Steve Poulathas, Flaster Greenberg co-managing shareholder, appeared on the Reinvent Rich Podcast, to talk about Pennsylvania’s new laws regarding Grantor Trusts with Irvin Schorsch, the founder and president of Pennsylvania Capital Management.
Listen to the podcast here.
Transcript below.
(···0.4s) I’m Irvin Schorsch, the founder and president of Pennsylvania Capital Management. Our mission is to not only create wealth and help our clients preserve it, but also to provide solutions through the lens of money and finance. As our clients’ lives change. I’m excited to introduce you to a game changing leader in the legal world. Steve is a partner at Flaster Greenberg here in the Philadelphia area with their multiple offices. And Steve works with many high net worth families. He shares with them the tools and estate planning strategies they need to protect their assets.
I’m very excited about our discussion today and what actionable steps our listeners can take away from this podcast. Today, our tax change is Pennsylvania finally catches up. Is it a trust bust or an opportunity? Steve, let’s jump right in. Many of our PCM Pennsylvania based clients have settled trust clients come to us as fiduciaries looking for advice and to keep them up to date on the latest developments in the tax law.
What exactly is Pennsylvania catching up to now? Great question, Irvin. Thank you for having me. It’s a pleasure to connect. We share many common clients and we share many opportunities where the two of us put our heads together to strategize and, and come up with great plans and solutions for our clients. And with, with every change in the law as we have here with Pennsylvania, it’s an opportunity to to strategize and see what we can make, whatever the government births to us in, in terms of changes. So Pennsylvania was the only state in the entire country to have a provision that did not recognize grantor trust.
So what does that mean? Grantor trust is, is the terminology given for a trust where the individuals who set up the trust, the grantor or another word is a settler? The people who set up the trust are taxed on the income and the deductions that pass through to the grantor. So Pennsylvania for years again, was the only state that did not recognize a grantor trust, which meant that the trust was the actual taxpayer.
Now that creates some obstacles, some opportunities, but with the change of the law where they now recognize grantor trust, it is an opportunity for individuals who are in Pennsylvania and who have settled Pennsylvania trust to examine if they need to revise their trust to update them and to see what new opportunities are available. Because being a grantor trust does have a lot of different powers and planning opportunities that should be pursued. Makes sense. Many of our clients set up trusts for estate planning purposes and to make gifts of their assets to their beneficiaries.
And one of the things that I’ve found extremely helpful to our clients that have these trusts is the sprinkle feature. You know, we’ve discussed for multiple clients where the husband or the wife in these examples were used to paying for college bills and they would send the money to the college or go pay for food and housing for their kids. And what you taught us, which I found extremely useful, was if the trust that they had had the sprinkle feature, instead of paying 35 to 40% all in in the form of taxes, after which you used the money to pay for the kids college expenses, you could sprinkle from the trust directly and only have a tax bill at the child’s rate, which may be zero or close to it.
Can you give us some details of how that works? Absolutely. So Irv, we we are blessed and have the pleasure to work with a lot of successful individuals, high net wealth individuals who have worked very hard and established wealth and each one has particular circumstances and needs in dealing with trust and dealing with family members, whether it’s children or other desired beneficiaries.
So with these special individuals that we work with, we have the opportunity to do some great stuff. But one of the great tools that they need is to build in flexibility to their plans and to be able to attend to specific circumstances. A lot of people have kids, but each child is unique.
Some go to college, some go get PhD, some go to graduate school. By putting a sprinkle feature into the trust that we’ve talked and worked with many clients with, we give them that flexibility. Not only do we do it on a tax advantage basis, but we’re able to allow them to customize. And I’ll give you the analogy of a faucet. Sometimes we want the faucet to run a little bit more. Sometimes we need to tighten it depending on the circumstances. Again, each child is different and we need to, we need to be attentive to these specific circumstances and give that flexibility to our clients.
And the sprinkle feature allows them exactly to do that. It allows them to, in a tax efficient way, make sure each beneficiary has what they need, not necessarily a fixed number that may be too much or a fixed number that may be too little. The sprinkle feature, as we’ve worked with together on many clients, gives us that special ability to be flexible and really attend to their unique circumstances. You know Steve, that rings a bell for me. I have found with multiple families, there’s an immediate need that we must fix now, right?
We can use that sprinkle feature, we can develop other strategies which we’ll get to our podcast. The flexibility that you’ve been able to build in for these specific clients and the watch it go from significant to modest or change from child to child as one goes off on their journey in life professionally while another one’s just going into college has been extremely helpful. Let’s do a case study here. A client, one of our clients just gifted interest in an LLC that holds income producing commercial real estate.
They’re no longer getting the income. Why would they want the trust to be a grantor trust and have to pay the income tax on the trust income, especially when they’re not getting any money at all? So this is, this is a new reality in Pennsylvania that a lot of clients who have these trusts need to be sensitive to. Under this example, using the prior law, the trust would be the taxpayer. So the grantor would not be responsible for the tax, but under the new law, this is somewhat of a burden, somewhat of an opportunity.
And it’s our job to put our heads together and make these opportunities for our clients. So in this example, we have an income producing property. The income goes into the trust under Pennsylvania’s law, if it’s a grant or trust for federal tax purposes, it’s gonna be a grant or a trust for Pennsylvania unless we change something. But the question you pose is why would we want there to be a grant or trust? Why do we want the income tax to pass through to the grantors? Well, the beauty of that is that if we’re in a taxable state situation and we want to exclude assets from our state and we want all the future appreciation to be outside of our states, we want those assets to grow as much as possible without the burdens of any expense in particular taxes.
So if the grantor pays the income taxes that are imposed on the income from the real estate, the beneficiaries of the trust get the benefit of the real estate, its income and all the future appreciation. In the meantime, the grantors are paying the taxes, they’re reducing their estate without using any of their exemptions.
Let me stop you for a second. When you say not using any of their exemption, I believe you’re referring to their lifetime estate exemption. Exactly. Irv, that’s the federal exemption. Currently about $13 million per spouse. But as you know, there’s the long place that that sunsets and it may go back to about half of that. Of course we are in the middle of an election year. So everything is is up in the air if there’s gonna be changes or not. As I said earlier, it’s so important to give our clients flexibility.
So even though you have a grantor trust, and it could be advantageous for the grantor to pay income taxes, if a trust is properly drafted, there may be an opportunity in the case that there is a need where the trust can reimburse the grantor or the income taxes. Again, in general it could be a estate planning benefit for the grantor to pay the taxes, but god forbid something happens and circumstances arise and they do need to be reimbursed, we would build that flexibility in for our clients.
While We’re on the subject of flexibility, Steve, I’m looking at a specific situation here where we have clients that hold a wide variety of liquid, often tradable investments. How could the ability to exchange personal for trust, for trust benefit them? Great question. And this is, this is where we get to be really creative and use some sophisticated planning. When you have a grantor trust under the, under the tax laws, the grantor is deemed to still be the owner of those assets for income tax purposes.
Although we can design the trust for those assets to be excluded from their estates for estate tax purposes, using that provision under a certain sections of the code. I’m not gonna bore people with tax codes right now, but there’s a provision that allows a grantor and the trust to exchange assets with no income tax recognition. And I’ll give you an example, many times I know you’ve worked with clients to try to maximize step up in basis when a client passes away so that the beneficiaries, the children or grandchildren can receive inherited assets with a stepped up basis equal to fair market value and then they can sell the assets with no taxable gain.
Well, if you put assets into a trust, sometimes you lose out on that step up in base. So if we have assets in a trust, I’m gonna make it up. Say we have Apple stock that we bought a long time ago with a very low basis and it’s in the trust, but outside of the trust your client has Google stock with a high basis.
We may wanna exchange the Google and Apple stock, of course equal value for, for the exchange and get the low basis Apple stock in the actual ownership of the grantor. So when they pass away, they will get that step up in basis. So we have a win-win situation by using this tool available for grantor trust. So Steve, let me get this straight. What you’re pointing out here is that in theory you could have your Apple example and let’s say that it doubles over the next 20 or 30 years.
You could make that trade before the individual that owned it died well into the future. So you could see what happens and then make the right tax moves at the right time. Exactly. So if you bought Apple stock, I’m gonna make this up for a hundred dollars a share 30 years ago and and the beneficiaries get that stock with a step up in basis where it’s worth a thousand dollars a share, your basis will step up to a thousand and that beneficiary will be able to sell it the next day with no taxable gain, a real win-win for our clients.
Tremendous way to help our clients. And just to to point out, I know this is consistent with you and your firm as well as for Pennsylvania Capital Management. Our role is to be serving as a partner to help our clients figure out what they need to do next as life changes. And a part of wealth management for us is understanding how their goals change as well, and whether it’s educating their kids, whether it’s working on estate planning through the kinds of strategies you and I are discussing today, it’s the way we see our value.
It’s not just about creating the wealth and protecting it from taxes in the most tax effective way, but it’s, it’s really an opportunity to help them see the opportunities and to avoid some of those dumb, dumb mistakes that they talk about as they go along. And, uh, we feel that’s, that’s a very important part of our mission. Next, when advising our clients, as you said earlier, we like, you wanna always give them flexibility and sometimes there’s hard decisions to make financially.
And one of the questions we’re often asked is, and I’d like your insights today, if a trust is irrevocable and it’s a grantor trust, is it true that you can’t make changes or are there strategies to make effective changes to an irrevocable trust? There are some sophisticated strategies that allow you to again, have flexibility and it’s important that clients have good advisors that work together so that we can monitor and identify situations where an opportunity has appeared, where there is a need for a change.
And, and one of the benefits I have working with the PCM team is we collaborate so nicely and we are continuously in communication and reviewing client matters where we’re on top of these opportunities. So for instance, in this case, say we have a situation where Pennsylvania changes the law and we no longer want to be a non-grant or trust as Pennsylvania was previously. Obviously the law makes that change.
But say we want to toggle back after we change the grant or trust in our, in our trust documents. As you know, Irvin, they’re like encyclopedias, they’re long, but there’s a reason for that length. All those provisions give us a lot of flexibility and opportunities to do planning. So there’s provisions in our trust document that’ll allow an independent party, a trust protector to give or take a certain power to the grantor. For instance, the power to exchange assets that we talked about in any particular tax year and shift the characterization of the trust from grantor to non grantor.
And that happens even though the trust is irrevocable because we’ve built in those provisions. But again, in working with our clients and their professionals, their financial fiduciaries, their accountants, we monitor these opportunities because clients present different facts every year. They enter different transactions, different business opportunities, different investments, and we monitor and analyze which situation would be best for them.
You know, Steve, you got me thinking here. Many of our clients eventually get around to wanting to do estate planning in some cases where we see the need, we bring up that concept early on. But not everyone is ready to separate with their, with their own assets. They’ve worked years and years, in some cases decades to create that wealth. We help them manage it and grow it and utilize it effectively to support the family, but also to create new wealth for, for the coming generations.
And many of them wanna make sure that they still have an income stream to cover their own living expenses in case something happens. Uh, and that obviously if that happens in the middle of their giving, they’re concerned, they don’t want to give up that, that opportunity to make changes. What do you recommend when you have multiple priorities like this? As we said earlier, no two clients are the same. We don’t have estate plans sitting on a shelf that we just pass out. Everyone is customized to attend to the particular needs that each client has.
You gave me a a specific fact pattern, a client who wants to do estate planning, but they still need some cash flow (···0.6s) and they’re not really ready to separate from assets, so they still want some control. So we take all these facts and circumstances and we have to analyze ’em and find out what exact plan or strategy works for this client. And you know, it’s interesting with the change that Pennsylvania has put in place, allowing trust in Pennsylvania now to be a grantor trust, it makes a certain strategy that was not necessarily available in Pennsylvania now available.
And that strategy’s, I’m gonna give you the, the technical name but then I’ll explain what it means. There’s a strategy called a sale to an intentionally defective grantor trust. What a mouthful, right? But I’ll explain what it means. So you have someone who has a particular asset that’s gonna appreciate, it can be a piece of real estate, it can be interest in a company, it can be a different types of asset and they wanna put it in trust for their kids, but they don’t wanna lose the income stream that they have.
They want to continue to have a certain level of cash flow. So with this strategy, instead of simply gifting the asset to the trust, if, if proper, properly structured with having certain amount available in the trust to, to facilitate a sale to the trust. So the grantor instead of gifting, sells this asset to the trust and gets a promissory note in return. Now because the grantor is the same taxpayer as the trust, when you have a grantor trust, that sale is, is a nonrecognition event for tax purposes.
It doesn’t create any tax liability. So you can sell these assets to the trust and in return you get a promissory note and the note will pay this grantor a certain amount of money equal to the fair market value of the assets that were sold over a period of time. (···0.6s) And then we will charge interest. But of course we would use what’s referred to as the a FR, the applicable federal rate. So we have again, a win-win situation.
We fund a trust for the future generations, but it’s done through a sale where the grantor gets a promissory note back and a stream of income, stream of cash over years that makes them whole for the sale of the asset. From the estate planning perspective, they haven’t used their exemption, but they have frozen the value of that asset. If I take a, a building real estate and I sell it to the trust, it’s worth a million dollars, but it’s gonna appreciate I sell it for a million dollars, I’m gonna get a note back for a million dollars.
But the cash that I’m getting back I’m going to use to live off of, which dissipates the assets in my name. But that real estate and old future appreciation is in the trust outside of my estate. Our, our clients expect us to customize our plans to listen to their particular needs and have us deliver things that make sense for them that will make sense for other parties or neighbors or family members, things that are perfectly customized for them.
And that’s, that’s one of the benefits we’ve had working together. You know, Steve, with the sun setting of the lifetime estate exemption and as you pointed out earlier, the strong possibility of the lifetime exemption amount dropping in half or more, this seems like an excellent time for our listeners to consider looking at their own situation to make sure they don’t lose that opportunity. ’cause it could well happen here. Absolutely. Obviously there’s no guarantees, but it’s certainly something that they need to be aware of.
Um, alright, I wanna bring up a, a totally different focus here for us to discuss. Unfortunately, more and more families end up in, in divorce situations, in some cases a second time or even more. And the um, unfortunately the stats don’t look so good. We have clients who have generated significant wealth but are concerned about leaving assets to their children or grandchildren because their, their, their issue is, will these gifted assets end up in unintended hands, for example, with the divorce situation.
How do we give clients comfort that their assets will be protected? Everyone, everyone has heard of a prenuptial agreement and many times parents can suggest or encourage or force their children to enter into prenuptial agreements before they get married. They definitely serve a purpose can be effective, (···0.6s) but as we all know, they’re not for everyone. Sometimes we don’t even get to marriage or divorce because of a prenup, uh, and things blow up.
So it’s our job to provide some alternatives to that. So again, I I’m not, not to diminish prenuptial agreements, they’re very important. They can be very effective, but you have to have two parties willing to sign them. So short of that, how do we protect assets? So trusts are regularly used to protect assets, but in order to achieve protection from creditors and creditors can be ex-spouses can be business creditors and can be, you know, God forbid someone is in a car accident and and not fully insured for the damages, there could be a creditor situation there.
How do we protect assets that are available to beneficiaries with all these different challenging circumstances that are out there? A key provision in the, in the trust is how assets are distributed. So in a trust we have the person who sets up the trust, but we didn’t talk about who manages or operates the trust. And that person is referred to as a trustee and a trustee can be an individual, can be a corporate trustee (···0.6s) or it can be trustees working together.
And in the trust document, we give powers to this trustee to operate and manage the trust. One of the main powers or jobs of the trustee is to make distribution. And there’s different standards that are available for a trustee. Trump trusts are set up that say every quarter or every year a certain amount of income or principal’s gonna come out. Other trusts say payments are distributed on a standard.
Many times we refer to the hemp standard, which stands for health, education, maintenance and support. And then another different type of standard is giving the trustee complete discretion. (···0.6s) So each of these standards we talked about, covers the pendulum of flexibility of how money can come out and be distributed from a trust. If we want the greatest amount of protection, we would give an independent trustee complete discretion. They would make sure that a distribution is not going to be made to anyone who it’s not intended to go to.
So we have those protections. In addition, of course, in a trust there would be spend thrift provisions, (···0.5s) again, a fancy legal word that simply means we’re gonna make sure the trusts assets and funds are not gonna be paid out to any potential creditor or to pay off any liabilities of the beneficiary. (···0.6s) So Irvin, you’re, you raised an excellent question.
(···0.5s) There are a few of the examples of the protections we can put in place to limit the op, the opportunities for people who should not be getting the assets. And uh, I hope our listeners enjoy that and take it to heart. At the end of the day, I wanna make sure that our listeners understand these concepts and our goal is to energize. We serve as a partner to our clients, as I mentioned earlier. And we find that in our field that’s often not the case. Meaning that there are a variety of providers out there that just offer a service managing money.
And my comment is, I, I hope that the takeaway for our readers to, or I should say our listeners today is very much one of stretching each other if it’s the husband or the wife or the children who are listening today that they back and say, we need to give a much clearer evaluation to what we’re doing and how we’re doing it. (···0.8s) I do wanna also point out, for those of you that wanna understand more what a fiduciary does, like we, we serve for our clients.
I’ve written a book called Who’s on Your Dream Team and who’s on your dream team will be out on Amazon here in the next few weeks. We would be delighted to provide to our listeners a copy of this book. It’s a short read. It talks about the stats which don’t serve the financial community well from their perspective of the vast majority, over 90% of the advisors are not fiduciaries. And we think it’s essential that every successful family be served by a fiduciary who will put the client’s interest ahead of their own.
And I know you take that seriously as well in your field and the fiduciary standard is of utmost importance to you and and how you serve your clients. So I want to thank you all for being here today. Steve and I have enjoyed this time with you. I also wanna point out that the discussion that we just had is for informational conversation purposes only and should not be relied on for legal or any other form of professional advice.
You want to seek out your own professionals and make sure that they’re relevant to you specifically. But we wanted to give you some illustrations of what we’ve seen in our experience. Steve, thank you for being with us today. It was a joy being with you. It was a pleasure, Evan. Thank you for having me. (···0.3s)
