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Estate Planning 101: Wills, Trusts and Estate Tax Planning Case Studies

Thinking about updating your estate plan? Whether due to the birth of a child, the death of a friend, reaching retirement, the sale of your business, reaching a certain age, or hitting the lottery, whatever the reason, most people eventually decide to see a lawyer about preparing a Will or updating their old one. By considering the particularities of a family's circumstances, the amount of wealth involved, and the desire to achieve estate tax savings and/or protection from creditors, what may start out in the client's mind as "updating my will" should result in the formulation of a comprehensive estate plan. This article will discuss the legal documents essential to both a basic estate plan and a more sophisticated plan in which estate tax planning for significant wealth is required. Obviously, specific recommendations require an analysis of each individual's or family's unique facts and circumstances.

The Basic Plan

Richard and Karen Murphy are each 50 years old. They have been married for 20 years and have 2 children, ages 17 and 15. They have old "I love you" wills executed years ago which simply leave all of their property to each other. As a result of a family friend being recently diagnosed with a severe illness, Richard and Karen finally decided to update their wills. Their accountant referred them to an attorney who specializes in estate planning.

Prior to meeting with the Murphy's, the attorney asks them to complete a confidential questionnaire listing their assets by fair market value and title. Their asset summary is as follows:

  • Asset
  • H
  • W
  • J
  • Residence
  • $250,000
  • Mortgage
  • ($50,000)
  • Cash & Investments
  • $85,000
  • Life Insurance (group)
  • $50,000
  • Vacation Home
  • $125,000
  • IRAs
  • $50,000
  • $75,000
  • $100,000
  • $75,000
  • $410,000

Based upon this personal net worth statement, before the Murphy's come in for the initial consultation, their attorney has already determined that an estate plan oriented toward saving federal or state estate taxes will not be necessary for the Murphy family since their federal taxable estate is below $600,000 and because they reside in a so-called "sponge tax" state. The Internal Revenue Service will not impose an estate tax on estates at or below $600,000 (sometimes called the "credit shelter amount" or the "exemption equivalent"). Because the estate tax imposed by a sponge tax state is equal to the "state death tax credit" allowed against the federal estate tax (zero in this case), no state estate taxes will be imposed. Accordingly, the Murphy's estate plan can be formulated without the need for estate tax planning at this point in their lives. As their net worth grows, however, so will the need to reconsider their estate plan in the future.

The plan recommended for the Murphy's will consist of nine documents:

Reciprocal Wills (2)
Family Trust
Durable Powers of Attorney (2)
Living Wills (2)
Health Care Proxies / Health Care Durable Powers. (2)

Reciprocal Wills. While it may be possible to plan the Murphy's estates to avoid probate, Reciprocal (simple) Wills are still necessary to direct the disposition of assets for which probate is required, nominate guardians for minor children, and to name executors to administer the estate. Without Wills, the Murphy's property would pass according to the laws of intestacy and, in most states, would divide the family property between the surviving spouse and children, not what the Murphy's had in mind. The Murphy's should continue to have simple Wills which bequeath all property to the surviving spouse. However, under their new Wills, if there was no surviving spouse (i.e., if one spouse was already deceased), property would instead pass to a Family Trust to be held for the children.

Family Trust. The purpose of the Family Trust is to hold and administer the family's assets for the benefit of the children in the event both spouses died prior to their children reaching a predetermined age. For this reason, this trust is sometimes referred to as a "stand by" trust. Selecting the age for distribution to children requires careful consideration by parents. When the question is put to many parents, age 21 is a common first response. Upon reflection, however, the prospect of a 21-year old son or daughter gaining unrestricted access to one-half of a $585,000 estate (in the Murphy's example) would cause most parents to reconsider. The Murphy's decided that their children would receive one-half of their share of the trust at age 30 and the remainder at age 35. Until these ages, income and principal of the trust would be distributable to the children in the discretion of the trustee(s). The Murphy's must also decide if the trustee's discretion will be absolute or subject to a predetermined standard (e.g., "health, education and support").

In the event that one of the Murphy children predeceased them, his share would be allocated to the surviving child. If a child predeceased them leaving children of his own (the Murphy's grandchildren), the Family Trust would hold such deceased child's share for the health, education and support of these grandchildren until they reached an age appropriate for distribution of the trust fund.

The Family Trust is completely revocable and amendable and could also serve as a probate avoidance trust should the Murphy's decide to fund the trust during their lifetimes. In this event, all trust property would be held exclusively for Richard and Karen during their lifetimes.

Durable Powers of Attorney. Durable Powers of Attorney can operate as a substitute for potentially lengthy and expensive court proceedings necessary to appoint a conservator (guardian) in the event either of the Murphy's were to become legally incapacitated. A power is considered "durable" because, unlike an ordinary power of attorney, it will not be terminated by the legal incapacity of the principal. Each spouse is generally appointed as the holder of the power for the other and is granted broad authority to act on behalf of and manage the other's business and financial affairs. Although the power is usually effective immediately, it is normally not intended to be utilized until one spouse becomes legally incapacitated. "Springing" durable powers of attorney, which delay the effectiveness of the power until an actual legal incapacity occurs, may also be utilized. Springing powers provide some comfort to persons who want absolute certainty that their power holder (legally known as the "attorney-in-fact") will not deal with their affairs while the principal is competent to do so. Springing powers can be problematic if the power holder has difficulty in establishing the existence of a legal incapacity to the satisfaction of the third party being asked to rely on the validity of the power. In addition to the benefits a durable power may confer by allowing the assets of an incapacitated person to be administered informally and cost effectively, in some cases dramatic estate and income tax benefits may be preserved by conferring special powers on the power holder, such as the power to make gifts, to establish trusts, and to make various elections under retirement plans. Approximately two-thirds of the states in the U.S. recognize durable powers.

Living Wills / Health Care Proxies. The final documents to be included in the Murphys' estate plan provide protection for their right to determine the course of their medical care in the event of future catastrophic illness. The decision to execute such documents is a matter of individual choice and involves intensely personal ethical and moral issues. While no two laws are identical, a Living Will generally allows a competent adult to create an enforceable medical directive regarding an express desire to avoid the artificial prolongation of the dying process, including instructions to withhold or withdraw life sustaining treatment in the event of a terminal diagnosis. The terminal illness is typically required to be imminent with no hope of recovery. Harvard Medical School published a form "Medical Directive" which contains an exhaustive list of medical instructions on a grid of 192 boxes indicating a person's wishes regarding treatments ranging from cardiopulmonary resuscitation & mechanical breathing to the use of antibiotics & diagnostic tests. Living Wills are recognized in at least 41 states.

A Health Care Proxy (or in some states, a durable power of attorney for health care) enables a competent adult to appoint another person to serve as his or her agent to make health care decisions if he or she becomes incapable of making health care decisions due to legal incapacity. The health care agent's decisions are legally binding.

The Tax-Motivated Estate Plan

The Murphy's neighbors, Elmo and Melissa Ellis are better of financially. As a result, their estate plan requires estate tax planning and additional documentation. For estates approaching $1 million and up, planning to utilize the marital deduction and the $600,000 federal estate tax exemption is critical. The federal estate tax can run as high as 55% for larger estates (plus an additional 15% for certain retirement plan assets) and can result in the federal government receiving a larger inheritance than the children. Assume the Ellis' questionnaire revealed the following assets:

  • Asset
  • H
  • W
  • J
  • Residence
  • $500,000
  • Cash & Investments
  • $750,000
  • Life Insurance (individual)
  • $500,000
  • Rental Property
  • $125,000
  • Family Owned Business
  • $1,000,000
  • IRAs
  • $75,000
  • $1,500,000
  • $200,000
  • $1,250,000

With a projected estate of $2,950,000, the Ellis family's estate planning options are dramatically different than their neighbors. The basic estate plan which was recommended for the Murphy's would result in estate taxes of approximately $1,071,500 being imposed upon the Ellis' estates. An estate tax-oriented plan could reduce these taxes by approximately $551,000. More sophisticated planning techniques could reduce this amount still further. The plan recommended for the Ellis family will consist of eleven documents (the new documents are shown in bold):

Pourover Wills (2)
A/B Family Trusts (2)
Irrevocable Life Insurance Trust
Durable Powers of Attorney (2)
Living Wills (2)
Health Care Proxies / Health Care Durable Powers

Pourover Wills. The importance of having updated Wills was discussed in the Rodgers plan and is similarly applicable to the Ellis Family. Due to the size of the Ellis' estates, however, their Wills will bequeath only tangible personal property (personal effects, jewelry, etc..) to the surviving spouse. The balance of their property (cash, real estate, and other financial assets) will pass or "pourover" to their Family Trust.

Family Trusts. Assuming Elmo predeceased Melissa, upon his death, his Family Trust (often called a "living trust" because it was created during his lifetime) would be the primary recipient of the majority of his property under his Will (excluding non-probate assets such as life insurance, IRAs, and assets previously transferred to the Trust during his lifetime). The trust is designed to minimize federal estate taxes at his death. During Elmo's lifetime, he would be the sole trustee (except in the event of his disability) and beneficiary of his trust. The terms of the trust require that all trust income and principal be paid solely to him, in his sole discretion. In this regard, the trust is nothing more than his alter ego while he is alive and legally competent. He can either allow the trust to remain unfunded until death, at which time the trust will be funded pursuant to the terms of his Will, or he can fund the trust during his lifetime. Funding the trust during Elmo's lifetime will have no tax consequences, but will avoid probate of any assets so transferred. It would also allow successor trustees to manage the trust assets for Elmo's benefit without a court supervised guardianship if he became legally incapacitated.

Upon Elmo's death, his Family Trust would be divided into two separate shares referred to as the Marital Trust (the "A" Trust) and the Residue Trust (the "B" Trust, also referred to by practitioners as the "credit shelter trust" or the "by-pass trust"). These two shares will secure for the Ellis family the maximum federal estate tax marital deduction combined with the full use of their $600,000 federal estate tax exemption equivalents.

Melissa could be given the unrestricted right to withdraw property from the Marital Trust (a general power of appointment). Alternatively, the Marital Trust could be drafted as a qualified terminable interest property ("QTIP") trust. With a QTIP trust, Melissa would instead receive all of the Marital Trust income each year during her lifetime, but principal distributions would be made to Melissa only in the trustees' discretion. A QTIP trust is very popular in second marriage circumstances, where a person wants to provide for their new spouse, but ensure that the trust property will be preserved for the children of the first marriage. The trustee's discretion could be absolute or subject to a standard (i.e., for Melissa's comfort, health, maintenance and support). Melissa could also be given the right to withdraw the greater of $5,000 or 5% percent of the assets of the Trust each year (a "5 and 5 power"). Upon Melissa's death, she could also be given a testamentary power of appointment to cause the trust assets to be distributed among the Ellis children and grandchildren as directed by her Last Will. If she does not exercise this power, the property remaining in the Marital Trust at her death would be transferred to the Residue Trust to be held and distributed according to the terms of that Trust.

During Melissa's lifetime, the trustees would have the discretion to pay both the income and principal of the Residue Trust for Melissa's primary benefit and secondarily for the children. In this way, the trustees may also be able to make distributions to the children during Melissa's lifetime, assuming her needs were adequately taken care of by her separate assets and distributions from the Marital Trust. Melissa could also been given a 5 and 5 power over the assets of the Residue Trust. Melissa could also be given a testamentary power of appointment over the Residue Trust allowing her to reallocate, pursuant to the terms of her Will, the manner in which the trust property is to be distributed to the children and any grandchildren. Property in the Residue Trust, no matter how much it has appreciated after Elmo's death, will be totally exempt from estate tax at Melissa's death.

Elmo and Melissa are each named as the initial trustee of their respective Family Trusts to serve during their lifetimes. As indicated above, they are also the sole beneficiary and trustee of their own trust during their lifetimes. Successor trustees (often one family trustee and one "disinterested" trustee) are appointed to administer the Family Trust after their deaths. The successor trustees will hold and manage the assets for the family's benefit. Melissa could be named as the family trustee of Elmo's trust upon his death. Elmo could be the family trustee of Melissa's trust if he survives her. The trustees are responsible for safely investing the trust property and making distributions to the beneficiaries in accordance with the terms of the Trust.

After all taxes and expenses are paid at Melissa's later death, all of the money and other property held in the Marital Trust would be added to the Residue Trust (assuming she did not exercise her testamentary powers of appointment). The Residue Trust would then hold the trust property for the children under the same terms (1/2 @ 30, 1/2 @ 35) as the Family Trust described above under the Murphy's estate plan discussion.

Insurance Trust. Transferring life insurance policies to an irrevocable trust can exempt the entire life insurance death benefit from estate taxation. There would be a three year waiting period (after the transfer of the policies) to achieve this tax result, although newly purchased policies, if properly applied for, should not be subject to this 3-year rule. Considering the 50% federal estate tax bracket projected for the Ellis' estate, the use of an irrevocable trust to hold Elmo's $500,000 life insurance policy would save approximately $250,000 of estate taxes by removing the proceeds from Melissa's future estate, resulting in a dollar-for-dollar increase in the assets inherited by the children.

Once the trust is created and a trustee appointed, sufficient funds would be thereafter transferred to the trust in order to enable the trustee to pay the annual premiums for the insurance. The trustee would also hold additional contributions for the Ellis children during Elmo's lifetime. Transfers to the trust from Elmo will be considered taxable gifts to the children as trust beneficiaries. In order to qualify such transfers for the $10,000 annual gift tax exclusion ($20,000 if a spouse joins in the gift), the children would be given the power to withdraw (a so-called "Crummey Power") the annual contributions to the trust each year. Potential tax headaches can arise if this annual power of withdrawal exceeds the greater of $5,000 or 5% of trust property. The IRS requires that notice be given to all beneficiaries entitled to exercise a power of withdrawal, informing them of their right to withdraw funds contributed to the trust for at least a 30 day period following the contribution in order to qualify for the annual gift tax exclusion. Children are expected to not exercise this power. The dispositive provisions of the trust holding insurance policies on Elmo's life would be similar to those described above for the Residue Trust.

In summary, the estate tax benefits of this plan when compared with the basic plan are as follows:

  • Federal Tax
  • State Tax
  • Total
  • Simple Wills
    Stand-By Trust
  • $893,900
  • $177,600
  • $1,071,500
  • Pourover Wills
    2 Family Trusts
    Insurance Trust
  • $431,700
  • $88,800
  • $520,500
  • $551,500

Survivorship Life Insurance. The Ellises may decide to fund the estate tax due at the second death with "survivorship" or "second-to-die" life insurance. This type of insurance is typically purchased as part of an overall estate plan to fund the estate taxes which cannot be eliminated by tax planning. Because the policy insures both lives simultaneously, it will not pay a death benefit until both spouses are deceased, the very time when the estate tax bill becomes due and payable (actually the bill is due nine months after the date of death).

Survivorship life insurance is commonly purchased to avoid a forced sale of a family's assets to pay estate taxes and/or to prevent the often dramatic shrinkage of a family's estate created by the burden of estate taxes. Elmo and Melissa might consider the purchase of a $520,500 survivorship policy to fund the payment of their projected estate tax. Depending on their health and the insurance company selected, at their ages a survivorship policy could be fully paid up (i.e., no more premiums) after payment of 10 annual premiums equal to approximately $6,500.

Survivorship insurance coverage is generally less expensive than two individual policies. If a policy is purchased, it too could be acquired by a separate irrevocable trust in order to exclude the entire death benefit from the Ellis's taxable estates so that the insurance proceeds will be exempt from estate tax. Survivorship insurance is a sophisticated financial product and requires the consultation of a qualified insurance professional.

Summary. The Murphy and Ellis families each received a comprehensive estate plan tailored to achieve individual, family and financial objectives. Additional planning is not necessary for the Murphys. The Ellis plan, however, could be expanded to further reduce the $520,500 projected estate tax. This would require implementation of one or more additional estate planning techniques, including the use of a qualified personal residence trust ("QPRT"), a grantor retained annuity trust ("GRAT"), a charitable remainder trust ("CRT"), a generation skipping or "dynasty" trust ("GST"), special planning for retirement plan assets, and implementation of an annual gifting program. These planning ideas will be discussed in future articles.

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