estate planning basics

Estate Planning Basics Brochure 2007 Estate Planning Basics This guide is designed to acquaint you with some of the basics of estate planning. There are three major goals of an estate plan: • Ensuring that your property benefits those whom you choose, in the manner you select; • Minimizing costs, including taxes, administrative expenses, court costs and fees; • Providing for management of your assets during your lifetime if you are disabled or wish to have someone else handle your finances and investments. Your estate plan can also provide for continued management of your assets after your death. In addition to the three major goals, the plan should address other issues as needed, such as income tax planning, insurance, retirement planning, family and charitable giving, and ownership succession for a family business. Your estate plan should be customized to fit your own family and financial situation. Before consulting your attorney at Edwards Angell Palmer & Dodge LLP, you should think over your basic goals and individual needs. You may have questions for us, but you will have a more productive meeting if you have given some consideration to the following: • Who are your dependents? • Who should be your beneficiaries? • Should they receive your property outright or in trust? • Who should be named as your executor (also known as a personal representative in some jurisdictions)? Trustee? • Who should serve as a guardian for any minor children? • Are there family members with special needs? • What are your assets and by whom are they owned? • Should you have a prenuptial or postnuptial agreement? • Who are the beneficiaries of your insurance and retirement benefits? A typical estate plan often calls for four different types of documents: a will, a power of attorney, a health care power of attorney and a revocable trust. Will A will is a document that directs the disposition of assets that are owned by you alone at the time of your death. Property that passes under your will may include real estate, intangible property such as bank accounts and stocks, and tangible property, such as home furnishings. Assets not owned in your sole name do not normally pass under your will. For example, property held in joint names with right of survivorship passes to the surviving joint owner; assets held in trust are distributed pursuant to the terms of the trust instrument; and death benefits under life insurance policies and retirement plans pass to the beneficiary named in the policy or the plan document. However, if your “estate” is named as beneficiary, the assets will pass under your will. The description of assets in your will can range from specific to general. For example, you might leave specific items, such as jewelry, to named individuals, and then leave all the “residue” or remainder of your assets to your spouse. You must decide who should serve as executor of your will. An executor is generally responsible for collecting your assets, paying your debts, filing tax returns, and distributing the remainder of your property to your beneficiaries. It is common to have a bank or trust company, lawyer or accountant and/or family member serve as executors of your estate. Co-executors may be particularly desirable if your estate is large or complex. If you name a family member, he or she can get assistance from a professional to help administer your estate. You may name alternate executors in the event your first choice is unable to serve. In many cases, the executor is paid a fee for administering your estate. If you have minor children, you must decide whom to designate as their guardian. The guardian is responsible for raising your children. Unless a trust is established, the guardian would be responsible for managing money you leave to support your children. However, designating trustees to hold your assets for your children’s benefit is an alternative way to provide for who will manage the assets you leave them, especially if you feel that the named guardian would not be an appropriate money manager. Unless the named guardian is a parent of the children, the guardian is not required to expend his/her own assets to support your children. Naturally, most people name a family member or close friend as guardian. You will have only one original will. We recommend that it be kept in a safe place, such as the will vault at Edwards Angell Palmer & Dodge LLP or with your corporate executor. Keep a photocopy of your will at home so that you have it handy for reference. You should review it and other estate planning documents every five years or whenever there is a significant change with your family or financial situation. Be sure that you are comfortable with the terms of the will. If you are not, an amendment (called a codicil) or a new will may be prepared. Changes should not be written on the document itself, as they will not be effective. You should contact us to make any changes. Power of Attorney A durable power of attorney authorizes a designated person or persons (usually family members) to act on your behalf in making financial and legal decisions. This document is generally used when authorized or when you are incapacitated. The use of a durable power of attorney often avoids the need to have a court-appointed guardian. The agent is able to manage your property and pay your bills without the expense and inconvenience of accounting to the probate court. The powers granted are quite general, unless specifically limited in the document. 2 Health Care Documents Health care documents (known as health care powers of attorney, health care proxies, designations of health care surrogate, or other variations for different jurisdictions) authorize your agent (usually a family member or friend) to make health care decisions on your behalf when you are unable to make these decisions for yourself either because of a temporary medical setback or an extended illness. These decisions may include termination of life support systems and performance of surgery. The authority in health care documents is quite broad, unless specifically limited in the document. You may also state that you do not want to be kept alive by “heroic measures” in the event that you are diagnosed with a terminal condition. This statement (called a “living will”) can be a stand-alone document or can be included in the health care document. Trusts A trust is an arrangement by which an individual (the settlor or trustor) names another (the trustee) to hold property for the benefit of someone else (the beneficiary). The trust document appoints an individual or corporate trustee to manage the transferred assets, and sets forth the respective interests of the trust beneficiaries. It also states the time and manner of distribution of the trust assets. A trustee must adhere to the provisions set forth in the trust document. The most common type of trust is a revocable trust, which may be revoked or amended at any time by the settlor. You may serve as your own trustee, with another person or corporate trustee on standby in case of disability or death. You may also retain responsibility for management of the assets until you become incompetent or decide to let the successor trustee take over. A revocable trust becomes irrevocable at death and can at that point either terminate or continue. If the settlor is survived by a spouse, the trust will often continue through the life of the spouse. If you have children, you should also consider when you want the trust to be distributed to them. Typically, the assets are held in trust at least until the youngest child has completed his or her education, or until such time when the children will be ready to handle the funds responsibly. In order to reduce estate taxes for future generations, trusts sometimes last through the lives of the children and even grandchildren. Your lawyer can help you decide if such a “generation-skipping” trust is appropriate for you. You may also wish to consider creating an irrevocable trust during your lifetime. These trusts would generally be created to remove assets from your taxable estate to minimize estate taxes. Common irrevocable trusts include insurance trusts, asset protection trusts, trusts for children and grandchildren (perhaps to create an educational fund) and trusts for charity. If you would like more information about these types of trusts, please ask us. 3 You should give careful thought to the selection of your trustee, especially if the trust will continue after your death. The trustee must manage trust assets, invest them, keep records, prepare tax returns, make distributions of income and sometimes principal, and account to the beneficiaries. You may name an individual (usually a family member) and/or a professional or bank authorized to exercise trust powers. You should include provisions for successors in the event a trustee is unable to serve. Federal Estate Taxes: The exclusion amount and marital deduction The federal government imposes a tax on the transfer of assets by inheritance or gift. Each person can transfer some assets free of tax. This amount, sometimes referred to as the “estate tax exclusion amount,” is currently set at $2 million. Under the current law enacted in 2001, the estate tax exclusion amount will gradually increase over the next few years, only to return to $1 million in 2011: 2007-2008 $2 million 2009 $3.5 million 2010 no estate tax for individuals dying in 2010 2011 $1 million This assumes the United States Congress does not act in the meantime to change the estate tax. Most estate planning experts feel another change is likely, perhaps in the near future. We will of course monitor legislative changes. Above $2 million, the tax rate is 45%. In addition, transfers from a person to his or her spouse (provided he or she is a U.S. citizen), no matter how large, are not subject to tax because of the “marital deduction” provided by the federal law. The unlimited marital deduction is available for assets passing to a non-U.S. citizen spouse only if a “Qualified Domestic Trust” is established. Using a combination of the exclusion amount and the marital deduction, under present law, your lawyer can prepare an estate plan that will pass up to $4 million from parents to children with no tax liability. Given the uncertainty of the estate tax law, it is difficult to provide examples. However, if your estate is valued at $2 million and you leave the entire amount outright to your spouse, your estate will not be liable for any estate taxes at your death because of the unlimited marital deduction. If, at your spouse’s subsequent death after 2010, when the federal estate tax exclusion amount returns to $1 million, the estate has increased in value to $2.5 million, your spouse’s exclusion amount would shelter $1 million of the $2.5 million estate, and the remaining $1.5 million would be subject to a net federal estate tax of $541,200 (and possibly an additional state estate tax depending upon your state of domicile). If, instead, you left the exclusion amount (for example, $2 million in 2007) for the benefit of your spouse in a trust (sometimes called a “family” or “bypass” trust), all estate tax would be avoided. At the time of your death, the family trust would have been sheltered by your estate tax exclusion amount. Upon the subsequent death of your spouse, the family trust would not be 4 taxable, regardless of its value. Your spouse’s own exclusion amount could protect additional assets owned by your spouse from estate tax. Changing ownership designations so that each spouse individually owns substantial assets can reduce estate taxes dramatically. If all $2 million of a couple’s total assets of $2 million were held in joint ownership, at the death of the first spouse, all property would pass directly to the surviving spouse, and no estate taxes would be due. However, if the assets increased in value to $2.5 million by the time of the surviving spouse’s death, as illustrated above, your spouse’s estate would owe federal estate tax of $541,200 and some additional state estate tax. If instead, the couple’s total assets of $2 million were split equally between the spouses, when the first spouse died, $1 million would pass into the bypass trust (and not be subject to estate tax at the first spouse’s death or at the second spouse’s death, regardless of its value). If the surviving spouse’s $1 million of assets increased to $1.5 million, no federal estate tax would be due because of the exclusion amount. State Estate Taxes For years many state estate tax systems were “coupled” or tied in with the federal estate tax system so that at death an individual could give away to anyone the same amount free of both federal and state estate taxes. In response to the rapidly increasing federal exemption, the legislatures of several states (including Connecticut, Massachusetts, New Jersey, New York, and Rhode Island), concerned about the loss of revenue as a result of fewer estates being taxed, have fully or partially “decoupled” from the federal estate tax system. The exemption in Connecticut is $2 million, the exemption in Massachusetts and New York is $1 million, and the exemption in New Jersey and Rhode Island is $675,000. Because it is difficult (if not impossible) to predict what the federal or state tax laws will be, it is important to structure your estate plan with flexibility in order to maximize the available exemptions. Figure #1 illustrates a typical estate plan utilizing the estate tax exclusion amount and marital deduction. If applying these techniques may not eliminate your estate tax liability, you should consider the following methods of removing assets from your taxable estate. 5 FIGURE #1 At death of first spouse (no taxes paid) Assets in sole name Joint property Retirement plan Tangible property Revocable Trust Family Trust = Estate Tax Exclusion Amount* Marital Trust = Balance Surviving Spouse Income & principal may be paid to surviving spouse and children All income and discretionary principal to surviving spouse Assets in surviving spouse's sole name At surviving spouse's death Not taxable Taxable, but reduced by surviving spouse's remaining exclusion amount. Taxable, but reduced by surviving spouse's exclusion amount. Surviving Spouse's Revocable Trust Separate shares for children Year 2007 2008 2009 2010 2011 Exclusion Amount* $2,000,000 $2,000,000 $3,500,000 no estate tax $1,000,000 Separate shares for children *This assumes the United States Congress does not act to change the law. 6 Irrevocable Life Insurance Trust An irrevocable life insurance trust can provide liquidity for payment of estate taxes while removing the value of life insurance proceeds from the taxable estate. If the estate is large enough, it can provide for significant estate tax savings. At the time of the transfer, the current cash value of the policies is considered to be a gift, as is each premium payment. Often, these gifts can be completely free of tax consequences. At your death, the entire proceeds of the policies can be collected free of estate tax. However, existing life insurance policies must be transferred at least three years before the death of the insured. If the individual dies within the three-year period, the proceeds remain taxable. In the case of a new policy, it is best to establish the irrevocable trust first and then have the trust purchase the insurance policy. Gifts Individuals may transfer gifts of up to $12,000 per year, to as many different individuals as they like, free of any gift tax. (This amount may increase somewhat from time to time by a cost-of-living adjustment factor.) Married couples, if they each agree to “split” the gift, may transfer as much as $24,000 to any individual free of tax, even if the gift is given only by one spouse. Gifts exceeding these annual exclusion limits reduce the available exclusion amount. The gift tax exclusion amount is set permanently at $1 million and does not increase incrementally with the estate tax exclusion amount. No gift tax is actually paid until your accumulated taxable gifts exceed the exclusion amount. A couple with several children can substantially reduce the size of their taxable estates with annual gifts of $24,000 to each child or $48,000 to each married child and his or her spouse without incurring any gift tax liability. Tuition or medical payments made directly to the providers are also exempt from gift tax regardless of the amount. More sophisticated gift techniques, such as minor’s trusts, “Crummey” trusts, family limited partnerships or other methods of transferring ownership of businesses or real estate at discounted values, may be suitable for your particular circumstances. For more information, please ask any of us listed at the end of these materials. Qualified State Tuition Programs Most states have established “Section 529 Plans,” which permit you to contribute to an investment account established for the purpose of meeting the costs of higher education for a designated beneficiary in a tax-advantaged manner. All investment earnings in a state-sponsored Section 529 Plan are free from federal income tax to the extent they are used to pay for qualified higher education expenses. Contributions to a Section 529 Plan are considered completed gifts under the gift tax law and qualify for the annual gift tax exclusion, which is currently $12,000. Spouses can elect to split the gift and thereby contribute $24,000 to a plan for the benefit of a single beneficiary. Moreover, you can elect to consolidate five years of contributions in one year for gift tax purposes with no adverse consequences. 7 To illustrate, a married couple can make a single contribution of $120,000 (5 x $12,000 x 2) to a Section 529 Plan without paying any gift taxes. If either of them dies within the five-year period, a pro-rated portion of the initial contribution will be included in his or her taxable estate. The owner of the account (usually the contributor) typically retains control of the withdrawals from the account. Withdrawals used to pay qualified higher education expenses (generally, books, fees, tuition, supplies, and with some limitations, room and board) of the designated beneficiary are not subject to federal income tax. Moreover, even though contributions to the account are considered completed gifts, many plans allow the owner to withdraw the funds for his or her own benefit, subject to certain penalties and income taxes on the earnings. Most states also permit the owner to change the designated beneficiary of the account to a family member of the initial beneficiary. For example, if the designated beneficiary decides not to attend college or receives a full scholarship, then the owner can change the designated beneficiary to a spouse, sibling, child or parent, or a first cousin of the initial designated beneficiary. Generally, the owner can change the beneficiary of the plan without adverse tax consequences. If, however, the new beneficiary is of a younger generation than the initial beneficiary, there may be gift and generation-skipping transfer tax liability. There are some drawbacks to Section 529 Plans. Subject to a few exceptions, distributions that are not used for a beneficiary’s qualified higher education expenses are subject to income tax and a 10% penalty. Further, plans offer limited investment vehicles with designated investment managers, and you may be able to change the investment selection only once a year. In addition, some plan charges are based on a flat fee, which can be high relative to the amount contributed. Charitable Gifts Gifts to charity often entitle you to income tax benefits as well as estate and gift tax reductions. If you do not wish to relinquish the income from assets you are giving to charity, you might consider setting up a trust in which you have a retained interest in the property. In a charitable remainder trust, you as settlor reserve for yourself and/or another person the right to receive income for life or up to 20 years, with the “remainder” ultimately passing to charity. You receive a charitable contribution income tax deduction, based upon an IRS formula, which is equal to the excess of the value of the property over the value of your retained right to receive income. These trusts are often funded with appreciated assets about to be sold, because immediate payment of capital gains taxes can be avoided. A charitable lead trust is a trust that pays an annual income to charity for a period of years and then passes the remaining assets to a non-charitable beneficiary. The value of the gift to the non-charitable beneficiary is reduced by a deduction based upon an 8 IRS formula, equal to the present value of the income interest going to charity. Usually, no income tax deduction is available. Charitable gifts at your death also generate a deduction for your estate for estate tax purposes. The estate tax charitable deduction is not limited by any percentage limitations, so you can transfer your entire estate to charity tax-free. Each situation involving a charitable transfer should be carefully analyzed with respect to both its income and its estate or gift tax impact. We will help you decide if these techniques are appropriate for you. Qualified Personal Residence Trust A qualified personal residence trust allows you to transfer your residence to a trust, reserving the use of the residence for yourself for a predetermined number of years. At the end of that period, your spouse can continue to use the residence, and ownership will eventually pass to your children. The value of your right to live in your house during that initial time period is determined by IRS tables. The amount of the gift you are making to your children is determined at the time you establish the trust, based on the current value of the residence less the value of your retained interest. This may allow for substantial estate tax savings. Suppose, for example, your home is worth $600,000. The IRS may value your retained interest in the home for a ten-year period at $342,000. The exact calculation depends on your age and interest rates and the duration of your retained interest. The gift to your children would be $258,000, the “remainder interest” in the property. This amount can be sheltered by your exemption equivalent amount. If, at the end of the trust, your home has appreciated in value to $1.2 million, you will have removed that amount from your estate by making a gift of only $258,000. Generation-Skipping Trusts A federal “generation-skipping” transfer (“GST”) tax is imposed on transfers of assets to individuals who are more than one generation younger than the transferor. This includes transfers of assets that are given outright or in trust, whether by lifetime gifts or transfers at death. The GST tax is in addition to the federal estate tax. Each individual has a GST exemption; this exemption is currently $2 million. Until 2009 the GST exemption and the estate tax exemption will be the same. Under current law, there will be no GST tax in 2010, but in 2011 the GST tax will be restored and the exemption will be $1 million (indexed for inflation). If the GST exemption is allocated to a trust, the GST trust, including any appreciation, is transferred to your grandchildren free of both estate and GST taxes at the time of your children’s deaths. The following example will help illustrate the benefits of GST planning. Assume that at your death $2 million passes to your child, and over your child’s lifetime, those assets grow to $3 million. At your child’s death after 2011, a federal estate tax of approximately $763,000 and an additional state estate tax, depending upon the child’s state of domicile, will be due (assuming a $1 million exclusion is available). The 9 residue (remainder after taxes) will be distributed to your grandchildren. If, instead, your estate plan places that $2 million in a trust for the benefit of your children and grandchildren, when your child dies, the $3 million will not be subject to estate tax, so your grandchildren will collect the entire amount. However, estate taxes on your estate at your death remain unchanged. The tax law does not allow a taxpayer to shelter an unlimited amount of assets. If an amount greater than the GST exemption is transferred in trust, or passes outright to a grandchild, the excess is subject to the GST tax at your child’s death, at a flat rate equal to the highest marginal estate tax rate (45% in 2007). It also doesn’t matter how many grandchildren you have -- the GST exemption for each grantor is limited to $2 million. Each spouse has a GST exemption, so that a married couple may transfer $4 million free of GST tax. With the use of the GST exemption and the sheltering of the appreciation in trust, planning can substantially increase the assets available for future generations. In addition, irrevocable trusts owning life insurance (particularly second-to-die life insurance) can “leverage” the GST exemption such that substantially more than $2 million (or $4 million for married couples) can pass free of estate and GST taxes. Figure #2 illustrates some of the available estate planning techniques, utilizing the exclusion amount, the unlimited marital deduction, and generation-skipping tax exemption. Amounts exceeding the $2 million generation-skipping exemption amount can either be distributed outright to children or held in trust to provide asset management and asset protection, even though there may be no or modest tax advantages to such trusts. 10 FIGURE #2 At death of first spouse (No taxes paid) Assets in sole name Joint property Retirement plan Tangible property Revocable Trust Family Trust A= Lesser of estate tax or GST exemption Marital Trust A = Balance of GST exemption** Family Trust B = Balance of estate tax exemption Marital Trust B = Balance Surviving spouse Income and principal may be paid to spouse, children & grandchildren Not taxable All income and discretionary principal to surviving spouse Income and principal may be paid to spouse, children & grandchildren Taxes due but paid out of Marital Trust B All income and discretionary principal to surviving spouse Taxes paid Assets in surviving spouse's sole name A t s u r v i v i n g s p o u s e ' s d e a t h Taxes paid Trust is divided into separate shares for children Trust is divided into separate shares for children Surviving Spouse's Revocable Trust Children's shares held in trust for life Family Trust = GST exemption** Family Share = Balance At child's death share is distributed to grandchildren free of estate and generation-skipping tax Distributed outright to children or held in trust Children's shares held in trust for life Year Exclusion Amount $2,000,000 $2,000,000 $3,500,000 no estate tax $1,000,000 At child's death share is distributed to grandchildren free of estate and generation-skipping tax Distributed outright to children or held in trust * This assumes the United States Congress does not act to change the law. **The GST exemption equals the estate tax exclusion amount; however, the exemption amounts actually available at death may differ due to lifetime gifting. 2007 2008 2009 2010 2011 11 Family Business Ownership of a family business, alone or together with family members, requires special consideration in your estate plan. It is important to take into account a range of issues, including gift and estate taxes, the need for liquidity, equitable treatment of family members, management in the event of disability, and succession of ownership. Take some time to think about the following questions: • What are your long-term plans for the business? • Will the business be sold during your lifetime? • Who will run the business in the event you become disabled or retire? • What will happen to the business at your death? • Are there family members that you would like to bring in to participate in the business? • Should you consider transferring all or partial ownership during your lifetime? • If you retire, do you need to receive an income from the business? • What are the needs for liquidity? Is life insurance needed? • Will there be sufficient funds to pay estate taxes at your death? • If there are other owners, do you need a buyout agreement to provide for transfer of ownership at death of an owner? • If the business represents a large portion of your estate, how will you provide equitable distribution of the estate among your beneficiaries? • Do you have a buy-sell agreement in place? Your attorney will help you create a plan that can protect the business, fund your retirement, arrange for transfer of ownership, and provide equitably for family members. Conclusion Here at Edwards Angell Palmer & Dodge LLP, we customize your estate plan to meet your individual needs and goals. Your financial and family situations change over time. Therefore, it is essential to review your estate plan regularly to make sure that your estate plan meets your current situation. Although we occasionally communicate with our clients about changes in tax laws that might affect estate plans, we cannot undertake to advise each client of the changes that might affect an individual situation. Therefore, it is in your best interest to review your plan with us at least every five years, and to be alert to changes in the tax law. Also, the following different life events should cause you to contact us about amending your estate plan: • Change in financial situation or assets • Additions to family • Marriage/divorce of self or beneficiary • Change in tax laws • Change of state of residence 12 Personal Asset Summary For Attorney: Direct Dial Number Husband Wife Address: Home phone: Fax: Children Or Other Beneficiaries: 1. Address 2. Address 3. Address 4. Address Are any more children planned? Special family circumstances: Additional Facts: Prior Marriages Existing Documents (Please List) Organ Donation? Special Funeral Instruction Non-Citizen Spouse? Accountant Financial Advisor Life Insurance Agent Other: Prenuptial Agreement - dated Include adopted beneficiaries? date of birth date of birth date of birth date of birth Office phone: E-mail: date of birth date of birth SSN: SSN: 13 Please insert dollar figures to the nearest thousand ASSETS Residence Mortgage Vacation Home Mortgage Other Real Estate Stocks, Bonds Bank Accounts Business Interests – % held: 1. Corporation 2. Partnership 3. LLC Life Insurance: Employment Insurance – Beneficiary: Term Insurance – Beneficiary: Permanent Insurance – Beneficiary: Retirement Plans: 1. IRA’s Beneficiary: 2. Qualified Plans Beneficiary: 3. Deferred Compensation Annuities Stock Options Tangibles Taxable Gifts Made to Date: Interests in Trusts Expectancies from Family Other Investments Buy/Sell Agreements Other Liabilities HIS HERS JOINT 14