Planning for income tax for heirs.

Posted in Planning, Tax planning at 9:52 am

It’s tempting to compare one’s assets to the exemption amounts for federal estate tax ($2 million in 2006, 2007, 2008) and conclude that there are no tax issues in planning one’s estate (or failing to plan).

Unfortunately, that’s only part of the story.

One often underappreciated aspect of estate planning is planning for income tax implications for heirs – ideally, one would like to give heirs assets that are subject to as little tax as possible. Most property that appreciates – for example, real estate, collectibles, and securities (stocks & mutual funds) get what’s called a “step up” in basis when it’s transferred at death.

For example, let’s say that Dad has a share of stock he bought long ago for $10 – the stock is now worth $100. If Dad sells that share of stock, he’ll owe income tax on the $90 of profit he made while holding the stock. The $10 purchase price (which may have been adjusted due to stock splits, reinvested dividends, and so forth) is what tax people call Dad’s “basis” in the stock.

Let’s also assume that Dad wants to give that share of stock to his daughter. If Dad gives that share of stock during Dad’s lifetime to Daughter, Daughter will get what’s called “carryover basis” – that means that Daughter’s basis in the stock will be the same as Dad’s basis, which was $10. If Daughter immediately sells the stock, she’ll also have to pay tax on the $90 of built-in profit.
However, if Dad keeps the stock and gives it to Daughter upon his death – either through a trust, or through a will – then the stock gets the “step-up” in basis, and Daughter’s new basis in the stock is the fair market value on the date that Dad died. This means that if Daughter immediately sells the stock, she’ll have (virtually) no tax to pay, since her basis (fair market value) will be very close to the sale price. Daughter may have a small gain or a small loss on the stock, but it won’t be very big if she sells the stock relatively quickly.

The same treatment applies to other property that appreciates – like real estate or collectibles.

Some property – like cash – is valued at its face value, so it doesn’t make sense to talk about getting a “step up basis” in, say, a bank account.

This sounds great, right? Well, there’s a catch. The only property that gets a step-up in basis is property that’s included in Dad’s “taxable estate” at his death. The good news is that the vast majority of people may have a “taxable estate” but pay no tax, because they get an exemption equal to the tax on the first $2 million of property (for people who die in 2006, 2007, 2008). So .. this means that Dad can pass along up to $2 million in property, all of which gets a step-up in basis for income tax purporses, without owing any estate tax.

If Dad passes more than $2 million in property to others at his death, then his estate will owe tax on the amounts above $2 million – unless the amounts beyond $2 million are given to recipients who have special exemptions. (Specifically, charities and Dad’s spouse, if she’s a US citizen. Charities and spouses who are US citizens can receive an unlimited amount of property at death without any estate tax obligations.)

In my practice, I find that most people notice (and appreciate) the step-up in basis when it is applied to real property. Specifically, the step-up in basis is very helpful to surviving spouses, especially if the shared home was titled as community property. When property is titled as community property, the entire property gets a step-up in basis upon the death of the first spouse.

Let’s say that Mom and Dad bought their house in 1970 for $100,000. Today, the house is worth $1,000,000. (These numbers will look crazy to non-California readers; but they’re not unusual for middle-class people here in Silicon Valley.)

If Mom and Dad sell the house, they’re going to have to pay tax on approximately $400,000 of capital gain – they can exclude the first $500,000 in capital gain when they sell their principal residence, but they’ve got $900,000 in profit – so they’ve still got another $400,000 that they’ll have to pay tax on.

Men tend to have shorter lifespans, so let’s suppose that Dad passes away first. Now – because of the step-up in basis and holding title as community property – Mom’s new basis in the home is $1,000,000. Mom can sell the house and her profit will be zero – so no tax will be due. Let’s say that Mom stays in the house 5 more years – and during those 5 years, the house appreciates another $200,000 in value, to $1,200,000. Mom can still sell the house without having a tax bill to worry about, since she’s got her $250,000 exclusion – applied to the $200,000 profit above Mom’s basis of $1,000,000, there’s still no taxable gain.

But let’s imagine that Mom doesn’t sell the house – Mom lives 10 more years, and the house appreciates in value to $1,500,000. Mom dies, leaving the house to her two kids. If the house is included in Mom’s taxable estate, the kids will get the step-up in basis again – so their basis in the house will be $1,500,000 (or, each kid will have a basis of $750,000 in their half of the house). This means that the kids, if they choose to sell the house, can keep the $750,000 each – with no estate tax, and no income tax due. That’s a pretty nice result, given that Mom & Dad’s original investment in the house was $100,000. $1.4 million in appreciation has passed to the children, tax-free, perfectly legally.


Suze Orman and Estate Planning

Posted in Living trusts, Planning, Wills at 1:27 am

Professor Gerry Beyer mentions that QVC is offering a $60 Suze Orman estate planning organizer – where “organizer” apparently means “plastic briefcase with LED flashlight built into the handle”. Sounds perfect for Maxwell Smart or Inspector Gadget.

If you can live without the plastic briefcase, you can get Suze Orman’s estate planning software from Amazon.com for approximately $14.

The downside is that you get what you pay for – specifically, you’ll get a document you can’t edit that specifies that it should be interpreted using California law. This is not especially remarkable if you are a California resident, as that’s probably what you intended.

On the other hand, if you happen to live in one of the other 49 states, it’s setting you up for an ugly surprise if administration of the trust or estate turns out to be anything other than perfectly smooth – because it’s going to be difficult and/or expensive to find someone in your state who’s also licensed in California and stays current regarding California trust law. If it turns out that there’s litigation regarding the trust, you’ll get to pay that expensive attorney even more than you otherwise would, because they’re going to have to spend extra time writing a detailed brief for the judge explaining California law .. since it’s pretty unlikely that you’ll randomly get assigned a local judge who’s got any knowledge about California law.

California law strikes me as an especially poor choice of law if someone was going to try to draft a “universal trust” since California law is essentially homegrown. California has not adopted the Uniform Trust Code and I don’t believe it will, though 19 other states have.

The marketing material says the resulting documents are “good in all 50 states” – which is literally true, but totally misleading. When I speak with someone who wants to bring an out-of-state trust into California, my advice is to amend and restate it to use California law for ease of understanding and administration. In a similar vein, when I talk to potential clients who live (or expect to live) in another state, my advice to them is that they not pay me to draft an estate plan, but that they seek a good estate planning attorney in their (intended) home state, who will know the local tricks and pitfalls.

“Good in all 50 states” is the legal equivalent of “one size fits all” – it’s a giant warning that what you’re getting wasn’t intended specifically for you, and if it happens to work out well it’s a happy accident.

I think it’d probably be better if the Suze Orman trust didn’t specify a state’s law at all – or if it chose the law of the state where the user lived, even if it means that the person who wrote the software doesn’t know how the language will be interpreted. Frankly, I don’t see how the person who wrote the software can have any faith that, say, a New York judge will reach a reasonable result under California law trying to interpret a do-it-yourself trust for a New York resident. (Nothing against New York, I wouldn’t want to try to litigate a trust that specified New York law in a California courtroom, either.) I gather that choosing California law allows the attorney involved in publishing the software to avoid the charge that she’s trying to practice law in states where she’s not admitted to practice .. but while that trick may save her bacon, it puts people who buy the software in a terrible posture.


LawGuru Question: One spouse’s planning after marriage

Posted in Planning at 11:00 pm

A LawGuru poster asks: “If I set up a trust for my grown children after I got re-married, does the spouse have any claim to that trust or any assets in that trust upon my death? Specifically, can I set up a separate trust without my spouse having access to it?”

The answer depends on what sort of property you own.

California is a community property state – this means that it’s important to understand the difference between community property and separate property.

Community property is property you acquire during your marriage, typically by working – or property you buy with community property money. (For example, if you work, your paycheck is considered community property – so things that you buy with that money will also be community property.) Community property also includes any interest, dividends, or capital gains earned by community property money or investments. (So, if you put your paycheck in the bank and earn some interest on the money, the interest will also be community property.)
Separate property is property you held before marriage, or property that you gain during the marriage by gift or inheritance. Separate property also includes the interest, dividends, or capital gains earned by separate property during your marriage. (If a family member wills you $1000, that will be your separate property; if you put that money in the bank and it earns interest, the interest will also be your separate property.)

That doesn’t sound so tough – but the hard part is figuring out where money went (lawyers and accountants call this “tracing”) when community property money and separate property money are mixed (“commingled”). If you’ve got a bank account where you deposit your paychecks, and then you get an inheritance, and you deposit the money from the inheritance into the same account .. and then you write some checks out of that account, perhaps to fix up your (community property) house and your (separate property) collectible automobile, it can be tough to determine whether the money that was spent was community money or separate money, and whether you made a gift by spending your separate property money on a community asset (the house) or if your spouse made a gift by allowing you to spend community money on a separate property asset (the car).

(Actually, there are a number of further complicating factors that I’m ignoring in the interest of clarity – if this is an important topic to you, you should sit down with an estate planning attorney or a divorce attorney – depending on your needs – to really pin down the specifics of your situation.)

Upon your death, you have the right to decide who will get all of your separate property, and one half of your community property. (The other half of your community property belongs to your spouse.)
So, if you have property that everyone agrees is separate property, you can give that to anyone you please, and your spouse has no right to object or to interfere. (Similarly, of course, your spouse can dispose of their separate property as they please ..)

You can also dispose of one half of your community property as you please, without your spouse’s consent.

The tricky part here is figuring out or agreeing about the characterization of some property as community property, and some property as separate property – you may think that certain money or certain property is obviously yours .. and your spouse may think it’s obviously community, or obviously theirs. The process is a little bit like negotiating a divorce settlement, without the divorce, because (ideally) the parties will continue to be married, but with a clearer idea of who owns what.

So, to come back to the question – yes, a married person can create an estate plan that disposes of their property to people other than their spouse, and the spouse can’t change it – but this is a delicate situation that requires both careful attention to detail (legal & factual) and a measure of diplomacy, because the process isn’t an easy or a comfortable one. You can ignore the issue (or find an attorney who will ignore the issue) but this simply defers the unpleasantness until after your death. This means you won’t have to deal with it, but it also makes it less likely your wishes will be carried out.


Estate Planning for Families with Pets

Posted in Living trusts, Planning at 11:21 pm

One frequently misunderstood or underappreciated area of estate planning concerns estate planning for pets.

No, this does not mean writing a will to designate who will inherit the bones your dog has buried in the sofa cushions. Nor does it mean leaving your house (or your Cadillac) to your cat.

From a legal perspective, pets are considered personal property, just like jewelry or clothing or other personal effects – so it doesn’t make any sense to think about leaving one item of property to another item of property, any more than we would say “Upon my death, I leave my house to my car.”

And, from a practical point of view, the idea goes nowhere quickly – animals are obviously incapable of managing property, and domestic animals are subject to capture by animal control authorities if they’re conspicuously uncontrolled by human beings.

So – if estate planning for pets isn’t concerned with those two red herrings – what is it all about?

In simple terms, estate planning for pets (and pet owners) consists of three basic steps:

  1. identifying the current strategy for pet care considered appropriate by the owner and recording that strategy in an understandable fashion;
  2. identifying one or more people, or one or more classes of people, who would be appropriate substitute trustees or caregivers in the event of the pet owner’s incapacity or death;
  3. identifying a sum of money which is likely to be sufficient to fund the care identified in step 1, and sufficient to compensate (as needed) the people identified in step 2 as they provide that care.

The desired care can be as elaborate or as simple as the owner/trustor desires – from providing for food, veterinary care, grooming, recreation, alternative therapies, prescription medications for chronic conditions, to providing funds for the animal’s eventual cremation or burial.

I typically suggest that an estate plan for pet care be implemented as a trust with a human beneficiary; California law allows for honorary pet trusts, but I believe those trusts are inferior because no person then has standing to object to mismanagement on the part of the trustee. Trust-based plans are also superior to outright gifts of cash because, managed correctly, they prevent the funds from being dissipated or lost due to the animal caretaker’s own financial distress, divorce, bankruptcy, or death.


California tweaks state Health Care Directive Registry

Posted in Incapacity planning, Legislation at 2:48 pm

AB 1676, passed during the 2005 Legislative session, makes further changes to California’s little-known Healthcare Directive Registry. California law allows registration of an Advance Health Care Directive with the Secretary of State; the new legislation directs the Secretary of State to work with the Attorney General and the Department of Health Services to develop written information about Advance Health Care Directives, and to make that information available on the websites of the Secretary of State, the Department of Health Services, the Attorney General, the Department of Managed Health Care, the Department of Insurance, the Board of Registered Nursing, and the Medical Board of California.

First steps towards Ladybird/Beneficiary Deeds in California

Posted in Legislation, Nonprobate transfers at 2:17 pm

Last year, the California Legislature passed – and Governor Schwarzenegger signed – legislation (AB 12) directing the California Law Review Commission to study California’s current methods for transferring property at death, the methods used in other states for transferring property at death, and to consider whether or not California should allow the use of “Ladybird” or “beneficiary deeds”. What is a Ladybird deed, and why should you care?
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