Estate Planning Is Risky Business, What Should You Do?
Estate planning is inherently fraught with risk and uncertainty, but some practical steps may mitigate some issues.
Estate plans all include lots of uncertainty and risk. Risk? What risk? Gee, are your investment returns guaranteed? Surely not. Many estate planning techniques are interest rate dependent. Who can predict interest rates? Many estate planning techniques depend on when you die. Die too early and a GRAT might not work. Die too late and a private annuity might shift value into your estate (increasing the estate tax) instead of shifting value out of your estate as intended. Does your home contractor guarantee you that nothing will ever go wrong? Of course not!
Even really common planning techniques, like an irrevocable life insurance trust (“ILIT”), are subject to uncertainty. The law on whether an insurance trust is a wholly grantor trust for income tax purposes (which can be really important to your planning) is as clear as mud. If the trustee can use income earned by the trust to pay insurance premiums on your life (you being the settlor that created the trust) does that make the trust a grantor trust for income tax purposes? It might. But does it make it a grantor trust as to income or principal as well? What if there is no income earned by the trust? What if there is no insurance in the trust? Certainty in estate planning is likely better than the weather channel, but it ain’t nowhere near guaranteed.
Oh, and by the way, and you might want to sit down for this one, tax laws change a lot! Yeah, that’s a shocker. So, whatever you did last year may not be optimal this year, and may not work well next year, and the year after it could be a disaster. And just to hopefully drive the point home, you wouldn’t drive your car for 50,000 miles without an oil change and expect it to hum, well your estate, insurance, and financial planning are no different. Get a checkup every 3-5,000 miles or face the risk of serious damage and more expensive repair bills. Your estate, financial, insurance and related planning is no different. Annual reviews are really essential. And that does not mean meeting with one of your advisers and assuming they have covered everything.
Identifying Risk Factors. Most advisers don’t hand out a list of the risks your plan or document contains. Wealth advisers and insurance consultants are great at having disclaimers in all their forecast and projections, but do you actually read and understand the disclosures? You should. Also, boilerplate disclosures are helpful in pointing out the general risks, but your unique circumstances always create a risk or two that might be different than the standard issues. Those are most likely communicated by your advisers but don’t be shy to ask. “Is there a risk I should be aware of I might be missing?” If you are engaging professional advisers, they will inform you of risks, but it is really your responsibility to ask questions and understand them. Also, if you really want a handle on the risks of a plan get your team around a table (or on a web conference) and ask them collectively.
For example, your estate planning attorney might design documents for a rolling GRAT estate plan. But it is the investment location decisions and investment performance issues that might determine the success of that plan. No doubt your attorney can provide some comment, but shouldn’t you have your investment adviser in on that discussion to understand better?
Your estate planning attorney can draft a life insurance trust but discussing risks of that plan without the insurance consultant that structured the insurance for that trust is like taking a shower in a raincoat. You need both involved. It’s no different then if you meet with your wealth adviser and she reviews your insurance coverage. That’s a great step. But your wealth adviser probably won’t understand your insurance trust or the plan that it relates to in the same manner as your estate planning attorney (even if your wealth adviser has estate planning attorneys on staff). You need both.
If you’re a real person doing estate planning, understand the risk factors each of your advisers points out during your meetings. Each adviser has different expertise, and each may identify different risk factors or different perspectives on the same concerns. Understand that some or many may apply to all the planning you have done, and there are assuredly other risk factors unique to your planning may not be communicated. No adviser, no matter how erudite knows everything (and even if you find the best in breed team of advisers that knows everything without an Ouija Board they cannot predict changes in the law!).
Team It. Different advisers can identify different risks. If you want to understand more of the risks, your planning might face, consult your entire advisory team. Members from different disciplines will have different insights. For example, your wealth manager, not your attorney or CPA, should be monitoring asset location decisions for securities as well as swap powers. But they need input from your attorney to understand the array of trusts, the tax status of those trusts, etc. This is essential to the success of many plans. Oh, and that disclaimer that you have to rely on your tax adviser for tax matters – really? If you’re using a pure investment adviser that might be the case (maybe). But if you’re working with a wealth adviser that provides comprehensive financial planning services (and many do but you need to understand the type of professional you hired and the scope of their expertise) they gotta get on this stuff since they have the handle on investment details other advisers generally don’t have. Further, the fact that any one of your advisers communicates verbally or in writing certain risks should never be interpreted as an indication that any such listing or communication is a comprehensive listing or communication of every risk involved. If you transfer assets to irrevocable trusts (e.g. to use the current exemption before it might be reduced) that might affect your property, casualty and liability coverage. Be certain to address that risk by involving the insurance adviser handling those matters.
Read Your Memos and Disclaimers. While you have probably already been told many of the risk factors (different ones by different advisers) that might affect you, likely few if any of your advisers committed lists to writing in the past. That might change because of recent case law. You might treat the warnings the same way you do the warning label on a good bottle of bourbon (ignore it) but that isn’t really wise. You should understand the risks, at least those that can be identified, and you as the client have to make the decision to proceed with planning despite the risks that can be identified, and with the understanding that there are always risks that cannot be identified. That is your right and responsibility as the client. All your advisers can do is guide you.
Deal with Risk. If you plan, and if you are over 18 you should regardless of wealth level, you have to understand that the results of any plan are never guaranteed. Many aspects of many, if not most, estate and related plans are not only uncertain, but subject to a wide spectrum of different views by other advisers, the courts, the IRS, and other authorities. Most strategies have negative consequences (e.g. save estate tax, lose basis step-up). Even many common strategies, techniques and transactions are subject to tax, legal, financial, and other risks and uncertainties. While all of your advisers no doubt endeavor to identify and inform you of some of the risks of a plan, all risks and issues with each component of a plan are not possible to identify or communicate. It’s your wealth you have to call the shots on what you are comfortable doing. Your advisers can recommend plans but if you proceed that is your call. If you don’t proceed, that too is your call including the risk doing nothing (gee that plan is costly and complicated).
There are some steps you can take to mitigate planning risk:
Mitigating Risk Tip #1: Creating a collaborative team will help identify more issues with your plan. Identifying issues is the first step to being able to address them. The risks of any transaction can be further compounded by improper administration of the plan, failure to meet annually to review and update the plan, changes in the tax and other laws that may reduce hoped for benefits or even result in more costly results then had no planning been pursued. Annual meetings with a collaborative advisor team may identify existing or new risks, help modify the plan to address changes in the law, mitigate risks, but still cannot provide certainty. If you do not meet regularly with a collaborative team of advisers your plan may not succeed. So, meeting with your entire planning team at least annually, before any significant transaction, and if there is a significant change in events (e.g. health issue, change in tax law, etc.). Regular pruning of your planning garden with your team is a great way to reduce (that word is not the equivalent to “eliminate”) risks.
Mitigating Risk Tip #2: Buy (or keep) life insurance. Yeah, I don’t sell it, so I can say it. You buy liability coverage to protect you from an auto accident. So buying life insurance to offset a loss of basis step up on assets transferred to an irrevocable trust, or life insurance in a SLAT to offset the risk of your spouse dying prematurely, life insurance in case the Blue Wave results in a dramatic reduction in the estate tax exemption, life insurance in case you don’t outlive the term of a GRAT you create, and so on, might all make sense. Insurance can protect against risk and there is a zillion (I counted them) ways you can creatively apply life insurance to mitigate planning risks. Long term care insurance or permanent life insurance with long-term care features, or even annuities (yeah, I said that word too) might be useful to mitigate longevity risk. So, if you want to reduce risk. Insure!
Mitigating Risk Tip #3: Get zealous about formalities. The folks at the IRS and the Plaintiff’s bar are smart cats. Why should they haggle over headache inducing nuances of tax esoterica if they can nail you on sloppy administration of a trust or other aspect of your estate plan? If you’re getting divorced and your ex’s attorney finds you deposited marital funds into your irrevocable pre-marital trust that’s an easier line of attack to piercing the trust protection, then arguing that the trust is somehow otherwise accessible. If you have an LLC and paid your personal estate planning bills, meals, travel and other personal expenses, that could be an easy chink in the entity armor. If you have an insurance trust and didn’t open a bank account, didn’t issue Crummey notices, never filed a gift tax return, and so on, doesn’t that make an easier avenue of challenge by just saying you ignored the trust so why should the IRS or a claimant be bound to respect it? If you created an irrevocable trust but had quarterly tax reimbursements paid, took loans out of the trust, and more, it starts to look like you had an implied agreement with the trustee. That won’t help your cause. Do your trust statements reflect the assets the trust owns? Are you filing the correct tax returns? Have your advisers help you monitor the admiration of your plan and if you find the inevitable goof up fix it. But do everything possible to avoid the goof-ups as that type of paper trail is not helpful. “Never commingle” should be your mantra. And get real. Paying attention to this kind of minutia is less exciting than watching paint dry, but critical to perhaps most of your planning. So, get the pros involved to help because mere mortals rarely get this stuff right.
Mitigating Risk Tip #4: Use an institutional trustee. Yeah, they charge you money, but Aunt Jane will serve as trustee for free and also give you homemade chocolate chip cookies at trust meetings. Skip the cookies and get a pro involved. Professional trustees keep records, have policies and procedures, are really independent, and more. Aunt Jane might be sweet but having her involved likely won’t reduce risks.
Mitigating Risk Tip #5: Use trust friendly jurisdictions. Sure, it’s simpler easier and cheaper to set up trusts in your home state but your beloved home state may not show the love you want to your trusts. States like Alaska, Delaware, Nevada and South Dakota (and the list is long and growing) have made a point of creating trust friendly environments. Using these jurisdictions might reduce some of the legal, tax and other risks your planning is exposed to.
Mitigating Risk Tip #6: Layers. You know about layers. When you go fly-fishing you wear skivvies, long-johns, maybe a shell and only on top of all that your waders — ‘cause that water can be cold even in summer. Well, your planning needs layers too! If you have irrevocable trusts perhaps one or more LLCs owned by the trusts can own underlying assets. If asset protection is a concern, layer insurance, and umbrella policies to serve as a line of defense before your trusts. If you are going to marry, even if you have trusts, get a prenup. If you completed a note sale transaction to lock in discounts and shift value out of your estate, revisit that plan and add new layers in future years. Might a trust that is the receptacle at the back-end of a GRAT be able to sell the remainder interest it will get from a GRAT to a dynasty trust? Might it be time to unwind a split-dollar agreement? Might an older trust be improved by decanting? Should appreciated assets be swapped back? Might powers of appointment be exercised? The list goes on. Planning needs to be tended to and new layers added to enhance the success of the initial or core plan.
So, planning is inherently risky. You have to make the decisions whether or not to proceed with each step of a plan because it is you who bears the burden of the choice and everyone has different views of risk. No planning is not necessarily less risky as that might assure you are leaving assets subject to a higher tax and the reach of claimants, and more.