Death and taxes are an undeniable reality. Understandably, most attempt to postpone each as long as possible, but ultimately there is a conclusion. The purpose of this article is to highlight the preparation that is necessary to best manage the consequences.
As each of us moves closer to the aforementioned, the tension caused by the need to put our financial house in order creates its own resistance and sometimes paralysis. Indeed, my observation is that 75 percent of the professional community have failed, and will continue to fail, in their estate planning obligations. The result of this inaction is confiscatory taxation and a potentially crippling probate (either with a will or worse, intestate), both of which unnecessarily burden families and lay waste to hard-won estate assets. Deferred maintenance as to estate planning, just as with a business operation, trades short-term comfort for eroded resources later.
To illustrate the point, a fictitious Mary and John Doe can be used as an example. Assume that the couple has two million dollars in assets. So as to make the following analysis more relevant for the reader, dividing or multiplying the monetary amounts to fit individual family wealth circumstances will provide a rough personal picture. Do consider insurance and inconspicuous assets in your compilations.
Assuming a failure to set up a credible estate plan, it makes little difference which of the Does dies first. There will be probate and, excluding court costs, there will be approximately $42,000 in fees (See the following table). Upon the death of the surviving spouse, additional probate fees will be in the area of $62,000 for a grand total of $104,000 in probate fees needlessly removed from the estate. As sobering as this might be, there is a vastly greater assault from federal estate taxes.
| PROBATE REPRESENTATION FEES | ||
|---|---|---|
| The combined statutory commission of the personal representative and of the attorney of record (California Probate Code Section 10800 as an example) is based on the total amount of asset inventory without reference to encumbrances or other obligations on property in the estate, and is computed as follows: | ||
| The first $15,000 | @ 8% | $1,200 |
| The next $85,000 | @ 6% | $5,100 |
| The next $900,000 | @ 4% | $36,000 |
| The next $9,000,000 | @ 2% | $180,000 |
Although the surviving spouse can generally avoid paying state and federal estate taxes upon the death of his or her spouse because of the Marital Deduction, without a strategic plan, the second death unleashes a taxation juggernaut. Despite the Unified Credit that protects the first $650,000 of the estate from federal tax, the estate of John and Mary Doe nevertheless faces federal estate taxation that will consume up to $345,000 of the family wealth (See the following table).
FEDERAL ESTATE TAX RATES
The Unified Credit is now $211,300 which is the exemption equivalent of the first $650,000 of an estate.
| Amount is Over: 0 $ 10,000 20,000 40,000 60,000 80,000 100,000 150,000 250,000 500,000 750,000 1,000,000 1,250,000 1,500,000 2,000,000 2,500,000 3,000,000 | But Not Over: $10,000 20,000 40,000 60,000 80,000 100,000 150,000 250,000 500,000 750,000 1,000,000 1,250,000 1,500,000 2,000,000 2,500,000 3,000,000 ———— | Tax on: 0 $ 1,800 3,800 8,200 13,000 18,200 23,800 38,800 70,800 155,800 248,300 345,800 448,300 555,800 780,800 1,025,800 1,290,800 | Rate on Excess of: 18% 20 22 24 26 28 30 32 34 37 39 41 43 45 49 53 55 |
In addition to the federal tax is the estate tax levied by the domicile state. Fortunately for Californians, voters long ago removed the state death tax, but observers have noted a subtle change in the political winds and there is no guarantee for the future. Most states have an estate tax but it is not imposed unless federal estate tax is due. The state estate tax is designated to pick up the amount of the allowable federal credit, resulting in no net increase in tax payable. Those states with an inheritance tax, as opposed to an estate tax, present additional challenges that may outflank the unwary.
As we return to the matter of John and Mary Doe’s two million dollar estate, it becomes clear that without basic estate planning, the death of the surviving spouse will culminate in the largely unnecessary loss of $104,000 to probate and a staggering $345,000 to federal death taxes. The bottom line is that nearly $450,000 will be stripped from the estate. Not included herein are additional, but avoidable, income taxes paid upon sale of appreciated marriage assets during the survivor’s lifetime.
The picture becomes even more grim for larger estates. By way of comparison, an unprotected estate of $10,000,000 will pay $4,664,500 in federal estate taxes and $340,000 in probate fees for a loss in excess of $5,000,000 to the estate.
Despite the bleak picture, with proper estate planning it is possible to drastically reduce death taxes and to completely sidestep probate. A business person must take time out of his or her busy schedule, while there is opportunity and legal capacity, to skillfully formulate an estate plan. It has often been said that if each of us gave as much attention to estate planning as we do to buying a new computer, we would shield our beneficiaries from debilitating probate paperwork and delay, and effectively protect the product of our life’s work. It is fair to say that a modestly-positioned businessperson can easily save his or her estate $10,000 for every hour given to strategic estate planning.
Listed below are some options that vary from a default position to sophisticated asset reconfigurations. A coordination of these and other strategies could virtually remove taxation and probate fees as a threat and vastly increase the efficiency of asset transfer.
INTESTACY
If we make no effort toward planning, the state will create one for us through intestacy proceedings in probate, without regard to our preferences or tax avoidance opportunities. Added to the chaos is the delay in settling the estate that can take years to complete.
WILL
This tool effectively employs strategies for directing assets and may utilize sophisticated trusts and other tax avoidance measures. Included in the use of a will, however, are the resulting probate fees and delay in asset transfer.
TRUSTS
Living Trusts provide a great opportunity for achieving the long-term intent of an estate plan, while at the same time avoiding the costs and delay of probate and, in some cases, of a significant portion of estate taxes. The Irrevocable Life Insurance Trust, the ever-popular Bypass and QTIP trusts, and other testamentary trusts, provide additional opportunity for tax minimization and other estate goals.
FAMILY LIMITED PARTNERSHIP
Under this structure, assets can be transferred to the partnership and thus provide opportunity to gift a percentage of ownership to family members each year. This achieves the need to reduce the size of estates for death tax avoidance and to reduce income tax exposure. Of additional importance is the fact that grantors can exercise leadership over the donated assets for an extended period.
FAMILY CORPORATIONS
This vehicle achieves similar objectives as the Family Limited Partnership. Unfortunately, without careful attention, families may invoke harmful tax consequences should they improperly make corporate property division or remove corporate assets.
LIMITED LIABILITY COMPANY
The recent advent of this option appears to provide opportunity, in the same way as the Family Limited Partnership, to gift ownership to others in order to achieve savings on income and estate taxes.
CHILDRENS’ TRUSTS
Most business people have heard of Section 2503 of the Internal Revenue Code, but are unsure as to how it might benefit them. The Section is complex, but among other features, allows diversion of income over to children. This is accomplished by gifting an asset and then renting it back as a business expense. The rental amount over the lease period may ultimately dwarf the initial gift value, achieving income tax benefits to the grantor. Further appreciation in the value of the gifted asset remains outside of the grantor’s estate and thus avoids estate taxation. An Educational Trust is a variation under the Section that sets aside funds for the future education of the grantor’s children. Regardless of title and objectives, there are unified credit, Crummey powers and other issues that will have to be carefully navigated.
CHARITABLE TRUSTS
There are three common versions of charitable trusts which are the Charitable Remainder Annuity, Charitable Remainder Unitrust and the Lead Trust. These trusts are used in conjunction with a Life Insurance Replacement Trust to provide for the maker’s needs during life and for the minimization of estate tax exposure upon death.
PRIVATE FOUNDATION
Individuals can reduce the size of their estate and thereby reduce income and estate taxes by donating to their own Charitable Foundation. An added benefit is that, provided the Foundation is in compliance with Internal Revenue Code Section 501 and IRS regulations, any income earned by the Foundation as the result of donated assets is tax free to the Foundation. Furthermore, the family and others involved can receive reasonable salaries for Foundation responsibilities. The Foundation may lose its tax-exempt status, however, should activities stray from its exclusively charitable purpose. The result of a properly created and run Private Foundation is the ability to apply learned business management skills to charitable giving, spread income from the assets donated, lower the donor’s income tax exposure and decrease the size of the estate so as to limit estate taxes upon death.
Conclusion
As shown in the partial and broad-brushed list above, there are abundant alternatives and combinations of strategies available to the businessperson. These strategies benefit those who are financially successful, those who expect to be, and those of even modest means who wish to achieve the same effective, purposeful management of their resources.
A poor use of valuable time is the do-it-yourself approach. Businesspersons need to identify objectives and engage in discussion with experts in estate planning to help develop and implement a strategic plan that, in a legally compliant way, achieves those objectives. Since death and taxes are certain, the business of living requires due diligence with the development of a strategic estate plan that provides efficiency and comfort to the wealth creator while living, and maximizes the benefit of a lifetime’s productivity for charitable and other family objectives upon death.
