Moore Colson :: News & Resource Center

Share your assets
How to provide for children from a previous marriage and your spouse

For most families, an estate plan is indispensable. It enables you to ensure your spouse and children are financially provided for and your wishes are carried out not only after your death, but also in the event you become incapacitated during your life. Having documentation in place also helps you share as much of your wealth as possible with your loved ones while minimizing the tax bite.

Estate planning can be complex even in the most traditional families. But today, second and third marriages are increasingly common, complicating the process even further. If you have children from a previous marriage, failing to plan can lead to unexpected — and unwanted — results.

Have a plan

It’s often said that “not to decide is to decide.” This holds true for estate planning: Without a plan, state law decides how your wealth will be distributed and to whom.

For example, if you die intestate — that is, without a will — state law may provide for a significant portion of your estate to go to your children from the previous marriage. But what if they’re financially independent adults who don’t need the assets as much as your current spouse and children? Even more troublesome, what if your children from the prior marriage are minors? In that case, your former spouse might gain control of the assets.

Fortunately, with a little planning, you can avoid results like these and share your wealth as you see fit.

Name children in your will

To provide for children from a previous marriage, you can simply name them in your will or trust and transfer assets to them directly or to a trust for their benefit. A disadvantage of this approach is that you may need these assets to provide for your current spouse and any children from that union.

Also, if estate tax is a concern, it may not be the most cost-effective strategy. Why? Because it doesn’t make the most of the estate tax marital deduction, which allows you to transfer an unlimited amount of assets to your spouse — either through lifetime gifts or bequests at death — without being subject to current gift or estate tax. One caveat: Different rules apply if your spouse is not a U.S. citizen.

But transferring all your assets to your spouse may not be a wise strategy either. For one thing, there’s no guarantee your spouse will use the assets to carry out your wishes. He or she may spend them all, leaving your children from the previous marriage with nothing, or use the assets to provide for a new spouse and children. Also, you’ll waste your estate tax exemption, which you can use to shield up to $2 million (increasing to $3.5 million in 2009) from estate taxes.

Although any assets your spouse receives are eligible for the marital deduction and you’ll owe no tax at your death, you’ll only defer the tax until your spouse dies. By forgoing the use of your estate tax exemption, the assets that could otherwise be sheltered from tax will be included in your spouse’s estate.

Consider a QTIP trust

So how do you strike a balance between providing for your current spouse and preserving your wealth for your children from a previous marriage? A qualified terminable interest property (QTIP) trust may be the answer. A QTIP trust is designed to take advantage of the marital deduction. But unlike most marital trusts, a QTIP allows you to avoid current estate taxes without giving your spouse control over the assets.

If you meet the QTIP trust requirements, which include paying out all of the trust’s income to your spouse at least annually, you can:

• Enjoy the benefits of the marital deduction,
• Provide your spouse with lifetime financial security, and
• Preserve the principal for your children.

You need not place all your assets in a QTIP trust. Depending on the size of your estate and your current spouse’s financial needs, you may want to transfer some assets to a QTIP trust and some to your children, either outright or in trust. That way, you can enjoy the benefits of a QTIP trust while taking advantage of your estate tax exemption.

Consider an ILIT

A QTIP trust can be a powerful tool that balances the needs of your current spouse and children with those of your children from a previous marriage. But in some cases, a QTIP trust isn’t the best choice. Consider this example:

Jim, who is 63 years old, recently married Carol, age 45. Jim has two children from a previous marriage, ages 42 and 39. Jim wants to ensure Carol can maintain her current lifestyle after he dies, but he also wants to share his wealth with his children. A QTIP trust would generate enough income to support Carol, but his children wouldn’t receive anything until Carol dies. Because Carol and the children are so close in age, this strategy effectively disinherits Jim’s children.

Under these circumstances, a better approach might be to set up an irrevocable life insurance trust (ILIT). The ILIT purchases insurance on Jim’s life and Jim makes gifts to the trust to cover the premiums. When Jim dies, the ILIT collects the insurance proceeds and pays them to Jim’s children.

Another option is for Jim to transfer an existing policy to the ILIT, but there may be gift tax consequences. So unless Jim lives for at least three years after creating the ILIT, the insurance proceeds would be included in his estate. If that’s the case, the gift tax consequences would be effectively neutralized. Either way, using an ILIT allows Jim’s children to receive their inheritance immediately and frees Jim’s remaining assets to provide for Carol.

Weigh your options

QTIP trusts and ILITs are just two estate planning techniques you can use to balance the needs of a current spouse and children with children from a previous marriage. The key is to articulate your goals and identify a strategy that will help you achieve those objectives in a cost-efficient manner.

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Fragile transactions
Handle shareholder loans with care

Shareholders of closely held corporations often look for ways to take money out of the company without triggering tax liability. C corporation shareholders, in particular, are concerned about double taxation: Earnings are taxed once at the corporate level and again at the individual level when they’re distributed to shareholders as dividends.

To avoid double taxation, C corporations usually pay out as much as they reasonably can to shareholder-employees as deductible compensation. Some corporations choose another route by making loans to their shareholders.

Because of this, the IRS, naturally, is suspicious of shareholder loans. So be sure to dot your i’s and cross your t’s when borrowing from your company. If you can’t prove the loan is legitimate, the IRS may treat it as a constructive dividend and hit you with back taxes, interest and penalties.

Making your case

Whether a distribution is classified as a loan or a dividend depends on whether the shareholder intended to repay the amounts received and the corporation intended to require repayment. In making this determination, the courts look at a number of factors, including whether:

• The promise to repay is evidenced by a note or other instrument,
• Interest was charged,
• The parties established a fixed repayment schedule,
• The shareholder gave collateral to secure payment,
• The shareholder made repayments,
• The shareholder had a reasonable prospect of repaying the amounts received and the corporation had sufficient funds to make the advance, and
• The parties conducted themselves as if the transaction were a loan.

No single factor is determinative. But the more factors you have in your favor, the better. It’s also important to document the loan in writing, charge a reasonable rate of interest, establish a repayment schedule and actually make the payments.

Interest and repayment key

In a recent Tax Court case, Teymourian v. Commissioner, the corporation’s CEO and majority shareholder borrowed more than $1.5 million from the company to buy a home and pay for other personal expenses. The disbursements were initially recorded as “advances” on the corporation’s books but were later changed to “notes.”

The Tax Court ruled the corporate disbursements were loans, not dividends, even though the parties failed to sign formal loan documents, establish a fixed repayment schedule or provide for collateral to secure repayment.

Despite the lack of documentation and collateral, the court held the distributions qualified as loans because the shareholder made reasonable interest payments, repaid a substantial amount of the principal ($400,000) and had a reasonable prospect of repaying the balance. Also, the parties’ conduct indicated they intended the disbursements to be loans.

Taking no chances

If you borrow from your corporation, be sure to document the loan and take other steps to formalize the transaction. Even though the taxpayer in Teymourian prevailed without documenting the transaction, it took a court battle to reach that result. Also, the Tax Court gave a great deal of weight to the fact that the taxpayer had repaid a substantial portion of the loan.

In cases where repayment hasn’t begun or only a small portion of the loan has been repaid, documenting and securing the loan is even more critical.

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There’s no better time than the present to plan your future
How succession planning can benefit your business

You’ve spent a lifetime building a successful company, and now you’re starting to look forward to the freedom of retirement. To ensure a worry-free exit from work, you need to plan for the continuance of your company.

Know where you stand

Before you can plan where you — and your business — are going, you need to know where you are. First, you’ll need to prepare a detailed financial analysis of your business. This typically involves reviewing historical data and ratios for past years. You’ll also need to determine your company’s value, which will generally require a professional business valuation.

Before you get too far along in the process, you need to make sure your business is transferable. Are there any restrictions on transferring your business, such as professional license restrictions, franchise agreements, lending agreements or other types of contracts? Your exit strategy and choice of a successor may also be affected if you are in an artistic, creative or otherwise unique business. Not just anyone will be able to step in and continue the business.

Take time to analyze operations and procedures and examine all contracts and agreements, which may help you determine whether there are restrictions or limitations on transfer or other factors that may affect the transition.

To establish where you want to go, you’ll need to thoughtfully consider your retirement goals and income needs. After all, your financial requirements and timing will drive the choice of exit strategies and shape your transition planning.

Possible scenarios

For many business owners, the successor of choice is a family member — or, perhaps more than one. Or, if you have co-owners, they can take over your ownership interest via terms provided in a shareholder agreement or other agreement between the owners.

But if there are no qualified family members or co-owners to fill your shoes, you may want to sell the business to a key employee. Because an employee may not have the funds to purchase the business outright, the purchase might be financed, at least in part, by payments from business profits.

Alternatively, you may want to transfer ownership to a key employee while you’re still at the company. This can be accomplished with incentive compensation that periodically transfers an interest in the company directly or that provides the employee with cash to purchase a partial interest. You can also transfer company ownership to one, or more, employees through a buyout, or to all employees by a sale to an Employee Stock Ownership Plan (ESOP).

Set up your team

Planning your exit strategy and succession isn’t a simple task. So, carefully choose a team of advisors to help you through the process. Typically, you’ll need a tax planner, estate planner and possibly a personal financial planner to advise you on the tax consequences and financial impact of certain scenarios. They can also help you determine your needs and objectives.

But you’ll also need a valuation expert to assess your company’s worth, an insurance advisor to review your insurance coverage and an attorney to draft the necessary agreements and documents. You may even need the expertise of an employee benefits consultant at some point in the process.

This may sound like a lot of experts (and a lot of money), but, remember, this is your retirement, the financial security of your heirs and the continuation of your business. That’s a lot to cover, and it pays to make sure it’s done right.

Clue in your family and key employees

Don’t make your plans in a vacuum. Talk to family members and key employees to ensure you aren’t misinterpreting their needs or interests.
You don’t need to divulge all aspects of your succession plan, but affected persons should be aware of plan elements that will affect them. For example, providing key employees with both information about the plan and a bonus tied to the business transfer may help ensure a seamless transition.

Plan while there’s still time

Because you’ll undoubtedly need a transition plan at some point, put it in place before it’s actually needed. Developing your succession plan now can provide benefits beyond the orderly transition of ownership. For example, as your team of experts goes through the exercise of developing your plan, they may also be able to advise you of current business opportunities or problems.

And planning the steps involved in the theoretical succession will help focus you on where the business may be headed and whether your goals will likely be met. Remember: The key to a successful transition is to define your exit goals, consider the options and plan accordingly.

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Not your run-of-the-mill retirement planning ideas

You work hard to ensure your long-term financial security. But is your money working as hard for you? In addition to making IRA and 401(k) contributions, here are some retirement planning ideas you may not have considered.

Taxable investments count too

Say the words “retirement planning,” and most people immediately think of their tax-deferred (or tax free, if a Roth account) IRAs and 401(k)s — or other employer-provided retirement plans. But investments that are currently taxable also have a place in your retirement planning.

After you’ve contributed the maximum to your IRA and employer-sponsored plan, build your portfolio of stocks, mutual funds, bonds and other taxable investments. Paying current tax isn’t all bad: Unlike income in your retirement accounts (which will be taxed as ordinary income when withdrawn), gains in your taxable accounts may be taxed at lower rates. These investments may also give you easier access to your funds should the need arise.

Because different investments have different tax treatments, you need to consider the type of investments that should go in your retirement accounts and those that are more suited for taxable accounts.

Capital gain and other tax-advantaged income may be best suited for a taxable account. Ideally, ordinary-income-earning investments would be in your retirement accounts (where they’re not currently taxed) and qualifying long-term capital gain and dividend (15% rate) investments and tax-free investments (such as municipal bonds) would remain outside your retirement accounts.

Work now, get paid later

Many executives and key employees have compensation arrangements, known as nonqualified deferred compensation, that pay them sometime in the future for services to be currently performed. This form of compensation allows you to accumulate funds for retirement while postponing tax until a later year — when you may be in a lower tax bracket.

Though these arrangements are subject to a variety of requirements and strict rules, they can effectively build up additional retirement funds.

Choose beneficiaries wisely

It’s always wise to plan ahead for transferring all assets at your death, but naming retirement plan beneficiaries requires additional thought. A spouse who inherits a retirement plan account can choose to roll over those funds to an IRA of his or her own and continue to defer tax on the funds until he or she reaches age 701⁄2 and must start taking distributions. If you bequeath the funds to your children, or others, they must begin to withdraw the retirement funds in the year following your death based on the distribution rules for nonspouse beneficiaries. The amount of the minimum required distributions will vary based on the age of the beneficiary.

You can also name a charity as a beneficiary. Doing so protects the funds from both income tax and estate tax. If you’re already planning to make a charitable bequest, bequeathing your retirement funds to the charity and your other assets to your children may result in your children netting a larger amount because they won’t lose part of their inheritance to income tax on the retirement funds.

Happy trails to you

Retirement planning can be complicated, and the results are fraught with uncertainty. But by knowing the ins and outs of different types of plans, carefully choosing the investments that go into them, and understanding the tax impact of your beneficiary choices, you’ll be better equipped to sail into retirement with peace of mind.

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