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Mistakes in Estate Planning

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October 2007
Mistakes in Estate Planning

Mr. and Mrs. Patel came to the U. S. in the early 70s with their three children (Niraj, Alpesh, and Nita). With a lot of hard work and diligence they bought their first motel with a little help of their friends and relatives shortly after their arrival. They were able to pay off their debts within a few years and started to build their portfolio.

First they bought a second motel, than a third, and eventually started building larger well known hotels. By the year 2006, they had amassed an impressive net worth of over $20 million. Then a tragedy struck their family. One night coming home from a party, their car was hit by a drunk driver and both Mr. and Mrs. Patel died in the crash.

A couple of years before their death, Mr. Patel had transferred several of his hotel properties to his sons Niraj and Alpesh to reduce his estate tax exposure. Niraj got property valued at an estimated $2.5M and Alpesh property valued at $1.8M. Mr. Patel also had several life insurance policies on his life that he owned,valued at $2.5M, and a $1M policy on his wife's life, of which she was the owner. Each of them were the primary beneficiaries of the other's policy. They each had a simple will stating that in the event of their death, the other should inherit everything and upon the second person's death, the children were to receive the assets equally.

For people with modest net worth and estates, this could be an okay strategy, but in the case of the Patels, it was a major disaster. Here was the outcome.

Mistake One: When Mr. Patel transferred his hotels to his sons, he made a taxable gift. In general, you are limited to gifts of $12,000/yr from one person to another in 2007. There is also a lifetime gifting limit of $1 million per person. In the case of Mr. Patel, he made a total gift of $4.3 M minus his $1 M exemption resulting in a possible gift tax on appx. $3.3 M at the highest rate of 45% or $1,485,000.

Mistake Two: Both Mr. and Mrs. Patel owned their own life insurance policies valued at a total of $3.5 M. Even though the death benefit from life insurance is tax free to the beneficiaries, if the policies are owned by the deceased person, the proceeds are included in the deceased's estate for estate tax purposes. The estate tax attributed on the $3.5 M life insurance policies at an approximate estate tax rate of 45% in 2006 resulted in $1,575,000 in estate taxes just on the life insurance policies alone. The biggest beneficiary of their life insurance was Uncle Sam.

Mistake Three: Mr. & Mrs. Patel did not plan adequately for payment of their estate taxes. After deducting their $1M exemption ($1M each already used for gifting purposes above) per person for a total of $2M from their total $20 million net worth, they were left with a taxable estate of approximately $16 M. Multiplied by the highest estate tax rate of 46%, the Patel children are left with an additional tax bill of $7,360,000 due within 9 months from the date of death. The children will need to liquidate several of their hotel properties in a fire sale to pay the estate and gift taxes.

Mistake Four: Outright distribution to children – One son is in the middle of being sued for one of the hotel properties, so inheritance will provide a windfall that may be lost in litigation. Other son is in the middle of a divorce, and most of that inheritance will end up with an ex-daughter-in-law.

I apologize for such a graphic and extreme example, but this is just an example of some of the common mistakes people tend to make when planning for their estates. There are many things the Patels could have done to reduce their estate and gift tax burdens and to make sure their net worth remained intact. I guess they thought they had plenty of time—but life tends to be uncertain.

There are many tools and techniques in estate planning available to us, including bypass trusts, insurance trusts, living trusts, private annuity transactions, as well as a host of charitable giving techniques. Unfortunately, it is not within the scope of this article to go into in depth details on all of these instruments and how you can use them to your benefit.

Most everyone needs some basic estate planning which could be as simple as a will, power of attorneys for healthcare and financial reasons, and a living will to give advance directives if you were ever on a life support system. There are also many non-tax reasons for estate planning., especially if you have minor children. At a minimum, every parent of a minor should write a will so that you have appointed a guardian of your choice, and trustees to manage the money for your children until they reach adulthood.

For people who have a sizeable net worth and estates in excess of $2M, you really should do some advanced planning or else one your largest benefactors could be the IRS. Seek out competent financial advisors and attorneys to assist you in your planning and implementation process. This is a highly specialized area and requires special attention. Avoid taking short cuts and "too good to be true" ways to plan your estate. The biggest mistake one can make is procrastination!

Moneywise is hosted by Rajesh Jyotishi with Shalin Financial Services, Inc. Rajesh is an investment advisor representative of SII Investments, Inc. A Registered Broker Dealer. Member of NASD/SIPC. Rajesh has been in the insurance, investments and financial planning field since 1991. For questions, he can be reached at 770-451-1932, ext. 101. Rajesh@khabar.com.


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