Suppose your doctor told you that you had exactly one month to live; how would you spend it? A few thoughts come to mind: For instance, I might stop any thought of exercising and order in a truck load of pie and ice cream. A diet would
be far down my list of priorities. Or, with little need to conserve money, I might decide to take a final trip to see all the things I haven’t yet seen. Or I might buy expensive gifts for my family, friends, property managers, and business associates; or I might gather my family and friends around me and throw a month-long farewell party in some exotic locale. I’d spend very little time worrying about lawsuits, tax audits, or convoluted transactions that I might ordinarily have been involved in. I would not be doing any last minute estate planning. I can do this because I’ve taken the time from a very young age to have an estate plan in place so that my family would be spared all the hassle of trying to settle my estate.
Over the course of the past few years, I’ve spent a lot of time helping heirs handle estates of deceased relatives. In almost every instance, if the dear departed had done even minimal tax planning, much of the ordeal imposed on the heirs could have been averted. Instead, family members wound up spending months sorting out the assets in the estate, and more months wrangling over who got what, and who paid for all the expenses associated with the estate. Hopefully, with this letter, I can motivate a few subscribers to either review existing estate plans, or to initiate them.
At about this point, a lot of people are going to stop reading either because they have no estate to worry about, or because they anticipate that they are years away from the need for estate planning. That’s a misconception; age and date of death aren’t necessarily correlated. Young people die in accidents and from diseases all the time; so it’s never too early to set up an orderly system to keep track of your transactions and investments, and to get an estate plan in place that the family understands and will be able to implement.
Estate planning involves more than merely minimizing Estate taxes. For many, these aren’t a factor at all. The principal reason for setting up an estate plan is to enable your heirs to get the benefit of your assets with the least amount of time, expense, and trouble. To do this, it’s necessary to decide who is supposed to get what, and to put this down in a writing that will withstand assaults from those who were left off your list. If you don’t, family members could spend years in court spending their limited funds trying to defend their right to the bequests you want them to have.
Take a hard look at your current assets and answer the following questions: How much or your new worth is easy to locate and to turn into cash? How much money must be paid out each month to creditors, and in what amounts? Where are your assets located? Where are the keys to the properties? Where are copies of your leases? Where are your insurance policies? Who else can sign on your bank accounts besides you? Where are they? How can they be contacted? Who has management authority over your rentals when you can’t be there? Who maintains the various systems and how much do you pay them? Where are your property files located? Do you have a safe deposit box? Who has the authority to open it? Does your State require it to be sealed upon your death? If you have property in Trusts, who are your Trustees, and who will have the authority to direct their actions when you can’t? Where are your corporate shares and stock record books? Who is your IRA Custodian or Trustee? Where are your old income and gift tax returns? Have you any “hand-shake” agreements with anyone that you need to document? How much of your estate could slip away because you haven’t told your family enough about your business dealings? Should you be doing something about this?
ADMINISTERING AN ESTATE REQUIRES DIFFERENT SKILLS . . .
As you’ve seen in the foregoing passage, there are myriad questions that will need answers in order for your estate to be settled. If you’ve got the foregoing covered, you’re in a lot better shape than most entrepreneurs and investors. If you haven’t, maybe this letter will jog you into taking some of the initial steps in planning your estate.
Let’s review some of the basics: When a property owner dies, he can no longer sign a Deed, Assignment, Release of Option, of even write a check to get money out of the bank. Nor can anyone else sign for him without specific authority to do so. A Power of Attorney won’t work. When property is held in a Trust, provisions can be incorporated for a replacement Trustee or Director; and for replacement Beneficiaries if need be. In such case, the Trustee usually holds title to everything, and can sign necessary documents to liquidate or distribute assets. If an estate is governed by a Will, then an order from the Probate Court is needed to authorize property to be liquidated or transferred. In either instance, whether a Trustee, Executor, or Personal Representative has been named to represent the estate, there are a lot of things that must be done before assets can be distributed to the heirs. Let‘s take a stroll through the estate distribution process to see all the things that must be done:
When a person dies, unless this takes place in an area away from civilization and nobody knows of it, several government agencies are notified. Among them are the Social Security Administration and the County which issues a death certificate. This is a key document that is often provided to the surviving spouse, or family members by funeral directors, but can be ordered from the County. What happens from that point on pretty much depends upon the estate plan, Will, or Trust that the dear departed had previously executed. A properly drawn Living Trust and Pour-Over Will are worth their weight in gold at this point. If there is no such estate plan, that’s where the fun begins:
Since nobody will have express authority to deal with the affairs of the deceased, an application must be made to the Probate Court to appoint someone. When the heirs can agree on one person, it’s fairly easy to get him or her appointed; but when they can’t agree, the court will appoint someone; often someone who had done this before. His job will be to round up all the assets and have them valued. Next, he’ll pay off all just claims, debts, and tax liabilities and then distribute them to the heirs in accordance with State law. Regardless who is appointed, he’ll be expensive and have no compunction against running up a lot of fees to be paid by the estate.
A lot of legislation has been proposed that will increase the threshold at which an estate will be taxed, but these have been narrowly defeated in the 2006 Congress. Currently, when the total assets — including life insurance and pending legal claims for damages when death is caused by culpable negligence — devised to non-spousal heirs are less than $2,000,000, this isn’t as critical as it would be for a larger estate. In view of the tremendous appreciation of real estate equities over the past few years, you’d be surprised how fast assets can add up to $2 million; and you won’t really know how close you are until the appraisals are made.
Take a moment and ponder just how difficult accurate net estate valuation would be for someone who knew nothing about corporations, LLCs, Trusts, Joint Ventures, Partnerships, partial ownership interests in real property, Options, Discounted Notes, etc.; and who had to arrive at their true fair market value as of the date of death of the deceased. You’d be surprised at how few people have the training to assign values to these various interests, or how few offer their services for hire. It can be a real bear, but it must be done if the estate is divided between combative heirs, or when it is over $2,000,000 in 2006. Before any distribution can be made, debts and Estate taxes must be calculated and paid.
ESTATE TAX AND INCOME TAXES COME OFF THE TOP . . .
In order to determine how many claims might be filed against estate assets and how much debt needs to be paid off, formal public notices must be run in the newspapers in the domicile of the deceased, and in other locales where he might have had business interests inviting anyone with a claim of any kind against the deceased to step forward and present their claim. Once the public has been placed on notice of the death of the decedent, they must either file their claim, or thereafter be barred from filing it. You can be sure there will be a number of claims for unpaid bills. It’s going to be his job to sort out the wheat from the chaff and to pay just debts. This could take months or even years. Meanwhile, the heirs must patiently wait for their inheritance.
The Executor, Trustee, or Personal Representative will be responsible for calculating the net taxable estate. This involves establishing the net taxable estate and filing all the necessary State and Federal estate tax forms. At the Federal level, the Estate Tax is calculated on the Form 706. This is a daunting 22 page report with 16 pages of instructions. It contains a variety of formulas that must be used to arrive at the estate tax. Probate software that can be used to complete this form is a great help. It can be obtained from Seldon Integrated Systems at www.seldonsystems.com or by calling 800-288-9169. This isn’t particularly “user-friendly” software, but it can be figured out in a couple of hours and can save countless hours of perplexity as the tax form is being completed.
To those who pay Estate taxes, it may seem barbarous that the government that has been so benign during life could suddenly turn vicious in taxing the dead; but when it has been calculated that a 100% tax on Estates would wipe out the national debt, it’s no wonder that government is eager to collect its due. Surviving spouses can be gifted or bequeathed unlimited assets free of Estate taxes. But, Estates in excess of $2,000,000 after all claims have been settled that are left to non-spousal heirs must pay federal taxes starting at 45% of net asset value. The excluded amount will climb to $3,500,000 in 2009, and will be unlimited in 2010. Following this date, all assets in excess of $1,000,000 will be taxed as high as 60%. State inheritance and estate taxes will be piled on top of this.
The great objection of many to the Estate tax is that the assets that have been acquired have already been taxed at least once — and in the case of corporate assets — sometimes twice prior to being included in the taxable estate. The $2,000,000 that is exempt from taxes is reduced by every taxable gift made over the lifetime of the decedent. Gifts made within the annual gift tax exemption are not counted in this calculation. Those vaunted so-called tax-free Roth IRAs get piled on top of all the other assets and are indirectly taxed like all the other assets.
What few people take into account is that Estate taxes must be paid prior to assets being distributed to the heirs. When the estate is comprised of real estate and mortgages, these must often be sold to raise the cash with which to pay estate taxes; thus they further burden the Estate with capital gains and ordinary income taxes at State and federal level piled on top of the Estate tax. When the amount of assets is very large, the Alternative Minimum Tax can also be applied. And when an IRA must be tapped within the 5-year penalty period, the 10% penalty fee can also be added to the mix.
It gets worse: The assets that are sold are often those that are most easily liquidated; which are probably the cream of the crop. The heirs are left with largely illiquid assets that may have to be sold at a discount in order to raise cash or to divide up. In a worst case scenario, in the highest tax brackets, as much as 90% of an estate can simply be eaten up by various State and federal taxes and liquidation of choice assets at discounted prices. Clearly, there are compelling reasons why those who will leave large estates and those who will inherit them should be actively involved in planning ways in which to reduce these taxes.
THEY CAN’T TAX WHAT YOU NO LONGER OWN!
Two scenarios are confronting those who are currently confronting the Estate tax: (1) Congress will eliminate it. This motion missed passage only by three votes in 2006 with a Republican-controlled Congress, and could be passed prior to the end of 2010 when the current law expires. (2) A Democrat Congress may decide that the government needs the money more than those who earned it, and simply allow the maximum exclusion for non-spousal heirs to revert back to $1,000,000.
The question one must ponder is whether to wait until the last minute to start taking evasive action, or to start the process now. Let’s look at both choices:
Suppose they eliminated the Estate Tax? Under the current mixed bag of tax-relief proposals coming out of Congress, if the estate tax were to be completely eliminated, a cap would be placed upon the amount of assets that would receive a step up in tax basis upon death. On the one hand, most estate-tax planning would become obsolete. Variations on this theme involve reducing the maximum estate tax rate and permitting some step up in tax basis upon death. None of this has any bearing on the need for entrepreneurs in any income bracket to set up Trusts to provide for the orderly liquidation and distribution of their assets.
Suppose they let the Estate tax exclusion revert back to $1,000,000, and tax the remaining estate at 60%, as has been proposed? To put things into perspective, things would be the same as they were in 2001 prior to the passage of the current law. Nonetheless, most of the estate plans that are in existence will become obsolete and have to be reworked. Accountants, lawyers, and insurance companies will have a field day as they devise new strategies for avoiding or minimizing these taxes. I think in either scenario would be the use of Tax-free charitable Trusts would be effective to avoid Estate Taxes.
The choice boils down to you choosing what the taxable portion of your estate is used for versus letting the government decide, it was an easy decision for me to set up several Charitable Remainder Trusts and to contribute appreciated real estate to them. Under the terms of these Trusts, my family remains in control of donated assets during mine and a portion of my heirs’ lifetimes. During this period all the earnings of the Trust up to 5% of the total assets in the Trust are paid out to us, and, subject to some convoluted calculations, taxed in accordance with the way they were earned. Thus, ordinary income is taxes as ordinary income, capital gains as capital gains, and tax-free income from municipal bonds is tax-free.
By donating appreciated assets, I avoid capital gains taxes, recapture of depreciation, and get a tax deduction for a charitable gift based upon the fair market value of the donated assets. I also remove them from my estate.
I get to identify specific charities to fund with the undistributed funds left in the Trust when it terminates, and I can name my own family foundation as the charity if I so choose. I did this 15 years ago, but I could have done it under the terms of my Will or Living Trust to remove assets at the last possible moment.
A Charitable Lead Trust works the opposite of a Charitable Remainder Trust. Assets are gifted to it for a specific period of time and a minimum yield is specified to compound for the benefit of the Trust. All earnings in excess of that are used by the named charity; which could also be my own family foundation. At the end of the specified period, an amount representing the value of the contributed assets plus their compounded earnings would be returned to my heirs. By carefully using discounting factors supplied by the IRS, this could be a way to transfer almost all of a major estate with much lower taxes. Using both charitable Lead and Remainder Trusts, the $200 million estate of Jackie Kennedy was taxed at the rate of about 8% while her heirs continued to receive about $10 million per year in income.
The bottom line is that estate planning is in everyone’s best interests, not just the super rich; but they can avoid a lot of Estate taxes if they want to.