It’s the little things that often sabotage an estate plan. You can work with your estate planner to get the right gifting program, trusts, and other strategies. But a mundane detail or two still could undo a lot of your work. Whether the estate is a few hundred thousand dollars or millions of dollars, it seems the same simple oversights commonly disrupt the plans.
Here are some key, little-known traps you need to avoid.
The family home. Suppose one spouse has sole title to the home. To take advantage of the lifetime estate tax exemption, the house is left to a “credit shelter trust” that entitles the surviving spouse to all income from the trust for life, then the house goes to the children.
But the trust and the will don’t specifically give the surviving spouse the right to live in the house rent free. This right might be implied, or it might not be, depending on the state and who is interpreting the documents. If the children have a falling out with the surviving spouse, they might decide to have the trust charge rent, or they might sell it or rent it to a paying tenant.
Even more likely, the IRS might conclude that the trust is making a gift to the surviving spouse of the rental value of the home. That could mean gift taxes. Money that should have stayed in the trust and gone to your children will go to the IRS instead.
The important lesson is not to leave anything implied in an estate plan. If you want your spouse to have the right to live in your house for life, then state it clearly.
Investing the trust. Trusts provide a number of estate and income tax benefits. But many people don’t realize that trusts are hit with very high income taxes. A trust is in the top income tax bracket after earning only $8,350 of income.
That means you don’t want the trust to invest for income unless that income is going to be distributed to the beneficiaries each year. Otherwise, the trustee should be investing in assets that are likely to earn capital gains and won’t generate much taxable income from year to year.
It is wise to select trustees who understand both your goals and the tax implications of their investment choices. Some estate plans include a separate letter to the trustees that spells out the goals of the trust and what the creator would want done in some situations. It is not legally binding, but it gives the trustee some clear direction.
Another trust investment problem occurs when the trust property is primarily one asset. It might be real estate, closely-held company stock, or the stock of a public company you’ve owned for years. There are two possible outcomes.
A trustee might conclude that you considered it a family asset to be retained for generations. The trustee won’t sell, even when the assets prospects or the family’s needs have changed. It is not unusual to run across trusts holding such assets that now are worth a fraction of their previous value, because the trustees believed they were to retain the assets for the family.
On the other hand, a trustee, aware of the prudent man investment rule and the need to diversify a portfolio, will sell the asset ? regardless of its prospects or other factors ? to structure a diversified portfolio. Growing small businesses and valuable real estate have been sold out of family trusts for this reason.
You need to provide both guidance and legal help to the trustee. If you don’t want the asset sold off just to provide diversification, then state in the trust agreement that the rule doesn’t apply and concentration of the portfolio in a small number of investments is permissible. You can even list the investments in which the portfolio may be concentrated, such as the family business.
You also should leave the trustee an explanation of your views about how long the asset should be held. Don’t leave the trustee and the children arguing over ?what mom and dad would have done.? You might even recommend an advisor or two for the trustee to consult in determining the prospects for the asset.
Retirement plans. The rules for retirement plans are getting more and more complicated, and fewer and fewer people get them right. The first rule is that the beneficiaries of your plan or IRA must be named in the plan documents. The plan administrator will ignore what is in your will.
The second rule is to check your power of attorney with the plan administrator. You should have a durable power of attorney that allows an individual to handle your financial affairs if you are unable to. But most IRAs and retirement plans won’t respect a power of attorney that isn’t on their forms or that doesn’t meet their specifications.
Powers of attorney. While we’re on the subject, to ensure the best tax results the power of attorney specifically must grant the power to make gifts on your behalf. In addition, the power should make clear that the power includes the right to make gifts that exceed the annual exempt amount and taxable gifts or gifts that use your lifetime estate and gift tax exemption. Otherwise, the IRS might argue that the gifts don’t count for tax purposes.
Serving as trustees. Many wills provide that property equal to the estate tax exemption amount will be left in a credit shelter trust. The surviving spouse gets the income and can get the principal when needed. Too often these trusts are set up so that the surviving spouse serves as trustee. That can cause the loss of the estate tax exemption. The IRS will argue that the surviving spouse has so much power over the trust assets the assets should be included in his or her estate. This essentially would void the credit shelter trust.
A better approach is to have an “uninterested party” serve as a trustee or co-trustee who has to approve certain acts, such as an adult child, or a family friend or adviser. Only this person, not the surviving spouse, should have the power to spend the trust principal on the surviving spouse’s behalf. And invasion of the principal should be allowed only under what the tax law calls “ascertainable standards,” such as for the health, education, or basic needs of the surviving spouse.
Too much power for the executor. Many people want their children to inherit equal amounts, but don’t specify how that is to be done. This can be a big problem when the estate is primarily a family business or other hard-to-value assets, especially when not all the children will be sharing ownership of that asset. For example, the children who won’t actually work at the business might not take ownership shares. Or they might share ownership but some will want to sell right away.
Don’t leave your executor the job of sorting this out. Specify how the family business or other assets are to be valued for this purpose. Then be sure that there are enough other assets to let the children inherit equal values. Otherwise the executor might feel compelled to sell the business to equalize inheritances. Or the child inheriting the business might have to borrow against it or find a minority owner to raise enough cash to spread out among the other children.
Here’s a tip to ensure that your estate plan doesn’t get caught in these or other trips. After your plan is complete, take it to another estate planner for a second opinion. You might learn a change is needed, or you might walk away with confidence that the plan will accomplish what you want.