Promises, Promises

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October 2009
Vol 32 No 12


          Remember the good old days before people stopped trusting their government and financial institutions?  That’s when trusting wage earners still believed that, if they paid into the Social Security system all their working lives, their money would be invested for their own use instead of being paid out to support social spending programs for others, many of whom had not paid much in.  Nobody explained that the cost of living raises built into their payroll taxes to offset inflation would be consumed by increases in their costs for Medicare and pharmaceuticals.  

          The sacrifices wage earners made to put aside part of their earnings into 401K Plans and IRAs were rewarded by government manipulation of the credit markets that made their investments shrink instead of compounding over the years.  The most conservative savers turned to, historically, the safest place to deposit savings, banks; only to see their money loaned out to speculators who gambled it away in the stock and housing market.  Outraged taxpayers watched in disgust while hundreds of billions of their tax dollars vanished in TARP without any audits or accountability.

          Despite all the high-sounding schemes and high-flown political rhetoric about how new programs were going to turn the economy around, nothing much has changed for over-extended borrowers and those who have lost their jobs.  The economy continues to contract and businesses continue to shut down.  The vaunted corporate mergers that government has orchestrated seem to have made strong financial institutions weaker without making weaker institutions stronger.  Loan defaults and bankruptcy filings continue to increase while the economy continues to sink.    
          An odd paradox seems to have surfaced.  While polls show that the public is disenchanted with the way the economy has been managed by Obama, causing his approval rating to fall below 60%; Obama remains personally popular in much the same way that JFK held onto his popularity despite the problems he created.  It seems that people like what Obama says and the way he says it without connecting his inspirational message with the things he is doing, or failing to do.  Maybe we need a voice off stage to interpret what is being said in terms of how it will affect us.

          For example, have you ever noticed that when a tax-paid politician says that “we’ve all got to make sacrifices”, that he’s talking about us, not himself.  He’ll continue to spend many times his salary on “perks”, overseas junkets, and his own special retirement plan that doesn’t depend upon Social Security.  The sacrifices he talks about are higher taxes with less to show for them.  Notice that most of the proposed new taxes aren’t going to take effect until after the mid-term elections of 2010; so trusting voters can return members of Congress to office. In 2011, we can count upon a 20% capital gains tax, a 39.6% top tax rate on ordinary income, AMT, and more rigorous IRS audits to make sure that everyone pays.

          This year, the way that estates are taxed will be changed to eliminate the zero tax on inheritances scheduled for next year.  In return for wiping out the 2010 tax treatment, the 2009 rules will probably be made permanent, with the first $3.5 million tax free to non-spousal heirs, and any excess would be taxed at 45%.  The gift tax exclusion would rise to $3.5 million.  The Republicans are bargaining for this to be increased to $5 million.  In either instance, for the majority of the readers of this newsletter, estate taxes won’t be a problem, but estate tax changes  could be important for long term house investors whose estates continue to grow.  

          When loans pay down, houses are traded up, and prices are boosted by inflation, its amazing how net worth compounds over the years.  In the last generation, this turned ordinary investors with just a few houses into millionaires.   Those who accumulate long term “keepers” at today’s depressed values and low fixed interest rates will see even more startling leaps in net worth over the next few years for the same reasons.  For them, $3.5 million won’t be that far out of reach.

          It’s mother’s milk to politicians to stir up the crowd by reminding voters that billions of dollars of wealth are being passed between generations without being shared by them.  They don’t point out that if all of the estates over $1 million were taxed at 50%, the net proceeds would run our multi-trillion dollar government about 3 days.  Still, it makes for good headlines and is a proven way to divide the electorate, the better to manipulate and control it.  

          When you talk to financial planners, many of them think of estates in terms of stocks, bonds, insurance, IRAs, Pension Plans, and cash savings.  They rarely consider large real estate portfolios that might need to be liquidated.  Especially worrisome could be illiquid valuable primary residences and/or second homes left in an estate to non-spousal heirs by the last parent to die.  They could comprise an extraordinary percentage of an otherwise tax-free estate.

          The same goes for extensive real estate holdings that heirs might have to break up in order to convert them to cash with which to pay estate taxes, thereby destroying much of their value.  At the same time this could trigger capital gains and Alternative Minimum Tax that would have to be paid before the heirs received any cash.  Worse yet, any estate taxes that would be due would be paid out of available cash, leaving heirs with a white elephant to quibble over, and very little cash.   

          For example, suppose in addition to various income-producing assets, an estate also held assets that pushed its value into the 45% taxable range.  If these low basis assets added up to $1,000,000; the estate tax would be $450,000.  To raise this, it’s not unreasonable to assume that $750,000 of these non-business/non-farm assets would have to be liquidated fairly quickly to pay the estate tax.  Why so much?  A sale would trigger a 20% federal capital gains tax; or $150,000.  To this we might add State Inheritance and Income Tax, if any; plus Alternative Minimum Tax; plus selling costs.  Taxes could add up to 75% of the value of the entire estate.  

          For those with small estates, who might be tempted to skip over this part of this month’s letter, estate planning is still going to be an important issue; not so much for tax reasons as for making certain that the estate you build and leave behind goes to the right people at the lowest possible cost in time and expense.
Even the smallest estates can trigger inter-family squabbling that could lead to law suits, Probate costs, much higher expenses, years of delay, etc.
          For many years, the Law of Perpetuities in most States prevented families from using a Perpetual Trust to hold illiquid assets.  Under such a Trust, the named Beneficiaries and their descendents would only inherit the duty and right to possess, occupy, use, manage, conserve, and protect estate assets rather than the assets.  In the foregoing example in which 75% of an estate might be taxed, only the financial equivalent of the rights passed on by a Trust would be includable in the estate.  That could shrink its value into the non-taxable range.  Better yet, it would leave the assets within the control of the family for generations to come.  
          When a special family or financial situation calls for it, control of estate assets can be legally set up in a jurisdiction outside the USA, however this requires the services of a firm that has wide and deep experience.  It isn’t cheap and all of the legal niceties must be observed; but it’s yet another alternative to consider for those who would confront ruinous estate taxes.  

          Even those with smaller estates might still want to see their assets allocated and used by their heirs for specific purposes.  This is something that few  Wills are flexible enough to accomplish; thus assets held in Trust by a hand-picked Trustee or Trust Company can be the best, simplest, and least expensive vehicle to use for estate planning purposes; particularly when family members might be estranged from one another, or have personal agendas that would interfere with the cooperative management and disposition of estate assets.  This is especially true when the person who leaves an estate wants the heirs to use it in a particular way.   

          Tax considerations aside, there are compelling reasons to have an estate plan, if for no other reason than to assure that the right people get the right stuff.  For some reason or other that I can’t fathom, otherwise intelligent people take a “Die and Dump” approach to planning their own estate.  It’s almost as if they resent their heirs outliving them, and plan to punish them by leaving them a jumble of assets and liabilities that must be sorted through in order to discover the net estate.  This happens a lot more often than you might imagine.

         One otherwise admirable friend of mine entered into a legal separation from his wife some 30 years before his demise.  They lived apart for three decades.  Unfortunately, he overlooked revising his will to reflect his changing situation. Because he had never filed for divorce, she was still his legal spouse; who inherited a very large estate tax free.  The net result was that his kids and grandchildren were cut out completely while she was able to spend the windfall on a procession of very charming companions.

         Another wealthy subscriber with an up to date Will owned property in a half dozen States, each of which insisted on probating the will as to assets situated in the respective State.  That guaranteed years of legal wrangles and mismanaged rentals in addition to millions of dollars of expenses and years of delay before the estate was finally settled.  A Trust could have circumvented these problems.

         What about those who routinely hold assets in Trusts and other entities that are unknown to their heirs?  I was contacted by the widow of a subscriber.  Her  deceased husband had been very secretive about his financial affairs.  He had titled both financial and real estate assets in a corporation that had failed to file its lists of officers and directors; and had failed to pay annual franchise fees to the State. Consequently, despite holding considerable wealth, it had lost its legal standing and nobody was empowered to either restore the corporation or distribute its assets.  With all the assets tied up in the corporation, she didn’t have the know-how or ready cash to hire legal counsel to straighten it all out.

         You can have an up-to-dated estate plan and still leave the wrong person in charge of it.  Similarly, when you duck the issue of making certain that you allocate assets to those who will be the best stewards of them, your estate plan can distribute the wrong assets to the wrong heirs.  For example, cash and liquid assets could be left to financially inexperienced and naïve heirs who could easily make the wrong decisions regarding them; or who could squander them on poor lifestyle choices.  Rental properties could be left to those who refused to manage them and who let them deteriorate along with their values.  What about assets left to those who were hooked on drugs or alcohol?  Do you really want to subsidize illegal bad habits?  Are there family members with special needs that must be provided for?
         Nobody can foresee or foretell future changes in the tax laws, the economy, the political environment, or demographics; so active management of assets in a Legacy Trust would be important.  To be able to achieve this, a succession of Trustees, Conservators, Protectors, etc. should be provided for within the trust document who have the experience, integrity, judgment and legal power to adjust the estate plan to meet the needs of the heirs.  This isn’t a “do-it-yourself” project that can be handled by simply buying a book of forms and a “how to” CD.  

         Designing and setting up an estate plan that will meet the future needs of your heirs can be just as challenging and satisfying as creating a financial estate in the first place.  You’ll need to get help from capable advisers from the fields of law, accounting, and insurance       

          In his excellent June 2009 FBM Report, Attorney F. Bentley Mooney Jr.     (, who has written numerous practical books on a wide range of subjects dealing with healthcare, tax, and offshore strategies, tax-free charitable trusts, and estate planning, includes suggested draft provisions for a Legacy Trust.  

          The uses of Trusts go back to 1800 BC Egypt.  These were Title-Holding Trusts that enabled a powerful family to pass on its assets to its heirs.  During his conquest of Egypt, Caesar liked what he saw and incorporated Trusts into Roman Civil Law to enable his assets to be held for the benefit of his heirs if he failed to return from battle.  Hadrian brought them to England where they were adopted into the Common Law by a succession of rulings that enabled weaker landowners to entrust their assets to powerful Nobles for protection.  Leaders trained under English Common Law drafted the U.S. Constitution, which prohibited States from passing laws that interfered with the rights of citizens to enter into (trust) contracts.  It became common for property owners to title their assets in the name of a Trust or a Trustee instead of in their own names.  The vast holdings of Florida’s Disneyworld were assembled via thousands of Trusts without anyone realizing what was happening.

          Along this 3000-year path, the uses of Trusts evolved to meet the needs of innovative people.  When Massachusetts Law restricted the use of corporations to raise money and hold property, the Massachusetts Business Trust was born.  When a land developer wanted to sell mortgaged lots for which no releases were available, the Illinois Land Trust was created.  This enabled a Trustee under the control of a Beneficiary to hold both Equitable and Legal title to land to conceal and protect ownership. When Wisconsin wanted to attract capital, it made it possible for a Perpetual Trust to be formed that would enable the avails and proceeds of an estate to be passed on to designated beneficiaries without gift or estate taxes.

          Alaska, Delaware, Nevada, and several other States have enacted laws that protect assets of Trusts from law-suits.  Opinions rained down from contingent fee lawyers that these Trusts could easily be broken, but thus far to my knowledge, none of those who decried them have ever gained access to assets held in these Asset Protection Trusts.  Despite the nay-sayers among the legal profession, the long history of thwarting legal attacks leaves little doubt that Trusts formed and administered according to law are viable.  But that says little about all of the ways that Trusts can be used to make creative transactions even more profitable.                      

          Let’s talk taxes:  There are two fundamental types of Trusts; taxable and non-taxable.  When a Trust remains directly or indirectly under the continuing control of its creator, or is revocable; it is not recognized by the IRS for federal tax purposes.  This is called a “Grantor” Trust.  Grantor Trusts require no special tax reporting.  The Beneficiaries report Trust income as if it had been paid directly to them even though they may have not received any of the funds.  You can see that a Grantor Trust can store up thousands of dollars for a Beneficiary that can be withdrawn privately, without any income tax consequences; or notoriety.  Without the need to file any public financial reports, a Grantor Trust can be a very effective holder of concealed assets for years.

         With a notable exception, all other Trusts are taxable, and must obtain a federal tax ID number. So long as a tax-paying Trust distributes all its income and profit each year, it isn’t taxed.  When it retains them, it is taxed at the highest progressive rates.  The exception to this rule is that Trusts that make distributions for qualifying purposes can compound income and gain tax-free for decades for the benefit of their creators.  The beneficiaries are only taxed when they receive a distribution; which is usually a tiny fraction of the Trust assets.  

         The Trusts that Jackie Kennedy Onassis set up reduced the tax on her $200 million estate to be only about 8% while providing her heirs with about $10 million per year in income. By mixing and matching different types of Trusts, amazingly complex financial arrangements can be structured that provide privacy, a means to raise money, a way to pass on huge estates, and a way to shelter income and profit from taxation for very long periods of time.  These strategies might seem sneaky, but they have withstood lawsuits and government seizures for centuries.

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1 Comment on “Promises, Promises”

  1. Hi Jack,

    I’ve recently started real estate investing and sold my first property a week ago! I am also an heir to an estate worth approximately 300k in Colorado. The owner of the estate is still alive and has another gentlemen and I as the beneficiaries of equal shares in his Will. What would be the best vehicle to use so that both heirs receive as much of the assets as possible? I believe there maybe a quick claim deed in place as well with the heirs on it.

    Thank you,


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