How To Wreck Your Estate Plan
(Without Even Trying)

by
Christopher Manes

So you've done everything right when it comes to looking out for your kids' inheritance. You hired an experienced attorney to advise you on an appropriate estate plan (not some guy who sells canned trusts for $50 a pop); you set up a living trust with your spouse to avoid probate expenses and estate taxes at your death; you transferred your property to the trust. Now you can just sit back and relax knowing that when you go to meet your maker your children will get everything you worked so hard for them to have.

Think again. Establishing an attorney-drafted estate plan (which usually means a living trust) is just the first step in insuring your children get the inheritance that you planned for them. Step two is negotiating the labyrinth of California's community property laws to avoid having someone other than your children inherit what you want to give them.

If you've been married for 35 years to the same person, and earned your assets together, so that almost everything you own is community property (that is, half yours, half your spouse's), then you probably can relax. But if you divorced and remarried (the demographic norm nowadays), and have children from a prior marriage, you need to carefully take stock of the assets you actually own and have a right to leave to your kids. The assets you think you own are very likely not completely yours to give. And your interest in the assets you do own may be slipping away even as you read this article -- unless you take the right actions.

Here are three principles to keep in mind in any estate plan -- let's call them Manes' Laws of Inheritance:

First, you can only make an inheritance of what you own.

Second, you have at least one silent partner in everything you own -- Uncle Sam; and you probably have a second partner -- your spouse, if you're married and live in California and don't have a prenuptial agreement saying otherwise.

Third, what you think you own separately can easily become co-owned by your spouse, unless you take steps to insure that doesn't happen.

Here's how Manes' Laws apply to a typical situation many people find themselves in nowadays. A man marries, has two kids, divorces, and remarries a woman with children by a prior marriage. The children are now adults, and may have kids of their own. The man establishes a living trust into which he transfers his residence, some stocks, and his business, a close corporation from which he takes a salary -- all owned by him before his second marriage. He doesn't have a prenuptial agreement with his second wife. His intent is that when he dies, all his second wife's separate property and one-half their community property will go to her own trust (usually called the "survivor's trust'), to do with as she pleases. But as for his property, he wants his wife to get only the income from the stocks, which will go equally to his children upon her death. Same with the business. And she can live rent-free in the residence, but at her death, the house also goes equally to his kids.

This is a typical estate plan for a twice-married man (which by the way is often not the best way to go, but there it is). And it's fraught with unseen dangers unless the man is careful how he handles the assets he expects his kids to get. Please note that all these principles apply to the twice-married women, also, especially if she brings substantial assets to her second marriage and has kids of her own. The only reason I'm using a man as an example is that as a practical (and actuarial) matter, men usually don't outlive their wives, and the second wife will usually be the trustee of the trust and hence, in control of the assets. But twice-married woman also must keep these principles in mind to insure their kids inherit what they intended.

Remember Manes' Law of Inheritance #1: the man can only give to his kids what he owns. He thinks he owns the residence because he purchased it before his second marriage. But does he? Here Manes' Law #2 and #3 kick in. Without a prenuptial agreement to the contrary, the man's salary is community property; that is, half of it belongs to his second wife, his children's stepmother. If he used his salary to pay the mortgage on his house, as typically happens, then half the mortgage payments are coming from his silent partner -- his second wife. As a result, with every mortgage payment, the stepmother is buying a community property interest in the residence, just as surely as if her name were put on the deed, and her one-half share of the community interest belongs to her, not her husband.

Poof! There goes the estate plan of our good-intentioned father. When he dies, his children will quickly learn that the house they thought was going to be theirs, in fact belongs in part to their stepmother's survivor's trust (assuming she consults a good probate attorney), and she can give that interest to anyone she wants -- most likely her own children. This is exactly what the man tried to avoid. It happened because he thought his planning for his kids ended with a properly drafted and funded trust, when that was just the beginning. He also needed to understand and work around California's community property system in handling the assets in the trust.

Here's another way our estate-planning-challenged man can go astray. He works night and day in his business, making it more and more successful. But being a prudent and forward-looking guy, the salary he takes from the corporation is much smaller than the money he would get if he did similar work for some other business he didn't owned. He figures he'd rather keep the profit in the business so that it grows and his kids will have more to share in the future when they inherit it. Sounds noble. In fact, his good intentions have once again tripped up on our community property system, and he's made sure not that his children get a bigger pie, but rather that the children of wife #2 will take a piece of the business he never intended for them.

Here's why. Without a written agreement with his wife to the contrary, the man's salary is community property. If he took the compensation he was reasonably entitled to, no problem. But if he takes a smaller salary, that means a portion of his salary was essentially given back to and reinvested in the business. Just like with the community mortgage payments in the residence, applying Manes' Law #3, the man's community salary is buying a community interest in the business with every under-compensated paycheck he gets. And half that interest belongs to the stepmother's survivor's trust. Again, when the man dies, you can be sure that the wife #2 will claim the interest if she has a competent attorney. The court will allocate a portion of the business to her trust, and she will give it to her kids. Suddenly, the man's children have unanticipated business partners: their half-siblings, who after the court battle over ownership of the corporation, are probably not going to be in the most cooperative mood.

The same principle applies whether the business is a corporation, partnership or a sole proprietorship. If the owner is under-compensated for his work, the community is buying into the business.

Sometimes there are ways to "fix" these unintentional gifts, even after your death, through a court-approved accounting, assuming your kids have an attorney who understands principal and income allocations and the stepmother doesn't. But don't count it.

Failure to take into consideration community property laws is the easiest way to make mincemeat out of your well-crafted, expensive estate plan. But there are others. Years after establishing the trust, our lackadaisical fellow may sell the residence and buy a new place. The real estate broker may advise him, as is often the case, to put title to the property in joint tenancy to avoid probate expenses. Having utterly forgotten about Manes' Law #1, the man does so, and upon his death, the residence doesn't go to his children at all, but belongs part and parcel to his second wife. His children might mount a court challenge, but the best they can do at that point is get the court to declare the property community, meaning they would only get a fifty-percent interest.

Let's assume the second wife is significantly younger than our guy is. In fact, she's not much older than his kids are. The jaunty husband's lawyer is smart enough to avoid giving her a life estate in the house (that is, she doesn't get to live in the residence rent-free for as long as she lives, which would essentially prevent the kids from ever benefiting from the house), or income from the business or investments. Instead, the man gives her a cash bequest of say $500,000, with everything else going to the kids. Sounds fair enough, but what about Manes' Law #2, and the silent partner, Uncle Sam? Unless the trust says otherwise, the kids are going to have to pay all the estate taxes from their share of the assets. The second wife won't pay any share of the tax. That's fine if it's what the man intended (though the children probably won't think much of the arrangement), but if our good father wants everyone to pay a proportionate share of the estate taxes based on what they get, he's got to make sure he tells the attorney so the trust will be drafted accordingly.

Any probate lawyer will tell you, people keep coming up with new and creative ways of demolishing their carefully designed estate plans. This article mentions only a couple of the most common method. I'm sure even now some readers are making up some new ones. The point is, you can't sit on your estate-planning laurels. Once you've established a trust that gives your children what you intend, you also need to administer the assets in a way that doesn't run afoul of California's community property systems and federal tax considerations. Otherwise, what your children may inherit from you is not your assets, but one long ugly probate lawsuit.