10 GREAT DRAFTING TIPS

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1 10 GREAT DRAFTING TIPS Presented by Salvatore J. LaMendola, J.D. Giarmarco, Mullins & Horton, P.C. 101 W. Big Beaver Road, 10th Floor Troy, MI (248) direct dial (248) fax

2 Mr. LaMendola concentrates his practice in charitable tax planning, private family foundations, and estate planning. Mr. LaMendola is a frequent presenter at planned giving, tax and estate planning seminars for both professionals and the general public. He is the author of The Five Levels of Charitable Planning, an informative brochure on charitable giving techniques. Mr. LaMendola has authored articles appearing in The Michigan Bar Journal and The CPA Journal. He is a contributing editor to the Succession Planning Section of Advising Closely Held Businesses in Michigan, an Institute of Continuing Legal Education publication; a contributing author to the Estate Planning Chapters of Practicing Financial Planning For Professionals, 7th ed.; and a co-editor of the website, an information resource for financial and estate planning professionals. Mr. LaMendola is a graduate of University of Notre Dame (B.B.A., highest honors, 1990; J.D., 1994). He is a member of the State Bar of Michigan (Section on: Probate and Estate Planning); the Oakland County Bar Association; the Michigan Association of Certified Public Accountants; and the Legal/Financial Advisory Board of the Community Foundation for Southeastern Michigan.

3 10 GREAT DRAFTING TIPS 1 I. AVOID FIRST DEATH BEQUESTS TO NON-SPOUSE BENEFICIARIES A. Problem: If your client is happily married and there is family harmony, avoid nonspousal bequests. Why? Non-spousal gifts soak up unified credit or result in the payment of estate tax. B. Suggested Solution: 1. Instead of making direct gifts to family members, consider making these gifts (whether of tangibles, real estate or cash) to the surviving spouse, with a request - but not a direction - that the survivor give them to the intended ultimate recipients. These gifts should now qualify for the estate tax marital deduction (as long as the surviving spouse is a US citizen). 2. The step-up in basis still applies and the surviving spouse can, at her discretion and timed under her control, give these items or amounts away under the protection of the annual exclusion (for both gift and generationskipping transfer tax purposes) or, even if the survivor pays gift tax, that tax will be about one-third lower than estate tax would have been. 3. An exception may be where the gift will either use the unified credit of the spouse dying first by the bequest or by the surviving spouse by a lifetime gift using the unified credit of the deceased spouse may be better because (for at least now) it is larger and may get to "work" earlier. II. AVOID FIRST DEATH CHARITABLE BEQUESTS A. Problem: If your client is happily married, consider avoid charitable bequests. Why? Charitable bequests pass free of estate tax, but no income tax deduction is permitted. B. Suggested Solution: 1. Bequeath to the surviving spouse the property or cash intended for charity. These bequests will now qualify for the marital rather than the charitable deduction. Afterward, the surviving spouse can turn around and make the gifts to charity (in the name of the first spouse to die) with essentially a "free" income tax deduction to boot. Moreover, the surviving spouse can decide which assets owned by him or her are best to give to charity. 1 The ideas and sample language of VIII(C)(1) described in this outline have been drawn from Archive Message #978 of the Steve Leimberg Estate Planning Newsletter, June 13, 2006.

4 2. An exception may be where the estate of the first spouse to die will include income in respect of a decedent (IRD) assets, such as retirement plans and IRAs. That type of asset gets no step-up in basis and it may be preferable, even if the client is married, to give the IRD directly to charity. 3. Whether or not the client is married, make sure the bequest to charity of the IRD asset represents a fractional share of the IRD. If the client makes a pecuniary (i.e. dollar amount) bequest to charity, funding that bequest with IRD almost certainly will result in the inherent income being taxed to the estate and without the benefit of an income tax charitable deduction. 4. Use a fractional share bequest and expressly authorize the fiduciaries to be able to fund it on a non-homogeneous basis. See Rev. Rul III. PAY CAREFUL ATTENTION TO TAX APPORTIONMENT A. Problem: 1. The tax apportionment clause may be the most potentially dangerous provision in a Will or revocable trust. Most lawyers direct that all taxes due by reason of death, whether on assets passing under or outside of that instrument, be paid from the residue. 2. But if there is a large asset included in the gross estate for tax purposes not passing under the instrument, such as a life insurance policy or retirement plan payable directly to a third person as opposed to a trust, the result of directing that taxes be paid from the residue can be devastating. Not only will the residue be reduced by that tax, but if the residue was intended to qualify for the marital deduction, the direction on taxes will reduce the marital deduction. This increases the taxable estate, increasing the taxes again and further reducing the marital deduction, and so on. B. Suggested Solution: 1. Consider directing in the tax apportionment clause that taxes be paid from the residue only on assets passing under the instrument. 2. The only exception is where you specifically identify an asset that should have a "free pass" on taxes. For example, interests in qualified plans or IRAs that pass to those who share in the residue. 4

5 IV. USE A GENERAL POWER OF APPOINTMENT TO AVOID AN UNDER FUNDED ESTATE TAX EXEMPTION A. Problem: The trust of the first spouse to die has insufficient assets to fully fund the available estate tax exemption. B. Suggested Solution: 1. Consider having each spouse use a revocable trust under which assets in the revocable trust of the surviving spouse can be pulled into the revocable living trust of the first spouse to die. The IRS has issued several private letter ruling approving that technique. 2. This permits the spouse dying first to have enough assets to fully fund his or her estate tax exemption. 3. Note: Even if the first-to-die spouse has adequate assets to fully fund his or her exemption, those assets may not be the "best" kind. For instance, if those assets include an IRA, the surviving spouse s revocable trust can grant a general power of appointment to the spouse dying first (thereby allowing assets in the surviving spouse s living trust to pass under the credit shelter trust of the deceased spouse). That way, the IRA can be paid directly to the surviving spouse who, in turn, can do a spousal roll over. C. Sample Language: 1. Provision in richer spouse s living trust: At my spouse s death, if I am still living, I give to my spouse a testamentary general power of appointment, exercisable alone and in all events to appoint part of the assets of the trust property, having a value equal to (i) the amount of my spouse s remaining applicable exclusion amount, less (ii) the value of my spouse s taxable estate (after considering all available deductions) determined by excluding the amount of those assets subject to this power, free of trust to my deceased spouse s estate or to or for the benefit of one or more persons or entities, in such proportions, outright, in trust, or otherwise as my spouse may direct in my spouse s Last Will and Testament. 2. Provision in poorer spouse s will: I exercise in favor of my estate the general power of appointment given to me by Article, Section of the LIVING TRUST, dated, as may be now or hereafter amended, and direct that assets having a value equal to (i) the amount of my remaining applicable exclusion amount, less (ii) the value of my taxable estate (after considering all available deductions), determined by excluding the amount of those assets subject to this power and excluding 5

6 the value of any qualified retirement plans and IRAs, be held, administered and distributed in accordance with the provisions of my revocable living trust referred to above as soon after my death as possible. V. USE LONG-TERM TRUSTS THAT ALLOW FOR USE OF ASSETS BY BENEFICIARIRES A. Problem: Long-term trusts can help future generations avoid transfer taxes, but require certain restrictions. B. Suggested Solution: Make sure that the trustee of each trust is authorized to buy assets for the use of the trust beneficiaries. Such rent free use of trust assets by a beneficiary does not result in imputed income to the beneficiary or the trust, continues complete spendthrift trust asset protection for the asset, and probably avoids generation-skipping transfer tax even if the beneficiary granted the discretionary use of the asset (such as a home or painting) is a skip person. C. Sample Language: In addition to distributions to a beneficiary, the Trustee may permit the use of any trust property by any beneficiary without the necessity of any compensation of any kind from the beneficiary to the trust for such use. In this regard, the Trustee may acquire any property, whether real or personal and whether income producing or not, which the Trustee believes desirable for the beneficiary s health, education, maintenance, support and best interests. Such property may include, but shall not be limited to, residential real estate, household furnishings and appliances, artwork and jewelry. In addition, the Trustee can invest trust property in a business in which the Trustee believes the beneficiary has reasonable prospects for success. VI. INCLUDE PROVISIONS THAT ALLOW A TRUST CHARITABLE INCOME TAX DEDUCTION A. Problem: The name of the game is flexibility. How can you build in more flexibility when your client and his/her family really care about charities? B. Suggested Solution: 1. Authorize the trustee - in a discretionary trust for descendants - with the written consent of beneficiaries, to distribute trust income to charity. Any payment pursuant to that provision should qualify for the charitable deduction under Code Sec. 642(c). Unlike the deduction for individuals under Section 170, a trust's deduction can be of 100% of its income and is not subject to the cutback of deductions rule of Code Sec

7 2. The nice thing is, if it turns out the charitable donation would be better made by the individual beneficiary, the trustee can give the income to the beneficiary who can make the donation himself or herself. VII. USE WORD FORMULAS IN SPLIT INTEREST TRUSTS A. Problem: Timing is everything. So is balance. But how do you get things just right when working with complex documents? B. Suggested Solution: When creating charitable remainder trusts, charitable lead trusts or GRATs, use formula clauses. The regulations and private letter rulings allow these. For example, if you want the remainder in a charitable remainder trust to equal the minimum required (10%), you can direct that the annuity or unitrust payment be that amount of percentage necessary to achieve that minimum value (but no more). See Reg (c)-3(c)(2)(vi)(a)(third, second to last and last sentences); and see Priv. Ltr. Rul for an illustration. C. Sample Language for Split-Interest Charitable Gift: 1. If any descendant of mine survives me, and if I have any remaining Unused GST Exemption (as hereinafter defined) at the time of my death, I give, devise and bequeath to the Trustees hereinafter named that pecuniary amount which, if held for the charitable term (as hereinafter defined), will cause the non-charitable remainder interests in the trust created hereunder to have a value as finally determined for federal estate tax purposes exactly equal to the maximum generation-skipping transfer tax exemption allowed to me under Section 2631(a) of the Internal Revenue Code of 1986, as amended, or any successor thereto (the Code ) (hereinafter, my GST Exemption ) reduced by the amount of my GST Exemption which I have allocated or am deemed to have allocated during my lifetime (hereinafter, my Unused GST Exemption ) or if it is not mathematically possible for the non-charitable remainder interests to equal my Unused GST Exemption exactly, such pecuniary amount so that the value of the non-charitable remainder interests are as mathematically close to, but less than, my Unused GST Exemption as possible. Such amount shall be held by the Trustees, IN TRUST, for the following uses and purposes 2. (a) Trust Term. The Trustees shall hold, manage, invest and reinvest the trust estate, and dispose of the net income and principal as provided in Paragraph (b) of this Article during a term which shall end upon the tenth (10 th ) anniversary of the date of this Agreement. (b) Disposition During Trust Term. In each taxable year of the trust (other than any short taxable year thereof and the taxable year in which the charitable interests end, for which specific provisions are hereinafter 7

8 made) the Trustees shall pay over such sum or sums to such one or more qualified charitable organizations (as hereinafter defined) as the Charitable Trustee, in the exercise of sole and absolute discretion, shall select, in such amounts or proportions, equal or unequal, including all to one to the exclusion of all others, as the Charitable Trustee, in the exercise of sole and absolute discretion, shall determine, as shall, in the aggregate, be equal to a percentage, rounded to the nearest one onethousandth of one percent, so that the value of the remainder of this Trust, as finally determined for federal gift tax purposes with respect to the transfers by the Grantor to this Trust is zero (or as close to but less than zero as is mathematically possible, if it is not mathematically possible to make the remainder equal zero), of the initial net fair market value of the trust assets. VIII. INCLUDE EXPRESSION OF INTENT LANGUAGE A. Problem: The law of just about every state requires that, in construing an instrument, the court should search for the intention of the grantor or testator and, once that intent is discerned, must construe the document so that intent is carried out, even by turning affirmatives into negatives, adding or deleting provisions, etc. Obviously, the tax and property effects of any construction may be far reaching. And even though Federal courts, in general, are free to make their own construction, they are bound to follow state law rules in doing so. B. Suggested Solution: Consider using "expressions of intent". For example, if the drafter intends a disposition to qualify for the marital deduction, why not expressly say so? That way, you can be sure (or just about certain) that the court will discern the actual intent and it will be carried out. C. Sample Language: 1. It is my intent that this disposition qualify for the estate tax marital deduction and I direct that this instrument be construed and the trust hereby created administered to carry out that intent. 2. The Trustee shall not have any power which would prevent the Charitable Trust from qualifying or continuing to qualify as, and I intend by Section to create, a charitable remainder trust described in Section 664 of the Code. All powers shall be exercisable and exercised, and they and this instrument shall be construed, consistently with the preceding sentence. IX. GIVE DESCENDANTS A LIMITED POWER OF APPOINTMENT A. Problem: How can we build in even greater flexibility? 8

9 B. Suggested Solution: There may be exceptions, but as a general rule, beneficiaries should be given a non-taxable (not a general) power of appointment. This adds tremendous flexibility in coping with changing conditions and changes in the law. In some cases, it will be appropriate to permit exercise only with the consent of a non-adverse party, such as an independent trustee. C. Sample Language: Upon the death of the primary beneficiary, the Trustee shall transfer, convey and pay over the trust estate, as it is then constituted, to or for the benefit of such one or more of the descendants of the Grantor (other than the primary beneficiary, his or her estate or creditors or the creditors of his or her estate) or such religious, scientific, charitable or educational organizations described in IRC Section 501(c)(3), in such proportions and upon such terms and conditions and estates, with the powers, in the manner and at the times as the beneficiary appoints by a valid last will or by a valid living trust agreement which specifically refers to this power, including, without limitation, the granting of a presently exercisable general or limited power of appointment. Provided, however, that the primary beneficiary is prohibited, without the prior written consent of the Trustee, from exercising such power of appointment over any trust created hereunder that has an inclusion ratio of less than one (1) for generation-skipping transfer tax purposes in a manner that would cause Code Section 2041(a)(3) or Code Section 2514(d) to apply by reason of such exercise, and any such exercise shall be void. In addition, the primary beneficiary may appoint an income interest for life (or a term of years) in favor of a spouse of a descendant of the Grantor, the remainder of which shall be payable to or for the benefit of one or more descendants of the Grantor or charity, other than the primary beneficiary, the primary beneficiary s estate and creditors, and the creditors of the primary beneficiary s estate. The primary beneficiary may, at any time and from time to time during his or her life, by a written, acknowledged instrument delivered to the Trustee, release such power of appointment with respect to any or all of the property subject to such power, or may further limit the persons or entities in whose favor or the extent to which this power may be exercised. If the primary beneficiary does not effectively exercise this power of appointment for any reason, in whole or in part, the trust estate, to the extent not effectively appointed by the primary beneficiary, shall, upon his or her death, be disposed of in accordance with the terms and conditions provided in Section below. X. PAY CAREFUL ATTENTION TO HOW DISCOUNTABLE ASSETS ARE HANDLED A. Problem: How can we make sure the IRS will not cut down our valuation "discount" if a client has assets such as a minority interest in a business? For 9

10 example, consider what would occur if the decedent owned limited partnership units but the IRS successfully argues that the underlying assets of the partnership are included in the gross estate. Yet the only asset the executor would have to fund any marital deduction or charitable deduction share would be the discounted limited partnership units. B. Suggested Solution: If you have "discounted" assets, such as a minority interest in a business or a non-controlling interest in an investment (such as a partnership), make sure to allocate those assets in a way that will not cause a marital or charitable deduction to be reduced. 10