One Couple's Eye-Opening Experience with the Importance of Estate Planning
The following is a fictional account drawn from several case studies recorded by F&H, as part of the Institute's ongoing research into the area of estate planning.
Frank and Sherry Millhouse realized they were in dangerous territory. When Frank was hospitalized with pneumonia, Sherry knew that ignoring the inevitable wasn't a smart idea. Although her husband's health was Sherry's primary concern, the fact that the couple had no estate plan weighed more heavily on her mind. The two had heard that tax laws might change in the next couple of years so they decided to wait before planning it out. But with no guarantee that Frank would fully recover, Sherry knew it was time to get their affairs in order, before it was too late. Together, the couple began discussing what to do with their belongings when they passed on. As Frank lay in bed, his constant worrying interfered with rest. He wanted to know that his wife was protected financially should something happen to him. He also worried about leaving money for their five adult children.
With Frank still recovering in the hospital, Sherry began organizing their important papers at home. If Frank's illness continued, she recognized that the responsibility for the household decisions would fall on her shoulders. Needless to say, the thought of managing their finances was daunting. While Sherry knew how to balance a checkbook, her husband always paid the bills and handled the financial decisions. She tried to read through some of Frank's records, squinting at the various loose pages containing his scribbles in the margins--it was like trying to decipher the Dead Sea Scrolls. More than ever, Sherry needed help and so she telephoned her eldest son, Gary. Gary suggested that his mom begin making a list of all their account information and valuables.
Feeling a little relieved after talking with her son, Sherry sat down at the kitchen table, flipped open her notepad, and began to make the list that her son recommended. It seemed easy enough...The couple had a house, two cars, a savings and checking account at ABC Bank, Frank's pension check, a few stocks, some jewelry and watches, and a collection of antique figurines. As Sherry began her list, she couldn't help but feel a little silly. After all, she didn't think that they owned very much--they were a typical middle-class couple who had settled comfortably into retirement. She began to doubt if they even needed an estate plan. However, as her list grew, she realized their assets quickly added up.
Of course, when she wasn't organizing papers, Sherry spent most of her time at the hospital with Frank. Within a week, the doctor released Frank into Sherry's care for further recovery at home. After celebrating Frank's return, the couple agreed that they shouldn't procrastinate preparing their estate plan any longer. When Frank felt well enough, Sherry scheduled an appointment with an estate-planning attorney by the name of Ralph Conway. Some time ago, a neighbor had suggested the services of Mr. Conway--he was a well-respected specialist with years of experience preparing both basic and complex estate plans. In preparation for the appointment, the couple wrote out instructions for their children upon their passing. They hoped the attorney could implement these instructions into the estate plan to eliminate questions as to how their assets should be divided...Little did they know at the time, that these instructions were just the tip of the estate planning iceberg.
The day of the appointment, Sherry awoke with butterflies in her stomach...Fact was, she had never been to an attorney's office before and it sounded intimidating. She felt vulnerable discussing personal affairs with someone she didn't know, but was glad that both she and Frank would be going together. Once at the law office, Mr. Conway explained that there were several things the trio would discuss in their meeting. He would make recommendations for their estate plan but, ultimately, it would be up to Frank and Sherry to choose the options they felt made the most sense.
Conway began by explaining a tax advantage available to spouses called the "Unlimited Marital Deduction." This tax provision would allow one spouse to transfer, upon death, an unlimited amount of property to the other spouse without incurring estate or gift tax. In other words, if Frank passed on, he could transfer everything he owned to Sherry without any taxes. The transfer would need to be reported to the IRS but, generally, it would be fully deductible on their estate tax return. If Sherry died before Frank, she could pass all of her property to her husband in the same way. This information was a relief to Frank since he was concerned about his wife paying hefty taxes after his death.
The attorney also explained the implications of a loss in mental ability. Should either Frank or Sherry lack "capacity" (lose the ability to understand the nature and effect of their acts), one spouse would need the authority to act on the other's behalf. The designation, which needed to be in writing, meant that if Frank became ill again and subsequently lost his mental abilities, Sherry (or one of their children) would have the power to make necessary decisions in a timely manner and in accordance with Frank's previously expressed wishes.
Frank and Sherry continued to listen as Mr. Conway described several types of documents, called "instruments." In accord with specific formalities, instruments like "wills" or "trusts" would design how the couple's assets would be distributed at their passing. Mr. Conway explained that if the two drafted nothing, the state would decide how their assets would be distributed. Frank and Sherry definitely didn't want that...They wanted their important belongings, the belongings they had worked a lifetime for, to be enjoyed by the people they chose.
As their discussion continued, Frank asked Mr. Conway to tell them more about the advantages and disadvantages of a simple will. He heard it was cheaper to draft a will and wanted to save money on his estate plan. Nodding his head, Conway explained that if they created a will, the estate would pass through probate at death. The Probate Court would oversee the distribution of the estate to their children (the beneficiaries). While some assets would avoid the probate process, others would require distribution by the Court. The Court would ensure that all creditors and taxes owed were paid. At first, Frank and Sherry thought that probate sounded reasonable, but when they learned of the time and expense, they were uneasy. The couple wanted to avoid additional attorney fees, administrative expenses, and court costs. Frank recalled the unfortunate experience of his cousin, Bill, who received only a few thousand dollars from his parents' estate after going through a two-year probate process. Plus, the probate attorney walked away with three times more money than Bill received! Frank and Sherry wanted their money to go to their children. . . and they didn't want them to wait through a long, costly process. Not to mention that the couple was uncomfortable with their will becoming a public record, open to public view.
Frank asked Mr. Conway what other options besides probate might be available to them. He wanted to find out more about that other instrument mentioned earlier, the "trust." Mr. Conway explained that with a trust, the state can't look to the decedent (the deceased person) for their assets. This result is accomplished when a person transfers their property to a trust. Once the property is transferred, the decedent doesn't own the property anymore. . . the trust owns it. In that way, the trust "lives" even though the person dies and that's why they call it a "living trust."
Although some of their large assets would avoid the probate process because of the nature of the asset (e.g. retirement plans and insurance proceeds are not probated), the couple still had significant assets that would need to be placed in a trust to avoid the potential headaches of probate. Mr. Conway outlined two types of living trusts: an irrevocable trust and a revocable trust. Both were living trusts, but each handled the assets in different ways. Following the explanation of the irrevocable trust, Frank felt confident that this particular type wouldn't fit their situation. Once the trust was set up and funded with their assets, it could not be changed or altered in any way. If either Frank or Sherry needed to revise the trust later in life because of changed circumstances, they wouldn't be able to alter or terminate it. Despite the potential estate and gift tax advantages that Frank and Sherry might enjoy from an irrevocable trust, the couple didn't like the finality of it--they valued their flexibility more.
As they learned more about the revocable trust, the couple agreed that it was the better choice for them. Yet, they still couldn't quite grasp what exactly a trust did for their estate plan or how it worked. Mr. Conway explained that they would "grant," or sign over, their assets to the trust. But the two were uncomfortable giving up ownership of their assets. And although the trust would be named "The Frank And Sherry Millhouse Family Trust," what if something went wrong? Would they lose their belongings? Understanding their apprehension, Mr. Conway discussed how a trust was just a convention. Frank and Sherry were not necessarily "giving up" their hard-earned assets, rather, they would be "co-trustees" of the trust--each would control and manage the trust.
Mr. Conway grabbed a sheet a paper and illustrated how it worked. He drew Frank and Sherry standing side-by-side. Each had their hands full, juggling the property they owned: their house, cars, retirement plans, jewelry, and the remainder of their belongings. Instead of juggling the assets with their hands, with a trust they could load most of the assets into the back of a truck. Although the assets were now out of their hands and into the trust, the assets couldn't go anywhere without a driver. Frank and Sherry would be co-drivers of the truck. Anywhere they wanted their assets to go, they would drive them there. The assets couldn't go away by themselves, or be driven by another driver, because Frank and Sherry had the key. The only way another person could drive the truck is if the couple gave that person the key.
Mr. Conway reassured them that they were in control: the trust was private and Frank and Sherry could still buy, sell, trade, invest, and reinvest property without obtaining the consent of a third party. Even so, Sherry began getting uneasy again. What if something unforeseen happened, and one or both of them couldn't drive the truck anymore? What if one of them lost capacity, or something worse? Since they no longer "owned" their assets, would the other spouse or children be locked out of the truck? Mr. Conway explained that they would name a "successor trustee" to manage the trust in the event they are unable to manage it. The successor trustee has a special duty to hold the property in trust for the benefit of the beneficiaries, as directed by the trust.
Frank also asked what would happen if they died with additional assets, assets that were acquired after the trust was made. Mr. Conway recommended that a "pour-over" will accompany the trust; in other words, the will "pours-over" into the trust any assets that weren't formally transferred to the trust. After the long discussion, Frank and Sherry agreed that they felt satisfied with the answers to their questions. They told Mr. Conway that they were comfortable establishing a revocable living trust and now wanted to talk about avoiding unwanted taxes. Mr. Conway discussed how their estate could be subjected to significant taxes if their taxable property exceeded a maximum allowable amount designated by the government.
Before becoming alarmed by the possibility of onerous taxes, Mr. Conway eased any potential anxiety by explaining a tax-saving tool called the "annual exclusion." If Frank and Sherry gave a gift to someone (a "donee"), they would owe gift tax. However, use of the annual exclusion escapes the gift tax. If done properly, annual gifts would allow the couple to provide for their intended heirs during their life, as opposed to leaving a bequest at death. Annual giving could minimize potential estate taxes and also result in no gift tax liability on the gift itself. Frank and Sherry could give unlimited gifts to different donees. The donees could be anyone in the world. But, the gifts are limited in amount. (The annual exclusion is limited to $11,000 per donee for the year 2004.) Conway explained the annual exclusion by working out a few scenarios, as follows:
- In the year 2004, Frank and Sherry decide to provide extra income for their son, Gary. Both mom and dad each give Gary $11,000 in cash. The total gift is $22,000. The gift is exempt from potential gift tax because of the annual exclusion.
- Sherry gave Gary $22,000 worth of stock in 2003. Although Sherry gave more than the allowable $11,000 exclusion amount per donee for 2003, if Frank consents to the gift, then it is tax exempt. The couple may "split" the gift because: (1) they are married, and (2) Frank gave his consent.
- Frank and Sherry gave their daughter, Wanda, $20,000 in 2003. In 2004, they want to "gift split" $24,000 to Wanda. $2,000 of the gift in 2004 would be subject to tax. The unused exclusion amount from 2003 cannot be carried over and used in 2004. Thus, if the parents give the gift of $24,000, they will be required to file a return (IRS Form 709) and report their total gifts to the IRS for that year. The annual exclusion would be applied against the total gifts on their return.
Following a discussion of the examples above, Frank and Sherry informed Mr. Conway that they liked the idea of using the annual exclusion. It could be a potentially great tax-saving device for their estate plan. Since their taxable estate would likely exceed the maximum allowable amount designated by the government, it made sense to make gifts on a yearly basis. The couple would rather give their assets up, rather than leave them in the estate to be taxed later. Ironically, by relinquishing some of their assets, their dollars would stretch farther to benefit the children and grandchildren.
With only a few additional details to be arranged, Mr. Conway told Frank and Sherry that he would have their estate plan ready in a few days and would contact them so they could review and sign the documents. As the couple climbed into their car after the appointment, they realized the significance of the meeting. Prior to that day, confronting the "what-if" scenarios of death had been too difficult to consider. Yet, Frank's hospitalization forced the couple to face the reality that death is a certainty. They always made excuses that it was too early or too inconvenient to prepare an estate plan. Plus, their estate seemed too small to warrant such planning. After discussing their goals and consulting with Mr. Conway, the couple understood firsthand that it pays to plan ahead. Frank and Sherry felt comforted knowing that they would be taken care of financially, if unforeseen circumstances arose. The two were content to decide who would receive a share of their assets, who would manage the estate, and how they could reduce estate taxes and administrative expenses. After the couple parked on the driveway of their home, they walked toward the front door, content with the knowledge that they had planned for each other and their children.