A PRIMER ON ESTATE PLANNING

© Copilevitz & Canter, LLC, 2000

In order to direct the distribution of your property after death, you must have a will⁽¹⁾. Estate planning means deciding now who gets your property later. Estate planning also involves tax planning to prevent the payment of unnecessary taxes. Federal estate taxes can erode a large share of your estate. The tax rate escalates from 18% to 55% of the value of the taxable estate. There are also state "death taxes." These vary depending on where you live. Estate planning includes disinheriting federal and state tax collectors to the extent legally permitted.

"Over and over again, courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions." Judge Learned Hand

A Will Is Essential to Estate Planning

If you die without a will, state law determines who gets your assets and how much each gets. You have no say in the matter--unless you have a will. State law requires your estate to be distributed in an inflexible way which does not take into consideration special circumstances, such as the disability of a spouse, or planning possibilities to save on taxes. This could mean your estate will be subject to unnecessary taxes.

If you do not make a will, the state where you are domiciled makes one for you. Dying without a will is known as "dying intestate." If you die intestate, the state law of distribution is, in effect, a "will"--but it is not likely to be one you would choose. In fact, the state's "will" may result in the exact opposite of your wishes!

A Will Enables You to Make Special Bequests

In addition to family members, you may wish to leave property to other loved ones. A will enables you to do this. Without a will, your wishes are ignored.

A Will Lets You Choose the Representative For Your Estate

Without a will, the court determines who serves as the administrator of your estate, also known as an executor or personal representative. The court approved administrator could be a stranger, e.g., a lawyer you never met. This person will be paid from your estate according to state law. With a will, you can select an individual or financial institution to manage your estate. You can also pre-arrange the compensation of the executor you select. A family member or trusted friend is usually willing to serve at no charge. You also may provide in your will that no bond will be required of your executor. This saves your estate the cost of a bond. Without a will, these options may not be available.

A Will Enables You to Create a Trust to Care For Another Person

Your will can create a trust which can provide income for a minor child, a spouse, a disabled sibling, or someone who is not able to manage money well. A testamentary trust is a powerful and flexible planning device. Income from the trust can provide lifetime support or support for a fixed term of years. The decision is up to you--if you make a will. After the income beneficiary's death, the assets can be distributed as you direct in the trust, e.g. to your children, grandchildren, or to a charity, or church, etc.

A Will Can Save Taxes

Taxes could substantially erode the portion of your estate passing to your loved ones. Without careful planning, your beneficiaries may receive less while federal and state governments get more. Without a will, the tax authorities may become the unintended "beneficiary" of a significant portion of your estate. With a will, planning can reduce tax liability. This preserves your property so that the maximum amount of your estate will pass to your beneficiaries.

The following general information, about federal tax law, explains how tax savings may be accomplished.

Federal Estate Tax Basics

On August 5, 1997 the Taxpayer Relief Act of 1997 ("Act") became law. It enacted the most comprehensive changes to estate and gift taxes since the Economic Recovery Tax Act of 1981. The law was amended in 1986 to increase the unified credit ("credit") against estate and gift taxes to $192,800. This credit translates into an estate "exemption," i.e. value of estate not subject to estate tax, of $600,000 for years after 1986--if the decedent has not made "taxable" gifts⁽²⁾ during his lifetime. The 1981 Act reduced the maximum estate and gift tax rate from 70 percent to 50 percent. The top rate is currently 55 percent.

The Act does not reduce estate and gift tax rates, but, rather, increases the credit⁽³⁾ and provides "targeted relief," particularly in the area of family businesses and family farms.

The current $192,800 unified credit was increased gradually. In 2006 the "exemption" will be $1 million. (The "exemption" will be $2 million for a married couple.)

Exclusion for "Qualified Family-Owned Business Interests"

"Qualified family-owned business interests" ("interests") are excluded from a taxable estate if and to the extent the value of such interests plus the "exemption" (see above) do not exceed $1.3 million.

The "interests" must constitute in excess of 50 percent of the decedent's estate. "Interests" include a sole proprietor's interest in a trade or business, as well as an interest in an entity carrying on a trade or business if the entity is at least 50 percent owned by one family, 70 percent by two families, or 90 percent by three families (of which the decedent's family owns at least 30 percent.) The principal place of business must be located in the United States and the entity's stock must not have been publicly traded within three years of death. The value of the family business interest is reduced to the extent the business holds passive assets, e.g., stock in a publicly traded corporation, excess cash, or marketable securities.

The exclusion is available only if the value of all transfers of "interests" made to "qualified heirs" at death, plus certain lifetime transfers to family members, exceeds 50 percent of the value of the adjusted gross estate. "Qualified heirs" include members of the decedent's family as well as any individual who has been actively employed by the trade or business for at least 10 years.

Furthermore, the decedent or a family member must have owned and "materially participated" in the trade or business for at least five of the eight years prior to the date of death, and, after the death of the taxpayer (i.e., the descendent whose estate is subject to tax), each "qualified heir" (or a family member of that qualified heir) must "materially participate" in the trade or business for at least five years in an eight-year period during the 10 years following the date of death. "Material participation" is generally determined by reference to all the "facts and circumstances" of the particular business.

If, within 10 years of death, a "qualified heir" fails the "material participation" requirement, or the property is disposed of (other than to a family member or through a conservation contribution), a recapture tax applies. The recapture tax is equal to the reduction in estate taxes attributable to the disqualified family-owned business interest. However, if the recapture event occurs more than six years after the date of death, the recapture tax is reduced by 20 percent, with a further 20 percent reduction for each year thereafter.

"Non-Taxable" Gifts and GST Exemption Are Indexed For Inflation

The $10,000 annual gift tax exclusion and the $1 million generation-skipping tax exemption are indexed for inflation.

Under prior law, the generation-skipping transfer tax (GSTT) "predeceased parent exception" excluded certain direct transfers by a grandparent to a grandchild if the child's parent was deceased. The exception now applies to transfers to collateral heirs (i.e., heirs other than direct descendants), provided that the decedent has no living lineal descendants at the time of the transfer. The exception is also extended to transfers in trust when a parent of a trust beneficiary is dead at the time the transfer is first subject to gift or estate tax. The modifications apply to generation-skipping transfers after 1997. Unlimited Marital Deduction

No taxes are assessed on gifts from one spouse to another, whether made during lifetime or at death. You can avoid all federal estate tax by providing in your will that all your property shall be given to your spouse. However, this may not be wise. If there is an "absolute gift" to your spouse, the value of his or her estate will increase. More estate taxes will be due at his or her death. The result may be a needless reduction in family wealth, viewed as the total of both spouses' estates.

Estate planning uses the credit, discussed above, which is available to each spouse individually, in conjunction with the marital deduction to reduce the amount of tax due on the surviving spouse's estate. Using a marital or family trust, both of these techniques are combined to reduce estate taxes on both estates, thus conserving family wealth. The property put in the trust created in the will of the first spouse to die will not be included in the surviving spouse's estate, if the trust is properly drafted. The property will pass to heirs with no reduction for estate tax.

This type of tax planning, which can save hundreds of thousands of dollars in taxes, is possible only if you have a will. If you die intestate, you die "at the mercy" of tax authorities.

Charitable Contributions Made in Your Will Save Estate Taxes

For every dollar your contribute in your will to a church, school, university, charity, etc.,your estate is entitled to a charitable contribution deduction. If your estate will be exposed to tax, as many estates will be, you should consider how charitable contributions can reduce tax liability. Unlike the income tax charitable deduction, the estate tax charitable deduction is unlimited. Charitable trusts may be created to reduce estate tax liability and provide an income for a lifetime or term of years to one or more loved ones.

Revocable Living Trust vs. Will

As noted above, revocable living trusts ("RLTs") are "will substitutes," recognized in all states. The RLT can own, hold and distribute assets to trust beneficiaries. An RLT is funded when legal title to assets is transferred to the trustee. It is a revocable trust that can be changed or amended by the grantor during his life. The RLT is called that because it comes into existence while the grantor is living and may be revoked (or amended) at any time during the grantor's lifetime. After the grantor's death, the trust becomes irrevocable, i.e., it cannot be changed or canceled.

Advantages of an RLT:

RLTs do not provide any different or additional income or estate tax savings (as compared to wills), but offer several "non-tax" advantages over wills.

Avoidance of Probate. Assets placed in an RLT are not subject to probate. This can save on probate costs (including the cost of an executor's bond). Because the assets in the RLT are not subject to the delays of the probate process, they can be distributed quickly and efficiently to beneficiaries. Generally, the trustee will only require proof of death and then will begin to manage the trust assets and distribute them according to the terms of the RLT.

Flexibility. Because the RLT is revocable, it can be changed or canceled at any time. If your circumstances change, the RLT can be easily amended. Also, if you move from state to state, the trust will be valid in all states. Wills can be changed or canceled but, generally, the process is more time consuming and expensive because of state laws governing the creation and amendment of wills.

Privacy. An RLT is totally confidential. It is not subject to disclosure to the probate court, as is a will. Wills become public documents. Also, when a will is probated, the court will require that a listing or inventory of the probate assets be filed. These inventories may also be public documents which reveal the assets that comprise the estate. This is not the case with an RLT. Neither the assets in the trust at the time of death nor terms of the trust nor identities of beneficiaries are required to be disclosed to the public. The only persons who need to be aware of the trust's existence, its assets, and its terms are you and the trustee.

Control. While you are alive, you continue to manage and control the assets in the trust just as you did prior to establishing the trust. You continue to direct how the assets will be invested and how the assets will be used during your lifetime. Of course, if you choose to designate someone other than yourself to handle the investment of the assets, you may either name that person as trustee or hire that person to give you investment advice.

In the RLT, you select the successor trustee who will control and distribute your assets after your death. The RLT will contain instructions regarding how the assets are to be invested and distributed. Property passing through the probate process is subject to the many complex state laws imposing rules on executors which often limit the investments and distributions executors can make.

Contestability. Trusts are generally more difficult for unhappy heirs to contest than wills.

Disability. One very important advantage of an RLT is the avoidance of a court supervised guardianship or conservatorship in the event you become incapacitated due to stroke, senility, or other form of incompetency. One in four Americans will experience some form of disability that lasts more than three months. The average disability lasts over a year. Ordinarily, when a disability occurs a conservator must be appointed by the court to manage your assets through strict court supervised procedures. Many times the conservator appointed by the court is not the person you would have chosen to manage your assets. If your assets are placed in your RLT before your incapacity, the expense and delay of a guardianship is avoided. The trustee of your trust would step into your shoes and manage your assets while you are disabled.

Out-of-State Properties. With a will, these can present additional expense and delay. If you live in State A and own real estate in State B, upon your death your executor must begin two probate proceedings--one in State A to deal with your assets located in State A and one in State B to deal with the transfer of title to the real estate located in State B. However, if the out of state property is placed in your RLT, upon your death such property will not be subject to probate either in State A or State B.

Continuation of Business. RLTs are very useful to business owners and their families. Whether the business is a sole proprietorship or a corporation, the business owner can transfer the business assets to the RLT. If the owner becomes disabled or dies, the successor trustee can step into the owner's shoes and handle the day to day affairs of the business without any interruption in the business. Because often a business is a primary source of income to the owner and his family, after the owner's death or disability, it is critical that the business continue to operate and generate the income needed to support the owner's family.

Disadvantages of an RLT

More Complex and Expensive than a Will. Most, if not all, of your assets must be titled in the name of the RLT. Once your assets are transferred to the RLT, you must keep separate trust records and not mix them with any personal accounts you have, such as joint accounts or pay-on-death (P.O.D.) accounts.

No Deadlines for Claims of Creditors. When a will is probated (or an estate without a will is probated), a deadline is imposed on creditors of the decedent. Creditors are required to present claims to the executor of the estate within a time period specified by state law. Each state has its own statute establishing this time period. It can range from 3 months to 1 year. These statutes also establish the procedures that a creditor must follow to present its claim. If a creditor does not follow the procedures within the statutory time period, the creditor loses his right to sue the estate to collect the debt. In most states, however, an RLT is not subject to such statutory procedures. Therefore, a creditor can sue the trust long after the death of the trustor. Even after the trust has terminated and all trust assets are distributed to beneficiaries, creditors can sue beneficiaries.

Does Not Avoid Creditor Claims During Your Life. A revocable RLT does not prevent your creditors from suing you or suing your trust to collect debts during your lifetime. Because you have maintained complete control over the trust assets, the courts treat you as the owner of the assets and can force you to pay trust assets to your creditors.

Does Not Eliminate the Need for a Will. Even though you have an RLT that is funded with all of your assets during your lifetime, you should also have a will. The will can name a guardian for your children, appoint an executor of your probate estate, and provide that no bond be required of your executor. Why do you need a "back-up" will? Because there may be assets that you have forgotten to transfer to your trust, an unexpected inheritance, or a lawsuit that must be filed on behalf of your estate after your death. A will covers these assets even if the will only provides that such assets "pour-over" to your RLT. Without the will, you will have died "intestate" and must follow the probate procedures for intestacy. Intestacy procedures are complex, time consuming and generally very expensive.

A Will Provides Supervision. The negative side of probate is expense and delay. The positive side is the court (usually via the commissioner of wills or accounts) watches over the executor, who must file accountings with the court. This oversight may deter embezzlement and prevent mistakes.

Caveat

This article is not intended as legal advice. References herein are to federal tax laws. State taxes vary from state to state. Most states assess "death taxes." Only an attorney licensed in your state can write a will for you. Consulting with an attorney skilled in estate planning is essential. The concepts discussed herein are intended to suggest strategies. They are for illustration only. Your certified public accountant or certified financial planner also can advise you as to how taxes may be reduced lawfully through careful planning.

End Notes:

1. As discussed below, the revocable living trust ("RLT") may serve as an effective will substitute.

2. A non-charitable gift in excess of $10,000 is potentially subject to federal gift tax. (See, discussion below.)

3. The credit available for estates of nonresident, noncitizen decedents who do not benefit from a treaty provision remains at $13,000. This translates into an "exemption" of $60,000.