California Law Disfavors Intestacy

In Estate of Stockird (2018) 30 Cal.App.5th 558, Cheryl Stockird wrote a holographic (handwritten) will, leaving 65 percent of her property to her longtime partner, John Aguirre, and the remaining 35 percent to Patricia Ambrose, who had been married to Stockird’s uncle. Ambrose died before Stockird.

When Stockird passed, Aguirre claimed that he was entitled to the 35 percent of her estate that was to go to Ambrose in addition to the 65 percent allocated to him. Stockird’s half-brother, Bruce Ramsden, argued that he was entitled to the 35 percent as Stockird’s next of kin.

California Probate Code section 21110, known as the anti-lapse statute, allows gifts to pass to heirs of the named recipient if the recipient is a blood relative of the transferor. Hence, if Alice leaves property to daughter Betty, but Betty predeceases Alice, then Betty’s children will receive the property in equal shares when Alice dies, i.e., the gift does not lapse because the law presumes that Alice would have wanted to provide for her grandchildren.

But the anti-lapse statute did not apply to the failed gift to Ambrose because she was not a blood relative of Stockird.

The allocation of the 35 percent share therefore turned on the rules set forth in California Probate Code section 21111.

The trial judge in Contra Costa County Superior Court found that the gift to Ambrose failed and resulted in a partial intestacy, such that the 35 percent would be distributable to Stockird’s heirs at law, i.e., the half-brother to whom she gave nothing in her will.

The Court of Appeal ruled that the trial judge had misinterpreted section 21111(b). Under that subsection, if a residuary gift is transferred to two or more persons and the gift to one of them fails without an alternative disposition, then the share passes to the other remainder beneficiary or beneficiaries in proportion to their respect interests. In construing the statute, the court relied on a legislative intent to avoid partial intestacy (by abolishing the “no residue of a residue” rule), as well as the Uniform Probate Code and the Restatement Third of Property.

Accordingly, the will should have been interpreted to favor Aguirre as the recipient of the 35 percent share. However, the Court of Appeal sent the case back to the Contra Costa court for further proceedings because Ambrose’s heirs (her children and grandchildren) had petitioned to reform the will to reflect Stockird’s supposed intent for the failed residuary gift to pass to them.

Under Estate of Duke (2015) 61 Cal.4th 871, a California court may reform an unambiguous will if “clear and convincing evidence establishes that the will contains a mistake in the expression of the testator’s intent at the time the will was drafted and also establishes the testator’s actual specific intent at the time the will was drafted.” This is not an easy hill to climb, but Ambrose’s heirs will have their day in court as the litigation continues.

Settlor Can Direct Particular Asset to Remainder Share Without Making a “Specific Gift”

While Stockird involved a handwritten will, lawyer-drafted estate plans are also susceptible to litigation over interpretation. Blech v. Blech (2018) 25 Cal.App.5th 989 provides an example.

Arthur Blech died in 2011 with an estate worth more than $65 million – most of it left to his four children in unequal shares. The Blech Ranch in San Luis Obispo County was worth $7.2 million when Arthur died, but (with California’s surging real estate market) was sold less than three years later for $14 million, leading to $2.3 million in capital gains tax.

The issue on appeal was whether the Ranch was a specific gift to Arthur’s son, Raymond Blech, or whether it was part of the remainder (or residue).

The Los Angeles County Superior Court deemed the Ranch a specific gift. Based on that ruling, Raymond claimed that he should have received the entire net appreciation on the sale of the Ranch, which would be about a $4.5 million swing in his favor.

Whoa, said the Court of Appeal. It looked to California Probate Code section 21117 for the categorization of “at-death transfers.” Under this section, a “residuary gift is a transfer of property that remains after all specific and general gifts have been satisfied.”

Construing the trust instrument as a whole, the appellate court found that Arthur intended for Raymond to receive 35 percent of the entire trust remainder, including the Ranch if it happened to be part of the trust estate at the time of distribution. This was consistent with Raymond’s historical involvement in the Ranch’s operations. Hence, the gift of the Ranch was an instruction to the trustee as to how to fund Raymond’s 35 percent share of the remainder, not a specific gift to him that preceded allocation of the remainder.

This is a case where the trial judge reached the correct outcome for the wrong reason. Despite the mischaracterization of the Ranch as a specific gift, the trial court’s ruling denying Raymond the full appreciation on the sale of the Ranch was correct. Once again, the analysis required application of the “rules of interpretation” in the Probate Code.

1. Enlarged Estate Tax Exemption

The 2017 tax reform legislation roughly doubled the transfer tax exemption to $11.4 million per individual, or $22.8 million per married couple, as adjusted for inflation in 2019 (the 2018 exemption was $11.18 million per person). Because the transfer tax exemption exempts both transfers at death and transfers made during life from estate, gift and GST taxes, the expansion has created an opportunity for wealthy clients to shield an even greater portion of their wealth from eventual taxation.

2. IRS Confirms: No Clawback for Post-Reform Transfer Tax Exemption

For transfer tax purposes, the IRS has released guidance confirming that clients will be allowed to make large gifts from 2018-2025 (when the expanded $11.4 million-per person transfer tax exemption is in place) without fear of any kind of “clawback” if the client dies in a later year, when the exemption is lower. This means that clients can take steps to use up the entire $22.8 million per-married-couple transfer tax exemption between 2019 and 2025 without any fear that they will be subject to transfer tax liability for those gifts in later years.

3. Inheriting an IRA

If a client inherits an IRA, the distribution requirements depend upon whether the clientbeneficiary is a spouse or non-spouse beneficiary. A spousal beneficiary has the option of rolling the funds into an inherited IRA or his or her own IRA, and can wait to begin taking RMDs until reaching age 70 1/2. A non-spousal beneficiary cannot wait until age 70½ to begin taking RMDs—he or she must either withdraw all funds within five years or based upon his or her life expectancy. RMDs will depend on whether the original owner died before or after his or her required beginning date.

4. Inheriting Qualified Plan Funds

While inherited IRAs often may be distributed over time, qualified plans (such as 401(k)s and profit-sharing plans) do not allow the funds to be distributed over the beneficiary’s life
expectancy. When a client inherits a 401(k), the funds typically must be distributed immediately in a single lump sum payment, resulting in an immediate tax liability for the beneficiary. Most plans will specifically require lump sum distribution treatment because of the administrative burdens associated with allowing stretched out distributions. Fortunately, designated beneficiaries of qualified plans have the ability to roll those funds into an inherited IRA. Because of this, clients should regularly review their beneficiary designations on qualified plans.

5. Formula Trusts Should Be Reevaluated Post-Reform

Many clients have used so-called “formula trusts” in their estate planning to take advantage of the full transfer tax exemption, which changes each year. Like many other estate planning techniques, these trusts will need to be reevaluated in light of the increased estate tax exemption amount. A particularly problematic issue may arise when the formula in the plan directs that assets up to the exemption amount will be placed into a credit shelter trust, with the remainder placed into a marital trust designed to take advantage of the marital deduction. With the enlarged estate tax exemption, some clients may find that no assets will remain to be transferred to the marital trust. This can present a problem if the surviving spouse is not also the beneficiary of the credit shelter trust (for example, if the decedent’s children are beneficiaries of that trust).

6. Portability Remains Possible Post-Reform

Portability simply allows a surviving spouse to make use of both his or her individual federal estate tax exemption and the exemption granted to a first-to-die spouse. The portability rules were not changed by tax reform. This generous estate tax exemption, however, can often cause a problem for surviving spouses when the entire estate of the first-to-die spouse is sheltered from estate tax. Clients and advisors alike commonly overlook a key requirement for obtaining the benefits of portability: you have to ask for it. Even if no estate tax is due upon the death of a first-to-die spouse, the executor of the estate must elect portability by filing an estate tax return on Form 706 within nine months of death, although an extension (requested by filing Form 4768) may be available if the executor can show good cause.

7. Reevaluating SLAT Trusts

A spousal lifetime access trust (SLAT) can potentially be useful in allowing clients to take advantage of the full transfer tax exemption before it expires after 2025. A SLAT is an irrevocable trust that can potentially allow a client to remove assets from his or her estate while also maintaining access to those assets during life. To fund a SLAT, a married client transfers assets into the irrevocable trust for the benefit of his or her spouse. An independent trustee is appointed to oversee the trust (adult children may serve as trustee so long as a concrete, ascertainable standard exists for trust distributions). The gift to the irrevocable trust removes the assets from the client’s estate, but allows the spouse to access the trust assets if necessary. The strategy allows the client to retain a degree of control over the assets, and also puts the assets out of the reach of creditors. However, the risk of divorce must also be considered—once the client creates the SLAT, if he or she divorces the spouse, the client could lose control of SLAT assets.

8. ING Trusts: Complete vs. Incomplete Gift Strategy

An ING trust is an intentionally non-grantor trust (or an irrevocable non-grantor trust) that is primarily designed to generate income tax savings, but can add value from an estate planning perspective in light of the temporary nature of the enlarged estate tax exemption. Central to the ING trust strategy is the presence of an “adverse party”—or a group of adverse parties—who control trust distributions to beneficiaries. Gifts to the trust can be either incomplete, allowing the trust creator to retain a degree of control over the assets and avoid gift taxes, or complete— meaning that the transfer would create a deduction from the client’s lifetime transfer tax exemption amount. For transfer tax purposes, the calculus on whether a complete or incomplete gift to the ING trust is most beneficial has changed post-reform—primarily because the IRS has confirmed that there will be no clawback of the currently high transfer tax exemption.

9. State-Level Estate Taxes Remain an Issue Post-Reform

Despite the generous federal-level transfer tax exemption, states that continue to impose their own estate taxes have largely decided against matching the federal exemption. Washington, D.C., determined that its exemption would remain at the $5.6 million level, while Hawaii kept its exemption at $5.49 million (the same as the federal exemption amount in 2017). In Maryland, the legislature decided to fix its exemption at $5 million for 2019 and beyond, although the state also adopted a portability regime that matches the federal portability rules to allow a surviving spouse to take advantage of his or her deceased spouse’s exemption. These changes are important, because they highlight the continued need for estate planning guidance for higher income clients who reside in states that continue to impose estate or inheritance taxes.

10. $11.4 Million Exemption Is Only Temporary: Flexibility Is Key

Finally, in all of their planning, clients should consistently be reminded that the $11.4 million per individual transfer tax exemption (as adjusted for inflation in 2019) is only temporary. After 2025, it is set to revert back to the pre-reform levels of around $6 million per individual, factoring in anticipated inflation adjustments. Clients should also be reminded that in reality, everything in the tax code is temporary—as political winds shift, so can tax rules that have been labeled as permanent. Because of this, flexibility is always key to the success of any estate planning strategy.

Example: Parents have an estate of $3 million and three children. They bequeath to a dynastic trust for each child a $1 million inheritance. That’s easy. The difficulties arise when the parents have children with very disparate needs; health issues or different wealth levels, for example. What if one child is a Wall Street tycoon and another a struggling school teacher, recently divorced and struggling to make ends meet? Should the same equal distribution be used? Perhaps in a different scenario, one child has a chronic medical condition that will result in truncating her career at age 45 and is struggling to face costly medical bills. Is equal really fair? A dramatic difference in the financial circumstances of one sibling versus another sibling may justify greater inheritance for the person in greater need, but a client needs to be at peace with that decision.

Many parents grapple with the conflict of leaving less to one child simply because he’s more successful or more to another who isn’t. The concept of fairness also applies to the giver, and she must consider if she’s being fair to herself. That’s a profound and significant change in perspective for many clients. Most tend to view the dispositive scheme from the perspective of heirs, not from their perspective. The client/benefactor’s wishes, desires and concerns should also be respected to be fully fair.

Normalize Experience

Estate planners should normalize the experience for the client. Make it understood that the client isn’t unique in having these concerns and conflicts. Perhaps the client isn’t comfortable with distributing the estate equally because she’s feeling torn. Or, by not distributing equally, she worries about creating resentments or feelings of favoritism among her chosen heirs.
Example: Your clients have two children. They want to leave their estate 70 percent to a child who has significant health issues and 30 percent to their other child who hasn’t faced significant challenges. They might worry that unequal distribution contributes to a feeling of unequal relationship. This may not sit well with the client’s heirs, but first and foremost, the clients need to determine that their decision is based on an appropriate foundation and not merely on preferential reasons (I like child A better than child B). As every estate planner knows, there are many options for how to handle the above intent. Another approach might be to leave the estate 30 percent to each child and bequeath 40 percent into a sprinkle trust with an independent trustee and direct that the funds in the trust be distributed to defray health care costs and other costs associated with health issues. That way, if the currently well child develops an issue, a more-long term fairness might be achieved.

Sorting Out Choices

Often, clients are uncomfortable and are prompted to assign unequal portions because they hold certain resentments, have a history of disappointments or feel more or less appreciated by one child or another. Sorting out choices based on logical factors versus emotionally driven factors is a formidable task for the client in conflict over equal versus fair. Attaining confidence that her position is based on reasonable considerations may contribute, in this example, to the client’s conviction that she’s being fair to herself, even if it isn’t unanimously popular among the heirs. By discussing with her heirs the process your client explored in arriving at a decision, your client can add a layer of completeness.

Facilitate Process

Estate planners and psychologist consultants can facilitate this difficult process that their clients are struggling with. The estate planner should try to uncover the client’s line of thinking, assure her that people commonly have to weigh these issues and help the client get to a result she feels is truly equitable. The planner may not be equipped to counsel on deep emotional issues, when a therapist may be required, but should conduct due diligence in guiding clients toward an appropriate plan. At the very least, the planner shouldn’t proceed until she’s confident the client has really thought everything through and advise her in a way that leads to clarity for herself.