Estate planning is concerned with the use, conservation and disposition of a person's property and wealth. This involves two elements: (1) minimizing the gift or estate tax consequences that occur when a person's property is passed to another either during life or at death; and (2) provisions for taking care of the decedent's spouse and family.
Both elements can be enormously complex, interrelated and often operate inversely. For instance, the goal of providing more for one's children or grandchildren and less for a surviving spouse may cause adverse estate tax consequences. This summary describes the fundamentals of estate planning.
I. DEFINITIONSThere are four main methods by which property is transferredat death:
1. WillA will is a written document that takes effect at the death of the person signing it (the "testator"). A will covers all property owned by the testator at death. A state court proceeding ("probate") is instituted and the provisions of the will are implemented under supervision of the probate court. Both the tax and family estate planning objectives of the decedent can be accomplished with a will.
2. Living TrustA living trust (sometimes called an "inter-vivos" trust) is a document that is revocable at any time by the person signing it ("grantor"). Living trusts have become quite popular as a method to avoid probate. To avoid probate, the trust must be funded; this means that title to the assets which the grantor owns personally must be actually transferred to the trust -- real property is deeded to the trust; bank accounts are switched to the trust; and stocks, bonds, partnership interests and other holdings are assigned or transferred to the trust.
NOTE : The grantor is usually the trustee and beneficiary of the trust during his or her lifetime.
Use of a Will vs. a Living Trust : Generally, with either a will or a trust the same estate tax consequences occur, and the same opportunities for tax and family planning are available. The debate over the value of each often centers around the savings of the costs incurred in a probate proceeding which typically run between 2 to 4 percent of the value of the probate estate. While a living trust which is fully funded with the grantor's assets prior to his or her death will eliminate probate, there may be advantages to probate which are also lost. In addition, the initial cost and maintenance of the living trust must be considered.
A realistic assessment of the net savings in using a living trust would be approximately 1 to 2 percent of the gross estate; an estate of $1,000,000 should save between $10,000 and $20,000 by using a living trust instead of a will.
The savings must be counter-balanced by the administrative burden of maintaining the assets in the trust over the period of one's life. There are other, non-economic advantages for using a trust which merit consideration such as privacy (a trust is not probated in open court) and upon the incapacity or death of the grantor, the trust continues to operate without court intervention.
3. Joint TenancyJoint tenancy is a method of holding title to property when two or more people own property together, but the last survivor will own the property outright. When a joint tenant dies, their interest goes automatically to the survivor; there is no probate and a will or living trust has absolutely no effect on joint tenancy property.
There may be adverse tax consequences to the joint tenant who dies first. There is a presumption that the entire fair market value of the property is part of the decedent's estate for estate tax purposes, unless the surviving joint tenant can prove (through financial records) the amount of their share of the payments made towards the purchase, improvement or upkeep of the jointly held property. For instance, if the surviving tenant can prove they made a 30 percent contribution towards the purchase, improvement or upkeep of the property, then 70 percent of the property will be included in the deceased tenant's estate for estate tax purposes.
4. Community PropertyCalifornia is a community property state which means that any earnings and assets acquired during the marriage belong equally to both spouses, regardless of who actually earned the income. Property acquired before marriage, or gifts and inheritances received by one spouse during a marriage, are generally the separate property of that spouse.
Upon the death of either spouse, the community property is split equally and the surviving spouse receives his or her share of community property outright. The deceased spouse's 50 percent share of community property is part of his or her estate and is subject to his or her will or living trust.
II. The Gift and Estate Tax Aspect To Estate PlanningThere are five basic tax concepts to estate planning:
1. Gift TaxA person may make a gift of $10,000 per year per recipient ("donee") without incurring a federal gift tax. There is no longer a California gift tax. For a married couple, the amount is $20,000 per year, per donee. In order to qualify, the gift must be completed presently; the gift cannot be placed in trust unless the beneficiary has the right to withdraw it within a reasonable period after the gift is made. In most circumstances, it is the person making the gift ("donor") who is taxed, not the donee.
2. Estate TaxThe federal estate tax is a tax levied on the property owned by the decedent at death. The tax is paid by the estate for the privilege of passing property to the donee(s). The tax is based on the fair market value of the property at the date of death or on the alternate valuation date (discussed below). California has eliminated a separate estate tax on the decedent's property.
3. Stepped-up Basis at DeathWhen a person dies, all assets owned by the decedent are valued at their fair market value, usually by appraisal, by the person (the executor of the will or trustee of the living trust) filing the federal estate tax return. The determination of fair market value is generally made as of the date of death, however, there is an alternative valuation date of 6 months after death available for estates that have decreased in value.
As a corollary to this rule, the tax basis of the decedent's property is "stepped-up" to the estate tax valuation amount. Tax basis refers to the value of the property for computing gain or loss. It is usually the cost of the property plus improvements and less any depreciation.
For example, if the decedent dies owning stock which they purchased for $5, but has a current value of $100, the full $100 value is used to determine the estate tax. The stock then receives a stepped-up basis of $100 in the hands of the donee. No income tax will be paid by the donee on the subsequent sale of stock for $100 or less; income tax will only be paid on the sale of stock for an amount in excess of $100 and only for that excess amount.
With community property, even though 50 percent passes outright to the surviving spouse, both portions of the community property receive a stepped-up basis at the death of the first spouse. If a married couple owns a house worth $500,000 which has a tax basis of $45,000, the tax basis for the entire house (both community property shares) is stepped-up to $500,000 upon the death of the first spouse, and a later sale of the house for $560,000 will result in only $60,000 in gain. A sale of the house for the same amount prior to the death of the first spouse would have caused a $515,000 gain.
The stepped-up basis rule does not apply to certain income the decedent earned prior to death. This income is considered income in respect to a decedent ("IRD"). IRD includes income from property sold prior to death, unpaid compensation and retirement benefits.
4. The Unified Estate and Gift Tax Credit and the Credit Exemption TrustEach person is entitled to a lifetime credit of $600,000 for gift and estate taxes called the "unified credit." This credit applies to gifts made over and above the $10,000 annual gift tax exclusion discussed previously. If a person makes an annual gift to a single donee of $50,000, then the additional $40,000 - which does not qualify for the annual gift tax exclusion - will reduce the unified credit from $600,000 to $560,000. The unified credit is phased out for estates over $10 million.
The unified credit may be used for property left to any donee, either outright or in trust. In a typical estate plan the unified credit amount is used by creating a trust for that amount for the surviving spouse during his or her lifetime. Upon the surviving spouse's death, the children would then become the beneficiaries of the trust. This trust is sometimes called an "exemption trust" or a "by-pass" trust since it is exempt from estate taxes and by-passes the surviving spouse's estate. The exemption trust may provide the surviving spouse with the following rights during his or her life without causing the trust to become part of the surviving spouse's estate for estate tax purposes: (1) all the trust's net income may be payable to the surviving spouse; (2) the trust's principal may be applied to the surviving spouse for their health, support, maintenance and education ("ascertainable standards"); and (3) the surviving spouse may have the noncumulative right to withdraw the greater of 5 percent or $5,000 of trust principal per calendar year for any reason ("5&5 power").
The unified credit plays a major role in estate planning because there is no estate tax for estates that are less than or equal to the unified credit. In most circumstances, there is no estate tax on estates of $600,000 or less.
5. The Marital Deduction and the Marital Deduction Q-TIP TrustThe decedent's gross estate is entitled to deduct all amounts passing to a surviving spouse which qualify for the marital deduction. The marital deduction can become extremely complicated, but it represents the most important deduction available to married couples. Property which passes to the surviving spouse under the marital deduction escapes taxation on the death of the first spouse, but that property then becomes part of the surviving spouse's estate for estate tax purposes. Oftentimes, because the surviving spouse is in a higher tax bracket, property passing under a marital deduction is taxed at a higher rate at the death of the surviving spouse.
The marital deduction applies to property that is left: (1) outright to a spouse; (2) in trust in which the spouse has the right to withdraw any or all of the property during their lifetime; and (3) property which is left in trust for the spouse's life under a Q-TIP ("qualified terminable interest property") trust.
A Q-TIP trust is an exception to the general rule that to qualify for a marital deduction, property must be left outright to the spouse or in trust in which all the principal may be withdrawn by the spouse. A Q-TIP trust may qualify for a marital deduction if the spouse is entitled to receive all the trust's income at least annually and during the spouse's lifetime, no person, including the spouse, is permitted to appoint any trust property to anyone other than the spouse. The person filing the estate tax return must properly elect to take a marital deduction for the Q-TIP trust.
The advantage of the Q-TIP trust is that the desires of the decedent spouse will control the ultimate disposition of the trust's assets, and the decedent's estate retains the benefit of the marital deduction. On the death of the surviving spouse, the assets in the Q-TIP trust are taxed in the surviving spouse's estate, but any increase in estate tax resulting from this inclusion is generally taken directly from the Q-TIP assets, not from the surviving spouse's other assets.
By prudently combining the unified credit with the marital deduction, the estate of the first spouse will pay no estate tax. The surviving spouse also has a unified credit that can be applied to any estate tax owing at their death. Therefore, for estates under $1,200,000 (2 x $600,000), assuming no increase in value during the time between the death of the first spouse and second spouse and assuming no reduction of the unified credit for either spouse, a properly structured estate plan eliminates taxation on both spouses' estates through the maximum use of the unified credit.
III. Using the Unified Credit in Estate PlanningAssume that:
- a married couple has all their assets as community property;
- the value of that community property is $1,000,000;
- the husband is the first to die and the wife lives another 8 years;
- the couple has two children; and
- no gifts were ever made that exceeded the annual gift tax exclusion.
Upon the death of the husband, the husband's estate (50% ofthe community property) is worth $500,000 and his wife retains her 50% share of the community property ($500,000). The husband's estate will pay no estate tax since his unified credit is worth $600,000.
Example 1 : If the husband leaves all his property outright to this wife, then his wife will have an estate totaling $1,000,000. On the death of his wife, assuming no growth in her estate, she will now have a $1,000,000 estate subject to estate tax, but a unified credit worth only $600,000. This means her estate will be subject to estate tax on the balance of $400,000. The tax will be $153,000 according to the current tax rate schedule.
Example 2 : Same facts as Example 1 except husband left his property to an exemption trust, which permitted his wife the right to receive all the income from the trust during her life and certain other powers (such as the power to invade the principal under an ascertainable standard and the 5&5 power discussed previously). Upon her death the trust assets could then be divided between the couple's two children and the exemption trust would not be part of the wife's estate for estate tax purposes. Upon her death, her estate would be worth $500,000 and her unified credit worth $600,000 would eliminate any estate taxes.
If we assume a 4% growth rate during the 8 years she outlives her husband, then under Example 1, her estate will appreciatefrom $1,000,000 to $1,368,600 and the estate tax will be $255,000.
Under Example 2, her estate consists of her share of community property valued at $500,000 which will appreciate to $684,285 and the estate tax will be $19,400, a reduction of $236,150.
IV. Non-tax Aspects of Estate PlanningCouples with minor children need to carefully plan their estates, although the focus is usually on taking care of the children rather than saving estate taxes. The major assets are usually life insurance and the family home. In case of the deaths of both parents, provisions for the guardian(s) for the children and trustee(s) for the property must be carefully considered. While the funding of these trusts might follow the exemption trust and marital deduction trust pattern, the exemption trust is geared for the care and support of the children.
Also, decisions must be made such as: Should the trustee(s) save and conserve the trust estate for the college education of the children? At what ages should the children receive the trust principal and what amounts and when? All at 21? Half at 25 and the remaining principal at 35? What happens if the children die without having any children? Who then receives the property? The decedent's family, a specified charity or charities?
A carefully planned estate will cover a variety of remote contingencies, provide for the continuing personal and financial care and support of the decedent's spouse and family, and reduce or eliminate estate taxes.