Marriage Plan B: When Obergefell Falls

There are potential changes to Supreme Court decisions coming, and it could impact a lot of my clients. In this case, I'm referring to the marriage equality ruling for nationwide same gender marriage in 2015 Obergefell v. Hodges. Prior to 2015, a lot of my couple clients who weren't able to marry under the law were utilizing estate planning documents and contracts to do what the law wouldn't. That lead me to create a trust system to maximize whatever tax breaks could be obtained between an unmarried couple while providing them all of the usual goals of combining property as one family unit, empowering each other to make financial and health care decisions, and laying out inheritance. This also lead me to write a now-out-of-date book called Estate Planning for Domestic Partners. 

It's no surprise to anyone, regardless of your political persuasion, that this Supreme Court is likely to overturn Obergefell. When that does happen, all of the anti-equality laws by the State will kick back in. Suddenly, this type of planning will become critical to same-gender partners in order to obtain at least most of the automatic rights they previously could obtain with a marriage license. However, all of the same myths and misconceptions that I wrote about in 2007 are popping up again. That's why I'm posting a rewrite of one of the chapters in Estate Planning for Domestic Partners that talks about these myths.

I guess it's also time for a rewrite of the book, although a livestream on the YouTube channel may come first. So please look for that if the topic is of interest to you.

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Common Misconceptions in Domestic Partner Estate Planning

Sometimes conventional wisdom is not so wise, and it takes more than advice from a friend to handle things the right way. Unfortunately, a lot of layperson advice gets followed and, in the area of estate and life planning, the problems are not realized until years later. In this chapter, we will review three of the most common life and estate planning mistakes and explain why they are mistakes. (For more information on other planning mistakes frequently made by domestic partners.

Specifically, we will look at:

• Wills
• Joint Property
• Beneficiary Designations.

Planning Mistake #1: Using Wills

Probably the most popular document for estate planning is the Last Will and Testament. All adults can spell out their wishes for what happens to their property after they pass on. As long as the format complies with state law and all debts and taxes are taken care of, their property goes to the people chosen. Of course, there are some exceptions in state laws, such as a wife not being able to completely cut out her husband, but by and large property goes to the designated beneficiaries.

A Last Will and Testament can name executors to handle the details of moving your estate through the probate process, nominate guardians to care for minors, and appoint trustees to manage the inheritance for underage beneficiaries. It can also designate beneficiaries, create age and other restrictions and provide specific instructions for handling certain property.

For domestic partners, drafting wills that name each other as beneficiaries may seem like the correct course of action to protect each other. After all, this is what most married couples also do. It is extremely important to note that using a will has some serious drawbacks regardless of your marital situation. First, using a will guarantees your assets go through the probate court before being distributed to your chosen beneficiaries, which means high settlement costs, time delays and a higher possibility of your plans being contested.

Probate is the legal process of transferring title of assets from a deceased person’s name to the names of the rightful beneficiaries and heirs. In the most basic terms, probate is a re-titling process. But in order for a court to be assured there is no embezzlement or corruption before transferring those assets, many inventories, appraisals and other tasks have to be completed, documented and reviewed before the court will let things go. It is this process, which was originally designed with good intentions, that causes the drawbacks.

The amount of money spent on the probate process may shock you. There have been numerous studies over the years. While there is considerable variance in the costs associated with probate, I feel comfortable estimating that probate eats up between four and ten percent (4 percent-10 percent) of an estate’s assets.

For example, let’s say our friends John and Tom have not done any estate and life planning except for having wills drawn up. John passes away, leaving Tom a condominium that includes furniture and appliances, a stock portfolio, and various other assets totaling $500,000. The rough estimate of probate costs would be between $20,000 and $50,000. There are some law firms that will actually charge a flat rate of five percent of the total value of the estate to handle all matters in settling the estate, so John’s estate would cost $25,000 to settle.

I can hear probate attorneys mumbling about how that’s ridiculous, and how the probate court fees are nowhere nearly that high. They’re right. Probate court fees are not that high, but their argument is just like the life insurance salespeople make when they say there are no taxes on life insurance proceeds. The probate court fees are not the issue. What is at issue are all of the attorney fees, appraisals, paperwork and related expenses necessary to complete the probate process. In North Carolina, probate court fees are 40 cents for every $1,000 and are capped at $6,000 in fees. Next time an attorney tells you probate is not that big of a deal and the probate court fees are low, be sure to ask him or her if that includes all of the other filing fees, appraisals and attorney fees as well, and if he or she would put it in writing.

Now, I want to be clear in criticizing some of my fellow attorneys. I have no problem with probate attorneys who take on difficult-to-settle estates. They put a lot time and effort into their work, and it is not their fault the probate court has stringent requirements they have to meet. It is quite probable they deserve every penny of the 4-10 percent they charge. My problem is with estate planning attorneys who tell their clients during the planning phase that they don’t need to avoid probate for their estates, or that probate is no big deal. These attorneys are either not knowledgeable in avoiding probate, or, much worse, they know exactly what they are doing and are counting on huge legal fees in the future for probating the inexpensive wills they draft now.

It also takes a significant amount of time to probate an estate. Settlement times vary even more greatly than costs, and there are some states with special, more rapid procedures for small estates. However, anywhere between six months and two years is a likely estimate for most estates, and that does not include those estates where the will is contested. Much of this is time is wasted on trips to the courthouse or to the attorney’s office, time spent gathering information in order to fill out detailed inventory and report forms, and time spent with your life in a holding pattern while all of the formalities of probate are observed. Even worse, particularly for domestic partner couples, the deceased’s accounts may be tied up during probate, leaving the other partner financially handicapped.

Wills are also much more susceptible to challenges than other methods of estate planning, such a revocable living trust. For domestic partners, protecting against challenges from the angry relatives who want to cause trouble may be the primary motivation for even addressing estate and life planning. Attorneys who suggest a Last Will and Testament and nothing more may be unknowingly setting their clients up for a fall.

The reason wills are easier to contest is because a will is formed at one point in time. The most frequent method of contesting a will is claiming the deceased was not “in their right mind” when he or she signed it. All that is needed to cast doubt on the will signing is behavior around the one point in time. Let’s say a person saw a psychologist the week before he signed his will. An upset beneficiary may start yelling and screaming “See! He was crazy to cut me out and leave everything to his live-in friend!” The one appointment combined with an emotional plea may be enough to move a judge to at least examine the state of mind of the will signer around the signing date.

This is not the case with a revocable living trust because it is not acted upon only once and not again until death like a will. If someone wanted to prove a person’s revocable living trust is invalid because the person was not in her right mind, then someone would have to cast doubt on her actions each and every time she acted with the trust. For example, if Jane’s brother doesn’t like the fact she is leaving all of her assets to her partner Betty and he wanted to show she was not in her right mind, he would have to show that was the case: 1) when Jane signed the trust, 2) when she transferred a savings account into the trust, 3) when she refinanced the house owned by the trust, 4) when she named the trust as a beneficiary on her IRA, and 5) every other time she acted as a trustee or beneficiary of the trust. This can be stretched to also include every time she wrote a check from an account owned by her trust.

In particular, attorneys have to be extremely careful in recommending wills for domestic partners because of the comparatively high number of relatives willing to make trouble over an estate. It is probably much safer to establish a revocable living trust and properly fund it for no other reason than to help deter challenges in the future.

While these three reasons—high settlement costs, delay and contestability—are all valid points to recommend using a revocable living trust to avoid probate, there are many more reasons to use a revocable living trust. In fact, an entire book has been written on this subject. For the foremost non-legal text on revocable living trusts, please read The Living Trust by Henry Abts III from McGraw-Hill.

By now, you hopefully have the right impression that probate is something to be avoided. Unless there is no one you trust to take care of your last wishes and you refuse to appoint a trust company, then there is no need for the probate court to be involved. There are a few ways to avoid probate, but some carry their own risks and costs. Of course, I’m referring to joint property and beneficiary designations.

Planning Mistake #2:  Using Joint Property

Whenever two people commit themselves to each other, they invariably get around to discussing how their home is titled. If one person owns the home, the person wants the partner to feel he or she has equal ownership in the house. So the natural urge is to re-title the house in both partners’ names with a right of survivorship. Simple? Yes. Effective? No.

What joint property fails to account for is the federal gift tax that allows only the first $12,000 (in the year this book was published) given from one person to another without the tax being imposed. Every dollar after that is subject to a gift tax. However, the federal government, in all of its renowned mercy, graciously allows $1 million to be gifted over the course of your life without you actually having to pay the tax. The downside is it also lowers the amount dollar-for-dollar you are allowed to pass on without estate taxes upon death.

Before we get to an example, and before you tune out completely because of the million dollar exemption, the real danger here is not the actual payment of tax, but the failure to file a gift tax form with the IRS. Because of two of the IRS’s favorite words “interest” and “penalties,” it is best to stay above board on all of these transactions. The other reason for reading on and keeping gifts to less than $12,000 a year is to avoid having to recreate records when the IRS audits a person’s estate and finds multiple gifts without a gift tax form being filled out. If you record all transactions properly and avoid situations where gifts of $12,000 or more per year are made between partners, then you can prevent huge accounting bills in the event of IRS action.

Please note this is only related to federal gift taxes. My own home state of North Carolina imposes a gift tax on every dollar above $12,000 gifted between domestic partners in a given year. For more information on how the gift tax may affect you in your own state, please see a qualified accountant or CPA in your area for specific tax advice.

Now, for the example:

John Doe and Tom Loe are partners, and they decide to live in Tom’s home. Instead of talking to an estate and life planning attorney, Tom talks to his brother’s mechanic’s sister-in-law who used to work as a real estate loan processor, and who tells Tom to just do a general warranty deed saying John and Tom own the house as joint tenants with a right of survivorship. Depending on the real estate attorney Tom gets to handle the deed, he or she may not even know or care about gift taxes. Tom’s house and land are worth $400,000, so half of it is a gift from Tom to John.

Looking at the numbers, the $200,000 gift was made from Tom to John. The first $12,000 is exempt in that year, so provided Tom does not make any more taxable gifts to John, there is a gift of $188,000 to be reported. If this is the first time Tom has to report any taxable gifts in excess of $12,000, then we can deduct the $188,000 from Tom’s lifetime gift exemptions of $1 million, and $722,000 remains that Tom can still gift during his life. You also have to deduct the $188,000 from the $2 million Tom can pass to others without estate taxes when he dies. That leaves $1,722,000 Tom can leave to others when he passes on.

The procedure for Tom to report these gifts is to fill out a federal gift tax form, currently Form 1026, as well as any gift tax forms his state requires. He should also keep a running total of all gifts given so he does not unintentionally give more than $1 million in taxable gifts during his life and would then have to lay out cash to pay the gift tax. The gift tax does not only apply to land, but everything else of value as well, such as stock and other accounts.

Another drawback to joint property with a right of survivorship is it only looks one step ahead. When one partner passes on, the other will receive the property, but what happens if both partners pass on together or within a short amount of time of each other? The property will have to go through probate before it can be distributed to the intended beneficiaries. Good life and estate planning looks more than one step ahead to cover multiple contingencies and avoid probate for all of them. With the right revocable living trust, the property can be titled in the name of the trust, all of these contingencies can be spelled out, and the property will go where it was intended without probate.

Let’s use an example to cure the referenced drawbacks of joint property. Rather than use joint property with a right of survivorship, Tom and John decide to create a joint revocable living trust with an integrated separate property agreement (which may be a Domestic Partner AB-SECURE Trust). John places the house into the trust and lists it as separate property belonging to him.

Now the house is owned by the trust, both John and Tom are equal trustees and owners of the trust, but the domestic partner property agreement keeps the property technically separate for gift tax purposes. It is also listed the house will go to Tom if John passes on, and if Tom passes on first then it will go to his nephew Greg. If Greg passes on, it will go to his cousin Peter. If Peter also passes on, it will go to his friend Bobby. And if Bobby passes on, it will go equally to his sisters Marcia, Jan and Cindy. Now the property not only avoids the gift tax problems associated with joint property, but it now lists multiple levels of beneficiaries who would receive the property upon death without the property having to go through probate.

Planning Mistake #3:  Beneficiary Designations

In an effort to make things simple and avoid probate on accounts and life insurance, many institutions allow their clients to name beneficiaries on the accounts, and many even allow a place to indicate a contingent beneficiary. While this is good for the client, it is also good for the company because now it is not in the middle of a probate proceeding that may be contested. Legally, the company is fulfilling its obligation after the death of the client once it transfers the account to the new named owner. In most cases, and depending on the company, it is a quick process taking a few days to handle the paperwork and make the transfer.

While beneficiary designations are not as lethal to some plans as wills and joint property with a right of survivorship, there are still some drawbacks to using beneficiary designations rather than a revocable living trust. As mentioned before with joint property, it only accounts for one transfer upon the death of the owner. If and when the owner passes on, it will go to the person or persons listed as the beneficiary. What if that person passes on before them? Financial institutions which allow for contingent beneficiaries have let the client take care of the first “what if” by listing a contingent beneficiary, but what if this beneficiary passes on as well?

By using a revocable living trust, all of the different contingencies can be listed within the trust, and now the account is handled properly, without probate, regardless of how many years pass by and how many different people may have passed on. Depending on the type of account, the account can either be placed into the trust directly or the beneficiary designation features on the account can name the trust as the beneficiary upon death. Now the account can stay in the individual partner’s name during life and name the trust as beneficiary upon death. The different methods of funding a revocable living trust include changing beneficiary designations the right way, and these techniques are covered more fully in Chapter Eight.

There is another serious drawback to using beneficiary designations, and the best way to illustrate this is through an example and a simple question.

Jane Smith and Betty Jones have a son, Tommy, who is 18. Jane and Betty each have managed to accumulate assets. Aside from the family home, their biggest assets are two brokerage accounts worth $500,000 each. One belongs to Jane and the other belongs to Betty, so Jane lists Betty as her primary beneficiary on the account and Betty lists Jane. Both list their son Tommy as contingent beneficiary. Betty and Jane are involved in a car accident and both pass on. Tommy will now receive their brokerage accounts, without probate. Now for the question—what do you think 18 year-old Tommy is going to do with the $1 million?

Most parents understand that while they love their children and they may be legal adults at 18, most 18 year olds are not responsible enough to effectively handle a large inheritance. By placing a child’s name on a beneficiary designation, the child gets control of the account at age 18, should anything happen to the parent. If instead, a revocable living trust was listed as the beneficiary, a trustee would manage this account for Tommy’s benefit until he reaches a more suitable age. Jane and Betty could plan ahead by naming a succession of trustees to handle things and choose the age of distribution, such as when Tommy turns 25 or 30 years of age.

We have now covered three of the biggest life and estate planning mistakes, as well as the reasons why they are mistakes. You have also seen there is hope for successful planning. The main method for avoiding the problems outlined here is covered in the chapters devoted to the revocable living trust. In many situations, it is exactly what domestic partners need as the core of their life and estate plans. Before we cover revocable living trusts in more detail in Chapters Five through Ten, we will look at some of the basic documents needed for domestic partners to effectively create a life and estate plan.