There is no denying that thinking about death, as well as planning for it, is unpleasant. The emotional burden of merely considering it often discourages one from engaging in financial or legal planning. However, the lack of a will and basic estate plan can have disastrous effects on your loved ones. The following is a brief case study of what could happen:
Tom, age, 46, was a successful businessman, providing for his family with a six-figure income. He and his wife Susan lived in a large home and sent their eight-year-old son, George, to a private school. Tom also had a 13-year-old daughter, Maggie, from a previous marriage. Tom and Susan’s lifestyle consumed all of their income, leaving only a modest savings account. Tom and Susan assumed that they would have time to save for retirement later in life. Then the unthinkable happened: Tom died of a heart attack.
The results of Tom’s lack of planning will be felt by his family members for the rest of their lives. Tom’s estate consisted primarily of the equity in the family home and a $1 million life insurance policy. Unfortunately, Tom never wrote a will, the house was titled solely in his name, and he had named his estate as the beneficiary of his life insurance policy. Because Tom died “intestate” (without a will), his assets were administered and distributed according to state law. The proceeds of the insurance policy were paid into Tom’s estate at death, but such funds remained tied up in probate for several months while a personal representative was appointed to settle Tom’s debts and distribute his assets; during this time legal and administrative fees consumed $50,000 of value from Tom’s estate. Even worse, Massachusetts law dictated that Susan was to receive only the first $100,000 of Tom’s estate while the remainder was to be split evenly between Susan and Tom’s daughter Maggie. In order to retain the home, Susan paid half of its net equity value of $200,000 to Maggie. Ultimately, after fees and expenses, Susan wound up with the (mortgaged) home and $425,000 in cash (the first $100,000 of the estate to which she was entitled, plus half of the remaining value of the life insurance policy’s cash proceeds, minus fees and expenses); Maggie wound up with $525,000 cash (her $100,000 payment in consideration of the home, plus half of the $900,000 insurance payout, minus fees and expenses).
Susan’s after tax income from the $425,000 cash and social security payments amounted to less than $40,000 per year. The current mortgage payment on their home was $30,000/year and George’s private school tuition amounted to another $6,000 per year. Susan, having been a stay at home mom the past 10 years, found the job market offered her little opportunity. She ultimately had to sell the house, pull George out of private school, and move to a more affordable community.
Despite receiving a sizeable inheritance, Maggie’s situation was equally tragic. Under Massachusetts law Maggie became an adult upon turning the age of eighteen. By that time, her account had grown to over $700,000, to which she gained unrestricted access on her eighteenth birthday. Maggie, as most young adults, knew little about managing money and seemed to have little use for her mother’s advice. Within a few years, the $700,000 was gone and the relationship between mother and daughter was forever damaged. All of the foregoing could have been avoided if Tom had taken a little time to develop a simple estate plan.
A will is a fundamental way to ensure that your estate is settled, managed, and distributed according to your wishes. A properly drafted will specifies who will receive your assets and can prevent unanticipated disagreements after your death. The old saying that “you do not know your relatives until you have shared an inheritance” really does hold true as arguments can and often do occur. A precise and clear will can prevent intra-family disputes by leaving little room for interpretation.
It is important to regularly revisit and update your will to verify its applicability with current law: a will created ten years ago may no longer provide the protections that it did at the time it was drafted. A review is also advisable when there is a change in your personal situation, such as: births of additional family members, deaths of beneficiaries named in the will, marriage or divorce, moving from one state to another, significant increases or decreases in the value of your property, changes in the tax laws, and lastly, if you want to change the way your property is distributed. Not every major life event means your will needs to be updated, but it is wise to discuss your specific situation with an experienced attorney.
In addition to a will, a complete estate plan will minimize the impact of probate through the use of trusts and other contractual devices, appoint a guardian for minor children, plan for incapacity, and shelter larger estates from state and Federal estate taxes. To discuss how best to draft a comprehensive will or an extensive estate planning strategy, contact the experienced attorneys at Freed Law LLC at email@example.com.
Recent strategies for avoiding the lengthy and expensive probate process
Contrary to popular opinion, avoiding probate does not have to be difficult. Many people can use the following simple and effective ways to ensure that all, or some, of their property passes directly to their heirs, without going through the lengthy and expensive probate court process.
What is Probate?
Probate is a legal process that takes place after someone passes away. It includes:
- Proving in court that a deceased person’s will is valid
- Identifying and inventorying the deceased person’s property
- Having the property appraised
- Paying debts and taxes of the estate, and
- Distributing the remaining property as the will (or state law, if there is no will) directs.
You have heard that you should avoid probate, but why?
Typically, probate involves paperwork, court appearances, accounting work and various tax filings, often with the involvement of attorneys and accountants. Any professionals’ and applicable court fees are paid from estate property, which would otherwise go to the people who inherit the deceased person’s property. In some cases, the probate court may supervise the administration of probate, adding to the complexity and expense. Additionally, if real estate is owned in more than one state, probate proceedings will be necessary in each state — unless probate-avoidance mechanisms such as those described below, or more detailed estate planning techniques, are used. Apart from expense, the other major drawback of probate is that it can be time-consuming, delaying the time at which one’s beneficiaries inherit the estate’s property by up to a year or more in some cases.
Revocable Living Trust
Living trusts have become popular as a means to let people make an end-run around probate. The advantage of holding your valuable property in trust is that after your death, the trust property is not part of your probate estate (it is, however, counted as part of your estate for federal estate tax purposes. That is because a trustee — not you as an individual — owns the trust property. After your death, the trustee can easily and quickly transfer the trust property to the family or friends you left it to, without going through the probate process. You specify in the trust document, which is similar to a will, who you want to inherit the property, and on what terms.
You can convert your bank accounts and retirement accounts to payable-on-death accounts. You accomplish this by filling out a simple form in which you name a beneficiary. When you pass away, the money goes directly to your beneficiary without going through probate. You can do the same for brokerage accounts, annuities, and stocks. Some states provide for a similar mechanism for vehicle and boat registrations, through the use of “beneficiary deeds” that get recorded at the state level.
Joint Ownership of Property
Properly done, joint ownership can provide a simple and easy way to avoid probate when the first owner passes. To take title with someone else in a way that will avoid probate, you state, on the paper that shows your ownership (e.g., a real estate deed or a bank account), how you want to hold title. Usually, no additional documents are needed. The following are three common methods of joint ownership, but only two of them are successful probate-avoidance mechanisms.
- Joint tenancy with right of survivorship: Since each joint tenant owns an undivided interest in the entire asset, when one owner passes away the other joint owner remains as the sole owner, thereby avoiding probate
- Tenancy by the entirety: In most states, married couples can take title in “tenancy by the entirety” rather than in joint tenancy. This is very similar to joint tenancy, but can be used only by married couples (or in a few states, by same-sex partners who have registered with the state). Both avoid probate in exactly the same way. However, unlike joint tenancy with right of survivorship, tenancy by the entirety affords a level of creditor protection: a creditor of only one spouse will have no claim against property owned by husband and wife and cannot force the sale of such property as long as both spouses are alive and the marriage is intact.
- *Tenancy in Common – A trap for the unwary: When two or more people own property as tenants in common the property does not automatically go to the surviving joint tenant(s) on death. Rather, each owner holds a partial interest in the property. For example, if Bill and Mary own a home as tenants in common, upon Bill’s death his interest in the home would go to his estate and be distributed either by the terms of his will or as determined by the probate court. Tenancy in common also permits co-owners to own different percentages whereas joint tenancy requires each joint tenant to own an undivided and equal share with all other joint tenants.
Giving away property while you are alive helps you avoid probate for a very simple reason: if you do not own an asset when you pass away, it does not have to go through probate. That lowers probate costs because, as a general rule, the higher the monetary value of the assets that go through probate, the higher the expense (typically 5% of the probate assets).
Simplified Procedures for Small Estates
Almost every state now offers shortcuts through probate (or a way around it completely) for “small estates.” Each state defines the term “small estates” differently.
To discuss how best to implement one, or a combination, of these probate avoidance strategies contact one of the knowledgeable attorneys via email at firstname.lastname@example.org or see our website for further information (www.freedlawllc.com).
Choice of Entity (continued)
Corporation (this discussion assumes a traditional – “C” rather than “S” – corporation). Corporations sit at the top of the business entity pecking order, in terms of formality of internal structure and management, and legal/compliance obligations. A corporation is the best vehicle for attracting investment, particularly from a broad or sophisticated investor base. Every state has corporate statutes that clearly establish stockholders’ rights, and over the long history of corporations, a robust body of case law has developed to further flesh out investor, creditor, and other associated parties’ rights, giving comfort to these third parties in their dealings with a corporation. Moreover, a corporation may issue multiple classes and series of stocks, which appeals to private equity and venture capital investors; these investors also prefer not to invest in pass-through tax entities such as partnerships or LLCs. Additionally, for a growing company, it is much simpler to issue equity incentives (e.g., stock options) from a corporation than from an LLC or partnership. For a mature company, the repertoire of available fringe benefits can be very advantageous from an employee attraction/retention standpoint, and attractive from a tax deductibility standpoint. A corporation provides limited liability to its shareholders: e.g., if you own ten shares of IBM stock, a worst-case scenario is that the company becomes insolvent and your shares become worthless – no one will come after you personally for any liabilities of the company. However, a corporation has two major drawbacks for a small business person:
- If profitable, the owners (stockholders) of a corporation potentially face double taxation – a tax at the corporate level on the corporation’s earnings, plus a tax at the shareholder level on the corporation’s after-tax income that is actually distributed to stockholders as dividends.
- If not profitable (the case w/ most startups), any losses are trapped at the entity level and do not flow through to the owners, as they would in the other entity forms described in this article.
Formalities/Expense/Administrative Burden. A corporation is the most expensive business entity to maintain, and requires observance of the greatest formalities. A corporation must pay formation and annual fees, prepare and file a charter, draft by-laws, establish a board of directors, issue stock, conduct regular meetings of the stockholders and the board, file annual reports, and maintain corporate records. In fairness, some of these elements also attend an LLC.
Limited Liability Company. A limited liability company (“LLC”) is a hybrid entity that combines certain features of corporations and partnerships, offering limited liability protection to its investors as well as flexible economic and management arrangements and pass-through taxation. For these reasons, as well as its ease of administration due to limited formal requirements, it is often the best choice for small business owners. Like a corporation, an LLC is treated as a separate legal entity, providing limited liability to its owners (known as members), even those that participate in management; contrast this with a partnership, in which the general partners have unlimited liability. Additionally, by default an LLC is disregarded for tax purposes, avoiding double-taxation and allowing its members to apply losses toward their personal income. Like a partnership, an LLC with more than one member must file an annual profit and loss statement with the IRS, and provide another form to each partner indicating that partner’s share of the profit or loss. An LLC affords the most flexibility of any structure for implementing unusual economic arrangements – the Massachusetts statute is largely enabling in nature, allowing nearly any arrangement that the members agree to, premised to a large extent on the principles of freedom of contract. It should also be noted that an LLC can be a single-member entity, making it useful for an individual seeking asset protection, but not necessarily outside investment (e.g., it is common to form a sole-member LLC as the owner of a rental property, for liability-remoteness reasons).
Limited Liability and Post-Formation Obligations
Unfortunately, for limited liability purposes, establishing a limited liability entity (limited partnership, limited liability company, or corporation) is not the end of a founder’s “legal” obligations – a failure to conduct the business as a truly discrete entity can risk it being disregarded for tax or liability purposes – a first year law school professor would refer to this as “piercing the corporate veil.” This means that an entity, even one as flexible as an LLC, needs to keep good records and be more than an extension of its owners in the eyes of the law. The following are basic record-keeping necessities and other indicia of a valid business that will help to ensure that a legal entity’s existence is respected by the authorities:
- minutes from meetings
- a corporate record book
- use of business cards, stationery, letterhead, etc. to give notice to third parties that they are dealing with an entity and not just an individual
- a website
- separate financial records (books) and a dedicated checking account
In a nutshell: if you are going through the trouble of setting up a limited liability entity, continue to take the time to maintain its viability.
Moreover, even if a business entity is properly formed and maintained, the following caveats should be noted: (i) in Massachusetts (and most other states), professional practices, whether formed as partnerships, LLCs or corporations, cannot limit their liability for professional malpractice/misdeeds (and may also be required to purchase malpractice, or errors and omissions, insurance); and (ii) although an entity’s debt is its own, and not its owners’, in practice a lender will typically require a startup business’ owner to guarantee the debt, and hence be responsible for its repayment.
Choosing a form of organization for a business enterprise can be a daunting decision for even the savviest entrepreneur. We hope that this article serves as a good primer on the topic, and Freed Law LLC is standing by to field your questions.
“Should I incorporate?” It’s a question most entrepreneurs ask themselves at some point, in the belief that it’s necessary to form a corporation in order to limit personal liability or establish a true “business,” often based on a vague appreciation of the advantages of the corporate form, perhaps informed by an vendor’s online recommendation (typically accompanied by an offer to do the formation work!). While each individual’s situation is different and a general reference source cannot comprehensively address this question, this article illustrates the primary differences between the basic “corporate” forms, to help a small business person analyze this fundamental decision.
As a starting point, the proper question typically isn’t “Should Iincorporate?” but rather “Should I form a business organization through which to conduct my business enterprise?” closely followed by the question “If so, what type of business ‘entity’ should I choose?” Digging down another level, several additional questions must be posed to properly inform the decision:
- How concerned am I that my business operations will expose me to liability? Sources of liability can include personal injury lawsuits, product or manufacturing defect lawsuits, intellectual property infringement, and vendor or lender debt claims.
- Will I take on a partner?
- Will I seek to attract outside funding, and if so, what type and on what terms?
- Do I expect to hire employees?
- What are my growth prospects or ambitions?
The following discussion addresses these operational considerations in the context of the choice of entity decision.
Choice of Entity
Sole proprietorship. Sole proprietorships are by far the most common form of small business. The “formation” costs are minimal – one simply conducts a business activity, typically using his or her personal bank account and name (or potentially a different name: if you see a moniker like “Harry Dunne, d/b/a Mutt Cuts,” that’s a sole proprietorship). This is adequate for many individuals who do not want to bring on a partner or investor, do not have a budget or tolerance for the administrative responsibilities of managing a more formal entity, and have limited concern that their business activities will expose them to personal liability. From a liability standpoint, the individual owns all of the assets and liabilities of the business, liabilities are not limited to the amount of capital set aside for the business, and existing liabilities are not extinguished upon the sale or dissolution of the sole proprietorship. From a tax standpoint, one simply files a Schedule C to one’s personal tax return, and any net profit or loss from the business is treated as either additional income or a tax deduction, respectively (though note that Federal self-employment tax must be paid on any profit). Despite the general lack of formalities, it is worth noting that Massachusetts law requires any person engaged in business under an assumed name to file a Business Certificate in the office of the clerk of the town or city in which the business is located.
Partnership. A partnership is the most basic multiple-owner form of business. Like a sole proprietorship, it is an unincorporated form of business organization and no written agreement or state filing is necessary to establish a general partnership (a state filing is, however, required to form a limited partnership). It is so basic that two individuals who split the costs and profits of a business venture, even in the absence of a formal agreement or legal filing, will be considered by law to be a partnership, and will be subject to the general provisions of the applicable state’s partnership statutes. A more deliberately formed partnership will typically entail a partnership agreement outlining the economic and other rights and responsibilities of each partner, which can be structured as simply (two friends tending a worm farm in their living room, agreeing to split their economic results 60/40) or as complexly (hedge funds, private equity funds, and venture capital funds are nearly always structured as partnerships, and their partnership agreements can be more than 100 pages long) as the owners require to achieve their goals. For tax purposes, a partnership is disregarded – it does not pay taxes at the entity level – rather, any profit or loss “flows-through” the partnership and is recognized by the partners on their individual tax returns, similarly to the way that a sole proprietor recognizes profit or loss. Nonetheless, a partnership must file an annual profit and loss statement with the IRS, and provide another form to each partner indicating that partner’s share of the profit or loss. With respect to liability, general partnerships assign undivided and unlimited liability to each partner for the debts and other liabilities incurred by the partnership (a concept referred to as “joint and several liability”). A limited partnership, typically used to raise money from passive investors (e.g., real estate or private equity investors) vests one or more general partners with all management responsibility and unlimited liability, while limited partners have no decision-making authority and are only liable for their contributions.
*** End of Part I ***
In the right situation, a revocable living trust can pave the way for a smooth, quick transfer of assets at death without the hassles of probate, which is the court-supervised process of settling an estate. Revocable living trusts (also called revocable inter vivos trusts) are trusts that you establish, and can revoke or alter, while you are alive.
Do assets in a living trust bypass probate? Yes. Only assets held in your name at death are “probate assets.” Assets not subject to probate include property that you own jointly with a right of survivorship, and property that passes by a beneficiary designation such as the proceeds of life insurance policies on your life, and IRAs and 401(k) plans, as well as the assets held in a revocable living trust. Some states have simplified their probate procedures, but elsewhere the process can be costly and time-consuming, eating up 5%, 10%, or more of a probate estate and lasting several years. Apart from increased speed and reduced expense, another benefit of bypassing probate is privacy: once probated, a will is a publicly available document, and the “probate assets” become a matter of public record. In contrast, neither the assets held in your revocable trust at death nor the trust’s distribution scheme will be disclosed to the public.
Does a living trust save taxes? Not necessarily. This is one of the biggest misconceptions about revocable living trusts. Because the creator of a revocable trust (you) retains the power to revoke the trust, you are treated as the owner of the trust property for income tax purposes. All items of trust income, deduction, and credit are reported on your personal income tax return regardless of whether any assets are paid out to you. Additionally, at death, the trust’s assets are included in your estate for estate tax purposes. Nonetheless, if your estate is large enough to be hit by the Federal estate tax – the exemption amount is currently $5 million – your lawyer can incorporate tax-saving measures into a revocable trust, or establish one or more irrevocable trusts to minimize your estate’s future tax burden. It is also worth noting that a living trust does not protect assets from creditors nor does a living trust serve to protect assets if you are sued.
Who should be named as beneficiaries, and who should serve as trustee? If you establish a trust, you and your spouse will typically be the lifetime beneficiaries of the trust with, perhaps, your spouse, children and grandchildren designated as beneficiaries after your death. Typically, you serve as your own trustee (or co-trustee with, say, your spouse or child or a financial institution), meaning you retain control of your assets for as long as you are able to manage your own affairs. When you die, the trust becomes irrevocable, and the then-serving trustee distributes or manages the assets as the trust document specifies.
Are there other advantages of revocable living trusts? One of a trust’s most valuable benefits is that it can provide a blueprint for handling your affairs if you become incapacitated. Your successor trustee (or co-trustee, if you name one) can take over for you. Trusts allow great flexibility in carrying out your wishes. For instance, you can specify in the trust exactly how you would like your trust’s assets to be spent, right down to what kind of nursing facility you prefer. In addition, actions by trustees may be accepted more readily by some financial institutions than actions by agents under durable powers of attorney. Further, if you own real estate, such as a vacation home, in another state, transferring it to a revocable living trust avoids exposure to that state’s probate process.
Is a living trust the only document I need to handle my estate? Even if you have a living trust, you still need a “pour-over” will. This form of will instructs your executor/personal representative to transfer to the trust any assets that you did not transfer before death so that they can be governed by the provisions of the living trust. A will is also necessary to name guardians for minor children. For a more detailed discussion regarding wills, see our September 7th blog post: “Why You Need a Will.” You should also have a durable power of attorney for financial matters and a health care proxy to guide the decisions to be made regarding your care upon incapacitation.
To discuss the roles of a will and living trust in your estate plan, or for help developing a comprehensive estate planning strategy, contact the experienced attorneys at Freed Law LLC at email@example.com.