The ease of legalease: What to know about legal terms

All occupations have their own industry-speak, and lawyers may be among the biggest offenders.

In our defense, some of the language of the law is in fact Latin. But understanding the terminology is important when it comes to knowing what documents you need in place and what is necessary to accomplish your estate planning goals.

Will vs. trust

I regularly get phone calls from clients wanting to update their wills, or beneficiaries wanting to know what their relative’s “will” says. In most cases, they’re really talking about the trust.

Wills: In California, if at the time of your death you have more than $166,250 in assets (with a few exceptions), your estate must go through probate in order to transfer those assets to your heirs. This is true even if you have a will that carefully dictates who is to receive your estate. The terms of the will, and the process for carrying those out, are overseen by the probate court and are public.

Trusts: It is very common to implement a living trust to hold title to your assets during your lifetime and for some period thereafter. Living trusts are called this because they are implemented during your lifetime, and they continue to “live” past your death.

Assets titled in the name of the trust will not be subject to probate proceedings. Instead, your named successor trustee will be charged with carrying out the terms of your trust, including the distribution of assets. The terms of your estate distribution are set forth in the trust itself, not in a will. Thus, the terms are private and not subject to court supervision.

Pour-over wills. Even with a trust in place, a will is necessary. The will provides that, in essence, if you forgot to title an asset in the name of the trust or recently acquired an asset in your individual name, such asset is to be “poured over” into the trust.

Not surprisingly, this is called a “pour-over will.” Thus, the will does not say who gets what or when—it says simply “give my assets to the trustee of my trust and let him/her deal with it” (only in fancy legal terms often involving Latin). The substantive stuff—the things people really want to know about—is in the trust, which is not a public document.

Incapacity documents

There is often much confusion regarding powers of attorney and conservatorships as well. In many cases, a duly activated power of attorney is all that is required. However, a court-;conservatorship may be necessary in more serious cases.

Power of attorney: A power of attorney is a document that authorizes a party to act on behalf of another. The power of attorney can be given voluntarily by the principal party—for example, an elderly parent who has the mental capacity but not the desire to continue managing financial affairs. Or, the power of attorney is activated when the principal is determined (usually by a physician) to be unable to handle their own financial affairs.

The agent named in the power of attorney only has the powers specified in the document and must act in good faith for the benefit of the principal.  A power of attorney is not valid after the principal has passed away. Importantly, the execution of the power of attorney by the principal, even when the principal is declared incapacitated by a physician, does not take any rights away from the principal. The principal may still act on their own behalf; it’s just that the agent can also act on the principal’s behalf.

Conservatorship: Where it is necessary to prevent a person from acting against their own interest, or in more serious cases of incapacity when a person is incapable of acting on their own behalf, a legal conservatorship is necessary.

A conservatorship is a legal proceeding wherein a determination of the need for a conservatorship of the person and/or the person’s estate is made, along with the appointment of the person(s) to act as conservator. Once a conservatorship is in place, the power of attorney is no longer valid, and the conservatee loses the right to act on their own behalf.

Health care documents

Another area of confusion is health care directives versus health care powers of attorney, “DNR” orders, and “POLST” documents.

Health care directive. This is the same thing as a health care power of attorney — it’s called an “Advance Health Care Directive” in California and a health care power of attorney in some other states. Whatever the name, it is a document that states who can make health care decisions for you if you are unable to, and, in general terms, what sorts of decisions you’d like made (pertaining to matters such as pain relief, life-sustaining treatments, and hospice care). The agent named in the health care directive is also the party responsible for decisions regarding post-death matters (organ donations, autopsies, choice of mortuary, cremation, burial, etc.)

DNR: A “do not resuscitate” order, known as a DNR is signed with your medical provider, although the agent named in your health care directive can be authorized to sign a DNR on your behalf.

POLST: Finally, a “POLST” is a “physician’s order for life sustaining treatment.” This is a document (frequently it’s pink) signed by a person, usually seriously ill and frail, and his or her physician.

This is a document relied upon by emergency medical personnel (who will not read or interpret the health care directive) because it includes a doctor’s orders based on the patient’s preferences for medical care. A POLST often includes a “DNR” order.  Keep a POLST handy and visible in the event emergency personnel respond to a 911 call.

Each of these documents serves a specific purpose and should be discussed, implemented, and reviewed with legal counsel and medical personnel on a regular basis.

Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles, CA. You can reach her at Teresa@trlawgroup.net

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Low interest rates present opportunities for your estate trusts

Last week we discussed some opportunities and incentives presented by The Coronavirus Aid, Relief and Economic Security Act (CARES) passed by Congress in late March 2020. This week we’ll focus on some opportunities presented by the historically low-interest rates that now exist.

When low rates are an advantage

Low-interest rates can be used for effective tax planning for higher net-worth individuals who need to remove assets from their taxable estates in a leveraged way and parents or grandparents looking to help their descendants in a tax-effective manner. The planning, however, can be complex and requires legal and tax advice.

Grantor retained annuity trusts

A Grantor Retained Annuity Trust (GRAT) works like the Charitable Remainder Trust we discussed last week, but the beneficiary is your child or another non-charitable person.

You create a trust — the GRAT — and transfer property to it. You receive the right to an annuity payment from the trust for a term of years. At the term’s end, what remains in the trust passes to your named beneficiary.

The gift of the remainder interest to your beneficiary is valued based on the present value of the estimated gift to the beneficiary, through a formula that includes a presumed interest rate known as the Section 7520 rate. The 7520 rate for the month of May is set at 0.80%.

In other words, you gift X$ into a GRAT and reserve the right to Y% annuity payments for 10 years, at which point the remaining trust assets are distributed to your beneficiary. The gift made is valued, for gift tax purposes, at $X less the Y% annual payments, assuming the trust funds grow at only 0.80%.

The GRAT yields an estate and gift tax savings if you survive the term of the trust and the trust property generates a return in excess of the 7520 rate (currently 0.80%). In other words, you pass along more value than that which was subject to gift tax. Gifting lower-value property (marketable securities or real estate which has recently declined in value) now to a longer-term GRAT that could yield a return in excess of the low 7520 rate, could result in substantial assets passing to your beneficiaries free of the estate and gift taxes.

This strategy works best when the 7520 rate is low, as it is now, and the grantor is likely to survive the chosen term of the trust.

Charitable lead trusts

Where a Charitable Remainder Trust can help you affect an IRA stretch as we discussed last week, a Charitable Lead Trust (CLT) can help you pass more assets to your heirs free of estate or gift tax, much like the GRAT.

In a CLT, the property is transferred to a trust you create that provides an annual payment to a charity for a specific term, with the remainder being paid to the named non-charitable beneficiary at the end of the term. You can get a charitable income tax deduction immediately, which is based on the value of the asset transferred to the trust, less the presumed value of what will remain in the trust at the term’s end thereby passing on to the non-charitable beneficiary.

With the 7520 rates being so low, the built-in presumption is that less will be available to your beneficiary and that results in a higher charitable deduction and a smaller presumed gift (hence lower gift tax or less gift tax exemption used up).

Sales to grantor trusts

Sale of partial business interests (perhaps discounted for minority interests and/or lack of marketability) to family members through an irrevocable grantor trust in exchange for an installment note is a common business succession planning technique. The lower interest rates, and perhaps lower values of real estate and/or business assets, make this an even more attractive tool.

The grantor trust is considered a separate entity for gift or estate tax purposes, but the income generated in the trust is passed through to the grantor (e.g. “mom and dad” who created the trust for the children’s benefit). The lower applicable federal interest rates (AFRs) allow for lower interest rates on the note and therefore, less income tax to the grantor. In addition, the post-sale appreciation on the transferred business interest passes to the children outside the estate of the parents, and therefore free of estate and gift taxes.

Intrafamily loans

A parent can loan assets or cash to a child or grandchild at the required AFR without making a gift, so long as the loan is honored and payments made as though the loan were between arms-length parties (i.e. non-relatives).

Often, the parent or grandparent will forgive the loan payments annually up to the annual gift tax exemption amount (currently $15,000). Currently, the AFR for a loan term of nine years or less is under 1%. The lower interest rates allow for more of the principal to be forgiven each year, and if the assets appreciate at a higher rate than the AFR, that return has been passed on to the child free of estate or gift tax.

The COVID-19 pandemic and the dire economic situation have certainly brought a lot of bad news. But with the incentives and opportunities discussed in our last several columns, there is at least a silver lining or at least some lemonade to be made, just in time for summer.

This is not legal or tax advice to you individually, and you should rely on your own attorney or tax advisor to guide you, particularly given the nuances of the various techniques described.

Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles, CA. She is also the #1 New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild” coming in Fall 2020.  You can reach her at Teresa@trlawgroup.net

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New limits on IRAs lead to other opportunities, incentives

As discussed in last week’s column, the Secure Act passed in December 2019 made some changes to IRAs that were not beneficial to those people hoping to pass their IRAs down to their heirs in a tax-efficient manner.

The opportunity to stretch distributions from an IRA over a beneficiary’s lifetime (and therefore accrue tax-free income inside the trust for a longer period) was effectively done away with for all but spouses.

Then along came COVID-19 and the never-before-seen hit to the economy.

But things aren’t all bad. The Cares Act, passed by Congress in late March 2020, presents some tax planning incentives and opportunities, ranging from the simple to the more complex with greater benefits.

Charitable deductions

Taxpayers who do not itemize their deductions can now add an additional $300 deduction for donations of cash to public charities to the standard deduction, thanks to a provision in the Cares Act. And you’d rather give your money to charity than the government, right? This provision applies to 2020 and years thereafter.

Additionally, for 2020 there is no cap on the deductibility of cash contributions to charities. Thus, you can donate up to 100% of your adjusted gross income (vs. 60% previously) and receive a deduction of the full amount. For corporations, the charitable deduction limit of 10% of taxable income is raised to 25%.

IRAs and charitable deductions

Individuals over 70½ have been able to donate up to $100,000 in IRA assets directly to charities without taking the distribution amount into taxable income. These qualified charitable distributions (QCDs) result in no income tax, the assets are removed from your estate and therefore are not subject to estate tax, and other assets remain for your non-charitable beneficiaries.

Now that one can elect to deduct 100% of your AGI for cash contributions to charity, an individual over 59½ years of age effectively has the same opportunity. If you’re over 59½ you will not be penalized for “early distributions” of retirement funds. Thus, you can take a large cash distribution from your IRA, contribute it to a charity, and receive a charitable deduction of the entire amount.

This is a good strategy for someone between the ages of 59½ and 70½  who is not dependent on the retirement funds being donated, and either needs to move those assets out of their estate, would rather not pay income tax on the eventual minimum distributions required at age 72 and thereafter and/or has charitable intent. This strategy, however, only works in 2020.

Creating an IRA stretch

The use of the “IRA Stretch” (i.e. the beneficiary’s ability to defer income tax by stretching out the distributions over the beneficiary’s lifetime) for all but a spouse has been a big blow to those with large IRAs hoping to give their beneficiaries a leg up in retirement planning.

There are, however, methods that effectively re-create the IRA stretch.

Charitable remainder trusts: A CRT is a trust that is created during your lifetime to which you contribute property and from which you or your beneficiary receive the right to a stream of income over a set term or lifetime.

At the end of the term, what remains in the trust is distributed to a charity (named by you or your beneficiary). If you establish a CRT to receive your IRA at your death, the IRA will pay to the CRT, which will cash it out tax-free (since it’s a charity and does not pay income tax).

The CRT will then pay the distributions to your beneficiary over their lifetime (or a set term), effectively keeping the proceeds growing tax-free for a much longer period of time than the 10-year distribution requirement had you left the IRA directly to the child.

There are rules, of course. The beneficiary must receive a minimum of 5% annually and a maximum of 50%; the remainder that goes to charity must be a minimum of 10% of the present value of the gift at the time the CRT is funded, and the distributions paid to the beneficiary will be subject to income tax in part (as would the IRA proceeds had the IRA been gifted directly).

The pros to a CRT are the deferral of income taxes, an estate tax deduction, and an asset-protected stream of income to your beneficiary. (Creditors, including ex-spouses, cannot reach the CRT assets).

There are however cons as well. Setting up a CRT requires an attorney and a trustee; the trustee must file a special CRT return and give a K-1 to the beneficiary; and if a beneficiary (your child) dies prematurely, the remaining CRT assets go to the charity, not your grandkids.

Because the IRA stretch was eliminated, it’s a good idea to reconsider naming a CRT instead of a child as a beneficiary of large IRAs. This is a technique that works best for large IRAs (perhaps $1 million or more) and can be used in 2020 and later years.

Charitable gift annuity: This annuity is a contract with a charity whereby an asset is donated in exchange for a stream of annuity payments. This works like a CRT, but without a trust. Instead, there is a contract with a licensed charity. (Please note: Not all public charities are licensed to provide annuities. If your favorite charity isn’t licensed, check with your local Community Foundation).

Thus, you can also gift your IRA to a charity in exchange for an annuity payable to your beneficiary, and again effectively create an IRA stretch.

Taking advantage of low rates: The historically low interest rates also can be used for effective tax planning for higher net-worth individuals who need to remove assets from their taxable estates in a leveraged way.

Grantor retained annuity trusts: GRAT works like a charitable remainder, but the remainder beneficiary is your child or another non-charitable person. You transfer property to the GRAT and receive the right to an annuity payment for a term of years.

At the term’s end, what remains in the trust passes to your named beneficiary. The gift you make to the trust is based on the present value of the estimated gift to the beneficiary, through a formula that includes a presumed interest rate known as the Section 7520 rate, which as of May is set at 0.80%.

In other words, you gift X dollars into a GRAT and reserve the right to 8% annuity payments for 10 years, at which point the remaining trust assets are paid to your beneficiary. The gift made is equal to $X less the 8% annual payments, assuming the trust funds grow at only 0.80%.

The GRAT yields an estate and gift tax savings if you survive the term of the trust and the trust property generates a return in excess of the 7520 rate (currently 0.80%). In other words, you pass along more value than that which was subject to a gift tax.

Gifting lower-value property (marketable securities or real estate which has recently declined in value) now to a longer-term GRAT that could yield a return in excess of the low 7520 rate could result in substantial assets passing free of the estate and gift taxes.

Legal and tax advice: The above discussion is not legal or tax advice for you specifically, readers, so be sure to rely on an attorney or tax adviser, particularly given the nuances of the various techniques.

Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles, CA. She is also the #1 New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild” coming in Fall 2020.  You can reach her at Teresa@trlawgroup.net.

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