HOW TO SETTLE AN ESTATE WHAT TO KNOW BEFORE YOU DIE Copyright  1995  by  J. Raymond Karam HOW TO SETTLE AN ESTATE WHAT TO KNOW BEFORE YOU DIE CONTENTS: I. Necessity for Probate a. Purpose of Probate 1. Complete chain of title 2. Opportunity for creditors to be satisfied b. Probate Avoidance 1. Living Trusts 2. Multiple Party Accounts A. Joint Accounts i. Rights of Survivorship B. Pay On Death Accounts C. Trust Accounts 3. Other Nontestamentary Arrangements A. Life Insurance B. Annuities C. IRA's and Retirement Accounts 4. Lifetime Gifts A. Gifts in Trust 5. Retained Life Estates 6. Community Property Administration 7. Probate as Muniment of Title 8. Order of No Necessity for Administration 9. Small Estate Administration II. Independent Administration a. Creation b. Requirements III. Dependent Administration a. When Applicable b. Court Supervision c. Accounting d. Closing Estate e. Claims Procedure IV. Taxes a. Income Tax 1. Decedent's Final Return 2. Income Taxation of Estates b. Estate Tax 1. 706 Return 2. Unified Credit 3. Marital Deduction 4. Life Insurance Proceeds V. Conclusion I. Necessity for Probate The probate process is that area of the law dealing with the administration of the estates of deceased persons.  Probate also deals with the estates of incompetent persons such as persons of unsound mind and minor or incapacitated persons; however this discussion will focus on the estates of deceased persons. Probate becomes necessary when the assets of an estate are in need of gathering, caretaking or otherwise in need of disposition or where there are debts to be paid. a. Purpose of Probate The main functions of the probate system are to provide a mechanism whereby the chain of title to property of a decedent can be completed and to permit the creditors of a decedent with an organized forum in which to satisfy their claims. The person charged with administering an estate is called the "personal representative" of the person whose property composes the estate. Personal representatives include Independent executors, Independent administrators, administrators, Administrators with will annexed, and guardians. 1. Complete chain of title The mere existence of a last will and testament does not in and of itself vest title to property in a beneficiary thereunder. The will must be adjudged to be authentic. It must be proved. "Probate" is a Latin word meaning "to prove". Once a will has been recognized by the proper court of competent jurisdiction, legal and equitable title in the property of the estate retroactively vests as provided in the will. 2. Opportunity for creditors to be satisfied When a person has creditors, and does not voluntarily satisfy them, those creditors must resort to legal process in order to collect their just debts. If that person dies, all of his creditors have a legitimate interest in the assets of his estate. The law even provides a procedure whereby probate proceedings may be initiated by a creditor. It is logical that beneficiaries should not receive clear title to a decedent's assets unless creditors' claims have first been satisfied. Texas has a very special exception to this, in certain limited cases, in its Homestead exemption. Furthermore, creditors are often subject to strict procedural requirements in order to preserve all of their rights. b. Probate Avoidance Although the probate system is noble in origin in the concept of providing government supervision of the passing of assets of a decedent, it is often sought to be avoided for reasons of cost savings, protection of privacy, avoidance of will contests and other sound business reasons. Probate avoidance is especially beneficial in cases that would result in the necessity of a guardianship which is among the most obtrusive type of probate known as dependent administration which is discussed later in this paper. What follows in this section is a brief discussion of some of the strategies often employed either in planning or post mortem to reduce or eliminate the real or perceived burdens and entanglements of probate. 1. Living Trusts Perhaps the most popular and often discussed method of probate avoidance is the living trust. This is a legal relationship that is created during the life of the owner of property whereby the ownership of property is set out by dividing the title into legal or "on paper" title and equitable title. Equitable title, also known as beneficial title refers to the use, ownership, and enjoyment of property. The holder of legal title, often called the trustee, holds the property for the benefit of the equitable title holders, often called beneficiaries. As long as this title is divided somewhere in the future, the creator of the trust may be trustee and beneficiary during his or her entire lifetime. The trust governs the passage of the property at the death of the trust creator and even at the death of the beneficiary and subsequent beneficiaries up to a point within reason. Since the trust instrument governs passage of title, probate is not necessary and is avoided. The creator of the trust has effectively written his or her own law that will govern the passage of property at death and there is no need for court involvement. In order for a trust to be effective in avoiding probate, the assets must be transferred to the trust during the lifetime of the creator of the trust. That is why the use of living trusts is often referred to as "pre-settling" an estate. 2. Multiple Party Accounts The type of ownership of a financial institution account is crucial in determining whether an account will pass outside of probate. The law recognizes a number of types of financial accounts the passage of ownership, at death, of which will be governed by the contract or agreement creating the account, and not by the decedent's will. Among these are Joint Accounts with rights of survivorship, Pay on Death Accounts and Trust Accounts. Although these accounts avoid probate, the executor of an estate can request, at the insistence of a creditor, within six months of death, that the financial institution turn the funds over to the estate to pay debts, taxes or administrative expenses. A. Joint Accounts A joint account is an account that is payable to two or more persons on demand. The ownership of the funds in the account is in proportion to the contributions of the parties unless there is clear and convincing evidence of contrary intent. Either party may withdraw the funds from the account at any time, even after the death of another party to the account. This does not however affect the ownership of the funds withdrawn and the withdrawing party may be called to account to the other party or parties or the executor of such other party's estate. i. Rights of Survivorship When a joint account specifically confers rights of survivorship, the ownership of the account will vest in the surviving party or parties upon the death of a party to the account. Rights of survivorship will not be inferred in a joint account unless the written agreement creating the account specifically so provides. Where rights of survivorship exist, the property in the account not only avoids probate, but is not governed by the terms of a will. For this reason many a carefully laid out estate plan is rendered worthless by the existence of nontestamentary arrangements as discussed in this article. B. Pay On Death Accounts Another type of multiple party account is the Pay on Death or P.O.D. account. An example of a POD designation would be: "Mom POD Sonny". The ownership of a POD account is in the original payee until death. If the POD payee dies first, the original payee's estate will be entitled to the account. If there are more than one POD payees, each POD payee must survive the original payee in order to be entitled to the proceeds. Community property may be the subject of a POD arrangement to the detriment of the surviving spouse unless such would constitute a fraud on the community. In the event that a minor is the POD payee, a guardianship may be necessary to take delivery of the funds for the minor. A guardianship is necessarily a dependent administration as will be discussed later as the most onerous form of probate and furthermore, continues to exist throughout the ward's minority. C. Trust Accounts A trust account is another type of multiple party account an example of which is: "Mom in trust for Sonny". These have been referred to as "Poor man's will" or Totten Trusts. The ownership of a trust account is in the trustee unless the deposit agreement provides otherwise or unless there is clear and convincing evidence of a contrary intent. Withdrawal of the funds may only be made by the beneficiary upon the death of the trustee unless permission is given by the trustee. 3. Other Nontestamentary Arrangements Some of today's largest typical assets which naturally avoid probate are life insurance contracts, fixed and variable annuities, IRA's and Retirement Plans. The economic significance of these types of assets is great and the statistical impact upon the reduction in probate assets these have on society cannot be ignored. A. Life Insurance A life insurance contract is the quintessential nontestamentary asset. It provides for a beneficiary at the death of the insured and unless the beneficiary designation is somehow tied to the will (for example the estate of the deceased is named as beneficiary), the will has no effect upon the passage of the proceeds. However as has been seen in other nontestamentary assets, even though an asset may effectively avoid probate, it is by no means unaffected by state law. For example, if a couple divorces, life insurance beneficiary designations in favor of the former spouse are void. Similarly if a beneficiary murders the insured, all benefits to the perpetrator will not be given effect. B. Annuities Annuities are insurance products which originally were a contract to pay the annuitant a fixed amount for life. If the annuitant died sooner than the predetermined life expectancy, the payments would stop, and if the life expectancy was exceeded the payments would continue until death. This is the opposite bet of life insurance where you are gambling that you will die soon. Annuities evolved in the ways that the annuity payments could be made, and began to resemble more traditional investment arrangements. Currently they provide a tax deferred growth. Payments received after age 59 1/2 are taxed equitably. Premature payments are subject to 10% excise tax. A new popular variation on the more traditional fixed annuities, which grow at a predetermined fixed rate, is the variable annuity, which is, in essence, a self directed mutual fund portfolio within the carcass of a legally recognized annuity. Probably the most exciting recent development in the field of insurance product applications for asset protection planning is the amendment to the state insurance code providing that annuities are to be exempt from creditors in the same way that life insurance has been. Prior to this amendment, annuities were only exempt when used in an employer provided plan of benefits, which meant that it would have to be an ERISA plan which involves many strict requirements. Annuities are nontestamentary assets which avoid probate and which, as in the case of life insurance and multiple party accounts, passes at death to the contractually named beneficiary without regard to contrary will provisions. C. IRA's and Retirement Accounts Qualified and nonqualified deferred compensation arrangements including individual retirement accounts are non probate assets.  Qualified plans including IRAs are investments which are not only tax deferred like annuities, but give rise in most cases to a tax deduction upon funding. Nonqualified Plans are retirement plans  which are not blessed by the IRS for deductibility and noninclusion in gross income. They do however avoid probate as do qualified plans because both types are trusts and govern their own passage at death. IRAs are assets that pass at death under contract and which are not subject to contrary will provisions. 4. Lifetime Gifts Perhaps the most rudimentary way of avoiding probate is the making of lifetime gifts. Gifts are taxed under the same tax scheme as estates. However gift taxes are tax exclusive which means that if you don't die within three years the tax paid on the gift escapes taxation. This distinction from estate taxes can best be understood by the following example: Assume a $3 million estate and a 50% unified transfer tax. A lifetime gift of $2 million would result in a tax of $1 million, with $2 million going to the recipient. A $3 million estate would result in  an estate tax of $1.5 million with only $1.5 million going to the recipient, a difference of $500,000. Also lifetime gifts are entitled to an annual exclusion from gift tax of $10,000 per donee. Unfortunately lifetime gifts are not entitled to the free step up in basis at death as are assets which are includible in a decedent's gross estate for federal estate tax purposes. Therefore appreciated property would result in capital gain upon subsequent resale by the donee if gifted during life but not if passing by reason of death. A. Gifts in Trust A large shortcoming of lifetime gifts is the loss of control of an asset to a donee who may not be up to the responsibility of ownership. This problem is addressed by gifting an asset to an irrevocable trust for the benefit of the donee. The grantor must not retain interests in the trust or powers to alter, amend, modify or revoke the trust; or else the trust property will be included in the grantor's taxable estate. The annual exclusion from gift tax does not apply to future interests, that is interests in which the use enjoyment or benefit is postponed as in the case of these types of trusts. This problem is usually addressed by giving the beneficiary a present withdrawal right exercisable at the time of the gift to the trust, thereby rendering the gift a "present interest" therefore eligible for the $10,000 annual exclusion from gift tax. 5. Retained Life Estates Another rudimentary probate avoidance technique is the retention of a life estate and conveyance of a remainder interest in the property. "Property" is defined in the law to mean a bundle of rights. The sticks in the bundle can be divided in any way.  In a life estate/remainder situation there is a division of the sticks temporally. In essence, this is what is happening in a living trust. Although these arrangements do qualify for free step up in basis at death, they are included in the gross federal taxable estate. 6. Community Property Administration A spouse is entitled to retain possession of sole management community property upon the death of the other spouse. Community property is property obtained during the marriage by other than gift, bequest, devise or inheritance. Sole management community property is community property earned by a spouse or by a spouse's separate property or sole management community property the control and possession of which is retained by the spouse and which is not commingled with joint management community property or with sole management community property of the other spouse. Joint management community property is commingled community property. Sole management community property is also sometimes called special community property. Sole management community property is not liable for the contractual or tort debts incurred prior to marriage or the contractual debts  of the other spouse. A spouse is entitled to partition of the community property after the probate inventory is filed with the court. In cases where probate administration is not undertaken, community property vests in the other spouse if there are no other heirs. In general, a spouse has certain inherent powers with regard to community property when the other spouse dies, such as powers relating to being able to sue, sell, lease, dispose for the payment of debts, and to collect claims. Other powers exist to preserve assets, wind up affairs and discharge claims. The law also provides procedures for a spouse to deal with community property at the death of the other spouse when the community property passes to someone other than the spouse and no executor has been appointed. A spouse may apply for what is called qualified community property administration. The court will grant broad powers and the spouse will not be subject to court supervision but must file a bond and an inventory within 90 days of appointment. Remarriage has no effect on qualified community property administration. Creditors may collect twelve months after the filing of the inventory. The qualified community property administration terminates twelve months after the filing of the bond, but continues as a statutory trust for the benefit of the heirs. 7. Probate as Muniment of Title Where there is no necessity for administration and no debts to be paid other than those secured by liens on real property, a will may be admitted to probate as a muniment of title. This simply completes the chain of title. This is advisable if no executor is available and is a quicker means of getting title into the hands of the beneficiary. The effect of this procedure is that no administration is necessary. The order admitting  the will as a muniment of title is sufficient legal authority for the beneficiary to collect an asset. 8. Order of No Necessity for Administration Upon a showing by affidavit of less than two debts, no need for partition of property, and no other necessity, the court will grant an order that no administration is necessary which will result in the beneficiaries receiving the property directly. In the case of decedents dying without a will, a determination of heirship is required. 9. Small Estate Administration Estates under $50,000 may be collected by affidavit of two persons after 30 days of death if no application for probate is pending. This provides an efficient means of collecting assets where there is no will. Third parties are released from any liability for delivering the assets to the heirs and liability is transferred to the distributees. II. Independent Administration In certain states, Texas included, the horrors of probate are ameliorated somewhat by a streamlined probate process known as Independent Administration. If Independent Administration is applicable, the probate process is much less involved than in the more traditional type of probate. The reason for this is that court supervision of the actions of the personal representative are kept to a minimum. Because of this lessened court involvement, the independent administrator is unhampered to go about the estate's business. This is not always good. Recall earlier discussions concerning the reasons behind the evolution of the probate system. The assets of the deceased must be protected for the benefit of those ultimately entitled to them. This is the reason for the court supervision. In most cases however, a prudent testator wishes to reduce expenses to the estate; particularly where the confidence in the executor is high, or where the potential for conflicting motivation is nonexistent. In certain cases, it may be advisable for an executor to opt to not have an independent administration. Some examples of this would include where an executor wishes to avoid later criticism of his or her actions by being able to rely upon court approval of all actions taken. Another example would be where the estate is insolvent or is in debt. In such a case, the executor may wish to force creditors to run the gamut of the often maze like procedures necessary to preserve a creditor's rights under traditional or "Dependent" Administration. In independent administration the pitfalls and booby traps for creditors do not exist. Instead, an independent administrator is generally subject to the ordinary legal procedures that exist for cases involving living debtors, and is generally personally liable for debts up to the assets of the estate which could have been available to pay those debts. An independent administrator may however avoid liability by "following the book" so to speak by giving required notices, etc. a. Creation Independent Administration is created in one of two ways. First the decedent's will can provide that the executor shall be "independent" or not subject to court supervision. The other way of being able to create an independent administration is where all of the distributees agree. It is also customary for a testator to waive the requirement that an executor waive the bond required of personal representatives by directing that no bond be required of the executor. b. Requirements In cases involving a will, a named executor files the will for probate and has it admitted to probate. The executor then files an oath and receives "Letters Testamentary" giving him the authority to do any act necessary to settle an estate. In cases not involving a will, Application is made, Heirship is determined, and the consent of all of the heirs is obtained. There is no further action to be taken in court except for the filing of an inventory, appraisement and list of claims. Creditors and charitable beneficiaries should be notified. In closing an independent administration, a representative may file a closing affidavit setting out that the estate has been administered and that any  creditors may proceed directly against the beneficiaries. The representative is relieved from further responsibility once the affidavit has been approved by the court. The application for probate, the order admitting the will to probate, and the approved inventory, appraisement, and list of claims form an adequate link in the chain of title to property of the decedent. Oftentimes, however in an abundance of meticulousness, an executor's deed is prepared granting the property of a decedent from the estate to the ultimate beneficiary. This is not necessary and is merely superfluous, but it often gives an intangible feeling of comfort to the parties. III. Dependent Administration Probate in the traditional sense is oft maligned because of the prolongation and expense usually associated with it. Notwithstanding the many opportunities that exist today to avoid probate or at the very least streamline it through independent administration, situations still arise where traditional probate administration is required. This type of administration has come to be called "Dependent Administration" to distinguish it from Independent Administration. This is the type of probate proceedings that folklore, literature, the conventional wisdom, and the collective unconscious have come to fear almost as much as the IRS. a. When Applicable Dependent Administration arises where there is no independent executor available under the terms of the will, or where there is no will and the consent to an independent administration cannot be obtained. It may be opted for in certain situations described earlier such as where creditors are sought to be put to test or where the representative wants to seek the comfort of court approval for his or her actions. It may also arise on a temporary basis pending a will contest. b. Court Supervision Dependent Administration involves court supervision of all actions taken by an administrator. Certain actions, such as the payment of taxes, court costs, liability and hazard insurance and bond premiums may be taken without court approval. A business or farm may be operated with court permission. Sales of property require prior approval and subsequent confirmation after report of the sale. Notification requirements permeate the process. At the foundation of the court supervision requirement is the desire to safeguard the estate. A personal representative is a fiduciary clothed with the highest duty recognized under the law and can be subjected to severe civil and criminal liability for breaches of their duty irrespective of whether dependent or independent. Yet there may be no means of redressing loss to the estate if the representative is insolvent or without bond. Society is served by a mechanism that enables property of a decedent to be administered with a high degree of accountability. c. Accounting A dependent administrator is required to account to the court annually. The accounting must include: the claims presented against the estate and the action taken with respect to each, property having come into the representative's knowledge or possession which has not been previously inventoried, changes to the property of the estate which have not been previously reported, the receipts of the estate, the disbursements of the estate, a description of the property being administered, a description of the cash belonging to the estate, and an affidavit verifying that the accounting is true, correct and complete in every respect. Dependent administrations involve the posting of a bond by the representative. The amount of the bond is usually determined by the amount of the personal property plus one year's anticipated income. The inventory filed at the beginning of the administration provides a means of insuring that the amount of bond is proper. Subsequent annual accountings help to insure that the bond amount continues to be appropriate. A means of reducing the amount of the bond is through a procedure known as a "safekeeping agreement" whereby the funds subject to safekeeping are deposited with an institution that has agreed that no withdrawals may be permitted without prior court approval. In such a case, after approving the safekeeping agreement, and upon deposit by the representative in the safekeeping account, the court will generally reduce the amount of the bond and the estate will save the amount of the difference in premium. d. Closing Estate All good things must end and after there is no longer a need for administration of the estate, it may be closed. The process of closing the estate begins with the final account. The final account is similar to the annual accountings but has a cutoff date for the last day of the estate's activity. It also sets forth a request that the court order the property still remaining on hand be delivered to the persons entitled thereto. After this is approved, and the representative has delivered the property as directed, an application to close the estate and to release the personal representative from his bond is made, and so ends the administration. The personal representative is not relieved of liability for wrongdoing however. e. Claims Procedure A particularly thorny area of probate administration involves the procedures relating to claims of creditors. As mentioned earlier, this procedure does not apply to independent administration where the creditors can generally pursue their claims under the procedures available for living debtors. In dependent administration, a creditor must present a claim within the time for the statute of limitations on the underlying debt. A claim should be filed within six months in order to give it priority against unsecured claims not filed within six months or in order to be valid at all if the debt is owed to  the personal representative. Upon receipt of the claim, the personal representative must either allow or reject the claim. Failure to allow or reject the claim within 90 days constitutes a deemed rejection. An allowed claim is presented to the court for approval. If a claim is  rejected, the creditor has a super short fuse of 30 days to sue on the rejected claim or be forever barred. Secured claim holders are required to elect, within six months, whether they want their claim to be treated as a matured secured claim or to be given preferred debt and lien status. If no election is made, the claim will be treated as having elected preferred debt and lien status. The difference in the two alternatives is that the preferred debt and lien is limited solely to the asset securing the debt. This has frustrated creditors in the past as in celebrated cases involving a crashed plane or diseased cattle where the creditors were limited to their worthless collateral. A matured secured claim has priority over everything but funeral and  last sickness up to $5,000, and administration expenses. This is usually the better way to go for a creditor but must be elected. However in an insolvent estate where the collateral is valuable, preferred debt and lien could be better because the creditor would have the absolute, undisputed, highest priority with regard to that particular asset. In Independent Administration, unlike as in Dependent Administration a claim will be treated as matured secured unless the creditor elects otherwise. IV. Taxes Often a large part of settling an estate is in dealing with the various taxes that are owed by the estate. Whether or not an estate is subject to probate is of limited relevance in most tax issues. The three main areas of taxation in the death situation are income taxes, estate tax and state inheritance tax. a. Income Tax The estates of decedents usually have two income tax reporting responsibilities. First is the final individual return for the decedent. Next, if the decedent's estate earns income while it is being administered, it must file an income tax return as a trust annually during the pendency of the administration. 1. Decedent's Final Return The final income tax return of the decedent is due on April 15 of the year following the death of a decedent. The return must be filed by a decedent's personal representative. It reports all income of the decedent up to the date of death. A surviving spouse may file a joint return with the deceased spouse in which case the year ends of both will be the end of the surviving spouse's tax year. A surviving spouse may use the lower joint return rates for two years after the year of death if providing an abode for a son or daughter. 2. Income Taxation of Estates A decedent's estate must file a Form 1041 Trust income tax return for each year in which it has gross income of $600. The tax year of the estate for income tax year is the calendar year. A personal representative may elect to have a fiscal year beginning on the anniversary of the date of death. As a trust, a decedent's estate will be subject to income tax brackets that are highly compressed. Income over $1,500 is taxed at the 28% bracket, and the rates move up rather quickly until income over $7,500 is taxed at the 39.6% "millionaire rate". A trust or estate receives a deduction for income which it distributes to beneficiaries. In this manner if the trust retains the income, it will be taxed on it; but if the beneficiary receives the income, the beneficiary will be taxed on it. b. Estate Tax Property owned by the decedent at death is subject to the federal estate tax. Avoiding probate has no effect upon the property's being subject to the estate tax. The gross estate for federal estate tax purposes includes property gifted during life in which an interest is retained during life, jointly owned property, Life insurance proceeds, the decedent's half of community property, property in which the decedent retained the power to alter, amend, modify of revoke the ultimate disposition, and certain gifts or transfers made within three years of death. Estates are taxed at a high rate. Estates over $600,000 are taxed at a rate of 37% and the rate increases about 2-3% per every $250,000 of gross estate. 1. 706 Return Form 706 Federal estate tax return must be filed by decedents whose estates exceed $600,000 in value, inclusive of taxable lifetime gifts. The return calculates the estate tax by adding together the estate on hand at death and any taxable gifts made during life. This provides a uniform transfer tax schematic which generally taxes gifts and estates under the same rules. However certain distinctions do exist as discussed earlier under the topic of Lifetime Gifts. 2. Unified Credit Every citizen is entitled to a lifetime credit against estate and gift tax of $192,800. This permits $600,000 of estate value and lifetime gifts to be exempt from taxation. We refer to the $192,800 as the Unified Credit. We refer to the $600,000 as the "Unified Credit exemption equivalent amount". 3. Marital Deduction Gifts and property passing to a spouse at death are generally not subject to taxation by virtue of the "unlimited marital deduction". The theory behind the justification for this is that the property will be taxed at the death of the second spouse to die. Unfortunately, at the death of the second spouse to die, there will only be one unified credit left because the unified credit of the first spouse to die went unused and expires if not used at death. A technique known as marital deduction planning has come to be the cornerstone of modern estate planning. Under this method, both unified credits of the husband and wife are utilized permitting $1.2 million to ultimately pass tax free instead of a mere $600,000 as would be the case where each spouse leaves everything outright to the other spouse. The way this work is that the testator leaves a formula amount of approximately $600,000 to a trust over which the surviving spouse has the right to income and principal as needed for health, support, maintenance, and education. Because the surviving spouse is not given a general power of appointment; defined as a power to appoint the principal to their self, creditors, estate or estate's creditors other than subject to an ascertainable standard; the property will not be included in the surviving spouse's estate upon the subsequent death notwithstanding the fact that the surviving spouse controlled and enjoyed the property. The trust, often called a "bypass trust" uses the unified credit of the first spouse to die so that it is not lost, squandered or wasted. The taxable estate of the second spouse to die is lighter by $600,000. 4. Life Insurance Proceeds Life insurance proceeds are included in the decedent's gross estate for federal estate tax purposes if the proceeds are payable to the estate or if the decedent insured possessed incidents of ownership in the policy. A policy acquired during marriage is presumed to be community property in which case one half of the proceeds are includible in the federal taxable estate. If a policy is separate property, the community estate will have a reimbursement right for the amount of the premiums paid. A policy transferred within three years of death or premiums paid within three years of death will be included in the estate for estate tax purposes. In most cases, the beneficiary of the policy is the spouse of the insured, in which case the unlimited marital deduction prevents the proceeds from being taxed at the death of the insured. The funds are still subject to taxation in the estate of the second spouse to die. A popular device for removing life insurance from both estates is the irrevocable life insurance trust. This method is a variation of the "bypass trust" described earlier. This plan usually involves purging any ownership interest in the spouse of the insured by way of a partition agreement converting ownership of the policy into the separate property of the insured spouse. The insured spouse then transfers the policy to an irrevocable trust for the benefit of the surviving spouse for life, with remainder after the surviving spouse's death to the children. The trust has the same qualities as the "bypass trust" described earlier, such as the absence of a general power of appointment, which cause it to avoid inclusion in the surviving spouse's estate. Unlike the bypass trust described in the discussion on marital deduction planning, the irrevocable life insurance is not limited to the $600,000 exemption equivalent amount. Instead the gifts to the trust from the separate property of the insured for payment of premiums, as well as the cash surrender value of the policy when initially transferred, are treated as taxable gifts subject to the $10,000 annual exclusion from gift tax and the unified credit. If the insured dies within three years of creating the irrevocable life insurance trust, the proceeds will be included in the decedent's gross estate for federal estate tax purposes. This may be avoided by making the initial application for insurance in the name of the trust. In this way, there never occurs a "transfer" for purposes of the rule requiring policy transfers within three years of death to be brought back into the estate for estate tax purposes. If this is not possible due to insurability reasons or for some other reason, it still makes sense to attempt the irrevocable life insurance trust because the worst thing that can happen is that the policy will be included as if you've done nothing at all, and the best thing that can happen is that the insured survives for three years and the policy is excluded from estate taxation. c.  State Inheritance Tax In Texas, the state inheritance tax is a "soak up" tax which means that it is based upon the credit for state death taxes paid allowed by the federal system. In this way, the Texas inheritance tax never amounts to an additional tax but rather carves out a portion of the federal tax for the state. Therefore if no federal estate tax is due, no Texas inheritance tax is due. V. Conclusion Settling an estate can involve numerous complexities many of which may be avoided with proper planning. Perhaps the most opportune time to attend to these matters is during life before many of the opportunities have lapsed. The most important thing is the education of the public to understand the matters entailed in settling an estate to both remove misconceptions and to make people aware of their alternatives.