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Slide 2 2012 Northern Trust Corporation Wealth Transfer Trends Near The Edge of the Fiscal Cliff Presented by: R. Hugh Magill Executive Vice President and Chief Fiduciary Officer northerntrust.com Slide 3 2 Demographic Trends TRENDSLEGAL ENVIRONMENTIMPLICATIONS Death & Taxes 2010 Tax Relief Act! 2013 And Beyond? Repeal of the Rule Against Perpetuities 2011 2012 Transfer Tax Window, State Death Taxes Slide 4 3 Planning Opportunities Under 2010 Tax Relief Act I. Evaluate Non-tax Issues - Sufficiency of Wealth - Role of Wealth in Family - Impact of Wealth Transfer II. Evaluate Assets - Basis - Appreciation Potential - Control/Management Issues III. Maximize Excludable Gifts - Annual Exclusion Gifts - Qualified Educational & Medical Transfers IV. Use Gift Exemption to Address Unique Family and Asset Circumstances - Loan Forgiveness - Compensating Gifts - Special Needs Trusts for Disabled Family Member - Special Purpose Trusts for Unique Assets V. Use Gift and GST Exemptions to Fund Long Term Trusts - Use states which have repealed, optioned or extended the rule against perpetuities - Design trusts with more than Lifetime flexibility Slide 5 4 Planning Opportunities Under 2010 Tax Relief Act (continued) VI. Use Leveraging Techniques for Large Transfers - Grantor retained annuity trusts - Gifts eligible for marketability and minority discounts - Sales or gifts to intentionally defective grantor trusts - Intra-family asset sales and low interest loans - Qualified personal residence trusts VII. Think Outside the Boxand the Code when Planning for non-traditional Families - Pre-fund inheritances for children of earlier marriage(s) - Use spray trusts sparingly in blended families - Plan for notice and disclosure - Be deliberate about discretionary standards - Consider non-qualified charitable remainder trusts Slide 6 5 Non-Qualified Charitable Remainder Trust Not Treated as Qualified Split Interest Trust Under Code Section 664 Life estate may include: Net income Unitrust or annuity interest Discretionary principal 5 & 5 withdrawal power No tiering for distributions (Code Section 664(b) No UBTI Not tax exempt under Code Section 664(c) No income tax deduction for present value of remainder interest Slide 7 6 Federal Estate Tax Exemptions and Rates Year Estate Tax Exemption Top Estate Tax Rate 1997$600,00055% 1998$625,00055% 1999$650,00055% 2000$675,00055% 2001$675,00055% 2002$1,000,00050% 2003$1,000,00049% 2004$1,500,00048% 2005$1,500,00047% 2006$2,000,00046% 2007$2,000,00045% 2008$2,000,00045% 2009$3,500,00045% 2010*$5,000,00035% 2011$5,000,00035% 2012$5,120,00035% 2013$1,000,00055% * 2010 Estates may elect between a $5million exemption and full basis step-up or an unlimited exemption and modified carryover basis Slide 8 7 Federal Estate Return Filing Statistics Data from Internal Revenue Service Year of Filing Estate Tax Exemption FETs Filed FETs Paying TaxNet FET Paid 2001$675,000109,56250,456$23.7BB 2004$1,000,000 - $1,500,00042,23919,294$22.2BB 2007$2,000,00038,03117,416$22.5BB 2009$2,000,000 - $3,500,00033,51514,713$20.6BB 2010$3,500,000 - $5,000,00015,1916,711$13.2BB 2011$5,000,000 or Unlimited4,5881,480$3.1BB Federal Estate Tax Returns Filing Statistics Slide 9 8 Federal Gift Tax Returns Filing Statistics Year of Gift Exemption709s Filed709s Paying Tax Gift Tax Paid 1997$ 600,000 218,00915,717$ 3.2BB 2003$ 1,000,000270,423 6,662$ 1.6BB 2009$ 1,000,000 234,714 10,718$ 2.7BB 2010$1,000,000223,093 9,645$ 2.5 BB 2011$1,000,000219,54410,982$ 6.2BB Data from Internal Revenue Service Slide 10 9 Estate Settlement: Perennial Opportunities Slide 11 10 Demographic Trends Death & Taxes 2001 Tax Act (EGTRRA) 2010 Tax Inaction Pre and Post-Mortem Estate Planning Strategies, De-Coupling, Formula Failures Changes in Capital Markets Prudent Investor Rule Uniform Prudent Management of Institutional Funds Act Evolution of Securities Markets and Asset Management Practices TRENDS LEGAL ENVIRONMENT IMPLICATIONS Slide 12 11 Traditional Trust Portfolio (Pre-Prudent Investor Rule) Large Cap Domestic Stocks 50% Domestic Bonds and Cash 50% Slide 13 12 Diversified Trust Portfolio Post-Prudent Investor Rule TIPS 2% Large Cap Stocks 19% Mid Cap Stocks 2% Small Cap Stocks 2% International Stocks 15% Emerging Markets 7% Corporate Bonds 16% High Yield Bonds 5% Global Real Estate 5% Commodities 4% Cash 2% Private Equity 4% Hedge Fund 17% Slide 14 13 Myriad Issues for the Prudent Fiduciary Investor 1. Nature of Trust Traditional net income/discretionary principle Total return unitrust Net income with principal adjustments Impact of unitrusts/adjustments on allocation of tax attributes 2. Cash flow requirements, risk tolerance 3. Time horizon 4. Trust Tax Attributes 5. Asset Location 6. Asset Allocation Slide 15 14 Myriad Issues for the Prudent Fiduciary Investor 7. Degree of diversification Asset Class Sub-asset Class Style Manager 8. Balance between active and passive investing 9. Balance between individually managed securities and commingled management 10. Proprietary v. delegated asset management 11. Ultimate costs of asset management/impact on return Slide 16 15 Demographic Trends Death & Taxes 2001 Tax Act (EGTRRA) 2010 Tax Inaction Pre and Post-Mortem Estate Planning Strategies, De-Coupling, Formula Failures Changes in Capital Markets Prudent Investor Rule Uniform Prudent Management of Institutional Funds Act Evolution of Securities Markets and Asset Management Practices TRENDS LEGAL ENVIRONMENT IMPLICATIONS Decline in Yields Unitrusts and Principal / Income Adjustments Changes in Asset Allocation, Distribution Practices, and Taxation of Distributions Slide 17 16 Slide 18 17 Slide 19 18 Slide 20 19 Unitrust & Adjustment Statutes 2012 State Power to Adjust Unitrust Conversion AlabamaYesNo AlaskaYes ArizonaYes ArkansasYesNo CaliforniaYes ColoradoYes ConnecticutYesNo DelawareYes District of ColumbiaYesNo FloridaYes GeorgiaYes HawaiiYesNo IdahoYesNo IllinoisNoYes IndianaYes IowaNoYes Slide 21 20 Unitrust & Adjustment Statutes 2012 (continued) State Power to Adjust Unitrust Conversion KansasYes KentuckyYesS/H LouisianaYesS/H MaineYes MarylandYes MassachusettsYesNo MichiganYesNo MinnesotaYesNo MississippiYesNo MissouriYes MontanaYesNo NebraskaYes NevadaYes New HampshireYes New JerseyYesS/H New MexicoYes New YorkYes Slide 22 21 Unitrust & Adjustment Statutes 2012 (continued) State Power to Adjust Unitrust Conversion North CarolinaYes North DakotaNo OhioYesS/H OklahomaYesNo OregonYes PennsylvaniaYes Rhode IslandYes South CarolinaYesNo South DakotaYes TennesseeYes TexasYes UtahYesNo VermontNoYes VirginiaYes WashingtonYes West VirginiaYes WisconsinYes WyomingYes S/H: These states enacted a 104 power to adjust with a safe harbor for unitrusts Slide 23 22 Demographic Trends Death & Taxes 2001 Tax Act (EGTRRA) 2010 Tax Inaction Pre and Post-Mortem Estate Planning Strategies, De-Coupling, Formula Failures Changes in Capital Markets Prudent Investor Rule Uniform Prudent Management of Institutional Funds Act Evolution of Securities Markets and Asset Management Practices Decline in Yields Unitrusts and Principal / Income Adjustments Changes in Asset Allocation, Distribution Practices, and Taxation of Distributions Wealth Diminution, Reconstitution Fiscal and Tax Environment Regulatory Environment Risk Aversion, Tax Navigation, Wealth Transfer Opportunities TRENDS LEGAL ENVIRONMENT IMPLICATIONS Slide 24 23 State Budget Shortfalls 2012 (in Billions) Slide 25 24 State Budget Shortfalls 2012 (continued) Slide 26 25 State Budget Shortfalls 2012 (continued) Slide 27 26 Navigating a Changing Tax Landscape Slide 28 27 Navigating a Changing Tax Landscape Rising Taxes: 2013 and Beyond Federal Income Taxes Ordinary income Capital gains Qualified dividends Federal Transfer Taxes State Taxes Income Transfer Sales Regional and Local Taxes Property Sales User fees Transaction fees Slide 29 28 Navigating a Changing Tax Landscape RISING TAXES IN 2013 and BEYOND Federal Income Taxes Ordinary income Capital gains Qualified dividends Federal Transfer Taxes State Taxes Income Transfer Sales Regional and Local Taxes Property Sales User fees Transaction fees TAX STRATEGIES Wealth Transfers in 2012 Planning for 2013 and Beyond Coordinated Tax Planning, Asset Management, and Fiduciary Management Asset Location Domicile/Situs Slide 30 29 Fiduciary Issues with Common Wealth Transfer Techniques I.Intentionally Defective Grantor Trusts Can trustee consider grantors tax circumstances in making investment decisions? If trust assets were acquired with an installment note and have declined in value, should the note terms be renegotiated? Should the grantor retain powers indefinitely? When should the trustee advise the beneficiaries about eventual issuance of K-1s? Slide 31 30 Fiduciary Issues with Common Wealth Transfer Techniques (continued) II.Grantor Retained Annuity Trusts For GRATs with asset price volatility, should the portfolio be: Actively managed, to reap gains Passively managed, to let values take their course Should assets with severely depressed values be re-purchased and re- GRATed? When Re-GRATing Should the power of substitution be used for an asset swap? If assets are re-purchased, what consideration should be provided? Cash - Installment note Slide 32 31 Demographic Trends Death & Taxes 2001 Tax Act (EGTRRA) 2010 Tax Inaction Pre and Post-Mortem Estate Planning Strategies, De-Coupling, Formula Failures Changes in Capital Markets Prudent Investor Rule Uniform Prudent Management of Institutional Funds Act Evolution of Securities Markets and Asset Management Practices Decline in Yields Unitrusts and Principal / Income Adjustments Changes in Asset Allocation, Distribution Practices, and Taxation of Distributions Wealth Diminution, Reconstitution Fiscal and Tax Environment Regulatory Environment Risk Aversion, Tax Navigation, Wealth Transfer Opportunities TRENDS LEGAL ENVIRONMENT IMPLICATIONS Client Mobility Uniform Trust Laws Non-Uniform State Tax Laws Tax Deterrents & Incentives to Mobility, Changes in Estate Planning & Trust Administration Slide 33 32 Uniform State Trust Laws Prudent investor Rule 42 Uniform Trust Code 24 Uniform Probate Code 17 Uniform Principal & Income Act 46 Uniform Transfers to Minors Act 45 Uniform Prudent Management of Institutional 49 Funds Act Uniform Marital Property Act 1 States Enacted Slide 34 33 Demographic Trends Death & Taxes 2001 Tax Act (EGTRRA) 2010 Tax Inaction Pre and Post-Mortem Estate Planning Strategies, De-Coupling, Formula Failures Changes in Capital Markets Prudent Investor Rule Uniform Prudent Management of Institutional Funds Act Evolution of Securities Markets and Asset Management Practices Decline in Yields Unitrusts and Principal / Income Adjustments Changes in Asset Allocation, Distribution Practices, and Taxation of Distributions Wealth Diminution, Reconstitution Fiscal and Tax Environment Regulatory Environment Risk Aversion, Tax Navigation, Wealth Transfer Opportunities Client Mobility Uniform Trust Laws Non-Uniform State Tax Laws Tax Deterrents & Incentives to Mobility, Changes in Estate Planning & Trust Administration New Generation of Clients Trust Friendly Jurisdictions, Fiscal Implications of Aging Population, Unfunded Federal And State Liabilities Legacy Planning, Family Governance, Planning and Administration for Non-Traditional Families, Modification of Trustee Duties, Situs Shopping TRENDS LEGAL ENVIRONMENT IMPLICATIONS Slide 35 34 Demographic Changes Reproductive Variables Conception In Utero Ex Utero Inter Vivos Posthumous Husband His sperm Donor sperm Wife Her egg Donor egg Pregnancy Wifes womb Surrogates womb Blended Families Composition Generational Overlap Expansion of Marriage and Definition of Spouse Increased Life Expectancies Slide 36 35 Echoes of a Changing Wealth Dialogue Perennial Concern:How much will I get? When? New Philosophical Issues:What will our legacy be? How much wealth is too much? When and how should we discuss wealth with children? How can we facilitate good family governance? New Practical Concerns:How will we provide for Aging Parents Dependent Children How will we provide for Disabled siblings Non marital partners How should we treat Full blooded children Half blooded children Step children Children of assisted conception New Tactical Issues:What is the best situs for wealth? Can we protect (our parents) assets from creditors claims? Can we change: irrevocable trust provisions, trustee duties, etc.? Slide 37 36 CHANGES IN TRUST DESIGN & FIDUCIARY IMPLICATIONS Slide 38 37 Changes In Trust Design - Conventional Trust TRUSTEE(s) General Asset Management Discretionary Administration Beneficiary Communications Specialized Asset Management Custody and Reporting Tax Planning and Compliance Slide 39 38 Changes In Trust Design - Bifurcated Trust Values Mission Goals Discretionary Administration Beneficiary Communications General Asset Management Tax Planning and Compliance Specialized Asset Management Custody and Reporting Investment Advisor Administrative Trustee Slide 40 39 Changes In Trust Design Enterprise Trust Values Mission Goals Discretionary Administration Beneficiary Communication, Custody, Reporting, Oversight Asset Managers Investment Consultant Special Asset Management Tax Planning & Compliance Trust Modification Fiduciary Removal Investment Advisor Tax Advisor Disc. Committee Special Assets Advisor Admin Trustee Trust Protector Slide 41 40 Practical Issues with Dispersion of Fiduciary Responsibility I.What standard of conduct applies to advisors? Few states provide a default For important advisory roles, the trust document should clarify that they are fiduciaries II.What degree of oversight should the primary trustee exercise over advisors actions (or inactions)? Consider the grantors intent and the feasibility of trustee oversight and draft accordingly Absent guidance in the trust document, only a few states provide standards for trustee intervention: Delaware: Trustees willful misconduct Uniform Trust Code: Advisors actions are manifestly contrary to the terms of the trust or the trustee knows the attempted exercise would constitute a serious breach of fiduciary duty that the person holding the power owes to the beneficiaries of the trust. Restatement (2d) If under the terms of a trust a person has power to control the action of the trustees in certain respects, the trustee is under a duty to act in accordance with the exercise of such power, unless the attempted exercise of the power violates the terms of the trust or is a violation of a fiduciary duty to which such person is subject in the exercise of the power. Slide 42 41 Asset Concentrations and the Duty of Diversification Maximizing Opportunities Minimizing Risks Slide 43 42 Statutory and Judicial Pronouncements on Diversification I.Uniform Prudent Investor Act, Section 3. Diversification A trustee shall diversify the investments of the trust unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying. II.Restatement Third, Trusts 91F. Because permissive provisions do not abrogate the trustees duty to act prudently and because diversification is fundamental to prudent risk management, trust provisions are strictly construed against dispensing with that requirement altogether Whether and to what extent a specific investment authorization may affect the normal duty to diversify the trust portfolio (see 90, Comment g) can be a difficult question of interpretation. Because permissive provisions do not abrogate the trustees duty to act prudently and because diversification is fundamental to prudent risk management, trust provisions are strictly construed against dispensing with that requirement altogether. Nevertheless, a relaxation in the degree of diversification may be justified under such an authorization by special opportunities for the trust or by special objectives of the settlor. III.Wood v. U.S. Bank, N.A. 160 Ohio App 3d 831, 2005 A trustees duty to diversity may be expanded, restricted, eliminated, or otherwise altered by the terms of the trust. But this statement is true only if the instrument creating the trust clearly indicates an intention to abrogate the common law, now statutory, duty to diversify. Slide 44 43 Client Concerns About Diversification Adverse Income Tax Consequences Unfamiliarity with Other Asset Classes Loss of Control Performance Expectations Impact on Portfolio Yield Legacy Holdings Fees Slide 45 44 Reasons for Non-Diversification Purpose of Trust Legacy Holdings Termination Date of Trust Interests of Beneficiaries Step-Up in Basis Illiquidity Loss of Controlling Interest Related Trusts Holdings Beneficiaries Assets Adverse Income Tax Consequences Slide 46 45 Retention Language Identify the Asset Explicitly Waive the Duty to Diversify Articulate the Reasons for Retention Address Asset Conversion Issues Equities: Mergers, Acquisitions, Spin-offs Real Estate: Sale, Reinvestment Identify the Circumstances Under Which, and by Whom, Sale Should be Considered Consider Modifying the Fiduciarys Standard of Care If the Asset has Unfunded Operating or Holding Costs, Endow Them If the Assets Retention May Cause Contention Among Beneficiaries: Provide a Mechanism for Dispute Resolution Protect the Fiduciary Slide 47 46 Asset Concentrations: Risk Management Process I. Policy Follow trust terms or state Prudent Investor Rule II. Process The trustee must have a process for identifying and evaluating concentrations III. Review Determine grantor intent and fiduciary responsibility IV. Evaluation Evaluate retention and diversification strategies V. Consultation Consult with beneficiaries, their counsel, and trustees counsel VI. Implementation Implement appropriate strategies VII. Documentation Memorialize the process Slide 48 47 Slide 49 48 Slide 50 49 Slide 51 50 Pre And Post-Mortem Estate Planning After The Repeal of the State Death Tax Credit Slide 52 51 State Estate / Inheritance Tax Landscape 2012 StateTypeExemption AlabamaNone AlaskaNone ArizonaNone ArkansasNone CaliforniaNone ColoradoNone ConnecticutEstate$2,000,000 DelawarePre-2001 Pickup$5,120,000 D. of ColumbiaPre-2001 Pickup$1,000,000 FloridaNone GeorgiaNone HawaiiEstate$5,120,000 IdahoNone IllinoisPre-2001 Pickup$3,500,000 IndianaInheritance IowaInheritance KansasNone KentuckyInheritance LouisianaNone Slide 53 52 State Estate / Inheritance Tax Landscape 2011 (continued) StateTypeExemption MainePre-2001 Pickup$1,000,000 MarylandPre-2001 Pickup & Inheritance $1,000,000 MassachusettsPickup$1,000,000 MichiganNone MinnesotaPre-2001 Pickup$1,000,000 MississippiNone MissouriNone MontanaNone NebraskaInheritance NevadaNone New HampshireNone New JerseyPre-2001 Pickup & Inheritance $ 675,000 New MexicoNone New YorkPre-2001 Pickup$1,000,000 North CarolinaPickup$5,120,000 North DakotaNone OhioEstate$338,333 OklahomaNone OregonPre-2001 Pickup$1,000,000 Slide 54 53 State Estate / Inheritance Tax Landscape 2011 (continued) StateTypeExemption PennsylvaniaInheritance Rhode IslandPre-2001 Pickup$ 892,865 South CarolinaNone South DakotaNone TennesseeInheritance TexasNone UtahNone VermontPickup$2,750,000 VirginiaNone WashingtonEstate$2,000,000 West VirginiaNone WisconsinNone WyomingNone Slide 55 54 Post-Mortem Perils in the Age of Decoupling I.EGTRRAs Replacement of the 2011 State Death Tax Credit with the 2058 State Death Tax Deduction precipitated: No federal revenue losses Substantial revenue losses in coupled states Myriad State death tax responses Maintenance of pre-EGTRRA pick-up tax (i.e., no tax after 2004) Decoupled tax tied to pre-EGTRRA 2011 Rejuvenated inheritance taxes Stand-alone state death taxes Several unconstitutional state death tax statutes when applied to non-domiciliary tangible assets (Cory v. White 457 U.S. 85 1982) Re-emergence of domicile as an important variable in transfer tax planning Unnecessary complexity in pre and post-mortem planning Slide 56 55 Estate Planning Compromises to the Decoupling Dilemma I.For States with no Transfer Tax or Full (Federal Level) Exclusion Bypass trust may be funded to full exclusion amount Pre EGTRRA minimum marital/maximum credit shelter formulas will generally fund the bypass trust to the full exemption amount II.For States with Transfer Tax and Lower Exclusion Preserve funding flexibility with a least tax formula and determine proper funding based on post-mortem circumstances Post-mortem funding techniques Spousal disclaimer of marital trust Partial QTIP election over marital trust Clayton QTIP election by executor (Clayton v. Commissioner 976 F.2d 1486 5 th Circuit 1992 and Treas. Reg. 20.2056(b)-7(d)(3)) State-only QTIP election for federal/state exemption gap Slide 57 56 Estate Planning Compromises to the Decoupling Dilemma (continued) III.Factors to Evaluate in Post-Mortem Funding Anticipated size of surviving spouses estate Surviving spouses life expectancy Surviving spouses needs for income and principal Possible federal and state transfer tax rates and exemptions at surviving spouses anticipated date of death IV.Solving the Non-Domiciliary Property Puzzle Know both states transfer tax systems and how they treat non-domiciliary property (and related liabilities) Use title to control treatment of the property as tangible (likely subject to local states tax) or intangible (likely subject to domiciliary states tax) Slide 58 57 Northern Trust Will and Trust Forms* Northern Trust Will and Trust Forms are available online at: http://wealthadvisor.northerntrust.comhttp://wealthadvisor.northerntrust.com Go to the Access Knowledge column and then click on the Will & Trust Forms link. * 2004 Northern Trust Corporation Slide 59 58 Northern Trust Will and Trust Forms* (continued) VI.Sample of Marital Trust Form FIFTH: If my wife survives me, the trustee as of my death shall set aside out of the trust estate as a separate trust for her benefit (undiminished to the extent possible by any estate or inheritance taxes or other charges) a fraction of the trust property of which (a) the numerator is the smallest amount which, if allowed as a federal estate tax marital deduction, would result in the least possible aggregate of (i) federal estate tax and (ii) state death taxes which are based upon the state death tax credit, that would be payable by reason of my death, and (b) the denominator is the federal estate tax value of the assets included in my gross estate which became (or the proceeds, investments or reinvestments of which became) trust property. In determining the amount of the numerator the trustee shall assume that none of the Bypass Trust qualifies for a federal estate tax deduction. For purposes of the preceding paragraph, the trust property is all property in the trust estate, including any property added thereto by my will, which was not paid pursuant to the preceding articles of this agreement and which would qualify for the federal estate tax marital deduction if it were distributed outright to my wife. For purposes of this agreement, my wife shall be deemed to have survived me if the order of our deaths cannot be proved. Any part of the trust disclaimed by my wife shall be added to or used to fund the Bypass Trust. The disclaimer shall not preclude my wife from receiving benefits from the disclaimed property in the Bypass Trust, but my wife shall not have any power to appoint the portion of the Bypass Trust attributable to the disclaimed property. My wife shall have the right by written notice to require the trustee to convert unproductive property in the trust to productive property within a reasonable time. The trust shall be designated the Marital Trust and shall be held and disposed of as follows: * 2004, Northern Trust Corporation Slide 60 59 Thank You