Avoid Estate Planning Mistakes That Can Cost Your Family Millions

September 2017
Personal Finances Estate Planning

With doctors’ incomes growing, and real estate and stock market values rising, doctors’ total wealth is growing rapidly, as discussed earlier in this issue. While that helps achieve a financially secure retirement, it increases your need for proper estate planning to avoid unnecessary taxes. Below are the most common estate planning mistakes doctors make, and how you can avoid them, to save your family millions of dollars in unnecessary federal and state death taxes. 

  1. No will – 30% of the doctors with whom we meet for tax and business planning have no wills or other estate planning documents in place. They’re convinced that if they don’t have a will, they won’t die. That’s a sucker’s bet, and one that often proves quite costly, says Blake W. Hassan, CPA, JD*, a tax attorney and CPA specializing in practice transition and estate planning matters.

    If you don’t have a will, your state of residence has one for you. Unfortunately, you may not like it. In many states, for doctors dying without a will (intestate) who leave a spouse and children, the spouse receives only one half of the assets with the remaining one half going to the children. Hassan says that most doctors want their spouse to benefit from 100% of their assets during their lifetime, with the children receiving the remaining property at the surviving spouse’s death. He notes that there’s an unlimited estate tax deduction for property left to a spouse; however, there’s a limit at both the federal and state level (for states that have a death tax) as to how much can be left to children before incurring an estate tax. Accordingly, if half the estate passes to the children, estate taxes would be due immediately that could have been deferred until the death of the surviving spouse.

    Furthermore, the court must appoint a guardian to hold the assets for the benefit of any minor children, with the children receiving the assets outright at age 18 or 21. Giving that much money to children at such a young age is a recipe for disaster, says Hassan. He’s seen more than his fair share of doctors’ inheritances wasted that way!

    While estate planning trusts may no longer be needed in order to minimize federal and state death taxes, they provide many other potential advantages, says Hassan. It’s critical that you establish a will and related trust to carry out your desires regarding the disposition of your assets, and provide protection of the funds for the benefit of your spouse and children by leaving them in trust to be distributed at a later age. 
  2. Naming incorrect retirement plan/IRA beneficiaries – Many doctors assume that retirement plan and IRA accounts will be distributed under the terms of their will. That’s not correct, says Hassan. Rather, these accounts must be distributed in accordance with the beneficiary designation on the account. Unfortunately, over 90% of doctors choose the wrong beneficiary designations, or fail to name a beneficiary at all, for their retirement plan and IRA accounts, he notes.

    Naming your estate as beneficiary will accelerate and can substantially increase the income taxes on the required distribution. Not a good idea, since amounts withdrawn from the account will be subject to income taxes upon withdrawal. Remember, the objective is to allow the account to grow tax deferred for as long as possible.

    As a general rule, it’s best to name your spouse as the primary beneficiary  in order to avoid death taxes on the account value in the doctor’s estate and reduce income taxes through allowing a longer distribution period (over the spouse’s life expectancy). Alternatively, you can set up a qualified terminable interest property (QTIP) trust for the benefit of the spouse and name it as the beneficiary, in order to maintain control over the disposition of the remaining proceeds at the death of the surviving spouse, while maintaining favorable income and estate tax treatment.

    Ordinarily, the children, or a trust established for their benefit, is named as contingent beneficiaries for these accounts, says Hassan. This is especially important for Roth IRA accounts, since there’s no income tax on distributions from the account and accordingly, all growth in the account will be tax free. Hassan recommends you make sure distributions to your children are made “per stirpes,” so that in the event your child predeceases you, any children of the deceased child will receive their share of the retirement plan and IRA assets.

    Doctors who are charitably inclined should consider naming a charitable organization as the contingent beneficiary of their retirement plan and taxable IRA accounts. This eliminates federal and state income and estate taxes on these proceeds for tremendous tax savings, while helping make sure that your children are not ruined by too much money!

    Finally, Hassan recommends that newly divorced doctors take immediate action to change the beneficiary designations under their retirement plan, IRA, and life insurance policies. Otherwise, despite a divorce, the benefits will pass directly to the named beneficiaries, including an ex-spouse, resulting in unnecessary taxes and excessive heartburn!
  3. Failing to shelter life insurance proceeds – Most doctors believe that life insurance proceeds are tax- free. While that’s true for income tax purposes, insurance proceeds are included in the doctor’s estate and subject to estate taxes if the doctor has any incidents of ownership over the insurance policy. Establishing an irrevocable life insurance trust as owner and beneficiary of your life insurance policy can avoid federal and state death taxes, maintain privacy, avoid probate costs on these funds, and protect them from the claims of creditors. While transferring an existing policy provides an estate tax exclusion following a three-year period, having the trust take out a new policy on you will result in an immediate exclusion and may also reduce premium costs.
  4. Failure to use lifetime gifts to reduce taxes – Doctors often pay millions of dollars in unnecessary estate taxes because they fail to take advantage of lifetime gifting opportunities, says Hassan. Each year, doctors can gift up to $14,000 per person without federal gift taxes. If the doctor is married, the spouse can join in through a “split gift election” to increase the tax-free gift amount to $28,000 per person, regardless of how the gifted assets are titled.

    Furthermore, the doctor and spouse can each transfer $5,490,000, or $10,980,000 combined, of assets down to the children tax-free. This transfer can be made during life, and is available at death to the extent not previously utilized. Making gifts now utilizing the annual exclusions, split gift election, and lifetime exemption can remove these assets and all future appreciation from your estate, reduce income taxes by shifting income to lower tax bracket children, and provide a measure of asset protection for the doctor. Finally, taking advantage of this opportunity through transferring assets into a family limited partnership (FLP) or family limited liability company (LLC) can also allow you to maintain control over the assets during your lifetime, by virtue of your capacity as a general partner/managing member.

    Finally, when you transfer assets into a family limited partnership in exchange for limited partnership units of equal value, and thereafter gift the limited partnership units to your children, you can take advantage of valuation discounts on the gifts of between 20-40%, due to their reduced marketability and minority ownership interest. Hassan says this can remove millions of dollars off the IRS radar screen, without gift or estate taxes! 
  5. Removing appreciated assets from estate prior to death – As a family member’s death approaches, most of the survivors want to transfer the property out of their name as quickly as possible, under the belief that fewer taxes will be owed. Unfortunately, these actions are usually counterproductive, says Hassan. Unless the total assets (net of all debt) exceeds $5,490,000, no federal estate taxes will be due. More importantly, assets received by gift have a carryover tax basis. This requires the donee of the gift to use the donor’s original cost basis for computing gain or loss on a future sale. Thus, if the doctor receives real estate worth $1,000,000 as a gift from his parent, for which the parent paid only $100,000, there will be a $900,000 capital gain at its later sale.

    Avoiding the gift and having the real estate included in the parent’s estate usually produces a much better tax result, says Hassan. That’s because assets included in the parent’s estate receive a “stepped up basis” to its true fair market value at date of death. Thus, if the doctor inherits the same piece of real estate worth $1,000,000, its basis is now stepped up to $1,000,000, and there will be no gain on its sale at that price. Assuming a combined 20% federal and state tax rate on the capital gain, the doctor saves $180,000 in income taxes by avoiding the gift and including the real estate in the parent’s estate. 
  6. Reporting estate assets at lowest possible value – Similarly, well-intentioned family members often place the lowest possible value on the assets that are included in the family member’s estate at date of death. While the true value of stocks, bonds, IRAs and retirement plans are usually easily determinable, that’s not the case for the value of real estate, professional practices, and other closely held business interests.

    In most cases, the family is best served by including the assets in the parent’s estate at the highest (rather than lowest) reasonable value, says Hassan, provided that this does not push the estate above the tax-free exemption amount (currently $5,490,000). Through doing so, the assets receive a stepped-up basis equal to their fair market value at date of death, eliminating any capital gain if sold at that price in the future.

    Hassan recalls one doctor who placed his office building in his father’s name to provide rental income for his retirement years. His father later died, leaving little in assets besides the office building which was included in his estate at an extremely low value ($300,000). Less than three years later, the doctor sold the office building for $600,000 and moved to a new location.

    Hassan ordered a real estate appraisal of the office building done as of the date of death. Based upon comparable sales at that time, it was determined that the true value of the office building was actually $600,000, not $300,000, at date of death. The estate tax return was amended, with the result that the $300,000 capital gain disappeared, eliminating $60,000 in federal and state income taxes to the doctor.
  7. Not filing an estate tax return – Hassan says that many doctors assume that if their estate is not over the $5,490,000 exemption amount, there’s no need to file a federal estate tax return since technically no return is required and no taxes are due. That’s not the case, says Hassan. In order for the surviving spouse to use their deceased spouse’s unused exemption amount, an estate tax return must be filed, and a portability election made, when the first spouse dies. Otherwise, the deceased spouse’s unused exemption amount will be lost, which can cause your family to pay up to $2,196,000 in unnecessary estate taxes.

* Blake Hassan is a tax attorney and CPA with McGill and Hassan, P.A., a law firm that specializes in providing legal services, such as practice transition and estate planning services, to dental professionals. For more information, call 704.424.5450.

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