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Ten Estate Planning Pitfalls
ill an estate plan work? Despite the best-laid plans and all the experience in the world, life has a way of unfolding in a manner that appears designed to illuminate the chink in our armor. The recurrence of certain "unforeseen" problems should warrant an upgrade in their status to "foreseeable," and yet some estates will undoubtedly find themselves in the very same predicaments. Let's examine 10 situations that continue to plague estates.
1. Inheriting a Problem
Consider the damnosa hereditas, a large and productive estate that, instead of nurturing heirs, turns out to be financially ruinous to every supposed "beneficiary" whom it purports to enrich. A devise of environmentally contaminated property is an example that promptly comes to mind. The cost of remediating its problems is greater than the property's value and even then you can't sell it or give it away. Other properties may, likewise, be so encumbered by intractable difficulties that one is better off not owning them in the first place.
The Deathbed Gift
A more subtle example of a nurturing estate gone bad has its roots in the commonplace procrastination and last-minute decision-making that, through innate human nature, will always play a role in estate planning. Unfortunately, the very circumstances of such end-of-life transfers raise a number of separate problems. Testamentary capacity is an obvious inquiry where the testator's health is deteriorating.
The circumstances of an infirmed individual who is dependent upon an heir may lend themselves to an allegation of undue influence as well. In addition, certain transfers within three years of death, such as a transfer of life insurance, are not completed transfers under §2035(d)(2). Aside from these potential issues, an estate plan must address the impact of capital gains on the beneficiaries that will follow from any lifetime transfers.
The Kiss of Debt
Mrs. B. owned a New England summer camp and planned to leave it to her three children. One of the children had plans for developing the camp into single-family homes and wanted to form a partnership of Mrs. B and the three siblings. These plans had been discussed, but had not been finalized. Upon learning that his mother was near death, the ambitious son took the partnership papers to the hospital. Mrs. B signed them before lapsing into a coma. As a result, three-fourths of the camp was transferred with its cost basis instead of a stepped-up basis.
The estate valued the camp at $860,000, double the purchase price of half of the property. The IRS valued the property at $4.6 million, based on the retail value of individual lots. In retrospect, the heirs might have argued that the value of the property was offset by development costs or reduced by minority interests. A judge valued the property at $2.7 million. Disclaimers might have undone the harm of the gift as well.
Start with an ill-advised transfer that forfeited the stepped-up basis, overlook the available post-mortem tools of valuation and disclaimers allow tax penalties and interest to start gaining momentum, and the end result was the destruction of a family. The heirs in this actual case now face $12 million of tax liens and have incurred $1 million of legal expenses over eight separate legal actions and 13 years of battle with the IRS. They can't accumulate assets lest they be seized. The financial and legal problems have broken up marriages and ruined lives, and the case remains unresolved even now.1
2. GST Exempt? Hands Off!
In regard to generation-skipping transfer (GST) trusts, there are many potential mistakes that need to be avoided. Practitioners are certainly aware of the GST tax under Chapter 13, §2601 et seq., as well as the exemption, which, for 2000, now stands at $1,030,000. A subtler problem arises when a transfer is made to a preexisting trust, which is tax exempt in either of two ways.
First, a trust to which all or a portion of an individual's GST exclusion has been allocated and that has a zero inclusion ratio, i.e., is completely covered by the exemption, should not be increased beyond the limits of the exemption because of the burdensome tax and tax accounting that will result. Second, and perhaps more significant, is the need to preserve the exempt status of GST trusts which were in existence and irrevocable on September 25, 1985, and are therefore grandfathered. Adding property to the trust may negate the exempt status proportionately.2
3. Marriage, Ethics and Estate Practice
The all-too-typical dilemma of representing both husband and wife is a situation that repeatedly confronts estate-planning professionals. Obviously, if one spouse has children from a previous marriage or each spouse has objectives that may conflict with the other's, a professional's prudent, but rarely followed course of action, may mean representing one spouse or the other or neither. Consider the unintended consequences of representing both spouses.
The Dirty Deed
Erskine Esquire represents both Giles and Mumsy, a perfectly ordinary couple who have been married for 25 seemingly contented years. Erskine inquires as to prior marriages and other children, but there are none. The interests and objectives of Giles and Mumsy overlap entirely. Everything is copacetic.
No sooner has an estate plan been designed and executed, than Giles takes Erskine aside to reveal that he has been discreetly carrying on a "liaison dangereux" with a courtesan named Ginger who, coincidentally, is in her eighth month of pregnancy. "Be a good fellow there, Erskine," said Giles, forcing a nervous smile, "and don't breathe a word to Mumsy." Erskine now has a dilemma. Is he ethically required to reveal to Mumsy, his client, the unpleasant but significant news about the likelihood of a paternity suit even though to do so will necessarily breach the confidence of his other client, Giles? Answer: Yes.3
With such a cautionary tale in mind, the pragmatic practitioner may want to 1) speak in private to each spouse to ask about indiscretions in the cupboards, 2) advise clients in writing about the potential for an ethical conflict stemming from the representation of spouses and indicating the right to a separate attorney that each might prefer, 3) decline to represent the spouse of a client with whom there is a long-standing relationship.
4. Feuding Family Syndrome
Siblings have been known to fight over every penny of their respective shares of an estate. Perceived inequities, differing levels of participation in a family business, and distribution of the family home or personal property are all potential flash points that can derail the administration of an estate and provoke vengeful litigation that exceeds the value of an estate in expenses. Naming one heir as an executor and having that news come as a surprise to that heir's grieving siblings may be ill advised. On the other hand, naming siblings as coexecutors in an attempt to be fair may be even more counterproductive. Siblings who have had conflicts during the testator's lifetime are not likely to mend their differences by making joint decisions about money. A professional fiduciary is preferable.4
5. The Recapture Surprise
Farms are subject to an insidious tax pitfall that can result years after an estate has availed itself of special-use valuation for farmland under IRC §2032A. To qualify for special-use valuation, the operation of the farm must remain in family hands. Despite having agreed to the conditions of the recapture tax at the time of death, circumstances change and heirs inevitably associate such tax arrangements with the settlement of the estate. They are therefore blind-sided by the sudden appearance of a recapture tax when the farm is sold or transferred to non-family members within 10 years of the decedent's death. Though it is not technically an estate or gift tax, a recapture tax can take its toll on an inheritance.5
6. Timely Payment of Estate Tax
There are few valid excuses for not paying estate tax in a timely fashion. For example, upholding prior case precedents, the Supreme Court has held that good-faith reliance on an attorney's advice was not a reasonable cause for filing an untimely estate tax return.
A simple fiduciary act like filing a tax return on time wouldn't seem to be extraordinarily serious. Yet tax penalties and interest for late filing can add up significantly. Consider the recent case of Estate of Sowell v. U.S. In that case, the estate owed about $2.33 million in estate tax but had about $1 million in liquid assets. The estate filed Form 4768 for a five-year extension, but did not appeal the denial of that extension. Nor did the estate demonstrate a reasonable cause for the delay under §6651. As a result, an additional $448,585 of penalties and interest were owed.6
7. The Excessive Non-Marital Trust
The basic two-trust arrangement for spouses calls for a marital trust and a non-marital credit shelter trust. Although the non-marital trust is generally designed to remain outside of the surviving spouse's estate, it is not necessary to build a complete firewall between the non-marital trust and the surviving spouse.
For example, a trustee's discretion to sprinkle income to various heirs, including the surviving spouse, would not preclude the use of the non-marital trust. Additional funds may be allocated from the non-marital trust to the surviving spouse by providing the spouse with certain invasion power if there is an ascertainable standard for doing so under §2040(b)(1)(A). A surviving spouse may also have a limited power of appointment without disqualifying the non-marital trust.
However, the desire to provide as much financial support to a surviving spouse as possible may, in some cases lead to undesirable tax results. A number of estate plans inevitably go too far and inadvertently create a general power of appointment in the assets by making the spouse a trustee with unbridled powers, thereby disqualifying the entire credit shelter.
8. Consumed Alive
How ironic that a cautious individual who, during life, assiduously avoided luxuries and hunted for bargains so as to amass an estate, could leave an estate plan that allows those assets to be so swiftly dissipated that they fail to have a meaningful purpose. Like the eighth plague of locusts, laying waste to the countryside, creditors and heirs alike can descend upon an estate and consume it, aided in part by the "bargain" of a "free" executor who waives fees but makes mistakes.
Forced conservation of assets begins with professional trust and estate administration to control the unlimited use of funds by heirs. Long-term trust arrangements can ensure that funds are set aside for specific purposes-piano lessons, a car upon graduation, tuition for college, etc. Trusts can also be very useful in shielding assets from the creditors that beneficiaries may be exposed to.7
9. A Blind Spot
Testators have a classic blind spot about their beneficiary designations. People tend to assume that a divorce will change beneficiary designations on insurance policies as a matter of law, much as a divorce affects wills in many jurisdictions. However, insurance policies are separately created contracts that establish their own rules for changing beneficiaries.
Example: Within a year of being married, an individual developed multiple sclerosis, which soon rendered him blind. After five years, the individual separated from his wife and was cared for by his father for the final seven years of his life. At his death, his will left all his property, including insurance benefits, to his father. Yet, applying state law (New York), the will's general testamentary statement was insufficient to affect a specific insurance policy's designated beneficiary. The method prescribed by the insurance contract must be followed in order to effect a change of beneficiary.
Two reasons were given for this unexpected result. First, it is important that insurance companies have a definitive means of ascertaining beneficiaries so as to promptly pay them. Uncertainties about language in wills raise the potential for additional claimants turning up and double liability for the insurer. Second, the law precludes speculation about the insured's intent.8
10. A Back-up Plan
It is difficult enough for testators to confront their own mortality by establishing estate plans, but to plan for a predeceased child is to contemplate the unimaginable --the ultimate family tragedy. Nevertheless, we make assumptions about longevity that are not always accurate. The estate plan that does not allow for contingent beneficiaries is simply incomplete.
References
1 Johnston, A gift or an estate? The New York Times, BU-16 (Oct. 31, 1999).
2 On adding property to grandfathered trusts, see Reg. §26.2601-1(b)(1)(i), Prop. Regs. §§26.2601-1(b)(4)(i)(A) through (D), and Letter Rulings 9308007, 9508025, and 199917022. For background, see, Moshman, Avoiding a GST Asteroid, Property & Probate, p. 24 (Sept., 1999), which appeared in alternate form in The Estate Analyst (Aug., 1998). For excellent analysis see, Eisen, Planning to minimize generation-skipping tax: tools and traps, 27 EP 2, p. 73 (Feb., 2000).
3 In a recent New Jersey Supreme Court case, A. v. B. v. Hill Wallack, A-86 (1999), it was held that the firm's duty of disclosure to one spouse outweighed its duty of confidentiality to the other. Hence, Mumsy must be told, even if that disclosure results in the decapitation of Giles.
4 See, The art and science of planning for siblings, The Estate Analyst (April, 1997).
5 A recapture tax also applies to the family-owned business deduction under §2057(c)(2)(A)(ii)-this was redesignated from §2033A.
6 U.S. v. Boyle, 469 U.S. 241 (1985); Estate of Sowell v. U.S., Court of Appeals, 5th Cir., No. 98-11066 (1999). The time demands of an executor's own business were rejected as an excuse in Reinhold, 7 TCM 697 and Bevan, TC Memo. 1989-256. A flurry of excuses-executor's youth and inexperience, complexity of assets, valuation problems, multiple wills, illiquidity, etc.-were rejected in DePaoli, 66 TCM 1493, TC Memo. 1993-557. However, there are exceptional circumstances that meet the test. In Buring v. Comm'r, TCM 1985-610 (1985), reasonable cause was established where there was an affirmative act consisting of an erroneous statement of the filing deadline by the estate's accountant. In, Brown v. U.S., U.S. Dist. Ct. Tenn. (1985), the attorney handling the estate tax return was hospitalized shortly before it was due and the elderly executor lacked the business prudence to take the proper actions.
7 Asset protection for estate-planning clientele, The Estate Analyst (Aug., 1995).
8 McCarthy v. Aetna Life Ins. Co., 92 NY2d 436 (1998).
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