the child’s creditors under federal law. It is fairly clear that this result would extend to any sort of inherited retirement account. Now there is spotty protection under state law in a few states, including North Carolina, if the heir happens to live in one of those states. But it is spotty, could easily change in light of Clark, and anyway people move around a lot. So relying on state law protections is a real gamble.

What is not clear: Are retirement accounts inherited by a surviving spouse protected from creditors? The Clark case does not address that. Logic applied to the reasoning in Clark would say spouses do NOT enjoy protection, either. But the law is not always logical and it may well not work out that way. This is a big deal, but at present the law is very unclear. We will deal with that thorny issue in a later post.

For now, what we can say is that you probably should NOT name your children (or anyone other than a spouse) as beneficiary (or contingent beneficiary) of your retirement account(s) directly unless it is a VERY small sum of money or you are VERY unlikely to die (I would like to get in on that one), or you just don’t care what happens.

The ideal solution would be to name a stand-alone IRA Beneficiary Trust as beneficiary of your retirement accounts. I discuss such a trust in our Estate Planning FAQ section and have written about them and their benefits elsewhere. If properly done, this will protect retirement funds left to any beneficiaries (spouse, children, cats) from their creditors.

It also presents numerous other advantages. There is NO one-size-fits-all package for estate planning. As we say over and over, the key to estate planning is planning. But this is a great option for many who want to insure that hard-saved retirement funds improve the life of their family and not the bottom-line of a creditor or of some other predator.

Another option is to name your properly-drafted revocable living trust (RLT) as beneficiary (using conduit provisions). This does not have nearly the level of protection as the stand-alone IRA trust. But it is simpler and it does help quite a bit, and it may be appropriate for you. It is certainly far preferable to naming beneficiaries directly in most (not quite all) circumstances.

The worst thing you can do is nothing. You have worked too hard for your money, and your family is too important to ignore the issue. This is why estate planning is critical. Call us, we can answer your questions about protecting retirement funds and other estate planning issues, and then craft and implement an estate plan that meets your needs and achieves your goals. Call us today to start the discussion.

The Added Advantage of an IRA Protection Trust

The Added Advantage of an IRA Protection TrustNaming a trust as the designated beneficiary of a your IRA has several very important advantages over directly naming the beneficiaries.

First, your chosen beneficiary may be a minor, not prudent with money, have marital or creditor issues, or may be disabled. Second, if the beneficiary dies before distribution, the contingent beneficiaries may not be correct. Third, the beneficiary may intentionally or unintentionally withdraw the IRA thereby incurring an unnecessary tax bill.

So we frequently have our clients name a revocable living trust as contingent beneficiary of an IRA. There are many times this is appropriate and will serve the client’s needs well.

However, naming the your revocable living trust as the beneficiary of your IRA, even with the appropriate “conduit-trust” language, may create issues with the operative age for the “stretch-out” of the required minimum distributions (RMDs). You see, the conduit language functions like naming the beneficiaries directly, except that it 1) adds the trust protection, 2) provides your contingency directions, and 3) makes it easy to maintain and amend your estate plan in the future. All of that is great, and probably worth the cost of the trust even if the trust provided no other benefits.

But despite the clear advantages, doing it this way shares two major drawbacks of naming beneficiaries directly: 1) the ‘stretch-provisions’ for all beneficiaries is based on the age of the oldest beneficiary, and 2) once the beneficiary has it, they can do what they want (including cash it out to pay for plasma TVs and granite countertops).

Enter the IRA Beneficiary Trust® (aka, IRA Protection Trust and a few other names). This can be used to insure that your beneficiaries (those who will receive the IRA’s after your death) “stretch-out” their taxable, required minimum IRA distributions over a much longer period of time. And while we call it an “IRA Trust”, it works with virtually any tax-deferred accounts, not just IRAs. With this trust, the age of each beneficiary becomes the operative age for that beneficiary’s required minimum distribution. If there is a significant age difference between the beneficiaries, this can be huge. And if you want, you can make them wait to withdraw the money until they reach that age (or any other age).

If children and grandchildren who inherit IRA funds keep the funds in the IRA for their lifetime, and only take the required minimum distributions each year (the “stretch-out”), the amount of wealth that can be retained in the family is very significant. For example, with a $100,000 IRA account, an annualized 8% return, and a 35 year old beneficiary, the total benefit is $1,228,630—and for a 10 year old beneficiary, the total benefit is $5,363,512! (And if you don’t have that much isn’t that all the more reason to maximize what you do have?)

Now, this benefit is obtained only if the beneficiary retains the inherited funds inside the IRA account. As we said, IF you choose to do so with the IRA beneficiary trust you can ‘force’ them to do this (because you can restrict distributions in the trust document). You can also, if you choose, provide life-long protection for the money from creditors, unhappy spouses, or required “spend-downs” for government benefits. Remember that absent a trust, inherited retirement accounts enjoy very little creditor-protection.

The relationship between IRA Agreements, IRA Accounts, and Trusts is complex and remains somewhat unsettled. And estate planning is itself complex because there are so many factors to consider. Some of the issues will be explored in future posts on this blog. Sorrell Law Firm is pleased to be able to offer our clients the IRA Beneficiary Trust® as yet another item in our arsenal in estate planning tools to provide you with the opportunity and ability to control your assets and maximize the benefit for yourself and your chosen heirs. Schedule an Estate Planning Session with us today. We will take the time to work with you to tailor an estate plan to your situation and your goals. And as your life changes (and it will) and as the politicians change the law (and they will); we will continue to be available to you to ensure that your estate plan meets your needs and accomplishes your goals.

Image Credit: Karla Landeros