AVOIDING ESTATE PLANNING MALPRACTICE

In Brief

Ten Trouble Spots

The practice of estate planning by CPAs can be highly leveraged. Because the amounts are large and tax rates high, effective tax planning can justify high fees. However, if mistakes are made, the same factors can cause significant settlements in malpractice cases brought against the CPA. The following are some of the trouble spots and how to effectively deal with them:

* Relying solely on the unlimited marital deduction. Consider the use of bypass trusts.

* Allowing surviving spouse unlimited access to trust. Limit access to principal to an ascertainable standard such as health, education, support, or maintenance.

* Noncoordination of probate and nonprobate assets. Change ownership of bank and brokerage accounts from right of survivorship to tenants in common.

* QTIP trust income. Surviving spouse must be entitled to all trust income at least annually.

* Boilerplate provisions. Critically evaluate all boilerplate language in light of a client's circumstances.

* Life insurance proceeds. Consider the use of an irrevocable life insurance trust.

* Gifts of future interests. Convert to gifts of present interests.

* Funding testamentary trusts. Fund testamentary trusts as soon as practical.

* Control of gift assets. Ensure that donors do not maintain control of assets they give away.

* Property passing to very wealthy. Parents should create a generation skipping trust.

Although it can be a highly rewarding part of a CPA's practice, estate planning often increases the risk of substantial malpractice claims. Clients enter the 41% Federal estate tax bracket as their taxable estates pass the $1 million mark and hit the 55% rate at just $3 million. An error or omission in an estate plan or its execution can be very costly.

Despite the hazards, estate planning often is a normal outgrowth of other parts of an accounting practice. As the person most knowledgeable of a client's financial affairs, a CPA should work closely with the client's attorney who drafts the will and related documents, both before and after the client dies. Reviewing a client's estate plan is especially critical if the attorney is not a specialist in the area. Ten of the most common trouble spots and how to avoid them are a means of addressing these hazards.

Relying Solely on Unlimited Marital Deduction

An unlimited marital deduction allows the transfer of any amount of property free of Federal gift or estate tax to a spouse who is a U.S. citizen. In addition, each person has a unified tax credit permitting the tax free transfer of up to $600,000 to nonspousal beneficiaries. A married couple has two such credits and may transfer up to a total of $1.2 million to their children or others.

In simple wills, spouses often designate each other as the sole beneficiary. Since this takes advantage of the marital deduction, the first to die pays no estate tax, but wastes his or her unified tax credit. All property is included in the survivor's estate at death, but only one unified tax credit is available.

Example. Ralph and Clara have a joint estate of $1.2 million. Ralph dies first, leaving his approximately one-half of the estate outright to Clara. When she dies, only $600,000 is protected by Clara's unified tax credit and transferred to beneficiaries free of tax. The estate tax liability on the remaining unprotected $600,000 is about $235,000. If Ralph had used his unified tax credit, they would have owed little or no estate tax.

The first to die could use his or her unified tax credit by transferring that share (up to $600,000) of the estate outright at death to children or other nonspousal beneficiaries. This strategy eliminates U.S. estate tax, but it may leave the surviving spouse with inadequate resources to continue a comfortable lifestyle, and beneficiaries might quickly dissipate their inheritance.

A better alternative is for each spouse to insert a bypass trust, sometimes referred to as a credit shelter trust or exemption equivalent trust, into their will or living trust. The surviving spouse, children, or both, are usually designated beneficiaries of the trust. The spouse who dies first uses his or her unified tax credit, transferring up to $600,000 into the trust without gift or estate tax. At the surviving spouse's death, bypass trust assets are exempt from estate tax under IRC section 2041.

Allowing Surviving Spouse Unlimited Access to Trust

Often, the surviving spouse serves as trustee of a bypass trust. In this circumstance, the trust must limit the surviving spouse's access to principal to an ascertainable standard such as "health, education, support, or maintenance." If the surviving spouse is capable of invading principal beyond this ascertainable standard, he or she is deemed to possess a general power of appointment under IRC section 2041(b), and trust assets are included in his or her estate at death.

This trap might be as subtle as failing to include a clause denying a beneficiary/trustee the use of trust assets to satisfy a legal obligation to support minor children. If the spouse dies before the children reach majority, trust properties may be included in his or her estate even if no property was distributed to them.

Example. Bart and Martha have two minor children they must support under state law. The bypass trust document in their wills provides that the survivor is to be both the trustee and a beneficiary and may distribute trust principal and income for the health, education, support, or maintenance of the survivor and the children. No clause prohibits him or her from satisfying a legal obligation to support. If Bart dies before either child reaches majority, Martha possesses a general power of appointment. If Martha then dies before both children reach majority, trust properties are included in her estate even if she never exercises the power.

Noncoordination of Probate and Nonprobate Assets

Assets generally cannot be used to fund trusts if their transfer at death is governed by survivorship clauses, beneficiary designations, or other agreements or contracts. Joint accounts with right of survivorship, life insurance, and IRAs and other retirement plans are examples of such "nonprobate" properties. They are transferable to a testamentary trust only if the trust or the owner's estate is the designated beneficiary or if the beneficiary predeceases the taxpayer. Otherwise, generally only "probate" properties can be transferred to a trust at death.

Generally, a client with a tax-oriented will should change ownership of bank and brokerage accounts from right of survivorship to tenants in common. A small account under the survivorship designation should remain to allow the survivor immediate access to cash after a spouse's death. Consideration should be given to naming the trustee of a bypass or other trust as the beneficiary of any life insurance policies. Without these changes, trusts may not be fully funded, costing the estate perhaps hundreds of thousands of dollars in estate tax.

Example. Harry and Janet, a married couple, have a joint estate of $2 million as follows:

Cash in bank account held jointly with right of survivorship $ 60,000

Janet's IRA, which names Harry as the beneficiary 80,000

Home owned as tenants in common 250,000

Harry's life insurance policy of which Janet is the beneficiary 750,000

Brokerage accounts held jointly with right of survivorship 860,000

$2,000,000

If Harry dies and his will creates a bypass trust, the only asset available to fund it is his portion of the residence. His remaining share of each item in the estate passes to Janet outright. If she died soon after, Janet's gross estate might be close to $1.9 million. By restructuring beneficiary designations and transferring Harry's insurance policy to a life insurance trust (see below), they could save more than $500,000 in estate tax.

Income and estate taxes on retirement plans are beyond the scope of this discussion. Beneficiary designations should be changed only after thoroughly examining a client's specific situation and possible tax ramifications.

QTIP Trust Income

A spouse whose share of the estate will exceed $600,000 should consider inserting an IRC section 2056(b)(7) qualified terminable interest property (QTIP) trust into the will or living trust. A bypass trust acts much as an auto's radiator, while a QTIP trust is the overflow reservoir. An executor transfers up to $600,000 of a decedent's share of the estate into a bypass trust and transfers the excess into a QTIP trust.

Sometimes referred to as a marital trust, a QTIP trust protects the overflow and manages it for the benefit of the surviving spouse. It also locks in the beneficiaries for this portion of the estate at the time the first spouse dies. While a bypass trust actually eliminates estate tax, a QTIP trust only postpones tax with the marital deduction in the same way an outright gift or bequest to a spouse does. IRC section 2044 includes QTIP trust assets in the surviving spouse's estate.

A key requirement of a QTIP trust is that the surviving spouse be entitled to all trust income at least annually. If this provision is omitted, no marital deduction is allowed and the spouse who dies first owes estate tax on any property transferred to the defective trust.

Example. Frank and Jane request tax-oriented wills creating bypass and QTIP trusts at the death of the first spouse. They want the QTIP trust to accumulate income not needed by the surviving spouse. This trust will not qualify for the marital deduction, and QTIP trust properties will be taxed at the first spouse's death.

A QTIP trust requires other provisions and a tax election that are beyond the scope of this discussion.

Boilerplate Provisions

A CPA should critically evaluate in light of a client's circumstances any boilerplate language that an attorney copies from a master form. Here are five
common provisions that may require modification:

* Consider eliminating clauses that call for payment of taxes from the "residue." Suppose an unmarried client with a $1.2 million estate gives specific bequests of $400,000 in real property to each of two children and the remainder of the estate to a third child. The entire $235,000 estate tax liability may come from
the third child's share, leaving only $165,000.

* Today's blended families and informal unions, sometimes with children born out of wedlock, often require a more liberal definition of "child" and "descendants" than is generally provided.

* A corporate fiduciary that charges market rates for administering a will or trust should not necessarily be relieved of liability for ordinary negligence with an exculpatory clause.

* A client may or may not wish to require a bond for a family member or friend who serves as fiduciary.

* It may be necessary to modify or eliminate the standard no-contest clause so that contentious children will receive some benefits.

Life Insurance Proceeds

Although generally not subject to Federal income tax, all or part of life insurance proceeds are subject to estate tax under IRC section 2042 if the insured has an incident of ownership such as the power to change beneficiaries or redirect the proceeds to his or her estate. Naming children as beneficiaries does not remove the proceeds from an insured's estate.

If the insurance is owned as tenants in common or as community property, only a portion of the proceeds is included in a decedent's estate; the remainder, in the survivor's. If the spouse is the beneficiary, the unlimited marital deduction eliminates the proceeds in computing the decedent's taxable estate but includes them all in the survivor's estate.

An irrevocable life insurance trust removes the proceeds from both spouses' estates. The trustee purchases a new policy or the insured transfers an existing policy to the trust, giving up all control over it. Purchasing a new policy is often preferable since the proceeds of a policy transferred within three years of death are included in the insured's estate under IRC section 2035(d)(2).

Example. Karen and Louis, a married couple, equally own $1.2 million of cash, real estate, investments, and personal property. They will owe no Federal estate tax on the $1.2 million since each has a will with a testamentary bypass trust. In addition, Louis has an $800,000 life insurance policy naming Karen as the primary beneficiary. If Louis dies first, Karen's estate could owe as much as $320,000 of estate tax on the proceeds. A life insurance trust would eliminate this tax and still allow Karen access to the entire $2 million estate, including the life insurance proceeds, for her remaining life.

Gifts of Future Interests

Just as U.S. estate tax applies to transfers at death, Federal gift tax applies to transfers during life. For gifts of a present interest, where the donee's possession and enjoyment begin immediately, the law grants an annual exemption of $10,000 per donee. The exemption is $20,000 if spouses join in a gift.

A gift of a future interest, where the donee's possession and enjoyment are delayed, does not qualify for the annual exclusion. The gift automatically uses up part of the donor's unified tax credit. The donor can transfer less property tax free at death to a bypass trust or outright to nonspousal beneficiaries and is more likely to owe estate tax.

Gifts to a trust created during a lifetime, such as funds for payment of premiums on life insurance or for a grandchild's education, are gifts of a future interest. They can be converted into gifts of a present interest in either of two ways, however.

* The grantor could create and make transfers to an IRC section 2503(c) trust that meets several criteria, including distribution of all remaining trust property to the beneficiary at age 21.

* The trust document can grant a Crummey withdrawal power to beneficiaries of the trust, allowing them to withdraw a stipulated amount of value (typically $10,000 or less) for a limited period of time. Each beneficiary must be notified and given an opportunity to exercise the Crummey withdrawal power, but most realize that doing so could discourage subsequent gifts to the trust.

Example. Gina, a single mother, creates a life insurance trust naming her two minor children sole beneficiaries and transfers $20,000 into trust for payment of premiums. The trust may not qualify under IRC section 2503(c), but the transfer still is eligible for the annual $10,000-per-donee exemption from gift tax if the trust document grants each child a Crummey withdrawal power. If the trustee fails to do so, the transfer reduces Gina's unified tax credit and the amount of property she can transfer tax free at death.

Funding Testamentary Trusts

Generally, a living trust helps the grantor avoid probate and is useful in managing property. It helps avoid Federal estate tax only if it includes testamentary bypass and QTIP trusts, appearing much like a tax oriented will that need not be probated.

When the grantor (who is usually the first trustee) dies, the substitute trustee owns legal title to the property, bypassing the probate process. At this point, any testamentary trusts included in a living trust should be funded. If this is not done for several years after death, sales and reinvestments may substantially change the character of an estate's assets and distributions may reduce the estate's property. Funding the trusts could be difficult with the assets remaining. Even worse, assets intended for a bypass trust could be included in the surviving spouse's estate if he or she (a) is both the trustee and a beneficiary and (b) has used properties for purposes other than health, education, support, or maintenance.

Example. Richard and Thelma executed a living trust that included testamentary bypass and QTIP trusts. When Richard died, trust properties consisted mainly of publicly held securities. During the next six years, Thelma neglected to fund Richard's bypass and QTIP trusts, reinvested a substantial portion of the assets, and withdrew money freely for a variety of personal reasons. After the delay, funding the testamentary trusts was impossible and the entire estate was taxed to Thelma at her death.

Control of Gift Assets

A client can reduce an estate before death with gifts that fall under the $10,000 annual exemption. However, this strategy fails if he or she retains for life either a) the possession or enjoyment of the property or the right to income from it or b) the right to designate who will receive the benefit.

Example. Susan transfers real estate to her daughter but retains a life estate in the property to reside there until death. IRC section 2036(a)(1) returns the entire value of the property to Susan's estate.

A taxpayer who gives away stock in a controlled corporation while directly or indirectly retaining voting rights is often caught by the same rule. For this purpose, a controlled corporation is one in which the grantor owns or constructively owns or controls 20% or more of the voting power.

Property Passing to the Very Wealthy

Stacking parents' properties on top of a wealthy child's estate subjects the child to even higher tax rates at death. A better strategy is for parents to create a generation-skipping trust. Often, this is simply a feature included in clients' bypass, QTIP, and/or life insurance trusts. Although they may designate children as lifetime trustees and beneficiaries, trust principal is excluded from the children's estates. Trust principal and income later benefit grandchildren and great grandchildren and eventually are distributed to descendants.

Each person may transfer up to $1 million of property into such a trust under IRC section 2631, assuming a proper allocation of the exemption among assets. A married couple may transfer $2 million. If they exceed the exemption amounts, the excess is subject to a flat 55% generation-skipping transfer tax that is added to any gift or estate tax they owe. Since the limits apply when the trust is funded, however, the amount eventually passing to descendants could total many millions.

Example. Through bypass trusts and a life insurance trust, Henry and Judith, a married couple, will escape estate tax on their $2 million estate. Judith's aged mother, Agnes, dies unexpectedly, leaving them $1 million. Agnes' estate owes about $150,000 of Federal estate tax after using her unified tax credit, and Henry and Judith's estate increases by the remaining $850,000. Although their entire estate was protected from estate tax, they will owe about $340,000 of tax on the $850,000 inheritance. If Agnes had chosen a generation skipping trust, the entire $850,000 would be passed on to Henry and Judith's children and grandchildren. None of it would be taxed at Henry's or Judith's death, even though they could access the trust's principal and income. *

Joseph R. Oliver, PhD, CPA, is a professor of accounting at Southwest Texas State University. Charles A. Granstaff, JD, CPA, is a practicing attorney in San Antonio, Texas. He is certified in estate planning and probate law by the Texas Board of Legal Specialization.