Estate planning is a critical component of wealth management for private clients. Translating the goals of an individual or family into effective legal and tax-efficient solutions can be a challenging task, which requires an intimate knowledge of, among other things, the tax and inheritance laws in a particular jurisdiction.
Estates, Wills, and Probate
Your estate is everything you own: financial assets; real estate; collections such as art, stamps, or coins; businesses; and non-tangible assets, such as trademarks, copyrights, and patents. Estate planning is the planning process associated with transferring your estate to others during your lifetime or at death so that the assets go to the individuals or entities you intend and in the most efficient way.
The most common tool used to transfer assets is a will. A will is the legal document that states the rights others will have to your assets at your death. The person transferring assets through a will is known as the testator.
Probate is a legal process that takes place at death, during which a court determines the validity of the decedent’s will, inventories the decedent’s property, resolves any claims against the decedent, and distributes remaining property according to the will. Probate involves considerable paperwork and court appearances, and all costs associated with the probate process, which can be significant, are borne by the decedent’s estate. If the decedent leaves no will or if the will is deemed invalid, the decedent is said to have died intestate and the distribution of assets is determined by the court.
Assets solely owned by the decedent must be transferred by a will through the probate process. Due to the cost, the time it takes, and the public nature of the probate process, however, individuals often take steps to avoid it. This can be accomplished through joint ownership with rights of survivorship, living trusts, retirement plans, life insurance, and other means which transfer assets outside the probate process.
Legal Systems, Forced Heirship, and Marital Property Regimes
A country’s legal system can affect the disposition of a will. For example, common law jurisdictions, such as the United Kingdom and the United States, generally allow a testator testamentary freedom of disposition by will; that is, the right to use their own judgment regarding the rights others will have over their property after death. Most civil law countries place restrictions on such disposition.
Civil Law is the world’s predominant legal system. In civil law states, judges apply general, abstract rules or concepts to particular cases. Common Law systems draw abstract rules from specific cases.
The distinction is arguably analogous to the distinction between deductive and inductive reasoning. Put differently, in civil systems law is developed primarily through legislative statutes or executive action. In common law systems, law is developed primarily through decisions of the courts.
Countries following Shari’a, the law of Islam, have substantial variation, but are more like civil law systems especially in regard to estate planning.
The legal concept of a trust is unique to the common law. A trust is a vehicle through which an individual entrusts certain assets to a trustee who manages the assets. Civil law countries may not recognize foreign trusts.
Ownership, like other legal principles in civil law, is a precise concept tempered by statutes that place certain limitations on the free disposition of one’s assets. Under forced heir ownership rules for example, children have the right to a fixed share of a parent’s estate. This right may exist whether or not the child is estranged or conceived outside of marriage. Wealthy individuals may attempt to move assets into an offshore trust governed by a different domicile to circumvent forced heirship rules. Recognizing this, many regimes apply clawback provisions that add the values back to the decedent’s estate before calculating the child’s share.
Spouses typically have similar guaranteed inheritance rights under civil law forced heirship regimes. In addition, spouses have marital property rights, which depend on the marital property regime that applies to their marriage. For example, under community property rights regimes, each spouse has an indivisible one-half interest in income earned during marriage.
In separate property regimes, prevalent in civil law countries, each spouse is able to own and control property as an individual, which enables each to dispose of property as they wish, subject to a spouse’s other rights.
Income, Wealth, and Wealth Transfer Taxes
An important part of estate planning is an understanding of how (or whether) assets are taxed when their ownership is transferred at or before death. In general, taxes are levied in one of four general ways:
- Tax on income
- Tax on spending
- Tax on wealth
- Tax on wealth transfers
Taxes on income can be levied at different rates for a variety of income categories such as compensatory income, investment income, etc.
Investment income is typically taxed in several possible ways. It can be taxed annually on either an accrual or cash basis as income or gains are received. Alternatively, tax can be deferred until the gain on an asset is ultimately recognized upon the sale or disposition of the asset.
Taxes on spending normally take the form of sales taxes where a tax is applied to certain types of purchases. These can be applied at the time of purchase or periodically through some computation of consumption.
Wealth-based taxes can come in several forms. A jurisdiction may levy taxes annually on the principal value of real estate, financial assets, tangible assets, etc. Tax based on one’s comprehensive wealth is often referred to as a net worth tax or net wealth tax.
The two primary forms of taxes on wealth transfers correspond to the primary ways of transferring assets: gifting assets during one’s lifetime, and bequeathing assets upon one’s death through a will or via some other structure.
In an estate planning context, lifetime gifts are sometimes referred to as lifetime gratuitous contracts, or inter vivos transfers, and are made during the lifetime of the donor.
Bequeathing assets or transferring them in some other way upon one’s death is referred to as a testamentary gratuitous transfer. The term “testamentary” refers to a transfer made after death. From a recipient’s perspective, it is called an inheritance. Similar to lifetime gifts, the taxation of testamentary transfers may depend upon the residency or domicile of the donor, the residency or domicile of the recipient, the type of asset, and the location of the asset.
Taxes on wealth transfer may be applied to the transferor or the recipient. These taxes may be applied at a flat rate or based on a progressive tax rate schedule, where the tax rate increases as the amount of wealth transferred increases. Often the tax is applied after the deduction of a statutory allowance. The tax rate may also depend on the relationship between transferor and recipient. Transfers to spouses, for instance, are often tax exempt.