Leslie Daff, JD, MBA - Orange County Estate Planning Lawyer

In Tax & Estate Planning Tip #9 we mentioned the importance of carefully selecting and maintaining appropriate fiduciaries in an estate plan and building in mechanisms to remove and replace them when necessary.  People often name spouses, if any, followed by family members or friends as successor trustee(s), executor(s), and agent(s) on financial powers of attorney.  However, in conflicted families or in complex estates, this may not be the best choice.

Where subtrusts are created after the first spouse’s death to protect his or her assets for beneficiaries such as children from a prior marriage, couples may want to consider having someone other than the surviving spouse serve as trustee, or having the surviving spouse serve with a co-trustee. Only in the friendliest families, however, should a remainder beneficiary, such as a stepchild, serve with the surviving spouse because of the conflicts of interest involved.

After the spouse, people often name children to serve.  However, will naming one child cause friction among other children?  If children serve jointly will it be cumbersome to get all signatures for all actions taken?  What is the tiebreaking mechanism if they cannot agree?  People may name other family members or friends for this reason.  But if there is no one with the requisite skills, there are other options, such as naming a CPA or other advisor.

 In a complex or conflicted family situation, a corporate trustee, who brings experience, objectivity, and impartiality to the situation may be a good option.   Corporate trustees should always be considered as a backstop fiduciary in an estate plan because of their perpetual existence.  

 Another option is to name a private professional fiduciary. Although not as highly regulated as corporate trustees, a good private professional fiduciary can provide similar organization skills and objectively.

Estate planning documents should always contain mechanisms to remove and replace fiduciaries when appropriate. Specifically, if an acting fiduciary is incapacitated but will not step down, documents may provide that he or she will have 10 days to submit to a medical evaluation to prove otherwise or the successor will step in.  Documents may also specify that a designated person, or group of people, may remove and replace a “bad” fiduciary, or a trust protector may be named for this role.  If there is a fiduciary vacancy, documents may specify how that vacancy can be filled without having to go to court.

Getting your parents to create or update their estate plan is a sensitive issue. As we watch our parents age, remarry, and/or become infirm, the need to plan becomes more urgent.  Here is what your parents should consider while they still have capacity:

1. Prepare basic estate planning documents to designate people to handle health care and financial matters upon incapacity and death without a conservatorship or probate.
    
2. Build in flexibility for tax purposes. Many plans split into A-B subtrusts when the first spouse dies even though the current portable estate tax exemption of $10 million per couple doesn’t necessitate it. Flexibility can be built into the plan instead to create subtrusts after the death of a spouse only if necessary.
    
3. Consider an irrevocable C (QTIP) subtrust for control purposes if you and your spouse have children from different marriages and you want to protect your children’s interests.
    
4. Selecting appropriate fiduciaries is among the most important decisions your parents will make and will be explored in an upcoming column.
    
5. Determination of incapacity.  Your parents should decide whether two licensed physicians or their attending physician will determine their incapacity, the trigger for a fiduciary to step in.
    
6. Plan for the family business with a buy-sell agreement or by equalizing assets between children who will be taking over the business and those who will not.
    
7. Keep the family vacation home in the family for generations by creating a vacation home limited liability company.
    
8. Protect a child’s inheritance from creditors, predators, and divorce by leaving it to the child in a lifetime trust.
    
9. Designate recipients of important personal effects in the estate planning documents in order to avoid conflict.
    
10. Seek professional advice.  Do-it-yourself planning, such as adding children to title on real property can have unintended consequences, such as losing the full step up in cost basis they would have received if they had inherited the property at death.

Starting the discussion is the most difficult step, and a child must avoid the appearance of undue influence. If your parents already have an estate plan, suggest they have an estate planning attorney review it. Many attorneys review plans and make recommendations at no charge.  Otherwise, start by discussing end-of-life health care decisions.  This dialogue often leads to more comprehensive planning.

If you have real estate you rent to others, losses from those rentals can provide a tax shelter, but the losses are often limited by the “passive activity loss” rules.  In short, the passive loss rules stop you from using losses from tax shelters to reduce your income from wages, self-employment income, interest, and dividends. 

To illustrate, assume Chris has $100,000 of wage income, $10,000 from a natural gas limited partnership (Passive Investment 1), and $30,000 of loss from a rental home (Passive Investment 2).  Chris’s desired income is for income tax reporting purposes is $80,000 ($100 + 10 - 30).  Instead Chris must report income of $100,000 ($100 + 10 – 10).  The extra $20,000 of loss from the rental is postponed until Chris has more passive income or sells the rental home.  However, there are three exceptions (opportunities) that would allow Chris to report the desired $80,000 of income. 

First, Chris could use the “middle class rental real estate” exception that allows owners to deduct $25,000 of rental real estate loss if the owner owns more than 10% of the rental property and the owner is actively involved in the rental, meaning he or she approve new tenants, sets the rental terms, collects checks, and oversees repairs. This exception is not available when the owner’s total income exceeds $150,000. 

A second way for Chris to deduct the rental real estate losses is to obtain a real estate license and use the “real estate professional” exception.  To qualify as a real estate professional, the owner must work more than half time and at least 750 hours per year in real estate businesses.

A third way for Chris to report the desired income of $80,000 is to qualify for the “significant personal services” exception.  If an owner rents his or her property for more than 30 days on average and provides significant personal services for tenants (gardening, housekeeping, sightseeing suggestions, transportation), the owner can deduct losses if he or she is actively involved in the real estate business, meaning the owner (and his or her spouse’s) involvement is more than 100 hours and no one is more involved than the owner and his or her spouse

Many people are finding their need for cash is greater than their need for life insurance.  Fortunately, there are numerous ways to get cash out of your policies. 

Borrow money from a cash value policy.  Proceeds from borrowing are not taxable and the interest rate on the loan is usually less than 4%.  The downside is the loan will reduce the insurance proceeds received at death. 

Viaticate your policy.  If you are terminally or chronically ill, you may be able to receive tax-free benefits from your policy while you are alive.  You are terminally ill if a physician certifies you have an illness that will result in death within 24 months.  You are chronically ill if a licensed health care practitioner certifies you need assistance performing at least two specified activities of daily living.

Surrender your policy. Even if you are not ill, you can redeem your policy for cash value.  You recover the premiums you paid tax free.  If the cash value exceeds your premiums, you must report the excess as taxable ordinary income.  If the cash value is less than the premiums paid, the cash you receive is not taxable, but you cannot claim a loss. 

Sell your policy.  There is an active market of independent investors and life-settlement providers who may be interested in buying your policy, even if it is a term policy.  Assume you own a $1 million policy.  Over 20 years, you have paid premiums of $100,000.  The cash value is $130,000, but a life settlement provider has offered you $180,000.  If you sell the policy, you will report an $80,000 gain ($180,000 – 100,000).   The $30,000 difference between the cash value and your basis is ordinary income.  The $50,000 amount received in excess of the cash value is long-term capital gain, taxed at a beneficial 0% or 15% rate.

Exchange your policy tax free for one more suited to your needs, such as one that can convert cash value to long-term care benefits.

Consider holding on to the policy.  Although premium payments are not deductible and the policy proceeds are subject to estate tax (unless the policy is held in an irrevocable life insurance trust), cash value growth and proceeds received by beneficiaries at death are not subject to income tax.

Read my article in the February 2012 edition of the Journal of Financial Planning entitled Selecting and Maintaining Appropriate Fiduciaries in an Estate Plan, which focuses on the trustees, executors, and agents on powers of atttorney for property and health care named in your estate planning documents.  Recent litigation against successor trustees for breach of fiduciary duties, including the "prudent investor rule," highlight the importance of not only carefully selecting fiduciaries, but also building mechanisms into your estate plan to have them removed and replaced when necessary - without ending up in court.

We face potential liability every day – whenever we get behind the wheel of a car, sign a contract, buy, sell, or rent real estate, sell a product or service, hire a contractor, fire an employee, or babysit a neighbor’s child.

Some assets are exempt from creditor claims by law (e.g., social security payments).  Thereafter, our first line of defense is generally insurance, including considerable amounts of umbrella insurance, which you can generally obtain for a just a few hundred dollars per year.

The next layer of protection is to use entities such as corporations, limited liability companies (LLCs), and limited partnerships (LPs).  For instance, a physician may set up a professional corporation (PC) or professional limited liability company (PLLC) to hold minimal assets and then set up one or more LLCs to hold valuable professional business equipment and lease it back to the PC or PLLC.  A real estate investor, on the other hand, may set up family limited partnership (FLP) or family limited liability company (FLLC) to hold rental properties.  This approach isolates liability arising from the rentals inside the FLLC, rather than exposing the investor’s other assets to the claims of renters.

Another layer of protection is to set up a domestic asset protection trust (DAPT) in a jurisdiction which permits them, such as Nevada.  If no claim is made against assets in a Nevada DAPT for two years, they become exempt from creditor claims.

Setting up a foreign asset protection trust (FAPT) is another option.  Offshore asset protection trusts in jurisdictions such as the Cook Islands provide creditor protection as soon as the offshore custodian obtains custody of the assets.  The Cook Islands do not recognize U.S. judgments, forcing a creditor to litigate there - a significant deterrent.

Finally, at your death, you can provide your beneficiaries with the gift of asset protection by drafting provisions into your estate plan to protect their inheritances from divorce, creditors, and predators.  Once they receive the inheritance “in hand” it may be too late.

The best time to undertake asset protection planning is now - before a creditor claim arises.  Otherwise a creditor can attack the asset protection plan, including transfers to family members and business associates, as fraudulent conveyances.

Many people do not claim home office expense deductions, fearing that doing so may trigger an IRS audit.  While such audits received much press in the 1990s, today with more people than ever working from home, the rules are more taxpayer- friendly.  Don’t fear taking a legitimate home office deduction. 

Essentially, you can claim a home office deduction for a room or a separately identifiable space, such as portion of a room or a storage area in your garage, that you use regularly and exclusively for business.  Business is defined broadly.  Using the space to manage your rental properties is a business use, but tracking your stock investments is not.  The location has to be the main office for any business (primary or secondary) you run.  Even if you work as an employee outside of the home, you may be able to claim a home office if you meet clients at your home or if your employer does not provide you with an office and you need a place to work.   

How much can you save?  Assume you own a 1,600 square-foot home with a purchase price of $1,000,000 ($800,000 home, $200,000 lot).  Your home-related expenses are $60,000 (real estate taxes $10,000; interest expense $40,000; insurance $2,000; maintenance $3,000; and utilities $5,000).  You use 160 square feet (10% of the home) to run your consulting business.  You can claim a home office deduction of $8,050 ($6,000 (10% of $60,000) plus depreciation of $2,050 ($800,000/39 years x 10%)).   Because this deduction offsets self-employment tax as well as federal and state income taxes, you will probably reduce your taxes by 50% ($4,025) or more. 

When you sell your home, you will have to report the depreciation you claimed as income, but you do not have to report the business-use portion of the gain (10% in our example) as income and you can still use the $250,000/$500,000 exclusion on the entire gain.   

One of the main benefits of claiming a home office deduction is the business mileage rules apply as soon as you leave your driveway.  If you drive 10,000 business miles at 55 cents per mile, that’s an additional $5,500 deduction ($2,250 tax savings) for the year

This year, resolve to get your basic estate plan in place or have your existing plan reviewed due to the myriad tax law changes last year.

 An estate plan ensures your financial and medical affairs are handled upon your incapacity and death without court intervention (conservatorship or probate).  It also enables you to minimize taxes and distribute your assets to beneficiaries in the manner you choose.

Without proper planning, your property can end up exposed to statutory probate fees in probate court.  If you die owning a house with a fair market value of $500,000, for example, a probate administrator and attorney will be entitled to probate fees totaling $26,000 (if the house is worth $1 million the fees will be $46,000).  For this reason, people often create a revocable living trust-centered estate plan, generally ranging in price from $750 to $2,500.  Property held in the name of a revocable living trust avoids probate.

A revocable living trust-centered estate plan typically consists of five documents: 

1.  A Revocable Living Trust is a contract between you as grantor (granting assets to the trust) and you as trustee (managing trust assets) for the benefit of the beneficiary (you while you are living and others you name after death). 

 2.  A Pour-Over Will acts as a safety net to pour assets that may not have been transferred to the trust before death into the trust so they can be distributed according to the trust’s terms.  You also nominate guardians for minor children in your will.

 3.  A Financial Power of Attorney enables a person you name to handle assets that are not in your trust during your incapacity (e.g., get them into your trust before death).

4.  An Advance Health Care Directive allows you to express your preferences regarding end-of-life care and to name an agent to make medical decisions for you if you cannot make them yourself. 

5.  Finally, a HIPAA Authorization circumvents medical privacy laws, enabling the people you name to discuss your medical condition with your health care providers.

Take steps now to protect your family and preserve your assets by at least getting “the basics” in order.

Probably the most effective last-minute tax-saving strategy is a charitable donation.  Considering federal and state income tax rates, you can reduce your tax by as much as 44% of your contribution ($44 on a $100 gift). 

There are many ways to give and many personal and community causes to support, including schools, churches, and charities.   

• To receive tax benefits for charitable donations on your personal tax return, you need to itemize deductions. 
• If you are a volunteer, you cannot deduct the value of your time but you can deduct your out-of-pocket expenses.  For instance, a volunteer can deduct mileage at 14 cents per mile, Little League coaches can deduct equipment purchases, and in a recent case, a humane society volunteer was able to deduct the cost of food, litter, and veterinary costs for cats she temporarily brought into her home.       
• Donating appreciated property (property that has increased in value since you purchased it) is more beneficial than donating cash.  Your deduction is based on the fair market value of the property you donate and you avoid recognizing the gain by donating the property instead of selling it.
• Avoid donating investment property that has gone down in value since you purchased it.  Sell the property, claim the capital loss, and donate the cash from the sale instead.   
• Donations of household items are hard to value.  Make a list, take a picture, and use an online calculator to determine the amount you can deduct.
• Want to help locally?  Review the list of charities at the Laguna Beach Community Foundation website (www.lagunabeachcf.org) or set up a donor-advised fund to obtain your charitable deduction now and decide on your charities later.   
• For 2011, IRA owners who have reached age 70½ can contribute up to $100,000 of otherwise taxable payouts directly to charity instead.
• If you charge a donation on your credit card, the contribution occurs when you charge it, not when you pay the bill.

Finally, remember you cannot take a deduction on your return unless you have an acknowledgement proving you made the donation.  For donations of property worth more than $5,000, you may need an appraisal.  Happy Giving and Happy New Year!

If you act quickly, you may be able to take advantage of the following tax breaks which expire at the end of 2011.

Residential Energy Credits, up to a lifetime cap of $500, are available for many energy improvements you make to your home.  Examples include credits up to $200 for windows, $50 for circulating fans, and $150 for hot water heaters, plus 10% of insulation and exterior door expenditures and 30% of heat pump, air conditioner, and solar power expenditures. 

The $4,000 deduction for higher education tuition and fees, not including books or room and board, ends this year.  The deduction cannot be claimed if you claim one of the education credits for the same expenses.  If you, your spouse, or your dependents are taking courses after the first of the year, you may want to pay these expenses this month. 

100% Bonus Depreciation is not available in 2012.  This provision allows the full cost of new business-use property to be depreciated in the year of purchase.  This break primarily favors big businesses, but it is also being used by individuals buying SUVs (and other vehicles with a gross vehicle weight in excess of 6,000 pounds).  They can fully depreciate their vehicles in the year of purchase.  The $25,000 limitation that usually applies to SUVs is circumvented by this tax break for the rest of this month.

Individual Retirement Account (IRA) Distributions to Charity.  If you are over 70 ½ and wish to donate to charity, reduce the amount of IRA included in your estate when you die,  and avoid income tax on this year’s required minimum distribution from your IRA, you can donate up to $100,000 directly from your IRA to charity.  By not reporting the distribution on your tax return, it is possible less of your Social Security benefits will be subject to tax and more itemized deductions can be claimed. 

There is still one week left to take advantage of these “gifts.”  Although Congress sometimes belatedly extends provisions for another year, given the government’s financial condition and the inability of Congress to enact legislation, this year may be different.

This month many financial advisers are searching their clients’ stock and bond portfolios for investments to sell for the tax benefits, referred to as “tax loss harvesting.”  Before you agree to sell, make sure you will reap the tax savings.  Here are some harvesting tips.

First, an investment should never be sold just for the tax benefits.  It should be sold when it is no longer the optimal investment for personal, market, and economic reasons.

Second, tax harvesting is not simply selling your loss stocks.  The ideal net loss (gains minus losses) is $3,000.  Losses in excess of $3,000 are not usable in the current year.  They are carried forward to next year and possibly for years to come.

Example:  Assume you sold mutual funds during the year for a gain of $10,000.  In your portfolio, you have $40,000 of losses from stocks you are thinking about selling.  From a tax perspective, you should sell only enough of the stock to generate $13,000 of losses.  Then your net loss would be a currently usable $3,000 ($10,000 - $13,000).  If you sell all the loss securities, you will report a net loss of $30,000 ($10,000 - $40,000).  You can use $3,000 of the loss on your 2011 tax return and will carry forward a loss of $27,000 ($30,000 - $3,000).  If you do not have gains to report in the coming years, it may take you until 2020, nine years $27,000/3,000 per year), to fully reap the benefits of your 2011 loss.

Third, if you have capital loss carryovers from prior years, it may be better to sell only appreciated investments.  However, if your 2011 income is low and you are in the 10% or 15% marginal tax rate bracket, there may be no tax generated by the sale of your long-term investments.  In this case, you may not want to sell anything and save your capital loss carryovers for a year it will actually reduce the taxes you owe.

Fourth, wait more than 30 days to reacquire any investment you sold at a loss.  Selling an investment at a loss and repurchasing it within 30 days, called a “wash sale,” cancels the immediate use of the loss.  There is no waiting period for reinvesting in property you sold at a gain.