Estate Deep Dive
What is an estate plan?
An estate plan is the set of instructions on what to do about you after you’re dead. Since you’re dead, you can’t handle your own affairs yourself anymore, so the estate plan explains what you want to happen. A well drafted estate plan also includes instructions on what you want in the event you are still alive but unable to speak for yourself. Dying without leaving any valid instructions is known as dying intestate. If you die intestate, all your money, things, pets, everything that doesn’t have pre-set instructions, gets kicked into the government’s default program for people who didn’t leave instructions. It’s not that bad as far as default options go, (it mostly directs things under next-of-kin principles), but it is painfully slow and every state has different rules and it almost certainly will have some twist making it unlikely that the outcome is what you would have chosen. Unless you are looking to make things difficult for your loved ones, you’ll want to avoid dying intestate. (Though if causing chaos from beyond the grave is a goal, dying intestate could be worth exploring.)
Estate planning is basically preparing your affairs for when you can’t handle them yourself anymore. The most common reason why you can’t handle them yourself anymore is because you are dead, but good estate plans address situations where you are alive but can’t speak for yourself as well. An estate plan could be viewed as covering your future in three ways:
- Protection while you are alive – Living Will, Medical and Durable Power of Attorney
- Smooth transfer after your death – Last Will & Testament, Revocable Living Trust
- Planned giving and tax savings – Irrevocable Trusts
Everyone, regardless of how much money they have, needs #1, Protection while you are alive. People that have positive net assets need at least a will and probably a trust for #2, Smooth transfer after your death. #3, Planned giving and tax savings using irrevocable trusts is more optional, primarily applicable to people with very large estates or people who have growth assets that could potentially turn into a very large estate.
If you are reading this, you almost certainly need #1 and #2. And the good thing about these is that if you don’t already have them, you can set them up today easily, and then change them easily in the future when your life circumstances change. Fewer people will need #3, and since you can’t change it as easily, you need to be more thoughtful in that part of the planning. But the sooner you start that planning the better because you will have more options to explore before windows start closing on what you can do.
A lot of estate planning, especially for younger people, is preparing so that if an unexpected bad thing happens, it can be a little less bad. If you end up on life support after an accident, your loved ones don’t have to struggle about what you would want because you’ve already told them in a legally recognized way. If you die unexpectedly, your loved ones don’t have to pay out of pocket for your funeral and then struggle in court for years to become the beneficiaries of your assets.
Most of these “insurance”-type preparations do not ever actually come into use, but there is another more “active” side to estate planning for things you actually do put into use. Presuming your eventual death and working backwards based on your stated desires, estate tax planners structure things to meet your goals while minimizing the taxes that will be incurred to do so. When working with assets that may appreciate significantly over a short period of time, generally the sooner the estate planning work begins, the greater the taxes that could potentially be saved. Historically, only the old and wealthy made use of estate planning, as the cost for the benefits was too high to be worth it unless the estate was very large. However, technology has advanced the industry enough so that an estate worth only $50,000, can affordably achieve the insurance-like benefits of estate planning.
The simple solution to prevent intestacy is to leave valid instructions in the form of a will. A legal will (sometimes known as a complete will or last will and testament) describes how you want things to be dealt with after your death. This includes things like specifying who you want in charge of carrying out your wishes (sometimes known as the executor or personal representative), how to distribute your financial assets and property, and can also include things like transferring digital accounts or childcare provisions. It is very important that the will will be valid under the laws of the relevant jurisdiction. A very bad thing is for a person to think they have a will, but to have made some error (e.g., invalid notarization, wrong number of witnesses) that makes the will invalid and the person dies intestate. While you can create your will yourself, because of the catastrophic results that can happen if done improperly, it is almost certainly worth consulting with a qualified lawyer to ensure the validity of your will for your specific situation, especially when your estate is worth millions of dollars.
After you die, your executor is charged with distributing your assets per your instructions. Some things, like retirement accounts and life insurance policies, have a named beneficiary which expedites the transfer. Most assets do not have a pre-assigned beneficiary like this and instead must go through a process in the courts known as probate. Probate is a sort of clearinghouse for the assets and liabilities of dead people. Basically, probate serves to make sure that an estate pays off the debts incurred by the person while they were alive before distributing the residual amount to the beneficiaries per the instructions in the will (or per the state’s government default rules if they died intestate). You could imagine a land grab type of situation after someone died where all their creditors and heirs rush to get as much money from the estate as quickly as possible. Probate solves that problem by slowing everything down and allowing everyone to submit their claims in an orderly fashion (knowing that the court will hear from everyone and there is no advantage to getting there first). However, probate really slows things down. Average probate experiences range from 6-9 months on the fast end to 18-24 months on the slow end.
Probate has other downsides besides speed. There are a variety of fees and expenses associated with processing an estate through probate. California has an explicit formula used to calculate the probate fees. Other states split the costs between the attorneys and the government more ambiguously, but fees can easily end up at 5% of the estate value. Further, as part of the probate process, the will becomes part of the public record and copies can be obtained by anyone willing to pay the courthouse for a copy. While the public having a copy of your will that says, “I leave everything to my partner,” probably isn’t a big invasion of privacy, it’s not hard to see the negative privacy implications of having your final instructions and sometimes rather specific distribution details part of the public record.
The natural questions then are “Can you avoid going through probate? How?” and the answers are an initially unsatisfying, “Yes, by having no assets subject to probate.” Probate only applies to assets that don’t have special pre-assigned instructions for their transfer after their owner’s death. Before, we mentioned life insurance and retirement accounts as having the special pre-assigned instructions and falling out outside of probate. Probably the most common type of pre-assigned instruction is joint tenancy with rights of survivorship. Most married couples that have joint accounts hold at least some of their assets this way, whereby if one of them dies, the assets automatically transfer to the other. For estate planning, there is another powerful means to get the special pre-assigned instruction treatment – trusts.
Assets held in trust are not subject to probate. Therefore, if the goal is to avoid probate, trusts are a very useful tool. Trusts are legal entities that distinguish and separate the legal ownership of a thing (held by the trustees) from its beneficial ownership (held by the beneficiaries). They are kind of like corporations or LLCs, but “somebody” must ultimately own a corporation or LLC. A trust qualifies as being the terminal owner “somebody” in the same way an individual does (and that a company or LLC do not), but with added benefits. During your lifetime, you can put your assets into a trust where you are both the trustee and beneficiary of the trust and can continue to use and enjoy the assets as you did before when they were owned in individual name. However, by putting the assets into a trust which contains instructions for what to do after your death, those assets qualify for the pre-assigned instruction treatment and avoid probate.
With a trust-based estate plan, at the time of your death, the theory is that you as an individual own nothing and your trust actually owns everything that is “yours.” You likely would still have a will (known as a pour-over will) that will just say to leave everything that might have accidentally ended up in your name to the trust, and the trust has all the real instructions for how to distribute everything that is “yours.” The design is for there to be no probate eligible assets in your estate. Everything you “have” has the special pre-assigned instructions. The assets inside the trust pass per the trust instructions without going through probate. Assets outside the trust are either owned jointly, and thus pass that way, or follow their own special distribution process, like IRAs.
A quite common and fairly effective (but risky) system of estate planning to transfer assets after death and avoid probate is as follows: a married couple hold their assets jointly with rights of survivorship until the first spouse passes. Then, all of the joint assets are automatically transferred to the surviving spouse’s individual name (avoiding probate). The surviving spouse then places all probatable assets inside a trust with instructions on how to administer them after they (the surviving spouse) die (again avoiding probate).
A natural question might be, “what happens if both spouses die at the same time?” The short answer is, under that kind of planning, the estate goes to probate. A professionally crafted estate plan will address edge cases like this very thoroughly and with knowledge of what courts are and are not willing to accept. A do-it-yourself estate plan or will is less likely to address these edge cases as well, if they address them at all. A perhaps good heuristic for how much estate planning you need is your response to your estate plan breaking down if both spouses die at the same time. If that is unacceptable and the possibility of simultaneous death derailing the estate plan seems too obvious of a flaw to be allowed, you should pay for a lawyer to create a full plan for you. If, on the other hand, you see simultaneous death as a sufficiently remote outcome that you’re willing to risk the plan failing to a known and identified risk, then do-it-yourself estate planning might be your solution.
The rough hierarchy of estate planning could be seen as:
- (worst of all worlds) do nothing/die intestate, have to go through probate, and have the default government rules decide for you;
- (better) make a will, make your loved ones go through probate, but at least get to decide for yourself what happens to your assets;
- (best) make a trust, avoid probate, get to decide for yourself what happens to your assets.
So why doesn’t everyone make a trust?
For a substantial portion of the population, spending time and money on estate planning really is a waste, as their estates are not solvent (meaning they have more liabilities than assets). Further, most states have a “small estate” exemption where estates of a fairly small value (under $166,250 in CA) do not have to go through probate. For estates of this size, the do-it-yourself planning can be sufficient and paying for a full-service attorney may be unnecessary.
Once someone thinks, “Hmm, I kind of have a lot of money here and I need to figure out what to do with it after I die,” they are on their way to either a trust or a will. A will is the simpler option but has probate risk once your assets exceed your state’s “small estate” exemption. A trust eliminates the probate risk, but historically could be a burden to administer. If someone has $25,000,000, the administrative burden of setting up and maintaining a trust has always been easily afforded. If someone has $250,000, the administrative burden of setting up and maintaining a trust is increasingly easily afforded.
Historically, you could imagine a kind of “efficient frontier” for the trust vs will debate, where everyone with $20M has trusts and no one with under $50,000 has trusts, and just a few with like $10,000,000 have them at age 20, and lots of people have trusts at age 80 even if they only have $200,000. People that are say, 45 with $5M are roughly evenly divided between trust and no trust, and trusts become increasingly popular below $1M beyond age 75. However, as the costs of trusts have come down, the frontier has shifted, and everyone subject to probate can affordably benefit from a trust.
Thus far we’ve been talking about trusts as fairly uniform things. However, there are many, many flavors of trusts. The one we’ve mostly been describing is known as a “revocable living trust,” but there are lots of other types of trust designed for different purposes.
A key distinction for understanding trusts is the difference between revocable and irrevocable trusts. The names are fairly useful here, but don’t give a complete picture. Helpfully for understanding, yet confusingly for spoken pronunciation, a revocable trust can be “revoked” by the trust’s grantor alone; an irrevocable trust cannot be “revoked” by the grantor alone. “Revoke” here meaning cancelled or annulled. Grantor is the person that puts the money/assets into the trust. This person is also sometimes referred to as the settlor. They are the person that initiates the trust to happen in the first place. One way to think of it is that revocable trusts are two-way doors, and as the grantor, you can go back and forth, cancelling or changing the terms. An irrevocable trust is more of a one-way door for the grantor; once you go through, you cannot easily go back.
Another helpful way of thinking can be to analogize to a will. The revocable trust has the instructions for how to distribute assets after the grantor/testator’s death. Just as someone could change the terms of their will if they are alive and legally competent, someone can similarly change the terms of their revocable trust. You could initially have your revocable trust passing assets to your brother, then later change the beneficiary to be your partner, then later your children. However, you cannot easily do that with an irrevocable trust. If you set up an irrevocable trust to benefit your brother, you can’t alone go back later and change the beneficiary to your partner. With an irrevocable trust, the transfer has already happened. Your brother would have to agree to be removed as beneficiary to unwind things from this point. Because it was an irrevocable trust, you as grantor no longer can unilaterally change things.
What benefit do irrevocable trusts offer? Why give up the ability to make changes? The main reason is estate taxes. Asset protection can be another. Currently in the United States, estate taxes are levied at up to 40% on the assets in an estate above the $12.06M exemption ($24.12M for a couple). If a person structures their holdings so that assets grow outside of their taxable estate by using irrevocable trusts, there is the potential to save a lot on taxes and limit the amount of potential exposure to judgments. But, if the grantor retains the ability to make changes as in a revocable trust, the trust is considered part or the grantor’s estate for estate tax purposes and can be attached by creditors. If the grantor cannot make changes as in an irrevocable trust, the trust is not considered part of the grantor’s estate for estate tax purposes and the assets in the trust are generally safe from the grantor’s creditors. Here are some heavily stylized examples to illustrate the concept.
Early Employee Evan has shares of his fast-growing pre-IPO company that are currently worth $10M. Evan and his wife Emma have three young children. Evan and Emma know that they ultimately want to leave most of their estate to their children and maybe grandchildren. They estimate the company shares may grow 10x over the next 10-15 years.
Evan and Emma may be good candidates for an irrevocable trust set up to benefit their children. In our example Scenario 1, they can place $3M of the $10M of pre-IPO shares, $1M for each child, into an irrevocable trust, keeping $7M for themselves in their revocable trust. The $3M counts against Evan and Emma’s lifetime exclusion in the year that they gift it into the trust, but only at the current $3M value, and after that it is out of their estate. (However, because it is out of their estate, they do not get any step up in cost basis upon their death like they would if it were in their estate at their death.) If, 15 years from now, the shares of the company have gone up 10x, and the irrevocable trust is worth $30M, Evan and Emma will have passed $30M to their children without incurring any estate or gift taxes. Further suppose the $7M they kept for themselves grew into $30M (lower returns from taxes, diversification, and spending). Based on the current estate tax exemptions and rates ($23.4M for couples, 40% tax above $1M), they would be subject to estate tax on about $9.6M of assets and owe about $3.8M in estate taxes, transferring an additional $26.2M to their heirs. Combined with the earlier $30M from the irrevocable trusts, that totals $56.2M transferred with only $3.8M lost to taxes.
Had Evan and Emma instead held their all their investments within their revocable trust (and thus within their estate) and not implemented the irrevocable trust plan, yet still received the same $60M outcome from a base of $10M pre-IPO shares, their estate tax would be about $14.6M, and they would only transfer $45.4M to their heirs. The effective estate tax rate is reduced 74% (from 24.3% to 6.3%) and there is a savings of $10.8M in estate tax by using the irrevocable trusts.
(It is worth noting that irrevocable trusts are not exempt from capital gain and income taxes. The basis of the shares carries over, (in this example, they would be near zero), so upon sale, significant capital gains are realized. With federal taxes about 24% and CA state taxes roughly 13%, there is about 37% of tax due upon sale of the zero basis holdings, which eliminates much of the tax savings compared to keeping the assets in their estate, paying estate tax, and taking the stepped-up cost basis before liquidating. Paying this tax can be deferred by not selling shares, but not totally eliminated.)
If the company stock performs better, the estate tax savings are even greater with irrevocable trusts. Suppose the same situation with Evan and Emma, but the assets in the trust grow 50x, to $150M (Call this Scenario 2). Evan and Emma’s revocable trust assets grow 10x, to a still quite impressive $70M. With the irrevocable trusts, they can end up transferring $200.2M to their heirs, paying $19.8M in estate tax. If they kept everything in their estate until it was worth the $220M then distributed at death, they would only transfer $141.4M and pay $78.6M in estate taxes. Using the irrevocable trusts reduces their effective estate tax rate from 35.7% to 9.0%, saving $58.8M in taxes.
The tax savings are impressive, but how will Evan and Emma feel when they have $70M, but their children’s trust is worth $150M? Probably fine, but that is not certain. If control over the assets is important, Evan and Emma can structure things where they have a fair amount of control over the assets in the irrevocable trust for their children. The irrevocable trust can easily be structured so that the children do not gain access to assets until some much later date. (And again, there are potentially significant income and capital gains taxes due within the irrevocable trust).
However, if Evan and Emma have $70M, and their children’s trust is worth $150M, and they now decide their children only should get $50M, and they’d prefer to give that other $100M to charity, there is limited recourse Evan and Emma can take. The gift to their children via the irrevocable trust has already happened. They cannot simply change the distribution instructions like they could if everything were still inside their revocable trust. They may be able convince their children to gift assets to charity, but they can no longer unilaterally change things.
An even more awkward situation occurs when the assets in the children’s irrevocable trust perform well, but the parent’s revocable trust assets perform poorly. Assume the same setup with Evan and Emma for Scenario 3, starting initially with $10M of pre-IPO stock. They keep $7M in their revocable trust and put $3M in an irrevocable trust for their children. Over some number of years, the irrevocable trust grows to $30M. However, through taxes, overspending, and poor investing, the revocable trust assets are only $2M. To restate, under this scenario, Evan and Emma’s have dwindled to $2M, but their children’s trust is worth $30M. The temptation to dip into the irrevocable trust to boost their lifestyles would be very strong, but still very wrong.
Perhaps assets may be gifted from the children back to the parents to support them in their old age, but this is a failed outcome. This outcome results in no estate tax being paid vs $3.4M if Evan and Emma had kept everything in their estate until it was worth the $32M then distributed at death. But Evan and Emma almost certainly would have been happier distributing $28.6M to their children as wealthy elderly parents and paying some estate tax rather than nearly running out of money while their children have $30M in trust.
The examples illustrate some of the benefits and risks that come from irrevocable trusts. If you have a giant estate and can plan ahead and don’t need to change your plan at all, irrevocable trusts can save very significant amounts of estate taxes. However, circumstances change, especially over long periods, and irrevocable trusts are not great at adapting. That is not to say an irrevocable trust cannot be changed; it’s just that they cannot be changed unilaterally by the grantor in the same way revocable trusts can. As a result, the lack of unilateral control can leave settlors regretting decisions made under earlier circumstances.
Further, the examples illustrate the importance of ongoing estate planning. In the examples, Evan and Emma did some initial estate planning and then let the plan run for 15 years without checking on it. Not keeping up to date on their overall estate plan caused them regret as they realized too late that some windows had closed. It is better to make small changes to keep the plan on track than to ignore it, hoping a major overhaul can solve all the problems later. It is not wrong to have to modify your estate plan; you should expect to make lots of changes to your estate plan over your lifetime. As your circumstances in life change, so should your estate plan.
Within irrevocable trusts, there is an alphabet soup of further specialized forms. Some actually common and not made-up examples include GRAT, CLAT, CRUT, IDGT, ILIT, QTIP, and SLAT. These are complex estate planning tools and should only be used in conjunction with the advice of a sophisticated estate planner. Details of how these work is beyond the scope of this guide for now, but will be included in future editions. However, as an end user of estate planning, you probably care less about the specific tools and how they work and more about the outcomes and results. Very few people think to themselves, “I want to structure my affairs so that I can make effective use of an irrevocable life insurance trust.” Very many people think to themselves, “I want to structure my affairs so that I can leave money to my kids and charities after my death.”
So, what is the core estate plan setup if you are a startup founder or employee? If you commit to hiring an estate planning attorney, what should you expect? If you are doing it yourself, what are the most important things to include?
- Last will and testament – Everyone should have a will unless they really like their state’s laws of intestacy. If you are not concerned about probate, the will could be your primary estate transfer instructions. If you are working with a lawyer and creating a trust-based plan, you will still have a will. With a trust, the will will likely be integrated into the plan to direct any wayward assets into the trust.
- Durable power of attorney – A durable power of attorney allows someone else to make legal and financial decisions on your behalf in the event you can’t. It will hopefully be unnecessary but is very beneficial in the event it becomes needed. A lot of estate planning is making unforeseen situations less unpleasant if they happen, which is exactly what this does.
- Health care power of attorney – The health care power of attorney is the same idea as the power of attorney above, but specifically for health care decisions. This can be the same person as your legal power of attorney or someone different. The standard legal power of attorney appointment does not cover health care decisions, so it is important to make sure you have POA for both legal and health care decisions.
- Living will – A set of instructions on your preferences for medical care, specifically around circumstances when you have a terminal condition or are in a persistent vegetative state. Combined with the health care power of attorney, this is sometimes called an “Advance Medical Directive.” Again, unlikely to actually be used, but if it is needed, it helps make a bad situation a little less bad.
- Beneficiary designations – These are the special pre-set instructions that allow assets like IRAs and life insurance to go through probate. They are not new documents to be created, but already exist if you have this type of account. It is important to make sure that the beneficiary information the administrator has on file reflects your current estate planning wishes.
- Revocable living trust – If you want to avoid probate, the revocable living trust will likely be the primary set of estate transfer instructions. The main question is when not if you set up your revocable living trust. If you don’t have many assets, it may make sense to wait until you are very old to put them into trust and save decades of trust administration. If you have a lot of assets, it may make sense to put them into trust now, regardless of your age. If you are unsure if you need a living trust or a will, gauging your reaction to your heirs having to go to court after your death to get their inheritance can be helpful. If your reaction is along the lines of, “Well, I don’t plan to die, so even if I did, my heirs having to go to court to get their windfall money doesn’t seem that bad,” you can probably stick with a will only plan. If your reaction is along the lines of, “That would be really bad. I don’t want them to have to spend time in court just to get the money that I want them to have,” then you should probably create the revocable trust now. Framed slightly differently, a revocable living trust is some work now, a little work for the rest of your life, and then it saves your heirs a ton of work. A will is a little work now, no work for the rest of your life, and then a ton of work for your heirs. If you don’t mind potentially leaving unpleasant work to your heirs, a will is the more efficient choice. However, if putting in some effort today to save future efforts by your heirs strikes you as a smart thing to do, a revocable living trust is the way to go. And remember, once you’ve made your revocable living trust, you aren’t done estate planning. You will need to adjust your plan as your life circumstances change. Eventually irrevocable trusts may make sense, and depending on your age and assets and goals, they may make sense immediately.