Chapter 15 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 *Concept Check* 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 2. Living Will and Durable Power of Attorney for Health Care 3. Ethical Wills J. What about Joint Ownership? 1. Tenancy in Common 2. Community Property *Concept Check* III. Trusts A. Why Use a Trust? 1. Managing and Conserving Property 2. Income and Estate Tax Savings 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 2. Testamentary Trust 3. Irrevocable Life Insurance Trust *Concept Check* IV. Federal Unified Transfer Taxes A. Gifts and Taxes B. Is It Taxable? C. Reasons for Making Lifetime Gifts *Concept Check* V. Calculating Estate Taxes A. Computing the Federal Estate Tax B. Portability *Concept Check* VI. Estate Planning Techniques A. Dividing B. Deferring C. Life Insurance as an Estate Planning Tool D. Future of the Estate Tax *Concept Check* Summary Financial Planning Exercises Applying Personal Finance Prepare Your Will! Critical Thinking Cases 15.1 A Long-Overdue Will for Latafat 15.2 Estate Taxes on Robert Hancock’s Estate Money Online! Major Topics While personal financial planning allows one to achieve personal financial goals and accumulate wealth for a variety of purposes, estate planning is designed to provide for the desired and efficient disposition at death of accumulated wealth to heirs and beneficiaries. If estate planning is properly performed, heirs and beneficiaries will receive the maximum distribution of the deceased's remaining assets in accordance with his or her wishes. It is impossible to understate the importance of estate planning in assuring that a deceased's wealth is distributed in the desired manner. The major topics covered in this chapter include: 1. The role of estate planning in the accumulation, preservation, and distribution of an estate in a manner that most effectively achieves an estate owner's personal goals. 2. Guidelines for preparing a will and summary of common features. 3. Requirements of a valid will, procedures for changing, revoking, and safeguarding a will, and estate administration. 4. The need for a power of attorney, living will, and durable power of attorney for healthcare. 5. Forms of joint ownership and their impact on estate planning. 6. The purposes, common types, and characteristics of trusts used in estate planning to provide for the transfer of property from one party to another for the benefit of a third party. 7. Discussion of gift taxes, including determination of the amount of a taxable gift and reasons for making a lifetime gift. 8. Procedures for computing federal estate taxes, and the role of state death taxes in this process. 9. Popular estate planning techniques: dividing, deferring, and using life insurance. Key Concepts The overriding objective of estate planning is to insure the orderly transfer of as much of one's estate as possible to heirs and/or designated beneficiaries. Most estate planning tools and techniques are legally based and, as a result, the use of an attorney in estate planning is essential. The estate planning process frequently involves a number of areas: wills, trusts, gift taxation, and estate taxation. The following phrases summarize the key concepts stressed in this chapter. 1. Causes of estate break up 2. Probate estate and gross estate 3. Absence of a valid will: intestacy 4. Preparation of a will 5. Requirements for and common features of a will 6. Changing or revoking a will 7. Codicils 8. Letter of last instructions 9. Estate administration 10. Power of attorney 11. Living will and durable power of attorney for healthcare 12. Ethical wills 13. Forms of joint ownership 14. Trust relationships and purposes 15. Types and characteristics of trusts 16. Gift tax determination and gifting motives 17. Estate tax computations 18. Estate planning tools and techniques 19. Probate process 20. Testator 21. Executor and Administrator 22. Right of survivorship 23. Joint tenancy and tenancy by the entirety 24. Tenancy in common 25. Community property 26. Grantor, trustee and beneficiaries 27. Living trust 28. Revocable living trust and Irrevocable living trust 29. Pour-over wills 30. Testamentary trust 31. Irrevocable life insurance trust 32. Application exclusion amount (AEA) 33. Unified rate schedule 34. Annual exclusion 35. Gift Splitting 36. Unified tax credit Answers to Concept Check Questions 15-1. Estate planning is important because it allows for the transfer of the maximum estate assets after taxes to the deceased's heirs and beneficiaries. Without an estate plan that directs the ultimate disposition of one's accumulated wealth, there is the chance that too little or even none of an estate will be left for one's heirs and beneficiaries to enjoy. By developing and implementing plans during one's lifetime, his or her wealth, or estate, can be accumulated, preserved, and upon death, distributed in the desired fashion. The goal of estate planning is therefore to accumulate, conserve, and distribute an estate in the manner that most effectively accomplishes the estate owner's objectives. The emphasis of estate planning is on achieving personal objectives and meeting the needs and desires of those involved. There are numerous forces which, if unchecked, tend to shrink an estate, reduce the usefulness of its assets, and frustrate the objectives of the person who built it. These include: death-related costs, such as debt repayment, taxes, and administrative expenses; inflationary effects; improper management of assets; lack of liquidity resulting in insufficient cash to pay death costs and other estate obligations; incorrect use of vehicles of transfer causing property to pass to unintended beneficiaries or to the proper beneficiaries in an improper manner or at an incorrect time; and disabilities to the wage earner—often called a "living death"—that result in a massive financial drain. The gross estate includes all the property subject to federal estate tax at a person's death, both probate and nonprobate property. Nonprobate property passes automatically without having to go through the probate process (the legal process of administering the estate of a decedent). Examples of nonprobate property include property held in trusts (the trust holds the legal title to the property), property titled in joint tenancy (the title of the property causes it to pass by operation of law), and life insurance benefits (passes by contract). The probate estate consists of all the other real and personal property that a person owns in his or her name at the time of death for which there is no other mechanism of transfer. The probate property is distributed according to the terms of the decedent’s will or by the state laws of intestate succession if there is no valid will. 15-2. The steps in the estate planning process include: 1. Assessing your family situation, evaluating its strengths and weaknesses, and setting estate planning goals. 2. Gathering comprehensive and accurate data on all aspects of the family. 3. Taking inventory of your assets and determining the value of your estate. 4. Designating beneficiaries of your estate's assets. 5. Estimating estate transfer costs. 6. Formulating and implementing your plan. 7. Reviewing your estate plan at least every 3 to 5 years and revising as circumstances dictate. The objective of the estate plan, of course, is to maximize the usefulness of one's assets during life and to achieve one’s personal objectives after death. Once the estate plan has been implemented, one must keep in mind that it is good only for as long as it fits the needs, desires, and circumstances of the parties involved. As these elements change, the estate plan must also be modified. 15-3. A will is a written, legally enforceable expression or declaration of a person's wishes concerning the disposition of his or her property upon death. A valid will is important because without one, an estate will be distributed in a fashion consistent with certain state statutes, not necessarily according to the wishes of the deceased. When a person dies intestate—without a valid will—the state laws typically "draw the will the decedent failed to make." State law would therefore determine the disposition of the decedent's probate property. Generally, the decedent's spouse is favored, followed by the children, and then other descendants. The statutes typically delineate the order in which descendants receive estate assets. If the deceased leaves no spouse, children, or other descendants, the decedent's parents, brothers, and sisters will receive a share of the estate. Aside from having lost control of the disposition of property to individuals or charities, the person who dies intestate also forfeits the privileges of naming a personal representative to guide the disposition of the estate, naming a guardian for persons and property, and specifying which beneficiaries are to bear certain tax burdens. In addition, estate shrinkage will probably not be minimized due to the loss of certain tax deductions and exclusions. 15-4. The eight basic clauses normally included as part of a will are listed and briefly described below: 1. Introductory clause—states the testator's place of residence and nullifies old and forgotten wills and codicils (legally binding modifications of an existing will). 2. Direction of payments clause—directs the estate with respect to certain payments of expenses. 3. Disposition of property—directs the disposition of personal effects, the passing of money to a specified party, and/or the distribution of residual assets after specific gifts have been made. 4. Appointment clause—used to appoint executors, guardians, and trustees, as well as their successors. 5. Tax clause—allocates the burden of taxes among the beneficiaries. In the absence of this clause, apportionment statutes of the testator's state will allocate the taxes among beneficiaries. 6. Simultaneous death clause—protects the testator in the case of the simultaneous death of his or her spouse. It is designed to avoid double probate of the same assets. The surviving spouse must live for a certain period of time beyond the death of the other spouse in order to be a beneficiary under the will. 7. Execution and attestation clause—provides for the testator's signature as a precaution against fraud. Many attorneys suggest initialing each page after the last line and including a signature in the left-hand margin of each page, which of course should be numbered. 8. Witness clause—contains the signatures of witnesses (whose minimum number is determined by state law) who sign in the presence of each other (and note their addresses on the will) to affirm that the will in question is actually that of the testator. To be valid, a will must be the product of a person with a sound mind; there must have been no undue influence (influence that would remove the testator's freedom of choice); the will itself must have been properly executed according to the laws of the state; and its execution must be free from fraud. Certain conditions are established for judging whether or not a testator is mentally competent. Generally, such capacity is assumed. Types of undue influence include threats, misrepresentations, inordinate flattery, or some physical or mental coercion employed to destroy the testator's freedom of choice. Most state statutes spell out requirements for proper execution of wills in a Will's Act or its equivalent. An ability to demonstrate that a will is that of the testator is also necessary for proper execution. 15-5. In order to change an existing will, a codicil, a simple and convenient, legal means of modifying an existing will, is drawn up. It is used when the will needs only minor modifications and is often a single-page document that reaffirms all the existing provisions of the will except the one to be changed. Where substantial changes are required, the preparation of a new will is usually preferable to a codicil. A will can be revoked either by the testator himself/herself, or in some cases, the law will revoke or modify it automatically. The testator can revoke a will by (1) making a later will that expressly revokes prior wills, (2) making a codicil that expressly revokes any wills, (3) making a later will that is inconsistent with a former will, and (4) physically mutilating, burning, tearing, or defacing the will with the intention of revoking it. Common situations in which the law, under certain circumstances, revokes or modifies a will are (a) divorce, (b) marriage, (c) birth or adoption, and (d) murder. 15-6. a. Intestacy describes the situation that exists when a person dies without a valid will. Some intestacy laws "draw the will the person failed to make" to determine the disposition of the probate property at his or her death. b. The testator is the person making the will, a written document expressing this person's wishes concerning how his or her property is to be distributed at death. c. A codicil is a simple and convenient legal means of modifying an existing will. It is used when a will needs only minor modifications and is often a single-page document that reaffirms all the existing provisions in the will except the one to be changed. d. A letter of last instructions is an informal memorandum separate from a will and expresses thoughts the testator wants to convey and instructions he/she wishes to have carried out that cannot properly be included in his/her will. A variety of directions related to such things as location of the will and other documents, funeral and burial instructions, and explanations of actions taken in the will might be included in the letter. 15-7. The probate process is the legal process of administering the estate of a decedent and distributes all the property that does not pass by some other mechanism (i.e., operation of law or legal contract—see number 15-1 above). The property in the probate estate is distributed according to the terms in the decedent’s will or by the state’s laws of intestate succession if no valid will can be found. The will is brought before the proper governmental unit, often the county court, and the validity of the will is determined. Before property can be distributed, debts, taxes, and claims against the estate must first be satisfied. Property remaining is then distributed according to the terms of the will (if possible—some of the property may have gone toward satisfying debts and/or taxes). If the decedent named a personal representative to manage the probate process in the will and if the court appoints this person so nominated in the will, this person is called the executor. If the decedent did not name a personal representative, died intestate, or the court does not choose to use the person so named in the will, then the court appoints an administrator to represent the estate. Reasons the court may not choose the person named in the will as the representative include: the person may have predeceased the testator, may be physically or mentally incapacitated, or may be deemed unfit (such as serving time in prison). The executor (or administrator) has the responsibility of representing the estate and seeing the probate process through to the end. The executor must collect the assets of the decedent, pay debts and taxes or provide for the payment of debts and taxes that are not currently due, distribute any remaining assets to the persons entitled to them by will or by the intestate law of the appropriate state, and must make an accounting to the court at various times during the probate process. Executors should not only be familiar with a testator's affairs, but they should also exhibit good administrative skills. 15-8. a. A power of attorney is a document naming the person you wish to act as your agent in managing your financial affairs. Powers of attorney can be either durable or nondurable, and state laws vary concerning these powers. In general, a nondurable power of attorney becomes legally invalid when the person issuing the power of attorney becomes incapacitated and is not a practical alternative for caring for the property of the ill or the elderly. An instance of when a nondurable power of attorney would be appropriate would be when someone is leaving the country and wants someone else to manage his financial affairs for him. A durable power of attorney for property (as distinguished from the durable power of attorney for healthcare described below) does allow the person named to act as your agent even if you do become incapacitated. It is a very powerful instrument and much thought should go into selecting someone very honest, trustworthy, and financially astute. A durable power of attorney is appropriate for someone who is ill or elderly and wishes to have someone to handle financial matters on his or her behalf should he or she become incapacitated. b. A living will describes in detail the medical treatments you wish to receive—or not receive—if you become terminally ill. It is very important that you discuss these plans with your physician, write the living will in very specific terms, and comply with state regulations. c. The durable power of attorney for health care also deals with medical care. It authorizes a particular person to make health care decisions if you cannot. Many financial planning experts recommend that you have both a living will and a durable power of attorney for health care. d. An ethical will or legacy statement is an informal document that can be added to the written will and read at the same time. It can take various forms, such as handwritten letters or journals, personal essays written on a computer, or even as video or audiotapes. The ethical will allows the maker a way to share his or her morals, business ethics, life experiences, wit and wisdom with family and friends. 15-9. Joint tenancy with right of survivorship is a type of ownership by two or more parties who share equal rights in and control of the property, with the survivor(s) continuing to hold all such rights on the death of one or more of the tenants. Each joint tenant can unilaterally sever the tenancy. A tenancy by the entirety is a form of ownership between husband and wife recognized in certain states in which the rights of the deceased spouse automatically pass to the survivor. A joint tenancy by the entirety can be severed (while both are alive) only by mutual agreement or terminated by divorce or conveyance by both spouses to a third party. This form of ownership is generally not recognized in community property states, and a few of the common law states no longer recognize it as well. The advantage of joint tenancy, the more common form of joint ownership, is that it offers a sense of family security, quick and easy transfer to the spouse at death, exemption of jointly owned property from the claims of the deceased's creditors, and avoidance of delays and publicity in the estate settlement process. The key disadvantage of joint tenancy is that the jointly owned property cannot be controlled by a will and therefore does not permit the first joint owner to die to control the property's disposition and management upon his or her death. Another disadvantage is that potential tax costs may be incurred in both the creation and the severance of a joint tenancy when the title is not held between spouses (for example, a father and daughter). Tenancy in common gives each co-owner the right to dispose of his or her share of the property as he or she wishes, without consulting the other partner(s). Unlike joint tenancy, in which the parties share equal rights and have rights of survivorship, tenancy in common may involve unequal shares and carries no rights of survivorship. Property titled in this manner likely will be part of the probate estate and pass according to the decedent's will or the state's laws of intestate succession in the absence of a valid will. 15-10. The right of survivorship is when the property which is held jointly passes directly to the surviving tenant(s) upon the death of the other. This passing happens automatically by operation of law and is free from the claims of the decedent's creditors, heirs, or personal representatives. Community property refers to all property acquired by the effort of either or both spouses during marriage while they make their primary residence in a community property state. Separate property is that which is owned by one spouse only. Property acquired prior to marriage or through gift or inheritance is considered separate property of the acquiring spouse. A written agreement is required to change community property to separate property, and vice versa. Unlike joint tenancy with right of survivorship, each spouse can leave his or her half of the community property to whomever he or she chooses. There is no right of survivorship inherent in this form of ownership. Therefore, without proper planning, a surviving spouse could find him or herself in the position of having to share ownership of property with someone else upon the death of the spouse. 15-11. A trust is a relationship created when one party, the grantor (also called the settler or creator) transfers property to a second party, the trustee (an organization or individual), for the benefit of third parties, beneficiaries, who may or may not include the grantor. The trustee holds the legal title to the property in the trust and must use the property and any income it produces solely for the benefit of trust beneficiaries. The trust generally is created by a written document. The grantor spells out the substantive provisions as well as certain administrative provisions. A trust may be living or testamentary and/or revocable or irrevocable. Trusts are created for many reasons, with the most common motives being to attain income and estate tax savings and to manage and conserve the property over a long period of time. A trustee must (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 the trustee should be young enough to survive the trust term), and (5) be able to make decisions impartially. 15-12. A living (inter vivos) trust is one created during the grantor's lifetime. It can be either revocable or irrevocable and can last for a limited period or continue long after the grantor's death. A revocable living trust is a living trust in which the grantor reserves the right to regain the trust property. The trust property is still in the grantor’s estate because the assets are not a completed gift, and the income off the trust is taxable to the grantor. An irrevocable living trust is one in which the grantor relinquishes title to the property placed in the trust as well as the right to revoke or terminate the trust. Depending on how the irrevocable living trust is set up, the trust assets may no longer be considered a part of the grantor’s estate and thus not subject to estate taxes. However, initially placing the property in the trust may trigger gift taxes, and if the income off the trust is not taxable to the grantor, it will be income taxable to either the trust itself or the beneficiaries. [Trusts and estates have their own schedule for income tax rates, and very little income is required to place these entities in the highest tax bracket.] Many types of trusts exist with various gift, income, and estate tax ramifications, and competent legal advice is needed prior to setting up a trust. 15-13. a. The grantor is a party in a trust relationship who transfers property to a second party, the trustee, for the benefit of third parties, the beneficiaries, who may or may not include the first party. b. A trustee is an organization or individual hired by the grantor to manage and conserve his or her property placed in a trust for the benefit of beneficiaries. c. The beneficiary is an individual who receives benefits—income or property—from a trust or from the estate of a decedent. d. A pour-over will is a provision in a will that provides for estate assets—after debts, expenses, taxes, and specific bequests—to "pour over" into a previously established revocable or irrevocable living trust. The pour-over will assures that property left out of the living trust, either inadvertently or deliberately, will make its way into the trust and thus be administered according to the terms of the trust. e. A testamentary trust is a trust created in a decedent's will. This type of trust does not provide any tax savings for the grantor, because he or she continues to own the property until his or her death. f. The major asset of an irrevocable life insurance trust is life insurance on the grantor; this type of trust is used to keep the proceeds of the life insurance policy out of an estate. The trustee can use the proceeds to pay for estate taxes and/or for the care of the deceased's spouse or children. 15-14. Gifts are generally defined with reference to the consideration received. A transfer for less than adequate and full consideration in money or money's worth is viewed as a gift. If some amount of consideration was received, but less than full consideration, the transfer would be considered a partial gift. A gift is usually considered to be made when the donor relinquishes dominion and control over the property or property interest transferred. a. For gift tax purposes, certain transfers or "gift equivalents" are not counted. The annual exclusion permits tax-free gifts of $13,000 (adjusted for inflation, as of 2012) per donor to any number of donees each year. It is available only for gifts of a present interest in property that the donee has the immediate and unrestricted right to use, possess, and enjoy upon receipt. b. Gift splitting is a method of reducing gift taxes whereby a gift given by one spouse, with the consent of his or her spouse, can be treated as if each had made one half of it. Therefore, with the consent of your spouse, even if it’s all your money or assets, up to $26,000 (as of 2012) can be given to any number of donees during the year. This feature allows married persons in common-law states to receive the same gift tax treatment as married taxpayers domiciled in community-property states. c. Charitable deductions, which are gifts given to a qualified charity (one to which deductible gifts can be made for income tax purposes), are not subject to any gift or estate taxes and have no limits on the amount given. However, there is a limit to the amount of the deduction which can be claimed in any given year on one’s income tax return, depending on the taxpayer’s adjusted gross income and the type of charitable organization. The excess contribution can be carried forward on one’s income tax return. d. An unlimited deduction for gift or estate tax purposes for property given by one spouse to another is called the marital deduction. An individual conceivably could give everything to his or her spouse during life or at death without gift or estate tax cost, provided the spouse is a U.S. citizen. 15-15. When a gift is given, control of the property is relinquished and the property from that point forward is no longer a part of the donor's estate. Property which is no longer in the estate is not subject to estate taxes at death. True, the size of the estate is smaller by the amount of the gift, but because of the gift, the property is already in the hands of the intended recipient. Gift giving allows the donor to minimize estate shrinkage by reducing estate taxes, thereby allowing the donor to maximize the amount of property passed to his/her heirs. Several tax-oriented reasons cause estate planners to recommend making lifetime gifts. These include: Gift Exclusion: Single individuals can give any number of donees up to $13,000 (as of 2012) each year entirely gift tax free. If the donor is married and the donor's spouse consents, the gift tax-free limit is increased to $26,000 (as of 2012) even if the entire gift is made from the donor's assets. If a taxable gift is made, i.e., a gift over the exclusion amount, only the excess portion is subject to gift taxes. Gift Tax Exclusion: Regardless of the size of a gift—and even if it is made less than three years before the donor's death—it typically will not be treated as part of the donor's gross estate. The taxable portion of lifetime gifts (gifts over the exclusion amount) does push up the rate at which the donor's estate will be taxed. Fortunately, when cash or other property qualifies for the annual exclusion, it is not taxable and therefore is both gift and estate tax free in all respects. Appreciation in Value: Appreciation in the value of a gift from the time it is made will not be included in the donor's estate, unless the gift is deemed not to have been a gift because the donor failed to relinquish control of the property. Credit Limit: Because of the credit that’s used to offset otherwise taxable gifts, gift taxes don’t have to be paid on cumulative lifetime gifts up to the applicable gift exclusion amount of $5,000,000. To the extent that the credit is used against lifetime gift taxes, it’s not available to offset estate taxes. Impact of Marital and Charitable Deduction: Because of the gift tax marital and charitable deductions, it is possible to give a spouse (who is a U.S. citizen) or a qualified charity an unlimited amount of money or other property entirely gift or estate tax free. 15-16. The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually eliminated estate taxes until the year 2010. Until 2011, if one spouse died but did not use his/her credit, the unused credit died with that spouse. The Tax Relief Act of 2010 increased the amount that can pass free of transfer taxes and also added the concept of “portability,” which allows any unused credit from a deceased spouse to carry over to a surviving spouse. Although portability is part of the 2012 law, it will not continue for 2013 and beyond, unless Congress continues the option. Regarding the general nature of the estate tax, the federal estate tax is levied on the transfer of property at death. The tax is determined according to the value of the property that the deceased transfers (or is deemed to transfer) to others. The unified tax credit reduces the amount of estate taxes owed. A certain amount of a deceased person's estate, called the exclusion amount, is excluded from estate taxes. The unified tax credit is the amount of estate taxes that would have been due on the excluded amount. Estate taxes are first calculated on the entire estate, and then the unified tax credit amount is subtracted off the total. 15-17. Computation of the federal estate tax due: The six stages involved in the computation of the federal estate tax are (1) determining the gross estate, (2) determining the adjusted gross estate, (3) calculating the taxable estate, (4) computing the estate tax base, (5) determining the total death taxes, and (6) determining the federal estate tax due. 15-18. Dividing: Each time a new tax-paying entity can be created, income taxes will be saved and estate accumulation stimulated. A variety of techniques, such as giving income-producing property to children, establishing a corporation, and fully qualifying for the federal estate tax marital deduction, exist for dividing one's estate to reduce taxes. Deferring: Because progressive tax rates penalize taxpayers whose maximum earnings (or estates) reach high levels, persons should attempt to minimize the total tax burden by spreading income over more than one tax year or deferring the tax to a later period. Deferring the tax to a later period gives the taxpayer an opportunity to invest the tax money for a longer period of time, and of course there’s always the possibility that the tax laws may change favorably. In addition, one’s financial situation may change such that yearly income may drop and the accumulated assets are used up during life and hence no longer in the estate. Financial Planning Exercises 1. Student lists will vary depending on family circumstances. The general objective should be to maximize the amount of the estate that passes to heirs. Some possible categories of personal objectives 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. Both David and Cheryl should have wills, with the main reason being they need to name the guardian for their children in the event they die in a common accident. Further, Cheryl should also have a will to protect the family when she dies. True, if David predeceases her, the house passes to her through joint tenancy and the insurance proceeds pass to her by contract (supposing that she is the named beneficiary), but then she needs to plan for the disposition of assets at her death. If she and David were to die as a result of the same accident and it was determined that David 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 David and Cheryl 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 Cheryl. 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. Student wills should include the clauses described in the text. 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. 4. 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. Students’ responses to whether or not they would record it will vary. 5. Before accepting the executor's role, you should be willing to assume responsibility for estate administration. This includes inventorying assets, determining their value, paying all debts and taxes, and disposing of assets in accordance with the deceased's wishes. While it helps to be comfortable with personal financial planning matters, the executor can hire legal and financial professionals to help with these duties. 6. Currently, each person can leave an estate of $5 million (through December 31, 2012) with no estate taxes being due. There is uncertainty about future applicable exclusion amounts. This makes estate planning complicated. George and Debbie’s combined estate is $1.4 million, so it will be possible for them to pass on the entire amount with no estate taxes due (each person currently has a $5 million exclusion, so together they have $10 million). However, they most assuredly need to consult an attorney concerning the best way to handle their estate. Trusts can be used to pass on their estate. Also, George and Debbie can establish trusts for their children from prior marriages, not only to assure that each receives the assets which should be rightfully theirs, but also that each child is properly provided for should their parents die. If the children are minors, trusts are a good way to manage and conserve the assets. The parents can also specify how the trust assets are to be used. George and Debbie should also make sure their property is titled in the most appropriate way, depending on if they live in a community property or common law state. It is entirely possible that they can avoid setting up trusts, which can be costly, if their assets are properly titled so as to pass as they wish for them to pass. Also, George and Debbie will want to specify clearly in their wills the disposition of personal property that they wish to leave to the children (Debbie’s family antiques, the jewelry from George’s late wife, etc.). They also need to name guardians for their children if they are still minors and executors for their respective estates. 7. Worksheet 15.2 appears on the following page. The net federal estate tax due is $816,620. Problem 7—Worksheet 15.2 8. Answers to this question may vary, depending on recent changes to estate tax laws. Even if estate taxes are eliminated entirely, individuals will still need to do estate planning for a variety of reasons, some of which are listed below: 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. Solutions to Critical Thinking Cases 15.1 A Long Overdue Will for Latafat 1. Yes, Latafat 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 Latafat 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 Latafat 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. 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. Property held in joint tenancy automatically transfers to the surviving joint tenant, hence upon Latafat’s death the mining stock worth $3 million and the Colorado home worth $1.5 million would belong immediately to Karen. There might be some confusion as to whether she should still receive 40% of the balance or whether the joint tenancy property should be taken into account. Note that the joint tenancy represents 29% of his estate $15.5 million estate---or does it? This raises the question of whether only half of the joint tenancy should be counted when figuring out the bequest to Karen because she already owns the other half of it. His estate plan needs to directly address these issues. 4. The living trust would be an appropriate estate planning technique for Latafat. With such a large estate, he should be looking for ways to minimize estate taxes so that more of his assets go to beneficiaries. He may wish to set up several trusts for his wife and sons, so that they will have assistance in managing the large amounts they will inherit. Trusts can also provide management continuity if he should become unable to administer the property. If he establishes irrevocable living trusts, he will reduce estate taxes because he would relinquish control of the property involved. He may wish to transfer some of his assets into this form of trust. Because he wants to allocate a certain amount of money for his sons' education, he can set up trusts that will ensure that the funds can only be used for this purpose. By using trusts, Latafat’s will would probably be shorter, because some assets would already be designated to trusts. There would be no time gap in the management of these assets because a living trust is already in existence at the time of death, whereas probate assets will not be managed until the court appoints a personal representative sometime after death. Living trust assets would avoid probate, which can be expensive (however, the costs of establishing and administering trusts can also be high). Trusts provide a measure of privacy, whereas probating the will is a public process. However, creditors have a much shorter time (typically 4 months) in which to make a claim against the assets going through probate; trust assets can often be subject to such claims for a period of 1-3 years. 5. The boys are both still in school and presumably not yet adults. Having them inherit a significant estate at such young ages will mean appointment of guardians of the estate for them, which in turn means annual court reporting with related attorney fees. Furthermore, guardianships generally must end when the child becomes an adult at age.18. This is still rather young to become a millionaire. The answer probably is for their interests to be held in trust, with benefits given immediately for education, medical, and such, but with actual distribution delayed perhaps until they reach 25 or 30 years of age. Their trustee could be given discretion to make some earlier distributions for such purposes as purchasing a home or starting a business. 6. If Latafat later decides to change or revoke his will, he has a few options. To change the will, he could use a codicil, which is a legal means of modifying an existing will. It is usually used when the will needs only minor modifications and is often a single-page document that reaffirms all the existing provisions in the will except the one to be changed. If substantial changes are to be made, a new will is usually preferable to a codicil. A will may be revoked by (a) making a later will that expressly revokes prior wills, (b) making a codicil that expressly revokes all wills earlier than the one being modified, (c) making a later will that is inconsistent with a former will, and (d) physically mutilating, burning, tearing, or defacing the will with the intention of revoking it. The law automatically revokes or modifies a will under certain circumstances, which vary from state to state but generally revolve around divorce, marriage, birth or adoption, and murder. Living trusts are normally simpler to revise than wills because an amendment to a living trust needs no formalities or witnesses and must be in the trustor’s handwriting anyway. However, remember that in an irrevocable trust, control of the assets has been severed. 7. As coexecutors of Latafat’s estate, Gary Ingram, his close friend and attorney, and Ceylan Sadik, his cousin, will share the duties of estate administration. Upon Latafat’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 Latafat’s will. Their responsibility will, therefore, be to carry out Latafat’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 Gary’s age, he is not a good candidate for trustee, even though he might be appropriate as a co-executor. Ceylan 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. 15.2 Estate Taxes on Robert Hancock’s Estate Robert’s estate taxes are computed on Worksheet 15.2 which follows. Answers to the Robert Hancock estate tax and probate questions Gross estate Probate Home $850,000 $850,000 Gross $4,570,000 Cabin $485,000 $485,000 Funeral ($15,000) ($15,000) Stk. bonds $1,890,000 $1,890,000 Admin ($36,000) ($36,000) Pension $645,000 $3,225,000 Debts ($90,000) ($90,000) Life insurance $700,000 Expenses ($25,000) ($25,000) Gross $4,570,000 Adj. gross estate $4,404,000 ($166,000) Charities Church ($60,000) ($60,000) High school ($25,000) ($25,000) Taxable estate $4,319,000 ($85,000) Adjusted tax gifts $260,000 Adj. taxable gifts $234,000 ($26,000) Estate tax base $4,553,000 ($85,000) $234,000 ($166,000) ($251,000) 1. The probate estate consists of the gross estate less non-probate assets. The gross estate amount of $4,570,000 is calculated in #2 which follows. Robert’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 $3,225,000 [$4,570,000 − ($700,000 + $645,000)]. 2. Robert’s gross estate consists of all his assets at the time of his death. 3. Determine the total allowable deductions. Funeral, debts, admin., expenses: $166,000. Charities: $85,000. Total: $251,000 4. In calculating the estate tax base, adjusted taxable gifts made after 1976 must be added back in. Prior to his death in 2012, he made a gift of $260,000 in stock to Nathan and Mary. At that time, $13,000 was the maximum yearly gift exclusion amount per person. Therefore $26,000 was excluded from taxation; the remaining $234,000 was a taxable gift which when added back to the taxable estate of $4,319,000 makes an estate tax base of $4,553,000. 5. In calculating the tentative tax, refer to Exhibit 15.7. For Robert’s estate, the tax on the first $500,000 is $155,800 and the maximum rate of tax over $500,000 is 35%, making his tentative tax $155,800 + ($4,053,000 × .35) or $1,574,350. Exhibit 15.8 shows that the unified tax credit for 2012 is $1,772,800. This unified tax credit is then subtracted from the estate tax base to arrive at the total death taxes of $0 ($1,574,350 − $1,772,800). 6. Case 15.2—Worksheet 15.2 7. While Robert left a sizable estate, no federal estate tax was due. In the event that the relatively low estate taxes do not hold in the future, some things can be done before death to minimize the shrinkage of an estate similar to Robert’s include: • Robert could have given the ownership of the life insurance policy to his son or established a life insurance trust with it in order to remove its value from his estate. We are not told whether the policy was a term or whole life policy with cash value, but the value for gift tax purposes while still alive is usually much less than the value for estate tax purposes after death. • Before his wife’s death, their wills could have established a credit shelter (or family or bypass) trust in order to preserve the available unified credit of the first to die (the exclusion amount when his wife passed away less the portion of the taxable gift attributed to her). These trusts can be set up such that the assets pass to the children but the surviving spouse gets the income off these assets or possibly can use part of these assets while still alive. When one spouse leaves everything to the other spouse, if the estate’s value is over the exclusion amount, then the amount of the unified credit available to the first to die is wasted. A credit shelter trust preserves the exclusion amount available to the first to die. • After his wife’s death, Robert should have realized that the estate taxes would be a problem for his family, and he could have started giving $10,000 to $13,000, a year to his son, daughter-in-law, and four grandchildren (depending on the year of the gift ), thereby excluding $60,000–$78,000 every year. He could also have increased charitable gifts during his life. • Robert could have sold his home and moved into something smaller and less expensive. The remainder of the dollars from the sale could have been used for gifts as mentioned above. He also had a cabin at the lake he could have sold or given to his children with only a small amount of gift taxes due. While there can be great sentimental attachment to property, many times people reach a point in life where they no longer wish to continue the upkeep of property. • Robert could have established a charitable trust or gifted property to a charitable foundation such that he could have received the income from the property for life, and then at his death the property would go to the charitable organization. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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