estate and the probate estate are generally less than all
property owned; the net estate is less because liabilities are subtracted, and
the probate estate is less because many things owned, such as those held in
joint tenancy and life insurance, pass outside the probate process. The gross
estate will equal or exceed the value of all property owned because it includes
all things owned and may also include things that are not owned, such as gift
taxes paid on gifts made within three years of the donor’s death. In Chapter 6
we will cover the concepts of the gross estate and the taxable estate in
detail.
CONCEPTS DEALING WITH TRANSFERS OF PROPERTY
One of the primary areas of emphasis in estate planning is
the transfer of property. This section will cover the terminology used in this
area.
Transfers of Legal, Beneficial, or Legal and
Beneficial Interests
A transfer or assignment of property refers to any
type of passing of property in which the transferor
gives up an interest to the transferee. The interest transferred can
be purely legal, purely beneficial, or both legal and beneficial. Legal interest refers to a situation
where title passes. For example, an independent trustee of a trust takes title
to all trust assets in order to manage the trust property, but cannot use it in
a manner inconsistent with the trust agreement. A mother who takes title as
custodian of a bank account established for her child’s benefit under the
Uniform Transfers to Minors Act[1] has legal title, but the beneficial
interest is owned by the child.
On the other hand, a purely beneficial interest occurs when a transferee receives something that carries
an economic benefit, but not title. Examples of beneficial interest in property
include the temporary or permanent right to possess, consume, pledge, or
otherwise benefit from property. If a friend lends you her car while your car
is in the shop, you have a beneficial interest in the car without having title.
As we will see, a trust beneficiary’s rights are purely beneficial.
Finally, an interest given up by the
transferor can be both legal and beneficial, such as where the transferee
receives both title and the beneficial interest. An outright transfer occurs
when one receives both legal and beneficial interests, without restrictions or
conditions, as typically happens when one person gives another a birthday
present.
Complete Versus Incomplete Transfers; Property
in General Versus a Specific Property Interest
Complete versus
incomplete transfers: overview. A transfer of property is said to be complete and irrevocable when it is no longer rescindable or amendable (i.e.,
when the transferor has totally relinquished all dominion and control over that
property). For example, after purchasing this book, at the expiration of the
returns period, you have made a completed transfer of money. On the other hand,
a transfer is said to be incomplete
and revocable while it is still
rescindable or amendable (i.e., made without total relinquishment of dominion
and control over that property).
Property in general versus an interest in
property. To fully distinguish
between complete and incomplete transfers, one must grasp the difference
between property in general and a specific interest in property. Property in general, such as 100 shares
of ABC stock, means the entire asset, whether physical or intangible, including
all rights and interests that go with ownership. In contrast, an interest in property means one or more
rights to property, such as the right to the first five years of dividends from
the 100 shares of ABC stock.
In estate
planning, more than one interest in a piece of property may be transferred in a
way that highlights the divisibility of the interests associated with property
ownership.
EXAMPLE 2 -
1. Tom transfers 100 shares of stock in
trust to Terry. The trust terms give Alan the right to all income for five
years, followed by Barbara having the right to receive income for ten years,
and finally, after 15 years, the trust is to terminate with the trust assets
distributed to Carl. Each person has received an “interest” in the stock.
Terry’s interest is a legal one (title), Alan and Barbara each have a
beneficial one, and Carl’s interest is both beneficial and legal. We’ll take a
more detailed look at trusts later in the chapter.
Complete, incomplete, and partially
complete transfers. A transfer of
each specific interest in property is either complete or incomplete, while the
transfer of more than one interest can be either totally complete, partially complete, or totally incomplete.
EXAMPLE 2 -
2. Continuing with the same facts as
above, if Tom retained the right to revoke or amend the entire trust, his
transfers of property into trust would be incomplete. On the other hand, if Tom
retained the right to revoke or amend only Alan’s interest, the transfer of
Alan’s interest would be incomplete, the transfer of Barbara and Carl’s
interests would be complete, and Tom’s overall transfer of the stock would be
said to be partially complete.
Finally, if Tom retained no rights whatsoever over the stock, the transfers of
interest to Alan, Barbara, and Carl would all be complete.
When we study
gift taxes, it will become clear that this issue of whether a transfer is
complete or incomplete is important because gift tax law treats completed
transfers, even of just a partial interest, as gifts subject to gift taxation.
Sale Versus Gift
Most commonly, completed transfers of property interests
are undertaken by sale, by gift, or by a combination of both sale and gift. A sale is a transfer of property under
which each transferor exchanges consideration
regarded as equivalent in value. By contrast, a gift is a transfer of property
for which the transferor takes back little or nothing of economic value in
exchange. The most common methods of making gift transfers are outright and in trust.
A bargain sale. A bargain sale occurs when a person (the
transferor) knowingly transfers property in exchange for property with an
economic value less than the property he or she is giving up. A bargain sale
involves a transfer that is a part sale and part gift. The notion of the
bargain sale requires us to define a gift somewhat more broadly than in the
last paragraph. Usually a gift is something given with nothing in return;
however, a bargain sale is obviously a gift, even though property is received
in exchange. Federal tax law treats the actual amount of the gift as the
difference between the respective values of the consideration exchanged. Thus,
a transfer during the life of the transferor will be either a gift or a sale,
with a gift defined to include a bargain
sale (i.e., an
exchange of considerations of unequal value, where the
parties know and intend them to be unequal).
Inter Vivos Transfer Versus Transfer at Death
A transfer of property can be inter vivos, meaning that it is made while the transferor is alive,
or it can be made at death. Inter vivos
is Latin for “among the living.” Transfers at death may be made pursuant to a
valid document, also called an instrument,
prepared by the owner before death (e.g., will, trust, title by joint tenancy,
or insurance beneficiary designation), or pursuant to state law (intestate
succession) in the event that no such document exists.
Fair Market Value of Transfer
The value of a transfer is measured by its fair market
value at the time of the transfer. Determining fair market value is the subject
of several sections in the text. A generally accepted definition of fair market value is “the price at which
the property would change hands between a willing buyer and a willing seller,
neither being under any compulsion to buy or sell, and both having reasonable
knowledge of the relevant facts.” The IRS uses this definition in the
regulations for valuing gifts and estates.[2]
BENEFICIARIES
A beneficiary or donee is a person who receives a gift of
a beneficial interest in property from a transferor. The transferor is called a
donor. Although, in the most general
sense, donee and beneficiary are synonymous, in certain contexts one or the
other term is more commonly used. For example, the recipient of an outright inter vivos gift from the donor is
usually called a donee. On the other hand, the recipient of a bequest by a will
or an interest in a trust is usually called a beneficiary. Occasionally, the
term donee is used to describe one
who has received something without also receiving any beneficial interest, such
as where one is given a limited power of appointment, an estate planning tool
discussed later.
WILLS, TRUSTS, AND PROBATE
In estate planning, a decedent
is a person who has died. When a person dies, property owned by the decedent
must be transferred. Each state takes special interest in ensuring that all
property owned by the decedent is transferred to the proper parties. State law
recognizes certain documents prepared by the decedent (wills, trusts, joint
tenancy arrangements, life insurance policies, etc.) as legally binding guides
for the proper disposition of the decedent’s property. A will is a written document that expresses a person’s desired
distribution of his or her property at death. The person making a will is
called the testator. The will is said
to make testamentary transfers, and
the actual process by which transfer is accomplished is the probate process. At
the death of a person, his or her will controls the transfer of property only
if there is no guide to the transfer that is recognized as superior. Thus, the
will controls property in the decedent’s name alone or held with another as a
tenant in common, but not property held in trust or in joint tenancy. Property
held in trust will be transferred according to the terms of the trust, not
according to the terms of the settlor’s will. Any attempt to transfer joint
tenancy property by a decedent co-owner’s will must fail since the right of
survivorship prevails over provisions in a will.
A trust is a
fiduciary relationship in which one person (the trustee) is the holder of the title to property (the trust estate or the trust corpus), subject to an equitable obligation to keep or use
the property for the benefit of another (the beneficiary). The trust
instrument is the written agreement between the settlor (the person creating and funding the trust) and the trustee that sets forth for whose
benefit the trust is created, how the trust estate is to be managed, its
duration, and to whom the corpus must be given when the trust terminates.
Trusts are described in greater detail later in the chapter.
Intestate, testate, and partially intestate. If a valid will is found, the decedent is
said to have died testate. If the
will does not dispose of all the decedent’s property, the decedent is said to
have died partially intestate. If no
will is found, the decedent is said to have died intestate. However, if all property is disposed of by alternative
means (e.g., trusts, joint tenancy), a will may not be necessary, and the
absence of a will would not cause any problems as there would be no property
without some mechanism of transfer.
In some cases,
the moment that death occurs has significance because it determines the rights
of beneficiaries, and, quite obviously, it is extremely important if the dying
person has authorized organ donations. The Uniform Determination of Death Act
addresses this issue by defining death as follows:
§ 1. [Determination
of Death]. An individual who has
sustained either (1) irreversible cessation of circulatory and respiratory
functions, or (2) irreversible cessation of all functions of the entire brain,
including the brain stem, is dead. A determination of death must be made in
accordance with accepted medical standards.[3]
Probate and the personal representative. Probate is the legal process of
administering the estate of a decedent. The probate estate consists of all
property belonging to the decedent for which there is no other mechanism of
transfer. Thus, the probate estate is that property whose disposition is guided
by either the decedent’s will or the state laws of intestate succession.
Generally, probate assets fall into
one of three groups: property owned by the decedent as an individual, interests
of the decedent held with others as tenants-in-common, and, in some community
property states, the decedent’s one-half interest in community property. Some
community property states, such as California, no longer require a probate for
property going to the surviving spouse whether that property is the decedent’s
half of the community property or is the decedent’s separate property. Non-probate assets include property held
in trusts or in joint tenancy, the proceeds of most insurance policies on the
life of the decedent (unless payable to the decedent’s estate), and most
retirement plan assets. Many of these terms will be described later in the
chapter.
In probate administration,
the judge of the probate court determines the validity of the will, if any, and
(after a period of administration) authorizes distribution of the probate
estate to creditors and beneficiaries. The court appoints a personal representative to act as
fiduciary to represent and manage the probate estate. If the court appoints the
person nominated in the will to be personal representative that person is
called the executor. In some states,
a female personal representative is called an executrix, however the trend is to use the term executor regardless
of gender. An administrator is a
person appointed by the court to represent the estate of a person who died
intestate. At times courts appoint someone other than the person(s) nominated
in the will. The person nominated may have predeceased the testator, may be
incapacitated, or perhaps is unfit (e.g., is serving time in prison for bank
robbery). If the decedent died with a valid will, but the court appoints
someone other than the person nominated in it, the personal representative is
called an administrator with will annexed.
The word
“fiduciary” is derived from the Latin word for “trust.” A fiduciary is a person in a position of trust, loyalty, and
confidence, who has the legal duty to act for the benefit of another, putting
that person’s interests above his or her own. Besides personal representatives,
fiduciaries include trustees, guardians, and agents.
Recipients of probate property. Beneficiaries of a decedent’s probate
property are called heirs, devisees, or legatees. An heir is a person who inherits property from a decedent whether by
will, intestate succession, or any other mechanism of transfer such as through
a trust or by joint tenancy. Heir at law
refers to the person (or persons) who have a right to an intestate decedent’s
property. This is usually accomplished by defining them as included in the
issue of the adoptive parent. Degrees of blood relationship, which are
important in determining heirs at law, will be covered in Chapter 4. A devisee is a beneficiary, under a will,
of a gift of real property. A devisee is said to receive a devise. A legatee is a
beneficiary, under a will, of a gift of personal property. A legatee is said to
receive a legacy or a bequest. The trend in modern usage is to
use the term bequest for any testamentary gift, whether of real or personal
property. The Uniform Probate Code, discussed in the next chapter, uses the
term “devise” both as a noun and a verb, to mean a bequest or the act of making
a bequest (whether of real or personal property) in connection with transfers
by will.
Issue refers to a person’s offspring or
progeny, including children, grandchildren, great-grandchildren, and the like.
A descendant is one who is descended
from a specific ancestor. Thus, the terms issue and descendants are used
interchangeably. Most state succession statutes treat adopted children as
though naturally born to their adoptive parents.
Types of bequests. Bequests are categorized as specific,
pecuniary, general, residuary, and/or class gifts. A specific bequest is a gift of a particular item of property capable
of being identified and distinguished from all other property in the testator’s
estate, e.g., “I leave all my household furnishings to Sally Ann,” and “I leave
my high school ring to my brother Bill.” If the property subject to a specific
bequest is sold, given away, or lost before the testator’s death, under the
common law doctrine of ademption
(from the Latin ademptio - a taking
away) the bequest fails, meaning the person does not receive anything to
replace the missing property. Although most states follow the common law
doctrine, some states’ statutes have exceptions that do not result in ademption
in certain circumstances, e.g., an asset was acquired by the decedent in a
manner that made it clear it was intended to replace specific devised real or
tangible property.[4] A general
bequest is a gift that can be satisfied out of the general assets of the
estate, e.g., the bequest “I leave 10 percent of my estate to my brother
Henry.”
At common law the term legacy meant a testamentary gift of
money; however, it has come to mean any bequest. Pecuniary bequest is the term used to describe a bequest expressed
as a specific dollar amount. It is called a pecuniary bequest even though the
executor has the option of satisfying it with cash or with assets worth the
specified dollar amount. Since the bequest could be paid from any account, or
be satisfied by the transfer of any asset not specifically bequeathed, a
pecuniary bequest is a type of general bequest. Pecuniary bequests are commonly
found in complex estate plans aimed at minimizing death taxes. The bequest is
likely to be expressed in terms of a formula, such as “I leave to my spouse the
least amount needed to reduce my death taxes to zero.” A pecuniary bequest is
distinguished from a fractional share
bequest, which uses fractions (or percentages) in defining the interests of
beneficiaries to certain property or to a portion of the estate (e.g., “I leave
65 percent of the residue of my estate to my sister Gladys, and the other 35
percent to my brother Marco.”)
What remains of the estate after all the
foregoing bequests are taken into account is called the residue of the estate. A residuary
bequest is a gift of that part of the testator’s estate not otherwise
disposed of by the will, e.g., “I leave the rest of my estate to Robert Moon.”
Generally, debts are paid out of the residue and not charged against the
specific bequests.
A class
gift is a gift to a group of individuals that may not be completely defined
at the time the gift is made (e.g., “I leave the residue of my estate to my
grandchildren living at the time of my death.”)
Occasionally, a testator dies leaving
insufficient assets to satisfy all bequests and pay all creditors. Under the
procedure called abatement, bequests
are eliminated or reduced so that all debts (and administration expenses) are
paid in full, or else the estate is exhausted. In those states that follow the
Uniform Probate Code (UPC), shares of the beneficiaries abate in the following
order: (1) probate property not disposed of in the will, if there are no
residuary bequests, (2) residuary bequests, (3) general bequests, and (4)
specific bequests. Some state statutes abate gifts to a spouse, or to issue,
only after abatement of gifts to persons not related to the decedent.
EXAMPLE 2 - 3.
Lawrence died in a UPC state. Lawrence’s will leaves his car to his son,
Sam, $20,000 cash to his sister, Vira, and the residue of his estate to his
wife, Mary Ellen. Assume that at his death Lawrence owned only the car and
$25,000 in cash, and he owed $6,000 in debts. Most states (perhaps all) would
require the $6,000 debt be paid, leaving just $19,000 in cash. The UPC
abatement would result in Vira getting the $19,000 balance, the car would go to
Sam, and Mary Ellen would receive nothing.
Disclaimers
Most people would welcome a large bequest, especially if it
came from a distant relative. After all, such gifts may make for financial
security. Yet there are times when it makes sense for a beneficiary to refuse a
gift or bequest. A disclaimer is an
unqualified refusal to accept a gift or bequest. Disclaiming may be preferable
when it avoids, reduces, or delays transfer taxes. Usually, a person will
disclaim property only if it will then pass to a person the disclaimant wants
to have it.
To be tax-effective, the disclaimer must meet
the requirements of both state property law and federal tax law. Under property
law, a disclaimant is treated as having predeceased
the decedent-donor. Consequently, the disclaimed property will pass under one
of two possible sets of legal guidelines. Either it will pass to the “alternate
taker” in accordance with the terms of the decedent’s transfer document (which
is usually a will or trust) or, if no such document exists or if the document
does not name an alternate taker, the property will pass under laws of
intestacy.
EXAMPLE 2 -
4. Bachelor Barry died recently, and
his will left an estate valued at $500,000 to his brother Mike, if living,
otherwise to Mike’s issue. Mike, age 87, wealthy and in poor health, has three
living children. If he immediately disclaims the inheritance, it will pass
under the will to his children. The transfer will not be treated as a gift from
Mike, but rather as though it passed to them directly from Barry.
EXAMPLE 2 -
5. Changing the facts in the previous
example a bit, assume Barry’s will stated that if Mike predeceased Barry, then
the bequest would go to Barry’s long time friend Charlie. If Mike disclaims,
Barry’s estate will pass to Charlie rather than to Mike’s children. Of course,
Mike could assign his interest in the estate to his children, but that would be
a gift from him to them.
A disclaimer is
considered to be tax-effective if it complies with the requirements in IRC §
2518 so the transfer is not treated as a gift by the disclaimant. When we take
up estate and gift taxes, we will cover in detail the requirements for a
tax-effective disclaimer, and we will illustrate ways in which disclaimers are
used to improve estate plans.
LIFE INSURANCE
A life insurance
policy is a contract in which the insurance company, in exchange for the
payment of premiums, agrees to pay a cash lump-sum amount (called the face value or policy proceeds) to a person designated in the policy to receive it
(the beneficiary) on the death of the
subject of the insurance (the insured).
Usually, the policy names alternate beneficiaries who will receive the proceeds
if the named beneficiary dies. One other important party in the life insurance
contract is the owner, who has title
to the policy, and who generally possesses both legal and beneficial interests
in the policy. As beneficial owner, the policy owner has the right to benefit
from the policy. Beneficial rights usually include the right to receive policy
dividends, the right to designate and to change the beneficiary, and the right
to surrender the policy. These rights can have economic value, even before the
death of the insured. Whether a life insurance policy has economic value prior
to the insured’s death depends on the type of policy. If the owner holds title
to the policy as the trustee of an irrevocable life insurance trust, then the
owner will have legal title but will most likely not have a beneficial
interest. Irrevocable life insurance trusts are used to keep life insurance
proceeds out of the estate of the insured. Such trusts are discussed in detail
later.
Most term life insurance policies have
minimal cash value prior to the death of the insured because the premium
charged, which increases over time along with the increasing risk of death,
simply buys pure protection. If the insured dies during the policy term, the
company will pay the face value; otherwise, it will pay nothing. Some
multi-year term policies (called level
term) have a constant premium for a
stated period (e.g., five or ten years). This requires a cash build-up during
the early years of the period which is used to pay the higher mortality risk in
the later years.
In contrast to a
term policy, a cash value policy
accumulates economic value because the insurer charges a constant premium that
is considerably higher than mortality costs require during the earlier years.
Part of this overpayment accumulates as a cash
surrender value, which, prior to the death of the insured, can be used by
the owner in one of two ways: (1) at any time the owner can surrender the
policy and receive this value in cash, or (2) the owner can request a policy
loan and borrow up to the amount of this value.
Life insurance
makes a significant contribution to estate planning because a policy can have
value prior to the insured’s death, can pay cash to the beneficiaries on the
insured’s death, and can be structured to avoid estate tax. It is said to be
the only asset that can create an instant
estate of substantial magnitude for a person of otherwise modest wealth. For a
family that includes dependent children, this may be an important means of
assuring the financial well-being of the surviving family members if a parent
dies. For the wealthy family, life insurance may provide needed cash to pay the
death taxes. A discussion of the types of life insurance and irrevocable life
insurance trusts is found in Chapter 15. To use life insurance properly, the
planner must be aware of the impact of taxes, a subject explained in detail in
Chapters 5 through 8.
TAXATION
In estate planning, the two principal types of taxing
authorities are the individual states and the federal government. The four
major types of taxes are gift tax, death tax, generation-skipping transfer tax,
and income tax.
A gift tax is a tax on a lifetime gift;
that is, a lifetime transfer of property for less than full consideration.
A death tax is essentially a tax levied on
certain property owned or transferred by the decedent at death. There are two
basic types of death tax statutes, which, depending on the format, are referred
to as either an estate tax or an inheritance tax. An estate tax is a tax on the decedent’s right to transfer property,
while an inheritance tax is a tax on
the right of a beneficiary to receive property from a decedent. Either way,
their net effect is essentially the same: they are both considered death taxes,
and the tax is usually paid by the executor out of the decedent’s estate before
the property is transferred to the heirs. With an inheritance tax, the amount
of death tax paid on any given size inheritance is likely to be greater for
remote relatives as compared to close relatives, and greatest for
non-relatives. For example, amounts going to a surviving spouse might not be
taxed at all, and bequests to a child might have a high exemption amount and/or
a lower tax rate than property going to a non-relative. The federal death tax
is referred to as the federal estate tax. The characteristic of an estate tax
is that, for any given net estate (i.e., after debts and expenses), the tax
will be the same regardless of who receives it. For example in the year 2001,
the federal tax on a $5 million bequest, after applying a $391,600 federal state
death tax credit, would be $1,778,650 whether the estate went to the decedent’s
children or went entirely to non-relatives.
However, the
federal estate tax is not a pure estate tax because it has two deductions based
on the status of the beneficiary. A complete marital deduction is allowed for
all property going to a surviving spouse (for a non-USA citizen spouse a
special trust might be required, but we’ll save that discussion until later),
and a complete charitable deduction is allowed for property going to qualified
charities. Since these are complete (100%) deductions, subtracted from the
gross estate before arriving at the taxable estate, and they are the only two
deductions based on the character of the beneficiary, little is lost in our
thinking of the federal death tax as an estate tax.
At the state
level, most states impose an estate tax and others have an inheritance tax. The
trend is to impose an estate tax that results in no additional cost to the
estate because, although it is paid to the state, the state death tax statute
sets the death taxes as equal to the state’s allowable share of the federal
state death tax credit. Because of the federal credit for state death taxes,
this so-called “pick-up tax” reduces
the federal death tax by an equivalent amount (i.e., a dollar-for-dollar
credit), thus there is no increase in the combined taxes. The calculation for
the “pick-up tax” is explained in Chapter 5. Thirty-three states (including
California, Florida, Nevada, and New York) use the “pick-up tax.”*** Query 1. Based on the above discussion,
what is the death tax collected by the state of Florida if one of its citizens
dies in 2001 leaving a taxable estate of $5 million?
A generation-skipping transfer tax is a
tax on certain property transferred to someone who is more than one generation
younger than the donor - a “skip person.” Thus, the surviving spouse and the
children of a decedent are not skip persons, but grandchildren and
great-grandchildren are. Without this tax, wealth could skip several generations
and escape one or more levels of transfer tax. For example, without the GSTT, a
gift or estate transfer of a $10 million parcel of land to a grandchild would
be subject once to a gift tax or death tax, but it would not be taxed twice. It
would be taxed twice if it went through the natural succession, i.e., once when
the property passes from the client to the child, and again when it passes from
the child to the grandchild. Chapter 12 covers the GSTT in more detail. It is
enough to say here that the federal generation-skipping transfer tax has a $1
million exemption per transferor, making careful planning
in this area necessary only for clients with fairly
substantial estates. Indeed, recent legislation dramatically increases the
exemption during the period 2004-2009 and eliminates the GSTT entirely in 2010.[5]
An income
tax is essentially a tax levied on income earned by a taxpayer during a
given year. Income tax laws usually distinguish five different taxpayers or
entities that must report income by filing income tax returns: individuals,
partnerships, corporations, estates, and trusts. Principles of taxation can
differ substantially for each. For instance, partnerships generally do not pay
income taxes because the partnership is treated as a passthrough entity, income and deductions are passed through to be
reported by the individual partners. Each taxpayer, including partnerships,
must submit an annual income tax return that reports certain items including
income, deductions, credits, and the tax due (calculated by using tax tables
applicable to that entity). Married individuals may file a joint income tax
return in which they report their combined income, deductions, and other
information on one return. This textbook will not try to cover income taxes in
detail as it is beyond the scope of this course; however, a good introduction
to the income taxation of trusts and estates is found in Chapter 8.
PROPERTY INTERESTS
Estate planning seeks to preserve and efficiently transfer
an individual’s wealth. Wealth is generally thought of as the property a person
owns. This section will describe some of the ways in which property can be
owned. Essentially, ownership can be classified in the following six ways:
$ The physical characteristics of property
(e.g., real versus personal)
$ The extent of ownership interest in
property (e.g., fee simple or a life estate)
$ The type of co-ownership (e.g., joint
tenancy versus tenants in common)
$ A legal versus a beneficial interest (e.g.,
property held in the name of the trustee versus a trust beneficial interest)
$ A present versus a future interest (e.g.,
an income interest in a trust versus a remainder interest)
$ A vested versus a contingent interest
(e.g., outright ownership of land versus a contingent remainder interest, where
the remainderman must outlive the income beneficiary or the trust property
reverts back to the trustor’s estate)
Classification of Property by Physical
Characteristics
Property is classified as real or personal. Real property includes ownership
interests in land and any improvements, such as buildings, fences, trees, and
the like, that are attached to the land. Curiously, an interest for years (a
leasehold) in real estate is considered personal property. Accordingly, a good
functional definition of personal
property is all property except interests in land and its improvements.
Property is
further divided into tangible and intangible property. Something is tangible if
it can be perceived by the senses as having a physical existence. Tangible personal property is personal
property whose utility comes primarily from its physical characteristics rather
than the legal rights conferred on the owner or possessor of the property.
Conversely, intangible personal property
derives its value from the legal rights it represents. Thus a newspaper is
tangible personal property because its value is based on the news printed
therein. Initially, one might pay 35 cents to read it. A few days later, the
value may drop to almost nothing, being useful only to wrap dead fish or as
recycled newspaper. Yet, a very old paper with an article of historical
significance on the front page may be worth a lot to collectors of old
newspapers. On the other hand, a stock certificate is valuable to the owner of
the certificate if the company is a going business, not because of the physical
characteristics of the paper it is printed on, but because of the rights it
represents, such as the right to vote for the board of directors, the right to
dividends when they are declared, and certain liquidation rights. If the
company has gone out of business, then the stock certificate has become
tangible personal property. The certificate may be worth only the value of the
paper it is printed on, or, if it is old or unusual for some reason, it may be
of some value as a collector’s item.
Intangible
personal property includes a chose in action, which is a claim for money or
property that could be recovered from another in a lawsuit, if such is
necessary. A chose in action, pronounced “shows,” represents the right to money
or property that is owed to the holder of the chose. That right can be
transferred, sold, or assigned to another, who can then act on it in his or her
own name. The person holding the chose as a result of a transfer is entitled to
keep any recovery.
EXAMPLE 2 -
6. Betty borrows $9,000 from Lenny,
agreeing to pay it back by December 31 of this year. Lenny signs a piece of
paper assigning to his daughter, Christine, his right to collect the debt.
Since the debt could be collected by a lawsuit if necessary, it is considered
to be a chose in action, and the assignment to Christine gives her the right to
collect it.
Basic Interests in Property
The three basic interests in property are fee simple, life
estate, and estate for years.
Fee simple. A fee simple interest,
often called a fee or a fee simple absolute, represents the
greatest interest that a person can have over real property and corresponds to our usual notion of full
ownership. Common rights include the right to possess, use, pledge, or transfer
the property. If you own a house, even if it is subject to a mortgage, you
probably have it in fee.
Life estate. A life estate interest
in property, like a fee simple, is a powerful form of ownership, but is
different in that the interest ceases on someone’s death. Ordinarily, the measuring life is that of the owner of
the interest. However, it could be any other person.
EXAMPLE 2 -
7. Doctor Bud assigns his interest in a
house to Gladis, his widowed mother, for her to use and enjoy until her death.
Gladis has received a life estate in the house. Her own life is the measuring
life.
A life estate
for the life of someone other than the owner of the interest is called an
estate for the life of another. These
are rarely used.
EXAMPLE 2 - 8. Facts are
similar to the previous example, except that Gladis’s interest will cease on
the death of Bud. Gladis still has a life estate in the house but now Bud’s
life, rather than her life, is the measuring life. She has an estate for the
life of another.
Ordinarily, the
owner of a life estate enjoys, for the length of a measuring life, complete
ownership, nearly equivalent to a fee, except that it will end on the life
tenant’s death. However, life estates are sometimes created so that the
recipient enjoys only a partial present interest in the property.
EXAMPLE 2 - 9. Aunt Jane, owner
of dividend-paying common stock, gives to her niece Barbie the right to receive
the dividends for as long as Barbie lives. Barbie has received a life estate in
the income of the stock. Under the customary arrangements, Barbie does not have
many rights in the stock itself. For example, she does not have the right to
possess or sell the stock, or to use it as collateral against a loan. The stock
will be held by someone else, either the original owner, or more commonly, a
trustee under a trust arrangement.
Trusts are used
extensively in estate planning and will be discussed in every chapter of this
book. An introduction to trusts follows this discussion of property.
Interest for years. Often, a person transfers possession and/or
enjoyment of property to another for a fixed period. This is called an estate for years—even if the fixed
period is something other than a certain number of years.
EXAMPLE 2 - 10. Professor
Jackson rents his cottage to Dr. Johnson, a visiting professor, for the spring
semester. Dr. Johnson has an estate “for years” even though the semester is
only four months long.
EXAMPLE 2 - 11. Mary is
presently enjoying a life estate, for her life, in the income from certain
common stock. Today Mary transfers to Mark her interest for the next two years.
If Mary does not survive the full two years, Mark’s interest will be cut off on
Mary’s death. Mary cannot transfer any greater interest than she actually owns,
and Mark’s interest is limited to that which Mary can legally give; thus, Mark
has an income interest in the stock, ending at the earlier of two years or
Mary’s death.
A common example
of an interest for years is a leasehold,
which entitles the lessee to possess and use the property (e.g., a house or
computer) for a specified time, usually in exchange for a fixed series of
payments. Leasehold interests can amount to a valuable part of a lessee’s
wealth if the fixed payments are below current market rates, and if the lessee
is permitted to “sublet” the property.
EXAMPLE 2 - 12. Five years ago,
Freda acquired a 15-year leasehold interest in a commercial building and is
obligated to pay $15,000 per year for the entire period. If the rent for
comparable buildings is $25,000 per year for the next ten years, and assuming a
discount rate of 8%, the value of Freda’s leasehold is the present value of
$10,000 for ten years, discounted at 8%, or $67,101 [see Table B, annuity
factor of 6.7101]. Freda could possibly sell her interest for that amount.
Concurrent Ownership
Property may be owned individually, in which case one
person owns and uses it, or it may be owned concurrently, by two or more
persons. Where there is concurrent
ownership, title may be taken as joint tenancy, tenants by the entirety,
tenants in common, or as community property.
A common
characteristic of all types of concurrent ownership is the undivided right to use the entire property, not just a physically
identifiable portion. In addition, the co-owners usually each have the right,
in the event of a dispute, to have the property physically divided
(partitioned), at which time concurrent ownership ends. If the nature of the
property is such that it cannot be partitioned, a court may order it sold and
the proceeds divided among the owners according to their respective shares.
Joint tenancy interests. The defining characteristic of property held
in joint tenancy is that, on the death of one co-owner, the decedent’s interest
automatically passes to the surviving owner(s). The owners are said to hold
title in joint tenancy, or it may be
said that they are joint tenants.
Property law, developed as part of our common law, requires that the interests
all be equal, and the owners’ respective shares should not be stated as part of
the title, thus, “Jim, John, and Jose, as joint tenants,” not “Jim, John, and
Jose, as joint tenants each owning a one-third share.” Because tenants in
common can own unequal shares, the share of each is usually expressed in the
title; therefore the second statement, with the shares defined as “one-third,”
might result in a claim by the heirs of a deceased co-owner that tenants in
common was actually intended and that the one-third interest belongs to them and
not to the surviving co-owners.
Under joint
tenancy, ownership passes to the surviving cotenant automatically at a
cotenant’s death by operation of law,
meaning that the law recognizes the transfer as immediate on the cotenant’s
death without any action required by the survivors. However some authorities,
such as banks, will require document revision in order to transact further
business. A title company will want proof of the death of a joint tenant before
it will issue title insurance should the survivors try to transfer title to
someone else.
EXAMPLE 2 - 13. John and Mary
own a house as joint tenants. At John’s death, Mary automatically becomes the
sole owner of the house. However, as a practical matter, she might have to
record an affidavit establishing the death of a joint tenant, with a certified
death certificate attached, in order to clear the title.
The automatic
right of survivorship inherent in joint tenancy prevails over other means of
transfers at death, including the will and the trust instrument.
EXAMPLE 2 - 14. Continuing the
prior example, if, John had executed a will that left his one-half interest in
the house to his son, Mary would still receive it by right of survivorship. The
joint tenancy designation supersedes the will.
However, in
certain jurisdictions, agreements can be executed between joint owners to
nullify a joint tenancy designation.
EXAMPLE 2 - 15. Continuing prior
examples, if John and Mary were to execute a written agreement stating their intention that the house, presently held in
joint tenancy, is in fact to be held by them as community property or as
tenants in common (see description below), many jurisdictions will honor the
agreement, and the house would not pass to Mary by automatic right of
survivorship.
Joint tenancy
interests in real estate are created by a written document called a deed. In
most states, one cotenant can unilaterally “sever” the joint tenancy without
the knowledge or consent of the other tenant(s).
EXAMPLE 2 -
16. Oscar, Ray, Sam, and Clark own
Green Acre Ranch as joint tenants. Without telling the other three, Sam deeds
his interest to his friend Ed. Sam has broken the joint tenancy insofar as his
interest is concerned. Ed owns a one-fourth interest as a tenant in common with
the other three holding title to three-fourths as joint tenants. If Ray then
dies, Oscar and Clark will own the three-fourths as joint tenants, and Ed will
continue to own one-fourth. If Ed dies, his share will go to his heirs, not to
the other co-owners.
Joint tenancies
are commonly created among family members, as they are the most likely to
appreciate the simplicity of this means of transfer and are least likely to be
concerned that the ultimate owner of the property may be determined by whom
among them lives the longest.
Interests by the entirety. An interest
by the entirety is like a joint tenancy in that it carries that key
characteristic of joint tenancy, the right of survivorship; however, an
interest by the entirety can be created only between husband and wife. Unlike
joint tenancy, neither spouse may transfer or encumber the property without the
consent of the other. Tenants by the entirety is a common law concept,
generally not recognized in the community property states. In addition, a few
of the common law states no longer recognize this form of ownership and will
treat an attempt to create it as merely joint tenancy. Where it is recognized,
since it is available only to married couples, a divorce will cause a tenants
by the entirety title to automatically transmute into a tenants in common form
of title.
Tenants in common. Like joint tenancy, tenants in common interests are held by two or more persons, each
having an undivided right to possess property. Unlike joint interests, however,
interests in common may be owned in unequal percentages, and when one owner
dies the remaining owners do not automatically succeed in ownership. Instead,
the decedent’s interest passes through his or her estate, by will or by the
laws of intestate succession. The interest can also be transferred to the
trustee of a trust and pass according to the provisions of the trust.
EXAMPLE 2 - 17. Jack owns a 16
percent real estate interest in common with two other individuals who,
combined, own the other 84 percent. Jack’s will leaves his entire estate to his
wife, Deanna. On Jack’s death, his will determines who will get his interest.
Therefore, the 16 percent interest will pass by the probate process to his
wife, Deanna, not to the other cotenants.
Interests in
common are the title of choice for non-related parties since this form of
title, in contrast to joint tenancy interests, creates a means of enjoying
common ownership without any of the co-owners losing the right of disposition
at death.
Community property interests. In the eight states recognizing it, community property is that property
acquired by the efforts of either spouse during their marriage while living in
a community property state, and other property which by the agreement of the
spouses is converted from separate property into community property. Separate property is all other property
owned by the spouses (e.g., acquired by only one of the spouses by gift,
devise, bequest or inheritance, or by a spouse domiciled in a common law state,
or acquired by either spouse prior to their marriage). The traditional
community property states are Arizona, California, Idaho, Louisiana, Nevada,
New Mexico, Texas, and Washington. In addition, Wisconsin has adopted the
Uniform Marital Property Act (UMPA)[6], which creates a presumption that property
owned by the spouses is property of the marriage, and, as such, it does not
belong to just one spouse. This presumption holds even if title to property is
in one spouse’s name alone. The “marriage property” presumption can be overcome
by evidence that sufficiently establishes otherwise, e.g., evidence that it was
owned prior to the marriage or acquired by inheritance.
When it comes to classifying income, most
of the community property states follow what is referred to as the California
rule, which is that income from community property is community property, as is
anything bought with that income, and income from separate property is separate
property, as is anything bought with that income. Three community property
states, Texas, Idaho, and Louisiana, follow what is called the Texas rule and
treat income earned from separate property during the marriage as community
property. Likewise, Wisconsin law provides, with some exceptions, that “income
earned or accrued by a spouse or attributable to property of a spouse during
marriage and after the determination date is marital property.”[7] The
“determination date” is the later of the couple’s marriage, their domicile in
Wisconsin, or the enactment of Wisconsin’s Marriage Property Act. Even Texas-rule
states treat the gain on separate property that is sold as separate property,
and, of course, anything bought with the proceeds of the sale is separate
property.
Community property is owned equally by
both spouses. Generally, both spouses must consent to a gift of community
property. Community property states allow couples to convert community property
to separate property, and vice versa, although some states require a written
agreement wherein the spouse whose interest is reduced acknowledges the fact
that something has been lost. Separate property is considered entirely owned by
the acquiring spouse. In states without community property provisions, of
course, all property is separate property. In those states, it would simply be
referred to as “the property owned by” Sam, Wanda, or whomever.
EXAMPLE 2 - 18. Pat
and Mary live in New Mexico, a community property state. When they married two
years ago, Pat owned a sports car that Mary now uses. Last year Mary’s father
gave her 100 shares of XYZ stock, which pays a quarterly dividend. Mary used
the last dividend check to buy a bicycle. Pat bought a rowboat from money saved
from his July paycheck. The stock and bicycle are Mary’s separate property. The
car is Pat’s separate property. All the other assets, including both salaries
and the rowboat, are community property. ***Query
2-2. If Louisiana was their home, what difference would it make insofar as
property ownership goes?
Community property laws represent the
attempt by certain state governments to impose greater fairness in property
ownership by married couples. Under old English common law, the husband owned
all property that either husband or wife acquired during their marriage. Even
after most states recognized the right of married women to own property, during
pre-World War II America, the husband typically earned most of the outside
income while the wife performed the non income-producing household chores;
therefore, husbands usually acquired title to almost all the family wealth. At
early common law, a wife was entitled to own none of this property until her
husband’s death, at which time she received a life estate in one-third of her
husband’s real property. Called a “dower” interest, it has been modified by
most common law states; however, it seldom gives the non-working spouse the
advantages inherent in the law of community property, which automatically gives
both spouses an immediate equal share in all the property acquired by their
efforts during the course of their marriage.
Arizona, California, Idaho, Washington,
and Wisconsin have a concept called quasi-community
property, which is defined as that property, acquired by a resident while
domiciled in a non-community property state, which would have been community
property had the resident been domiciled in a community property state at the
time of acquisition. For example, if a married couple moves to California
owning common stock acquired with salary earned during the marriage while they
were residents of New York, the stock is quasi-community property. Essentially,
quasi-community property is treated as separate property of the acquiring
spouse until divorce or death. If the parties divorce, the property is divided
in a manner similar to community property. Treatment at death depends on which
spouse dies first. If the acquiring spouse dies first, the surviving spouse is
entitled to one-half of the property. On the other hand, the other spouse’s
interest in the property ceases, if he or she dies first.
Joint tenancy (JT) and community property
(CP) have several major similarities and differences that are summarized in the
outline below:
1.
Major Similarities:
a. Both
involve ownership by more than one person.
b. The
owners have equal ownership rights and equal rights to use the entire property.
Their interests are undivided.
c. Any
owner may demand a division of the property into separate, equal shares.
2. Major
Differences:
a. CP
exists only between spouses. JT can exist between any two or more persons.
b. CP
rights arise automatically, by operation of law under state statute, even if
title or possession is taken by just one of the spouses. Hence, CP is created
immediately on acquisition of the property. JT rights are usually created by an
agreement of the parties (e.g., they ask that stock be issued in their names as
joint tenants) and are not governmentally imposed.
c. JT
includes automatic right of succession to ownership (right of survivorship) by
surviving joint owners. This right takes priority over any will. In contrast,
CP includes no automatic succession to ownership of the decedent’s share by the
surviving spouse. Therefore, at death, a spouse can transfer his or her share
of CP, by will, to someone other than the spouse. However, intestacy will
ordinarily result in succession by the surviving spouse under most state laws
of intestate succession.
d. Property
held in JT will not be subject to the probate process. In contrast, the
decedent’s share of CP may be subject to probate. Some CP states no longer
require a probate if the property is left to the surviving spouse or if,
because of intestacy, the surviving spouse will receive the property by the
laws of intestate succession.
It is important to make two observations
regarding item 2c: First, some states, such as New York, recognize an agreement
between the spouses declaring that specified property is held in joint tenancy
“for convenience only;” and second, Arizona, Idaho, Nevada, and Washington have
enacted statutes that allow the designation “community property with right of
survivorship.” This results in the property being treated like joint tenancy.
The decedent spouse’s will does not control disposition, and the property
transfers to the surviving spouse by operation of law, meaning there is no need
for probate.
Legal Versus Beneficial Interests: Introduction
to the Trust
Usually, the owner of property has all the rights to
possess and enjoy it; however, these interests can be divided so one party has
just the “bare legal title” and is responsible for preserving and managing
property for the benefit of another, and the other is entitled to enjoy the
property in specified ways. The former holds the legal interest while the latter holds a beneficial interest, also called an equitable interest, in the property. Trusts are the most common
legal arrangement to employ this division.
There are three
major parties to the trust: trustor, trustee, and beneficiary. The trustor, also called grantor, creator, or settlor, is
the person who creates the trust, and whose property is used to fund the trust. The property held in a
trust is called the principal, but
also the corpus, the res (Latin for things), or
the trust estate. The trustee is the person, persons, or
entity (e.g., bank trust department) who takes legal title to the trust
property and manages the trust estate. Usually the trust instrument names an
initial trustee and several alternates. The trust beneficiary is the person or persons who are named to enjoy
beneficial interest in the trust. Placing property in a trust is called funding the trust. Funding is
accomplished by transferring title of the property into the name of the
trustee. Figure 2-1 illustrates the relationship between the parties to the
trust.
A trust can be living or inter vivos, meaning it is funded during the life of the trustor,
or it can be testamentary, to take
effect at the trustor’s death with the funding mechanism being the probate
process. A testamentary trust is one created by the trustor’s will. An example
of the provisions of a testamentary trust can be found in Chapter 3, Exhibit
3-3.
EXAMPLE 2 - 19. On November 23,
1996, trustor Harold Stuart transferred 1,000 shares of ABC stock in trust to
Uncle Jay as trustee, with the income payable to Harold’s son, Chet, for 11
years, after which the corpus of the trust reverts to Harold. Jay receives only
legal title which would probably read, “Jay Stuart, as trustee of the Chet
Stuart Trust, dated 11/23/96.” Jay is responsible for managing the property
during the term of the trust. He can sell the stock and buy other investments
in his name, as trustee, but he may not use trust assets for his own benefit,
and he is required to distribute all income to Chet, the income beneficiary.
Chet has a beneficial interest, that is, an estate for years in the income of
the trust.
Reasons for creating trusts. Clients
may wish to include trusts in their estate plans for five principal reasons: to
provide for multiple beneficiaries, to manage their property if they become
incapacitated, to protect beneficiaries from themselves and others, to avoid
probate, and to avoid or reduce transfer taxes. Since these factors are
discussed in detail in numerous sections of the text, the following commentary
will be brief.
First, clients
may wish to leave their property to more than one person, either at the same
time or successively, over a period of time, and may need an arrangement that
will fairly protect each beneficiary’s individual property rights.
EXAMPLE 2 - 20. After his death,
Constantine wants to let his second wife enjoy the use of his property for the
rest of her life. After her death, Constantine wants the income from his
property to be payable to the children of his first marriage until they reach
age 30, at which time he wants them to receive the principal outright. By
executing a trust, Constantine can appoint a responsible trustee (even his
second wife, if both of them are comfortable with the arrangement) to manage
the property for what may turn out to be a very long time.
A transfer into a trust is sometimes
called a split interest transfer,
because it divides rights to the corpus into two or more interests, usually an
income interest for a specified period of years or for the beneficiary’s life,
and a “remainder” interest in the principal. Remainder interests will be
described shortly and income versus principal interests will be covered a
little later.
Second, clients may create trusts to manage their property if they become
incapacitated. If, due to injury or old age, a person becomes unable to
manage his or her property, who will do so? On petition, a court will appoint
someone to manage the estate of a disabled person. Depending on the
jurisdiction, the court-appointed caretaker is called a conservator (i.e., one charged with “conserving” the disabled
person’s assets) or a guardian (i.e.,
one “guarding” the person’s interests). Some states use the term guardian only
for minors and use the term conservator for adults (the person being cared for
is called the conservatee). Other
states use guardian whether the person cared for is a minor or an adult. In
either case, the person caring for the estate must make annual reports to the
court and, depending on the circumstances, may have to get court approval for
certain expenditures or to sell certain assets.
EXAMPLE 2 - 21. Several years
ago, Linda Smith created a revocable
living trust, changing the title of all her property to read “Linda Smith,
trustee of the Linda Smith Revocable Living Trust, dated March 19, 1998.” The
terms of the trust provide that if Linda becomes incapacitated during her
lifetime, her brother Tom will become successor trustee. Linda has taken steps
to avoid expensive court procedures to determine who should be appointed
guardian or conservator of her property if she becomes incapacitated before
death. The trust has the added benefit of allowing Linda’s estate to avoid
probate when she dies.
Third, clients
may wish to create trusts to protect
beneficiaries from themselves and others.[8] As we will see in the next chapter, trust
documents typically contain provisions restricting use of the property by
beneficiaries. For example, trust instruments often provide that the trustee’s
discretion will determine the amount and timing of distributions to
beneficiaries. In addition, they often prohibit any beneficiary from pledging
his or her interest in the trust property as collateral for a loan. Many other
restrictions can be included.
Fourth, a trust that is funded during the
trustor’s lifetime allows the property that is placed in the trust to avoid the probate process. Trusts funded
while the trustor is alive are called living
trusts. Trusts can also be funded through the probate process, either by
means of a pour-over will (a will
that has a previously established trust as its primary beneficiary) or by means
of a testamentary trust (a trust is
incorporated within the body of the will). The probate process, and various
means of avoiding probate, are discussed in more detail in Chapter 10.
Fifth, clients may wish to use trusts to avoid or reduce taxes. On the inside
front cover of the textbook is a table that shows the amount that can be passed
tax-free (meaning without the payment of gift or estate taxes). Note that for
the year 2002 the applicable exclusion amount (i.e., the tax-free amount) is
$1,000,000. In general, the applicable exclusion amount has little relevance
when property is transferred from one spouse to the other because there is a
100% marital deduction, but it is very important when property passes to other family
members, e.g., to the children. A fair amount of estate planning revolves
around using the two applicable exclusion amounts, one for each parent, while
keeping the couple’s combined estate intact for as long as either of them is
alive. This is usually accomplished by holding in trust, for the benefit of the
surviving spouse, the estate of the first spouse to die, with the children
named as the remaindermen. By doing this, the trust estate is not merged with
the surviving spouse’s estate, and both spouses’ applicable exclusion amounts
are used. This text will have a great deal to say about tax planning using
trusts after examining the taxation of gifts, estates, trusts, and
beneficiaries in Chapters 5 through 7.
Power of Appointment
In arranging property transfers into trust or otherwise,
clients can add considerable flexibility to their estate plans by granting a
power of appointment. A power of
appointment is a power to name someone to receive a beneficial interest in
property. The grantor of the power is called the donor. The person receiving the power is called the holder or donee. The parties to whom the holder may appoint (i.e., give)
property by exercising the power are
called the permissible appointees,
and the parties whom the holder actually appoints are called the appointees. In addition, the persons who
receive the property if the holder permits the power to lapse (i.e., does not exercise the power within the permitted
period) are called the takers in default.
In some cases, the holder of a power of appointment can release the power by formally relinquishing the right to exercise
the power.
Depending on how
it is written, a power of appointment can be exercisable either during the
lifetime of the holder or at his or her death, or both during lifetime and at
death. If exercisable during lifetime it is exercisable either sometime during
the holder’s entire lifetime, or only for a stated period. A testamentary power is only exercisable
at the holder’s death, usually by a provision in the holder’s will. The
broadest powers allow the holder to exercise both during lifetime and at death.
EXAMPLE 2 -
22. Assume that Dona grants Harold a
power of appointment over her 100 shares of ABC stock, permitting Harold to
appoint the stock to Anna, Bobby, or Carol, and designating Terry as the taker
in default should Harold fail to appoint the stock within 90 days. Shortly
thereafter, Harold appoints Bobby to receive the stock. Dona was the donor,
Harold was the holder (of the power), Anna, Bobby, and Carol were the
permissible appointees, and Bobby was the actual appointee (of the stock).
Terry, the taker in default, didn’t get to “take” because the holder did not
permit the power to lapse.
Powers of
appointment are most often established within the framework of a trust. Figure
2-2 illustrates the relationship between the parties involved in the power of
appointment.
Comparing
the relationship between the parties to a power of appointment with the parties
to a trust, the donor of the power is usually the trustor. The holder is
commonly the trustee but may also be one or more beneficiaries or a trusted
friend of the trustor. The permissible appointees are usually the trust’s
beneficiaries. Trustee powers of appointment may be over trust income, principal,
or both income and principal. Trustees may also be granted the power to distribute income among a group of
beneficiaries, which is referred to as “sprinkling the income” of the trust.
Where the trustee has this discretion, the trust is referred to as a
“sprinkling trust.” Almost humorously (we estate planners are always looking
for a good laugh), the term “spray” is sometimes used to describe a trust
clause that gives the trustee discretion to distribute
principal in different amounts among permissible beneficiaries. Trust
powers of appointment are extremely important estate planning tools and will be
discussed frequently in this book.
In the chapter
on estate taxes, we will see that death taxes play an important role in the use
of powers of appointment—so much so that we commonly classify two types of
powers using Internal Revenue Code classifications. Under the Code, a power of
appointment is either a general power
of appointment or a non-general power
of appointment, also called a limited
or special power of appointment.
We’ll define these terms in greater detail when we start working on estate
taxes, noting how the wording of a power can cause property to be included in
the holder’s estate, subjecting it to tax. The next example shows a common use of
a power of appointment.
EXAMPLE 2 -
23. Charles, a single parent, died
recently, and his will placed some of his property in trust for the benefit of
his children. A bank is named trustee and is given a non-general power of
appointment over the corpus. The bank has, among other things, discretion to
distribute corpus to the children in accordance with their needs “for their
proper support, health, and education.” This year, the trustee has distributed
$6,000 to one son and $4,000 to a daughter to pay their college tuition.
Powers of
appointment can add great flexibility to a person’s estate plan by enabling
someone to direct trust dispositions after taking into account changes in
circumstances that occur long after the person’s death. According to common
law, property subject to a power of appointment is not considered legally owned
by the holder, rather, the holder is treated as merely a proxy for the donor.
However, when it comes to federal estate and gift tax law, some powers cause
the holder to be treated as if he or she owned the property, at least to the
extent that the holder has control over the property. We take up the matter of
general and limited powers later in the text.
Present Versus Future Interests and Vested
Versus Contingent Interests
A beneficial interest in property may be classified as a
present interest or a future interest, depending on whether the owner has the
immediate right to possess or enjoy the property. We will see later that this
distinction is of great importance in connection with the $10,000 annual gift
tax exclusion.
An owner of a present interest has an immediate right
to possess or enjoy the property while an owner of a future interest does not, because the latter’s right to possess or
enjoy the property is delayed, either by a specific period of time or until the
happening of a future event. The most common types of future interests are
reversions and remainders. A reversion
is a future interest in property that is retained by the transferor after the
transferor transfers to another some interest in the property. The reversion
will become a present interest of the transferor, or the transferor’s estate,
at the termination of all interests that were transferred, i.e., at some point
in time the donor will get the property back.
EXAMPLE 2 - 24. Jerry transfers
property, in trust, to Eve for her life. The trust document was silent as to
what should happen to the property after Eve’s death. By not designating a
remainderman, Jerry has retained a reversion, also called a reversionary
interest. The trust property will belong to Jerry, if he is still alive when
Eve dies, otherwise, it will belong to his estate (the interest will pass
according to his estate plan).
Technically, a remainder is the right to use, possess,
and enjoy property after all prior owners’ interests end, and all interests
must have been created at the same time by a single document. It is a type of
future interest held by someone other than the transferor and it will become a
present interest when all other interests have ended. The preceding definition
of remainder is unnecessarily technical for our purposes, because most
remainders in estate planning are quite simple. In estate planning, remainders
usually arise in the context of trusts, where the remainderman is entitled to
the remaining trust assets at the termination of the trust. In many, if not
most, trust situations, the remaindermen are the settlors’ children or
grandchildren, who will receive the remainder at the death of both settlors
(usually a married couple) who are likely to have retained joint life estates
in a revocable trust. In some of these estate plans, the trust changes at the
death of one spouse into several trusts, including one or more irrevocable
trusts. Where multiple trusts are formed at the death of one spouse, the
survivor usually has a life estate in all the trusts, even any that are
irrevocable, and the children wait as remaindermen until the surviving spouse
dies.
EXAMPLE 2 - 25. George
irrevocably transfers property to Sally for her life, then to John or his
estate. John’s future interest in the property is a remainder. It is not a
reversion because it does not return to George.
A vested remainder is a remainder that is
non-forfeitable; it is a remainder whose possession and enjoyment are delayed only by time, and is not dependent on
the happening (or not happening) of any future event.
EXAMPLE 2 - 26. With regard to the transfer by George in the previous
example, John’s remainder is vested. Nothing prevents him or his estate from
receiving possession, except the passage of time. Morbidly but accurately
speaking, eventually Sally will die.
A contingent remainder is a remainder that
is not vested; that is, it is a remainder whose possession and enjoyment are
dependent on the happening of a future event, not on just the passage of time.
EXAMPLE 2 - 27. Catherine
transfers property to Flo for her life, then outright in fee simple to Jason,
if alive, otherwise to Chris, if alive, and if not, then it reverts to
Catherine. Jason and Chris each have a contingent remainder interest in the
property and Catherine has a contingent reversionary interest. If Jason
outlives Flo, the property is his; Chris is next in line if Jason doesn’t make
it. Finally, Catherine, or her estate, will get the property back if neither
Jason nor Chris lives.
Totten Trusts. The Totten
trust is not really a trust at all, but rather is a bank account that is
payable to another on the death of the account owner. It got its names from a
case in which the court decided in favor of the designated other person, over
the claim of the decedent’s executor. This mechanism of transferring a bank
account at the death of the owner is recognized in most, but not all, states.
Title is likely to read, “Jane Smith, in trust for Michael Smith,” or “Jane
Smith, payable on her death to Michael Smith.” In either case, Michael’s
interest does not vest until Jane dies. Indeed, in spite of the use of the
words, “in trust for,” there is no trustee and neither Jane nor the financial
institution has a fiduciary responsibility to Michael. Jane may withdraw all
the funds or she may change title without Michael ever knowing that the account
existed. Once Jane dies, Michael would be able to claim the account by
presenting a certified death certificate.
A few more
examples, presented in the context of common transfer devices, should help to
clarify the distinctions discussed above.
EXAMPLE 2 - 28. When Gary died,
his will created a trust funded with his entire estate. The terms of the trust
give income to his wife, Joan, for her life. At Joan’s death, the trust
terminates and the property passes outright in fee to Gary’s son Max, if still
alive, otherwise to the Salvation Army. At Gary’s death, Joan received a
present interest called a life estate in the income, and Max and the Salvation
Army each received a future interest, called a contingent remainder. Max and
the Salvation Army share something in common; only one of the interests can
ever become a present interest since an event will occur which will defeat one
or the other interest. Max’s interest will cease if he predeceases Joan. The
Salvation Army’s interest will cease if Max survives Joan. Therefore, both have
contingent remainder interests because possession is dependent on the happening
of a future event, not on just the mere passage of time.
EXAMPLE 2 - 29. Sam left
property in trust, giving his wife, June, income for life with the remainder
going to Sam’s son, Kurt, or Kurt’s estate. Kurt has a vested remainder in the property.
Although initially a future interest, it is certain that it will become a
present interest someday; it cannot be defeated. Only the passage of time keeps
Kurt’s interest from being a present interest. Of course, Kurt may not be alive
to enjoy the property, but the beneficiaries of his estate will.
We have seen
that the transfer of property in trust results in a division into two
interests, with the trustee receiving the legal interest and the beneficiaries
receiving the beneficial interests. In addition, transfers into trust typically
result in a second type of division of interests when the beneficial interests
are split among two or more beneficiaries. Ordinarily, one group of
beneficiaries, called the income
beneficiaries, receives a life estate or estate for years in the trust
income, while the other group, called the remaindermen,
receives the remainder at the termination of the income interests. The many
reasons for splitting beneficial interests into a life estate, or into an
estate for years and a remainder, will be explained in later chapters. At
present, the reader should simply be aware of the interest-splitting nature of
the trust. You should recognize that, at the time of the transfer into the
trust, the life estate and estate for years are usually, but not always,
present vested interests; the remainder is a future interest, either vested or
contingent.
Mathematics of Remainders, Reversions and Income
Interests
The previous section described the nature of remainders,
reversions, life estates, and interests for years. These concepts are important
to understanding later chapters, because many common estate planning techniques
require their creation.
Up to now, the
description of these interests has been qualitative rather than quantitative.
Estate planning is inherently “numbers oriented” for two principal reasons.
First, estate planning decisions often have a sizable impact on family wealth, and clients want to
discuss that effect with the planner. Second, property transfer decisions often
have tax consequences that must be
projected and evaluated.
Thus, it is
important to understand the quantitative nature of remainders, reversions, life
estates, and interests for years. This section demonstrates how they are
calculated.
Overview of IRS valuation tables. The calculations can be most easily
performed with the help of tables published by the Internal Revenue Service.
The Service’s complete “Alpha” volume runs 800 pages and costs about $32.[9] It includes six different tables and lists
tens of thousands of values, most of which are derived from discount rates
ranging from 2.2 percent to 26 percent, at two-tenths of one percentage point
intervals. This conforms precisely with Internal Revenue Code valuation rules,
often requiring the use of a current monthly discount rate that is equal to 120
percent of what is called the “applicable federal mid-term rate” (AFMR), which,
in turn, is derived from the average market yield on U.S. Treasury obligations
with maturities of three to nine years.[10] The rate, often referred to as the §7520
rate, has been rounded to the nearest two tenths of a percentage. Since these
rates are published monthly by the Treasury Department, you do not have to
figure out the rate. If a rate is given in an example or in problems at the end
of the chapters, use that rate to determine the appropriate table to use (do
not multiply it by 120% as that has already been done).
For obvious practical reasons, this text
cannot include all pages from the IRS volume but reproduces many of the most
useful ones. Appendix A includes part of IRS Tables “S,” “B,” “K,” and “ 90CM,”
the four most commonly used tables in estate planning. Appendix Table S and
Table B are abridged to list a sampling of present value factors for discount
rates of 6, 8, 10, and 12%. Table K gives adjustment factors where payments are
made other than annually. Tables S and B assume an annual payment, with the
first payment at the end of the first year. We will be using the actuarial
factors in examples and problems as they are especially helpful in the planning stage, when estimates are
useful in calculating the values of life estates, remainders, and the like.
Table 90CM is a one-page mortality table, useful for valuing interests that are
contingent on survival.
The following series of examples will
illustrate the use of these four tables for the valuation of four basic
property interests: remainders, reversions, annuities for life, and annuities
for a term certain. The discussion
makes it clear that the choice of table for a particular problem depends in
part on whether the interest to be valued is predicated on the fact that
someone will be paid either all income or a fixed annuity (1) for a fixed
number of years, or (2) for life. All examples will assume, unless otherwise
stated, that the appropriate rate is 10%, payments are annual, and that the
first payment is at the end of the first year.
Valuations predicated on income for term
certain: IRS Table B. Each of the first
four examples show the value of an income interest that is for a fixed period of time, also called a term certain.
Valuation
of income for term certain. We
use IRS Table B to determine the value of a beneficiary’s income interest for a
term certain. The term is usually given as a certain number of years.
EXAMPLE 2 -
30. Today Dana creates an irrevocable
trust, transferring $200,000 in property to the trustee. The trustee is
required to distribute annually all income earned from the property to Harry
(or his heirs) for a period of ten years. Then, the trust terminates, and all
trust principal will be distributed to Stephen (or his heirs). The current
value of Harry’s ten-year annuity for a term certain is calculated using Table
B (10%) as follows: the income interest factor for 10 years is 0.614457, thus
the current value of Harry’s income interest is $122,891 [$200,000 * 0.614457].
Valuation
of a vested remainder after income for a term certain. Similarly, IRS Table B allows us to
determine what portion of the property’s total value should be allocated to a
beneficiary’s vested remainder interest that follows someone else’s income
interest for a definite period of time (i.e., after the “term certain”).
EXAMPLE 2 - 31. Continuing as in
the previous example, the current value of Stephen’s vested remainder interest
can be calculated starting with the same table. The remainder factor found in
Table B (10%) corresponding to 10 years is 0.385543. Thus, the present value of
his vested remainder interest is $77,109 [$200,000 * 0.385543].
In the previous
two examples, since Harry and Stephen’s interests represent the only two
interests in the trust assets, it is logical that the sum of their initial
values should total $200,000, the initial value of the trust principal. And for
the same reason, it is also logical that the sum of the two table values should
add up to one. Consequently, each table value can be determined in a slightly
different way. If one value is known, the other can be determined by simply
subtracting the known value from 1.0. Thus, the table value for Stephen’s
interest, 0.385543, could have been
calculated by subtracting the table value for Harry’s interest, 0.614457, from
the number 1.0; or, the remainder value could have been determined by
subtracting the value of the income interest from the value of the whole trust
(e.g., $200,000 - $122,891 = $77,109).
Valuation
of a reversion. In determining
the value of a reversionary interest, one takes the same steps as if it were a
remainder interest.
EXAMPLE 2 - 32. Revising the terms
of the trust in the above ongoing example, assume that, at the end of 10 years,
the trust will terminate and trust principal will be distributed back to the
trustor, Dana (or her heirs). The initial value of Dana’s reversion, $77,109, is exactly equal to the value of Stephen’s
remainder.
Valuation
of a remainder (after term certain) contingent on survival. A remainder after a term certain that is
contingent on the remainderman’s survival of the term is calculated by
multiplying the value of the vested remainder by the probability of the
remainderman being alive at the end of the trust. IRS Mortality Table, 90CM,
reprinted in Appendix A, shows the number of people expected to be living at
each age based on statistics for the 1990 census. For example, out of 100,000
people born alive (age 0 = birth), only 95,373 of them are expected to be alive
at age 40. Calculating the probability of a person age X surviving to age Y is
determined by dividing the number of people alive at age Y by the number alive
at age X. Thus, the probability of a newborn reaching age of 40 is 0.95373
[95,373 ) 100,000].
EXAMPLE 2 - 33. Revising the facts
again in this ongoing example, assume that Stephen is currently age 40, that
his remainder is contingent on his surviving the ten-year period, and that if
he fails to survive, the trust principal will pass to someone else. Using Table
90CM, the probability of Stephen surviving to age 50 is calculated by dividing
92,370 (the number alive at age 50) by 95,373 (the number alive at age 40),
resulting in the quotient 0.96851. Thus, the value of Stephen’s contingent remainder is $74,681 [0.96851
* $77,109].
Valuation
of an annuity for a term certain.
Now, consider a new example in which the annual annuity payment for a
term certain is known.
EXAMPLE 2 - 34. A trust provides
for an annual distribution to Brett of $4,000 per year for 15 years, with the
first payment to be made exactly one year after the trust is established. The
current value of Brett’s 15-year annuity interest is calculated in the
following manner: Using IRS Table B (10%), the annuity value corresponding to
15 years is 7.6061. Thus, the current value of Brett’s annuity interest is
$30,424 [$4,000 x 7.6061]. The values in the annuity column are simply the
present value factors for an annuity of $1 for a set period of time.
All the
calculations in the above examples involve either an income interest or an
annuity for a fixed number of years. The next section deals with examples
involving a different inherent property interest: an income interest or an
annuity for life.
Valuations predicated on an income interest
for life: IRS Table S. Each of the
next three examples demonstrates the calculation of the value of an income
interest that is for someone’s lifetime. For these calculations, we must use
IRS Table S for the appropriate interest rate (see Appendix A).
Valuation
of a life estate. IRS Table S
indicates what portion of a property’s total value is reflected in the value of
a beneficiary’s income or annuity interest for life. The regulations do not
allow the use of Table S where the person with the measuring life (e.g., the
person with a life estate) is terminally ill at the time the interest is being
valued. The regulations define terminal illness as “an incurable illness or
other deteriorating physical condition . . . if there is at least a 50 percent
probability that the individual will die within one year.” However, if the
person actually lives 18 months or longer, there is a presumption that the
person was not terminally ill, unless the contrary is established by clear and
convincing evidence.[11] In the examples that follow, unless stated
to the contrary, we will assume that the person was not terminally ill, and
that Table S can be used to value the interests.
EXAMPLE 2 - 35. This year Martha creates a trust and funds it with assets
that have a value of $100,000. The trust provides Charles, age 50, with a life
estate. At Charles’s death, distribution of the remainder is to be made to
Samuel (or his heirs). Using IRS Table S (10%), the current value of Charles’s
life estate is calculated as follows: the “life estate” factor corresponding to
age 50 is 0.87963. Thus, the current value of Charles’s life estate interest is
$87,963 [$100,000 x 0.87963].
Valuation
of vested remainder after life estate. Similarly, IRS Table S indicates what
portion of a trust’s total value should be allocated to a beneficiary’s vested
remainder after the termination of an annuity for life.
EXAMPLE 2 - 36. Continuing the
previous example, the current value of Samuel’s remainder interest is
determined from the same table. For 10%, the “remainder” value corresponding to
age 50 is 0.12037. Thus the current value of Samuel’s vested remainder interest
is $12,037 [$100,000 x 0.12037].
Similar to the
earlier discussion, since Charles’s and Samuel’s interests represent the only
two interests in the trust assets, it is logical that the sum of their current
values should total $100,000, the current total value of the trust principal.
And again, for the same reason, the sum of the two table values adds up to one.
Finally, we can determine each of the table values by subtracting the known
table value from 1.0.
Valuation
of reversion after life estate.
As with reversions after an income interest or an annuity interest for a
term certain, reversions after a life estate are calculated in exactly the same
manner as remainders.
Valuation
of annuity for life. Now
consider a different example in which the annuity payment is fixed as a
specific dollar amount.
EXAMPLE 2 - 37. Muhammad, age
40, is the beneficiary of a testamentary trust which is required to pay him
$10,000 per year for life, with the first payment to be made in exactly one
year. Again, using IRS Table S (10%), the “annuity” value corresponding to age
40 is 9.3589.[12] Thus, the current value of this life
estate is $93,589 [$10,000 * 9.3589]. If the payments were to be made monthly
(instead of annually) with the first payment at the end of the first month, we
would use Table K as well. The factor from Table K for a monthly payment, 10%
rate, is 1.0450, hence the value would be $97,801 [$93,589 * 1.0450].
These IRS tables will be used to value
property interests in several sections of the text, covering such estate
planning techniques as annual exclusion gifts (Chapter 7), a minor’s income
trusts (Chapter 13), private annuities (Chapter 14), and charitable remainder
trusts (Chapter 14).