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Client Alert: Recent Developments in Estate Planning

By Scott Dondershine, CPA, Esq.

A few years ago my firm circulated a Client Alert advising clients as to recent developments in estate planning. Today, we are circulating a new Client Alert as a result of additional important changes affecting almost every person’s estate plan. This Client Alert provides general guidance only (primarily for residents of Virginia, Maryland and D.C.) and should not be relied upon for legal advice.

I. New Strategies in Creditor Protection Planning. Now, more than ever, it is easier to provide individuals (especially those living in Virginia) with creditor protection planning as part of an estate plan.

A. Creditor Protection for Grantor’s. Although revocable living trusts established in Virginia, Maryland and D.C. are generally not designed to provide significant protection against the creditors of a grantor, a recent change in Virginia law provides residents of Virginia with a unique opportunity to protect assets from creditors of the grantor. The change codified in Section 55-20.2 of the Code of Virginia affects property that is owned as tenants by the entireties that is then transferred to one or more revocable living trusts.

Only married persons can own property as tenants by the entireties as long as the property is correctly titled as such. While real estate deeds for property owned by a married couple usually include the requisite language, investment accounts do not and are more typically titled as joint tenants by right of survivorship and not as tenants by the entireties — unless, you specifically request titling as tenants by the entireties.

Tenants by the entireties titling is usually preferable than joint tenants with right of survivorship since the creditors of one spouse generally cannot reach property that is owned with the other spouse as tenants by the entireties. The same is not true of property titled joint tenancy by right of survivorship or as tenants in common.

Unfortunately, owning property jointly usually conflicts with the goal of reducing estate taxes by making sure that each spouse has enough separately owned assets with which to absorb the first spouse to die’s estate tax exemption, i.e., the applicable exclusion amount that currently is $2,000,000. A recent change to Virginia Code Section 55-20.2 now provides that real or personal property owned as tenants by the entireties can be conveyed to one or more revocable living trusts established by the spouses (thus being “separate” property for estate tax exemption purposes) while still retaining the characteristic of tenants by the entireties property for creditor protection purposes. In other words, the statute allows the best of both words, i.e., utilization of both spouses’ applicable exclusion amounts and creditor protection.

In light of the statutory change my firm is recommending that all clients review the titling of assets to make sure that any real or personal property transferred to the revocable living trust of one or both spouses is first owned as tenants by the entireties and then is transferred to the revocable living trusts. Section 55-20.2 does not specifically address whether property can be conveyed to just one spouse’s trust (as opposed to a portion to each spouse’s separate trusts) and it may be prudent to transfer a portion of any joint property to each separate trust until more guidance becomes available.

If property, such as an investment account, is owned jointly but not as tenants by the entireties, we are recommending that the property first be titled as tenants by the entireties and then transferred to the trust(s). If property is already owned by the trust(s), it may also be worth the exercise of taking the property out of the trust(s), owning it as tenants by the entities and then re-transferring it to the trust(s). Although multiple transfers are needed as establishing a paper trail is important, taking advantage of the favorable change in Virginia law could become important if one spouse develops a problem with creditors after the transfers.

B. Creditor Protection for Beneficiaries. Using trusts for creditor protection purposes can be explained by thinking about your favorite toothpaste. Toothpaste squeezed out of a tube becomes accessible to the squeezer. An asset distributed to a beneficiary from a revocable living trust becomes accessible to the creditors of the beneficiary.

It used to be commonplace for trusts to have “mandatory” distributions to children at certain ages. For instance, one-third of the principal at age 30, one-half of the remaining balance at 35 and the rest at age 40. If a child becomes subject to a creditor proceeding such as a divorce, then a separate clause in the trust, known as the “spendthrift” provision, permits the trustee to withhold or delay the distribution so that the assets are not received by the creditor. Spendthrift clauses are helpful in delaying distributions in order to prevent creditor attachment of assets but are not effective to prevent creditors from seizing assets already distributed out of the trust (or out of the toothpaste tube).

Many states have recently considered and adopted the Uniform Trust Code (“UTC”), including Virginia and the District of Columbia, and other states are considering adopting the UTC (including Maryland). Unfortunately, the UTC contains a provision allowing creditors to reach distributions that are delayed in certain circumstances (due to spendthrift language) if the distributions would have otherwise been made pursuant to trust terms that make the same “mandatory” (e.g., 1/3 of the principal at 30, ½ of the remaining principal at 35 and the balance at 40). Section 55-545.06 of the Code of Virginia and Section 19-1305.6 of the District of Columbia Code.

I predict that the adoption of the UTC by more and more states will increase the use of “dynasty trust” provisions. Dynasty trust language causes trust assets to continue to be held in sub-trusts established for each child rather than automatically distributing assets at certain ages. Each child can become a co-trustee of his or her sub-trust with (for maximum protection) a trustee that is “independent” of the child, e.g., in broad generalities not a close family member, being the co-trustee with the authority to make distributions to the child for his or her “general welfare or care” or some other standard. Since the assets would remain in trust until needed by the beneficiary, the “toothpaste” is not distributed until it is consumed by the child and not by the creditors! We therefore recommend that your plan be reviewed for possible incorporation of dynasty trust provisions.

II. Other Reasons to Revisit Your Plan. In addition to revisiting plans to take advantage of creditor protection planning, you may want to make sure that you have properly considered the impact of other changes.

A. Changes in the HIPAA Regulations. Final regulations were promulgated a few years ago interpreting the Health Insurance Portability And Accountability Act (“HIPAA”). The regulations may make it more difficult for your agents under your powers of attorney to receive medical information on your behalf if you become disabled. Your documents may need to be revised to specifically refer to your agents having the authority under the HIPAA regulations to review your medical records. You may also want to amend your trust documents enabling the review of medical information regarding the ability of current trustees to continue serving.

B. State Tax Impact of the EGTRRA. The Economic Growth and Tax Relief Reconciliation Act of 2001 (the “2001 Federal Act”) “temporarily” eliminates federal estate taxes by phasing out the tax rates between 2002 and 2010 (when the rates will be eliminated). The 2001 Federal Act also raises the applicable exclusion amount available to shelter assets from estate taxes from the current amount of $2,000,000 to $3,500,000 in 2009.

Unfortunately, the legislation makes the repeal temporary, meaning that unless the current or a future President and Congress agree to make the repeal permanent the taxes will be reinstated in 2011. Under current legislation, in 2011, the applicable exclusion amount will return to $1,000,000.

The estate tax laws in many states are “tied” to the federal estate tax laws. Before the adoption of the 2001 Federal Act, many states imposed a state estate tax that was exactly equal to the amount that federal law provided as a credit for state death taxes. The 2001 Federal Act caused numerous problems in the states tying the state death tax laws to the federal estate tax laws.

The laws of Virginia, Maryland and D.C. have been revised several times in recent years as a result of the chaos caused by the 2001 Federal Act. Although Virginia generally no longer imposes state estate taxes for people dying on or after July 1, 2007 and before January 1, 2011, Maryland and D.C. impose a state estate tax for estates of over $1,000,000 – regardless of whether federal law exempts from federal estate a greater amount of assets.

A very appropriate estate tax strategy for most married couples is for the first spouse to die to utilize the applicable exclusion amount by placing separately owned assets in a bypass or family trust. The result is that a Maryland resident dying with, for instance $1,500,000 in assets, would pay $64,400 even though no federal estate tax would be due. Although it may make sense in some situations to pay the state tax since that would enable a greater amount of assets to escape federal estate tax through the applicable exclusion amount, in other situations it may not be prudent to fully utilize the applicable exclusion amount. Maryland and D.C. residents probably should revise their revocable trust agreements or other documents to not “force” the trustees and other representatives to take the full applicable exclusion amount if the same would result in state death taxes.

III. Summary. The bottom line is that residents of all states probably should have their estate plans reviewed in order to reduce exposure to the claims of creditors, for compliance with HIPAA and adequately address any state tax issue. It also may be appropriate and prudent to review the titling of all assets to make sure that all (1) appropriate assets are placed in revocable trusts in order to reduce exposure to probate and for better incapacity planning and (2) assets are properly titled to reduce and possibly eliminate projected estate taxes.

Unfortunately as you can see, the estate tax and other laws are becoming more complicated – not easier to understand. The changes may require updates or modification to your trusts. We can discuss the issues in this Client Alert with you in greater detail, if desired.

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this Client Alert is not intended or written to be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in this Client Alert.