Reviewing And Analyzing Your Client's Estate Documents, A CPA’s Perspective
By Ronald A. Friedman, CPA, CFP
August 22, 2008 | Download Full Article PDF
Introduction
A client recently informed me his step-father was seriously ill and asked if I would review his mother and step-father’s estate documents to make sure all was in order. His mother and stepfather had engaged an attorney to execute trusts and pour-over wills about ten years earlier.
In reviewing these documents, I quickly discovered that instead of one the attorney had executed two wills for his step-father with conflicting depository provisions. Each of the step-father’s wills were signed and notarized on the same date, but up to this point no one had noticed that the wills were different. To further complicate matters, the attorney had made the same mistake with the mother’s wills. Needless to say (unless one is planning on dying more than once), an individual should only have one will. This was a second marriage for both spouses, each having children from prior marriages. The wills contained differing provisions as to which children would receive the bequests. The wills differed also in that they each named different executors. Left unattended, these documents would very likely result in a legal and emotional family disaster. Thankfully, we caught the error in time to rectify the problem. I would like to say situations like this are rare, but in fact they are all too common. All too often these problems are not discovered until after the death of a spouse when options are significantly limited.
With the aging of our population, most financial professionals can expect to encounter similar situations with increasing frequency. And, as this example clearly illustrates, all the members of an individual’s professional financial team must develop the skills necessary to review and analyze a client's estate documents with an emphasis on assessing their practical real life implications and communicating these issues in a meaningful way to the client. The ability to explain these often complex issues in a highly charged emotional environment is, for many of us, one of the most difficult skills to acquire. With this in mind, the following article includes a discussion on how to prepare and utilize flow-charts and document summary outlines (and the like) to aid in communication.
Every member of the client’s financial team needs to develop these skills as each provides an integral facet of the client’s overall financial planning needs. And each approaches the client from a slightly different perspective. The author is a CPA with a specialized practice involving estate, gift and fiduciary engagements. Thus, this article is written from the perspective of the CPA. However, these issues are pertinent to all other financial professionals.
Estate documents may be quite numerous, complex and varied. This article focuses on documents most commonly encountered in practice including wills, trusts, beneficiary designations, deeds and investment account titles. Each of these documents contain numerous provisions, many beyond the scope of this article. However, in practice the reader can expect to regularly encounter certain critical provisions within these documents.
A few of the more complex provisions addressed will include analyzing and understanding marital deduction formulas, trustee provisions and estate tax and expense allocation.
Provisions in estate documents directly impact many other items including the following:
- Preparation of estate tax returns
- Preparation of fiduciary income tax returns
- Preparation of individual income tax
returns - Preparation of fiduciary accounting
- Proper allocation to sub-trusts after death of
client. - Beneficiary allocation
- Allocation of Generation Skipping Tax
(GST) exemption - Allocation of expenses and taxes, I.E. which beneficiaries bear the burden of these costs.
- Postmortem estate tax planning
Client Service Opportunity
Once an attorney completes and executes a client’s estate documents, he may not see that client again for many years. Conversely, a CPA usually meets with his clients at least once a year and often much more frequently. Thus, the CPA is in an excellent position to offer and provide very valuable services relating to estate planning and administration, including the following:
A. Obtaining copies of all estate documents to be reviewed and maintained in client’s permanent files.
B. Review, understand and translate. Prepare flowcharts, summaries etc. Help client to understand documents.
C. Recognize when changing circumstances necessitate changes in these estate documents and assist attorney with changes.
D. Confirm that deeds, titles, designated beneficiaries and EINs have been correctly changed in accordance with the trust documents. Much of this process can be done in conjunction with preparation of the tax returns since the CPA will have received 1099s, investment statements, escrow statements etc.
E. After death of client, complete necessary estate administration and compliance.
An estate document review may take place during the planning stages while the client is still alive or during the compliance stages after death. During the planning stages, we should illustrate and discuss the estate document provisions with the client. It is important that our clients have a clear understanding of what these documents actually say. Preparing estate tax projections and flowcharts is often an effective approach. It is at this point that modifications can still be made by the client’s attorney.
During the compliance stages (after the client dies), each member of the financial team needs to acquire a clear understanding of the estate documents in order to correctly prepare the Estate Tax Return (Form 706), Fiduciary Income Tax Returns (Forms 1041), Individual Income Tax Return (Form 1040) and to prepare a proposed sub-trust allocation and follow through with implementation of the allocation.
Will
A Will in its simplest form says who gets my assets when I die and who is in charge of making sure the assets get distributed in accordance with my wishes. The person in charge is called the executor. The will normally names one or more executors and includes instructions for successor executors if the named executors are unable to serve.
In larger estates, a trust document is commonly executed in tandem with a “Pour-Over Will”. A Pour-Over Will simply instructs the executor to transfer assets to the trust that have not already been so. If the planning has been done correctly, most assets should have already been transferred to the trust so the will should have little purpose other than to act as a catch-all. However, assets not transferred to the trust prior to the death will probably require a probate proceeding to get them into the trust, defeating one of the primary benefits of having a trust in the first place.
Many wills include provisions which address the allocation of estate tax and expenses. A pour-over will often defers to the trust provisions. Caution: sometimes there will be a conflict between the allocation provisions in the Will and the Trust, requiring careful analysis.
Caution: In many states Wills and trusts executed prior to marriage have no validity after a client remarries. These documents must be updated after remarriage or the client will be treated as if he or she died intestate. 1
Deeds and Titles
We often encounter situations where a client executes an elaborate trust and fails to fund it properly. Follow through is crucial. A trust is rendered useless unless and until assets are transferred into it. This process includes the following:
Record quitclaim deeds for real estate
Change title on brokerage accounts and
bank accountsChange title for interests in partnerships,
LLCs, corporations, etc.In some cases, change designated beneficiaries for life insurance policies, IRAs and pension plans (addressed more fully below).
Remember, the Trust has no control of assets unless they are actually in the trust. Thus, it is crucial during the planning process to confirm all assets have been properly transferred.
Joint Tenancy With Right Of Survivorship (JTWROS)
Assets do not always have to be in a trust to avoid probate. For example, an asset can be held as JTWROS or can have a designated beneficiary. JTWROS is probably the most common form of ownership among married couples because it is simple and can avoid probate without the need for a trust. (Caution: for most lenders JTWROS is the default title but it may not always be the best choice as discussed below). When the first spouse dies, property transfers automatically to the surviving spouse. No probate is required. However, in larger estates this form of ownership is not without its problems.
Beware: property held as JTWROS is controlled neither by will nor by trust. So any special provisions in either of these documents will not apply, often leading to some unexpected consequences. More importantly, although probate is avoided when the first spouse dies, it is not avoided when the second spouse dies. Here is a typical scenario:
John and Mary Jones own a home in La Jolla, CA with a cost basis of $1,000,000 and a fair market value of $3,000,000 held as JTWROS. John dies and the house automatically is transferred to Mary. Mary dies one year later. Since the house is now held by her individually, it must go through probate. Total probate fees in California on $3,000,000 would be about $86,000.
Property held as JTWROS creates some interesting income tax issues for residents of community property states. If property is deemed to be the community property of a married couple and the first spouse dies, the property gets a step-up in basis for both the decedent’s and the survivor’s share of community property.2 However, for purposes of this rule, property held as JTWROS is not generally deemed to be community property. Consequently, when property is held as JTWROS and the first spouse dies, the property gets a step-up in basis only for the decedent’s one-half joint interest.
Thus, in our example above, when John dies Mary’s cost basis would be $2,000,000. Conversely, if the property were deemed to be community property Mary’s cost basis would be $3,000,000.
Community Property With Right Of Survivorship (CPWROS)
Several years ago, California created a new way for married couples to hold property called Community Property With Right Of Survivorship (CPWROS). Similar to JTWROS, when the first spouse dies, property transfers automatically to the surviving spouse. No probate is required. However unlike JTWROS, property held as CPWROS is deemed to be community property and therefore when the first spouse dies the property gets a step-up in basis for both the decedent’s and the survivor’s share of community property. (Caution: probate may still be required on the death of the surviving spouse).
Community Property Agreement
A third alternative is for the married couple to execute a separately signed Community Property Agreement. This agreement says that both spouses agree to treat their assets as community property regardless of title, and that property is held in JTWROS for convenience purposes only. Beware, a Community Property Agreement may have unintended and unexpected consequences in the event of a divorce!
Designated Beneficiary
Another classification of assets that may avoid probate without being in a trust are those containing provisions for naming a designated beneficiary including: life insurance policies, annuities, IRAs and qualified employee pension plans. Typically, a trust is neither the owner nor the beneficiary. Generally it is best to name an individual or individuals as primary beneficiary and perhaps the trust as contingent beneficiary. Caution: generally, one should avoid naming a trust as beneficiary of a retirement plan. This could severely limit the ability to defer distributions unless the trust contains special language to avoid this problem.
Caution: the client’s surviving spouse is always deemed to be designated beneficiary of a qualified employee pension plan covered by ERISA (regardless of beneficiary designation to the contrary) unless the surviving spouse has signed a waiver.
Trusts
Trusts are as complex and varied as the individuals for whom they are created. This article is written with the assumption the reader has basic knowledge of the fundamentals of trust and estate law, and will focus on those provisions that have the most impact in practice. Keep in mind that volumes have been written on this subject. Thus, the following is a cursory discussion of a number of the provisions most pertinent to the reader.
Near the very beginning of most trusts are provisions identifying the trustors, trustees and successor trustees. The trustor is simply the individual contributing assets to the trust. The trustee is the individual or entity having the fiduciary responsibility to manage the trust assets. The successor trustee is the individual or entity to be appointed when the original trustee is unwilling or unable to serve. Needless to say, it is important to clearly identify the acting trustee since the trustee is the individual or entity that has the power to engage your services.
Many trusts instruct the trustee to make specific bequests. For example, “I leave all my jewelry and art collection to my sister Marcie Carcie.”
There is usually a provision dealing with the allocation of estate tax and expenses. This very important provision determines which beneficiaries are responsible for or bear the burden of paying the expenses and taxes.
Sometime a trust will leave assets to a charitable organization. This bequest can be of a specific amount or of a percentage of the estate. It is important to determine if the bequest is to be made before expenses and taxes or net of these. When the charitable organization bears part of the burden of the taxes and or expenses, the practitioner must do an interrelated calculation to compute the correct charitable deduction.
After the specific bequests are made, and taxes and expenses are paid, the remaining assets are typically allocated to a number of sub-trusts. (Discussed more fully below).
Is the trustee required to prepare and distribute a fiduciary accounting? This question should be answered in the trust. Note the trustee is required to prepare a fiduciary accounting unless the trust specifically waives the requirement. If the trust is silent an accounting must be prepared unless all of the beneficiaries agree to a waiver.
Sub-Trust Allocation
One of the most common situations we encounter in our practice involves a married couple where one of the spouses has just passed away. The couple often have a trust and pour-over will and the surviving spouse is the successor trustee. In this situation we must find the trust provisions that instruct the trustee how to allocate the assets. Typically, after the specific bequests are distributed and the expenses and taxes are paid, the remaining corpus will be divided into two or more sub-trusts. In our practice, we typically see divisions into from three to six sub-trusts. The trust provisions dealing with sub-trust allocation are among the most critical and complex. Generally, this sub-trust allocation serves four purposes:
To utilize the unlimited marital deduction to transfer assets to the surviving spouse free of current estate tax
To utilize the exemption equivalent ($2,000,000 in 2008) and remove this amount from the estate of the surviving spouse.
To ensure the surviving spouse has enough income to live on.
To help ensure the decedent’s children receive the decedent’s assets after the surviving spouse passes away. In other words, to make it difficult for the surviving spouse to give the assets away to a new boyfriend or girlfriend.
There is no uniform protocol for naming sub-trusts in practice. Nevertheless, the sub-trusts tend to fall into one of three categories. For convenience we will use the following terminology: Survivor’s Trust, Credit Trust and Marital or QTIP Trust.
The Survivor’s Trust typically consists of the surviving spouse’s separate property and her share of community property. This trust normally remains revocable and the surviving spouse has a general power of appointment. The trust assets will be included in the estate of the surviving spouse when he or she passes away.
The Credit Trust is structured to utilize the exemption equivalent. It may be funded with a pecuniary (or dollar) amount or with the residuary. This is discussed more fully in the section on the Marital Deduction Formula. The surviving spouse may or may not have the right to trust income and or principal for an “ascertainable standard”. This trust is irrevocable and the surviving spouse has no general power of appointment over the corpus. The trust assets will not be included in the estate of the surviving spouse when he or she passes away. The transfer to the Credit Trust is reported as part of the taxable estate on line three of the decedent’s Form 706. Hence, it will not be included in the gross estate of the surviving spouse under IRC § 2044. Note the tax on $2,000,000 is $780,800 which would be completely offset by the unified credit of $780,000.
Any assets not allocated to the Survivor’s Trust or the Credit Trust will go into the Marital Trust. It may be funded with a pecuniary amount or with the residuary. The surviving spouse must have the right to receive all of the trust income and may have a right to trust principal under an ascertainable standard. The executor or trustee has the right to elect to treat the trust as qualified terminable interest property (QTIP) (the election qualifies the trust for the marital deduction) under IRC § 2056(b)(7). If the election is made, the transfer will qualify for the unlimited marital deduction and will not be included in the taxable estate of the decedent. In certain cases the executor may not wish to make the election where the prior transfer credit may be available. The surviving spouse does not have a general power of appointment, however if the QTIP election was made and the marital deduction utilized; the corpus will be included in the estate of the surviving spouse’s under IRC § 2044.
In some cases the surviving spouse may be granted a limited power of appointment to direct the remainder to one or more of the decedent’s children. However the surviving spouse is never granted a general power of appointment and may not appoint the corpus to anyone else. This is sometimes known as the Evil Step-Mother clause.
By way of example, let’s assume that husband dies first and the fair market value of the total estate as of the date of death is $10,000,000 and this is all community property. If the sub-trust allocation is as described above the date of death allocation would be as follows:
Survivor’s Trust - $5,000,000
Credit Shelter Trust - $2,000,000
Marital Trust - $3,000,000
Marital Deduction Formula
In our example above, we have determined the funding amount for each sub-trust based on date of death values. But what happens when these values change after the date of death? The trust provision that answer this question is commonly referred to as the Marital Deduction Formula. In virtually every case a lengthy period of time will elapse from date of death until the sub-trusts are actually funded. This may be a period of several months or several years. Thus, one of the more complex problems in postmortem trust administration involves the proper allocation of the appreciation or depreciation occurring in assets between date of death and date of distribution. The marital deduction formula controls which trust receives the appreciation or depreciation in assets between date of death and date of distribution. Commonly, the marital deduction formula grants the trustee discretion to distribute assets in kind on a non prorata basis. This allows the trustee to first set target funding amounts and then pick and choose the specific assets used to hit the funding target.
In practice, there occur many variations. Nevertheless the marital deduction formulas typically fall into three categories:
Pecuniary Marital/Residuary Credit (date of distribution funding)
A pecuniary marital formula calculates the amount of the Marital Trust in terms of a dollar (pecuniary) amount based on date-of-death values. The value of the Marital Trust is set at date of death. All appreciation or depreciation is allocated to the Credit Trust.
Pecuniary Credit/Residuary Marital (date of distribution funding)
A pecuniary credit formula calculates the amount of the Credit Trust in terms of a dollar (pecuniary) amount based on date-of-death values. The value of the Credit Trust is set at date of death. All appreciation or depreciation is allocated to the Marital Trust.
The pecuniary formulas above specify a “date of distribution funding”. A “date of distribution funding” formula provides for funding the pecuniary gift with date of distribution values. Hence, the pecuniary gift is frozen and the residuary gift receives all the appreciation or depreciation.
In some cases, the pecuniary bequest specifies the use of a Fairly Representative Formula. A fairly representative formula specifies the assets used to fund the pecuniary bequest are to be valued as of the date of death, but must be prorated so that the assets distributed to the Credit Trust and the Marital Trust are fairly representative of the post-death appreciation and depreciation. Thus, a pecuniary bequest with fairly representative funding functions much the same as a fractional share funding formula (discussed below).
Fractional Share
A fractional share funding formula expresses the credit share or the marital share as a percentage or fraction of the decedent’s estate, e.g. “the Marital Trust shall consist of the smallest fractional share of the decedent’s interest in the trust estate that will eliminate federal estate tax by reason of the decedent’s death.” With a fractional share formula, the post-death appreciation or depreciation is ratably shared between the pecuniary and residuary shares.
Income Tax On Funding A Pecuniary Bequest
The funding of a pecuniary bequest with assets in kind using date of distribution values may result in a taxable event, causing realization of gain or loss equal to the difference between the date of death value and the date of distribution value. - Reg. § 1.661(a)-2(f)(1) and § 1.1014-4(a)(3)
If trust assets have appreciated in value, the trust must recognize the gain upon funding.
However, if trust assets have depreciated in value, the trust cannot recognize a loss upon funding the pecuniary formula bequest. – IRC § 267(a)(1) (b). In other words, the gain must be recognized, but the loss may not be utilized to offset the gain.
However, it is possible to recognize an offsetting loss if an election is made to treat the trust as an estate for income tax purposes under IRC § 645. A trust may not recognize a loss on funding because a trust may not recognize loss between related parties. An estate may recognize such a loss. - IRC § 267(b)(13)
The funding of a fractional gift or residuary gift is not a taxable event. – Reg. § § 1.661(a)(-2(f), 1.1014-4(a)(3)
Avoiding Family Conflicts
The best way to avoid or at least minimize family conflicts is through clear, consistent and regular communication with the client and client’s family. We have found the use of flow charts and trust summaries to be very effective. Whenever possible, it is best to recognize and deal with family conflicts during the planning cycle rather than after the death of client.
Estate Planning And Administration Systems
To deal efficiently and effectively in this complex practice niche the practitioner should strive towards developing and utilizing systems to streamline work flow and client communication. The author has developed (and is continuing to develop) an in-house estate compliance system which has proved to be quite helpful.
Finally, throughout the estate engagement it is important to involve and communicate with all the members of the client’s financial team including the attorney, investment advisor, insurance agent and valuation expert. Every team member should clearly understand which tasks they are responsible for performing.
Citations
1 E.G. California Probate Code § 21610 states: Except as provided in Section 21611, if a decedent fails to provide in a testamentary instrument for the decedent's surviving spouse who married the decedent after the execution of all of the decedent's testamentary instruments, the omitted spouse shall receive a share in the decedent's estate, consisting of the following property in said estate:
(a) The one-half of the community property that belongs to the decedent under Section 100.
(b) The one-half of the quasi-community property that belongs to the decedent under Section 101.
(c) A share of the separate property of the decedent equal in value to that which the spouse would have received if the decedent had died without having executed a testamentary instrument, but in no event is the share to be more than one-half the value of the separate property in the estate.