Estate planning is the process of planning the accumulation, conservation, and distribution of an estate in the manner that most efficiently and effectively accomplishes your personal tax and nontax objectives. Every estate is planned – either by the individual or by the state and federal governments. By your action now, you can strongly influence, if not determine, what will happen in your clients' futures.
This list is devoted to the types of problems that can cost your clients dearly in terms of dollars and unbelievable heartache. And so, without further ado, here are ten areas of common (and serious) mistakes that can be easily solved by periodically reviewing your clients' plans.
Mistake 1: Improper Use of Jointly-Held Property
If used excessively or used by the wrong parties (especially by unmarried individuals, or where one spouse is not a United States citizen) the otherwise “poor man’s will” becomes a poor will for an otherwise good man or woman. In short, jointly held property can become a nightmare of unexpected tax and nontax problems including:
A. When property is titled jointly, there is the potential for both federal and state gift tax, particularly with non-spouses and non-citizen spouses.
B. There is the possibility of double federal estate taxation; if the joint ownership is between individuals other than spouses, the entire property will be taxed in the estate of the first joint owner to die – except to the extent the survivor can prove contribution to the property. Then, whatever the survivor receives and does not consume or give away will be included (and taxed a second time) in the survivor’s gross estate. With non-citizen spouses, the typical rules associated with the marital deduction do not apply, and the client may need to utilize a Qualified Domestic Trust (QDOT) to avoid the immediate imposition of the federal estate tax.
C. Once jointly owned property with right of survivorship has passed to the survivor, the provisions of the decedent’s will are ineffective. This means the property is left outright to the survivor who is then without the benefit of management protection or investment advice or the property could be left to a person not intended to be benefited.
D. Even when property is jointly owned by spouses, the surviving spouse can give away or at death leave the formerly jointly owned property to anyone the surviving spouse wants; regardless of the desires of the deceased spouse. In other words, holding property jointly results in a total loss of control at the first death since the surviving spouse can completely ignore (and in fact may not know) the decedent’s wishes as to the ultimate disposition of the property. Whether this is an issue depends upon the specific facts of the situation. However, this loss of control can be especially horrendous when the joint owners are not related or are clearly not in agreement as to the ultimate recipient of the property.
E. Since the jointly held property passes directly to the survivor (who then could possibly squander, gamble, give away, or lose the property to creditors), the decedent’s executor could be faced with a lack of adequate cash to pay estate taxes and other settlement expenses. By the same token, since joint assets pass directly to the survivor, it is important to keep in mind how the taxes associated with these assets are to be allocated among the other beneficiaries of the estate. It is entirely possible that the joint assets can pass to one person, and the taxes associated with these assets be charged to another.
F. A well-drawn estate plan is designed to avoid double taxation – often by passing at least a portion of the estate into a CEBT (Credit Equivalent Bypass Trust). In this manner, up to $5,250,000 in 2013, can be sheltered from federal estate tax at both the first decedent’s death and then again (since the surviving spouse has only an income interest) escape estate tax at the death of the surviving spouse. But holding property in joint tenancy thwarts that objective. Instead of going to a bypass trust to avoid a second tax, the property goes directly to the survivor and will be taxed at the survivor’s death. So the unified credit of the first spouse to die is wasted.
G Some clients title assets in joint names in order to increase the FDIC insurance limitations. This occurs because FDIC insurance provides for $250,000 of protection for each owner on an account at that particular financial institution. Therefore, by titling assets in joint names, the amount of the protection is increased. However, by titling assets in joint names, these assets are bypassing the provisions of the estate documents, which can create other problems.
Mistake 2: Improperly Arranged Life Insurance
A. The proceeds of life insurance are often payable to a beneficiary at the wrong time (before that person is emotionally, physically, or legally capable of handling it) or in the wrong manner (outright instead of being paid over a period of years or paid into trust).
B. There is inadequate insurance on the life of the key person in a family (the breadwinner) or the key person in a corporation (the rainmaker).
C. Often, no contingent (backup) beneficiary has been named. The “Rule of Two” should be applied here. In every dispositive document (any legal instrument that will transfer property at death) there should be – for every name in the document – at least two backups. So, whenever possible, there should be not only back-up beneficiaries but also contingent executors, trustees, guardians, and trust protectors.
D. The proceeds of the policy are includable in the gross estate of the insured because the policy was owned by the insured and either never transferred, or was transferred within three years of the insured’s death. The solution is to have a responsible financially competent adult beneficiary (or a trust), acting without specific direction from the insured and using his (or its) own money, purchase and own the insurance from its inception. That party should also be named beneficiary (the insured and the insured’s estate should not be named beneficiary).
E. When the policy owner of a policy on the life of another names a third party as beneficiary, at the death of the insured, the proceeds are treated as a gift to the beneficiary from the policy owner. For example, if a wife purchases a policy on her husband’s life but names her children as beneficiaries, at the husband’s death she is making a gift in the amount of the proceeds to the children.
F. If a corporation names someone other than itself (or its creditor) as the beneficiary of insurance on the life of a key employee, when the proceeds are paid, the IRS will argue that the proceeds are not income tax free and should be treated as either dividends, if paid to or on behalf of a shareholder, or compensation, if paid to an employee who is not a shareholder (assuming the premiums were never reported as income or there was no split dollar agreement or no Table 2001 income reported). Worse yet, if the insured owned more than 50 percent of the corporation’s stock, he is deemed to have incidents of ownership (that means federal estate tax inclusion of the proceeds) in the policy on his life. So, for example, the same $1,000,000 proceeds could be taxed as a dividend for income tax purposes (as much as $396,000 of income tax in 2013 for those earning more than $400,000 (single) and $450,000 (married filing jointly) and also be taxed as an asset in the estate for estate tax purposes (as much as $400,000 of estate tax).
G. Whenever life insurance is paid to the insured’s estate, it is needlessly subjected to the claims of the insured’s creditors and in many states unnecessarily subjected to state inheritance tax costs. Probate costs are increased without reason and the proceeds are then subjected to the potential for an attack on the will or an election against the will. Although, in some rare cases, it may make sense for the estate to be named beneficiary of a modest amount of life insurance (e.g., an amount sufficient to pay estimated debts in an estate small enough to pay no federal estate tax), in most estate planning situations life insurance should be payable only to a named beneficiary, a trust, or a business entity.
H. If a life insurance policy – or any interest in a life insurance policy – is transferred for any kind of valuable consideration in money or money’s worth, the proceeds may lose their income tax free status. For example, if a child buys the $1,000,000 term insurance policy owned on her father’s life from his corporation or business partner, when she receives the proceeds, the entire $1,000,000 could be subjected to ordinary income tax (for as much as $396,000 in 2013). These rules are usually described as the transfer for value rules with respect to life insurance, and are set forth in Sec. 101(a)(2) of the Internal Revenue Code.
I. Where a husband is required by a divorce decree or separation agreement to purchase or maintain insurance on his life, he will receive no income tax deduction for premium payments if he owns the policy – even if his ex-wife is named as irrevocable beneficiary. No alimony deduction is allowed on the cash values in a policy the husband is required to transfer to his ex-wife under a divorce decree. The safest way to assure a deduction is for the husband to increase his tax deductible alimony and for the ex-wife to purchase new insurance on his life, which she owns and on which she is the beneficiary. It is extremely important for each spouse recently divorced to immediately review his own life, health, disability, and other insurance situation.
J. Failing to update beneficiary designation to reflect changes to the estate planning documents. If an individual names his estate as the beneficiary of life insurance policies, the manner in which the money is disbursed is automatically updated as the will is changed. However, when an individual maintains a revocable living trust, it is important to check if the beneficiary designation needs updating as the document is changed. For example, with a new will, the document will almost assuredly revoke all prior wills. But this is not the case with revocable trusts. If an insurance policy is paid to a particular revocable trust, it will be paid to that Trust even if the document is "abandoned" in favor of a new document. Therefore, when life insurance is paid to a revocable trust, it is better to make amendments to that Trust so that the beneficiary designation has a lesser chance of requiring updating. The problem with this approach is that if a person makes a lot of changes to their documents, you can wind up with a lot of amendments. At some point, it may make sense to truly start over with a new Trust; but when doing so, make sure all beneficiary designations are updated.
Mistake 3: Lack of Liquidity
Most people don’t have the slightest idea of how much it will cost to settle their estates or how quickly the taxes and other expenses must be paid. Worse yet, they don’t realize that a forced (and, possibly, fire) sale of their most precious assets, highest income producing property, or loss of control of their family business will result from an insufficiency of cash. (If you haven’t checked, how do you know your executor will have enough cash to avoid a forced sale?)
Liquidity demands have increased significantly in the last few years and should be revisited by those who have not done a “what if …” hypothetical probate. Among the expenses that demand cash from the estate’s executor are:
- Federal estate taxes
- State death taxes
- Federal income taxes (including taxes on pension distributions)
- State income taxes (including taxes on pension distributions)
- Probate and administration costs
- Payment of maturing debts
- Maintenance and welfare of family
- Payment of specific cash bequests
- Funds to continue operation of family business, meet payroll and inventory costs, recruit replacement personnel, and pay for mistakes while new management is learning the business
- Generation-skipping transfer tax (top estate tax rate)
Most larger estates will be subjected to almost all of these taxes and costs.
Mistake 4: Choice of the Wrong Executor
Naming the wrong people to administer the estate can be disastrous. The person who administers the estate must – with dispatch – often without compensation, with great personal financial risk, and without conflict of interest:
- Collect all assets
- Pay all obligations
- Distribute the remaining assets to beneficiaries
Although this three step process seems simple, in reality these tasks are highly complex, time consuming, and, in some cases, technically demanding. Is the named executor capable of carrying out these tasks?
Selection of a beneficiary as an executor can result in a conflict of interest. That person may be forced to choose between his personal interest and that of the other beneficiaries. This problem can potentially be solved by adding an independent third party, such as a bank trust department, to serve alone or together with a family member.
Selection of a business associate may result in a conflict of interest. If the executor’s job is to decide whether or not to sell the business interest or the task is to obtain the highest possible sales price, the executor will be responsible for the course of action that will best serve the beneficiaries’ interests. Yet that may be diametrically opposed to the executor’s personal interest. For example, if the business were to be sold, the executor may be selling himself out of a job. As such, the executor may demand a higher price for the business than he would expect a buyer to pay in order to discourage the business from being sold.
Sometimes the selected executor has neither the time nor the inclination to devote to the sometimes long and drawn out process of estate administration. Another consideration is whether the executor lives in the state of the testator. This can become a problem in a state such as Florida, (where the executor is referred to as the Personal Representative). In Florida, the Personal Representative must be a resident, or a close family member.
Lastly, the appointment of executors who do not know, or get along well with, the family members they are to serve sometimes results in chaos. A similar problem can occur if more than one executor is chosen and the executors do not get along with each other.
Mistake 5: Will Errors
One of the greatest mistakes is dying without a valid will. This results in “intestacy,” which is another way of saying that the state will force its own will upon the heirs it chooses.
Too many wills have not been updated. A will should be reviewed at least:
- At the birth, adoption, or death of a child
- Upon the marriage, divorce, or separation of anyone named in the will
- Upon every major tax law change
- Upon a move of the testator to a new state
- On a significant change in income or wealth of either the testator or a beneficiary
- On any major change in the needs, circumstances, or objectives of the testator or the beneficiaries
Mistake 6: Leaving Everything to Your Spouse
Far too many people feel that there will be no federal estate tax because of the unlimited estate tax marital deduction and so they leave their entire estates to their spouses. But upon the death of the surviving spouse, everything that the surviving spouse received (assuming it has not been consumed or given away) is then piled on top of the assets that spouse owns. It is then that the “second death wallop” occurs with federal estate tax starting on taxable amounts in excess of $5,250,000 in 2013. The solution can be simple: the establishment of a CEBT (credit equivalent bypass trust). Up to $5,250,000 in 2013 can be left to a trust that provides income to the surviving spouse as well as other financial security, but will not be taxed in his estate no matter when he dies or no matter how large trust funds grow. The balance of the estate can go in trust or outright to the surviving spouse. If that amount together with the surviving spouse’s own assets doesn’t exceed the unified credit applicable exclusion for the survivor’s year of death, this portion will also pass estate tax free when the surviving spouse dies. This is good planning even though the unused credit shelter amount of a spouse may be used by the survivor under the deceased spouses unused exclusion amount rules. For reasons to be discussed in chapter 24 there may be technical issues with multiple marriages, lost opportunities, and lost generation skipping opportunities if property is held jointly with right of survivorship or left entirely to the surviving spouse, which makes the standard credit shelter planning still the best way to go for many taxpayers.
Some individuals leave huge amounts outright to a surviving spouse, amounts that they themselves have never managed (few people have ever managed huge amounts at one time, let alone managed spouses at any time). Often the survivor doesn’t have the slightest training or experience in handling and investing a large stock portfolio, real estate holdings, or running a family business. Leaving everything to a spouse also wastes an opportunity to skip generations and potentially save future generations significant taxes.
NOTE that the 2010 Tax Relief Act amended IRC Section 2010(c)(2) to provide that the applicable exclusion amount is the sum of the basic exclusion amount (the portion of the unused $5 million exemption (adjusted for inflation to $5,250,000 in 2013)), plus the Deceased Spousal Unused Exclusion Amount (DSUEA).
Mistake 7: Improper Disposition of Assets
An improper disposition of assets occurs whenever the wrong asset goes to the wrong person in the wrong manner or at the wrong time. Leaving an entire estate to a surviving spouse or leaving a large or complex estate outright to a spouse unprepared or unwilling to handle it is a good example. Leaving a sizeable estate outright to a teenager or to an emotionally or mentally challenged person are also common examples.
Equal but inequitable distributions are common. If an estate is divided equally among four children who have drastically different income or capital needs, an equal distribution can be very unfair. Consider, for example, four children, the oldest of which is a brilliant and financially successful medical doctor and the youngest of which has serious learning disabilities and is still in junior high school. Think of a family with a physically handicapped child and three healthy children with no physical problems. Obviously, their needs and circumstances are not the same. Should each child receive an equal share? The proper solution may be a “sprinkle” or spray provision in a trust that empowers the trustee to provide extra income or additional principal to a child that needs or deserves more or who is in an unusually low income tax bracket in a given year.
Obvious examples of improper dispositions include the gift of a high powered sports car to a child, or to a senior citizen who no longer drives. “That can’t happen in my estate,” many people would be tempted to say. But upon the death of a primary beneficiary at the same time or soon after the testator, quite often there is no secondary beneficiary named, or the second beneficiary who is named shouldn’t receive the asset in the same manner as the primary beneficiary. The solution is to consider a trust or custodial arrangements and to provide in the will or other dispositive instruments for young children and legally incompetent people. Consider also the importance of a well-planned “common disaster” or “simultaneous death” provision, so that the asset avoids needless second probates and double inheritance taxes and goes to the right person in the right manner.
Mistake 8: Failure to Stabilize and Maximize Value
Many business owners have not stabilized the value of their businesses in the event of the disability or death of key personnel. What economic “shock absorbers” have been put in place to cushion the blow caused if a key employee dies, becomes permanently disabled, or is lured away by competition at the absolutely worst possible time? Who will pay for the fixed expenses of the practice or business if the key employee is not there to generate income? Key employee life and disability insurance, coupled with good business overhead coverage, will certainly help.
Buy-sell agreements are essential to a business that is to survive the death of one of its owners. Yet many businesses have no such agreement. Or the agreement isn’t in writing. Or the price (or price setting mechanism) doesn’t reflect the current value of the business. Or the agreement isn’t properly funded. So there is no guarantee that the heirs will receive the price they are entitled to – or no assurance that the surviving owners will have the cash they need to buy out the heirs (especially the dissident ones who want to tell them how to run their company).
Wills, trusts, life insurance contracts, qualified plans, IRAs, and tax deferred annuities without “backup” beneficiaries mean that money that could otherwise pass outside of the probate estate may instead be subjected unnecessarily to such costs and risks. The value of all those instruments and wealth transfer tools can be enhanced at no cost by merely naming secondary beneficiaries. It can also be a problem to name a minor child as the direct beneficiary of an asset. Since a minor cannot legally own assets, this may result in needing to have a guardian appointed for the minor child to help manage these assets. The guardian may have to be someone other than the minor’s parent. The solution to this problem is to make sure that beneficiary designations are properly coordinated with the estate plan.
Mistake 9: Lack of Adequate Records
It can drive the executor crazy – and cost thousands of dollars of expenses – if estate and financial documents are difficult or impossible to find. Too many people hide assets such as cash in books or drawers, or even under mattresses. Take out a safe deposit box. Tell your executor where it is and make sure your executor has or can get the key and has access to it. Put all your important documents in that box. Each year, put an updated list of the names, phone numbers, and email addresses of advisors your family can count on in the box. Check with your attorney on the rules that apply at death: some safe deposit boxes are frozen (the state requires that the bank seal the box from entry until the inheritance tax examiner can inventory the contents) and there can be lengthy delays in getting to the papers in the box. It is also advisable to maintain a personal inventory of important information such as account information; and insurance policy schedules.
It is possible for an executor to obtain new copies of old income tax returns from the IRS – but why put the executor to the trouble and expense? Be sure to keep tax returns and records at least six years.
Many survivors have never been told what the decedent’s goals were, what assets they can rely on for income or capital needs, or how best to utilize the available resources. Most widows or surviving children never had a meaningful discussion with the decedent about their financial security if something were to happen.
Mistake 10: Lack of a “Master Strategy” Game Plan
Do it yourself estate and financial planning is the closest thing to do it yourself brain surgery. Few people can do it successfully. Yet, even do it yourself planning – from taking courses, reading books, or listening to radio shows on the subject – is sometimes preferable to no planning. Actually, an intelligent layman can learn and do quite a bit if the time is taken at least once a year to quantify in dollar terms financial needs and objectives (here’s what we must have and here’s what we’d like to have), current financial status (here’s where we are), and a game plan for getting to the goal in the most efficient and effective way. Using the right team of CPA, attorney, life insurance agent, trust officer, and other financial services professionals to conduct an annual “Financial Firedrill” to help formulate and execute that plan can make all the difference.
The Bottom Line
A key principle in estate planning is that you can’t eliminate the big mistakes in your estate plan until you’ve identified them. Stage a “financial firedrill” with each of your clients each year. Encourage them to stay educated on their financial plan, and to educate their survivors – before they are the survivors! Teach them how to handle money and make decisions. Show them, by example, how to read the bottom line on where their financial security stands.