ESTATE PLANNING FOR CLIENTS WITH AND CLIENTS WITHOUT A TAXABLE ESTATE

February 19, 2018 | Author: Marsha Mason | Category: N/A
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ESTATE PLANNING FOR CLIENTS WITH AND CLIENTS WITHOUT A TAXABLE ESTATE

LEONARD WEINER, J.D., C.P.A., M.B.A. Certified in Tax Law, and in Estate Planning & Probate Law, by Texas Board of Legal Specialization Certified in Elder Law by the National Elder Law Foundation

5599 San Felipe, Suite 900, Houston, Texas 77056 Telephone (713) 624-4294 / Fax (713) 624-4295 National (800) 458-2331 Direct Dial (713) 624-4296 [email protected]

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Leonard Weiner, J.D., C.P.A., M.B.A Law Firm of Leonard Weiner & Associates, P.C. 5599 San Felipe, Suite 900 Houston, Texas 77056 (713) 624-4294 CERTIFICATIONS: Estate Planning and Probate Law - Texas Board of Legal Specialization Tax Law - Texas Board of Legal Specialization Elder Law – National Elder Law Foundation Certified Public Accountant - Texas AWARDS: President's Award - Houston Bar Association - Outstanding Service Presidential Citation - Houston Chapter of Texas Society of Certified Public Accountants - Valuable Contribution Louis S. Goldberg Memorial Award for Outstanding Achievement - American Association of Attorney - Certified Public Accountants, Inc. OFFICES (former): President of the American Association of Attorney - Certified Public Accountants, Inc. President, Texas Chapter of the National Academy of Elder Law Attorneys, Inc. Chairman, Houston Tax Forum Treasurer of the Houston Bar Association Secretary of the Houston Bar Association Corporate Counsel Section Board of Directors of Houston Chapter of Texas Society of Certified Public Accountants Chairman of the Houston Bar Association’s (HBA’s) Section of Taxation Chairman of HBA's Continuing Legal Education Committee and Finance Committee MEMBERSHIPS (present and former): Texas Society Certified Public Accountants, Inc. and its Houston Chapter National Academy of Elder Law Attorneys, Inc. and their Texas Chapter American, Texas, and Houston Bar Associations and their Tax, Estate Planning and Probate Sections American Association of Attorney - Certified Public Accountants, Inc. and its Texas Chapter Federal Bar Association The IRS District Director's Liaison Committee Houston Bankruptcy Conference Houston Estate and Business Planning Council Houston Estate and Financial Forum WealthCounsel, LLC, a Community of Estate Planning Practitioners EDUCATION: Wharton School of Finance (BS) Georgetown University Law Center (JD) University of Maryland (MBA) LICENSED TO PRACTICE LAW WHERE APPROXIMATELY 94% OF AMERICA LIVES: Texas, California, New York, Florida, Pennsylvania, Illinois, Ohio, Michigan, New Jersey, North Carolina, Missouri, Wisconsin, Maryland, District of Columbia, Virginia, Oregon, Minnesota, Oklahoma, Kentucky, Colorado, Nebraska, Georgia, Alaska, Massachusetts, Connecticut, West Virginia, Montana, Wyoming, Tennessee, North Dakota, Iowa, Indiana, Arizona, South Carolina, Alabama, Louisiana, Washington, Kansas, and Arkansas. #154646

TABLE OF CONTENTS I.

II.

III.

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Introduction............................................................................................................... A. We Will Discuss .................................................................................................. B. Estate Planning..................................................................................................... 1. What is it? ...................................................................................................... 2. Transfer Tax Techniques ............................................................................... 3. Income Tax Techniques Related to Assets Which Will be Inherited ............ C. Tax Landscape ..................................................................................................... 1. Annual Expenditures and Future Burdens are High and Growing ................ 2. Our Growing Negative Financial Position..................................................... 3. Tax Laws and Cutting Benefits Such as Social Security or Medicare are decided by Politicians Who Regularly Must Compete for Votes .................. 4. Tax Collection................................................................................................ 5. History of the Estate Tax ............................................................................... Current Selected Estate and Gift (“Transfer”) Tax Law Provisions.......................... A. Estate Tax............................................................................................................. 1. Increased Exemption...................................................................................... 2. How do You Plan for 2009 to 2011 and Beyond........................................... 3. Carry Over Basis............................................................................................ 4. Lowered Tax Rates ........................................................................................ 5. No 5% Surtax................................................................................................. B. The Gift Tax......................................................................................................... 1. In General....................................................................................................... 2. Why the Gift Tax was not Repealed or Synchronized with the Estate Tax Exemptions .................................................................................................... 3. The Annual Exclusion.................................................................................... 4. Other Transfers Which do not Count Towards the Lifetime Limit ............... 5. Gifts to Foreign Spouses................................................................................ 6. The Need to File Gift Tax Returns ................................................................ 7. The Gift Tax is Less Than the Estate Tax...................................................... C. State Death Tax Credit now Completely Phased Out.......................................... D. Qualified Prepaid Tuition Programs: 529 Accounts........................................... 1. No Income Taxes ........................................................................................... 2. Gifts Today can be Stretched to Five Years Worth of Annual Exclusions ... 3. No Estate Tax................................................................................................. 4. Creditor Protection......................................................................................... 5. You May Help Your Clients .......................................................................... E. Transfers to Trusts in 2010 .................................................................................. F. Reciprocal Trust Doctrine.................................................................................... G. Conservation Easements ...................................................................................... H. Using General Powers of Appointment ............................................................... I. Discounts Are Not Allowed for Income Tax Liability Within an IRA ............... Non-Tax Estate Planning ........................................................................................... A. Your Clients’ Planning Alternatives are to Use a Will, Living Trust, Special Accounts, or to do Nothing.................................................................................. 1. What is Best for Your Client .........................................................................

1 1 1 1 2 2 2 2 3 4 4 4 5 5 5 5 5 6 6 6 6 7 7 7 8 8 8 9 9 9 10 10 10 11 11 11 12 12 13 13 13 13

2. 3. 4. 5. 6.

IV.

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Why Consider a Living Trust ........................................................................ Simple Wills and Simple Living Trusts......................................................... Subtrusts for Descendants in a Will or Living Trust ..................................... Durable Powers of Attorney (“POA”) for Financial Matters ........................ Durable Special Powers of Attorney (POA) for IRAs, 401k’s, and Other Retirement Plans, Insurance Policies, and Annuities..................................... 7. Beneficiary Designation for IRAs, 401k’s, and Other Retirement Plans ...... 8. Beneficiary Designations for Life Insurance Policies ................................... 9. Qualifying for Nursing Home Medicaid Public Assistance .......................... 10. Permissible Asset Protection.......................................................................... 11. New Bankruptcy Law .................................................................................... 12. Special Needs Trusts...................................................................................... 13. Incentive Trust ............................................................................................... 14. Ethical Wills................................................................................................... 15. Provisions for Guardians of Minors and Incompetent Adults ....................... 16. Provisions to Protect a Child’s or Surviving Spouse’s Inheritance from Their Spouses................................................................................................. B. Impact of Societal Megatrends due to the Aging of the Baby Boomers ............. 1. Natural Anxiety as People Age...................................................................... 2. Capacity Concerns ......................................................................................... 3. “Short Portable Mental Status Questionnaire” .............................................. C. Healthcare Documents ......................................................................................... 1. Drafting Changes due to the Health Insurance Portability and Accountability Act of 1996 (“HIPPA”)......................................................... 2. Consider Utilizing One or More of the Following......................................... D. Designation of a Guardian of the Person and/or Estate of a Minor Child ........... E. Some of the Limitations of and Problems Caused by Trying to Rely Upon Special and Multiple Party Accounts as an Alternative to a Will or Living Trust ..................................................................................................................... 1. Pay or Transfer on Death (“POD” or “TOD”) Designations Compared to Living Trusts.................................................................................................. 2. The Decedent’s Creditors have Access to These Special Accounts by Statute Unlike with Living Trusts.................................................................. 3. With a WROS Account (CPWROS or JTWROS)......................................... Income, Estate, and/or Gift Tax Planning.................................................................. A. Do Your Client’s Existing Estate Documents Need to be Reviewed or Amended .............................................................................................................. 1. Assets Equal to Amount of Estate Tax Exemption........................................ 2. Assets Equal to Generation Skipping Tax Exemption Amount..................... 3. If Tax Laws Change and Your Client Becomes Incapacitated, What Then?.............................................................................................................. B. Tax Planned Wills and Living Trusts .................................................................. C. Life Insurance ...................................................................................................... D. Family Limited Partnerships (“FLPs”) ................................................................ 1. FLPs are Alive and Well................................................................................ 2. Recommendations and Considerations .......................................................... E. Using an Intentionally Defective Grantor Trust (IDGT) ..................................... F. Advantages of Gift Giving During Lifetime........................................................

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V.

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G. Gifting a Fractional Interest in Realty ................................................................. H. Some of your Clients may be able to Take Advantage of the Basic Rules to Save Income Taxes for Their Family when the Inherited Property is Sold......... 1. The Tax Basis of Transferred Assets ............................................................. 2. Reverse Gifts and Ricochet Gifts................................................................... 3. Use of Powers of Appointment...................................................................... I. Sale of Remainder Interest................................................................................... J. Roth 401(k) .......................................................................................................... K. Conversion to Roth IRA ...................................................................................... L. Inheritance Trust or Conduit Trust Provisions in a Will or Living Trust ............ M. Private Annuity (“PA”)........................................................................................ N. Self-Canceling Installment Note (“SCIN”) ......................................................... O. Charitable Remainder Trusts (“CRT”) including CRATs, CRUTs, and NIMCRUTs.......................................................................................................... P. GRATs ................................................................................................................. Q. Tax Planned Wills and Living Trusts .................................................................. 1. Simple Will or Living Trust with a GST Option ........................................... 2. Will or Trust with Bypass Trust Only............................................................ 3. Will or Living Trust with Disclaimer Trust................................................... 4. Will or Living Trust with Bypass and Marital Trusts.................................... 5. Will or Living Trust with Bypass, Marital, and Separate Descendents’ Trusts............................................................................................................. 6. Will or Living Trust with Bypass, GST Exempt and Nonexempt Marital, and GST Exempt and Nonexempt Descendents’ Trusts................................ 7. Lifetime Trusts (GST).................................................................................... R. Charitable Lead Annuity Trust (“CLAT”)........................................................... S. Additional Charitable Opportunities.................................................................... T. Leveraged Credit Shelter Trust............................................................................ Conclusion

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ESTATE PLANNING OPPORTUNITIES I.

INTRODUCTION – Our mission is to help you help your clients who do and those who do not now have a taxable estate with their estate planning and coordinate certain income and transfer tax (estate or gift tax) saving opportunities with their non-tax estate planning goals. Some clients without a taxable estate may need gift tax planning. The exemption amounts for gifts and estates are different. Some clients may not have a taxable estate only because they engage you to help them with their planning. As the exemption amount increases more clients may need your help to plan for income tax savings related to what will be inherited by their loved ones. Planning, when they had a taxable estate, to obtain discounts may have saved them estate taxes. However, reducing the value of their taxable estate also reduces their heirs’ basis. With higher estate tax exemptions many of your clients may now benefit by planning to increase basis. And there are many ways to plan to reduce income taxes related to what your clients’ loved ones may inherit. Many clients are not static. You and they may benefit by planning for both where they are moving and where they are today if that is possible A. We Will Discuss (1) what estate planning encompasses, (2) the tax landscape, and (3) some opportunities and strategies that may be available to help your clients and their families with their total estate plan. B. Estate Planning. 1. What is it. Many clients think about and discuss both their tax and non-tax estate planning together. They often ask estate planners to help them a. during their lifetime to build up, preserve, and protect their estate from taxes and other financial risks; b. make some important healthcare and financial decisions to protect themselves and their loved ones while they may still do so before and in case they become incapacitated; c. plan the distributions or transfers of their estate to be made during and after their lifetime to their loved ones and sometimes to charity(ies) so 1. when their assets are transferred there is minimal shrinkage due to taxes, costs, and other financial risks, 2. these distributions or transfers pass to the beneficiaries who, when and how your clients wants, and 3. the beneficiaries are protected so they do not lose what they received and, in some cases, accomplish goals set by your client.

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2. Transfer Tax Techniques. There are many techniques available to reduce taxes related to transfers made both during and after the client’s lifetime. They accomplish this in one or more of the following ways. a. Utilize available gift or estate tax exemptions or exclusions to take advantage of tax-free transfers which your clients may use or lose; b. Reduce or “discount” the value of assets transferred for tax computation purposes; c. Shift future appreciation of assets to loved ones (i.e., “freeze the value”) of assets for transfer tax purposes which are or will be transferred from your client to their loved one(s) as early as your client feels emotionally and financially secure to do that; d. Avoid the tax on both the transfer tax and the income tax if possible; and e. Use the IRS’ Actuarial Tables to your client’s benefit to reduce transfer taxes when that may be possible. 3. Income Tax Techniques related to assets which will be inherited. Reduce future income taxes of your heirs related to transferred assets by a. Maximizing basis step up to reduce future capital gains to reduce future capital gains. i.

Ricochet gifts.

ii. Recognize losses before the decedent passes. iii. Substitute cash for low basis assets in GRATs or IDGTs so they get a basis step up. b. Extending the tax deferral (“deferral”) for IRAs, 401(k)s, and other tax deferred retirement plans. c. Converting IRAs to Roth IRAs which are more valuable to your client’s heirs and it also avoids transfer tax on an income tax. d. Avoid the tax on both the transfer tax and the income tax if possible. C. Tax Landscape. Our government needs tax revenues. 1. Annual Expenditures and future burdens are high and growing.

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a. Nondiscretionary Expenses i. Medicare $29,900,000,000 (beginning of 2006) 1. Social Security – $5,700,000,000 (beginning of 2006) 2. In the next 13 years, persons over 65 in the U.S. will increase by 44%. In the same period, the number of persons under 19 will grow by 13%. So either there will be a large increase in FICA taxes or there will be cuts in benefits. ii. National Defense iii. The U.S. Comptroller General projected for 2010 a national debt in excess of $11 trillion with interest due equal to the current Pentagon Budget. b. Discretionary Expenditures (“Pork”). Legislators from both parties continue to spend more almost every year than we earn and more than they spent the prior year. c. What is a billion? i. A billion minutes ago Jesus was alive. ii. A billion hours ago our ancestors were living in the Stone Age. iii. A billion dollars ago was only about 8 hours, at the rate our government is spending. 2. Our Growing Negative Financial Position makes it more difficult to increase our national debt in order to reduce taxes. We have a large negative Balance of Payments and large annual budget deficits increasing our national debt. a. One risk that our leaders face is that as our National Debt and our Balance of Payments Deficits grow that will cause (i) interest rates here to rise which normally causes recession and (ii) our currency to devalue causing higher prices for imports. These are like hidden taxes that reduce our standard of living. b. Foreign creditors hold over 43% or 4.8 trillion of our debt. c. As our budget and balance of payment deficits grow, our risk increases that one or more our creditors may cause a “run on the bank.”

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3. Tax laws and cutting benefits such as Social Security or Medicare are decided by politicians who regularly must compete for votes. That makes it difficult for them to vote for unpopular legislation. Many politicians are very vulnerable because their elections are decided by less than a 1% difference of the votes. 4. Tax Collection a. IRS Auditors. IRS announced in July 2006 that they will reduce by approximately forty percent the number of lawyers who audit estate and gift tax returns even though they are the most productive auditors collecting additional taxes for each hour they work. i. IRS previously said that (a) 85% of large taxable gifts it audited short-changed our government. (b) 10% of estates audited generated 80% of the additional taxes. ii. Critics say that auditing a larger percentage of transfer tax rates would yield significantly more taxes. b. The Tax Gap. “Tax Gap” is the difference between what the IRS collects each year and what it should be collecting. IRS researchers have estimated this gap at around 290 billion. c. Tax Cheating. Is part of the tax gap. A Senate report estimates that cheating using foreign schemes equals about 7 cents of each dollar paid by honest taxpayers. 5. History of the Estate Tax a. Our first estate tax was enacted July 6, 1797, to help pay for naval rearmament during hostilities between US and France. After four years the need for the revenue passed and the tax was terminated. b. A tax on inheritances was passed in 1862, during the Civil War, but was repealed in 1870. c. In 1898, an estate tax again appeared to help fund the Spanish American War. It was repealed in 1902. d. During World War I, an estate tax was again imposed. The amount has fluctuated but to date it has not been eliminated.

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II. Current Selected Estate And Gift (“Transfer”) Tax Law Provisions. The following is based on the law as it existed when this outline was submitted on its due date. A. Estate Tax. 1. Increased Exemption. Since the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Tax Act”), the estate tax exemption has been increasing each year. In 2006, it will be $2,000,000 and will continue to increase until 2009 when it reaches $3,500,000. In 2010, there will be no estate tax at all. However, because the 2001 Tax Act’s provisions were not made permanent these provisions will be repealed. If no changes are made, the estate tax will be reinstated in 2011 and the exemption will be $1,000,000. 2. How Do You Plan For 2009 To 2011 And Beyond? No one knows for sure what Congress will do. Because we do not know what will happen or when our clients will pass away, we suggest that Wills and Revocable Living Trusts provide for all known contingencies including those discussed below. 3. Carry Over Basis. If and when the Estate Tax disappears, it is supposed to be replaced by greater income taxes to replace the lost revenue. That is to be accomplished by eliminating the step up in basis at the time of an individual’s death except for some exemptions for smaller estates and for surviving spouses. When Congress previously tried to eliminate the basis step up that caused so many problems and complaints from voters that law was soon changed and the basis step up on death was reinstated. a. Currently, property that is inherited may receive a step up in cost basis to the fair market value of the property as of the decedent’s date of death (unless values are lower than the cost basis, in which can basis is stepped down). For example, if Joe inherits $5,000 of stock that his father purchased for $1,000, then Joe’s basis for determining gain or loss when he sells that stock will be the higher $5,000 value. To make up for the loss of funds that will occur when the estate tax is repealed in 2010, new tax laws will take effect regarding step up in basis of inherited assets. b. In 2010, inherited assets will not get the full step up in basis. Instead, the first $4,300,000 will receive a step up if the property is left to a spouse and only the first $1,300,000 will receive a step up when property is left to persons other than a spouse. If the decedent is not a U.S. citizen, only $60,000 of assets will receive the basis step up. This new step up in basis rule will be repealed at the end of 2010. c. A large practical problem with the carryover basis rule is that taxpayers who vote will need to track an asset’s basis for much longer periods of time than under the current rules. If many of them are penalized for not having the appropriate records, they will probably complain to legislators.

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4. Lowered Tax Rates. The maximum estate tax also decreases as a result of the 2001 Tax Act and will be reduced to 45% in the year 2007. However, if the tax laws are not changed, the estate tax will be reinstated in 2011 at the 2001 rates (37% to 55%). 2001 TAX ACT CHANGES Year

Estate Tax Exemption

Gift Tax Exemption

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

$675,000 $1,000,000 $1,000,000 $1,500,000 $1,500,000 $2,000,000 $2,000,000 $2,000,000 $3,500,000 No Estate Taxes

$675,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000

Highest Estate & Gift Tax Rates 55% 50% 49% 48% 47% 46% 45% 45% 45% No estate tax.

$1,000,000

Gift tax equal to top individual income tax rate (which under current law means it would be a 35% tax) 55%

2011

$1,000,000

5. No 5% Surtax. The 5% surtax on estates above $10,000,000 has also been repealed. This surtax used to be imposed because Congress did not want extremely large estates to be able to take advantage of the 18% to 53% rates which used to be assessed on the first $3,000,000 of an estate’s value and the surtax would ensure that they effectively paid a flat 55% tax on every dollar included in the estate. The surtax was therefore imposed on about $11,595,000 worth of estate assets (effectively, all the dollars between $10,000,000 and $21,595,000) so that every dollar above and below $21,595,000 would be hit with the maximum 55% estate tax bracket. B. The Gift Tax 1. In General. Generally, all property transferred, directly or indirectly, during the transferor’s lifetime to any other person is potentially subject to gift taxes. Gifts that exceed an individual’s lifetime gift tax exemption or which are not otherwise exempt from the gift tax will result in the use of all or a portion of the transferor’s lifetime gift tax exemption. Any such exemption used during life reduces the exemption available at death by the same amount.

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Before the 2001 Tax Act was enacted, the available lifetime gift tax exemption was equal to the estate tax exemption. As of January 1, 2002, the 2001 Tax Act increased the lifetime gift tax exemption to $1,000,000. The gift tax exemption will not increase as the estate tax exemption does nor will it have a hiatus in 2010 (the Tax Act addressed estate taxes not gift taxes). In 2010, the gift tax will apply to gifts in excess of $1,000,000 and the tax will be equal to the highest marginal income tax bracket. 2. Why the Gift Tax Was Not (i) Repealed or (ii) Synchronized with the Estate Tax Exemptions. a. Impact on Income Tax. If there were no gift tax, individuals could reduce the amount of income tax they pay by transferring income producing assets to other family members in lower income tax brackets. b. Impact on Estate Tax. If the gift tax were repealed, wealthy individuals could give away huge portions of their estates to avoid future estate taxes. Without the Gift Tax, huge transfers to trusts could be sheltered from estate taxes for generations. One may wonder if any legislators who voted for this law and vigorously advocate eliminating the estate tax realized that it will be difficult to permanently repeal the estate tax. 3. The Annual Exclusion. The annual exclusion is indexed for inflation starting in 1997 and can only increase in increments of $1,000. That exclusion was $11,000 in 2005 and should increase to $12,000 in 2006. That means that every person may give any other person $12,000 in cash or other property without triggering the application of the gift tax. 4. Other Transfers Which Do Not Count Towards the Lifetime Limit. In addition to the annual exclusion, an unlimited amount of the following transfers for an unlimited number of people (beneficiaries) do not count toward the $1,000,000 lifetime limit: a. Payments Made Directly To Qualifying Educational Organizations. Payments made directly to a school for the benefit of an individual (such as child or grandchild) do not count as part of the annual exclusion or as a gift which reduces a person’s applicable exclusion. A qualifying educational organization is one which maintains a regular faculty and curriculum and normally has an enrolled body of students in attendance at the school. Qualified payments include tuition but not payments for books, supplies, dormitory fees, board and other similar expenses. Taxpayers cannot use a trust to achieve these medical and education exclusions but they may be able to prepay expenses if the provider is agreeable. b. Payments Made Directly to Medical Providers. Payments made directly to the medical provider for diagnosis, cure, mitigation, treatment or

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prevention of disease, transportation, and medical insurance are excluded. However, if the patient is later reimbursed by insurance, the payment becomes a gift and will count towards the annual exclusion. c. HEET. A dynasty trust to pay for future health and education expenses designed to finesse the generation skipping tax. d. Gifts to Political Organizations. e. Gifts to Charities. 5. Gifts to Foreign Spouses. There is generally no gift tax for gifts to a spouse; however, there is if the spouse is not a U.S. citizen. The annual exclusion for gifts to noncitizen spouses under sections 2503 and 2523 (i)(2) are indexed for inflation so for gifts made in 2006 the annual exclusion was $120,000; for 2007 it will be $125,000. 6. The Need To File Gift Tax Returns. It is important to remind clients to file gift tax returns (IRS Form 709) each year to report gifts including gifts made in trust which exceed the lesser of: (1) the annual exclusion from the gift tax, or (2) the dollar amount of each beneficiary’s withdrawal right specified in their Trust Agreement. Gift tax returns may also need to be filed for generation skipping transfer (“GST”) tax purposes if a Trust Agreement creates separate trusts (generation skipping trusts) which last for the beneficiaries’ lifetimes. Also, because of the length of time each trust will exist, it is possible that the trust property will be subject to the generation skipping transfer (“GST”) tax if distributions are made during the term of a trust or upon the termination of a trust to any grandchildren or great-grandchildren (or to other “skip persons” for GST purposes). A client can avoid the imposition of the GST tax if he or she allocates (or is deemed to have allocated) a portion of their GST exemption as he or she make gifts in trust each year. Allocations of GST exemption to some gifts made in trust may be deemed to have been made even if they do not file gift tax returns. It may be advisable to prepare and file gift tax returns regardless of the amount of the gift to a trust to track the amount of GST exemption used over the client’s lifetime. If no gift tax returns are filed, it is recommended that a detailed listing be kept of all the gifts made or treated as having been made to the trust so that there is a running total of the amount of GST exemption deemed to have been allocated during the client’s lifetime. 7. The Gift Tax Is Less Than The Estate Tax. The tax rates are the same. a. Taxable gifts are currently taxed at a maximum effective rate of 31.034%, compared to a maximum 45% rate at one’s death. The difference is that unlike the estate tax, assets used to pay the gift tax are not themselves subject to tax. That is sometimes referred to as the Gift Tax is (computed)

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“exclusive” (of the assets used to pay the tax) and the Estate Tax is “inclusive.” b. The effective gift tax rate is lower because the gift tax paid is removed from the tax base. If the donor dies within three years after making a gift, the tax paid on the gift is added to the value of the gross estate, resulting in a “grossing up” of the original gift. c. However, many clients are reluctant to pay gift taxes other than in special circumstances while the Estate Tax exemption amount is increasing. For example, in order to start the statute of limitations running, a client may (i) not fully zero out a GRAT and instead make a small taxable gift and pay a small gift tax or (ii) make a gift of a large discounted Family Limited Partnership interest. They may also want to shift future appreciation now or to avoid any Section 2036(a) IRC issues which apply to estate tax but not to gift tax. C. State Death Tax Credit Now Completely Phased Out. In the past, taxable estates (generally, those which exceed $1,500,000 in 2005, or more in subsequent years) could claim a credit for any state death taxes paid, up to the maximum amount set forth in Internal Revenue Code Sec. 2011(b). This credit essentially subsidized the states because taxes which would otherwise have been paid to the Federal government were instead being paid to the states. With the impending loss of estate tax in 2010, the Federal government undoubtedly realized it would need to make up some of its losses of revenue. One way to do that was to reduce, and eventually eliminate, the state death tax credit so in 2002, the amount of the state death tax credit began to be reduced and as of January 1, 2005 it was completely eliminated. Until the federal estate tax is repealed in 2010, the state death tax credit reduction can be taken as an estate tax deduction. State death tax liabilities, if any, will be deductible in determining a decedent’s taxable estate. States who derive a large portion of their revenue from death taxes (states such as New York and Pennsylvania derive more than 2% of their state revenue from their death taxes) cannot afford to lose the death tax revenue and have been modifying their inheritance and estate tax laws to try to avoid the loss of revenue. D. Qualified Prepaid Tuition Programs: 529 Accounts. There are many options available for our clients to save for their children’s and grandchildren’s college education. The 529 Plans authorized in the 2001 Tax Act provide gift tax, income tax, and estate tax benefits to make them a good investment alternative for this purpose. 1. No Income Taxes. Some major advantages of 529 accounts are that the earnings are income tax free and now, after the 2001 Tax Act changed the laws, most withdrawals are also income tax free. After-tax money must be used to create the accounts, but capital gains, dividends, and interest earned in the account are generally tax free and withdrawals are subject to income taxes only when they are not used for college tuition, room, board and other authorized expenses.

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2. Gifts Today Can Be Stretched to Five Years Worth of Annual Exclusions. Another advantage is that gifts to a 529 account not only qualify for the $12,000 (2006) annual gift tax exclusion, but the laws allow donors to make five years worth of gifts all at once today and elect to treat them as having been made equally over a five year period. The election is made on the top of page two of IRS Form 709 (the gift tax return form). This means that a married couple can give as much as $120,000 to each child or grandchild in 2006. 3. No Estate Tax. For estate tax purposes, the amounts contributed to a 529 account will be excluded from the donor’s estate even though the donor can remain in control of the account. However, if a donor elects to spread contributions over five years for gift tax purposes, and he or she passes away within that five year period, a portion of the gift will be included in his or her gross estate. 4. Creditor Protection. Effective September 1, 2003, the Texas legislature made 529 accounts completely creditor proof. The text of the statute reads as follows: “Chapter 42, Property Code, is amended by adding Section 42.002 to read as follows: Sec. 42.002. EXEMPTION FOR COLLEGE SAVINGS PLANS. (a) In addition to the exemption prescribed by Section 42.001, a person’s right to the assets held in or to receive payments or benefits under any of the following is exempt from attachment, execution, and seizure for the satisfaction of debts: (1) any fund or plan established under Subchapter F, Chapter 54, Education Code, including the person’s interest in a prepaid tuition contract; (2) any fund or plan established under Subchapter G, Chapter 54, Education Code, including the person’s interest in a savings trust account; or (3) any qualified tuition program of any state that meets the requirements of Section 529, Internal Revenue Code of 1986, as amended. (b) If any portion of this section is held to be invalid or preempted by the federal law in whole or in part or in certain circumstances, this section remains in effect in all other respects to the maximum extent permitted by law.

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SECTION 2. (a) This Act takes effect September 1, 2003.” 5. You may help your clients. There are many 529 plans with different amounts of commissions and other costs which may be hidden from consumers. All 529 plans are not the same. You can help your clients comparison shop and analyze the differences so they obtain the best value available for them. E. Transfers To Trust in 2010. In 2010, transfers to trusts will be treated as taxable gifts unless the trust to which the property is transferred is treated as being wholly owned by the person making the gift or by the spouse of the person making the gift. The primary purpose of this change in the law appears to be an effort to prevent income shifting. One consequence of this change is that all of the provisions commonly added to trust agreements giving beneficiaries the right to withdraw funds (known as “Crummey Withdrawal Rights”) will no longer have the effect of making transfers to the trust qualify for the annual exclusion. F. Reciprocal Trust Doctrine. The reciprocal trust doctrine generally prevents family members from creating irrevocable trusts for each other which are identical in nature. The result of this doctrine being applied is that both such trusts will be ignored when this occurs. In United States v. Estate of Grace, 395 U.S. 316 (1969), a husband and wife each created irrevocable trusts with income to the other for life, and upon the spouse’s death, principal to their descendants. The US Supreme Court applied a “relative economic status” test and concluded that the arrangement, to the extent of mutual value, left the settlors in approximately the same economic position as they would have been in had they created trust naming themselves as life beneficiaries. The IRS also takes the position that the reciprocal trust doctrine can be triggered by §§2036(a)(2) and 2038, involving powers to control beneficial enjoyment. In Ltr. Rul. 2004-26008, Husband and Wife each wanted to create an irrevocable life insurance trust that would hold a policy insuring its grantor’s life. Each spouse is the trustee of the other’s spouse’s trust. The two trusts are identical in several respects. Among other factors discussed, during their joint lifetimes, the principal or income is distributable to the spouse and their son as necessary or advisable for their health, support, maintenance, and education. After the death of the settlor and the spouse, the trust continues for the son and his descendants. The trusts would differ as follows: Husband’s trust provides that after the son passes away but while he and his wife are both living Wife (i) will have a noncumulative personal right to withdraw, during any calendar year, from principal up to $5,000 to 5% of the value of the trust principal, and (ii) has a power to appointment over Husband’s trust, with the power exercisable, outright or in trust, in favor of Husband’s descendants and the spouses of such descendants. Wife’s trust provides that, except with respect to the marital trust, Husband will be a beneficiary of her trust only if (i) Husband’s net worth is less than $X, (ii) Husband’s income from personal services for a calendar year is less than $Y and (ii) at least three years have elapsed after Wife’s death.

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IRS first discussed United States v. Estate of Grace and then ruled that the two trusts differ substantially enough that the two trust are not interrelated, and therefore, neither trust will be included in either spouse’s gross estate under the reciprocal trust doctrine. G. Conservation Easements. IRC Section 2031(c) allows property to be excluded from a decedent’s estate when it is subject to a qualified conservation easement. Prior to 2001, the land needed to be located: 1. In or within 25 miles of a metropolitan area (as defined by the Office of Management and Budget); 2. In or within 25 miles of a national park or wilderness area; or 3. In or within 10 miles of an Urban National Forest (as defined by the Forest Service). For those decedents dying after December 31, 2000, the land can be now located anywhere in the United States or in a United States possession. H. Using General Powers of Appointment. One problem for some married couples is when one spouse has a larger amount of property than the other. This sometimes occurs in Texas even though we are a community property state. For example, one spouse may inherit separate property or your clients may move here from another state. Another tax problem for some couples is that most of their assets are in one or both spouse’s IRA. So that both spouses were able to fully use their available estate tax exemptions at death, it was often necessary for the spouse with more assets to give some assets to the other spouse. Many spouses with more assets were not comfortable with this plan. IRS Letter Rulings 200101021 (1/8/01), 2002010051 (3/8/02), 200403094 (1/16/04), and 200604028 (1/27/06) have allowed the use of a revocable living trust arrangement which enables a wealthier spouse to retain control over assets but still allow the poorer spouse’s exemption from estate taxes to be fully utilized. In 200403094, Husband created a trust and funded it with his separate property. In the Trust Agreement, Husband reserved the right to amend or revoke the trust and the right to withdraw income or principal. The Trust Agreement also allowed distributions to the Husband for his best interests. If Wife passed away first, she would be given a testamentary general power of appointment, exercisable alone and in all events, to appoint part of the assets of the Trust Estate, having a value equal to (i) the amount of Wife’s remaining applicable exclusion amount less (ii) the value of her taxable estate determined by excluding the amount of those assets subject to this power, free of trust to her estate or to or for the benefit of one or more persons or entities, in such proportions, outright, in trust, or otherwise as she may direct in her will. In other words, Wife was given the ability to appoint a portion of Husband’s estate to a bypass trust, which may reduce Husband’s taxable estate and the estate tax. This technique may also be used creatively by some of your clients with equal estates or with most of their assets in one spouse’s IRA.

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I. Discounts Are Not Allowed for Income Tax Liability Within an IRA. Taxpayers have argued for several years that when valuing an IRA the built-in income tax liability within the IRA should be considered. However, it was decided in Ltr. Rul. (T.A.M.) 200247001, and in Estate of Smith v. United States, 2004-1 U.S.T.C. ¶ 60,476 (S.D. Tex. 2004) that these types of discounts are not available. The court also noted that any concern that the same asset would generate both estate tax and income tax liability (as income in respect of a decedent) was addressed by Congress’s enactment of the §691(c) deduction. III.

Non-Tax Estate Planning A. Your Clients’ Planning Alternatives are to Use a Will, Living Trust, Special Accounts, or to do Nothing. 1. What is best for your client? a. Does your client want to make things easier for his or her spouse and other loved ones after he or she passes away? Does one spouse want things to be easier for him or her if they are the survivor? Does your client want to make things easier and less costly for themselves and their loved ones in case one or both of them has Alzheimer’s or some other form of dementia? They should seriously consider a Living Trust. b. Is your client disorganized or put off financial matters to the very last minute? A Will may be better for them. c. Special accounts are JTWROS, CPWROS, POD and TOD. See III.D below which discusses the limitation and problems cause when most people use them. Only a small percentage of clients can rely solely upon them. d. Why have a Will or Living Trust instead of nothing? i. To provide asset protection for their children, which your clients cannot provide for themselves, by including Spendthrift Trusts for them in the client’s Will or Living Trust. 1. Protect their inheritance in case of a divorce, a bad law suit, a risky occupation, or an unfortunate accident. This may also keep your client’s estate in their family bloodline. 2. There are new developments in the law in many states regarding what provisions in Spendthrift Trusts will be honored. We have an increasingly mobile population which means that your clients’ loved ones may move and be governed by the law in another state.

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3. This is probably a good time for your clients who are concerned about providing this asset protection to their descendants to have their current documents reviewed and updated, if that is needed. Most Wills and Living Trusts can be amended before your client or his or her spouse pass away. ii. To include provisions that will have the effect of saving income or transfer taxes. Your client may avoid a taxable estate only if they sign a Will or Living Trust with such provisions. iii. To avoid or reduce the risk, cost and acrimony of a Will contest. Living Trusts normally provide better protection against this risk. iv. To save (with a Will) or eliminate (with a properly funded Living Trust) the costs and time of one or two probate administrations. v. A Living Trust should or a testamentary Trust (created in the Will) may contain provisions to protect a surviving spouse from the risk of a financial guardianship if he or she becomes incapacitated and protect minors who inherit from a guardianship until they become adults. vi. To allow your client to decide who inherits from their estate and how much they inherit instead of the Texas Legislature making those decisions. If your client does not have a Will or a Living Trust, the surviving spouse may inherit less, especially if the decedent had any children from a prior relationship. Without a Living Trust or Will, your clients’ probate property is inherited as follows: WHO INHERITS WHEN THERE IS NO WILL OR TRUST OR, TEXAS' ESTATE PLAN FOR THOSE WHO DO NOT PLAN Marital Status/Children

Property Type

Married with children from prior relationship Real Property

Personal Property

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Separate Property 1/3 to surviving spouse for life, remainder to children (or descendants) 2/3 to children, in equal shares, (or descendants) subject to life estate to surviving spouse 1/3 to surviving spouse

Community Property 1/2 retained surviving spouse

by

1/2 to children, in equal shares (or descendants) 1/2 retained surviving spouse

by

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2/3 to children, in 1/2 to children, in equal shares (or equal shares (or descendants) descendants) 1/2 to spouse Married with no Real Property children but with surviving parents, siblings, etc. Personal Property

surviving

1/2 to parents, in equal shares, or their descendants, if parents deceased All to surviving spouse

All to spouse

surviving

All to spouse

surviving

Unmarried, no Real Property children but with surviving parents Personal Property or siblings, etc.

All to parents, in equal shares, or their N/A descendants, if parents deceased

with Real Property Personal Property

Equally to children or N/A their descendants

Unmarried children

Real Property Married, children only of marriage

Personal Property

1/3 to surviving spouse for life, remainder to children (or descendants) 2/3 to children, in equal shares, (or descendants) subject to life estate 1/3 to surviving spouse 2/3 to children, in equal shares (or descendants)

All to spouse

surviving

All to spouse

surviving

f. You will do your clients a favor to inquire if they have a Will or a Living Trust which is current and updated for changes in their and their loved ones lives and for their current tax needs. i. If they do not, you may encourage them to have one prepared and to sign it. ii. Two things are certain. We will all pass away and talking about estate planning, a Will or a Living Trust will not cause death.

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iii. You may help your clients avoid a mistake made by each of Abraham Lincoln, Pablo Picasso, Sonny Bono, and James Dean. James Dean died at the age of 25 without a Will. His entire estate passed to his father who had abandoned him as a child. The licensing fees generate $1 to $3 million annually. 2. Why Consider a Living Trust? Living Trusts allow many potential conveniences that are significant to many clients which are not available with Wills. Not all Living Trusts are equal. a. Your clients retain as much control during their lifetimes over their financial matters as they had without a Living Trust. They are normally the Trustmakers, the Trustees, and the Beneficiaries. The ability to maintain control is important to your clients. Many clients would not take advantage of the power of appointment techniques without using a Living Trust because then they may use and maintain control over their assets and need not give those assets outright to their spouse or another loved one. b. A Living Trust is accident-proof to prevent a costly error which may destroy their estate tax Credit Shelter, which is currently $2,000,000. Eliminate the risk that the employees of their bank or their broker will automatically set up their accounts as Community Property with Rights of Survivorship (CPWROS). Banks and brokers routinely establish new accounts for individuals as CPWROS but do not do that for trust accounts. Using such accounts may cause your client to convert a non-taxable estate into one that is taxable. The WROS feature pre-empts the Will’s provisions funding the credit shelter trust for the assets in those accounts. c. Privacy. Anyone can go to the probate court to learn what assets were owned by the decedent and who will inherit what. You do not even need to go to the courthouse to read about Ken Lay’s estate. All you had to do was read a newspaper. d. Avoid Probate. i. Avoid fees, costs, risks, and time of two probates for a couple. ii. It is less expensive and easier for your clients to identify and re-title assets in their names as Trustees now when they are alive and well than for strangers or the surviving spouse to do so after the decedent passes away or suffers dementia. iii. Avoids ancillary probates in each state where your client has realty or minerals which your client either inherited or purchased.

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e. Living Trusts are more portable than Wills if your client moves to another state. f. Avoid A Financial Guardianship. In case of incapacity such as Alzheimer’s or another form of dementia, your clients may eliminate or mitigate the risk of a costly, cumbersome, and controlling financial guardianship, which is in some respects like a probate, for the rest of their lives. i. Dementia may creep up on clients. They should establish the Trust before it is too late and they no longer have the legal capacity to create it. The probability is much greater that we will all become incapacitated before we pass away than vice versa. ii. Most financial guardianships may be costly, cumbersome, and controlling each year for the rest of your client’s life. Children of a parent who was forced into a financial guardianship normally establish their own Living Trusts. iii. Most, if not all, transfer agents, some title companies, and even some banks or brokers may refuse to honor financial Powers of Attorney even though the document complies with all legal requirements. Your clients may not be able to use, sell or transfer certain assets without establishing a financial guardianship for the rest of their lives. iv. Groucho Marx had a Will but a court declared him incompetent over his repeated objections. There was a very expensive, lengthy and public guardianship battle between his long time companion, Erin Fleming, and Groucho’s family. g. Provide for special needs of a child during the parents’ incapacity without the risk of relying on a specially drafted power of attorney to try to accomplish this. h. Living Trusts are normally easier to amend than a Will. Because of that, some clients may use an unfunded Living Trust because they may change the Trust document later. Sometimes they want to sign a preliminary document quickly, such as before a trip. Other times it is because they have a complex distribution plan that may change over time. i. As clients age, more of them read about, talk to friends about and ultimately ask for a Living Trust. If your client is likely to end up with one, why not do it when they next update their tax and non-tax estate plan?

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j. Living Trusts may provide better asset protection than any other alternative for the decedent’s loved ones, including their spouse. One of the purposes of probate is to help the creditors of the decedent. k. It is harder for beneficiaries to contest a Living Trust than a Will. Even if the Will contest is without merit, there is a risk that someone other than the choice of the decedent may be appointed as the executor until the contest is resolved. That and the defense of the will contest may cause significant costs and delays for the estate or the heirs. l. Note: The Living Trust must be funded to provide these and other benefits. That means that the title to your client’s assets should be changed from them individually to each of them as Trustees of their Living Trust. i. Beneficiary designations, including those for life insurance (almost always) and/or (sometimes for) IRAs, 401(k)s and other tax deferred retirement plans, may and often should be made to the Trustee of their Living Trust. A Living or other Trust may be named as the primary or a contingent beneficiary. See PLR 2005 37044 discussing the conduit Trust provisions to achieve a stretch out for trusts. ii. You may assist your client with this process if you want to do so. At a minimum, verify with your clients who have a Living Trust that they have re-titled their assets, that they have added their Living Trust as a beneficiary of life insurance and retirement plans when that is best for them, and that any new assets which they purchase are titled in their names as Trustees of their Living Trust. That should be easy for them to accomplish. There are very few exceptions, such as automobiles that need not be re-titled to a Living Trust because historically they have been transferred by Affidavit at the motor vehicle title office. m. Living Trusts allow your clients to each make enforceable revisions to their bequests of specific items of tangible personal property (unlike a Will) and also save attorney fees. n. Tax Savings. There are even transfer and income tax advantages that may be facilitated by using a Living Trust for convenience and control purposes with a Power of Appointment. See also II.H above. Your clients may create a step up in basis for beneficiaries other than a surviving spouse, or may save both income and estate tax in an estate with large IRAs or tax deferred retirement accounts relative to other assets or save estate tax unrelated to retirement assets. The only way your clients may use this technique and still maintain use and control of the assets and the flexibility to change at any time is by using a Living Trust.

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o. Living Trusts may be structured to allow a Trustee, an agent under a Power of Attorney, or a Trust Protector to amend the terms of the trust if your clients are incapacitated and cannot do that themselves, to accommodate changes in tax law or other law, such as to qualify your clients for Medicaid nursing home or other public assistance. It has been suggested by some that clients may want to appoint an agent in a power of attorney to make revisions due to changes in the tax law for a client’s Will. However, neither we nor other attorneys with whom we communicate on a Listserve were able to find any definitive authority that an agent under a power of attorney has that authority in Texas. A properly drafted Living Trust is a better alternative to achieve this. 3. Simple Wills and Simple Living Trusts. Simple Wills are most often used when an individual has a small estate and wants to leave all of his or her assets to his or her spouse or to his or her descendants per stirpes. Typically, Simple Wills are designed so that the husband and wife leave all of their property to each other, or if they have both passed away, their property is distributed to their descendants, per stirpes. Per stirpes is an efficient way to say that all children will share equally but if one child passes away before the parents pass away and that child left one or more children, those grandchildren will receive and share that deceased child’s share. If the deceased child left no descendants, then the parents’ surviving children will share equally from the parents’ estate. When a Simple Will or a Simple Living Trust is used it may be wise to add a Contingent Trust for any person under the age 18, 21, or any other age the client chooses to protect their inheritance or for beneficiaries who are incapacitated or minors to avoid unnecessary delays and expenses associated with a financial guardianship proceeding. A financial guardianship must be established until the beneficiary becomes an adult or is no longer incapacitated. If a person has established a Living Trust, a Pourover Will would normally be signed to “pour” over after their death into their Trust any assets not already titled in their name as trustee. This may provide a safety net to catch any property that may not have been transferred or connected (with an appropriate beneficiary designation) to the Living Trust so it may pass less costly and as your client desires. Sometimes married couples with larger estates do not want a tax planned Will or Living Trust because they do not want to spend the extra money or they do not care if their children pay estate taxes. If such clients decide they prefer a Simple Will or Simple Living Trust, it is good practice to advise them in a letter that you recommended a tax planned Will or a tax planned Revocable Living Trust to save taxes but they preferred to use a simpler approach. This may help them and be very beneficial to you if the heirs think you are responsible for the taxes that reduced their inheritance.

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4. Subtrusts for Descendants in a Will or Living Trust. a. Pooled (or Pot) Trust. Sometimes a client with more than one child will want to make sure that a younger child receives the same benefit (such as paid costs for college) that the older child or children received while the parents were alive. A way to do this is to pool their estate into a single trust that benefits all of the children, including paying for their educations, until the youngest reaches a certain age or completes a certain level of education. After that occurs, the remaining trust assets can then be divided equally among the children. A pooled trust can be included in a Will or a Living Trust. For example, assume the parents pass away and leave three children, two of whom have already been college educated. If the parents’ estate is immediately divided equally, that will penalize the youngest since his education is paid from his share instead of from the pool. In effect, the other two, whose educations were paid for by the parents, end up with more. b. Individual Trusts for Each Beneficiary Until a Specified Age. Clients may want to include additional features in their Will or Living Trust to provide a Trust for each child or grandchild. These features may be one of the following: i. Providing that the child or grandchild beneficiary may elect to be a cotrustee or sole trustee when they have attained a certain age; ii. Providing that the trust will remain for the beneficiary’s lifetime to provide asset protection for them and to qualify all or part of it for GST exemption; iii. Allowing portions of the trust to be distributed outright to a beneficiary when the beneficiary attains certain ages, such as one-third at 21, one-half at 25, and the remainder at 30; iv. Providing for distributions to the beneficiary’s descendants during and/or after the beneficiary’s lifetime; v. Including special provisions for naming successor trustees; and vi. Granting the beneficiary a special power of appointment (either during lifetime or at death). vii. To also provide Incentive Trust provisions or Special Needs Trusts for loved ones who may be incapacitated.

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5. Durable Powers of Attorney (“POA”) for financial matters to name an agent to act on behalf of your client (1) immediately or (ii) if and when your client becomes incapacitated and is unable to act. There are many provisions that should be added to the statutory form to meet your client’s needs. Even though some third parties may not honor the Power of Attorney, it is still normally better for your clients to sign one when they are competent than to not have one. 6. Durable Special Powers of Attorney (POA) for IRAs, 401k’s, and other retirement plans, insurance policies and annuities allow the client to name an agent to act on the client’s behalf only with regards to the client’s IRAs, 401k’s, retirement plans, insurance policies, and annuities if the client is unable to act. It is recommended that if such a power of attorney is prepared and signed, the client should send a copy of it to the administrator or company to confirm in writing that they will accept the power of attorney as written or advise if they want other provisions to be included. One brokerage firm would not even do that. The client then decided to use a Living Trust instead. Your clients know in advance who are these firms so they have the luxury of communicating with and may be able to satisfy their POA requirements before the client may become incapacitated and it is too late to add any needed provisions. Your clients may not know in advance who else may be asked to honor their financial powers of attorney. 7. Beneficiary Designations for IRAs, 401k’s, and other retirement plans should be used to coordinate with your clients’ other signed estate planning documents for tax and non-tax purposes. a. The bulk of some clients’ estates are initially distributed by beneficiary designations because most of their estate assets are in a tax deferred retirement plan or a life insurance policy. The failure to coordinate their beneficiary designations with their other estate planning may undo what your clients want. b. Adding conduit provisions to clients’ Living Trust or Testamentary Trusts (established in their Wills) with properly worded beneficiary designations will allow the beneficiary(ies) to defer the payout of tax deferred retirement plan assets and increase their net after-income tax inheritance. John Denver’s failure to even name a beneficiary for his retirement plan caused his daughter to lose millions of dollars in taxes and the loss of tax-free deferrals and compounding. c. For non-tax purposes, if the beneficiary is incapacitated, it may be better to designate the Living Trust as the beneficiary. Otherwise, if the benefits are paid to that beneficiary, he or she may be forced into a costly, cumbersome, and controlling financial guardianship for the rest of their life to access those assets. Trusts may also keep the inheritance in the family bloodline and protect the inheritance against the beneficiaries’ future creditors. A conduit trust is a much better beneficiary for a minor than a guardianship.

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8. Beneficiary Designations for life insurance policies. It is normally best to have your client’s life insurance paid to a properly prepared Living Trust or Testamentary Trust (created by their Will) unless your client wants different beneficiaries or different shares for the policies. 9. Qualifying for Nursing Home Medicaid Public Assistance. This can be significant since many no frills nursing homes in our area cost more than $3,000 per month. The new law, the Deficit Reduction Act of 2005 (“DRA”), effective February 8, 2005 provided for the following: a. Places exemption limits on the value of an applicant’s home; b. Restricts the use of annuities; c. Changes the look-back period; d. Changes the start of the penalty period; e. Eliminates the ability to round down when calculating penalty periods; f. Applies asset transfer rules to eligibility for home-based Medicaid benefits; g. Requires the use of income-first rule; h. Permits the purchase of a “life estate” in real estate; i. Expands the Long Term Care “partnership” program to all 50 states; and j. Restricts the use of SCINS and other loan-type transactions. The most significant is the penalty for giving away assets to qualify. All gifts made in the last five years are aggregated and the penalty begins only when the Applicant otherwise qualifies but for the transfer penalty. This will significantly and adversely affect many unwary families who failed to properly plan. Another significant change is that Texas is now implementing estate recovery which means that the exempt homestead may be sold after the institutionalized person (and surviving spouse, if any) passes away to pay for Medicaid benefits given during their lifetime. There are, however, ways to plan in advance to protect the family. The current Medicaid allowances are listed on Exhibit 1. 10. Permissible Asset Protection. Estate planners are often consulted by clients to determine the safest and smartest way to own or acquire certain assets. Your client may not transfer any assets with the intent to delay, defraud or hinder their creditors. The Fraudulent Transfer Act allows those creditors to undo such transfers. For example, putting assets in a spouse’s name would not provide any protection against a creditor and may even be counter-productive. There are different strategies which your clients may utilize, depending upon the nature of the liability and the type of asset. It is always best for your clients to be prepared and to have planned and implemented the appropriate strategy before the

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liability was incurred. It has been reported that one in four Americans is sued during their lifetime. That ratio may be higher for your clients whose net worth is higher. a. Direct liability to your client for his or her acts or omissions may allow his or her creditors to ultimately seize his or her non-exempt assets, including interests in his or her business and their investments. Consider the following: i. A properly prepared Partition Agreement may help the uninvolved spouse protect his or her half of community property from the tort (not contractual) liabilities of his or her spouse if the Agreement is signed before the event occurred which created the liability for the claim. Negligence and malpractice are tort claims. ii. Family Limited Partnerships used for legitimate purposes may help. For example, the inheritance and lifetime gifts for many clients’ children have been protected from a bad lawsuit, a divorce, a risky occupation, or a bad accident. Because of some adverse changes in the law for spendthrift trusts in many states, Family Limited Partnerships may offer better protection in the long run than most spendthrift trusts. We are an increasingly mobile society. And often clients and their children and grandchildren move to another jurisdiction. b. Indirect Upward Liability. Your client may become personally liable for an act or omission by their business entity. Each of the following entities poses some potential liability risk to their owners: C or S corporation and a Texas LLC or LLP. Most clients want to choose the best entity to save taxes and protect them from liability. c. Indirect sideways liability from separate business divisions or projects. Your clients should use multiple appropriate entities to eliminate or reduce this risk. They do not want a bad lawsuit in one division or project to contaminate all of your client’s business assets. d. A properly designed Inheritor’s Trust for any business opportunity or investment. These, however, are subject to some adverse changes in the law in many jurisdictions affecting spendthrift trusts and we live in a mobile society. It must in fact be established by someone else for your client’s benefit. This is not to be confused with the Inheritance Trust, which is a conduit trust to accept IRA, 401(k), or tax deferred retirement plan funds. 11. New Bankruptcy Law. There are many provisions in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) that may affect your clients but the following four seem to be of more importance to estate planners. a. Domestic Asset Protection Trusts (“DAPT”). Section 548(e) provides for a 10-year lookback period to undo transfers to a self-settled trust “or

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similar device” if the debtor made the transfer with the actual intent to hinder, delay, or defraud present or future creditors. There are other potential problems with DAPTs and with foreign asset protection trusts. The following states have enacted legislation to allow a DAPT to be created in their state subject to their laws: Delaware, Nevada, Missouri, Oklahoma, Rhode Island, South Dakota and Utah. Some states offer more and others offer less potential DAPT benefits. A “similar device” may include a wide variety of planning tools in which the settlor retains an interest. The legislative history may indicate that a qualified retirement plan is a “similar device” subject to the 10-year clawback. The term “transfer” now expressly includes transfers made in anticipation of a judgment resulting from (A) violations of federal or state securities laws, and (B) fraud, deceit, or manipulation of a fiduciary capacity in the purchase or sale of securities. These new provisions highlight the need for settlors to be able to show a legitimate estate planning or business purpose for making transfers to a DAPT to avoid challenges. Your clients may prefer to achieve some estate tax benefits and remove certain assets from their estate by using CRTs, CLTs, GRATs, QPRTs, inter vivos QTIPs, or trusts funded with the exemption equivalent amount. b. Homestead exemptions. The following changes may impact clients in states with generous homestead exemptions such as Texas and Florida. Debtors may choose all of either the federal or state exemptions. i. State Law Exemptions – Value Limited. The value of the homestead exemption is limited to $125,000 if the debtor acquired the homestead within 1,215 days (approximately 40 months) before filing the petition pursuant to Subsection (p) of Section 522. Note that this does not apply to any amount transferred from the debtor’s prior residence if the prior residence was acquired outside the 1,215 day period and if the prior residence is in the same state as the new residence. The homestead exemption is capped at $125,000 by §522(q) (except it may be increased if reasonably necessary for the support of the debtor and his dependents) if the debtor is 1. convicted of a felony evidencing that the filing of bankruptcy was abusive; or 2. owes a debt arising from (a) violations of federal or state securities laws, (b) fraud, deceit, or manipulation of a fiduciary capacity in the purchase or sale of securities, (c)

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violations of RICO, or (d) any other criminal act, intentional tort, or willful or reckless conduct resulting in physical injuries of the preceding five years. ii. Value of Homestead Exemption Reduced. Subsections (o) through (q) of Section 522 reduce the value of the state homestead exemption in a bankruptcy case to the extent (a) its value is attributable to property the debtor “disposed of” in the 10-year period preceding the petition date, (b) the debtor disposed of the property with the intent to hinder, delay, or defraud a creditor, and (c) such property or portion thereof would not have been exempt on the date the petition was filed if the debtor had not so disposed of it. c. Retirement plan and IRA protection. i. Section 522(d)(10)(E) says that certain retirement plan payments are a federal exemption to the extent reasonably necessary for the support of the debtor and his or her dependents. In April 2005, the U.S. Supreme Court held in Rousey v. Jacoway, that the statute’s exemption included IRAs. ii. Section 522(n) caps the IRA exemption to $1 million exclusive of amounts attributed to qualified rollovers. SEPs and SIMPLE-IRAs are expressly excluded from this cap. Individuals who participate in 403(b) and 457 plans may want to roll their large IRAs into those plans because they have no such cap. It is wise for bankruptcy purposes to keep IRAs with rollovers separate from IRAs with annual contributions because of the unlimited exemption for rollover contributions. iii. Retirement funds that have received a favorable ruling of qualified status from the IRS now may be exempted from the bankruptcy estate under §522(b)(4). Funds that have not received a favorable determination are exempt if the debtor establishes that a court or the IRS has not issued a contrary ruling and either that the funds have been administered in substantial compliance with the IRC or that the debtor was not responsible for such failure to comply. Rollovers from one exempt fund to another will not lose exempt status under §522(b)(4)(C). An exemption for either “eligible rollover distributions” (defined under IRC §402(c)) or distributions from certain qualified plans that are rolled over into another qualified plan within 60 days is permitted by Section 522(b)(4)(D). d. 529 Plans. Debtors may opt for the Texas exemption. The federal exemption exists but it is more restrictive and convoluted.

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12. Special Needs Trusts. A trust established by a Will or Living Trust or as a separate trust so that it does not cause a child or other loved one who is receiving public benefits, including SSI and Medicaid health benefits, from losing those benefits. Depending on the rules in the applicable jurisdiction and the preference of your clients after they understand both their choices and the likely scenarios that may occur, your clients may provide that distributions will be made at the Trustee’s discretion or they may specifically prohibit any income or principal from being used for a purpose (such as providing food) which would cause the child to lose the public benefits. Instead, the trust would provide that income and principal should be used only to supplement those benefits but may permit the Trustee to exercise its discretion at all times. Such an approach may be better to protect the child if the public benefits become insufficient to meet the child’s needs. 13. Incentive Trust. There are many alternative ways to structure these. This may be important to some of your clients. Incentives which may be rewarded by greater trust distributions may include a. education achievements (such as a mandatory grade point average), b. a level of earned income annually, c. community service, d. demonstrating an ability to manage money, e. completing certain degrees such as BS, M.B.A., Ph.D., M.D., etc., f. getting along civilly with certain individuals such as siblings, g. visiting the surviving spouse, h. refraining from abusing drugs or alcohol, and i. contributions to charities. 14. Ethical Wills. For some clients, what they value is of equal or greater importance than what they own. These may be one, two or a few more pages in a separate document entitled “Ethical Will.” These are used when a parent feels it is important for them to relate to their children and grandchildren some words of wisdom and values that they have learned and pass them on to future generations so they will know more about the parents and to assist them to live good and happy lives. 15. Provisions for Guardians of Minors and Incompetent Adults. It is normally better to put these in a separate document which complies with specific legal requirements than to include them in a Will. This makes it easier to revise them

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later if needed (which often happens) and it is easier in certain scenarios to use or act upon these provisions in a separate document than in a Will. 16. Provisions to Protect a Child’s or Surviving Spouse’s Inheritance From Their Spouses. These are often overlooked and may protect the beneficiary and also allow them to avoid any blame from their spouse for such protection which was imposed by the decedent, not their decision or choice. B. Impact of Societal Megatrends due to the Aging of the Baby Boomers. Clients often consider these when they focus on their other estate planning needs. 1. Natural Anxiety as People Age. Many people are concerned about whether they can preserve their dignity and independence as they age and what will happen if they lose capacity to make decisions for themselves. 2. Capacity Concerns. Dementia is the most usual cause of lack of capacity and is a condition, not a disease. Most often its cause is Alzheimer’s disease. The incidence of dementia is estimated to double every 5 years after age 60, ranging from 1% at age 60 to 35% at age 85. Revocable Living Trusts are used often to address incapacity issues and are better than Powers of Attorney. 3. “Short Portable Mental Status Questionnaire.” Ten questions to help determine whether an individual has capacity (many of which can be woven into an estate planning conference). (1) Date; (2) day of the week; (3) name of this location/office; (4) individual’s phone number; (5) individual’s age; (6) individual’s date of birth; (7) name of the current President; (8) name of the President before current President; (9) mother’s maiden name; (10) subtract three from 20, and keep subtracting three from each new number all the way down. Scoring scale: 0-2 errors – normal; 3-4 errors – mild cognitive impairment; 5-7 errors – moderate cognitive impairment; 8-10 errors – severe cognitive impairment. C. Healthcare Documents. Clients often consider these when they focus on their other estate planning needs. 1. Drafting Changes Due To the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”). HIPAA requires health care providers to protect the confidentiality of each patient’s health care information. The law requires that all health care providers make reasonable efforts to limit the amount of protected health information disclosed to accomplish the intended purpose of a particular disclosure or request for disclosure. Many previously prepared estate planning documents, such as powers of attorney (POA) and Revocable Living Trusts, have language saying that the agent named or the successor Trustee may not begin to act until the principal is unable to make decisions for himself or herself. Because of the limitations HIPAA places on healthcare providers it may be difficult or impossible to get a physician to talk with

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anyone about the principal’s possible incapacity or to supply a written letter which those Trust and POA documents require. Without that written letter, your client may be forced into a financial guardianship even though there is an agent ready to act under the power of attorney or a Trustee ready to act in a Living Trust. a. HIPAA Release Forms. At the very least, clients should have a “HIPAA Release” document which names one or more individuals who may speak with the client’s healthcare providers to obtain information about the individual’s possible incapacity. b. Amend Documents Now To Allow A Disability Panel To Determine Incapacity. Many families have been blindsided by HIPAA because the client’s documents do not provide for a Disability Panel to decide if the client is incapacitated. This Panel would consist of persons chosen in advance by the client, normally the client’s closest family and/or friends and physicians (if they will participate). The Panel determines if the client has become incapacitated for purposes of whether a successor Trustee should take control of a Living Trust and/or an agent named in a power of attorney should begin acting for the client. Without this Disability Panel, if doctors decline to provide the written confirmation of incapacity, your client will likely be forced into a financial guardianship even though they previously signed a valid power of attorney or Living Trust document. 2. Consider utilizing one or more of the following, depending upon your client’s individual needs, wants, and desires. a. Durable Powers of Attorney for Healthcare. Appoints an agent to make healthcare decisions for your client (the principal) if he or she is unable to communicate his or her wishes to the healthcare provider. b. Directives to Physicians, Family or Surrogates (a.k.a. Living Will) which may include one or more choices from a list of health and comfort care options. The Schiavo case caused many people to consider what choices they want to make for themselves and to realize the importance of such a document. This Directive is used to communicate the client’s wishes about medical decisions if he or she is unable to make his or her wishes known because of illness or injury and is on life support with no foreseeable improvement likely to occur. Regardless of your client’s choices, it is important that the family knows your client’s preference, especially when there is a possibility of disagreement among family members. There have been many sad stories of families torn apart by arguments over what decision to make for an incapacitated parent or spouse in this situation. This risk of acrimony is even greater, but is not limited to, blended families with children from either both a first and second marriage or when the spouses each have children from a prior marriage.

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c. Designation of Guardian of the Estate of an Adult. This document names an individual (and successors) to serve as Guardian of the client’s estate. This document may also be used to exclude from serving as guardian certain individuals the client names. If a client has a Living Trust, the successor Trustee would typically be able to take over the client’s financial affairs (but only for those assets titled in the name of the Living Trust) in the event he or she becomes unable to do so (thus saving the risk, expense and/or trouble of a financial guardianship). d. Designation of Guardian of the Person of an Adult. This document names an individual (and successors) to care for the physical needs of a client if he or she is ever unable to do so. It may also be used to exclude from serving as guardian certain individuals the client names. This Designation is usually combined with the Designation of Guardian of the Estate of an Adult. e. Declaration of Mental Health Treatment. If an individual is determined to be unable to understand the nature and consequences of a proposed mental health treatment or lacks the capacity to make mental health treatment decisions, this document allows the client to make such decisions in advance. "Mental health treatment" is defined as electroconvulsive or other convulsive treatment, treatment of mental illness with psychoactive medication, and preferences regarding emergency mental health treatment. Since no one, including the agent named in your client’s Healthcare Power of Attorney, can make these decisions for your client, it is important that your client make these decisions and memorialize them in a Declaration of Mental Health Treatment while he or she has capacity. Clients with family members who have had Alzheimer’s or other forms of dementia, or depression, bipolar disorder, or other mental illness should consider using such a document. f. Appointment of Agent to Control the Disposition of Remains. This document appoints an individual to determine what happens to the client’s physical remains after he or she has passed away. The client may specify in this document what is to specially be done with his or her remains, i.e. cremation or burial. g. Statement Regarding Anatomical Gifts. Clients may designate in this document whether they want to donate any organs or tissue and whether they want to limit such donations to certain persons and/or institutions. Clients may also make such designations on their Texas Drivers License but the document allows them to be more specific, if necessary. h. Care and Comfort Options. Clients may add to their Directive to Physicians or state in a separate document specific wishes for many potential scenarios including, but not limited to, the following.

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(i) how comfortable they want to be in a final illness (i.e., cool most cloth put on their head if they have a fever, have warm baths often, have favorite music played when possible until time of death, etc.), (ii) how they wish to have others treat them (have people with them when possible until their time of death, hand held and to be talked to when possible, have the members of their church or synagogue told that they are sick and asked to pray for and visit them, etc.), and (iii) what they want their loved ones to know (have family members and loved ones know that they love them, family and friends to think about what they were like before they had a terminal illness, specific things they want their loved ones to remember about them, etc.). D. Designation of a Guardian of the Person and/or Estate of a Minor Child names a guardian for those of the client’s children who are under the age of 18. The client may name one person to act as guardian of both the child(ren)’s person and estate or they may name one person to serve as guardian of the estate (to handle the child’s financial affairs (those not in a Trust for the child’s benefit)) and one person to serve as the guardian of the person (to care for the physical needs of the child). We recommend that this be in a separate document to make it easier if the client later wants to revise it or in case it is ever needed before the parent passes away. E. Some of the Limitations of and Problems Caused by Trying to Rely Upon Special and Multiple Party Accounts as an Alternative to a Will or Living Trust. 1. Pay or Transfer on Death (“POD” or “TOD”) Designations Compared to Living Trusts. a. TODs won’t work for all assets. Assets not subject to TOD will go through probate. b. If the owner becomes incapacitated, they will still risk a financial guardianship to manage their affairs. The TOD does nothing for them. c. If the owner (donor of the account) becomes incapacitated, they will lack the ability to change beneficiaries if they wanted to do so. d. TODs must be changed for every account or asset when the beneficiaries change, whereas a trust may be changed once for all accounts or assets. e. If the beneficiary predeceases the donor, then the assets go through probate. f. It can be extremely difficult to equalize distributions with multiple accounts and different TOD designations; you may normally equalize more easily in a Living Trust or Will.

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g. Beneficiaries receive assets outright, free of trust so they are not asset protected. h. Special needs beneficiaries may be forced into a costly, cumbersome and controlling financial guardianship for the rest of their lives in contrast to what may be provided for in a Trust created in either a Living Trust or a Will. And they may lose their public benefits which may be avoided with a Special Needs Trust created in a Living Trust or a Will. i. Beneficiaries may cash out the account immediately, which may leave the estate with a tax liability and no funds to pay it. The Executor could have a problem obtaining contribution from the TOD beneficiaries to pay estate taxes due. j. TODs do not permit estate tax apportionment as you can in a Living Trust or a Will. k. TODs do not take advantage of estate tax exemption planning as you can in a Living Trust or a Will. l. TODs do not normally allow for alternative beneficiaries in case the original beneficiary dies. m. TODs are sometimes forgotten when the owner later changes his Will or Living Trust. So, the wrong person may eventually receive the TOD assets. Most clients do not think about their beneficiary designations except when they are opening the account. n. TODs fool some clients into thinking they do not need to do real planning. The only advantage and reason to do a TOD is probate avoidance. Estate planning is much more than probate avoidance. 2. The decedent’s creditors have access to these special accounts by statute unlike with Living Trusts. a. POD or TOD – If assets of the decedent’s estate are insufficient to pay debts, taxes, administration expenses, and statutory allowances (for the surviving spouse and minor children) or if there is a claim by a secured creditor who has a lien on the account, the payee or beneficiary of a POD account must account to the decedent’s personal representative for amounts the decedent owned immediately prior to passing away to the extent necessary to discharge such claims and charges. See Section 442 of the Texas Probate Code. b. CPWROS – The portion of a CPWROS account over which a deceased spouse had the sole or joint management, control and disposition prior to death may be accessed to pay such deceased spouse’s liabilities after the spouse passes away

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regardless of the right of survivorship. The surviving spouse, as the beneficiary of the right of survivorship, must account to the deceased spouse’s personal representative for the property he or she received from the account upon the deceased spouse’s death. A creditor may not seek payment from such account if the creditor makes a written demand to the personal representative. 3. With a WROS account (CPWROS or JTWROS) a. Your client may undo their tax plan and cause a non-taxable estate to become taxable. See also III.A.2.b. b. These accounts do nothing for your client and for your client’s survivor (spouse or beneficiary) in the event they become incapacitated compared to what can be provided for in a Living Trust. c. Some of the other problems listed above for TOD accounts also apply to WROS accounts. IV. Income, Estate and/or Gift Tax Planning. Estate planning may reduce the value of your client’s estate to or below the exemption amount so that it is no longer taxable. Clients with no taxable estate may still benefit from gift tax planning. Many clients are not aware of what may be done to reduce future income taxes of inheritances when they think of estate planning. A. Do Your Client’s Existing Estate Documents Need To Be Reviewed or Amended? The following are some of the situations in which it may be advisable to amend an existing signed Will or Revocable Living Trust. 1. Assets Equal to Amount of Estate Tax Exemption. Avoid Passing Estate in whole or in part to the Wrong Persons. When this outline was submitted the exemption was scheduled to increase to $3,500,000 in 2009, and then becomes unlimited in 2010. An estate plan that gives an amount of assets equal to the available estate tax exemption (or an amount to reduce the tax to zero) to an individual, to a trust, or to a charity may be too much now. It may be important to review the plan with your client. Some tax planned documents were drafted so that a dollar amount of property defined to be equal to the available estate tax exemption is given outright to children, to a trust for the children, to a bypass trust benefiting the entire family, or to third parties and the remainder of the estate passes to a spouse or to charity. One solution may be to provide for an amount equal to the exemption for the recipient but never to exceed a cap of a set dollar amount or a percentage of the estate. 2. Assets Equal to Generation Skipping Tax Exemption Amount. Because the GST exemption is scheduled to increase along with the estate tax exemption to $3,500,000 by 2009 and then unlimited in 2010, the following plan may not

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ultimately be implemented as originally contemplated. A client may have structured an estate plan so that the available GST exemption is given to a trust for grandchildren. One situation is that the trust could end up with $3,500,000 instead of the intended amount of $1,000,000, leaving the other beneficiaries with little or nothing. Another possibility is that if the client passes away the year that the GST tax is repealed, then, depending on the definition used in the document, it is possible that no gift would be made to the trust (example: if the amount is defined as that portion of the estate subject to the GST tax) or the entire estate would pass to the grandchildren (example: if the amount is defined as that portion of the estate which can pass without being subject to the GST tax). One alternative is to set a maximum limit to the amount passing to the trust for grandchildren or other recipients. This cap may also be a set dollar amount or a percentage of the estate. 3. If Tax Laws Change and Your Client Becomes Incapacitated, What Then? If you have any clients who want to have their Living Trust amended in the future based on changes in the tax law should he or she become incapacitated, then their Living Trust should allow the Trustee, a Trust Protector, or an agent under a power of attorney to amend the client’s documents. They would have the ability to modify an existing Living Trust to take advantage of any new tax law changes (keeping in mind the client’s overall dispositive plan). See II.A.2.o above. That option does not appear to exist with a Will. B. Tax Planned Wills and Living Trusts. It may still be wise to include tax planning provisions to maximize the Credit Shelter Trust, the GST Exemption amount and preserve the Marital Deduction for several reasons. 1. Your client may have a taxable estate and not realize it or not tell you about all of their assets, retirement plans, and life insurance. 2. The law may change again subjecting clients with less net worth to the estate tax. 3. Other than using more paper these provisions should not create any problems even if they may not be used. C. Life Insurance. 1. If the insured owns the policy, the proceeds will be included in his or her taxable estate. To avoid that, an Irrevocable Life Insurance Trust (“ILIT”) is useful to keep the proceeds out of the insured’s taxable estate. The ILIT should be designed to include current spendthrift asset protection provisions for the beneficiary to address changes occurring in many jurisdictions.

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2. Such trusts may provide for liquidity to benefit the surviving spouse but may also provide funds outside of the transfer tax system to be used like a family bank to make loans to pay estate tax or for other purposes, provide cash flow to family members, purchase assets, and replace property which passed to a charity. 3. Your client’s children may own the policy but after the policy proceeds are paid to the beneficiary, they may lose control over the cash. A child could intentionally or unintentionally transfer the funds to the wrong person (i.e., a son- or daughter-in-law instead of to a grandchild) or lose them to a creditor. D. Family Limited Partnerships (“FLPs”). 1. FLPs are alive and well. When they are properly designed, executed, managed, maintained and valued, they can be quite effective to provide both non-tax and tax benefits for your clients. There have been some cases over the last few years that point out that when the FLP is not properly designed, executed, managed, maintained and valued, they fail to meet their intended objectives. But those are a small percentage of all FLPs. a. The crux is if there was a valid reason, other than saving transfer taxes, to utilize the partnership. The other element which you see most often in the bad cases is the taxpayer using assets in the partnership for their personal benefit. If your client can avoid that and have a legitimate reason to use the partnership other than the save transfer tax they should prevail if they act reasonably. b. Some Recent Taxpayer Victories. i. The Smith case, a Pennsylvania U.S. District Court tax refund jury decision, allowed “significant (67%) discount for FLP interests. Smith, 94 AFTR2d 2004-5627 (DC Pa., 2004). ii. Kelley v. Commissioner, T.C. Memo 2005-235, October 11, 2005. It allowed a 12% minority discount and 23% marketability discount. There was a 94.93% interest in a FLP whose sole assets were cash and CDs and a 33.33% interest in a LLC. It was tried before Judge Vasquez from Texas. The IRS dropped all Section 2036 issues shortly before trial. iii. Estate of Charlotte Dean Temple, U.S. District Court, March 10, 2006, taxpayer won $7 million in gift tax refunds. Court concluded at a combined 38 percent discount for lack of control and lack of marketability for the minority gifts made in the FLP.

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2. Recommendations and Considerations. a. Accounting and Distributions. records and books.

Maintain complete partnership

b. Segregation of Partnership From Personal Matters. Do not commingle partnership and personal assets. It is essential that FLP business be totally separate from personal business. Never pay personal expenses with partnership assets or transfer personal use assets into the FLP. If however, there is any personal use of a partnership’s assets, provide and enforce that each partner must promptly pay the FLP the fair market value for that usage. c. Operate FLP as An Ongoing Business. General partners should (1) maintain records of the partnership’s activities and send copies to the limited partners, (2) conduct business in the name of the FLP, and not in a personal capacity, and (3) sign documents on behalf of the limited partnership so that it is clear that actions are being taken by the limited partnership. Use partnership letterhead, business cards, etc. d. Hold Annual Meetings and Keep Minutes or Sign Annual Consents. FLP partners should discuss partnership activities, objectives, review transactions that occurred or that are planned for the future, and any distributions that will be made. Final decisions regarding the matters discussed at such meetings will be made by the general partners and evidenced in signed minutes or consents. e. Retain Sufficient Assets Out of the FLP. Be sure to retain enough assets outside of the FLP to live comfortably and to pay all anticipated expenditures. Do not pay estate taxes from the FLP. The FLP or an ILIT may in certain circumstances loan money to the estate (or Living Trust) or purchase assets from them and those proceeds may be used to pay estate taxes. f. Avoid Making Non-Pro Rata Distributions. That is mandatory for partnerships with fixed percentage ownership and vigorously recommended for other partnerships which may allow ownership to vary with changes in the capital accounts (that occur in many commercial enterprise partnerships). g. Use and Establish the Partnership for Some Valid Purpose(s) Other Than To Save Estate Tax. This has become very important for Section 2036(a) issues which have become the basis upon which IRS has attacked many FLPs. Section 2036(a) provides: “(a) General rule The value of the gross estate shall include the value of all property to the extent of any interest therein of which the

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decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death— (1) the possession or enjoyment of, or the right to the income from, the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom.” h. The General Partner. Some partnerships appoint a person or entity who is considered for tax purposes to be independent and not subservient to the clients who established the FLP serve as a general partner or special general partner to determine partner distributions. Some appoint an adult child to this position. However, this should not be necessary if your clients want to continue to make decisions on all matters. i. Provide for the Fiduciary Duty of the General Partners. That fiduciary duty was very important in U.S. v. Byrum, 408 U.S. 125 (1972). ii. Have an ascertainable standard for distributions. iii. Many commentators have disagreed with the Section 2036(a)(2) analysis made by the Tax Court in its second Strangi decision. That interpretation has not been ruled upon by a U.S. Circuit Court of Appeals. There are many reasons why a Circuit Court may not agree with it. One is that the general partner in Strangi had no “right” to “designate the persons who shall possess or enjoy the property or the income therefrom.” The partners were the only ones who could receive distributions. The general partner in Strangi had only the right to designate when the distributions were made. The general partner in Strangi had no right to designate that any other person could enjoy the past, present or future income of or partner distributions from that partnership. i. Management Fees. Your clients may want to consider paying reasonable management fees to the FLP’s general partner(s) or manager(s). j. File a Partnership Tax Return for Each Year when the partnership existed, even early years when there may be no activity.

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k. Consider Making Gifts of Limited Partnership Interests. If less is owned at death, not only is the estate less but your client may have a better argument for valuation discounts. l. Follow the Provisions In the Partnership Agreement. m. Act Early. FLPs should be established and funded as early as possible to avoid the appearance of a deathbed partnership that was created just to obtain significant valuation discounts. E. Using an Intentionally Defective Grantor Trust (IDGT). 1. The IDGT may purchase assets, including an asset discounted for tax value such as an interest in a family partnership or other business entity or a fractional interest in realty. There may be entity interest discounts for lack of marketability, minority interest, and for a partnership or LLC if it is only an assignee interest in that entity. a. Or your client may want to make a gift of the asset to an IDGT solely to remove future appreciation and freeze its value. b. This sale also removes future appreciation from your client’s estate like any other installment sale would. If the sale is made for a down payment and a long term payout, then your client leverages their gift tax exemption. The gift would be limited to the seed if the seed capital was a 10% down payment so a larger amount can be transferred and only 10% of its value would use up any gift tax exemption. i. It is said that for the sale to be respected the value of equity inside the grantor trust must be 10% of the total value. Some commentators say that it not required and others say that depending on the situation the equity amount could be as low as 1%. ii. Another approach is to make the grantor’s spouse a beneficiary and have him or her give a guarantee to help support the “seed” cushion. There are some cases that indicate that a beneficiary’s guarantee is not a gift. The leading case is Bradford (34 T.C. (1059 (1960)), in which the IRS acquiesced. c. There would be no capital gains or interest income reported on the sale or note payments because it is a Grantor Trust. 2. An “IDGT,” sometimes referred to merely as a “Grantor Trust,” is a trust that is structured so that the grantor is taxed on the income of the trust rather than the trust or its beneficiaries. “Defective” trusts are irrevocable under the transfer tax rules and completed transfers of property but they contain one or more provisions that cause the

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grantor to remain taxable on the trust’s income. Such trusts are typically multigenerational in scope so that they benefit multiple beneficiaries in multiple generations. Although “defective” for income tax purposes, they are totally effective for estate tax purposes to remove the trust assets from the grantor’s taxable estate. When structured carefully and properly and all transactions are made at arm’s length, IDGT’s can be an attractive estate planning technique for purchasing closely held business entities, in intrafamily transfers. a. The desired result of an IDGT is achieved by drafting a trust to fail certain tests contained in Code Sections 673 – 677, which would otherwise cause the income of the trust to be taxed to the grantor. It is important to choose a defect for income tax purposes which does not trigger inclusion in the grantor’s estate under provisions reaching transfers with retained powers, such as Code Sec. 2036 or 2038. b. The use of intentionally defective grantor trusts is authorized in Rev. Ruling 2004-64, 2004-27 IRB 7 which makes it clear that the grantor’s payment of the income taxes on the income of a grantor trust will not be treated as a gift to the trust beneficiaries. This result is important because none of the payments of income tax, which could be huge, will be treated as gifts by the grantor. i. That avoids paying a transfer tax on the income tax. ii. If a parent were to transfer property outright to a child and than agree to pay the income tax incurred associated with that property instead of creating an intentionally defective grantor trust, the payment of the tax would be an additional gift. iii. For trusts created after October 3, 2004, Rev Rul 2004-64 also clarifies that, if the governing instrument or applicable state law requires the trustee to reimburse the grantor for the income taxes, the full value of the trust property will be included in the grantor’s gross estate where. However, if the trustee does not pay the grantor’s income taxes, or if the trustee pays them under a discretionary power rather than a mandatory requirement, the trust assets will not be included in the grantor’s estate. 3. Debt v. Equity. The trust assets should not be included in the grantor/seller’s gross estate under §2036 if the note that is received from the trust is treated as debt rather than equity. Miller v. Commissioner, 71 T.C.M. 1975 (1996), aff’d, 113 F.3d 1241 (9th Cir. 1997) identified nine objective factors to determine if the transfer was made with a real expectation of repayment and an intention to enforce the debt. a. See also Roth Steel Tube Company v. Commissioner of Internal Revenue Service, 800 F.2d 625 (6th Cir. 1986), Stinnet’s Pontiac Service, Inc.

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v. Commissioner of Internal Revenue Service, 730 F.2d 634 (11th Cir. 1984), and Santa Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005-104. b. However, Judge Laro extended Miller and Santa Monica by six new factors in Rosen, T.C. Memo. 2006-115. (Among the factors mentioned by Judge Laro to disregard treating partnership distributions as mere advances under loans are that the decedent never intended to repay the advances, there was no fixed maturity date or payment schedule, no interest (or principal) payments were made, the decedent had no ability to honor a demand for payment, repayment of the note depended solely on the FLP’s success, transfers were made to meet the decedent’s daily needs, and there was no collateral. He also questioned the adequacy of interest on the note.) Several commentators have criticized the Santa Monica decision. 4. Valuation and Sections 2701-2702. A gift results if the value of the transferred assets exceeds the value of the note. One “defined value” approach to avoid (or minimize) the gift risk is to include language in the trust agreement stating that any gift before Date 1 will pass to a gift trust and any gift after that date goes 90% to incomplete gift trust and 10% to a completed gift trust. The initial “seed gift” to the trust would be made before that date. a. Another possibility is to use a disclaimer even for a sale to a grantor trust. The trust agreement would specifically include language permitting a trust beneficiary to disclaim any gift made to the trust and that the disclaimed asset passes to some other transferee like a charity, back to the donor or to another transferee that does not have any gift tax consequences. The beneficiary would disclaim after a sale to the trust using a formula: “To the extent of any gift made by father to me, I disclaim 99% of the gift.” b. In Karmazin, (T.C. Docket No. 2127-03, filed Feb. 10, 2003) the IRS made a number of arguments to avoid respecting a sale of limited partnership units to a grantor trust, including §§2701 and 2702. Karmazin was ultimately settled favorably for the taxpayer. In the Dallas case (T.C. Memo 2006-212), the IRS agent made arguments under §§2701 and 2702 in the audit negotiations to disregard a sale to grantor trust transaction, but the IRS dropped that argument before trial and tried the case as a valuation dispute. In that case, the IRS respected the note as debt. 5. Advantages of Sale to an IDGT. a. The excess of the total rate of return over the interest rate will pass to the trust’s beneficiaries free of any transfer taxes. For example, Bill sells to an IDGT for the benefit of Chelsea $1,000,000 worth of assets, which are expected to produce a total return of 8%. He takes back a ten-year note with interest only payments and a $1,000,000 balloon payment at the end of the

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term. Assuming a minimum interest rate is 5%, the total wealth transferred to Chelsea in ten years is as follows:

1 2 3 4 5 6 7 8 9 10

Beginning Balance $1,000,000 $1,030,000 $1,062,400 $1,097,392 $1,135,183 $1,175,998 $1,220,078 $1,267,684 $1,319,099 $1,374,627

Growth at 8% $80,000 $82,400 $84,992 $87,791 $90,815 $94,080 $97,606 $101,415 $105,528 $109,970

Installment Payments ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($1,050,000)

Transfer Balance $1,030,000 $1,062,400 $1,097,392 $1,135,183 $1,175,998 $1,220,078 $1,267,684 $1,319,099 $1,374,627 $434,597

i. Discount adjustment. 1. If the seller leverages a sale to an IDGT by selling assets that qualify for a discount adjustment (e.g. limited partnership units or closely held stock), because of the lack of marketability and/or minority discount, the rate of return on the underlying assets sold to an IDGT does not have to exceed the interest rate on the installment note in order for an effective wealth transfer to take place. Or if it does exceed that, the transfer gain is even larger. 2. Assume that Hillary sells $1,000,000 worth of limited partner units expected to produce a total return of 8% to an IDGT for the benefit of Chelsea. Because of the lack of marketability and control, the values of the limited partner units were only worth $700,000. In exchange for the transfer, Hillary takes a back a ten-year note providing for interest only payments and a $700,000 balloon payment at the end of the term. Assuming a minimum interest rate of 5%, the total transfer to Chelsea is as follows: Impact of Discount Adjustments Beginning Balance 1 2 3 4 5 6 7 8

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$1,000,000 $1,030,000 $1,062,400 $1,097,392 $1,135,183 $1,175,998 $1,220,078 $1,267,684

Taxable Income at 8% $80,000 $82,400 $84,992 $87,791 $90,815 $94,080 $97,606 $101,415

Installment Payment

Ending Balance

Beginning Balance

($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000)

$1,030,000 $1,062,400 $1,097,392 $1,135,183 $1,175,998 $1,220,078 $1,267,684 $1,319,099

$1,000,000 $1,045,000 $1,093,600 $1,146,088 $1,202,775 $1,263,997 $1,330,117 $1,401,526

Taxable Income at 8% $80,000 $83,600 $87,484 $91,687 $96,222 $101,120 $106,409 $112,122

Installment Payment

Transfer Balance

($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000) ($35,000)

$1,045,000 $1,093,600 $1,146,088 $1,202,775 $1,263,997 $1,330,117 $1,401,526 $1,478,648

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9 $1,319,099 $105,528 ($50,000) 10 $1,374,627 $109,970 ($1,050,000) Additional Wealth Transferred

$1,374,627 $434,597

$1,478,648 $1,561,940

$118,292 $124,955

($35,000) ($735,000)

$1,561,940 $951,895 $ 517,298

ii. The impact of Back End-Loading. 1. Assuming that the assets sold produce a rate of return that exceeds the interest rate on the note, the longer the principal payment can be delayed, the better. To the extent principal payments are made earlier, the children have less money to produce the higher return. More back end-loading is possible with an IDGT than with a GRAT. With a GRAT, the increase in the amount of annuity payment from one year to the next is 20%. In Bill’s example above, $434,597 of appreciation was transferred tax-free to Chelsea, and $151,748 of it was due to back end-loading. 2. Bill sells to an IDGT $1,000,000 worth of assets, which are expected to produce a total return of 8%. Because he can take back interest only payments during the term of the note with a balloon payment at the end of the term and because of the deferral of the payments, he can transfer more assets to his beneficiaries. Assuming a minimum interest rate of 5%, the total transfer to Bill’s beneficiaries would be as follows: Impact of Back End-Loading Beginning Balance

Taxable Installment Income Payment at 8% 1 $1,000,000 $80,000 ($129,505) 2 $950,495 $76,040 ($129,505) 3 $897,030 $71,762 ($129,505) 4 $839,288 $67,143 ($129,505) 5 $776,927 $62,154 ($129,505) 6 $709,576 $56,766 ($129,505) 7 $636,838 $50,947 ($129,505) 8 $558,280 $44,662 ($129,505) 9 $473,438 $37,875 ($129,505) 10 $381,809 $30,545 ($129,505) Additional Wealth Transferred

Ending Balance

Beginning Balance

$950,495 $897,030 $839,288 $776,927 $709,576 $636,838 $558,280 $473,438 $381,809 $282,849

$1,000,000 $1,030,000 $1,062,400 $1,097,392 $1,135,183 $1,175,998 $1,220,078 $1,267,684 $1,319,999 $1,374,627

Taxable Income at 8% $80,000 $82,400 $84,992 $87,791 $90,815 $94,080 $97,606 $101,415 $105,528 $109,970

Installment Payment

Transfer Balance

($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($50,000) ($1,050,000)

$1,030,000 $1,062,400 $1,097,392 $1,135,183 $1,175,998 $1,220,078 $1,267,684 $1,319,099 $1,374,627 $434,597 $ 151,748

iii. The benefits resulting from a sale to an IDGT. More tax-free appreciation in excess of the AFR interest rate using back end-loading, discounting the asset sold, using the AFR instead of the GRAT rate which is 20% higher and income taxed on any income earned by the IDGT were paid by the parent. b. Compared to a GRAT.

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i. The interest rate is approximately 20% less than the GRAT 7520 rate. ii. The grantor can pass away during the term and there is no Section 2036 pullback of the asset into the grantor’s estate. iii. However, upon death of the grantor, the IDGT becomes a nongrantor trust, whereby all future income will be taxed at the trust level. c. The IDGT can get low-basis assets back into the hands of the senior generation for step-up purposes. Either the IDGT can use the assets that were “sold” to it to pay back the grantor or the grantor can exchange cash or high basis assets for what was sold. F. Advantages of Gift Giving During Lifetime. Gifting may be a powerful tool over time to reduce the size of your client’s taxable estate. 1. It keeps future appreciation of the gifted asset out of your client’s estate. 2. It may cost less to transfer assets during lifetime. The difference is between tax exclusive and tax inclusive. 3. The Annual Exclusion is like a coupon for a tax-free transfer for each of their loved ones. Your clients either use it or lose it. 4. Three reasons clients may prefer to make gifts of FLP interests are: a. It is basically a paper accounting transaction which does not reduce your client’s cash or liquidity. b. They leverage the gift by the discount on the gifted interest. Remember there is no 2036(a) counterpart to the gift tax rules. c. They love their children and want them to inherit from their estate but not just yet. So long as their documents and conduct satisfy the Hackl requirements (which may be done painlessly), it is a gift of nothing tangible until the future with a current free transfer exclusion. 5. Because the lifetime gift exemption is less than the death exemption, some of your clients without a taxable estate may still want to make gifts and leverage their lifetime exemption to transfer more than the exemption amount on a tax-free basis. 6. Your client may want to make the gift large enough to pay a small tax and start the statute of limitations.

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G. Gifting A Fractional Interest in Realty. Since 1993, courts have ruled on eight applicable undivided interest cases with discounts averaging approximately 32%. H. Some of Your Clients May Be Able To Take Advantage Of The Basis Rules to Save Income Taxes For Their Family When the Inherited Property Is Sold. 1. The Tax Basis of Transferred Assets. a. The general rule is that the income tax basis of property received from a decedent is the value at the date of death. This may cause a “step up” or “step down” in basis. IRC §1014(a). b. The basis of an appreciated asset received by gift is the same as in the hands of the donor. IRC §1015. 2. Reverse Gifts and Ricochet Gifts. This opportunity exists when a trusted member of your client’s family has or expects to have a shorter than normal life expectancy. This is a gift that keeps giving, or proof that it is better to give and then receive. a. Your client may transfer appreciated assets to that person before they pass away and get the “step up” when they inherit the asset back by bequest. This is a “reverse gift.” i. Risks 1. A risk in the reverse gift technique is that the donee will give the property to someone else or will lose the asset to a creditor claim. Be careful who you pick. 2. Another risk is that the asset will disqualify the donee for Medicaid or other government programs. ii. Using a Trust. The reverse gift technique may also work if the ultimate recipient is a trust of which the original owner of the property is a discretionary beneficiary along with others. The trustee must have total discretion over what, if anything, the original donor gets. This makes it actuarially difficult to determine what portion of the property went back to the original donor. b. If a person gives appreciated assets to a donor who passes away within a year and then the original owner (or spouse) gets them back, there is no stepup. IRC §1014(e).

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i. This “reverse gift” technique will still work if the recipient lives at least a year after the original gift. If the recipient does pass away within a year, the parties are no worse off. ii. The technique also works for “ricochet” gifts where the owner of property wants to give it to a third person, but first transfers it to a family member with a shorter life expectancy who bequests the property to the ultimate recipient. iii. This may also be a tax-free transfer because the ailing relative does not use all of his or her unified credit. c. Example. Widow’s son, Richard, has $50,000 of Google stock that he bought for $20,000. He gives the stock to widow using annual exclusions and unified credit. Widow passes away two years later when the stock is worth $200,000. She will bequeath the stock back to Richard. He sells the stock later for $220,000. Richard’s taxable capital gain is $20,000 not $200,000, or 10% of what it would have been but for the reversible gift. d. Texas Community Property Rules. i. What is Community vs. Separate Property. 1. Generally, in Texas, all wages of either spouse and property acquired with those wages are community property unless they agree otherwise. 2. The property that a spouse brings into the marriage or receives by gift is typically the spouse’s separate property unless the parties agree otherwise or commingle their assets so that tracing is not possible. ii. When the first spouse passes away, all separate property and half of the community property of the deceased passes to the deceased’s heirs by Will, trust or the intestacy rules. 1. The other half of the community property (previously owned by the surviving spouse) becomes the separate property of the surviving spouse. 2. When anyone passes away, the basis of the deceased’s property, including half of his or her community property, gets a step up (or step-down) in basis. IRC §1014(a).

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3. However, as an added bonus, the community property share of the surviving spouse also gets the “step-up.” IRC §1014(c). iii. A spouse with large amounts of appreciated separate property can retitle it as community property. At the other spouse’s death, the property will get a complete step-up. 1. Do not forget that if a person gives appreciated assets to a donee who passes away within a year and then the original owner (or spouse) gets them back, there is no step-up. IRC §1014(e). 2. A risk of retitling separate property is that the couple could divorce or the sicker spouse may choose to leave his or her assets to someone other than the healthier spouse. 3. Use of Powers of Appointment. This is another gift that you give and may receive or it may step up the basis of the gifted property if the ultimate beneficiary is someone other than your client’s spouse (because of the one year rule in §1014e) such as their children or grandchildren. See also II.H. and III.A.2.o above. I. Sale of Remainder Interest. This is another way to remove some future appreciation from your client’s estate and to freeze the value of the remainder interest for transfer tax purposes. If a parent sells a remainder interest in any property, including their home, then the parent owns only a life estate interest in that property. His or her children are to receive the property after the parent passes away. A remainder interest is an estate in property which takes effect in the future at the expiration of a life estate or a term of years. Such an interest may be sold while the parent is still living, if there are no restrictions on its transferability, or it may be transferred to a family limited partnership. The fair market value of such interests is determined by taking into consideration the value of the parent’s life estate which will depend on factors such as the parent’s age and state of health. J. Roth 401(k). Like the Roth IRA, the Roth 401(k) is funded with after-tax dollars and is not subject to taxation when there is a qualified withdrawal. Unlike the Roth IRA though, the Roth 401(k) (a) is available to everyone regardless of income instead of to just those individuals below the income threshold of $110,000 (or $160,000 for a married couple) and (b) has a 2006 contribution limit of $15,000 plus $5,000 for those over 50. Administration costs of the 401(k) may also be less than those of a Roth IRA and the contributions could still qualify for an employer match. (Note that funds that are employer-matched will have to be tracked separately because they are considered taxable income when withdrawn.) There are still total contribution caps for highly compensated employees and separate accounts will be required because pre-tax contributions cannot be commingled with post-tax contributions. Lower compensated employees may contribute to both their Roth IRA and their Roth 401(k) and since the Roth 401(k) distribution is not taxable income, it will lower taxable

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income in retirement and it may even help increase estate assets by leaving the heirs with an income tax-free inheritance. The contribution to the Roth 401(k) does not lower the employee’s taxable income when the contribution is made. Roth 401(k)s that are rolled over into a Roth IRA does not have the requirement for minimum distributions at age 70 but in order for earnings to come out tax-free, distributions must be made after the owner is 59 and occur five years after starting to participate. If clients want to use a Roth 401(k), they should consider the fact that it is subject to sunset provisions and unless extended they will expire after December 31, 2010. Presumably, if no extension is made, Roth 401(k) contributions may continue to be held but no contributions may be added to the account. K. Conversion to a Roth IRA. This depends upon many factors including your client’s expected income, their estimated life expectancy, and the projected size of their taxable estate. For some clients, this conversion has multiple advantages of reducing their taxes and/or the taxes of their heirs. First, it reduces their taxable estate by the amount of income tax paid at the time of conversion. Second, it reduces their total income tax that will be paid in the future but for the conversion. Third, Roth IRA funds are a better asset to leave to an heir or to fund a Credit Shelter Trust because there is no tax on future payments from the IRA. None of it maybe lost to pay income taxes. Fourth, it reduces their income taxes on future payments from the IRA. Some commentators have said that conversions may save certain clients up to $1.60 over time for each dollar of tax paid at the time of the conversion. The Tax Increase and Prevention Act (signed May 17, 2006) allows conversion in year 2010 regardless of the amount of your client’s income. This should create a win-win opportunity for most of your clients unless they are allergic to accelerating income tax even though that may save more income tax later and it may save estate tax later. Currently, there is a ceiling of $100,000 adjusted gross income for converting an IRA to a Roth. Roth IRAs are not deductible but their earnings are permanently tax-free and Roth IRAs have no minimum distribution at age 70½. A conversion is treated as a taxable distribution. Tax payers may recognize the conversion income in 2010 and average it over the next two years. While this provision does not extend to 401(k) plans, nothing prevents Roth IRA conversions that have received rolled over 401(k) balances when an employee terminates employment. Since 2010 is the last year for the current low income tax rates the amount converted to Roth IRAs may be very large if Congress does not extend the lower income tax rates. It may be a good idea to consider Roth conversion every year (even before 2010) for the amounts that your clients may be eligible to convert. L. Inheritance Trust or Conduit Trust Provisions in a Will or Living Trust. Inheritance Trusts, which are not to be confused with the Inheritor’s Trust, are stand alone trusts, one for each beneficiary, to extend the tax deferral for inherited IRAs, 401(k)s, and other retirement plans. They allow the payout to proceed more slowly based on the age of the beneficiary by using the conduit provision in the retirement plan Regs. This may also be accomplished by adding conduit provisions to the client’s Living Trust or Trusts in their Wills. Beneficiary designations to each specific (sub)trust in compliance with the Regs are also needed to fund the Inheritors Trusts or Conduit Trusts created in their Will or Living Trust. See PLR 200537044.

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M. Private Annuity (“PA”). Depending on their facts, this is a technique which may allow your client to use the IRS’s actuarial tables to save estate tax. 1. With private annuities, a seller sells assets to a buyer, (who is not in the business of selling annuities), usually a family member, in exchange for the buyer’s unsecured promise to make annuity payments to the seller on a regular basis for the remainder his or her life. The annuity payments’ value is not includible in the seller’s estate. 2. The annuity’s actuarial value is determined by IRS actuarial tables, Table 90CM. However, you may not use the tables if there is at least a 50% chance that the seller will pass away within a year because of a health issue. See Reg. §25.75203(b)(3). A doctor’s statement may be obtained to bolster the argument that the seller is expected to live a least one year but the IRS may dispute the diagnosis. If the seller lives at least 18 months following the sale to the buyer, it is presumed that the seller was likely to live a year and to prove otherwise, IRS must do so with clear and convincing evidence. 3. The Treasury and IRS proposed Regulations on October 17, 2006 under IRC Sections 72 and 1001 that will significantly impact Private Annuities and Private Annuity Trusts. In general, the proposed Regs would end the tax deferral of an exchange of property for most private or commercial annuity contracts issued after October 18, 2006. The seller of property for an annuity will immediately recognize gain if they realized the full fair market value of the annuity contract. Rev.Rul. 69-74 will be obsolete effective April 18, 2007 for exchanges described in Sections 1.10011(j)(2)(ii) and 1.72-6 (e)(2)(ii), and effective October 18, 2006 for all other exchanges of property for an annuity. It may be possible to retain the income tax benefits which existed before this proposed regulation was issued if the assets are sold to a grantor trust in exchange for the annuity. 4. Advantages of Private Annuities. a. The transaction affords the seller guaranteed income for the rest of his or her life. And the seller’s capital gains are spread out over the life expectancy as determined by the IRS actuarial tables. b. If designed to do so, there will not be any gift tax on the transaction and future appreciation of the assets sold to the buyer will be outside of the seller’s estate. c. If the seller passes away before the time determined by the IRS actuarial tables, then the assets are transferred to the buyer at a bargain price with no gift or estate tax. Because the obligation to make annuity payments ceases upon the annuitant’s death, the annuity has no value for estate tax purposes.

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d. The asset remains within the family circle, which, in the case of family businesses, can be very important. 5. Disadvantages of Private Annuities. a. Sufficient liquid assets are needed by the buyer to pay the annuity to the seller. If the buyer wastes the assets or does not invest them wisely, the seller may not receive the annuity. And, interest on the assets cannot be deducted by the buyer. b. The seller may outlive the annuity and receive more assets than originally bargained and if the seller waives an annuity payment, the waived payment may be deemed a gift. 6. This and four other techniques discussed below (PAT, PAPAV, SCIN and CLAT) each allow your clients to increase the amount of transfer tax which is saved when your clients realize that their or their parents’ life expectancy is less than others of the same age. It is a way to use the IRS Actuarial Tables to your client’s advantage. 7. Private Annuity Trust (“PAT”). a. An irrevocable trust instead of an individual may purchase assets to better protect the assets from creditors, spendthrift family members, and exspouses. To make the sale legitimate, the seller may have to include other assets in the trust. b. All formalities of the trust must be observed. The Trustee must be independent from the grantor and make all annuity payments and the grantor cannot dictate how the trust operates or manages its assets. Otherwise, IRS may attempt to challenge the transaction claiming it was a gift with a retained income interest, which would mean that the assets would be included in the seller’s estate. 8. Private Annuity Per Autre Vie “(PAPAV”). a. An annuity based on the duration of the life of someone other than the seller. Such person would typically be relatively young but may have some disability or illness that could shorten his or her life significantly. The person considered the “measuring life” must be likely to survive at least one year and it is important to have a doctor’s report. b. If the seller passes away first, the actuarial value of remaining payments will be included in the seller’s estate. If the measuring life passes

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away first, the payments stop and the buyer keeps the assets but the assets are not included in the seller’s estate. N. Self-Canceling Installment Note (“SCIN”). 1. A seller transfers assets to a buyer, who is usually a family member, in exchange for a promissory note. If the note is not fully repaid before the seller passes away, it terminates and no additional payments are owed to the seller or his or her estate. The note must be similar to those used in commercial transaction and the interest rate must be the applicable federal rate (AFR) or greater. 2. A premium, which may be a higher interest rate or a higher purchase price, is paid by the buyer to reflect the actuarial likelihood that the seller will pass away before the buyer repays the note. A good appraisal is strongly recommended. The risk premium is determined by using the term/life annuity factor from Table 90CM in order to take into account the likelihood of the seller dying before the SCIN term ends. However, the term of the SCIN must be less than the seller’s life expectancy. If it is not, the transaction will be treated as a private annuity rather than an installment sale for income tax purposes. See GCM 39503 (June 28, 1985). 3. Advantages. a. If structured to do so, there will not be any gift tax on the transaction. Future appreciation of the assets sold to the buyer will be outside of the seller’s estate. And, if the seller passes away before the time determined by the IRS actuarial tables, then the buyer gets the assets at a bargain. b. Capital gains are spread out over the life expectancy as determined by the IRS actuarial tables unless a grantor trust (IDGT) buys the assets. And, the asset remains within the family, which, in the case of family businesses, can be very important. c. You can combine a SCIN with an installment sale to an IDGT or a regular installment sale. 4. Disadvantages. a. Sufficient liquid assets are needed to pay the seller. If the buyer wastes the assets or does not invest them wisely, the seller may not get paid. The seller may live longer than estimated, which is good, but when he or she receives more assets than originally bargained that will inflate, not reduce, the taxable estate. b. If the buyer’s assets are so few to cause the IRS to claim it is unlikely the note will be repaid, the transaction may be re-characterized as a gift.

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O. Charitable Remainder Trusts (“CRT”) including CRATS, CRUTS, and NIMCRUTs. Clients who have a desire to make a charitable contribution (and depending upon their facts) may use a CRT to save capital gains, other income taxes and estate taxes and provide some permissible asset protection for themselves and/or their beneficiaries. They may also generate some tax deferral and compounding. Clients and their loved ones may receive distributions from the CRT at least annually, for life, or for a term of years. Using a CRT may also extend the income tax deferral on IRAs, 401(k)s, and other tax qualified retirement plans contributed to the CRT. A minimum ultimate irrevocable remainder contribution to charity must be made equal to ten percent of the net fair market value of the contribution to the CRT. CRTs are governed by Section 664 IRC. An Irrevocable Life Insurance Trust (“ILIT”) may also be established to replace for the family the amount given to charity. The life insurance would be estate and income tax free and it may be financed by the taxes saved due to the charitable deduction for establishing the CRT. This combination will normally generate a win-win situation for the parents, their loved ones, and the charity, who as a group will receive more (after taxes) than they would have received but for the parents using a CRT. P. GRATs. These work well if the asset(s) transferred have sufficient income or liquidity and appreciation. They will work better if you use cascading GRATs to prevent investments which decrease in value from reducing the tax benefit of those assets which increase in value. 1. A GRAT may be used to transfer substantial assets (such as publicly traded securities and many other assets) at a very low effective-gift-tax-rate or with minimal use of unified credit. Following the decision in Walton (115 T.C. 589) a GRAT may be used to transfer from the donor substantial assets at zero gift tax cost and without using any applicable exclusion amount. Property will pass tax-free to the remainder beneficiaries whenever the total return on the trust assets exceeds the applicable IRC §7520 rate. The amount of the tax-free transfer is the future value of the assets transferred to the GRAT minus the future value of the assets transferred back to the grantor. 2. Operation of the GRAT (IRC §§2701 & 2702). A GRAT is a split interest trust in which a grantor retains the annuity interest while transferring the remainder interest to non-charitable beneficiaries such as children or a trust for children. The amount of the taxable gift is the value of the property transferred to the trust minus the present value of the retained annuity interest. Thus, by setting the present value of the annuity stream equal to the full value of the property transferred to the GRAT, the amount of the taxable gift is reduced to zero and the GRAT is said to be “zeroedout.” 3. Structuring the GRAT. There is substantial flexibility in designing a GRAT. The Grantor is allowed to choose: (a) the length of the GRAT; (b) the cash flow retained by the grantor (the annuity rate); and (c) the GRAT beneficiaries. 4. Payment of the Annuity. a. The GRAT provisions must state that the grantor be paid an annuity at least annually (IRC §2702(a)(1). The annuity amount should be either: i. A stated dollar amount (Treas. Reg. §25.2702-3(b)(1)(ii)(A), or #154254

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ii. An amount determined as a specified percentage of the initial value of the property transferred to the GRAT. (Treas. Reg. §25.27023(b)(1)(iii)(B)). b. Alternatives for the GRAT to meet its obligation to pay the annuity include distributions of: i. Trust earnings – Generally the most desirable distribution method. None of the initial principal is depleted and the underlying property should continue to grow at the projected growth rate. ii. In-kind distributions – Distribute GRAT property to the individual with no gain recognized by the grantor (See Rev. Rul. 85-13 (1985-1 CB 184). (Also see Rothstein v. U.S. 735 F2d 704 (2d Cir. 1984) in which the court held that there was a taxable transaction when assets were distributed from a grantor trust back to the grantor.) Although the distribution of earnings is more desirable, the distribution of stock continues to freeze growth at the IRC §7520 rate for the property remaining within the GRAT. If the property in the GRAT is paid out in-kind, the grantor could “ReGRAT’ the in-kind distribution, which can be a powerful tax savings opportunity. 5. The GRAT will terminate if a. Both spouses outlive the GRAT term b. Both spouses die during the GRAT term c. One spouse died during the GRAT term 6. Basic Advantage of GRATs a. Any property remaining in the trust at the end of the GRAT term will pass to the remainder beneficiaries with no further tax consequences. If the total return the trust assets actually produce is equal to or less than the rate assumed by the IRS (IRC §7520 rate) there will be nothing left in the trust to pass to the children at the end of the GRAT term. If the actual total return substantially exceeds the IRC §7520 rate, a very large amount of property will be in the trust to pass tax-free to the children. The following chart illustrates the amount remaining in a ten-year GRAT that passes tax-free to children when the IRC §7520 rate is 4% and the growth rate is 8%.

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Beginning Growth at Balance 8% 1 $1,000,000 $80,000 2 $956,271 $76,538 3 $909,980 $72,798 4 $859,499 $68,760 5 $804,980 $64,398 6 $746,099 $59,688 7 $682,508 $54,601 8 $613,830 $49,106 9 $539,657 $43,173 10 $459,551 $36,764 The tax-free wealth transferred to the GRAT

Payment ($123,279) ($123,279) ($123,279) ($123,279) ($123,279) ($123,279) ($123,279) ($123,279) ($123,279) ($123,279)

Transfer Balance $956,721 $909,980 $859,499 $804,980 $746,099 $682,508 $613,830 $539,657 $459,551 $373,036 $ 337,036

i. There are very few disadvantages with a zeroed-out GRAT. Little is lost even if the assets do not produce a total return in excess of the IRC §7520 rate. The trust will simply burn out early and the assets end up back in the grantor’s hands. There has been no payment of gift tax or use of unified credit and the only thing lost is the cost to establish the GRAT. ii. The GRAT will be an income tax defective grantor trust (IRC §§671-679) which means that the grantor of the trust will pay income tax on 100% of the trust’s income. If the grantor pays the income tax instead of the trust, there is more in the GRAT at the end of the GRAT term to pass to the children. In effect, there is an additional gift taxfree transfer to the children. The following chart illustrates the advantage of paying income taxes with non-GRAT assets. Impact of Income Taxes Beginning Balance

Taxable Income Tax Income at 35% at 8% 1 $1,000,000 $80,000 ($28,000) 2 $1,052,000 $84,160 ($29,456) 3 $1,106,704 $88,536 ($30,988) 4 $1,164,253 $93,140 ($32,599) 5 $1,224,794 $97,983 ($34,294) 6 $1,288,483 $103,079 ($36,078) 7 $1,355,484 $108,439 ($37,954) 8 $1,425,969 $114,078 ($39,927) 9 $1,500,120 $120,010 ($42,003) 10 $1,578,126 $126,250 ($44,188) ADDITIONAL WEALTH TRANSFERRED

Ending Balance

Beginning Balance

$1,052,000 $1,106,704 $1,164,253 $1,224,794 $1,288,483 $1,355,484 $1,425,969 $1,500,120 $1,578,126 $1,660,188

$1,000,000 $1,080,000 $1,166,400 $1,259,712 $1,360,489 $1,469,328 $1,586,874 $1,713,824 $1,850,930 $1,999,005

Taxable Income at 8% $80,000 $86,400 $93,312 $100,777 $108,839 $117,546 $126,950 $137,106 $148,074 $159,920

Income Tax at 35% -

Transfer Balance $1,080,000 $1,166,400 $1,259,712 $1,360,489 $1,469,328 $1,586,874 $1,713,824 $1,850,930 $1,999,005 $2,158,925 $ 498,737

NOTE: Because the grantor paid the taxes on the GRAT income an additional $498,737 passed to the trust’s beneficiaries. b. Disadvantages of GRATS i. If the grantor dies during the term of the GRAT, the entire interest may be brought back into the estate. The IRS has argued that #154254

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either Section §2036 or Section §2039 requires inclusion of the full value of the GRAT assets as of the date of death. IRC §2036 requires inclusion of only the amount needed to continue the GRAT payments in perpetuity. If this is the actual position taken, it appears this would generally result in a lesser amount being reported as part of the grantor’s taxable estate. 1. One could argue that even this latter rate is too high. Some commentators have argued that the amount includable should be only the amount needed to make the remaining payments, assuming a total return on the trust assets equal to the IRC §7520 rate. 2. Death during the GRAT term can be problematic from several perspectives: a. The appreciation will be included in the estate if the property has appreciated greatly,. b. The stock returning to the estate may represent control being shifted back to the estate which can be very problematic in that the estate would have to value the stock as a controlling interest. To avoid this issue, one could recapitalize most corporations, transfer voting stock into short-term GRATs (two, three or four year GRATs), and transfer non-voting stock into a longer-term GRAT. ii. Generation skipping issues. A GRAT is probably not the best means to transfer a property interest to one’s grandchildren. GST exemption cannot be allocated to a GRAT until the end of the GRAT term which does not give one the advantage of reducing the retained life estate from the valuation calculation. c. Using Separate GRATs for Different Assets. i. Since assets that are performing well can be adversely affected by those assets that are not, it is recommended that separate GRATs be created for each type of transferred asset. ii. Assume that Rudolph Giuliani owns $100,000 of A, B, and C stock each. The annual rates of return for A, B and C are 12%, 8% and -2%, respectively. Assuming a 4% IRC §7520 rate and a ten-year term, the advantage of contributing each stock to multiple individual GRATs can be illustrated as follows:

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Year 1 2 3 4 5 6 7 8 9 10

Single GRAT $281,013 $260,887 $239,553 $216,939 $192,969 $167,560 $140,626 $112,077 $81,814 $49,736

Multiple GRATs $281,013 $261,927 $242,703 $223,301 $203,677 $165,573 $158,054 $149,907 $141,080 $131,514

d. Combining GRATs and Discounts i. Closely-held businesses ii. Assume that Mitt Romney, age 50, transfers the non-voting stock of his company into a ten-year GRAT. Prior to valuation adjustments the value of the non-voting stock is $1,000,000. Because non-voting stock has a lack of marketability and control associated with it, the non-voting stock is only $700,000. Assuming a growth rate of 8% and IRC §7520 rate of 4%, the economic advantage associated with valuation adjustments is as follows: Assumptions Value of Assets Transferred to GRAT

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With Adjustments $700,000

Without Adjustments $1,000,000

Term of GRAT

10 years

10 years

GRAT Annuity Payment (Annually)

$86,304

$123,291

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Impact of Valuation Adjustments Beginning Balance

Taxable GRAT Income Payment at 8% 1 $1,000,000 $80,000 ($123,291) 2 $956,709 $76,537 ($123,291) 3 $909,955 $72,796 ($123,291) 4 $859,460 $68,757 ($123,291) 5 $804,926 $64,394 ($123,291) 6 $746,029 $59,682 ($123,291) 7 $682,420 $54,594 ($123,291) 8 $613,723 $49,098 ($123,291) 9 $539,530 $43,162 ($123,291) 10 $459,401 $36,752 ($123,291) ADDITIONAL WEALTH TRANSFERRED

Ending Balance

Beginning Balance

$956,709 $909,955 $859,460 $804,926 $746,029 $682,420 $613,723 $539,530 $459,401 $372,862

$1,000,000 $993,696 $986,888 $979,535 $971,593 $963,017 $953,754 $943,751 $932,947 $921,278

Taxable Income at 8% $80,000 $79,496 $78,951 $78,363 $77,727 $77,401 $76,300 $75,500 $74,636 $73,702

GRAT Payment

Transfer Balance

($86,304) ($86,304) ($86,304) ($86,304) ($86,304) ($86,304) ($86,304) ($86,304) ($86,304) ($86,304)

$993,696 $986,888 $979,535 $971,593 $963,017 $953,754 $943,751 $932,947 $921,278 $908,677 $ 535,814

iii. Significant income earned by the GRAT may be problematic to the grantor if the cash flow from the GRAT is less than the tax liability generated by the GRAT. In such a case, the grantor may owe more tax than the income he or she received from the GRAT. But if the Donor’s goal is to transfer wealth to the next generation and the Donor has the liquidity to pay the taxes then paying those income taxes without paying any gift taxes on those income taxes is beneficial. e. Other Strategies to Enhance Wealth Transfer i. Deferring the annuity payment. A trust may elect to treat a current tax year distribution as having been made in the prior tax year if the distribution is made within 105 days after the close of the tax year (Treas. Reg. §25.2702-3(b)(4). ii. Limiting the frequency of the annuity payment. 1. Normally, the best strategy is to make as few payments from a GRAT as possible. By doing so, more wealth is transferred from the GRAT to the remainder beneficiaries because more appreciation is left in the GRAT and less appreciation left in the hands of the grantor. However, a GRAT cannot make payments to the grantor less frequently than annually under IRC §2702(b),. 2. Using a fiscal year for GRAT rather than the calendar year. The Service held in PLR 9519029 that a calendar tax year-end GRAT could pay the annuity on the anniversary date of the trust. 3. Increasing annuity payments. a. The annuity payment can be increased by up to 20% over that of the previous year under Treas. Reg. §25.2702-3(b)(1) (ii)(B). #154254

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b. Assume that John Edwards transferred $1,000,000 to a ten-year GRAT in 2004. When the trust was funded, John’s attorney drafted a provision in the trust document requiring the GRAT to increase its annual payments to John by 20% over the prior year. Assuming a growth rate of 8% and an IRC §7520 rate of 4%, the wealth transfer benefit derived from the increasing annual GRAT payments is shown as follows: Impact of Increasing Annuity Payments Beginning Balance

Taxable GRAT Income Payment at 8% 1 $1,000,000 $80,000 ($123,291) 2 $956,709 $76,537 ($123,291) 3 $909,955 $72,796 ($123,291) 4 $859,460 $68,757 ($123,291) 5 $804,926 $64,394 ($123,291) 6 $746,029 $59,682 ($123,291) 7 $682,420 $54,594 ($123,291) 8 $613,723 $49,098 ($123,291) 9 $539,530 $43,162 ($123,291) 10 $459,401 $36,752 ($123,291) ADDITIONAL WEALTH TRANSFERRED

Ending Balance

Beginning Balance

$956,709 $909,955 $859,460 $804,926 $746,029 $682,420 $613,723 $539,530 $459,401 $372,862

$1,000,000 $1,029,732 $1,051,789 $1,063,546 $1,061,767 $1,042,472 $1,000,787 $930,751 $825,092 $674,956

Taxable Income at 8% $80,000 $82,739 $84,143 $85,084 $84,941 $83,398 $80,063 $74,460 $66,007 $53,996

GRAT Payment

Transfer Balance

($50,268) ($60,322) ($72,386) ($86,863) ($104,236) ($125,083) ($150,099) ($180,119) ($216,143) ($259,372)

$1,029,732 $1,051,789 $1,063,546 $1,061,767 $1,042,472 $1,000,787 $930,751 $825,092 $674,956 $469,580 $ 96,718

4. Buying assets back from the GRAT. GRATs are generally funded with rapidly-appreciating assets. As a result, the underlying assets in the GRAT will normally have a fairly low basis (IRC §1015) which means that the remainder beneficiaries will have a low basis in the assets from the GRAT because the assets contributed to a GRAT have a carryover basis from the grantor. However, the grantor can repurchase the highlyappreciated assets from the GRAT before the end of the term so that the grantor substitutes cash (or some other high basis assets) for the low basis assets initially contributed to the GRAT. The grantor then holds the highly-appreciated assets until death, when the basis of the assets is increased to the date of death value. Q. Tax Planned Wills and Living Trusts. 1. Simple Will or Living Trust with a GST Option. Married clients with estates that will likely not exceed $2,000,000 do not have a compelling need to have tax planned Wills or Revocable Trust prepared for them. However, if they have a child, creating generation skipping trusts for their child and grandchildren should be considered. The married couple’s property could be left outright to the surviving spouse at the first spouse’s death, but at the death of the surviving spouse the Will or Trust would create generation skipping trusts for the children. 2. Will or Trust with Bypass Trust only. This type of plan is most often used when the spouses’ combined estate is likely to exceed $2,000,000 but not $4,000,000. It places up to $2,000,000 (or an amount which is equal to your client’s Applicable #154254

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Exclusion) into a trust (the “Bypass Trust” or “Family Trust”) which is designed to avoid estate taxes upon the death of the survivor of the two spouses. The Bypass Trust can be designed to make distributions after the surviving spouse’s death to the spouses’ children and grandchildren. And you may elect that the Bypass and Credit Shelter amount for each spouse be exempt for GST purposes. 3. Will or Living Trust with Disclaimer Trust. Like a Bypass Trust, a Disclaimer Trust is designed to exclude assets from the surviving spouse’s estate and may be drafted into a Will or Revocable Trust in place of a Bypass Trust. It typically provides that all of the decedent’s estate will pass to the surviving spouse, but any property the surviving spouse disclaims will pass to a Disclaimer Trust. Because the decision to fund the Disclaimer Trust may be made up to nine months after the death of the first spouse to pass away, its “wait and see” approach is making it a popular planning tool. 4. Will or Living Trust with Bypass and Marital Trusts. Often referred to as an “A/B Will” or an “A/B Revocable Trust,” this type of Will or Revocable Trust is most often used when the spouses’ combined estate will likely exceed $2,000,000. The plan is that up to $2,000,000 (or an amount which is equal to your client’s Applicable Exclusion) is placed into a Bypass Trust which is designed to avoid estate taxes upon the death of the surviving spouse, and the balance of the estate is placed into a Qualified Terminable Interest Property (“QTIP”) Marital Trust. And you may elect that the Bypass and Credit Shelter amount be exempt for GST purposes and even elect a portion of the QTIP be exempt to the extent that the GST exemption of the decedent has not been used. 5. Will or Living Trust with Bypass, Marital, and Separate Descendants’ Trusts. Like the A/B Will or Trust, a Will or Trust which uses a Bypass, Marital, and Descendants’ Trust may be used when the spouses’ combined estate will likely exceed $2,000,000. It is designed to place up to $2,000,000 (or an amount equal to the client’s Applicable Exclusion) into a Bypass Trust (which is designed to avoid estate taxes upon the death of the surviving spouse) and the balance of the estate is placed into a Qualified Terminable Interest Property (“QTIP”) Marital Trust. After the death of the surviving spouse the Marital and Bypass Trusts would terminate and the Trustee would distribute all remaining trust assets to separate trusts for each of the children (and subsequently, to additional trusts for other descendants). And you may elect that the Bypass or Credit Shelter amount be exempt for GST purposes. The trust language typically states that each child will be the primary beneficiary of his or her trust, and income and principal of each such trust will be distributable for that child’s health, education, maintenance and support. The client may specify that each beneficiary may act as the sole or a cotrustee of his or her trust when they reach certain ages and each trust may continue for as long as the client wants. 6. Will or Living Trust with Bypass, GST Exempt and Nonexempt Marital, and GST Exempt and Nonexempt Descendants’ Trusts. When a client has a larger estate the Will or Living Trust is sometimes drafted so that the Marital Trust is automatically divided into two Marital Trusts, one which is exempt from the generation skipping transfer tax, and the other which is not. With such a plan for individual who passes away in 2006 and who has not utilized any portion of his estate #154254

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tax exemption or GST exemption, the Bypass or Credit Shelter Trust will receive $2,000,000, the Exempt Marital Trust will receive nothing (or the remainder of your client’s remaining GST exemption, which is currently $2,000,000, after part of it is allocated to the Bypass Trust), and the Nonexempt Marital Trust will receive the balance of the estate. However, because of the impact of the gift, estate and generation skipping taxes, the amounts in each of the three trusts described above will vary and it is possible that fewer subtrusts would be needed. After the death of the surviving spouse the Trustee would typically distribute all remaining trust assets to two trusts for each child or grandchild, one which is exempt from the generation skipping transfer tax, and the other of which is not. 7. Lifetime Trusts (GST). A Will or Trust may include long-term trusts for each of the children (and subsequently, additional trusts for other descendants) when an individual client has an estate which exceeds several hundred thousand dollars. The trusts would typically be drafted so that each child (or grandchild) is the primary beneficiary of his or her trust, and income and principal of each such trust will be distributable for that child’s health, education, maintenance, and support. If the child passes away before the entire trust property is distributed, the child’s descendants become the beneficiaries of such trust. Such individual trusts may continue for as long as the client wants. Beginning in 2006, the GST exemption is $2,000,000 but it is scheduled to increase to $3,500,000 in 2009. Even though those who make large gifts while alive will be limited by the $1,000,000 gift tax exemption, those who make transfers at death will be able to place a large dollar amounts into GST exempt trusts which are designed to last for many years (or even indefinitely if the trust is established in a state which has abolished the Rule Against Perpetuities). It now appears to be unlikely that estate taxes will be permanently repealed so establishing a dynasty trust which will escape further estate taxation for generations will be quite appealing to many clients. R. Charitable Lead Annuity Trust (“CLAT”). 1. For most CLATs, your client would transfer assets to an irrevocable trust in exchange for an annuity to be paid to a charity over the span of their lifetime. 2. Unless your client retains too much control over the trust there will not normally be any estate tax issue. But, there is a taxable gift to the extent that the value of the assets exceeds the actuarial value of the annuity payments to the charity. If the annuity payment is high enough, the taxable gift amount can be zero. 3. The value of the annuity payments is calculated under the IRS actuarial tables based on the grantor’s age. The rules are similar to those for a private annuity. The measuring life for the annuity may be someone other than the grantor if he or she is not related. 4. Advantages. a. The family may receive a significant portion of the value of the assets without paying estate or gift tax, if the grantor passes away soon (but not too #154254

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soon) after the gift. Future appreciation of the assets sold to the trust will be outside of the grantor’s estate. b. The grantor’s favorite charity, which may be the grantor’s private family foundation or donor advised fund and controlled by the family, will receive all of the value to the extent the grantor’s family does not. 5. Disadvantages. a. The charity may end up getting almost everything depending upon how long the grantor lives. Any taxable gift amount will not qualify for the annual exclusion. b. A CLAT is (i) not a tax-exempt entity (unlike a CRT) so it must pay income taxes, however, it does get to deduct the payments to the charity, and (ii) subject to the private foundation rules so there can be no excess business holdings, self-dealing, or jeopardy investments. S. Additional Charitable Opportunities. 1. Donor Advised Funds. These are easiest to establish and maintain. 2. Private Foundations. These allow your clients to retain control. 3. Public Foundations. These are the most complex and costly to establish and maintain. T. Leveraged Credit Shelter Trust. 1. This is a standard bypass trust for the surviving spouse for income tax purposes. 2. The advantages are: a. Assets in the bypass trust could compound income tax-free (if the surviving spouse has sufficient assets to pay the income taxes on the bypass trust’s income). b. The surviving spouse can enter into income tax-free transactions with the bypass trust. For example, the surviving spouse could swap cash for appreciated assets before his or her death so that the appreciated assets would be in the surviving spouse’s estate and get a stepped up basis. c. The bypass trust can be created using the deceased spouse’s estate tax and GST exemptions (or using the surviving spouse’s GST exemption). d. Distributions could be made to other family members after the first spouse’s death without gift tax consequences. The surviving spouse could also have a broad limited testamentary power of appointment over the trust. #154254

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3. Method. Assume that husband is expected to predecease wife. Wife should create an inter vivos QTIP trust for husband. Alternatively (and more aggressively), the trust could be a revocable inter vivos QTIP trust in which the power to revoke the trust lapses when husband dies. At the husband’s death, the assets pass to a bypass trust for wife that allows the trustee to make discretionary distributions for wife’s and other family members’ health, education support and maintenance and if assets in the trust exceed husband’s remaining estate tax exemption, the excess, which is determined under a formula, would pass to a QTIP trust for wife or back to wife outright. 4. Tax Effects. a. Wife makes a completed gift when the trust is created. Wife will file a Form 709 for that year and make the QTIP election for the trust so the gift qualifies for the gift tax marital deduction. Note that this approach cannot be used for a gift to a non-citizen spouse since there is no lifetime QTIP (or QDOT) available for gifts to a non-citizen spouse. b. If the more aggressive revocable inter vivos QTIP approach is used, the gift is not complete when the trust is created because of the wife’s revocation power. The gift from the wife to husband is completed when the revocation power lapses at husband’s death. (Support: PLRs 200604028, 200403094, 200210051, 200101021; cf. Estate of Sarah Greve v. Commissioner, T.C. Memo. 2004-91 (decedent could withdraw assets from trust only with consent of adverse party, which meant it was not a general power of appointment, but requirement to get consent of adverse party terminated at the decedent’s death; held that the general power of appointment came into being at the moment of death and the property was includible in the decedent’s gross estate). c. The completed gift to the QTIP trust for husband should qualify for the gift tax marital deduction if the QTIP election is made for the year of the gift to the trust. (If wife is given a power of appointment over the bypass trust, a question could be raised as to whether the gift tax marital deduction is available. A literal reading of §2523(b)(2) might suggest that giving a spouse a power of appointment, even a testamentary power, might raise a marital deduction risk. However, commentators have said that a literal interpretation of the wording of §2523(b)(2) does not make sense, e.g., Pennell, Estate Tax Marital Deduction, BNA Tax Mgt. Portfolio 843, n. 542. Legislative history for the 1981 Act that enacted the QTIP provision suggests that powers of appointment that only become exercisable after the death of the original donee spouse are permissible.) d. The trust assets are included in husband’s estate under §2044. e. The trust agreement provides that assets up to husband’s remaining estate tax exemption amount pass to a bypass trust for wife and assets over that amount pass to a QTIP trust for wife or to wife outright. There is therefore no estate tax in husband’s estate on assets passing to the bypass trust. #154254

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f. Husband can allocate his GST exemption to the bypass trust (i.e., wife would not make the ‘reverse QTIP” election). The bypass trust can therefore be GST exempt using husband’s GST exemption. In the alternative, wife could make the reverse QTIP election and allocate her GST exemption to the inter vivos QTIP when it is created, so that future appreciation after that time would be GST exempt and husband could then allocate his GST exemption available at his death to a QTIP trust that he would create for wife (he would make the reverse QTIP election as to the QTIP trust that he creates at his death). g. If distributions are made from the bypass trust to anyone other than the surviving spouse, husband should not be making a gift (especially if the distributions are by ascertainable standards). See Treas. Reg. §25.25111(g)(2). h. Trust assets are not includible in wife’s estate at wife’s subsequent death under §2036 or 2038 despite her retained beneficial interest or powers because of Treas. Reg. §25.2523(f)-1(f) Ex. 11 (“because S is treated as the transferor of the property, the property is not subject to inclusion in D’s gross estate under section 2036 or section 2038”) [Mitchell Gans says “Example 11 is the biggest inadvertent giveaway the IRS has ever done.”] i. Treas. Reg. §25.2523(f)-1(f) Ex. 11 does not address the risk of inclusion under §2041. To prevent the possibility of IRS arguing that wife’s creditors might be able to reach the trust assets (because she contributed her assets to fund what eventually passed to the trust), and that wife’s ability to allow trust assets to be used to satisfy her creditors might be a §2041 general power of appointment, include in the trust agreement that distributions may only be made to wife or her creditors for health, education, support and maintenance to get the HEMS exception under §2041. [However, the entire trust might still be reachable by wife’s creditors under some states’ laws despite the existence of the standard, thus raising the possibility of a §2041 risk. Reportedly, this situation exists in very few states and possibly only in Massachusetts. The general rule is that the grantor’s creditors can reach only the trust assets that the trustee could distribute to the grantor under a maximum exercise of discretion. See Restatement (Third) of Trusts, §60, Comment f.] j. Section 2033 may also apply because of wife’s potential ability to subject the trust assets to her creditors. However, wife’s ability to add more creditors with rights to the trust assets ends at her death. If the right lapses at death, §2033 should not apply. Lapsing at death does not avoid the §2041 hook, but it does avoid the §2033 hook. k. Assets in the bypass trust are treated as a grantor trust as to wife. This is because there is a disconnect in the way the regulations treat as the transferor of the trust that is created as passing under a QTIP trust for estate vs. income tax purposes. While the first decedent spouse is treated as the transferor for estate tax purposes (as to §§2036 and 2038), the original donor #154254

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spouse continues to be treated as the grantor for purposes of the grantor trust rules. Treas. Reg. §671-2(e)(5) provides: “If a trust makes a gratuitous transfer of property to another trust, the grantor of the transferor trust generally will be treated as the grantor of the transferee trust. However, if a person with a general power of appointment over the transferor trust exercises that power in favor of another trust, then such person will be treated as the grantor of the transferee trust, even if the grantor of the transferor trust is treated as the owner of the transferor trust under subpart E of part I, subchapter J, chapter 1 of the Internal Revenue Code [i.e., the grantor trust rules].” l. Wife does not make a taxable gift when she pays the income taxes of the bypass trust. Rev. Rul 2004-64. 5. Reciprocal Trusts. Because no one knows which spouse will die first, should each spouse create a revocable QTIP trust for the other spouse? There should not be a “reciprocal trust” doctrine problem under the Grace case, but that risk could be avoided by drafting differences in the trust terms. Estate of Levy v. Comm’r, 46 T.C.M. 910 (1983) (one trust gave broad inter vivos special power of appointment and other trust did not; trusts were not substantially identical and reciprocal trust doctrine did not apply); Letter Ruling 200426008 (citation to and apparent acceptance of Estate of Levy). Another approach would be that husband and wife could create their own trusts at different times (i.e., more than one year apart). 6. Caveat. It may not be possible to “toggle off” the grantor trust treatment, and the surviving spouse could potentially be stuck with paying income taxes on an ever growing, huge trust. (There may be potential gift implications if wife subsequently relinquishes her right to receive discretionary distributions from the bypass trust.) V.

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Exhibit 1

MEDICAID - TEXAS 2006

2007* Spousal Monthly Maintenance Needs Allowance:

$2,488.50

$2,541 Minimum Community Spouse Resource Allowance:

$19,908

$20,328 Maximum Community Spouse Resource Allowance:

$99,540

$101,640

Monthly Personal Needs Allowance: $60

$60 Resource Allowance for an Individual:

$2,000

$2,000 Divestment Penalty Divisor: $3,549** $117.08 daily

$3,549 after 9/1 $117.08 daily Income Cap Amount Per Person: $1,809

$1,869 Resource Allowance for a Couple (both husband and wife in a nursing home):

$3,000

$3,000

* to the extent that 2007 numbers have been disclosed; ** will probably increase later

revised as of December 11, 2007

LEONARD WEINER, J.D., C.P.A., M.B.A. Certified in Tax Law, and in Estate Planning & Probate Law, by Texas Board of Legal Specialization Certified in Elder Law by the National Elder Law Foundation Direct Dial (713) 624-4296 [email protected]

5599 San Felipe, Suite 900 Houston, Texas 77056 Telephone (713) 624-4294 / (713) 961-5222 Fax (713) 624-4295 National (800) 458-2331 #154254

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Exhibit 2 Estate Planning Glossary* Annual Exclusion Gifts – refers to the $12,000 you can give gift tax-free to as many people as you want, every year. The gift does not reduce your $1 million lifetime gift tax exclusion, and can be $24,000 per year if your spouse agrees (a “split gift”). Annuity – a fixed amount that is typically payable to you for a period of years, your lifetime, or a combination of the two. While an annuity offers you the certainty of a steady payment, it is not considered a hedge against inflation. Applicable Credit Amount – formerly referred to as the “unified credit.” This credit applies against Federal estate tax, and in 2007 and 2008, it shelters property worth $2 million; in 2009, it will shelter property worth $3.5 million. In 2010, the estate tax disappears for the year, and by 2011, it reappears. At that time, the applicable credit amount will drop to its pre-2001 Tax Act level of $345,800, and will only shelter property worth $1 million. Applicable Exclusion Amount – the amount of property you can shelter from estate tax because of the Applicable Credit Amount (see above). Ascertainable Standard – this refers to a clearly discernable standard by which a trustee is allowed to pay out income or principal to a trust beneficiary. A typical ascertainable standard permits distributions for a beneficiary’s “health, education, maintenance and support.” Such standards are particularly important when a trustee has a “beneficial interest” in the trust – i.e., is eligible for principal or income distributions – and will help ensure that the trust property won’t be taxable in the trustee/beneficiary’s estate. Charitable Deduction – the deduction against income, estate and gift taxes for gifts to charity. There are limitations on the charitable income tax deduction, but no limitations on the charitable estate or gift tax deduction. Charitable Gift Annuity – an annuity that you receive from a charity in exchange for a gift to that charity (the annuity also can be payable to someone of your choosing). If you contribute cash for the annuity, your annuity payments are treated as part ordinary income and part return of your investment; if you contribute appreciated property, your gift is treated as a “bargain sale,” so that your annuity payments are treated as part ordinary income, part long-term capital gain (assuming you owned the asset for more than a year) and part return of your investment. If you outlive your life expectancy and are still receiving payments, they will be treated as ordinary income. When you make your charitable contribution, the present value of charity’s remainder interest is eligible for a charitable income tax deduction. Typically, the rates a charity will pay are lower than commercial rates, and are generally based on recommendations from the American Council on Charitable Gift Annuities. A charitable gift annuity can be a good way to benefit charity and retain an income stream. ______________________ *This glossary was prepared by Blanche Lark Christerson from the Private Wealth Management Division of Deutsche Bank. It is reprinted here with their permission.

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Charitable Lead Trust (CLT) – a “split-interest” trust that is the inverse of a charitable remainder trust (see below). With a CLT, charity gets the “up-front” income interest, generally for a period of years, and your heirs get the remainder interest, or what’s left over after the income interest ends. You generally don’t get an income tax deduction for the charitable interest, although you do get a gift or estate tax deduction for it (that deduction offsets the gift of the remainder interest). As with the CRT, the income interest must be either an annuity (a fixed amount that remains the same regardless of the trust’s value) or a unitrust interest (a variable amount that goes up or down depending on the trust’s value). Unlike the CRT, there is no minimum required percentage for the annuity or unitrust payout. A CLAT is a charitable lead annuity trust and a CLUT is a charitable lead unitrust. Charitable Remainder Trust (CRT) – a “split-interest” trust that is the inverse of a charitable lead trust (see above). With a CRT, the “up-front” income interest goes to an individual for a period of years (no more than 20) or life, and the “remainder interest” (what’s left over after the income interest ends) goes to charity. The income interest is a taxable gift if it is payable to someone other than you or your spouse. The charitable remainder interest is not subject to estate or gift tax, and is eligible for a charitable income tax deduction (subject to limitations) if you set up the trust during your life. Lifetime CRTs can be an effective way to diversify lowbasis assets while deferring capital gains tax. Because the trust is tax-exempt, it sells the assets tax-free and has 100% of the proceeds available to generate income for you. Although you are taxable on the trust’s payout, it likely will be subject to favorable capital gains tax rates if the trust is invested for growth. The payout must be either an annuity (a fixed amount that remains the same regardless of the trust’s value) or a unitrust interest (a variable amount that goes up or down depending on the trust’s value). With a CRAT (an annuity trust), the payout must equal at least 5% of the trust’s initial value, but no more than 50% of that value; with a CRUT (a unitrust), the payout must equal at least 5% of the trust’s annual value, but no more than 50% of that value. The present value of the charitable remainder must equal at least 10% of the trust’s initial value. There are several variations on a CRUT, including a “FLIP-CRUT.” With this, the trust initially pays the lesser of its income or at least 5% of its annual value, and on a specified date or an occurrence that’s outside of your control (such as marriage, divorce or the birth of a child), the trust becomes a regular CRUT. The FLIP-CRUT can therefore offer taxdeferred savings and potentially serve as an additional retirement account. Community Property – the property ownership system that applies in nine states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. (Alaska has an elective community property system.) With community property, you and your spouse are each deemed to own one-half of the property. When the first of you dies, the cost basis of all of your community property is adjusted to its fair market value. Assuming the property has appreciated, this basis “step-up” wipes out all of the property’s built-in capital gains. This is more favorable than how jointly held spousal property is generally treated in the rest of the United States. In those jurisdictions, when the first spouse dies, only one-half of the jointly held property gets a basis adjustment, so that only one-half of the built-in capital gains disappear. Credit Shelter Amount – refers to the amount you can shelter from estate tax. Through 2008, this amount is $2 million. With proper planning, a husband and wife collectively can shelter $4 million from estate tax through 2008 ($7 million in 2009, or $3.5 million each). See Applicable Exclusion Amount, above, and Credit Shelter Trust, below.

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Credit Shelter Trust – a trust that is typically created under your will and is funded with the amount you can protect from estate tax (see Applicable Exclusion Amount, above). A credit shelter trust is usually for your surviving spouse and children, and can pass tax-free to your children at your spouse’s death. It thus shelters the trust property from estate tax in both your and your spouse’s estates. Crummey Power – refers to a trust beneficiary’s limited right (usually for 30 days) to withdraw property that is added to a trust. The power is designed to ensure that your gift to the trust qualifies for the annual exclusion by giving the beneficiary a “present interest” in the gift (i.e., the right to withdraw it). If the trust does not have Crummey powers, your gift to it will erode part of your $1 million lifetime gift tax exclusion. Crummey powers are typically used in irrevocable life insurance trusts. (“Crummey” was the name of the taxpayer whose court case gave rise to this technique; see Annual Exclusion Gifts, above.) Decoupling – refers to what a number of states (over 20) have done to preserve their state death tax credit revenues. In other words, decoupled states have untied themselves from the federal system so that they can continue to receive state death tax dollars that otherwise disappeared completely in 2005. The effect of living in a decoupled state such as New York, New Jersey, Illinois or Massachusetts, is that your estate taxes are higher. Donor-Advised Fund – refers to a charitable fund that is typically run by a community trust or a financial institution. Your contribution to the fund goes in a separate account, and is eligible for an upfront income tax deduction even though the dollars may not be paid to charity until a later date. The funds grow tax-free, and you may recommend how your charitable donations are used. Because the fund is treated as a public charity, your gifts are not subject to the restrictive charitable income tax limits imposed on gifts to a private foundation. A donor-advised fund can be an attractive way to make directed charitable gifts without the complications of a private foundation (see below). Dynasty Trust – a trust that is created in one of several jurisdictions that has abolished the “rule against perpetuities” (see below). A dynasty trust could theoretically last “forever” and need not terminate when the law usually requires trusts to terminate – generally about 100 years after they are created. Such trusts are typically set up in Delaware or South Dakota. Estate Tax – a tax on the transfer of property at death. If your taxable estate plus your adjusted taxable gifts (post-1976 lifetime gifts that erode your $1 million gift tax exclusion and are not includible in your estate) exceed the applicable exclusion amount (see above), then your estate will be subject to estate tax. The 2001 Tax Act repealed the estate tax in 2010, but just for that one year. Prior to that one year of repeal, the amount you can protect from estate tax has been increasing, and the top estate tax rate has been decreasing: from 2007 through 2009, it is 45%. Assuming the estate tax returns in 2011, the top rate again will be 55%. Estate Tax Exclusion – the amount of property you can protect from estate tax (see Applicable Exclusion Amount, above). Executor – the individual, bank or trust company named in your will to administer your assets at your death and to see that the terms of your will are carried out (the bank or trust company is called a “corporate” executor). The executor’s duties include figuring out what you owned, gathering your assets, determining your debts and liabilities, and filing your estate tax return and final income tax return. The executor also must make a number of post-mortem tax planning #154254

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decisions and preserve your estate’s assets before they are distributed. This can mean managing those assets, making sure they are appropriately insured and securing insurance if they are not. Family Limited Partnership (FLP) – a pass-through entity that is used to hold assets and create valuation discounts for gifts of limited partnership interests (“pass-through” means that the partnership’s income passes through to the partners, and is not separately taxed to the partnership). Valuation discounts are generally available for gifts of limited partnership interests because the rights and powers of limited partners are restricted: e.g., the limited partners cannot transfer their interest, participate in the management of the underlying partnership assets, access the underlying property, control partnership distributions or easily withdraw from the partnership. FLPs (along with limited liability companies, which have been similarly used) are under much scrutiny from the IRS. Judging by recent cases, an FLP is more likely to survive that scrutiny if there is a “legitimate non-tax purpose” behind it, and it is funded with some kind of working business, rather than just marketable securities. Fiduciary – one who stands in a relationship of trust to others, and often, holds people’s assets. Executors and trustees, for example, are fiduciaries. A bank or trust company is a “corporate” fiduciary. As then-Judge Benjamin Cardozo described the fiduciary’s standard of behavior in a 1928 New York Court of Appeals case (Meinhard v. Salmon), it requires “[n]ot honesty alone, but the punctilio of an honor the most sensitive.” 529 Plan – a tax-preferred account that allows you to save for your child’s higher education. All 50 states offer them, and there are many variations within the plans. The following website is a springboard for accessing all the different plans: http://www.collegesavings.org/. Generation-Skipping Transfer Tax (GST) – a transfer tax that is in addition to the estate or gift tax. Its rate is generally equal to the highest estate tax rate (45% through 2009); the tax applies (in 2007 and 2008) to transfers over $2 million to people such as grandchildren, regardless of whether the transfer is outright or in trust. In 2009, the GST applies to transfers over $3.5 million. In 2010, the tax is repealed, but is scheduled to come back the following year, when it will apply to generation-skipping transfers over $1 million, indexed for inflation. The purpose of the GST is to make sure that tax is collected when property passes from generation to generation. Gift Tax – a tax on lifetime transfers of property that exceed $1 million in the aggregate. Its top tax rate is the same as the top estate tax rate (45% through 2009). In 2010, when the estate tax is repealed, the gift tax remains, and will have a top rate of 35%. In 2011, that top rate tax is scheduled to go back to 55%. Grantor – you are a grantor if you establish a trust while you’re alive. Another term for this is “settlor” or “trustor.” Grantor Retained Annuity Trust (GRAT) – a trust that transfers future appreciation to your heirs. Typically, you fund a GRAT with property that is likely to appreciate significantly or is a “cash cow.” With the GRAT, you receive an annuity for a period of time, generally two to three years. At the end of that period, whatever is left in the GRAT (the “remainder interest”) passes either outright or in further trust to the heirs you’ve named in the trust. You are deemed to make a gift when you fund the GRAT, but because the present value of your right to receive the annuity is worth something, the value of that gift is reduced. It is possible to structure a GRAT to make your annuity equal 100% of what you put into the trust so that there is no gift (a “zeroed#154254

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out GRAT”). Assuming the GRAT outperforms the interest rate used to value your annuity (see the 7520 Rate, below), that “excess” will pass tax-free to your heirs. Grantor Trust – a trust you create while you’re alive, and of which you are the owner for income tax purposes. In other words, you report the trust’s income, deductions and credits as part of your income tax, and don’t treat the trust as a separate taxpayer. A “defective” grantor trust is deliberately structured to be taxable to you for income tax purposes, but is not includible in your estate for estate tax purposes. The advantage of such a trust is that your payment of the trust’s income taxes is a tax-free gift to the trust and its beneficiaries, since neither will have to pay any tax on the trust’s realized income. Gross Estate – refers to everything you own at death, including your individually owned property, your share of jointly held property, pension plans, insurance benefits, etc. Determining the size of your gross estate is the first step in determining your potential estate tax liability. Health Care Proxy – the document in which you name an individual to be your “health care agent” or “health care surrogate.” This individual will make health care decisions for you when you no longer can. The rules regarding health care proxies vary from state to state. See Living Will, below. Incentive trust – refers to a trust that is typically created under your Will, and that is designed to encourage your beneficiaries in certain types of behavior, such as achieving high grades, gainful employment, etc. Such a trust might permit principal distributions to the beneficiary, for example, that are equal to the beneficiary's wage income. Although well-meaning, incentive trusts can inadvertently penalize beneficiaries: e.g., children who choose low-paying professions or stay home to raise a family won’t get as much as the child who becomes an investment banker – probably not what you had in mind. Income Beneficiary – the individual or entity currently eligible to receive income from a trust. Depending on the type of trust, the trustee may be required to pay out the income, or may have discretion to do so. An individual’s income interest, for example, typically ends at death. Inheritance Tax – a tax that some states impose at your death. Contrary to an estate tax, which is imposed on property passing at your death, an inheritance tax is imposed based on the recipient of the property: in general, the closer the degree of kinship, the lower the tax. In Terrorem Clause – refers to a clause in a will (or trust) that threatens to deprive you of your inheritance if you challenge the document giving you the inheritance. Courts are generally reluctant to enforce “no-contest” clauses and construe statutes authorizing them very narrowly. In some jurisdictions, such as Florida, these clauses are unenforceable. Irrevocable Life Insurance Trust (ILIT) – an irrevocable trust that you set up during your lifetime to hold insurance on your life. The purpose of the trust is to remove the insurance from your taxable estate and that of your spouse, if you’re married. Typically, your surviving spouse and children are the beneficiaries, and at your spouse’s death, the trust passes estate tax-free to your children. Insurance trusts generally use “Crummey powers” (see above) to secure the annual exclusion for gifts to the trust that are intended to pay the insurance premiums. If you fund the trust with an existing policy, you must live for three years after setting up the trust to keep the insurance out of your estate; if your trustee buys the policy on your life, the three-year survivorship rule does not apply. #154254

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“Kiddie Tax” – an income tax rule that applies to children under the age of 18. It requires that their “unearned income” in excess of $1,700 (the 2007 threshold) be taxed at their parents’ highest rate. (Unearned income refers to items such as interest, dividends and capital gains.) Custodial accounts under the Uniform Transfers to Minors Act, for example, are subject to the kiddie tax (see UTMA/UGMA accounts, below). Living Will – a document that sets forth your health care wishes when you no longer can. The document can request, for example, that you not be kept in a “persistent vegetative state,” or it can also request that every measure be taken to keep you alive (in general, the law presumes that you would want to be kept alive; the living will usually rebuts that presumption). Most states recognize living wills, which are often coupled with a “health care proxy” (see above). Marital Deduction – the deduction against estate or gift taxes that applies when you make gifts to your spouse. The gifts can be outright or in trust. The marital deduction postpones estate tax until your surviving spouse dies. It is unlimited if your spouse is a U.S. citizen, and subject to restrictions if your spouse is not a U.S. citizen (see QDOT, below). Minor’s Trust – a trust that holds property for a minor (let’s say it’s your child), and is sometimes referred to as a “2503(c) trust.” It is a receptacle for annual exclusion gifts, and does not require Crummey notices (see Crummey Powers, above). The trust must be solely for your child, and can be used for your child’s benefit before he reaches age 21, when it must be turned over to him. Some trusts, however, are structured to give the child a “window of opportunity” to terminate the trust at age 21, and continue on if the child doesn’t seize the opportunity. Per Capita – “by the head.” Trust documents occasionally provide that when the income beneficiary dies (i.e., the individual who’s currently eligible to receive trust income), the remaining trust property will pass to the individual’s “surviving issue, per capita and not per stirpes.” This means that all of the income beneficiary’s surviving descendants take an equal share of what’s left of the trust. To illustrate, assume that Mom is an income beneficiary, and has three children, each of whom has two children. At her death, the property passes to her surviving issue, per capita and not per stirpes. Because Mom has nine surviving descendants (three children and six grandchildren), each one receives 1/9 of the trust remainder. The more usual distribution, however, is per stirpes (see below). Per Stirpes – by the “stocks” or “by the roots.” Trust documents often provide that when the income beneficiary dies (i.e., the individual who’s currently eligible to receive trust income), the remaining trust property will pass to the individual’s “surviving issue, per stirpes.” This means, for example, that grandchildren split whatever share their deceased parent would have received. To illustrate, assume that Mom is an income beneficiary, and has three children, each of whom has two children. Mom’s son predeceases her. At Mom’s death, the property passes to her surviving issue, per stirpes. Her two living children will each take 1/3, and her predeceased son’s two children will each take 1/6 (i.e., they split their father’s 1/3 share). Contrast this disposition with “per capita” (see above). Power of Appointment – your right to direct who takes trust property, either when you’re alive or at your death. A “general power of appointment” (GPA) means that in addition to directing the property to other people, you also can direct it to yourself, your estate, your creditors or the creditors of your estate. The property over which you have a GPA is includible in your estate for estate tax purposes. A “limited power of appointment” (LPA) means that you cannot give the #154254

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property to yourself, your estate, your creditors or the creditors of your estate – even though, depending on how broadly the power is written, you could conceivably give it to anyone else. The property over which you have an LPA is not includible in your estate for estate tax purposes. Power of Attorney – a document wherein you name an individual to act as your “attorneyinfact” and transact business on your behalf. Note that the attorney-in-fact is not authorized, for example, to make annual exclusion gifts (see above) unless the document so states. A “durable” power of attorney is effective when executed and remains so even when you become incompetent. A “springing” power of attorney does not become effective until a stated event occurs, such as your incompetence. Any power of attorney ends at your death, when your attorney-in-fact can no longer act on your or your estate’s behalf. Present Value – this refers to what a future dollar (or revenue stream) is worth in today’s dollars. For example, in a GRAT (see above), the present value of your annuity stream is subtracted from the value of the property you transfer to the GRAT to determine the value of your gift to your heirs (they get what’s left over). In other words, if the present value of your annuity is 100%, the present value of the remainder gift is zero. The 7520 rate (see below) is the interest rate used to make this computation. Private Foundation – a charitable entity that you can create either as a trust or a corporation, and that can last in perpetuity. It gives you maximum control over your charitable giving, and lets you direct how the foundation uses its contributions. Private foundations have a number of rules that must be scrupulously followed, such as minimum amounts that must be paid out annually and prohibitions on self-dealing. The income tax deduction for lifetime contributions to private foundations is subject to a number of limitations, whereas the gift and estate tax deduction for such contributions is unlimited (e.g., if you contribute to a private foundation under your will, that gift is fully deductible). Probate Estate – assets that you own in your own name that are governed by your will, and not by contract or state law. In other words, the probate estate includes things like real estate held in your own name, bank and brokerage accounts and tangible personal property. It does not include, for example, life insurance, jointly held property and qualified plan benefits and IRAs. Required minimum distribution – refers to the minimum amount you must start taking from a qualified plan, such as a 401(k) or a pension or profit sharing plan, when you retire or reach age 70 ½, whichever happens later. With IRAs, however, you must start taking these distributions when you reach age 70 ½, regardless of whether you are still working. Right of election – refers to your surviving spouse’s right to “elect against” your will. If your spouse makes the election, he or she will receive the portion of your estate to which state law entitles surviving spouses. This “elective share” is in lieu of the provisions you made for your spouse in your will. QDOT – a “qualified domestic trust.” This trust qualifies for the marital deduction and is used to postpone estate tax when the decedent’s surviving spouse is not a U.S. citizen. It can be structured as 1) a QTIP trust (see below), where the surviving spouse receives all of the trust’s income; 2) a “general power of appointment” trust, where the surviving spouse receives all of the trust’s income and can direct what happens to the property at his or her death; 3) a charitable remainder trust, where the surviving spouse is the only income beneficiary; or 4) an “estate trust,” where trust income accumulates and the trust pours into the surviving spouse’s estate at #154254

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his or her death. A QDOT is onerous in that principal distributions to the surviving spouse (unless they are “hardship” related), will trigger estate tax – or what would have been taxable at the first spouse’s death on the principal distributions had the trust not been in existence. The QDOT is thus a “pay as you go” tax regime, contrasted with the QTIP trust, which is a “pay once you’re gone” tax regime. QTIP Trust – a “qualified terminable interest property” trust. This trust qualifies for the marital deduction and therefore postpones estate tax. Your surviving spouse must receive all of the trust’s income at least annually, and may receive, if you wish, principal distributions at the trustee’s discretion. When your spouse dies, the trust is taxable in your spouse’s estate. After taxes, the property passes as you provided under the terms of the trust. QTIP trusts are especially useful in second marriages, where you want to provide for your surviving spouse but ensure that the children from your first marriage receive any remaining trust property when your spouse dies. Qualified Personal Residence Trust (QPRT) – a trust to which you transfer a “personal residence” (i.e., a principal residence or a vacation home) and retain the right to use the residence for a term of years. At the end of the trust term, the residence goes to your heirs. Although you are deemed to make a gift when you transfer the residence to the trust, that gift is reduced by the present value of your right to use the residence and direct what happens to it if you die during the trust term. No matter how much the residence appreciates by the time your heirs receive it, it won’t be subject to gift tax. For the QPRT to be successful, you must outlive the trust term. Qualified Plan – refers to various retirement vehicles, including pension, profit sharing plans and 401(k) plans; it also loosely refers to IRAs (individual retirement accounts). Remainderman – the individual or entity (such as a trust) that takes whatever is left in a trust when the income beneficiary’s interest is over (see income beneficiary above). Revocable Trust – a trust that you can revoke or amend at any time. A revocable trust – also known as a “living trust” – offers no transfer tax savings, but serves as an asset management vehicle during your life, and can help provide for you if you become disabled or incompetent. At your death, it serves as a will substitute and governs the disposition of assets you transferred to it during your life and at your death (usually through a “pour-over” will). Rule Against Perpetuities – the general rule that a trust must terminate within “lives in being” plus 21 years. In other words, unless the jurisdiction that governs the trust has abolished its rule against perpetuities (see “dynasty trust” above), a trust generally must terminate 21 years after the death of the last beneficiary who was alive when the trust was created. The theory behind the rule is that property interests should not be tied up forever. A trust that lasts for the perpetuities period often runs for about 100 years. Sale to a Defective Grantor Trust – like the GRAT (see above), this technique is a play on potential appreciation. It involves selling an asset to a trust in exchange for a note that is usually interest-only (i.e., a balloon note). Because of the trust’s structure, neither gain from the sale nor interest on the note is taxable to you. Any appreciation in excess of the note’s interest rate goes to the trust, and ultimately your heirs, gift-tax free. If you die while the note is outstanding, there is uncertainty as to the income tax consequences of the transaction.

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Second-to-die/Survivorship Life Insurance – a cost-effective insurance policy on two people’s lives that does not pay out until the death of both insureds. It is frequently used to insure husbands and wives, and can help replenish the wealth lost to estate taxes at the surviving spouse’s death. It is also used as a source of cash for paying the estate tax of an illiquid estate. Typically, second-to-die insurance policies on husbands and wives are placed in irrevocable life insurance trusts (see above) to ensure that the policies will not be subject to estate tax in either spouse’s estate. 7520 Rate – an interest rate that the IRS publishes monthly. It is an assumed rate of return, and is used to determine the present value of things like annuities, life estates, and income and remainder interests (“7520” refers to the section of the Internal Revenue Code that defines this rate). For example, you use the 7520 rate to determine the present value of your annuity in a GRAT, and the present value of your retained interests in a QPRT. The 7520 rate is sometimes referred to as the “hurdle rate”; the more your property outperforms it, the better the result (i.e., more property is removed from your estate). Stepped-up Basis – the upward adjustment in basis that occurs when you die owning appreciated assets (if the assets have depreciated, you get a “step-down” in basis). In other words, when you die, because your assets are generally valued as of your death, this value serves as the new cost basis. The effect of this is to wipe out any built-in capital gains, so that if your heirs cash in their inheritance, they won’t pay capital gains tax (assuming the asset hasn’t appreciated between your death and when it’s sold). Note that when the estate tax disappears in 2010, so does the basis step-up: instead, there will be “carryover basis” (subject to a few exceptions) – meaning that your heirs inherit your cost basis and pay capital gains tax when they cash in their (appreciated) inheritance. Carryover basis means that you need to keep careful records of all capital improvements and dividend reinvestments: if your heirs can’t prove your basis, the likely presumption is that it’s zero. Transfer Tax – the tax on the transfer of property. Estate, gift and generation-skipping transfer taxes are all transfer taxes. Trust – an entity where the trustee holds legal title to the assets, and the beneficiaries (the people who benefit from the trust) hold beneficial title to the assets. A trust can help save people from themselves, potentially insulate assets from creditors and offer tax savings. Trustee – the individual or bank or trust company named to administer a trust’s assets. The trustee’s duties include managing the trust’s assets, making appropriate distributions to beneficiaries and filing the necessary tax returns for the trust. When a bank or trust company fills that role, it is called a “corporate” trustee. UTMA/UGMA accounts – refers to “custodial” accounts under the Uniform Transfers to Minors Act and the Uniform Gifts to Minors Act (UTMA is an updated version of UGMA). Both Acts provide a simple framework for transferring property to minors: in general, UTMA lets you give a broader class of assets than UGMA and holds those assets until the minor reaches age 21 (unless you select age 18 when you set up the account); UGMA usually requires the minor to receive the property at age 18, unless you select age 21. More states are adopting UTMA.

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