Avoiding Probate

Many people want to avoid probate for the following reasons:

  • It is expensive.
  • It takes time.
  • It is public. An estimate of the value of your assets is filed, and an inventory of property may be filed
  • It provides a forum for creditors to get paid.
  • It allows a spouse to claim a statutory share of the estate.

On the other hand

  • It is often just as or more expensive to arrange your affairs to avoid probate, and it often does not work. Also, many of the expensive things which must be done after death must be done whether or not there is probate.
  • Probate allows creditor claims to be barred. If proper notice is given, claims are barred unless they are filed within a certain time. Creditors can also attack arrangements meant to avoid probate if they were also meant to avoid creditors.

Whether or not it is desirable to avoid probate must be determined in each individual case. Many people believe that avoidance of probate avoids estate taxes. That is not so and should not be a consideration.

How can you avoid probate?

By not having any assets which require a will or the law to say who gets them when you die. If they pass to someone named in some document other than a will or the statutes, you avoid probate.

Among devices which will do this are:

  • Trusts
  • Joint Tenancies
  • Beneficiary designations
  • Pay on death accounts.

In smaller estates use of the last three items is often very effective. But if any substantial amount of assets exist in your sole name without any beneficiary designation, there will still be probate. If you are going to avoid probate, you must make these arrangements for all your property. You must also arrange to have all property you acquire in the future subject to such arrangements. The same can be said of living trusts which are a very popular way of avoiding probate. There will still be probate if only some of your assets are transferred to the trust. All your property must be transferred to the trust to avoid probate. Just signing the trust document is not enough.

Why is it important to have a Will?

  • Can say who gets what
  • Can choose executor and guardian for kids
  • Can waive surety on executor’s bond – (a surety is an insurance company that agrees to pay if executor defaults – quite expensive)
  • Can direct the executor to take specific action he might not otherwise be able to take (retain family company)
  • Can give some property free of debts and other property subject to debts
  • Can make gifts of specific items to particular people
  • Can make conditional gifts, i.e., to X if he does something and if he does not to Y ( must be a legal condition)
  • Can disinherit wife or kids
  • Cannot defeat wife’s right to take against will – she can elect to take what will gives or 1/3 of the probate estate if there are descendants or one-half if there are no descendants.
  • Cannot defeat spouse’s award, which is in addition to what will give spouse, of the amount necessary for support for nine months – at least $10,000 plus $5000 for each dependent child.

In Illinois, you must be 18 or over and of sound mind and memory to make a valid will. The will’s signing must be witnessed by at least two sane and able adults who will not get anything under your will when you die and who see you sign in the presence of each other. Wills can contain language creating trusts to which property is given. They can also give property to trusts that have already been created. Wills that do this are called pour over wills, i.e., the estate’s assets pour over to a trust.

A will should dispose of all your property not otherwise disposed of. It should provide for property otherwise disposed of if it does wind up in your probate estate – i.e. if the named beneficiary on a life insurance policy dies before you. It should provide for all possibilities as to survivorship – i.e., a will giving property to a spouse and children should specify who gets the property if there are no surviving spouse and children.

What happens if you don’t have a will?

The state dictates who gets your property and who will be the administrator (manager) of your estate and who will be the guardian of your children if your spouse has already died and who will be your guardian if you are disabled.

If you die without a will survived by a spouse and children, the spouse gets one-half, and the children get the rest. There are no exceptions.

Guardianships are expensive and time-consuming, and if money or property is involved, court approval is needed for everything.

All your property must be collected and sold unless all the beneficiaries agree to keep it. The family business or farm must be sold.

There is no provision for professional management of your estate.

There will be a probate of your estate if it exceeds $50,000. This is a court determination of who is entitled to your property and supervision of its collection and distribution.

Taxes may be a lot higher.

Joint and Mutual Wills

A joint and mutual will is one executed by two parties (testators). In it, each testator makes gifts upon his or her death. The gifts are usually reciprocal. Each testator’s gifts are considered to be in return for the other testator’s gifts.

Because of this, the joint and mutual will is a contract. While the parties are both alive, they are free to change the terms of the will, but upon the death of one, the will is irrevocable.

What is an irrevocable trust?

These are trusts which the person who created the trust cannot revoke or amend. A transfer of assets to such a trust results in a gift to the trust’s beneficiaries for tax purposes. Thus, the assets transferred are usually out of the transferor’s taxable estate.

Joint Trusts

When spouses (or anyone else) together create one trust, it is called a joint trust. These trusts are common in community property states but are not widely used in Illinois because of the adverse estate and gift tax consequences that may result. Recently the tax rules have been eased in some private letter rulings, and there are also many non-taxable estates, so the use of joint trusts is increasing. However, there are still many technical pitfalls, and separate trusts are usually advisable.

These should not be confused with joint wills. When both spouses share one will, it is called a joint will. Joint wills, for a variety of reasons, should not be used.

What is a Dynasty Trust?

This is a trust that is held for the benefit of successive generations for a very long time. The trustee holds the assets with a direction to pay the income to children, then grandchildren, then great-grandchildren and so on.

Since each person only has a life interest in the trust, the trust assets would not be in his or her taxable estate. However, the trust would be subject to generation-skipping taxes, so the value of such trusts on creation is usually limited to the exemption under the generation-skipping tax.

In the past, the duration of trust was limited by the rule against perpetuities. A trust could last only so long as a life in being upon creation of the trust plus 21 years. The “life in being” refers to all the current beneficiaries. Certain states now allow you to opt-out of this rule.

What is a Grantor Retained Annuity Trust (GRAT)?

This is a trust created by someone (grantor) who transfers assets to the trust. It is irrevocable. The trust exists for a set term of years. At the end of the term of years, someone else (such as a child) gets the trust assets. This person is called the remainderman and gets the remainder. During the term of the trust, the grantor retains the right to an annuity payment. When the trust is created, the remainder interest is treated as a gift.

The present value of the annuity payments is deducted from the total value of the trust assets to determine the value of the gift. In this way, the trust assets can be transferred to the remainderman free of gift tax or at a discounted value. This is done by structuring the annuity payment and term of the trust so that the value of the remainder is very little. For instance, $1,000,000 could be transferred to a two-year trust by a father, with the remainder payable to his daughter. Valuation is done under IRS tables in which the rate of return is assumed. The trust could call for two yearly payments of about $533,000 each. This would give the remainder almost no value upon the creation of the trust. If the tables used for this example assume about a 4.4% rate of return. (the assumed interest rate changes each month) $1,000,000 will yield two yearly payments of $553,000. Nothing will be left after that. If the trust assets actually get a higher return, there would still be funds left in the trust at the end of 2 years. In this case, over $70,000 if the trust assets actually earned 9%. This would pass to the daughter free of gift tax. If the return on the trust assets was 4.4% or less, there would be no transfer of funds to the daughter, but the grantor would get all of his funds back and the earnings on them (fewer transaction costs).

The annuity payment is a fixed percentage of the initial trust assets or a fixed amount. It must be paid each year. The value of the remainder (and thus the gift) is determined by the annuity payment amount, the length of the trust term and the interest rate used in the IRS tables.

GRATS exist under special rules meant to avoid undervaluation of the remainder of interest given to family members. Under these rules, in Section 2702, special valuation principles apply when an interest in a trust is given to certain family members and interest is retained by the grantor (or other family members). To begin with, the value of the retained interest is treated as 0 unless it is a qualified interest. This means the entire value of the trust assets is treated as a gift. If the interest retained by the grantor is a qualified interest, then it is valued under actuarial principles and interest rates determined by Section 7520. One type of qualified interest is the fixed annual annuity type of payment.

While the creation of the GRAT involves a gift, the entire value of the trust assets is in the grantor’s taxable estate if the grantor dies during the trust term. For this reason, GRATS often contain a reversion (the assets revert back to the grantor’s estate) if the grantor dies during the trust term. This is not a disqualified interest and will not reduce the value of the gift under Section 2702.

A retained unitrust interest – the right to receive a set percentage of the value of the trust assets, the value of which is determined annually – is also a qualified interest. A trust providing for this type of payment is a grantor retained unitrust or GRUT.

The family members to which 2702 applies are spouse, ancestors, descendants and siblings, and spouses of any foregoing. Nieces and nephews, fiances or domestic partners are not included. When the transfer is not to a family member included in 2702, the trust is called a Grantor Retained Interest Trust (GRIT) and standard actuarial valuation principles apply (i.e., it is not assumed that the retained interest of the grantor is worthless unless it is a qualified interest.)

The GRAT is usually arranged so that the remainder has no value. This is called a zeroed-out GRAT. This is done to avoid paying gift tax. If the actual rate of return on the trust assets is less than the IRS rate, then there will be no assets left for the remainderman at the end of the term. A donor does not know in advance if this will happen. Therefore creating a GRAT with a high remainder value can result in payment of gift tax when the remainderman gets less than the amount tax was paid on. If the GRAT is zeroed out, this does not happen. If actual returns are less than the IRS rate, the grantor gets his or her funds back with interest and pays no tax. If actual returns exceed the IRS rate, a tax-free gift goes to the remainderman.

In early 2014 the IRS tables provided for an interest rate near 2%. The lower this rate, the higher the chances of making the tax-free gift. In other words, the easier it is for the actual rate of return to exceed the IRS rate.

What is a Grantor Retained Unitrust (GRUT)?

The GRUT is the same type of trust as a GRAT, except instead of an annual payment set upon creation of the trust, the payment is specified as a fixed percentage of the value of the trust assets determined annually. Because of this, the GRUT does not have the same potential for discounted giving. In a GRAT, if the trust assets earn more than the rate of return used by IRS in determining values, the property passes to the remaindermen free of gift tax. In a GRUT, if the trust earns more than the payout rate, the earnings stay in the trust, increase the value of the trust assets, and increase the payment the following year, with a consequent lessening of the remainder value.

Crummey Trust/Crummey Powers

There is a yearly exclusion from gift tax of $13,000 per year per donee in 2009 (the amount rises periodically). This applies only to gifts of present interests. A gift in trust is not considered a present interest. For instance, there is a gift in trust if you give money to a trustee to hold and pay the income to grandchildren each year until the youngest reaches 25, when all the rest of the trust assets are distributed to them. Since the grandchildren cannot get the trust assets presently, this is not considered a present gift.

If the children are given a right to withdraw the money contributed to the trust for a limited time after the contribution. Their interest in the contribution is present, and the contribution qualifies for the annual gift tax exclusion. The right to withdraw the contribution is called a Crummey power after a case by this name established by the principal.

The beneficiary who has the power to withdraw the contribution or leave it in the trust is said to have a power of appointment. The beneficiary can appoint who gets the contribution – in effect, either the beneficiary or the person who gets the trust assets after the beneficiary’s interest ends. Unfortunately, the exercise of a power of appointment in favor of someone else – or expiration of the right to exercise power with the result that someone else then gets the property – constitutes a gift. When the trust income beneficiary decides not to withdraw the contribution and his or her right to withdraw expires, the result is that the contribution stays in the trust as to principal and ultimately passes to the remainderman. This is a gift to the remainderman. Since the remainder is not a present interest, this gift does not qualify for the yearly exclusion.

There is an exception to the rule that a power of appointment’s expiration (lapse) can constitute a gift. To constitute a gift, the property subject to the power must be greater than $5000 or 5% of the value of the assets, out of which the exercise could be satisfied. For this reason, Crummey withdrawal rights are often limited to $5000.

Crummey rights are often seen in trusts used to make gifts to children who are minors or persons who have no ability to manage investments. They are also often seen in irrevocable life insurance trusts where the grantor must make continuing payments to the trust to enable it to pay the premiums on the life insurance.

Disclaimer: The site is for educational purposes only, as well as to give general information. This blog is not intended to provide specific legal advice. The site should not be used as a substitute for legal advice from a licensed professional attorney in your state.