The Tools of Estate Planning Part I: Identifying the Tools 1

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1 The Tools of Estate Planning Part I: Identifying the Tools 1 Estate planning is a term which has many meanings to many people. To some it may mean reducing federal estate taxes; to others, avoiding probate. It is, in fact, a concept rather than any particular form of planning or legal process. There are various tools that are used by estate planners in helping individuals to attain their estate planning objectives. Some of these tools, such as the manner in which one owns property, are being used by your clients right now, whether they intend that or not. Even the fact of whether or not someone has a will is an estate planning decision. The real questions are whether clients understand what they have done, consciously or unconsciously, and whether that accomplishes what they want. The following listing of the different estate planning tools is intended to show what all might be available in helping clients meet their estate planning goals. It does not include all possible tools, such as family limited partnerships or other techniques that are used more in the context of estate and gift tax avoidance. With the unified credit allowing each individual to pass $2 million worth of assets in 2007 and the probability of significant increases in that amount, if not outright repeal, most individuals and couples no longer need concern themselves with estate tax avoidance. Nor does it include asset protection techniques (except to the extent available through tenancy by the entirety) or Medicaid planning. Property Ownership Real property law in the United States has often been described as a bundle of rights which can be divided up nearly any way an individual could desire. One who owns the entire bundle is said to own it in fee simple absolute. This means that person owns every property right that goes with owning land. If an individual is the sole owner of that piece of property, it is, in a sense, that person s absolutely. But, there are a number of things that can be done with those basic property rights. First of all, there can be more than one owner of the same piece of property. This is known as concurrent ownership, which really means nothing more than simultaneous ownership. It is concurrent because more than one person owns an interest in the property at the same time. The forms of concurrent ownership are tenancies in common, joint tenancies with right of survivorship, tenancies by the entirety, and community property. These (except for community property) are discussed in more detail below. Second, various interests can be carved out of the bundle. For example, the owner could rent the land to someone. This is a leasehold estate and is a property interest in the land which belongs to someone else, in this case the lessee (renter). During the period of the lease the lessee, not the owner, has the exclusive right to the use of the property under the terms of their lease. At the end of the lease, of course, the property comes back, or reverts, to the owner automatically. The owner once more has full ownership. The owner might sell mineral or timber rights or might grant an easement to a utility. These are all some form of property interest being granted to someone other than the owner, meaning there are decreasing numbers of property sticks in the owner s bundle because they have gone to someone else. 1 Copyright 2007, Kenneth K. Wright, Olive Blvd, Ste 202, Chesterfield, MO 63017, (314) EE--1

2 In the discussions that follow, we will be using the terms estate and tenant. In property law, an estate is some sort of interest that someone owns in property, such as a life estate, mineral estate or fee simple estate. A tenant is someone who is the owner of a property interest. Thus, a life tenant is the owner of a life estate; a tenant in common is one who owns a property interest in common with other tenants. A tenant is also one who is renting property because he is the tenant (owner) of the leasehold estate. What we will find with property ownership is that each of these two aspects, tenancies and estates, can be manipulated independently of each other to accomplish client objectives. Concurrent Ownership Tenancy in Common A tenancy in common exists when two or more persons own undivided interests in a particular property. For example, if two persons own property as equal tenants in common, then each one owns an undivided one-half interest in the property. What this means is that each one simultaneously owns 100% of the physical property, but only to the extent of a separate one-half of the value of the property. This means that each is entitled to one-half of the income from the property, is liable for one-half of the expenses and is entitled to an equal voice in the management of the property. That one-half interest is in the entire property, however, not in any identifiable part of it. The interests do not have to be equal: one person can have an undivided one-fourth interest, another an undivided one-fourth and a third person an undivided one-half interest. The tenancy in common is generally the presumed form of concurrent ownership among unmarried individuals if a different form of ownership, such as a joint tenancy with right of survivorship, is not expressly stated. Perhaps the best way to illustrate the concept of concurrent ownership is to visualize two color transparencies, one blue and one yellow. Each represents a separate property interest owned by two respective individuals. If they combine their property interests, the color of the combined transparencies becomes green, the combination of the two colors. Before, we could easily distinguish their separate interests because they were represented by separate and distinct colors. We know that the property interest represented by the green is owned one-half by the contributor of the color yellow and one-half by the contributor of the color blue. We cannot, however, point to any portion of the property interest represented by the color green and identify that as belonging to either yellow or blue; each owns one-half of the entire, indivisible whole. The primary feature that distinguishes a tenancy in common from a joint tenancy with right of survivorship or a tenancy by the entirety is that a tenancy in common is inheritable. The owner of an undivided one-half interest can not only sell or give away his or her interest, but can pass it to his or her heirs. Because an interest in property as a tenant in common is capable of being inherited, it is known as an inheritable interest. This is very important, because it allows the owner to exercise post-death control over where the property goes and does not go. This lets us, for example, create a form of ownership between husband and wife which in effect gives each of them separate ownership in their assets without actually having to divide the assets physically in order to reduce the estate taxes payable by them on their combined. An owner of a tenancy in common can also transfer their interest at any time during life, whether the other owner or owners agree to the transfer or not. EE--2

3 Joint Tenancy with Right of Survivorship The joint tenancy with right of survivorship, hereafter referred to as JTROS, is like a tenancy in common as far as the fact that there is concurrent ownership of separate undivided interests in the entire property among the joint tenants. There are two features that distinguish the JTROS from the tenancy in common, however. First, all of the joint tenants must own equal interests. Thus, if there are two joint tenants, each must own an undivided one-half interest; if there are four, each must own an undivided onefourth interest. There cannot be unequal fractional shares. Second, while joint tenants can sell or give away their undivided interest during life, the interest is not inheritable at death by their heirs. Instead, when a joint tenant dies, their interest automatically passes to and is divided among the surviving joint tenants, giving each of them a proportionately larger interest in the property. The last person alive becomes the owner of the entire property and can then pass it to their heirs, as it is, of course, no longer subject to the joint tenancy. This form of property ownership is sometimes used for probate avoidance because the interest that passes to the surviving joint tenant does so completely automatically by operation of law and therefore does not require that the property go through probate. Perhaps the easiest way to understand this distinction between tenancies in common and joint tenancies with right of survivorship is that in a JTROS the owners in effect created a contract among themselves when the property was acquired. The terms of this contract are that each tenant has an interest in the property that he is free to dispose of during his life, but which passes to the surviving tenants at his death. This is the reason why jointly owned property does not pass through probate the interest of the individual tenant has already been disposed of as a matter of law, so that there is no need to involve the probate process. Tenancy by the Entirety A JTROS or a tenancy in common can exist between any persons, whether related or not. The tenancy by the entirety is a form of ownership which can exist only between husband and wife. It is a legal fiction which considers the spouses to constitute a single ownership unit of the entire property. In other words, each spouse owns not only 100% of the physical property, but also simultaneously owns 100% of the value of the property. Since each owns all of the property, the property cannot be sold without the consent of both of them. Nor can the creditors of just one of the spouses go against entireties property to satisfy the debt of that one spouse, since the spouse does not have any separately identifiable interest in the property. Upon the death of the first spouse, the surviving spouse does not succeed to the interest of the first spouse; instead, the surviving spouse remains as the sole owner of his or her entire interest which is, of course, the whole property. This form of ownership is also used as a means of avoiding probate, since the ownership change occurs as a matter of law. There is therefore no possibility of post-death control over the property, making it unusable when estate tax avoidance is necessary. Not all states only about half permit tenancy by the entirety, and the rules applicable to tenancy by the entirety vary from state to state. EE--3

4 Estates A property interest, or estate, simply describes the extent of your ownership interest in a particular property. When we think of owning a piece of property, we are generally thinking in terms of owning the entire bundle of property rights associated with that piece of property, which is called fee simple absolute. There are really many different kinds of property interests, however, some of which are quite common and useful, others of which are so obscure and impractical that they have actually been eliminated under the laws of many states. One of the most important ways of dividing estates is between those owners who are presently entitled to the possession and use of the property and those who are not entitled to possession and use of the property until some future event or time. The former estate is generally called a present interest, the latter a future interest. For example, one who is renting property is entitled to the present possession of the property and therefore owns the present interest; the landlord is not entitled to possession again until the expiration of the lease and so has a future interest. Another way that present and future interests can be divided is by means of the life estate. The person who is the life tenant, who owns the life estate, is entitled to the use of the property for that person s life. That means that the life tenant is entitled to live on the property and to the renewable income from the property, such as rents or the proceeds from crops. When the life tenant dies, the interest automatically terminates, since it had been given to the life tenant only for life. Who takes the property then? It cannot be willed to anyone else by the life tenant, since the interest terminated automatically at death, which is why it is also referred to as a terminable interest. It must be remembered that the only thing that has been transferred in a life estate is the right to the present use of the property. As in a lease, underlying ownership of the property (and of the future interest) continues to be with someone other than the life tenant. Thus, when the life estate is created, the grantor (the one who created or granted the life estate for the life tenant) will identify who the underlying owner is. If the grantor does nothing more than create a life estate, without saying anything more about the property, then the grantor continues to be the underlying owner because not all the property has been given away. We describe this as a reversion, since the property will automatically revert to the grantor after the death of the life tenant. On the other hand, the grantor may, at the same time the life estate is created, give underlying ownership of the property to someone else. This person is called the remainder person, since the remainder person gets what remains after the life estate. More importantly, however, we use reversion and remainder to indicate whether the grantor continues to be the underlying owner of the property now subject to a life estate or has transferred that underlying ownership to someone else. Thus, if A makes a deed in which A says property is to go to B for life, B owns the present interest, which is called a life estate. Because A has not given away all interests in the property, however, A will be entitled automatically to the present interest upon the death of B and so owns the future interest that is known as the reversion. If A says, however, to B for life, then to C for life, remainder to D, what do we have? Here, B has the a life estate; this will be followed by another life estate in C, so C has a future interest in a life estate while B is still alive. This future interest in C automatically becomes a EE--4

5 present interest in the form of a life estate upon the death of B. D also owns a future interest, since D will get the present interest after the death of C. However, D is also the remainder person, so D is also the underlying owner of the property during the two intervening life estates. It is important to understand that the owner of the reversionary or remainder interest owns everything about the property except the right to use it during the time that someone else is the owner of the present interest. The reversion or remainder could be sold or given away, and is inheritable. Anyone taking it, however, would take it still subject to the ownership of the present interest by someone else. *It is also important to realize that, if someone gives the remainder interest in property to someone else but reserves a life estate, that person will have full use of the property for life, but there will be no probate of the property at the person s death. This is because the transfer of the underlying ownership of the property occurred while the grantor was alive, so that there is no transfer at death that would be subject to probate. Trusts A trust is an arrangement that can be thought of as combining two different kinds of law with the result of giving us what is probably the single most flexible estate planning tool there is. The two types of law that are used in a trust are property law and contract law. Property law allows us to divide ownership of different property interests among different owners. Each owner has certain rights and obligations with respect to that owner s interest in the property. The property interests that are involved in a trust are legal and beneficial. The owner of a legal interest in property is the one who has the right to manage and control the property. These functions are those which are commonly performed by trustees, meaning that a trustee owns the legal title to assets that are held in trust by the trustee. Although the trustee may be paid compensation for services as a trustee, the trustee is not permitted as a trustee also to own the beneficial interest in the property. If the trustee owns both the legal and beneficial interests, no trust exists because the trustee owns all of the interests in the property. The right to benefit from the property is the ownership of the beneficial or equitable interest in the property. The persons who own this interest are referred to, for obvious reasons, as beneficiaries. The beneficiaries are entitled to whatever benefit is associated with the property. This might be income from the property or the right to use property. Although beneficiaries have the right to the benefit from property, they do not, as beneficiaries, have the right to manage or control the property. Beneficiaries may be divided into two classes, those who have the present right to benefit from the property and those whose right to benefit from the property will occur sometime in the future, subject to some prior condition or event. For example, a trust may require income to be paid to an individual s spouse for life, then to the individual s children for their lives. While the spouse is alive, the spouse, as a beneficiary, would have a present interest. The children, who will not be entitled to benefit from the trust until after the death of the spouse, have a future beneficial interest which is commonly referred to as a future interest. A person could have only a future interest in the trust allowing the person to receive the benefit only during life. More commonly, however, the owner of the future interest, such as the settlor s children, will also acquire full ownership of the trust assets. In this case we have a term for the owner of the future interest, just as we do with life estates. This person, who will EE--5

6 eventually own both the legal and beneficial interests in the trust, is referred to as owning the reversion or remainder. A reversion means that ownership of the legal and beneficial interests will revert to the person who originally created the trust. A remainder means that the legal and beneficial interests will pass to a person other than the one who originally created the trust. Whether the interest is a reversion or a remainder is determined solely on the basis of what the trust says, not who actually winds up with the property. For example, if a reversion is created, but the person who set up the trust dies before the trust terminates, the reversion is a property interest owned by that person and which will be inherited, but which still remains a reversion. For estate planning purposes, however, we want trusts with remainder beneficiaries, as the object is to pass property, not get it back. Example 1. Reversion. S transfers property to T to pay the income to B for life. Since there has been no disposition of the trust assets following the death of B, S is treated as automatically having retained a reversion, and the property will, upon B s death, revert to S free of trust. If S has died, the reversion will go to whomever has inherited it from S (and will be subject to probate if there has been no probate avoidance planning). Example 2. Remainder. S transfers property to T in trust to pay income to B for life, remainder at B s death to R. Upon the death of B, the trust assets will be distributed to R free of trust, and will not go back to S. If R has died before B, the remainder interest is property owned by R and will pass to R s heirs. The primary difference between a life estate and a trust, therefore, is that we have added the trustee, who is the party responsible for managing and investing the trust assets for the present benefit of the beneficiary while at the same time safeguarding those assets so that they will go to the remainder person upon the death of the beneficiary. In a life estate, on the other hand, the life tenant is responsible for management as well as being entitled to the benefit. What we have really done in a trust is to subdivide the present interest between one who is responsible for managing the property (the trustee) and the one who is entitled to the present benefits of the property (the beneficiary). With a life estate, both of these functions are in the same person. The remainder or reversion remains unaffected. The person who creates a trust may be referred to as the settlor, grantor or trustor. (Today, the term most widely used is settlor.) A settlor creates a trust by expressing a clear intent that some property be held in trust by a person named as trustee for the benefit of one or more beneficiaries. In addition, it is necessary that title to the property be transferred to the trustee or that the property be delivered to the trustee. This is referred to as funding. Trusts are normally in writing, but it is possible to have an oral trust. A trust involving real estate does require a written trust, however, because of the statute of frauds. It is literally possible, however, for a settlor to say, I give $100,000 to T in trust for the benefit of B for life, remainder at B s death to R. Assuming the $100,000 has been delivered to T, a trust has been formed. This means that T owns the legal interest in the $100,000, B owns the beneficial interest, and R owns the remainder. But, how do we know exactly what the rights and obligations of each of these parties are? This is where contract law comes in. In addition to property law, we use contract law to set up the terms of how the trust will work. This is the trust agreement, sometimes called a trust indenture. The trust agreement tells EE--6

7 the trustee how the settlor wants the trust to be managed, the terms and conditions associated with the beneficiary s interest, and the circumstances upon which and how distribution in termination of the trust will be made to the remainder beneficiary. The contract is between the settlor and the trustee. The beneficiary and remainder beneficiary are not parties to the contract, but both of them have a stake in it. They would therefore both be entitled to bring suit for any breach of the contract that affects their respective interests. If the settlor fails to set out the terms of the trust in a trust agreement or a situation arises not covered by the trust agreement, we look to state law to determine the answer. This law may be found in state statutes that govern the conduct of trustees, in case law created by the courts, or a combination of the two. In a sense, therefore, every trust always has a trust agreement: to the extent the settlor has not written the agreement, the state has. Because the trust agreement is nothing more than a contract, there is a great deal of flexibility in what a settlor can put in the agreement. For example, the settlor could place restrictions on what a trustee could do with real estate, something that might not be possible to do directly on the deed to the real estate itself. The settlor can plan for contingencies, giving individuals a great deal of flexibility in their estate planning. In fact, most living trusts contain a right of revocation and amendment reserved by the settlor, which has no effect on the validity of the trust. Instead, the beneficiary and remainder beneficiary are viewed as having a valid interest so long as there has been no revocation of that interest. Assuming that a trust agreement fails to address an issue or even that there is no trust agreement at all, reference must be made to the applicable state law to determine the answer. It is usually obvious what state law applies to a trust. For example, if a resident of Missouri creates a trust in Missouri with a Missouri trustee, it is most probable that Missouri law will govern interpretations of the trust. A settlor may, however, designate which state s laws are to govern interpretations of the trust. In that case, the settlor s direction will be respected. For example, the Missouri settlor could have designated the laws of the state of New York to be used for issues affecting interpretation of the trust. Such a direction will generally be respected. It may not always be clear which state law is to be used to interpret a trust. If a resident of Missouri creates a trust in Missouri with a Missouri trustee, it is most probable that Missouri law will govern interpretations of the trust. A settlor may, however, designate which state s laws are to govern interpretations of the trust. In that case, the settlor s direction will be respected. For example, the Missouri settlor could have designated the laws of the state of New York to be used for issues affecting interpretation of the trust. Such a direction will generally be respected. But what if a Missouri resident who is a part-year resident of Florida creates a trust in Florida with a Delaware trustee and has no provision addressing which state s law is to govern? Situations like this are, quite frankly, ones that require a written legal opinion or, if things are bad enough, a declaratory judgment by an appropriate court. Issues may also arise concerning which state (or in some cases states) has the right to tax a trust, especially after the death of the settlor. Jurisdiction to tax is very different from determining the law that applies for purposes of interpretation, since money is at stake. A provision in a trust agreement designating which state s law is to govern the trust has no effect for purposes of taxation. Instead, states may look for any kind of connection between the trust and the state in order to establish a basis for some form of taxation. It is not unheard of, in fact, for several states to impose taxes on the same trust. If there is any doubt concerning jurisdiction to tax, it is prudent to seek a legal opinion on the matter. EE--7

8 Many people have heard of various trusts, such as living trusts, testamentary trusts, revocable trusts, Crummey trusts, life insurance trusts, or charitable remainder trusts. The classical trust for both probate avoidance and estate tax planning, for example, is the living revocable trust, meaning simply that it is created while the grantor is alive and that the grantor retains the right to revoke (or amend). The important thing to remember is that such terms are merely descriptions of the manner in which the trust was created or what the trust is intended to accomplish. What we do is simply place some adjective in front of the word trust to describe some aspect of the trust. But the basic legal principals of trusts are unchanged by the addition of such labels. Wills Wills are legal documents. A will is the document which operates to transfer a person's property at death if the property does not pass by some other means, such as tenancy by the entirety, joint tenancy with right of survivorship, life estate, or trust. A will can do many other things: establish guardianships for minor children, create trusts for surviving spouses or other beneficiaries, provide for burial arrangements or simply make final statements. The principal effect of dying with or without a will is whether property that passes through probate passes as desired by the decedent or under the intestacy laws. If no property passes through probate, of course, this is irrelevant. Wills should always be prepared for clients, however, in case the client fails to carry out the necessary requirements, such as funding a living trust, for keeping property from passing through probate. Nonprobate Transfers Another probate avoidance device in those states which permit it is to title property in beneficiary form under a nonprobate transfers law. This is done by titling the property in the name of the owner or owners with a designation that the property is to be transferred or paid on death (TOD or POD) to a named individual or individuals, who are the beneficiaries. In Missouri, the effect of doing this is generally as follows: The beneficiaries have no ownership interest whatever in the property. The owner or owners can at any time sell, mortgage or do anything else with the property, including executing a new instrument without the beneficiary designation, thus revoking it. None of these actions requires the consent of the beneficiaries. The same rights would apply to a surviving joint owner. If the TOD or POD designation is still in effect on the death of the last owner, the beneficiaries automatically own the property without its having to go through probate. Unless a different form or percentage of ownership is specified, the beneficiaries all take as equal tenants in common. If a beneficiary is a family member, the death of the beneficiary prior to the death of the owner does not cut off the beneficiary s interest, as would be the case in a EE--8

9 joint tenancy. Instead, the interest to that beneficiary passes to the beneficiary s children, commonly referred to as lineal distribution per stirpes. 1 The Missouri Nonprobate Transfers Law is found at Chapter 461, RSMo. It is one of the most comprehensive nonprobate transfers laws in the nation and is an excellent means of simple probate avoidance. Nearly all forms of property can be titled in beneficiary form, including property held through titles issued by the Department of Revenue, which is covered under a different statute. Perhaps the most well known nonprobate instrument is the so-called beneficiary deed. If the instrument of title is issued by a third party, that party can refuse to register its instrument in beneficiary form. Disclaimers Disclaimers An individual who is offered a gift by someone who is living can reject the gift. If it is rejected, there are no income or gift tax consequences because the person to whom the gift was offered never accepted it. An inheritance of property from a decedent is simply a gift which is made at someone=s death rather than during their life. There are a couple of problems with this, however. If property passes through probate, title to the property vests immediately in those who are to inherit the property, subject only to the property=s administration by the executor. In the case of a revocable transfer made during life, such as through a living trust, the transfer becomes fixed at the settlor=s date of death because it is no longer subject to revocation. Thus, in both cases, the person inheriting the property (using Ainherit@ in a broad sense) acquires an irrevocable right to the property as of the donor=s date of death. How, then, does one refuse to accept a gift from someone who has died, when the transfer has already automatically occurred? This is what disclaimers are all about. A disclaimer is a legal procedure under state law by which one refuses to accept a testamentary (in connection with death) gift. One problem, though, is determining what to do with the gift which has been disclaimed. If a refusal to accept a gift is made while the donor is alive, the donor determines where the property will then go. Since, in this case, the donor has died, another rule must be found. In this case, we determine where the property will go by pretending that the person making the disclaimer died prior to the donor=s death. We then look to see where the property would have gone had that person predeceased and the property passes that way. Example. A parent=s estate plan provides for all of their property to be divided equally among three children. If any child has predeceased the parent, their share is to be inherited by their children. Upon the parent=s death, one of the children, who already has a sizeable estate, would like to avoid adding the inheritance from the parent to the child=s estate. If the child disclaims the inheritance, the child will be treated as having predeceased the parent. In that case, the child=s 1. This can be denied by following the names of the beneficiaries with the phrase no lineal distribution per stirpes. Although non-family members do not automatically have such rights, the beneficiary designation may affirmatively include them. EE--9

10 one-third share would pass to the grandchildren. Thus, the disclaimer can be used to bypass the child=s estate and to pass the assets directly to the grandchildren. Another problem that occurs with inherited property that is not usually present in lifetime transfers is the fact that title has already vested. If an individual has inherited $100,000 worth of property and is already treated as having title to the property under state law, a subsequent disclaimer will cause the property to go to someone else. Assuming the person receiving the property under the disclaimer has paid nothing for it, the one making the disclaimer has given up a valuable right for no consideration. This is therefore treated as a gift for federal gift tax purposes. There is an exception to the gift treatment, however. Code ' 2518 provides that, if the disclaimer is a qualified disclaimer, the person making the disclaimer will not be treated as having made a gift of the property interest disclaimed. The requirements for a qualified disclaimer under Code ' 2518 are that it be an irrevocable and unqualified refusal by a person to accept an interest in property and: 1. the refusal is in writing; 2. the writing is received by the transferor of the interest, the executor, or the trustee of the legal title to the property interest being disclaimed not later than 9 months after the later of the date on which the transfer creating the interest is made or becomes irrevocable or the day on which the person making the disclaimer attains age 21; 3. the person making the disclaimer has not accepted the interest or any of its benefits; and, 4. as a result of the disclaimer, the interest being disclaimed passes without any direction or the receipt of any consideration on the part of the person making it and passes either to or for the benefit of the spouse of the decedent or to or for the benefit of a person other than the one making the disclaimer. In Missouri disclaimers are generally governed by '' through The requirements for a disclaimer under Missouri law mirror those of ' It is critically important to examine possibilities for use of disclaimers as soon as an individual dies is because of the acceptance of benefit limitation. Acceptance means some kind of an act that is consistent with ownership of the interest in the property. Some acts that indicate acceptance of benefit include using the property (although use by a surviving joint tenant is permitted), accepting dividends, interest, or rents from the property, and directing others to act with respect to the property in a manner indicating ownership. Thus, it is important to determine as soon as possible whether a disclaimer might be necessary or desirable, what assets might be subject to disclaimer, and what the beneficiary of those assets needs to do to prevent acceptance of benefit. Business Entities A business owned by a client can pose special problems for the estate planner. If the business has already been set up as some form of entity, the planner must know how to deal EE--10

11 properly with that entity under both state law and federal tax law. It would not do, for example, to create an estate plan which causes loss of a subchapter S election. Unfortunately, many general practitioners aren t even conscious of their own ignorance regarding tax issues. This is especially true with limited liability companies (LLCs), since they can be designed in such a manner that they can mimic any form of entity for federal tax purposes while remaining the same basic entity under state law. The following table contains a comparison of both state and federal tax characteristics of the different entities. Sole proprietorships as such are not included, since a sole proprietor is simply an individual who deals with his or her own assets in a commercial context. Not discussed below, but very important for one considering incorporation, is the use of the statutory close corporation provisions of through , RSMo. The purpose of the statutory close corporation provisions is to recognize some of the unique characteristics and needs of closely held corporations and to provide them with more flexibility under the corporation statutes than has been provided to traditional corporations. Even today, most corporation statutes seem more oriented toward large, formal corporations rather than the more loosely organized and operated closely held corporations. Statutory close corporation status is elective and is available to both general business corporations and professional corporations. Except to the extent expressly modified by the close corporation provisions, the regular rules applicable to a corporation continue to apply to a statutory close corporation. As a rule of thumb, any closely held corporation should elect to be a statutory close corporation unless there is a good reason not to be. And, in fact, there does not appear to be any down side to statutory close corporation status. The results of electing to be a statutory close corporation can be summarized as follows: 1. there are statutory limitations on stock transfers and statutory buy-sell provisions following the death of a shareholder that can apply automatically or which can be modified or eliminated through a shareholder agreement; 2. there is increased flexibility in the governance of the corporation, including the ability of shareholder agreements to bind directors (which cannot be done in a regular corporation); 3. there is statutory protection against loss of federal tax elections, such as the subchapter S election; 4. there is probably somewhat decreased exposure to having the corporate veil pierced for purposes of holding the shareholders personally liable; and, 5. there is more statutory protection of minority shareholders than under regular corporate law. A newly formed corporation becomes a statutory close corporation by including in its articles of incorporation a statement that it is a statutory close corporation. An existing corporation with fifty or fewer shareholders can become a statutory close corporation by amending its articles of incorporation to include such a statement. The amendment must be approved by at least two-thirds of the shareholders. If the amendment is adopted, any EE--11

12 shareholders voting against the amendment are entitled to assert dissenters' rights to have their shares redeemed. EE--12

13 EE--13 COMPARISON OF BUSINESS ENTITIES Limited Liability Company (LLC) General/Limited Partnership Limited Liability Partnership (LLP) Entity Name Limited, Ltd. LC or LLC generally must appear. Limited Partnership, Limited, Ltd. or L.P. generally must appear. "Registered limited liability partnership," "limited liability partnership," "RLLP" or "LLP" generally must appear. Filing Required for Formation Articles of Organization None Registration Statement Internal Governing Instrument Operating Agreement Partnership Agreement Partnership Agreement Degree of flexibility Extremely flexible both under state law and federal tax law. Extremely flexible both under state law and federal tax law. Extremely flexible both under state law and federal tax law. Liability for entity debts and obligations No member liable General partner liable. Limited partner generally protected Varies by state, but no partner liability in Missouri. However, must file annual renewal certificate to maintain limited liability. This is a potential for disaster. S Corporation C Corporation Corporation, Company, Incorporated or abbreviation of one of these must appear. Corporation, Company, Incorporated or abbreviation of one of these must appear. Articles of Incorporation Articles of Incorporation Bylaws Bylaws More formal structure under state law limits flexibility. Most inflexible for federal tax purposes. More formal structure under state law limits flexibility. Relatively inflexible for federal tax purposes. No shareholder liable. No shareholder liable.

14 EE--14 Legal right to participation in management by all equity owners Ownership restrictions Types of ownership interests Yes in membermanaged, no in manager-managed except to extent permitted in operating agreement. General partner only unless limited partners permitted by partnership agreement. General partner only unless limited partners permitted by partnership agreement. Shareholders vote for directors, who manage entity. Voting may be limited by shares. None under state law. For federal tax purposes, at least 2 members needed to qualify as partnership; no upper limit on number of members. One member LLCs are disregarded entities. May elect to be classified as a corporation and may then also elect subchapter S. At least 2 partners, (one general, one limited for limited partnership). No restrictions on types of persons who may be partners. At least 2 partners. No restrictions on types of persons who may be partners. None under state law. For federal tax purposes, 100 shareholder limit. Also, significant restrictions on types of shareholders. No corporations (except in case of qualified subchapter S subsidiary), partnerships, nonresident aliens or foreign entities. Only certain qualifying trusts. No restrictions. No restrictions No restrictions. Single class of stock only, meaning no differences in distribution or liquidation rights, but there may be differences in voting rights. Shareholders vote for directors, who manage entity. Voting may be limited by shares. None. No restrictions, but less flexible than unincorporated entities.

15 EE--15 Ownership of subsidiary entities permitted Dissolution events Federal/state corporate income tax applicable Annual Report/ Franchise Tax No restrictions. No restrictions No restrictions. No restrictions, but S subsidiary requires qualified subchapter S election. Death, retirement, resignation, expulsion or bankruptcy of any member generally results in dissolution, but entity generally continues. Death, retirement, resignation, expulsion or bankruptcy of partner generally results in dissolution unless remaining partners agree to continue business. Death, retirement, resignation, expulsion or bankruptcy of general partner generally results in dissolution unless remaining general partner or all remaining partners agree to continue business. Dissolution does not result from changes in shareholder ownership. No, if taxed as partnership. Yes, if corporate status elected for federal tax purposes. No, if taxed as partnership. Yes, if corporate status elected. No, if taxed as partnership. Yes, if corporate status elected. Generally, no. Possible entity-level tax on excess net passive income and on built-in gains in the case of former C corporations. None regardless of federal tax classification. None regardless of federal tax classification. Annual registration fee. Annual report, possible franchise tax. No restrictions. Dissolution does not result from changes in shareholder ownership. Yes. Annual report, possible franchise tax.

16 EE--16 Contributions of appreciated or debtencumbered property Special allocations of income, gain, loss, etc. Inclusion of entity debt in basis for interest Nontaxable, unless the contribution results in net reduction of member s liabilities in excess of member s basis in LLC. Nontaxable unless the contribution results in net reduction of partner s liabilities in excess of partner s basis. Nontaxable unless the contribution results in net reduction of partner s liabilities in excess of partner s basis. Taxable, unless shareholder has control (80% voting power) immediately after the contribution. Income if liabilities assumed exceed basis in contributed property. Permitted. Permitted. Permitted. Not permitted. Singleclass-of-stock limitation requires pro rata allocations. Yes. LLC debt is allocated among members under partnership rules and included in members' tax basis. Yes. LLC debt is allocated among members under partnership rules and included in members' tax basis. Yes. LLC debt is allocated among members under partnership rules and included in members' tax basis. No. Tax basis of a shareholder s stock does not include any share of entity debt, even if the debt is guaranteed by the shareholder. Taxable, unless shareholder has control (80% voting power) immediately after the contribution. Income if liabilities assumed exceed basis in contributed property. Not applicable. No.

17 EE--17 Distribution of property, (other than cash) Generally, no recognition of gain or loss until member sells or disposes of the distributed property. Exceptions for distribution that is deemed to include member s share of unrealized receivables or inventory items and for cash in excess of basis. Liquidation Proportionate liquidations generally nontaxable except to extent cash exceeds basis. Basis adjustment on transfer of interest Election permitted to adjust inside basis of assets to reflect transferee s outside basis. Fringe Benefits None for members, but may provide for family members. Generally, no recognition of gain or loss until member sells or disposes of the distributed property. Exceptions for distribution that is deemed to include member s share of unrealized receivables or inventory items and for cash in excess of basis. Proportionate liquidations generally nontaxable except to extent cash exceeds basis. Election permitted to adjust inside basis of assets to reflect transferee s outside basis. None for partners, but may provide for family members. Generally, no recognition of gain or loss until member sells or disposes of the distributed property. Exceptions for distribution that is deemed to include member s share of unrealized receivables or inventory items and for cash in excess of basis. Proportionate liquidations generally nontaxable except to extent cash exceeds basis. Election permitted to adjust inside basis of assets to reflect transferee s outside basis. None for partners, but may provide for family members. Distribution of appreciated property treated as sale by the corporation and causes pro rata recognition of gain, but not loss, at shareholder level. Treated as distribution to shareholder. Taxable at corporate level but generally nontaxable at shareholder level due to pass-through of corporate tax items and basis step up. Inside basis adjustment to reflect different outside basis not permitted. None for more than 2% shareholders, imputed stock ownership to family members Distribution of appreciated property treated as sale by the corporation and causes recognition of gain, but not loss, at corporate level. Treated as distribution to shareholder. Taxable at both corporate and shareholder level. Inside basis adjustment to reflect different outside basis not permitted. Available for all employees.

18 EE--18 Estate Planning Pros/Cons Very flexible due to contract approach of operating agreement and lack of adverse tax consequences of liquidation (unless corporate status elected for federal tax purposes). Very flexible due to contract approach of operating agreement and lack of adverse tax consequences of liquidation (unless corporate status elected for federal tax purposes). Very flexible due to contract approach of operating agreement and lack of adverse tax consequences of liquidation (unless corporate status elected for federal tax purposes). Least flexible due to limitations on shareholders and classes of stock. Complicated tax issues on liquidation. More flexible than S corporation, but worst choice from tax perspective.

19 Financial and Medical Durable Powers of Attorney Incompetency is a problem that many people have to deal with and for which very few plan properly. There are two forms of incompetency. One is the inability of an individual to take care of his or her financial affairs. This may require the appointment of a conservator, a person who is legally responsible for handling the incompetent's financial affairs. The other form of incompetency is the inability to care for one's physical needs, requiring the appointment of a guardian. A guardian can consent to such things as medical care of the ward (the one who is incompetent), nursing home care and similar measures. Because conservatorship and guardianship are separate functions, they can be appointed only as needed and can also be assigned to different persons. Unfortunately, the appointment of a conservator or guardian is a legal proceeding, meaning courts, judges, lawyers and other unpleasantness. Periodic accountings will have to be made to the court, which will also have to approve any major decisions concerning the individual. There can be substantial costs involved in all this, which will come from the assets of the incompetent. Plus, of course, there is always the relative public nature of the proceedings. It is therefore something that most of us would rather avoid. As a result, people try to use devices that will allow their affairs to be taken care of by someone without the need for a conservatorship or guardianship. A parent might put a child's name on a bank account, for example, so that the child can write checks to pay bills for the parent. But this takes care of only very limited needs. So, to take care of broader needs, a power of attorney is sometimes used. A power of attorney allows the person to whom it is given (the agent or attorney in fact ) to perform acts for the giver (the principal ) as if the principal personally had performed the acts. The powers granted may be limited to certain specified acts, such as selling a particular piece of property, or may be unrestricted, a general power of attorney. However, a power of attorney can be revoked by the principal. Furthermore, it is automatically revoked by the death or incompetence of the principal. That means that when it is actually needed the most, it's no good. To help overcome this problem of automatic revocation by incompetence, all states now permit a person to execute a durable power of attorney. Such a power is not affected by the incompetency of the principal. However, it usually must specifically state that it is a durable power of attorney. Some states even have statutory forms that can be copied by anyone. Missouri does not, except for declarations (living wills).a durable power of attorney should be considered as a part of any estate plan. One should also be concerned with one s ability to insure that health care decisions are made and carried out the way one would want in the event of inability through physical disability to express one s desires. This is taken care of through the use of a durable power of attorney for health care. This type of power allows appointing someone else to make health care decisions for an individual who is unable to do so. If permitted, that person usually may also make the decision to withdraw nutrition and hydration. Note that the durable power of attorney for financial affairs and the durable power of attorney for health care can be separate powers that can be given to different people. In choosing someone to act on his or her behalf, therefore, a client should ask these questions: If I am unable to make my own decisions, whom would I most trust to look after my financial affairs the way I would want, and whom would I most trust to carry out my health care decisions the way I would want? They may very well not be the same person. All states allow a person to execute a so-called living will, although some states have incorporated this into their durable power of attorney for health care. This is not really a will or even part of a will, but a declaration regarding the use of death-prolonging procedures and is designed to prevent such measures. Its function has been largely replaced by the durable power of attorney for health care, but it should still be included as part of a complete estate plan. Page 19 EE--19

20 INTERVIEWING & COUNSELING YOUR ESTATE PLANNING CLIENT Kenneth K. Wright 2600 Forum Blvd Ste E Columbia, Missouri Most clients who go to a lawyer for estate planning do so because of one or more of the following reasons: (1) probate avoidance; (2) estate tax avoidance; or, (3) to provide for minor children. Less common will be the need to provide for succession of a family-owned business. If you intend to engage in estate planning, you need first to match your knowledge and skills to the services you will offer. Even basic estate planning requires you to be able to draw from the law of wills, probate, nonprobate transfers, guardianship, trusts, fiduciary administration, and property. More sophisticated estate planning adds business law, contract law, estate, gift, and generation-skipping taxes, and income tax. If you are wrong, you have potential malpractice exposure not only with respect to your immediate clients, but also their heirs. Small wonder, then, that lawyers whose principal practice is estate planning pay the second-highest malpractice premiums. The questionnaire which follows in these materials can be used by you as a basis for developing a client questionnaire. In its present form it is, in fact, so long that many clients will be overwhelmed by it and will make only a haphazard attempt to complete it. Its greater value is to you to serve as a checklist during client interviews and estate planning. You should avoid relying entirely on a client questionnaire for purposes of designing an estate plan. Nothing can replace an interview with the client in which the client feels comfortable enough to speak freely. If you are a good listener, you may very well pick up issues that would not appear from a questionnaire. And, as you acquire more experience, you will be able to spot issues from clues that the client or the client's information give you. You must also be willing to ask the not nice questions that will bring sensitive issues out into the open so that you can help the client deal with them. Remember, your role should be as a problem solver for the client and not just as a scrivener of documents. No checklist can replace good listening skills! Page 20 EE--20