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The Importance of an Estate Plan

By Scott A. Dondershine, CPA, Esq.

I. Introduction. Many people lack adequate estate plans because the need for an estate plan was never properly described or understood. This Article describes the benefits of an estate plan in an easy-to-read question and answer format. It provides general guidance only and cannot be relied upon for legal advice.

II. Why do I Need an Estate Plan? There are five fundamental reasons why everybody, regardless of the value of assets owned, should have an estate plan. Five key benefits of an estate plan are (1) ensuring that the intended beneficiaries receive the assets of a decedent in a prudent manner, (2) minimizing any complications with and the need for probate, (3) providing for management of assets in the event of incapacity, (4) protecting assets from creditors and (5) substantially reducing estate taxes that could otherwise be due upon a person’s death.

A. Distributing Assets in the Intended Manner. In the event that a person dies without having an estate plan, including use of a Will and revocable living trust (if appropriate), all property owned by that person that is not distributed to another person by operation of law or otherwise (such as property owned jointly with right of survivorship, life insurance or retirement assets) is distributed as provided under state law. A state’s distribution scheme often conflicts with a person’s intentions.

By way of example, assume that Andy has a child, Diane, from a prior marriage. Andy then marries Michelle but Michelle and Diane never really get along. Andy dies one year later, and shortly thereafter, Michelle marries Casanova. Even though Andy may want Michelle to have the use of his property upon his death for Michelle’s general welfare and support, Andy may want Diane to receive the ultimate use of his property upon Michelle’s death. Under Virginia law, however, if Andy dies without a Will, Diane inherits two-thirds and Michelle inherits the remaining one-third of Andy’s estate outright.

There are two problems with the foregoing result. First, Diane may not have the maturity to handle the responsibility of inheriting two-thirds of Andy’s estate outright. Second, Michelle may name Casanova the sole beneficiary of her estate to the effect that Casanova and not Diane would ultimately inherit such assets. A better result is obtained by distributing Andy’s estate to a trust, the assets of which would provide for the care of Michelle and Diane during Michelle’s remaining lifetime. Upon Michelle’s death, the assets would continue in trust for Diane’s benefit, e.g., to fund her college education and graduate school, with ultimate distribution to her when she has sufficient maturity to handle the responsibility of managing assets that would then be worth considerably more, e.g., one-third at age 30, one-half of the remaining balance at age 35 and the remaining portion at age 40. Most clients use trusts to, in part, delay the time period in which children ultimately receive assets until a time when the children are sufficiently mature. In short, a basic reason to devise an estate plan is to ensure your property passes to your intended beneficiaries in the time and manner that you intend.

B. Minimizing Need for Probate. Probate is the legal process whereby a court ensures that all assets legally owned by a decedent are distributed appropriately. The probate process usually requires that notice be given to all interested parties, including creditors, and a personal representative be appointed to ensure that all debts are paid and all remaining assets are distributed in accordance with either the decedent’s Will, or if none, applicable state law. The main disadvantages of probate are that it can be expensive (costs can range between three percent and 10 percent of an estate’s value) and time consuming (it can be six months to two years or sometimes longer before assets are completely distributed). Probate is even more expensive and time consuming if real estate is owned in more than one jurisdiction since real estate must be probated in the jurisdiction where located. In addition, since probate is a public process any “interested party” can become involved.

As discussed below, assets transferred or assigned to a revocable living trust do not go through probate. The grantor can be the trustee of the trust and retain full access to the assets transferred into the trust. Although the assets will be included in the grantor’s taxable estate for estate tax purposes, the assets avoid probate since they are assigned to a trust.

C. Incapacity Planning. There is a strong positive correlation between the rise of life expectancies and the percentage of people who can expect to become incapacitated at some point in their lifetimes. An estate plan should address what will happen when and if a person becomes incapacitated without the need for a court appointed guardian, conservator or other fiduciary. A primary and one or more alternate agents should be appointed in a medical power of attorney to make medical decisions on behalf of a person who has become incapacitated. The same persons can also be named in a “living will” to work with doctors and determine whether to remove life support. Agents should also be appointed in a general durable power of attorney to make financial decisions on behalf of a person who has become incapacitated.

Unfortunately, as discussed below, banks and financial institutions are becoming more reluctant to recognize general durable powers of attorney for fear that the powers authorized could have been revoked and may no longer be valid. A revocable living trust reduces exposure to the foregoing risk, offering superior planning in the event of incapacity.

D. Asset Protection Planning. An estate plan should also consider whether and to what degree asset protection planning is needed. Asset protection planning attempts to protect a person’s assets from his or her own creditors or the creditors of his or her beneficiaries.

E. Reducing Projected Estate Taxes. The other fundamental reason for establishing an estate plan is to properly utilize the applicable exclusion amount (formerly known as the “unified credit”) of both spouses if planning for married persons. In 2001, the federal government passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (the “Act”). The Act “temporarily” eliminates federal estate taxes by phasing out the tax rates by 2010 (when the rates will be eliminated). The Act also raises the applicable exclusion amount available to shelter assets from federal estate taxes from the current amount of $1,500,000 (in 2004 and 2005) to $3,500,000 in 2009.

Unfortunately, however, the legislation makes the repeal temporary, meaning that unless the current or a future President and Congress agree to make the repeal permanent the federal estate tax laws will be reinstated in 2011. In 2011, the applicable exclusion amount will be $1,000,000 under existing law. Many practitioners do not believe that the repeal will be made permanent, especially under the current political climate. Given the uncertainty in the laws, it is prudent to plan as if the taxes will not be repealed, the amount of assets that can be sheltered by a decedent’s applicable exclusion amount is $1,000,000 and the federal estate tax rates will not change.

Proper estate planning currently enables two married persons to “shelter” $2,000,000 in assets from federal estate taxes based upon the applicable exclusion amount available in and after 2011. Assume that the first spouse to die possesses $1,000,000 of assets at death and directs all of his or her assets outright (as opposed to in trust) to the surviving spouse who also owns $1,000,000 of assets. If the decedent’s assets are distributed outright, upon the surviving spouse’s death all of the initial decedent spouse’s property that remains in the surviving spouse’s possession at death will be included in the estate of the surviving spouse and will be subjected to estate tax. Assuming that the property of the first spouse to die remains intact at the survivor’s death, the taxable estate would be $2,000,000 with an estate tax of $345,800.

A better result is obtained if the first spouse to die directs the assets sheltered by his/her applicable exclusion amount into a “bypass” or “credit shelter” trust created under his/her Will or revocable living trust. The surviving spouse would then have the use and benefit of both the income and principal of the trust, but would not have $1,000,000 of the initial decedent spouse’s property taxed in the surviving spouse’s estate. The initial decedent spouse’s $1,000,000 would instead “bypass” the surviving spouse’s estate, saving the surviving spouse’s estate up to $345,800 in federal estate taxes. Any assets can be directed into a trust to “bypass” the surviving spouse’s estate except assets that the surviving spouse will receive by operation of law such as a personal residence that is owned jointly or life insurance or retirement assets that name the surviving spouse as the beneficiary. Proper utilization of the applicable exclusion amount therefore enables both spouses combined to shelter up to $2,000,000 in assets from federal estate taxes.

Estate tax planning is needed for all estates where both spouses currently or in the future may have $1,000,000 or more in combined assets. For instance, under current law federal estate taxes of $102,500 would be due if a couple had $1,250,000 of assets with no estate plan or a plan that did not consider estate taxes based upon the tax rates that will apply in and after 2011.

Estate planners employ other methods to efficiently utilize the applicable exclusion amount of the first spouse to die, including disclaimer trusts. The impact of state estate and inheritance taxes also must be considered. A full discussion of the other methods and state taxes is beyond the scope of this Article. Estate planners should describe to clients the impact of state taxes and the different methods for salvaging the first spouse to die’s applicable exclusion amount and let their clients choose the estate tax reduction method that is most appropriate to a particular situation.

III. Why Should We Worry About Efficiently Utilizing Our Applicable Exclusion Amounts if We Have Less than $1,000,000 in Assets? This question is frequently asked, however a majority who ask this question realize after a few moments of discussion that they have overlooked a number of assets and really have in excess of the amount of assets that can be sheltered by the applicable exclusion amount. Assets that are often overlooked (but which are included in an estate for estate tax purposes) include:

A. The proceeds expected to be received from most individual or group life insurance policies.

B. Anticipated inheritances.

C. Wealth that will be created when stock options are exercised.

D. Property that is owned jointly with another person.

E. The total market value of any retirement plans, IRA’s, or 401(k) plans.

F. The market value of cars and household effects, including china, crystal and furniture.

G. The market value of rare coins, stamps and fine art.

H. The market value of any assets contributed to a revocable living trust.

Another consideration is that the assets that are included in an estate for estate tax purposes are valued at the market value of such assets when a person dies. Even if a person today has less than the amount of assets that can be sheltered by the applicable exclusion amount, such assets probably will appreciate substantially between the date an estate plan is devised and the date of death. Accumulation of new assets through savings, inheritances or gifts from other persons is also likely. Even if it does not appear that a person will have assets greater than the amount that can be sheltered by the applicable exclusion amount, planning for tax exposure in a Will or revocable living trust that is needed anyway to ensure that assets are properly distributed is still preferable. If a Will or revocable living trust is being drafted primarily for non-tax reasons it is inexpensive and prudent to address potential estate tax exposure. As the adage goes, it is “better to be safe than sorry!”

For persons who actually have less than the applicable exclusion amount in assets and who have a remote chance of accumulating additional assets (little opportunities for inheriting assets, appreciation in existing assets or saving to accumulate new assets), we recommend a Will to at least accomplish the goal of distributing assets in the desired fashion and often a revocable living trust to avoid probate and for superior asset protection and incapacity planning.

IV. What Planning Opportunities Are Available If Our Combined Estates Exceed $2,000,000? As discussed above, proper utilization of the applicable tax exclusion of both spouses can shelter $2,000,000 in assets from estate taxes. For combined estates in excess of $2,000,000, a combination of mechanisms can be used to reduce and/or eliminate estate taxes. Some of the more widely used tools include the following:

A. Making Gifts Outright During Lifetime to Reduce the Assets Otherwise Included in an Estate. Although gifts are taxable to the donor at the same tax rate that is imposed on an estate, a donor can make gifts of up to $11,000 annually to a specific donee tax-free (the exclusion used to be $10,000 but is indexed for inflation). Married persons can give a combined $22,000 to a specific donee every year, and if the donee is also married, a married donor couple can give a total of $44,000 per year to the married donee couple tax-free! If the donors have three children, each married, the gifts can total $132,000 total per year tax-free! Over several years, such gifts can substantially reduce the size of a married couple’s combined estates.

B. Gifting Assets Into an Irrevocable Trust To Reduce the Assets Otherwise Included in an Estate. Another estate reduction technique is to gift assets to an irrevocable trust. For instance, a donor can contribute stock and other appreciable assets to an irrevocable trust for the benefit of the donor’s family. The donor’s spouse and children can have access to the use and enjoyment of the assets included in the trust as determined by the terms of the trust. The benefit of gifting such assets into an irrevocable trust is two-fold. First, since the assets gifted will hopefully appreciate in value between the time the gift is made and the date the donor dies, the value of assets subject to gift taxes will be substantially less than the value of assets that would have been subject to estate taxes had they not been gifted. In a properly designed irrevocable trust, once assets are gifted such assets are removed entirely from the donor’s estate and accordingly will not be taxed upon the donor’s death. As an example, growth-oriented stock worth $200,000 at the time of transfer to an irrevocable trust will not be included in the donor’s estate for tax purposes even though the stock is worth $600,000 upon the donor’s death. The amount taxed is thus “frozen” with the appreciation never being subject to estate or gift taxes. Moreover, even if gift taxes are incurred, any resulting liability can be offset by the person’s applicable exclusion amount, although the available applicable exclusion amount remaining to shelter assets from estate taxes will be reduced commensurately.

Although the face value of assets gifted is usually subject to gift taxes, if the donor of a gift retains certain “strings” such as the right to income from the assets during the donor’s lifetime, the amount of the gift that is actually subject to tax is reduced by the “value” placed upon such “strings.” Various estate planning tools, such as family limited partnerships, grantor retained income trusts and charitable remainder trusts, all utilize this concept to reduce the value of a gift below face value so as to limit any applicable gift tax.

C. Removing Life Insurance Proceeds From a Taxable Estate. As explained above, proceeds of a policy on the life of a decedent owned by the decedent are generally included in the decedent’s estate for estate tax purposes regardless of who actually receives the proceeds upon the decedent’s death. If an insurance policy is assigned to a properly drafted life insurance trust at least three years before the date of the insured’s death, the proceeds will be received by the trust and will be removed entirely from the insured’s taxable estate. Depending upon the type of insurance, the trust can be set up to benefit the same persons who would have received the proceeds directly. For example, a surviving spouse could still have access to and use of the proceeds during his/her life, with any remaining proceeds being distributed outright to the insured’s children upon the surviving spouse’s death. The significant difference is that the proceeds are excluded from the taxable estates of both the decedent and the surviving spouse.

V. What are the Benefits of a Revocable Living Trust? A revocable living trust is simply a set of instructions for managing and distributing the assets of a grantor. The grantor is the person establishing the trust. The grantor usually retains the right to amend or terminate the trust and remove the assets from the trust. The grantor also usually is the trustee (or co-trustee) of the trust. The grantor, therefore, does not lose any control over the trust assets. However, since the grantor no longer owns legal title to the assets (the assets are instead assigned to the trust), the assets avoid probate.

Another often overlooked advantage of a revocable living trust is superior incapacity planning. The importance of this advantage is increasing as people live longer and have a greater chance of being incapacitated at some point with banks and other financial institutions becoming more reluctant to recognize the authority of an agent appointed under a general power of attorney. Some practitioners have predicted that the authority of an agent appointed under a general power of attorney is not respected 50% of the time. This means that 50% of the time that agents try to withdraw cash out of a bank account controlled by an incapacitated person the bank or financial institution refuses to recognize the authority granted to the agent, instead requiring a court-appointed fiduciary. The concern of the bank or financial institution is not knowing for sure that the authority granted to an agent has not been revoked. If a bank or financial institution acknowledges the authority of an agent whose authority has been revoked, then the bank or financial institution could become embroiled in litigation based upon permitting a withdrawal from an incapacitated person’s account without the proper authority.

A better solution and one that should not be questioned by a third party is for a grantor to transfer his or her assets to a revocable living trust prior to becoming incapacitated. The grantor could serve as trustee unless he or she becomes incapacitated in which case a spouse or other person could become the sole trustee. The trustee would then have the unquestionable authority to make decisions about the assets then held in the trust, without fear that a bank or financial institution might not recognize the authority.

Use of a revocable living trust also provides for enhanced asset protection. Assets distributed through a Will are subject to levy by the creditors of a beneficiary. Assets distributed through a revocable living trust can remain in trust with specific instructions (often referred to as a “spendthrift” clause) for the trustees to not make distributions to the creditors of one or more beneficiaries.

Finally, a revocable living trust is a private document whereas distributing assets through a Will is a “public process.” Interested parties can access probate records to learn of pertinent facts about a decedent’s wealth and Will.

A word of caution about revocable living trusts — they are not for everybody. Assets must be transferred to a revocable living trust (a process known as “funding”) in order for the assets to avoid probate. A Will is still needed to distribute any assets not transferred into trust. Depending upon a particular person’s situation, the disadvantages of probate may not be significant.

VI. Conclusion. At David, Brody & Dondershine, LLP, we recognize that devising an estate plan is an important decision that requires careful consideration. No two estate plans are identical. The process of devising a plan is an interactive process involving discussions with the client as to the options so that the client can then make an informed decision as to the structure of his or her estate plan. The end result is that assets are distributed in the manner and at the time intended, while the costs of taxes and probate are substantially reduced and in many cases eliminated. A sound estate plan can also provide for financial management of assets in the event of incapacity and protection of assets from creditors.