1. Failure to Plan
A. Believing that their estate is not large enough to warrant any kind of planning (confusing probate exemptions with estate tax exemptions).
i. Probate begins if an estate has $75k of titled real estate or $75k of titled personal property (i.e., cars, bank accounts, etc.). Probate is the process of transferring titles from the decedent’s name to the name of the heirs. The Will (or intestate succession laws) control who is going to receive the asset. But Probate is the administrative procedure to actually transfer (re-title) the asset.
ii. Federal Exemption is $5,430,000 in 2014. Sometimes people will think that they should do an estate plan only if their assets are over the exemption amount. We need to help people understand that there are benefits to estate planning in addition to the estate taxes aspects.
B. Thinking that they are not “old enough” to worry about planning – not going to die.
C. Believing all assets in their Estate will automatically pass to their Spouse – Some clients believe that the fact that they are married, and that Arizona is a community property state, that all of their assets will automatically pass to a surviving spouse, without an estate plan. Community property laws are in place to ensure that a spouse is not disinherited. They have nothing to do with the ability to avoid probate. The clients need a Trust, or some probate avoiding instrument (right of survivorship, etc.) to avoid probate.
D. Believing Congress will repeal the estate tax or make other changes to the law that reduces the need for estate taxes.
2. Improper Estate Plan
A. There are many clients who have a Will that probably need a Trust. There are also many clients that have a Trust and don’t probably need it. Start with a discussion as to the advantages of a Trust. If none of those interest the client, then a Will is sufficient. Here are some of the main advantages of a Trust:
i. Avoid Probate – As discussed above, probate avoidance alone may not be enough reason to set up a trust because there are ways to avoid probate without a trust. (Right of Survivorship, Payable on Death, Beneficiary Designations, etc.) However, if the client has real estate (timeshares, oil leases, etc.) in other states that is probably sufficient cause to have a trust. Otherwise, there will be multiple probates. Arizona Courts can only have jurisdiction over assets in Arizona.
ii. Provide two federal estate tax exemptions – for married couples with a net worth in excess of $5,000,000 a Trust is still the most popular way to get two federal exemptions. Remember, without proper planning, the exemption of the first decedent to die could be lost or wasted unless the assets pass to a “Credit Shelter Trust”. (Review the Flowchart of an A/B Trust).
iii. Controlling beyond the Grave – there are many reasons why a client wants to implement some controls and restrictions on the inheritance passed to their spouse or their children.
a) Restrictions on Children
1. Minor children – implement a sub-trust that specifies the timing of certain powers. Typically, I like 3 “breakpoints”, age 25, 30 and 35. Review the flowchart of a sub-Trust for the kids.
2. Handicapped Children – these kids will need a “Special Needs Trust” to make sure that the benefits they receive from the Trust do not disqualify them from any government assistance they are receiving.
3. Creditor protection – as discussed above, a Sub-Trust created by a parent for the benefit of his children cannot be penetrated by potential creditors. This is true even though the child has discretionary distribution powers as the Trustee to make distributions to himself.
b.) Restrictions on Spouses
1. Restrict access to principal.
2. Provide creditor protection.
3. Restrict the ability to change a future beneficiary.
4. Providing for professional money management. Most children will need professional management of the assets that they inherit. If a child inherits several hundred thousand dollars or even several million dollars, it is difficult for them to go from a lifestyle of paycheck to paycheck to a lifestyle of stocks, bonds, annuities, etc.
B. Not planning adequately for the size of their Estate – type of Trust needed:
i. There are three main types of Revocable Trusts. Continuation, Mandatory A/B, and Discretionary A/B. With larger estates, there are also A/B/C Trusts and maybe even a D trust. As the federal exemption continues to increase, most clients can get by with a much simpler estate plan. For example, most clients who have a mandatory A/B Trust should consider amending it to a Discretionary A/B Trust which gives the surviving spouse a 9-month option to decide whether or not they want to split the trust (using a Qualified Disclaimer).
ii. Using Generation Skipping Planning – Most clients don’t understand that “generation skipping” does not mean that they are skipping the kids out of an inheritance. What it means is that the client has the ability to skip the IRS out of a Generation worth of estate taxes. Generation-skipping not only applies to the client planning for his children but also don’t overlook possible inheritances that may be coming from the parents of your clients.
iii. Integration of the IRA into the estate plan – most clients, and many advisors don’t understand the IRA distribution rules sufficiently to make an informed decision as to who should be the beneficiary of the IRA (should it be the Trust, the spouse, the children, etc.). Although this issue is not as critical as it once was because of the increase in the exemption, it is still a critical issue for anyone who has an IRA in excess of $500k. Generally, I prefer to keep the IRA out of the Trust and name the spouse as the primary beneficiary and the kids as the contingent beneficiaries. But, there are several main exceptions to this general rule. The primary exception would be in situations where there are children of a prior marriage. In this case, you may want to consider naming a QTIP Trust as the primary beneficiary. This is an entire topic in and of itself. Anytime the client has an IRA that is over $500k, careful planning and consideration should be given to the beneficiary designation.
3. Understanding ways to avoid probate without a Trust
There are many ways to avoid probate between spouses without creating a Revocable Trust. As such, it is my opinion that probate avoidance is not the most critical factor in creating a trust. Probate is usually caused when the surviving spouse dies. Furthermore, even clients with a Trust may end up in probate if the assets have not been properly titled into the trust. For those clients who do not want a trust, here are a few of the more common techniques that can be used to avoid probate:
A. Beneficiary Deed – this is not the same as joint ownership. Under a beneficiary deed, the beneficiaries (usually the kids) are not co-owners of the property. They are beneficiaries that receive a vested interest only after the death(s) of the property owners.
B. P.O.D.s, (payable on death) – most bank accounts, brokerage accounts, etc. allow the owner of the account to designate a beneficiary as the recipient of the account upon the death of the owner. Once again, the beneficiary is not an owner and doesn’t become vested as an owner until the account holder dies.
C. Beneficiary Designations of Life Insurance, IRAs and Annuities – many investment products allow the owner of the contract to name a primary and a contingent beneficiary. These types of arrangements avoid probate upon the death of the owner.
D. Jointly owned property with rights of survivorship – most accounts and documents of title, such as car titles, deeds, etc. allow two people to co-own property as joint tenants. This form of co-ownership will avoid probate as well so long as the account had “rights of survivorship”. Under this form of ownership, each person is an owner. Because of the inherent risks involved in divorce, bankruptcy and lawsuits, I would not recommend this type of ownership except as between spouses.
4. Poor Design of the Estate Plan
Many people do not give enough thought towards the design and key provisions of an estate plan. This is becoming more and more common due to the large number of “Trust Mills” in operation today. It is difficult for a Revocable Trust to not be legal under state law. However, it is too common for the Trust or the Will to be poorly drafted. Here are some of the key provisions that should be carefully considered:
A. Trustee/Personal Representative – these are the people that are going to be in charge of the financial issues of the estate plan. Many times, people would be better served to use professional fiduciaries. However, most people don’t take the time and effort to interview and become better acquainted with the services offered by professionals.
i. Professional, family member, Corporate – in some cases, a corporate trustee is not a good fit (ie where there is lots of real estate) In these situations, careful thought should be given to evaluating the other options available.
ii. Separation of functions – I don’t like the financial people to also be the “guardians” over the minor children. I like to separate these functions.
B. Using Sub-Trusts for Spouses and Children – most estate plans provide for the outright disposition of the assets upon the death of the Trustors. I prefer to have the assets remain in Trust wherein the beneficiaries can receive creditor protection and wherein certain restrictions may be imposed.
C. Improper or outdated Tax Clauses (A/B Trusts using the wrong allocation clause (ie using a pecuniary clause when there are many IRD assets wherein a formula allocation clause should be used) – funding the Trust with IRAs – references to Unified Credit, State Tax Credits, Business Exemptions)
D. Impact on the increase in the Federal Exemption: In some cases, the disposition of the estate plan is tied to the federal estate tax exemption. I common example is in second marriages where the exemption amount passes to the kids and the remainder goes into a marital trust for the spouse. As the exemption increases, this type of plan needs to be reviewed regularly.
E. Drafting flexibility using Powers of Appointment and Disclaimers: with all of the uncertainty in the future of the estate tax system, the draftsman should build in flexibility where ever possible. – i.e., giving the kids the option to have a Generation Skip Trust, or an outright inheritance can be accomplished using a power of appointment and a disclaimer. Disclaimers are also common in creating a multi-tiered beneficiary designation for an IRA.
F. Preparing documents on their own or online without legal assistance. Self-help Wills and Trusts can be successful in small and uncomplicated estates. However, most of them fail to go far enough and cover all of the possible scenarios with respect to what happens if certain beneficiaries fail to survive.
G. Trust Protector – adding a Trust Protector and grant powers to an individual to make revisions to the estate plan after you become disabled or die.
5. Creating a Trust but never Funding It
A. Not knowing what to fund to the Trust – Generally speaking, every titled asset should be changed over to the Trust. However, I personally choose to keep cars and checking accounts out of the Trust. Also, as stated above, I am not a big fan of naming the Trust as the beneficiary of the IRA. Some clients will attempt to transfer everything over to a Trust using a blanket “assignment” form. Better planning suggests that you physically re-title every asset into the trust.
B. Not keeping the Trust properly funded in the future – sell real estate in the name of the trust, but not setting up the Promissory Note in the name of the Trust.
C. Failure to keep Schedule A current. Although Schedule A is not a legal document, it does make the administration of the Trust much quicker an easier in cases where it is current and complete.
6. Failure to Coordinate Other Assets
Most people do not understand the priority of the disposition of the assets. As a general rule, a funded trust has priority over the provisions in a Will and assets with beneficiary designations or survivorship clauses have priority over the Trust. The main point here is that the legal document creating the Will or the Trust is not enough. To finish the plan, one must review the beneficiary designations, P.O.D. accounts, etc. to make sure that they are compatible with the estate plan.
A. Beneficiary Designations in Life Insurance, IRAs and Annuities to affect the estate plan.
B. Improper Titling of Real Estate – people sometimes get confused and make mistakes with the titling or real estate, or their brokerage accounts. If the client has a trust, generally the account needs to be titled in the name of the Trust. If the client doesn’t have a trust, then they should understand the differences in the following forms of ownership:
i. Joint Tenancy Right of Survivorship – avoids probate when the first spouse dies. However, only receive a step up in basis on the half of the account owned by the decedent.
ii. Community Property – receive a “double stepped up basis”. Not only the decedent’s half is stepped up, but also the survivor’s half. However, there is no survivorship feature so there is a probate at the death of the first spouse and the second spouse.
iii. Tenants in Common – used commonly between business partners, not spouses. No survivorship feature, and only get a step up in basis on the decedent’s half.
iv. Community Property with Right of Survivorship – this should be the preferred form of ownership between spouses who do not have children of a prior marriage. Avoids probate because of the survivorship feature and also receives a double stepped up basis.
7. Lack of Understanding of the Operation of the Estate Plan
A. Believing the Revocable Trust protects from creditors, divorce, etc. – the law in Arizona, as well as most states, is that you cannot achieve creditor protection in a trust established by you for your own benefit. (“self-settled trusts”) However, you can achieve creditor protection for your children by establishing a sub-trust for them. Also, many states are not changing their legislation to allow for creditor protection for self-settled trusts. (i.e. Alaska, Delaware, Nevada, etc.)
B. Believing that the Power of Attorney is effective after death so that transfers can be made after the death of a spouse without probate. The power under a Power of Attorney becomes null and void upon the death of the principal.
C. Not understanding what probate is, and how it can be avoided. Probate is a state court procedure to transfer the title of various assets upon the death of the decedent. It has nothing to do with the federal estate tax laws.
D. Not understanding the Federal Estate Tax- many wealthy people underestimate the power of the estate tax because they have a friend who lost a spouse, and avoided the estate tax. They don’t realize that there is a marital deduction such that the estate taxes are almost always deferred until the death of the surviving spouse.
8. Proper Storage of Documents and Communicating the Estate Plan
A. Storing all important documents in a safety deposit box without naming one of the children as a signer on the box. If you have a box, use it. If you don’t, then make sure you store your documents in a safe place and make sure that the successor Trustee and your Personal Representative have copies.
B. Giving copies to the appropriate people – some clients are very private and do not want their children to have a copy of the plan. Other clients are very open about the plan. I prefer being open and giving copies of the plan to all of your children, not just the Successor Trustee. The Trust administration will go much better if all of the children understand the plan and know what is going to happen.
C. Copies of Personal Property Lists – most Wills have a provision that refers to a separate list wherein the client can designate the disposition of certain items of personal property. Make sure that your advisors keep a copy of this list along with your Personal Representative.
9. Failure to Update the Estate Plan:
(Amend estate plan, change beneficiary designations, etc)
Most clients go too long without reviewing or giving additional thought to their estate plan. We recommend at least a review every time there is a significant event in your life.
A. Divorce – of the clients, or any of their children.
B. Death – of a spouse or any of the children or grandchildren.
C. Change in the size of the estate – a sudden increase or decrease in your net worth.
D.Change in law – whenever there is a major change in the law which is usually very much published.
10. Failure to consider the magnitude of other Estate Planning Documents
A. Powers of Attorney – when do they begin, when do they end, and how broad or limited should they be. There is much abuse with respect to powers of attorney. All powers end at the death of the principle. They can also be drafted to end much sooner. Another critical question is “when does a Power of Attorney begin?” Most powers begin when the client signs the document. However, the power can be drafted to begin at a later date. I prefer a “springing power”. That is a power of attorney that “springs” into effect only when the client becomes incapacitated to the point that he or she can no longer manage his or her affairs.
B. Living Wills – Pull the plug, how soon and under what circumstances. Most clients do not want their lives to be artificially prolonged. As such, they want their lives to terminate in the event of a “terminal condition, irreversible coma or persistent vegetative state. Most clients confuse a Living Will with a Health Care Power of Attorney. They are separate documents. The Health Care Power gives your agent the authority to make medical decisions for you. But, it does not give them the authority to withdraw life support. The client must make this decision in a Living Will.
C. Beneficiary Designations – I previously stated clients need to review all of their beneficiary designations when they execute an estate plan. They must make sure that the beneficiary designations are compatible with their estate plan.