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Sept 1992

Preserving family net worth. (Cover Story)

by Knight, Lee G.

    Abstract- The heaviest tax burden that a family as a unit of taxation may incur comes from transfers of assets by gift and by death to heirs and other beneficiaries. The current US system of taxation operates in such a way that all taxable gifts given by the taxpayers during their lifetime, combined with the value of their taxable estates at the time of death, are subject to a federal tax. Individuals who have accumulated considerable wealth during their lifetimes are potentially subject to heavy tax obligations upon transfer of their assets to beneficiaries. Poor estate planning can diminish the net worth of these individuals. Well drafted and executed wills, carefully analyzed terms of the life insurance policy, and effective use of the marital deduction can help minimize a taxpayer's gift and estate tax burden.

The largest potential bite threatening the taxpayer today from the IRS's pack of attack dogs is in the gift and estate tax area. Since 1975, the gift and estate tax system has undergone a series of significant changes in both the approaches to taxation and the thresholds of amounts becoming taxable. As the system presently operates, the total of taxable gifts made during a lifetime and the value of the taxable estate at death are aggregated and subject to a federal tax using a graduated rate structure.

A unified tax credit, presently in the amount of $192,800, is available to apply against the gift and estate taxes that were paid during lifetime or become payable at death. Once the lifetime unified credit is exceeded, at the point cumulative gift and estate taxable transfers exceed $600,000, the balance is taxed at rates beginning at 37% and moving up to 55% for cumulative taxable transfers in excess of $3,000,000. The highest rate is scheduled to become 50% after 1992, with a bubble effect for transfers in excess of $10,000,000 to progressively eliminate the benefit of the unified credit.

High-net-worth individuals, and some not so high, face the prospect of a significant tax cost of transferring assets to heirs and others. There are many planning opportunities for reducing the tax cost. The resulting recommendations often emphasize sophisticated planning techniques such as long-range programs of inter-vivos giving, asset freezes, and charitable remainder trusts. As the value of the potential estate grows, the more important it is to consider these devices. These are the realm of the sophisticated tax advisor and planner.

Every person who has had the good fortune to accumulate wealth in their lifetime should be aware of the fundamentals of estate planning, such as properly drafted and executed wills and effective use of the marital deduction. Also to be considered is the role of life insurance in estate planning. In many cases, it is the life insurance proceeds that, when included in the estate, trigger heavy tax burden. When talking about estate planning, the approach should not be on an individual basis, but rather by considering the family unit as a whole.


Under the U.S. system of taxation, individuals are viewed as the basic unit of taxation. Most members of a family, however, tend to regard the family as the economicc and financial unit. For example, a wage earner with a spouse and three children generally budgets his or her income according to the needs of five persons rather than one individual. Similarly, a family with a teenager who receives a college scholarship usually perceives the scholarship as a financial benefit to the family.

The concept of family tax planning is a product of the same economic perspective. One objective is to minimize taxes paid by the family unit, versus taxes paid by individual family members. The highest tax burden facing a family unit relates to transfers by gift and by death.


A will is the core document of an estate plan and it is the primary vehicle through which the estate plan is implemented. When a person dies without a will (intestate), his or her property will be distributed according to state probate rules, perhaps rigidly written, impersonal, and without consideration for the decedent's wishes. Valuable assets may be frozen in probate for weeks, months, or even years depending on the state.

If children are involved, the court will appoint an administrator, usually the surviving spouse, and require him or her to periodically account for spending the children's money. Aside from this inconvenience, the surviving spouse, who may even be a stepparent, has no legal need to comply with the decedent's undocumented wishes.

If both parents die simultaneously, the courts appoint an administrator and guardian. The person appointed may be the closest, most financially secure relative, but one that the decedent would never have selected for any number of reasons. If a close relative is unavailable or unwilling to serve as administrator, the court may appoint a professional administrator, at 2% to 5% of the estate each year. The latter arrangement provides little incentive to settle the estate quickly or to minimize the estate for tax purposes.

Is a Will Always Necessary?

Procrastination, cost, and unwillingness to discuss death are common reasons for a large number of the U.S. population dying intestate. Other reasons include a lack of concern for the potential significant tax cost; all property is jointly owned; or the existence of living trusts. Do any of these reasons provide sufficient justification for not writing a will?

Procrastination. Procrastination may be tied to a belief that the will is premature while the estate is being built. Most of the consequences of dying intestate are just as devastating, or perhaps more so, while the estate is being accumulated. Estate assets have not reached their expected levels, while the needs of dependents, e.g., school-age children, are likely to be at their highest level.

A will is not cast in concrete. The testator is free to revoke or change the will as the estate and needs of dependents change. In fact, periodic monitoring is encouraged. Marriage or divorce requires updating an existing will. A move to a state with different legal requirements or a change in the testator's financial well-being may alter critical provisions. Changing tax laws alone justify periodically checking existing wills.

Small changes, such as a beneficiary or the amount of a particular bequest may be handled through codicils that meet the same legal requirements as the will itself. If the codicils become too numerous or complicated, it may be better to revise the entire document to avoid any question of its validity.

Cost of Preparation. The cost of will preparation ranges between a few hundred dollars to several thousand dollars, depending on the nature and size of the potential estate and the sophistication of the planning employed to minimize the tax bite. In all cases, fees can be lowered by ensuring that the lawyer spends less time during preparation. Providing the lawyer with accurate lists of assets, debts, beneficiaries, and how property is titled (single, joint, trust, etc.) should provide substantial fee savings.

Small Estates. The belief that a will is not needed for small estates overlooks a testator's other desires, as well as the interplay of federal estate and gift taxes and the overall assessment of estate taxes. The testator may have used up all or part of his or her unified credit giving substantial gifts. Also, many estates not subject to federal taxes will be subject to state taxes. Proper planning, including a will, may eliminate or lessen these problems.

Joint Ownership. Putting all property in joint ownership overrides the provisions of a will by allowing the property to pass outright to the joint owner. Such action, however, may have undesirable side effects. Joint ownership is a permanent transfer of an interest in property, i.e., it cannot be taken back without the recipient's permission. If the relationship between the joint owners deteriorates, the original owner may be prevented from disposing of the property. Even if the relationship between the joint owners is good, the surviving owner may not use the property in the same manner as the decedent would have.

For example: Jack and Jane, a couple in their thirties with no children, own all their property jointly and do not have a will. Their parents are still living, and Jane knows that she will have to provide financial assistance to her parents when they retire. If Jane dies intestate, the property will pass to Jack, and upon his death, the property will pass to his parents. Jane's parents will receive nothing from their daughter's estate, regardless of their need.

Holding property jointly may have undesirable income tax consequences if sold by the surviving spouse. The income tax basis of inherited property used in determining a taxpayer's gain or loss on disposal of the property is the property's fair market value at the decedent's date of death. The step-up in basis may create a tax saving opportunity, or it may represent a tax pitfall when disposing of the property. The result depends on the state of residency, whether it is a community property or common law state, and how the property is titled. If residency is in a community property state, and the property is held as community property, a full step-up in basis will occur on the death of either spouse. If residency is in a common law state, the extent to which there is a step-up in basis depends on how the property is titled. The example in Exhibit 1 shows that joint ownership is not the best way to title property that has appreciated since acquisition; rather, placing it in the name of the first to die produces the lowest tax liability upon subsequent sale of the property.

Mortality tables suggest that a husband the same age will predecease the wife, but a wife may not be comfortable with placing all property in the husband's name, in part, because of fear of divorce. Couples should discuss the issue and determine whether the potential tax savings outweigh any emotional discomfort resulting from placing the property in only one spouse's name. Additionally, it should be noted that almost all states have adopted the law of equitable distribution, which provides for an even division of property acquired during the couple's marriage.

Living Trust. The revocable living trust or inter-vivos trust has been widely touted as a means of avoiding the negatives of probate-- expenses, public disclosures, and excessive time for asset distribution. These advantages must be evaluated carefully.

The revocable living trust provides for management of trust assets while the individual is living and provides for the disposition of these assets upon the individual's death. Only those assets that actually have been conveyed (funded) to the living trust before death, however, avoid probate. Thus, the trust must be accompanied by a pourover will, providing that assets not held by the trust at death are to be added to the trust following the probate process.

Preparation of two documents generally means more legal fees and expenses. There will be a savings in probate fees, but it may be quite modest, compared to the cost of the living trust and the accompanying pourover will.

Avoiding the probate process also may subject the decedent's beneficiaries to claims of creditors. The probate laws of most states provide specific procedures under which the claims of creditors can be resolved expeditiously or terminated at an individual's death.

Asset management provided through trustees while an individual is living may be important should the individual become incompetent. The same management assistance often can be provided through effective use of a durable power of attorney.

Since the assets in the revocable living trust prior to death do not have to be disclosed through the probate process, a revocable living trust may provide greater privacy and confidentiality regarding an individual's assets and financial affairs after death. In some states, the estate inventory passing through probate is subject to inspection only by the clerk of the court, his or her representative, the executor or personal representative of the decedent and his or her attorney, as well as other persons financially interested in the estate. Thus, the privacy of a living trust compared to a will may be more apparent than real.

While use of a living trust may expedite the distribution of estate assets, the delay involved in probate sometimes may be advantageous to beneficiaries. Most probate delays come from the time it takes to identify, resolve, or terminate creditor claims which should only enhance the position of the beneficiaries.

Where a federal estate tax return is required with the need to keep the estate open until final clearance of tax matters, the use of a revocable living trust does not always expedite asset distribution.

Elements of a Valid Will

Generally, only attorneys are authorized to draft wills, although there is movement in some states to allow a paralegal to draft simple wills. The testator's engagement of an attorney to draft a will does not validate it. The following execution formalities also must be adhered to:

1. The will generally must be in writing. Some states allow oral (nuncupative) wills, while others require that oral wills be reduced to writing within a specified period, e.g., 30 days.

2. The will must be signed (mark, thumbprint, or any other writing) by the testator.

3. The will must be witnessed at least two competent individuals signing their names in the presence of the testator and the testator signing in their presence. A competent witness usually means any financially disinterested individual possessing the mental capacity to testify in a probate proceeding.

4. The testator must have attained the age of 18 (14 in some states) and posses the requisite mental capacity to execute a will. The mental capacity requirement requires that the testator, 1) know the general extent and nature of his or her property, 2) know the typical beneficiaries of his or her beneficience, and 3) understand the disposition plan being contemplated for his or her property.

Functions of the Will

The will should clearly instruct survivors on how to distribute the testator's property. It should provide for the upbringing of the testator's children and address the issue of simultaneous death. Finally, the will should designate an estate executor, the person responsible for inventorying all estate property, paying estate creditors, and dividing the estate among the heirs.

Distribution Instructions. A person generally may dispose of property as he or she sees fit, as long as the rights of others are not injured. Thus, the will should be drafted carefully to ensure that the property to be distributed and the recipients are clearly identifiable. If money is being left, either percentages or specific dollar amounts may be designated for particular beneficiaries. Using percentages will ensure that no beneficiaries are omitted because of insufficient assets at the testator's death. For gifts of jewelry, furniture, and other personal effects, the descriptions of the items should be as detailed as possible to avoid subsequent misunderstanding and disagreements.

Disinheriting natural heirs is possible, but may create probate delays and, in some cases, be overturned. In most states, a spouse cannot be given less than what he or she would have received under intestacy laws. The freedom of the surviving spouse can be constrained by putting the legal minimum in trust and giving him or her access only to the income from that trust.

Disinheriting a child is permissible in all states except Louisiana. The testator, however, should make it clear in the will that disinheritance was intended. Otherwise, the child might claim he or she was overlooked by mistake.

Providing for Children. Providing for the upbringing of a testator's children is one of the will's most important functions. The will should name a guardian for minor children and provide instructions for financing their upbringing. Since most courts normally name a relative as guardian in the absence of a will, reasons for naming someone other than a relative should be clearly explained. The court generally will uphold such wishes, except in the case of a surviving natural parent who wants guardianship.

Financing the upbringing of children can be accomplished in one of two ways. Property may be left to the children, with their guardian or someone else named as conservator of the assets. The conservator must obtain permission to pay the children's expenses from the legacy, account to the court for the assets' management, and post a bond, the cost of which comes out of the estate. A more flexible alternative is to place assets in trust for the children, with their guardian as trustee or co-trustee. With either alternative, the testator also may want to specify how the assets should be distributed if the child dies before reaching the legal age to write a will. Otherwise, the assets in the child's estate will pass to statutory beneficiaries.

Simultaneous Death. The Uniform Simultaneous Death Act provides that if two persons die together--as in an automobile or airplane accident-- each is presumed to have survived the other. For example, the husband's will is read as if the wife died before him, and the wife's will is read as if her husband died before her. This presents a tax trap for those who do not plan carefully. The marital deduction will be unavailable to either spouse, thus causing assets in each estate in excess of $600,000 to be taxed. To the extent the value of the assets in the two estates is relatively out of balance, one estate may pay a disproportionate higher tax than the other.

Selecting an Executor. The qualifications of an estate executor can make a difference in assets available for distribution, to whom they are distributed, and how quickly. It can also affect family relationships. The significance of the executor is charged with assembling and valuing the decedent's assets; filing income, estate, and inheritance tax returns; paying taxes; distributing assets to heirs; and accounting for all transactions during administration of the estate.

While the estate is open, the executor has to keep funds invested. Some assets may be sold to pay taxes or for other purposes; the executor has to decide which ones and when. There may be a small business to be managed or liquidated. It may be necessary to value family-owned or closely held companies. Understanding the tax consequences of his or her actions can be invaluable.

Typically, executors receive fees ranging from 2% to 5% of the estate, depending on state law. Family members named as executors often waive these fees. In other cases, lower fees may be negotiated.

Understanding the responsibilities, should the testator select a professional or a family member as executor? There is no universally right answer to this question. For a personal touch and required professional expertise, the testator may want to name a bank trust department and a family member as co-executors. Finally, if a significant portion of the estate is going into trust, it may be helpful for the executor and trustee to be the same. The trustee will know the necessary paperwork has been done, and a relationship with the family or other beneficiaries already exists.


The unlimited marital deduction permits deferral of estate tax on wealth accumulated by a married couple until the surviving spouse dies. Because of the time value of money, this deferral may produce a higher net estate, even if transfer of assets to the surviving spouse causes the assets to be taxed later at a higher rate. The postponement of tax until the death of the second spouse also increases the length of time during which estate planning objectives can be accomplished. The surviving spouse can continue or even accelerate a program of inter- vivos lifetime giving to younger generation family members. The added time also provides the surviving spouse an opportunity to seek advice on areas of estate planning neglected before the death of the first spouse.

Property Subject to Marital Deduction

The marital deduction is allowed only for property included in the decreased spouse's gross estate that passes or has passed to the surviving spouse. Property that passes from the decedent to the surviving spouse includes any interest received as, 1) the decedent's legatee, devisee, heir, or donee, 2) the decedent's surviving tenant by the entirety or joint tenant (joint ownership of property), 3) the appointee under the decedent's exercise (or lapse or release) of a general power of appointment, or 4) the beneficiary of insurance on the life of the decedent.

Planning for Marital Deduction

When planning for the estate tax marital deduction, both tax and non- tax factors should be considered. Two major approaches have been developed to guide tax planning: 1) equalization, and 2) deferral.

The goal of the first approach is to equalize the estates of both spouses and minimize the effect of the progressive rate structure. For example, the estate tax on $2,000,000 is more than double the estate tax on $1,000,000-$780,000 versus $691,600 (2 X $345,800 tax on $1,000,000).

The deferral approach focuses on postponing estate taxation as long as possible to take advantage of the time value of money. For example, consider the illustration in Exhibit 2.

Deferral Approach is Generally Best. Barring certain circumstances, the deferral approach generally is preferable to the equalization approach. By maximizing the marital deduction on the first spouse to die, not only are taxes saved, but the surviving spouse may trim his or her future estate tax by entering into a program of lifetime giving. By making optimum use of the annual exclusion, considerable amounts can be gifted without incurring any transfer tax.

Circumstances Warranting Equalization Approach. Despite the general appeal of the deferral approach, some circumstances warrant use of the equalization approach. For example, consider the following three separate situations:

1. Both spouses are of advanced age or in poor health; neither is expected to survive the other for a prolonged period.

2. The spouse expected to survive has considerable assets of his or her own.

3. The property passing to the surviving spouse is expected to appreciate substantially between the deaths of the two spouses.

In situation one, the benefits offered by the deferral approach clearly will not be realized if the expected period between the deaths of the two spouses materializes. The deferral savings will be minimized and there is little time for neglected estate planning.

In situation two, deferral savings may not exceed the cost of the rate tradeoff. For example, a spouse passing a $250,000 estate to a surviving spouse who already has assets of $1,000,000 trades a 32% bracket for a later 43% bracket.

In situation three, deferral savings may not exceed the added tax on appreciation of the property. For example, if property worth $250,000 at the death of the first spouse appreciates to $1,000,000 when the surviving spouse dies, the deferral savings must exceed an added cost of $275,000 at the time of the surviving spouse's death.

Non-tax or even non-financial considerations may warrant use of the equalization approach. Many couples will find predicting who will die first offensive. Equalizing the estates may be more acceptable even if the overall tax liability winds up higher.


Insurance agents traditionally have promoted life insurance as a means of passing money tax-free to heirs as well as providing liquidity to the estate. The tax-free benefit means the heirs will pay no federal or state income taxes on death benefits. The benefits, however, may be included in the insured's estate and be subject to estate taxes.

Keeping Proceeds Out of the Estate

Steps can be taken to keep life insurance proceeds out of the estate. Generally, the benefits may be excluded if they are, 1) payable to someone other than the estate or for the estate's benefit (e.g., administrator, executor) and, 2) payable under a policy for which the decedent did not possess any incidents of ownership. The term incidents of ownership not only means ownership in a technical, legal sense, but also the right of the insured and his or her estate to economic benefits of the policy. This latter right may be evidenced by the insured's retention of power to change beneficiaries, revoke an assignment, pledge the policy for a loan, or surrender or cancel the policy. To ensure that benefits are excluded from the decedent's gross estate, the insured should not retain any of these rights.

Life Insurance Trust May Be Solution. Creating a life insurance trust may be the most effective means of avoiding the incidents of ownership peril. The insured would be the grantor or creator of the trust, select a trustee to administer the trust, and name one or more beneficiaries. The trust becomes the owner of the life insurance policy, and each year the grantor gives money to the trust to pay the premium. Any amount can be given, but to avoid an incident of ownership, the amount should not be the same as the premium payment. Typically, the amount funded each year is $10,000, the maximum that can be gifted each year to a single recipient without incurring a gift tax.

By avoiding estate taxes, the life insurance trust provides added liquidity to the heirs. For example, the trust may help to preserve a family business. When the owner dies, the trustee may use the proceeds of life insurance to buy the business from the estate. If money was not available, the business might have to be sold to pay estate taxes.

A life insurance trust is not cost- or risk-free. If the insured dies within three years of transferring an existing policy, estate tax law ignores the trust. Once the grantor establishes the trust and its terms, it is irrevocable. The assets are totally controlled by the trustee. Finally, there are the legal and administrative costs of creating and maintaining a trust.

Liquidity Benefit of Life Insurance

Insurance can provide liquidity to pay estate taxes and other expenses upon the insured's death. With the unlimited marital deduction, liquidity may not be a problem until the second dies. Traditional life insurance does not necessarily, cost-effectively, satisfy the need. A better solution may be to purchase survivorship or second-to-die insurance, where the proceeds are paid when the second spouse dies.

Survivorship Insurance Versus Other Investments. Survivorship life insurance generally compares favorably to non-life insurance investments that could provide the liquidity heirs need to pay estate taxes and other expenses. For example, a couple, both age 60, with a 20-year combined life expectancy, can prepay a $1,000,000 survivor life policy with seven premiums of $20,085 (a present value of $119,000, assuming a 6% rate of interest). Upon the death of the surviving spouse, the couple's heirs will receive approximately $1,000,000 free of income taxes to cover estate taxes. By contrast, if the couple invests $119,000 in a bond with an after-tax yield of 6%, approximately $381,000 will be available to the heirs upon the death of the second spouse at the end of 20 years. Survivorship insurance also may provide a better source of liquidity than other investments in the form of cash value for the surviving spouse.

Survivorship Insurance Versus Other Life Insurance Products. Survivorship insurance also compares favorably to traditional life insurance products for liquidity. Currently, policies are being written from $50,000 to $35,000,000. Even if one of the parties previously has been declined insurance, he or she may be able to obtain survivorship insurance.

The cost of survivorship insurance also compares favorably to other insurance products. The cost of a $1,000,000 survivorship insurance policy is approximately one-fifth the cost of a $1,000,000 policy on the life of the husband alone, one-third the cost of a $500,000 policy on each spouse, and one-half the cost of a $1,000,000 policy on the life of the wife alone. For estate tax purposes, survivorship insurance benefits can be kept out of the estate by the same means as other life insurance products.


In addition to fulfilling the needs and desires of the testator, the bottom line is preserving family net worth. An elementary understanding of the gift and estate tax system and the importance of a properly drawn, up-to-date will is essential for all high net worth individuals. Beyond that, specific planning leading toward significant reductions in tax consequences should be left to CPAs and other knowledgeable professionals.

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