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estate planning
Ron Coleman is an attorney specializing in income tax and estate planning for individual and business clients. In practice since 1978, Mr. Coleman was formerly associated with the international law firm of Thelen, Marrin, Johnson and Bridges. Mr. Coleman is also a certified public accountant, formerly with the international accounting firms of Price Waterhouse and Deloitte Haskins and Sells, and is a registered investment advisor. Mr. Coleman received his A.B., English, from UCLA, MBA (Magna Cum Laude) from Boston University, Juris Doctor (Magna Cum Laude) from the University of Santa Clara School of Law, where he served as Business Editor of the Law Review, and Master of Legal Letters (LL.M.) in Tax from Golden Gate University School of Law. Mr. Coleman is admitted to practice before all the courts in the State of California, the United States Federal Court, and the United States Tax Court. Mr. Coleman has taught estate and gift taxation in the Master of Tax program at San Jose State University and corporate taxation for the American College in its Master of Financial Planning program. He is an advisor to several private foundations for their income development and planned giving programs. Estate planning is the process of arranging for the orderly disposition of your assets, both during your lifetime and after your death, in such a way as to minimize: 1. Taxes 2. Fees and expenses 3. Legal and financial complications III. PROBATE AND ESTATE PLANNING Probate is the administration of the deceased's estate by a court pursuant to the terms of the will or, if there is no will, according to the laws of intestate succession. The court supervises the inventory and appraisal of assets, the payment of creditors' claims, and the distribution of assets in accordance with the will provisions or under the laws of intestate succession. 2. Advantages
3. Disadvantages
Probate fees are based upon the gross value of property, without reduction for mortgages or other debt against the property. A person who dies without a will is said to die intestate. In such case, the deceased's property generally will be subject to probate, and the property will pass to those heirs as determined by the laws of the state in which the deceased resided, without regard for the deceased's wishes.
- Avoids distribution under laws of intestacy
- Requires probate
D. PROPERTY THAT AVOIDS PROBATE
1. Life insurance proceeds
A living trust is a trust that you create while you are living, as opposed to a testamentary trust, which is created after your death, for example by your will. A revocable trust can be altered, amended, or revoked, whereas an irrevocable trust generally cannot be revoked or changed in any way. Therefore, a revocable living trust is a trust that is created during lifetime and that may be altered, amended, or revoked at any time while the individual(s) who created the trust are living.
1. Avoids probate costs, delay, publicity
1. Establishment cost higher than that of a simple will
- Trustor. The trustor is the creator of the trust. Sometimes referred to as the grantor or settlor. - Trustee. The trustee holds legal title to the trust assets and preserves and invests those assets for the benefit of the trust beneficiaries. Usually, the trustors also act as trustees. Upon the death of the first spouse, the surviving spouse can continue to serve as trustee. In the event of death or incapacity of the surviving spouse, the designated successor trustee will serve. Adult children may be competent to serve as successor trustees. Where there are minor children, a third party should be designated as successor trustee, either an individual or an institution such as a bank. - Beneficiary. The beneficiary is the person or persons for whose benefit the trust was established and to whom the trustee owes a duty to preserve and invest the trust assets prudently. Generally, while the trustor is alive, he or she is the beneficiary. Upon the death of the first spouse, the surviving spouse usually continues to receive all trust income. After the death of the second spouse or the single trustor, the children or other designated beneficiaries receive the property, either in trust or outright when they reach a specified age, for example, one-half at age 25 and the balance at age 30.
1. Probate and conservatorship are avoided only on transferred property.
A. $12,000 ANNUAL GIFT EXCLUSION The federal gift tax and estate tax system are unified, that is, the first $1,000,000 of transfers of property (other than to spouses or to charities), whether during your lifetime or after your death, will not be subject to gift tax or estate tax. Transfers in excess of $1,000,000 generally will face gift tax or estate tax. However, the first $11,000 in gifts made by a donor to any one donee during each calendar year generally is not taxable and a gift tax return usually is not required to be filed. Therefore, if you and your husband or wife have two children, the two of you could transfer $44,000 per year to your children. With an ongoing gift program extending over 10 years, $440,000 in gifts could be passed tax-free to the children ($880,000, if each child has a spouse). That $440,000, plus future appreciation, will be removed from your taxable estates. Despite the application of the so-called "kiddie tax" on unearned income of children under 14, an annual gift tax program can be an effective part of the overall estate plan. The federal estate tax applies to taxable estates exceeding $2,000,000 and ranges from 41 to 50 percent. California's inheritance tax is a "pick-up" tax, i.e., it is equal to the state tax credit allowed by the federal tax code. Therefore, the estate tax liability is actually a combination of federal and California tax. If the value of your adjusted taxable estate is less
than $1,000,000 at the time of your death, there will be no estate tax liability.
In the case of married person, the value of his or her estate includes
all of his or her separate property and one-half of the couple's community
property. In calculating an individual's estate value, proceeds of
life insurance owned by the individual will be included.
In addition to the $1,000,000 individual exemption, generally there is an unlimited marital deduction for gift and estate transfers between husband and wife. Thus, usually there is no federal estate tax when a husband or wife dies and leaves his or her assets to the surviving spouse. However, on the death of the surviving spouse and transfer of property to the children or other family members, her estate, in excess of $1,000,000, will face federal estate tax. If the surviving spouse is not a United States citizen, special requirements must be met in order for the unlimited marital deduction to be available, including that the property must be placed in a trust designating a U.S. citizen or a U.S. corporation as a co-trustee. D. THE A-B TRUST
Assume that Husband and Wife have combined net assets of $1,000,000. In situation 1, Husband dies leaving all his property outright to Wife, who later dies leaving all her property to their children. In Situation 2, the couple's living trust provides for the establishment of a trust after Husband's death to benefit Wife during her lifetime with the remainder to pass to the children upon her death, the so-called Bypass Trust. Assume that Wife lives an additional 10 years and her estate grows at an annual rate of 7% (property doubles in value in 10 years at 7% compounded annual appreciation). In situation 1, when Wife dies, her estate, which includes her husband's property, is valued at $2,000,000 and the estate tax liability is $435,000. Probate fees could add another $100,000 or more, for total death costs of more than $500,000. In situation 2, Wife's estate does not include the value of her husband's property, which has been placed in the Bypass Trust for her benefit. Therefore, Wife's estate is valued at $1,000,000 and there is no estate tax liability. Use of the living trust will also avoid probate fees. Situation 2, by establishing a trust, reduces combined estate tax on the two estates by $435,000. In larger estates facing higher tax rates, the reduction can be as much as $500,000. Proper estate planning saves taxes. The QTIP Trust can be used where the value of the marital estate is expected to exceed $2 million at the death of the first spouse. (More specifically, where the value of the predeceased spouse's one-half of community property and all of his or her separate property exceeds $1,000,000 at the first death). The acronym "QTIP" stands for Qualified Terminable Interest Property, and essentially it is a lifetime income interest in property given to the surviving spouse. The Problem: Husband and Wife have a net worth of $3 million. Husband and wife each have children and property from a previous marriage. When Husband dies, the provisions of his living trust can establish a testamentary trust for the benefit of his children, funded with his $1,000,000 exemption amount. The remaining $500,000 of his assets, however, will face immediate tax unless passed to his wife. But if the transfer is outright, Wife can spend or transfer those assets to her children or a new husband. The Solution - The QTIP Trust: Rather than
transferring the $500,000 outright to the surviving spouse, the living
trust or will can establish a QTIP trust, in which the surviving spouse
receives all income from the trust for life, with the right to receive
certain amounts of trust principal. Upon the death of the surviving
spouse, the property will be included in his or her estate for tax purposes,
but the property will pass to those beneficiaries designated by the predeceased
spouse. Alternatively, the surviving spouse could be given a limited
power to appoint the property among a group of beneficiaries designated
by the predeceased spouse.
Your gross estate will include the proceeds of any insurance on your life if you own the policy. While the unlimited marital deduction will remove those proceeds from your taxable estate, those proceeds will be included in your spouse's estate subject to tax unless spent or disposed of during her lifetime. For example, $1 million policy proceeds subject to a 50 percent estate tax would leave net proceeds of only $500,000. Therefore, primarily as a technique to avoid estate tax on the death of the surviving spouse, we recommend that individuals consider establishing during their lifetime irrevocable life insurance trusts to own the policies. Typically, for policies insuring one life, e.g., the primary wage earner, the surviving spouse is entitled to all the income from the invested proceeds during his or her lifetime. At the death of the second spouse, the trust could continue for the benefit of minor children, or the trustee could use the proceeds to buy estate assets, loan money to the estate, or distribute trust assets to the beneficiaries to pay death taxes and other expenses. B. QUALIFIED PERSONAL RESIDENCE TRUST (QPRT) This is designed to save estate taxes by leveraging the lifetime $1,000,000 unified credit exemption equivalent. A grantor, often a parent, transfers his or her residence to a trust for a term of years and reserves the right to continue residing there during the term of the trust. At the end of the trust term, the residence is transferred, either outright or in trust, for children or other beneficiaries. Because the grantor has the current enjoyment of the residence, only the discounted present value of the remainder interest is considered a gift. A transfer of a $750,000 home to a 10-year QPRT by a 65-year old would result in a gift of about $286,000, which is within the lifetime exemption, resulting in no gift tax. Assuming an annual growth rate of 5% and an estate tax bracket of 50%, this technique could save over $850,000 in death taxes, assuming death occurred 20 years after the initial transfer to the trust. C. CHARITABLE REMAINDER TRUSTS Charitable contributions made during the donor's lifetime can be more advantageous than a testamentary contribution. A charitable contribution during your lifetime will not only keep the property out of your taxable estate, but it will also provide a current income tax deduction. The charitable remainder trust may be especially beneficial where there are highly appreciated but low income-producing assets, such as real estate (including a principal residence) or a closely held business. The transfer to the trust generally is not taxable; the trust may sell those assets without facing income tax, and then the trustee can invest the proceeds in higher-yielding assets, thus increasing the donor's life income stream. For donors with children or other heirs, a portion of the increase in income and tax benefit of the charitable deduction can be used to replace the asset value via life insurance. Example: A couple both aged 67 have a $750,000 home purchased several years ago for $50,000. The owners have retired, the children are grown, and the owners want to move to a smaller, less expensive retirement home. If the couple sells the house outright, gain recognized will be $200,000 (after taking advantage of the $500,000 exclusion from gain on the sale of a principal residence). Assuming a combined Federal and California income tax rate of 30 percent, the tax will be $60,000. Instead, the owners transfers one-third of the house to the charitable remainder trust, and owners and the trust simultaneously sell their interests to a buyer. Owner's gain is completely sheltered by the $500,000 residential exclusion. The trust's gain is exempt from income tax because it is a charitable trust. Therefore, net proceeds for investment are increased by $60,000. Assuming an 8 percent trust payout rate, owners' annual income is increased by $4,800. In addition, owners take an income tax charitable deduction for the present value of the property that passes to the charity upon their death, based on their life expectancy and the trust payout rate they choose. In this case, the deduction would be about $60,000 (subject, however, to a limitation of 30 percent of adjusted gross income). A portion of that increased income and the tax benefit from the charitable deduction can purchase life insurance to replace the $250,000 trust assets that will pass to charity. D. Qualified Domestic Trust for Non-Citizen Spouses If the surviving spouse is not a United States citizen, special requirements must be met in order for the unlimited marital deduction to be available, including that the property must be placed in a trust designating a U.S. citizen or a U.S. corporation as a co-trustee. The first $1,000,000 given to the surviving spouse by the deceased spouse is exempt from estate tax, regardless of the citizen-ship of the survivor. However, amounts in excess of $1,000,000 left to the surviving spouse by the deceased spouse must be placed into a Qualified Domestic Trust in order to defer estate tax until the death of the second spouse. A Qualified Domestic Trust is an irrevocable trust established for the benefit of the surviving spouse. The surviving spouse must receive all income of the trust. Distributions of principal from a Qualified Domestic Trust, both during the lifetime of the surviving spouse and at the spouse's death, are subject to estate tax, unless the distribution to the surviving spouse is on account of hardship. The value of assets in your estate in excess of $1,000,000 will be subject to estate tax, at marginal rates of between 41% and 50%. After the payment of that tax, the net amount will be included in your child's taxable estate, again potentially subject to an estate tax of 41% to 50%. A 50% estate tax levied at both your and your child's deaths will result in your grandchildren receiving only 25% of the amount subject to tax in your estate. To avoid such a result you can place assets in trust for your children, giving them an income interest in trust assets during their lifetime and access to trust principal as needed for health, maintenance, and support. A properly established "generation- skipping" trust will allow your children and grandchildren liberal use of the assets without those assets being included in their taxable estates. Because of the ability of a generation-skipping trust to avoid estate tax for several generations, the amount that you can place into a generation-skipping trust without adverse tax consequences is limited to $1.1 million per transferor (indexed for inflation). Example: Fred and Wanda Rogers, aged 65, with
two adult children, have a $1 million estate. They have established
a revocable living trust that will divide into A-B trusts upon the death
of the first spouse. Based on their life expectancies of about 20 years
and a 5% annual appreciation of their assets, their after-tax estates that
will pass to their children will be about $2.5 million, or $1.25 million
per child. Added to the children's own taxable estates, that $2.5
million might face up to 50% estate tax in the children's estates, or $1,250,000,
leaving the grandchildren with $1,250,000. Instead, the Rogers amend their
living trust to provide that upon the death of the first spouse, the surviving
spouse will make a generation-skipping tax election with respect to $1.1
million of the predeceased spouse's property, which will
include $1,000,000 in the Bypass Trust and $100,000 in the Marital Deduction
Trust. Upon the death of the second spouse, that $1.1 million (and
its appreciation between first death and second death) and $1.1 million of
the surviving spouse's property will be placed in two separate generation-skipping
trusts for the benefit of the Rogers' children during their lifetimes and,
if desired, during the lifetimes of the grandchildren and great grandchildren
as well. Any of the Rogers' trust assets in excess of the generation-skipping
exempt amount will pass outright to the Rogers' children at the second
death. The use of a generation-skipping trust does not reduce estate
tax imposed on the estates of Fred and Wanda, but it does reduce estate
taxes on the estates of the Rogers' children. The result is that the full
$2.2 million (and its growth) passes from generation to generation without
estate tax.
The greatest risk to long-range retirement security is the erosion of our purchasing power through inflation. Not volatility of stocks, not the current decline in values of real estate, but the slow, steady rise of prices due to inflation. One dollar today will, in 15 years, have the purchasing power of 50 cents, given 5% annual inflation. At 6% inflation, that halving of the dollar occurs in just 12 years. If all your financial assets are fixed income investments--e.g., savings accounts, CDs, T-bills, and municipal bonds--and you spend the entire income, the purchasing power of your principal inevitably will decline. Men and women live longer nowadays. If you are 60 years of age, you have a life expectancy of 23 years if you are male, 26 years if you are female. If you retire at 62, you will have 20 years or more of retirement. Today's dollar sitting in a bank savings account is "safe" for today, but in 20 years that dollar will only be worth 45 cents. Therefore, a sensible investment strategy in retirement should include not only cash and fixed instruments, but equities as well. Moreover, a sound portfolio could very well include foreign investments--as a means of further diversifying one's portfolio and thereby reducing investment risk. A common concern of cautious, conservative investors is the volatility of the stock markets--witness the 500 point drop of the Dow Jones industrials in October 1987, nearly a 25% decline. Yet today, 14 years later, the Dow has recovered that 25% drop and has grown at an average annual rate of about 12 percent. In the short term, the stock markets are volatile, but in the long run stocks have always outperformed bonds and other fixed instruments. In any 15-year period from 1926 to today, stocks (as measured by the Standard & Poor 500--the 500 largest companies in America) have outperformed 30-day Treasury bills 100 percent of the time. Modern portfolio analysis, widely used by the large pension funds, has determined that fully 94 percent of a portfolio's performance is derived from the proper mix of asset classes (such as large cap stocks, fixed instruments, international equities, real estate, etc.), while only 6 percent of performance is attributable to factors such as market timing and selection of particular stocks). Therefore, a sound approach is to invest in only index funds--funds that mirror the asset class as a whole, such as the Standard & Poor's 500. Other index funds are available for international stocks, international bonds, small capitalized stocks, etc. With the aid of computers to determine the proper mix of asset classes, the investor can minimize his or her risk without giving up superior returns. VII. COMPREHENSIVE ESTATE PLAN A. THE LIVING TRUST: The revocable living trust is the central document in your estate plan. It governs the disposition of your assets after your death and, for a married couple, it can reduce estate taxes. The funded living trust also avoids probate and conservatorship. B. POUR-OVER WILL: If
there is significant investment property that has not been transferred
to the living trust during your lifetime, the pour-over will provides that
those assets are to be transferred to your trust for disposition in accordance
with the terms of the trust. The will also transfers personal effects
to the surviving spouse or others and provides for the nomination of a
guardian for minor children.
D. DURABLE POWER OF ATTORNEY FOR HEALTH CARE: This special form of power of attorney gives your spouse or another individual or individuals the legal authority to make medical decisions (including the termination of life support) for you if you are incapacitated and unable to make those decisions personally. E. PROPERTY AGREEMENT: This document, for married couples, can convert property, whether separate property or held in joint tenancy, to community property. If either spouse wants to maintain specific items as separate property, the property agreement can accommodate that. In most cases, the purpose of the property agreement is to convert joint tenancy property to community property and thereby, on the death of the first spouse, obtain an income tax basis increase to fair market value for both husband's and wife's halves of the property. Joint tenancy ownership allows the basis of only the deceased spouse's half of the property to be increased. F. TRANSFER DOCUMENTS:
Probate and conservatorship are avoided only as to property transferred
to the living trust. To transfer real estate to the trust, a deed
and a preliminary change of ownership report must be prepared. For
other assets, such as brokerage accounts, bank accounts, and stocks and
bonds, letters to the transfer agents or custodians should be prepared.
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