The usefulness of many estate planning vehicles lasts less than a generation.
A host of estate planning strategies can slash taxes and help preserve family wealth. These include charitable trusts, family limited partnerships, and irrevocable family trusts. Events don’t always unfold as planned, and over time changes would be helpful. Unfortunately, most good estate planning devices must be “irrevocable.” Once created they are supposed to be locked in.
The good news is that there is almost always a second chance to change an estate plan. When circumstances or tax laws change, there often are ways to change or opt out of an estate planning vehicle. Let’s take a look at some of these strategies.
Family limited partnerships. FLPs were perhaps the most popular estate planning tool for the wealthy over the last 15 years. Many of those FLPs will last for many years. Others will need to be changed, or unwound as the lawyers say.
Some families want to unwind their FLPs because of a concern about the IRS’s attack on FLPs (see the next article).
Changing circumstances are more common. Because of the extended bear market and 2001 estate tax law, some estates no longer are taxable. Sometimes, the family changes. Some of the children want or need to take their value out instead of investing together. In these and other circumstances it is a good idea to unwind the FLP.
Unlike other vehicles, FLPs are meant to end at some point, and there are several ways to do that. The key is to find the best strategy for your family and to avoid unnecessary taxes.
All the assets could be sold and the assets distributed to the partners. Or the property could be divided up and distributed to the partners, if that is practical. If some partners want to keep the FLP going, they might be able to borrow against the assets and distribute cash to the withdrawing partners. Sometimes the departing partners will accept a note and a stream of payments from the other partners instead of a lump sum.
There are other solutions short of ending the partnership. An FLP could be split into different FLPs if the partners divide into factions and the property can be divided. If some partners have cash needs, the FLP might borrow against or sell some assets and distribute the cash. The FLP also might make loans to partners who need cash.
Whichever route is used, it is important to get advice from an expert in the taxation of partnerships. For example, if property is held by the FLP for less than seven years and distributed to a partner who did not contribute it to the FLP, the contributing partner might be taxed. If the children received their FLP interests as a gift or the partnership has debt, there could be unexpected tax consequences. If the parents have passed away, the children should not unwind the partnership until the estate receives an estate-tax closing letter from the IRS.
Charitable trusts. The bull market was a great time to set up charitable remainder trusts. But the bear market ruined many projections and became a good reason to terminate some CRTs.
In a CRT, appreciated property is contributed to a trust. The donor (or a designated beneficiary) gets income equal to a percentage of the trust’s value each year. A charity eventually inherits the trust’s remainder after the income beneficiary dies. The donor gets a charitable contribution deduction equal to the present value of the charity’s remainder interest in the trust. The trust can sell and re-invest the property contributed to it, and no one pays taxes on the sale of the appreciated asset.
The bull market was a great time to set up CRTs, because many people had appreciated assets and high incomes. Many CRTs, however, make income payments of a percentage of the trust’s value each year. If the trust’s investments declined by half in the bear market, then the beneficiary’s income declined by half.
The 2003 tax law created another reason to terminate a CRT. The annual income distributions from the trust usually are ordinary income, taxed at the recipient’s top rate. But if the CRT is terminated, each dollar distributed to the beneficiary is taxed as long-term capital gains at the top 15% rate.
It turns out that the IRS is generous in giving permission to terminate CRTs. The IRS approves the terminations on two main conditions. All parties to the trust must agree. Those parties usually are the donor, the income beneficiary, the trustee, and the charity. The charity is happy to agree, because it gets the money sooner. The other parties usually are the same person or are related to the donor in some way. In some states, such as New York, the attorney general also must agree. The second condition is that the charity must get its fair share of the trust as computed under the IRS’s present value rules.
To terminate a CRT, get all the parties to agree then seek a private letter ruling from the IRS with the help of an experienced tax attorney. That way, you won’t have any tax surprises after a few years.
An easier way to terminate a CRT is to donate the income interest to the charity. That ends the trust, but it also means the charity gets all the money. It is not a good option if the income beneficiary needs the money. Sometimes the charity is willing to buy the income interest from the beneficiary or exchange it for a gift annuity.
Irrevocable trusts. An irrevocable trust can be the best or worst estate planning tool. The trusts can slash taxes, ensure continued professional management, and protect property from heirs and their creditors. Or a trust can leave a beneficiary without access to cash when it is really needed. Even a professional trustee might mismanage the property, or the trustee might have a narrow view of what are necessary living expenses.
It is best to set up a trust with some escape hatches. Give the beneficiary the option of changing corporate trustees no more often than every five years. Or name a corporate trustee to do the back office work and paperwork, but name a family member or friend to decide on distributions and other matters. Let this co-trustee be able to replace the corporate trustee. Or name a “trust protector” who can decide to end the trust when it is in the best interests of the beneficiary. You should leave the trustee detailed explanations of when you believe money should be distributed and when it shouldn’t be. All these strategies were discussed in past visits and are available in the web site Archive.
When a trust does not have any of these escape hatches, there still are options. Most states allow an irrevocable trust to be terminated if all the parties agree. The parties have to jointly petition a court to terminate the trust, so it will cost some money in lawyer’s fees. It could become quite involved if the trust has many beneficiaries. Some states make this harder than others. The attorney general might have to agree to the termination. Another legal option is to argue that the trust should be terminated because there was some mistake when it was created. This could result in back taxes if it is successful.
One or more parties to the trust can go to court and argue that circumstances have changed enough that the trust terms should be changed. Courts are hesitant to do this and require significant changes in circumstances.
A final option is for the beneficiary to sue the trustee for breach of duty. This can get expensive, and the trustee’s legal defense is paid from trust assets. Yet, sometimes the threat of a suit is enough to get the trustee to either change its behavior or agree to a change in the trust.