This Article is written for people who know they should have an estate plan in place to protect their spouse and children in the event of their demise, and perhaps also to cover end-of-life health issues, but don’t know where to begin. We hope that by reading this Article you will gain a better understanding of what a good estate plan should consist of, and know exactly what your next steps should be.
CONTENTS OF ARTICLE
Good Estate Planning Should Start By Focusing on Your Lifetime Needs
Questions to Consider:
✔ “What will happen if I can no longer manage and protect my property?”
✔ “What will happen if I become unable to make my own health care decisions?”
Incapacity occurring at some point during your lifetime is the contingency to be planned for. If no planning has been done prior to your incapacity, by default state law will dictate the result, which is a system called Guardianship. Guardianship can include:
✔ Guardianship over your person, including health care decision-making, and/or
✔ Guardianship over your property.
Why Guardianship Should Be Avoided
✔ Guardianship is a public proceeding. Private and possibly embarrassing matters, such as evidence of your weakened mental state and related behavior, would be revealed in open court.
✔ The Court will choose your Guardian(s), not you or your family. A bank may be named as the Guardian of your property, especially if enough money is involved or if there is evidence of family disagreement. If an individual is appointed, he or she will have to post a bond and pay yearly premiums.
✔Guardians have limited authority to act. Court approval will be required before expenditures can be made for your needs. Legal costs and delays will be incurred each time Court approval is needed.
Lifetime incapacity can be addressed by the use of at least three (or perhaps all four) of the following documents, which are discussed in detail below:
I. DURABLE HEALTH CARE POWER OF ATTORNEY
II. LIVING WILL A/K/A ADVANCE HEALTH CARE DIRECTIVE
III. DURABLE POWER OF ATTORNEY FOR PROPERTY MANAGEMENT
IV. REVOCABLE LIFETIME TRUST
In the Durable Health Care Power of Attorney you can appoint one or more persons to make health care decisions for you if a health care provider would find that you are incapable of making such decisions for yourself. For example, you could authorize your health care agent to:
✔ Consent to specific types of health care treatment and medical and surgical procedures for you, or to withhold such consent.
✔ Select or discharge your health care providers, including physicians, nurses, hospitals, and nursing care facilities.
✔ Hire and dismiss other medical, social service, and support personnel.
✔ Request that the physician responsible for your care issue a do-not-resuscitate (DNR) order, if deemed necessary to carry out your wishes.
✔ Discuss with the physician or other health care professional responsible for your care, if you have an advanced chronic progressive illness or state of frailty, the level and types of medical treatment that you would want to receive or would choose to decline, and to sign a Pennsylvania Orders for Life-Sustaining Treatment (POLST) as your surrogate.
Please see our article, POLST’s Place in End-of-Life Planning: Turning Wishes into Action for more information.
Nutrition and Hydration
How do you want to instruct your agent regarding nutrition (food) and hydration (water)? Do you want to be provided with food and water under all circumstances? What if food and water can only be provided by some artificial or invasive means (e.g., a gastric feeding tube surgically implanted in your stomach or intestines, or through a tube inserted into your nose, arteries, or veins) — would that affect your agent’s decision?
To guide your agent in this decision-making process, you could choose to direct them to first consult with your doctors and other appropriate parties.
If based on those consultations your agent determines that gastric tube feeding or some other artificial or invasive method would be excessively burdensome to you or disproportionate compared with the expected benefits of such measures, you could instruct your agent that you would then want such artificial or invasive measures to be withheld or withdrawn.
The Living Will (also known as an Advance Health Care Directive) will be triggered in case you are later found to be in an end-stage medical condition or a state of permanent unconsciousness. You can state in advance your intentions as to what specific kinds of life-sustaining medical treatment you want withheld or withdrawn if either event occurs.
Examples of life-sustaining treatment that you could decline include:
✔ Heart-lung resuscitation (CPR),
✔ Mechanical ventilator (breathing machine),
✔ Dialysis (kidney machine),
✔ Radiation treatment, or
By the same token, you could express your wish to be given medication that would provide comfort and relieve pain.
What About Nutrition and Hydration?
If you would have an incurable and irreversible medical condition that will result in death, should nutrition (food) and hydration (water) be withheld or withdrawn from you? Do you consider food and water simply as additional kinds of treatment that can be discontinued along with the other examples listed above, or do they represent essential care that as a matter of human dignity you should never be denied?
Likewise, in your Living Will you can indicate if you want Alzheimer’s disease or some other form of advanced-stage dementia to be included in the definition of an “end-stage medical condition” for purposes of triggering your Living Will.
Under Pennsylvania law, if you do not so indicate, a diagnosis of advanced-stage dementia or Alzheimer’s disease will not be enough to make your Living Will operative.
If properly drafted, your instructions in your health-care document will be binding on your doctors and other health care providers. But to ensure this result, you should give a copy of your health-care document to your primary care physician for inclusion in your medical record.
NOTE: For more information on this topic, see the Article on Health Care Powers of Attorney and Advance Directives on this web site.
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In a Durable Power of Attorney you (referred to as the “principal”) can delegate to one or more persons (who are called “agents”) the power to manage your property for your benefit if you later become unable to do so yourself. You can name two or more agents to serve consecutively or concurrently.
When Does the Durable Power of Attorney Become Effective?
● Upon Signing. You can make your Durable Power of Attorney effective as soon as you sign it, with your agents able to act when they sign a written acknowledgment accepting their duties. In this case, to prevent your agent from using the document prematurely without your knowledge, the document could be held for safekeeping by your attorney or other trusted third party, with the understanding that it would not be released until you became incompetent, as certified to by your physician.
● Upon Incompetency. Alternatively, the Durable Power of Attorney itself could state that the agent’s powers would not become effective until and unless there was a finding of incompetency made by a physician. The downside with this approach is that satisfying the precondition of incompetency will likely take some time, which could be harmful if quick action would be necessary in a particular matter.
What Are the Duties of an Agent under a Durable Power of Attorney?
While agents are given extensive powers over the principal’s property, they also have several duties that they must perform on the principal’s behalf.
Mandatory Duties of Agent
Agents are required to:
✔ Act in accordance with the principal’s reasonable expectations, to the extent the agent actually knows them; otherwise, to act in the principal’s best interest.
✔ Act in good faith, which means to act honestly.
✔ Act only within the limits of the authority granted in the power of attorney.
Defining Your “Reasonable Expectations” and “Best Interest”
The purpose of the reasonable expectations standard is to ensure that the actions taken by your agent will most likely be the same actions you would have taken were you able to do so. For example, your agent should be directed to use the reasonable expectations standard when considering whether or not to sell your current residence; to increase or decrease the amount spent on your maintenance and support by more than a minimal amount; to change the composition of your investment assets; to make gifts of your assets to family members or other third parties; and generally to take any action regarding your property or financial affairs that is more than purely ministerial in nature or what the agent would be required to do in any event.
How can your agent know what you would want done on a particular issue? First, you could state that you expect your agent to discuss a proposed action with you personally, if and to the extent that you are able to understand the risks and benefits of such action. Your agent would then carry out the directions and preferences you would communicate at that time.
If a physician would find that you are incapable of understanding such risks and benefits, or of effectively communicating your choices and preferences, your agent would be excused from consulting with you, but in that case you would direct him or her to consider any credible evidence of your prior written or oral instructions, directions, and preferences that pertain to the proposed action, including those found in the Power of Attorney itself. As part of this process, you could authorize your agent to consult with your family members, professional advisors, and other persons with whom you may have had discussions relevant to the proposed action, to determine whether any of them can provide such evidence. Your agent should then decide what if any action to take based on your directions and preferences as are manifest from such evidence.
If after following the process described above your agents do not know enough about your choices and preferences on which to base an action, they would then decide on what if any action to take based on what they do know of your choices and preferences, as well as their own good faith judgment as to what action, if any, would be in your best interest. “Best interest” could refer to a general rule that your agents invest and manage your property so that there will always be sufficient funds available with which to pay the estimated costs of your maintenance, support, and health care for the expected duration of your life.
Other Duties of Agent
Among the other duties of agents that can be modified or eliminated in the Power of Attorney include the duty to:
✔ Act so as not to create a conflict of interest that impairs the agent’s ability to act impartially in your best interest.
✔ Keep a record of all receipts, disbursements, and transactions made on behalf of the principal, and to disclose such records to you and anyone else you may authorize.
✔ Cooperate with a person who has authority to make health-care decisions for the principal to carry out the principal’s reasonable expectations to the extent actually known by the agent and, otherwise, act in the principal’s best interest.
✔ Attempt to preserve the principal’s estate plan, to the extent known by the agent, if preserving the plan is consistent with the principal’s best interest.
What Are the Powers of an Agent under a Durable Power of Attorney?
In a general Durable Power of Attorney, you give your agent the authority to take all actions regarding your property and financial affairs as fully and effectively as you could do yourself. Among the specific powers typically granted the agent are to engage in:
✔ Banking and financial transactions, including the power to write checks on your accounts to pay your bills
✔ Real property transactions, including maintaining and, if necessary, selling your residence
✔ Stock, bond and other securities transactions
✔ Insurance and retirement plan transactions
In addition, you can authorize your agent to:
✔ Enter your safe deposit boxes
✔ Change the beneficiary designations on your life insurance policies and retirement accounts, but only if necessary to make such designations consistent with your underlying estate plan
✔ Receive government benefits (Social Security has its own procedures whereby another person — called a “representative payee” — can receive a recipient’s Social Security checks.)
✔ Pursue tax matters, including having your principal’s income tax returns prepared and filed.
Should Your Agent Be Authorized to Make Gifts of Your Property? How Should Gifts Be Limited?
The basic duty of the agent is to protect and conserve your property for your benefit. However, you can also authorize your agent to make limited gifts of your assets during your lifetime. This gifting power can help reduce potential death taxes, and accelerate your eligibility for Medicaid.
Limitations on Gifting Power
Limitation on Donees
To avoid abuse of the gifting power, you could limit the potential recipients of gifts to only those persons whom you yourself have named in your will to receive your property after your death (e.g., spouse, children, and grandchildren). If your agent is a member of this group, you could prohibit him or her from making gifts solely or disproportionately to himself or herself or his or her immediate family members.
Limitation on Amounts
Gifts intended for tax-saving purposes can be limited to the federal gift tax annual exclusion amount (for 2018, $15,000 per donee) or to the Pennsylvania inheritance tax exemption amount for lifetime gifts.
NOTE: Since the federal estate tax exemption will temporarily be well in excess of $11 million (in 2026 it will return to $5 million), the need to make lifetime gifts to reduce federal estate taxes at death, at least in the near future, has been substantially reduced — if not eliminated — for many families.
Compensation of Agent
Pennsylvania law provides that in the absence of a specific provision to the contrary appearing in the power of attorney, an agent is entitled to reasonable compensation based upon the actual responsibilities assumed and performed.
Preventing Financial Abuse by Agents
To better ensure that the powers you give your agents in your Durable Power of Attorney will not be abused to your detriment, consider including the following provisions in the document:
Name Two Agents to Serve Together
A “checks-and-balances” approach (e.g., requiring two signatures for check-writing) will reduce the risk of self-dealing, which can arise when only one agent has control over your funds.
Require Your Agents to Disclose Record of Transactions
Direct your agents to provide you (and anyone else whom you may designate if you later become incapacitated) with a record of the transactions (receipts, disbursements, sales) they’ve engaged in on your behalf. Disclosure could be required at fixed intervals (e.g., every December 31) or upon request.
Pennsylvania law requires every agent to keep a full and accurate record of all “actions, receipts and disbursements” made on behalf of the principal. Why not then have your agent disclose these records on an as-needed basis?
The Revocable Lifetime Trust serves a twofold purpose: During your lifetime it the most effective way to have your property managed and applied for your benefit, if you become unable to do so yourself; at death, it will allow the trust assets to pass directly to your beneficiaries, thus avoiding the transfer costs of probate.
A trust is a “three corner” legal arrangement whereby you (either by yourself or jointly with your spouse) as settlor transfer property to a trustee to hold and distribute for the use of a beneficiary. With a Revocable Lifetime Trust, you can start out playing all three roles, being not only the settlor, but also the sole trustee and beneficiary of your own trust. But in that case you would also name one or more backup trustees to step in if you later become unable to manage your financial affairs, as would be determined by your own physician.
With a Revocable Lifetime Trust you select all of its terms. You define the appropriate standards for the trustee to consider when deciding on making distributions of trust property to you or for your benefit.
For example, you could direct the trustee to make discretionary distributions as needed to provide for your health, support, and maintenance in the style of life to which you have become accustomed.
Choice of Trustees
You can choose who will be your backup trustee(s) if you later cease to serve. It is important to name trustees who will have both the time and the talent to do a good job for you. Many options and combinations are available when choosing backup trustees.
✔ You could appoint your spouse and then one or more of your children to serve concurrently or consecutively.
✔ Likewise, a local trust company could be named as backup trustee.
✔ Or you could appoint both an individual and a trust company to serve together as co-trustees.
✔ Another option would be to appoint an individual to serve as sole trustee, but require that he or she hire a professional money manager to invest the trust assets, to ensure the prudent management of the assets.
Do I Need Both a Financial Durable Power of Attorney and a Revocable Lifetime Trust?
The simple answer is “not necessarily.” Between the two, the Financial Durable Power of Attorney is the more essential document that every adult should have. At a minimum it will avoid a court-supervised guardianship and allow for the protection of your assets in the event of incapacity.
Choosing to create a Revocable Lifetime Trust will depend on several factors, including the type of assets you have, your age, whether you own real estate in other states, etc.
As a general rule, the Revocable Lifetime Trust is ideally suited for someone with investment assets (apart from retirement accounts) or parcels of real estate located in more than one state.
Comparing the Financial Durable Power of Attorney and the Revocable Lifetime Trust
While both techniques share some characteristics, such as using another person or entity to act as a fiduciary on your behalf in the event of lifetime incapacity, there are also important differences.
✔ The Revocable Lifetime Trust is distribution-focused, i.e., its primary purpose is to ensure that funds will be paid out as needed to take care of your living expenses and health needs. The Trustee must act in a pro-active, affirmative manner to make sure that the Trust property is prudently invested and your needs are provided for.
✔ By contrast, the Durable Power of Attorney is more directed at preserving and safeguarding assets. The agent is usually under no affirmative duty to consider your needs or to pay out any funds for your care.
Third Party Treatment. Banks, investment firms, and other third parties tend to honor the Trustee’s authority much more readily than they do an agent’s, especially if the principal did not use the firm’s own preprinted power of attorney form.
BUT — these differences are not meant to suggest that it’s an “either/or” choice between the two. Ideally the Revocable Lifetime Trust should work together with the Durable Power of Attorney.
For example, you do not have to transfer all of your assets, including your residence and tangible assets, to your Trust when it is created. You could initially fund the Trust with just your investment assets, such as mutual funds, stocks, and bonds. You (or your agent, if you later become disabled) could continue funding your Trust over time as your other assets are sold and converted to cash.
In any event, the trustee’s powers by definition will be limited only to property that has been titled in the Trust’s name. The Trust thus cannot hope to solve issues arising from your other business and financial affairs, such as dealing with retirement accounts, Social Security payments, or filing your personal income tax returns, if you are not able to handle any of these matters.
However, an agent with the proper authority under a Durable Power of Attorney could handle these matters.
Is Joint Ownership an Alternative?
Adding the name of a child or other family member to your bank accounts or other assets, to make them joint owners with right of survivorship, is not a solution to the problem of lifetime incapacity, especially when compared to the advantages offered by the Durable Power of Attorney and Revocable Lifetime Trust.
Exclusively Death-Time Focus
Joint ownership with right of survivorship is focused solely on how title will pass at the first owner’s death. Survivorship assets will pass outside probate and may possibly reduce Pennsylvania inheritance tax.
However, the survivorship feature may unintentionally violate the terms of your estate plan. For example, a parent’s will may provide that all assets are to pass to all the surviving children share and share alike. But an asset that is held in joint names by the parent and only one child will result in that asset passing directly — and exclusively — to that one child, and not under the will, so that the other children will receive no part of it.
No Benefit During Lifetime
Joint ownership will be of no help to you in the event of your lifetime incapacity, since the other joint owner will have no duty to use the account to provide for your needs, and actually will have no incentive to do so, since funds retained in the account will pass to that owner at your death.
Joint Account “Nightmare”
Even worse, if your child or other person whose name has been added to a joint asset should predecease you, you will be forced to pay Pennsylvania inheritance tax on his or her share of the asset, in effect paying a death tax on part of your own property!
DON’T WAIT TOO LONG TO PLAN FOR LIFETIME NEEDS
Once you lose the mental capacity to make decisions, all planning opportunities will be lost.
Questions to Consider:
■ Whom do I want to receive my property at my death?
■ What if one of my intended beneficiaries does not survive me — who then should receive his or her bequest?
■ How can I reduce the federal and state death taxes my family might have to pay?
Why Everyone Needs a Will
If you die without a valid will, state law will dictate who will — and who will not — take your property, and who will have the right to administer your estate.
Without a will, your property will pass outright to your “heirs,” who will be defined by state law, in pre-determined shares. If an heir is a minor or incapacitated at that time, the Court will impose a guardianship over his or her property.
Death taxes and estate expenses cannot be minimized.
Advantages to Having a Will
■ You can choose who will wind up your affairs after your death.
■ You can make gifts of specific assets (e.g., jewelry or family heirlooms) to named individuals.
■ You can name both primary and contingent beneficiaries to receive the residue of your estate.
■ You can create a trust to hold the property intended for a beneficiary who is a minor, or who may be eligible to receive needs-based benefits such as Medicaid or SSI.
■ You can make charitable bequests.
But Having Only a Will May Not Be Enough!
Understand which of your assets will pass under your Will, and which will not. Good planning calls for coordinating how each of your assets will pass at death, so that there will be a consistent result. Property will pass in accordance with how it is titled. For instance:
Jointly owned property with right of survivorship – passes directly to the surviving owners, not under your Will. Includes husband and wife property
Beneficiary-designation property – includes retirement accounts, annuities, and life insurance. Will pass directly to the persons you have named in the contract as beneficiaries, unless the beneficiary is your “estate.”
Contractual property. Examples are death-time benefits payable under a deferred compensation plan, or the proceeds of sale of closely-held stock under a buy-sell agreement. Will pass to the persons designated in the contract.
Solely owned property – May be all that will pass under your Will.
If property is titled in several names, but not with right of survivorship, the decedent’s fractional interest in the property will pass to his or estate, not to the surviving co-owners.
Choice of Fiduciaries
It is important to choose the right fiduciaries for your beneficiaries, including:
■ Executors — who are charged with handling the details of winding up your affairs
■ Guardians — if you are the parent of minor children, you can nominate one or more persons to have custody of your children
■ Trustees — to manage the Trusts you will providing for in your Will. (See the discussion on trusts below.)
Each of your fiduciaries should have both the TIME and TALENT to do a good job.
Special Planning Needs for a Minor, Disabled, or Elderly Beneficiary
You can establish trusts for beneficiaries such as minor children or grandchildren, elderly parents, or others who may be unable to manage their bequest.
Special planning is required for intended beneficiaries who are currently receiving (or may be eligible in the future to receive) S.S.I. or Medicaid benefits, since your bequest to them may render them ineligible for such benefits.
See Article on Special Needs Trusts for Disabled and Medicaid-Qualified Beneficiaries on this web site.
Making Lifetime and Death-Time Planning Work Together: The Unique Advantages of Revocable Lifetime Trust
The Revocable Lifetime Trust can provide that at your death any assets remaining in the Trust will pass directly to your designated beneficiaries. With these provisions, the Trust assets will avoid going through the probate process.
The Revocable Lifetime Trust and Durable Power of Attorney may authorize lifetime gifts of your property to designated family members.
A Will (called a “Pour Over Will”) is still needed, even if you have a Revocable Lifetime Trust. The Will can dispose of any assets that are not held in the Trust at your death.
Once your estate plan is completed, it is important that you have a practical and effective way of informing your chosen agents, executors, and caregivers of the details of your medical and financial situation if they should later need to step in to help you. For example, your health care agents should be able to quickly find out who your doctors and other health care providers are, as well as what medicines you are currently taking. Your agents appointed for finances and property management should be able to ascertain what assets you own and what your debts and on-going expenses may be. In the event of your death, your wishes regarding your funeral and burial should be made known without delay to those you have authorized to make those arrangements.
It will be critical for all of these persons to know where your important papers are located, since they may be asked to produce them before they will be allowed to help you.
Getting this information to your helpers will be especially important if you do not have a spouse or any adult children living close by. In that case, the persons you have chosen will probably have no idea where this information and documents may be located, and you may be harmed as a result.
At the same time, you will want to retain strict privacy and confidentiality, so that this information will be disclosed only if and when necessary, and only to the persons you have authorized to see it.
As a courtesy, we have prepared a booklet titled Information My Family Should Know that can accomplish these purposes.
We encourage you to use it for your own planning purposes. You can also provide a blank copy to your parents or older relatives and have them complete it as part of their own estate planning process.
Both federal and state taxes (as well as foreign death tax) can be imposed on the transfer of wealth during lifetime and at death. These taxes include:
Federal Estate Tax
Imposed on the transfer of property at death, as well as lifetime transfers of property where the decedent retained the use of the property, or the right to revoke the transfer, that did not end prior to death.
The tax will be payable only if and to the extent that the net value of the taxable assets exceeds the exclusion amount applicable in the year of death. For 2018 the adjusted exemption amount is expected to be $11.2 million per person, so that a married couple could shelter a combined $22.4 million. However, as of 2026 the exemptions will return to 2017 level of $5 million, as adjusted for inflation.
Pennsylvania Inheritance Tax
Imposed on both property transferred at the time of death and property transferred during life if the transferor retained one or more interests in the property, and property gifted within one year of death if the total of such gifts per donee exceeds a set exemption amount.
NOTE: This state inheritance tax is imposed separately from the federal estate tax. Unlike federal law, there is no exclusion amount applicable to Pennsylvania inheritance tax.
Federal Gift Tax
Levied on gifts made during one’s lifetime, if and to the extent that the total gifts made by the donor in any calendar year to any donee exceed an annual exclusion amount, which for gifts made in 2018 will be $15,000.
For gifts that exceed the annual exclusion amount, the gift tax on such excess can be avoided by using the same $11.2 million exclusion amount discussed above. The donor will not actually have to pay any gift tax until the total amount of his or her lifetime gifts made in all years exceeds the exclusion amount applicable in the year in which the new gift is made.
To the extent that the exclusion amount is used up during life to offset taxable gifts, it will not be available at death to reduce the estate tax.
Other State Estate Taxes
If you are domiciled in Pennsylvania but own real estate or tangible personal property (e.g., a boat or automobile) that is located in one or more other states, death taxes may be due to those states.
There will not be double taxation, because Pennsylvania cannot tax real estate or tangible personal property located outside the Commonwealth.
Federal Generation-Skipping Transfer (GST)
Tax that applies to certain transfers from grandparents to grandchildren or more remote descendants. This GST tax is in addition to the Federal Estate Tax and Federal Gift Tax. The exemption applicable to gift and estate taxes also applies to the GST tax, as well as the gift tax annual exclusion.
Foreign Death Taxes
Real estate or tangible personal property located in a foreign country may be subject to a death-time transfer tax imposed by that country. The IRS taxes all assets owned by a U.S. citizen at death, including property located in a foreign country. Depending on the country involved, the IRS may allow a credit for any taxes that are paid to the foreign nation on the same property, or will permit such taxes to be used as a deduction from the federal gross estate.
Double Taxation on Retirement Benefits and Other Income Tax-Deferred Assets
Assets that consist wholly or partially of tax-deferred income are subject to two types of taxes when they pass to beneficiaries on account of the owner’s death. Examples of such tax-deferred assets are qualified retirement accounts, annuities, and certain United States Savings Bonds.
First, there will be federal estate tax and possibly state inheritance taxes imposed on the date-of-death value of those assets. In addition, federal income tax will be payable by the recipient of the income, whether the estate or individual beneficiaries, based on the amount of tax-deferred income received in any calendar year.
Pennsylvania does not impose an income tax on distributions from retirement accounts.
EXAMPLE: Bill Lynch dies in 2018 at age 79 owning assets valued at $2.5 million. Of the total, $600,000 represents the value of his IRA account, which Bill left to two of his nephews. Bill’s estate will not owe any federal estate tax, because his total assets are less than the $11.2 million exclusion amount, but both Pennsylvania inheritance tax and federal income taxes will have to be paid on the $600,000 IRA account. The inheritance tax will be due within nine months of death. The federal income taxes can be spread out over several years, depending on how much each nephew withdraws in a given calendar year (a certain minimum amount will have to be taken each year).
Who Will Pay the Taxes?
The federal income tax on the tax-deferred income paid after death will be the responsibility of the person or entity receiving the payments. However, the responsibility for the federal estate tax and Pennsylvania inheritance tax imposed on the date-of-death value of the tax-deferred income will depend on whether or not the decedent left a Will, and if so, whether the Will contains a tax apportionment clause.
Check with your attorney as to the existence of such a clause in the will, and what its effect may be.
What Property Is Subject to Wealth Transfer Taxes?
The definition of “gross estate” for wealth transfer tax purposes is much broader than the “probate property” that passes under a person’s will. The gross estate includes not only all property that the decedent owned or controlled at the time of death, but also any property the title to which the decedent had transferred during life but still retained the use and enjoyment of it until death, or the right to revoke the transfer. For example,
➤ Revocable Lifetime Trust
Property held in the typical revocable trust created by a settlor for his or her benefit during lifetime as a probate-avoidance technique is includable in the settlor’s gross estate for tax purposes, both because the settlor was the beneficiary of the trust until death but also because he or she never gave up the right to revoke the trust and recover back the trust property.
➤ Retained Interest in Residence
Likewise, if a parent during his or her lifetime transfers the title to his or her residence by deed to the children, but continues to reside in the home until death, the parent’s retained use and possession will cause the residence to be includable in his or her gross estate at its date-of-death value.
To avoid that result, after the transfer of title the parent could enter into a bona fides lease arrangement with the children, where the parent as tenant would pay fair-market rent to the children as owners-lessors for the entire period that the parent would reside there.
It is essential that the rent charged be able to pass the “fair-market rent” test, i.e., the rent paid by the parent should be equal to the rents being paid for comparable homes in the same vicinity. Moreover, the rental amount should be periodically reviewed and adjusted as necessary to keep it current with changes in market conditions. The best evidence of fair-market rent would be the written opinion given by a local real estate rental company based on its knowledge 0f the rental market.
WHAT NOT TO DO: Do not simply have the parent pay the property’s real estate taxes and homeowners’ insurance premiums and call that “rent.”
In all events, be forewarned that the IRS and Pennsylvania Department of Revenue will likely challenge an attempt to exclude the residence from the parent’s gross estate for estate tax and inheritance tax purposes, if the parent continued to reside there until death. The burden will be on the estate to prove both that (1) the rents being charged over the years represented fair-market value, and (2) the rents were actually paid by the parent throughout the lease term.
Lifetime Gifts and Other Tax-Saving Techniques
Estate taxes are most effectively reduced by actions taken by the property owner during his or her lifetime.
Some common lifetime tax-saving techniques include:
Annual Exclusion Gifts. Gifts made within the federal gift tax annual exclusion limit, which for 2018 will be $15,000 per donee, will not use up the individual’s unified exclusion amount ($11.2 million for 2018). The annual exclusion amount for gifts may increase in future years based on inflation.
Irrevocable life insurance trust created by the insured to own and be the beneficiary of life insurance. This technique will keep the insurance proceeds paid at the insured’s death out of the taxable estate.
Charitable Remainder Trust
Allows the tax-advantaged sale of highly appreciated real estate, stocks, or other assets.
Guarantees an income-stream to the beneficiary over either a set term of years or his or her lifetime.
At the end of the beneficiary’s interest, the remaining assets will pass to one or more charities selected by the grantor.
Charitable Lead Trust
Will reduce the taxable value of assets ultimately intended for family members by creating an initial interest in selected charities. The charities will receive a percentage of the assets for a fixed number of years, at the end of which the assets will pass to the family members.
Family Limited Partnership and Limited Liability Company
Holding business-related assets, such as rental real estate or actively managed investments, in a Family Limited Partnership or Limited Liability Company, which has a business purpose, can result in the reduction in the valuation of such assets for gift and estate tax purposes. Discounts are allowed for restrictions placed on the transferability of ownership interests during life and at death, and if the asset does not represent a controlling interest in the business.
Grantor Retained Income Trust, Annuity Trust, or Unitrust
This technique involves the owner making an irrevocable transfer of property to a trust but retaining the right to receive the income or a fixed or variable annuity payment from the trust over a set term of years, at which time the remainder interest takes effect for the benefit of others. If the owner survives to the end of the term, the trust assets will not be included in his or her taxable estate at death. A gift tax will be triggered by the initial transfer to the trust, but it will be imposed only on the value of the remainder interest. Thus a possibly significant portion of the asset’s total value can escape any gift or estate tax.
Death-Time Tax-Saving Techniques
Portability of First Spouse’s Unused Exclusion Amount to the Surviving Spouse
Federal law now provides married taxpayers with a simple path to full use of both spouses’ exclusion amounts. When the first spouse dies, his or her estate must file a federal estate tax return on which the executor calculates the unused amount of that spouse’s exclusion amount and elects to have that amount carried over to the surviving spouse. The surviving spouse’s estate then can use such unused amount, plus the surviving spouse’s own exclusion amount, to reduce the size of the taxable estate at the surviving spouse’s estate.
This “portability” rule eliminates the need for spouses to unwind jointly owned property as part of the estate planning process in an attempt to ensure that each will own assets equal to the exemption amount (since the order of deaths cannot be known in advance). Now they can continue to own their property jointly if they wish.
Portability Not Automatic. One important caveat to portability is that the surviving spouse’s estate’s use of the first spouse’s unused exclusion amount will not be automatic. To have the unused exclusion amount available at the surviving spouse’s death, the executor of the first spouse’s estate must have filed a Federal Estate Tax Return in which the unused exclusion amount was computed and an election made; otherwise, such amount will not be useable by the surviving spouse’s estate. In addition, the return must have been timely filed (the filing deadline is usually nine months after death).
Thus, planning for the use of the unused exclusion amount must be done at the first spouse’s death. If not done then, it will be too late to claim the unused exclusion amount at the surviving spouse’s death.
EXAMPLE: Peter and his wife, Barbara, together own property valued at $14 million, of which Peter owns $1 million in his sole name, with the balance owned jointly. In his will Peter makes a bequest of $500,000 to his daughter from a prior marriage, but leaves everything else to Barbara. Assuming that Peter would die first in 2018, his executor would file a federal estate tax return in which a marital deduction of $13.5 million would be claimed for all the assets passing to Barbara. The $500,000 bequest to the daughter would be taxable, but would be offset by the (presumed) $11.2 million exclusion available to Peter’s estate. On the federal estate tax return, Peter’s executor would calculate that the amount of Peter’s unused exclusion amount is $10.7 million ($11.2 million less $500,000) and elect that this amount could be used at Barbara’s death. Assuming that Barbara’s assets at death would have grown to $17 million, her executor could first apply the unused $10.7 million exclusion carried over (“ported”) from Peter’s estate, and would then need to use $6.3 million of Barbara’s exclusion amount to reduce her taxable estate to zero.
Tax Reasons for Not Using Portability
An essential issue to consider when planning for married couples is to decide whether their assets are now (or are likely to become) large enough to suggest that they go beyond the simple “all to my spouse” type of estate plan, and engage in more sophisticated planning.
For married couples whose combined assets will be in excess of the federal estate tax exclusion amount, good planning should involve the utilization of the federal estate tax exclusion amount of the first spouse to die.
One way of accomplishing that is to use the “Disclaimer Trust” approach for allowing the surviving spouse’s “credit shelter” trust to be created and funded after the first spouse’s death. This technique affords maximum flexibility in choosing how much, if any, of the assets should be placed into trust for the surviving spouse.
Charitable Remainder and Lead Trusts
Same rules as with lifetime charitable trusts.
➤ Go over the appropriate Questionnaire based on your marital status
➤ List the assets that you presently own, including their current values
➤ Double-check the beneficiary designations on your life insurance policies and retirement accounts.
➤ Think about whom you would want to manage your assets, or make health care decisions, if you cannot do so (and if you are married, if your spouse cannot serve in that role)
➤ If you have minor children, discuss with your spouse whom you would want to name as their guardians if something would happen to both of you, and whom you would entrust with your property to hold in trust and use it to provide for your children
➤ Schedule a meeting with Martin to discuss your goals and objectives and finalize the plan, which he will implement for you