How a Distribution Trustee May Protect Your Beneficiaries

If you have read anything that I have written, you know that I am a fan of trusts. They can be drafted to do all kinds of magical things to protect both grantors and beneficiaries. Many of our clients with significant assets wish to leave their assets to beneficiaries in a trust that the beneficiary controls.By adding a Distribution Trustee to a beneficiary’s trust, we can bifurcate the role of the trustee, separating the managerial and investment responsibilities from the distribution making authority. This results in stronger creditor protection and forces your beneficiary to think about large purchases. This strategy can be important when you want your  beneficiaries to have the ability to control their trust assets, but also wish to give them a higher level of creditor protection. We often make the beneficiary his or her own trustee as to administrative and investment matters and give the beneficiary the authority to name a friend or other unrelated third party to make distributions. You can also designate the Distribution Trustee yourself.

North Carolina’s version of the Uniform Trust Code (“UTC”) makes it clear that a creditor may not reach the interest of a beneficiary who is also a trustee or co-trustee, or otherwise compel a distribution, if the trustee's discretion to make distributions for the trustee's own benefit is limited by an ascertainable standard. We typically use the ascertainable standard of “health, education, maintenance, or support.” So even without a distribution trustee, North Carolina law gives pretty good creditor protection to beneficiary-controlled trust, if they are drafted correctly.

But there are a few issues that you may want to consider. First, judges don’t always understand, agree on, or follow the law. On June 5, 2018, the North Carolina Court of Appeal issued opinions in 10 civil cases. In half of these ten cases, the Court of Appeals affirmed the trial court with no dissent. In three cases, the Court of Appeals affirmed, but there was a dissent. In one case the trial court judgment was vacated. And in one case, the Court of Appeals said the trial court got part of it right and part of it wrong. Three days later, the North Carolina Supreme Court issued 5 opinions in civil cases. One was reversed and remanded. Two were affirmed without dissent. And two were affirmed but had dissenting opinions. Without any knowledge of the substance of the cases, we can say that in the first half of June 2018, the North Carolina appellate courts didn’t fully approve what the lower courts did in about half of the cases, and in several they sent the case back down with instructions to do it over. No matter how good your case is, you can always lose.

I have seen lots of things happen in court that shouldn’t have happened. Most of the time the cases don’t get appealed. The litigants get mad with their lawyers, the judge, the legal system, and the opposing party. But they don’t want to keep spending money fighting when there are no guarantees. The solution is to stay out of court. If you can’t stay out of court, you need to win at the trial level. While I can imagine a judge ignoring or misinterpreting the nuances of law of beneficiary-controlled trusts, I can’t think of a situation where a judge would: 1) make a Distribution Trustee a party to a case against a beneficiary that does not involve claims against the trust; and 2) ordering the Distribution Trustee to make a distribution to the beneficiary’s creditors.

Perhaps more realistically, your child could move to a state that doesn’t have the level of creditor protection that we have in North Carolina.

Finally, if your child doesn’t keep the checkbook, it takes away the possibility of spontaneous financial decisions. Your son can’t buy a new car on the way home from work because he’s frustrated that the Bluetooth won’t connect and the oil needs changing. Your daughter may not order $10K worth of new clothes if she must ask her friend to pay the credit card bill next month.    

In the worst-case scenario, a creditor may be able to step into the beneficiary’s shoes to force a distribution or your child ignores the terms of the trust and wastes money. But if the power to make distributions is vested solely in the discretion of an independent Distribution Trustee, the beneficiary can otherwise control all other aspects of his trust without exposing the trust to creditors’ claims.

Every case is different, and we can't give you specific recommendations unless we understand your specific facts. But there are many cases in which a Distribution Trustee should be considered.

What is HIPAA and How Does it Affect my Estate Plan?

All of our estate plans include at least three health care documents – a health care power of attorney, a living will, and a HIPAA release. We are often asked why we do a separate HIPAA release. The short reason is that it clears up any questions about who can talk to your doctors. For a longer reason, keep reading.   

Congress passed the Health Insurance Portability and Accountability Act, commonly known as HIPAA, in 1996. The HIPAA Privacy Rule is a set of standards created by the United States Department of Health and Human Services to implement the requirements of HIPAA. The Privacy Rule permits you to control the use and disclosure of your Protected Health Information (PHI).

PHI includes information that relates to your past, present, or future physical or mental health or condition, health care, or payment for health care. There are several different “identifiers” that constitute PHI. They include everything from your name to your license plate number. HIPAA does not preempt state laws that are more stringent. But state rules generally cannot be less restrictive.

Anyone who is authorized under state law to act on your behalf in making health care decisions is your “personal representative” for HIPAA purposes. Generally, the parents of unemancipated minors are authorized to exercise the rights of those children under HIPAA, but there are some exceptions. The administrator or executor of your estate is also treated as a personal representative under the HIPAA Privacy Rule to the extent that PHI is relevant to his or her duties. You may also provide a valid authorization for the release of PHI.

The Privacy Rule requires covered entities to treat your personal representative or designated agent just as they would treat you.  A health care provider is not required to disclose your PHI to a personal representative if the provider reasonably believes that you have been or may be the victim of domestic violence, abuse, or neglect by the personal representative and that such disclosure would not be in your best interest.  

Although your health care providers are not required to disclose PHI to your family members who are not personal representatives, there are times when a provider may do so. For example, if you were injured and could not consent to treatment, the medical provider can share your PHI with a family member or friend who is not a personal representative if the provider believes such disclosure would be in your best interest.

HIPAA does not require a specific HIPAA waiver in health care powers of attorney. However, there are two reasons why we prepare a separate HIPAA release. The first is that that making health care decisions is a different matter than obtaining information. You may have several family members that you would like to be able to talk to your doctors, but one specific person who should make health care decisions when you can’t do it yourself. The second reason is that you may want someone to be considered a personal representative for HIPAA purposes before your health care power of attorney becomes effective. HIPAA states that anyone who has authority to act on your behalf in making health care decisions is a personal representative. We typically state that your health care power of attorney becomes effective when your treating physician determines that you can no longer make health care decisions. This could leave some ambiguity as to whether or not your health care agent is a personal representative for HIPAA purposes. Spelling it out makes it clear. Health care providers are cautious about sharing PHI with others. If you specify in a notarized writing that you have designated certain persons as personal representative, there is no question.

Is Your Child’s Financial Future Worth More than a Year of Cable TV?

Maybe not. Maybe you think that estate planning for the middle class means avoiding probate when you can. Maybe you think it is your beneficiaries’ job to best use what they inherit. If that is your position, then you are not alone. Most lawyers, bankers, and financial advisors agree with you. But that thinking is short-sighted and based on a lack of knowledge. In some situations, I might characterize it as irresponsible.

Personal responsibility is important. There are many situations in which my influence on my children’s success is based solely on parenting decisions that were made many years ago. But that does not apply to protecting their inheritance. I am comfortable with the fact that my children are one bad decision away from losing their assets. The same goes for me. And you. So we should all be careful and insure against known risks. But it is unnecessary to subject assets that I worked for to the consequences of my children’s bad luck or bad decisions.

Management of inherited assets is different from other management decisions. You have the ability to give your children protections that they can’t give themselves. You can protect your assets from your children’s divorce, business failure, exploitation, or split-second bad decisions. They can’t do that after they inherit.

In May 2018, the price of one year of the “ultimate” level of cable, internet, and home phone in Wilson, North Carolina is $1,978.80. If paying this amount every year for 200 channels is a wise use of your funds, would it be worth paying that amount one time to protect your $1M IRA from being lost to creditors, predators, or bad decisions?  

If you are paying your financial advisor 1% per year to increase your investment returns, is it worth paying 1% one time to protect those assets from the threats that your family faces.

Our clients are not opposed to protecting their children. But there are several hurdles that they have to overcome before embracing that idea. First, they don’t understand what might go wrong. Almost every day someone answers one of my questions with “I never thought about that.” Our clients also don’t understand their options. They assume that their only choice is making an outright gift. They also don’t like to write checks. Your cable bill is probably an automatic payment. The management fees on your 401K are deducted from your account. It’s still real money. But you don't feel it. Finally, our clients do what their friends and family do. All of your neighbors have HGTV and ESPN. If all of your neighbors had retirement trusts, you would want one too. But your neighbors probably haven’t ever thought about these issues either.

You are not guaranteed tomorrow. You have an opportunity right now to set up your estate in a way that it will be a benefit to your descendants for many years to come no matter what their circumstances. Everyone has a different tolerance for risk. It is not my goal to convince you to plan a certain way or to spend a lot of money on an estate plan. But it is my goal to get you to think about it

The Importance of Choosing a Trustee

Naming the right trustee is just as important as having the right trust document.  We often draft irrevocable trusts for estate tax planning, asset protection, and long-term care planning purposes.  In addition, most of the Wills and revocable trusts that we design will one day become irrevocable trusts. 

It feels good to name your spouse or child as trustee. You feel good because you don’t have to pay your favorite financial institution thousands of dollars per year. Your family members feel good because they have been appointed to a position of honor.  In many cases, we name the trust maker’s children to serve as the trustee or successor trustee. But it is not always a great idea. Everyone should go into this with their eyes open. The job description should say: “Will be overworked and underpaid, while being accused of charging too much for not doing anything. Will not be able to please anyone. May be sued.”   

When serving as trustee, you can’t fly by the seat of your pants. You can’t use your gut. You can’t rely on logic or reason unless you understand the law and the facts. Sometimes it is a good idea to name your spouse or child. Sometimes there are good reasons to use a corporate trustee. Your niece may be a good choice. Every case is different. You will not find a perfect trustee. Thankfully, you don’t need to. You just need someone who is willing  to do it right.

Fixing a Broken Trust

While many things get better with age, the same cannot be said for some irrevocable trusts.  If you are the beneficiary of trust created by your grandfather fifty years ago, that trust may no longer make sense. If you created an irrevocable trust yourself 20 years ago in a completely different tax environment, it may no longer makes sense. In many cases, the trust can be fixed by “decanting” the old broken trust into a brand new one.

The word decant means to pour wine from one container into another so its aromas and flavors will be more vibrant upon serving. Decanting an irrevocable trust means transferring some or all of the property held in an existing trust into a brand new trust with different and more favorable terms.

Decanting a trust makes sense under several different ferent circumstances, including when you’d like to:

  • Change the trustee provisions to clarify who can or cannot serve as the truste
  • Expand or limit the powers of the trustee
  • Convert a trust that terminates when a beneficiary reaches a certain age into a lifetime trust.
  • Change a support trust into a full discretionary trust to protect the trust assets from the beneficiary’s creditors.
  • Clarify ambiguous provisions or drafting errors in the existing trust.
  • Change the governing law or trust situs to a less taxing or more beneficiary friendly state.
  • Add, modify, or remove powers of appointment for tax or other reasons
  • Merge similar trusts into a single trust for the same beneficiary.
  • Create separate trusts from a single trust to address the differing needs of multiple beneficiaries.
  • Provide for and protect a special needs beneficiary. 

In trusts that we create today, we build in the ability to make many of these changes through trust protectors. Many attorneys do not use trust protectors, and I have never seen a 20-year-old trust that had trust protector provisions. A trust agreement may also contain specific instructions with regard to when or how a trust may be decanted. However, trusts typically do not include these provisions either.

Fortunately, North Carolina has a trust decanting statute that makes this possible. There are several conditions that the new trust must meet. There are also tax issues that must be considered. However, decanting can take an inadequate trust and make it work.  Decanting is not the only way to fix a broken irrevocable trust. We can help you evaluate options available to fix your broken trust and determine which method will work the best for your situation.

New N.C. Power of Attorney Act Makes Important Changes

A financial power of attorney may be your most important estate planning document. If you do not have a Will or a medical power of attorney, North Carolina law determines who gets your stuff and who makes medical decisions. But if you don't have a financial power of attorney, there is no one named in default to make decisions if you are incapacitated. The only remedy in such a case is to request that a guardian be appointed. Guardianship is generally something to be avoided. The N.C. Uniform Financial Power of Attorney Act went into effect on January 1, 2018. It is the first major overhaul of this law since the early 1980’s. 

The new law does not impact health care powers of attorney or health care documents for a minor child, and any existing general financial power of attorney on record is still valid.

The new act applies to powers of attorney created before, on, or after January 1, 2018 unless it contains a clear indication of contrary intent or the application of a particular provision would “substantially impair the rights of party.” However, the powers conferred by the older power of attorney statute will apply to statutory short form powers of attorney that were executed prior to 2018. These powers are not as broad as the those in the new statute.

There is a new short form power of attorney, as well as a short form limited power of attorney for real property. We do not typically use the short form statutory power of attorney, but the new one is much more comprehensive than the prior version. 

The new law makes it clear that copies of powers of attorney and not the original document are sufficient for agents to be able to transact business on behalf of their principals. Financial institutions were increasingly requiring agents to produce the original power of attorney, with original signatures.

The new law also specifically states that the power of attorney does not have to be recorded to be effective unless it is being used to transfer real property. I do not know how financial institutions will respond to this change. I expect that most or all of them will continue to require recording. But the law is clear that failure to record the power of attorney is not a valid reason to refuse to accept a power of attorney after January 1, 2018.

As with the prior law, anyone who unreasonably refuses to accept a power of attorney may be exposed to liability for doing so. There are a lot of exceptions to this. But you have to have a valid reason for refusing. I have seen a lot of invalid reasons in the past. 

There have always been questions about gifting with a power of attorney. The new law clarifies that the power of an agent to make gifts must be specifically stated in the documents. The requirement that the agent cannot make gifts to himself without explicit authority helps to prevent the agent from misusing the funds of the principal.

Under the new law, a financial power of attorney is by definition “durable,” meaning it is still active even though the principal is incompetent, even though it may not state explicitly it is durable. Under the former law, if the principal becomes mentally incompetent, the agent’s authority terminates, unless the instrument specifically states explicitly it is durable.

The power of an agent terminates if there is a judgment of absolute divorce between a principal and the agent, unless the instrument provides that the agency continues after divorce. This was not the law previously. This doesn't address the common situation where spouses are separated, but not divorced. If you are separated and do not want your spouse to handle your financial affairs, you should revoke your power of attorney. Of course, this isn't always the case. I am surprised by the number of clients who tell me that they don't want to be married anymore, but that their ex spouse is the best person to make financial or medical decisions if they can't do it themselves. 

There is a lot more to the new law. If you have a power of attorney that was executed prior to January 1, 2018, you should consider executing a new power of attorney under the new law. While powers of attorney that were effective under the old law are supposed to remain effective, they lack the advantages of the new law and over time may be increasingly hard to use.

Estate Planning for the Middle Class After Tax Reform

If you prepared an estate plan 20 years ago, there is a good chance that you considered estate taxes, even if you had an estate of moderate size. But after the American Taxpayer Relief Act of 2012 and the repeal of North Carolina’s inheritance tax in 2013, a married couple in North Carolina could give away more than $10 million either during life or at death without paying any transfer taxes. This made estate taxes irrelevant to most people. Those who did face the possibility of paying estate taxes could usually avoid them with minimal planning. 

The tax reform bill passed last December doubles the estate, gift, and generation skipping transfer tax exemptions. This means that even fewer people will pay estate taxes than before. It also clears the way to focus on other issues, such as income and capital gains tax planning, asset protection and disability planning.   

One of the most important changes in planning for the middle class is that taxes do not always have to drive your estate plan. If you have a large life insurance policy, cash, non-qualified investments, or a business, you can focus on how to protect yourself and your beneficiaries instead of minimizing taxes. With taxes out of the way, we can plan for what happens when one spouse lives much longer than the other, the surviving spouse remarries in his or her 70s, or you have an extended stay in a nursing home. We can also think about how to protect your children and grandchildren without being boxed in by estate tax implications.

Income and capital gains are the taxes that can cause problems for the middle class. Most of our clients' largest assets are real estate and retirement accounts. These two types of property highlight the different tax issues that are faced by most people.

For those who have large retirement accounts, it is important to balance asset protection with tax efficiency. There are numerous problems that can occur with retirement accounts. Efficient tax planning has little benefit if your son’s inheritance caused him to lose Medicaid and SSI. Your investment returns are irrelevant if your IRA ends up being lost to a judgment creditor or going to the son-in-law you have never liked. And you probably didn't max out your 401K contributions for 40 years so your 18-year-old grandson can cash in a $100K IRA to buy a $70K pickup truck. All of these problems are fairly easy to prevent if you don’t mind if your children have to pay income taxes on the entire account balance within five years of your death. That might be fine with a $50K IRA.  But the stakes go up if your IRA is worth $1 million. Then we have to do more complicated planning to accomplish your goals.

For estates that are comprised largely of appreciated property, capital gains taxes are a bigger issue. We regularly see this with family farms and beach houses. Older estate plans may be the exact opposite of what you need in the current tax environment. For decades, estate planners have advised clients to establish trusts for surviving spouses that intentionally do not qualify for the marital deduction and do not cause estate inclusion when the surviving spouse later dies. These trusts use a decedent’s estate tax exemption to make sure the exemption isn’t wasted. They were very effective 20 years ago. But if you have a tax-driven estate plan that was drafted before 2012, it could ensure that your family pays more taxes rather than fewer. Old fashioned second marriage protection often consisted of leaving property to your spouse for life and then to your children. We have seen this cause massive capital gains problems. All of these capital gains issues can be prevented.  

For most people, the new tax bill clears the way to ignore transfer taxes and focus on other issues. Every tax law change is eventually replaced by another. The estate tax provisions of the new tax bill go away after 2025 if they are not changed before. Therefore, flexibility is more important than ever. Everyone should take the time now to review your estate plan to make sure it accomplishes your goals under current law.

New Tax Laws Create Estate Planning Opportunities

On December 22, 2017, President Trump signed into law the largest federal tax overhaul in more than 30 years. This law, technically called “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018,” will have a major impact on estate planning.  Beginning January 1, 2018, the unified exemption for gift, estate, and generation skipping transfer (“GST”) tax is approximately $11.2 million per tax payer. Married couples may transfer more than $22 million without paying a transfer tax. For those with taxable estates, this temporary doubling of the estate, gift, and GST tax exemptions opens opportunities to forever protect assets from transfer taxes. For others, it could provide opportunities for a basis adjustment at death that did not exist under prior law. Here are some things that you need to know:  
 
The increased exemptions create opportunities to leverage gifting opportunities. For several reasons, making a lifetime gift using some or all of the gift tax exemption is more tax-efficient than waiting to use the same exemption at death. By moving assets to a trust, the grantor removes the asset from his or her estate. Neither the assets nor the growth in value over the grantor’s life will be included in the grantor’s estate or subject to estate tax. If the gift is to a “grantor” trust, the income remains taxable to the Grantor. This further leverages the gift because the taxes that the Grantor pays on the income is essentially a tax-free gift to the trust beneficiaries. This has always been an important tool for assets that are expected to appreciate. It is particularly effective now, because the estate tax exemption at death may be much lower than the current gift tax exemption. I will explain that in more detail below. Under prior law, the mechanics of the estate tax calculation could “claw back” some of the increased exemption and require the lower exemption in place at the time of death to apply. However, the new act directs the Treasury Department to issue regulations to eliminate claw-back. There are no absolutes. However, the potential for clients with large estates to avoid transfer taxes are greater than ever.
  
The increased exemptions create the ability to protect property for multiple generations. The GST tax imposes a tax on gifts and bequest above the applicable exclusion that avoid gift or estate tax by skipping one or more generations. It is the government’s defense to an end-run around the estate and gift tax. The primary target of the GST tax are certain trusts that provide distributions for the benefit of a child for life with the remainder continuing on for the grandchildren. Under the current estate tax rules, those assets would not be taxed at the child's death unless the child has sufficient powers over the trust to cause the assets to be included in the child's estate. In this case, the economic benefits of the trust do not "skip" the children, but the estate transfer tax is "skipped" at the death of the children. The GST tax would be imposed when the grandchildren receive the trust assets. By allocating the GST exemption to a trust, the assets held in the trust can pass from generation to generation without incurring gift or estate tax. For the time being, there is a historic opportunity to create dynasty trusts. The GST tax is not portable. So if one spouse passes away without using his or her GST exemption, it is forever lost.  

These planning opportunities may be temporary. We don’t know how long this will last. The increased exemption amounts expire on December 31, 2025 if the law is not changed before. In the Senate, all Republicans voted for the bill and all Democrats voted against it. In the House, twelve Republicans voted against it. Modification of this bill is guaranteed to be an issue for 2018 mid-term elections and the next presidential election. This legislation could be heavily modified if the political pendulum swings in the other direction. Of course, it could also be renewed in 2026. The present value of future savings diminishes with time. It is also important to note that there has never been a reduction in exemption amounts once they have been raised. However, there has never been such a large change in the exemption amount. There is vehement opposition to this provision of the bill and a divisive political climate. This bill was touted as tax relief to the middle class. There is not much of an argument that this portion of the bill helps the middle class. Although no one knows the future, many of these opportunities may go away permanently by 2026.
 
There are several different ways to leverage these planning opportunities. This may include generation-skipping "dynasty" trusts, insurance trusts, intentionally defective grantor trusts, grantor retained annuity trusts, and outright gifts. However, many clients may wish to retain their wealth for their own use during their lifetimes, passing it to future generations only at death. Others may be charitably inclined. This could be a perfect opportunity for married couples to use a spousal lifetime access trust (“SLAT”). A SLAT allows one spouse to make a gift to an irrevocable trust that names the other spouse as a lifetime beneficiary of the trust. The gift constitutes a completed gift to remove the asset from the gifting spouse’s estate, and “freezes” the value of the gift for transfer tax purposes, but ensures that he or she will still have access to trust assets through the donee spouse as long as they remain married to each other. A SLAT will offer increased protection against future changes to the tax laws with little downside risk. This may also be an appropriate time to leverage gifts to support the funding of life insurance trusts. With the capital gains rate and the net investment income tax remaining the same as under prior law, charitable remainder trusts will remain good options for clients who wish to sell appreciated assets.

There are important capital gains issues that must be considered. Any assets transferred out of the grantor’s estate will not receive a step up in basis upon the Grantor’s death. Clients with low basis assets that will likely be sold by their heirs may wish to ensure that these assets remain in their estate. If the asset under consideration is not likely to be sold even after death, or in the case of assets with a high basis, such as cash or recently acquired property, then the estate and GST tax benefits may outweigh the benefits of the basis adjustment for taxable estates. For some clients, it may be appropriate to reverse prior gifting to move them back into your estate. Every situation is different.

Flexibility is more important than ever. We build in as many tools as possible to add flexibility to estate plans by using tools like trust protectors, “second look” estate tax planning, and strategic uses of powers of appointment. These provisions are more important than ever. But those strategies only work to preserve options that are available at the time you need them. If this law changes before 2026, or it is not renewed, some of the opportunities available now may never exist again.
 
There may be an unanticipated impact on existing estate plans. The increased exemptions may skew some existing estate plans. This is particularly true if for plans that were drafted before 2012. Many estate plans for married couples use a formula to divide assets at the first death between a “marital” portion passing to or held in a trust for the surviving and a “bypass” portion intended to bypass the estate of the surviving spouse. The bypass portion is typically allocated to a trust for the surviving spouse and/or descendants. Similarly, at the second death, the estate plan may have a formula dividing assets, based on the GST exemption, between children and grandchildren. Depending on the exact language of the document, this division may need to be different now because of the much larger exemptions. We have seen numerous estate plans that are drafted in a way that would require all assets under the exemption amount to be placed in the bypass trust. This can have significant capital gains tax implications. It is important for clients to review their estate planning documents to make sure they continue to reflect their intentions.

Everyone needs to review their existing documents to determine the impact of tax reform. For the very wealthy, there may be new opportunities to save millions in transfer taxes. For others, there may be opportunities to avoid or minimize capital gains. 

We would be happy to discuss the effects of tax reform on your particular situation. 

Why LLCs are a Better Choice than Corporations for Small Businesses

There are a lot of misconceptions about the difference between LLCs and S-Corporations. We almost never form statutory corporations. However, we routinely create LLCs that are taxed as S-corporations. This article will summarize why we believe that there are very few situations in which a corporation should be formed if it will be taxed under subchapter S, and why every small business corporation should consider converting to an LLC.

1. How a business is taxed and how it is organized under state law are different issues.

There is no such thing as an S-corporation or a C-corporation under the North Carolina Business Corporation Act. There are only corporations. Once you form a corporation, it is taxed under subchapter C unless you elect to be taxed under subchapter S. These are tax issues. But when it comes to non-tax matters, a corporation is a corporation.

2. An LLC can be taxed the same way as a corporation.

Many people think that a multi-member LLC must be taxed as a partnership and that a sole member LLC is disregarded for tax purposes. Those are the default tax classifications. But an LLC with one member can be taxed as if it were a sole proprietorship, a C-corporation or an S-Corporation. An LLC with more than one member can be taxed as a partnership, a C-corporation or an S-Corporation. How a business entity should be taxed is a complicated issue that should be based on specific facts. But it has very little to do with the legal structure. If your CPA told you that your business needs to be an S-corporation, he or she meant that you need to be taxed as an S-corporation.

3. LLCs require fewer formalities than corporations.

Corporations have several required statutory formalities. A large percentage of the corporations that we have represented have a corporate notebook that has a set of bylaws, stock certificates, articles of incorporation, and nothing else. Sometimes those documents haven’t even been signed. It is not uncommon for a very successful family owned business to have never had an annual meeting. Some don’t have any corporate documents, and the only way we can tell who owns the business is from the tax returns.

LLCs require less maintenance. The North Carolina Limited Liability Act specifically says that the purpose of the Act is to “provide a flexible framework under which one or more persons may organize and manage one or more businesses as they determine to be appropriate with minimum prescribed formalities or constraints.”

One way to fix this problem is to simply do what your organizational documents say you are supposed to do. Another is to operate under a form that doesn't require you to do things that you know you are not going to do. 

4. Because LLCs have fewer requirements, they may better protect your personal assets from the company’s creditors.

One of the reasons for forming a business entity is to protect your personal liabilities from the potential creditors of the business. Neither corporate shareholders nor members of an LLC are liable for the obligations of the business solely by reason of being an owner. However, that is not an absolute rule. “Piercing the corporate veil” is a judicial remedy that is used in extraordinary circumstances to allow the creditors of a business entity to go after the owners’ personal assets. The concept of “piercing the corporate veil” applies to LLCs as well as corporations.

There are several reasons that can lead to veil piercing. Many have nothing to do with how your business is organized. If you use your business to commit fraud or it is grossly under capitalized, you may be personally liable for the business’s debts, regardless of how it is structured. But one factor in determining whether or not to pierce the corporate veil is failure to comply with corporate formalities.  A recent North Carolina Court of Appeals held that non-compliance with corporate formalities “is of less relevance in the context of an LLC, which is subject to far fewer formal statutory requirements than is a corporation.”

Our courts will not allow business owners to abuse the business’s existence to the detriment of third parties. But when there are almost no formal requirements, the plaintiff suing your company cannot show that the business has failed to meet them.

5. LLCs can protect your ownership interest in the business from your personal creditors.

The charging order is probably the most important benefit of an LLC. The North Carolina Limited Liability Act says that the entry of a charging order is the exclusive remedy that a judgment creditor of an LLC owner may use to satisfy the judgment from the LLC. A charging order gives a judgment creditor the right to distributions from the LLC. The debtor's membership interest in the LLC cannot be seized and sold to satisfy a creditor’s judgment. This is not the case with shares of a corporation. 

One caveat is that the future of charging order protection for a sole member LLC is not certain. The original policy reason for the charging order is to keep other LLC members from being unfairly affected by the seizure of LLC assets, or of the LLC interest itself. That reason does not exist for sole member LLCs. Several courts across the country have ruled that charging order protection is not available to sole member LLCs. Therefore, if asset protection is an important factor, an LLC should have more than one member.

6. In North Carolina, it is easy to change an S-Corporation to an LLC taxed as an S-Corporation.

North Carolina has a procedure for statutory conversion of a corporation to an LLC. If you do not change the tax classification of your business, you can accomplish this without tax implications. This is not the case if you change the tax classification of your business.

These factors, taken together, show that LLCs are more flexible than corporations and can provide all of the same benefits as corporations. An LLC is the best structure for almost any new small business. If you own an S-corporation, particularly one with more than one owner, and asset protection is a concern, you should consider the benefits of converting from a corporation to an LLC.   

 

Estates and Real Estate

Real estate often causes confusion for personal representatives. In most cases, real estate is not an estate asset. Title to real estate vests automatically in the deceased person’s heirs at the time of death. If the decedent left the real estate to beneficiaries in his or her Will, title becomes vested in the beneficiaries when the Will is probated and relates back to the time of death. 

There are two instances in which real estate can become an asset of the estate. The first is when a Will leaves the real estate to the executor and directs the executor to sell the real estate. The second scenario is when there are insufficient assets to pay the creditors of the estate and the real estate must be brought into the estate and sold to pay creditors.

It is important that the personal representative and the beneficiaries who inherit real estate understand that because real estate is not an estate asset, rent payments are also not estate assets and expenses related to real estate, including utilities, taxes, mortgage payments, and maintenance are not estate expenses. This means that those expenses may not be paid from estate funds. 

In many cases, one of the persons inheriting real estate is also the personal representative. This creates a potential for the personal representative to make incorrect disbursements and breach his or her fiduciary duties to the other beneficiaries or the creditors of the estate. It can also create a problem when beneficiaries inherit real estate that is encumbered by a mortgage, and do not have the ability to make the mortgage payments.

When there is cash in the estate, the beneficiaries often wish to use these funds to make payments on the real estate. However, this is not an appropriate use of estate funds. And until the time period for creditors’ claims has expired, estate assets should not be disbursed to beneficiaries. A personal representative who makes incorrect payments from an estate will be personally liable for these distributions if there are creditors or other beneficiaries who were entitled to those funds.  These problems can be prevented through proper estate planning.

If you have been named as the personal representative of an estate, we would be pleased to guide you through the process.

Five Reasons to Protect Your Retirement Accounts

Your 401K or IRA may be your largest asset. Although these accounts were designed to provide additional income during your retirement, many people leave substantial amounts in their retirement accounts at their death. You can simply designate a beneficiary for these accounts. But there are several reasons why you may wish to provide some additional protections for your beneficiaries.

You have substantial amounts.  The more you have in your account, the more likely you will want to add protections. For small accounts, the benefits of the protections may not be worth the additional hassle of administering a trust. However, you should remember that in many cases, your beneficiaries will simply cash in the account, pay the taxes, and spend the money as they choose.

You believe your beneficiary may waste the funds.  If you are concerned about you’re your beneficiary will spend the inheritance, you should leave your retirement accounts in trust so you can provide oversight and instruction on how much they receive and when they receive it.

You are concerned about lawsuits, divorce, or other possible legal actions.  Inherited IRAs have very good creditor protection in North Carolina. However, required minimum distributions will not be protected. Also, your beneficiary is not forced to leave the funds in the IRA.

You have beneficiaries who receive assistance.  If one of your beneficiaries receives, or may qualify for, a need-based governmental assistance program, it is important to know that inheriting from an IRA may cause them to lose those benefits. A trust designed specifically to receive these assets can avoid disqualification.

You are remarried and have children from a previous marriage.  If you are remarried and have children from a previous marriage, your spouse could intentionally or unintentionally disinherit your children.  You can avoid this by naming the spouse as a lifetime beneficiary of a trust and then having assets pass onto your children after his or her death.

Any trust that is the beneficiary of a retirement account must be designed to hold these accounts. If the trust does not qualify as a designated beneficiary, your beneficiaries will receive the benefits of the trust, but may lose the ability to defer income tax on the account. 

You have worked hard to save the money in your retirement accounts. They provide you with the peace of mind that you have a safety net. You have the opportunity to ensure that these accounts can serve the same purpose for your beneficiaries. 

Tax Reform Proposal Released

On September 27, 2017, the Trump Administration, the House Committee on Ways and Means, and the Senate Committee on Finance released a tax proposal entitled “The Unified Framework for Fixing Our Broken Tax Code.” For individuals, the proposal aims to:

  • Reduce the number of tax brackets from seven to three (maybe), with rates of 12, 25, and 35 percent. It does not specify where the brackets start and end. It also says that “an additional top rate may apply.” So there may be four tax brackets.
  • Almost double the standard deduction from its current amount to $24,000 for married taxpayers filing jointly and $12,000 for single filers.
  • Repeal personal exemptions for dependents and increase the child tax credit to an unspecified amount and increase the income levels at which the child tax credit begins to phase out.
  • Expand the child tax credit concept to give a $500 credit to anyone caring for a family member who isn’t a child, regardless of age.  
  • Repeal the individual alternative minimum tax.
  • Eliminate most itemized deductions (including deductions for state and local income taxes), but retain tax incentives for home mortgage interest and charitable contributions.
  • Repeal the estate and generation-skipping transfer taxes. There is no mention of the gift tax. It also does not specify whether the plan would maintain stepped-up basis, which lets heirs revalue assets they get by bequest, minimizing or avoiding capital gains taxes. Some past proposals to eliminate the estate tax include provisions for carry-over basis, where heirs would owe capital gains taxes on inherited assets.
  • Eliminate the deduction for state and local taxes.

There are also several changes for businesses. Most of the businesses that we represent are either pass-through or disregarded entities, so I won’t go through many of these. However, here are some highlights:

  • The corporate tax rate would be lowered from 35 percent to 20 percent.
  • The corporate alternative minimum tax would be eliminated.  
  • The maximum tax rate for pass-through businesses—like partnerships, LLCs taxed as partnerships, and subchapter S corporations— would be limited to 25 percent instead of the individual tax rates that currently apply.

The Unified Framework is low on details. But the different interest groups have responded as expected. Conservative groups and politicians are hailing this as a historic opportunity. President Trump called it a revolutionary change and a “middle class miracle.” Speaker of the House Paul Ryan said that “[t]his is our best opportunity in a generation to deliver real middle-class tax relief, create jobs here at home, and fuel unprecedented economic growth.” However, progressive groups and Democrats are criticizing the proposal as benefiting the wealthy to the detriment of the lower classes. Senator Charles Schumer said it should be called “wealth-fare.” One commentator called the proposal a “$5 trillion love note to the wealthy.” Another said it is a solution looking for a problem.

There is no explanation of how to pay for the proposed tax cuts. Republicans say economic growth will compensate for lost revenue. Senator Patrick Toomey, who sits on the Finance Committee, said he was confident that a growing economy would pay for the tax cuts. This assumption is likely to be challenged.

Trusts and Taxes

When we design a trust, we want to make sure that it accomplishes your goals. Our focus is usually on balancing protections with access to trust property. But it is also important to understand how a trust will be taxed.

Trusts are categorized as either grantor trusts or non-grantor trusts, depending on how ownership and control over the trust are outlined. In some cases, we go to a lot of effort to ensure that a trust is either a grantor trust or a non-grantor trust. A grantor trust results in the grantor being responsible for the income tax liability of the trust, regardless of whether the trust income is distributed to beneficiaries or not. Grantor trusts are ignored for tax purposes.

Most of the time if we are creating a grantor trust, we want taxes allocated to the person who created the trust. But sometimes it is a good idea to tax the income to the beneficiary. We can design trusts to be grantor trusts as to the beneficiary. However, this probably weakens the creditor protection that the trust would otherwise provide.  

A trust that is not a grantor trust is a non-grantor trust. Non-grantor trusts are considered a separate tax entity. They are categorized as either simple or complex. A simple trust has three requirements. It must distribute all income to the beneficiaries. It cannot distribute principal. And it cannot make distributions to charities. Any trust that does not meet the requirements for a simple trust is a complex trust.

With a simple trust, all income is distributed to the beneficiaries. The trust reports all income, but is entitled to a deduction for the entire amount distributed to beneficiaries. The result is that the trust only pays tax on capital gains. With a complex trust, distributions can include ordinary income, dividends, capital gains and principal. The trust could also earn income that is not distributed, and there may be a deduction for distributions to charities. The result is that the allocation of the tax and any deductions between the trust and its beneficiaries can be quite complex.

In many cases, we create trusts that become complex trusts upon the grantor’s death. These trusts provide valuable lifetime protections for children or other beneficiaries. But the taxation is not as simple as it could be if we did not provide those protections.  We have to balance these protections with the administrative burden of managing the trust. If you are leaving a child $50,000 it may make sense to leave that property in a grantor trust that allows unrestricted access and does not require a separate tax return. But this will depend on the facts of your situation. If creditor protection, divorce protection, or maintaining needs-based government assistance is are concerns, this may not be a good option. On the other hand, if you are you are leaving your child a much larger inheritance, he or she may be better off if there are more protection and flexibility, but a little extra accounting complexity. 

It is important to understand what you are doing when you create an estate plan. When our clients are fully informed, they tend to leave assets to their loved ones in trust. Understanding the basics of how a trust will be taxed should play into that decision.

If you have questions about whether or not a trust is the right tool for you, we would be happy to discuss this with you.

Will You Outlive Your Assets?

When I was about to turn 16, I had saved around $1,500. Most of it came from working in tobacco the three prior summers. I was excited to spend it all on a 1974 Volkswagen. A few years later, my wife and I used all of our savings for a down payment on our first house. We didn’t mind doing without a few things while we saved because owning a house was a priority.  But I don’t feel the same way about paying for a nursing home. It is not that I don’t think I should have to pay for it. I just don’t like the idea of working my whole life and saving to pay for something that I don’t really want. 

I hope I never need long-term care. Unfortunately, the odds aren’t in my favor. About 70% of people over the age of 65 will require at least a temporary stay in a long-term care facility. One-third of seniors will develop some form of dementia. These numbers have all kinds of implications. There are two related issues that I deal with every day. The first is that if you live long enough, someone will have to make decisions for you. The second is that there may come a time when you can’t live at home. You need to plan for both.

You should not assume that because you have a Will and power of attorney, you have sufficient incapacity protections in place. Incapacity planning is one of the most important components of an overall estate plan. I have seen the hurt feelings and permanent damage to families when a child files a petition to have a parent declared incompetent. I have seen the loss of dignity and control when that petition is granted. And I have seen both of those happen when the parent had a power of attorney in place. Dignity and control are two things that I value. So I have a detailed plan in place for the transition of decision-making authority upon my incapacity.

We can fix that problem as long as you have the ability to make decisions. But planning for long-term care is more complicated. It is important to understand that Medicare will only pay for certain short-term stays in a rehab facility. Longer stays are not covered. And Medicare never pays for assisted living. Your medical insurance also will not pay for long-term care either. That leaves three possibilities. You can pay for it yourself. You can purchase insurance to pay for long-term care. Or, if you qualify, there are several government programs that may help.

The eligibility rules for government programs aren’t fair or logical. I know of some people who have no money, but still do not qualify for help. And I know of others whom I would consider wealthy, but are receiving benefits. The VA has recently proposed new rules that would make qualifying for VA Aid and Attendance more difficult. It is hard for me to imagine that Medicaid can continue to provide the same level of coverage in the future. The number of senior citizens in North Carolina is projected to double between 2010 and 2030. The number of workers per every social security beneficiary will drop from the current 2.8 to 2.2 by 2035. We will have twice as many seniors, and fewer people working and paying taxes. It is probably not wise to rely on Medicaid to pay for nursing home care.    

Many seniors need assisted living rather that skilled nursing. In Wilson County, we have the same number of assisted living facilities as skilled nursing facilities. Medicaid does not help pay for assisted living facilities in North Carolina. The program that helps low-income seniors pay for assisted living is called State-County Special Assistance. There are very strict income limits for Special Assistance, and most people do not qualify. If you are a veteran who served during a period of war, or the surviving spouse of such a veteran, you may qualify for VA Aid and Attendance, which will provide some help for assisted living. These limited options for help leave the majority of people without government assistance for assisted living.   

Obtaining assistance to pay for long-term care of any type is already difficult, and will likely become more difficult. But this doesn’t mean that you should ignore long-term care planning. On the contrary, it means that you must plan for it. In order to do so, you must understand the legal, financial and tax issues involved. As part of your overall plan to pay for long-term care, you may wish to preserve certain specific assets, such as a family farm or a cash reserve, even under a worst-case scenario. You also may wish to purchase a long-term care insurance policy or some type of hybrid insurance policy to shift the risk to an insurance company. Or you may decide that you can self insure.

To make these decisions, you must evaluate several factors, including your income, your standard of living, the type and value of your assets, and family dynamics. You must understand the legal, financial and tax issues that affect your plan. And you must design a plan that takes all of these things into account.

If you don’t plan for long-term care, you are leaving your well-being to chance. You are also setting yourself up for the possibility of having to spend your life savings on a nursing home and still having the State Medicaid Agency force the sale of your house after your death. You need a team of advisors to help guide you through that process. We would be happy to be a part of that team.

Timing and Circumstances are Critical in Asset Protection

Several clients have contacted me over the last few months about protecting their assets from creditors after they have been notified of a potential claim against them. Unfortunately, when you need the protection, it is too late. 

A common misconception is that only wealthy families and people in high-risk professions need to plan for asset protection.  In reality, anyone can be sued and lose all of his or her assets. A car accident, foreclosure, job loss, medical crisis, business failure, or even a dog bite can result in a judgment against you. One of my clients with a modest income recently settled a lawsuit that could have resulted in the loss of his home.  

You are probably taking advantage of several basic asset protection strategies without knowing it. For example, the first line of defense against liability is insurance, including homeowner’s, automobile, professional liability, general liability, long-term care, and umbrella policies. In North Carolina, if you and your spouse purchased real estate while married, that property is not subject to either of your individual creditors for so long as you remain married. Keep in mind that if you purchased property jointly and then got married, you do not have this protection. You would need to re-title the property. You would also lose this protection if you are divorced or your spouse passes away. I once collected on a judgment after a couple divorced. Assets held in 401(k)s and IRAs are also excluded from creditors. In North Carolina and a few other states, inherited IRAs are also protected.

If you are a landlord, real estate investor, business owner, work in a high-risk profession, or have accumulated or inherited a significant amount of unprotected property, you may wish to consider more sophisticated asset protection planning.  

If you take the time to read the articles that I write, you will recognize that I have a pattern of bringing up trusts in just about everything that I write. Leaving your assets in trust can keep your children, spouse or other beneficiaries from having to worry about these issues. Protecting your money from your creditors is hard. Protecting your money from your beneficiaries’ creditors is not. One of the best gifts that you can give your children is an inheritance that protected from their creditors and predators. 

Call us if you would like to discuss asset protection strategies for yourself or your beneficiaries.

Knowing What Could Go Wrong

I have noticed two general perspectives on how to plan for wealth transfer at death. The first group has one objective – do it as simply as possible. The second group analyzes the potential risks, balances that risk with the expense and administrative hurdles of protecting from those risks, and comes to a reasoned determination of the level of protections that they wish to provide.

It is my job to move clients from the first group to the second. If my clients are comfortable with the risks that they are taking, then I am comfortable too. You can’t decide how to plan unless you know what might go wrong. A simple and straightforward estate plan may be the right prescription for you. But a “simple” plan is a solution, not an objective. 

When I first meet with new clients about estate planning most of them have not even considered the possibility of placing any protections around the assets that they will leave their beneficiaries. The first reaction to the concept of a trust is often negative. They think trusts are for rich people. They imagine that trusts are expensive to create and maintain, that their children will have limited access to their inheritance, and that a bank trust officer will control their property. Many clients have said that if they leave their assets in trust, their children will think they don’t trust them. So they have never considered anything other than outright distributions. Most people don’t necessarily want to leave distributions outright. They just have bad information and don’t know that there is an alternative that can protect their children and give them control without adding significant expense.

I will not go through all of the possible benefits of leaving assets in trust. But trusts are versatile tools that can accomplish all kinds of different things. They are the Swiss Army knife of estate planning. You can choose how they are taxed, who makes decisions about trust assets, when the decision-maker is removed, who gets the benefit of the trust, how long the trust lasts, and what kind of protections they provide. You can create trusts that protect your children all kinds of potential problems and still leave them in control of the assets.  

Unless you are leaving small amounts to competent, responsible adults, I believe that some type of trust is usually a better option than outright distributions. There are three reasons to leave outright distributions. The first is that you do not believe that the risk of any of the potential problems happening to one of your beneficiaries justifies the extra administrative hassle of administering a trust. The second is that you do not believe that the additional costs of setting up the trust is justified by the level of risk. The third is that you just don’t care if the money you worked for is lost.

I can’t quantify the risk of your child getting divorced, filing bankruptcy, being sued, having a stroke, suffering a debilitating injury or being diagnosed with a life-threatening illness. But I have seen all of these things happen many times. Even if the chances of one of these problems negatively affecting one of your children may be low, the potential consequences could be severe.  

Leaving assets to your children in trust doesn’t show that you don’t trust them. It shows that no matter how life treats them, their parents cared enough to make sure their inheritance was protected. If you want to consider the best way to protect your beneficiaries, we will be glad to explain the details. 

When an Unfunded Revocable Trust is Better than a Will

In most cases, a fully funded revocable trust is the most comprehensive way to structure an estate plan. If you have very few assets, or almost all of your assets are retirement accounts, that may not be the case. But for the middle-class people, a revocable trust based estate plan is the best way to go. For a revocable trust to work the way it is intended, it must be funded. You will still get some benefit from an unfunded trust. But you won’t get the most out of it.

A lot of my clients come in with an old unfunded trust. Most of them don't know why the trust wasn't funded. If your revocable trust has outright distributions at death, there are little or no benefits to having an unfunded trust. But if you are leaving assets to your beneficiaries in trust, an unfunded trust gives you flexibility and some level of privacy.

Some estate planning attorneys will say that if you are not going to fund the trust, you may as well have a will. But I approach this a different way. If you are going to do a Will with trusts for your beneficiaries, why not make a separate trust the beneficiary of your will? You can either have a long will with a trust that will be permanently on display in the Clerk's office, or you can have a pour over will that says "I leave all of my probate assets to the trustee of my revocable trust." With a fully-funded trust, everything remains private. With an unfunded trust, your assets will be listed in an inventory in the court file. But who gets them and how they get them will not be public.

A trust-based plan also gives you flexibility. Just because you don't fund your trust now doesn't mean you never will. If you have a will-based plan, you can't decide to fund the trust later, because the trust is not funded until your death. But with a trust-based plan, you can fund it at any time. If you partially fund the trust, you can make modifications later without having to re-title the assets. This means that if you do not believe that you can make the necessary investment to create and fund a trust will all the features that you would like, you can still create a simple revocable trust now, partially fund it, and make modifications in the future.

If you decide to make your trust the beneficiary of a life insurance policy or retirement account, naming sub-trusts created under a revocable trust are safer beneficiaries than testamentary trusts created under a will. The revocable trust exists now. It will continue to exist unless you revoke it. But if you leave assets payable to a trust created under your will, that trust may never be created. If you change your will and forget to change your beneficiaries, or if your will is never located, the asset will be paid to your estate. Both life insurance and inherited

IRAs are protected from your creditors. If they are paid to your estate, you lose that protection. There could also be serious tax issues if your retirement accounts have to be paid to your estate. Also, some financial institutions will not allow testamentary trusts created under a will to be beneficiaries of their accounts.

It is always best to fund the trust. But if you choose not to re-title assets now, you should consider an estate plan that gives you the flexibility to maximize its potential at a later time.

It's April and We Still Have No Guidance on Changes to VA Aid & Attendance

I meet with someone just about every week who needs assisted living or in-home care, but does not have the money to pay for it. Unfortunately, most of the time, they also make too much money to qualify for help through the state. If the person needing care is a veteran who served during a period of war or the surviving spouse of a veteran who served during a period of war, VA  Aid & Attendance can be the perfect solution. The income and asset limitations are more lenient than either Medicaid or Special Assistance. There is no estate recovery.  And at the present time, there are no gift penalties and no look-back period. There are many planning opportunities for qualified veterans. 

More than two years ago, the VA published a proposed rule that would significantly change VA planning. It would amend the portion of the code of federal regulations that would create a 3-year look-back period and a transfer penalty.  The VA did not initially give any guidance on when the proposed rules would come into effect. However, in October 2016, a VA staff member stated that because of the complexity of the rule and the large number of comments received, the VA did not anticipate publishing the final rule before April 2017. It is now the end of April and the rule is not in effect. The newest unofficial estimate is that it may come into effect later this year. 

I was more cautious about VA planning last fall. At this point, it does not seem likely that the new rules will be implemented anytime soon. While every case is different, in most cases, I am suggesting that clients move forward with VA planning. If you or a loved one are a veteran who served during a period of war and needs assisted living or in-home assistance, please call us at 252-289-9800 to set up a time to discuss this opportunity. 

A Short Comparison of Wills and Revocable Trusts

I explain the differences between will-based plans and revocable trust-based plans to just about every day. This summary will not go into great detail, but will cover the basics.  

Things that Revocable Trusts Can Do that Wills Cannot

  • Avoid guardianship. A revocable trust allows you to designate when, who and how someone takes over if you become incapacitated and unable to manage your own affairs. Wills only become effective when you die, so they are useless in avoiding guardianship proceedings during your life. If you have a will-based plan, you will have to rely on a financial power of attorney for incapacity planning. Because powers of attorney do not take away your ability to make financial decisions upon your incapacity, an incompetency proceeding could still be necessary.   
  • Bypass probate. Property held in a revocable trust does not pass through probate. Your trust doesn’t die with you. A new trustee takes over. The probate process is essentially a way to transfer title. A will has no effect until it is probated. Therefore, property that passes using a will must go through probate.  Probate is a public process and can be costly and time consuming. In most cases, it is preferable to avoid probate.  
  • Maintain privacy after your death. Wills are public documents; trusts are not. Anyone, including your inquisitive neighbor, can discover the details of your estate if you have a will. Trusts allow you to maintain your family’s privacy after death. 
  • Help protect you from court challenges. Although court challenges to wills and trusts occur, a person who is disinherited by a trust will have a harder time contesting the trust because they won’t have a right to get a copy of the trust document. Under North Carolina’s trust code, a trustee’s duty to give information about the trust is to the beneficiaries only.
  • Help you organize Your assets. You don’t have to have a trust to organize your assets. But if you fund the trust, you have to organize. You will review all of your beneficiary designations and title to all of your assets. You may end up consolidating assets. We often refer to trusts as buckets. When you fund your trust, you will inventory your assets and put them in the bucket. This takes some of the burden off of your Successor Trustee or Executor.

Things that Wills Can Do that Revocable Trusts Cannot 

  • Name guardians for children. A revocable trust cannot be used to name guardians to care for minor children. Should you choose a revocable trust-based plan, your will can designate your choice of guardian. You can also use a designation of standby guardian to facilitate this transfer upon your death or disability.
  • Ensure that the court supervises the estate administration. This is something that we generally try to avoid. But in some cases, it may be preferable to have the court approve each distribution and supervise your Executor.  
  • Protect your spouse’s assets from the costs of long-term care. Revocable trusts don’t mix well with Medicaid planning. One of the tools that we use to protect the last surviving spouse from having to spend all of his or her assets on a nursing home is a special needs trust. For some unknown reason, this only works for trusts created in wills.  

Things that Both Wills and Trusts Can Do

  • Allow revisions to your document. Both wills and revocable trusts can be revised whenever your intentions or circumstances change so long as you have the legal capacity to execute them. 
  • Name your beneficiaries. Both wills and trusts allow you to name beneficiaries for your assets.  You will controls only assets in your individual name that do not pass automatically at your death. Your trust will only transfer those assets that have been transferred to your revocable trust. 
  • Provide asset protection for beneficiaries. Trusts and wills can be crafted to include protective sub-trusts which allow your beneficiaries access but keep the assets from being seized by their creditors such as divorcing spouses, judgment creditors, and a bankruptcy trustee. The difference is that if the trusts are created in a will, they also become a public record.

We discuss the differences between wills and trusts in detail with our clients. We look at each client’s goals, financial situation and family dynamics to design an estate plan tailored to their needs. If you would like more information about which type plan may be right for you, we would be happy to discuss this with you.  

Life Insurance and Irrevocable Life Insurance Trusts

Life insurance can significantly leverage your wealth. It is a cost-effective way to help your loved ones deal with the financial consequences of losing you. In most cases, the build-up of internal cash value in a life insurance policy is not subject to current income taxation. Similarly, the receipt of death benefits by the named beneficiaries is generally not considered income.

Fortunately, North Carolina also provides significant protection of life insurance proceeds from your creditors. By statute, insurance on your life is not available to pay your creditors so long as it is payable to someone other than your estate. If you want to be extra cautious, make sure your insurance policy proceeds are payable to your spouse or children. Article X, Section 5 of the North Carolina Constitution protects all life insurance paid to your spouse or children from your creditors.  

The proceeds of a life insurance policy may provide a means to satisfy mortgages or pay other debts, such as the costs of your last illness or your funeral expenses. Life insurance can also be used to equalize inheritance to your beneficiaries when you leave a business, a farm or other assets to one child. It may also be used to provide funds for a surviving business partner to buy your ownership interest. In some cases, life insurance proceeds are invested to provide a source of support for your heirs. It may also provide liquidity to for the payment of federal estate taxes.

A decade ago, estate tax planning often drove the estate plan. However, in the current era of fairly high estate tax exclusions, estate planning is usually focused on the best way to protect your beneficiaries and enhance their lives. There is a great deal of flexibility in how to handle life insurance in non-taxable estates.

But for estates with assets greater than the applicable exclusion, life insurance may be an essential component of the estate plan. This is particularly true in taxable estates with little liquidity. You can’t pay estate taxes with land or an interest in a closely-held business. But your gross estate for estate tax purposes consists of the value of all property that you owned or in which you had an interest at the time of your death.

If you have any “incidents of ownership” in a life insurance policy at death or have transferred those incidents of ownership during the past three years, your gross estate includes the death benefit proceeds of your life insurance policy. The current maximum estate tax rate is 40%. So if you have a taxable estate, the effective value of a life insurance policy owned in your name is reduced by 40%. That is a good reason to remove your life insurance from your estate. There are several ways to remove the life insurance from your taxable estate.

The simplest – and most dangerous – way to remove life insurance from your estate is to have a third party, such as a child, own the policy. The premiums could be funded with a bonus if that child works in your business. But when a child buys a policy on your life, there are several potential problems. Perhaps the most significant is problem is that you lose control of ownership and beneficiary designations in the case or your child’s death or disability. You want to make certain that the policy ends up in the right hands in those cases. Specifically, you don’t want the policy coming back into your hands. You also want to make sure that someone else, such as your child’s spouse, doesn’t have the ability to change the beneficiary designation. Although the proceeds are protected from your creditors, they are not protected from your beneficiary’s creditors. If that child owes money when you die, his or her creditors will be paid from the proceeds. Leaving the policy to a child will cause estate tax inclusion in his or her estate. Of course, if they have to spend it on estate taxes, that won’t matter. But if your child died in a car wreck six months after you, before the estate tax was paid, that entire amount would be a part of his or her estate. Another consideration is that if the benefits are paid to a child, and that child pays debts that would have been attributable to other children, there could be a gift tax issue. Finally, there is no way to take advantages of Generation Skipping Transfer Tax saving strategies with this kind of ownership. So having a child own an insurance policy is somewhat dangerous. 

Another common alternative is to let your business own the policy. However, there are several concerns with this option as well. Creditors of the business could make claims against the policy value. Also, premiums paid by the company are not deductible. Should the company ever wish to distribute the policy, there could be tax implications. Generally, death benefits payable to the business are not taxed as income. However, there are situations in which they could be. And although the death benefit will generally not be considered a part of your estate, it will increase the value of your business interest, which will be part of your estate. So there are concerns with this method as well.  

The safest alternative if you have a taxable estate is an irrevocable life insurance trust (“ILIT”). An ILIT is a trust that is designed specifically to hold life insurance policies and keep them outside your estate. The trust normally receives cash gifts from you during your lifetime, and the trustee uses those gifts to maintain a life insurance policy on your life. When structured correctly, the value of the property transferred to an ILIT is removed from your gross estate for estate tax purposes. The property is not subject to estate tax or to your beneficiaries’ creditors or predators at your death.

If existing policies are gifted to an ILIT, you must live at least three years from the date of transfer to have the death proceeds excluded from your taxable estate. Therefore, when possible, it is best to replace existing policies with new policies which are owned from the outset by the ILIT trustee. However, there are more advanced strategies to avoid this three-year inclusion issue, such as a sale to the trust.  

Each time a premium payment is made through the trust, the trustee must send certain notification letters to each of the beneficiaries, including any minors. These are referred to as Crummey notices. Crummey was the 1968 decision by the Ninth Circuit Court of Appeals that approved of this procedure. The purpose of these notices is to ensure that the funds paid to the trust are considered completed gifts. The gift tax exclusion applies only if these notification letters are properly sent each time a premium contribution is made to the trust, or a policy is transferred into the trust. Your trustees should keep a file containing all of the notification letters.

If you have or may have a taxable estate, life insurance may be necessary in order to provide liquidity to pay estate taxes. Although ILITs are inflexible and require maintenance, they overcome many of the problems of the other forms of ownership