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Estate Planning Update



Under current law, you are allowed to give cash, assets and other property totaling up to $10,000 per year to as many individuals as you desire without incurring a gift tax or using any part of your unified credit exemption (presently $650,000; increasing to $675,000 in 2000). This $10,000 annual gift tax exclusion applies to outright gifts and may also apply to a gift in trust if the gift qualifies as a "present interest."

Remember that December 31, 1999 is the last day that gifts can be made using the annual gift tax exclusion for 1999. Checks must clear the bank prior to that date for the exclusion to apply. For future reference, note that making gifts earlier in the year will have a more favorable tax benefit. If cash, stock or other assets are transferred early in the year, the growth during the year, including dividends and interest on the property, belongs to the done.


Following a national trend, Pennsylvania recently adopted the Prudent Investor Rule. The Rule applies to trustees and guardians, but not executors, custodians under the Uniform Transfers to Minors Act or agents under a power of attorney. It gives greater discretion than they previously had in choosing appropriate investments for funds they control. The rule reads, "A fiduciary shall invest and manage property held in a trust as a prudent investor would, by considering the purposes, terms and other circumstances of the trust, and by pursuing an overall investment strategy reasonably suited to the trust."

The degree of care which a trustee or guardian must now exercise is "reasonable care, skill and caution in making and implementing investment and management decisions." Additionally, a fiduciary with special investment skills must exercise those skills to meet the prudent investor standard. The fiduciary may invest in any type of investment, so long as he or she has met the standard of care.

This changes the landscape of fiduciary law significantly in the past, fiduciaries were often afraid to use non-traditional investment vehicles for fear of breaching their fiduciary duty. Now they must do so cautiously, but may use such vehicles if appropriate to the particular trust. The new Rule also permits an individual Trustee to hire investment managers and to delegate day-to-day control of a portfolio to the "investment agent." A Trustee making this delegation must exercise prudence in selecting the investment agent, must establish the scope of authority granted the investment agent and must periodically review the investment agent's performance. Similarly, one Trustee may delegate certain investment and management functions to a co-Trustee for example, when an individual co-Trustee gives the day-to-day management of a portfolio to a corporate co-Trustee.

According to the rule, the factors a fiduciary should consider before deciding how to invest funds include the size of the trust; the nature and estimated duration of the fiduciary relationship; the liquidity and distribution requirements; the expected tax consequences; overall investment strategy; an asset's special relationship or special value; the needs of the beneficiaries for present and future distributions; and the income and resources of the beneficiaries of the related trusts.

In addition, the fiduciary must diversify investments, unless there is a compelling reason not to or the governing instrument permits non-diversification. The Prudent Investor Rule is a default rule which applies unless the governing instrument indicates otherwise.

(FTC v. Affordable Media, CCA-9, No. 98-16378)

Since 1993, Asset Protection Trusts have been a high-profile planning tool. The basic asset protection plan, the spendthrift trust, has been around for generations. However, the spendthrift trust is not an ironclad protection against creditors, particularly when the debtor is the creator of the trust and one of its beneficiaries. Early in this decade, another technique began to generate a great deal of interest. This involves creating a trust in, or moving a trust to, a foreign country that does not recognize U.S. judgments or other legal processes. Because a U.S. person creating a trust may be unwilling to put significant assets in the hands of a foreign trustee and leave those assets completely at the mercy of a foreign court, the scheme calls for the creator of the trust to retain a degree of control by serving as co-trustee. In addition, the trust document also names a "trust protector," who has the ability to remove trustees, possibly veto actions by the trustees and move the trust to another jurisdiction. Thus, if legal action is started by a creditor in the foreign country, the trust protector moves the assets to another country, forcing the creditor to start proceedings anew. In many cases the person creating the trust also serves as trust protector. However, "anti-duress" provisions give the foreign trustee the right to remove the settlor from the position of co-trustee or trust protector.

A recent case in Nevada shows just how dicey these trusts can be. A husband and wife (the defendants) became involved in a telemarketing venture. They had created an asset protection trust in the Cook Islands. It was believed that their profits from the telemarketing venture flowed into that trust. The Federal Trade Commission commenced action against them after investors in their venture claimed to have lost considerable amounts of money. The district court issued a temporary restraining order and a preliminary injunction, which required the defendants to repatriate any assets held for their benefit outside of the United States. The defendants then instructed the Cook Islands trustee to comply with the preliminary injunction. At this point, the trust worked as was intended. The Cook Islands trustee removed the defendants as trustees and refused to repatriate the assets. The court countered by holding the defendants in civil contempt. The defendants appealed, claiming that it was impossible for them to comply with the court's order.

The 9th Circuit affirmed the district court. As a result, the defendants faced a serious threat of spending time in jail.

Whether this opinion sounds the death knell for offshore asset protection trusts is still uncertain. The facts in this case are particularly bad for the defendants. First, Judge Wiggins' opinion referring to the telemarketing venture as "a Ponzi scheme" does not make them particularly loveable parties. Second, the defendants were not only co-trustees, but also trust protectors. Third, their powers as trust protectors went beyond a power to veto trustees' decisions. Their powers included the affirmative power to appoint new trustees, and the opinion notes that the trust instrument was drafted to make the anti-duress provisions subject to the trust protectors' powers rather than making the trust protectors' powers subject to the anti-duress provisions. In the court's opinion, then, the defendants did have the power to force the foreign trustee to repatriate the trust assets to the United States.

The main purpose of asset protection trusts is protection from creditors, not relief from the estate and gift taxes. In our opinion, asset protection trusts, under the right set of circumstances, may serve a valid purpose in estate planning. However, they are not for everyone, and they do require expert drafting.


If so, you might want to review your beneficiary designation. Many financial institutions provide a standard form to investors opening Roth IRAs, which may unintentionally cause a problem for a spouse beneficiary. The form is known as "Form 5305-R" and it prompts investors to agree that their spouse should automatically become the owner of the IRA upon their death if the spouse is named sole beneficiary. In many cases this is an appropriate choice; however, in cases where the decedent has reached age 59 + and the spouse has not, an estate planning problem may arise. If a spouse becomes the owner of a Roth IRA when he or she is under age 59 + and needs the funds to live on, the spouse will pay a penalty plus taxes on any earnings withdrawn. If the spouse had not been named the owner but was named beneficiary, he or she could have left the account in the decedent's name, and taken the earnings out without paying income tax or penalties. The IRS recently announced that it will allow owners to amend their beneficiary designation choices. If you wish to do so, or if you are not sure whether you need to, feel free to call us to discuss your particular estate plan.


Governor Ridge recently signed new legislation that makes many changes to the Pennsylvania statutes governing powers of attorney. Under the new law, the person holding the power is referred to as the "agent" rather than the "attorney-in-fact." While not substantively significant, this more properly reflects the principal/agent relationship that is created when a power of attorney is executed. More substantive changes involve new rules on the power of an agent to make gifts on behalf of the principal and certain added requirements to the execution of the power of attorney.

From a tax standpoint, a power of attorney can be a useful device to reduce estate tax by allowing the agent to make gifts for a disabled person. Under the new law, an authorization in a power of attorney "to make gifts" will now be interpreted to authorize gifts not to exceed the $10,000 annual exclusion amount of the principal and his or her spouse. The statute also limits the parties to whom the agent may make such gifts to certain family members. A person who wishes to give his or her agent the power to make gifts in excess of the annual exclusion amounts or to persons other than the statutorily defined group must specifically grant such a power in the document.

The new statute directs that a power of attorney must include a statement on the front of the power signed by the principal stating that he or she is aware of the effect of the power and a statement at the end signed by the agent that he or she understands the fiduciary nature of the relationship. Failure to attach the statement signed by the principal will not render the power of attorney invalid. However, if questioned, the agent will be required to prove that the power was properly granted and thus make it difficult to use the power effectively. Failure to attach the statement signed by the agent will render the power of attorney ineffective.

Does this mean that you should execute new powers of attorney? No. The new law applies to all powers of attorney executed after April 12, 2000. However, as banks and other institutions become aware of the new requirements, powers executed under the old statute may become more and more difficult to use. Therefore, you should consider executing new powers of attorney as part of your next estate planning review. Of course, if you wish to act sooner, we are ready to help.


In today's investment environment, income yields are at historic lows while appreciation in stock values soars. As a result, many trust beneficiaries have seen the size of their trust funds grow while they receive less of a current return. However, the rules in Pennsylvania regulating the amounts that can be distributed from certain charitable trusts and endowments have changed. Previously, charitable trusts that directed that "income" (i.e., interest, dividends and rents) only be distributed to the charitable beneficiary faced the inherent conflict between the need for principal growth and the need to generate income. Endowments had some leeway in allocating capital gains in a particular year to income but still faced the same problem as charitable trusts although perhaps to a lesser degree.

The Pennsylvania legislature changed this by providing that the trustee of a charitable trust, or the board of directors of an endowment, could "redefine" income to be a specified percentage (between 2 percent and 7 percent) of the average of the fair market value of the trust for the three preceding years. This allows the charity to share in the principal growth of the trust and allows the trustee to invest the trust portfolio without facing the income/principal conflict.

These types of trust are commonly called "total return trusts." While such trusts are common in the field of charitable giving and will no doubt become more common, the total return concept is spreading into the private area as well. These trusts provide that the income beneficiary receive an annual percentage of the value of the trust including capital appreciation as well as income earned in that year. This means that the trustee may focus the investments on growth (stocks) and less on fixed income (bonds). A variation on this pattern is to provide the beneficiary each year with the choice of withdrawing the percentage payment.

Studies of historic market returns indicate that a payout of 4 percent or less over the long term have preserved principal. Should all new trusts be drafted this way? Perhaps, but there are still questions concerning the income taxation of such trusts and they must be carefully drafted if the trust is intended to qualify for the federal estate tax marital deduction. Furthermore, a total return trust may look good to an income beneficiary in today's environment of strong capital growth. However, many may remember certificates of deposit that paid 15 percent. An income beneficiary who benefits from a 4 percent return today must realize that he or she may be foregoing a higher return in the future. That said, total return trusts present an interesting new technique for estate planning.


Premiums for group term life insurance benefits paid by an employer are generally received income tax-free to the extent of the first $50,000 of death benefits. If the benefit is greater than $50,000, the employee is taxed on the premium for the excess coverage. Under final IRS regulations effective July 1, 1999, employees will not be taxed on the excess coverage if it is designated to a charity. The taxpayer may not, however, claim a charitable income tax deduction for the value of these premiums.


Many of our clients ask us about the benefits of creating a private foundation in order to obtain an income tax deduction in the current year while retaining control over the investment of the funds and the eventual distribution of monies to charities of their choice. There is some cost in retaining this control, however. In addition to the limitations on deductions to private foundations, a host of complex rules apply to the administration of these entities. These include a 1 percent tax on net investment income, stringent self-dealing penalties, restrictions on investments in certain blocks of corporate stock and a 5 percent minimum distribution requirement. Perhaps most important, the deduction for gifts of appreciated property (except for certain publicly traded securities) is limited to the donor's income tax basis. This makes it difficult to receive a worthwhile charitable deduction for a gift of stock of a closely held company.

These restrictions do not apply to gifts to public charities (charities that receive their contributions from a wide base of donors). For this reason, some clients have looked to the "supporting organization" rather than the private foundation. The supporting organization is created to support one or more specified public charities. It is treated as a public charity and therefore allows greater donor control without the restrictions of a private foundation. The supporting organization must meet one of three tests that are designed to ensure that the organization will be operated in a manner that is responsive to broad public needs.

Although clearly not appropriate for all clients, the supporting organization can resolve some perplexing charitable planning issues for certain individuals, especially those who own closely held businesses.

The Estate Planning Update is a publication of Pepper Hamilton LLP.
The material in this update is based on laws, court decision, administrative rulings
and congressional materials, and should not be construed as legal advice or legal opinions on specific facts.

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