Newsletter: February 2010

February 26, 2010

In this issue: The Importance of a Well-Designed Estate and Wealth Management Plan

THE IMPORTANCE OF...

In this month’s edition of the Smith and Condeni LLP Internet Newsletter, we turn our attention to the importance of some of the finer details of a well-designed estate and wealth management plan; details that in our experience are often overlooked and potentially disastrous for many of our clients.

...Looking Before You Leap

A client recently asked us to explain the tax implications of a family arrangement involving a $3,000,000 second-to-die life insurance contract owned by Child 1 on the lives of Mom and Dad.

Under the arrangement, Mom and Dad are gifting the an amount equal to the premium cost to Child 1, who is using the gifts to make the annual premium payments to the insurance company. Child 1, as the owner of the policy, has named herself and her brother, Child 2 (our client), as equal beneficiaries of the policy. Ostensibly, the family sees this arrangement as a simple way to avoid estate taxation of the policy death benefit upon the death of Mom and Dad, since neither Mom nor Dad owns the policy.

While this arrangement may have the benefit of simplicity from the family’s standpoint, the underlying tax implications are actually quite complex and detrimental to the family’s estate and wealth management plan, as illustrated below.

Under the terms of the family’s existing arrangement, upon the death of Mom and Dad, the following events will be deemed to have occurred:

• Child 1 will have made a gift of $1,500,000 to Child 2.
• Child 1’s gift will require her to use her entire $1,000,000 lifetime gift tax credit if she wishes to reduce her gift tax costs.
• Because she has exhausted her entire $1,000,000 lifetime gift tax credit, Child 1’s federal estate tax credit will be reduced by a like amount, resulting in the following:
  • Assuming a federal estate tax rate of 45%, this may result in an additional $450,000 estate tax liability on Child 1’s estate.
  • The reduction of her federal estate tax credit will also limit Child 1’s tax planning opportunities during her lifetime.
• The portion of the gift not covered by Child 1’s lifetime gift tax credit ($500,000) will be taxed at the applicable gift tax rate. Assuming that the applicable rate is 45%, Child 1 will owe a gift tax of $225,000.

While it is possible for the family to “fix” the situation and avoid the adverse tax consequences outlined above with proper planning, in this situation it seems unlikely that this will occur; the last we heard from our client is that Mom and Dad’s estate planning attorney does not see a problem with the arrangement. This seems very frightening to us!

...Having Your Assets Properly Titled

While having well-drafted estate planning documents in place is certainly one of the most important elements of a successful estate and wealth management plan, those documents, in and of themselves, do not constitute a “complete” plan; numerous other elements must be analyzed and coordinated to ensure the client’s intention, as expressed the estate planning documents, is realized. One such element, often overlooked, is making sure that the client’s assets are titled properly.

Some of the benefits of proper titling include asset protection and the avoidance of probate upon the client’s passing. For married clients, this component of the estate planning process can also ensure that both husband and wife’s estate tax credits are fully utilized.

To highlight the importance and impact of proper titling in estate planning, consider the following:

We recently met with a married couple to discuss updates to their existing estate plan, which was originally created in 2000. The clients have a combined net worth of around $7,000,000, and each has an “A-B” trust in place for estate tax planning purposes. While the trust arrangement were clearly intended to maximize the use of the couple’s respective estate tax credits, a lack of clear instruction from the prior attorney with regard to proper titling of the clients’ assets essentially negated the estate tax-savings benefits of the trust arrangement:

• Because an “A-B” trust arrangement was in place, proper asset titling would have put the clients’ projected estate tax liability (Federal and Ohio) at around $170,000.
• However, because most of the clients’ assets were titled either jointly or payable-on-death to the survivor of the two of them, we projected the clients’ estate tax liability at nearly $1,300,000.
• In this scenario, proper titling of the clients’ assets alone generated an estate tax-savings of about $1,130,000.¹

To make sure that assets are titled properly, our attorneys prepare detailed schedules listing all of the client’s assets, and provide clear instructions to both the client and their advisors to make sure these instructions are properly followed and implemented.

...Keeping Business Records Up-to-date

It is very common for us to review business entity records that are unorganized and/or severely out-of-date. A client’s failure to observe proper record keeping practices can lead to disastrous consequences, as illustrated below:

A client recently told of us of his experience with the IRS and its assessment against him for unpaid employment taxes on a Company with which he had little direct activity or participation. The details are as follows:

• Years ago, Client financed the start-up costs of a Company that his son and daughter-in-law created together. In return for his financial contribution, Client was appointed to the Company’s Board of Directors and was named as the Company’s Vice President. Client never actually participated in the day-to-day business of the Company, electing instead to leave its operation to his son and daughter-in-law.
• Years later, Client’s son and daughter-in-law divorced. As part of the settlement from the divorce, Client’s former daughter-in-law was granted sole ownership of the Company. She did not run the Company very well and neglected to pay $60,000 in employment taxes owed by the Company.
• Because neither the Company nor Client’s former daughter-in-law had the financial resources to pay the taxes, the IRS assessed the Client for the payment of the unpaid taxes. Although Client never actively participated in the Company, the fact that he was named in the Company’s Records as a Director and Officer of the Company was sufficient for the IRS’s assessment against Client personally to stand; Client was therefore obligated to pay the assessment for the unpaid taxes, along with interest and penalties thereon.

This unfortunate situation could have been resolved if the Company records were kept up-to-date. In our experience, very few business owners attend to this important administrative function. One of the lessons of this case is that Officers and Board Members should also take the initiative to either be actively involved in business matters or resign.

FINAL THOUGHTS

As most of you have likely experienced, clients do not always consult their advisors before taking action on matters they incorrectly assume are unrelated to their estate and wealth management plans. As advisors, it is our first responsibility to make sure our clients know when to seek our advice to ensure all aspects of their plans are properly coordinated. However, knowing that our clients will inevitably enter into arrangements without our knowledge or input, it is also our responsibility to do our best to catch any errors that they may have made.

1. These estate tax calculations assume that we will have a federal estate tax with an estate tax credit of $3,500,000, and a top tax rate of 45%; Ohio estate taxes are also included in these calculations.

 

Please contact Smith and Condeni for more information. We look forward to hearing from you.