Understanding the Basics of Estate Planning

A. The Simple Estate Plan

A simple estate plan should include a will, a durable power of attorney and a health care proxy. The purpose of each document is as follows:

1.) The Will: Who Gets What When I Die?

A will determines how your “probate estate” will be distributed upon your death. Many married couples leave everything to their surviving spouse and rely on the spouse to make bequests to their children. Others may choose to leave something directly to their children under their own will or they may leave their property in trust for their surviving spouse with the remainder going to their children when the spouse dies. This is especially where there are children from a prior marriage.

A properly drafted will should contain provisions that will minimize the burden of probating your estate under Massachusetts ’s law. Your will should also appoint an executor and alternate executor. Married couples usually appoint their spouse and name an alternate in case the spouse is unable or unwilling to serve. If you do not name an executor, the probate court will decide who should administer your estate. Although family members are given a preference, this is not guaranteed. Your will should also name a guardian for any minor children. This creates a presumption in favor of their appointment and greatly reduces potential guardianship disputes.

As noted above, a will only controls the disposition of your “probate estate”. Many common types of assets pass outside your will and are not included in your probate estate. For example, property held jointly with a right of survivorship passes directly to the surviving joint owner outside of the will. Bank accounts, stock brokerage accounts and government bonds that carry a “payable upon death” (POD) or “transfer on death” (TOD) designation also pass outside of probate. In addition, assets held in trusts pass by the terms of the trust and are not part of your probate estate. This is why some people use so-called “living trusts” to avoid probate. This is more fully discussed below in Section B.1. Finally, assets that pass by beneficiary designation are not included in your probate estate. Such assets include life insurance benefits and retirement accounts such as annuities, 401(k) plans and IRAs. It is critical that your estate plan considers the different forms of ownership.

2.) The Durable Power of Attorney: Who Runs My Affairs If I Become Incapacitated?

A durable power of attorney is used to appoint an “attorney-in-fact” to act as your agent and handle your affairs if you become unable to do so yourself. Typically, this is your spouse. For instance, if you were to have an incapacitating accident, a durable power of attorney would give your attorney-in-fact the power to act on your behalf regarding your financial and business matters such as banking, sale of real estate, dealing with investments, etc. You should also name an alternate to serve in case your spouse is unable to do so. Finally, you can also use your power of attorney to nominate someone to act as your guardian if this becomes necessary in the future.

3.) The Health Care Proxy: Who Makes Health Care Decisions If I Become Incapacitated?

In Massachusetts, a Health Care Proxy is a document that gives your “health care agent” the power to make health care decisions for you. In other states, this is known as a “living will” or “advanced directive”. The power granted under a health care proxy is effective only if you become incapacitated as certified in writing by your attending physician. If you regain the capacity to make you own decisions, the powers of the health care agent lapse. A health care proxy merely gives decision-making power to another person. Typically, it does not include specific instructions about particular types of medical treatments because, under Massachusetts law, such instructions are not binding. However, it always a good idea to let your health care agent know what your wishes are. You may want to consider preparing a “living will” that, although not binding, gives a more specific expression of your wishes with respect to life sustaining measures.

B. The Uses of Trusts in Estate Planning

A trust is a vehicle by which legal and beneficial ownership of property are separated. The creator of the trust (the “grantor”) transfers assets into the name of the trustee. The trustee holds legal title to the assets of the trust for the benefit of the beneficiaries. The trustee may act in any manner that the trust document permits but has a fiduciary duty to use such assets for the benefit of the beneficiaries as the trust documents directs. With a typical revocable trust, the grantor acts as his own trustee and is the primary beneficiary during his lifetime. When the grantor dies and the trust becomes irrevocable, a successor trustee takes over and the new beneficiaries are typically the grantor’s spouse and children.

There are several ways in which you can use a trust as part of your estate planning. In deciding whether a trust is necessary you should review your situation and weigh the benefits a trust offers against the potential costs associated with trust establishment and administration. Trusts are a very useful tool in estate planning. The most common uses of trusts are as follows:

1.) Providing for Incapacity.

A well drafted durable power of attorney and health care proxy are often the only documents thatare needed to appoint someone to take care of your personal, medical and financial matters in the event of your incapacity. However, there are occasions when this technique falls short of expectations, especially when it come to the sale or mortgage of real estate. In addition, there may be situations where you may need to have a guardian appointed by the probate court. This can be very expensive and, more importantly, time consuming. If your assets are held in a living trust and you and your spouse act as co-trustees, then no guardianship proceedings would be required for dealing with your property if you become incapacitated. Instead, your spouse would continue to act as trustee and can deal with the trust assets without being formally appointed as your guardian or obtaining approval of the courts.

2.) Avoiding Probate: The “Living Trust”.

As noted above, a will only controls the disposition of your probate estate. This is why some people use a so-called “living trust” to reduce or eliminate the need for probate. A “living trust” is a revocable trust. You transfer all or most of your assets to the trust. You act as trustee and you are the primary beneficiary. In other words, you maintain legal control and beneficial enjoyment of your assets just as if you owned them directly. When you die, your assets are passed on in accordance with the terms of the trust and are not subject to probate. The main advantage of bypassing probate is the avoidance of many of the administrative hassles and fees normally associated with probate administration. Probate of your estate can take as long as a year. During that time, it may be difficult for your heirs to access your assets. Court fees and administrative costs in Massachusetts for a simple uncontested probate run in the neighborhood of $750 to $1500 assuming there are no disputes over the will. Attorney fees add another $2000 to $10,000 to the cost.

3.) Estate Tax Planning: Minimizing Estate Tax.

The use of revocable andirrevocable trusts are a very effective way to minimize federal and Massachusetts estate taxes. Estate taxes are more fully discussed in Section C. below. Revocable trusts can serve double duty as both a “living trust” to avoid probate and as a “credit shelter trust” to minimize estate taxes. Irrevocable trusts are an effective way to remove the proceeds of life insurance from your taxable estate and can also serve as a vehicle for making lifetime gifts that reduce your taxable estate.

4.) Management of Wealth: Providing for the Needs of Minor Children, Spendthrifts and Heirs with Special Needs.

Many people prefer to leave their estate in trust if the beneficiaries under their will are minors or incapacitated. This allows the assets to be managed by a trustee who has a fiduciary duty to act in the best interests of the beneficiaries. Without a trust, the assets inherited by children could go into a custodial account or directly to the guardian of the child. The custodian or guardian is not subject to the same level of legal duty with respect to the assets as a trustee would be. Furthermore, if the legacy is substantial, using a trust removes the incentive for someone who might otherwise try to get custody of the minor just so they can gain access to the assets. In addition, a trust allows for the use of professionals to manage the assets. For instance, a close family relative may be the best guardian for your surviving children but may not be particularly astute when it comes to financial matters. A trust allows you to split responsibility for the care of your children by delegating different roles to those most capable of handling them.

Another reason for leaving assets in trust is to control how the assets are spent. The trust can provide when and for what reasons distributions can be made. Without a trust, the custodian or guardian has very broad discretion to decide how to spend the money. Furthermore, without a trust, the child would get full access to the assets when they reach eighteen – an age when they may lack the maturity or ability to manage large sums. Many parents believe it is better to make distributions over time (i.e., 25% at age 25, 25% at age 30, etc.) A trust allows for this. A trust is also effective if your heir has a history of wasting money due to spendthrift habits, drug abuse, gambling problems, etc. A trust can effectively restrict their access while still providing for the essentials in life.

Finally, a trust can provide protection from your heir’s creditors. A simple “spendthrift” provision would make it difficult for the beneficiary’s creditors to make a claim against the assets of the trust. This may be appropriate where your heir is involved in particularly risky business ventures or has a troubled marriage and wishes to restrict his spouse’s access to their inheritance.

C. Estate Taxes: An Overview of Tax Avoidance Strategies

1.) The Ever Changing Scope of Estate Tax Law: The Only Certainty is Uncertainty.

Under federal and Massachusetts’s law, all assets you own at the time of your death are included in your taxable estate regardless of whether they are part of your probate estate. This includes property you own solely, one-half of the value of property you own jointly with your spouse, all retirement accounts and IRAs as well as a the benefits under any life insurance policies on your life if you own the policies yourself. Under current law, combined estate tax rates can reach as high as 50% of the taxable estate.

The principal way to minimize estate tax is to take advantage of the estate tax unified credit. For deaths occurring in 2005, under federal law there the unified credit results in an effective exemption for the first $1,500,000 in assets. Under Massachusetts law, the effective exemption is $950,000. For example, a $1,500,000 estate would result in no federal taxes, but $550,000 would be subject to Massachusetts tax.

In a typical situation where all assets are left to your surviving spouse, there is no tax at the time of your death regardless of the size of the estate because there is a 100% marital deduction. However, all of the assets would then be owned by your surviving spouse and would be includible in his or her estate when he or she dies. At that time, only the surviving spouse’s exemption can be used to shelter assets form tax because the predeceased spouse’s exemption amount does not carry over to the surviving spouse. In effect, the benefit of the predeceased spouse’s exemption is lost. If the survivor’s exemption amount is not be enough to shelter the combined value of the couple’s assets, the an estate tax will be owed.

2.) Credit Shelter Trusts: Preserving the Full Benefit of Your Unified Credit.

With married couples, the use of a “credit shelter trust” assures that you benefit from the full amount of the effective exemption provided by each spouse’s unified credit. Under this strategy, your estate plan documents would provide that an amount up to your exemption would be payable to a so-called “credit shelter trust” that benefits the surviving spouse during his or her life and then passes to other heirs upon the death of the spouse. Any amounts transferred to the credit shelter trust would be sheltered by the exemption of the predeceased spouse. More importantly, the assets in the credit shelter trust would not be counted as part of the taxable estate of the surviving spouse even if he or she is a beneficiary. In this manner, you assure that the effective exemption of each spouse is fully utilized.

Generally, a credit shelter trust will provide that the surviving spouse is entitled to the annual income earned by the trust but can only invade principal for his or her “health, education, maintenance and support in their accustomed manner of living”. This is a relatively broad standard but it is not unlimited. For instance, the survivor could not invade the principal to finance luxury items such as a jewelry, a fur coat, a boat or to make gifts to others. However, they could use it for food, clothing, rent, mortgages, certain vacation expenses , even a second home if that was their accustomed standard of living. Of course, the surviving spouse could manage around this restriction by spending their own assets on luxury items and using assets of the credit shelter trust for all essential expenses. Furthermore, the trust may also provided that and “independent trustee” could be make distributions to the surviving spouse for any reason.

Under current law, the use of credit shelter trust would allow a married couple to shelter up to two time the effective exemption amounts. For couples with larger estate, more advanced techniques such as an irrevocable trust might also be warranted.

3.) Life Insurance and Irrevocable Trusts

As a general rule, the benefits paid under life insurance policies on your own life will be included in your taxable estate if your estate is the beneficiary of the insurance proceeds (by designation or default) or if you possessed certain “incidents of ownership” in the policy at your death.

Avoiding the first situation is easy; just make sure your estate is not designated as beneficiary of the policy. In this regard, you should always name individual persons or trusts as primary. Moreover, you should also make sure you name alternate beneficiaries because many policies provide that benefits are payable to the estate if the primary beneficiary is not alive and no alternate is named. The second rule regarding the “incidents of ownership” is more complex. Clearly, if you are the named owner of the policy, the proceeds are included in your estate regardless of who the beneficiary is. However, simply having someone else possess legal title to the policy will not avoid this result if you retain so-called “incidents of ownership” in the policy which include the power to change beneficiaries, assign the policy, pledge the policy as security for a loan, borrow against the policy's cash surrender value, or surrender or cancel the policy. Keep in mind that merely having any of the above powers will cause the proceeds to be taxed in your estate even if you never exercise them.

One way to avoid inclusion in your taxable estate is to transfer all incidents of ownership to another person such as your spouse. However, if that person dies before you, the policy may revert back to you. More importantly, if the insurance benefits are paid to your spouse, they would be become part of her taxable estate and be taxed when they die. A better strategy is to transfer existing policies to an irrevocable life insurance trust and name the trust as beneficiary. Your spouse and children could be named as beneficiaries of the irrevocable trust. The life insurance trust would contain provisions similar to the credit shelter trust (i.e., income to the surviving spouse with a limited right to receive principal distributions if the spouse is trustee and an unlimited right if there is an independent trustee.)

Typically, the policy is transferred to the trust and annual gifts to the trust are made to provide funds to pay the premiums on the policies. The trust could also buy new insurance with funds contributed by the insured. As long as the trust agreement gives the insured person none of the ownership rights described above, the proceeds will not be included in his or her taxable estate. The life insurance trust would contain provisions similar to the credit shelter trust (i.e., income to the surviving spouse with a limited right to receive principal distributions if the spouse is trustee and an unlimited right if there is an independent trustee.)

If you are considering setting up a life insurance trust with a policy you own currently you should do it as soon as possible. Because of a three-year lookback rule, the benefits will still be part of your taxable estate if you die within three years of the transfer. If the trustee purchases the policies directly form the insurance company, the three-year lookback rule does not apply. For this reason, if you plan to buy more insurance in the near future, you should set up the trust first and have the trust buy the insurance. This would avoid the three-year lookback rule.

D. Summary

Even if your total assets are modest, a simple estate plan assures that their transfer at your death will go as smoothly as possible and minimize the burden on your heirs. Moreover, in today’s era of high real estate values and low cost life insurance, the use of trusts are not just for the wealthy. When one considers the multiple uses of trusts, it is often easy to conclude that the best strategy is to have a trust document drafted and available for use if estate tax, probate and family considerations warrant. The up-front expense is relatively minor and the peace of mind can be major.

Are you in need of an experienced Massachusetts Estate Planning Attorney? If you or anyone you know needs a Massachusetts Estate Planning Attorney, please contact Kerstein, Coren & Lichtenstein LLP.