Estate Planning 101: The Importance of Developing an Estate Plan
At some point, most people will contemplate estate planning. Often, this is prior to or shortly after a significant life event, such as marriage, the birth of a child, or the death of a loved one. However, estate planning can have somewhat of a morbid connotation – after all, it is planning for the management of your assets after you cannot, either due to incapacity or death. In addition, many incorrectly believe that estate planning is only necessary for “wealthy” individuals. As a result, it is common for people to delay estate planning (or even avoid it altogether).
The truth is that a proper estate plan can benefit most everyone. Put simply, estate planning is the process of getting your affairs in order. An estate plan will appoint guardians to care for your minor children, avoid probate on your estate, minimize or avoid estate taxes upon your death, and make it easier for your family members following your death or incapacity.
This Estate Planning 101 summarizes several estate planning concepts and provides some background information to help prepare you for a discussion with your estate planning attorney.
Specifically, this section will address the following topics:
- Overview of Estate and Gift Taxes
- Disposition of Your Assets Upon Death
- Revocable Trusts
- Durable Powers of Attorney for Finances
- Advance Health Care Directives
Overview of Estate and Gift Taxes
Estate and gift taxes are taxes imposed by the federal government on property that you own when you die or that you gift to others. California does not currently impose gift or estate taxes. Estate and gift taxes are often referred to as “transfer taxes” because they are taxes imposed on property that you transfer at death (estate taxes) and taxes on property that you transfer during your lifetime (gift taxes).
The following are the two primary exemptions or deductions from estate and gift taxes:
- the applicable exclusion; and
- the marital deduction.
The Applicable Exclusion
Under current law, every individual has an amount of assets that they can own at death or gift during their lifetime without incurring any transfer tax. This is referred to as the applicable exclusion. The applicable exclusion is available to U.S. taxpayers. The estate and gift tax applicable exclusion amounts are “unified,” meaning that a person can use the exclusion during his or her lifetime by making taxable gifts to others and any applicable exclusion not applied to lifetime gifts can be applied to property held at death. Currently (in 2019), the applicable exclusion is $11.4 million. This means that a person may gift up to $11.4 million in assets during his or her lifetime or, if they make no taxable gifts, die owning assets totaling $11.4 million and pay no gift or estate taxes. The tax rate on lifetime gifts or estates worth more than $11.4 million is 40%. Under current law, the applicable exclusion is adjusted annually with inflation. Accordingly, it should increase modestly each year. Notably, there has been a substantial increase in the applicable exclusion as well as a substantial decrease in gift and estate tax rates over the past several years. As recently as 2001, the applicable exclusion amount was only $675,000, and the gift and estate tax rate was as high as 55%.
A spouse can transfer an unlimited amount of property to his or her surviving spouse without paying estate or gift tax so long as the surviving spouse is a U.S. citizen. This is referred to as the “marital deduction.” The marital deduction also applies to married same-sex couples. For a married couple, if all of the couple’s assets are transferred to the surviving spouse, the marital deduction will avoid the application of estate taxes on the death of the first spouse. However, property escaping estate tax on the death of the first spouse will be subject to estate tax on the death of the surviving spouse.
Because the applicable exclusion has increased so much, many estates fall below the exclusion amount, resulting in decedents not needing or using all of their available applicable exclusion. Under current law, married couples (including married same-sex couples) now have the ability to transfer their unused applicable exclusion amounts to the surviving spouse through what is referred to as “portability.”
The surviving spouse can transfer or “port” any unused portion of the deceased spouse’s applicable exclusion amount to be applied to the survivor’s transfer taxes. By using portability, a married couple may shield up to $22.4 million from estate tax in 2019 ($11.4 million from each spouse). Prior to portability, in order to utilize the deceased spouse’s exemption, estate planners often created trusts requiring the surviving spouse to split the couple’s assets into an irrevocable “bypass” or “exemption” trust on the death of the first spouse. This is more fully discussed below. With portability, that may no longer be necessary for tax purposes. All of the couple’s assets may be passed to the surviving spouse and the surviving spouse may elect portability and maintain complete control of all the assets during his or her lifetime. With portability, many people are able to simplify their estate plans and still fully-utilize both spouses’ exclusions.
A second gift tax exclusion worth mentioning is the annual exclusion. A person can exclude gifts of up to $15,000 (in 2019) per person per calendar year – this is referred to as the “annual exclusion.” A married couple can combine their annual exclusions and gift of up to $30,000 per person per year. As long as the gifts to each individual remain within the exclusion amount, there is no gift tax reporting requirement and the gifts won’t use any of the applicable exclusion amount. As a result, annual exclusion gifts are a very popular (and efficient) way to transfer assets.
Disposition of Your Assets upon Death
Often, one of the most important estate planning issues for a client is how their property will be distributed after they die.
Probate, quite simply, is a court proceeding which clears title to property passing from the decedent (the person who died) to those persons named in the decedent’s will, or if there was no will, to the decedent’s heirs under the California laws of intestate succession. There are major disadvantages to probate, including the following:
First, probate fees are based on the gross value of property in the estate at the time of the decedent’s death. None of the decedent’s debts are taken into account. Probate fees are automatically determined and awarded by law. To add insult to injury, the fee, once calculated, is paid twice – once to the attorney and then again to the executor or administrator. In addition, any “extra events” in a probate, such as litigation and selling real property produce “extraordinary” fees for the attorney and the executor. For example, if an estate’s only asset is a house with a fair market value of $1,000,000 with a mortgage of $800,000, the probate fees will be calculated based upon the entire $1 million, despite the estate only having $200,000 in equity. A $1 million estate will produce $46,000 in fees plus costs, not including any extraordinary fees which may be due for selling the house.
Second, the average length of a probate proceeding is between 12 and 24 months. During this time, the beneficiaries of the estate do not have legal title to the assets they ultimately are to inherit, and simple tasks involving property become unnecessarily cumbersome. For instance, refinancing a loan, selling property, exchanging property, or running a business, may require court approval, resulting in delays (and additional costs).
Many people have the misconception that if they have a will, all of their property will avoid probate; however, this is not the case. Rather, probate carries out the purposes of the will for property that does not pass outside of probate.
There are various forms of holding title to property which will determine whether an asset is to be “probated.” Generally, all assets owned by the decedent will be included in the probate estate, except property passing:
- by operation of law or contract; and
- property titled in the name of a revocable living trust (see discussion below).
Property Passing by Operation of Law or Contract
Certain types of assets are transferred immediately upon death and are not subject to probate. Examples of these assets are as follows:
- Joint Tenancy: When a person holds an asset in joint tenancy, their interest in the asset passes automatically to the surviving joint tenant(s) when they die.
- Community Property with Right of Survivorship: This is a form of community property which, like joint tenancy, automatically passes to the surviving spouse.
- Retirement Accounts, Annuity Contracts or Life Insurance: These pass to the named beneficiary of the assets upon the death of the owner.
Creating and funding a living trust is a method of avoiding probate, and oftentimes will be the most important part of an estate plan. The trust will set forth a clear and complete plan for the management of your assets upon your incapacity or death and avoid the need for probate. Unlike probate, a revocable living trust provides for private administration, outside of the courts, and there are no statutory fees, allowing for the administration of the trust upon the death of the decedent to generally be more efficient and less costly than probate.
Settlor Maintains Control of Assets During Lifetime
Essentially, when creating the trust, you transfer assets to a trust reserving, for your lifetime, all of the beneficial right of the trust, including the right to amend and revoke it. In other words, it is your trust, all of your assets are still under your control. Legal title to the assets in the trust is held by the trustee of the trust, rather than you individually. A major benefit of this arrangement is that the assets in the trust to avoid probate at the time of your death.
Although the trustee of the revocable living trust holds legal title to the assets of the trust, you are the trustee of the trust and you have the power to amend or revoke the trust during your lifetime. Accordingly, you retain the same control and power of the assets in the trust as if you had continued to be the individual owner. You will be treated as if you owned all the assets of the trust for income tax purposes. In addition, the trust uses your social security number, and all tax reporting is on your individual income tax return. Basically, the only difference between the trust owning the assets and you owning the assets, individually, is a fiction of title allowing you to avoid probate.
Funding of Revocable Living Trust and Use of Pour-Over Wills
In order to avoid probate through the use of a revocable living trust, the assets must be retitled from you to the trust before you die. This is often referred to as “trust funding.” Many people form a revocable living trust, but then do not properly fund it. As a result, assets not properly transferred to the trust will be subject to probate. Because any assets which are held by you as an individual may be subject to probate upon your death, a Will is typically created in conjunction with your revocable living trust. A Will provides that those remaining assets are be transferred (or “poured-over”) to the trust upon your death. Although those assets being “poured-over” to the trust will not avoid probate, the Will ensures that the ultimate distribution is in accordance with your wishes, as you provided in the trust instrument. Additionally, the Will also sets forth the guardians you nominate for any minor children living at the time of your death.
Joint Revocable Living Trusts for Married Couples
In California, married couples generally create a joint revocable living trust for their assets. During your lifetimes, generally, you and your spouse will serve as co-trustees of the trust. You and your spouse will designate who will serve as trustee if you are unable to serve. You will also designate how the trust assets will be distributed after the death of the first of you (for example, to your spouse in trust for life, then to your children in equal shares).
Upon the death of the first spouse, the trust may be allocated to the surviving spouse or divided into separate trust shares for the benefit of the surviving spouse. Traditional estate planning often focused on utilizing the applicable exclusions of both spouses. This was accomplished by creating an irrevocable exemption or bypass trust with the decedent’s portion of the trust assets. These types of trusts, often referred to as “A-B” Trusts are discussed below.
However, because of portability and because the applicable exclusion has increased so much, that type of planning may no longer be necessary. All of the trust assets may pass to the surviving spouse, and the surviving spouse may maintain complete control of all the assets during his or her lifetime and still exclude $22.8 million (in 2019) from estate tax by electing portability. Note, individuals often have reasons (other than estate tax) to allocate a portion of the trust assets to irrevocable sub-trusts on the death of the first spouse. For example, many people who divorce and remarry desire that their children ultimately receive their assets, as opposed to the new spouse or new spouse’s children from a prior or subsequent marriage. What is important in this situation is that the ultimate distribution of the trust assets is directed by the first spouse and not the surviving spouse. In those cases, an “A-B” Trust might be more appropriate. These trusts are utilized now more so that the ultimate distribution of the trust assets of the first spouse is directed by the first spouse and not the surviving spouse. In those cases, an “A-B” Trust might be more appropriate.
The “A-B” Trust provides for the creation of two trusts upon the death of the first spouse, an “A Trust” and a “B Trust”. The surviving spouse’s share of the couple’s assets will be allocated to the A Trust (often called the “Survivor’s Trust”). The deceased spouse’s share of the couple’s assets – up to the applicable exclusion amount ($11.4 million in 2019) will be allocated to the B Trust (often called an “Exemption Trust”). If the deceased spouse’s share of the couples’ assets exceeds the applicable exclusion amount, then the excess will be allocated to the A Trust. Assets in the B Trust, however, will be subject to protection under the applicable exclusion since assets up to $11.4 million (in 2019) will not be subject to the estate tax – even at the death of the surviving spouse.
The surviving spouse can retain substantial rights and benefits over the B Trust and can even act as trustee. However, in order for the B Trust to qualify for the tax savings, the surviving spouse may not control the ultimate disposition of the B Trust, and it becomes irrevocable upon the death of the first spouse. The ultimate beneficiaries are predetermined by the trust instrument while both spouses are alive. The predetermined distribution of the trust assets while both spouses are alive may also protect future beneficiaries from being removed after the first spouse’s death and maintain the deceased spouse’s intentions of who the estate should ultimately be distributed to.
The surviving spouse will retain full control over the A Trust and has the unlimited right to withdraw principal at any time during his or her life. The surviving spouse has, upon his or her death, a general testamentary power of appointment over assets in the A Trust (i.e., he or she can change the beneficiaries or give the property away as he or she sees fit). The portion of the total estate going into the A Trust will not be subject to estate tax on the first spouse’s death since this portion of the estate will qualify for the marital deduction (assuming the surviving spouse is a U.S. citizen). The assets remaining in the A Trust on the surviving spouse’s death will be included in his or her own estate since the surviving spouse is deemed the owner of these assets.
Traditionally, A-B Trusts were used because use of a deceased spouse’s applicable exclusion amount was not automatically transferred to the surviving spouse without this advanced tax planning. Now with portability, this trust may no longer be needed for estate tax purposes; however, this trust structure still provides creditor protection of the B Trust and allow for income tax planning for the surviving spouse, in addition to the benefits described above. Note, because the marital deduction is only available to U.S. citizens, a special type of Trust (called a Qualified Domestic Trust or “QDOT”) is created for surviving spouses who are not U.S. citizens. A discussion of a QDOT is beyond the discussion set forth herein.
Durable Powers of Attorney for Finances
The Durable Power of Attorney for Finance appoints an agent to act on your behalf for your financial affairs, such as paying your bills, accessing your bank accounts and filing your income taxes. When a client becomes disabled and is no longer able to handle their day-to-day financial decisions, many financial institutions want a Durable Power of Attorney for Finance. Because of this, clients will also sign Durable Powers of Attorney for Finance (DPA for Finance) in addition to a trust. In some circumstances, a client may also need to fill out the DPA for Finance for their specific financial institution to be sure that there will be no push back from the financial institution if a disability should occur.
The DPA for Finance also allows you to nominate a conservator of your estate in the event there is a formal conservatorship proceeding over you in court.
Advance Health Care Directives
In the last several years, the appropriate use of life support systems to keep hospitalized patients alive has become an integral part of estate planning considerations. Lawyers and their clients have focused their attention on these issues as health care providers have become increasingly unwilling to make health care decisions on behalf of their patients. When considering an overall estate plan, it is important to consider who will make decisions regarding life-sustaining treatments. More and more clients are interested in making sure their health care decisions are well documented. The Advance Health Care Directive appoints an agent to make health care decisions on your behalf. Health care decision-making powers include authorizing or withholding life support, depending on your preferences.
The Advance Health Care Directive also allows you to nominate a conservator of your person in the event there is a formal conservatorship proceeding over you in court.
This Estate Planning 101 has set out to explain and simplify some of the basic concepts of estate planning. Note, however, that this only touches the tip of the iceberg and is by no means a comprehensive overview of estate planning. We hope that this has enlightened you and has encouraged you to think seriously about your own estate plan. Please do not hesitate to contact this office with any questions or comments you might have.
For more information, please contact Mike Balikian at email@example.com.