The “Non-Probate Revolution” – Estate Tax and Administration Issues

Consequences of the Non-Probate Revolution: 

Tax and  Administration Issues for Estates

By  Richard W. Mulvey, CPA, MA

The term “non-probate revolution” is generally attributed to law professor John H. Langbein, who, while at the University of Chicago in 1984, published a seminal work that examined the declining importance of the probate process  and with it, the future of the laws of succession.  Langbein discussed the growing number of financial institutions that were administering “non-court” methods of transferring assets, namely banks, life insurance companies, brokerages, and pension plans.  He went on to identify the central cause of the decline of probate assets, generally the “changes in the nature of wealth and in patterns of wealth-holding,” including the rise of financial intermediaries.  Thirty years later, this revolution continues, and has not lost any momentum.  In fact, it is picking up more steam in recent years.

The Desire to Avoid Probate

What are the reasons for this relatively recent change, from assets passing to heirs via wills and the probate process, to the more immediate transfers of assets, avoiding probate altogether?  Several reasons have given rise to this change, this attempt to avoid the probate process.  First, the term “probate” to many people means “delay.”  Who wants any delay in receiving assets upon one’s death?  All parties involved have some interest in expediency when it comes to disposing of the assets of an estate.  In addition, the probate process can be costly.  In fact, the delay factor itself can add costs to the process, in legal fees and court costs.  A third factor accounting for the increased use of non-probate methods of transfer is the relative secrecy that can be achieved when probate is avoided.  An extended
probate proceeding can also raise the possibility of claims and challenges to the estate.

The probate process and the term itself date back to at least the 1400’s, according to English legal records.  Its principal purposes have not changed.  The main purposes of the probate process are the collection and preservation of the estate assets, the payment of debts and taxes, and the orderly distribution of the assets.  This process aims to uphold the deceased’s intentions and also gives notice and protections to creditors and others with a potential interest in an estate.  What is interesting to note is that with the recent efforts to avoid the probate process, some of these intended benefits are being lost, mainly the orderly payment of all obligations.

Non-Probate Assets

Non-probate assets are those assets which pass, upon someone’s death, to a survivor by operation of law.  By contrast, probate assets are transferred either according to one’s last will and testament, through a court proceeding, or through the laws of intestacy.  Non-probate assets have either a designated beneficiary to whom title of the asset will pass, or a joint ownership of the asset.  Examples of non-probate assets with named beneficiaries include life insurance policies, Individual Retirement Accounts, 401(K) accounts, annuity accounts, and revocable trusts.

Joint ownership assets typically include jointly-owned bank accounts, transfer-on-death, or TOD, brokerage accounts, and jointly held real estate.  Brokerage accounts with transfer-on-death stipulations are becoming much more common in recent years, as it seems most wealth management advisors are becoming increasingly aware of a simple way for these assets to avoid probate.

Pitfalls of the Non-Probate Revolution

Non-probate assets, then, by nature, are not readily available to pay various obligations of the estate.  Upon death, the estate may immediately have obligations such as bank loans, mortgages, and other debts of the decedent.  Depending on the size of the estate, there may or may not be substantial estate taxes due based on the value of the estate assets, both probate and non-probate assets.  With certain exceptions, these estate taxes are typically due within nine months of death.  There are many other obligations that may arise during the administration of the estate, and they may be substantial.  These include court costs, attorney fees, appraisal fees, accounting fees and other expenses necessary to maintain and preserve the assets of the estate.  It is pretty easy to see that when a majority of the deceased’s assets pass outside of probate, there may not be enough probate assets from which to satisfy all of the estate’s obligations.

The lack of a “bucket” of assets from which to pay specific bequests, taxes, and other obligations is certainly a troublesome situation for the
executors or administrators.  Certain other factors can exacerbate this situation. During certain periods of time, steep, rapid market declines in stocks or real estate can quickly erode an estate’s assets.  Think of the years 2007 and 2008, when stocks were falling so rapidly that even with the use of an alternate valuation date, it would have been tough to pay the estate taxes due on valuations that had fallen so far.

Extensive use of these non-probate vehicles can give rise to other pitfalls in the estate administration process. Designations such as IRA and 401(K) beneficiaries are much simpler for an interested party to change and to manipulate than are provisions in a will.  These orders are
also much quicker to effect and done in much more secrecy.  Sometimes an unusual designation will give rise to questions and challenges by interested parties, thus delaying the final administration of the estate.

The All Too Common Example

Let’s look at a simplified but all too common example of an estate with extensive non-probate assets and a corresponding large liquidity problem.  Mr. Moneybags passes away at age 95 with the following assets:  1) an IRA account with his son as beneficiary, 2) a life insurance policy with his grandson as beneficiary, and 3) a brokerage account with a transfer-on-death order to his son.  All of the assets will pass
directly, immediately, outside of probate. If Mr. Moneybags expressed in his will that certain bequests were to be given, say, to charities, there are no funds from which to disburse these.  Likewise, there is no money from which to pay his attorney or his accountant. Furthermore, if the total of Mr. Moneybags’ assets is large enough, there may be estate taxes due, possibly substantial, and rather quickly.  There are simply no probate assets from which to pay the taxes, legal fees and other expenses necessary to effect an orderly distribution of his estate.

Matter  of the Estate of Turco

A recent case from New Jersey demonstrates just how difficult it can be for an estate fiduciary to satisfy all creditors and bequests when there is a lack of liquidity in an estate.  In the Matter of the Estate of Turco, the decedent, Jerry Turco, died in 2005 with an estate valued at approximately $30 million dollars.  The estate consisted mainly of real estate held in closely-held corporations, and as such there was
very little liquidity in the probate assets. There was also $4.5 million in life insurance paid to trusts for benefit of the decedent’s grandchildren.  The insurance proceeds were, of course, not part of the probate assets.

At the date of death (or alternate valuation date) the estate had a federal tax liability of over $15 million and other liabilities of over $6 million.  In subsequent years, the values of the probate assets, mainly the real estate, tumbled to $7.5 million, thus leaving the estate in the position of insolvency.  The administrator of the estate sought court approval to “claw-back” against the life insurance proceeds in order to satisfy
obligations of the estate.  The court denied this application, however, and further ruled that although the IRS or creditors could pursue non-probate assets, the probate estate must be fully liquidated and all tax issues resolved before any claw-back of non-probate assets by the administrator could be considered.  More specifically, all offers in compromise to the IRS would have to have been attempted before any non-probate assets could have been pursued.  This case is a prime example that claw-back is not always a possible solution for the estate
that lacks liquidity.

In conclusion, while non-probate vehicles such as retirement accounts and life insurance policies can play an integral role in the planning of one’s estate, they should not be used so extensively as to put the estate in an illiquid position or to needlessly complicate the duties of the fiduciary.  The estate plan should take a comprehensive approach, considering all available assets and all possible obligations, and
should be orchestrated by an experienced estate planning professional.

Richard W. Mulvey concentrates much of his CPA practice on estate taxes, fiduciary taxes, gift taxes, and estate tax planning for his individual and business clients.  Mulvey is a member of the Estate Planning Council of Eastern New York and has been licensed as a Certified Public Accountant in the State of New York since 1983.  He operates his accounting practice in upstate Rensselaer County and can be reached at (518) 283-1818 or by email at rickmulvey@nycap.rr.com.     

 

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