The 9 Steps to Financial Freedom (19 page)

In the year 2012, if Pop and Mom die, and Tim and Daniel inherit a business worth more than $5,120,000, they are going to owe estate taxes. And because the ownership of the business and house and bank accounts will have passed to them under a will rather than a trust, they could be hit with huge probate fees as well.

Is there a way for Sherry’s family to reduce the federal estate tax that would be owed on an estate worth more than $5,120,000? Yes. Tim and Daniel’s father could really take care of it by setting up a
tax-planning trust
. This is a trust for those with estates worth more than $5,120,000 in 2012.

Depending on whom you talk to, these trusts can be known as
credit shelter trusts, bypass trusts
, or
A/B trusts:
they’re all the same thing. I like to call them bypass trusts, because I just love the thought of bypassing taxes.

As of 2012, the bypass trust can eliminate federal estate taxes on estates of married couples valued at $10,240,000.

Federal estate taxes fall into the realm of the IRS and don’t vary from state to state the way probate fees do, so don’t confuse estate taxes with probate. Probate fees are determined in each state and cover the cost of processing a will through the court system. (Please note, however, that some states also impose their own estate tax.) Federal estate taxes are the share of the estate owed to the IRS if you leave more than the amount of exemption to anyone other than your spouse. Unless, that is, you eliminate or minimize the sting by setting up a bypass trust.

In Sherry’s family’s case, here’s how the inevitable deaths of Mom and Pop would play themselves out with and without a bypass trust.

There are two main ways to reduce or eliminate federal estate tax on the first spouse’s death. One is the unlimited marital deduction, and the other is the exemption or credit shelter amount that can be left estate tax-free to any beneficiaries including your spouse. Husbands and wives can leave an unlimited amount of wealth to each other without owing any estate tax whatsoever, as long as you’re married to a U.S. citizen. (If you’re married to a non–U.S. citizen, you need to consult an estate lawyer now!) Each individual can pass on to his or her beneficiaries other than a spouse, the $5,120,000 exemption that is in place through 2012. Congress had not yet
decided what to do after 2012. So be sure to stay abreast of new legislation as it develops.

Let’s say the family business is worth $6 million when Pop, Sherry’s father-in-law, dies. Assuming he dies first, and all the assets are passed to Mom, she would owe nothing in estate taxes. She receives the six-million-dollar estate and owes nothing. But let’s say Mom dies in 2012. Now she has the whole $6 million on her side of the balance sheet but can only leave the credit shelter amount for that year of $5,120,000 to her kids without their having to pay estate tax. No one ever got the benefit of Pop’s credit shelter amount because he just passed everything to Mom.

So when Mom dies the kids will have to pay a total estate tax bill of $308,000. (Based on the maximum estate tax rate of 35 percent for 2012.)

If, however, before either Mom or Pop dies, $6 million is separated out of Pop’s individual name and into two shares, each for $3 million, and Pop’s share is held in trust for the benefit of Mom when he dies, and the family follows certain rules, then the IRS will see the money as if it never left Pop’s side of the balance sheet. The $3 million that’s Pop’s “half” can be passed down free and clear when Mom dies, because it’s less than or equal to the credit shelter amount for 2012 of $5,120,000. As for Mom, the $3 million on her side of the balance sheet can be passed down in the same way when she dies. Remember, in the year 2012, you each get this $5,120,000 credit shelter amount. But most of us who are married don’t take full advantage of it. We just simply leave everything to a spouse who was able to get everything anyway, so in effect the first spouse to die wastes the credit shelter amount exemption. To take full advantage of it, you can set up a bypass trust. The deceased’s half of the money goes into the trust, preserving this exemption. However, a positive development is that for 2012 a change in federal law makes it automatic for spouses to inherit each other’s exemption
amount. But because it is not clear what the law will be after 2012, you can ensure your family will be in great shape by using a bypass trust.

Mom can be her own trustee over Pop’s half so she has full management and control over it. Depending upon how the trust was drafted, she can have an absolute right to all the income generated by his half, and she can spend any part or all of the $3 million if she needs it. The key word is “needs.” She has to spend her entire $3 million before she starts spending his. Finally, Mom can’t change who gets Pop’s share of the estate after he dies. The beneficiaries named by Pop are the ones who will get the money. And Mom will have to file separate tax returns each year, one for her half and one for Pop’s. That’s it. These are minor restrictions to endure for a savings of $308,000.

The way things are set up now, Sherry’s family will encounter another problem when either Pop or Mom dies: probate. Remember, as it stands now, the business is in Pop’s name alone, and he is passing it on with a will to Mom, who will then (with her will) pass it to her sons.

To transfer the title to the assets when Pop dies, or to have Mom’s name put on the papers, there are procedures in most states that allow you to sign an affidavit with a certified death certificate so you don’t need to go to probate court to transfer assets from spouse to spouse. But look out if your state doesn’t allow this and you haven’t checked the form of ownership on the deeds
to real property like your home. If there are names on the titles other than Mom’s or Pop’s, you may be in for a rude surprise. If this is the case, or you don’t know how you hold title to real estate, or what the words by your name on the deed mean, seek legal counsel. Ask your attorney to put what you want to know in writing so you understand the consequences of the many types of ownership forms out there. The words “joint tenant” and “tenants in common” (or the absence of any such words) have different meanings and can make the difference between a $150 fee to transfer ownership and thousands of dollars in fees or even more, depending on the value of the real estate.

But the simple procedures available to most surviving spouses to change title to a home, business, bank, or brokerage account cannot help Daniel or Tim when Mom dies. If everything is left to them via her will, they’ll have to go through the probate procedure and be hit with unnecessary probate fees. The probate fees that Daniel and Tim would have to pay in California are about $55,000.

If you add together the probate fees and the estate taxes, Tim and Daniel will owe more than $308,000 when Mom dies—and no, they can’t send the IRS or pay the lawyers’ fees with some rusty old machines. Where would they get that kind of money? They don’t have it, and it would be owed within nine months of Mom’s death unless they qualified for certain limited extensions.

Estate taxes are due nine months from the date of death. Under very special circumstances, you can get an extension for six months, but it’s not as easy as you might hope, and you also have to pay interest on the sums due. When you have acquired
enough money to have to pay estate tax, the government thinks you will be smart enough to have planned for the day you’ll owe the money and just assumes, often wrongly, that you’ll have it on hand. This can be a real problem if you didn’t plan at all, because you and your parents (or whoever you’ll be inheriting money or property from) have never discussed it.

If you’re left an inheritance of assets such as real estate that might not be so easy to cash in fast, or assets that you didn’t want to cash in, and you have no liquid cash of your own, you could be in a very precarious situation. Advance knowledge of what will happen when the time comes gives you time to prepare, either by getting a life insurance policy that would help pay the death benefits or by liquidating assets sooner rather than later.

Sherry’s family’s situation is different from most. In their situation the main asset they will be inheriting is a family business. Under the Internal Revenue Code Section 6166, they might be allowed to pay off their estate tax over a ten-year period of time, with interest.

For most people, it would be worse. Most people owe estate taxes nine months from the date of death, and that’s that. If you can’t pay your estate tax, interest will be charged. If you inherit a closely held business, the rate is 2 percent. It’s great to get an inheritance—unless you’re not prepared for it.

Let’s take Sherry’s story one step further. Assume that after Tim and Daniel inherit the business, one or the other of the brothers dies. They have left the business to each other via a will, so the surviving brother will have to come up with money to pay estate taxes, even before he inherits anything, since estate taxes have to be paid before the deceased’s property can be distributed.

What is more, and family business notwithstanding, Sherry or Christine will be at the mercy of the surviving brother and not protected in any way.

Sherry had very good reason indeed to be worried.

Is there a way for Sherry’s family to avoid paying probate fees? Yes. As we’ve seen, these assets should have been put in a revocable living trust (
this page
) instead of being left to one or the other brother via these various wills, so that they would pass smoothly and without probate fees from family member to family member.

If Sherry’s family were to set up a bypass trust now, before Mom or Pop died, the scene that would inevitably play itself out would be a much, much brighter one.

In the first place, Mom would retain control over everything she and Pop worked for without any court intervention. When she died, Tim and Daniel would inherit the shares in the company—and would not owe one penny of estate taxes in the year 2012 for the first $5,120,000 they inherited. In this scenario, rather than owing $350,000 in estate taxes, they would owe nothing. Zero. And you can add in another $54,000 or so savings, because neither probate fees nor court costs would be owed, either. For estates valued at more than $5,120,000 in 2012, this is an urgent matter.

This plan will not work unless it’s put into place before one of the spouses dies. How? Simple. You amend your revocable living trust (or will, but I hope you’ll have a trust) to specify that after one or the other of you dies, the assets from his or her half of the estate will be put into a new trust, this bypass trust. In effect, you’re putting the money from a revocable trust into an irrevocable trust, because the ultimate beneficiaries have been specified by the spouse who has died, and they cannot be changed.

In the majority of states the revocable living trust is the original trust created jointly by the two spouses. It is the instrument that enables the surviving spouse, after the first one has died, to divide the estate into two shares, the survivor’s trust and the bypass trust. In the revocable living trust, set up while you’re both alive, you specify what happens when one spouse dies and the other is still living and then what happens when both spouses have died.

In some states, however—and check with your estate planning attorney on this—it may be better to use two individual trusts from the beginning, one for the husband and one for the wife. It works the same way, though. The trust set up by the first person to die becomes irrevocable on death but provides that the assets are held for the benefit of the surviving spouse for his or her lifetime. The surviving spouse’s trust continues on the way it always has. After the death of the surviving spouse, it pays out, from both parts of the bypass trust, what’s promised to the beneficiaries. In community property states, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin, we start with a revocable living trust, which provides for what happens when one spouse dies and when both die, and the trust specifies that the revocable living trust can be split into two trust shares upon the death of the first spouse. The trust continues
on as it always has, but you must create the bypass trust at the first death.

After the first spouse dies, the surviving spouse will have to carefully value everything, all the marital assets, and divide them up, at least on paper. (In order to get the maximum benefit in capital gains treatment if you ever want to sell appreciated assets in the future, you’ll need to get a valuation on your assets sooner or later anyway.) This will require the assistance of a good attorney. If the attorney can’t explain the plan to you in a way that you can understand completely, then go to someone else. Don’t pay the attorney the full amount (you may be required to pay a retainer) until all your questions have been answered. If someone tells you it’s too technical to explain, most likely they don’t understand it, either. There are some technical points, but there is no reason you can’t understand the main terms of the trust and why it says what it does.

In the case of Sherry’s family, if Pop or Mom dies before they can be persuaded of the value of a bypass trust, it will be too late and the error will be costly.

It’s easy to tell whether you need a bypass trust. With your spouse, do a quick addition of everything you own—any expected life insurance proceeds due on policies owned by you or your spouse, the equity in your house, your retirement accounts, additional investments, your cars, everything. Now subtract any money you owe. If, to your amazement, you are married and your assets are worth more than the current credit shelter amount of $5,120,000 as of 2012, then, yes, you need a bypass trust. As I mentioned earlier, even though spouses can automatically inherit each other’s unused estate tax exemptions
in 2012, the law past 2012 is not set. So that is reason to still have a bypass trust.