Maybe it’s just because I’m writing in April, but it seems like I’ve heard quite a few stories lately of disastrous estate settlements. Someone died. They thought they had planned for a smooth and easy settlement of their affairs, but bad things happened instead.

Knowing what can go wrong is one important step toward avoiding estate problems.

First, what is your estate? You might assume your estate is the property directed by your will through probate court. You have heard, for instance, that your life insurance isn’t part of your estate.

By this definition, your estate would not include your individual retirement account passing to named beneficiaries, assets you hold in your living trust, property you’ve already deeded to your child (even with income reserved for life), real estate or bank accounts held in joint-tenant ownership, or a loan to your child which is forgiven on death. Certainly, your estate would not include property you already gave away.

Well, none of those items would be considered part of your probate estate. In many instances, a person will die with almost no probate estate. But the IRS has a different definition of estate. A recent tax court case confirmed that the estate — taxable estate — includes much more than the probate assets.

Grandpa Bob

For example, everyone thought that at Grandpa Bob’s death in 1999, things had gone so smoothly, and there was no need for professional advice. Bob had given machinery to his grandson a few months before he died; nothing more to do. Bob had sold some land to heirs, retaining only the income for life (a life estate) from the property.

On death, the transfer was automatically complete. One heir owed Bob some money, and under his will Bob forgave the loan, and no one disputed it. Bob’s life insurance was payable to beneficiaries, as was his IRA. Bob had added a child as an equal joint owner with right of survivorship on some property; on death, the child became sole owner. Bob had only a few minor assets beyond that, which passed according to his will and without a hitch

Almost 20 years after Bob’s death, the IRS caught up with the family and assessed estate taxes, penalties and interest. The fair market value of the gifted machinery as of death was counted as part of Bob’s taxable estate, as was the value of the life estate property. The loan balance owed and forgiven at death was part of his taxable estate. The insurance and IRA that beneficiaries received was included, along with the full value of the joint property as of death. Finally, the miscellaneous assets that passed under his will were part of Bob’s taxable estate.

No one had stopped the family from taking possession and control of the assets. The way things were set up, the family thought they didn’t need professional help. But when the IRS found out, they were ordered to pay significant back taxes — and even more significant penalties and interest.

Preventing disaster

Failure to pay estate taxes is not the only kind of disaster. A man who knew what I do told me he was helping loved ones finalize a deceased in-law’s very simple affairs. The in-law had died, most of his assets were in a living trust, and he had a traditional IRA payable to the trust. The man told me the date of death, and that they had collected the IRA and other assets into the trust account. They paid final expenses and debts, and were about to divide and distribute the money to the seven beneficiaries.

At this point the man paused, hoping for affirmation. Unfortunately, I had none to offer. First, the IRA could have been drawn out over a period of years instead of all at once. Second, by waiting three weeks too long to ask a professional, he had caused all the IRA money to be taxed to the trust instead of being taxed to the beneficiaries. These two mistakes cost the heirs about 45% of the IRA in income taxes. Taxes should have been less than half that.

I’m out of space to tell you about the inheritance that was lost to divorce, and the lawsuit that took another, both because the amateur trustee handling the estate didn’t know how to carry out the decedent’s plan. Maybe we’ll come back to that another day. But just remember this: Handling an estate is risky business, so get professional help early.

Source: Curt Ferguson, The Estate Planning Center