McNees Insights- Estate Planning – Spring 2015
March 24, 2015
In this Issue: In Defense of Probate l Life Insurance and Estate Planning l Who Will Get Your Assets – The Hazards of Beneficiary Designations
In Defense of Probate
A critical goal of estate planning is to ease the burdens of administering the client’s estate for her beneficiaries. Clients rightfully wish to streamline the process for settlement of their affairs and seek guidance on how best to achieve that. In the popular press, avoidance of the probate process is often cited as a solution.
Countless articles and books have been written on the subject, painting the process with a broad (and misleading) brush as overly bureaucratic, costly and time-consuming. While there are sound benefits to avoiding probate in certain cases, adherence to the anti-probate doctrine has increasingly supplanted thoughtful estate planning as a goal. The results are too often unintended, expensive and divisive of family harmony.
Technically, the word ‘probate’ refers to the act or process of proving a Will to be the authentic last will and testament of a decedent. However, the term probate has come to encompass the entire process of settling an estate from death to the ultimate distribution of assets. This includes major drivers of time and expense that are unrelated to probate such as tax reporting and resolution of disputes over distribution.
At death, probate assets are transferred by Will and non-probate assets are transferred by some other mechanism, typically, joint ownership or a beneficiary designation. Avoidance of probate causes assets to pass more or less directly to beneficiaries rather than passing through a Will. Often, particularly with married couples, this is the preferred manner of property transfer, the simplest example being a jointly owned home passing automatically to the surviving spouse. Other common non-probate transfers of property include life insurance and annuity proceeds passing to the beneficiary of the contract.
While the specifics of the legal process vary from jurisdiction to jurisdiction, here in Pennsylvania the ‘probate’ aspect of estate administration is quite simple in the vast majority of cases. The executor named in a Will takes the original of that Will to the office of the Register of Wills in the county of the decedent’s residence, along with a death certificate and a petition asking that the Will be admitted to probate and the executor be officially appointed. The executor takes an oath to faithfully administer the estate according to law, the petition is processed, and the executor receives his official appointment (letters) either on site or the next day. Following appointment, the process requires only that the executor notify the estate beneficiaries of his appointment and inventory the assets of the estate for the Register.
The probate fees, so frequently cited as a primary reason to avoid the process, are relatively modest. On an inventory value of $500,000, for instance, the fee is $675.50 in Dauphin County, less than 1/7th of one percent. These fees are almost never worth the cost of probate avoidance itself. Barring any disputes among the executor and the beneficiaries, Pennsylvania requires no other court supervision and administration ends with filing a short status report with the court.
The other aspects of the estate settlement process have chiefly to do with tax reporting and payment. In most cases, a Pennsylvania Inheritance Tax Return is required and in very large estates, a federal Estate Tax Return. Contrary to inferences made by the anti-probate advocates, taxes will not be minimized by avoiding probate; but, perhaps counter-intuitively, serious tax issues can be caused by probate avoidance. This is one reason that we caution clients to avoid falling into the anti-probate trap.
Converting an asset that would otherwise pass by Will may create more problems than it solves. Joint bank accounts are frequently established between parent and child to address a number of perceived issues, but that form of titling can have serious and costly consequences. If the child predeceases the parent, for instance, the parent will have to pay tax on her own funds because joint accounts are generally taxed at the death of either owner regardless of who funded the account. If the parent has more than one child, the asset will pass only to the co-owner, bypassing his or her sibling(s).
Almost always, there are alternate strategies that more effectively address the issues that motivate creation of non-probate assets. For example, a parent who wishes to allow her child to sign checks for her to pay bills is better served by naming the child as Agent under a Power of Attorney. Simply putting the child’s name on the account actually changes the ownership of the account whereas a power of attorney authorizes the child to act for and in the interests of the parent. In addition, a Power of Attorney gives the child authority with respect to other transactions that may be desirable for the child to effect on the parent’s behalf.
In our view, probate is often a reasonable and necessary aspect of a sound estate plan. Executors have specific and enforceable fiduciary responsibilities to the beneficiaries. The fact that the Executor is required to give certain notices to the beneficiaries ensures some level of communication among the parties. A Will can easily direct funds to trusts or custodianships for minor children, whereas designation of a minor child as a beneficiary on an account will necessitate establishment of a court-supervised guardianship, a costly, cumbersome process that, perhaps most troublingly, ends abruptly at age 18 (not an age at which the typical child is fiscally mature). Assets passing through a Will are available to pay the taxes on behalf of multiple beneficiaries rather than the liability and responsibility for filing returns passing directly to each.
Of course, there are reasons to avoid probate in specific cases. For Pennsylvania residents with real property in other states, such as New Jersey or Florida, we often recommend that clients transfer title to such property to a Revocable Trust to allow it to bypass the costs of probate in a remote jurisdiction. Designation of a beneficiary on a qualified retirement plan may ensure preferential tax treatment. And new federal tax rules have made joint spousal ownership of business and investment assets once again a preferable form of ownership for some clients.
Pennsylvania law minimizes many of the perceived costs of probate and in many cases, probate will be a desirable aspect of estate settlement. Before making avoidance of probate the goal, estate planning clients should consult their advisors to come up with effective alternatives.
Life Insurance and Estate Planning
Life insurance can play an important role in estate planning. It is important to understand the uses and purposes of life insurance and the tax consequences of owning a policy and receiving a death benefit.
One of the most common uses of life insurance is to replace lost income of a spouse. The difficulties of losing a spouse can be compounded greatly by the loss of a spouse’s income. One of the key features of life insurance is that the receipt of the death benefit generally is not taxable income to the beneficiary (the death benefit is taxable income if there has been a “transfer for value” of the policy). Therefore, the life insurance death benefit can provide financial stability to the insured’s family.
Clients should also not lose sight of the value of a spouse not in the workforce. Life insurance is often acquired on the life of the “stay-at-home” parent to provide financial resources to the employed spouse if there is an unexpected death. The value of the contributions of the stay-at-home parent should not be underestimated.
A common planning purpose for life insurance is to purchase a policy with the idea that the death benefit will be used to pay federal estate tax or to replace the value of other assets used for this purpose. The federal estate tax exemption amount currently is $5,430,000 per person. Although the death benefit of a life insurance policy is part of the decedent’s taxable estate, fewer persons are subject to this tax than in the past. This planning use of life insurance, therefore, is not as widespread as in the past. Some clients, though, set up “Life Insurance Trusts” in the past when the estate tax exemption amount was much lower. It is prudent to review these arrangements to make sure the ownership of the policy should be continued, whether in the trust or otherwise.
We are often asked by clients how to avoid the Pennsylvania inheritance tax. Pennsylvania unfortunately does not have an exemption amount like the federal estate tax. However, the inheritance tax does not apply to a life insurance death benefit, so funding a life insurance policy is one way of taking a taxable asset (cash) and converting it into a non-taxable asset (the death benefit).
Funding Buy-Sell Obligations
Life insurance often is acquired by business owners to provide funds to carry out a buy-sell obligation between the owners. The death benefit provides the liquidity needed to close the purchase and sale of the business interest and to allow the surviving business owner to focus on operating the business.
Types of Life Insurance Policies
A variety of life insurance products are available, and the determination of which product is best for you should be made in consultation with your professional advisors. For example, a term life insurance policy may be best suited for you or you may want a policy that has cash value (whole life or universal life). You should also consider whether the policy will insure one life or will insure joint lives. A “second-to-die” policy often is purchased by spouses to pay estate tax since most estate plans defer the payment of estate tax until the death of both spouses. There may also be options regarding premium payments, policy loans, surrender charges, and contract riders. It is important to note that life insurance is regulated at the state level, so the policies that are issued are approved in advance by the Department of Insurance. Nevertheless, selecting the right type of policy can be complex given the variety of choices in the market, so it is important to consult with your professional advisors when purchasing life insurance.
Generally speaking, the life insurance policy should be owned by the insured, by a trust, or by the insured’s business party (for a buy-sell). Occasionally, we will see a client who owns life insurance insuring the life of another person, such as a child or a spouse. Although there is nothing wrong with these arrangements, the risk is that the owner of the policy will die before the insured party. If so, the life insurance contract will be part of the deceased owner’s estate and the disposition of the policy will be controlled by his or her Last Will and Testament. As noted above, in some cases the transfer of a life insurance policy will be a “transfer for value.” If there is a transfer for value, then the death benefit is taxable income to the beneficiary. A transfer for value occurs if, upon the death of the policy owner, the life insurance policy is transferred to anyone other than the insured party.
Some clients will seek to exclude the death benefit of a life insurance policy from the their estate (and therefore escape federal estate tax) by having their children own the life insurance policy insuring the client’s life. There is nothing wrong with this arrangement either, but the risk is that the child will go through a divorce or bankruptcy. The life insurance policy is property owned by the child that any creditor, such as a divorcing spouse or a bank, may go after.
Life insurance can be an important part of your estate plan. Its uses and purposes will vary based on a client’s situation. Each client, in consultation with his or her professional advisors, should be sure to understand the purpose and function of the life insurance being acquired as well as the type of policy being acquired.
Who will get Your Assets – The Hazards of Beneficiary Designations
Most people assume that their Wills will control where their assets go after they die. Increasingly, however, beneficiary designations are controlling how assets are distributed, and sometimes with unexpected results. Beneficiary designation forms are completed not only for life insurance and retirement plan assets, but also with respect to many bank and brokerage accounts, sometimes without the full knowledge of the account owner. These bank and brokerage accounts with beneficiary designations built in are sometimes called payable-on-death (POD) or transfer-on-death (TOD) accounts. With a POD or TOD account, there is no transfer of ownership during lifetime, with the transfer to the named beneficiary occurring at the death of the account owner.
TOD and POD accounts differ from jointly-held accounts, where ownership is shared with one or more other individuals during their life time, with any of the joint owners having the right to withdraw money from the account at any time. Ownership of a joint account vests in the surviving joint owner(s) at the death of the first joint owner to die. There are also accounts where someone else is designated as having check writing authority, but this feature lapses at death, with the asset then falling into the estate of the deceased account owner.
It is quite often the case that people are not aware of what kind of account they are getting when opening a new account at a bank or with a stockbroker. The question is asked “Would you like to put someone else’s name on the account?”, but this can mean a variety of things. However, how the account is titled can mean a big difference with how the account is treated during the estate administration process. If for example, an oldest child is named as the beneficiary of a POD or TOD account, the entire amount in the account will be transferred to the oldest child at the death of the account owner, with the other children inheriting nothing from the account. Meanwhile, the account owner might have thought that the oldest child merely had check writing authority. For obvious reasons, this can result in discord among the account owner’s children.
Even if someone’s accounts are properly titled to include all children as the death beneficiaries, titling all accounts in POD or TOD format can leave no assets in an estate to pay inheritance taxes or to fulfill special bequests to individuals or charity. This can make life very difficult for an executor. In addition, POD and TOD accounts typically are “frozen” at the death of the account owner, with no transfer occurring until the Pennsylvania Department of Revenue is satisfied that appropriate inheritance taxes will be paid. Thus, it can take longer to access POD and TOD accounts than is the case with regular probate assets.
Another disadvantage of POD and TOD accounts, as well as other assets with beneficiary designations such as retirement plan assets, is that if one of the death beneficiaries predeceases the account owner, the predeceased beneficiary’s children will not inherit, but rather the account will be divided among the surviving beneficiaries. This is a problem that can be easily avoided with probate assets, with the “per stirpes” designation meaning that a deceased beneficiary’s shares goes instead to his or her children.
While in some cases there are very good reasons to use POD and TOD accounts, too often the designation is used carelessly and without the knowledge of the account owner’s estate planning attorney, with sometimes unfortunate results. Furthermore, how an account is titled is information that institutions are prohibited from sharing with those who are not the account owners, making this information difficult to access. The situation is made worse because those working for these institutions are not always familiar with the variations in the different types of accounts or the effects of making certain designations.
The moral of the story is that it is extremely important for you to know how your various accounts are titled, and that your attorney is familiar with this information. In addition, you should be reviewing your account designations on a regular basis, to make sure that the death beneficiaries named have kept up with changing circumstance. Your Will does not control assets with beneficiary designations, so merely updating your will cannot fix improperly titled assets.
© 2015 McNees Wallace & Nurick LLC
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