Just What the Doctor Didn't Order: Why Wills Alone Don't Work For Most Physicians.
Physicians have worked too hard and have sacrificed too much to throw it all away with an inadequate estate plan. After undergraduate college, four years of medical school, a grueling residency lasting anywhere from three to eight years, and often a fellowship, physicians enter practice with high debt and have to play catch-up to their college peers, who have already been in the workforce for years and have begun accumulating assets. People working 50 or even 60 hours a week in other occupations feel abused by their employers, even when paid overtime, and if such work is self-imposed, are considered workaholics. Contrast this with resident physicians who have been mandated to decrease their workload to a "mere" 80-hour workweek. Physicians accumulate significant assets over the course of their career and have high liability, and special protections and strategies are needed to pass on and preserve those assets while minimizing the estate tax bite. While a simple will may be adequate for Joe the plumber, it is likely not adequate for you.
Scenario: Dr. Brown is an ENT surgeon with assets worth $5,500,000. He came from humble beginnings and has worked his way up. He was still actively practicing but suddenly died from a heart attack and his will is being probated (a court process that determines who gets what and makes sure his debts are paid). His wife died last year in a car accident and also had a will leaving everything outright to her husband, including a $1,000,000 life insurance policy, on the advice of their attorney. Dr. Brown has three adult children, Sam, Bill, and Martha. Sam is an architect and married with two children. Bill is a special needs child and lives in a group home. Martha is single and financially irresponsible. Dr. Brown's home is worth $500,000. Dr. Brown was depressed after his wife died and had Sam's name put on the house for convenience. Dr. Brown also has a $2,500,000 life insurance policy payable to his estate. He has $500,000 in his pen- sion, $500,000 in stocks, and an office building interest of $500,000 (building is owned by his partnership with a total value of $2,500,000). Dr. Brown paid 50% total tax during his working years for federal and state tax obligations. Dr. Brown's will directs that $1,000,000 go to his favorite charity, and the remainder be distributed outright amongst his 3 children in equal shares. Hence each child will inherit $1,500,000. What is wrong with this plan?
GOALS OF ESTATE PLANNING
Estate planning is a global concept involving much more than the mere transfer of assets at death. It involves 1) planning for mental or physical incapacity while living, 2) transferring assets both during life and at death in a manner consistent with your personal values and philosophy, and 3) protection of beneficiaries of your estate from ex-spouses, lawsuits, creditors, other "predators," and even themselves. A will is about assets, whereas an estate plan is about people and passing on your legacy. A will is not effective until death; an estate plan begins now. With a properly construct- ed estate plan, you can plan for incapacity and determine the amount, manner and timing of distribution of your assets to your beneficiaries both during life and after death.
The most neglected aspect of estate planning is failure to protect your own assets and those passed to your descendants. It is easier to protect assets you pass on to your descendants than your own assets. A complete discussion of asset protection is beyond the scope of this article. Suffice it to say that it is relatively easy to protect assets passed to your descendants from their creditors, ex-spouses, lawsuits, and other "predators." Given the divorce rate over 50% and our highly litigious society, such scenarios are likely. This is not an attempt to avoid legitimate creditors, but is an attempt to preserve your beneficiaries' assets for their benefit. Reduction of estate taxes, for those with a taxable estate, is only one aspect of estate planning, albeit very important. There are a plethora of legal vehicles and strategies to achieve all of the above. In essence, a well crafted estate plan is not a form and is not simply about money and saving taxes; it is an ongoing process implemented with the estate planning attorney as the quarterback, and may require the assistance of your accountant, insurance professional, or financial advisor in order to pass on your legacy on your terms.
PITFALLS OF A WILL
It is generally true that only one of three people have a will; physicians in my experience do better. While a will alone may be an adequate estate planning device for the worker with a small or average estate, it is inadequate for most physicians. The reason for this is not what a will does, but what a will does not do. For many people, including phy- sicians, it is not possible to achieve the goals of estate planning listed above with only a will.
Probate is a court process that ensures all your final debts are paid and your assets are distributed, whether or not you have a will. A common misconception is that a will avoids probate. A will does not avoid pro- bate! Probate can be an expensive and lengthy process, and is a matter of public record. Probate can take over a year to distribute assets while attorney fees are piling up, and can consume 2-3% or more of a complex estate. Probate is essentially a voluntary lawsuit you file against yourself, with your own money, and if your will is contested, will be decided by an unknown judge, without you having any opportunity to defend yourself or explain your intent. A will is not difficult to contest since it is not legally binding until after your death. Accusations can be made by any beneficiary, and many years may have passed and any witnesses may be dead or incompetent to testify themselves.
The only way to avoid probate is to place assets in joint ownership, in a living or revocable trust, or transfer them via beneficiary designations such as occurs in pensions, life insurance, or annuities. A trust is a separate legal entity whereby the owner of assets transfers legal title to a trustee that holds property for the benefit of the grantor (creator) of the trust or his or her heirs. A living trust is a trust set up during the grantor's lifetime, and is synonymous with a revocable trust. A living trust, unlike a will, becomes a legally valid document the moment it is executed, and requires retitling of assets and other formalities that will act as proof of the grantor's competence. Upon death, assets are transferred almost immediately without having a judge sign off.
Scenario: Dr. Brown's probate is not going well. It has been over a year and the assets have not been distributed because of a slip and fall judgment against Dr. Brown's partnership resulting in a lien on the office building. Furthermore, Dr. Brown did not have an adequate exit plan from the partnership in the event of death or disability, so no funds are available to buy him out. Since his dad's death, Sam's wife has been thinking of divorce. She visits a divorce lawyer, who advises her not to file for divorce until Sam receives his inheritance and deposits the monies in their joint account. Meanwhile, Medicaid has gotten wind of Bill's windfall inheritance, and has cut him off. Martha has never been real responsible financially, and just can't wait "to get the big check."
A will does not provide for incapacity. If you become unable to make financial, personal and business decisions, who will do this? It is not automatic that your spouse will assume these functions. If no one is legally designated to act on your behalf, court intervention is required. This can consume thousands of dollars, take months, and cause unnecessary emotional strain. A durable power of attorney (DPOA), which legally gives another person the authority to make financial and personal decisions and sign for you after incapacity, is a good head start. A DPOA may not be recognized by certain financial or business entities, who may require yearly updates, which cannot be done if you are already incapacitated. A living trust avoids this problem for assets titled in the name of the trust, whereby the trustee or successor trustee is essentially stepping into your shoes and signing as if they were you, not merely as your agent as is the case with a DPOA.
Scenario: Dr. Brown named his wife as executor of his estate. He failed to name additional replacement executors, and failed to have his will updated after his wife's death. Sam feels he is the most responsible person to be executor, but Martha is contesting this with the probate court as she feels the whole process is taking way too long, and she "wants her money now." In the meantime, estate bills are piling up with no one with authority to sign checks.
C. Joint Ownership
A will does not provide for the distribution of jointly owned property. On death, jointly owned property passes immediately to the survivor. Joint ownership, while initially having sex-appeal, has its problems. There is double liability exposure to judgments, debts, and divorce. There may be gift tax implications, inadvertent disinheritance of heirs, or passing of property to unintended heirs. Most importantly, joint ownership overrides both wills and trusts. Many people don't know this. The most common example is a jointly owned home. This may not be a problem for a stable long- term marriage. However, many older adults who have lost a spouse and jointly title their home with one of their nearby children for convenience, will inadvertently disinherit their other children.
Scenario: Dr. Brown's home was jointly titled with Sam just prior to his death. At death, Sam now assumes full title to the home as his dad's interest extinguished upon his death. This overrides the will transferring the home in equal shares to Sam, Bill, and Martha. Sam's divorce proceed- ing was deliberately delayed by his wife's lawyer until the inheritance was distributed. It was argued the home was now a marital asset as it was acquired during the marriage, and 50% of the equity in the home was given to Sam's now ex-wife by the divorce judge. The home had to be sold in a down market at a loss to pay off Sam's ex-wife. This now leaves $5,000,000 in the estate, with $1,000,000 going to charity and $4,000,000 to be split 3 ways among Sam, Bill, and Martha, or $1,333,333 each. Sam's ex-wife now gets half of Sam's $1.3 million. Bill and Martha now will inherit only $1.3 million instead of $1.5 million. Martha is upset because Sam got a larger portion of the inheritance than she.
D. Beneficiary Designations
A will does not direct distribution of assets at death requiring beneficiary designations such as life insurance, annuities, qualified pensions, and IRAs. Beneficiary designations override a will and are very difficult to challenge legally. They must be taken into account when drafting a will so that all of your assets, both those inside and outside of a will, are transferred according to your wishes. Failure to update such designations due to changing circumstances, such as remarriage, may result in assets going to your ex-spouse, or even to your second spouse, and eventually to your second spouse's children, thus disinheriting your own biological children.
Physicians are likely to have higher insurance levels and pensions than most people, and therefore such policies have a greater likelihood of putting their estates over the limit and incurring estate tax, or resulting in their assets not being distributed according to their wishes if it is assumed their will controls. Many physicians will benefit from an irrevocable life insurance trust (ILIT) which will keep such policies out of their estates altogether. The laws governing pension plans and IRAs are very complex, and scrupulous attention to detail is necessary in order to rollover pension plans into IRAs, and to "stretch" out IRA distributions over the lifetime of your children without triggering an inadvertent distribution of the plan with the IRS demanding immediate payment of income tax. If the rules are not followed, the IRS may require the pension or IRA to be distributed within 5 years of death or based on the oldest beneficiary's life expectancy if multiple beneficiaries are listed. A well coordinated estate plan must consider joint ownership and beneficiary designations on life insurance and pensions with provisions placed in a will or living trust.
Scenario: Dr. Brown's $2.5 million life insurance was pay- able to his estate, and was assessed 45% estate taxes, leaving only $1,375,000 for his children. He could have easily put the insurance policy in an ILIT, which would have kept it completely out of his estate, with no estate taxes owed. He remembers his insurance salesman telling him insurance was not taxed, but this was only a half truth. Insurance does not incur income taxes, but it does incur estate taxes if part of the estate, as in Dr. Brown's case.
E. Estate Taxes
A will does not necessarily save or eliminate, and may increase estate taxes. A brief review of estate tax law is necessary to put this in perspective. An estate, from the IRS point of view, includes all assets - bank accounts, homes, life insurance, pensions, mutual fund and brokerage accounts, business interests, real estate, etc. A taxable estate under current law is an estate with total assets over $3,500,000 in 2009, $0 in 2010 (estate tax is repealed), and back down to $1,000,000 in 2011 and beyond. The estate tax rate is 45% in 2009, 0% in 2010, and 55% in 2011. The amount that is excluded from any estate tax is referred to in IRS speak as the applicable exclusion. This can be thought of as a "get out of estate tax free card" issued by the IRS to every taxpayer. However, you either use it or lose it; it is not transferable, even to a spouse. There are proponents in Washington who wish to raise or lower or keep stable the applicable exclusion or even make it portable between spouses. Congress may well change the law this year. Stay tuned. Since life insurance and pensions are included in the definition of one's estate, and if the applicable exclusion does indeed decrease to $1,000,000 in 2011 as is the current law, most physicians will possess taxable estates.
In a taxable estate, the applicable exclusion is wasted where a will leaves everything to the surviving spouse. This is the worst result, since this problem can easily be avoided by the first spouse to die leaving up to the applicable exclusion amount in a bypass trust, with language mandating that income and principle be available for health, education, maintenance, and support of the surviving spouse.
In taxable estates, assets should be equalized to take full advantage of the applicable exclusion by setting up bypass trusts for the surviving spouse. It should be understood that not leaving everything outright to your spouse will not dis- inherit the spouse. There are legal ways to leave everything FOR your spouse, rather than TO your spouse, thereby taking advantage of your applicable exclusion. Language can be inserted in the controlling documents such that the assets will only be available to the surviving spouse until his or her death, and then and only then can other beneficiaries (i.e. children) be entitled to distributions. This should mitigate any concerns among physicians that their surviving spouse will die in poverty.
There are a variety of techniques using trusts whereby the estate of a married couple can be reduced, taking full advantage of each spouse's applicable exclusion, and where all assets are still available for both spouses while living and then for the surviving spouse until his or her death. Trusts are used for probate avoidance, estate tax reduction, asset protection, and management of assets. While a trust set up during lifetime avoids probate, a trust set up in a will, called a testamentary trust, is subject to probate. Types of trusts that will provide for a spouse and simultaneously save estate taxes are marital trusts, qualified terminable interest in property trusts (QTIPs), bypass trusts, and irrevocable life insurance trusts (ILITs).
A grantor trust is a special type of irrevocable trust where the grantor, the one who funds the trust, is personally responsible for paying income taxes on trust income, rather than using the trust assets to pay income. Examples include grantor retained annuity trusts (GRATs), grantor retained income trusts (GRITs), grantor retained unitrusts (GRUTs), and qualified personal residence trusts (QPRTs). This has a two-fold beneficial effect: 1) highly appreciated assets will grow outside of your estate unburdened by income taxes, and 2) payment of income taxes from the grantor's estate further reduces the grantor's taxable estate upon death of the grantor.
Scenario: Dr. Brown will pay estate taxes of 45% on anything above the applicable exclusion in his year of death, which is $3,500,000 in 2009. His estate is valued at $5,500,000. Dr. Brown will take a $1,000,000 deduction for the portion going to charity. Therefore he will pay taxes on the remaining $1,000,000 or $450,000 tax. Dr. Brown should have equalized his assets with his wife, and she could have utilized a bypass trust for her husband's benefit until he died, then to the children. This would have resulted in no estate taxes for either of them. There is a technique, where assets are unequally distributed between spouses, for the wealthier spouse to place approximately half the assets in a living QTIP (qualified terminable interest in property) trust where the wealthier spouse maintains control, but the assets are available to the other spouse and included in the other spouse's estate. This too would have been an option for the Browns. An ILIT would also have worked. The Browns could have utilized numerous techniques to completely eliminate estate taxes. In 2011, if the applicable exclusion remains at $1 million, the estate tax bite for Dr. Brown would have been 55% of $3.5 million ($5.5 million–$2 million [$1 million exclusion + $1 million charitable donation]) or $1,925,000!
Other techniques include family limited partnerships (FLPs, which take advantage of lack of marketability and minority discounts), lifetime gifting (currently $13,000 annually to an unlimited number of persons without incurring gift tax), and charitable gifting. FLPs are beyond the scope of this article.
Lifetime gifting, if over the $1,000,000 applicable lifetime gift tax exclusion, will incur payment of gift tax at a 45% rate, but gift taxes are tax-exclusive, meaning that gift taxes paid are not included in the gift, whereas estate taxes are tax-inclusive, i.e. paid from money included in the estate. What this means is the tax rate is effectively lower than the stated rate when making a gift as opposed to distribution of the same amount from an estate. For example, assuming the $1,000,000 lifetime gift tax exclusion has been exhausted, an additional gift of $1,000,000, incurs a gift tax of $450,000; hence a total of $1,450,000 is required by the donor to make the $1,000,000 gift. However, in a taxable estate, for amounts transferred above the applicable estate tax exclusion, it would require $1,818,181 to distribute that same $1,000,000, since 45% estate tax on $1,818,181 is $818,181. The difference in tax paid is $368,181. Hence at a 45% gift and estate tax rate, the effective gift tax ultimately paid is 31% of the total amount required to pay the gift, even though the rates are ostensibly identical. Lifetime gifting therefore has a tax advantage over transferring assets at death, as well as the opportunity for the donor to mentor and teach the recipient how to handle money, and to cut off any recipient deemed incompetent or irresponsible in financial affairs. A downfall of gifting is running out of money before you die. However, gifting of assets does not cause a step-up in basis (basis is the value you originally paid for an asset) at death, whereas assets passing at death carry with them a step-up in basis (i.e. the new stepped up basis will be the value at time of death, not the original cost of the asset), meaning there will be higher capital gains taxes on assets subsequently sold if received through gifting rather than from an estate. This will likely not override the potential taxes saved through gifting, but this may not be true if capital gains tax rates are increased.
Scenario: Lifetime gifting and a family limited partnership would also have worked for the Browns.There are a number of vehicles that can be utilized for charitable gifting, such as charitable remainder and lead trusts, which are very favorable to the taxpayer. Estate planning for taxable estates, using the techniques above, is best done by an attorney concentrating in this highly complex area, as formalities must be adhered to and the laws are constantly changing.
F. Protection of Beneficiaries
A will does not protect beneficiaries from creditors, ex- spouses, lawsuits or bankruptcy if outright distributions of assets are made to the beneficiaries. This is true of most wills. Wills can be drafted such that beneficiaries receive their interests in trust, with carefully drafted language with strong creditor protections in place. Living trusts can also be drafted so that at death there is a division into subtrusts with creditor protection for the beneficiaries. As a matter of public policy, beneficiary assets placed in trust cannot be protected from the following creditors: 1) IRS, 2) court order for child support, and 3) court ordered alimony. Such assets, however, are considered sole and separate property and not part of the marital estate if proper safeguards are followed. Furthermore,assets placed in trust for beneficiaries can have language consistent with a special needs trust, so such assets would not cut the beneficiary off from Medicaid or SSI (supple- mental security income). Keep in mind that the stronger the language conferring protection from creditors or potential creditors, the more restrictions placed upon distributions to the beneficiary.
Scenario: Dr. Brown could have simply directed in his will that all his assets be distributed in equal shares in separate trusts for his children's benefit. In the alternative, Dr. Brown could have had a living trust divided into equal shares for his children upon his death. Sam's and Martha's trusts should have included language for creditor protection and spend- thrift clauses. Such language would likely have prevented Sam's wife from obtaining any of Sam's inheritance during the divorce. Martha, the spendthrift, would be subject to the discretion of a trustee for any distributions made to her. Bill's trust would have language making it a special needs trust, and Medicaid payments to Bill would not be cut off. Dr. Brown could have placed his home in a trust with Sam as the trustee, which would trifurcate upon Dr. Brown's death into separate trusts for Sam, Bill, and Martha as beneficiaries, again with creditor protection, special needs, and spendthrift language. This would have enabled Sam to engage in legal transactions regarding the home, would likely have prevented his ex-wife from claiming it as a marital asset, and would have equally divided the proceeds for Sam, Bill, and Martha. The trustee could have decided to wait for sale until the real estate market rebounded.
It is evident that having only a will may have dire unintended consequences in terms of passing on and preserving your legacy. It is vital that physicians consult with an attorney with in-depth knowledge of sophisticated estate planning techniques to ensure their legacy is passed on and their assets protected. Disclaimer: This article is not intended as legal advice. Each reader should consult his or her own attorney.