Although the following is an older article, it still applies now. Since we do not know if Congress will extend the 2012 estate exemption of $5 million, let it revert to $1 million or set some other amount, it is imperative to review your estate plans (or lack of).
Original Author: Martin S. Finn, CPA and Attorney
Martin S. Finn, CPA, LL.M., is a partner in the law firm of Lavelle & Finn, LLP in Latham, New York.
As this Practice Alert (excerpted from a more extensive article in the December 2007 issue of Practical Tax Strategies Practical Tax Strategies ¶ 12200706 ) explains, seasoned professionals, attorneys, CPAs, and other tax practitioners are expected to do the right thing for their clients each and every time. Yet, sadly, the tax laws are so complicated and ever-changing that it should come as no surprise to anyone that the possibility for error exists everywhere. Fortunately, the same odious changes that can leave “seasoned professionals” scratching their heads can also present some of the best money-saving opportunities for their clients if properly structured into their plan. As trusted arbiters of advice, practitioners must be ever vigilant of the changes, traps, and hurdles to increase the likelihood of preparing a flawless plan for clients.
Mistake #1. Forgetting to name successor agents, proxies, executors, and trustees in estate planning documents. Forgetting to name successor agents is a common mistake in several essential estate planning documents. It is important to name successor agents in the estate planning documents that take effect during life, such as a power of attorney, health care proxy, and lifetime trusts, as well as the documents that take effect at death, including a last will and testament and testamentary trusts. Successors allow for continued viability of the granted powers, even after the death or incapacity of the primary agent, executor, trustee, etc. Furthermore, naming successors avoids the necessity of a court proceeding, which results in the client losing control over the process.
Mistake # 2. Neglecting to properly structure a business venture to protect personal assets from business creditors. Business owners face risk and the threat of liability from every direction. Some of these risks include business failure, employee torts, product liability, and employee terminations. A business owner can distance himself or herself personally from business risks by forming the proper business entity under which to operate the business. The several types of possible entities afford different degrees of protection. Consequently, while no magic bullet will provide all-purpose, one-size-fits-all protection, a business owner can take various measures to afford the best level of protection for his or her business and personal assets. Included among the various entity options for business owners are sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). Regardless of the form of entity created, a different form of entity should be considered for each valuable component of the business, such as separate lines of business, equipment, and real estate. In addition, estate planning needs to be integrated with asset protection planning, including the transfer of interests to heirs.
Mistake # 3. A married couple not taking advantage of both estate tax exemption amounts ($2 million in 2008) that are available to them, due to inadequate wills and assets owned the wrong way. Planning for estate tax is extremely difficult. At the same time, it is extremely important. When assets pass from one person to another (or one generation to another), significant taxes can be assessed under current laws. By gearing plans to current law and building in sufficient flexibility so that plans can be adapted as the laws change, you can conceivably reduce the tax bill encountered on death. One common error that occurs in the estate planning process is a married couple failing to take advantage of each spouse’s federal estate tax exemption. If the combined estates of the spouses exceed $2 million in 2008, a savings can be achieved by using the unified credit to shelter part of the first decedent spouse’s estate. This tax savings can be achieved in various ways.
First, the client can make an outright bequest to someone other than the surviving spouse (e.g., children or grandchildren). In addition to an outright bequest, a bequest can be made in trust for the benefit of the surviving spouse (or other persons)-e.g., a bequest to a “credit shelter trust” (CST) or “bypass” trust. This bequest would not qualify for the marital deduction. Trust terms can include rights of the spouse or children to the income, discretionary principal distributions, and demand distributions (i.e., “5 & 5” power). The trust property is included in the decedent spouse’s estate but is offset by his exemption amount. When the surviving spouse dies, the property will not be included in his or her estate. When using a CST, assets must be retitled and the beneficiary designations need to be coordinated. This can ensure that each spouse has sufficient assets to fund the credit shelter trust regardless of which spouse is the first to die.
After funding the credit shelter, the balance of the deceased spouse’s estate can be distributed outright to the surviving spouse or may be left in trust. However, the trust generally needs to qualify for marital deduction treatment in order to avoid taxation at the death of the first spouse. ( Code Sec. 2056 ) A common type of trust to use for these purposes is a qualified terminable interest property (QTIP) trust.
In addition to using each spouse’s federal estate tax exemption, the client should make plans for minimizing state death taxes. The 2001 Tax Act phased out the state death credit and, in 2005, replaced it with a deduction for state death taxes paid. ( Code Sec. 2058 and Code Sec. 2011 ) To avoid the loss of revenue, many states have “decoupled” from the federal rules by not adopting the necessary conforming legislation or by adopting separate estate tax rules. For example, while the federal estate tax exemption is $2 million in 2008, the New York estate tax exemption remains at $1 million.
Several available options address the estate tax issues that arise from state “decoupling.” First, a person may fund the credit shelter portion of their estate with the full federal exemption amount. Another way of reducing state estate tax exposure due to decoupling is to combine a CST with a QTIP trust. If a CST/QTIP combination is not preferred, the entire estate may be placed in a QTIP trust.
There are other ways to reduce state estate taxes that do not involve the establishment of a trust. For instance, sometimes the easiest way to avoid state estate tax is to change one’s domicile. Another option is to make deathbed gifts to decrease the assets held in the estate at death.
One final technique to take advantage of each spouse’s federal and state tax exemption is the use of disclaimers. Wills can be drafted to provide for the entire estate to pass outright to the surviving spouse, but to the extent the spouse disclaims any amount, the disclaimed property passes to the CST or bypass trust. Appropriate language directing disclaimed property to the trust is required in the will. In order for a disclaimer to be valid:
- The refusal must be in writing and be irrevocable.
- The disclaimer must be made within nine months of the date of death.
- The surviving spouse cannot have accepted any interest or benefits in the disclaimed property.
- The surviving spouse cannot direct where the disclaimed property will be distributed ( Code Sec. 2518 ).
Mistake #4 . For businesses owned by more than one individual, neglecting to have an owners’ agreement and a binding buy-sell arrangement (with funding) . Much like dewy-eyed lovers forging a romantic relationship, many prospective “partners” in a business have high expectations for the future of that business. The last thing on anyone’s mind is the possibility of business “divorce.” Yet a binding buy-sell agreement is arguably one of the most important documents a multi-owner business entity can have. A “buy-sell” agreement is an agreement between the owners of the business, or among the owners of the business and the entity, to purchase and sell interests of the business at a price set in the agreement on the occurrence of certain future events. Such events may include:
- An offer by an outside party to purchase the owner’s interest.
- Termination of employment.
Business owners who have buy-sell agreements are comforted in knowing that they have structured an orderly transition of ownership and management of a business, protected the business from internal conflicts, and restricted the future ownership of business interests. In addition, business owners can use buy-sell agreements to address estate planning and business planning concerns. For instance, the buy-sell agreement can establish estate value as well as improve estate liquidity by assuring a market for the business interest.
Mistake # 5. Having inadequate beneficiary designations for retirement plans and IRAs that do not coordinate with the rest of the estate plan (aka “having all your ducks in a row”) . Although the final minimum required distribution regulations ( Reg. § 1.401(a)(9)-1 through Reg. § 1.401(a)(9)-9 ) have made planning with retirement plans and IRAs somewhat easier, dealing with these assets in an estate plan can still pose some of the most difficult and complex issues that a planner will face.
As part of the estate planning process, the planner must review all beneficiary designation forms for life insurance policies, annuity arrangements, retirement plans (including IRAs), etc. For retirement plans, the planner should also review the plan document itself to understand all of the beneficiary options. The planner will need to coordinate beneficiary designations with the balance of the estate plan, including will and trust provisions, marital provisions, credit shelter provisions, and trusts for children or disabled heirs. Intricate drafting is required to avoid disastrous income and estate tax results.
Mistake # 6. Neglecting to hold regular shareholder/member/partner and board of director meetings for a business entity, failing to prepare written minutes based on each meeting to include in the entity’s records, and ignoring other formalities to assure that the entity is respected for all purposes . A “corporate veil” is terminology used to explain the layer of protection that separates the individuals involved in the business from the entity itself. The courts can “pierce the corporate (or business) veil” and hold the business owner personally liable for failure to conduct the business properly.
Mistake # 7 . Failing to properly plan for family business succession. In order to avoid this mistake, a family member’s desire to participate in the family business should be evaluated. When planning for business succession, a client should consider types of entities that lend themselves to transfers of entity interests to family members with little or no loss of management or control to the patriarch. Examples of these entities are:
- Family limited partnerships (FLPs).
- Limited liability companies (LLCs).
- Subchapter S corporations (with voting and nonvoting stock interests).
An understanding of estate and gift tax ramifications of gifts of entity interests, such as valuation issues and available discounts, is also crucial. The main goal is to allow the donor to retain control and derive income from the entity, while removing considerable estate value through gifts of interests, or making gifts using the applicable exemption amount ($1 million) or the annual gift tax exclusion amount.
Mistake # 8 . Failing to consider the income tax ramifications of each personal, investment, or business decision; and failing to take advantage of all available deductions, credits, and opportunities. There are two concepts that tax practitioners can take to the bank: Every investment or business decision a client makes has income tax implications; and the tax laws will change every year. Failing to consider income tax issues and be aware of changing tax laws can result in an additional significant cost to a decision or transaction. Here are some issues clients face that have income tax ramifications. In deciding which type of entity is appropriate for operating a business, tax treatment is important. Upon the purchase of a business that is structured as an asset transaction, as most are, the purchase price can be allocated to the purchased assets in various ways that have differing tax consequences. Another way to take advantage of available income tax saving opportunities is to maximize contributions to 401(k) plans and IRAs. Trust taxation issues also need to be considered to avoid problems under this mistake. Under this category, clients need to consider trust tax rates, beneficiary tax rates, and grantor trust rules to be sure that trust income is being taxed in the right place.
Mistake # 9 . Failing to incorporate trusts adequately for asset protection purposes (i.e., inability, disability, creditors, and predators of beneficiaries) in the estate plan. One major benefit of having a trust is the asset protection it provides. Predator deterrence can be needed on account of future ex-spouses, in-laws, outlaws, and others who may notice that an heir is now worth millions. Trusts generally get the future victim out of the middle and serve as a controlled release of family wealth. Furthermore, it becomes more difficult for even a non-malicious predator to spend someone else’s children’s inheritance. Another advantage is creditor protection. Third-party inter vivos trusts (i.e., not self-settled) and testamentary trusts are excellent asset-protection devices. Also, state law or trust agreements usually contain “spendthrift provisions,” barring beneficiaries from pledging or borrowing against their trust interest as collateral.
Mistake # 10. Failing to consider the options available to finance long-term care needs . The good news? We are living longer. Life expectancy continues to increase among Americans. About 40% of the people living to age 65 are projected to live to be 90 by the middle of this century, compared to 25% in 1980. That means lower premiums for life insurance, reduced annual required distributions from IRAs, and more time for seniors to spend with loved ones or to pursue favored pastimes. The bad news? We are living longer. The older one is, the less likely he or she will be able to live independently. An AARP study has found that 82% of individuals 85 and older have a chronic condition or disability for which they might need assistance. In the language of the growing industry that has developed to serve seniors, many people will require long-term care.
Absent advanced planning, an individual’s personal financial resources will be the source of payment for most, if not all, long-term care costs. One financing option to consider is long-term care insurance. A potential alternative to long-term care insurance is to purchase life insurance to replace the wealth lost by the family to long-term care costs. Medicaid is another source of funds for long-term care financing.
Conclusion. Financial survival can be a formidable task regardless of a client’s station in life. Fortunately, savvy use of planning techniques for estates with both business and personal assets should help to avoid the ten mistakes discussed here. Considering financial stresses that abound today, bad news is not hard to find. Although death and taxes are sad facts for all of us, they do not have to mean the entire road ahead is a downhill one. Paying close attention to planning, and being aware of the potential pitfalls can lead to positive results.
© 2008 Thomson/RIA. All rights reserved.
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