PART 1

CHAPTER 1

Introduction to Estate Planning

WHAT IS ESTATE PLANNING?

Estate planning is an essential part of financial planning. Financial planning helps people plan for and meet their needs and wants during their lives. Education planning helps them educate their children. Insurance planning helps provide security against events such as disabilities or accidents. Retirement planning helps create a secure and pleasant retirement. Estate planning’s focus is the time and situations surrounding the end of life. People do not live forever; sooner or later, death will bring about a fundamental transition. Estate planning seeks to maximize end-of-life well being for the client and the client’s survivors. One definition of estate planning is “personal and financial planning for end-of-life transitions involving the transfer of personal responsibilities and financial assets and liabilities.”

There are two main threads in estate planning, the personal and the financial.

Planning for their transfer as part of the end-of-life transition is an essential element of both. Planning for the transfer of personal responsibilities for self includes such issues as healthcare, incompetence, management of property and personal care. Personal responsibilities for others include children and other dependants. Planning for the transfer of financial assets and liabilities includes ensuring assets are efficiently transferred to the chosen recipients and that liabilities are efficiently met. A major part of efficiency is minimizing the amount the government takes as taxes. Because all elements of estate planning are so closely intertwined, it is difficult to separate them. This text is used by students of financial planning so its main focus will be on financial issues and future wealth transfers. As estate size increases, the importance of taxes as a financial issue increases. Therefore, a major focus of this text is taxes and strategies and tactics for minimizing them.

Planning for future wealth transfers usually requires the preparation of contracts, such as life insurance policies and other documents including wills, trusts, deeds, and powers of attorney. These documents set forth in writing a blueprint for the future management of the individual’s financial affairs.

Successful estate planning requires an understanding of many areas of law including the law of property, wills, trusts, future interests, estate administration, intestacy, insurance, income taxation, gift taxation, and estate taxation.

How can knowledge of such an extensive subject benefit you, the reader? As a knowledgeable planner, you can help clients avoid the adverse consequences of inadequate or faulty estate planning. Here are some common situations that arise without proper planning.

EXAMPLE 1 - 1. Joanne died last week, survived by her husband and their two young daughters. Because Joanne did not write a will, the intestate laws of her state require that two-thirds of her $300,000 estate pass to her daughters, who will each, upon turning 18, receive the property outright from their guardian-father. The other one-third passes to Joanne’s husband. He is shocked that he is not inheriting it all and that as guardian of the daughters’ estates he must file annual accountings with the court. In addition to the problem of inefficient distribution, larger estates may owe both state and federal taxes—taxes that could have been minimized by estate planning.

EXAMPLE 1 - 2. Marge and Henry, parents of five-year-old twins, died suddenly without an estate plan. The probate court appointed Marge’s sister Julie as guardian for the twins. Marge and Henry had been quite critical of how Julie and her husband were raising their own children, but they had not expressed their concerns to anyone else and the court simply followed statutory guidelines in selecting Marge’s sister for the job.

EXAMPLE 1 - 3. Maggie was 80 when she died leaving an estate with a net value of $300,000. Six weeks prior to her death, she gave ABC common stock worth $90,000 to her son, Charlie. Maggie’s $14,000 basis in the stock became Charlie’s basis. Now, if he sells it he will recognize considerable capital gains. Had Maggie kept the stock until her death, giving it to Charlie at that time, he could have sold it at little or no income tax cost, because his basis would have been the stock’s value as of her date of death.

EXAMPLE 1 - 4. Shortly before Christine died at the age of 75, her family lawyer drafted a simple will, leaving her wealth (estimated to be $1,500,000) to her husband, Evan. He is quite ill and, since his own estate is worth about the same as Christine’s, he realizes that, as owner of all the family wealth, estate taxes may be due shortly when he dies. Most of the tax could have been avoided if Christine’s estate plan had just incorporated the sophisticated estate planning device known as a bypass trust.

EXAMPLE 1 - 5. Suppose that instead of receiving the property by will (as in the preceding example), Evan received it as surviving joint tenant. Evan’s estate would be faced with the same estate tax problem at his death.

EXAMPLE 1- 6. Leslie is the elderly founder of a highly successful real estate sales company. Unfortunately, she has not done any estate planning and is now very ill. Her children are struggling with several problems, including how to generate sufficient liquidity to pay the estate taxes and whether to sell the business. Because only a person with a real estate license (which none of the children have) can operate a real estate office, they fear that the business will sell for much less after Leslie dies compared to its value now. Indeed, it could have sold for even more money several years ago when Leslie would have been active in seeking buyers and working with them on a transition.

EXAMPLE 1 - 7. Elmer, a wealthy man, had a severe stroke three months ago. Unable to communicate, he is hooked up to machines that keep him alive. The doctors say his prognosis is very poor. His family realizes that they should have encouraged Elmer to consult an estate planner years ago while he was still able to express his desires. Documents could have been drafted that would have nominated a person or persons to manage his wealth during his incapacity and would have directed the eventual distribution of his wealth after his death. Other documents would have articulated the appropriate level of medical intervention. Whether the decisions of the doctors and the family concerning his care or the pattern of distribution mandated by the laws of intestate succession really match his desires will never be known. In addition, if the family cannot reach agreement on medical treatment, a costly court battle could ensue.

EXAMPLE 1 - 8. Several years before he died, at the advice of a friend, Marty executed a revocable living trust leaving all his property to several close friends rather than to the few relatives who had been rather cool to him for years. The trust was completed by filling in the blanks of a form photocopied from the pages of a popular “how to” book. Thinking that the trust took care of his estate, Marty tore up his will (the one that left everything to the same set of friends as specified in the trust). He failed to transfer his assets into the trust and he did not make a new will. A careful reading of the how-to book would have called to his attention the need to fund the trust by transferring assets to the trustee of the trust and the importance of something called a pour-over will. Marty did not realize that his self-made estate plan was ineffective in avoiding probate. Worse yet, it did not control who received his estate. Because he did not transfer his property to the trustee of the trust and because he died without a will, Marty’s estate will be distributed to his relatives in a manner specified in his state’s intestate succession laws.

EXAMPLE 1 - 9. At his death, Coldwell owned real estate in six states, including his state of residence. His simple will left his estate to his three children. In addition to the probate in his state of domicile, there were five ancillary probates, forcing Coldwell’s family to pay court filing fees and hire probate attorneys in all six states. Had Coldwell’s estate plan used a living trust, these probates (and their associated expenses) would have been avoided.

EXAMPLE 1 - 10. Many years before her death Lola bought Sammy’s $30,000 life insurance policy for $5,000. They jointly notified the insurance company to change the beneficiary to Lola and send all further premium notices to her address, but they did not request a change of ownership. Since Lola had worked in real estate, she insisted they complete a form called a “Bill of Sale” that she purchased at a stationery store, setting forth the details of the sale, including the identification of policy, and that Sammy sign it before a notary. She recorded this document at the county recorder’s office. Eventually Lola had paid sufficient premiums to pay the policy completely. After Lola went into a nursing home, Sammy used a change of beneficiary form supplied by the insurance company to change the beneficiary back to his daughter. After Lola died, her son discovered the Bill of Sale and contacted the insurance company only to learn that Sammy had died two years earlier and they had paid the proceeds to Sammy’s daughter. Because the company had never been notified of the change in ownership, they correctly followed Sammy’s change of beneficiary designation. His daughter might have been liable, but she lived in another state and claimed to have spent almost all the money. Lola’s son concluded that the amount he would have to pay lawyers and the uncertainty of collecting made it unrealistic to pursue his claim. If Lola had just had Sammy signed an irrevocable assignment of the policy to her and sent it to the insurance company, he would have been unable to change the beneficiary designation.

Problems like these occur because people tend to avoid estate planning or attempt “do-it-yourself” solutions that do not work in the manner desired. Lay people have many misconceptions about estate planning because it is a technical subject and the laws vary from state to state. Many people choose to ignore their estate planning needs because estate planning forces them to discuss matters related to their own death. Overcoming inertia often requires the thoughtful, caring encouragement of loved ones and the sensitive approach of the estate planner.

DEVELOPING AN ESTATE PLAN

Developing an estate plan should result in a set of recommendations and related documents that skillfully allow for the best use, conservation, and transfer of the client’s wealth. In 1996, the Certified Financial Planner Board of Standards, Inc., (the Board or the CFP Board) identified the following steps in the financial planning process: (1) establishing and defining the client-planner relationship; (2) gathering client data, including goals; (3) analyzing and evaluating the client’s financial status (an income statement and net-worth balance sheet); (4) developing and presenting financial planning recommendations and/or alternatives; (5) implementing the financial planning recommendations; and (6) monitoring the financial planning recommendations.

Establishing the Client-Planner Relationship

The planner must take the lead in explaining to the client the financial planning process. Some of the issues and concepts will already be familiar to the client, e.g., the purpose of a will, but other matters such as estate taxation or the use of trusts may be quite foreign. The role of the estate planner should be made clear and should be set forth in an engagement letter that spells out the services to be performed. The cooperation of the client is important to building a successful plan. So the planner must make the client aware of his or her responsibilities, including gathering information, working with the planner to implement the plan, and keeping the planner informed of changes that might require its modification.

Acquiring Client Facts and Goals

To make meaningful recommendations, the planner must acquire sufficient information about the client and the client’s family. Essential information must be collected to give the planner a fairly complete picture of the client’s family, his or her financial situation, and what the client expects to achieve by implementing an estate plan.

The importance of family. The estate planning opportunities for a wealthy married couple seeking to transfer an estate to the next generation are greater than those available for a single wealthy parent. Likewise, the estate planning needs of a young couple with minor children will be quite different from a couple whose children are grown. Family members may also be suitable choices for fiduciary positions such as executor, guardian, and trustee. The planner needs to be aware of special concerns, e.g., a child with special health needs or a child who is having drug addiction problems. In these situations, special trust planning that provides for long-term asset management may be appropriate.

The client’s financial situation and objectives. To understand the client’s financial situation, the planner will require several types of statements. First, he or she will need a current balance sheet, showing the fair market value of all assets and liabilities. Information on each asset should include the manner in which title is held, the date of acquisition, and current adjusted tax basis.

EXAMPLE 1 - 11. Relying on Marlene’s representation that all her property was in her name alone, an inexperienced planner failed to examine a copy of the deed, and prepared a will that left all her property to her husband. After she died, it was discovered that the most valuable parcel of real estate (acquired by Marlene long before the couple had married) was held in joint tenancy with Marlene’s niece. Of course, the niece became the sole owner.

For liabilities, the client should list the lender and the loan terms (maturity, a payment schedule, interest rate, collateral, etc.). In addition to a description of assets and liabilities, the planner will need a cash flow statement, describing sources of income and major categories of expenses.

The planner will also need other facts, such as information about the client’s expectation of receiving significant gifts or inheritances, and the names of the client’s other advisers, including accountants, lawyers, investment brokers, life underwriters, real estate agents, physicians, and religious advisers. Further, the planner will need a description of the client’s and the spouse’s financial objectives, a self-appraisal of their ability to manage their finances, and the location of any estate planning documents such as wills.

The process of gathering client data, organizing it and putting it in written form is extremely important even though it can be tedious. Often clients use the planner’s summary document as a convenient reference. Gathering information can alert a client to important issues so they can be considered calmly and preemptively rather than in the stress of damage control. For example, when gathering documents, a client may realize an insurance policy is misplaced and be able to make a simple call to replace it.

The client’s objectives. The planner also needs an understanding of the client’s objectives, especially with regard to dispositive preferences (i.e., the plan as to who gets what) for the spouse, the children, and charities; and whether significant transfers are likely to be made during the person’s life or only at his or her death.

Many planners develop questionnaires to help them acquire information as efficiently as possible and checklists to help them avoid overlooking important issues. A sample questionnaire is included in Appendix 1A at the end of this chapter.

The planner should routinely examine existing documents, such as the will and evidence of title to property. Too often, client questionnaire information is inaccurate. Double checking as much information as possible can help avoid mistakes that would be damaging to the client or embarrassing to the planner.

Analyzing and Evaluating the Client’s Financial Status

After acquiring the necessary facts, the planner will review the facts and prepare a plan making preliminary recommendations and, where appropriate, alternatives. The most common recommendations fall into two areas: financial planning for property transfers and personal planning for the client’s incapacity and death.

Developing and Presenting Recommendations and/or Alternatives

Financial planning for property transfers. The major purpose of the plan is to efficiently distribute the client’s wealth to the proper persons, in the proper amount, and at the proper time. To do this, the planner must keep in mind the following considerations that relate to more specific estate planning goals:

•Deciding whether to use a trust or some other means to avoid probate as a means of transferring property at the death of the client

•Examining alternatives to reduce and possibly eliminate transfer taxes at the death of the client and the client’s spouse

•Considering lifetime transfers, partly to reduce transfer costs and partly to shift taxable income to a person with a lower tax bracket

•Arranging to provide the needed liquidity at the client’s disability or death

•Devising a strategy to unwind the client’s business affairs in a manner that maintains the greatest income and value for the survivors

Personal planning for incapacity and death. Personal planning for a client’s incapacity tends to focus on arranging for someone to care for the client and the client’s property if the client becomes incapacitated. It may also include making funeral or cremation arrangements, and assuring that at the time of death certain religious formalities will be faithfully followed. Personal planning also includes the important task of arranging for someone to care for the client’s children if both parents become incapacitated (or die) before the children reach adulthood.

Because this text is primarily devoted to these and other objectives and techniques, further explanation will be provided in subsequent chapters.

Implementing the Plan

After the specifics of a plan are agreed upon, the planner and client should implement it. Transfer documents are drafted by an attorney and executed by the client. An insurance agent may be needed to secure the appropriate insurance contracts. If a trust is included in the plan and the client wants a bank trust department named as either initial trustee or as a successor trustee, one of the bank trust officers should be contacted for authorization and advice before the trust document is completed. The trust officer may want the bank’s legal department to review the document to make sure that its terms are ones they are willing to carry out. The client should feel comfortable with the bank trust department’s personnel, including their investment philosophy and how they interact with trust beneficiaries.

A person “executes” a document by taking all of the steps necessary to render it valid. For example, execution of a will normally requires, among other things, that the client sign the will in the presence of witnesses who, by their own signatures, attest to the authenticity of the client’s signature. Other documents have other technical requirements such as a simple signature or a notarized signature.

Monitoring the Financial Planning Recommendations

Depending on the scope of the engagement, part of the estate planning process may include monitoring the estate plan over a long period of time. Laws change, and the client’s personal situation and objectives may change. By keeping current, the planner can periodically suggest appropriate revisions to the plan. Events that are likely to require plan revision include marriage, divorce, birth of a child, new legislation, and new court decisions.

For example in 1981, Congress passed the Economic Recovery Tax Act (ERTA) which made many significant changes to the federal transfer taxation laws. One major change involved the taxation of property passing at death to a surviving spouse. Prior to the change, wills and trusts of wealthy individuals were likely to contain a provision that had the effect of passing to the surviving spouse only half of the decedent’s estate, because that was the maximum amount that qualified for the marital deduction.

However, for transfers that occurred after 1981, the maximum marital deduction increased to cover the person’s entire estate so long as it was left to the surviving spouse. Concerned that many clients whose estate plans were drafted with the old maximum in mind might not want to leave their entire estate to their spouses, Congress included a transition rule that had the effect of limiting, for most estates, the transfer to the surviving spouse of half of the decedent’s estate if the plan used words like, “I leave to my spouse the maximum amount that qualifies for the marital deduction.” The transition rule required the phrase be interpreted as though it said, “I leave to my spouse the maximum amount that qualifies for the marital deduction based upon the law in effect at the time this document was executed.” Thus, people who wanted the new 100% marital deduction had to change their wills to get it even though the language they originally used should have had that effect.

The 100% marital deduction became available to those who revised their plans after the law changed, and the estate plans for those people living (dying) in states that passed legislation that said “maximum marital deduction” are to be interpreted to mean the maximum under the new federal law. Thus, most transfer documents had to be revised to take advantage of the more beneficial tax provisions. Many planners contacted their clients to encourage them to update their plans in light of the new law. Chapter 18 has a discussion of the use of disclaimers and other postmortem tax planning techniques to remedy some of the problems that may occur for wealthy clients who die without revising their pre-ERTA estate plans.

THE ESTATE PLANNING TEAM

Generally, estate planning is not conducted by just one professional. The job requires the diverse knowledge and skills of a number of practitioners, including attorneys, accountants, life underwriters, trust officers, and financial planners. These professionals are referred to as the estate planning team. Next, we describe the unique contribution each team member makes to the overall planning process.

Attorney

In most states, only an attorney may legally accept payment for rendering legal advice and drafting legal documents. This makes the attorney an indispensable team member in the estate planning process. If the documents are to correctly express the client’s estate plan, their preparation requires an attorney with the ability to make precise legal distinctions. The working years for these documents may be measured in decades, operating long after the client is deceased, and they are likely to be viewed as the final authority concerning the client’s estate planning objectives. Thus, by putting an estate plan in print, the attorney puts his or her professional skill to the test. Eventually, the results (good or bad) will be there for all to see.

Most attorneys accept the responsibility of coordinating the actions of the other members of the estate planning team. This is especially true if the attorney specializes in estate planning and taxation.

The attorney’s role might not end at the client’s death. He or she may be hired to advise the personal representative of the deceased client’s estate. The attorney is likely to aid in the transfer of the client’s assets to surviving beneficiaries or in the allocation of assets to various trusts. In addition, the attorney may engage in postmortem tax planning, a job which, as we will see in Chapter 18, entails choosing certain tax options available after the client’s death and the preparation of various estate tax returns.

Accountant

By preparing the client’s financial statements and yearly tax returns, the accountant is likely to be the professional having the earliest and most frequent contact with the client. Typically, these forms are so financially revealing to accountants that financial planners have described them as the client’s “annual financial report.”

The accountant is often able to spot specific financial problems requiring attention, especially with regard to the client’s business interests. Perhaps the accountant’s most important service to the client, insofar as estate planning is concerned, is in encouraging the client to begin the estate planning process. Once the process begins, the accountant may be hired to prepare the client’s financial balance sheet, income statement, and cash flow statements. After the client’s death, the accountant will probably be called upon to complete the required income tax returns and, if necessary, the estate tax returns.

Life Underwriter

The life underwriter’s crucial role is to help the client select appropriate insurance to meet the liquidity needs that arise in the event of the client’s disability or death. The efficient use of life insurance requires an understanding of estate planning to minimize transfer costs and assure an adequate level of financial support for the client’s surviving beneficiaries.

Given life insurance’s natural connection to wealth transfer planning, the life underwriter may be the first professional to recommend estate planning to the client. He or she may therefore be in a position to select the other members of the client’s estate planning team.

Trust Officer

A skilled professional executor and trustee, the trust officer performs fiduciary services for clients and estates. A fiduciary is a person having a legal duty to act for the benefit of another. The word fiduciary is derived from the Latin word for “trust.” A fiduciary is any person in a position of trust, loyalty, and confidence, who has the legal duty to act for the benefit of another person, putting that other person’s interests above his or her own. Besides trustees, fiduciaries include executors, administrators of estates, guardians, and agents (see Chapter 2 for a further discussion).

If selected to serve as the executor of the client’s estate, the trust officer manages assets that are transferred through the probate process. Similarly, if selected to serve as trustee of a trust created by the client, the trust officer manages assets placed in the trust. Thus, the trust officer can be particularly helpful in the planning stage on the long-term management of assets. It is wise in the planning stages to determine what parameters have been set by various trust departments with regard to the trusts or estates each is willing to handle. Some bank trust departments will not accept a fiduciary position for estates below a certain size, such as those below $500,000. They may also be reluctant to serve as trustee if too much supervision of a beneficiary is expected or if the trust is expected to retain assets that are difficult to manage.

EXAMPLE 1 - 12. Martha’s trust named her local bank’s trust department to serve as successor trustee of her living trust. After her death, the trust is to provide income during the life of her son, Curtis, and after his death, it is to be distributed to his issue (children, grandchildren, etc.) if any. Otherwise, it will be distributed to Martha’s brother William, or William’s issue. Because Curtis had a long history of substance abuse, the trust had a clause that required the trustee to withhold distribution of income if Curtis failed to stay free of drugs and alcohol. It also allowed the trustee to distribute trust corpus (trust principal) if the trustee thought it would contribute to Curtis’s well-being. When Martha died, Curtis was 50, unemployed, and childless. Since the bank’s trust officers had not been consulted when the trust was drafted, the bank refused to serve as trustee. It considered the responsibility of deciding when and whether to distribute income and corpus to Curtis to be too great a burden. *** Query 1. What risk would the bank take if it accepted the job of trustee?