Frustration often fills the chasm between theory and practice. That phenomenon is evident in a number of different estate planning contexts, both during an individual’s (or a couple’s) lifetime and when it comes time to administer a decedent’s estate.
What follows are examples of four complications that can arise for heirs if they were overlooked during the estate planning process.
POD or ITF Accounts
Some of these problems arise because of a lack of awareness of how many financial institutions interpret the law with respect to their clients’ accounts. One notable example involves the Catch-22 that defeats the likely intent of owners of payable on death (POD), or what are sometimes referred to as in trust for (ITF), accounts.
Under New York law (specifically, Estates, Powers & Trusts Law (EPTL) §7-5.2 (4)), funds in a bank deposit account are payable to the beneficiary of an ITF account on the death of the account owner – as long as the depositor’s will contains no provision revoking the trust. New York considers ITF or POD accounts to be, in effect, revocable trusts and thus terminable by a will (and, for that matter, at will).
Consequently, while most practitioners believe that assets in a POD/ITF account pass without requiring probate of the account owner’s will, in practice what happens is that, in accordance with EPTL §7-5.2, some financial firms will not release the funds in a POD/ITF account until the owner’s will has been admitted to probate. The probate process of course almost always confirms that the POD/ITF designation has not been revoked.
Moreover, that policy is generally applied almost universally by some financial firms, meaning that many accounts established by non-New York residents with non-New York beneficiaries would still, in effect, be subject to New York rules.
Seemingly mystifyingly — for those unaware of the history of ITF accounts, which have their origin in a 1904 New York court case (In re Totten) that involved deposit accounts — this rule applies to deposit accounts only. Financial institutions holding assets in a brokerage account that name a beneficiary — sometimes referred to as a Transfer on Death (TOD) account — are not subject to the law that governs deposit accounts.
The lesson here is that advisors should check in advance with the firms their clients do business with to be sure that, if POD or ITF (or TOD, for that matter) accounts — or any other accounts that have a designated beneficiary — are created, the beneficiaries of those accounts would have assets available to them in the manner in which they expect them to be, i.e., outside of probate.
With respect to transfers that occur during lifetime, couples who have moved from one of the 39 separate property states (the District of Columbia is also a separate property jurisdiction) to one of the 11 community property states often do not appreciate the importance of transmuting before transferring property to a trust, especially one that names the spouse as a beneficiary.
Consider this example. A couple moves to a community property state. The husband gives earnings to an irrevocable trust that owns a life insurance policy. The trustee then uses the amount contributed to pay insurance premiums. The beneficiaries on the death of the husband include the wife. The result? The estate tax-effectiveness of the trust has been largely if not completely undermined.
That’s because the wife will (or at least should) be deemed to have gifted 50% (say, depending on the specific facts) of the earnings to the trust. The wife will be treated as the grantor and a beneficiary of 50% of the trust, with the unpleasant and unexpected income- and estate-tax consequences one might expect.
The solution, of course, is transmutation. In this example, the husband should first have a transmutation agreement that stipulates the earnings are being transferred to an account specifically identified as a separate property account. (Simply moving the assets to an account in one spouse’s name won’t cut it.) The transfer should be made from the new account to the insurance trust.
In other contexts, professional advisors recommend strategies that build in a waiting period before transferring assets from a husband to wife, and then from a wife to a trust, so that these steps won’t be viewed legally as one integrated transaction, with potentially deleterious tax consequences. However, the transmutation strategy is often faster. It is quite common for a husband to transmute community property into separate property on Monday and then transfer on Tuesday that separate property to a trust that names the wife as a beneficiary.
But the work has to be done. Taxing authorities will want to see evidence of transmutation. Otherwise, they will presume that the property transferred was community property.
Because of the intricacies involved, asset titling can be especially important in community property states. For instance, spouses domiciled in community property states sometimes title assets as joint tenants with right of survivorship (JTWROS). However, doing so can create a presumption that the assets in the account are separate property, even if on contribution they were in fact community property.
Loss of a full step-up in basis on the death of the first spouse to die is a potentially deleterious knock-on effect of a JTWROS account held by spouses domiciled in a community property state; at least in California, the presumption in that case is that the assets in that account are separate property. On the other hand, in a divorce context, California flips the presumption: If earned during marriage, the assets held in a JTWROS account would be presumed to be community property. To be sure, the presumptions can be rebutted, but the process of doing so entails, again, production of evidence that the property was to retain its character as community property.
One additional consideration for spouses moving from a separate property to a community property state such as California is that the couple may think that their marital assets retain their character as separate property, but in fact those assets are treated as quasi-community property. Where one spouse earns considerably more than the other, he or she may be surprised to learn that, in the event of a divorce (but not death), the (presumably) poorer spouse would be entitled to one-half of those assets, in keeping with the public policy of protecting the less wealthy spouse in case of divorce.
These are just four situations that illustrate the importance of not only knowing the theory underlying estate planning principles but also how those principles are applied in practice.
Jordan Sprechman is a vice chairman and the practice lead for U.S. Wealth Advisory at J.P. Morgan Private Bank. Gigi Orta is an executive director at J.P. Morgan Private Bank in San Francisco.