Brown & Associates - Attorneys & Counselors at Law, P.L.L.C.

REVOCABLE TRUSTS AND DEFERRED ANNUITIES MAKE ESTATE PLANNING EASIER
(10/7/01)

In the past, I've talked about the benefits and opportunities available to you if you use a Revocable Living Trust (Trust). I've also reminded you that it isn't enough to "have" a Trust--you must also "fund" it. If you set up a Trust, but retain ownership of all your assets in your own name(s), it's like making a peanut butter and jelly sandwich and leaving the peanut butter off. It's somewhat satisfying, but the job is only half done.

If you leave assets out of your Trust, your personal representative may have to probate your estate and make your intentions and assets public. This is something you were trying to avoid and now your estate will be confronted with the expense and complexities inherent in any judicial proceeding.

I own some deferred annuities. What should I do with them?

Before you start transferring assets into your Trust, you need to figure out if there are going to be any adverse tax consequences. This is particularly important if you are looking at deferred annuities. Merely changing ownership from your individual name to the Trust could generate income tax, something you would probably prefer to avoid.

If you transfer your deferred annuity to your Trust, your Trust is considered your "agent" and you will not have to pay income tax on your deferred gain. This exception is only available for "revocable" trusts, not irrevocable trusts, partnerships or limited liability companies. Unless you can categorize your irrevocable trust or partnership as an agent under Internal Revenue Code §72(u)(1), you will have to recognize the deferred gain in the annuity at the time of transfer.

What If I Name my Trust as Beneficiary?

This might be all right. It won't create any immediate income tax issues, but it could cause problems in the future. Let me explain why.

In most of the Trusts we prepare, at your death your Trust will be split into two separate trusts (a "Credit Shelter" or "Family Trust" and a "Marital Trust"). Your Trustee will have to decide to which of these two sub-trusts the annuity should be allocated.

If the Trustee transfers the annuity to the Family Trust, the Trustee will have to pay income tax on the deferred gain. This is because the Family Trust is irrevocable and since you are now deceased, the Family Trust becomes a non-grantor Trust. Because of this, it doesn't qualify for the "agent" exception I mentioned above. All deferred income will have to be reported by the Family Trust at its federal income tax rates. This means the Trustee will have to pay a tax of approximately 40% on the gain.

A related problem is that because the taxes come out of the amount allocated to the Family Trust, your Family Trust may wind up being underfunded. For 2001, you can exempt $675,000 from the Federal estate tax. Let's say you fund your Family Trust with a $675,000 annuity. Up to now, everything is okay. But guess what, you forgot the annuity had deferred gain of some $400,000. Now your Trustee is going to have to take approximately $155,000 out of the Family Trust to pay the federal income tax. This doesn't take into consideration any state income taxes which might be assessed.

Suddenly, the Family Trust is down to $520,000. You have thrown away tax-free assets of $155,000. Unless your trust split formula properly addresses this problem, your estate could wind up paying far more estate taxes than necessary.

For this reason, to the extent possible your Trustee should fund the Family Trust with other assets and not your annuity (or IRA or retirement plan, either).

You won't avoid this problem by having the annuity allocated to the Marital Trust since it is also a non-grantor Trust and will be subject to the same rules on reporting deferred gain.

Okay--you've told me what NOT to do. What SHOULD I do?

I hate these tough questions. Fortunately, this time I have an answer. Don't transfer the annuity to your Trust. Retain your individual ownership. You give up the asset management control your Trustee would have if you become disabled, but it isn't worth the tax consequences. Instead, as I said last week, make sure you have a solid Durable Power of Attorney with very precise language outlining your agent's powers. This should be more than sufficient for your agent to be able to reach out for the annuity proceeds should you become disabled.

I can live with that. What next?

Unless you need to use the annuity to fully fund your Family Trust at your death, don't change anything. Assuming you are married and comfortable with your spouse's ability to manage funds, name her as the primary beneficiary and your children as contingent beneficiaries.

If you think you might need the annuity to fully fund your Family Trust, then name your spouse as the primary beneficiary and your Trust as the contingent beneficiary. This way, your spouse can decide, based on her financial circumstances at the time of your death, how best to proceed. If she needs to use the annuity to fund the Family Trust for estate tax purposes, she can disclaim the amount needed to fund the Family Trust and retain her right to collect the balance. To the extent the annuity is not used to fund the Family Trust and remains payable to your spouse, she will be able to avoid paying income taxes on that portion of the deferred gain.

This is just a short summary of the income and estate tax traps that await the unwary. And these are just the tip of the iceberg. Before you make estate planning decisions involving deferred annuities, be sure you consult with a qualified estate planning attorney who is knowledgeable in the field of annuity planning.

To return to the Strategic Planning Articles click here.