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Chapter 15 Preserving Your Estate How Will This Affect Me? No, you can‘t take it with you . But there’s a next best thing: A carefully designed estate plan will allow your loved ones and family to keep as much of your accumulated wealth as possible. This chapter explains the role of estate planning and the importance of a will. It discusses the use and design of living wills, advance medical directives, and trusts. It also explains how federal estate taxes are calculated. After reading this chapter you should understand the key elements in handling and preserving your estate for your loved ones. Goal is not to make the students lawyers, but the chapter does include some legal terms that are important to understand. Included are: 1. Estate planning involves deciding what to distribute to which of your heirs, people planning and asset planning 2. The difference between probate and gross estate 3. Types of ownership on property, especially right of survivorship 4. Use of lifetime gifts equal or less than annual exclusion to reduce gross estate without using any credit 5. The Applicable Exclusion Amount that is derived from the credit amount and the importance of the portability of the credit between spouses 6. Use of a life insurance trust to exclude life insurance from the gross estate Learning Objectives 15-1 Describe the role of estate planning in personal financial planning, and identify the seven steps involved in the process. The students need to understand the difference between people planning and asset planning even though there is no estate tax. If this planning is not done, the estate will incur significant and unnecessary costs. 15-2 Recognize the importance of preparing a will and other documents to protect you and your estate. The sections and content of a will is in the chapter. Let the students read it—better to spend your class time on what happens if there is no will. When the court appoints an executor in cases with there is no will, the court will also approve a fee that is about 4% of the estate. With a will, the fee can be waived. 15-3 Explain how trusts are used in estate planning. Trusts are useful to all to provide for minors and special needs situations. Trusts use to reduce tax is for high income taxpayers and will be suggested by lawyers. For this course, the use of trusts is to provide professional management of assets when the beneficiaries cannot do so themselves. 15-4 Determine whether a gift will be taxable and use planned gifts to reduce estate taxes. The text does not spend a lot of time on what is or is not a gift. For this course do not worry about the unusual situations concerning gifts. Just focus on the annual exclusion and the fact that it is for all gifts during the year and applies per done. So if you have ten grandkids, you can give away $140,000 per year with no tax or return required. 15-5 Calculate federal taxes due on an estate. Worksheet 15.2 covers the computation of the tax. Going over that will be sufficient. 15-6 Use effective estate planning techniques to minimize estate taxes. There is a short list in the chapter. You should discuss each of these. Because of these techniques, commentators refer to the transfer tax as an “elective tax”, that is you elect to pay the tax because you do no planning for the tax. Lastly and again, estate planning is not tax planning alone. Estate planning is deciding what to do with your assets after you are dead. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. • Estate planning is one of the key elements of personal financial planning. Fact: One of the principal objectives of financial planning is to transfer as much accumulated wealth to your heirs and designate beneficiaries as possible – a goal that is made easier through effective estate planning. • The wealthy are the only ones who need to make out wills. Fantasy: Nothing could be further from the truth! While the wealthy many have more motivation to do so, anyone who has accumulated an estate – no matter how small – should have a will draw up that sets out how the estate is to be distributed to heirs and/or beneficiaries. • Due to recent changes in the law, a person no longer has to be mentally competent in order to draw up a valid will. Fantasy: A person still must be mentally competent in order to draw up (or have drawn up) a legally enforceable will. • Once a will is drawn up, it is relatively simple to make minor changes to it. Fact: As long as the changes are minor, a simple and convenient way to legally modify an existing will is a codicil, which is a short, legal document that specifies the changes. • In order for a living trust to be legally enforceable, it must be irrevocable. Fantasy: A legally enforceable living trust, which is created and exists during the lifetime of the person(s) setting it up, may be either revocable (giving the grantor the right to revoke the trust) or irrevocable (beyond the reach of the grantor). • There are no federal estate taxes on estates of up to $5,430,000 for individuals. Fact: Such estates pass to their heirs and/or beneficiaries free from estates taxes. And this limit is doubled to $10,680,000 for married couples. Only larger estates are subject to these taxes. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False Estate planning is one of the key elements of personal financial planning. 2. True False The wealthy are the only ones who need to make out wills. 3. True False Due to recent changes in the law, a person no longer has to be mentally competent in order to draw up a valid will. 4. True False Once a will is drawn up, it is relatively simple to make minor changes to it. 5. True False In order for a living trust to be legally enforceable, it must be irrevocable. 6. True False There are no federal estate taxes on estates of up to $5,430,000 for individuals. Answers: 1. True 2. False 3. False 4. True 5. False 6. True YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. In class, you could ask the students what they found on the sites. YOU CAN DO IT NOW Estate Planning Conversations Dealing with the prospect of each other’s deaths in a family is never comfortable. But careful estate planning will assure that your intentions are best served in light of the family’s needs. A useful perspective on how to have such a conversation may be found at: https://www.fidelity.com/estate-planning-inheritance/estate-planning/talking-estate-planning. The sooner the conversation happens, the more confident you can be that your estate plan will have the intended results. You can do it now. YOU CAN DO IT NOW Importance of Naming Alternative Beneficiaries When you name beneficiaries on financial accounts or in your will, it’s important to name alternate (contingent) beneficiaries as well. This will make clear what happens if your first choice beneficiary doesn’t outlive you. See http://www.nolo.com/legal-encyclopedia/why-naming-alternate-beneficiaries-your-will-is-so-important.html for some useful tips on naming beneficiaries and related key issues. You can do it now. Financial Impact of Personal Choices Read and think about the choices being made. Do you agree or not? Ask the students to discuss the choices being made. The Unintended Effects of Lewis’s Beneficiary Designations Lewis Jenkins died suddenly in 2015. He had amassed a significant estate and had an attorney write a will that would distribute his assets among his wife, Mila, and two grown daughters, Lyla and Zara, as he wished. Apart from his will, he had heard that it made sense to name beneficiaries on his investment accounts so that those assets would go directly to his family and bypass the sometimes long and costly probate process. Lewis had been previously married to Elise Jenkins, who survived him. Lewis named his wife, Mila, as the beneficiary to most of his investment accounts and designated one account to his daughter, Lydia, and one account to his daughter, Lyla, and one account to his daughter, Zara. He intended for his daughters to get equal amounts. While trying to be careful, Lewis forgot that he hadn’t changed the beneficiary on one investment account from Elise, his prior wife, to his current wife, Mila. That account was worth $50,000 at his death. So what was the effect of Lewis’s beneficiary designations? His wife Mila received most of the investment accounts as he had intended. However, the $50,000 account that had not been updated to name Mila as the beneficiary went to Lewis’s prior wife, Elise, which is not what he intended. While it seemed fair to Lewis to designate one investment account to each of his daughters and the accounts had the same initial values, the accounts had grown to different values by the time of his death. Lyla’s account had grown to $100,000 while Zara’s account had grown to $200,000. Lewis had intended that his daughters receive equal amounts, but they did not. Lewis could have achieved his objective by naming both of his daughters as beneficiaries on both of the accounts. And had Lewis reviewed his beneficiary designations at least once a year, he may well have discovered that he’d forgotten to make an important change. Financial Planning Exercises 1. Estate planning objectives. Generate a list of estate planning objectives that apply to your personal family situation. Be sure to consider the size of your potential estate as well as people planning and asset planning. Estate planning is not just about taxes. The student may not share information about their family, rather just using general family situations. That should be sufficient for this problem. Estate planning is planning how you will distribute your property. Regardless of the taxability of your estate, you have to plan what do to with your property. Asset planning refers to your plan to distribute your assets. People planning is deciding who to give which asset. All heirs are not equal and giving the same thing or dollars to each heir is not necessarily treating each “equally.” One kid may really appreciate and enjoy antiques; another could care less about them. People planning is taking into consideration the personality and desires of each heir in deciding which property to give the heir. Among the possible objectives to consider are: providing financial security for spouse and children (adequate funds to maintain lifestyle, for college education, etc.), arranging for professional management of assets if necessary, naming guardians for minor children, arranging for transfer of business ownership interests, providing for dependent parents or other relatives, and disposing of assets equitably. 2. Importance of writing a will. Emilia and Kevin Boyd are in their mid-30s and have two children, ages 8 and 5. They have combined annual income of $150,000 and own a house in joint tenancy with a market value of $410,000, on which they have a mortgage of $300,000. Darrell has $100,000 in group term life insurance and an individual universal life policy of $150,000. However, the Boykins haven’t prepared their wills. Kevin plans to draw one up soon, but they think that Emilia doesn’t need one because the house is jointly owned. As their financial planner, explain why it’s important for both Emilia and Kevin to draft will as soon as possible. Both Emilia and Kevin should have wills. One major reason is they need to name the guardian for their children in the event they die in a common accident. Further, Emilia should also have a will to protect the family when she dies. True, if Kevin predeceases her, the house passes to her through joint tenancy and the insurance proceeds pass to her by contract (assuming that she is the named beneficiary), but then she needs to plan for the disposition of assets at her death. If she and Kevin were to die as a result of the same accident and it was determined that Kevin died first, she would inherit the life insurance proceeds and all other assets. But since she also dies, then the state laws will determine how the property will pass and the courts will appoint guardians for the children and for the property going to the children (minors have a limited right to receive property outright). With a will, she can express her wishes in these matters as well as specify who should receive any personal property. Both Emilia and Kevin should review their wills on a regular basis to make sure they continue to reflect their wishes. [They should also consider more life insurance, particularly on Emilia. They both work, and in the absence of one of their incomes, the survivor’s earnings may be insufficient to support their mortgage payments, provide a college education for the children, and possibly pay for some additional child care costs while the children are young.] 3. Qualifications of estate executor. Your best friend has asked you to be executor of his estate. What qualifications do you need, and would you accept the responsibility? An executor, sometimes called the decedent’s personal representative, must collect the decedent’s assets, pay debts or provide for payment of debts that are not currently due, and distribute any remaining assets to the person entitled to them by will or by the intestate succession law of the appropriate state. Because of the importance of the estate administration process, you should select executors who are not only familiar with testator’s affairs but also can effectively handle the responsibilities of being an executor. Many would argue that the executor should be a bank trust department or a professional such as a lawyer. The amount of detail work to be done can be a problem for a relative with little experience in such matters. But typically relatives will do the work for less money than lawyers and trust departments. 4. Will and last letter preparation. Prepare a basic will for yourself, using the guidelines presented in the text; also prepare your brief letter of last instructions. Student wills should include the clauses described in the text in Exhibit 15.3. The letter of last instructions should cover the location of the will and other important documents, funeral preferences, the names of professional advisors, and any other information that will assist the executor to carry out his or her wishes when administering the estate. 5. Topics in an ethical will. State the topics you would cover in your ethical will. Would you consider recording it digitally? Ethical wills are personal statements of values, blessings, life’s lessons, and hopes and dreams for the future. They are informal documents that are usually added to formal wills and read at the same time. They offer a way to share your morals, business ethics, life experiences, family stories and history, and more with future generations. They can take various forms, such as handwritten letters or journals, personal essays written on a computer, or even a digitally recorded discourse to be shared on DVD or audiotape. Most people will favor digitally recording their statements. It is their last chance to be on the screen. 6. Trusts in estate planning. Frank Shaw, 48, and Victoria Ferguson, 44, were married five years ago. There are children from their prior marriages, two children for Frank and one child for Victoria. The couple’s estate is valued at $1.4 million, including a house valued at $475,000, a vacation home in the mountains, investments, antique furniture that has been in Victoria’s family for many years, and jewelry belonging to Frank’s first wife. Discuss how they could use trusts as part of their estate planning and suggest some other ideas for them to consider when preparing their wills and related documents. Trusts are very useful to provide professional management of property for the benefit of another. Frank and Victoria have a small estate. Their primary concern will be taking care of their children in case of death of one or both. A testamentary trust could be designed to set aside some funds to provide for a college education of the kids. The trust could be funded with the vacation home in the mountains with the expectation that the trust would sell the property to provide funds for education expenses. Also, a separate testamentary trust could be established to hold the antique property until Victoria’s child is eighteen. At that time, the property could be turned over to that child with a letter of instruction urging the child to keep the property in the family. The trusts would not be established if the children are through college and the age of majority at the time of the Frank’s and Victoria’s deaths. 7. Calculation of estate taxes. Use Worksheet 15.1. When Jackson Holmes died unmarried in 2018 he left an estate valued at $15,850,000. His trust directed distribution as follows: $20,000 to local hospital, $160,000 to his alma mater, and the remainder to his three adult children. Death-related costs and expenses were $6,800 for funeral expenses, $40,000 paid to attorneys, $5,000 paid to accountants, and $30,000 paid to the trustee of his living trust. In addition, there were debts of $125,000. Use Exhibits 15.5 and 15.6 to calculate the federal estate tax due on Jackson’s estate. Worksheet 15.2 [as a word table] is below.
Computing Federal Estate Tax Due
Name: Jackson Holmes Date: May 4, 2018
Line Computation Item Amount Total Amount
1 Gross Estate $15,850,000
2 Subtract sum of a) Funeral Expenses $6,800
b)Administrative Expenses 75,000
c)Debts 125,000
Total (206,800)
3 Result Adjusted Gross Estate $15,643,200
4 Subtract: a) Marital deduction
b) Charitable deduction 180,000
Total (180,000)
5 Result Taxable estate $15,463,200
6 Add Post-1976 taxable gifts 0
7 Result Estate Tax Base $15,463,200
8 Compute Tax Tentative tax on estate tax base $6,131,080
9 Subtract sum of a) Gift Tax paid on post 1976 gifts 0
b) Unified Tax Credit--2018 credit 4,417,800 4,417,800
10 Result 1,713,280
11 Subtract Other Credits 0
12 Result: Federal estate Tax Due $1,713,280
Use Exhibit 15.5 to calculate the tentative tax.
Use Exhibit 15.6 to determine the appropriate unified tax credit.
Note: the amount on line 7, the estate tax base is significant since many states will assess their estate tax as a percentage of the federal estate tax base.
8. Lifetime gifting strategy. Camila Ortiz has accumulated substantial wealth and plans to gift some of her wealth to her son Diego. She is considering two assets: a beach house, which cost $300,000 twenty years ago and now has a fair market value of $750,000; and shares in three mutual funds, which cost her $550,000 five years ago and now have a fair market value of $750,000. Prepare a memo advising Rosa which property to give to Marcos. In your memo, consider two scenarios: one where Diego sells the property and one where he does not. Student memo formats may vary but should include some of the following information regarding Camila’s gift to her son Diego and whether he decides to keep the gift or sell it. Giving gifts reduce the taxable estate in two ways. First, any future appreciation of the gifted property is excluded from the estate because the decedent does not own the property on the date of death. Second, if the gift is so large that taxes are due, the money used to pay the tax is also removed from the estate. (There is an exception for gift taxes paid within 3 years of death.) In this exercise the big issue is the impact on Diego’s income taxes. If the gifted property is sold by Diego for a gain, it should be noted that property received by gift has a tax basis equal to its basis in Camila’s hands (i.e., a carryover basis). In other words, if the beach house is gifted, the basis to Diego will be $300,000; if passed through the estate, its basis to Diego will be $750,000. As long as the property is not sold or depreciated, the basis really does not matter until the time of conversion. However, if Diego sells the beach house, then there is a difference in income tax of $90,000 (*20% capital gains rate multiplied by the difference in basis or $450,000) between receiving the property by gift versus through the estate. The same holds true with the mutual funds. That is, if Diego sells the mutual funds, he will have a gain of $200,000, selling price of $750,000 less his carryover basis of $550,000. As a result, if Diego sells both the beach house and stock at their fair values, the capital gains taxes would be $130,000 [Fair value $1,500,000 − $850,000 basis = $650,000 difference × *20% capital gains rate]. If Camila does not make any gifts electing to pass the property through the estate, there will be no gain subject to the income tax [basis of inherited property is its FMV at time of death], a saving of $130,000. If Diego intends to keep the property, for example keep the beach house, then the basis issue is of little matter. As noted above, basis only matters if the property is to be sold. The other issue is income. The mutual funds will generate income [dividends and capital gains] that will be available to Diego and taxable to Diego most likely at the 20% capital gain rate. The beach house will not generate income, but will have expenses such as taxes, insurance, and maintenance. Which property to gift? Most kids want cash; thus the mutual funds may be the preferred gift. If he sells the funds, the gain will be less than the gain from the beach house. If he keeps the funds, there will be some money from the earnings of the mutual funds. 9. Calculating federal transfer tax on estate. Ronald Knight died in 2018, leaving an estate of $23 million. Ronald’s wife died in 2015. In 2009, Ronald gave his son Jamie, property that resulted in a taxable gift of $3 million and upon which Ronald paid $885,000 in transfer taxes. Ronald had made no other taxable gifts during his life. His will provided a charitable bequest of $1 million to his church. Determine the federal transfer tax on Ronald’s estate. Worksheet 15.2 [as a word table] is below.
Computing Federal Estate Tax Due
Name: Ronald Knight Date: May 4, 2018
Line Computation Item Amount Total Amount
1 Gross Estate $23,000,000
2 Subtract sum of a) Funeral Expenses
b)Administrative Expenses
c)Debts
Total
3 Result Adjusted Gross Estate 23,000,000
4 Subtract: a) Marital deduction
b) Charitable deduction 1,000,000
Total (1,000,000)
5 Result Taxable estate $22,000,000
6 Add Post-1976 taxable gifts 3,000,000 3,000,000
7 Result Estate Tax Base $25,000,000
8 Compute Tax Tentative tax on estate tax base $9,945,800
9 Subtract sum of a) Gift Tax paid on post 1976 gifts 0
b) Unified Tax Credit--2018 credit 4,417,800 4,417,800
10 Result 5,528,000
11 Subtract Other Credits 0
12 Result: Federal estate Tax Due $5,528,000
Use Exhibit 15.5 to calculate the tentative tax.
Use Exhibit 15.6 to determine the appropriate unified tax credit.
Note: the amount on line 7, the estate tax base is significant since many states will assess their estate tax as a percentage of the federal estate tax base.
10. Recent estate taxes legislation. Summarize important legislation affecting estate taxes, and briefly describe the impact on estate planning. Explain why getting rid of the estate tax doesn’t eliminate the need for estate planning. Congress is not likely to modify the transfer tax before 2019, if then. But if it does, the changes will be either eliminate the tax altogether or modify the amount of the credit and subsequent Applicable Exclusion Amount. The 2018 credit is $4,417,800 which offsets the tax on $11,180,000 of taxable estate. The credit is adjusted each year for inflation. I would be willing to bet a package of Ritz crackers that the Congress will not change the estate tax during the congress that runs from 2019-2020. Recall that estate planning is planning how to distribute your assets and the people to whom you give your assets. These decisions need to be made regardless of whether there is a tax on the estate. Other issues include: a. When minor children are involved, guardians need to be named in the event that both parents die. Otherwise, the state will decide the guardian for the children. b. Trusts need to be established to take care of certain special needs children for the remainder of their lives. c. Trusts may also need to be established to care for the surviving spouse, particularly as they become elderly and/or incapacitated. d. Assets need to be divided up in an equitable manner among the heirs. e. Insurance planning needs to be done to provide for the surviving spouse and/or children and/or to take care of debts, final expenses, and transfer costs. Test Yourself 15-1 Discuss the importance and goals of estate planning. Explain why estates often break up. Distinguish between the probate estate and the gross estate.
probate estate The real and personal property owned by a person that can be transferred at death.
gross estate All property that might be subject to federal estate taxes on a person’s death.
The states versus federal interest in estates is that the property of the decedent goes to the person it is supposed to go to. At death property is transferred by property law and by probate law. Any property that is jointly owned with right of survivorship will be transferred by property to the joint owner—such property will not be a part of the probate estate. Also, if property held by contract (such as investment account, mutual funds, bank account, etc.) has a named beneficiary, that property will be transferred to the beneficiary by property law—such property will not be a part of the probate estate. All other property will be in the probate estate. The gross estate is the federal term for all property owned in any way by the decedent. Thus, gross estate will include jointly owned property as well as property subject to a contract. Of course it also include the probate estate. The purpose of the gross estate is to compute the transfer tax on estates. 15-2 Briefly describe the steps involved in the estate planning process. Exhibit 12.2 list seven steps in the estate planning process. They are: 1. Assess your family situation and set estate planning goals. 2. Gather comprehensive and accurate data. 3. List all assets and determine the ownership and value of your estate. 4. Designate beneficiaries of your estate’s assets. 5. Estimate estate transfer costs; includes tax and other transaction costs. 6. Formulate and implement your plan. 7. Review the plan periodically and revise it as necessary. 15-3 What is a will? Why is it important? Describe the consequences of dying intestate.
will A written and legally enforceable document expressing how a person’s property should be distributed on his or her death.
You can’t take your property with you when you die, so it has to be transferred to someone. As mentioned in 1 above, jointly owned property and property subject to a contract that specifies a named beneficiary will be transferred by property law. The probate estate is the rest of your property and the state government looks to you to tell them where the property should go. You do this through a will. If you do not have a will, you are said to die intestate and the state intestate laws govern who gets the property. Those laws may be OK with you, or not. The way for you to control the distribution of your property on your death is to write a will. 15-4 Describe the basic clauses normally included in a will and the requirements regarding who may make a valid will. Exhibit 15.5 displays a sample will with eight sections or clauses that are normally found in a will. Section 15-2c of the chapter discusses the common features of the will and appears on pages 607-609. The will must do three things: Provide a plan for distributing the testator’s assets according to his or her wishes, the beneficiaries’ needs and federal and state dispositive tax laws. Consider the changes in family circumstances that might occur after it execution. Be concise and complete in describing the testator’s desires. Section 3 and 4 specifies the disposition of the property and appoints an executor to take care of the distribution of the property and other matters as needed by the estate. 15-5 How can changes in the provisions of a will be made legally? In what four ways can a will be revoked? Minor changes in the will may be made by a codicil, a short document that reaffirms all existing provisions in the will except the one to be changed. The codicil should be executed and witnessed in the same formal manner as a will. The will may be revoked by any one of the following: 1. Making a later will that expressly revokes prior wills. 2. Making a codicil that expressly revokes all well before the one being modified. 3. Making a later will that is inconsistent with a former will. 4. Physically mutilating, burning, tearing, or defacing the will with the intention of revoking it. 15-6 Explain these terms: (a) intestacy, (b) testator, (c) codicil, (d) letter of last instructions.
intestacy The situation that exists when a person dies without a valid will.
testator The person who makes a will that provides for the disposition of property at his or her death.
codicil A document that legally modifies a will without revoking it.
letter of last instructions An informal memorandum that is separate from a will and contains suggestions or recommendations for carrying out a decedent’s wishes.
15-7 What is meant by the probate process? Who is an executor, and what is the executor’s role in estate settlement? In the probate process, money owed to the decedent is collect, creditors (including tax authorities) are paid, and what remains is distributed to the appropriate persons. The person who makes this happens is the executor as named in the decedent’s will or if no will, by the laws of intestacy which provide for the probate court to appoint an administrator. The executor or administrator becomes the decedent’s legal representative, taking care of such matters as collecting bank accounts and other contract, releasing liability and creating clear title to make real estate marketable. Executors should be familiar with the decedent and their affairs, and they should be able to effectively handle the responsibilities of being an executor. 15-8 Describe briefly the importance of these documents in estate planning: (a) power of attorney, (b) living will, (c) durable power of attorney for health care, and (d) ethical will. Power of Attorney: Through a power of attorney, you give a person complete control over your financial affairs. The “attorney” may sell your property, write checks on your accounts, manage your property in every sense of the word. If you do not wish to give complete control, you may execute a limited power that only allows control over what you specify in the power. Most third parties look to the general power to specify the transactions involving the third party. Thus, a bank will expect the general power to specify that the person so designated has the power to use the bank account. Living Will: A document that precisely states the treatments a person wants if he or she becomes terminally ill. The document must be precise and as specific as possible or it may be disregarded. Durable Power of Attorney for Health Care: Through the durable power of attorney for health care, you authorize an individual to make health care decisions for you if you are unable to do so either by temporarily or permanently. Unlike the living will, it applies in any case where you can’t communicate your wishes, not just when you are terminally ill. Ethical Wills: A personal statement left for family, friends, and community that shares your values blessings, life’s lessons, and hopes and dreams for the future. Also called legacy letter. It does not transfer any property and has no legal standing. For example, you may say that you do not want your heir to get a divorce, but the document does not limit the ability of the heir to divorce. 15-9 Define and differentiate between joint tenancy and tenancy by the entirety. Discuss the advantages and disadvantages of joint ownership. How does tenancy in common differ from joint tenancy? Joint tenancy describes a type of property ownership where there are more than one owner and that all surviving owners take ownership of all the property at the death of one of the owners. Tenancy by the entirety is a special form of joint tenancy between a husband and wife. The advantage over joint tenancy is protection from bankruptcy laws. With tenancy by the entirely, each joint tenancy is consider to own the entire property, thus, the creditors from bankruptcy of one cannot reach the property owned by the other. Tenancy in common has more than one owner, hence joint owners, but there is no right of survivorship. So at your death, your share of the property owned as tenancy in common will be included in your estate and distributed by will or intestacy laws. Joint ownership in general, allows multi parties to join together to invest in some property without forming an entity such as a partnership or LLC. They are co-owners and if right of survivorship applies, at the death of one, the property is automatically transferred to the remaining owners without the probate court being involved. 15-10 What is the right of survivorship? What is community property and how does it differ from joint tenancy with regard to the right of survivorship?
right of survivorship The right of surviving joint owners of property to receive title to the deceased joint owner’s interest in the property.
community property All marital property co-owned equally by both spouses while living is a community property state.
If the state used community property laws, the property that a person acquires while married is considered to the half owned by each spouse. The right of survivorship does not apply to the property and at death, the decedent must transfer their half to their heir, one of whom may be the spouse. 15-11 Describe the basic trust arrangement, and discuss typical reasons for establishing trusts. What essential qualities should a trustee possess?
trust A legal relationship created when one party transfers property to a second party for the benefit of third parties.
The grantor transfers property to the trust. The provisions of the trust are carried out by the trustee. The trust specifies who is to benefit from the trust, called the beneficiaries. Each of these parties may be different individuals or they may all be the same person. The essential qualities for a trustee are to honest and knowledgeable. The text specifies five qualities: 1. Possess sound business knowledge and judgment. 2. Have an intimate knowledge of the beneficiary’s needs and financial situation. 3. Be skilled in investment and trust management. 4. Be available to beneficiaries (specifically, this means that the trustee should be young enough to survive the trust term.) 5. Be able to make decisions impartially. 15-12 What is a living (inter vivos) trust? Distinguish between a revocable living trust and in irrevocable living trust.
living (inter vivos) trust A trust created and funded during the grantor’s lifetime.
Revocable means that the trust may be revoked or discarded at the option of the grantor. Irrevocable means that the grantor cannot change their mind, the trust cannot be revoked by the grantor. For federal income tax, a revocable trust is ignored. The grantor is subject to tax on the income from the property. An irrevocable trust is recognized for federal income tax purpose; the trust or its beneficiaries are responsible for the tax on the income from the property. 15-13 Explain each of these terms: (a) grantor, (b) trustee, (c) beneficiary, (d) pour-over will, testamentary trust, and (f) irrevocable life insurance trust.
grantor A person who creates a trust and whose property is transferred into it. Also called settlor, trustor creator.
trustee An organization or individual selected by a grantor to manage and conserve property placed in trust for the benefit of the beneficiaries.
beneficiaries Those who receive benefits—property or income—from a trust or from the estate of a decedent. A grantor can be a beneficiary of his own trust.
pour-over will, testamentary trust A provision in a will that provides for the passing of the estate—after debts, expenses, taxes, and specific bequests—to an existing living trust. A revocable living trust becomes irrevocable at the death of the grantor. A testamentary trust is a trust created by a decedent’s will and funded through the probate process.
Irrevocable life insurance trust An irrevocable trust in which the major asset is life insurance on the grantor’s life. If establish at least three years before the decedent’s death, the life insurance is not included in the gross estate as long as neither the estate nor decedent is the named beneficiary.
15-14 What is a gift, and when is a gift made? Describe the following terms as they relate to the federal gift taxes: (a) annual exclusion, (b) gift splitting, (c) charitable deduction, and (d) marital deduction. A gift is a transfer for less than full and adequate consideration. The donor must have charitable or altruistic motives. The gift is made when the ownership of the property is transferred to the done. Annual exclusion: In order to reduce the administrative burden on the taxpayer and the government, gifts made during the year that total less than the specified amount [$14,000 in 2015] are subject to the gift tax. No return is required. If the total gifts to a person exceed the specified amount, a gift tax return is required. Gift splitting: Basically the provision allows a joint return for gifts. At the option of the spouses, gift by one may be considered to be made half by one and half by the other spouse. This is an election that must be elected on a tax return; thus a gift tax return must be filed to elect this option. Charitable deduction: Similar to the income tax, gifts to a 501(c)(3) organization may be deducted when computing the taxable gifts. Unlike the income tax, there is no limit on the amount that may be deductible. Marital deduction: Any gift between spouses may be deductible on a gift tax return. (Same is true for an estate tax return also.) Thus, property may be transferred between spouses with no tax consequences. A gift tax return must be filed to take this deduction. Of course it does not apply to gift subject to the annual exclusion. 15-15 Discuss the reasons estate planners cite for making lifetime gifts. How can gift giving be used to reduce estate shrinkage? The estate tax is assessed on the property owned by the decedent at the time of their death. If the property was gifted before their death, it is not in the gross estate. Any taxable gift made after 1976 will be added back to the gross estate in determining the taxable estate, but the amount added is the value when the gift was made which could be much less than the value of that property on the date of death. Also, if the gift result in a gift tax being paid, then the amount of cash used to pay the tax will also be out of the gross estate and it will not be added back to determine taxable estate. Lastly, if the gift is below the annual exclusion, the property will be out of the gross estate and no tax will have to be paid. 15-16 Explain the general nature of the federal estate tax. How does the unified tax credit affect the amount of estate tax owed? What is the portability concept? The unified transfer tax applies to two type of transfers: transfers by gift [referred to as the gift tax] and transfers through an estate [referred to as the estate tax]. The beginning point for the estate tax is the gross estate, all property owned, in whole or part, by the decedent on the date of death. From this amount deductions are taken including expenses relating to the estate, charitable deductions and marital deduction. To this tentative tax base, all taxable gifts made since 1976 are added to arrive at taxable estate. A graduated rate with a top rate of 40% is applied and the tentative tax computed. From this tentative tax, the unified transfer tax credit is deducted to arrive at the tax due. The credit for 2015 is $2,117,800 which will completely offset the tax on a taxable estate of $5,430,000. The $5,430,000 is referred to as the applicable exclusion amount. Effective in 2011, a decedent could elect to allow their spouse to use any unneeded credit to reduce their [the second spouse to die] tax referred to as the portability concept. Thus, with the election, a married couple may use a total credit of $4, 235,600 which will offset tax on total estate of $10,860,000. These amounts assume both spouses died in 2015. The credit will change yearly, thus the total estate reduced by the credit will change yearly. 15-17 Explain the general procedure used to calculate the federal estate tax due. Compute the gross estate, subtract the total deductions, add taxable gifts since 1976, compute tax using schedule in Exhibit 15.7, and then subtract the applicable unified transfer tax credit to determine tax due. 15-18 Describe and discuss each of the techniques used in estate planning. Primary techniques are: Gift giving, gift an amount less than the annual exclusion each year to each person you desire to receive some of your estate and there will be no tax due nor will there be a tax return due. Charitable Contributions, better to give while you are alive rather than through the estate. If given while you are alive you save income tax and the property is out of your gross estate, thus your estate tax is reduced also. Elect portability for the unified tax credit. If the election is not made, each party to a marriage only gets one credit. Use Life Insurance Trust. If you set up a life insurance trust at least three years before death, the amount of life insurance received will not be in your gross estate. Valuation issues. The gross estate is the fair market value on the date of death. Because of the way the market reacts to large amounts of stock or real estate being sold during a short period, valuation of property in an estate or transfer by gift are subject to a variety of discounts. The major of these are minority interest, marketability discount, and blockage discounts. Trusts. Trusts may be used in certain cases to reduce the transfer taxes. These cases involve large estates and high transaction costs [professional fees]. They are worth it for large estates [over $20 million] but not smaller ones. Criterial Thinking Cases 15.1 A Long-Overdue Will for Carsten In the late 1980s, Carsten Richter, from Germany, migrated to the United States, where he is now a citizen. A man of many talents and deep foresight, he has built a large fleet of oceangoing oil tankers during his stay in the United States. Now a wealthy man in his 60s, he resides in Aspen, Colorado, with his second wife, Gabriela, age 50. They have two sons, one in junior high and one a high-school freshman. For some time, Carsten has considered preparing a will to ensure that his estate will be property distributed when he dies. A survey of his estate reveals the following:
Ranch in Colorado $1,000,000
Condominium in Santa Barbara 800,000
House in Aspen 1,500,000
Franchise in ice cream stores 2,000,000
Stock in Google 5,000,000
Stock in Wal-Mart 1,000,000
Stock in Silver Mines International 3,000,000
Other assets 200,000
Total Assets $14,500,000
The house and the Silver Mines International shares are held in joint tenancy with his wife, but all other property is in his name alone. He desires that there be a separate fund of $1 million for his sons’ education and that the balance of his estate be divided as follows: 40 percent to his sons; 40 percent to his wife, and 20 percent to given to other relatives, friends and charitable institutions. He has scheduled an appointment for drafting his will with his attorney and close friend, Forrest Gauthier. Carsten would like to appoint Forrest, who is 70 years old and Carsten’s cousin Heinrich Richter (a CPA) as co-executors. If one of them predeceases Carsten, he’d like First National Bank to serve as co-executor. Critical Thinking Questions 1. Does Carsten really need a will? Explain why or why not? What would happen to his estate if he were to die without a will? Yes, Carsten really needs a will. Without a valid will, the statutes of the state of Colorado would govern the disposition of his sizable estate. This situation would not provide for minimum estate shrinkage, nor would it result in the transfer of assets to those whom Carsten would choose. If Karen is not the mother of his two sons, a battle could ensue over property, and as the sons are still in high school, they are probably not yet “of age,” so their guardian needs to be named. Because Carsten owns property in several states, the states could possibly fight over which is his state of domicile—something which could be avoided with a valid will. 2. Explain to Carsten the common features that need to be incorporated into a will. His will should contain eight distinct parts: (1) Introductory Clause—stating his place of residence and nullifying old and forgotten wills and codicils (legally binding modifications of an existing will). (2) Direction of Payments—directing his estate with respect to certain payments of expenses. (3) Disposition of Property—disposing of his personal effects, passing money to specified parties, or distributing his residual assets after specific gifts have been made. (4) Appointment Clause—appointing his executors, guardians, and trustees, as well as their successors. (5) Tax Clause—allocating his burden of taxes among his beneficiaries. Otherwise, apportionment statutes of his state will allocate the taxes among beneficiaries. (6) Simultaneous Death Clause—protecting his estate against a common disaster or simultaneous death of his spouse. This clause attempts to avoid double probate of the same assets. (7) Execution and Attestation Clause—providing his signature as a precaution against fraud. Many attorneys suggest initialing each page after the last line and including a signature on the left-hand margin of each page, which of course should be numbered. (8) Witness Clause—containing the signatures of the required number of witnesses, who sign in the presence of each other (with their addresses noted on the will) in order to affirm that the will in question is actually his. 3. Might the manner in which titles are held thwart his estate planning desires? What should be done to avoid problems? The property titled joint with right of survivorship will pass to the survivor regardless of a will provision otherwise. The form of ownership must be consistent with the will or unforeseen results will occur. 4. Is a living trust an appropriate part of his estate plan? How would a living trust change the nature of Carsten’s will? Certainly either a living will or a durable power for health care should be provided. Carsten needs to provide for how he want his health care handled. In addition he has substantial wealth which could attract the curious and bring unwanted publicity to the estate. A living trust established by the will could add privacy to the estate. 5. How does the age of his children complicate the estate plan? What Special provisions should he consider? Minor children need to be cared for either by trusts and/or guardians (godparents). Funds are best managed by a trust to insure that the funds will last as long as possible. With nothing but guardianships, the funds would go to the kids when they reach 18. Generally, that is much too young to wisely manage large sums of wealth. Better to have in a trust with professional manager. 6. What options are available to Carsten if he decides later to change or revoke the will? Is it more difficult to change a living trust? Minor changes in the will may be made by a codicil, a short document that reaffirms all existing provisions in the will except the one to be changed. The codicil should be executed and witnessed in the same formal manner as a will. The will may be revoked by any one of the following: 1. Making a later will that expressly revokes prior wills. 2. Making a codicil that expressly revokes all well before the one being modified. 3. Making a later will that is inconsistent with a former will. 4. Physically mutilating, burning, tearing, or defacing the will with the intention of revoking it. 7. What duties will Forrest Gauthier and Heinrich Richter have to perform as co-executors of Carsten’s estate? If a trust is created, what should Carsten consider in his selection of a trustee or co-trustees? Might Forest and Heinrich, serving together, be a good choice? As co-executors of Carsten’s estate, Forrest Gauthier, his close friend and attorney, Heinrich Richter, his cousin, will share the duties of estate administration. Upon Carsten’s death, they must take inventory and value his assets, pay his debts or provide for payment of debts that are not yet due, and distribute any remaining assets to the persons entitled to them as specified in Carsten’s will. Their responsibility will, therefore, be to carry out Carsten’s wishes as specified in his will once all legal obligations related to the probate process have been satisfied. Generally, a trustee’s job is long term, e.g., until the youngest boy reaches 30 years of age, and involves long term investing and management of the trust’s assets. Given Forrest’s age, he is not a good candidate for trustee, even though he might be appropriate as a co-executor. Heinrich seems to be a good selection for both. He is young enough that it is likely he can serve for many years and his training as a CPA will come in handy in both executor and trustee capacities. A trustee does not have to be an expert in investments merely smart enough to know when he or she needs help and where to find it. Also, the bank will become co-trustee at the death of one of the other co-trustees. 15.2 Estate Taxes on Saul Schwab’s Estate Saul Schwab’s, of Knoxville, Tennessee, was 65 when he retired in 2010. Camille, his wife of 40 years, passed away the next year. Her will left everything to Saul. Although Camille’s estate was valued at $2,250,000, there was no estate tax due because of the 100 percent marital deduction. Their only child, Eli, is married to Kathleen; they have four children, two in college and two in high school. In 2011, Saul made a gift of Apple stock worth $260,000 jointly to Eli and Kathleen. Because of the two $13,000 annual exclusions and the unified credit, no gift taxes were due. When Saul died in 2015, his home was valued at $890,000, his vacation cabin on a lake was valued at $485,000, his investments in stocks and bonds at $1,890,000, and his pension funds at $645,000 (Eli was named beneficiary). Saul also owned a life insurance policy that paid proceeds of $700,000 to Eli. He left $60,000 to his church and $25,000 to his high school to start a scholarship fund in his wife’s name. The rest of the estate was left to Eli. Funeral costs were $15,000. Debts were $90,000 and miscellaneous expenses were $25,000. Attorney and accounting fees came to $36,000. Use Worksheet 15.2 to guide your calculations as you complete these exercises. Worksheet 15.2 is below.
Computing Federal Estate Tax Due
Name: Saul Schwab Date: May 4, 2016
Line Computation Item Amount Total Amount
1 Gross Estate $4,610,000
2 Subtract sum of a) Funeral Expenses $15,000
b)Administrative Expenses 61,000
c)Debts 90,000
Total (166,000)
3 Result Adjusted Gross Estate $4,444,000
4 Subtract: a) Marital deduction
b) Charitable deduction 85,000
Total (85,000)
5 Result Taxable estate $4,359,000
6 Add Post-1976 taxable gifts (Eli only) 117,000
7 Result Estate Tax Base $4,736,000
8 Compute Tax Tentative tax on estate tax base $1,736,200
9 Subtract sum of a) Gift Tax paid on post 1976 gifts 0
b) Unified Tax Credit--2015 credit 2,117,800 2,117,800
10 Result 0
11 Subtract Other Credits 0
12 Result: Federal estate Tax Due $0
Use Exhibit 15.7 to calculate the tentative tax.
Use Exhibit 15.8 to determine the appropriate unified tax credit.
Critical Thinking Questions 1. Compute the value of Saul’s probate estate. The probate estate consists of the gross estate less non-probate assets. The gross estate amount of $4,610,000 is calculated in #1 above. Saul’s non-probate assets consist of his life insurance policy ($700,000) and his pension fund ($645,000) which will pass by contract to his son Nathan, his named beneficiary. Therefore, the amount of his probate estate is $3,265,000 [$4,610,000 − ($700,000 + $645,000)]. 2. Compute the value of Saul’s gross estate. Gross estate is: 3. Determine the total allowable deductions. Deduction are: 4. Calculate the estate tax base, taking into account the gifts to Eli and Kathleen (remember that the annual exclusions “adjust” the taxable gifts). The gift of stock was valued at $260,000 with half to Eli and half to Kathleen. Kathleen’s half will be subject to the annual exclusion of $13,000 and a marital deduction of $117,000, for $0 taxable gift. Eli half of $130,000 is subject to the annual exclusion of $13,000 for a net of $117,000. The gifts to be added back are only Eli’s share, $117,000. 5. Use Exhibit 15.7 to determine the tentative tax on estate tax base. Taxable estate with gifts = $4,736,000, from line 7 of Worksheet 15.2. Tax is $345,800 + ($4,736,000 - $1,000,000) = $1,736,200 6. Subtract the appropriate unified tax credit (Exhibit 15.8) for 2012 from the tentative tax on estate tax base to arrive at the federal estate tax due. The credit is $2,117,800. The tax due is $0, the credit is greater. 7. Comment on the estate shrinkage experienced by Robert’s estate. What might have been done to reduce this shrinkage? Explain. Primary techniques are: Gift giving, gift an amount less than the annual exclusion each year to each person you desire to receive some of your estate and there will be no tax due nor will there be a tax return due. Charitable Contributions, better to give while you are alive rather than through the estate. If given while you are alive you save income tax and the property is out of your gross estate, thus your estate tax is reduced also. Elect portability for the unified tax credit. If the election is not made, each party to a marriage only gets one credit. Not necessary in this case since his estate was less than $5,340,000 even with his wife’s estate. Use Life Insurance Trust. If you set up a life insurance trust at least three years before death, the amount of life insurance received will not be in your gross estate. Terms Found in the Chapter
administrator The personal representative of the estate appointed by the court if the decedent dies intestate.
annual exclusion Under the federal gift tax law, the amount that can be given each year without being subject to the gift tax—for example, $14,000 in 2015. This amount is indexed for inflation.
applicable exclusion amount (AEA) Credit given to each person that can be applied to the amount of federal estate tax owed by that person at death. In 2009 the AEA was $3,500,000. In 2015, the AEA is $5,400,000.
beneficiaries Those who receive benefits—property or income—from a trust or from the estate of a decedent. A grantor can be a beneficiary of his own trust.
codicil A document that legally modifies a will without revoking it.
community property All marital property co-owned equally by both spouses while living is a community property state.
durable power of attorney for financial matters Legal document that authorizes another person to take over someone’s financial affairs and act on this or her behalf.
durable power of attorney for health care A written power of attorney authorizing an individual to make health care decisions on behalf of the principal when the principal is unable to make such decisions. Also called advanced directive for health care.
estate planning The process of developing a plan to administer and distribute your assets in a manner consistent with your wishes and the needs of your survivors, while minimizing taxes.
estate tax A tax levied on the value of property transferred at the owner’s death.
ethical will A personal statement left for family, friends, and community that shares your values blessings, life’s lessons, and hopes and dreams for the future. Also called legacy letter.
executor The personal representative of an estate designated in the decedent’s will.
gift splitting A method of reducing gift taxes, a gift given by one spouse, with the consent of the other spouse, can be treated as if each had given one-half of it.
gift tax A tax levied on the value of certain gifts made during the giver’s lifetime.
grantor A person who creates a trust and whose property is transferred into it. Also called settlor, trustor creator.
gross estate All property that might be subject to federal estate taxes on a person’s death.
intestacy The situation that exists when a person dies without a valid will.
irrevocable living trust A trust in which the grantor gives up the right to revoke or terminate the trust.
Irrevocable life insurance trust An irrevocable trust in which the major asset is life insurance on the grantor’s life.
joint tenancy A type of ownership by two or more parties, with the survivor(s) continuing to hold all such property on the death of one or more of the owners.
letter of last instructions An informal memorandum that is separate from a will and contains suggestions or recommendations for carrying out a decedent’s wishes.
living (inter vivos) trust A trust created and funded during the grantor’s lifetime.
living will A document that precisely states the treatments a person wants if he or she becomes terminally ill.
pour-over will A provision in a will that provides for the passing of the estate—after debts, expenses, taxes, and specific bequests—to an existing living trust.
probate estate The real and personal property owned by a person that can be transferred at death.
probate process The court-supervised disposition of a decedent’s estate.
right of survivorship The right of surviving joint owners of property to receive title to the deceased joint owner’s interest in the property.
revocable living trust A trust in which the grantor reserves the right to revoke the trust and regain trust property. The grantor can serve as the initial trustee.
tenancy by the entirety A form of ownership by husband and wife, recognized in certain states, in which property automatically passes to the surviving spouse.
tenancy in common A form of co-ownership under which there is no right of survivorship and each co-owner can leave his or her share to whomever he or she desires.
testamentary trust A trust created by a decedent’s will and funded through the probate process.
testator The person who makes a will that provides for the disposition of property at his or her death.
trust A legal relationship created when one party transfers property to a second party for the benefit of third parties.
trustee An organization or individual selected by a grantor to manage and conserve property placed in trust for the benefit of the beneficiaries.
unified rate schedule A graduated table of rates applied to all taxable transfers; used for both federal gift and estate tax purposes.
unified tax credit The credit that can be applied against the tentative tax on estate tax base.
will A written and legally enforceable document expressing how a person’s property should be distributed on his or her death.
Preserving Your Estate Chapter Outline Learning Goals I. Principles of Estate Planning A. Who Needs Estate Planning? 1. People Planning 2. Asset Planning B. Why Does an Estate Break Up? C. What Is Your Estate? D. The Estate Planning Process II. Thy Will Be Done… A. Absence of a Valid Will: Intestacy B. Preparing the Will C. Common Features of the Will D. Requirements of a Valid Will E. Changing or Revoking the Will: Codicils 1. Changing the Will 2. Revoking the Will F. Safeguarding the Will G. Letter of Last Instructions H. Administration of an Estate I. Other Important Estate Planning Documents 1. Power of Attorney Living Will and Durable Power of Attorney for Health Care Ethical Wills J. What about Joint Ownership? 1. Tenancy in Common 2. Community Property III. Trusts A. Why Use a Trust? 1. Income and Estate Tax Savings 2. Managing and Conserving Property B. Selecting a Trustee C. Common Types and Characteristics of Trusts 1. Living Trusts a. Revocable Living Trust b. Irrevocable Living Trust c. Living Trusts and Pour-Over Wills Testamentary Trust Irrevocable Life Insurance Trust Federal Unified Transfer Taxes Gifts and Taxes Is It Taxable? Reasons for Making Lifetime Gifts V. Calculating Estate Taxes A. Computing the Federal Estate Tax B. Portability VI. Estate Planning Techniques Gift Giving Program Use of the Unified Tax Credit Charitable Contributions Life Insurance as an Estate Planning Tool Trusts Valuation Issues VII. Future of Estate Taxes Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
