ESTATE PLANNING: WILLS AND TRUSTS AND BUY AND SELL AGREEMENTS

Introduction:

The legal process by which property is passed from a person who has died to his or her heirs is called "probate" and the usual method for determining who shall inherit the various assets entails the Court enforcing the instructions in a written document designating heirs called a "will".

Recently, in an effort to avoid some of the costs of probate, it has become popular to create a legal document called a "trust" in which instructions for distributions after death are contained and which, if properly prepared, transfers assets after one's death without court involvement (and formal probate) but which achieves intended post death distribution as effectively as a will.

If one dies without a will or a trust already written the Court will apply statutory rules as to who will inherit what assets. While the rules become quite complex, and while who inherits what depends on the nature of ownership of the property, usually the spouse will inherit all community property and separate property of the deceased person will be divided between the spouse and the living children. Dying without an effective will or trust is termed dying intestate. The process of analyzing the assets and family needs of a person and drafting appropriate wills, trusts and related documents is called estate planning.

While the law will allocate who will inherit from you even if there is no will or trust with that governmentally dictated transfer along set statutory guidelines, most people wish to create their own plan as to what will happen to their property and family upon their death. Yet, studies throughout the United States have long indicated that many people delay or avoid creating wills and that over ninety percent of people who actually go to the time and expense of creating a will never return to the attorney office to actually sign it.

This odd fact seems inexplicable until one realizes that planning for one's own death is a most unpleasant activity, one easily delayed if one wishes. After all, it is the surviving family that ends up paying the cost of poor estate planning. However, the cost of poor estate planning can be very high, both in terms of not providing structures to most effectively care for children or the elderly surviving spouse and in having to pay large estate taxes that perhaps could have been minimized with correct estate planning.

2. Can One Draft One's Own Estate Plan?

The estate planning process involves both family, financial and tax planning which can become quite complex. It also involves integrating into the plan the use of wills, trusts, powers of attorney, living wills, charitable gifts, life time gifts, and decisions regarding means to hold title to property (such as community property or separate property, joint tenancy or tenancy in common, etc.) While bookstores and software stores abound in preformed trusts and wills, and while many good books are written for the layperson so as to allow the creation of one's own estate plan, for any sizable estate or if one has minor children or elderly persons depending on the proceeds of the estate, it is extremely risky to create one's own plan.

The reason for the need for professional help is not just the complexity of the documents and the knowledge required to understand how to integrate into a single plan the numerous legal and structural tools available, but also the drastic damage to a person's assets that estate taxes can wreck if careful planning is not achieved. Estate taxes can easily take fifty percent of a person's estate, due nine months from date of death. Once death occurs, it is usually too late to engage in the type of planning that can avoid many of these taxes. And such planning requires an extensive range of knowledge.

An example will perhaps illustrate how subtle the planning must be:

Joint tenancy is a form of mutual ownership of property in which two or more persons own an undivided common interest in property and if one dies, title immediately and automatically transfers entirely to the surviving joint tenant. If one owns property in joint tenancy with one's spouse one can bypass probate entirely upon death since the property will automatically transfer to the surviving joint tenant and one need not go to the expense of a full probate. One can save perhaps several thousand dollars in executor and attorney's fees by holding property in joint tenancy and no probate will be needed for that property. it seems like a very good move to hold all your property with your spouse in joint tenancy, right? Wrong. Income tax would greatly punish such a decision.

For example, assume a married couple owns some rental property together. Assume the husband dies. If they had decided to own the property as community property rather than joint tenancy the wife would have received a stepped up basis for income tax purposes on the entire value of the property. That means that for purposes of computing income tax, the basis of the property is revalued NOT at what the couple bought it for but the value of the property as of date of death. The appreciation of the property between the initial purchase and the date of death is never subject to income tax!

However, if they had owed the property in joint tenancy, the surviving spouse would only get a stepped up basis on one half of the property owned under current tax law.

Let us put in some numbers. Assume a husband and wife own an apartment house they rent out. If the property they owned was purchased for one hundred thousand dollars and right after death of the husband the wife sold it for three hundred thousand dollars, the two hundred thousand dollar gain is income tax free (if held in community property). However, if that same property was held in joint tenancy, income tax capital gains tax is applied to one half of the gain (but only if held in joint tenancy).

There would no tax on the two hundred thousand dollar gain if held in community property and tax at perhaps twenty percent on one half of the two hundred thousand dollar gain if held as joint tenancy. That is a twenty thousand dollar tax bill that was incurred to save perhaps a thousand dollars in probate costs.

There are other aspects to the above transaction worth noting. There is a community property set aside procedure that could have minimized the cost of probate if the property was held in community property. Further, while holding the property in joint tenancy might be thought to reduce estate taxes (since the wife already owned one half of the property) in reality there is no estate tax for transfers between husband and wife thus the above transfer effectively wasted eighteen or nineteen thousand dollars.

The above example is one of the simpler errors often made by persons creating their own estate plan. In maneuvering in the complex laws regarding probate, trusts, income tax and estate tax, one needs expert advice from experienced financial planners, insurance brokers, CPAs and attorneys and to "save" money by creating with help one's own estate plan can be the most expensive mistake a person with assets can make.

The cost of estate planning in terms of attorney fees varies widely but most simple wills will cost less than one thousand dollars while a very complex estate plan involving millions of dollars may cost over ten thousand dollars. Nevertheless, it is seldom that good estate planning will cost more than a fraction of the taxes that can be saved once a good plan is implemented.

3. What Is a Will and How are They Made?

A will is simply a written document that provides for the transfer of assets upon death of the person drafting it. Normally, it is witnessed by two persons, appoints someone to probate the estate (the executor) lists who the heirs are, and apportions the assets among them. If one wishes to disinherit a relative who otherwise would receive by statue a portion of your estate (such as children or a spouse) one also so provides in the Will. Wills can be as short as a page or two or over thirty pages long. Quite often Wills provide for trusts to be created upon the death of a person (testamentary trusts) appointing assets into the trust for a particular person or purpose. A typical testamentary trust provides for minor children, apportioning a part of the estate to the children, instructing the person in charge of the trust (trustee) as to how to invest the funds and when to distribute them (for college or upon marriage, for example.)

One can write one's own will so long as one is of sound mind and has testamentary intent. That is , one is aware of what one owns and intends by the document to transfer the property upon one's death.

Wills may be altered until the moment of death (and often are) and are rigorously enforced by the probate courts who adhere to the doctrine that a person should be free to determine what happens to one's assets upon death.

Wills can be attacked by any interested party (will contest) and the most common attacks are unsound mind of the deceased (did not know what he or she was doing) and undue influence (the mind of the deceased was overcome by the improper pressure of a third party.) Novels and movies to the contrary, it is extremely difficult to overturn a will based on the above doctrines with the attacking party having a very heavy burden of proof.

4. Intervivos Trusts and Their Primary Uses

A trust created to be effective during the lifetime of the person creating the trust is a "living trust" or, in Latin, an Intervivos trust. (A trust contained in your Will becomes operative only upon your death and is a Testamentary trust.)

A trust is just a unique form of contract in which a person with assets (the trustor) enters into an agreement with a trustworthy person (the trustee) to hold specified assets for the benefit of a person or group of persons (the beneficiary). This American invention, however, is quite useful when one wants to protect a person who for whatever reason is unable in your opinion to have total control of an asset, but to still have the person receive the benefit of the asset.

The most common trusts are for children. A person will appoint a relative or trusted friend to hold assets in trust for minor children until they reach a certain age. Another common trust is to hold assets for an elderly relative no longer able to take care of him or herself.

A trustee has a fiduciary duty to the beneficiaries, the highest duty known to law (equivalent to a spouse to his or her spouse, a lawyer to a client, etc.). If the trustee breaches that duty by taking the assets or ignoring the instructions in the trust document, the trustee is personally liable to the beneficiaries or the trustor...or both. A suit for breach of that duty can begin decades after the act is done since only when the beneficiaries are of legal age and when reasonable care would have discovered the wrongdoing does the statute of limitations begin to run.

Indeed, this office engaged in prolonged litigation in the 1980s concerning wrongdoing that occurred in the 1950s involving a trust created in the 1940s and an estate created in the 1920s in which the wrongdoing was only discovered in the 1980s long after the death of the embezzling trustee. A judgement was eventually entered against persons who had received the embezzled assets from the wrongdoing trustee twenty years after she died.

It is therefore critical to note that the trustee undertakes a tremendous responsibility when assuming the role of trustee. While simple errors of judgment will not necessarily result in legal action against the trustee, negligence or wrongdoing can cause action decades after the act.

It is also critical to note that Trusts often last decades, and can last a hundred years or more theoretically. When drafting a trust which can eventually pay sums to your grandchild, it is common to have a clause that if a beneficiary dies before inheriting, his or her bequest goes to his or her children. In reality, you are creating a plan that will affect your great grandchildren and attempting to plan for a life that will not begin for perhaps sixty years. Consider that the trustees may be making decisions having to do with the education of your great grandchildren in universities situated on the Moon and involving science not dreamed of today and with beneficiaries whose lifetimes may exceed one hundred and fifty years. You are making plans for people who will live in a world as alien to you as yours would be to a soldier in the Spanish American War. Clearly, your instructions must be drafted with precision yet with enough flexibility to work in a world you can only vaguely imagine. Perhaps no other legal decision you make will have such widespread effects for so many people for so long as the creation of a trust.

Most trustees receive fees based on a small percentage of what is in the trust and for extraordinary effort, may receive more fees. Fees are normally set in the trust for Intervivos trusts and by court for testamentary trusts. While many trustees are family members or friends willing to waive fees, it must be remembered that the tasks of a trustee-to make wise investments and carry out your instructions at the risk of personal liability-are significant and that some compensation is certainly warranted.

INTERVIVOS TRUSTS AND AVOIDING PROBATE

The cost of probate involves fees paid to the executor and the attorney which is normally a small percentage of what is in the estate and is set by statue though may be voluntarily negotiated by the parties. Depending on the size of the estate and the type of inheritance, those fees can be substantial. (Community property going to a spouse is normally not expensive with specially reduced rates, etc.) In a million dollar estate going to the next generation, the attorney fees and the executor fees could easily exceed thirty five thousand dollars, depending on the complexity of the estate and the manner of holding the property. Quite often the executor is the surviving spouse or relative who waives their fees but regardless the fees are not nominal.

Additionally, probate is a public forum in which all assets are listed in a public document. If one wants to avoid public disclosure of one's assets, trusts are again a valuable tool. Lastly, a probate normally lasts at least a year and often more than two years. While preliminary distributions can be made, the need for complete accountings filed with the Court and the backlog of the courts make a probate that closes before a year has passed quite unusual.

The above detriments of probate have led more and more people to create a trust during their lives in which they place their assets, making themselves the Trustors, Trustees and beneficiaries. They can withdraw or add assets during their lives at any time (thus the Intervivos trust is "revocable") but upon death the trust becomes permanent ("irrevocable") and the instructions to the surviving trustor are to distribute the assets as directed in the trust, usually for life to the surviving trust, then outright outside of the trust to the children or grandchildren. For those assets in the Trust, no probate is needed since the trust already provides for distribution and probate does not affect assets distributed in the trust.

It is critical to understand that for most purposes an revocable trust does NOT save any sums in taxes. Since it may be revoked at anytime until death, the government has treated the trusts as, effectively, nonexistent for tax purposes. It is only in the savings of the fees and costs and probate, and the private nature of the transfer, that the Intervivos trust may save money for the family.

Depending on the complexity of the trust, the cost of creating such Intervivos trusts can range from about five hundred dollars to several thousand dollars. It is critical to note that the assets transferred into the trust must be legally held by the trust. A common mistake is to list the property in the trust...but not to change title on the property thereby rendering the trust useless. For example, if you are putting a piece of real estate in the trust, a title deed from you to the trust should be created...and recorded.

Irrevocable Trusts are living trusts which cannot be revoked by the Trustor...they are completed gifts and no different than transferring an asset to any other person. A gift tax may be due and the asset can not be retrieved absent consent of the beneficiary and trustee...and could result in another gift tax being levied upon the return of the asset previously transferred. Irrevocable trusts are not tax neutral. A gift tax may be paid when created and the trust, itself, becomes a separate taxable entity. Thus an income producing asset, previously taxed to the trustor, is now taxed to the trust or, if distributed to the beneficiary, is taxed to the beneficiary.

The danger of an irrevocable trust is simple-it is an irretrievable gift and one no longer has access to the asset if one changes one's mind. The benefit is tax transfer but this should only be considered if the trustor is in a high tax bracket or there are other tax advantages available due to the nature of the asset.

5. Life Insurance and Estate Planning

Life insurance can play an important role in estate planning, especially to fund estate taxes (in large estates) or to provide for the raising of a family after the death of a income producer (in small estates.) There are numerous complex ways to own life insurance in trusts that allow one to control the use of the proceeds but to avoid having the life insurance included in one's estate for estate tax purposes. Most of the time, life insurance can be owned in such a manner that the proceeds are NOT counted as part of your estate when computing estate taxes and this is a tremendous advantage. Once again, recall that estate tax, after the initial six hundred and fifty thousand dollars of gifting (increasing annually to over one million in the next five years) quickly rises in rates to fifty five percent.

Life insurance as an alternative investment to stocks, bonds or real estate is more problematical, despite the claims of the various aggressive insurance companies who create increasingly complex methods of computing cash value and the like so that after a period of time the insurance becomes quite valuable. The problem, of course, is that the only way the insurance company could pay you a return on your insurance premium and also provide you the benefit of insurance is by having a return significantly lower than the prevailing market. This obvious fact is often hidden in remarkably complex and confusing insurance plans and policies which would make even a lawyer blush.

But when combined with a valid use, such as providing for minors or providing for liquidity for business or estate tax purposes upon the death of a income provider, insurance can be invaluable.

6. Durable Powers of Attorneys: Living Wills: Nomination of Guardians

When one becomes incapable of handling one's own assets or health decisions, it is critical to have a competent and honest person take over those responsibilities. Assuming you have done no planning, the usual procedure is for a relative to petition the court to appoint a conservator who is required to collect all your assets, account for them, and take care of you for a fee approved by the court.

Of all the proceedings destined to destroy a family and its relationships, a petition to appoint a conservator ranks highest. Put bluntly, if contested, it is a proceeding in which the family member is trying to prove to the satisfaction of the Court that a person, usually a parent or spouse, is incompetent. Testimony of witnesses and experts is heard at remarkable expense while your mother or father, wife or husband sits there and listens to you and your family describe their more embarrassing actions or hear experts explain how childlike or foolish they have become. Win or lose, the hearing will forever disrupt the relationship within the family.

Often our clients in such situations elect to risk loss of critical assets rather subject the family to such a destructive proceeding. The pain of having to make such a decision is hard to imagine unless one faces the dilemma of either watching the hard won assets of a life time wasted by a mother or father who thinks they are doing the best they can...but are no more capable of making informed financial decisions than a child or, instead, forcing that parent to face a humiliating public experience in court.

There is a alternative choice and it is one that each person should elect to take. By executing a durable power of attorney for assets while competent, a person may avoid the entire court battle and simply provide that if two doctors declare one incompetent, the power of attorney appoints someone else to take over control of assets or, if a durable power of attorney for medical care is also executed, for medical decisions. Assuming two doctors declare that competency returns, the durable power is immediately retracted and one assumes sole control of assets or medical care once again. In the powers of attorney one may specify in detail precisely what medical care is to be used and how the assets are to be held. Most importantly, one selects the persons to occupy the role of care giver or asset protector, and the durable power will be enforced by the Court.

The form for the power of attorney for medical care is set by statute and is a "fill in form" that anyone can complete. The form for the power of attorney for assets is more complex and requires legal advice. Both forms are easily completed and will cost less than a few hundred dollars at most. The typical conservatorship hearing costs well in excess of ten thousand dollars.

LIVING WILL

Another short form is the Directive to Physicians often called the Living Will. It is a form that directs the doctor not to use life preserving medical care if one is "brain dead" or if further medical treatment has no chance of doing other than prolonging life. Euthanasia (mercy killing) is illegal in this State. The living will does not allow it...it simply directs the physician to limit medical care if there is no chance for recovery and to allow the patient to die naturally. Quite often the Living Will is combined with the Durable Power of Attorney for Medical Care.

NOMINATION OF GUARDIANS FOR MINORS

Another short form nominates those you feel should care for your children should you and your spouse become incapacitated. While the Court will be guided by your nomination, the Court maintains the right to always act in the best interest of the child...and will almost always ignore a nomination which interfers with those who have an existing right to custody, such as a spouse.

7. BUY AND SELL AGREEMENTS IN CLOSE CORPORATIONS OR OTHER BUSINESS ENTITIES

One who owns a small business quickly realizes that, upon death, the value of the business may plummet to zero if there is no one there to run it or buy it and that a company worth millions one day may be worth zero upon the death of its managing owner. Thus an asset which is often the most valuable asset for a family is suddenly gutted and the family left with nothing.

Equally galling is the result when a key employee who owns a small percentage of a business and assumes greater and greater responsibility as the years pass, suddenly has the majority stockholder die and the untutored spouse or child of the stockholder suddenly come into the company with effective control and often little knowledge of the business. A common result is the employee leaving in a rage and starting a competing business.

The usual scenario in both cases is the disruption or destruction of an asset worth a great deal with both the estate of the decedent and the minority owners dismayed and injured by this result.

Again, advance planning easily alters the scenario to the benefit of all. The usual method is that the owners agree ahead of time that in the event of the death of either, the remaining shareholders or owners will buy out the estate's interest in the business at a preset formula, usually allowing a twenty percent down payment and ten years to buy out the remaining price at prime plus two or three percent. This allows the estate to convert the business interest to cash by selling to the only people interested in buying...the existing owners. It allows the existing owners to know that they will ultimately own the business at a fair price with time to buy it out. Life insurance can even be used to pay for te ddown payment or even the entire purchase price.

These types of arrangements are called "Buy and Sell Agreements" and are integrated into the entire estate plan. Often a client who has no other owners of the business will bonus a small amount of interest to a promising employee on the condition that the employee will sign the Buy and Sell, thus assuring continuity and benefit to the family of the existing owner while giving the employee the knowledge that ultimately he may be the owner of the business.

8. CONCLUSION

A successful business client put it well: "The most important decisions one makes in life are made without forethought or the type of logical analysis one uses in buying the most inexpensive trinket...be it choice of college, choice of spouse or choice of careers, most of us base it on emotion or have the choice imposed upon us by forces or influences we do not always even recognize."

What that client did not mention is that perhaps the most important choice for the economic future of the family is also often not made with care and forethought-namely estate planning. Death and incompetence are things most of us pretend will not occur and are dark shadows always on the horizon, best ignored if one is to enjoy life.

The price for such self indulgent blindness is often paid by the spouse or the next generation. If one has a sense of duty to family, it is hard to conceive of a greater obligation than to make the plans for your own demise since if you do not, who will? Your spouse? Your children? In reality, it is the government itself who will take over that responsibility, electing who shall inherit what and taxing the family to the maximum. Your choice thus is quite simple: either you or the government will determine how best to protect your family in the event of your death.

Do you not owe it to them to take that burden on yourself? That requires intelligent estate planning since most of the decisions should come from the person whose estate it will be. Once fully established, an estate plan need only be reviewed upon unusual events such as the death or marriage of a close relative or a radical alteration in assets or the tax laws.

Estate planning requires the calm consideration of death and disease, of incompetence and disability, all subjects one might consider wise to avoid. However, the opposite is actually the case; Jean de la Fontaine in 1676 put it quite well: "Death never takes the wise man by surprise; he is always ready to go."

These Articles are to give the reader a general description of certain areas of the law. Legal advice is necessary to apply these legal concepts to your particular situation. The Reader should obtain competent legal advice before relying on the Articles.

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