Category: Estate Planning

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Estate Planning Income Tax Spousal Rights

Beware of the SLAT Divorce Trap

Andrew M. Logan —

The Spousal Lifetime Access Trust, or SLAT, has become one of the most popular estate planning strategies employed by married couples. It is an irrevocable trust created by one spouse (the “grantor”) for the benefit of the other spouse and, usually, other family members. Like many irrevocable trusts, the assets transferred to a SLAT, along with any appreciation generated after the transfer, should be removed from the grantor’s and beneficiary-spouse’s estate for estate tax purposes. One of the unique benefits of a SLAT is that it allows the grantor to retain indirect access to the trust’s assets through distributions to the beneficiary-spouse. SLATs seemingly provide a way for grantors to “have their cake and eat it too,” but there may be unanticipated tax consequences to the grantor if the marriage to the beneficiary-spouse ends in divorce.

Because the grantor’s spouse is a beneficiary, a SLAT is usually taxed as a so-called “grantor trust” for income tax purposes. This means that the grantor is responsible for paying the SLAT’s income and capital gains taxes, even though the SLAT’s assets have been removed from the grantor’s estate for estate tax purposes. Under current law, the grantor’s payment of the SLAT’s income tax liabilities is in effect an additional tax-free gift to the SLAT each year. These payments allow the assets of the SLAT to grow without being depleted by the payment of income taxes.

As long as the grantor and the beneficiary-spouse are married, they will both be able to reap the benefits of the SLAT.[1] However, if they divorce, the grantor will not only lose indirect access to the SLAT’s assets, but will also remain liable for its income taxes if the beneficiary-spouse remains a beneficiary of the SLAT following the divorce.[2] Section 672(e) of the Internal Revenue Code , the so-called “spousal unity rule,” provides that the grantor is treated as holding any power or interest held by the grantor’s spouse at the time the power or interest was created, even if that individual subsequently ceases to be the grantor’s spouse.

Consider the following example. In 2020, George created a SLAT for the benefit of his then spouse, Sally, which provided for discretionary income and principal distributions to Sally during her lifetime. In 2023, George and Sally divorced and the trust agreement provides that Sally will continue to be a permissible beneficiary of the SLAT even after a divorce. Accordingly, following the divorce, the SLAT will likely remain a grantor trust as to George because the spousal unity rule only looks at when Sally’s interest in the trust was created, and not at the time of the George and Sally’s divorce. This means that George will continue to be responsible for paying the taxes[3] on the SLAT’s assets, even though he no longer has indirect access to the trust property.[4] Fortunately for couples who are contemplating creating a new SLAT, the effects of the “divorce trap” can be mitigated with proper planning and structuring. For couples with existing SLATs, they should carefully review the trust terms to confirm what happens in the event of divorce. It may be possible to address the “divorce trap” issues in a post-nuptial agreement and/or a trust modification or decanting.

[1] Of course, if the beneficiary-spouse predeceases the grantor, the grantor would then lose his or her indirect access to the trust property.

[2] The trust agreement will typically address the beneficiary-spouse’s interest in the SLAT following a divorce. The trust agreement may provide that the beneficiary-spouse will continue to be a beneficiary following a divorce or will cease to be a beneficiary. The spousal unity rule is only implicated if the beneficiary-spouse continues to be a beneficiary following the divorce.

[3] In a number of states, the trust agreement can include a provision authorizing an independent trustee, in the independent trustee’s discretion, to make distributions to the grantor to reimburse the grantor for the income tax liabilities of the SLAT. If this reimbursement provision is structured correctly, it should not result in the assets of the SLAT being includable in the grantor’s estate for estate tax purposes.

[4] Prior to the Tax Cuts and Jobs Act of 2017, following a divorce from a spouse who continued to be a beneficiary of a SLAT, if distributions were made to the former spouse, the SLAT’s taxable income, up to the amount of distributable net income, could have been carried out to the spouse, potentially reducing the income to be reported on the grantor’s personal income tax returns. However, following the 2017 Act, this is no longer the case, and the grantor must carry the full amount of the SLAT’s income tax liabilities on his or her personal returns, regardless of whether distributions are made to the former spouse.

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Estate Planning

Before You Pack Your Swimsuit. . .

Haley B. Bybee —

With most of the world finally back open to visitors, people are more eager to travel than ever before. Whether you are planning an African safari, a Caribbean cruise, or the ultimate Patagonia adventure, your pre-travel checklist should always include a review of your estate plan and related documents. So, before you pack your swimsuit for your next vacation, follow the steps outlined below.

  1. Call Your Estate Planning Attorney. Often, clients wait until the week before their trip to contact their attorneys about putting together an estate plan. Although it is possible to prepare and execute a set of estate planning documents within a week, it is preferable to give yourself time to consider your estate planning options and make thoughtful decisions. Depending on the complexity of your estate plan, it could take anywhere from weeks to months to complete your plan. For that reason, as soon as your book your trip (or well before you book your trip), give your attorney a call to discuss your estate plan.
  2. Review or Execute a Power of Attorney and Healthcare Proxy and Discuss with Your Agents. Clients are sometimes surprised to know that their “estate plans” include documents that are effective during their lifetimes. Financial Powers of Attorney and Healthcare Proxies allow you to name an agent who may make financial decisions and healthcare decisions, respectively, on your behalf. These documents are often coupled with a Living Will and Health Insurance Portability and Accountability Act (“HIPAA”) Authorization, which will guide your agents in their decision making and give them access to essential information about your health. Before you embark on your next voyage, you should not only execute these documents but also advise your designated agents of your travel plans, your banking information, healthcare wishes and, crucially, where the original documents are located. You may also wish to send copies of the documents to your agents. In the unlikely event of an accident, your agents should be ready to act and know where to find your Power of Attorney, Healthcare Proxy, Living Will, and HIPAA Authorization.
  3. Name Guardians for Your Minor Children. Whether you are bringing your children with you or traveling solo, you should name a guardian for your minor children in your Will or in a separate document. If you fail to name a guardian for your children, after your death a court will independently select a guardian. When selecting a guardian, it is important that you discuss the decision with your child’s other parent[1] and the potential guardian. You may also include special language in your Will expressing your wishes about your child’s schooling, extracurricular activities, and general care. In addition, you may give the named guardian specific funds that may be used to renovate the guardian’s home to allow your children to comfortably live with him or her. It is recommended you revisit your guardianship designations before your vacation and every few years to ensure that the named guardian is still willing and capable of caring for your minor children.
  4. Sign Your Will and Trust. Wills and trusts are the backbone of every estate plan. They contain instructions that direct the disposition of your assets. Trusts are a particularly useful tool for avoiding probate and reducing administrative burdens in the administration of your estate. Clients generally have an idea about how they would like their assets to be distributed upon death but sometimes have difficulty determining who to name as beneficiaries if none of their descendants or close relatives survive them. Clients frequently name charities or their “heirs-at-law” (i.e., closest living relatives) as so-called “contingent beneficiaries.” Although it is unlikely that contingent beneficiaries will ever benefit from your estate, it is important to identify them in your estate plan, especially when the entire family is going on vacation together. For instance, consider the Steinberg family, late of Scarsdale, New York, who were all killed in a plane accident in Costa Rica on December 31, 2017.
  5. Tell Your Friends and/or Family Where to Find Your Documents. After taking the time to prepare and sign your estate planning documents, it is crucial you advise your friends or family where to find such documents. Copies of some documents may be accepted by some institutions, but it is important that your friends or family know where originals are kept. It is also important that your documents are accessible to your friends or family. For example, your friends or family may not have access to your safety deposit box. For that reason, we always recommend that your attorney keep an original set of your documents, and you give your attorney’s contact information to your friends or family.

Ultimately, completing your estate plan before you leave town will allow you to know that (1) someone trustworthy will be making decisions on your behalf in the event of an accident and (2) your loved ones are taken care of in the event of your death. So, before you pack your swimsuit to go scuba diving at the Great Barrier Reef, swimming with the sharks in the Maldives, or relaxing with a drink on the beach in the Seychelles, give the Tax, Benefits, and Private Client practice group at Blank Rome a call.

[1] It is strongly encouraged for both parents to name the same guardians in their Wills as the Will of the second parent to die will control who is appointed as guardian. This is typically not a concern for parents who are in an intact marriage, but issues may arise when parents are separated or divorced.

Categories
Estate Planning Estate Tax Exemption Capture Planning Gift Tax

IRC Section 2701 and Gifts of Carried Interests

James R. O’Neill —

James O'Neill's headshot photo

The transfer in the course of estate planning of a fund manager’s carried interest early in the life of a fund (when the carried interest has a modest value) can be an attractive way in which to remove anticipated future appreciation from the manager’s estate at a nominal gift tax cost. However, any transfer of a carried interest could be subject to the special valuation rules of Internal Revenue Code (“IRC”) Section 2701 and result in an unexpected deemed gift and substantial gift tax liability. If the entire carried interest is transferred, the capital interest in the fund retained by the manager may be valued at zero for gift tax purposes under Section 2701, and the manager may be deemed to have made a gift of his entire interest in the fund, including his capital interest, rather than just the carried interest.

One way to achieve the desired estate planning result and avoid the applicability of Section 2701 is the sale of a derivative, based on the performance of the manager’s carried interest, rather than a transfer of the carried interest itself. Typically, the sale would be made to an intentionally defective grantor trust (also simply known as a “grantor trust”) for the benefit of family members. The use of a derivative contract to transfer the value of the carried interest does not require the actual transfer of the carried interest itself, thereby avoiding the applicability of Section 2701. Under this approach, the manager enters into a derivative contract with the trust agreeing to pay the trust at a future settlement date, usually set near the end of the fund’s life, the fair market value of the carried interest on the settlement date. For more aggressive planning, the payment may be set in the derivative contract as a multiple of the value of the carried interest on the settlement date. The derivative contract also can be structured so that the payment is required only after the carried interest has exceeded a certain total return, using a hurdle amount. For its part, the trust pays to the manager upon execution of the derivative contract the present value of the trust’s right to receive the future payment on the settlement date. That present value is determined by an appraisal of the trust’s future right (at current fair market value) upon execution of the derivative contract, which is generally significantly less than what the trust will actually receive upon the settlement date.

For example, if the present value of the trust’s right to receive the future payment based on the carried interest is appraised currently at $500,000, the trust pays the manager that amount upon execution of the derivative contract. If the value of that carried interest is five million dollars at the future settlement date, the manager pays to the trust that five million dollars on the settlement date at conclusion of the term of the derivative contract. A gift tax return is filed to report the sale to the trust (and a zero-dollar gift) of the appraised value of the derivative based on the carried interest to start the running of the statute of limitations for the Internal Revenue Service to audit the gift tax return. Given that the derivative was sold to the trust and there is no reportable gift value, there are no gift tax consequences associated with the sale.

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Estate Planning

ChatGPT, Esq. Has Entered the Legal Chatroom

Sara K. Osinski —

ChatGPT passed the bar exam on its first try. To make matters more alarming, ChatGPT can draft someone’s Will in a matter of minutes.

Before sounding the unemployment alarms, what is ChatGPT exactly? ChatGPT is a chatbot powered by artificial intelligence (“AI”) that produces human-like responses in text form. Since its launch in November 2022, ChatGPT has provided quick responses to simple estate planning and estate administration questions; generated accessible online templates; and drafted briefs, responses, complaints, Wills, and trusts. Additionally, unlike attorneys, ChatGPT does not charge an hourly rate or a flat fee.

While ChatGPT may sound like an attorney’s nightmare, it will not be able to replace attorneys altogether. OpenAI, the creators of ChatGPT, warn that ChatGPT should not be relied upon for advice. In fact, when a user asks ChatGPT any legal question, the chatbot will warn the user as follows: “I’m sorry, but as an AI language model, I am not authorized to provide legal services or advice. It’s important to consult with a licensed attorney who is qualified to provide you with legal advice.” Despite this warning, when framing the question correctly, a user can eventually acquire a draft Will or trust template through ChatGPT. Although helpful, this template provides a false sense of security for the user, especially one who does not have a legal background in tax or trusts and estates. This means that if ChatGPT drafts a Will or trust, the user will likely need to do additional research, not only in the area of tax or trusts and estates, but also in other related substantive practice areas, to ensure the information provided is accurate, thereby leaving room for error, both human and computer.

Additionally, while ChatGPT is a helpful and cost-efficient tool, the user will need to ask the appropriate questions in order to prepare and execute their estate planning documents accurately. As there are many nuances to each person’s estate plan and complexity arising from the ever-changing tax code, there are many questions that a user may not consider if they are not familiar with the estate and tax planning process. For instance, if a user executes his or her ChatGPT-generated Will without asking ChatGPT (or a reliable trusts and estates attorney) how to do so under relevant state laws, if such Will is executed incorrectly, the consequences may be as serious as having an invalid and inoperable Will upon his or her death. Therefore, instead of the user’s assets passing according to his or her intent, the state law for those users who die with an invalid Will controls the distribution process.

This could also result in substantial unintended tax consequences that otherwise could have been avoided had the user consulted with a reliable trusts and estates attorney. The user may also fail to consider certain obligations that he or she has to his or her spouse (or others) under the terms of a marital agreement or certain marital obligations that arise under state law. When preparing estate planning documents, a reliable trusts and estates attorney not only considers the areas of tax and trusts and estates, but also may need to consider issuing arising in the areas of matrimonial law, corporate law and securities, real estate law, and intellectual property. Working with a law firm with a wide range of practice areas will generally result in the preparation of a comprehensive estate plan that can address all of these substantive areas of the law. Individuals without formal legal training will likely not know how these practice areas intersect in preparing an estate plan.

Another consideration to using ChatGPT as your trusts and estates attorney replacement is that estate planning and estate administration can be a highly emotional process. Therefore, if a user is utilizing ChatGPT while under a highly emotional state, fatal errors are likely to occur. Deadlines may be missed, information left out of a Will or trust, estate planning documents incorrectly executed, estate administration forms incorrectly filled, etc. Additionally, while ChatGPT may provide simple responses to legal questions, because its responses are computer generated, they cannot provide an emotional sounding board for a user who is experiencing intense emotions with his or her estate planning or estate administration process.

An additional consideration when thinking about using ChatGPT for estate planning or estate administration is that these documents involve personal and sensitive information that should only be shared between the user, the user’s attorney, and the user’s loved ones. While the user can take a multitude of precautions, any content created online using ChatGPT is at risk for being hacked or stolen by malicious hackers. A Will and other estate planning documents should be treated with the utmost care and attention, and that includes protecting the privacy of such documents.

While ChatGPT may be good at taking a test, due to the nature of the underlying technology, it may never be capable of genuine reasoning, providing human compassion, and applying creativity to an individual’s legal questions. There are a whole host of potential concerns and problems with using ChatGPT to prepare an estate plan. As such, this program should not be used as a substitute for a trusts and estates attorney.

Categories
Estate Planning Estate Tax Exemption Capture Planning Gift Tax Income Tax

Irrevocable Trusts: Who Is the Taxpayer?

Kyle G. Durante —

In establishing and funding an irrevocable trust, a common question is who is responsible for the income tax liabilities associated with the trust? Many individuals assume that the trust is a separate and independent taxpayer, requiring the trustees to file income tax returns for the trust. However, that is not always the case.

Irrevocable trusts are either classified as “grantor trusts” or “non-grantor trusts.” When an irrevocable trust is classified as a grantor trust, the trust is treated as identical to the settlor or the donor, requiring the settlor to report all matters of income and deduction with respect to the trust on his or her own individual income tax returns. When an irrevocable trust is classified as a non-grantor trust, the trust is deemed to be a separate taxpayer, requiring the trustees to file annual income tax returns for the trust (known as fiduciary income tax returns) reporting all matters of income and deduction with respect to the trust.

Generally, whether an irrevocable trust will be classified as a grantor or non-grantor trust depends on certain powers that may have been retained by the settlor with respect to the trust, who are the beneficiaries of the trust, and certain provisions in the trust. For instance, if the settlor retained the power of substitution (also known as a swap power), if the trustees have the power to use trust income to pay premiums on a life insurance policy insuring the life of the settlor or if the settlor’s spouse is a permissible beneficiary of the income of the trust, the irrevocable trust will be deemed to be a grantor trust. As a general rule, although not always the case, an irrevocable life insurance trust (holding a life insurance policy insuring the life of the settlor) or a spousal lifetime access trust (“SLAT”) will almost always be deemed a grantor trust during the settlor’s lifetime.

At first blush, a grantor trust may be seen as a harmful result given that the settlor is transferring property to an irrevocable trust (of which the settlor is generally not a beneficiary and no longer has access to the property) but the settlor remains liable for the income tax bill. However, establishing an irrevocable trust as a grantor trust can have significant transfer tax benefits. By establishing a grantor trust, each year the settlor will report and pay any associated income tax liabilities with respect to the trust. Under current law, the payment of tax liabilities that would otherwise be paid by the trust is, in essence, a tax-free gift to the trust each year. As such, the payment of the trust’s tax liabilities by the settlor will permit the settlor to further deplete the assets in his or her own name (that will be subject to estate tax at his or her death) without using any of the settlor’s gift/estate tax exemption.

With respect to grantor trusts, of course, once the settlor dies, the trust will generally cease to be a grantor trust and convert to a non-grantor trust. It may also, however, be possible to convert the trust from a grantor trust to a non-grantor trust, and vice versa, during the settlor’s lifetime, if that would be desirable.

Irrevocable trusts are further subclassified under the Internal Revenue Code as either foreign or domestic trusts. As a general rule, domestic trusts are subject to U.S. income tax on their world-wide income, while foreign trusts are subject to U.S. income tax on only their U.S.-sourced income. The implications of each such classification and the tests to determine such classifications will be addressed in an upcoming cross-border estate planning series.

Categories
Estate Planning Matrimonial Law Spousal Rights

Don’t Forget the Will with the Prenuptial Agreement

Sean R. Weissbart —

Sean Weissbart's headshot photo

Many prenuptial agreements include detailed provisions regulating the division of the parties’ property in a divorce but include no waivers of rights the law provides to a surviving spouse at death. The most well known of these rights is the right of election. The surviving spouse’s right of election, essentially, prevents the first spouse to die from fully disinheriting the survivor. Generally, in New York, if a surviving spouse does not inherit at least one-third of the deceased spouse’s assets, the surviving spouse can file a claim to receive this threshold amount—even when the deceased spouse’s Will (or other testamentary documents) names different beneficiaries.

It is common for prenuptial agreements—particularly between parties without children—to not waive spousal rights at death. After all, many individuals getting married have no objection to their beloved receiving at least one-third of their assets at death.

However, in some states, when a married person without children dies without a Will, his or her surviving spouse receives all of the deceased spouse’s assets. For instance, in New York, all assets of a married person without children dying without a Will (or other testamentary document) are distributed to the spouse; parents, siblings, nieces, nephews, and other relatives or friends receive nothing.

Consider the following example. Wanda, who has worked for years and has five million dollars of pre-marital assets in a brokerage account in her own name, is marrying Harry, who just graduated school and has few assets. Wanda requests that Harry sign a prenuptial agreement to protect this five million dollars from division in divorce, but the agreement is silent regarding distribution of her assets at death. Imagine Wanda has parents with limited means, a sick relative who needs money for medical care, and nieces and nephews she loves like children. If she dies before Harry without a Will (or other testamentary documents), these other loved ones would receive nothing.

What should Wanda do? The answer is simple. Before marrying Harry, Wanda should sign a Will that bequeaths assets to Harry and these close relatives. Of course, to avoid Harry exercising his right of election, her Will should bequeath to Harry, at least, the minimum threshold necessary to satisfy what Harry’s right of election would be; but her Will can freely dispose of her remaining assets however she’d like.

Many individuals sign prenuptial agreements, get married, but don’t simultaneously sign Wills. Indeed, the most common catalyst for a first Will is having children (you need a Will to appoint a guardian), which may happen years after marriage. So, in that rush to the alter, don’t forget to also sign a Will.

Categories
Estate Planning

Welcome to Future Wealth Navigator

Sean R. Weissbart, Andrew J. Haas, and Kyle G. Durante —

Welcome to Future Wealth Navigator!

Authored by Blank Rome LLP’s dedicated Trusts & Estates team of seasoned estate and tax planning and administration attorneys from across the country, Future Wealth Navigator is a one-stop shop for all matters trusts and estates. Readers can expect in-depth analysis and discussion of hot-topic issues in the trusts and estates realm, including issues related to estate and trust planning, administration, and litigation; trending estate planning tools and vehicles; and recent and proposed changes to the wealth transfer tax regime; plus analysis of other overlapping substantive practice areas, such as matrimonial and corporate law.

At first blush, many assume that trusts and estates is simply preparing for the disposition of assets upon death. Although that is a key component to any effective estate plan, the trusts and estates practice is far more complex and expansive. Client’s seek the guidance of seasoned estate planning attorneys for a myriad of other reasons, such as structuring the disposition of assets in the most tax-efficient matter, lifetime gifting and estate/gift tax exemption capture strategies, charitable giving and the establishment and maintenance of charitable entities, the sale and restructuring of business entities, contested estate disputes, assistance with the administration of trusts and decedents’ estates, preparation of certain types of tax returns (such as gift tax returns and estates tax returns), and overlapping matrimonial issues, such as addressing trusts and estates matters in negotiating a prenuptial or postnuptial agreement or upon the commencement of divorce proceedings.

Whether you are looking for a welcome distraction or to navigate through hot-topic issues that you might want to address in your own estate planning, Future Wealth Navigator is your trusted guide!

Sean Weissbart's headshot photo
Sean R. Weissbart
Andrew J. Haas
Kyle G. Durante