Federal Estate and Gift Taxes - an Introduction

The federal estate and gift taxes--we sometimes call them "wealth transfer taxes"--are the reason for much of what I do for my higher net-worth clients.  These taxes have gotten a lot of attention and debate time among pundits and politicians recently, and we're going to be talking about them a lot on this blog.  This post is the first in a series on how these taxes work, and what you can do to minimize their impact on your family.

The stated policy purpose of the wealth transfer taxes is to prevent the creation of large concentrations of inherited private wealth.  The tax is therefore supposed to be paid only by "the wealthy."  There's a never-ending debate over whether this is a proper thing for the government to be taxing in the first place, and whether it's not so much a tax on dynastic wealth as it is a tax on upward mobility--but all I want to talk about on this blog is how the taxes work, and how good estate planning responds to them.

While the estate tax is imposed on any transfer at death, and the gift tax on any transfer during lifetime, the Internal Revenue Code gives you a "unified credit" which cancels out the tax on a certain amount of wealth being transferred. We usually talk about the "exemption equivalent" amount that is protected from the credit, rather than the amount of the credit, because it's easier for clients to understand.  However you want to think of it, if the wealth that you have to pass on to the next generation is less than the exemption equivalent, the federal wealth transfer taxes aren't an issue you need to worry about.  (The Ohio estate tax might be, but that's another topic for another time only if you die before January 1, 2013.)


Right now, the exemption equivalent is $5 million, but that could change in a very taxpayer-unfavorable way at the end of next year.  We'll go into why that is in a future installment.

There are a couple of other mechanisms that provide relief from the estate and gift taxes.  The policy of the current estate tax is to tax accumulated wealth once per generation, so transfers between spouses are accorded a "marital deduction" and are thereby not taxed.  Also, mostly for administrative convenience, you are allowed a certain amount of gifts each year, the "annual exclusion," which are not counted for tax purposes.  The annual exclusion is $13,000 per recipient per year, and that number is adjusted for inflation from time to time.

In our next installment, we'll talk about what gets included in an estate for estate tax purposes.

(Updated in response to the repeal of the Ohio estate tax effective 1/1/13.)

Retirement Assets Payable to an Estate

Qualified retirement assets, like traditional IRAs and 401(k)s and ESOPs and pension accounts, usually have a death beneficiary designated. This allows them to pass outside of probate. If the beneficiary is a surviving spouse, the spouse can "roll over" the assets into her own IRA and defer taking distributions until her "required beginning date."  Other individuals, or trusts which are designed to qualify as "designated beneficiaries," have to start taking distributions the following year, but they get to stretch the distributions out over their life expectancy.  This deferral is important because distributions out of an IRA or other retirement account are taxed as ordinary income for the year you receive them, and assets that aren't distributed yet continue to grow tax-free.

So what happens if the account owner didn't designate a death beneficiary? This happened in an estate I'm just finishing up. The decedent was a relatively young gentleman who never got around to doing any estate planning--no will, no death beneficiary designations--"no nothin'," as they sometimes say. Because there was no death beneficiary on his pension account, it became payable to his estate by default.

He had two heirs who each got a 50% share of the estate. Due to the peculiarities of how qualified plan distributions work, the pension trustee could not make distribution straight to the heirs.  The estate had to first open an IRA account. The pension plan made a "direct transfer" to the estate IRA.  The heirs each opened an individual IRA, and the estate immediately transferred the assets in equal shares to their accounts. 

Because the pension plan did not have a "designated beneficiary," the heirs are required to take distribution of the IRA within five years.  This isn't as good as taking it out over one's life expectancy, but at least they can get some deferral.

Probate and How to Avoid It

Many clients come to me wanting, among other things, to "avoid probate"--that is, to avoid having assets in their estate administered in the probate court.  There are several reasons why you might want to do this:

• Privacy is the biggest reason: anything that gets filed in probate court, including an inventory or account showing the value of assets, is part of the public record and accessible to everyone.
• In Ohio, where I practice, assets in a probate estate are subject to the claims of creditors of the deceased, while most non-probate assets are not.  This is not true in some other states.
• Probate administration is a slow-moving process, and keeping assets out of probate often permits them to be distributed faster.  This is not necessarily true in large estates, where the preparation, filing, and possible auditing of the federal estate tax return is usually the most important factor determining the speed of distribution.

So how do you tell if something is going to go through probate, or avoid probate?  If an asset is in your name individually and does not pass to someone other than your estate at death by contract or operation of law, it’s a probate asset.  If any asset you don't own directly passes to your estate at death, it’s a probate asset.  Anything else is not a probate asset.  For example:

• Things you've given away before you die are not probate assets because, well duh!, you no longer own them at death.
• Property in a revocable trust is owned by the trustee, and not by you individually.  Even if you are serving as your own trustee, you hold the trust property in a fiduciary, not individual, capacity.  So long as the trust document tells us what to do with the property when you die, the trust will not be a probate asset.
• What you have saved in a retirement plan account or IRA is technically owned by the plan trustee or IRA custodian in trust for your benefit.  Like the revocable trust corpus, it will not be a probate asset so long as you've named a beneficiary.
• If you have insurance on your life, it doesn't matter whether you own the policy or someone else does--so long as you've designated a death beneficiary, the proceeds will not go through probate.
• Real estate held in a joint & survivor or survivorship tenancy, or for which you've designated a transfer-on-death beneficiary, does not go through probate because title passes by operation of law at your death.
• Securities or bank accounts titled “joint & survivor” or which have transfer-on-death beneficiary designations, do not go through probate either, though in this instance it's because title passes by contract (the account agreement with whatever institution you're dealing with) rather than operation of law.
• Property interests which terminate at death do not become part of the probate estate because the property no longer exists.  Examples of this would be an old-style pension that pays you an annuity for life, but has no death benefit.

Intestate Succession

What happens if someone dies "intestate"--that is, without having made a will?  Who gets their property?

The answer is provided by something called the "statute of descent and distribution."  This law tells us what to do with a deceased person's property. It's the legislature's attempt to guess what the deceased would have wanted if he or she had been asked the question or had bothered to tell us, and it's not an unreasonable guess in most instances. The people who take under the statute of descent and distribution are known as "heirs at law" or, in some situations, "next of kin."

We'll take a look at how one such statute works after the jump.

What is a Trust?

Trusts are a common estate planning device, but many people (including a few lawyers!) don't completely understand what one is.  We’ll start the discussion with a definition of a trust that I've used in several CLE presentations I've given:

A trust is a relationship created by a grantor who transfers legal title to property (known as the trust corpus or trust principal) to a trustee, who holds it as a fiduciary for the benefit of one or more beneficiaries.   The beneficiaries’ rights of enjoyment are set forth in the terms of the trust, which are usually contained in a governing document (which may be called a “Declaration of Trust” or “Trust Agreement” or a “Declaration and Agreement of Trust” or sometimes just a “Trust.”)

There are several important concepts contained in that definition: 

• A trust is a fiduciary relationship between the trustee and the beneficiaries, not a separate legal entity (person) like a corporation or LLC. 
• Since the trust is a relationship and not an entity, legal title to the trust corpus is held by the trustee.  While we often casually speak about "the trust" doing something (conveying property, making a distribution, or so on) as if it were an entity, it's actually the trustee who is the actor.
• Since the trustee is a fiduciary for the beneficiaries, it naturally follows that beneficiaries are the persons with standing to enforce the terms of the trust—that is, they’re the ones who sue the trustee when the trustee fails to follow the terms of the trust.

The terms of a trust do not need to be written down in order for there to be a valid trust,  but they usually will be found in a governing document.  At the minimum, a trust’s governing document should do all of the following:

• Clearly identify the parties to the trust: the grantor, trustee, beneficiaries, and any trust advisors.
• Indicate if the trust is revocable or irrevocable, and identify who may hold powers to amend the terms of the trust (reserved powers to amend; powers of appointment).
• Clearly set forth the dispositive (enjoyment) terms of the trust (including those circumstances where the distribution is subject to review or approval by a trust advisor or other outside party) so that the trust accomplishes the grantor’s objectives.
• Provide a mechanism for succession in the office of trustee.
• Confer powers on the trustee to permit him to efficiently manage the trust. While the dispositive provisions of every trust--who gets what, when--will be unique, basic trustee powers and other “administrivia” will not vary much from document to document.  (The Ohio Trust Code has a nearly-comprehensive set of statutory trustee powers which drafters may incorporate by reference, and most of us who practice in this area have standard language we use for nearly every trust document. Some trust companies have their own standard trustee power language which they will require in the document as a condition of accepting the trust.)
• Do all of these things with sufficient clarity that both the trustee and the beneficiary can understand what the trustee is supposed to do and who receives what without having to ask a judge to construe or interpret the document.

Fiduciary Duty

The terms "fiduciary" and "fiduciary duty" get used a lot in estate planning. The legal term "fiudciary" derives from the Latin words fides, meaning "faith", fiducia, meaning "trust," and fiduciarius, meaning "holding in trust." As a generic term, a "fiduciary" is a person who has ownership or control of property for the benefit of someone else.

A trustee owns title to the property in a trust, but holds it for the benefit of the trust's beneficiaries, not himself. We would therefore say that the trustee is a fiduciary over the trust property. While a trustee is the classic example of a fiduciary, there are others: the executor or administrator of an estate is a fiduciary with respect to the estate; a guardian is a fiduciary with respect to the property of the ward (person under guardianship); an agent under a power of attorney is a fiduciary with respect to the property of her principal; and the officers and directors of a corporation are fiduciaries with respect to the corporation's assets (which are owned by the shareholders).

If you're a fiduciary, you have a "fiduciary duty." Fiduciary duty is often described as the highest duty of loyalty in the legal system. My shorthand explanation I use with clients is that "fiduciary duty" means "it ain't your money!"  For instance, a trustee owes a "fiduciary duty" to the trust beneficiaries to manage that property for their benefit in accordance with the terms of the trust. If the trustee breaches that duty by using the trust property for his own benefit, that is a rather serious matter. The trustee will be liable to the beneficiary for damages caused, and for any profits he made, will very likely be removed by the court, and in certain situations may be hit with punitive damages, statutory penalties, and even criminal prosecution.

Trust Protectors and Trust Advisors

A "trust advisor" or "trust protector" is a person who has some official role in the administration of a trust, but is not the trustee.  In our office, we call them "advisors"; "protector" is a term that tends to be favored in Commonwealth countries.  An advisor/protector can have as much or as little control as the situation demands:

• He or she can be a pure advisor: the trustee is directed to consult with the advisor on certain matters, but is not bound by the advice given.
• The advisor can have veto power over particular actions, such as selling a business or making discretionary distributions to a beneficiary.
• The advisor can have the power to direct the trustee on certain matters.  A couple of common arrangements are to have an advisor directing the trustee in voting shares in a closely-held business, or in making insurance investments in a life insurance trust.  (Some banks and trust companies will require an advisor with authority over the selection of insurance policies as a condition of accepting a life insurance trust.)
• The advisor can have the power to remove the trustee, and/or name a successor trustee.

There can be multiple advisors, each with a particular area of responsibility.  There will also be language in the trust providing that the trustee will not be liable to the beneficiaries for any actions taken on the advice, or at the direction, of a trust advisor.

If you want to learn more about trust advisors and protectors, there is a very good short article on them at the Forbes magazine website.