Wills, Trusts, Estates and Taxation

Abstract

An estate is all that a person owns, both real and personal property, and is essentially a person's net worth. Within the context of estate planning, two other types of "estates" are also relevant. The taxable estate is that portion of the estate that will be subject to federal estate taxes and possibly state taxes. The probate estate is that portion of the estate that must be probated before it can be distributed. This article reviews wills and trusts, and other common components of most estate plans, in light of the two most relevant concerns: taxes and probate.

Keywords Estate; Estate Tax; Joint Tenancy; Probate; Trust; Will

Law > Wills, Trusts, Estates & Taxation

Overview

An estate is all that a person owns, both real and personal property, and is essentially a person's net worth. Within the context of estate planning, two other types of "estates" are also relevant. The taxable estate is that portion of the estate that will be subject to federal estate taxes and possibly state taxes. The probate estate is that portion of the estate that must be probated before it can be distributed. The interplay and content of these three values of estate will drive most estate planning. The general principle is to eliminate the probate and taxable estates to the greatest extent possible. This is done through estate planning arrangements that include wills, trusts, certain property ownership arrangements and other devices.

The area of wills and estates is loaded with jargon. In this essay, three main ways that property can pass from one to another are discussed. This discussion requires the use of traditional technical language that should be addressed up front to avoid confusion and to attach modern simplified equivalent language where possible. A property can be passed along according to a will, under state law, and according to a trust.

Sometimes a will is called "last will and testament," but for all purposes, including legal uses, just the word "will" suffices. Traditionally, wills used the phrase "I give, devise, and bequeath." The modern approach is to use only word "give." A modern document titled "Will" that states "I give…" means exactly the same thing as document titled "Last Will and Testament" that states "I give, devise, and bequeath." The will has two basic parties: the person creating the will and the parties taking under the will. The person making the will is called the "testator." As a technical matter, property distributed under a will is a legacy, devise, or bequest. A legacy is a gift of money, a devise is a gift of personal property, and a bequest is a gift of personal property other than money. The person taking then becomes a devisee or legatee. The delineations regarding the different types of gifts are sometimes used and not always used exactly as defined. For our purposes, and for most purposes, they need not be mentioned again, but if seen, they should be understood to relate to the passing of property under a will.

If a person did not make plans for their estate, or made plans that failed to address all property, state law dictates how their estate is to be distributed. A person who dies without making plans for their estate is termed "an intestate" or is said to have died intestate. The people who receive the property under state law are called "distributes" or "heirs." The word "heir," in this highly technical sense, refers only to people that receive property under state law; however, the word is more loosely used to refer to people that also receive property under a will.

Trusts are arrangements used to transfer property from one person to another. The person that establishes a trust can be called a "settlor," "trustor," or "creator." The person who receives property under a trust arrangement is called a "beneficiary." The word "beneficiary" is also generally used to mean any person who is designated to benefit from legal arrangement, as in a will, life insurance policy, etc.

In keeping with the modern approach, we will try to streamline our vocabulary. For our purposes, any person making a will is a testator. Any person receiving under a will or under state law is an heir. Although in discussion it may seem otherwise, heirs are only heirs after the testator or intestate dies. Legally, no living person has heirs, only "heirs apparent." Anything that an heir receives is simply a gift or property. A person starting a trust will be called a "settlor," and a person receiving property under the trust will called a "beneficiary."

A will is a document that directs how a person's estate is to be distributed after their death. A will is a highly formal document that requires the testator to have capacity and must almost always be written, signed, and witnessed according to state law. A will can direct almost any distribution of property that a testator has an interest in at death to almost any heirs (except laws that prevent a spouse from being left out of a will). A will only creates an interest in property after the testator has died—until that time, the testator is free to change or revoke the will. Upon the testator's death, interested parties must present the will for probate in the appropriate court. Probate is a court-supervised process by which the validity of the will may be tested, and the debts and assets of the estate are collected. The executor is the person who actually collects the debts and assets of the estate to make the final distribution. Executors are usually appointed in the will and can be a relative, friend, lawyer, bank, or trust company. If the person named as executor declines the appointment or the will does not name an executor, the court will appoint the equivalent, called an "administrator." The probate process is usually lengthy, taking an average of a year or more. The probate process is also expensive; it involves lawyers, accountants, appraisers, and filing fees for the court. For these reasons, it is wise to try to avoid probate.

Even though it is preferable to avoid probate to the greatest extent possible, everyone should have a will. First, if a person dies without a will, they are said to die intestate. In that case, their property is distributed according the relevant state intestacy law. Intestacy laws represent a legislative judgment about how most people would want their property divided. Typically, the property would first go to a spouse and then be divided among children and grandchildren, then to parents and siblings and so on. In a case where virtually no family can be located, after a period of time, the property will ultimately go the state or escheat. To avoid the intestacy law and to distribute property exactly according to personal desires, a will or other estate plan is required. Wills also act as backups to other estate planning tools. Property may have been overlooked or newly acquired and not covered by some other arrangement. Wills are also important in that they allow a person to appoint personal and financial guardians for minor children.

There are several options to limit the property that passes under a will and through probate. Trusts, joint tenancies, certain bank account trusts, and life insurance are common options. A trust is a legal arrangement whereby a settlor splits ownership of their property into two parts, the legal title and the beneficial interest. The legal title to the property is conveyed to a fiduciary, called a "trustee." The trustee holds and manages the property for the exclusive use of the beneficiary or beneficiaries, including pets in many states. A fiduciary is one who owes another the duties of good faith, trust, confidence, and candor and must exercise a high standard of care in managing another's money or property. In order to discharge those fiduciary duties, a trustee is generally required to apply, at least, the skill and prudence that a capable and careful person would exercise in conduct of their personal business. Trustees also have a duty of loyalty, which means that a trustee must administer the trust solely in the interests of the beneficiaries without regard to the interests of any third party. Among other obligations, the trustee also has the duty to preserve and protect the trust property, to keep the trust property separate from all other property, and to invest and make the trust property productive. The burden of trustee can be heavy, and many trustees are professionals. As a practical matter, a person should only accept an appointment as trustee with full knowledge of the scope of the commitment (Goldberg, 2007).

Once a settlor creates a trust, the settlor can still use trust property; in fact, the settlor can usually be the trustee and beneficiary under the trust so long as there is at least one other beneficiary. Trust arrangements, in this context, are sometimes referred to as "inter-vivos trusts," "living trust," or "revocable trusts." All three terms refer to the same general arrangement where the settlor retains the right to use the property and can change the terms, or revoke the trust at anytime before death. This is opposed to an irrevocable trust, which does not allow the settlor to change it or revoke it after the trust has been established. At the grantor's death, the trust becomes irrevocable and can no longer be altered or revoked. At that point the trustee, usually named in the trust instrument, would take control of the trust and distribute the property to the beneficiaries as appropriate. Property held in trust avoids probate and can also be used to prevent a beneficiary from wasting an inheritance.

Trust property does not have to be distributed entirely at the grantor's death. The trust instrument can provide for any number of distributions to a beneficiary. A trust can provide for a periodic income distribution to the beneficiary until a certain age at which the entire principal may be handed over. The trust can provide for discretion on the part of the trustee to distribute trust property according to a certain standard, for example, the education and health of a beneficiary or to keep the beneficiary comfortable according to a certain lifestyle. These types of trusts are generally called "discretionary trusts" or "support trusts." A spendthrift trust is a type of trust that protects the beneficiary's interest in the trust from certain creditors.

A joint tenancy is a way for co-owners to hold property together, typically real property. The critical feature of the joint tenancy for estate planning purposes is called "the right of survivorship." With the right of survivorship, if one co-owner dies, that ownership automatically transfers to the other owner or owners. If two people own a house as joint tenants and one of them dies, the other owns the entire property. If three people own a property as joint tenants, when one dies the other two own half each. The operation of the right of survivorship applies even if there were provisions in a will or trust to the contrary. The joint tenant ownership form should be compared to another co-ownership form called "tenants in common." Tenants in common interests in property do not automatically vest in co-owners and is transferable by will or trust. A form of joint tenancy, available in some states exclusively for married couples, is called "tenancy by the entireties" (TBE). A TBE has the right of survivorship. While a co-ownership with a right of survivorship will avoid probate, it does not remove property from a person's taxable estate.

Joint tenancies can also be set-up in bank accounts. A joint tenancy in a bank account operates essentially the same way as joint tenants in real property. Unless otherwise arranged with dual consent, bank accounts with the right of survivorship (JTWROS) allow each tenant to withdraw all the funds in an account at anytime. If a person intends to transfer their funds at death, a JTWROS account carries the risk that the other person may withdraw funds during the life of the primary depositor or, if dual consent is required, the primary depositor would need the consent of the other tenant to withdraw funds. To resolve this problem, bank accounts can be designated as a pay-on-death (POD) account. A POD account, sometimes called an "informal trust," "bank account trust," or "Totten trust," allows a depositor to retain full control over the funds during their lifetime. Upon the depositor's death, the designated beneficiary can have immediate access to the funds by presenting proof identity and a copy of the death certificate to the bank. Funds transferred by banks accounts are included in a decedent's taxable estate.

A related device that operates in the same manner as a POD bank account is called a transfer on death (TOD) designation. Transfer on death registrations can be attached to stocks, mutual funds, bonds, and brokerage accounts. POD and TOD designations, like a joint tenant taking under a right of survivorship, will pass regardless of the terms of will or trust. For example, if a person intended their children to share equally but left them accounts with unequal value, those children would have to agree to transfer money to equalize the shares (Goldwasser, 2006).

Life insurance is often a part of an estate plan. Life insurance proceeds go directly to the beneficiary named by the purchaser and do not go through probate. Insurance proceeds are a ready source of cash, a "liquid" asset, that can be used for burial expenses, estates debts, and any estate taxes that may be due.

Other tools involved in the estate planning process are durable powers of attorney, health care proxies, and living wills. These documents do not transfer property in the event of death, but help others to manage a person's affairs if they become incapacitated. A durable power of attorney is a document that allows another person to make transactions on behalf of the donor, or person giving the power. A donor can give a wide array of authority exercisable during their life and without any further consent, to another including the power to manage a business, use bank accounts, and buy and sell real property. A health care proxy nominates a person to make the health care decisions for another. Closely related to the health care proxy is the living will. A living will expresses a person's wishes with respect to life support in the event that they become terminally ill.

The digital age has ushered in a new form of property: digital assets, which can include e-mails, photographs, social media accounts, funds-transfer accounts (as through PayPal), and the like. However, the law has been slow to respond to this phenomenon in terms who can access and control these assets after the owner dies and how. Meanwhile, unauthorized access of a person's digital accounts is considered an illegal violation of privacy and an act of hacking, posing a problem for executors and heirs (Bissett & Blair, 2014). The situation is further complicated by disparate terms of use for various service providers, such as e-mail clients (Bissett & Blair, 2014). As of mid-2015, about nineteen states had or were seeking to enact legislation that would grant permission to a fiduciary to access some or all of these digital assets. Some proposed laws would require the executor of an estate to obtain a court order first (McCarthy, 2015). Financial advisers have begun to recommend that individuals specify a fiduciary for that purpose and enumerate their various digital assets in their wills, just as they would for their tangible assets (Parthemer, Feffer & Klein, 2014; Bissett & Blair, 2014).

Applications

Through the use of trusts and other devices, probate can be largely eliminated and property can pass relatively quickly and easily. However, the issue of taxes is a separate matter. While separate states may have taxes relevant to estates, this discussion focuses on federal estate tax considerations. Computing the precise amount of tax that may be owed by an estate and the precise legal measures that may be taken to avoid liability for taxes is difficult and often regarded as one of the most complicated fields of law. However, generally, a taxable estate is the gross estate minus the allowable deductions. The gross estate includes all property in which a person had an interest at death and life insurance proceeds, property transfers within three years of death, and trusts that a person established and retained certain powers in. Allowable deductions include funeral expenses, debts owed at death, and marital deduction (the amount passing to the surviving spouse) (Gallo, 2013). The size of a taxable estate can be reduced during life through the use of gifts. If after gifts and allowable deductions a taxable estate is still large enough to be potentially liable for tax, a unified credit can be used to erase part or all of the liability. The tax rates and the size of a taxable estate became a bone of contention, and federal legislation fluctuated for more than a decade. An estate of less than $2 million was exempt from estate tax for deaths occurring in 2007 and 2008. For deaths occurring in 2009, estates less that $3.5 million were exempt. The estate tax was repealed altogether for deaths occurring in 2010 (Clifford, 2006; IRS, 2006). In 2011 the estate tax was reinstated on estates over $5 million and indexed to inflation (Smith & Block, 2013). Consequently, the minimum estate value for which tax would be due to the Internal Revenue Service rose to $5.25 million in 2013, $5.34 million in 2014, and $5.43 million in 2015.

Estate tax and gifts are connected because gifts given during life lower the value of an estate and therefore the possibility of an estate tax. The gift tax applies to gifts that occur whenever property is transferred without the expectation of receiving something of equal value in return. Under that definition, selling something for less than what it is worth, or making a low interest loan, may be a gift. While the general rule is that any gift is taxable, there are numerous nontaxable gifts including gifts for tuition and medical expenses paid directly to the institution, to a spouse, to political organizations, to charities, and any gifts less than the exclusion amount. The exclusion rule allows every person to give to any number of people nontaxable annual gifts so long as each recipient's total gift does not exceed $14,000 (beginning in 2013). However, tax is payable on an amount that exceeds $14,000. Married couples can enhance their gift giving to an individual with gift splitting, whereby half the gift comes from one spouse and half from the other. If a gift is still taxable after all those exceptions, unified credit can be used to eliminate it. The amount of the gift tax would be subtracted from the lifetime unified credit (IRS, 2006).

The unified credit eliminates or reduces both estate and gift tax. Each person has several hundred thousand to millions of dollars of credit as applied to gifts and estates. The amount of personal credit is a lifetime total, and each annual application of the credit during life reduces the total amount of credit. Thus the more credit applied to gifts, the less unified credit will be available to eliminate estate taxes at death.

According to a 2015 report by the congressional Joint Committee on Taxation, one-fifth of 1 percent, or 0.002 percent, of estates were subject to estate tax in 2013. For those larger estates, when both probate avoidance and tax reduction are at issue, more sophisticated estate planning vehicles are available. Those strategies can include life insurance trust, family limited liability partnerships or family limited liability companies, grantor retained annuity trusts, and other trusts to hold real estate for the benefit of children and certain charitable donations. Estate plans for these larger estates are exceedingly complex and are mentioned here to simply make the reader aware that estate planning does not end with wills, trusts, and other nonprobate transfers (Giarmarco, 2006).

The estate tax, or "death tax," as it some times called by opponents, is a political topic. Legislation that would have amounted to a near repeal of the estate tax after 2010 was stalled in the U.S. Senate in August of 2006. According the Joint Committee on Taxation, the legislation would have cost the government $268 billion between 2007–2016, or 80 percent of a full repeal. A repeal of the estate tax was then estimated to reduce federal revenue by $1 trillion over twenty years. In 2015, the Congressional Budget Office projected that estate taxes would bring the government $246 billion in revenue between 2016 and 2025. Opponents of the legislation also claimed that the repeal would remove a strong incentive for wealthy Americans to make charitable gifts through their estates, citing a possible 22 percent reduction in those gifts. Proponents of the legislation claimed that the estate tax law as it stood would devastate small business and farm owners (Schauer, 2006). On the state level, fifteen states and the District of Columbia imposed a tax on estates as of 2015, with six also levying inheritance taxes (i.e., on the property transferred to heirs such as spouses, children, and other relatives), according to the Tax Foundation, a nonprofit think tank.

IRS Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Terms & Concepts

Beneficiary: A party designated to benefit from trust property. Generally, a party intended to benefit from any legal arrangement.

Convey: A legal transfer of ownership usually by writing.

Escheat: Process by which property left by a decedent and unclaimed by family or other takers is turned over to the state.

Fiduciary: A person that has a duty to act in the best interest of another, which involves certain duties in specific situations.

Intestate: Describes a person that dies without a will.

Intestacy law: State law that determines how an estate will be distributed in the absence of a will.

Inter-vivos trusts: A trust that takes effect during the grantor's life. Also called a living trust. Compare- Testamentary trust: a trust created by a will that takes effect after the testator's death.

Liquid asset: Assets that can quickly be turned into cash, e.g., securities, marketable notes, or accounts receivable. Compare- Illiquid asset: An asset not readily converted into cash because lack of demand, absence of an established market, or substantial cost or time required for liquidation, e.g. real property.

Probate estate: That portion of an estate that must be probated because the property passes under a will.

Probate: Court-supervised process that confirms the validity of a will and where assets and debts of an estate are collected and settled and then distributed.

Revocable Trust: A condition inserted into a trust where the settlor retains the right to terminate the trust and recover the trust property.

Settlor, Trustor, Donor or Creator: Different names that refer to the person who places property in a trust.

Taxable estate: That portion of an estate subject to federal tax determined by the gross estate minus the allowable deductions.

Trust: A legally enforceable arrangement whereby a trustee holds legal title to property at the request of another (settlor) for the benefit of some third party (beneficiary).

Will: A document by which a person directs the distribution of their estate upon death.

Bibliography

Bissett, W., & Blair, A. W. (2014). Planning implications of new legislation for digital assets. Journal of Financial Planning, 27(12), 21-24. Retrieved December 10, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=99811387&site=bsi-live

Bogert, G.T. (1987), Trusts (6th ed.). Hornbook series student edition, St. Paul, MN: West Publishing.

Busch, J. (2013). Estate and inheritance tax updates and trends at the state level. Journal of State Taxation, 31, 35-48. Retrieved October 31, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89541160&site=ehost-live

Clifford, D. (1992), Plan your estate with a living trust (2nd ed.). Berkeley, CA: Nolo Press.

Clifford, D. (2006) Quick and legal will book (4th ed.). Berkeley, CA: Nolo Press.

Gallo, J. J. (2013). Allocating assets between a bypass trust and a marital trust. Journal of Financial Planning, 26, 35-39. Retrieved October 31, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89622159&site=ehost-live

Garner, B. (Ed.)(1999). Black's Law Dictionary (7th ed.). St. Paul, MN: West Publishing.

United States Internal Revenue Service, (2006) Publication 950, Introduction to Estate and Gift Taxes.

Giarmarco, J. (2006). Five levels of estate planning. Advisor Today, 101, 50-52. Retrieved March 27, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21490241&site=ehost-live

McCarthy, E. (2015). Digital estate planning:Plugging the gap. Retirement Advisor, 16(8), 40-43. Retrieved December 10, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=108630620&site=bsi-live

Parthemer, M. R., Feffer, J. G., & Klein, S. A. (2014). Estate planning with digital assets—Where are we now?. Journal Of Financial Service Professionals, 68(2), 19-21. Retrieved December 10, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=94827986&site=bsi-live

Smith, A., & Block, S. (2013). Tax planning gets easier. Kiplinger's Personal Finance, 67, 11-12. Retrieved October 31, 2013, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85760302&site=ehost-live ..FT.

Suggested Reading

Basi, B., & Renwick, M. (2006). Where there's a will. Industrial Distribution, 95, 63-65. Retrieved March 27, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21259633&site=ehost-live

Goldwasser, J. (2006). Estate planning LITE. Kiplinger's Personal Finance, 60, 93-93. Retrieved March 27, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19978636&site=ehost-live

Ngai, V. (2015). Back to the basics of estate planning. CPA Journal, 85(1), 58-63. Retrieved December 10, 2015, from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=100887061&site=bsi-live

Schauer, C. (2006). Estate tax repeal and the role of the CPA. Sum News, 17, 6-7. Retrieved March 30, 2007, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23803251&site=ehost-live

Goldberg, S. (2007). In you they TRUST. Kiplinger's Personal Finance, 61, 90-92. Retrieved March 30, 2007, from EBCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23961396&site=ehost-live