GTH Estate Planning Blog

Now having the duty to inform nephew Walter and other beneficiaries of the trust Uncle Nils has established, Lars considers for a few days what to do about it. He's concerned about undermining Walter's motivation even further. Lars must not only let Walter know there is a trust; he has to tell him annually about the assets, income and expenses of the trust, and a few other details.

Lars has proclaimed in other settings that when there's an awkward situation it's usually best to just go to the other party and try to talk about it. So he takes his own advice and invites Walter out to lunch on a Saturday. Over sandwiches and soft drinks Lars asks Walter how community college is going (Lars refrains from reminding Walter that it's his fifth year there). The nephew gives a noncommittal response and jumps the conversation ahead by asking Lars "Why did you want to have lunch with me?"

Lars's conversation with lawyer Duncan resumes. As trustee of the new $500,000 trust for relatives, Lars must not only give them initial notice, he has to share a detailed annual report of the following:

Receipts and disbursements during the year;

Assets and liabilities and their values at year's beginning and end;

Trustee compensation (here none);

Agents (brokers etc.) hired by the trustee and their relationship to him;

Trust debts incurred;

Any conflict of interest transactions;

A notice that a beneficiary may petition the Court for review of the report; and

A statement that any lawsuit against the trustee must be brought within three years.

Another tax season behind him, Lars is having one of his periodic late-afternoon check-ins with lawyer friend Duncan, mostly on wealthy Uncle Nils's affairs. Duncan like Lars has a nice but not fancy office, befitting a sensible personality and a modest prominence in a medium-sized city. Duncan had recently helped to establish the $500,000 trust given by Uncle Nils for relatives. Lars is trustee.

Duncan tells Lars there is new Washington law defining a trustee's duty to inform the beneficiaries. Lars is sensing from Duncan's earnest tone and widened eyes that he should be more than a little bit concerned about the requirements.

There are two main parts of the law. First, a newly defined duty to inform beneficiaries of the existence of the trust at the outset. This initial notice must tell of the existence of the trust, of who gave it (here Nils), of who is Trustee (here Lars) and how he may be contacted, and of the beneficiary's right to request information about the trust.

There are eight beneficiaries of the $500,000 trust: Lars, his wife Kyra, his three children and one grandchild, and Lars's sister and her son. The main idea of this "generation-skipping" trust is to pay income to Lars and Kyra from one share, and to Lars's sister from another, for their lifetimes and then to pass on to the next generation without being subject to estate tax in the first generation of beneficiaries. Distributions of principal may be made to either generation as needed, but this isn't expected. Lars has to give this initial notice now. So what's the problem?

CPA Lars has ruminated in recent weeks on the reasons wealthy people aren't jumping on the opportunity to make large tax-saving gifts. Part of it, he thinks, is concern about having enough for the long haul.

Lars has a conversation with a banker friend that tweaks his view a little. He likes having his view tweaked. They're talking about the phenomenon and the benefit of working longer. It goes something like this: investment yields are low, and this makes dollars from working more significant. The banker puts it this way: if a person can make say $150,000 working, what's the equivalent of that in a bond portfolio? If bond yields are four percent, it would take about $4 million of them to produce the $150,000. So in a very limited sense working one more year is like having millions invested.

Lars realizes this is just one perspective; for instance at the end of the year the investor would still have the bonds and the worker wouldn't have them. But the idea causes him to calculate in another way. What does it buy to work another year? Is it a double benefit, a twofer?

As March yields to April, Lars is excited to check the first-quarter results of his investment bet with his wealthy Uncle. Nils, a winner in his real estate career but (Lars thinks) naïve in securities investing, has put all his entry in the bet ($500,000) in precious metals: half in gold and lesser percentages in silver, palladium, and platinum.

How has Nils done in the first quarter? Gold has done well, with an almost 7% increase. Although his other three choices are also precious metals, they don't correlate with the gold. Palladium is down just a little. The other two, silver and platinum, are up more than 16% each, rather spectacular for just three months. Nils doesn't know why his commodities don't correlate. Lars wonders whether it has something to do with industrial demand for some of them. On a weighted average basis, Nils's choices for the quarter are up 9.21%, not counting management fees or commissions (a subject for another day).

Lars has a couple of theories on his wealthy clients' reluctance to take advantage of the near-perfect storm for making large tax-saving gifts. One is the recent economic scare, the one that started in 2008. Even with things seeming to move toward normal again (but who knows?), most of us feel less secure than we did five or ten years ago. Even if our net worth might now have exceeded what it was then. A Lars client with say $4 or $5 million of net worth and thinking about retiring on it, must contemplate possibly losing a million or two off it in a wrenching market. Even good bonds, for crying out loud, took a big hit for a time there.

And yields are way down, particularly for the short-to-intermediate bonds that are more likely to avoid big losses of principal when interest rates rise. Retired people, even wealthy ones, have a great concern about income, an often exaggerated one Lars thinks. When an oldish guy quits working and starts relying on his investments for cash flow, he wants investment income (including the yield on his retirement plan holdings) to replace the income he was getting by working. Understandable, Lars muses, but a bit flawed.

Lars is telling his wealthiest clients it seems like a near-perfect storm of factors favoring large gifts in 2012:

The Federal exemption is high ($5 million), but this will be revisited by Congress in 2013.

Asset values are off what they were a few years ago.

Congress might also revisit current law permitting valuation adjustments for lack of control and lack of marketability of family-owned entities.

Interest rates are low for loans and sales of assets to future generations.

There is no State gift tax (in Washington). The State doesn't add large lifetime gifts in the estate tax calculation the way the Federal rules do.

Few of his clients, though, have taken much advantage of the situation. Lars tries to figure out why.

To refine his study of the wealthy a bit, Lars finds a sub-group within his 32, of the 11 with net worth in excess of $20 million. This still falls short of the league of the Carnegies and Rockefellers, but in Lars's town it's a bunch. Eight of the 11 are in real estate, an even higher ratio than in the larger group. The eight are evenly divided between commercial and residential success, and the four residential are equally split between single-family and multi-family. So maybe real estate is the thing, but there are different ways to do it.

How does leverage enter in? There are six of the 11 who made it in real estate without inheritance (more on the heirship thing in a minute). Lars eyes these six. All of them have borrowed a lot of money. It looks like leverage is critical. This might be a bit self-evident to some, but Lars wants to numbers-test a little. He figures: let's go back to our example of Cervantes and Panza. Panza has $1 million in cash and stocks and Cervantes the same value of equity in real estate.

Cervantes' $1 million consists of a $2 million property with a 5% mortgage for $1 million. Let's also assume each has an investment return of 7.5% per year (a little optimistic during these hard times, but not unreasonable for good investors over decades). Panza will gain $75,000 a year. Cervantes will have $150,000 of gain less $50,000 of interest expense, for an advance of $100,000.

Lars has stumbled upon a shortcut method for studying how the rich get rich. With 2012 being such a good year for making tax-saving gifts, he has early in the year made a list of 32 clients he'll follow up with specially. They are candidates for making large gifts and therefore rich people. It might not be a perfect sample for his new study, but it's a sample. He is Lars-type excited to test his real estate hypothesis, and learn other things. His initial tally is supportive: 17 of the 32 have mostly real estate.

Of the 17, he finds four especially interesting: a lawyer, a physician, and a two CPAs each of whom started out in those fields, began buying real estate, and used their professional incomes to feed it and keep buying more. Three of the four actually kept their hourly jobs for decades. Lars wonders: how do people have the energy to do this? He feels pretty consumed by his CPA practice and family life.

He sees that another 11 of the 32 have made their money on what he calls "business": things like banking, wholesaling, insurance, and employee stock options. A few of the 32 are just plain hard to characterize.

Nils is a rich guy, with a net worth of something like $20 million. Our CPA friend and Nils's nephew Lars is considerably less wealthy, but he has much more than the average person. Lars has many very wealthy clients. He's happy himself being less wealthy but quite comfortable, but he does find it interesting to think about how rich people get and stay rich. It's sort of part of his job to help people do this.

So he's started looking at his list of clients for clues. This is not done out of envy but of (mostly professional) curiosity. He realizes he has at least one preconception upon taking on this unscientific study. OK, let's make it sound a little more scholarly and say Lars has a hypothesis.

We have seen how rich Uncle Nils is likely to save estate taxes by taking advantage of the increased Federal gift tax exemption, and his State's (Washington's) failure to tax gifts at all. Those savings are projected at $200,000 on his $500,000 gift of cash and securities to a trust for relatives. He might have saved another $50,000 for his heirs by using a family investment partnership or LLC to make his gift.

Nils can create even more savings by qualifying his gift to the trust for the annual gift tax exclusion. Here's how that works. Under the law in effect in 2012, Nils has a $5 million lifetime exemption from gift tax. This means (assuming the law isn't changed before he uses it) that he may give up to $5 million to relatives before paying any Federal gift tax. In addition to the lifetime exemption there is an annual exclusion that allows him to give $13,000 per year per recipient before even using any of the lifetime exemption. The idea is that givers shouldn't have to report small gifts. But a bunch of relatively small gifts can amount to something significant, especially if repeated year after year. Particularly if the gifts accrue gain and income after they are made, there is a fairly miraculous effect similar to the miracle of compounding in the investment world.

Last week we saw that Nils's gift of $500,000 to a trust for relatives in 2012 was likely to yield about $200,000 in tax savings, by getting future gain and income out of his estate, and by avoiding State estate tax altogether. There is another potential benefit of current law that Nils did not take advantage of this time, having to do with the valuation of certain kinds of assets.

Let's say that instead of giving cash and securities, Nils had given a 25% interest in a $2 million investment partnership (or limited liability company) to the trust. Wouldn't this still be a $500,000 gift? The answer is pretty clearly no. Why? It has mostly to do with marketability and control.

If someone gives you $500,000 in cash and securities, you can sell them and go out and buy a half million dollar yacht. Great, huh? However, if you got a 25% interest in a $2 million investment partnership instead, it would be evidenced by a piece of paper certifying your ownership, that you could not use to buy that yacht. You'd have to sell the partnership interest, or persuade the other owners to liquidate the entity. However, most partnership agreements restrict the ability to sell to any but existing partners, who might not be buying. And your 25% wouldn't give you enough of a vote to force a liquidation. For these reasons your interest would likely remain illiquid, and worth something less than $500,000 in sale value. How much less? An expert would probably say about 30% less. So instead of a $500,000 yacht you'd have a piece of paper worth $350,000.

Lars has explained to Nils the likely estate tax benefits of giving $500,000 to a trust for relatives this year. Nils is able to do this without immediate tax because the formerly $1 million gift tax exemption (the amount one may give during lifetime without paying gift tax) was increased to $5 million for 2011 and 2012. Nils had already used the $1 million exemption.

One benefit Lars has pointed out, is that future income and gain on the $500,000 will occur outside Nils's taxable estate, rather than within it. Lars has a guess on how that will work out. Nils, in his eighties, has a remaining life expectancy of only about six years (although his hardy and determined nature seems to promise more). The trust is likely to have about $200,000 of income and gain over the six years. If we figure the combined State and Federal estate tax rate will be 50% when Nils dies, then this should produce about $100,000 in savings for Nils's estate.

As we have seen uncle Nils has given $500,000 of his assets to a new trust for relatives, placing Lars in charge of it as trustee.

This is a good year for Nils to make the gift, due to many factors. The most obvious, to Nils and Lars, is that the Federal exemption for making gifts (without paying gift tax) was increased from $1 million to $5 million for years 2011 and 2012. This law is to be revisited in 2013 and we don't know what Congress will do then.

Lars and Nils have made their bet. Nils is putting his $500,000 on precious metals. Lars as trustee of a new family trust with the same amount, is investing in diversified fashion. We'll check in from time to time on how this bet is going.

Trustees, who are investing money for other people, are obliged to strive for safety and a good return at the same time, not always an easy combination. They must also balance the interests of different classes of beneficiaries. For instance if a trust pays income to a surviving spouse and then goes on to children (or, not uncommonly, to stepchildren), then the trust should ordinarily have a mix of bond-like producers of income for the spouse, and stock-like holdings promising long-term gain for the children.

The duties and legal exposure of a trustee are illustrated in Estate of Cooper, a case decided by the Washington Court of Appeals in 1996. In oversimplified terms the surviving husband was lifetime income beneficiary as well as trustee. He got sued by the children who were to receive the trust after his lifetime.