For years, financial planners and advisors have preached the creed of “avoiding probate.” In their efforts to avoid probate at all costs, planners sometimes overlook key income, gift and estate tax consequences. This article explores some of the problems associated with indiscriminate probate avoidance, and provides guidance in minimizing those problems.
Overuse of joint ownership
Financial planners often inform clients that jointly owned property will pass free from probate. This is true. State statutes recognize that property owned joined with a right of survivorship, or in tenants by the entireties form, will pass to the surviving joint tenant free from probate.
In their efforts to avoid probate, property owners sometimes fail to make full use of the federal estate tax applicable exclusion amount. Individuals with A/B trusts or other estate planning vehicles designed to use the applicable exclusion amount may fail to transfer property into the names of their trusts, preferring to keep joint ownership of property.
While both approaches avoid probate, the joint and survivorship approach prevents the assets from funding a credit shelter trust and making use of the owner’s applicable exclusion amount. The stakes are high. Under current law, failure to use the applicable exclusion amount can add up to $920,000 on the federal estate tax bill.
Avoiding probate without a plan
There are many ways to avoid probate, including use of beneficiary designations, joint and survivorship ownership, and transfer on death designations for real property and autos. When using these tools, it is very important to consider provisions for debts, administrative expenses, and taxes.
A decedent’s liability to creditors, plus the burdens of state and federal estate taxes and administration expenses, stays with that decedent’s estate. The beneficiaries of the probate estate bear the burden of these costs, even when they are generated by assets passing in non-probate form.
In extreme cases, probate avoidance renders an estate insolvent and incapable of paying such administration expenses, debts, and estate taxes. This may cause creditors and governmental agencies to pursue the beneficiaries or surviving joint tenants in an effort to collect on the amounts owed. This is time-consuming and often costly for heirs, as they must now fight over whether or not they are legally obligated to pay such costs.
In many jurisdictions, such as Ohio, Medicaid recovery is also a potential concern. Ohio recently enacted a law allowing the state Medicaid recovery fund to go after non-probate assets to recover payments advanced on behalf of a Medicaid recipient. Without the claim structure of the probate court, recovery against non-probate assets can be decidedly less orderly and equitable.
Incorrect beneficiary designations
With life insurance policies, IRAs, 401(k)s and other qualified plans, individuals often name beneficiaries to inherit assets immediately upon death. While the assets may pass free from probate, incorrect beneficiary designations can generate unintended income tax consequences.
For example, if a QTIP marital trust is named as a beneficiary of an IRA, the deferral associated with a spousal rollover may be lost. Likewise, if IRA assets are distributed to a trust of which there are multiple beneficiaries, the trust will be forced to make distributions based on the oldest beneficiary’s age, as opposed to the individual ages of each beneficiary.
Also, significant differences in the ages of beneficiaries can result in negative income tax consequences for the younger beneficiaries. Careful review of the testator’s estate tax exposure, and of beneficiary needs, can prevent such negative results.
Problems with co-ownership
Sometimes, a single individual will name a child as a co-owner of property to avoid probating the asset. Unfortunately, by allowing the asset to pass free from probate to the surviving co-owner, the assets pass free from the specific terms of the decedent’s will. When there are multiple beneficiaries under the will, this creates problems as the surviving co-tenant has no legal duty to divide the property equally among the remaining will beneficiaries.
There is also a potential gift tax consequence because the transfer of the assets into joint ownership usually results in a completed gift equal to the fair market value of the asset for federal gift tax purposes. Finally, a co-owner immediately acquires the right to divide the property through a partition action. None of these are desirable planning results.
All in all, probate avoidance for its own sake is not the panacea represented by some financial planners and advisors. It is critically important that clients understand the income, gift and estate tax ramifications that will arise as a result of using each probate avoidance technique proposed.