Best Practices: Estate Planning

How Estate Taxes Work

Estate taxes represent some of the most confiscatory taxes on the books. But according to TEC speakers George Daniels, David Hokanson and Stephen Wolff, you don't have to pay them -- if you do the proper estate planning. In fact, as long as you understand the tax codes, you can pass the entire value of your estate on to your children without paying any estate taxes, sell highly appreciated assets without paying a dime in capital gains taxes, and take an additional current income tax deduction for opting out of paying your estate and capital gains taxes.

Three specific taxes apply to estate planning:

1. Estate taxes apply when you transfer assets to someone else upon your death. At that time, the government taxes your right to transfer those assets.
   
   
2. Gift taxes were instituted to prevent people from gifting away assets upon their deathbeds.
   
   
3. Generation skipping transfer taxes (GSTT) prevent wealthy taxpayers from leaving their estates to their grandchildren in order to pay one generation of estate tax instead of two.

However, says Wolff, by using three advanced estate planning strategies you can dramatically reduce these taxes or eliminate them altogether:

1. Gifting away assets while still alive (rather than at your death) lowers the value of your estate and significantly reduces estate taxes.
   
   
2. Discounting involves gifting in such a manner that the value of the assets look smaller to the IRS.
   
   
3. Leveraging allows you to gift assets in a manner whereby you retain control of the assets, enjoy the income from the assets during your lifetime and remove them from your estate, thereby avoiding any estate taxes.

Many people believe that estate planning involves a very aggressive approach that will land them in hot water with the IRS. On the contrary, says Hokanson, estate planning represents one of the safest and most secure strategies your accountants and attorneys can use. The key is to recognize that Uncle Sam wants you to give to charity rather than pay taxes and to use the tax codes accordingly.

Why Do Estate Planning?

When Joe Robbie (the former owner of the Miami Dolphins) died, his heirs were forced to sell the team as well as Joe Robbie stadium in order to raise the cash to pay the estate taxes. They also lost millions of dollars to lawyer's fees and other related expenses. In contrast, Sam Walton, the legendary founder of Wal-Mart, left an estate valued at roughly $25 billion, yet his heirs didn't pay a penny in estate taxes. The difference? Walton had a carefully conceived and crafted estate plan that took advantage of every legal opportunity offered by the estate tax codes. Robbie, on the other hand, had no estate plan at all.

Most business owners know they face sizeable estate taxes, yet few do anything about it. According to Wolff, 85 percent of wealthy Americans do only the most basic estate planning. Of the 15 percent that attempt advanced estate planning, the majority fail to accomplish their intended goals. Worse, of family businesses that fail after being passed on to the next generation, 97 percent are forced to sell the business in order to raise the cash to pay estate taxes. Wolff attributes much of the high failure rate to basic human nature.

"Every year, untold millions of dollars are unnecessarily lost to estate taxes because of the dreaded 'P' word -- procrastination," he explains. "It takes a highly motivated individual to invest their time and energy into planning something that will benefit others, especially when you consider that the person won't be around to see the results of his or her hard work."

According to Daniels, proper estate planning does far more than just reduce or eliminate estate taxes. It also:

• Prevents children and grandchildren from fighting over money, the business and "sentimental" items in the estate
  
  
• Prepares children and grandchildren for the wealth they will receive
  
  
• Protects the assets you leave behind from the ravages of divorce, lawsuits and other creditor actions
  
  
• Creates tax-deferred cash flow streams for yourself if you become disabled and for your family when you die
  
  
• Maximizes the value of your business in family buy-sell agreements or an outside sale
  
  
• Prepares the business to continue (whether kept or sold) after you are gone.

Creating the Estate Plan

In order to create an effective estate plan, you must first create a vision and then set concrete goals and objectives. Once you have a clear idea of where you want to go and what you want to accomplish, then you can proceed with building the plan. To avoid common estate planning problems, Wolff recommends working with an estate planning firm that has experience in three critical areas:

1. Minimizing estate taxes
   
   
2. Creating a succession plan for the business
   
   
3. Family dynamics

In particular, look for an estate planning firm that has experience in all areas, not just the tax laws. Family dynamics and other "soft" issues play a huge role in the success of your plan.

To provide a blueprint for your estate plan, Hokanson recommends creating a "family wealth vision." This vision, typically expressed through a written "family letter of intent," answers such critical questions as:

• What are we trying to achieve as a family?
  
  
• What legacy do I want to leave for those who come behind me?
  
  
• How do we want to distribute the family wealth?
  
  
• What goals do we hope to accomplish with this distribution?

"Having a family vision helps your advisors understand exactly what you're trying to achieve, thus ensuring that you drive the planning process rather than your attorney or tax advisor," explains Hokanson.

Once you have a working blueprint, creating an estate plan involves four basic steps:

1. Conduct a current estate analysis. Crunch the numbers to get an accurate value of your estate. Then compare the taxes you owe (prior to estate planning) to your vision and goals. This provides the starting point for identifying the appropriate strategies, tactics and estate planning tools needed to minimize estate taxes and accomplish your philanthropic goals.
   
   
2. Assemble your team of advisors. The team must include your estate planning firm, an experienced estate tax attorney and your CPA. It may also include an investment specialist or money manager, a life insurance broker and/or other outside specialists. For very large or complex estates, you may want to add an additional CPA that specializes in estate taxes.
   
   
3. Design and implement the plan. A good estate plan includes:
   
   
• Fundamental documentation, including a living trust, wills and other ancillary documents, such as power of attorney for health care and asset maintenance
  
  
• Estate planning tools that remove assets from the estate balance sheet while leaving you in control of the assets
  
  
• Estate planning tools that set up a gifting program as outlined in your estate planning family letter of intent
  
  
• Documentation or language that provides for the transfer of sentimental items that have limited financial value but tremendous emotional value to family members
  
  
4. Review and update the plan as needed. In general, an estate plan should be reviewed every two or three years. However, any changes in tax laws, family circumstances or estate planning goals necessitates an immediate review.

To facilitate the update and review process, Wolff recommends creating an estate plan administrative manual. This provides the business owner and his or her advisors with a written record of not just what was done but why it was done. The manual also helps the CPA with ongoing maintenance of the plan.

Principles of Estate Planning

Before engaging in estate planning, say Hokanson and Daniels, it helps to understand several "big picture" principles:

• Estate planning involves more than just money. According to Hokanson, estate planning (which he calls "family wealth counseling") should address three separate aspects of family wealth: financial, social and spiritual.
  
  
• It's the people, not the documents. According to Daniels, documents play an important role in the process, but people make the real difference.
  
  
• Communication = success. The ultimate success or failure of your estate plan lies in how well you communicate to your advisors, family and anyone else affected by the disposition of your estate.
  
  
• Educate your children. Lack of education can ruin even the best of estate plans. For that reason, Daniels recommends continually educating your children in how to handle money, how to be good business people (in any business) and how to succeed in life.
  
  
• Do no harm. In addition to minimizing taxes, an estate plan should ensure that your children have financial incentives to work hard and become contributing members of their communities, prevent family conflicts, prepare your children and grandchildren for the wealth they will receive, protect against divorce and protect your assets so the business continues.

Many things can derail an otherwise sound estate plan. Wolff cautions against the following estate planning mistakes:

• Procrastination/lack of planning
  
  
• Lack of clear estate planning goals
  
  
• Failure to update the plan
  
  
• Lack of succession planning for the business
  
  
• Thinking your existing general advisors have the answers
  
  
• Lack of coordination among your estate planning team
  
  
• Over-dependence on life insurance
  
  
• Ignoring the human dynamics

"Above all," he says, "don't make the mistake of thinking you can't do anything about your estate taxes. The tax code provides the solutions, but it's up to you to take advantage of them."

Estate Planning Tools

According to our experts, the following tools form the basic foundation for any effective estate plan.

• Wills are legal documents that specify what happens to your assets when you die. If you do nothing else in the way of estate planning, at least have a will.
  
  
• Trusts are legal entities that can own assets, are managed by one or more trustees and have designated beneficiaries. They play a vital role in estate planning because they allow you to control and protect assets while minimizing tax liabilities.
  
  
• Life insurance is typically used as a source of funds for buy-sell agreements and paying estate taxes.
  
  
• Family limited partnerships (FLPs) allow you to receive discounts when making gifts or transferring assets, protect assets from creditors and lawsuits, shift taxable income and remove highly appreciated assets from the estate.
  
  
• Employment contracts can provide lifetime income to you and/or your family upon your death, disability or the sale of the business.
  
  
• Asset protection entities allow you to protect your assets from creditors and realize significant tax and income savings.

"Use caution when implementing these sophisticated estate planning tools," warns Daniels. "Do the research, hire specialists and push them to do exactly what you want. It may cost more money up front, but the payoff on the back end will dwarf your initial investment."

Using Trusts Properly

Trusts allow you to control and protect assets while minimizing tax liabilities. For estate planning purposes, the most commonly used trusts include:

• Funded living trusts contain and hold title to all your major assets (except for your home) while you are alive. Their primary purpose is to give you immediate and total control over your assets should you die or become disabled.
  
  
• QTIP (qualified terminable interest property) trusts enable the surviving spouse to receive income from assets during his or her lifetime while passing on ownership of the assets to the designated beneficiaries (usually the children).
  
  
• Charitable trusts are typically used to gift high-value assets out of the estate in order to avoid capital gains and estate taxes and create income for senior members of the family.
  
  
• Family legacy trusts are used to reduce or avoid taxation at each generation.
  
  
• Enhanced income trusts eliminate capital gains taxes at the sale of an appreciated property. A secondary purpose involves removing assets from the taxable estate and eliminating all estate taxes.
  
  
• Deferred inheritance trusts are used to create a charitable endowment within your family foundation. They are typically used by families who want to include current giving in the estate plan.
  
  
• Family foundations are generally set up as the beneficiaries of enhanced income trusts. They allow you to create an endowment that your family completely controls, support charitable activities and receive compensation for your charitable work.
  
  
• Asset replacement trusts remove your life insurance policy from your estate, thereby avoiding any estate taxes.
  
  
• Grantor retained annuity trusts (GRATs) allow you to retain the right to the income stream when you transfer discounted assets to a family limited partnership.

"Trusts are complex, sophisticated estate planning tools," cautions Hokanson. "When set up properly, they allow you to achieve very ambitious estate planning goals. When bungled, however, they can cause untold damage to your family, your business and your estate. To avoid problems, use only experienced professionals who specialize in this area and who understand your overall estate planning goals."

Your choice of trustees has a lot to do with how well your trusts support your estate plan. Daniels recommends having four different trustees:

1. Business trustee. An experienced manager to run the business.
   
   
2. Financial trustee. An experienced financial manager to handle any investments in the trust.
   
   
3. Distributing trustee. Someone to handle any monetary distributions to the family.
   
   
4. Watchdog trustee. Someone to make sure the other trustees do their jobs properly.

Daniels believes that trusts with children and young adults as the beneficiaries need an additional trustee(s). The "distribution and maturity" trustee should know the child well enough to assess his or her ability to make mature decisions regarding the trust and the business.

Another key decision regarding minor children involves naming guardians. Most people select parents, siblings or close relatives to assume guardianship of their children. However, siblings don't necessarily make the best choice, especially if they live in a different community or have different notions than you about parenting. In some situations, a best friend's parents can make better guardians.

Also, don't overlook financial concerns. It takes a lot of time and money to raise a child. Consider paying your guardian an annual stipend, giving them extra resources to have a larger home or even allowing them to move into your home if you die.

Communication Tools

Communicating your estate planning goals and objectives plays an essential role in the eventual success of your plan. Our experts recommend the following tools for ensuring that everyone involved understands the plan and works toward the same ultimate outcome.

• Family letter of intent. The family letter of intent identifies specific estate planning goals, provides clarity and direction, and serves as a touchstone for all key decisions during the planning process. According to Hokanson, it represents the single most important estate planning document.
  
  
• Annual common-sense business letter. This letter addresses critical business succession issues in the event of your premature death or mental disability. Daniels recommends updating the letter each year and giving a copy to your family, the executor of your estate and your management team.
  
  
• Annual common-sense personal letter. This letter to your spouse and family members should include a list of all your assets and accounts, locations of all legal documents, computer passwords and hidden assets, instructions for disbursement of sentimental items and any imbalances that might cause conflict when settling the estate (i.e., a large loan from the parents to one child).
  
  
• "I love you" letter. An "I love you" letter (or videotape) lets family members or other loved ones know what they meant to you during your lifetime. According to Daniels, it is often the most valuable thing you can leave behind, especially if you have very young children.
  
  
• Family meetings. These provide a great way to open the channels of communication and discuss business, personal and estate planning issues before the parents die.

Divvying Up the Estate

In nearly one-third of all estates, the children end up fighting over something, usually sentimental or valuable items. These family feuds often last for years. To avoid conflict among siblings, Daniels recommends two "family auctions" whereby the children bid on the items they want.

The first auction involves purely sentimental and nominal value items. The second auction involves more valuable items, such as expensive jewelry, artwork, collectibles, the family home and recreational properties. In each case, the children bid on the items they want the most, with the first auction using poker chips and the second auction using the real value of the estate.

"These two auctions reduce or eliminate competition between siblings and force each child to answer the question, 'How much do I want this item compared to that one?'" says Daniels. "Plus, the auction process treats everyone fairly, a major issue when settling estates.

"The goal is to end up with happy children, not to force things a certain way. If the auction doesn't work, do it again or try something else. Keep working at it until you reach a fair and equitable distribution that all the children can live with. Nothing should be cast in stone."

Contributing Experts:

David Hokanson

David Hokanson is a member/manager of Family Wealth Counselors, L.L.C., a registered investment advisor that provides comprehensive personal financial planning and family wealth counseling. He also serves as a consultant for the National Center for Financial Education, Inc., a nonprofit corporation dedicated to helping consumers do a better job of spending, saving, investing, insuring and planning for their financial future. Hokanson is a member of the International Association of Financial Planners and the Institute for Certified Financial Planners, and is co-author of "Family Wealth Counseling: Getting to the Heart of the Matter." He has addressed dozens of TEC groups on the subject of "Maximum Wealth Control Strategies."

Stephen Wolff

Stephen Wolff specializes in providing advanced estate planning for clients with large estates. He has successfully completed the Chartered Life Underwriter and Chartered Financial Consultant designations through the American College, and has earned the Accredited Estate Planner designation from the National Association of Estate Planning Councils. A regular keynote speaker at estate planning seminars, he is frequently interviewed on radio and television regarding estate planning issues and has published many articles on the subject. A member of TEC 66 in Orange County, he addresses TEC groups on the subject of "Estate Planning: The Preservation of Wealth.

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