Probate is the court supervised legal process by which a deceased person’s assets are collected, managed, and distributed to beneficiaries, after payment is made on creditors’ claims. In many States, probate has a very negative reputation as an expensive and cumbersome process that may adversely impact families and delay asset distribution. This stigma often results in bad probate avoidance strategies being offered by online sources, hairdressers, bartenders and neighbors. Even professionals such as bank employees, investment managers, accountants, and attorneys not specializing in estate planning can offer poor suggestions regarding ways to avoid probate.
Any strategy designed to avoid probate MUST be carefully examined in the context of an overall management and distribution plan. Although strategies to transfer (i) life insurance proceeds, (ii) IRAs, (ii) 401(k)s, (iii) joint tenancy with right of survivorship accounts, (iv) life estates, and (iv) assets outright to a beneficiary prior to death may have a proper purpose AND “pass outside of probate,” their uninformed use can also result in dramatic, unintended consequences.
This article is narrowly focused on the risks associated with the improper, and ill-advised, use of joint tenancy with right of survivorship accounts as a strategy for avoiding probate. Risks surrounding other probate avoidance strategies will be addressed in subsequent articles.
Joint Tenancy with Right of Survivorship (JTWROS)– This is a method in which financial accounts or real property are titled in the name of two or more owners. At the death of one owner, the ownership automatically passes to the surviving owner. These accounts overrule any contrary intent expressed in a Will.
An Illustration of Potential Unintended Consequences- An 85-year-old widow is advised that she can avoid probate of her $4M brokerage account if she simply changes her account to include her three adult sons (Larry, Moe, and Curly) on a JTWROS account. She is told that when she dies, the account assets will pass automatically to her sons. Although technically true, this strategy failed to consider the following:
- Survivorship is the key to ownership. If Curly dies before the mother, then upon the mother’s death only Larry and Moe become owners of the assets as the survivors. Curly’s children would be disinherited and receive NONE of the assets, contrary to the mother’s intent.
- Subject to claims of creditors. Now that the sons are additional owners of the account that includes their Social Security Numbers, the assets may be subject to the claims of creditors, bankruptcy, tax liens, and judgment creditors of the sons. A spouse may pressure a husband to access funds for personal use or be subject to a spouse’s partial claim in a divorce proceeding (income from separate property is community property). The mother could lose all of her assets prior to her death. Sarcastically, owning no assets at death will also avoid probate.
- Survivors have access to the entire account. Upon the mother’s death, each surviving son has immediate access to the jointly owned assets and can withdraw the assets without approval of other joint tenants at any time. For example, Larry would have the legal contractual ability to withdraw all or a substantial portion of the assets without the knowledge or approval of either Moe or Curly.
- Capital gains tax exposure. As a result of the gift, the sons will be burdened with the mother’s cost basis in the underlying assets. Upon the mother’s death, the sons will not receive a step up in basis to the date of death fair market value of the asset. This will result in unexpected capital gains taxes when the assets are liquidated by the sons. A capital gains tax is incurred when the amount for which an asset is sold exceeds its cost basis. For example, if the cost basis in an asset is $1,000 and is sold for $3,000 there is a $2,000 capital gain. However, if the same asset is inherited after the death of the owner, the beneficiary would receive a step up in in the basis to the fair market value of $3,000. If the asset then sold for $3,000, there is no capital gains tax incurred.
- May not avoid probate completely. Upon the mother’s death, it may still be necessary to go to probate to transfer ownership of real estate or other assets. Because the $4M is paid directly to the sons, the mother’s probate estate may lack liquidity to pay debts and/or taxes.
- Estate and gift tax concerns may arise in large estates. Upon the creation of the joint tenancy, the IRS may deem that the mother made a $1M gift to each of her sons. This realization may not occur until after the mother’s death and could result in adverse estate tax consequences for large estates. (Note: a more detailed discussion of the estate and gift tax applications will follow in a later article).
- Potential income tax concerns. As owners of the accounts, income from the account could be allocated to each of the sons. If the mother pays the taxes, new issues could arise.
The mother could have avoided probate AND avoided the above referenced risks above by creating a Living Trust for which she was the primary beneficiary during her lifetime. Upon her death, the assets would be divided into three equal shares for the benefit of her sons and/or the children of any deceased son. The sons would also receive a step up in basis. A Trust would also provide for the management of her assets during any period of incapacity.