Published by and reprinted with the permission of the Illinois State Bar Association, Trusts & Estates Newsletter, March 2020, Volume 66 No. 9.
by Kenneth Piercey, JD
Is There a Better Way?
As attorneys, we often rely on our analytical and critical thinking skills to best serve our clients. While these skills are crucial to providing sound legal counsel, it can sometimes lead us to undervalue the power creativity can bring to the practice of law. Our firm has found that when we combine our expertise in estate and tax planning with a desire to provide client- centered service, we can harness the power of creativity to find unique solutions to complex problems. The following are a few examples of innovative estate planning strategies that can be used to achieve better outcomes for clients.
Divorce Protection on Inherited Assets
We have found that clients are almost always concerned about their child’s inheritance being cut in half in the event that their child receives their share, does not protect it, and then subsequently divorces. This concern is warranted, because according to the American Psychological Association, “…about 40 to 50 percent of married couples in the United States divorce.” Of course, a child’s inheritance is generally protected from divorce, provided that the child does not commingle it by placing it in a joint account with his or her spouse. Let’s imagine a typical conversation that an inheriting child would have with his spouse. “Honey, my attorney has advised me to keep my inheritance in my own name, to prevent you from taking half of it away if we divorce, so I am going to keep my inherited funds separate.” This scenario, at the very least, likely creates stress on the child’s marriage, especially if the relationship is already strained. It also adds an element of distrust that may never have been present in the relationship prior to the inheritance. In addition, we have often witnessed the beneficiary’s spouse convince the inheriting spouse to commingle the inheritance and later acquire a portion of the inheritance in the divorce decree.
If the client is interested in avoiding this problem, a potential solution is for the trust to require the married beneficiary to submit to the trustee either a premarital agreement or a postnuptial agreement that requires that the inherited funds are to remain separate and nonmarital property, before a lump sum is distributed to the married trust beneficiary. The child’s spouse may be upset, but the anger, even if unjustified, would likely be directed to the deceased parent, rather than the spouse of the child, which would arguably go a long way to remove the potential spousal relationship strain. In addition, if the funds are never commingled, this strategy can even prevent the incentive to file for divorce.
Retirement Accounts Lost to Claims or Irresponsible Beneficiary Decisions after Death
The Supreme Court of the United States has ruled that inherited retirement accounts are no longer protected from bankruptcy and the claims of creditors. Before this ruling was entered, inherited retirement accounts were protected from almost all judgments and claims. This new ruling means that all of a client’s retirement account assets could be lost to creditors shortly after death, because retirement accounts often name individuals as beneficiaries directly, which is not protected from creditors. Furthermore, if the trust beneficiaries are minors or not yet mature enough to handle unrestricted access to a large inherited IRA, naming the beneficiaries individually also creates the additional risk of poor liquidation decisions once the child reaches majority resulting in larger taxes followed by an imprudent spending spree.
Consider naming each beneficiary’s share of your client’s trust as the beneficiary of a client’s IRA (after any spouse), and carefully drafting the trust so that it qualifies as a designated beneficiary under the Internal Revenue Code. This can result in each beneficiary obtaining the benefit of tax deferral of an inherited IRA (generally 10 years under the Secure Act), as well as affording each beneficiary with all of the protections that a trust can provide, including a schedule of distributions over time, to protect from imprudent tax and spending decisions.
Creditor Protection
Claims and litigation can be commonplace after death. Most trusts we read state that after death, “the trustee shall pay all debts and claims” of the deceased.While this may sound reasonable, often there may be unreasonable or frivolous claims asserted against a decedent’s trust. When the trust is written to force the trustee to pay or defend all claims, the trustee may have to deplete the entirety of the trust’s assets defending a lawsuit or paying damages.
Consider writing a client’s trust so that the trustee is not required to pay all claims, as such a requirement may open the door to additional trust liability. In addition, if a client desires to implement strategic gifting to an irrevocable trust for Medicaid planning, asset protection, or estate tax planning, not only can the gifted assets be protected from the client’s creditors, but each trust beneficiary’s share can also be protected from creditors and claims if spendthrift trust provisions are included. As you can see from the cases below, the highest level of protection is obtained when assets are retained in trust for the benefit of trust beneficiaries, rather than distributed outright to the beneficiaries.
Prevent an Inheritance from Disqualifying a Beneficiary from Government Benefits
A few years ago, we consulted with a client (we will call her “Trish”), who had less than $2,000 in total assets, had skin cancer and was receiving Medicaid benefits, which paid for her substantial medical costs. Her father passed away and she was a named beneficiary of her father’s will and was to receive about a $400,000.00 inheritance.
Unfortunately, Trish’s skin cancer treatments cost over $200,000.00 per year, and Medicaid rules do not generally permit anyone to inherit more than $2,000.00 without disqualification from its benefits. Therefore, upon receipt of her inheritance, Trish ran the risk of no longer qualifying for Medicaid coverage, and she would have to spend her entire $400,000.00 inheritance on her costly medical care that would otherwise be covered by Medicaid benefits, with limited exceptions.
Furthermore, Trish could not gift or disclaim her inheritance without inclusion of the inheritance for Medicaid purposes. Consider instead writing a client’s trust to prevent a beneficiary from losing valuable Medicaid benefits. A trust can provide that the beneficiary’s share is distributed to a third-party special needs sub-trust, rather than to the beneficiary directly, preserving valuable Medicaid benefits, and allowing the beneficiary to spend the inheritance on other important expenses not covered by Medicaid.
Alternative Dispute Resolution
When a valid dispute arises, the default solution is usually costly and time-consuming court litigation. This can generate huge legal fees, resulting in the beneficiaries receiving much less than the client would have likely intended. Binding arbitration clauses are commonplace in many other contracts, so consider including a binding arbitration clause in your client’s trust, as binding arbitration can be much more efficient and much less expensive than the standard county courthouse dispute. The new 2020 Illinois Trust Code also recognizes this binding arbitration power.
Probate on a Deceased Beneficiary’s Share
We have found many trusts protect a beneficiary’s assets from probate if such beneficiary predeceases the settlor of the trust. But what happens when a beneficiary passes away after the settlor passes away, but before final distribution of such deceased beneficiary’s share? Unfortunately, if this issue is not adequately addressed in the trust document, a probate court case may have to be opened in order to access the post- deceased trust beneficiary’s share. Consider drafting a client’s trust to also cover the contingency of a trust beneficiary passing away after the settlor, and make sure to provide clear distribution instructions to avoid the default probate estate rules from applying to a deceased beneficiary’s share.
The Unmotivated Beneficiary
We frequently meet with clients who have a child lacking in motivation or the desire to pursue gainful employment. Usually, the last thing a parent wants for their unmotivated child is for their wealth, after death, to create an additional incentive for the child to work even less. In this situation, consider adding a “work ethic” clause to your client’s trust, which could include a payout of a beneficiary’s share based on the amount of income the beneficiary earns each year. For example, the trust could payout based on health, education, support and maintenance, but also pay an additional amount each year based on a percentage of the beneficiary’s annual earnings, to create an incentive for the beneficiary to pursue gainful employment. The trust could also provide payment to an employment recruiter to assist in locating a job, or a career counselor to assist in locating a career that may be more enjoyable for the beneficiary.
Estate Tax Elimination
The Honorable US Appeals Court Judge Learned Hand famously stated: “There are two systems of taxation in our country: one for the informed and one for the uninformed.” We have found that many clients and even attorneys are not aware that there are many strategies, used either separately or in combination, that can eliminate all estate taxes for a client whose estate is otherwise subject to estate taxes. For 2020 decedents, the Illinois estate tax exemption is $4 million, and the Federal estate tax exemption is $11.58 million. We have also discovered that when clients are made aware of their large estate tax liability, due within nine months after their date of death, they are motivated to learn more about the strategies available to redirect their wealth away from taxes, and at the same time are able to provide more for their family and/or charities or causes for which they are most passionate. Most of the strategies involve some form of a freeze, squeeze, leverage or arbitrage. Some of these strategies include:
- Lifetime and Testamentary Gifts to family and to charity
- Family/Marital/QTIP Trusts
- Irrevocable Life Insurance Trusts
- Qualified Personal Residence Trusts
- Grantor Retained Annuity Trusts and Grantor Retained Unitrusts
- Gifts and Sales (using Private Annuities and Self-Cancelling Installment Notes)
- Intentionally Defective Grantor Trusts and Dynasty Trusts
- Inter-vivos and Testamentary Charitable Remainder Trusts and Charitable Lead Annuity Trusts
- Asset Protection Trusts
- Limited Liability Companies and Family Limited Partnerships
Figures 1 and 2 provide an example of one of our private clients (we will call them “John and Susan Sample”) with a large estate tax liability, and the planning that we implemented to eliminate their estate taxes. The planning began in 2003 and has not fully matured, but continues to accomplish their goals. The area of estate tax elimination planning is an incredibly complex and rapidly changing area of the law. I acknowledge and recognize the contributions of my partner Rodney H. Piercey in both this article and in this area of the law, as well as those outside experts who have assisted us in providing innovative solutions to eliminating estate tax liability, including CPA Robert Keebler and attorneys Thomas W. Abendroth, Steven J. Oshins, Lawrence Brody, John Porter and Jerome Hesch.
Figure 1
Figure 2
Finding a Better Way
As is true for many attorneys, our work often goes beyond the technical to the extremely personal. This means that a “one size fits all” answer rarely is the best one. To find the best answer we must approach each client’s problem as a unique and complex set of challenges. Hopefully this article has helped you identify often overlooked issues in the area of estate planning as well as potential creative solutions to address them. And perhaps, it will inspire you to create your own innovative solutions in your practice.