I wrote recently about pot trusts and how they can be used to provide for a more equitable distribution for minor children. As I mentioned, pot trusts allow all trust assets to be held in a common “pot” for the benefit of children until a certain triggering event occurs (attaining a certain age, graduating from college, etc.) for all of the children. Pot trusts are used as an alternative to the more-common method of dividing the trust into separate shares at the death of the trust creator.

I’ve been working on a pot trust for a client and thought I’d share the clause I’m drafting. This particular client wants the trust assets to be held in trust until all of his children have either graduated from college and had two years of graduate education or have reached age 26. One of the children has already been in drug rehabilitation, so the client wants to be sure that the pot trust isn’t drained to provide for that child’s drug problems. He wants to do this by capping the total amount of drug and alcohol related expenses to $20,000.00 for any one child. Here’s the clauses that I’m using:

4.01       Management of Trust for the Benefit of My Children.

Until all of my children have either completed all undergraduate education and at least two years of graduate education or attained the age of twenty-six (26) years, whichever occurs first, the Trustee shall from time to time pay to or use and apply for the benefit of any child of mine so much of the net income of this Trust and principal thereof, in such amounts and proportions, equal or unequal, as the Trustee may deem necessary for the health, support or maintenance of such child in accordance with his or her standard of living prior to my death, and for the education of such child at any available level and at any formal educational institution, whether or not accredited, including college and postgraduate schools; provided, however, that in no circumstances shall my Trustee make more than Twenty Thousand Dollars ($20,000.00) in aggregate distributions to pay for any single child’s care in alcohol or drug rehabilitation facilities or programs.  In each case, the Trustee shall take into consideration other income and assets of such child and trusts of which he or she is a beneficiary and which are known to the Trustee.  The Trustee (i) may pay all or part or none of the net income or principal of the Trust or both; (ii) may make unequal payments; (iii) may from time to time exclude one or more of such persons from payments hereunder; and (iv) may make payments to any such person who is living at the time of such payments even though such person is not living at the time of the creation of the Trust.  Any part of the net income of the Trust not so paid or used shall be accumulated, added to and made a part of the principal of such Trust.

4.02       Distribution of Trust.

As soon as practical after the date upon which all of my children have either completed all undergraduate education and at least two years of graduate education or attained the age of twenty-six (26), whichever occurs first, the Trustee shall divide the Trust into as many shares as there are children of mine then living, and one share for the then living descendants, collectively, of each deceased child of mine (a “Child’s Share”).  The Trustee shall distribute, outright and free of trust, one Child’s Share to each child of mine and one share to the living descendants, collectively, of each deceased child of mine, the lineal and adopted lineal descendants of any child who predeceases me to take the share such deceased child would have taken if living, per stirpes and not per capita, subject to the provisions of Section 4.03 hereof.

4.03       Trust for Descendant of a Deceased Child of Mine.

If any part or share of the Trust becomes distributable to a descendant of a deceased child of mine who is under the age of twenty-six (26) years, then though his or her share shall be vested in him or her, the Trustee may, but shall not be required to, continue to hold the same in trust with all of the powers and authority given to the Trustee with respect to other trust property held hereunder, until such descendant attains the age of twenty-six (26) years.

So what do you think? Is it helpful? Any room for improvement? Let me know in the comments below.

There seems to be a great deal of confusion about the annual exclusion from gift taxes.  Most of my clients with taxable estates have been told that they can give a certain amount (currently $13,000) per individual each year. Many view this as a hard rule.  They believe that any gift over the annual exclusion will have catastrophic tax consequences.

This isn’t always the case.  The vast majority of people need not be concerned with gifting more than $13,000 per year, especially under the current estate tax laws.  Let’s take a quick look at the estate and gift tax rules involving the annual exclusion to see why.

What is the Annual Exclusion? A Quick Primer

The annual exclusion is an amount that the Internal Revenue Code allows you to give away to as many people that you wish, each year, without the amount being subject to gift tax or requiring the filing of a gift tax return.  The annual exclusion is currently $13,000 but is indexed for inflation in $1,000 increments.

As a planning tool, the annual exclusion allows clients to reduce the value of their taxable estate.  Every $13,000 that is gifted under the annual exclusion is $13,000 less that will be subject to estate tax at the client’s death.

For example, assume that a husband and wife have three grown children and three grandchildren.  By giving the annual exclusion amount to each child and grandchild, husband and wife could make annual exclusion gifts of $78,000 per year ($13,000 X 6 beneficiaries).  The same husband and wife could also make annual exclusion gifts to the spouses of their children, allowing them to gift another $39,000 per year ($117,000 total).  That’s $117,000 more that the client can leave to the next generation free of gift and estate taxes.

The annual exclusion can also be leveraged to give away more than $13,000 of actual economic value to each recipient free of estate or gift taxes. For example, annual exclusion gifts are commonly used in conjunction with family limited partnerships.  The children are given limited partnership interests that already reflect a discounted value.  Over time, the aggregate amount shifted to the children includes far more than the sum of each year’s $13,000 annual exclusion.

Why Most Clients Can Ignore the Annual Exclusion Amount

As mentioned earlier, many people are vaguely aware of these rules and assume that they are absolutely prohibited from gifting more than $13,000 per year. But this isn’t the case. To understand why, you need to understand what happens if the gift exceeds $13,000.

Say that Joel, an unmarried man, has an estate worth $1 million.  In 2012, Joel decides to give his $100,000 vacation home to his daughter Sally.  This gift clearly exceeds Joel’s $13,000 annual exclusion.  Does that mean that Joel or Sally will need to pay taxes on the transfer?

The answer is “no.”  Each person has a certain amount (called the applicable exclusion amount) that he or she can give away during their lifetime and at death without being subject to estate or gift taxes. That amount is currently $5 million.  That means that Joel can give an aggregate of $5 million away during his lifetime or at his death without worrying about estate taxes.  Since Joel’s estate is only worth $1 million he doesn’t need to worry about being subject to estate or gift tax on any lifetime transfers. The gift of the vacation home to Sally will not be subject to gift taxes.

Gifts in excess of the annual exclusion only reduce the overall applicable exclusion amount.  Under current law, each gift in excess of $13,000 will chip away at the $5 million that a person could otherwise transfer free of estate and gift taxes.

In Joel’s case, he gave away $87,000 more than the annual exclusion amount ($100,000 value of home less $13,000 annual exclusion amount).  This $87,000 will reduce his applicable exclusion amount of $5 million to $4,913,000.  Since Joel’s estate is only worth $1 million, his remaining $4,913,000 exemption will easily cover the value of his estate at death.  No estate or gift taxes will be paid on the transfer of the home to Sally.

That isn’t to say that the transfer of the home has no tax consequences, though.  There are two primary effects of the transfer of the home:

• Because the IRS needs to be able to track the reduction of the applicable exclusion amount, Joel will need to file a gift tax return to report the value of the transfer.  This is purely a reporting issue.  No estate or gift taxes will need to be paid.
• Sally will take Joel’s basis in the vacation home.  This means that any appreciation in the home at the time of the transfer will follow the home into Sally’s hands.  When Sally sells the home, she will pay taxes on any appreciation that accrued during her lifetime and any appreciation that accrued while Joel owned the home.  If Joel held the property until his death, any appreciation that accrued during Joel’s lifetime would be wiped out.

These two rules (the need to file a gift tax return for gifts in excess of the annual exclusion and the transferred basis rule) are the only two that most clients need to know.  Because the value of most people’s estates doesn’t exceed the applicable exclusion amount (currently $5 million per person, $10 million per married couple), most people don’t need to worry about paying gift taxes for gifts in excess of the annual exclusion amount (currently $13,000).

A disclaimer is a refusal by someone to accept property that was left to them through a trust or estate. The person signing the disclaimer makes an irrevocable and unqualified decision to refuse any interest in the disclaimed property.

Disclaimers are incredibly useful for straightening out tax planning and drafting problems with an estate plan.  The disclaimer allows a “second look,” giving attorneys the ability to rewrite portion f of the estate plan to reach tax or practical goals or to fix problems with the estate.  Common examples include:

• Avoiding generation-skipping transfer tax problems;
• Asset protection by preventing disclaimed property from becoming subject to a beneficiary’s creditors;
• Remedying the failure to make full use of the decedent’s annual exclusion amount;
• Adjusting between the credit shelter and marital deduction bequests in a decedent’s estate; and
• Preventing acceptance of problem assets, such as environmentally-contaminated real estate.

Qualified Disclaimers

All disclaimers should be “qualified disclaimers,” a term of art referring to disclaimers meeting the requirements of Section 2518(a) of the Internal Revenue Code.  If the disclaimer is a qualified disclaimer, it is treated as though it had never been transferred for tax purposes.  In order to qualify, the disclaimer must meet the following requirements:

• It must be irrevocable.  The disclaimant can’t leave open the possibility of changing his or her mind.
• It must be unqualified.  The disclaimant can’t make the disclaimer contingent on anything or redirect the distribution of the asset.
• It must be in writing.
• It must be delivered to the transferor of the interest, or his or her legal representative, or the holder of legal title to the property within 9 months of the later of:
  • The date upon which the transfer creating the interest is made or
  • The date upon which the disclaimant turns 21.
• The disclaimant must not have accepted any interest in the disclaimed property or any of it’s benefits.
• The disclaimed interest must pass to the surviving spouse of the decedent or some other person without any direction by the disclaimant.

Partial Disclaimers

The Internal Revenue Code allows partial disclaimers.  As long as the requirements of Section 2518(b) are satisfied, the transfer of an undivided portion of an interest in property is treated as a qualified disclaimer of that interest.

A premarital agreement can be a tough topic to discuss and a tricky document to draft.  The discussion part is primarily the concern of the client.  Although the attorney can make suggestions about why premarital agreements might be a good idea in a given situation, it’s up to the clients to discuss this sensitive matter with each other.  But the drafting falls squarely on the attorney.

The drafting difficulty is a result of the interdisciplinary nature of premarital agreements.  At a minimum, the attorney needs to be familiar with estate planning, probate (including elective shares and other spousal rights), and matrimonial/family law.  Other laws affecting marital property can also come into play.

Take, for example, retirement plans.  If one spouse makes contributions to a retirement plan during marriage, should the premarital agreement require that he or she make equal contributions to the other spouse’s retirement plan?  That may seem like a good idea – unless you know that the husband’s retirement plan is a 401k and the wife’s retirement plan is an IRA, and that the contribution limits for these two types of plans are the same.  To make this judgment call, you would need at least some familiarity with the rules governing retirement plans.

In situations like this, where other areas of law or even non-legal rules could be involved, it is best to take a collaborative approach.  In the above example, working with the client’s financial advisor could help you spot the retirement planning issues that you might otherwise miss.  It’s best to hit the problem from as many different angles as possible.  This shared expertise will help ensure that the premarital plan will work as intended.

How would you like to set up a pot trust for your kids?

Actually, it isn’t as bad as it sounds.  A pot trust has nothing to do with illegal herbal recreation.

Pot trusts are designed to equitably distribute assets to a group of children with a range of ages.  For example, assume that a husband and wife want to distribute their assets to their children at the death of the second spouse.  Assume that their youngest child is 11 and their oldest is just finishing college.  Would it be fair to split the assets between these two children?

The answer in most cases is “no.”  The 25-year-old child has already been supported for the bulk of his youth.  He can spend his share of the trust on whatever he chooses.  The younger child, though, still has some years of dependency.  Her share will be spent on providing for her needs over the next decade or so.  The goal of dividing the estate between the children, which seemed fair enough at first, turns out to favor older children to the detriment of younger children.

Pot trusts are used to address this problem by delaying the division of assets.  Instead of dividing the assets equally upon the death of the second spouse, a pot trust could be used as a receptacle (“pot”) to hold the property until the youngest child graduates from college.  Until then, the money is held in the pot.  It can be spent on either child, but the primary purpose of the trust is to provide for the younger child until he reaches the age of self-sufficiency.

Once the younger child graduates from college (or reaches whatever trigger is described in the trust), the division of assets is finally made. At that point, the trust assets can be distributed to both of the children.  Each will have had their room, board, and college paid for, and each will receive an equal share of whatever is left after payment of those expenses.  This is a much fairer result in many situations.