October 1995
Vol 19 No 2
Recently, a subscriber and personal friend, George, suddenly passed away without any warning. It wasn't time for him to go. He was in relatively good health. He'd attended one of my seminars within the past few months. His life wasn't particularly stressful. One moment he was with us, and the next he was gone. I liked George. I'll miss him. He was about my age. His family's composition was similar to mine. His passing should make us all pause to ponder our own fates.
George did a lot of things right in his life. A West Pointer, he had a full and fruitful military career. He was a successful investor. He encouraged his offspring to attend seminars and subscribe to this letter. Besides a legacy of solid standards and values, George left a profitable real estate portfolio with manageable debt, which will provide an income for his survivors. More importantly, he left a well prepared successor generation to take up the baton and keep things running smoothly. Not every family will be so well provided for. There's much we can learn from him.
Other survivors aren't always so fortunate. There's an old saying, if you don't like your spouse, keep him/her in the dark about your finances. At a seminar in Miami one time, a recently widowed lady asked me to help her with a decision. She was being asked by an Options Trader whether or not he should cover a short position. To do so would cost her every dime she had left. The problem was, she didn't know or understand the commodities market. or what to do. She had no financial friends upon whom she could rely for competent advice. A lifetime of striving to build personal financial security depended upon her getting the right answer and making the correct decision. I didn't understand the commodities markets either. I wasn't much help.
It's funny that the very same people who keep spare flashlight batteries, put anti-freeze into their cars, watch weather forecasts to stave off trouble, and check the air in their spare tire don't prepare for their early, untimely demise. Our widow's husband had 'protected' her from the complexities of financial investment. He hadn't prepared her for coping with life after his death. There are many husbands out there who have overlooked the fact that they could outlive their wives. How well have estate plans been implemented for the estates of wives who invest in real estate?
To a large extent, because it may not seem particularly critical to us at the moment, we're all guilty of putting off estate planning. Since none of us really knows for certain which day will be his or her last on this earth, doesn't it make sense to invest some serious time putting our affairs in order? Regardless of our age or physical condition? Or marital status? Or the size of our estate?
This month, we're going to discuss both conventional and creative estate planning. If you think you're too young to be concerned yet, are you too young to be involved in a fatal accident? Are your parents? If you're not planning your estate, would you be better off if your parents were planning theirs?
The first step in planning the disposition of your estate is to recognize that you don't control the time-table. You should plan as if you weren't going to survive the day. Start with what you now have, and revise your plan as your situation changes. As the years pass, your assets, family composition and obligations will undergo change. You'll have to periodically update your planning to accommodate changes in your personal situation.
IT'S NEVER TOO EARLY TO START
At age 17, while enduring basic training in the Air Force, I was ordered to make out a will. With an income of $54 per month and no money, I thought this was odd, but my superiors knew best. You see, military personnel don't always have the luxury of dying of old age. The USAF wanted everyone to have their affairs in order. I duly made out a will. I left everything, including a $5000 Insurance policy to my widowed mother. I had no dependents to care for – – yet.
Seven years later, on the occasion of my first anniversary, I revised my will, naming my wife as my sole heir and as the sole beneficiary on a new, larger insurance policy. I also executed an unlimited Durable Power of Attorney giving her complete dominion over all assets. Four years after that, our family had increased by two. My estate was slowly growing. I owned 5 building lots in Florida, a car, a new mobile home, and a budding portfolio of mortgages and mutual fund shares. I had no debt. My will now had a codicil which added my kids as successors to my wife, and she executed a will naming me as primary beneficiary, with the children as successor beneficiaries in the event we were killed in a common accident.
At about that time, my wife and I undertook an extremely important step in my estate planning. Two particularly close friends, Chet and Glendine, agreed to be guardians for our preschool children if we were both suddenly taken away without warning. First, we formed a Living Trust. It named myself and my wife as the initial Trustees. They were named jointly as Successor Trustees. They were given total control of all assets and insurance proceeds to use in their total discretion to pay for the care of our small children in the event they were left alone, unprotected. They were selected primarily because of their standards and values, but they were also qualified investors. They would be able to wisely use the small estate left to support the kids. We wanted our offspring to have real parents who would help them grow up with a solid set of values. Trusted, capable financial friends are invaluable in estate planning.
Let's see. We've got a Durable Power of Attorney, each of us has a Will, Life Insurance, a Living Trust. We've found good friends to help raise our kids and take care of our assets. So far, so good. Over the next few years, we focused on earning a living as our assets ebbed and flowed over the rocky road to riches. Back then, gifts between spouses in excess of $3000 were taxable, and it was presumed that the first spouse to die owned everything unless the survivor could prove otherwise and had paid gift taxes as required by law. We set out on a family program of separating my wife's and my own estate and of focusing our efforts to equalize the value of assets owned by each of us. We pyramided her assets primarily via tax-free exchanges and Options. In a few more years, our estates were roughly equal, and have remained so to this day.
By dividing our estates, it became possible to take advantage of two $600,000 estate tax exemptions. Suppose I still owned everything in my name. Assuming that my wife would out-live me, upon my death, she'd be able to inherit everything with a step up in basis to fair market value. My $600,000 estate tax exemption would have been wasted. Upon her subsequent death, she'd only have a single $600,000 exemption. The full brunt of estate taxes would be levied against remaining assets. Bear in mind, there is serious talk in Congress about reducing the $600,000 tax exemption to $200,000. If that were to happen, this strategy is even more beneficial to the survivors.
Many people get lured into holding assets as 'joint tenants with rights of survivorship' or as 'tenants by the entireties'. The problem with this is that, while this effectively avoids probate, it deprives the survivor of any step up in the taxable basis of the property upon the death of the co-owner. It's far better to divide assets equally between spouses in a stable marriage. Perhaps marriages become a lot more stable when assets are divided between each partner as their sole and separate property.
In some States, there's a special tax advantage to those holding assets as 'Community Property' rather than separately. Upon the death of either spouse, the remaining spouse gets a step up in basis on all the property owned. Basis is stepped up again upon the subsequent death of the surviving spouse. Why is this important? The added basis can be depreciated and there is less recognized taxable gain on sale. Financial planning can be critical in community property States.
TRUSTS CAN PLAY AN IMPORTANT ROLE . . .
Revocable Living Trusts avoid the probate process but the Trustee must still pay off debts and death taxes. As assets accumulate, a more sophisticated Living Trust is needed. This is commonly called an 'A/B' Trust because it divides the estate between a surviving spouse and his/her heirs to take maximum advantage of the $600,000 estate tax exemption mentioned previously. A/B Trust language usually states that there will be a Spousal Trust (A) and a Family Trust (B) set up under the Living Trust. The maximum tax free amount of assets that can be conveyed tax free in one year ($610,000) is left to the Family Trust for the benefit of the beneficiaries.
The Spouse is given the right to income from the Family Trust for life, after which, everything reverts to the heirs. All remaining assets are left to the Spousal Trust under the control of the spouse. The residue of this Trust usually reverts to the heirs upon death. Revocable Living Trusts can be changed at any time. Assets can be added or removed as you choose. If you change spouses, you can change the trust. Or if heirs misbehave, you can eliminate them from the Trust.
A Trust's 'Spend Thrift' clause can prevent creditors from attaching Trust assets. Specific arrangements can be made for the care and treatment of the beneficiary and of the assets by pre-appointed Trustees for elderly people who have no family members to undertake the responsibility for managing property and disposing of assets in order to pay medical bills and living expenses.
It's important to remember when forming any kind of Trust that creating the legal documentation is only half the battle. You must also actually convey all your property into the trust. For real estate, this can be done with a Quitclaim Deed. For vehicles, boats, RVs, a new title can be issued in the name of the Trustee for the Trust. Other personal property should be clearly identified with descriptions, serial numbers, photographs, video tapes, etc. and included as Exhibits referenced in the Trust itself. Stocks, bonds, brokerage, mutual funds, bank accounts, mortgage paper, insurance policies should all be assigned to the Trust. Remember, if you don't put assets into Trust, your Trust will be of little value.
A revocable Living Trust has a major weakness when it comes to larger estates. It doesn't save any estate taxes once an estate has been divided up between spouses. For estate tax avoidance and reduction planning, you'll need to use an Irrevocable Trust with an 'adverse party' as the Trustee -in total control, subject to the Declaration of Trust over the assets.
It's odd how normally intelligent people balk at letting go of their assets even when it can cost their estates millions of dollars in estate taxes. Giving up legal control is absolutely essential. You can continue to influence how your assets are managed through the Trust Agreement provisions. Typically, assets are placed under the control of adult heirs either singly or as co-Trustees with an institutional Trustee. During your lifetime, you may decide to fore go the expense of an institutional Trustee. Upon your death, the Trust could require that one be retained in the event our heirs aren't capable of making financial decisions without counsel. It's far better that your heirs be trained to manage money.
Obviously, it's best for your heirs to become involved in managing your assets. This way, they'll be qualified to take complete control as trustees of your trust. If you want to avoid family disputes over how to manage your assets, set up multiple trusts, one for each heir, and place assets into each which suits their capabilities and interests. This is especially beneficial when it comes to leaving family business interests in an estate. There are special valuation rules and estate tax payment plans for family farms and businesses that save real money.
FAMILY PLANNING IS THE KEY TO PASSING ON MAXIMUM VALUES
Let's presume you went to an estate auction and were asked to bid on minority shares of a closely held family corporation. Would you be willing to bid as much to own a non-controlling interest in an intangible as you would for the property itself? The tax law recognizes lack of marketability and lack of control over property inside an entity is worth less than it would be if held by an individual. Discounts of between 40% and 85% have been allowed in estate and gift valuation because of this. Placing your property into a separate entity enables a lot more of it to be gifted in advance of death, or inherited without taxation. When the most capable heir remains in charge of the entity and manages assets for the benefit of the others, fantastic estate tax savings can be realized.
Let's discuss gifting strategies a moment. When assets are gifted prior to death, they are removed from the estate for tax purposes, and all the appreciation, income, tax benefits, possession, and use is passed on to the next generation subject only to gift taxes. By adroit use of the one-time $600,000 gift tax exemption and annual $10,000 exemption per donee, combined with the discounts mentioned above, an astonishing amount of assets can be gifted prior to death tax free. The bad news is that there's no step up in taxable basis on gifts, but there's no step up in basis in cash either, whether inherited or not. Thus it makes sense to gift either appreciating and income producing assets or cash to your heirs, and to retain amortizing and income producing assets such as mortgages and lease sandwich positions to produce current income if you want to minimize estate taxes.
Now we come to the next stage in estate planning. Insurance. Suppose you had the choice of paying $100,000 in estate taxes or of paying $10,000 in insurance premiums. Which would you choose? Normally, insurance companies spread risks among the insured, but when it comes to life insurance, there's no risk to spread. Everyone dies. The only risks the insurance companies can hedge is when insureds die. Rather than spreading risk of death, they statistically spread the timing of death. By investing in a large, well established company with a proven track record, you are really only diversifying a portion of your assets under another's management just as you do when you make a bank deposit or buy a mutual fund. But there's tax-magic in insurance policies. When they're owned and paid for by an Irrevocable Trust for the benefit of your heirs, all the proceeds are both income and estate tax free. These proceeds can then be used to either pay estate taxes or to help the next generation continue to build the dynasty.
Trusts and insurance in combination with private foundations have been the great wealth builders and preservers of the 20th century for those who use them properly. The final link in your estate planning might well be to create a charitable trust into which free and clear assets can be gifted. Not only are all capital gains taxes avoided, but deductions are allowed based upon the current fair market value of the assets regardless of the adjusted cost basis. For the remainder of your life, you'll be able to use the assets yourself, or for the production of income. Upon your demise, they will go to the bonafide charity of your choice. This could easily be your own Private Family Foundation. You could specify that it be administered by your heirs and by their heirs in perpetuity.
To quote a wise friend of mine, 'It's just as important to die successfully as to live successfully.' By getting your family's estate planning done now, you'll have passed a major milepost on the way to a full and well rounded successful life. Don't put off this vital financial aspect of your life. Start formulating and implementing your estate plan while you can. Do it now!
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