Why You Need an Estate Plan


The purpose of an estate plan is multi-faceted.  It helps you direct your assets to the people you want to have them, when you want them to have them.  It minimizes taxes, administration costs, and probate hassles and expenses.  It provides protection for yourself and your beneficiaries.  And finally, a will can allow you to have control even after you die.

According to Michael Burnett, estate planning attorney, “A will is absolutely essential for anyone with minor children, as it will allow you to designate who will care for your children if both parents die.  Without a will, a court is left to decide who should care for your children, without guidance from you.”

I admit, at first glance it would look like current transfer laws are set up for the fairly wealthy, at least in terms of minimization of taxes.  2012 laws allow you exclude up to $5,120,000 of estate assets from transfer taxation.  However, the laws benefit those with less than that amount, because it allows you to not pay any transfer tax.  Pretty cool, huh?  Those with over $5,120,000 in assets, however, will pay some transfer tax – sometimes a lot of it – if they don’t plan carefully.

What is transfer taxation, you ask?  It’s the tax you pay for the privilege of leaving someone else your money and personal possessions.  You can thank Thomas Paine for this idea.  Sure, us patriots value his most famous work, Common Sense, where he states that “all hereditary government is in its nature tyranny.”  His lesser known works, however, include The Rights of Man and Agrarian Justice, where he expanded his hereditary tyranny concept to include economic power.  He pushed an inheritance tax to balance out what he considered to be the unfair distribution of property among the landed elite.

So…. $5,120,000.  Seems like a lot.  But guess what?  That amount only lasts for 2012. Starting in 2013, if Congress does nothing, the exclusion amount will revert back to previous levels.  That pivot point is $1 million.  If you have a good-paying job that allows you to save adequately for retirement and have a nice house, you could easily go over that limit.  So if you’d rather have the higher limit, die this year.

What Can You Do?

I assume you’d rather not die this year.  There are steps you can take to protect your assets.  The first step is to work with an attorney to create a will.

A will allows you to distribute your property how you want to.  If you die without a will, called dying intestate, the state will decide how to distribute your property.

A will can be useful for other things besides distribution of property.  It names someone to settle your estate. It establishes domicile – your state of residency.  It names guardians for your minor or incapacitated children. It establishes the order of death in case of a common accident.  You can also use a will to create trusts.

A will goes through probate.  Probate is a process under state law for settling an estate.  Some states have an onerous probate process, which increases expenses.  Some property, such as real estate and tangible (touchable, like art) personal property need to be probated in the state where it is located.  So if you live in Georgia, and have a mountain cabin in North Carolina, you’ll be probating in two states, making things more expensive.

Some things don’t transfer through a will.  Jointly owned property (such as property owned as joint tenants with right of survivorship or tenants by entirety) will transfer outside of a will by operation of law because joint owners are on the title.  Other property, such as life insurance proceeds or annuities, will transfer by contract, because beneficiaries are named on the contract.

A will is also a public document.  Notice will be published to allow creditors to make claims against the estate.  The documents filed with the courts are a matter of public record, meaning anyone can go look them up.  This can get dicey if you plan on disinheriting a person who thinks they should get something from you, or if you plan to distribute unequally.  (Although, there are some laws that prevent the complete disinheritance of, or less than minimal distribution to, spouse and children.)

Again, What Can You Do?

You can work with your attorney to add a trust to your estate plan.  A trust does not negate the need for a will.  But a trust and a will need to be complementary and work together.

A trust is an arrangement where a trustee is appointed to take title to property and manage it for the benefit of one or more beneficiaries as guided by the trust document.  Trusts can be in one of two forms – revocable and irrevocable.

The benefits of a revocable trust are to provide professional management of assets during the grantor’s lifetime (the person who set up the trust and put the assets in it); to provide management of assets in the event of incapacity; to avoid the probate process; to avoid ancillary administration (the two state example); and to maintain privacy (no notice or court documents).

The benefits of an irrevocable trust include removing assets from the taxable estate (because the grantor relinquishes right to the assets); to remove assets from probate (just like revocables); and to protect from creditors (useful for spendthrift beneficiaries).  The decision of whether to use revocable or irrevocable trusts depends on what your goals are.

Trusts are also defined by when they are created.  Living trusts are created while the grantor is still alive.  Testamentary trusts are created by the will.  Note that the testamentary trust does not avoid probate, since the assets to fund the trust come from probate-able assets.

If the probate process in your state is simple and quick, if your heirs/beneficiaries are smart about managing money, if you don’t care if strangers know how you distributed your assets, then maybe a will is all you need.  You should work with an attorney to create both wills and trusts, which will cost money; however, the benefits of creating a trust often outweigh the additional legal costs it entails.

Let’s Get Back to Taxes

One of the reasons for creating a trust has to do with taxes.  There are two types of transfer taxes – estate taxes and gift taxes.  Let’s talk about estate taxes first.

The taxable estate is different from the probate estate.  Things that escape probate do not necessarily escape taxation.  For instance, the life insurance you own on yourself goes into your taxable estate, even though it escapes probate by issue of contract.

You may be tempted to give away some of your assets while you are still living, called lifetime gifts.  This can be a useful tool, if used wisely.   Lifetime gifts are subject to an exclusion limit, just like estate taxes.  Currently that exclusion limit is the same as estate taxes.

There is a unified schedule for estate and gift taxes.  While lifetime gift taxes are calculated at the time of the gift, in certain instances they get added back into the estate for estate tax calculation purposes.

Note that the exclusion amount is not what is used to calculate the actual tax owed.  Instead a tax credit is used.  I bet you’re wondering what the difference is between the exclusion amount and the tax credit.  The tax credit is the actual amount of tax saved on the exclusion amount.  Let’s see how this works.

Say your estate is worth $5,500,000, and you died in 2011.  (The exclusion amount and the credit amount for 2011 were $5,000,000 and $1,730,800, respectively.)  Estate taxes have a sliding scale based on amount of assets, with the percentage tax rate increasing as the estate value increases.   There are charts that outline this scale.  For the $5,500,000 estate, the base tax amount for $500,000 (the highest on the chart) is $155,800.  The balance of the estate over $500,000 (in this case, $5,000,000) is taxed at a rate of 35%, the maximum rate.  The result of the 35% calculation is added to the base of $155,800, to result in a total tentative tax of $1,905,800.  This is the tentative tax on the entire $5,500,000.  Here is where the tax credit comes in.  The tax credit of $1,730,800 is subtracted from the tentative tax to result in an actual tax due of $175,000.

Notice that the tax calculation is based on the total estate value, not the value less the exclusion amount.  This makes the estate taxes tax inclusive, meaning that the amount from the estate that will be used to pay estate taxes is included in the tax calculation, resulting in higher taxes.  (Sounds convoluted, but there is a form for that.)  If the exclusion was taken first, and then the tax calculated on the amount left over, it would result in a lower tax bill of $155,800, in our example.  Guess which one the IRS prefers?

Regarding 2013.  We’ve already noted that the 2013 exclusion amount will revert to $1,000,000 in 2013 if Congress does nothing.  That’s not the only thing that will happen.  The credit amount will reduce to $345,800 and the maximum tax rate will go up to 55%.

Portability will also go away.  Currently, a surviving spouse is able to “inherit” the unused portion of the exclusion not used by the deceased spouse.  Meaning that if the deceased spouse left an estate valued at $2,500,000, the surviving spouse upon his/her own death could apply his/her own exclusion amount of $5,000,000 to his/her own estate, plus the left over amount from the first deceased spouse – in this case, another $2,500,000.  In 2013, portability of the exclusion amount will no longer be available.

One of the benefits of doing lifetime gifts is that gift taxes are tax exclusive, meaning that the funds used to pay the gift tax is excluded from the taxable base.   (There’s a form for this calculation, too.  And don’t worry – your accountant will take care of all this.)  The way lifetime gift taxes are calculated results in a lower tax bill than if the amount was included in the estate.

“Lifetime and annual gift exclusions are a powerful planning tool and can often be used to fund irrevocable trusts in order to reduce your taxable estate.  One example would be to create an Irrevocable Life Insurance Trust (ILIT) and have the ILIT purchase life insurance on you.  You would then use your personal annual exclusion to gift the amount required each year to pay the life insurance premium.  This would keep the cash payout from the life insurance at your death out of your taxable estate,” Burnett says.  The 2011/2012 annual gift tax exclusion is $13,000.

Deciding whether to distribute your assets through lifetime gifts or through your estate depends on a number of factors.  If you gift and reduce the amount of your estate, you leave less in the estate for your heirs.  Another disadvantage of doing lifetime gifts is that you lose the ability to step up the basis in the asset.  For instance, if you bought a piece of real estate for $100,000, and at the time of the gift it was worth $1,000,000, the person who receives the gift will also have a basis of $100,000.  Which means when he goes to sell the property, he will be taxed on the capital gains of $900,000 – the difference between the current value and the basis (original value).

The advantages of doing lifetime gifts (beyond the tax advantages) may override the disadvantages.  Advantages include privacy; personal gratification watching the gift receiver enjoy the gift; ability to shift income the asset produces (i.e., rental income on real estate) from you in a higher tax bracket to your gift receiver in a lower tax bracket; achievement of personal objectives, such a child’s education; and trial run to see how well the gift receiver manages the asset received.

There are many more things that can be said about estate and/or gift taxation.  There is the unlimited marital deduction, the generation skipping transfer tax, gifts that are excluded from taxation, the process for valuating estate or gifted property, etc.   A good financial planner and an accountant can help you navigate these things.

All legal advice and documents, such as wills and trusts, are best provided by your estate planning attorney.

* Input provided by Michael S. Burnett, Esq.  www.msb-law.com


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