Every year we tend to get a lot of new trust administration clients in November and December. Most people know that if their parent or grandparent had a living trust, they may be able to avoid probate. However, most people don’t know what is involved in a trust administration. We’ve prepared a guide outlining the basic steps to administer a trust.
An estate plan is simply a set of legal documents that instruct your loved ones how to manage your assets when you pass away, and if you have young children, it identifies the persons you want to raise your children. It also authorizes the persons you choose to manage your assets and make health care decisions for you if you become incapacitated. An estate plan can also leverage your assets to reduce or eliminate estate taxes and capital gains taxes, and it can be structured to significantly protect the inheritance you leave your spouse and children from divorce claims and lawsuits.
As you can see, estate planning has to do with death and taxes, and as Ben Franklin said, “in this world nothing can be said to be certain, except death and taxes.” Since everyone will have to deal with death and taxes, everyone needs an estate plan.
The type of estate plan you need will depend on your family, your assets and your goals. At a minimum, you will need a will, which lays out who you want to receive your assets, a durable power of attorney, which names the persons you want to manage your affairs if you become incapacitated and an advance health care directive and HIPAA, which authorize the persons you want to make health care decisions for you if you can’t. If you own a home, you will also want a revocable living trust so your estate won’t have to go through probate.
In June, the US Supreme Court ruled in Clark v. Rameker that inherited IRAs will not be protected in bankruptcy.
Here is a brief summary of the case:
Mom established IRA in 2000 and named her daughter as beneficiary. Mom died in 2001. In 2010, daughter and her husband filed for bankruptcy and tried to exempt daughter’s inherited IRA, worth $300,000, from the bankruptcy estate. The US Supreme Court, in a rare unanimous decision, ruled that an inherited IRA is not a “retirement fund” and, therefore, is not an exempt asset in bankruptcy.
What if you want to protect your IRA for your children from bankruptcy?
The best way to protect your IRA for your children is to use a trust. Under the Bankruptcy Code, an inherited IRA that is controlled by a trust will be excluded from bankruptcy and would not be subject to the ruling in Clark v. Rameker. There are two ways to use a trust with your IRA:
1. Name a sub-trust of your revocable living trust as the beneficiary of your IRA, or
2. Create a Stand Alone Retirement Plan Trust and name it as the beneficiary of your IRA.
Naming a sub-trust of your revocable living trust as beneficiary requires your living trust to include sub-trusts. A sub-trust is a separate trust that is created for the benefit of your child when you and your spouse pass away. We often refer to these as “inheritance protection trusts.” For almost all of our clients, we recommend including inheritance protection trusts in their revocable living trust to better protect their children’s inheritance from lawsuits and divorce claims.
The problem with naming sub-trusts of your revocable living trust as beneficiaries of your IRA is that the trust may not qualify for stretch-out treatment, and if not, the IRA would have to be paid out in five years. This would negate the IRA’s main benefit of tax deferred growth.
The better solution is to use a stand alone retirement plan trust. This is a trust separate from a revocable living trust. It has a singular purpose to be the beneficiary of an IRA. Because of its singular purpose, it will more easily qualify for stretch out and allow your children’s inherited IRA to be significantly protected from lawsuits, divorces and even bankruptcy.
If you are ready to start a business, congratulations, you are on the road to one of the purest forms of American freedom. But you must know it will not be easy. It is fraught with challenges. But it will give you freedom, the freedom to determine how to structure your life.
One of the basic issues you must sort out is how to organize your business. The main options are 1) sole proprietor 2) LLC (limited liability company) or 3) S corporation. Below is a very brief summary of the three options.
1. SOLE PROPRIETORSHIP. This is the best option for most people starting a small or microbusiness. It’s easy to set up. All you need is a tax identification number, a business bank account, a business license (which you can get after you are up and running) and a fictitious business name if you are operating under a name other than your own. The downside of a sole proprietorship is it affords you no asset protection and all of your net income will be subject to payroll tax.
2. LLC. LLCs can be set up as a partnership (more than one owner) or a single member LLC (only one owner, or if in a community property state like California, a husband and wife who can choose to be treated as one owner). LLCs can provide a barrier between business law suits and your personal assets. In most cases, multi-member LLCs are taxed as a partnership and single member LLCs are taxes as a sole proprietorship.
To establish an LLC, you must file Articles of Organization with the state Secretary of State, file a Statement of Information, execute an Operating Agreement, get a tax identification number and an LLC bank account and get a business license. It requires substantially more effort than a sole proprietorship, but if you want to protect your personal assets from business lawsuits or claims, then an LLC can give you the protection you need. Net profits will be subject to payroll taxes.
California makes LLC not so attractive for businesses that gross more than $250,000. An LLC must pay the state a minimum of $800 per year for the privilege of being a California LLC. In addition, California levies a gross receipts tax which is an additional $900 for LLCs that gross $250,000 or more and $2,500 for LLCs that gross more than $500,000, and it goes up from there. Because of the gross receipts tax, we usually don’t recommend our small and microbusiness clients use an LLC if they will gross more than $250,000. In fact, in most cases, we don’t recommend LLCs for operating businesses. But we do recommend LLCs for our clients who want to protect passive investments, like owning rental real estate.
3. S CORPORATION. S corporations are usually the best choice for small and microbusinesses in California. To establish an S corporation, you must file Articles of Incorporation with the Secretary of State, file a Statement of Information, get a tax identification number, execute Bylaws, Organizational Minutes, issue Share Certificates and open a corporate bank account and get a business license. This takes a bit more effort than an LLC. The corporation will have to pay a minimum state tax of $800, but if your business will gross more than $250,000, it will most likely be a better choice than an LLC, as corporations do not have to pay a gross receipts tax. In addition, with an S corporation, you may be able to pay yourself partly in salary, which is subject to the payroll tax, and partly as a shareholder distribution. Shareholder distributions are not subject to payroll taxes, so by separating your W2 payroll income from your shareholder distributions, you may be able to save in payroll taxes.
CONCLUSION. If you are just starting out and your are in a low liability business, then a sole proprietorship may be the best choice until you are up an running. If you need liability protection and you do not expect to ever gross more than $250,000, then an LLC may be the best choice If you need liability protection and expect to gross more than $250,000, then in most cases, an S corporation may be the best choice. And if you need an entity to hold rental properties for liability protection, then an LLC may be the best choice.
In Clark v. Rameker (June 12, 2014) the US Supreme Court ruled that inherited IRAs will not be protected against bankruptcy.
Ruth Heffron established a traditional IRA in 2000, and then promptly died the following year. At the time of Ruth’s passing, there was $450,000 in the IRA
The sole beneficiary-on-death of Ruth’s IRA was her daughter, Heidi Heffon-Clark. After Ruth passed, Heidi decided to take monthly distributions from the IRA.
Heidi received distributions for 9 years, which brings us to the year 2010 when Heidi and her husband filed for Chapter 7 bankruptcy. In their schedules, the couple listed Heidi’s inherited IRA as being an exempt asset.
The Bankruptcy Trustee (“BKT”) and the couples’ creditors disagreed, and claimed that the funds from the inherited IRA were merely Heidi’s inheritance — and thus became an asset of the Bankruptcy Estate that was subject to distribution to creditors — and were nothing like exempt “retirement funds” within the meaning of federal bankruptcy law . . .
Writing for a unanimous Court, Justice Sotomayor concluded that an inherited IRA is an inheritance and not a retirement plan, and, therefore, it is not protected by the federal bankruptcy code.
Is there a way to protect the IRA your leave your children? Yes. As Jay Adkisson explains:
For planners, however, the work-around is pretty simple: Folks with IRAs who want the balance of the moneys to be protected from their heirs’ creditors should designate a spendthrift trust as the beneficiary of the balance, and not their heirs directly.
Indeed, this decision will probably cause a mini-boom in estate planning, and cause folks with anything like significant amounts in their IRAs to create trusts for their heirs instead of on death leaving those heirs the IRA accounts outright.
But that should be true for any significant asset, not just inherited IRAs. Probably one of the dumbest things one can do is to leave significant assets to their heirs outright, instead of leaving it to their heirs in a spendthrift trust.
Even when debtors don’t have any current assets, it is a common practice for creditors to keep their judgments alive, set alerts in Google for the debtors’ names and the names of their parents, and then wait to see if they inherit any money. I can’t tell you how many times I have seen in my practice where a debtor didn’t have anything, but then somebody died, and the judgment was satisfied out of their inheritance.
Planning to leave assets in spendthrift trusts for children, to keep the assets out of the hands of the childrens’ creditors, has a long and established history in Anglo-American law — Thomas Jefferson created just such a trust for the benefit of one of his daughters, Martha, who married a husband who had financial difficulties. There is nothing slick or sleazy about it, but rather it is just good planning completely sanctioned by the spendthrift laws of each state.
Last year, I wrote about the benefit of using a stand alone retirement plan trust. With this new Supreme Court ruling, it is even more applicable.