This Memorandum summarizes many basic estate planning concepts and ideas. A review of this information should help you to better understand our future estate planning discussions.
Basic Documents
The basic estate planning documents are a Pourover Will and Revocable Trust.
1. POUROVER WILL: Coupled with a Revocable Trust, your Will need only (i) provide for distribution of tangible personal property, (ii) transfer to your Revocable Trust all property not previously transferred to the Trust, and (iii) appoint a personal representative of your estate and a guardian for your minor children. The Pourover Will is a short document because all the major provisions regarding the distribution and administration of your estate will be contained in the Revocable Trust Agreement.
If you do not create a Revocable Trust, all the provisions for the administration and disposition of your assets will be in your Will. Like the Revocable Trust, your Will can be changed as often as you like prior to your death.
2. REVOCABLE TRUST: A Revocable Trust is a trust to which you transfer all or part of your assets during your life, while retaining for life the right to income from the trust, the right to withdraw or add assets, and the right to revoke or amend the trust. You may be named as a Trustee or Co-Trustee of the trust, but this is not required.
Because of the complete control you retain over the trust during your life, the trust is ignored for both income tax and estate tax purposes. All of the trust income is taxed directly to you, whether or not it is distributed, because you are treated as the “owner” of the trust for income tax purposes — you report all trust income and deductions of the trust on your individual income tax return. (Your social security number is used for identification purposes for assets held in the trust.) In addition, all of the assets of the trust are treated as owned by you at your death for federal estate tax purposes (the estate tax laws are the same whether or not an asset is subject to probate). Accordingly, lifetime income and gift tax advantages and reduction of estate taxes at death are not normally factors in deciding to create a Revocable Trust.
Advantages
However, there are a number of non-tax advantages of a Revocable Trust which should be considered:
1. ASSET MANAGEMENT IN THE EVENT OF DISABILITY. A Revocable Trust can function as a vehicle for the management of your assets in the event you become disabled and are unable to handle your business affairs. Title to all assets placed in a Revocable Trust is held by the Trustee, and in the event you become disabled and cannot manage your business affairs, the successor Trustee you have designated will automatically take over management of the assets of the Revocable Trust.
Thus, a Revocable Trust can be beneficial not only in situations where, because of sickness or injury, you are no longer physically able to attend to your business affairs, but also in the event you become “disabled” as defined under state law. Without a Revocable Trust and its successor Trustee provisions, a guardian of your estate may have to be appointed by the local probate court to manage your property. The expenses, delays, and restrictions of a court-supervised guardianship over your estate are avoided if your assets are held and managed by the successor Trustee of your Revocable Trust. You should also note that if your disability ceases, you can resume your position as Trustee of the trust, if you desire.
It is important to note at this point that if you have a Durable Power of Attorney for Property, you already enjoy most, if not all, of these advantages of a Revocable Trust. Your Attorney-in-Fact under your Durable Power of Attorney is able to deal with and manage your property much as a successor Trustee would, thereby avoiding the necessity of a court supervised guardianship. A Durable Power of Attorney is much simpler to create and maintain than a Revocable Trust — it need only be executed to be effective. A disadvantage of the Durable Power of Attorney relative to a Revocable Trust is that it is sometimes difficult to get third parties to recognize the power and authority of your Attorney-in-Fact to act on your behalf.
2. AVOIDING PROBATE. Any assets held in a Revocable Trust at your death are not subject to probate administration and pass to the trust beneficiaries under the terms of the trust agreement. Again, use of a Revocable Trust avoids many of the administrative expenses, fees of court-appointed representatives, publicity, delay, and restrictions on the management of your assets that result if your estate is subject to probate administration. However, because independent administration is the standard form of administration in Illinois (unless you expressly forbid independent administration in your Will, your executor requests supervised administration, or an interested person, i.e., a beneficiary, objects to independent administration) the expense, delay, and management restrictions of the probate process are much less burdensome than in the past, and may not be significantly greater than those associated with the management of your assets in a Revocable Trust upon your death.
3. Trustee FLEXIBILITY. After your disability or death, the Trustee of a Revocable Trust has more flexibility in terms of the administration of your assets held in the trust than does your guardian or executor over the same assets under supervised probate administration if not held in a trust. Nevertheless, the Trustee will be required to account to the trust beneficiaries regarding the administration of the trust, and can be required to account to a court if it appears that the Trustee is not carrying out his duties under the Trust properly. Thus, the Trust beneficiaries are protected against wrong-doing or mismanagement by the Trustee.
4. AVOIDING PUBLICITY. Without a Revocable Trust, in the event of your disability or death, your court-appointed guardian or executor, as the case may be, will be required to report the details of his or her administration to the supervising court. Additionally, at your death, your Will must be filed with the court, and becomes a document of public record; thus, all of the details regarding the disposition and administration of your property provided for under your Will become matters of public record. Since a Revocable Trust need not be filed with any court, and since the administration of the assets in the trust need not be reported to any supervising authority, use of a Revocable Trust avoids undesirable publicity.
5. CONTINUITY OF MANAGEMENT. Use of a Revocable Trust can provide for continuity of investment and management of your assets, even after your death. This may be important if the trust beneficiaries are unwilling or unable to adequately manage the assets themselves. Of course, your Will can do as much, by providing for the creation of testamentary trusts upon your death.
6. TRANSFER OF ASSETS AFTER DEATH. Finally, a Revocable Trust can be drafted so as to carry out all of your estate planning goals with respect to the disposition of your property following your death, just as can be done under a Will. That is, any type of dispositive plan, whether determined with estate tax consequences in mind or not, can be provided for under a Revocable Trust in the same way it can be provided for under a Will.
Disadvantages
There are some possible disadvantages of such a trust, which also need to be considered:
1. FUNDING OF TRUST. The benefits described above are available only if you actually fund (that is, transfer your assets to) the Revocable Trust during your life. This will involve some time and effort on your part and some expense in re-registering securities and re-titling other assets; any such costs should be minimal, but you need to be aware of the possible inconvenience of initially transferring your assets to the Trust. Also, when you acquire additional assets, you will have to remember to take title in the name of the Trustee, not in your individual name.
2. SEPARATE TAXABLE ENTITY. While you serve as the Trustee (or Co-Trustee) of your Revocable Trust, it is not necessary to file separate income tax returns for the trust, but if you are not a Trustee of your trust (or cease to act as one), the trust is a separate taxable entity and will need its own federal taxpayer identification number, and will also need to file its own fiduciary income tax return each year.
3. GIFTS FROM TRUST. Under current law, a greater degree of care must be exercised in making lifetime gifts out of assets held in a Revocable Trust. In many, if not most, instances, a transfer directly from the trust will be brought back into your estate for estate tax purposes if you die within three (3) years of making the gift. Therefore, a three-step procedure must be followed. The assets to be gifted must first be withdrawn by you, titled in your individual name and then transferred to the Donee.
4. TAXABLE YEAR. From an income tax point of view, after death, Revocable Trusts have always been less advantageous than probate estates. This is because income accumulated in a probate estate can be taxed to the estate at its own separate (and presumably lower) income tax brackets, but income accumulated in a Revocable Trust after death will effectively be taxed at the rates of the trust beneficiaries (with some limited exceptions). Because the 1986 Tax Reform Act reduced the tax advantage of accumulating income in an estate (by reducing the amount that an be accumulated at lower income tax rates), this potential disadvantage of a Revocable Trust has become less important.
Trusts (including Revocable Trusts, for the taxable years beginning after death) are no longer able to elect a fiscal year ending in a month other than December (that is, a trust must use the calendar year as its taxable year). In contrast, probate estates are able to elect fiscal years other than the calendar year, which permits the estate to defer the time for reporting income beyond the calendar year in which the personal representative actually receives the income. However, this benefit of utilizing probate administration appears to be of limited importance in most circumstances, given the fact that probate administration cannot continue indefinitely.
Summary
In summary, despite minor tax disadvantages, it appears that the use of a Revocable Trust in estate planning continues to offer some benefits in terms of facilitating administration of assets (particularly in the event of your death or disability), continuity of competent investment and administrative services, and the avoidance of the publicity and expense involved in a guardianship or probate administration. During your lifetime, however, the existence of the Revocable Trust, even though fully funded with all of your assets, should not result in any undesirable restrictions upon your power with respect to your property.
Estate Planning
Aside from deciding who will be the beneficiaries of your estate, there are several things to consider in beginning the estate planning process.
1. MARITAL DEDUCTION. You may transfer an unlimited amount of money or property to your spouse, during life or at death, without incurring any gift or estate tax liability. With the proper use of the unlimited marital deduction, it is possible for you to guarantee that no estate tax will be due until after both you and your spouse have died.
In order to qualify for the marital deduction, a gift or bequest to your spouse must be made (i) outright to your spouse, or (ii) to one of the types of marital trusts described in paragraph 3 below.
2. UNIFIED CREDIT. It is not always best to provide for all your property to qualify for the marital deduction. The Federal tax law provides for what is called a “unified credit” which allows you or your estate to take a credit against the gift or estate tax. This amount is usually referred to in terms of its “exemption equivalent” or “tax exempt amount” which is the maximum value of property you may transfer during your lifetime or at death and not incur gift or estate tax liability. If you have made no taxable gifts (gifts in excess of the $13,000 annual exclusion discussed below) since 1976, you can have an estate of up to $5,000,000 and still pay no estate tax, regardless of who receives your property. You can also use part or all of your unified credit prior to death by making gifts in excess of annual exclusions.
If you simply provide that all of your property passes to your surviving spouse, your estate will not be able to utilize this unified credit. Because all amounts which qualify for the marital deduction will be included in your spouse’s taxable estate, failure to use the unified credit may unnecessarily increase the amount of estate tax due upon your spouse’s death.
The best approach in many instances is to make maximum use of the unified credit by placing the tax exempt portion of your estate into a residuary trust for the benefit of your spouse and descendants. This trust is structured so that, upon your spouse’s death, the assets will pass to your descendants without being included in your spouse’s taxable estate. The remainder of your estate can then pass to your spouse in a form which will qualify for the marital deduction and your estate will still not incur estate tax liability.
3. MARITAL TRUST. As stated above, that portion of your estate which you decide to give your spouse can be placed in trust (i) to provide for investment and management help for your spouse, and/or (ii) to ensure that the property passes to your descendants upon your spouse’s death. Basically there are two types of trusts which can be used for the marital deduction; (i) the general power of appointment (GPA) trust or (ii) the qualified terminable interest property (QTIP) trust. In either case, your spouse must receive all the net income from the trust during his or her lifetime. The basic difference between the GPA trust and QTIP trust can be summarized as follows:
(a) The GPA trust may give your spouse flexibility to make distributions to your descendants during your spouse’s lifetime while the QTIP trust must prohibit all such distributions.
(b) The GPA trust must give your spouse the power to direct where the trust assets go upon your spouse’s death (i.e., to whomever she directs), whereas the QTIP trust may restrict your spouse’s power to alter your distribution scheme (i.e., only among your descendants).
In other words, the GPA trust gives your spouse more flexibility and the QTIP trust provides you with more certainty. Either way, any remaining trust estate will be included in your spouse’s taxable estate at death.
4. RESIDUARY TRUST. The Residuary Trust will initially receive the tax exempt portion of your estate for the benefit of your surviving spouse and descendants. Unlike the Marital Trust, the Residuary Trust can provide for substantial flexibility and give broader discretion to the Trustee. This trust may be structured as a single trust for the benefit of all your descendants or separate trusts for each of your children (and such child’s descendants). The main advantage of the single trust, aside from its simplicity, is the fact that it provides for a single fund available for the benefit of the family unit. This may more accurately reflect how you currently manage your family’s financial situation. Utilizing separate trusts has the advantage that each child can draw only from his or her own funds, thus reducing any possible future conflict among the family members. Any distributions to your spouse would be made equally out of each of the trusts created for the children. In addition, the use of separate trusts may achieve certain income tax advantages in that each separate trust may be in a lower tax bracket than the one large trust. The type of trust arrangement which is best for you will depend on your goals and your family’s needs.
5. CONTINGENT TRUST. A Contingent Trust will be established whenever a beneficiary, to whom a distribution of principal on termination of any trust is to be made, has not become a certain age (i.e., age 21 or age 25). The Trustee continues to hold the property in a separate trust until the beneficiary becomes the specified age.
6. EXECUTOR/TRUSTEES. The executor named in your Will is the one responsible for (i) determining the extent and value of your valid debts and expenses, and (ii) distributing the property in accordance with the provisions of your Will. This process usually takes from one to two years. If you have a Pourover Will, the executor will transfer assets to the successor Trustee of your Revocable Trust. The successor Trustee adds these assets to the assets which you have transferred to the trust during your lifetime, and holds or distributes all assets in accordance with the provisions of the trust agreement. If you don’t have a Revocable Trust, the executor will distribute specific bequests and transfer assets to the Trustee of any trusts created in your Will. A Trustee’s responsibilities may continue for many years. Although the same person or entity (Bank or Trust Company) could be both executor and Trustee, you may name separate persons or entities for each task.
Each executor and Trustee should be given broad discretionary powers in order to deal with circumstances which cannot now be contemplated. In this respect, the naming of an executor and successor Trustee is an important consideration and you should have complete confidence in the person or entity named.
Gifts
The law provides that any individual can make gifts to one or more individuals of up to $13,000 per year without having to pay gift tax (a married couple can make a joint gift of up to $26,000 per individual per year). The only restriction is that the gift be what is called a “present interest,” which means that the beneficiary of the gift must have the current right to benefit from the gift (not subject to another’s discretion). Sometimes transfers in trust can be present interests (see discussion of withdrawal trust below). These tax-free gifts can be made each year to as many individuals as you like. For example, you and your spouse can join in making a gift of $26,000 per year to each of your children. If your children marry and have children, you could make similar annual gifts to each of your children, their spouses, and to your grandchildren. The result is that you can transfer a significant amount of wealth during your lifetime to the family members who would otherwise receive it at your death, without generating any tax liability. As a consequence, your taxable estate at death is reduced.
In addition to this limited annual exclusion, the law now allows an unlimited gift tax exclusion for all amounts paid by you (on behalf of any beneficiary) directly to an educational institution for tuition or to a health care institution for medical services. Therefore, any amounts you expend for your children’s education or medical expenses (assuming they are adults and you are no longer obligated to support them) will not constitute a taxable gift. Furthermore, these amounts will not reduce the available $13,000 annual exclusion discussed above. Use of any of the exclusions discussed above will not affect the amount of your available unified credit.
Lifetime Trusts
There are several types of trusts you can utilize during your lifetime to accomplish many of your tax and non-tax goals. Through the use of trusts, you can provide for expert management and investment of your assets for the benefit of yourself or your family. (This is particularly important should you become incapacitated at some time in the future). A trust can also achieve certain income and estate tax advantages, such as (i) transferring the income from certain assets to other members of your family who may be in a lower tax bracket [this benefit is not as significant now as in the past due to recent income tax law changes] or (ii) decreasing the size of your taxable estate by transferring portions of your estate to other family members during your lifetime.
This booklet has already discussed the use of a Revocable Trust. The following is a brief summary of two types of irrevocable trusts commonly used:
1. WITHDRAWAL TRUST. Because the $13,000 annual gift tax exclusion is only allowed for present interests, this trust is usually structured so that the gifts to the trust qualify as present interests. One method for doing this is to include a provision in the trust which gives the beneficiaries a right to demand withdrawal of the amount you contribute. Because it is likely that none of the beneficiaries will exercise this withdrawal right, you can achieve the advantage of placing the funds in trust for the benefit of the beneficiaries while still avoiding the payment of a gift tax. This type of trust may continue for as long as you wish and is particularly suited for use with life insurance policies (as discussed later).
2. 2503(c) TRUST. Another way of having a trust qualify for the annual gift tax exclusion is to follow the guidelines set out in Internal Revenue Code Section 2503(c). This trust is designed for children under age 21 and must provide that the income from the trust is to be utilized only for the benefit of the child. When the child reaches age 21, the assets and any accumulated income in the trust must be distributed to the child, or the child must be given the power to demand that distribution (it is possible to limit the time period during which this demand may be made, after which the trust would continue without the beneficiary having a right to demand distributions). In the event the child dies before age 21, the assets and all accumulated income in the trust must be distributed to the child’s estate or in the manner designated by the child pursuant to a general power of appointment. This type of trust is often used to provide funds for college and other educational expenses.
Life Insurance
For estate tax purposes, the proceeds of a life insurance policy are included in the estate of the individual who holds the rights of ownership in the policy, not the insured or the beneficiary. Therefore, if you own an insurance policy on your own life, the proceeds of that policy will be included in your taxable estate. On the other hand, if another individual owns the insurance policy, the proceeds will not be included in your taxable estate even though you are the insured. In some instances, it might be advantageous for you to divest yourself of ownership in any life insurance policy on your own life. To do this, you must make sure that you are not the designated owner, that you have no rights in the policy, and that you are not directly making the premium payments.
With the unlimited marital deduction, it probably makes no difference that you are the owner of an insurance policy on your own life if your surviving spouse is the beneficiary of that policy. The marital deduction will cancel out any tax liability generated by the insurance policy. However, to the extent your spouse does not spend the proceeds, they will be included in his or her estate. This may unnecessarily increase the size of your surviving spouse’s estate for estate tax purposes.
A common method of avoiding this future taxation is through a life insurance trust established for the benefit of your surviving spouse and children. By using a withdrawal trust (discussed above) which qualifies for the annual gift tax exclusion, you can make the premium payments on the insurance policy. An insurance trust should not be used for the purpose of holding income-producing properties. If so, you may have to pay income tax on the trust income, reducing the amount available to pay life insurance premiums.
Life insurance can perform additional estate planning functions. First, a life insurance policy can create an estate where none exists, or expand an already existing estate to provide additional assets to pass to your surviving family members. It is important to remember that, under current law, proceeds from life insurance policies are not taxable as income to the beneficiary. Second, life insurance proceeds can be utilized to pay the taxes and other administrative expenses required at your death. It is not uncommon for an individual to have a very large estate and yet still have a very small amount of cash available to pay the necessary taxes and expenses. Life insurance proceeds can provide instant cash which can be used to pay these debts, taxes and expenses. Even if the life insurance is in an irrevocable trust, the proceeds could be used to buy assets from your estate and thus provide the needed liquidity. Third, if you are involved in some type of closely held business or partnership arrangement, the insurance proceeds can provide funding for a “buy-sell” or “cross purchase” agreement.
Retirement and Other Employment Benefits
In the process of establishing your estate plan, it is essential that you know the terms and conditions of any retirement or employee benefit plan from which you have the right to receive future distributions. The proceeds of these plans will be included in your estate for estate tax purposes. Therefore, the designation of beneficiaries under such plans should be made in a manner which is consistent with the provisions of your will. If your surviving spouse is the beneficiary of all of these plans, the unlimited marital deduction will off-set any additional estate tax liability resulting from the existence of these plans.
Recent changes in the tax laws also provide for certain elections regarding the timing and amount of withdrawal of funds from benefit plans, the taxation of excess accumulations and proper designation and taxation of beneficiaries. If you have substantial amounts in any such plan, we should discuss the tax provisions.
Generation-Skipping Tax
The Tax Reform Act of 1986 included a newly established tax on generation-skipping transfers. In simplest terms, this tax applies to transfers in trust for two or more generations (i.e. children and grandchildren) and to direct gifts to someone who is at least two generations below the donor (i.e. grandchild). There are certain limited exclusions to the application of this tax. The most important of these is a $5,000,000 exclusion per donor, which means the tax will generally only be of concern to persons with large estates. While the specific details and application of this tax are too complicated for purposes of this memorandum, it is important for you to be aware that the generation-skipping tax exists.
Other Documents
1. LIVING WILL. A Living Will is a declaration of intent made by an individual stating that if he or she has an incurable or terminal condition, then his or her life should not be prolonged by artificial means that merely prolong the dying process. Illinois has adopted a statutory form of Living Will, which many people choose to sign.
2. HEALTH CARE POWER OF ATTORNEY. An Illinois Statutory Health Care Power of Attorney names someone to act as your agent to make medical and personal care decisions for you in the event that you are unable to make such decisions for yourself. Included in the statutory form is a direction to your agent as to your wishes concerning life support.
3. PROPERTY POWER OF ATTORNEY: An Illinois Power of Attorney for Property (also known as a Durable Power of Attorney) can be used either in place of, or in conjunction with, a Revocable Trust, to provide for management of assets should you be unable or unwilling to manage them yourself.
Importance of Planning
Each family situation is unique and needs to be carefully discussed and analyzed in light of your financial, retirement and estate planning goals. Our job is to ask the right questions and point out the available legal and tax alternatives, so that you can decide how best to meet your objectives in minimizing taxes and distributing your assets to your family and other intended beneficiaries. We look forward to being of assistance to you in this important area of the law.