BASICS OF ESTATE PLANNING
I. INTRODUCTION
There’s an old adage which says there are only three certainties in life: Life, Death, and Taxes. Even children understand this (at least the life and death part), as captured by the more modern adage: “He who dies with the most toys…still dies.”
But there is another certainty: everyone who lives will acquire an estate. An “estate” is simply the sum of a person’s assets, minus all debts and liabilities. [For those who like equations: Estate = (Assets) – (Liabilities).] Even the homeless guy on the corner holding a sign, “Will work for food,” has an estate: the clothes on his back and his sign. Everyone has an estate! But this presents a problem: since everyone has an estate, and since everyone will eventually die (and since nobody can take their estate with them), what happens to a person’s estate after they die? Is it up for grabs to whoever wants the person’s stuff? Does the government confiscate the estate? Do the person’s relatives take the estate? If so, how is it distributed? In what percentages? And to whom? Are there any rules of law that address these problems or otherwise govern the division of one’s estate?
Fortunately, the laws of wills and trusts developed to address these issues, and provide mechanisms for dealing with the distribution of one’s estate. Accordingly, “estate planning” is simply the process of planning for the disposal of one’s estate. Today, there are essentially two ways in which an estate can be distributed:
- Probate Code
- Estate Plan
II. PROBATE v. ESTATE PLAN – What’s the Difference?
A. Probate
When a person dies without a written estate plan, the government will provide for the distribution of that person’s estate through a process called “probate,” which is governed by the state’s Probate Code. In California, the Probate Code provides a default, one-size-fits-all scheme for distributing one’s estate, where the estate is distributed according to the Probate Code’s rules of distribution, without exception.
Probate is initiated by filing a “petition” with the Superior Court (similar to a lawsuit). A personal representative (“administrator” or “executor”) is then appointed to oversee and manage the estate property throughout the probate process. If the person dies testate (i.e. with a will), the executor will normally be appointed in the will; however, if the person dies intestate (i.e. without a will), the court will have to appoint an executor.
Once the petition is filed, an official “Notice to Creditors” must be published three times in a local newspaper and mailed directly to everyone named in the will, giving creditors a set amount of time to file any claims they have against the estate. The executor will collect all the assets, pay off the creditors, and distribute the remaining estate. Finally, when the process is complete, the executor will file a petition for discharge, and the estate will be closed.
While probate may sound fine and dandy, it has considerable drawbacks. First, since the estate is distributed according to the one-size-fits-all Probate Code scheme, there is no discretion as to how the assets will be distributed, or to whom. And just like a one-size-fits-all t-shirt never fits anyone quite right, the Probate Code distribution scheme rarely fits anyone’s particular circumstances appropriately. For example, under the Probate Code, an estate is distributed in the exact same percentages to each of the decedent’s children. But did your father really intend to give you and your brother the exact same share of his estate when your brother is Charles Manson? Or for another example, in probate, a person’s entire share of the estate will be distributed immediately (in one lump sum), regardless of whether that person is a minor. But do you really want your entire estate to be given to your 16 year-old son as a gigantic one-time payment – especially when your son is Charlie Sheen and intends to blow his entire inheritance on hookers and drugs before his 18th birthday?!?! [Or would you rather arrange for “staggered” (limited) distributions of your estate until lil’ Charlie is old enough to manage his inheritance responsibly?] Unfortunately, with probate, you are stuck with these problems.
Probate is also extremely expensive, as property distributed through probate is subject to an estate tax, and the probate process includes various fees to the court, fees to the probate attorney, fees to a “probate referee,” and fees to the executor. Most of these fees are set by California statute as a percentage of the gross estate, and can ultimately cost more than 10% of the total estate!
Probate is public and litigious, as the probated estate (including a list of assets) must published in a local newspaper and any person can file a “will contest” claiming to be a beneficiary or creditor of the estate. A will contest is a lawsuit, and the parties must litigate the validity of these third party claims. If the estate is large, it’s not uncommon for scam artists to file will contests to try to get a piece of the action. If the scammer wins, he will take part of the estate; if he loses, his claim will still need to be litigated (using funds of the estate) – so either way, the value of the estate will be further diminished. Ultimately, with the combination of fees, will contests, lawsuits and sub-lawsuits, and estate taxes, it’s not uncommon for probate to end up costing 50% of the total estate!
If you’re already seeing the significant drawbacks and limitations of probate, don’t abandon all hope and think your beloved parents’ estate will be reduced to nothing more than a collection of belts and your dad’s first generation iPod – a carefully drafted estate plan can solve all these problems!
B. Estate Plan
If you don’t like the Probate Code’s scheme for distributing your estate, you can draft your own personalized estate plan to effectuate your particular needs and desires. An estate plan is essentially a contract governing how one’s estate will be administered and distributed, but can also be utilized to achieve a variety of other objectives – such as sheltering your assets from various taxes, protecting your assets from creditors, avoiding or minimizing probate costs, authorizing individuals to act on your behalf if you become incapacitated, etc.
In contrast to probate, the administration of an estate plan is private (not public), significantly less expensive (usually involving the simple one-time fee of drafting the estate plan), is often far more difficult to contest, and devises the estate according to one’s actual wishes and desires. While the ways to draft an estate plan are essentially limitless, a basic estate plan will usually contain at least four documents:
- Living Trust
- Will
- Financial Power of Attorney
- Advance Healthcare Directive
The reasons these four documents should be included in any estate plan is because, together, they address essentially every major issue that should be considered when planning for the inevitable – they provide a base, or foundation, upon which you can further develop and tailor your plan to satisfy your particular needs and desires. A brief description of each of these documents is provided below.
1. Living Trust
Unlike a will (discussed below), which is simply a written document designating what happens with one’s estate when one dies, a “trust” is actually a distinct legal entity, similar to a corporation or partnership. A trust is an arrangement involving three parties – a trustor, a trustee, and a beneficiary – whereby one person, the trustor, gives legal title to his property to another person, a trustee, and the trustee holds legal title to the property for the benefit of another person, called a beneficiary. For those who are visually-oriented, think of a trust as a fictional box (a “trust box”) in which you (trustor) place all your assets – your home, your cars, your life insurance, etc. – along with a set of instructions on how the assets are to be used and distributed. You would then give your trust box to your best friend (trustee), to hold for your benefit of someone else (beneficiary).
The concept of a trust as a distinct legal entity developed in England during the Crusades: When a landowner left England to fight in the Crusades, he needed someone to run his estate in his absence. To achieve this, he would convey ownership of his lands to a friend, on the understanding that ownership would be conveyed back on his return. However, Crusaders would often return to find their “friend” (and now legal owner) refusing to give back title to the property. While no law existed at the time to protect the Crusader, the English Courts of Equity determined it was unfair for the friend to break his promise and refuse to reconvey the land to the Crusader, and ruled that the legal owner (the friend) held title for the benefit of the original owner (the Crusader), and must be compelled to give it back to him when requested. Over time, this relationship – where one party would hold property for the benefit of another – became known as a “trust.” [In the example above, the Crusader was both the trustor and the beneficiary – the friend was the trustee, holding title to the Crusader’s land for the Crusader’s benefit.] While originally developed to protect property held during one’s life, trusts eventually began to be used as tools to protect and transfer land and other assets after one’s death.
Today, there are many different kinds of trusts (AB trusts, charitable trusts, revocable and irrevocable trusts, etc.), which can all be drafted in different ways and utilized to achieve a variety of objectives – such as sheltering one’s property from taxes during one’s life, reducing or avoiding estate taxes, protecting one’s assets from creditors, planning for the distribution of one’s assets, etc. But regardless of how they are used, trusts act as the centerpiece of a modern-day estate plan.
2. Will
A will is basically a document stating what will happen with one’s estate when one dies. Wills have been around even longer than trusts, and originally developed out of the need to convey property at death.
In modern times, wills have largely been replaced by trusts, but are still generally used in two ways: to address guardianship issues – i.e. to designate who is to become guardian of one’s children in the event of death (something trusts cannot do, since children are not mere “assets” which can be placed in trust); and to serve as a last-ditch catch-all for property not specifically named in the trust (called a “pour-over will”). A pour-over will basically says that any property owned by the trustor at the time of his death that is not specifically named in the trust will be “poured over” into the trust and distributed according to the terms of the trust. [Keeping with the cheesy “trust box” analogy, think of a pour-over will as a fictional sac (a “will sac”) that holds all of your assets. When you die, all property owned by you will be thrown into the will sac. While most of your property will already be safely stored in the trust box, some of it may not be (perhaps you acquired the property after the last time you updated your trust). Once all your property is collected in the will sac, the trustee will take out the trust box, place it on the ground, and then take the will sac and “pour” all the remaining property into the trust box. Then, the trustee will use the trust instructions to distribute all the property contained in the trust box – which now includes all the extra, unidentified, property poured into it from the will sac.]
3. Financial Power of Attorney
In addition to planning for the management and ultimate distribution of one’s estate, a properly drafted estate plan should also anticipate other considerations, such as who will manage and have access to one’s finances in the event one becomes sick, incapacitated (i.e. in a coma), or incompetent. In general, a document called a “Power of Attorney” allows you to name someone to have the power to make decisions for you under pre-defined situations. A Financial Power of Attorney specifically elects an individual to manage one’s finances and assets when you are unavailable.
4. Advance Healthcare Directive
Finally, an estate plan should also plan for illness or injury, and designate who will make medical decisions on your behalf (as well as what those decisions should be) in the event you are unable to make them yourself. An Advance Healthcare Directive is used to achieve this end.
An Advance Healthcare Directive is a document giving specified individuals the right to one’s medical information (which is otherwise unavailable due to HIPPA and other laws) and authorization to make medical and end-of-life decisions on one’s behalf, as well as instructions as to what those choices should be (e.g. whether to remain on life support, etc.) A prime example of failure to have an Advance Healthcare Directive was witnessed in the Terry Schievo case – without directions as to Terry’s final wishes, nobody knew what decisions should be made or who should be making them. While thinking of these end-of-life decisions can be uncomfortable, but failure to plan ahead could result in FAR worse consequences.
III. CONCLUSION
Now that you know the basics of estate planning, keep in mind the only certainties in life: since Life, Death and Taxes are three things nobody can escape, every person should consider how to improve their life, plan for their death, and minimize taxes to the greatest extent. An estate plan accomplishes all of these goals. So regardless of your particular situation – whether you are a young married couple living the American dream with a house, two cars, and a child on the way; or a single entrepreneur with a few assets whose looking for a tax shelter – you should contact us to discuss your specific situation and the various benefits an estate plan could offer.
At E. Johnson Law, we provide our clients with a superior level of estate planning knowledge and services, as we work closely with Brin Legal | Financial – a well-established estate planning law firm with over 25 years of experience. If you’re interested in learning more about estate planning, or you have a friend or family member you believe could benefit from an estate plan, please do not hesitate to contact us.
