By Peter A. Karl, III
Looking into the Future
As the baby boom generation ages, issues of asset protection, estate planning, and eldercare are of greater importance. Advisors to individuals and businesses need to bear in mind certain tax and estate planning issues so assets are not depleted by eldercare expenses or taxes after death. The following questions focus on the most often asked, and sometimes sensitive, points. For instance, what assets and income can an individual retain when Medicaid is paying expenses for an institutionalized spouse? Good planning used too late can sometimes create more problems than it solves.
The type and provisions of wills, trusts, and other estate planning instruments have enormous impact, both short- and long-term, on the individual and family, heirs, and business partners. Situations are highly individual, and there are no simple answers. However, knowing current legislation and tax law and proactively using the available tools will minimize expenses and maximize long-term benefits to all parties.
1. What strategies can the average taxpayer use to protect assets when establishing ownership in investment realty or a business (e.g., to avoid the expense of creating a legal entity when adequate tort liability protection is not available)?
The simplest opportunity for asset protection occurs during the initial titling of assets, when the business is being formed or investment realty is being purchased. Two basic strategies accomplish the objective:
* Between a husband and wife, the business spouse would initially hold title to the business assets (or ownership in a closely held entity such as corporate stock, a partnership interest, or an LLC membership unit), while the nonbusiness spouse would hold title to the family's personal use assets.
The benefits of this arrangement are best illustrated by a future IRS assessment for unpaid withholding taxes (the 100% penalty). In this situation, mere co-ownership of the business by a spouse who is not even involved with the enterprise may result in the IRS imputing that both spouses should be regarded as "responsible parties" for the trust tax arrearages stemming from unpaid employee income tax and FICA withholdings. This can happen despite the supposed shield of the business entity with liability insulation, such as in C or S corporations and LLCs. As a result, the IRS may include the family assets at the time of levy or when it calculates an offer in compromise.
This business/nonbusiness asset splitting strategy is also beneficial for estate planning purposes in order to divide assets between the spouses. This will ensure adequate funding of a testamentary trust upon the death of the first spouse to take advantage of the unified credit for family estate tax savings.
* With respect to co-ownership of assets such as a personal residence, a tenancy by the entirety interest created by a husband and wife affords better protection than a property held by nonmarried individuals as joint tenants or tenants in common (such as a camp held jointly by a father and son). The problem with the latter two forms of co-ownership is that a creditor of a joint tenant or tenant in common can institute a partition action (a court-sponsored auction of the property), which could result in a nonliable co-owner being involuntarily divested of the property interest. This would not happen when the realty is held as tenants by the entirety in a situation when one spouse is being pursued by creditors.
2. When retitling assets for asset protection, when can a creditor argue that a fraudulent conveyance has occurred (i.e., assets transferred being deemed as a fraud to the creditors)?
The judicial standard is whether any "badges of fraud" exist. This fraud includes when an individual, for inadequate consideration, transfers property while insolvent or threatened by litigation from present creditors. If a court finds "clear and convincing evidence" of a fraudulent conveyance, the asset/s transferred (or their value) could be retrieved from the recipient under a transferee liability theory.
3. When determining initially what assets should be divided between the husband and wife when one spouse is involved in a business with liability exposure, how does the state of domicile affect asset protection?
Although the bankruptcy code is Federal, state bankruptcy exemptions vary widely. For example, the homestead exemption for the principal residence is only $10,000 in New York but unlimited in states such as Florida and Texas.
Therefore, the specific state provisions should be thoroughly examined to determine the planning opportunities (such as converting nonexempt assets to exempt ones) and pitfalls such as dealing with tax arrearages. (See "Answers to 20 Questions on Dealing with IRS Collections," The CPA Journal, February 1999.)
4. When an individual wants to become a resident of another state by changing domicile (to take advantage of asset protection or to shift from a high income and estate tax state to a lower one), how is it determined whether such a change has occurred?
The domicile of an individual entails a substantial physical presence in one state (as compared to another locale) along with the intention to remain there in the future.
Primary factors include the following:
* Time spent in the state (e.g., more or less than 183 days),
* Location of family and personal items,
* Maintenance of a home, and
* Active business involvement.
Secondary factors include the following:
* Primary address at which bank statements, bills, and other correspondence related to family affairs are received;
* Active involvement in community groups;
* Location of safe deposit boxes;
* Burial plot;
* Car, boat, and airplane registrations and driver's license;
* Affidavit of domicile;
* Voter registration and voting pattern;
* Homestead exemption (if applicable);
* Frequency and nature of use of professionals;
* Nature and level of telephone activity;
* Telephone directory listings;
* Special resident exemptions and benefits;
* Citations in wills and other legal documents; and
* Location where the will was executed.
5. Of the various types of legal entities available in the event that adequate tort liability insurance protection cannot be obtained, which is preferred for real estate or business ownership?
A limited liability company (LLC) provides the same liability protection as a C or S corporation without the accompanying "tax baggage." Upon the retitling of, for example, real property from an entity to its principals (in a nonliquidating or liquidating distribution), three significantly different results could occur, depending on the type of legal entity holding title:
* Double taxation--C corporation: an "as if," constructive sale in which gain is recognized by the entity along with a possible dividend to the shareholders.
* Single taxation--S corporation: an "as if," constructive sale in which gain is passed through to the shareholders.
* Zero taxation--LLC or limited liability partnership (LLP).
In addition, the popular family limited partnership (FLP) can provide valuation discounting (for transfer tax purposes with respect to business and real estate holdings). However, the general partner of the FLP still has unlimited exposure, subjecting this partner's assets to forfeiture in litigation (other than assets exempt under the bankruptcy provisions). This situation is in contrast to the generally liability-free condition for members of a family limited liability company (in which control is shared or delegated among the owner-members).
6. What asset protection benefit exists in using a legal entity when co-owners invest in real estate?
By using an entity for the holding of investment realty, the individual can convert tangible assets into an intangible personal property interest (such as a partnership or LLC membership interest, with the choice depending upon whether adequate and reasonable tort liability insurance coverage exists). As a result of this conversion, a creditor's remedies are generally restricted to a "charging order" that is applied against the debtor's ownership interest in the entity. This way, the judgment creditor only has the rights of an assignee (as if a voluntary assignment of the interest had occurred), which entitles the creditor to receive the portion of distributions in the future to which the debtor would have been entitled, if any. The charging order does not permit the creditor to obtain any interest in the underlying assets of the entity (unless it is solely owned).
7. How can a corporation organized in a state such as Nevada be used in conjunction with a family limited partnership to enhance asset protection of a closely held business in the situation where the business's older generation is concerned with a potential lawsuit or divorce against one of the enterprise's younger generation owners?
Besides having no income tax, Nevada is the only state that does not require public disclosure of corporate officers and shareholders. (A growing number of states allow this information to be readily accessible, e.g., via the Internet.)
Accordingly, a viable asset protection strategy is to have the investment realty or business titled in the name of a Nevada corporation. This corporate entity would be taxed federally under subchapter C (i.e., an entity not requiring the issuance of a Form K-1 to reduce shareholder disclosure to creditors) with its stock owned entirely by an FLP. The FLP can be established, for example, with the parents as the general partners, having a 2% interest, and the children as limited partners, receiving their interest by gift or sale (e.g., having a 98% interest as limited partners). This "entity layering" technique reinforces the concept that the limited partnership is the only entity option in which control can be retained in this scenario, by the parents, despite having only a "superminority interest." This entity affords a degree of insulation in the event of subsequent legal action against one of the limited partners.
8. What, if any, creditor protection exists for retirement plans?
The answer depends on whether or not the plan is covered under ERISA. ERISA plans [including profit sharing, ESOP money and purchase pension plans, and target benefit and 401(k) plans] have generally been exempt from creditors, while non-ERISA plans must rely on state bankruptcy exemptions for protection. This point was confirmed in a 1992 U.S. Supreme Court case (Patterson v. Shumate 112 S. Ct. 2242), in which the Court held that pension plans covered by ERISA are generally not subject to the control of the bankruptcy trustee because ERISA states that the benefits of pension plans cannot be assigned or alienated.
9. How can trusts be used for liability insulation?
A trust that is irrevocable and provides for no retention of benefits by its creator provides the greatest protection against creditors that attempt to seize assets titled in the name of the trust. Otherwise, a creditor "steps in the shoes" of the trust creator, which would allow a creditor to, for example, revoke a revocable trust or receive benefits for which the grantor is eligible under the provisions of the irrevocable trust. If the creator of an irrevocable trust retains a limited power of appointment pursuant to Regulations section 25.2511-2, the transfer is considered incomplete for gift tax purposes even though the assets transferred can be exempt from creditors. Because the trust assets are included in the grantor's taxable estate, the beneficiaries will receive a "stepped-up" income tax basis with respect to the assets subsequently distributed. (See "Answers to 20 Questions on the Use of Trusts," The CPA Journal, September 1998.)
10. How does the concept of a spendthrift trust protect underlying trust assets from the claims of a beneficiary's creditors?
Most states recognize the concept of a spendthrift trust, which protects the beneficiary's future benefits in the trust from the claims of creditors. However, this provision is unenforceable where a trust creator is also a beneficiary.
11. How can a discretionary or sprinkling trust provide additional asset protection to a trust beneficiary?
When the grantor of a trust wants maximum flexibility for beneficiaries (such as a spouse or children), a sprinkling irrevocable trust (either in the living or testamentary form) can be created that allows the independent trustee to disburse income or principal at his sole discretion according to the health, education, support, or maintenance needs of the beneficiary.
Trust provisions that defer absolute outright distribution to minors (typically until age 18 or 21) are best postponed until age 25. Though the trust language should permit interim distributions at the discretion of the trustee, this deferral will avoid a windfall being received by the beneficiary while undergraduate or graduate educational pursuits are still being considered.
12. Which U.S. jurisdiction currently has the most liberal living trust laws?
The state of Alaska has the most liberal living trust laws as a result of the April 1997 Alaska Trust Act. This law's unique provisions include the following:
* Future creditors of the trust creator are precluded from reaching the trust assets (unless a fraudulent conveyance exists) even though the creator can also be a discretionary beneficiary with trust distributions being in the determination of an independent Alaskan trustee. The IRS, in Revenue Ruling 76-103, stated that for a transfer to a trust to be considered a completed gift (and therefore not subject to subsequent estate taxation), the applicable state law must not allow for attachment of the trust principal by creditors.
* Repeal of the rule against perpetuities allowing for the perpetual continuation of a trust.
Whether a state such as Alaska will be able to provide true asset protection as accomplished by a properly structured foreign asset protection trust (APT) remains to be seen. States such as Nevada (as of July 1, 1999) permit the creation of a business trust with transferable certificates of beneficial interest (tantamount to shares of stock). Consequently, these types of trusts may be useful for the holding of property located outside of Nevada.
13. What role do foreign trusts have in asset protection?
A trust created and trusteed in a foreign jurisdiction places the assets outside the reach of U.S. courts. Such a trust creates a substantial burden for creditors, who must then litigate in a foreign court that may not recognize U.S. judgments. Despite the proliferation of foreign trusts touting income tax savings benefits, the IRS has considered these trusts to be tantamount to tax evasion when formed for any purpose encompassing tax avoidance. In fact, a properly structured foreign trust is usually a grantor trust under IRC section 671, with the creator being required to report the foreign source income along with filing Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts.
14. How is a jurisdiction for a foreign APT selected?
The following issues are relevant in determining whether a particular foreign country is appropriate:
* What is the statute of limitations for creditors to present a claim for fraudulent conveyances?
* To what extent can a trust creator also be a beneficiary?
* Are foreign judgments recognized by U.S. courts?
* What is the rule against perpetuities?
* Does the country allow for a "trust protector" (who would have veto powers to override or replace the foreign trustee)?
15. What are the major asset protection considerations in estate planning?
In planning for larger estates (generally, those in which the combined assets of husband and wife, including the "invisible assets" of life insurance and retirement plans, exceed the Federal unified credit equivalency amount), a testamentary trust funded at the death of the first spouse, known as the unified credit bypass shelter trust (UCBST), is often used. This illustrates why the estate tax is sometimes referred to as a "voluntary tax"--an unintended donation of assets as a result of the lack of proper planning (i.e., with the execution of the appropriate documentation and asset severing between spouses). The assets allocated to the UCBST (along with any subsequent increase in their valuation) are not subject to Federal estate taxes (and are reduced or possibly eliminated from any state assessment) at the death of both spouses. This type of trust can also isolate these assets from the creditors of the surviving spouse (such as a nursing home). This benefit is diluted to the extent there exists a mandatory income distribution or a "five and five power," which permits the surviving spouse to invade principal to the extent of the greater of $5,000 or five percent of the trust principal. The reason for the dilution is that the creditor is entitled to obtain what the beneficiary would receive.
A testamentary trust that provides for distributions of income and principal at the trustees' discretion should be considered even in estate plans without an estate tax problem, especially when the surviving spouse might encounter health problems (and an accompanying need for nursing home confinement).
16. What steps can be taken to protect the assets of older individuals concerned about losing their assets upon entering a nursing home?
The first step in elder planning should always be a cost-benefit analysis of long-term care and nursing home insurance. If this coverage is unavailable or prohibitive, other strategies include the following:
* Family gifting, either to the beneficiaries outright or to an irrevocable trust that provides income only to the creator. This gifting strategy can either be in advance or upon institutionalization of an individual in a nursing home the cost for which will be on a private pay basis for an interim basis prior to applying for Medicaid. Outright transfers have a 36-month "look back period," while transfers to a living trust have a 60-month time frame of review. When applying for Medicaid payment of nursing home costs, any transfers accomplished within the applicable time period must be factored into the formula to determine what contribution is expected on behalf of the spouse being institutionalized. The number of months of Medicaid ineligibility (which is not limited to 36 or 60 months) is calculated by dividing the average monthly cost of nursing home care (of the particular county in New York) into the impermissible transfer that occured during the lookback period. For example, if the average monthly cost for the nursing home is $5,000 and a $500,000 outright gift occurs during the 36 months preceding the Medicaid application, the ineligibility period for Medicaid is 100 months. In addition, any income generated from an irrevocable trust after the expiration of the 60-month period must still be factored into the amount to be contributed.
* Separation of an asset into two interests through the creation of a life estate in which an elderly couple retains a life interest in property (such as the family homestead) with the remainder to their children upon the death of the second spouse. This strategy prevents the full value of the remainder interest from being considered for Medicaid consideration after three years have elapsed. The creation of this type of interest does not generally preclude the continued availability of real property tax exemptions for a personal residence (e.g., elderly, military, and New York's STAR exemption). In addition, the remainderman will receive a stepped-up income tax basis upon the death of the life tenant/s in contrast to a carryover basis had the transfer been an outright one.
* A grantor retained annuity or income trust (GRAT or GRIT) similarly removes the remainder interest from Medicaid consideration 60 months from its creation.
17. What assets or income can the community spouse retain when Medicaid is paying on behalf of the institutionalized spouse?
In addition to being able to retain certain exempt assets, such as the family homestead, the community spouse has an exempt "resource amount" of assets and a monthly income exemption in New York ($84,120 and $2,103, respectively, in 2000). These figures vary from state to state (as long as the amounts meet the minimum required by the Federal government). The community spouse will be expected to contribute assets for the benefit of the institutionalized spouse in excess of this resource amount and exempt assets (which, besides the residence, also includes the first $12,000 of rental property value provided the net income generated reflects at least a 6% return on the property's equity) along with 25% of the income exceeding the monthly allowance. For purposes of this calculation, New York does not include the following items as income (though the underlying asset can be considered a nonexempt resource):
* Lump sum distributions from IRAs and annuities (though Social Security income is included),
* Interest from Series E or EE bonds,
* Capital gains (unless they are a distribution from a mutual fund or money market account), and
* Nonperiodic income such as interest from a CD or the growth from a zero coupon bond prior to the month the income becomes available (i.e., the month of maturity or reinvestment).
If the individual is single, obviously the community spouse allowance cannot be used to shelter assets and income, with the resulting exposure of the assets or income to the contribution formula under Medicaid. However, this institutionalized individual, in New York, has several other options under 2000 law:
* Retain $3,600 in cash or other liquid investments.
* Keep $2,000 worth of personal belongings.
* Create an irrevocable living trust to prepay burial and funeral expenses.
* Establish a burial reserve of $1,500 or retain the cash value of life insurance provided the aggregate face value of the policies do not exceed the nominal amount of $1,500.
* Receive $50 per month of income for personal needs.
18. When reviewing a long-term care insurance policy to minimize exposing assets to a nursing home, what are the relevant considerations?
Weigh the cost of the policy against the following typical options:
* Daily nursing home benefit (compared to the daily rate in the client's locale)
* Percentage of the daily benefit that may be used toward home health care
* Number of years over which benefits are payable or the maximum total benefits payable by the insurance company
* Initial waiting or elimination period before benefits are payable (nothing that Medicare will, provided certain conditions are met, fully cover the first 20 days of nursing home coverage and a portion of the next 80 days)
* The specific coverage for Alzheimer's or related diseases (i.e., at what point in the progression of the illness does the insured become eligible for benefits)
* Inflation adjustments to the daily benefit (simple or compound interest calculation)
* Any discount for joint spousal policies
* Waiver of premium
* Company rating.
Given the probabilities of eventual long-term illness among the elderly population as a whole, long-term care should be considered by all except those on either extreme of the economic scale. Depending upon the options selected, annual premiums will vary greatly. It should be noted that New York provides for a specific itemized deduction with respect to premiums paid for a long-term insurance policy. While this expenditure is subject to the medical deduction limitation on the Federal return based on AGI, the maximum amount that a New York taxpayer can deduct is dependent upon the age of the payor (e.g., if age 6170, the deduction is $2,120; if over age 70, $2,660).
19. How does asset protection vary across the different types of long-term care insurance policies?
Certain states, including New York, have established a partnership program, through the Robert Wood Johnson Foundation, with the following three partners (with accompanying responsibilities):
* The insured, who agrees to pay the cost for a partnership policy providing three years of nursing care in an institution, six years of home care coverage, or a combination of both. This type of policy is prepackaged, with certain of the previous options (such as the inflation rider) being predetermined.
* The insurance company, which provides the applicable benefits under the policy (i.e., three years for a nursing home stay, six years for home care, or a combination of both) for care providers located in New York.
* New York State, which agrees not to require any "spend-down of assets" (i.e., "resources") for Medicaid qualifications when the three- or six-year benefit period expires. However, 25% of the family income in excess of the monthly income allowance of $2,103 (in 2000) will be applied toward the cost of the long-term care. The partnership program does allow for the unlimited transfer of assets ("resources") without penalty in order to reduce this income contribution (i.e., to minimize the income that is being generated from the "fruits of capital").
If an individual has significant income from the "fruits of labor" (such as a pension), this income is included in the 25% calculation. The planner should then also consider what is called a nonpartnership LTC policy, which is a regular policy with a recommended minimum coverage of five years.
20. What other recommendations can help protect a family's assets?
If an individual might be entering a nursing home in the near future--
* investigate the feasibility relating to the purchase of an immediate annuity (funded with nonexempt liquid assets) that is nonassignable, irrevocable, and one without a cash value (having a term certain income based on the annuitant's actuarial life expectancy). The monthly income would be payable first to the creator (which would be subject to the Medicaid income contribution calculation). Upon death, the remaining payments, if any, would be paid to a beneficiary other than the estate of the owner/annuitant.
* convert nonexempt assets under Medicaid to an exempt asset, such as a larger home to be purchased by the community spouse.
* investigate the retitling of assets (at a discounted transfer value) into an LLP or LLC that converts tangible assets into an intangible personal property interest with the underlying asset and income distributions subject to the control of the owners of the entity (See "Twenty Questions on Selection of a Legal Entity," The CPA Journal, August 1999).
* check the testamentary documentation and beneficiary designations (life insurance, annuities, retirement plans, and IRAs) of the community spouse to verify that in the event of a premature death the institutionalized spouse will not be the recipient.
For purposes of determining the need for Medicare Supplemental Insurance Coverage (Medigap), review the gaps in Medicare coverage for those age 64 and over, such as the following:
* Those created by deductibles and copayments under Part A of Medicare.
* The financial exposure under Part B that pays for only 80% of the reasonable charges (which medical bill may be greater than the Medicare-approved amount).
A durable power of attorney will save legal expenses that would arise if one spouse is deemed incompetent and cannot execute the required documents or undertake financial transactions. These powers between spouses are usually reciprocal (i.e., naming each other), and a successor should always be named.
A living will or health care proxy gives the caregiver authority to follow the wishes (such as of not prolonging medical care) of an individual in an artificial support or coma condition with no hope for recovery. The living will is a general statement of intention used in this situation. The proxy, in New York State, is equivalent to a specific power of attorney appointing a health care agent (or successor) to lobby the medical provider in circumstances when the patient cannot.
For an elder client who is eliminating probate (through a living trust or otherwise) and desires to avoid having the family's safe-deposit box locked upon death, consideration should be given to changing the ownership of the box to an adult child with the parent appointed deputy, which designation allows for full access while retaining the keys and billing address. *
Peter A. Karl, III, JD, CPA, is with the law firm of Paravati, Karl, Green & DeBella in Utica, N.Y., and an associate professor at the State University of New YorkInstitute of Technology (Utica-Rome).
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