Estate planning for the rest of us

By Louise M. Clayton-Kastenholz, CPA

I work in the world of death and taxes. For those starting to feel sorry for me, please don’t; I really do enjoy my job. There is great job security, and the clients never complain. Now that the estate tax exemption amount is up to around $11 million per person, or $22 million per married couple, I have been amazed at the number of people who think I soon will be out of a job.

Nothing could be farther from the truth. I did not prepare many estate tax returns when the exemption amount was “only” $1 million, and the nature of my job was no different. I help clients navigate the unfamiliar territory of dealing with the business end of the end of life. So if the estate tax will never factor in, then what planning is really necessary, and why do our clients need us? In this article, we will take a look at the factors that affect estate planning for the rest of us.

Essentially, the goal of estate planning is to arrange the maximum transfer of the enjoyment and control of your assets (and the payment of your debts), with the minimum cost in money or trouble to the people who you are leaving behind. The goal is the same whether you have $100, $100,000, or $100,000,000. Though the goal is fairly simple, there is no one-size-fits-all answer for how to meet it. Depending on a person’s family situation and the nature of their assets and liabilities, there are multitudes of different ways to meet a client’s goals.

Intestacy — The Default Plan

More than half of Americans do not have a will. But they still have a plan, thanks to intestacy laws. All states have them, and Virginia’s are straightforward. Inheritance starts with the surviving spouse if there is one, divided between the surviving spouse and children if there are children not in common with the surviving spouse. If there is no surviving spouse, then just the children; if there are no children, then on to other relatives in an ever-widening, but logical, circle. With no will to name an executor, the court has to appoint an administrator, which can create extra time and expense.

If for some reason the court determines that a will is invalid, then the intestacy laws would come in to play. Most attorneys include a self-proving affidavit with the wills they draft and have those signed when the will is signed to avoid the difficulties of validating a will. Although most people have chosen intestacy, consciously or otherwise, it is extremely limiting.

Last Will and Testament

Aside from a desire to depart from the state’s rules for who should inherit what, there are plenty of good reasons to make a will. A will names an executor, or co-executors, and then imparts powers to carry out the instructions given. A will can also provide guidance to the executor about how to carry out the instructions. A common example is in the distribution of tangible personal property: by a list left by

the testator, by the executor’s choice or by each beneficiary having the opportunity to choose, with instruction on dealing with anything not chosen or inappropriate for distribution.

It is crucial to make a will — even with a trust already in place — to control the disposition of those assets that were not transferred into the trust. It could be as simple as a “pour-over” will leaving the residue of the estate to the trust, or it could be a mechanism to work entirely separately from the trust. Even with very diligent planning and implementation, the will inevitably governs disposition of at least one asset.

Transfers Outside of Probate

It is entirely possible for a reasonably wealthy person, without the use of a trust, to have such a small probate estate as to fall within the small estate statutes. Most Americans’ two largest assets are their house and their Individual Retirement Accounts (IRA). If the house is owned jointly with their spouse (either with right of survivorship or as tenants by the entirety), and the IRA account has a properly designated beneficiary, those assets will never be part of the probate estate. Even if a house is not jointly owned, real estate in Virginia transfers as of date of death and does not go through the probate process.

There are other ways that assets can be titled to avoid probate. Transfer on death, or pay on death, designations can be made on financial assets such as bank or brokerage accounts. With those designations, the bank or brokerage will transfer the asset to the designated recipient upon notification and proof of death of the original owner. The transfer of ownership through survivorship, titling or beneficiary designation takes place by operation of law, and not according to the will.

Clients who wish to avoid probate, and the expense of creating a trust, should consider some of these titling options. Likewise, joint accounts will not go through probate. Elderly clients often create a joint account with one of their children for convenience in day-to-day financial matters, and should be reminded that the co-owning child has no obligation to share the account with their siblings after the parent’s death.

Revocable Living Trust

A revocable living trust (RLT) is a popular estate planning tool, for good reason. A will only determines the disposition of assets at death; there is no allowance for incapacity, or for voluntarily allowing another to control the assets. An RLT allows the grantor to continue to exercise control over his or her assets, even to the point of revoking the trust, while providing for those other eventualities. Trusts can be administered by the grantor, or with one or more other trustees. Trusts can also be set up with protectors, who have duties different from the trustee and can act in a non-fiduciary capacity.

Assets do not have to be transferred to the trust after death if they are already titled to the trust. This avoids probate, and also makes a much smoother transition, allowing the payment of expenses or receipt of income to continue relatively seamlessly. In order to avoid probate, the trust must be funded during life. Even a pour-over will still goes through probate. Trusts can be particularly useful in situations where there are some assets located in another state, avoiding the potential costs and inconvenience of ancillary probate in those states. The downside is the initial expense to set up the trust. Since the cost of probate in Virginia is relatively low, the cost of setting up a trust can be more than the cost of probate for a modest estate.

Selection of Executor or Trustee

The selection of the executor or trustee is very important for implementing an estate plan. Often the surviving spouse, or one or more of the decedent’s children, are named as executors or successor trustees. In a happy family that gets along well, that can work, as long as the person named is emotionally and practically up to the task. In a contentious family situation, especially in the case of “blended families” where the spouses have children from previous marriages, it may be best to consider asking a professional such as the client’s attorney to act as executor. The fee for a professional administrator may be worthwhile to avoid subjecting a family member to scrutiny and potential hostility.

Accounting — To the Commissioner or the Beneficiaries

Fiduciaries have a duty to report the income and expenditures of an estate or trust. In the case of an estate or testamentary trust, that reporting is done through a fiduciary inventory and annual accountings to the Commissioner of Accounts for the decedent’s city or county. The inventory and accountings are matters of public record, which is one of the reasons why many want to avoid probate.

The accounting is considered part of the fiduciary’s duties. If the fiduciary is receiving compensation, and hires a professional to prepare or assist in preparing the accounting, the allowable fiduciary fee is reduced by the amount paid to the professional. Fees paid for tax preparation do not reduce allowable fiduciary compensation.

Even the trustee of an inter-vivos trust, which is not under the supervision of the court, has a duty to report to the beneficiaries. In most cases, that reporting is only necessary upon request of the beneficiary and a copy of the trust’s tax return will often suffice. However, getting back to those contentious relatives, remainder beneficiaries may make demands for accountings from fiduciaries, particularly if the fiduciary is also the income beneficiary.

Death and Taxes

Even if we never have to file an estate tax return, there are plenty of income tax returns to be filed for estates. And trusts. And deceased clients. And beneficiaries. Even the simplest situation will result in at least one Form 1041 needing to be filed, for the estate to report income earned after the decedent’s death and until the assets are distributed to the beneficiaries. For many trusts, a 1041 is needed for many years through the lives of one or more income beneficiaries, before the assets are transferred to the remainder beneficiaries. The filing threshold for a 1041 is very low — $600 gross income, or any taxable income. With an exemption amount of only $100 for any trust that is not required to distribute all income currently, it is very easy to have a filing requirement even with less than $600 of gross income.

The decedent’s final 1040 needs to be filed as well, usually by the executor or other personal representative, or jointly with the surviving spouse. The couple is still considered married if one spouse died during the year, so the filing can be either joint or separate for a decedent who was married at the time of death. Income and deductions belonging to the decedent are cut off at death, although medical expenses are deductible even if paid after death. There are some planning opportunities when filing a final 1040, but the main issue is usually the cut-off of income.

An estate or trust that makes distributions will need to issue Schedules K-1 to the beneficiaries. They need to know that the K-1 will be forthcoming, and that they are only taxed on their share of the income earned by the trust or estate’s assets. Often beneficiaries are concerned that they will be taxed on their inheritances, and understanding that this is not the case can be a great relief.

Basis and Holding Period

Inherited assets have a “stepped up” (or occasionally, stepped down) basis and a long-term holding period regardless of when they were purchased or sold. Gifts, however, have “carryover basis” meaning that the donee takes on the donor’s basis and acquisition date. Generally, it is better for a client to hold on to assets and let beneficiaries inherit them than to gift the asset during life. As a planning tool, the best assets to gift are those with minimal or no appreciation, such as cash or recent purchases, while highly appreciated assets should be held.

When working on fiduciary tax returns, remember that both basis and holding period for inherited assets are affected. The broker may not have adjusted the basis or term for sales of inherited stock. Clients often provide cost for a house that sold, not realizing that there is a step up to fair market value at date of death.

Life Insurance

Life insurance can be a useful planning tool and provide needed liquidity. In a taxable estate, a life insurance policy can provide the funds to pay the estate taxes for a largely illiquid estate. Life insurance proceeds can be very helpful for paying an estate’s outstanding debt. If the client is a small business owner with only one child involved in the business, life insurance can provide funds to equalize the inheritances of the other children. Life insurance proceeds are not taxable to the beneficiary.

Run the Numbers

When your client wants to discuss estate planning — a discussion we should encourage — we owe them the kind of analysis that makes us their most trusted advisor. We know their assets and income, we know at least something about their family, and reading through their planning documents will tell us more. We also can determine the financial implications of their ideas, better than any of their other advisors; we know how the dollars will play out, and we can impart that knowledge to them.

Louise M. Clayton-Kastenholz, CPA, is a tax manager in the Williamsburg office of PBMares, LLP. She heads the estate and trust segment of the firm’s practice. Her specialty areas include estate tax, estate and trust fiduciary tax returns and fiduciary accountings, as well assisting clients in estate and trust administration and planning.