San Jose Estate Planning Attorney Blog

Avoiding Probate is often a key goal for clients in their estate planning.  This article will give you eight examples of property that passes directly to your beneficiaries without the need for probate.

1.   Property Passing Outright to the Surviving Spouse

California has a very simple probate procedure for property that passes outright to the surviving spouse.  The spouse may file a Spousal Property Petition with the probate court.  If no one objects, the court will generally grant the petition and the property will ordered to the surviving spouse.  We commonly do these for estates where the first spouse died without a Will or a Trust.  Under California law, under those circumstances, the surviving spouse would get all of the Community Property and a third to half of any Separate Property of the deceased spouse.  The Spousal Property Petition avoids the need for the lengthy and expensive probate process most client's dread needing.

2.   Estates of Less than $150,000 in Value

Small estates do not have to go through the full probate process.  A Section 13100 affidavit is given to the institution holding the property.  Upon receipt of the affidavit, the institution will turn over the asset the Personal Representative for distribution to the proper beneficiaries.  You cannot do a 13100 affidavit, however, if the estate consists of any real property, no matter the size of the estate.

3.   Assets in a Trust.

Generally, assets that are in a Trust do not pass through probate.  The Trust terms declare who is to receive the property when the Trustmaker's pass away.  The Trustee follows the terms of the Trust and distributes the property to the Trust beneficiaries.

4.   Life Insurance

If there is a valid beneficiary designation the life insurance will be distributed to the beneficiaries named on the designation.  The life insurance contract governs who the beneficiary will be, so there is no need to probate the life insurance policy.  However, if there is no named beneficiary of the policy, then the insurance company will usually require that the policy be included in the probate so they know who should get the death benefit of the policy.

5.   Retirement Plans and Annuities

In the same way that life insurance usually avoids probate, retirement plans like your 401(k), 403(b), etc. avoid probate if there is a valid beneficiary designation.  Avoiding probate of the retirement plans is especially important due to the negative income tax consequences of having the probate estate as the recipient of the plan proceeds.

6.   Bank and Brokerage Accounts

Most financial institutions offers the ability to use a beneficiary designation on the account.  This will cause the account to pass to the named beneficiary and avoid probating the account.  Sometimes these are called “Pay on Death” designations.  Other times, they may be called “Totten Trusts.”

7.   Buy-Sell Agreements

In a Buy-Sell Agreement, the owners of a business agree among themselves to purchase the ownership interest from any owner who passes away.  This allows the business to continue operating the way it has in the past without interference from the spouse or children of the deceased owner.  In exchange for purchasing the ownership interest, the surviving business owners pay the deceased owner's beneficiaries in cash or in kind.  These payments are made directly to the beneficiary and avoid probate.

7.   Property Held as Joint Tenancy

If you own property as Joint Tenants, title to the property will pass to the remaining joint tenants on the death of one of the joint tenants.  I would not advise using Joint Tenancy as your method for transfering property outside of probate without consulting a lawyer to work out the potential problems and unintended consequences that can occur.  Certainly, do not expect that if you name one of the children as the joint tenant that you are leaving the property to all of the children.  The property passes by law to the surviving joint tenants, not all of the brothers and sisters of that joint tenant.

One of the best strategies for clients with wealth is to find ways to maximize the value and economic efficiency of that weath in a way that benefits the family without increasing the tax impact on the client's estate.  An intrafamily loan is often an excellent strategy.

Loans to the children and grandchildren can be used to help the kids purchase a home, pay for living expenses, start a business, and many other things.  With short term interest rates less than .25% per year, even loaning funds for investment purposes can be an excellent freezing technique for the client's estate.

Here are 5 tips to avoiding traps when making an intrafamily loan.

1.   Always Have the Loan in Writing

The importance of making the loan in writing cannot be overstated.  How do you prove to the IRS what the terms of the loan were?  What if someone dies before repayment of the loan?  Who gets the future income and payments?  Will other family members be upset that one child got “free” money that they didn't get?  If you need to prove that the loan was a bona fide loan and not a gift (very important for tax purposes) you will need documentation to prove it.

2.   Take Advantage of the Annual Gift Tax Exclusion

Every year, a client can give $13,000 to as many different individuals as they wish.  If the client is married, the couple may give a combined $26,000 per year.  If there is a loan outstanding, the client could potentially forgive the annual exclusion amount of the loan each year until it is paid off.  This is often preferable to an outright gift that use up exemption and may create negative tax consequences.  However, be careful not to merely “loan” the money and then never expect repayment because of future forgiveness of the annual exclusion amounts.  This may impact whether or not you actually make a bona fide loan in the first place.  You will want to work with a qualified attorney to help avoid that pitfall.

3.   Show That You Intended to Collect the Loan

This follows from the comment above.  You must have every intention of collecting according to the terms of the loan.  I think it is important to have some repayment history on the loan. 

4.   What if the Loan is in Default

It is not appropriate to let a loan linger in default.  This goes towards whether or not you have a bona fide loan.  Some attempt at collecting should be made.  If the loan is secured, for example, against a house, you will need to consider whether or not foreclosure is appropriate.

5.   Charge Interest on the Loan

The Treasury Regulations require that interest be paid on the loan at the Applicable Federal Rate (AFR).  The AFR is divided into Short Term (up to 3 years), Mid-Term (3 to 9 years), and Long Term (over 9 years) interest rates.  In any intrafamily loan, you must charge at least the appropriate interest rate.  In most cases this interest is taxable income to the client and should be reported on their 1040 income tax return.  Even if the interest is not paid or is forgiven as a gift, the interest income is still reportable taxable income.

A power of appointment can be an effective estate planning technique, facilitating how your property may ultimately pass to your heirs.  There are two types of powers of appointment: general & limited. Both of these powers are the same with one exception:  The general power allows the power holder to appoint the property to themself, their estate, their creditors, or the creditors of their estate.  If you grant a general power of appointment, allowing the power holder to appoint to themself, the property will be included in the powerholder's estate for estate tax purposes.

Greatest Benefit of Creating a Power of Appointment

There is one great benefit to granting a power of appointment to the beneficiary of a trust you create:  Flexibility!!!

It is very difficult to know what the future will hold.  What are the needs and wants of the beneficiary in the future. Who is better able to manage the trust assets as they pass to third and fourth generations?  A Power of Appointment can create that flexibility to allow each beneficiary to make the best appropriate decision based on the information they have available rather than mandating a distribution scheme that may be inappropriate in the future.

Reasons to Choose a Limited Power of Appointment

Most of the time, the attorney will recommend a limited power of appointment. This will create flexibility in your estate plan by allowing the beneficiary of the trust to determine who gets the trust property next (after they die) without having to worry about estate tax inclusion.  This also allows you to preserve the generation skipping transfer tax exemption so all of the assets in that trust that are exempt will not be included in the beneficiary's estate, no matter how large they have grown into.

Reasons to Choose a General Power of Appointment

You should not create a general power of appointment without the recommendation of your attorney.  The power of the beneficiary to appoint the property to him or her self, their estate, their creditors or the creditors of his or her estate will cause the enitire trust amount to be included in the estate of the beneficiary for estate tax purposes.  The whole trust estate could also be subject to the payment of the claims from creditors of the beneficiary.  Finally, the beneficiary may be able to subvert the original intent of the trustmaker (or power grantor) by appointing the property to his or her estate and then leaving the property to someone else in their Will.