Why do I need estate planning?
You have worked hard to earn your assets during your lifetime and the goal of your estate plan should be to ensure that those assets pass as you intend upon your death. It may seem like an unnecessary and costly endeavor to speak to an attorney about estate planning because no one likes to think about their own mortality and you may never witness the benefits of your estate planning documents. You may be thinking, “The estate tax exemption is now almost $11.2 million per person and $22.4 million per couple (and indexed for inflation!!), why should I pay money now to have someone draft documents to use when I’m dead?” Frankly, that is an understandable question, but without proper planning and careful consideration, your assets may not pass to your intended beneficiaries and may be unnecessarily exposed to various creditors, including state and federal taxing authorities.
The estate planning process is not limited to considerations of assets passing only upon your death. Estate planning includes directing gifts to individuals or charities during your lifetime, which can result in reducing your overall tax obligations. Important planning techniques can and should also be used to provide management of your assets and appoint someone to make your health care decisions if you are incapacitated. If done correctly, you can avoid oversight by the probate and family court during your lifetime and at death, which can be costly and time consuming. Importantly, the Massachusetts estate tax exemption is $1 million, which means that estate taxes often factor into a complete estate plan regardless of federal exemption amounts.
As with anything we deal with in our day-to-day lives, estate planning can be as simple or as complicated as you want. A good estate planning attorney is similar to a good contractor. You could certainly remodel your own bathroom, given enough time and some guidance, but you are probably not aware of all the tools, techniques or finishes available, which leads to a time consuming endeavor that might not turn out exactly how you hoped for. Or worse, the remodel looks great on the surface, but there is a material issue that was not considered and that leads to costly repairs years down the road. No one enjoys paying legal fees especially when the benefits of which may not be witnessed by the client. Just as a great contractor, your estate planning attorney can guide you and, sometimes more importantly, your family through the wealth transfer process known as estate planning.
Despite what you may have heard or read, there is not one catchall estate plan. There are many considerations for both a client and his or her family. Depending on the intentions and goals of the client, there are many different avenues a client’s estate plan can take. Some considerations include, (i) whether you want to distribute property to your children outright at your death or when your child reaches a certain age, (ii) whether you want to have your assets held in trust for the lifetime of your children for their benefit to offer protection from creditors (including divorcing spouses) and sometimes protections from themselves, or (iii) whether you would like to donate to your preferred charity. Depending on these considerations and many more, a custom plan can be constructed to fulfill the client’s intentions, limit court involvement and reduce transfer taxes owed to federal and state governments.
Constructing an Estate Plan
There are two types of property when dealing with an estate: 1) probate property, and 2) non-probate property. The characterization of the type of property is determined by how the property passes upon one’s death (i.e. whether there is a mechanism to pass property to a person or an entity at death built into the asset itself).
Probate property is anything that is titled in the decedent’s name alone (i.e. real estate, a bank account or brokerage account in the decedent’s sole name). Since there is no mechanism or authority to transfer the property upon the owner’s death, the bank or other holder of the assets has no instructions regarding how and where to transfer the property. A personal representative (formerly known as an executor) will then have to be appointed by the court and granted the authority to distribute the assets pursuant to the decedent’s will, if the decedent has a will, or otherwise they will pass pursuant to state statute.
Non-probate property includes all property that passes by operation of law or beneficiary designation. These assets include jointly owned accounts; accounts with beneficiary designations such as life insurance policies and retirement accounts; and any “payable on death” accounts. Non-probate assets will pass pursuant to the beneficiary designation or joint ownership and not by will or intestacy. If property is titled in the name of a revocable trust (discussed below), the provisions of the trust document provide how assets are dealt with after the trust creator’s death and therefore, assets held in trust are also non-probate property.
As with a good construction project, it is imperative not only to know the tools to use, but also how the nuances of every tool works with the others. It is important to coordinate how probate and non-probate assets are passing upon death. If assets are not passing pursuant to one overall plan, there is a chance that they will not pass according to your wishes. A good estate planning attorney will work to fuse your intentions, the types of your assets and your documents into one coherent structured plan.
What is in the Estate Planner’s “Toolbox”:
Basic Documents (i.e. you should have these):
Health Care Proxy – A health care proxy is a document used by an individual to appoint a person to make healthcare decisions on your behalf if you are incapable of making healthcare decisions on your own.
Durable Power of Attorney – A durable power of attorney is a document permitting a person, the “attorney-in-fact”, to make decisions or act on your behalf with respect to financial matters, such as paying bills or managing investments. This Durable Power of Attorney stays in effect when/if you become incapacitated or unable to handle matters yourself.
Will – A will is a document that an individual, known as the testator (male) or testatrix (female), executes to establish how they would like their probate property to be distributed after they have passed away. The will only governs the disposition of probate property. It will not affect the disposition of non-probate property. A personal representative is nominated in the will and his or her duty will be to manage the testator’s or testatrix’s estate until all probate property has been distributed. If a person dies without a will, or with a will that fails to dispose of all property, they have died “intestate” and the individual’s property will be disposed of according to the applicable state’s intestacy statute. The will is also the document where you will name guardians and/or conservators for any minor children.
Next Level Documents (i.e. these offer benefits to almost everyone, but you wouldn’t be completely lost without them):
Lifetime Revocable Trust (LRT) – A “trust” is a relationship – the Donor gives property to the Trustee to hold for the benefit of the Beneficiaries. This relationship is memorialized in a document that outlines the parameters under which the Trustee will hold the property for the Beneficiaries. A lifetime revocable trust is traditionally used to minimize estate taxes and avoid probate court. During the Donor’s lifetime, assets can be titled in the name of the trust and held by the trust. The LRT is revocable at any time by the Donor and the terms may be altered at any time by the Donor. While the Donor is alive, the LRT is what is known as a “grantor trust” and any income derived by assets in the name of the trust will be attributed to the Donor.
Realty (Nominee) Trust – A trust specifically designed to hold real estate (or potentially some other specific asset). The beneficiaries of the trust have all the control, but this document converts a beneficiary’s ownership of real estate into the ownership of intangible beneficial interest in the trust. This allows the beneficiary to avoid probate court on their death and allows efficient transfer of their interest during their lifetime (a deed will not be recorded for any transfer because the transfer is of beneficial interest of the trust (not the actual property) and the trust retains ownership of the underlying real estate in the public record).
Scalpel Documents (i.e. for very specific scenarios when the other tools described above fail to address the unique needs of a client):
Irrevocable Trusts: Similar to the LRT described above with three key differences: 1) the document cannot be amended or terminated, except in rare circumstances; 2) the trust obtains its own taxpayer identification number and the trust generally will need to file its own tax return, and 3) the Donor generally does not retain any interest in the irrevocable trust, because transfers to the trust are meant to be gifts. Different types of irrevocable trusts are:
Irrevocable Life Insurance Trust (ILIT) – An irrevocable life insurance trust is an irrevocable trust designed to own life insurance policies on the life of the Donor. The ILIT owns the individual’s life insurance policy and the trustee pays the premium (generally with money from annual gifts made by the Donor). Since the ILIT, not the decedent, is the owner of the policy, the life insurance proceeds are excluded from the decedent’s taxable estate. Because the life insurance payout is income tax free cash not subject to tax, it can offer liquidity to the estate and/or the ILIT’s beneficiaries. An ILIT effectively reduces estate tax liability, protects the cash value of the life insurance policy from creditors, and allows control over the distribution of the proceeds of the policy.
Qualified Personal Residence Trust (QPRT) – A qualified personal residence trust is an irrevocable trust that allows a lifetime transfer of a personal residence to the QPRT for continuous rent-free use of the residence for the term of the trust. If the Donor survives the trust term, the residence either passes to the beneficiaries of the trust or it can remain in trust for their benefit. Since the Donor needs to survive the trust term, the value of the gift will be at a greatly reduced value.
Grantor Retained Annuity Trust (GRAT) – A grantor retained annuity trust is an irrevocable trust generally used to make gifts to family members for little to no gift tax consequence. The Donor transfers property into an irrevocable trust and in exchange the Donor will receive back from the Trustee fixed annual payments for the term of the trust based on original fair market value of the property transferred. At the end of the specified trust term, any remaining value in the trust is passed to the designated beneficiaries as a gift. In sum, it is an irrevocable trust funded by gifts from the Donor, and is designed to shift future appreciation on quickly appreciating assets to the next generation during the Donor’s lifetime.
Spousal Lifetime Access Trust (SLAT) – A spousal lifetime access trust allows a spouse to use their gift tax exemptions while retaining limited access to the gifted property in the event it is needed. A Donor creates an irrevocable trust and transfers property to such trust which allows limited distributions to be made to the Donor’s spouse. Ultimately, the property may be invested and held as a safety net for the beneficiary-spouse or accumulated for the eventual benefit of future beneficiaries.
Intentionally Defective Grantor Trust (IDGT) – An intentionally defective grantor trust is an estate planning tool used to freeze the value of an asset for estate tax purposes while transferring assets out of the estate free of gift tax. It is a complete transfer to a trust for estate tax purposes but an incomplete/defective transfer for income tax purposes. Thus the Donor, although not a beneficiary, is taxed on all the trust’s income. If properly executed, the trust will receive the gross income generated from the trust’s income-producing assets, rather than the net income after taxes that is typical of an irrevocable trust. This allows a greater value to pass to the trust’s beneficiaries without using any additional gift tax exemptions of the Donor because the payment of the income tax is not a further gift.
Family Limited Partnerships (or LLCs) – Family limited partnerships are a complicated approach to managing family wealth. Generally, the older generation (grandparents/parents) enter into a partnership by becoming owners with a minimal stake in a business and thereby establish themselves as general partners in a family limited partnership. Over time, by gifting limited partnership interests, the younger generation (children) become limited partners with a majority stake in the business allowing a low tax or tax-free wealth transfer. There are many restrictions on this type of entity and they have historically been highly scrutinized by the IRS.
Charitable Documents (i.e. vehicles that can be set up to achieve ongoing charitable contributions):
Private Foundation – A private foundation is a legal entity set up solely for charitable purposes and is classified as a tax-exempt 501(c)(3) organization by the IRS. Unlike a public charity, which obtains funds from public fundraising to support its activities, the funding for a private foundation typically comes from an individual, a family, or a corporation. Contributions to public charities and private foundations are both eligible for income tax deductions, but the annual limits on contributions are slightly different. The private foundation generally stays under the control of the Donor or the Donor’s family and they will determine the foundation’s mission and determine how and why any funds are distributed. The foundation can exist in perpetuity, so it is a great mechanism to set up a charitable giving fund for multiple generations to take part in.
Charitable Remainder Trust (CRUT / CRAT) – A charitable remainder trust is a unique tax-exempt irrevocable trust designed to reduce taxes. The Donor transfers property/assets to the trust. A beneficiary, whether the Donor or someone else, receives income for the term of the trust and at the end of the term (or the death of the beneficiary), the remainder of the assets go to a charity. This allows an individual to receive an income stream for a period of time, while also providing for the appreciation to pass to a charity. The Donor receives an income tax charitable deduction for the transfer, based on the fair market value of the assets transferred to the trust, with a discount for the delay that will occur before the charity receives the asset.
Charitable Lead Trusts (CLUT / CLAT) – The opposite of CRUT and CRAT above, except that trust’s income will be distributed to charities for the term of the trust. When the trust term is complete, any remaining trust property is distributed to the beneficiaries.
Donor Advised Fund: A donor advised fund is a fund or account that is maintained and operated by a tax exempt 501(c)(3) organization, which is called a sponsoring organization. Donors make income tax deductible contributions to the sponsoring organization. Once the Donor makes the contribution, the organization has legal control over it, but the Donor, or the Donor’s representative, are able to advise the organization on how the funds are distributed and how the assets in the account are invested.
There are also many variations to each of the documents described above. They are discussed in their simplest form in this article. You should consult a licensed attorney before any of the documents are drafted and any estate plan is implemented.
This material is provided for illustrative purposes only. The material is not intended to constitute investment, financial or tax advice. You should contact your accountant or tax professional for advice regarding your specific situation. Effort has been made to ensure that the material presented is accurate at the time of publication. This information, however, is meant as an overview and not a full and exhaustive review of a complicated law. It should not be relied upon for actions, as it may not be applicable for your specific situation.
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