Fundamentals of Estate Planning
February 2021
Professor Anne-Marie Rhodes
The purpose of today's lecture is to provide a basic framework for the estate planning process. The focus will be on people and property issues, basic documents, and the impact of taxes on the transfer of property, using the law of Illinois as the template. Our discussion cannot and will not be exhaustive as there is limited time available to us. Similarly the attached outline is offered only as a starting point; it is purposefully brought down to basics in order to emphasize the fundamentals. A particular client situation and documents, of course, will differ somewhat from our discussion.
Attached to this outline is a glossary of some common terms used in estate planning.
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Estate Planning: traditionally, the planning for the use and disposition of one's property both during lifetime as well as at death, involving the transfer of property to or for the benefit of chosen beneficiaries.
Four Main Components:
1. People
Decedent or Donor Beneficiaries
2. Property
Probate Non-probate
3. Time
Lifetime At death
4. Analysis of Transfer Tax Impact
Estate Tax Gift Tax Generation-Skipping Tax
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D E C E D E N T
Testate - or - Intestate (dies with a valid complete will) (dies without a valid complete will) Executor is named by decedent to Administrator is appointed by court oversee probate process. to oversee probate process Property would be disposed of as provided in will.
Under Illinois law property would be disposed of as follows:
(a) If spouse and descendants: ½ to spouse ½ to descendants per stirpes
(b) If no spouse but at least one descendant: all to descendants per stirpes
(c) If spouse but no descendant: all to spouse
(d) No spouse and no descendants: then all to parents, brothers, and sisters in equal shares (except (i) if one parent deceased, then surviving parent receives double portion, and (ii) descendants of deceased brother/sister receive share deceased brother/sister would have received)
(e) If none of (a) - (d) applies: ½ to maternal grandparents (or their descendants per stirpes) and ½ to paternal grandparents (or their descendants per stirpes)
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P R O P E R T Y
Probate - or - Non-Probate (property owned solely by decedent (property in which decedent had an that does not automatically pass to interest but which automatically another at decedent’s death). Only passes to another at decedent’s probate property is subject to court's death) administration.
Examples of Non-Probate Property:
home owned as joint tenants or tenants by the entirety
Life insurance with a designated beneficiary
IRA and retirement plans with a designated beneficiary
bank account "POD"
property held in trust
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Limitations on Power to Dispose of Property at Death
Formal Limitations:
Writing, signed, witnesses
"Rule against Perpetuity" or Qualified Perpetual Trust
Spousal Protection:
Surviving spouse in Illinois has right to renounce a will and take 1/3 (or ½, if no living descendant of decedent) of decedent spouse's probate estate
Surviving spouse has rights to certain qualified retirement plans
Real property owned in community property states owned half by each spouse
Private Arrangements:
Prenuptial agreements may vary spouses' rights in each other's property
Buy-sell agreements may limit power to transfer stock
Societal Limitations:
Federal Transfer (estate, gift, generation-skipping) Taxes
State and Local Taxes
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Will: a writing signed by the testator and witnessed by two or more credible persons.
Outline of a "Simple" Will
ARTICLE FIRST: Testator directs executor to pay taxes and expenses
ARTICLE SECOND: Testator identifies her marital status and closest family members.
ARTICLE THIRD: Testator gives personal and household effects to whomever testator chooses.
ARTICLE FOURTH: Testator gives residue (or balance) of estate to whomever testator chooses.
ARTICLE FIFTH: Testator names the executor and gives various powers to the executor.
Signature
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Outline of Will with Contingent Trust for Children
ARTICLE FIRST: Testator directs executor to pay taxes and expenses and to coordinate with trustee.
ARTICLE SECOND: Testator identifies testator's marital status and closest family members.
ARTICLE THIRD: Testator gives personal and household effects to whomever testator chooses.
ARTICLE FOURTH: Testator gives residue (or balance) of estate to testator's spouse outright and free of trust, if the spouse survives testator, otherwise to testator's brother John Doe as trustee. This property shall be held in trust upon the following terms:
Option 1 (Single Fund): As of testator's death, trustee holds all the trust property as a single fund, using so much or all of income and principal of the trust for the children's health, support, education, and best interest, as the trustee deems advisable. Trust ends when there is no child under the age of 21 (or whatever age testator has chosen), and trustee distributes the trust property to testator's then living descendants per stirpes -or- Option 2 (Separate Shares): As of testator's death, trustee divides the trust estate in equal shares to create one share for each living child (and a share for descendants of any deceased child). Trustee will either be required to pay child the income from child's share or have discretion to use income for child's benefit. Trustee will typically have discretion to use principal of the child's share for the child's benefit. When the child reaches the age of 30 (or whatever age testator has chosen), the trust ends and child gets the property. -or- Option 3 (Hybrid): A combination of options 1 and 2. It starts as a single fund, but then separates into separate shares when there is no child under the age of 21 (or whatever age is chosen).
ARTICLE FIFTH: Testator provides rules of trust operations and gives trustee various administrative and managerial powers.
ARTICLE SIXTH: Testator nominates guardian for minor children or for disabled adult children.
ARTICLE SEVENTH: Testator names the executor and grants executor same powers given trustee.
Signature
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Impact of Estate, Gift and Generation-Skipping Taxes
Three Transfer Taxes*:
(1) Estate Tax* is imposed on the transfer of property at death. Generally, all property owned by or subject to control of the decedent (probate as well as non- probate) is subject to tax. In general, for 2021, the first $11,700,000 is free of estate tax (to extent the similar gift tax-free amount is not used during lifetime). Each year, the estate tax-free amount is likely to change because it is indexed for inflation. Amounts passing to a spouse or a charity are tax-free. The maximum federal estate tax rate is 40%. Illinois will also impose a tax on estates in excess of $4,000,000 but some of the Illinois tax may be a deduction on the federal estate tax return.
(2) Gift Tax* is imposed on the transfer of property by gift during lifetime. There is a $15,000 per donee annual exclusion from the gift tax (that is, I can give up to $15,000 to each of my five siblings each and every year without a tax, but a gift of $75,000 to one of them would be treated differently). Gifts to a spouse and charity are also tax-free, as are paying tuition and medical expenses for anyone. For 2021, the tax-free amount is $11,700,000 for lifetime gift transfers. The gift tax rates are the same as for the estate tax.
(3) Generation - Skipping Tax* is imposed on certain transfers of property that cross two or more generations. There is an exemption equal to the estate tax-free amount. The GST tax is imposed as a flat tax rate equal to the maximum estate tax rate.
* The tax-free amounts are always subject to change. For 2021, some believe that with a change in administrations and significant federal outlays, there may be a greater likelihood of a downward change in the tax-free amounts.
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Outline of Will with $11,700,000 By-Pass Trust
ARTICLE FIRST: Testator directs executor to pay taxes and expenses and to coordinate with trustee.
ARTICLE SECOND: Testator identifies testator's marital status and closest family members.
ARTICLE THIRD: Testator gives personal and household effects to whomever testator chooses.
ARTICLE FOURTH: Testator gives residue (or balance) of estate to testator's spouse as trustee. This property shall be held in trust upon the following terms:
A. If spouse survives, divide estate into two parts: the $11,700,000 tax-free amount and the excess, if any. The $11,700,000 shall be held in trust (often called “Family Trust”) as follows:
(i) During spouse’s lifetime, all income of the Family Trust shall be paid to spouse and as much of the principal as is necessary for spouse’s health and support.
(ii) At spouse’s death, the Family Trust will either continue in trust (see p. 7 for options for children) or will terminate and be distributed to beneficiaries free of tax.
B. If spouse survives, the amount, if any, over $11,700,000 is either given outright to spouse or held in a Marital Trust. The terms are often similar to the Family Trust, but the Marital Trust is subject to estate tax at the death of the surviving spouse.
C. If spouse doesn’t survive, testator will either distribute directly to beneficiaries or create trusts for their benefit.
ARTICLE FIFTH: Testator provides rules of trust operations and gives trustee various administrative and managerial powers.
ARTICLE SIXTH: Testator nominates guardian for minor children or for disabled adult children.
ARTICLE SEVENTH: Testator names the executor and grants executor same powers given trustee.
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Pour Over Will and Declaration of Trust With G.S.T. Planning
"Pour-Over" Will:
ARTICLE FIRST: Testator directs executor to pay taxes and expenses and to coordinate with trustee.
ARTICLE SECOND: Testator identifies testator's marital status and closest family members.
ARTICLE THIRD: Testator gives personal and household effects to whomever testator chooses.
ARTICLE FOURTH: Testator gives residue of estate to the trustee of testator's declaration of trust established during testator's lifetime.
ARTICLE FIFTH: Testator names the executor and gives various powers to the executor.
Signature
Declaration of Trust:
PREAMBLE Settlor of trust states that settlor is creating a trust and will be first trustee. Terms of trust are:
ARTICLE FIRST: During settlor's lifetime, all income and principal is for settlor's benefit as settlor wishes. If settlor becomes disabled, new/successor trustee is to use all trust property for settlor's benefit (and for benefit of settlor's dependents) during settlor's lifetime.
ARTICLE SECOND: Upon settlor's death, trustee to coordinate payment of taxes and expenses with executor.
ARTICLE THIRD: Settlor identifies settlor's marital status and closest family members.
ARTICLE FOURTH: If settlor's spouse survives the settlor, then upon settlor's death the trustee will first create the $11,700,000 tax-free by-pass trust. The trustee is to allocate $11,700,000 of the GST exemption to this trust. This trust generally held for surviving spouse's benefit during survivor's lifetime.
ARTICLE FIFTH: If settlor's spouse survives, then upon settlor's death the balance of trust estate is the marital amount. This amount can be given outright to
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the survivor or held in trust for the survivor's sole benefit during survivor's lifetime.
ARTICLE SIXTH: If settlor's spouse does not survive settlor, then at settlor's death, the trustee is to create two separate new trusts, by dividing the trust estate into two portions.
$ the first $11,700,000 will be a GST exempt trust $ amount remaining, if any, will be the GST non-exempt amount
ARTICLE SEVENTH: At death of the survivor of settlor and spouse, trustee to allocate
$ all GST exempt property (whether under Articles Fourth and Fifth or under Article Sixth) into one trust
$ all GST non-exempt property - either in trust or outright to children
ARTICLE EIGHT At death of survivor of settlor and spouse, the GST exempt trust held for lifetime benefit of children, and at children's deaths, trust can continue in trust for grandchildren or be distributed outright.
ARTICLE NINTH Settlor provides rules of trust operations and gives trustee various administrative and managerial powers; settlor provides for successors to act as trustee.
ARTICLE TENTH Settlor reserves right to amend or revoke the trust as settlor wishes.
Signature
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Three Common Techniques Regarding Transfer Taxes
Gift-giving: Removing Value from Estate
To extent property is given away during lifetime, it will generally not be included in the donor's (transferor's) estate. This will also remove the post-transfer appreciation on the property.
1. Tax-free giving
$ $15,000 per donee annual exclusion
$ "Ed/med" exclusion: payments to school or health care provider are non- taxable
$ Both techniques can avoid GST tax as well
2. Lifetime tax-free amount
$11,700,000 (or if gift-split with spouse, $23,400,000) gift during lifetime.
3. Taxable gifts
Gifts in excess of gift tax-free amount will generate payment of gift tax. In very large estates, this may be appropriate. Whatever gift tax is actually paid will generally be removed from gross estate. This removal of gift tax paid can also save estate taxes.
4. Spousal gifts
Gifts to a spouse are tax-free. Spouse must be U.S. citizen, otherwise restrictions.
5. Charitable gifts
Gifts to qualified charities can be tax free.
6. Leveraged "Giving"
Irrevocable life insurance trust for new policies can prevent insurance proceeds from ever being considered in estate at all.
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Using Valuation Discounts: Destroying Tax Value
If an estate includes an ownership interest in a closely held business, valuation is a critical issue for tax purposes. The first step is to value the business as a whole and then to value the person's ownership interest.
Let's say a company's value is $100. If an individual's interest exceeds 50%, for example 51%, then the value will start at 51% of the company's value and be increased by a premium for control. Control premiums often are in the 10-20% (and higher) range. A 51% interest might be valued at $60. Conversely if the interest is less than 50%, for example 49%, then the value starts at 49% and is decreased by a minority discount. A lack of marketability discount may also apply. This combination of discounts can often be in a 25-35% range. The value of a 49% interest therefore could be about $35. Thus a 2% differential in ownership (51% to 49%) could easily yield a 25% swing in value.
If a person owns more than a 50% interest, gift giving of a sufficient number of shares to reduce holdings to less than 50% should be seriously considered. The gift giving of stock could utilize annual exclusion gifts, unified credit amount gifts, and spousal and charitable gifts.
Using Deductions
1. Marital Deduction
Transfers to a spouse are tax-free. Lifetime gifts to a spouse should be considered to bring the less wealthy spouse up to the tax-free amount ($11,700,000). This way each spouse, no matter who dies first, can create a $11,700,000 tax-free trust at death. Portability is now a new tax technique that minimizes the federal tax consequences of the order of death. Deathtime marital transfers should be considered to defer estate tax until death of survivor. Illinois State death taxes do not have portability.
2. Charitable Deduction
Transfers to charity are tax-free. Split gifts to family and charities that meet statutory requirements can be advantageous.
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Glossary
Administrator: the person or entity responsible for the administration of an intestate (no will) estate or of a testate estate if the will does not appoint an executor. The duties and requirements are basically the same as for an executor. In an Illinois court's appointment of administrator, priority is given (in order) to the spouse, beneficiaries, children, grandchildren, parents, siblings and so on.
Annual exclusion: the amount that is exempt from gift tax for one person to transfer to any person during a calendar year, currently $15,000.00 (indexed for inflation after 1998).
"Crummey" rights of withdrawal: a beneficiary's right to withdraw for a limited period of time a certain portion or amount contributed to a trust in a year by a donor, in order to qualify the contribution as a present interest and thus a tax-free gift by the donor. Depending on individual facts, a "Crummey" right may be limited to $5,000, $15,000, or $30,000 in a year.
Decedent: the deceased person.
Descendants: the lineal progeny of a person, including those of the remotest degree; i.e. children, grandchildren, great-grandchildren, etc.
Descendants, per stirpes: a method of dividing property among descendants, whereby the descendants of a deceased person take the share that their deceased ancestor would have received if living. Thus, if you have three children, A, B, C, and one (say A) predeceases you leaving two children, D and E, those two grandchildren will share A's 1/3 of your estate (i.e. each will receive 1/6). The process of representation repeats indefinitely (if grandchild D also had predeceased you, leaving two children F and G, those two would share D's 1/6).
Estate Planning: traditionally, the planning for the use and disposition of one's property both during lifetime as well as at death, involving the transfer of property to or for the benefit of chosen beneficiaries. Today estate planning also involves disability planning; recognizing and coordinating the process for individual health care decisions and financial decisions in the event of a disability.
Executor: the person or entity appointed by the will who is responsible for the administration of the testate estate. The executor's three duties are to (1) gather assets; (2) pay expenses, claims, debts and taxes; and (3) distribute the remaining assets. In Illinois, an executor must be 18 or older, a U.S. resident, and not be of unsound mind, a disabled person, or a convicted felon.
GST exemption: the amount that a donor can allocate to transfers in trust or outright (or combinations thereof) that will exclude such transfers and the appreciation thereon from the generation skipping transfer tax. Currently it is set at $11,700,000, and keyed to the estate tax tax- free amount.
Guardian of the estate: the person or entity who is appointed by the court and charged with the care, management, and investment of a minor's or disabled person's property.
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Guardian of the person: the person who is appointed by the court and charged with the personal custody, care, and nurturing of a minor (a person under 18 in Illinois) or a disabled person. The guardian must meet same requirements as an executor.
Heirs: those persons who, in the absence of a will, would by virtue of the jurisdiction's laws receive the property owned solely by the decedent at the time of his death. The laws are known as the rules of descent and distribution, or the intestate rules, and they can vary from state to state. In Illinois, the first rule is one-half to spouse and one-half to descendants per stirpes. If there is no spouse, then all to descendants per stirpes; and if no descendants, then all to spouse. If there is neither spouse nor a descendant, then to parents and siblings in equal parts (but a surviving parent receives a double part, and descendants of a deceased sibling take per stirpes). Additional contingencies are provided for by the statute.
Intestate, Intestacy: when a person dies without a valid will. The disposition of intestate property is governed by the jurisdiction's rules of descent and distribution.
Life Insurance Trust Agreement: a special form of an irrevocable trust which typically (1) purchases and holds in trust a policy of insurance on the grantor's life, (2) to which the grantor makes annual tax-free contributions (which are subject to Crummey rights of withdrawal) and (3) that the trustee uses to pay the annual insurance premium, and which then (4) the trustee collects the proceeds of insurance at grantor's death, free of estate tax. The terms of the trust at grantor's death will vary depending on individual circumstances. The trust may terminate or continue for a short period of time or for a beneficiary's lifetime.
Personal property: everything other than real property.
Portability: To the extent the first spouse to die does not fully use his or her unified credit amount, that unused amount is added (subject to procedural requirements) to the surviving spouse’s tax- free amount to be used during the survivor’s lifetime or at death. Sometimes referred to as the DSUE amount.
Power of appointment: the right given by one person to another to appoint, or select, the ultimate takers of property, often from a defined group of permissible takers. Typically, this right is given to an income beneficiary of a trust to choose at his or her death one or more persons from among a defined class of persons, who will then succeed to the ownership of the property in the trust or for whose benefit the property will continue in trust. An example is: "Upon the death of my wife/husband, the principal of the trust shall be held in trust hereunder or distributed to or in trust for such one or more of my descendants as my wife/husband may appoint by her/his will making specific reference to this power of appointment." For tax purposes, if the power can be used directly or indirectly for the benefit of the holder of the power (i.e., the holder can benefit herself), it is a general power of appointment and is therefore taxable to the holder of the power.
Power of attorney: the delegation by one person to another to act as agent on the person’s behalf. The delegation may be general or special. Illinois has created special statutory health-care powers of attorney and property powers of attorney.
Probate: the court process by which title to property owned solely by decedent is ultimately
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transferred to its new owner. If the decedent died testate (with a will), probate involves the determination of the validity of the decedent's will. Probate is often used to distinguish the property subject to court control (i.e., property owned solely by decedent at time of death) from non-probate property (i.e., property not so subject, e.g., joint tenancy, life insurance, trusts and so forth). "Independent administration" is a streamlined court process for the administration of an estate which, if all parties are able and agree, basically only requires court appearances to open and then to close the estate. Supervised administration more fully involves the court in the day- to-day administration of an estate.
Q-Tip: a trust created during lifetime or at the donor's death for a spouse that qualifies for the Federal estate (or gift) tax marital deduction. A Q-tip trust can be structured in one of two ways: (1) to be the amount of the estate in excess of the then current tax-free ($11,700,000) amount, or (2) to be the entire estate. In either scenario, the estate will pass free of tax. A Q-tip must give the spouse all the income for the spouse's lifetime, and the spouse must be the only beneficiary during the spouse's lifetime. A spouse may (but need not) have a power of appointment at his or her death.
Real Property: land and fixtures, real estate.
Testate, Testacy: when a person dies with a valid will.
Transfer Taxes: there are three taxes imposed at the federal level on the transfer of property: estate tax (transfers at death), gift tax (transfers during lifetime), and generation - skipping transfer tax (newest of the tree - taxes transfers that "skip" a generation, e.g., grandparent to grandchild). Each tax has exceptions and exclusions.
Trust: a method of holding ownership to property, whereby legal title to property is in the name of a trustee, but the equitable or beneficial title is in the name of a beneficiary; also referred to as "splitting title." A trust can be either (i) inter vivos, created during the Settlor's (the person who creates the trust) lifetime, or (ii) testamentary (created by decedent's will and therefore only at decedent's death). A trust can be either (i) irrevocable (unable to be changed) or (ii) revocable. A trust can be either (i) a declaration of trust (where settlor is also the sole trustee) or (ii) trust agreement (someone else is a trustee).
Today "living trust" is a popular phrase. Generally it refers to an inter vivos trust (whether a declaration of trust or a trust agreement) created by the Settlor for his or her lifetime benefit and which continues after the Settlor's death. Its main advantages are that it continues to manage the assets in the event of the Settlor's disability (i.e., no guardian of estate is needed) and that it avoids probate of the trust's assets at death (since the trust dictates new owner or beneficiary). Contrary to the implications of some advertising, there are NO special tax advantages to a living trust over a testamentary trust.
Unified Credit: the mechanism for the tax-free amount that anyone is able to give at death. Currently, the credit yields the tax-free amount of $11,700,000.
Will (Testament): in Illinois, a writing signed by the testator and witnessed by two or more credible persons. A will is completely revocable or changeable by the testator at any time. Usually a will includes dispositive provisions, appoints an executor and, if appropriate, a guardian for a
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minor or disabled child, and provides instructions for the administration of the estate. A will may provide within its terms for the creation of a trust or trusts; if so, these trusts are called "testamentary trusts." A "pour-over" will provides that the decedent's probate property is to be given to a separate inter vivos trust created by the decedent.
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