Does Your Estate Plan Make These 5 Big Tax Mistakes?

Estate planning has numerous benefits for you and your loved ones. With a comprehensive estate plan, you can protect your property and your heirs. One of the common reasons many people create estate plans is to address tax matters. However, without the assistance of an experienced Maryland estate-planning attorney, an individual could make big tax mistakes that are costly for those the person is trying to protect.

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Five Common Estate Planning Tax Mistakes

1.  Failing to Select State Law to Govern Your Trust Agreements

The trust situs is the home state of your trust. That state’s laws govern the creation and administration of your trusts. In most cases, the trust situs is the state in which you reside. However, trust laws and estate laws vary by state. Therefore, the laws in another state could benefit the trust administration and the trust’s beneficiaries more than the laws in the state in which you reside.

Unfortunately, the choice of a state to govern trust agreements is often overlooked during estate planning. Some attorneys fail to discuss the pros and cons of choosing another state as the base for a trust agreement with their clients. There are several factors to consider when deciding whether to switch the trust situs from the grantor’s state to another state.

For instance, what are the costs involved in setting up the trust in another state, including fees for a local trustee and attorney? Do the advantages provided by a specific state’s trust, estate, and creditor laws outweigh the cost and other factors to make it more favorable to base your trust in another state?

2.  Failing to Address a Trust’s Swap Powers

Irrevocable trusts are popular estate planning tools used by many people to provide for beneficiaries and protect property. They can also eliminate or decrease the tax consequences for estates and beneficiaries. For the most part, irrevocable trusts do not permit the grantor to change the terms of the trust, including removing property from the trust once the transfer to the trust is complete. However, some trust agreements contain swap powers for the grantor.

With swap powers, a grantor can “swap” personal assets for trust assets. In other words, you could transfer an asset in your name to the trust in exchange for removing a trust asset of equivalent value back into your personal name. Swap or substitute powers allow grantors a limited amount of control over the trust assets.

However, swap powers can create tax consequences for the grantor. If the grantor is not careful, the grantor could incur a significant personal income tax debt by swapping property with the trust. Most irrevocable trusts are set up as grantor trusts. The grantor reports the trust income on the grantor’s personal tax returns. Instead of the trust paying taxes on the trust income, the grantor pays personal income taxes on the income.

Before swapping property with an irrevocable trust, discuss the swap with an estate planning attorney, CPA, and financial advisor to ensure that the swap is made according to the terms of the trust agreement and state trust laws and that the swap does not create a burdensome tax liability for the grantor.

3.  Failing to Maintain an FLP or LLC Properly

Limited Liability Companies (LLCs) and Family Limited Partnerships (FLPs) can be used as part of an estate plan and family wealth plan to protect business assets and family investment property. Some families and individuals use FLPs and LLCs to decrease gift and estate taxes. They are also used to protect property from creditors or other parties.

Problems arise when the formalities required to maintain these entities are ignored. For instance, co-mingling personal assets can remove the creditor protection and estate planning benefits offered by transferring property to these entities. The protections offered by these entities may also be ignored if assets are not legally transferred to the entities.

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Another problem that might arise when using LLCs and FLPs as part of your estate plan is failing to review the benefits these entities provide when there are major changes in tax or estate laws. The reason for creating and maintaining these entities could become moot with changes in the law. The benefits initially provided by using these entities to hold property could turn into disadvantages with changes to the tax code or estate law.

Failing to review the operation and documentation for these legal entities and the current laws that impact their usefulness in an estate plan can create more problems and additional taxes for heirs and beneficiaries.

4.  Failing to Consider Life Insurance

Wealthy individuals and families create estate plans designed to minimize or avoid estate and gift taxes. However, if they fail to consider life insurance proceeds in their estate plan, their heirs and estate could suffer.

By allowing the trust to own the life insurance policy, the individual avoids inadvertently increasing the value of the estate for estate tax purposes.
— Steve Thienel

Death benefits from life insurance policies are not taxable as income for the beneficiaries. However, the proceeds of life insurance policies could be included in the calculation of state tax if the insured maintained an ownership interest in the policy when he or she died.

To avoid the ownership interest issue, an individual can transfer the life insurance policy to an Irrevocable Life Insurance Trust (ILIT) or use an ILIT to purchase a life insurance policy. By allowing the trust to own the life insurance policy, the individual avoids inadvertently increasing the value of the estate for estate tax purposes. An ILIT also helps avoid any remaining amount of life insurance proceeds remaining when the beneficiary dies from being taxed as part of the beneficiary’s estate.

5.  Choosing the Wrong Type of Trust for Your IRA

Some individuals use IRA Trusts to hold title to the IRA or to act as the beneficiary for the IRA upon their death. While there are many advantages of using an IRA trust as part of your estate plan, failing to pay attention to the terms of the trust can accelerate taxes owed on the IRA funds.

The terms of a trust agreement determine whether the tax deferral benefits of an IRA remain after the IRA is transferred to or inherited by the trust. If the trust agreement does not contain language that makes the trust a see-through trust, you could lose many benefits offered by investing funds in an IRA.

Contact a Maryland Estate-Planning Attorney for Help

Estate planning can be a complicated and challenging undertaking, especially for wealthy individuals and individuals who can benefit from utilizing special estate planning tools. The legal advice and guidance of a Maryland estate-planning attorney can help prevent errors or mistakes that could cause costly and time-consuming legal problems and issues for your heirs. Contact Thienel Law today. Maryland estate-planning attorney Steve Thienel is dedicated to assisting clients in Maryland, Virginia, and throughout the DC Metro area.