With less than 1% of taxpayers now being subject to federal estate tax under the new tax laws, the emphasis for tax planning for most of us has shifted from estate tax planning to income tax planning. Many people have retirement accounts of sufficient size to warrant more attention to income tax planning for those assets.
A participant’s retirement account is funded with tax-deductible contributions during his or her high earning years, presumably when he or she is in a higher income tax bracket than after retirement. By making contributions during a participant’s high-earning years, the participant not only delays the payment of taxes on the contributions, but also is likely to have lower tax rates when distributions are later made.
The participant gets tax deductions for contributions to the account, and the account builds value tax-free until distributed. Maximum funding of a retirement account during one’s working years is usually a very effective tax planning technique.
DISTRIBUTION RULES DURING OWNER’S LIFETIME
With a traditional IRA, the owner has to begin taking required minimum distributions (RMD) for the calendar year in which he or she reaches age 72, by April 1 of the following calendar year.
Prior to the adoption of the “Setting Every Community Up for Retirement Enhancement” (SECURE) Act in December 2019, the required beginning date for IRAs was April 1 of the year after which the IRA owner attained age 70½. The old rule is applicable through 2019, but not to 2020 or later years. Under the old rule, if the IRA owner’s birthday was on or before June 30, the required beginning date would be April 1 of the following calendar year, but if his or her birthday was on or after July 1, the required beginning date was one year later, also on April 1. The new rule under the SECURE Act makes April 1 of the following year after you attain age 72 as the required beginning date, no matter whether your actual birth date is in the first six months or the last six months of the year.
There is a “uniform lifetime table” whereby the RMD or required minimum distribution is determined, based on the life expectancy of the account owner and the life expectancy of a second person who is 10 years younger, but if a taxpayer is married to a spouse who is more than 10 years younger, the account owner may use a “joint and survivor table,” based on the taxpayer’s age and the actual age of the younger spouse. The Life Expectancy Factor under the uniform lifetime table for an IRA owned by for a person who is age 70, is 27.4 years; for age 80 is 18.7 years; for age 90 is 11.4 years; and for age 100 is 6.3 years. The reason those life expectancies seem so long is because they are based on the life expectancies of the second to die of two lives, using 2-life tables, based on the age of the account owner and the age of a person who is ten years younger.
Please be aware that the uniform lifetime table applies to every IRA owner (not including owners of “inherited” IRA accounts), except someone with a spouse who is more than 10 years younger. It applies to someone with an older spouse, to someone with no spouse, and to a participant who has not named a beneficiary at all for his or her retirement account. It also applies to someone who has designated his or her children, grandchildren, or others – except for a spouse who is more than 10 years younger – as beneficiaries of his or her account.
Distributions from an IRA or qualified plan before the taxpayer reaches age 59½ are ordinarily subject to a 10% early withdrawal penalty, but there are exceptions to the general rule: If the IRA owner qualifies as a first-time homebuyer, for example, he or she can withdraw up to $10,000, penalty-free, to use as a down payment or to help build a home. With the cost of higher education spiraling, people are also allowed to turn to their IRAs to help pay certain college expenses, penalty-free, from their IRAs – for tuition, books and other qualifying expenses – as long as the student (you, your spouse, your child, or your grandchild) is enrolled more than half-time at an eligible educational institution. Distributions for those purposes are not subject to the 10% early withdrawal penalty, but they are subject to regular income tax.
Early withdrawals also may be allowed penalty-free through a “Substantially Equal Periodic Payment” (SEPP) plan, with specified annual distributions for a period of five years or until the account-owner reaches age 59½, whichever comes later. Again, income tax must still be paid on the SEPP withdrawals, but no penalties. A SEPP plan is best suited to those who need a steady stream of income prior to age 59½, perhaps to compensate someone whose career has ended earlier than anticipated.
SEPP plans can be boons to those who need access to retirement funds earlier than age 59½, but starting a SEPP early – or even withdrawals for educational expenses or for a down payment on a new home – will have implications for your security later, in retirement. If you spend the money now, it will not be available when you are older. Before you embark on a SEPP plan, you should get the advice of your financial planner.
DIRECT TRANSFER FROM IRA TO CHARITY
If you are fortunate enough that you do not need your IRA distribution for living expenses, and if you are charitably inclined, you can avoid income tax by making a direct distribution from your IRA, up to $100,000/year, to a charitable organization. This is called a “Qualified Charitable Distribution” or QCD. If you file a joint income tax return and if your spouse also has an IRA, your spouse can also make a QCD of up to $100,000 from his or her IRA, which will not be taxable on your joint tax return. The gift will also reduce the value of your IRA account, thereby reducing your required minimum distributions (RMDs) in the future.
QCDs may be made only from IRAs – not from 401(k)s or other similar retirement accounts – but you can roll over funds from a 401(k) account to an IRA, then make the gift from the IRA to the charity. This takes extra time, and you must meet the deadline (usually December 31) for completing the charitable gift.
The charity to which you make the gift must be a 501(c)(3) organization, eligible to receive QCDs, but may not be (a) a private foundation, (b) a “supporting organization,” which is an exempt organization which carries out its exempt purposes by supporting other exempt organizations, or (c) a Donor-Advised Fund of “sponsoring organization,” which is a public charity which accepts and manages such funds, and from which distributions may be made to other charitable organizations, as recommended by individuals or families.
Please note that the QCD is not included in your taxable income, so you cannot claim an itemized charitable deduction for your gift on your income tax return. Otherwise, you would be getting a double benefit, i.e., (1) the distribution to charity would not be taxable income on your tax return, and (2) if it had been deductible, you would also get an itemized charitable deduction on your tax return. That would be too good to be true and is not allowed. However, you can still claim a standard deduction on your personal return – not an itemized charitable deduction – in addition to excluding the income.
Another benefit is that, since the qualified charitable distribution is not counted as part of your income, it will not be subject to the limitation to charitable deductions on your income tax return – that is, charitable deductions cannot exceed 60% of your adjusted taxable income. Consequently, it is less painful tax-wise to make large charitable contributions in this manner, for those with ample other means of support.
THREE WAYS TO MINIMIZE TAXES ON REQUIRED MINIMUM DISTRIBUTIONS
One simple step, if the account owner is still working after age 72, would be for him or her to continue making contributions after that age to his or her IRA or 401(k) or similar account, which would provide an income tax deduction to offset income from the required minimum distribution. For example, if a 75-year-old person has an RMD of $5,000 from his or her IRA, and if he or she contributes $7,000 to his or her 401(k) from his or her earnings, the deduction would more than offset the taxable income from the RMD. The age limit for IRA contributions – formerly 70½ – has been removed by the SECURE Act.
There is another exception for calculating the required minimum distribution for a taxpayer older than 72 who works for a non-profit entity or who works for a for-profit company in which he or she owns less than 5% of the company, if the employer has a 401(k) program which accepts rollovers from IRAs. In that case a taxpayer may be able to roll over his or her IRA into the company’s plan, and thereafter not be required to take required minimum distributions applicable to IRAs from that account until actual retirement from that employer. If you are still employed, you will need to inquire with your employer, to see if you can roll over your IRA to the company’s 401(k) plan and if so, whether you can defer distributions until you retire.
Another (more complicated) alternative, allowed by the IRS since 2014, would be to purchase a Qualified Longevity Annuity Contract (QLAC) inside your IRA. Many consider an annuity to be a poor investment for an IRA, since both annuities and IRAs are “tax shelters” – and to hold a tax shelter within a tax shelter is a redundancy and wastes the tax benefit of one of the shelters. You get the benefit of only one tax shelter when an IRA owns an annuity.
But the purchase of a QLAC within an IRA offers a different kind of tax advantage: the purchase of a QLAC is a retirement strategy in which an IRA owner can defer a portion of his or her required minimum distributions (RMDs) until a certain age (maximum limit is age 85). A QLAC is an annuity bought with a chunk of money from an IRA now, for payouts starting years later, but no later than at age 85. Money tied up in the QLAC is not counted in calculating your RMD, so the QLAC reduces your required minimum distribution (RMD). Also, it allows the value of the annuity to grow tax-free until you reach the annuity starting age, typically at age 85. Qualified longevity annuity contracts (QLACs) can be bought inside an IRA with (a) up to 25% of the IRA’s value or (b) the amount of $135,000 (in 2020) – whichever is smaller. The annuity would be paid to the annuitant or annuitants for life after the starting age, which provides a guaranteed stream of income which the annuitant or annuitants will not outlive.
The tax benefit of purchasing a QLAC is to reduce income taxes by removing money from the calculation of the required minimum distributions (RMDs) from your IRA after attaining age 72. QLACs are legal creatures created by the IRS to address the fears of many individuals as they grow older, of outliving their money. A QLAC is an investment vehicle to guarantee that some of the funds in a retirement account may be turned into a lifetime stream of income without violating the required minimum distribution rules. The annuity will be paid, no matter how long the individual lives – that is, the recipient cannot outlive the annuity payments.
Annuities provide guaranteed payments to the annuitants during their lifetimes, but at the death of the annuitant (or surviving annuitant, as the case may be) the payments stop. Consequently, an annuity itself is not a good vehicle for passing wealth to persons other than the annuitants. If an annuitant dies (or both annuitants die, if applicable) unexpectedly early, the annuity would prove to have been a poor investment, but if the annuitants outlive their actuarial life expectancies, the annuity may prove to have been a very good investment. Even though nothing would pass to the family at the death of the last surviving annuitant, the annuity payments would presumably allow the annuitant or annuitants to preserve other assets, which would pass to the annuitants’ survivors.
To prevent a total loss of premiums paid for an annuity if the annuitant or annuitants die early, the annuity (including a QLAC), may be custom-designed in some respects to meet your needs. For example, (a) a QLAC could be a joint annuity with the primary annuitant’s spouse, whereby the annuity payments continue for the lifetime of the spouse, if he or she survives, (b) the annuity may guarantee that any unused premium at the annuitant’s death will be refunded, and/or (c) the annuity payments may be adjusted for inflation. Under (b) above, if the annuitant originally paid $100,000 for an annuity, and if the annuitant died before the annuity had paid out $100,000 in total annuity payments, then the remainder of the $100,000 would be refunded.
There are negatives to owning a QLAC in your retirement account. For example, (1) if you need money sooner than originally expected, you could not get payments from the annuity in advance, and (2) your annuity would be only as secure as the company which issued the annuity – so your money would be at risk if the company became insolvent. You need to consult with your financial advisor before embarking on such a strategy.
PROS AND CONS TO ROLLING OVER IRA TO 401(k) – AND VICE-VERSA
An IRA-to-401(k) rollover offers benefits, such as (a) earlier access to the money at age 55 without penalty (as compared to age 59½ for an IRA), and without a Substantially Equal Periodic Payment Plan (SEPP) , (b) postponing required minimum distributions if still working for the employer with the 401(k) plan, and (c) in some instances, easier conversions to Roth IRAs. Also, in some states (other than North Carolina), 401(k) accounts have protections against creditors that IRAs don’t provide; in North Carolina, IRAs are protected against creditors. Also, loans are allowable from 401(k)s, whereas loans from IRAs are not allowed. Generally, you do not want to borrow against your 401(k) account, but, if you have a temporary need which can be repaid in the future, you may, as a last resort, be able to borrow from your 401(k) and to repay the loan with interest.
There are a lot of circumstances where a traditional IRA has a leg up on a 401(k) account, which is why so many people roll their 401(k) accounts into IRAs. Advantages can be wider investment selection, often lower investment costs, and looser rules for hardship withdrawals, without penalty – for reasons such as higher education expenses and first-time home purchase (limit $10,000).
DISTRIBUTIONS AFTER DEATH OF IRA OWNER/PARTICIPANT
It is very important for you to complete the beneficiary designation forms for your retirement account. Sometimes participants fail to fill in the necessary paperwork, or when they do fill in those documents, it is without professional advice. If no beneficiary is named, the default beneficiary is often the participant’s estate. Although naming an estate or trust as a beneficiary may seem logical, you’ve got to be careful. Doing so may subject an estate or trust to unexpected rules and implications, and sometimes imposes them with tax results which might seem unfair or even nonsensical.
Some rules which apply to beneficiaries of IRAs are:
If a spouse is the beneficiary of the owner’s IRA at the owner’s death, the spouse can “roll over” the balance in the account into his or her IRA, or into a “rollover IRA” opened by the surviving spouse, on which the spouse will be subject to similar distribution rules as an original IRA owner. That is, the RMD will be based on the joint life expectancies of the surviving spouse and an individual who is 10 years younger. If the spouse is under age 72, distributions from the rollover IRA will not be required until the spouse reaches age 72. However, the surviving spouse may take discretionary withdrawals before age 72 and can receive distributions in excess of required minimum distribution (RMD) after reaching age 72.
If a beneficiary is someone other than a spouse, the account may not be “rolled over” into the beneficiary’s IRA or a rollover IRA, but the IRA may be transferred to an “inherited IRA” account, which is not the same as a spousal “rollover” account. A beneficiary other than a spouse must take RMDs from the inherited IRA account starting the following calendar year, no matter what the age of the beneficiary. That is, the beneficiary of an inherited IRA cannot wait until he or she reaches age 72 before taking distributions. Since annual distributions are mandatory, there is no 10% penalty for distributions from inherited IRAs made to beneficiaries under the age of 59½. Under the old rules applicable prior to the enactment of the SECURE Act effective December 20, 2019 – an inherited IRA was subject to a one-life mortality table instead of a two-life table, and life expectancy was not recalculated as the beneficiary grew older. Under the SECURE Act applicable to accounts of participants who died on or after January 1, 2020, an inherited IRA must generally be distributed to the beneficiary over a period of no more than 10 years.
On a different related topic, the IRS has not issued guidelines – but there have been several private letter rulings (requiring some expense to taxpayers) – to allow spousal rollovers of qualified plans and IRA benefits when an estate or trust is the beneficiary of the account, (a) when the spouse is sole beneficiary of the estate or trust, and (b) has a general power of appointment over the trust. This can apply where there is no named beneficiary and the “default” beneficiary is the participant’s estate.
In a 2018 private letter ruling, a decedent failed to designate any post-death beneficiary and the plan was payable by default to the decedent’s estate. The decedent had no will, and under state law the estate was split among the surviving spouse and the children. The children were adults with no children of their own and all executed valid disclaimers, leaving the spouse as sole beneficiary of the estate. The IRS approved a spousal rollover in that case.
“STRETCH” IRA STRATEGY
“Stretch IRAs” have been popular for many years as a strategy for slowing down the mandatory payout of IRAs, by designating much younger beneficiaries at the owner’s death – such as grandchildren – to take advantage of their longer life expectancies (and consequently, lower required minimum distributions) than older beneficiaries. Until adoption of the SECURE Act discussed in the following paragraph, an IRA left to a beneficiary other than a spouse was payable over the life expectancy of the beneficiary. That is, if the beneficiary had an actuarial life expectancy of 30 years , the required minimum distribution (RMD) for Year 1 would be 1/30th of the account’s value, for Year 2 would be 1/29th of the account’s value, etc. If the beneficiary died before the account was closed out, his or her successor would continue, on the original beneficiary’s schedule until the account was depleted.
That tactic has been brought to a screeching halt – the SECURE Act, signed into law on December 20, 2019, and generally effective on January 1, 2020, has changed that all, by generally requiring that inherited IRAs by beneficiaries other than spouses must be paid out in no more than 10 years. That is, inherited IRAs left to much-younger beneficiaries will generally need to be paid out in 10 years, instead of over the actuarial life expectancy of the beneficiary. There are exceptions applicable to certain “eligible designated beneficiaries.” If your current estate plan includes a “stretch” IRA, you should go back and re-visit your plan, to see whether it still fits your needs, given the new 10-year payout rule.
An “eligible designated beneficiary” who is not subject to the 10-year payout requirement includes an individual who is (i) the employee, or IRA owner, (ii) a spouse of the participant, (iii) a minor child of the participant, (iv) a person who is disabled or “chronically ill,” as defined in Internal Revenue Code Section 401(a)(9)(E)(ii)(IV), or (v) any individual who is not more than 10 years younger than the participant. But upon the death of the “eligible designated beneficiary,” the 10-year rule kicks in, instead of continuing to be distributed over the remaining life expectancy of the original “eligible designated beneficiary.” When a minor beneficiary attains the age of majority applicable in his or her state (usually age 18 or 21), the 10-year rule kicks in, but a child may be treated as though he or she had not reached the age of majority, if he or she (a) has not completed a specified course of education as described under Internal Revenue Code Section 401(a)(9)-6 and is under 26 years of age, or (b) if applicable, so long as the child continues to be disabled after reaching the age of majority, see Reg. § 1.401(a)(9)-6, A-15.
The new legislation will not affect the terms of payout for original designated beneficiaries of participants who died before January 1, 2020, and it will be applicable only to accounts of participants who die on or after January 1, 2020, subject to the proviso that, instead of continuing to follow an original designated beneficiary’s minimum distribution schedule if the original designated beneficiary dies on or after January 1, 2020, the distribution schedule for any successor beneficiaries will be re-set to a 10-year payout schedule.
A POSSIBLE ALTERNATIVE WHICH SPREADS OUT RETIREMENT DISTRIBUTIONS
An alternative strategy which is still available would be to leave an IRA upon death to a charitable remainder trust (CRT), which would pay a flat percentage each year to the beneficiary or beneficiaries, either for their lifetimes or for a term not to exceed 20 years, whichever the Trust Grantor selects, following rules applicable to IRAs. A CRT is a tax shelter itself, and no income tax would be payable when the IRA was paid to the CRT, but distributions from the CRT to individual beneficiaries of the trust would be taxable to those individual beneficiaries when distributed. In the meantime, the investments inside the CRT could accrue tax-free, perhaps allowing the value of the CRT to grow. At the death of the last surviving beneficiary, the trust would terminate, and the account would be paid to a charitable beneficiary or beneficiaries, as set forth in the trust agreement for the CRT.
Because laws are changed from time to time, and because it is possible for a retirement account owner to become incapacitated, it is a good strategy for the owner to have a durable power of attorney which would be effective in the event of incapacity, specifically empowering the Agent under the durable power of attorney, on behalf of the owner, to change the beneficiaries of retirement accounts and even to create entities such as charitable remainder trusts.
SECURE ACT OF 2019
The SECURE Act was enacted in December, 2019, to expand the opportunities for individuals to increase their savings and to make administrative simplifications to the retirement system. In addition to some of the changes discussed above (moving the required beginning date to age 72 instead of age 70½, permitting deductible IRA contributions after the required beginning date for withdrawals, generally eliminating “stretch” IRAs, etc.), the SECURE Act makes it easier for small businesses to offer multiple employer plans by allowing otherwise-completely unrelated employers to join the same plan, and It also makes it easier for long-time part-time employees to participate in elective deferrals, and it allows penalty-free distributions from qualified plans and IRAs for births and adoptions. Also, penalty-free distributions are allowed from defined-benefit plans or IRAs for the birth or adoption of a child. These withdrawals may be repaid to such a retirement account.
The old rules were not repealed, but the provisions of the SECURE Act were superimposed on the old rules. Consequently, the ins-and-outs of the SECURE Act are very complicated, and there is a separate blog on our law firm’s website which discusses that Act in more detail.
Donor-Advised funds are a tax-advantaged way to make gifts to charities over time. A donor-advised fund is basically an account with a public charity which has a donor-advised program and which qualifies as a “sponsoring organization.” Gifts are made to the fund, which is held in the name of the donor or in the name or names of the donor’s family members. Gifts from donors to the fund qualify as charitable deductions for income tax purposes, and distributions are made from the fund to charitable organizations over time. Distributions from the fund do not count as additional charitable deductions for the donor, since the donor has already gotten a charitable deduction when the original gift was made to the fund.
Donor-advised funds are usually opened during the lifetimes of the donors, and distributions are made to charitable organizations which the donors select. Since the sponsoring organization is responsible for seeing that the tax laws have been complied with, the donors make “recommendations,” and not binding directives, as to the distributions to tax-exempt organizations. Normally those requests are honored unless the requested done does not qualify as a tax-exempt organization. Donor-advised funds may also be created, or increased at death under a will or trust agreement of the donor, often with family members of the donor to make distribution recommendations to the charitable organization after the deaths of the donors.
Donor-advised funds may be used to support a number of public charities. They are sometimes used as alternatives to private foundations.
Private foundations are separate legal entities created by a donor or donors. They require ongoing maintenance and expense. Also, the donors receive smaller tax benefits than they would receive with a similar gift to a donor-advised fund at a public charity. Legally, a private foundation allows the donor or donors to retain more control over the investments, grants, and control of the entity.
Donors often prefer a donor-advised fund instead of a private foundation for convenience, reduced costs, greater tax benefits and ease of gifting, with no worries about minimum distributions or the tax issue of excise tax on net investment income, which would be applicable to a private foundation.
The donors may make a large charitable gift to the donor-advised fund, and have the gift used to make periodic distributions over time, with the donors not having to worry about compliance costs and requirements.
“Bunching” of Charitable Deductions
Under the new tax laws with higher standard deductions, donors who traditionally have made charitable gifts of several thousand dollars a year in deductible contributions now often receive reduced or no tax benefits from making their customary annual distributions.
For example, consider married donors with $120,000 annual income, who traditionally give about $5,000 per year to charitable organizations. On their tax returns, they cannot claim medical deductions of less than 10% in 2019 (formerly 7.5% in 2017 and 2018), so often the
taxpayers would not itemize medical deductions. They cannot deduct more than $10,000 per year in state and local taxes, and there is no longer a deduction for miscellaneous itemized deductions. Unless they have high home mortgage interest, if they donate $5,000 to charitable organizations in 2019, their total deductions may be less than their standard deduction of $24,400 (in 2019), in which case they would receive no income tax benefit for charitable gifts totaling $5,000.
In the alternative, let’s consider “bunching” their contributions by the use of a donor-advised fund. For example, they could give $50,000 to a donor-advised fund in 2019. If their itemized deductions otherwise would be $10,000 in state and local taxes and $5,000 in home mortgage interest, the gift to the donor-advised fund itemized tax deductions would now total $65,000 ($50,000 gift to the donor-advised fund, plus $10,000 in state and local taxes and $5,000 in mortgage interest), as compared to a standard deduction of $24,400. Their income taxes for 2019 would be reduced by over $10,000, assuming they were in a 28% marginal tax bracket.
The donor-advised fund would receive $50,000 in gifts, but it would be possible to distribute from the fund only the donors’ customary $5,000 to charitable organizations, as requested by the donors. The charities would receive their customary gifts in 2019 and the donor-advised fund would retain the remaining $45,000. In future years similar gifts could be made from the donor-advised fund each year, as directed by the donors or their family.
The donors could resume claiming a standard deduction on their subsequent income tax returns, until the fund was depleted. If the donors died or became incapacitated, their families could continue to make charitable contributions from the fund.
The above example illustrates moderate gifting and the effect of “bunching,” but donor-advised funds are often utilized for very large gifts, often at the death of a donor, sometimes in lieu of a private foundation.
Families With Existing Private Foundations
If the donors already have a private foundation which they find expensive and burdensome to maintain, the private foundation could distribute its assets to a donor-advised fund with a sponsoring organization. The sponsoring organization would then be responsible for compliance with federal laws, instead of the donors or their family’s being responsible.
Another possible benefit would be to bring one’s children into the gifting process during the donors’ lifetimes. After the donors’ deaths, the children would continue to make recommendations for charitable gifts from the donor-advised fund.
Most sponsoring organizations allow grantors or designated family members as advisors for charitable gifts for at least one generation, and some allow two generations.
Most community foundations have donor-advised fund programs and sometimes other organizations such as colleges and universities maintain similar funds, where a certain percentage of contributions must go to the sponsoring organization itself, such as 50%, and the remainder can go to other charitable organizations.
A donor who wishes to establish an ongoing philanthropic program – for themselves and/or their families – should consider establishing a donor-advised foundation as part of their ongoing gifting, and possibly establishing the habit of ongoing gifting to charities for their families.
In Winston-Salem, the Winston-Salem Foundation, Suite 200, 751 West Fourth Street, Winston-Salem, NC 27102, (336) 725-2381, can be contacted about the establishment of a donor-advised fund. See https://www.wsfoundation.org/contact.
Several larger cities and counties in North Carolina have large community foundations, similar to The Winston-Salem Foundation. The North Carolina Community Foundation is a single statewide community foundation with a network of affiliate foundations across the state, which serve many rural and less-populated counties, and which can serve as a sponsoring organization for donor-advised funds in their communities. A list of affiliated community foundations funds can be found at nccommunityfoundation.org/communities.
It is very easy to set up a donor-advised fund with a sponsoring organization. Just contact the organization and see whether it is a sponsoring organization for donor-advised funds. If so, they will meet with you and draft a letter whereby the organization agrees to be the sponsoring organization for your donor-advised fund, which describes the purposes for your fund, etc. They will make it easy for you.
Estate planning is more than simply deciding who gets your assets after your death. It includes a wide range of matters, such as (1) planning for yourself and for your family in the event you become incapacitated; (2) the appointment of guardians for your minor children, if any, in the event of the deaths of both parents; (3) the protection of assets for minors, or for beneficiaries who cannot manage money, are incapacitated, or otherwise need asset protection; (4) planning for family members who are nonresidents or noncitizens of the United States; and (5) planning for a myriad of other personal issues for your family, including tax planning.
Please note that the reasons listed above for estate planning are not necessarily limited to wealthy individuals. It can be very important to a person of modest means to see that his or her assets are used to benefit the proper beneficiaries in a wise and appropriate manner.
We hope the following discussions will be helpful:
Wills are a common estate planning tool and are the most basic device for planning the distribution of an estate upon death. Wills that are 100% handwritten by the Testator and which are either kept with the decedent’s valuable papers or are given to someone else for safekeeping, are called “holographic” wills and do not have to be witnessed, provided that two witnesses attest to Probate Court as to the Testator’s handwriting, when the holographic will is presented to the court for probate after the decedent’s death. North Carolina wills that are not entirely in the Testator’s handwriting must have two witnesses, and preferably both witnesses and the Testator will sign in the presence of a Notary Public. If there was no notary public for the signatures of the testator and the witnesses, the Clerk of Superior Court may still probate the will, after the witnesses’ signatures have been duly proven to the Court.
Unless the Will is filed with the Court and is found by the court to be valid, a purported Will has no legal significance, so any paper which purports to be a will should be filed with the Court and you should request the Court to “probate” the Will (i.e., to certify the document to be valid). By the way, a Will can be probated (i.e., certified) without having a full court administration.
Probate (Court Administration):
One meaning of “probate” is the process whereby a decedent’s will is presented to the Probate Court (i.e., The Office of the Clerk of Superior Court) and the Court determines whether or not the will is valid. In an effort to avoid confusion, we will refer to that process as “probate (certification).”
If the will is found to be valid, an Executor or other personal representative will be appointed to take control of the decedent’s assets, and to notify creditors by direct notice and/or publication of a newspaper notice to creditors. That person will be responsible for tax filings, if applicable, and for paying debts and administration expenses. This process is also called “Probate” of the Estate, and to avoid confusion we will sometimes refer to this process as “probate (administration).” The executor pays valid claims and the remaining assets are distributed to the beneficiaries pursuant to the terms of the will. After these things have been done properly, the Probate Court will close the estate file.
Probate Avoidance (or Avoiding Court-Supervised Administration of an Estate):
Since probate (administration) documents are matters of public record, the family can maintain some privacy, while saving some court charges, by avoiding probate (administration). Probate (administration) can be avoided in several ways, such as by joint ownership of assets with survivorship or by naming beneficiaries in ownership documents, which will pass outside probate. Revocable trusts also hold assets in the name of the trustee, and the trust’s assets do not pass through court probate (administration).
Consequently, many individuals seek to avoid probate (administration), or at least to minimize the process, by a combination of joint accounts with survivorship, by naming beneficiaries for transfer on death of bank and brokerage accounts, and by naming beneficiaries for other assets, including life insurance and retirement accounts. Real estate can pass by survivorship to a joint tenant with survivorship rights, or to a surviving spouse under a “tenancy by the entirety” (a form of joint ownership applicable only to husbands and wives).
Irrevocable Trusts may be used as estate planning tools, sometimes to hold life insurance policies and often for the distribution of assets for the benefit of family members who are minors or developmentally-disabled beneficiaries, and sometimes to prevent wasteful spending by a spendthrift child, or to protect assets for a family member who is in a shaky marriage or who is in a high-risk job or profession. Also, certain types of trusts can provide for management of assets and the disposition of assets to protect family wealth for several generations and are typically called generation-skipping trusts (GST) or “Dynasty” Trusts.
This article cross-references you to other related topics, such as the following:
Who gets your assets if you die without a will? This is not as simple as one might think. North Carolina has laws which deal with the disposition of the estates of decedents who die without wills, called the North Carolina Intestate Succession Act, some provisions of which might surprise you and likely would not be what you would want. Also, please be aware that some assets pass by beneficiary designation or by survivorship to individuals and do not pass under the Intestate Succession Act.
Do you need a Durable Power of Attorney, a legal document which authorizes someone to act for you and to sign legal papers on your behalf if you are incapacitated?
Do you need a Health Care Power of Attorney and Advance Directive, to authorize someone to make health care decisions for you, which may include decisions whether or not to resort to extraordinary means to prolong your life if you are terminally and incurably ill, and to allow you to die a natural death in those circumstances?
Should you have a Revocable Living Trust to avoid the need for court probate at your death, i.e. court supervision, to insure that any assets belonging to you at the time of your death are used to pay your debts, funeral and administration expenses, etc., or can you rely on family members or other trusted individuals to administer your assets without court supervision? A revocable trust is not a matter of public record and affords your loved ones with some privacy concerning the assets which you own on the date of death and to whom those assets have been left.
Would it be appropriate to create Irrevocable Trusts for the benefit of others, either during your lifetime or after your death?
If you are a business owner or partner in a business or LLC, should you consider having a Business Succession Plan for the transfer of your business interest upon your retirement, death or disability?
Would your family benefit from tax planning? With the federal estate tax exemption equivalent at $11.4 million in 2019 and increasing each year, the need for estate tax planning is not very important to many of us. But there are other tax issues, such as income tax considerations, which could benefit a family of moderate wealth, such as step-up in the cost basis of assets upon death.
This article cannot include all the estate planning possibilities and alternatives, but it is intended to give an overview of the issues involved.
It is becoming more frequent for one spouse to be a non-citizen of the United States. A different set of rules applies to non-citizen spouses than to US citizens, even if the non-citizen spouse has resided in the US for many years, and even if he or she has children who are US citizens.
When it comes to basic estate planning, residents who are non-citizens should have documents similar to those of citizens. The estate of a resident spouse who is a non-citizen must be administered in the United States, just like the estate of a US citizen, and the same rules generally apply to estate tax returns for non-citizens as for citizens. Both spouses should have wills, durable powers of attorney for financial matters, health care powers of attorney, declarations of desire to die a natural death, and sometimes revocable trusts, just like spouses who are both U.S. citizens.
A US citizen can leave property to someone who is not a US citizen or a resident, the same as he or she can leave property to US citizens. This applies not only to wills, but also to joint bank accounts, retirement accounts, life insurance, etc. However, there are some tax issues and complications about which married couples, one of whom is a non-citizen, should be aware – especially if they have high net worth, but in some instances when they have moderate wealth.
PROPERTY TRANSFERRED TO A NON-CITIZEN SPOUSE
The most notable differences between estate planning and estate administration, where there is at least one non-citizen spouse – as contrasted with estates with two spouses who are both US citizens – concern gift and estate taxes. A US citizen or resident may make unlimited transfers of assets – either during life or at death – to a spouse who is a US citizen, without gift or estate tax consequences, but if one spouse is a noncitizen, (a)transfers to the non-citizen at death generally do not qualify for the estate tax marital deduction, and (b)lifetime transfers to a US citizen or resident to a non-citizen spouse without gift tax consequences are limited per year to $155,000 in 2019, indexed for inflation in the future – which is generous, but is not unlimited.
The simplest and best way to deal with tax issues arising out of the fact that one spouse is not a US citizen would be for the non-citizen to apply for US citizenship. He or she does not necessarily have to give up citizenship in his or her native country. The US allows dual citizenship, but some countries do not. A person with dual citizenship gets all the tax benefits of being a US citizen.
In the planning process for a married couple, one of whom is a non-citizen and does not want to apply for citizenship, the tax benefits of making gifts to the non-citizen spouse within the annual gift tax exclusion limit, should be considered as a possible useful tool.
Because the threshold for estate tax is so high ($11.4 million in 2019 and indexed for inflation) it is not important for most of us to utilize the estate tax marital deduction in our planning, but (a) for couples with high net worth, estate taxes may be a very important consideration, and (b) the current lifetime exemption is scheduled to expire in 2025, and it is possible that the laws could be re-written before that date, so it is advisable to consider addressing those possible eventualities in one’s estate planning.
When both spouses are U.S. citizens, the first spouse to die can leave any amount of money or other assets to the surviving spouse, either outright or in a “marital trust,” completely free of estate tax. By utilizing the unlimited marital deduction, a couple can completely avoid federal estate taxes at the first spouse’s death, even if the deceased spouse has an extremely net worth. If the surviving spouse is a non-citizen, on the other hand, the transfers from the decedent to the surviving spouse will not automatically qualify for the estate tax marital deduction, and other steps must be taken, if the deceased spouse has a large estate, to avoid unnecessary estate tax.
Those assets may be made to qualify for the estate tax marital deduction, even after the death of the US citizen or resident spouse, if (a) the surviving spouse becomes a U.S. citizen on or before the filing deadline for the decedent’s federal estate tax return (within nine months after the date of death unless a six-month filing extension is obtained, in which case the filing deadline would be 15 months after the date of death, instead of nine months), or, (b) in the alternative, those assets are put into a Qualified Domestic Trust (QDOT) for the benefit of the surviving spouse prior to that estate tax filing deadline, and a QDOT election is made on a timely-filed estate tax return for the decedent.
Because there may be unexpected delays in an application for citizenship, a QDOT trust agreement should be drafted in favor of the noncitizen spouse, even if the spouse has applied for citizenship, and if the citizenship application has not been approved some time prior to the filing deadline, the assets should be transferred to the QDOT. If the QDOT is created and funded in a timely manner, and if the appropriate tax election is made on the Form 706, US Estate Tax Return for the decedent’s estate, the QDOT assets would qualify for the unlimited marital deduction.
If a surviving spouse becomes a US citizen after the QDOT has been created and funded, the trust assets may later be distributed to the spouse and the trust terminated, if the terms of the trust agreement so allow.
BEWARE “TAX TRAP” WHEN A DECEASED SPOUSE IS A NONRESIDENT ALIEN
Because the lifetime gift and estate tax exemption applicable to a U.S. citizen or resident is so high ($11.4 million in 2019), many people (including many attorneys) are not aware that a different set of rules is applicable to “US-situated” assets belonging to nonresident aliens, including spouses of U.S. citizens, and they may have to pay extremely high estate taxes, if a nonresident alien spouse dies first and leaves his or her “US-situated” assets in a manner which does not qualify for the estate tax marital deduction.
An estate tax return (Form 706-NA) must be filed if a nonresident alien’s “US-situated” assets exceed $60,000 in value – a much lower threshold than one might expect. “US situated” assets include real estate, tangible personal property (i.e., “things” like jewelry, furniture, collectibles and home furnishings) in the United States, and securities of U.S. companies. Certain countries have treaties with the U.S. government, which may impact the taxation of those assets.
Please note that lifetime taxable gifts made by a nonresident alien are taken into consideration in determining whether or not the tax filing threshold for an estate tax return has been met, as lifetime taxable gifts are included in the taxable assets belonging to a deceased nonresident alien. That is, gift tax and estate tax are unified for nonresident aliens in much the same manner as for US citizens and residents, but with a much lower exclusion amount.
Property left by a nonresident alien spouse to a spouse who is a US citizen will qualify for the estate tax marital deduction on the Form 706-NA, Federal Estate Tax Return for Nonresident Aliens, but property left to a non-citizen spouse must be put into a Qualified Domestic Trust (QDOT) and all the QDOT requirements must be met, in order to qualify for the estate tax marital deduction on the estate tax return for a nonresident alien decedent. If the deceased spouse is a nonresident alien, there is a good possibility that the other spouse will be a US resident only, instead of being a US citizen, so special care should be taken in order to qualify property left to a non-citizen spouse for the estate tax marital deduction. .
A determination as to which assets are “US-situated” assets and which are not, is often difficult to determine – that is, which assets may be subject to US estate tax for the estate of a nonresident alien. For example, currency which is physically located in the United States is subject to estate tax, but cash deposits in US banks are not subject to estate tax. Go figure?? It is possible that bonds would be taxable if owned directly by the decedent, but would not be taxable if owned by a partnership which is not subject to US estate tax.
Consequently, we recommend that you consult with an experienced tax professional concerning possible estate tax on US-situated assets for a nonresident alien.
This material is intended for informational purposes only and should not be construed as legal or tax advice, and is not intended to replace the advice of a qualified tax professional.
If a loved one passes away, and after the funeral and other personal matters have been attended to, someone needs to determine whether an estate administration will be needed, whereby a personal representative for the decedent (usually called an “executor” or “administrator”) will be appointed by the probate court (the Clerk of Superior Court in North Carolina) to pay debts, funeral and administration expenses, file tax returns, etc., and to distribute the remaining assets to devisees (under a will) or to heirs (if there is no will).
Whether or not you make an appointment with our office, we suggest that you make a copy of the attachment linked to this article, titledItems to Bring to Your Initial Appointmentand gather the information included on that list, in order to determine how to proceed. That information will be needed to determine whether an estate administration will be needed or is not needed. If you would like, an attorney in our office will be happy to meet with you to make such determination.
A North Carolina Will should be filed and probated in the office of the Clerk of Superior Court in the county of the Decedent’s residence. The word “probate” has two common meanings concerning estates: The first is that the probate of a will is the process by which the Probate Court determines a Will to be valid or not valid. If valid, the Court “probates” the Will, or certifies it to be the Decedent’s Will; we will refer to this meaning as “certification,” in an effort to minimize confusion. The second meaning of “probate” refers to the process by which the estate of a decedent is administered, i.e. The probate of an estate is the administration of the estate with the Court. We will refer to this meaning as “administration,” to minimize confusion.
If there are no assets or very few assets in the Decedent’s name, it may be possible to avoid a full administration of the Decedent’s estate. For example, it may be possible to have the title to a motor vehicle transferred to a new owner without having to go through a full estate administration. Likewise, tax or medical refund checks can often be cashed without a full administration of an estate, but other procedures will need to be followed. See linked article describing alternatives to full administration of a decedent’s estate.
Please be aware that assets payable at death to a named beneficiary, or assets owned in joint names by co-owners with survivorship rights, etc. are generally not required to go through a full administration in Probate Court. Also, real estate left to specific individuals under a Will generally goes directly to the named individuals, and does not technically go through court administration, but if title is to be transferred by those individuals within two years after death, it will usually be necessary to have an administration of a decedent’s estate. In that case, an Executor would be appointed by the Court, who could release the real estate from potential creditors’ claims.
If you gather the information shown in the Items to Bring to Your Initial Appointment, our office will be happy to meet with you and advise you whether or not a full administration will be needed, and to discuss what you will need to do.
Whether or not a full administration is required, the original Will should be filed with the Court and certified by the Court to be a valid will. Occasionally assets are overlooked at the time of death and are discovered later, perhaps years later, in which case it is easier to transfer those later-discovered assets to the proper recipients if the will was certified to be a valid will shortly after the date of the decedent’s death, rather than waiting until later to have the will probated.
If you have a preliminary meeting with our office to evaluate what you will need to do to settle a Decedent’s Estate, you will not be required to retain our firm to represent you. You may go to another attorney or even try to administer the estate by yourself without an attorney, if you wish.
When someone dies, the person who will be responsible for handling the estate needs to look for the deceased person’s original will and to have it filed with the probate court (the Office of the Clerk of Superior Court in North Carolina) in the county where the decedent resided.
If there is a will, the will probably names an executor, who will be responsible for handling the estate. If there is no will, the closest family member will generally be responsible for handling a decedent’s estate and will be called the “administrator,” rather than the executor.
If you do not know whether there is a will, the person or people who were closest to the decedent should look for a will and take responsibility for it, if one is found.
If you do not know where to look, look in places like desk drawers, file cabinets, and boxes of personal papers at home (or at work, if applicable). Some people keep wills in a safe deposit box at a bank or credit union, but it may be difficult to access the box unless you are a co-owner or you have been specifically given access by the decedent by signature card at the bank or credit union. If you locate a box and cannot access it, you may need to contact the office of the clerk of court for permission to enter the box.
If you know who the decedent’s lawyer was, the lawyer may have the original signed Will, so you should contact him or her, or notify him or her of the decedent’s death. If the lawyer has the will, he or she may insist on filing it with the court himself, instead of giving the original to you, but the lawyer should be willing to give a copy to the named executor.
If you find a copy of the will, but cannot locate the original, and if the attorney does not have the original or notes which indicate where the original was to be kept, one possible place to check is with the probate court in the county where the decedent was residing at the time the will was written, as well as the county where he or she resided at death. The Office of the Clerk of Superior Court in North Carolina will hold original wills filed for safekeeping. The clerk’s office will not give you the original will if one is being held there, even if the decedent had moved to a different county before his or her death, but will advise you if they have a will and they will cooperate with the clerk’s office in the county of the decedent’s residency at death. Most jurisdictions permit a later discovered will to be admitted to probate, even though a previously probated will has not been set aside. There are no specific procedures in the North Carolina General Statutes dealing with the situation. The clerk of court is vested with exclusive original jurisdiction over wills, but will caveats or probates in solemn form can eventually be determined by a superior court judge. North Carolina case law appears to require the first will to be set aside before the second will can be admitted to probate, since the probate of the second will is considered to be a collateral attack upon the probate of the first will. This presents a conundrum, or a chicken-or-egg problem, concerning how one should proceed.
Since there are no guidelines in the General Statutes, different counties may follow slightly different procedures. We suggest filing the second will with the clerk of superior court, who may decline to proceed until a caveat or probate in solemn form of the first will has been concluded. But the upshot is that the first will can be set aside, and the second will can eventually be probated.
Wills are typically headed by a title like, “Will of John Doe” or “Last Will and Testament.” A will which was prepared by a lawyer might be stapled to a piece of colored paper (often blue or gray) and might be kept in an envelope marked “Will” or “Estate Planning Documents”, etc.
You might find a handwritten document, which may or may not be titled as a will, but the substance of which may actually be a will. Handwritten wills (called “holographic” wills) may be valid in North Carolina under certain circumstances. Sometimes, a signed document which simply says “I leave my personal residence to Mary Doe” might be a valid will, even though it is not titled as a will. Holographic wills must be 100% in the Testator’s handwriting and holographic wills are not witnessed. If a handwritten will is witnessed, it must be probated as a witnessed will.
Holographic wills in North Carolina should be kept with the decedent’s valuable papers or given to a third party, to hold for safekeeping.
“Codicils” are documents which change or add to the terms of a will without entirely revoking the prior will. Most people simply write new wills and revoke their old ones, but sometimes they write codicils, instead. Each apparent codicil should be filed for probate with the probate court. Codicils may be witnessed, just like a will, or they may be handwritten. Holographic codicils are subject to the same rules as holographic wills. A witnessed will may be modified by a holographic codicil. Both documents must be probated by the probate court.
Whether or not a full estate administration is necessary, the person who has possession of the original will must file it with the probate court in the county of the decedent’s residence after the death of the will-maker (the “Testator”) .
If you find only a copy of the will and cannot find the original, it is possible that you can file the copy with the probate court and present evidence that it should be accepted as the original. To prevail, however, you will need a credible explanation as to why the original document is not available, and to present evidence to that effect.
If you have reason to believe that someone has an original will but does not want to produce it, you can ask the clerk of superior court to bring that person in front of a probate judge, and to produce the original will.
It is suggested that you ask an experienced probate attorney to assist you.
It is more common now than it was, even a few years ago, for United States citizens to make financial provision in their estate planning documents for non-US citizens and nonresidents of the United States.
We have linked an article concerning Qualified Domestic Trusts (QDOT’s) for noncitizen spouses of United States citizens or residents. Bequests to non-citizens do not qualify for the federal estate tax marital deduction, even where the noncitizen spouse has been married to a US citizen or resident and has been living in the United States for many years. Perhaps he or she has several children who are US citizens. That discussion deals with United States Estate Tax, which is a special tax on large transfers of wealth from a person at death to other persons, which is separate and apart from income tax. Large lifetime gifts to non-citizens, including non-citizen spouses, are subject to United States Gift Tax, linked is a discussion of Gift Tax, Estate Tax and GST tax. Gift Tax was originally adopted to prevent individuals from avoiding Estate Tax by making lifetime gifts. Estate Tax and Gift Tax work in tandem with each other.
This article deals with a tax with which most of us are very familiar – income tax. The rules are very complicated for nonresident alien beneficiaries of US estates and trusts, as discussed below.
That is, this article discusses the income tax complications when an estate or trust has beneficiaries who both are noncitizens and nonresidents of the US – called nonresident aliens.
For income tax purposes, a non-US citizen who is a resident of the US pays income tax on his or her income just like citizens, and he or she is considered a “US Person” for income tax purposes.
Beneficiaries may be classified for US tax purposes as “US persons” and not as nonresidents, under certain fact situations. US persons include United States citizens, resident aliens (holders of green cards), and residents who meet the “substantial presence” test (generally those in the United States for 183 or more days each year over a 3-year period), or residents of Mexico or Canada who regularly commute to jobs inside the US. Others who may be classified as U.S. persons include certain government-related individuals, certain teachers and students, and some individuals with medical conditions which were originally contracted within the United States.
Generally traditional estate planning tools such as wills, trusts, life insurance, Section 529 educational savings plans, and annual gifting may be used for transfers to nonresident beneficiaries who are not US citizens. Some financial institutions require the completion of special forms and registrations for life insurance or for brokerage accounts that are payable to a nonresident alien beneficiary. But the transfer of income-producing assets to nonresidents can create income tax complications, whether or not they pass through an estate or trust.
Naming nonresident aliens as beneficiaries of US estates or trusts can be tricky because they may be subject not only to US tax laws, but also the laws of the country where foreign beneficiaries reside. There may be US taxes to be paid and/or taxes of the foreign country, and there are regulations, tax treaties, tax credits, etc. which may be applicable.
When a decedent dies and leaves assets to foreign beneficiaries, the executor or administrator of the decedent’s estate must determine the tax status of each foreign beneficiary, and whether it is necessary to withhold United States income tax on distributions of income from the US estate to each foreign beneficiary. The executor or administrator is required to file tax forms which are not required for estates that have no foreign beneficiaries.
Similar issues arise when a trust is created which has nonresident beneficiaries. Unlike most decedents’ estates, which are temporary in nature, trusts often last many years, during which time the trust must continue to comply with the laws of the United States and the laws of the applicable foreign country or countries.
In order to determine the tax status of a foreign beneficiary, the executor, administrator or trustee (collectively as referred to as Fiduciary) should provide to each foreign beneficiary a Form W-8BEN, to be filled in by the beneficiary and returned to the Fiduciary. That form requires the name of the individual beneficiary, his/her country of citizenship, personal residence address and mailing address, and foreign tax identification number, if any. If a foreign beneficiary also has a US Tax Identification Number (e.g. SSN), it must be included also.
Generally, a Fiduciary can rely on the information provided by the foreign beneficiary on that form for up to three years, but a new Form W-8BEN must be obtained from each foreign beneficiary every three years, updating his/her information, if he or she remains an income beneficiary.
The withholding rate for income distributions to foreign beneficiaries is usually 30%, which a Fiduciary is required to withhold from income distributions. The Fiduciary has a legal responsibility to pay those withheld income taxes to the United States Treasury each year. In many instances the foreign beneficiary receives a deduction or credit on his or her income tax return in his or her home country for US taxes paid, which softens the impact of the high US withholding tax rate but that does not simplify the filing requirements for the Fiduciary.
Withholding tax is required for a foreign beneficiary, for income which is distributed to the beneficiary – as a general rule there is no withholding tax on distributions of principal, such as a monetary bequest which does not include income earned on the monetary amount.
The withholding rates for some countries are sometimes less than 30%, due to tax treaties between the United States government and the foreign country. The rules for tax credits also vary from country to country.
Another complication for a US estate or trust is the requirement that the estate or trust must file Forms 1042, 1042-T and 1042-S in a timely manner for each applicable tax year. Form 1042 concerns how much income will be withheld for income tax withholding purposes for US-source income, for tax withholding purposes. Form 1042-S is concerned with payments of US source income made to foreign persons, and a separate Form 1042-S is required for each beneficiary. Form 1042-T is the Annual Summary and Transmittal of Forms 1042-S for the estate or trust.
Nonresident aliens who have US income from an estate or trust are required to file a Form 1040NR or a Form 1040NR-EZ in the United States, as well as any necessary tax filings in the beneficiary’s home country.
In summary, it is important for someone administering an estate or trust to know of these requirements when there are foreign beneficiaries of the estate or trust. They should also be aware of foreign beneficiaries of retirement accounts or life insurance policies, or persons who will receive assets as a surviving co-owner of assets, even if those assets do not go through probate. Often even an experienced estate planning or administration professional should seek advice and assistance from other professionals who deal regularly with nonresident beneficiaries.
Estate Tax, Gift Tax and Generation-Skipping Transfer (GST) Tax have nothing to do with income tax. The recipient of a gift or inherited property does not owe income tax on the gift or inheritance. Gift taxes, if any, are the primary responsibility of the donor. Those taxes are totally separate and apart from income tax. One income tax-related point, however, is that the recipient of property which has appreciated in value since acquired by the donor, takes the donor’s cost basis for income tax purposes, instead of the value of the gifted property on the date of the gift, and if the recipient sells the property at a higher value than the donor’s cost basis, there will be capital gains tax upon the sale. When appreciated property is transferred at death, instead of by lifetime gift, the recipient’s cost basis is stepped-up to the date-of-death value.
The modern estate tax was enacted in 1916. It is a tax on the transfer of assets of substantial value by a deceased person to others. The tax applies to property transferred by will or to transfers at death under state law, such as the North Carolina Intestate Succession Act. It also applies to property transferred by beneficiary designation, such as retirement accounts and life insurance proceeds on policies owned by a decedent, as well as property owned jointly with right of survivorship, payable-on-death or transfer-on-death accounts, etc., at least to the extent to which the decedent contributed to joint accounts, and transfers passing at death under revocable trust agreements.
Proponents of estate taxes consider it to be a progressive, fair source of government funding, and a good way to break up large accumulations of wealth in wealthy families. Winston Churchill once described estate taxes as “a certain corrective against the development of a class of the idle rich.”
Not too long after the adoption of the estate tax laws, people started giving away assets during their lifetimes, often on their deathbeds, to avoid estate tax at death, as a result of which, federal gift tax laws were adopted several years later, covering lifetime gifts.
To encourage some lifetime gifts in limited amounts, the gift tax laws give some “wiggle room” in allowing gifts without gift tax ramifications. Gifts which are currently exempt from gift tax include: gifts from a donor to an individual recipient which do not exceed a total value of $15,000 in a calendar year, gifts to spouses who are US citizens, and gifts for tuition as an educational expense and certain medical expenses. But please note that educational and medical gifts may not be given to an individual who uses the money to pay those expenses. Instead they must be paid directly to the educational institution or medical provider. Medical insurance premiums qualify for the medical exception, if paid directly to the insurer. Tuition and medical gifts are described in more detail under another article.
After the onset of gift taxes, creative tax planners came up with other devices to avoid estate and gift taxes on the transfer of wealth from one generation to another: Gifts could be made directly to grandchildren, for example, instead of to children, which would eventually skip a generation for gift or estate tax purposes. Also, taxable gifts could be made to trusts, instead of individuals. The trusts would have beneficiaries of multiple generations, and would not become part of the taxable estates of one or more generations of beneficiaries to receive benefits from the trusts. The trusts could make distributions to beneficiaries of one generation, without the value of the trust’s assets being subject to estate tax for a beneficiary at the time of his or her death. The trusts could simply “hang out there,” not belonging to any beneficiary for estate tax purposes, for multiple generations, without being subject to estate tax at the death of any beneficiary. Under the terms of the trust agreements, distributions could be made in the trustee’s discretion to beneficiaries from any generation, but without the principal value of the trust ever becoming part of a beneficiary’s taxable estate.
To limit that from being abused, a “generation-skipping” transfer tax was adopted in 1976. There could be perfectly good non-tax reasons for some “generation-skipping” gifts, such as the protection of assets for grandchildren if their parent had financial or other personal problems. Consequently, generation-skipping gifts were not abolished for tax reasons, but they were limited instead.
The generation-skipping transfer tax laws are very complicated and are commonly used only by very wealthy families, so we will not discuss those laws in detail here, but we will focus on gift tax and estate tax laws and their unified tax system. We recommend that anyone who is interested in generation-skipping transfer tax planning should discuss the same with one or more qualified professionals.
Federal Estate Tax
The federal estate tax applies to the transfer of property from US citizens or residents at death. Under the Tax Cuts and Jobs Act effective in 2018, the estate tax exemption is now $11.4 million (in 2019) for single persons, and with effective tax planning, $22.8 million for married couples. That Act is currently scheduled to be effective only through 2025, during which time the exemption will be indexed annually for inflation. Taxes on assets in excess of the exemption are taxed at a 40% rate. However, if a decedent is married, he or she may leave unlimited assets in excess of that value to his or her spouse, either outright, in a “marital trust” or in a “Qualified Domestic Trust” (QDOT) for non-citizen spouses, free of estate taxes at the first spouse’s death, but which will later be taxable as part of the surviving spouse’s estate. For a marital trust or a QDOT to qualify for the estate tax marital deduction, certain rules must be followed. We have a separate article discussing QDOT trusts for noncitizen spouses.
The tax basis (for capital gains tax purposes) is stepped up to the date-of-death value, which means that any unrealized capital gains on that date are never subject to capital gains tax. Journalist Michael Kinsley called this the “angel of death loophole.”
The estates of both US citizens and US residents are subject to estate tax.
Please be aware that different rules apply to estate taxes where one spouse is a non-citizen of the United States, even if the non-citizen spouse has been a resident of the United States for many years. Transfers to a non-citizen spouse do not qualify for the estate tax marital deduction unless they are left to a QDOT trust, and a certain election is made on a timely-filed estate tax return. But if the spouse becomes a US citizen before the filing deadline for the estate tax return, those transfers would qualify for the deduction without a QDOT.
Also be aware that estates of non-citizens who are nonresidents of the United States (“nonresident aliens”) and who own certain assets located in the United States, are required to file estate tax returns (on Forms 706-NA) for those “US-situated” assets, if those assets exceed $60,000 in value. That is, the applicable exemption for nonresident aliens on those assets is only $60,000, in stark contrast with an exemption of $11.4 million in 2019 for US citizens or residents.
Federal Gift Tax
Congress enacted the federal gift tax to prevent US citizens and residents from avoiding estate tax by transferring their wealth before they die.
The federal gift tax laws currently allow an amount each year that may be disregarded for both gift (and later estate) tax purposes, called the “annual exclusion.” The current exclusion in 2019 is $15,000 per year for total gifts to a recipient made during the year, applicable to “present interest” gifts. That is, a gift which is to take effect in the future, instead of immediately, does not qualify for the annual exclusion. The annual exclusion is granted to a donor separately for each recipient. A married couple would each have annual exclusions, so the couple could collectively give $30,000 in 2019 to a recipient, and the collective gifts could be made either from their separate assets or from the assets of both spouses, to each recipient.
The gift tax laws also provide a lifetime exemption for taxable gifts made by US citizens and residents (currently $11.4 million per donor in 2019), which is the same amount as the federal estate tax exemption, and the gift tax laws and the estate tax laws are integrated into one “unified” system, i.e. – taxable lifetime gifts reduce the exemption amount available at death on the federal estate tax return, and any taxes actually paid on lifetime gifts are credited toward the federal estate tax at death.
Gifts to spouses who are US citizens are not taxable, and there is no limit to the amount which can qualify for the gift tax marital exclusion. However, the unlimited marital exclusion does not apply for non-citizen spouses, even if they have been residents for many years. Gifts from a US citizen or resident to a non-citizen spouse are exempt up to $154,000 per year in 2019, indexed for inflation.
Another rule applicable to noncitizen spouses: If a US citizen or US resident spouse deposits money into an account in joint names with a spouse who is a US citizen, there is no gift unless the other spouse withdraws money from the account; that is, if the spouse who transferred the money into the account dies, the entire balance transferred by the decedent is treated as part of the taxable estate of the deceased spouse. However, if the account is a joint account with a noncitizen spouse with right of survivorship, then the account is generally treated as owned one-half by each spouse, meaning that a taxable gift has occurred on the creation of the account, except to the extent that money was contributed by the noncitizen spouse, and would be treated as a taxable gift, to the extent that it exceeds the annual gift tax exclusion (of $154,000 in 2019, indexed for inflation). There is a narrow exception to that rule, however, if the parties can prove that their intent was that the money was not to be withdrawn by the noncitizen spouse except for a special purpose which had not occurred.
Gifts include more than just cash transfers. Gifts of assets other than cash (e.g., stocks and bonds, mutual fund shares, partnership or LLC interests, parcels of real estate, etc.) are taxed at their fair market value on the date of the gift. The payment of rent or similar expenses for an adult recipient would be a taxable gift. If someone lends a large amount of money to someone else, either interest-free or at a very low rate of interest (the US Treasury Department publishes an official rate of interest each month, called the Applicable Federal Rate (AFR); if you charge less than the AFR for loans of totaling more than $10,000 to the borrower, the difference is deemed to be a gift).
Gift Tax Marital Deduction for Same-Sex Marriages
North Carolina denied marriage rights to same-sex couples by statute adopted in 1996. A state constitutional amendment was approved in 2012 which defined marriage between a man and a woman as the only “domestic legal union.” This amendment was approved by North Carolina voters by 61% to 39% vote.
In 1996 a federal law was adopted titled the Defense of Marriage Act (DOMA), Section 3 of which defined marriage as the legal union of one man and one woman.
Since those dates, state and federal court decisions have affected federal gift, estate and GST tax laws as they apply to same-sex marriages.
In 2013 a US Supreme Court decision recognized same-sex marriages for gift, estate and GST tax, provided that those marriages were valid under the laws of the states in which those marriages occurred, and it made no difference whether either spouse was a resident of the state in which the marriage occurred. It also makes no difference whether same-sex marriages are recognized in the state of residence of the married couples.
In Notice 2017-15, the IRS described the procedures which same-sex couples may use to re-calculate the marital exclusion amounts for property transferred to spouses before the US Supreme Court invalidated Section 3 of DOMA in 2013, if the gifts did not qualify for the marital deduction for federal gift, estate or GST tax purposes, solely because of DOMA.
If the applicable limitations period has not expired, a taxpayer may file an amended gift tax return or a supplemental estate tax return, on which he or she may claim a refund for taxes which have been paid, as well as restoration of the taxpayer’s applicable exclusion amount.
After the limitation period has expired, no refund can be claimed, but Notice 2017-15 allows the taxpayer to recalculate his or her applicable exclusion amount as a result of recognizing the marriage, and may recalculate the taxpayer’s remaining applicable exclusion amount as directed by the IRS in its forms and instructions.
Many of the issues have been resolved in a taxpayer-friendly way.
This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified tax professional.
The North Carolina General Statutes contain very detailed procedures for establishing or contesting the validity of wills. Wills must be “probated,” that is, found by the Probate Court (the Clerk of Superior Court) to be properly executed and valid, before an Executor or other personal representative will be appointed to settle a decedent’s estate.
There are two different procedures for determining the validity of a will, called 1)probate in common form, and 2)probate in solemn form.
Probate in Common Form
Almost all the time, wills are probated in common form, which is a relatively simple and inexpensive procedure in which a will is approved by the Probate Court when the paperwork is correct. The clerk of superior court must notify by mail all devisees whose addresses are known, but no formal hearing is required at that time.
Since those individuals have not been given an opportunity to contest the will, a will which has been probated in common form may be later challenged by persons who have legal standing to do so.
Occasionally a will which has already been probated in common form is superseded by a later dated will. Most jurisdictions permit a later-discovered will to be admitted to probate, even though a previously-probated will has not been set aside. There are no specific procedures in the North Carolina General Statutes dealing with the situation. The clerk of court is vested with exclusive original jurisdiction over wills, but will caveats or probates in solemn form can eventually be determined by a superior court judge. North Carolina case law appears to require the first will to be set aside before the second will can be admitted to probate, since the probate of the second will is considered to be a collateral attack upon the probate of the first will. This presents a conundrum, or a chicken-or-egg problem, concerning how one should proceed.
Since there are no specific procedures in the General Statutes, different counties may vary slightly in dealing with later-dated wills. We suggest filing the second will with the clerk of superior court, who may decline to proceed until a caveat or probate in solemn form of the first will has been concluded. But the upshot is that the first will can be set aside, and the second will can eventually be probated.
When an interested party contests the validity of a probated will, he or she must file a “caveat” with the Clerk of Superior Court. When the caveat proceeding has been filed, the Clerk of Superior Court orders the Executor to suspend the estate administration pending the outcome of the caveat proceeding.
A will caveat generally must be filed at the time of probate or within three years thereafter. If, however, a Caveator is under 18 years of age or is legally incompetent, then a caveat may be filed at any time within three years after that individual has reached 18 years of age, or within three years after his or her disability has been removed.
Caveats may be filed only by persons who are interested in the estate, such as heirs at law or next of kin, or individuals who claim under an earlier or later document which purports to be the will of the Decedent. If an original document purporting to be a will cannot be found, but a copy is available, there is a rebuttable presumption that the will was revoked, but the absence of the original document does not necessarily defeat the standing of those who present a copy of the lost will for probate. A copy of the missing will may be presented to the Court for probate, and evidence must be presented to support a finding that the original will was not revoked by the testator.
The validity of a purported will may be challenged for various reasons, but the most common are (a)undue influence, or (b)lack of testamentary capacity. A later-dated instrument purporting to be a will may be a third reason.
Some wills contain provisions intended to discourage will caveats, which provide that anyone that challenges the will, will forfeit any benefits which he or she would receive under the will. These are called “in terrorem clauses” and are intended to scare away any would-be challengers. Those forfeiture provisions may or may not be enforceable: if a court finds that a will caveat was in good faith and with probable cause, the in terrorem clause would likely be deemed to be unenforceable.
Probate in Solemn Form
If a person who files a will for probate wants to settle the issue of the document’s validity up-front, instead of having to hold his or her breath for three years to see whether the Will will be contested, the procedure for settling the matter sooner, rather than later, is called “Probate in Solemn Form.”
The person applying for probate of a will may file a Petition for Probate in Solemn Form, instead of relying on a Probate in Common Form, the less formal procedure which was discussed above.
Under a Probate in Solemn Form, the Clerk of Court issues a summons to all parties interested in the estate and schedules a hearing at which the petitioner presents the evidence necessary to probate the will (i.e., to certify its validity). This is in contrast to a Probate in Common Form, where there is no hearing at this point.
If any interested party wants to contest the validity of the will, he or she must either (a) file a will caveat before the hearing, or (b) present facts at the hearing (called “devasavit vel non”) pertinent to the validity of the will, after which the Clerk will transfer the matter to Superior Court, to be heard as a caveat proceeding.
If no interested party contests the validity of the will at the hearing before the Clerk, the probate in solemn form becomes binding, and no interested party who was properly served in the proceeding may file a subsequent contest or caveat of the probated will.
If someone has initially initiated a Probate in Common Form, he or she would not be barred from later applying for a Probate in Solemn Form.
Much of the time it is not necessary to go through a full estate administration for a decedent’s estate, due to one or more of the reasons discussed below, particularly if the estate is modest in size.
Estate administration is not needed for the transfer of non-probate assets, such as real property owned jointly with right of survivorship, life insurance or retirement accounts payable to a named beneficiary, bank accounts or securities accounts which are payable on death or transferred on death to a named beneficiary or beneficiaries, etc.
Also, assets titled in the name of a revocable trust will pass under the provisions of the trust agreement and do not go through a full court administration.
There is one exception to the above, which occasionally applies to bank accounts under a signature card which refers to NCGS Section 41-2.1, sometimes on old accounts which were opened years ago, which cannot generally be closed without the appointment of a personal representative for an estate.
Generally, a “small estate” is defined as personal property, less liens and encumbrances, totaling no more than $20,000 in value, except where the surviving spouse is the sole heir or devisee, in which the maximum amount is increased to $30,000. The facts may be established by affidavit.
An administration of small estates may be avoided if the Family Allowances available to the spouse and to minor family dependents equal or do not exceed the personal property in the decedent’s estate.
The Year’s Allowance for a surviving spouse in 2019 is $60,000 and the allowance for minor dependents is $5,000.
Minor dependents must be under 18 years of age to qualify for a Family Allowance.
In certain instances where the surviving spouse is the sole heir or devisee, the estate proceeding may be started as a summary administration.
Summary administration is not allowed if any property passes to the spouse in trust, or if the decedent’s will specifically states that summary administration may not be used.
In a summary administration, the attorney brings a copy of the Order of Summary Administration, for the clerk’s signature and certification, for each asset to be transferred to the spouse.
Please note that the liability for debts of the decedent continues under this procedure. The only way to cut off the claims of creditors is through regular administration with published notice to creditors, etc.
Notice to Creditors
When there is a full administration of a decedent’s estate, the executor or other personal representative is required to publish a notice to creditors weekly for four weeks in a newspaper of general circulation in the county in which the estate is being administered.
When pursuing an alternative to full administration, such notice is not required.
However, when pursuing an alternative, any person otherwise qualified to serve as personal representative may file a petition with the clerk of superior court to be appointed as limited personal representative to provide a notice to creditors without administration in certain circumstances, including:
(i) When a decedent has died testate (i.e., with a will) or intestate (i.e., without a will), leaving no property which is subject to probate and no real property devised to the executor;
(ii) When a decedent’s estate is being administered by collection by affidavit;
(iii) When a decedent’s estate is being administered under the Summary Administration provisions of the General Statutes
(iv) When a decedent’s estate consists only of a motor vehicle that may be transferred by procedure as described above; or
(v) When a decedent has left assets that may be treated as “assets of an estate for limited purposes” as described in NCGS 28A-15-10, such as a joint account with survivorship under NCGS 41-2.1 as described above, applicable occasionally to accounts with old signature cards.
Transfers of Motor Vehicles
If the estate consists of motor vehicles only, or if the estate consists of motor vehicles and other personal property valued at less than the applicable family allowances described above, it may be possible to avoid a full administration of the estate by using the family allowance procedure to transfer other assets to the spouse and children and by using the procedure in NCGS Section 20-77(b) to transfer title to the motor vehicles.
The Division of Motor Vehicles has issued a Form MVR-317, “Affidavit of Authority to Transfer Title, for transferring titles to motor vehicles out of the name of a deceased owner.
This procedure applies where the Clerk has not allotted the vehicle as part of a year’s allowance and (1) the decedent has died without a will and no personal representative has qualified or is expected to qualify, or (2) the decedent has died with a will and with a small estate which, in the opinion of the clerk, does not justify the expense of probate and administration
All of the heirs of the decedent must sign the affidavit before a notary public, and the parent of a minor child may sign on behalf of the child.
The clerk must also sign the affidavit after the heirs have signed.
Sales of Real Property Left to Heirs or Devisees
Unless real estate is willed directly to the decedent’s estate or the personal representative is expressly directed in the will to sell the real estate, title to real estate generally vests in the heirs or devisees the instant that the decedent dies, and it passes outside the administered estate.
However, the interests of the heirs or devisees in the property is subject to divestment if it is necessary for the personal representative of the estate to sell real property which belonged to the decedent on the date of death, to generate cash with which to pay creditors, administration expenses, etc.
In that case, the personal representative of the estate may file a special proceeding before the clerk of superior court for permission to bring the real property into the administered estate and to sell the same.
If granted, the personal representative may bring the property into the estate and sell the property as directed by the clerk of superior court.
Because of the possibility that the personal representative can do this, the title left to the heirs or devisees is subject to a “cloud on title” for two years after the decedent’s death or until the probate estate has been closed.
To enable the heirs or devisees to sell the real property sooner than that, while the estate is being administered, when it appears that it will not be necessary to bring the property into the estate and to sell the property to pay creditors, etc., the executor or other personal representative may join in the execution of a deed of sale by the heirs or devisees, essentially to indicate that the estate has sufficient assets, other than real estate, to satisfy the debts of the estate.
The heirs or devisees cannot sell the real property within two years after the date of death, without the executor’s joinder on the deed.
Unless someone qualifies as executor or administrator of the decedent’s estate, nobody would be authorized to sign the deed, so it would be necessary for someone to qualify as personal representative of the estate, it the heirs or devisees wanted to sell the property within two years after the date of death.
To protect himself or herself against possible personal liability for releasing the property as an asset with which to pay creditors, if necessary, the executor or other personal representative may insist on holding the proceeds of sale in escrow temporarily, until the estate has been closed or until two years has passed after the date of death.