A recent Wisconsin Supreme Court ruling provided a big blow to “simple” Wisconsin probate avoidance plans and reinforced the need for a good revocable living trust by overturning a long-standing state and federal estate tax assumption. The court ruled that anyone receiving an inheritance through a “pay upon death” (POD) or “transfer upon death” (TOD) designation is not responsible for paying their fair share of state or federal estate taxes. Instead, those estate taxes are paid out of the residue of the estate. (http://bit.ly/ax3qLr)
While this is not what most people want in their estates, the law has been interpreted in Wisconsin to make it so. (Federal estate taxes have to be paid, but it is generally left to state law to determine who is responsible for paying those taxes.) Typically, people want their estate tax apportioned among all of their assets no matter how it got to their beneficiaries.
What this means for estate planners in Wisconsin is that the simple technique of avoiding probate by using a POD or TOD has tax consequences under the law. Now planners have to take into consideration how taxes are paid on an asset by asset basis and advise their clients. Take a simple example of a widower with two sons and a family business worth $1 million. He wants to leave his sons equal assets, but only one of his sons works in the business and would like to continue the business after Dad passes on. After talking with his financial advisor, he decides to buy two life insurance policies. He purchases a $500,000 policy naming as beneficiary (POD) the son who is taking over the business, and he purchases a $1.5 million policy naming as beneficiary (POD) the other son. But now in his will or trust he names the first son to receive the business. Now he has a $3 million total estate, leaving $1.5 million to one son as the $1 million business and $500,000 in life insurance, and leaving $1.5 million in insurance proceeds to the other son. He assumes that each son will pay their fair share of taxes, so now the son receiving the business will have more than enough money to pay any estate taxes.
The problem is that is not how Wisconsin apportions estate taxes (and based on the ruling, attorneys, CPAs and financial advisors in other states should look at how this is treated in their states). The taxes on the $3 million estate are on the non-POD and non-TOD assets, so the approximate $1 million in estate taxes (under the 2011 rules) is against the business assets first. This means that the business is completely gone or the son receiving the business has to give up his $500,000 in life insurance AND find another $500,000 or he has to sell off the business. The other son may walk away with his full $1.5 million in insurance without paying any estate taxes.
The better solution, to make sure that everyone pays their fair share of taxes and avoid probate, is to have a revocable living trust handle all of these distributions. The business can be owned by the trust and both insurance policies, or one combined policy, can name the trust as the beneficiary. The trust can then state that the estate is to be split evenly but the son who is working in the business is to receive the business as part of his share of the trust estate. Now the trust can pay the $1 million in taxes leaving the business to the correct son and $1 million in life insurance proceeds to the other son. This is an equal estate split, but the taxes are paid as the father intended.