Estate Planning Mistakes:
5 Not So Easy Pieces

Five Essential Estate Planning Mistakes

The estate planning process can be a mine field for the uninformed. The process of estate planning involves the coordination of the various assets of an individual into a cohesive, comprehensive plan to provide for family members. The real trick here is to analyze all assets whether held individually, jointly, and those that pass by beneficiary designations to come up with an effective overall and integrated strategy to deal with these assets. In many cases assets are incorrectly titled and need to be realigned. Often times beneficiary designations for life insurance and retirement plans need to be changed to obtain better tax and estate plan results.

The following are some of the common mistakes or misconceptions in this area, along with related estate and tax planning strategies to address these issues and to improve a client’s tax posture.

Failure To Draft A Will

The failure to draft a will results in the following problems or disadvantages:

• Intestacy Rules of Succession Control When There Is No Will: The rules of intestate succession of the state of residence of the decedent determine who will receive the estate assets. These state rules of intestate succession are a poor substitute for a person’s actual wishes. A well crafted will allows you to determine and control who gets what and when they are allowed to receive assets of your estate. Oftentimes a trust is drafted as part of a will or as a stand alone document to provide for management and preservation of assets for those in need of a trust due to youth, inexperience dealing with financial assets, lack of financial skills or special needs.
• Naming Fiduciary: Without a will, you have given up the right to name a person to administer your estate. Leaving this to state law or a judge is obviously not a good idea.
• Bond Required: Without a will some states require a bond for anyone who serves as administrator. If an out of state relative needs to be named or wants to serve as administrator, posting of bond is almost always required. The cost of such bond would far exceed the cost of drafting of a will in most cases.
• Guardianship: A will allows the naming of a guardian for young children. Most people do not want a judge to decide who should care for their loved ones in the event of an untimely death.
• Avoidance of Estate Litigation: Having a well drafted will can help avoid costly, time consuming and often bitter litigation between family members. This is especially the case in second marriages.

Leaving All Your Assets To Your Spouse

Although what may have seemed a good idea and was the natural inclination of most married people, leaving everything to your spouse was not a good idea under prior law. Where a decedent had a will that simply gave everything to the surviving spouse, under the old tax rules they would have failed to utilize their exemption. When the second spouse died they included in their estate the assets received from the first spouse to die. Before the “portability” rules were enacted, the the exemption of the first spouse to die could not be utilized at the second death of the surviving spouse.

To correct this problem, federal laws were enacted that allow for the “portability” of the first spouse’s exemption. These new portability rules allow for the second spouse to use the first spouse’s unused exemption.

As a result, portability allows for the full utilization of both spouses unified credit in most cases. However, there are some important limitations and special rules that may limit the value of portability. Here are some portability rules to keep in mind:

• If the surviving spouse remarries, then children may not get the assets that there father or mother may have wanted to go to them.
  • One solution: Use of trusts: For example, a unified credit trust set upon the death of the first spouse would allow for the tax saving discussed above and would insure that the decedent’s assets will end up in the hands of the children of the first marriage.
• If the surviving spouse enters into a second marriage, the portability amount from the first marriage may be lost if the second spouse dies.  In such a situation, the surviving spouse must use the remaining unified credit of the second spouse that died.  If that second spouse has used up or reduced their unified credit during their lifetime, the surviving spouse must use this lesser unified credit.
• Although portability now seems to be firmly established as part of federal estate tax law, no one knows whether portability will remain part of the law in the future.
• When there are assets that may appreciate over time, portability may not be the answer. Putting assets into a unified credit trust at the first to die instead of relying on portability will remove all appreciation from these assets from the second to die spouse and could result in huge tax savings to the family.
  • The use of trusts generally and the unified credit trust specifically for tax reasons, also offer other benefits such as the following:
    • Creditor protection
    • Problems associated with second marriages.
    • Protect young children from loss of assets due to bad marriages, legal problems, creditor claims, bad business decisions, bankruptcies.
• Gifts to Grandchildren: If a spouse wants to take advantage of their generation skipping transfer tax (GST) exemption, then the first spouse needs to establish a so-called GST trust or dynasty trust. Portability does not extend to the GST exemption.  As a result, if the first spouse to die does not utilize their GST exemption it does not get allocated to the surviving spouse under the portability rules.

This is a lot to consider, so where does this leave most taxpayers? In certain circumstances, taxpayers will want to insure that they are able to utilize their unified credit exemption regardless of what the surviving spouse does. In such a case, they can eliminate estate taxes by placing their assets in a credit shelter trust. If correctly structured, the unified credit trust can also provide the surviving spouse and/or descendants with income for life and access to the principal as needed, but the assets will pass free of federal estate taxes. The savings here could be quite significant and the planning is much more certain. Finally, using this mechanism combined with GST tax exempt trust provisions can accommodate a client who wishes to create a dynasty or generation skipping trust.

In families where things are more predictable, it may be feasible to still leave assets to the surviving spouse and relying on the portability rules to minimize or eliminate federal estate taxes, but subject to the risks and limitations discussed above.

Where assets are more modest in amount, federal estate taxes may not currently be a concern.  Be aware that for 2020, the unified credit (exemption from tax) is $10,580,000 for any decedent. The amount of course is doubled for a married couple. This would exempt most taxpayers from a federal estate tax.  But be aware that the new administration may need to decrease this exemption amount as a result of the mounting federal deficit and the massive costs of the pandemic.  This would result in more complicated planning for most taxpayers. 

Owning Assets Jointly

Although jointly help property can be easy to establish, the following are some issues to consider when holding assets in this way:

• Portability: From a federal estate tax perspective, portability allows married  couples to utilize both of their unified credits in most cases, subject to the limitations discussed above.
• Wills Are Still Needed: Many people mistakenly believe that by owning all their property as joint tenants, there is no need to have wills since joint property passes to the other outside of will.
  • But if the spouses die simultaneously, wills are needed to transfer the property. 
  • Also, although the joint property is not controlled by a will at the death of the first spouse and the joint property passes to the surviving spouse, the surviving spouse must have a will to provide for who will receive these assets.
• Second Marriages: Joint tenancy type arrangements can be extremely problematic where there is a second marriage. If assets pass to the surviving joint tenant on the first joint tenant’s death, such assets become the sole property of the survivor. That survivor is free to draft a will that does not provide for the children of the deceased spouse.
  • This can create family discord and expensive, time consuming, contentious and expensive litigation. This situation needs to be discussed and planned for with an experienced estate attorney.
• Loss of the Step-Up in Basis Tax Advantage: Transferring of assets into joint tenancy with other family members (not a spouse) raise other problems. Taxpayers do not realize that a lifetime transfer of real estate may result in loss of a an important tax break.  When property is gifted while alive the donee (the person that receive the gift) takes a carryover basis in the property (what the gifting party paid for the property plus improvements).  But if the donee receives the property from an estate they get a step up in basis to the date of death.  This eliminates any gain on the sale of the property.  For more details of why this is so important please read The Biggest Tax Loser: Misguided Gifts of Real Estate by Uninformed Do It Yourselfers, Realtors & Attorneys.
  • Gift tax, gift tax filing responsibilities and income tax issues are raised by such scenarios. For an article that details these problems please read IRS Checking Real Estate Transfers For Unreported Gifts.

Failure To Own Life Insurance Properly

Naming the beneficiary of a life insurance policy seems simple enough but as they say “the devil is in the details.” Where a husband and wife suffer a simultaneous death and small children are named as contingent beneficiaries of the life insurance proceeds, an expensive and time consuming probate court procedure will be needed to appoint someone to administer the policy proceeds. The person the court appoints as trustee may not be the person the deceased parties would have chosen. This could be a very expensive and problematic situation.  By drafting a trust and having the trust named as the contingent beneficiary and not young children solves this problem.

Second Marriages: Where a second marriage is involved and the second spouse is named beneficiary, these proceeds may never end up benefiting the deceased spouse’s children.Once again a trust could be drafted to receive the insurance proceeds and to provide for both the surviving spouse and children from the first marriage.

Federal Estate Tax: From a federal estate tax perspective, people are surprised that life insurance owned by an individual is included in their taxable estate at death. This may result in federal estate taxes being paid on insurance proceeds at death.

• To avoid federal estate taxes, often times an irrevocable life insurance trust is utilized to own such policies to remove them from the taxable estate.
• To pay premiums on such policy held in trust there can be gift tax implications. However, if the trust is drafted properly and certain documentation and notices (a so-called Crummey notice) are given each year, the insured can make annual gifts to the trusts that qualify for the annual donee exclusion to pay for the insurance premiums on such policies.
• Finally, if a current policy is transferred to an irrevocable trust, care must be taken to account for the 3 year rule under federal law. This rule pulls back into the estate the insurance policy transferred to the irrevocable trust if the taxpayer dies within 3 years of the date of transfer. Special drafting considerations need to be employed in this context. It is often recommended that an irrevocable trust is first drafted and then the trustee purchases the life insurance policy to avoid this three year rule.

Failure To Have A Gift Giving Plan

Taxpayers sometime fail to recognize they can give $15,000 per year to as many donees as they desire. In addition, the spouse can join in such gift for an additional $15,000 annual donee exclusion. This will allow for gifts of $30,000 per year to as many donees as desired. Note that this gift must be a present interest gift as defined by the Internal Revenue Code, regulations and case law. Basically, a present interest gift is one where the recipient can enjoy the immediate benefits of such a gift in a significant way. In addition, a taxpayer has a unified credit of $10,580,000 to utilize against lifetime gifts. For more on this topic, related and other gift strategies please review Gift Giving: Tax Advantages.

There are other gift giving strategies that may be available depending upon the situation. For example, the use of a family limited partnership can be a powerful transfer vehicle that can create estate and income tax savings for a family. Please see the article Family Limited Partnerships to explore these tax benefits.

Gifting of shares in a closely held business to those involved in a family business can be quite advantageous especially if the value of such shares are currently depressed due to the current financial conditions. For using tax strategies such as minority interest and lack of marketability discounts and how they create tax advantages in a bad economy please read my article Gifting Shares of Stock In A Bad Economy that was published in the Tax Corner section of the Journal of Accountancy in September 2009.

Depending on the situation other gift giving strategies such as the following may be utilized:

• Intentionally defective grantor trusts
• Qualified personal residence trusts
• Charitable remainder and charitable lead trusts.  For more on charitable lead trusts see Charitable Lead Trusts
• Qualified tuition plans see College Tuition: Discover How Grandparents Can Help Their Grandchildren and Save Taxes Too and   Section 529 Plans: Gift Tax Rules and other qualified transfers
• Qualified medical transfers

Warning

The above are just highlights of some mistakes that can occur without proper planning. The reality is that any estate plan must be tailored to the client’s family needs while taking gift, estate and income taxes into account. The special financial needs of family members also need to be considered. Blended families and second marriages raise special practical, legal and tax considerations.

Bringing together a person’s diverse assets to fit into an integrated and comprehensive estate plan that results in wills, trusts and other documents that actually work as intended is at the heart of sound estate planning.

Steven has been providing outstanding legal advice to me for seventeen years. He is THE authority on estate planning and financial planning. Steven is a compassionate and thorough attorney who thinks of every possible contingency. He easily explains complicated issues, and it has been my pleasure to recommend him to my friends.
Gwen Bland