What Happens If a Trust Is Invalid?

Lessons about gifting, blended families, entity formalities, trusts and estate planning may all be found in the outcome of a tax case described in The Dallas Morning News’ article “The Smaldino case: Tax court opinion leads to estate planning angst.” The case involves gift taxes, and more particularly, a gift of LLC interest to a dynasty trust. The interest started out in the husband’s trust, transferred to the wife, who then transferred them to a dynasty trust, created to benefit some of the husband’s children from a prior marriage.

You may know that taxpayers are not required to report gifts between spouses. The husband’s gift to his spouse was, therefore, not reported to the IRS. The wife did report her gift to the IRS, but she didn’t need to pay any gift taxes because the reported value didn’t exceed her own lifetime gift tax exemption. Therefore, no gift taxes were due or paid on the transfer of the LLC interest to the trust.

The IRS assessed the husband a $1,154,000 gift tax deficiency, which was subsequently held up by the tax court. What was wrong?

The IRS and the tax court found a number of red flags. For starters, the wife held her LLC interest for only one day, before transferring it to the trust.

In testimony before the court, the wife said she had committed to transferring the shares to the trust even before she received the assignment of the shares. She clearly stated that she would have not changed her mind about transferring the assets, which were to benefit her stepchildren. Her timing was too hasty, however.

The husband, who was in control of the LLC, neglected to amend the LLC documents to reflect his wife’s owning an interest in the LLC. As a result, she was never recognized formally as a member of the LLC. The LLC documents made a clear distinction between the roles and duties of an assignee and a member. He executed the assignment of the interest, but she never became a member of the LLC.

The tax court also found a number of the corporate documents simply unbelievable. Several were undated. Others had an “effective date,” but lacked the date of signing.

One could say the IRS was being picky, but the IRS doesn’t have the ability to disregard documents, for two reasons. One is the doctrine of the tax court known as “substance over form.” The substance of a transaction, rather than the form it is presented in, determines the tax determination. The second is something families need to take seriously: when transactions involve family members, the IRS uses a fine-tooth comb to be sure transactions are legitimate.

When estate planning entities are created and transactions take place, consistency in actions is needed to demonstrate intent. All of the rules and practices must be followed, and when family members are involved, those involved must go above and beyond to avoid any appearance of impropriety.

An estate planning attorney with experience in creating LLCs, transferring interests and procedures required by the IRS, does more than create documents. He or she educates clients and explain how the transactions should be carried out to ensure that proper procedures are being followed. In this case, the mistakes far outweighed any benefits from the transaction.

Reference: The Dallas Morning News (Dec. 19, 2021) “The Smaldino case: Tax court opinion leads to estate planning angst”

How Do You Split an Estate in a Blended Family?

Estate planning attorneys know just how often blended families with the best of intentions find themselves embroiled in disputes, when the couple fails to address what will happen after the first spouse dies. According to the article “In blended families, estate planning can have unintended issues” from The News-Enterprise, this is more likely to occur when spouses marry after their separate children are already adults, don’t live in the parent’s home and have their own lives and families.

In this case, the spouse is seen as the parent’s spouse, rather than the child’s parent. There may be love and respect. However, it’s a different relationship from long-term blended families where the stepparent was actively engaged with all of the children’s upbringing and parents consider all of the children as their own.

For the long-term blended family, the planning must be intentional. However, there may be less concern about the surviving spouse changing beneficiaries and depriving the other spouse’s children of their inheritance. The estate planning attorney must still address this as a possibility.

When relationships between spouses and stepchildren are not as close, or are rocky, estate planning must proceed as if the relationship between stepparents and stepsiblings will evaporate on the death of the natural parent. If one spouse’s intention is to leave all of their wealth to the surviving spouse, the plan must anticipate trouble, even litigation.

In some families, there is no intent to deprive anyone of an inheritance. However, failing to plan appropriately—having a will, setting up trusts, etc.—is not done and the estate plan disinherits children.

It’s important for the will, trusts and any other estate planning documents to define the term “children” and in some cases, use the specific names of the children. This is especially important when there are other family members with the same or similar names.

As long as the parents are well and healthy, estate plans can be amended. If one of the parents becomes incapacitated, changes cannot be legally made to their wills. If one spouse dies and the survivor remarries and names a new spouse as their beneficiary, it’s possible for all of the children to lose their inheritances.

Most people don’t intend to disinherit their own children or their stepchildren. However, this occurs often when the spouses neglect to revise their estate plan when they marry again, or if there is no estate plan at all. An estate planning attorney has seen many different versions of this and can create a plan to achieve your wishes and protect your children.

A final note: be realistic about what may occur when you pass. While your spouse may fully intend to maintain relationships with your children, lives and relationships change. With an intentional estate plan, parents can take comfort in knowing their property will be passed to the next generation—or two—as they wish.

Reference: The News-Enterprise (Dec. 7, 2021) “In blended families, estate planning can have unintended issues”

Trusts Make Sense Even When You Aren’t a Billionaire

Trusts are used to solve problems in estate planning, giving great flexibility in how assets are divided after your death, no matter how modest or massive the size of your estate, according to an article titled “3 Reasons a trust may make sense for your family even though your name isn’t Trump, Gates or Rockefeller” from Market Watch. Don’t worry about anyone thinking your children are “trust fund babies.” Using trusts in your estate plan is a smart move, for many reasons.

There are two basic types of trust. A Revocable Trust is flexible and can be changed at any time by the person who creates the trust, known as the “grantor.” These are commonly used because they allow a high degree of control, while you are living. It’s as if you owned the asset, but you don’t—the trust does.

Once the trust is created, homes, bank and investment accounts and any other asset you want to be owned by the trust are retitled in the name of the trust. This is a step that sometimes gets forgotten, with terrible consequences. Once that’s done, then any documents that need to be signed regarding the trust are signed by you as the trustee, not as yourself. You can continue to sell or manage the assets as you did before they were moved into the trust.

There are many kinds of trusts for particular situations. A Special Needs Trust, or “SNT,” is used to help a disabled person, without making them ineligible for government benefits. A Charitable Trust is used to leave money to a favorite charity, while providing income to a family member during their lifetime. A real estate trust can be used for real property.

Assets that are placed in trusts do not go through the probate process and can control how your assets are distributed to heirs, both in timing and conditions.

An Irrevocable Trust is permanent and once created, cannot be changed. This type of trust is often used to save on estate taxes, by taking the asset out of your taxable estate. Funds you want to take out of your estate and bequeath to grandchildren are often placed in an irrevocable trust.

If you have relationships, properties or goals that are not straightforward, talk with your estate planning attorney about how trusts might benefit you and your family. Here’s why this makes sense:

Reducing estate taxes. While the federal exemption is $11.58 million in 2020 and $11.7 million in 2021, state estate tax exemptions are far lower. New York excludes $6 million, but Massachusetts exempts $1 million. An estate planning attorney in your state will know what your state’s estate taxes are, and how trusts can be used to protect your assets.

If you own property in a second or third state, your heirs will face a second or third round of probate and estate taxes. If the properties are placed in a trust, there’s less management, paperwork and costs to settling your estate.

Avoiding family battles. Families are a bit more complicated now than in the past. There are second and third marriages, children born to parents who don’t feel the need to marry and long-term relationships that serve couples without being married. Trusts can be established for estate planning goals in a way that traditional wills do not. For instance, stepchildren do not enjoy any legal protection when it comes to estate law. If you die when your children are young, a trust can be set up so your children will receive income and/or principal at whatever age you determine. Otherwise, with a will, the child will receive their full inheritance when they reach the legal age set by the state. An 18- or 21-year-old is rarely mature enough to manage a sudden influx of money. You can control how the money is distributed.

Protect your assets while you are living. Having a trust in place prepares you and your family for the changes that often accompany aging, like Alzheimer’s disease. A trust also protects aging adults from predators who seek to take advantage of them. Elder financial abuse is an enormous problem, when trusting adults give money to unscrupulous people—even family members.

Talk with an estate planning attorney about your wishes and your worries. They will be able to create an estate plan and trusts that will protect you, your family and your legacy.

Reference: Market Watch (Dec. 4, 2020) “3 Reasons a trust may make sense for your family even though your name isn’t Trump, Gates or Rockefeller”