Naming heirs

One of the most crucial steps in estate planning is to name the heirs (typically children and other blood or though marriage related individuals, although not exclusively) and specify how the money and property are to be divvied up among them.

If your client dies intestate (without a will or other governing document that names the heirs and beneficiaries to the estate), then the state’s inheritance laws kick in, which may result in the last people your client wanted to benefit from his estate being the first considered as rightful heirs. And, if the government can’t find anyone who has legitimate claim to the estate, then the government gets to keep the assets. I’ve yet to meet a client who would be happy about either of those possible eventualities.

Naming the heirs and figuring out how to divvy up the estate among them can range from simple to complex. For example, if a husband and wife have a couple of adult children together who are successful, independent professionals and are amicable to one another, setting up their estate may be a simple matter of stating that if either the husband or wife dies, the other is named to the estate, and if they both die, the estate is split 50/50 between the two children.

Naming heirs can become more complicated in various situations; for example, when a client has many different family members across multiple marriages — children, grandchildren, ex-spouses, and so on. Another common example is a client who owns a business that none of the children wants or is qualified to take over, or when two or more want control of the business.

Complications also arise when distributions are or are perceived to be unfair by one or more heirs; for example, when one heir is a professional, earns a good living, and stays in close contact with mom and dad, while the other has been in and out of rehab a few times, drops off the map for months on end, and generally disrupts the family peace. Disinheriting the troublesome offspring may be a no-brainer for some clients, but most parents feel obligated to leave something to every child.

Many times those who’ve been a pain-in-the-posterior during the parents’ life prove to be just that into and after their parents’ death. They’ll hire attorneys to sue the estate for more than their fair share, costing money and suffering to all survivors.

Encourage your clients to be proactive in thwarting such strife by being extremely specific in their estate planning documents. For example, your client can stipulate in the family’s trust that the problem child will be entitled to ongoing funds, at certain intervals, as long as he doesn’t challenge the estate in court. (Most reputable attorneys would advise the problem child to take the funds as provided and back off from filing additional claims unless some new material factor becomes evident.)

Such an arrangement wouldn’t resolve the family dysfunction, but it would budget for ongoing support and relieve the more stable heir from having to waste precious time, money, and sanity trying to resolve inheritance issues in court in an effort that ultimately drives the siblings even further apart.

Sibling rivalry isn’t the only case in which being proactive helps. Another example is an ex-husband who raised the children and never remarried. Accommodating for his needs in the estate planning documentation can reduce the possibility of having him fighting with his own children over her estate.

The bottom line is that too many households lose tons of money in attorney’s fees fighting over what ends up being peanuts after the attorney’s fees are deducted.

When naming heirs, make sure your clients factor in their own feelings, as well as those who will be affected by the news. Clients may even hire a family psychologist to provide guidance with the goal of removing their own pain and biases toward heirs or perhaps even come to understand the role they themselves may have played in the family dysfunction. Your clients should also protect their own future interests to ensure that they’re properly cared for in the event they can’t care for and make decisions for themselves.

Naming beneficiaries

Naming beneficiaries (any blood/family related and/or nonrelated individuals, also can include charitable organizations) can be as simple as submitting an updated beneficiary form to the manager of any retirement accounts. Many brokers enable customers to update their named beneficiaries online.

Be sure your client updates the named beneficiaries for all accounts, including all IRS tax-qualified accounts (401K plans, IRAs, SEP IRAs, and so on) and any and all annuity contracts such as fixed, variable, and income. In addition, be sure to review that the heirs named in the estate planning documentation are the same as those named as beneficiaries of those retirement accounts. A named beneficiary who’s not referenced in the estate planning documents can spur on a fresh battle when the time comes to settle the estate. A client’s trust and will should leave no room for confusion for heirs and beneficiaries, which may include special gifts to beneficiaries through designations made on qualified accounts. This is perfectly legitimate but just requires extra attention.

Planning for business succession or continuity

If you’re pursuing small-business owners as clients, great idea! Financial advice tailored to the closely held small business owner (and family) is sadly lacking, especially in the areas of business succession and continuity. Small-business owners are often too busy running the business and raising a family to think about what will happen to the business when they’re no longer able or willing to run it. Or they ignore the uncomfortable inevitabilities. I’ve had clients tell me boldly, “I’ll be dead. What do I care what happens to the business?”

This kind of defensive, reflexive response is pretty common but wholly wrong, and you must leap into the trenches on this one. Clients must understand the great peril that befalls a family or closely held business, especially if other business partners outside the nuclear family are involved. Other business partners will jump at the chance to take advantage of another partner’s lack of planning.

Here are a couple ways you can help your small-business clients:

• If the business is a partnership, advise your client to install a fully funded cross-purchase, buy-sell agreement for all partners. With this arrangement, all business owners agree to buy the business interests of any owner who dies or becomes disabled. To ensure funding is available to buy out the departing owner’s interest, the business owners obtain life and disability buy-out insurance on the other owners. In the case of an owner’s death, funds are paid to the deceased owner’s family in exchange for its interest in the business.

  The agreement should require that the owners revalue the business annually (or hire an objective third-party appraiser to do so), so if a trigger event occurs, valuation isn’t decided solely by the remaining owners.

• Advise clients to include in their cross-purchase agreement plans for buying out owners if other trigger events occur, such as retirement, divorce, personal bankruptcy, or the firing of one of the owners.
• Ask your clients what they plan to do when they retire. Who will run the business? Who’s the backup manager? What’s the plan B? Often, the owner has someone in mind but hasn’t put it in writing. Sometimes the owner hasn’t even told the person he has in mind and doesn’t know if that person would be interested. The exit strategy needs to be formalized, captured in writing, and communicated to everyone that the plan may ultimately impact.

Keep in mind that unless you’re an attorney, you’re not the one formalizing the agreements. As financial advisor, you get the ball rolling and perhaps recommend a lawyer and certain insurance policies.

Get comfortable asking the uncomfortable questions. Ensuring that a business continues to operate after one (perhaps the only) owner withdraws or departs, is a major impact area for financial advisors. Unfortunately, too few financial advisors make this issue a priority and fear being out of their depth or upsetting their clients by calling attention to unsettling prospects. Getting comfortable with the uncomfortable is a great way to differentiate yourself from competing financial advisors.

Accounting for estate taxes

If you have any clients with a net worth more than $11.2 million (or $22.4 million for a married couple), their estate may be subject to a 40 percent federal estate tax at the time of their death. For a married couple’s estate valued at $12 million, the federal estate tax would be $4,800,000! In addition, the estate may also have to pay a state estate or inheritance tax.

To protect the estate from a tax hit of this magnitude or greater, strongly encourage your clients to take out a life insurance policy that covers a significant portion of the total estate and inheritance tax bill. When your client dies, the life insurance policy will pay a big tax-free death benefit to the heirs at the same time the IRS comes to collect the taxes, and they only accept cash.

Don’t forget to plan for any estate or inheritance taxes levied by the states. As of this writing, 15 states and the District of Columbia have an estate tax, and six states have an inheritance tax. In Washington state, the estate tax can be as high as 20 percent. In addition, the net worth threshold that’s subject to estate or inheritance tax is much lower than at the federal level. For example, in Oregon, a net worth of anything more than $1 million is subject to estate tax.

The federal estate tax is political football that’s kicked back and forth with the regularity of changes in the White House administration. Given the extreme indebtedness of the U.S. government, the federal estate tax is likely to return with a vengeance in the not too distant future — a higher percentage and a lower net worth threshold. Considering a future congressional need to balance the federal budget, a return to the early 2000s when the exclusion amount was $1 million and the tax rate was 55 percent is likely.

Federal and state governments write the rules and can change them at any time, so keep abreast of both federal and state estate and inheritance tax legislation. More importantly, you and your clients need to think ahead and perhaps even plan for the worst. After all, as your clients age, their life insurance premiums increase dramatically. If a client with a high net worth has a life expectancy of more than 20 years, he is likely to see the return of something like the federal estate tax of the early 2000s. He would probably benefit by locking into a suitable permanent life insurance policy now with much lower premiums than if he were to wait.

Managing estate liquidity (or lack thereof)

Estates heavily invested in real estate or business interests aren’t very liquid because such assets aren’t easily divested. A need to sell these assets quickly results in what’s called a fire sale, in which buyers can purchase assets for pennies on the dollar. One of your jobs is to ensure that heirs aren’t forced to liquidate in a hurry or into a deeply discounted buyer’s market. This challenge is made more difficult by any of the following circumstances:

• The number of heirs is large and their interests and needs diverse.
• Market conditions are unfavorable for the sale of the assets.
• The disposal demands of the trust require or drive the need to sell assets quickly.
• No funding is in place to cover estate or inheritance taxes, resulting in a need to sell assets to pay the taxes due. (Even a relatively small tax bill can cause a liquidity crisis.)
• Heirs who have no desire, interest, ability, or inclination to own the assets (for example, if the asset is a business) or who need or want their inheritance quickly.

Here are a few ways you can help your clients’ heirs avert a liquidity crisis:

• Strongly encourage your clients to buy enough life insurance to cover any and all estate and inheritance taxes along with any costs related to the estate settlement.
• Discuss these liquidity issues with your clients and work together to address the issues proactively. You and your clients may even want to work toward making their estate more liquid as they advance in age.
• Upon the death of your client, meet with the heirs to discuss their needs and expectations and to explain to them what they stand to lose if they need to liquidate assets in a hurry.

Considering capital market conditions at time of death

When auditing client portfolios, beware of highly concentrated holdings (assets that represent more than 25 percent of an estate’s value) and bring them to your clients’ attention. An example of a concentrated holding is a large position in a publicly traded company; maybe the matriarch worked there for 40 years and never sold those vested shares. Another example would be a commercial office building in the middle of downtown Detroit just before the 2008–09 recession.

Concentrated holdings can make for a colossal headache when the time comes to settle an estate. If the market crashes prior to, during, or shortly after the estate settlement, heirs may be stuck holding the bag with little or nothing in it, especially if they need to sell in a hurry. This is what’s known as a “bad heir day” — when an expected inheritance is wiped out due to an unanticipated market condition or event. As you may expect, heirs won’t be happy. Even worse, if you were the financial advisor who had advised your clients on such investments, you could find yourself on the receiving end of a liability claim.

The moral of this story is to work toward minimizing a client’s exposure to risk by diversifying his holdings. See Chapter 7 for details.

Handling differences over a closely held business

Family businesses are notorious for breeding bad feelings among family members, and this continues and often intensifies when the last surviving head of the family dies or is no longer in a position to call the shots. Two or more heirs may fight over control of the business. Others may want their fair share, so they can do their own things. One sibling may be deemed heir apparent in the future management of the business and feel disadvantaged as the one who has to shoulder the responsibility, while a sibling gets to play artist at the local art school (always seems to be the case). With such disparity of interests, how can an estate plan be fair to both heirs?

Ultimately, the family must resolve such issues, but as financial advisor to the head(s) of the family, you can help navigate this minefield by engaging your clients in a discussion of the issues and possibilities. Here are a couple options:

• Your client, the head of the family, figures out a way to inspire and arrange for the heirs to work together in harmony, each contributing in his own unique way to the business’s success and reaping the rewards. Unfortunately, this scenario is highly unlikely. Heirs display their level of interest early on, and disinterested siblings rarely become happy, active participants in the business after the parents pass away.
• Heirs who are actively engaged in the business inherit the business, and other assets are used to provide for heirs who have little or no interest in the business. Family businesses are managed best by engaged family members who reap the fruits of their labor. Forcing them to share the success of the business with less or nonengaged family members removes some of the performance incentive and often leads to bitter divisions, so leaving the business to the heir most interested and able to manage it is usually best.

If clients express a desire to name two or more heirs as co-CEOs, encourage them to carefully reconsider. Having two CEOs usually leads to further complications down the road. Suggest that one heir own and manage the business while the others who want to participate in the business agree to do so in a different capacity with compensation and equity that align with their respective positions. For example, one heir may be skilled in management and operations, while another is geared more toward marketing and sales. The head(s) of family should encourage each heir to develop those strengths and then should track their contributions to ownership, remuneration, and recognition.

This is another area where a large life insurance policy can do wonders. The benefits from the policy can be used to equalize inheritance on day one of the settlement, while the estate provides for fair equity ownership and/or awards for heirs who want to participate in the business moving forward.

Fair doesn’t necessarily mean equal or the same. Defer to your client, the head of the family, who is currently running the business. He is best able to articulate his desire for business succession and continuity, while ensuring that all his children are adequately and fairly provided for.

Anticipating a struggle for control

Detailed instructions in your client’s settlement documents remove much of the ambiguity that often stirs conflict among heirs, but clients should still anticipate some struggle for control when the time comes to settle the estate. I’ve found that heirs don’t really know how they feel about their inheritance until a dramatic event stirs their thoughts, such as Mom being rushed to the hospital for chest pains and later learning that she just had a bad case of indigestion. The incident triggers thoughts and concerns that linger long afterward but can mark a good starting point for discussions.

To identify sources of potential future conflicts over the estate, engage your clients in a discussion about the heirs of their estate. Be inquisitive regarding their children’s demeanors and behaviors. Ask questions that reveal hidden sentiment or avoidance, such as:

• Do your children take vacations together? Vacationing together is a good sign that heirs will be less likely to fight over the distribution of assets.
• Do they see each other away from family holiday gatherings? Again, if siblings spend quality time together, they’re less likely to quibble.
• Is one child more involved in caring for or managing the finances of the parent(s) as they age? A child who provides more care may expect more from the settlement.

These are just a few questions that could help you identify a future possible challenge in the transition of a business or other family assets.

A family counselor may be able to alleviate some of the discord resulting from family dysfunction. Although families are likely to take issue with an outsider’s suggestion that they need family therapy, if you help them understand the potential waste of time, energy, and money due to family in-fighting, they may heed your advice.

Checking out donor-advised funds

Years ago, people had to be extremely wealthy to develop, implement, and manage a charitable strategy. Today, donor-advised funds (DAFs) serve as a turn-key solution to creating and managing charitable-giving programs.

DAFs allow donors to make tax-deductible charitable contributions over the course of a given tax year to receive an immediate tax benefit. The donors can then award grants from the fund to IRS-designated charitable organizations whenever they so desire.

Your clients can establish and contribute to a DAF over the course of their lives or even set up a contribution as part of the estate settlement. The DAF can then be passed to one or more heirs of the estate to manage.

Considering private family foundations

If family members want to play a more active role, the family may want to consider setting up a private family foundation (PFF) — a charitable foundation established, funded, and run by family members. In addition to providing tax benefits, the PFF can hire (and pay) family members to run it. PFFs can be paired with DAFs to maximize the tax benefits.

If you have clients who express an interest in starting a PFF, check out the Foundation Source (www.foundationsource.com) for information and resources to facilitate the creation of a PFF for your clients.

Brushing up on CRTs and CLTs

To formalize giving as part of the estate settlement, clients can set up charitable trusts, which serve the following three purposes:

• Enable the client to give money to charitable organizations.
• Reduce income, estate, or gift taxes.
• Provide a limited monetary benefit to the client or to heirs of the estate.

In this section, I introduce two common charitable trusts you may want to present to your clients.

Enlist the assistance of a qualified lawyer to set up any charitable trust.