Inheriting an Individual Retirement Account - Part II- Taxing Issues

The last two newsletters, I discussed issues with estate planning and Individual Retirement Accounts, or IRAs. You can read more about inheriting options (here) and tax issues (here). This month, I will wrap up my three part series addressing procedural issues that trip many people up concerning IRAs.

The first big concern with an IRA is that the value of the IRA will be included in the owner's taxable estate. It is impossible to avoid. An IRA cannot be given away during life or put into a trust for the benefit of others. Such actions would trigger an income tax consequence because ownership of the account was changed.

Further, if the IRA owner's overall estate will be large enough to incur estate taxes (federal and/or state), than other assets will have to be used to reduce the tax or the IRA owner will need to purchase life insurance to pay the estate tax. Estate taxes can be avoided when the surviving spouse is the beneficiary of the IRA funds by using the marital deduction.

Not every IRA owner will have a surviving spouse. Most wills state that the residuary of a person's estate will be used to pay for any estate taxes. Thus, if the IRA is a large percentage of the estate and estate taxes are paid from the residuary portion of the estate, the taxes attributed to the IRA could consume the after-tax value of residuary shares of the estate. For example, Dad names Child A the beneficiary of his IRA and Child B the residuary beneficiary because the IRA and residuary are almost equal. But, Dad's estate has incurred an estate tax liability, then Child B's share will shrink to pay for Child A's IRA inheritance. If the estate tax uses up all of Child B's residuary share but there is still an estate tax liability then the estate will reach into Child A's IRA share to pay off any further tax liability.

Second, if the beneficiaries do not have sufficient funds to pay the incurred taxes, the beneficiaries will have to take a distribution from the IRA. Distributions from an IRA are included in a person's gross income. That could push beneficiaries into higher income tax brackets. Further, if the beneficiary needs another distribution from the IRA to pay the higher income tax liability, the beneficiary is in the process of creating a vicious loop that will likely wipe out the assets in the IRA to pay tax liabilities.

To avoid these issues, the best solution is to devise an estate plan that estimates how much the estate tax will be and determine which part of the estate will pay the estate tax. Or, the IRA owner will have to analyze whether it makes sense to purchase additional life insurance to pay the taxes.

The other issue the estate might have to be concerned with is the income tax liability incurred to the beneficiaries. I as previously mentioned, IRA distributions are included in a person's gross income and taxed. The income tax liability incurred by the beneficiary might influence whom the IRA owner will name as the IRA beneficiary. In short, a non-IRA asset of equal value to an IRA asset is more "valuable" because of its liquidity i.e. ability to be sold.

Next time I will get into the procedural issues that many people stumble over when inheriting an IRA.

Basics of Estate Planning: When to Review Your Estate Plan?

One of the many questions that I get from clients who have just finished signing their estate planning documents is when to next review an estate plan to determine if the estate plan still "works." Well, like I have said several times "it depends." Most times the trigger is a major life changing event; other times are just periodically during the process of life.

There is no hard and fast rule as to when to review a plan but there are times when it does make sense. For example, you should review estate planning documents in the following instances:

• Death. Death of a loved one, especially of a spouse, should initiate the review a person's estate plan. Death means a potential change in your beneficiaries; not only in your testamentary documents (aka will and/or revocable living trust) but also with assets that transfer through beneficiary designations. If your spouse has passed away, it is even more important to review your plan because many people nominate their spouse in fiduciary roles like personal representative, trustee, power of attorney, etc.
• Divorce. Divorce is a dramatic change in a person's life. It is the end of a marriage but also generates the need to update estate planning documents. It could mean changing beneficiaries, trustees, agents in your power of attorney, etc., since your spouse is no longer there. But, if a child gets divorced, you will also want to ensure that your plan, if you wish, incorporates your grandchildren but not your child's ex-spouse.
• Getting married. You will want to update your estate planning documents to incorporate your new spouse into the plan. You will need to address your beneficiary designations. If you made a pre-nuptial agreement before getting married, the changes to your plan will need to align that agreement. If the marriage will blend two families together, like the "Brady Bunch," you will want to make sure your estate plan incorporates or intentionally does not incorporate step-children.
• Having children. Upon the birth of your first child, your plan will need to ensure that it accounts for the new addition and that you have proper guardians appointed. When you have other additional children, or adopt a child, you will want to review whether your plan incorporates pretermitted children.
• Health Issues. If you have health issues, and, if you don't have a plan, you better put one in place. Also, if you think someone might have health concerns in the future, like a child with special needs, you might consider special provisions in your estate plan to cover these expenses.
• Nearing retirement. Through most of your adult life you have been accumulating wealth. In retirement, you will likely be decreasing your wealth. That financial change might cause a change in your estate plan thinking.
• Selling/Buying a business. Selling a business might generate a significant tax liability. Alterations to your estate plan might reduce that liability. Buying or starting a business will mean that business needs to be incorporated into your estate plan.
• Winning the lottery. Stranger things have happened, but winning a significant amount of money, via the lottery or inheritance, means likely changes to an estate plan.
• Changes in the law. The last twelve years have been an interesting time for estate planning. The changes have caused many people to alter their estate plans to conform to new laws. Earlier this year Congress said that the federal estate tax law is "permanent." I don't believe that for a second. No federal tax law is ever permanent and state estate tax laws change all the time. Your plan needs to account for those alterations.
• Every Five to Seven Years. If the items above have not occurred to you, you still should review the plan to make sure your desires are still the same and your estate plan does what you want it to do.

Estate of the Month: Too Many Heirs, Can Spoil The Cavern

Last time, I described the situation of the reclusive heiress - Huguette Clark - that did not have any children and, thus, did not have any heirs within her blood line. This month, I am addressing the opposite problem. Having too many children, or heirs, and not creating an estate plan that would adequately ease any family tension over the inheritance. The Washington Post published an article on March 14, 2013 entitled "The Rift - A family dynasty fights over the future of Luray Caverns" describing some of the issues.

Many readers have likely had the opportunity to visit Luray Caverns, but, in this case, the ugliness of the ongoing estate/trust litigation happening above ground outshines the natural beauty below it. For those that don't know, Luray Caverns attracts over 400,000 visitors a year to the scenic Shenandoah Valley. Luray Caverns were "discovered" by a small band of explorers on August 13, 1878 and became an instant sensation in the area. After numerous legal disputes over ownership of the Caverns, Theodore Clay Northcott bought ownership of the Caverns in 1905. His family has owned the Luray Caverns ever since. And, that is where the problems arise.

Northcutt had one daughter and she had one son, Ted Graves. Ted Graves and his wife, Rebecca, have six children. Ted Graves died in 2010 and Rebecca died in 2012. But, as you can see from the discussion below, the six children (Rebecca Graves Hudson, Katherine Graves Fichtler, Elizabeth Graves Vitu, John Graves, Rod Graves and Cornelia Graves Spain) have been in an almost constant legal free-for-all as far back as 2004, before even Ted or Rebecca passed away. As you would suspect, much of the litigations has revolved around ownership and/or inheritance of the Luray Caverns, estimated at approximately $20 million.

In 2000, the Graves siblings met to discuss how the Caverns would be held after the death of their parents. In truth, they should be commended for such foresight. But, in practice, it has been a disaster. The Graves siblings decided the best estate planning tool to manage the Caverns was to utilize a buy/sell agreement.

A buy/sell agreement is an agreement between co-owners of a business that governs the situation if a co-owner dies or is otherwise forced to leave the business, or chooses to leave the business. It sets the rights of who can buy a departing partner/shareholder's share of the business, what events will trigger such a buyout and what price will be paid for that departing partner/shareholder's interest in the business. It is often used in family business because it restricts the ability of existing family member shareholders from selling their interest in the family business to outsiders. However, in this case, it has bound siblings together that want nothing to do with each other.

The second major issue arose due to management conflicts between Rebecca Graves and several other siblings that worked for the business that oversaw the operation of the Luray Caverns. Rebecca started working with the Caverns in 1982, became the general manager in 1988 and then president in 2004. But, she was ousted as President only a few months later. While there were strong allegations of Rebecca being overbearing, her biggest fault was drafting a favorable golden parachute agreement for herself and telling her brothers their golden parachute agreements were equivalent. But, they weren't.

Ted Graves quickly stepped in and demoted her to a mere staff position. Rebecca's contention was that her younger siblings, particularly Cornelia, turned their parents against Rebecca and that her father's actions were done at the behest of John (now President of the company), Rod (now V.P.) and Cornelia. Rebecca was sued by the Caverns to rescind her agreement. After several years of litigation, the case was settled for undisclosed terms. Nothing like working at a place where you are suing the boss or the boss is suing you.

But, litigation did not stop there. Nathan Miller, the general counsel, and a co-trustee of one the trust that manages most of the shares of the Caverns, was sued and allowed to be released from his duties after advising Rebecca Graves on the compensation package. Of course, there was a lawsuit between the older siblings (Rebecca, Katherine and Elizabeth), the younger siblings (John, Rod and Cornelia) and the parents over who would replace Miller as co-Trustee.

Then there is the age-old argument about whether children not involved in the business are entitled to the same portion of the business as those children involved in the business. In the Graves case, the younger siblings sued Katherine and Elizabeth to void their inheritances because of lack of participation in the business. Katherine lives in Montana, and Elizabeth lives in France, and neither work for the Caverns.

Now, the average person will say, "I don't have my own company, much less one worth $20 million." But, tweaking the facts just a tad makes Elizabeth and Katherine's situation applicable to many families. For example, what if there are 4 children and three of the children have moved to different parts of the country. But, one child stayed near mom and has done the "heavy" lifting in caring for mom as she ages. There is a natural tendency for that close child to feel "entitled" to a larger share of mom's estate because of the "extra" work that child has done relative to the other 3 children. Situations like this happen all the time and are the reasons there are estate litigations.

The real take away from all of this is that Ted and Rebecca Graves inadequately contemplated how the discord among their children would grow over the Caverns when both passed away. The conflict wasn't even manageable while Ted and Rebecca were alive. It was surely going to get worse on their passing. And, as you can see, it has spilled onto the front page of the newspaper.

Like most parents, I would imagine the Graves only could see the best in their children. And their love clouded their ability to see the need for a stronger estate plan that would reduce sibling conflict.