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Avoiding Probate
How
to avoid probate.
Certain property owned
by the deceased may avoid probate either inadvertently or through
advance planning. In some cases a deceased may have arranged his
affairs by using a living trust in an attempt to entirely avoid
probate. Sometimes this type of planning is effective, but sometimes
there must be probate proceedings even when a living trust is created.
This article describes the pros and cons of avoiding probate. It also
describes a number of will substitutes - including putting property in
joint names - that are frequently used to avoid probate. Finally, the
article details the use of living trusts.
WHY PEOPLE TRY TO AVOID
PROBATE
Probate is about as
popular as a root canal job. Even people who really know nothing about
the process have a very negative image of it. Most adults have heard
horror stories of endless court proceedings and large legal fees
depleting the estate left to a poor widow. And in fact, probate
procedures are often time-consuming and expensive.
High Probate Fees
Legal Fees.
Legal fees to probate an
estate can significantly diminish the amount received by
beneficiaries.
The more time the
attorney spends helping the executor, the higher the legal bills will
be. The states have varying rules concerning attorney fees for
handling probate matters. Some states have adopted a percentage
system, whereby the attorney is paid a flat fee based on the value of
the estate. The percentage paid to the attorney decreases as the value
of the estate increases. In other states the attorney gets a
"reasonable fee" based on the number of hours worked and the
difficulty of the work.
Ancillary
Administration. If an individual owns real estate in a state other
than his residence, there will have to be additional ancillary
administration in the state where the real estate is located. If
property is owned in a number of states, there may have to be several
such proceedings. Ancillary administration adds substantial costs to
the probate bill, largely due to increases in legal fees.
Other Professional
Expenses. Legal fees and the executor's fee aren't the only
expenses of probate. Property must be valued for the court, so
appraisers often have to be hired. Tax returns must be filed for both
the deceased and the estate, so accountants must be hired. If the
decedent died owning over $600,000 of property, death taxes will be
due. This type of tax work can be expensive, especially if the estate
is audited by the IRS. In general, the larger the probate estate, the
greater the costs and the longer the delays.
EXAMPLE Assume
both Mr. Jones and Mr. Smith die owning $1 million of property in a
state that calculates both legal fees and executor fees based on the
value of the estate. Assume that the combined fee percentage is 8
percent of the estate's assets. Assume that all of Mr. Jones's estate
will pass through probate, but $400,000 of Smith's real estate will
pass outside probate. The fees on Jones's property will be $80,000 ($1
million X 8%) while the fees on Smith's will be only $48,000 ($600,000
X 8%). The $32,000 fee reduction is directly attributable to the fact
that Smith arranged to keep the property out of the probate estate.
Instead of going to the lawyers and executor, the $32,000 will go to
the heirs.
OBSERVATION An
executor may not view a reduction in the executor's fee as an
advantage. Most executors put in a lot of hard work and earn their
fees.
PLANNING TIP
If the surviving spouse is serving as executor and is to receive the
bulk of the estate, it makes sense for him to serve without receiving
a fee. If the funds are received as a fee, the amount must be declared
as income on the individuals Form 1040 and taxes must be paid on it.
If the surviving spouse receives the funds as an heir, however, the
amount is received tax-free. On the other hand, an executor's fee is
deductible in computing any federal estate tax. If the estate tax rate
is higher than the surviving spouse's marginal income tax rate, it may
be preferable to take the fee. Executors should check with their tax
advisor before making this decision. The decision generally doesn't
have to be made until the estate is being closed.
Delay
In addition to the
complaints about high fees, heirs frequently complain about delays in
probate. In most states, it is difficult to close any estate in less
than six months, and twelve months is more common for even
uncomplicated estates.
Lawsuits.
Occasionally estates and executors get involved in lawsuits. Someone
may sue the estate over unresolved business dealings that he had with
the deceased before death. The executor may have to finish up a
lawsuit filed by the deceased or may have to file a lawsuit to recover
property owned by the decedent but held by others. Whatever the case,
civil lawsuits move slowly and will invariably slow down the probate
process.
Will Contests.
The cost and delay of probate will expand greatly if a will is
contested by a disappointed heir. A will contest usually tries to set
aside a will in favor of an earlier will.
ASSETS PASSING OUTSIDE
PROBATE
Finally, you should keep
in mind that even when there is a probate procedure with an executor,
some assets avoid probate by passing outside the estate, namely,
property held in joint names, such as joint bank accounts; real
property held in joint names; and property held in inter vivos,
or living trusts. Such will substitutes will be discussed in more
detail below.
USING WILL SUBSTITUTES
With advance planning,
probate may be avoided altogether. In other cases this type of
planning can at least reduce the cost and duration of the probate
procedure.
Advantages of Will
Substitutes
A will substitute
is any transfer of property that occurs outside the state probate
process - the property's title is transferred without falling into the
probate estate. There are three primary advantages to this technique:
-
the transfer of
title will be immediate upon the death of the decedent;
-
the transfer will go
unpublicized; and
-
will substitutes
reduce probate fees.
Prompt Transfer of
Title. Using will substitutes insures that the transfer of title
will be immediate upon the death of the decedent. Transfers from
probate estates take many months and even years in extreme cases -
justifiable cause for complaints by heirs. When will substitutes are
used, title vests promptly and delay is avoided.
No Publicity.
Another advantage to using will substitutes is that the transfer is a
private transaction rather than a matter of public record. Because the
transfer is not made in the will, it will be difficult and, in some
cases, impossible for uninvolved parties to learn the details of the
transfer. If the deceased was well-known, the press may be interested
in publicizing the contents of the will. The family may wish to keep
potentially embarrassing bequests private. Even when there are no
embarrassing facts, privacy is often desirable. Many individuals wish
to keep their wealth a private matter.
Smaller Estates
If a person's estate is
expected to be relatively small, it may be efficient to dispose of
most of the decedent's property through the will substitute technique.
In some states, the costs associated with probating an estate will be
so high for even small estates that it is far more efficient to leave
most of the property in will substitutes.
Joint Ownership
Joint ownership of
property is a common form of will substitute, which allows one
co-owner to leave property to the other. The property will
automatically be owned by the co-owner on death, and so never pass
through the probate estate. Spouses may jointly own homes and other
property, and on the death of the first spouse, ownership of the
property passes entirely to the other. Joint ownership is probably the
most common type of will substitute.
Types of
Co-ownership. There is more than one way to take co-ownership of
property. Property ownership is a matter of state law. Nine states -
Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,
Washington, and Wisconsin - use the community property system which
creates a special type of co-interest between spouses. The other
states are known as common law states. These states generally do not
focus on marital status in establishing co-ownership.
There are actually five
common types of co-ownership:
-
joint tenancy
-
tenancy in common
-
tenancy by the
entireties
-
community property
-
marital property
Joint Tenancy and
Tenancy in Common. There is a legal distinction between joint
tenancy and tenancy in common. During life they are quite similar,
though not identical. On the death of a co-owner, the difference is
quite extreme. Both joint tenancy and tenancy in common are forms of
"concurrent" co-ownership. Two or more individuals may own
property in the same or different percentages.
Survivorship Issues.
A joint tenancy is usually defined as "Joint tenancy with right
of survivorship." This means that when one of the joint tenants
dies, the deceased's interest passes automatically to the surviving
tenants.
EXAMPLE Three
brothers each own a one-third interest in a parcel of land as joint
tenants with right of survivorship. If one brother dies, his interest
will pass to the other brothers. The two surviving brothers will then
each own a one-half interest in the parcel. This would be true even if
the deceased's will read: "I leave all of my property to my
wife." The deceased's interest in the land ceased on his death
and his wife will not have an interest in the parcel.
A tenancy in common is a
form of ownership in which each owner has an undivided interest in the
property. If co-owners take title as tenants in common the result is
different than if they are joint tenants with right of survivorship. A
tenancy in common can be sold, gifted, willed, or passed through the
laws of intestacy.
EXAMPLE Suppose
the same three brothers in the prior example own the same parcel of
land, but as tenants in common. The deceased brother's interest would
pass to his surviving spouse under the terms of his will. The two
surviving brothers would continue to own a one-third interest, as
would the surviving spouse. The result would probably be the same if
the deceased brother died without a will and had no children.
Creation of the Legal
Interest. If a party really wants to create a joint tenancy, title
must be taken as joint owners with right of survivorship rather than
as tenants in common. The legal designation on the title or deed, not
the intent of the deceased, will control. Although joint tenants seem
to have survivorship rights in one another's property, a joint tenant
can "sever" the joint tenancy and create a tenancy in
common.
EXAMPLE Three
brothers take title to a parcel of land as joint tenants with right of
survivorship. When one brother learns that his wife will not receive
his interest at death, he severs the joint tenancy and becomes a
tenant in common. He then will be able to leave the property to his
wife - or anyone else - in his will.
Tenancy by the
Entireties. A few states still recognize tenancy by the entirety.
This form of ownership can only exist between a married couple, and
ceases on the death of one spouse or divorce. The legal implications
are essentially identical to joint ownership with right of
survivorship, except that the tenancy cannot be converted to a tenancy
in common unless the marriage is dissolved or both spouses consent to
the conversion. This type of tenancy prevents one spouse from selling
- and sometimes mortgaging - marital property without the other
spouse's consent.
Community Property.
Nine states have community property systems. Although the details of
the state systems differ in some respects, the general scheme is
similar. Community property only relates to married couples. In a
community property state, the spouses typically own property that is
community property and also property that each spouse owns
individually. Each spouse has a one-half undivided interest in each
item of community property. At death, a spouse can dispose of all his
separate property, but only his one-half interest in the community
property. In some states a spouse cannot make a lifetime gift of
community property without the other spouse's consent.
PLANNING TIP A
competent local attorney should accurately classify each item of
property as community property or separate property. An agreement
between the spouses is recommended when classification is in doubt.
Marital Property.
Although there are some state-by-state variations, all nine community
property states use the same basic scheme to determine if a surviving
spouse has a legal interest in property acquired during marriage. The
situation is far more complicated in the other states. In some
noncommuntiy property states, legal title controls. In others, there
is still a presumption that property acquired during marriage belongs
solely to the husband. In still other states, a surviving spouse will
have legal rights only in property that is owned by the spouses in
joint tenancy with right of survivorship. Other states, however,
recognize the concept of marital property, which gives the surviving
spouse some rights in property acquired during marriage, recognizing
that couples frequently don't give much thought to the legal
implications of putting names on deeds and car titles.
Other Commonly Held
Types of Property
Spouses and other family
members commonly hold property in joint names, such as joint bank
accounts with right of survivorship, bank account trusts, and U.S.
savings bonds. There is no legal limitation on who may be a co-owner.
Additionally, an individual may make a gift of a fractional interest
in property. For example, a person could give someone a 20 percent
interest in a piece of real estate, which would then become theirs on
death.
WARNING
Individuals should always get legal advice before placing property in
joint ownership. State laws distinguish between tenancy in the
entireties, tenancy in common, and joint tenancy with right of
survivorship. The disposition of the property at the time of death
depends on the technical designation of the co-ownership.
Unfortunately, property is often titled without legal advice and
property owners do not understand the implications for their heirs. If
joint tenancy has been arranged, executors should anticipate that they
may face some unpleasant moments with disappointed heirs.
Disadvantages of
Joint Ownership
Creating joint interests
in property is not always advisable, even between spouses. Property
can be lost if one spouse files for bankruptcy - or worse, for
divorce. The law of property varies state by state and can be tricky.
Although beneficiary designations can be handled by laypersons,
retitling property in joint names should only be done with the advice
of an attorney.
Future Interests
Besides concurrent joint
ownership, it is possible to give away so-called future interests
in property either currently or in a will. A person who has a future
interest has an ownership interest in property but with delayed
possession. For example, Grey might want his son to have his farm
after his death, but Grey wishes to live on the property for the
remainder of his life. Grey could retain a life estate in the property
and give his son a remainder interest. Both Grey and his son would be
owners but only Grey would have current possession. Grey would have
the right to use the property for his life, but it would automatically
become his son's property on Grey's death. This type of ownership is
also an effective will substitute and can avoid probate.
There are a number of
different future interests that can be tailored to meet particular
needs. As with other types of ownership, there may be federal estate
tax implications even though the property passes outside the probate
estate for state law purposes.
Transferring a joint
interest in property may create a taxable gift. This sort of tax
determination should be undertaken by an attorney. Similarly, although
jointly held property may pass outside the state probate estate, it
may be included in the taxable estate for federal estate tax purposes.
This sort of tax determination should be undertaken by an experienced
estate planner.
OTHER WILL SUBSTITUTES
Although joint ownership
of property is the most common type of will substitute it is not the
only one. An executor is likely to encounter one or more of these when
probating an estate. Other types of will substitutes include:
Another type of will
substitute is the living trust, which holds all of an individual's
property. Living trusts have become increasingly popular because they
avoid the delay and expense of probate. These will be discussed later
in the article.
All of these will
substitutes have a beneficiary designation. When the owner dies, title
to the property automatically vests in the beneficiary without going
through probate. Because in many states both the executor's fee and
fees for attorneys are based on the value of the property in the
estate, the use of such will substitutes can effectively reduce
probate fees.
LIVING TRUSTS
OBSERVATION Technically,
any trust that is established during a grantor's life is called an
inter vivos or living trust. However, in popular usage, living trust
frequently refers to an inter vivos trust intended to work as a will
substitute. The trust is used in place of a will with the intent of
avoiding probate.
Generally, a living
trust operates as a will substitute. Instead of using a will to
distribute property at death, an individual will transfer legal title
to his property to the living trust during his life. The grantor of a
living trust gives control over the trust property to a trustee. The
trust is therefore operative during the grantor's life. Eventually,
when he dies, the trustee who administers the trust will distribute
the property to those parties that the deceased designated.
Although such trusts may
be irrevocable, trusts used as will substitutes are typically set up
as revocable trusts so that may be easily changed or canceled.
Living trusts have
become increasingly popular because they avoid the delay and expense
of probate. However in some states, because probate costs are not as
high as generally perceived, a living trust may provide little in the
way of savings.
The biggest advantage of
a living trust is the avoidance of state probate fees and delay.
Because the legal title to the property has been transferred to the
trust, the property will pass outside probate. Accordingly, there will
be little delay in distributing the assets, and probate fees will
largely be eliminated.
Disadvantages of
Living Trusts
There are some
disadvantages to living trusts that are not always noted. First, there
are set-up costs and trustee's fees. In some states where probate fees
are relatively low, the costs associated with the trust will be about
the same as those that would arise in the probate of a will, assuming
that the person's affairs are in good order.
Selecting a Trustee
Additionally, a person
must select a trustee who will be absolutely honest. The person
establishing the trust is free to select either an individual or an
institution, such as a trust company or a bank, to serve as trustee.
Although a trustee has a fiduciary duty to protect the trust assets,
individuals have on occasion stolen trust assets. The grantor of the
trust should monitor the trustee's activities with some degree of
diligence.
Because the trustee of
the living trust will be working closely with the family and other
heirs during their bereavement, the trustee's personal qualities are
important. If possible, the person establishing the trust should take
the time to introduce his heirs to the trustee and make sure that they
understand how the trust will work after his death.
Deciding Between a
Will and a Living Trust
Setting up a living
trust is not terribly complicated and, in fact, the terms of most
living trusts closely parallel the provisions in a typical will.
Attorneys who prepare wills also typically prepare living trusts for
clients at their request.
The fee for establishing
a trust will typically be higher than for preparing a will, and
additional costs will be incurred related to transferring legal title
to the assets. However, because the trust will be outside probate, the
fees after death should be minimal.
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