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Capacity Requirements

Proper execution of a legal instrument requires that the person signing have sufficient mental “capacity” to understand the implications of the document. While most people speak of legal “capacity” or “competence” as a rigid black line — either the person has it or doesn’t — in fact it can be quite variable depending on the person’s abilities and the function for which capacity is required.

One side of the capacity equation involves the client’s abilities, which may change from day to day (or even during the day), depending on the course of the illness, fatigue and the effects of medication. On the other side, greater understanding is required for some legal activities than for others. For instance, the capacity required for entering into a contract is higher than that required to execute a will.

The standard definition of capacity for wills has been aptly summed up by the Mississippi Supreme Court:

  1. Did the testatrix have the ability at the time of the will to understand and appreciate the effects of her act?
  2. Did the testatrix have the ability at the time of the will to understand the natural objects or persons to receive her bounty and their relation to her?
  3. Was the testatrix capable of determining at the time of the will what disposition she desired to make of her property?

This is a relatively “low threshold,” meaning that signing a will does not require a great deal of capacity. The fact that the next day the testator does not remember the will signing and is not sufficiently “with it” to execute a will then does not invalidate the will if he understood it when he signed it.

The standard of capacity with respect to durable powers of attorney varies from jurisdiction to jurisdiction. Some courts and practitioners argue that this threshold can be quite low. The client need only know that he trusts the attorney-in-fact to manage his financial affairs. Others argue that since the attorney-in-fact generally has the right to enter into contracts on behalf of the principal, the principal should have capacity to enter into contracts as well. The threshold for entering into contracts is fairly high.

The standards for entering into a contract are different because the individual must know not only the nature of her property and the person with whom she is dealing, but also the broader context of the market in which she is agreeing to buy or sell services or property.

As a practical matter, in assessing a client’s capacity to execute a legal document, attorneys generally ask the question, “Is anyone going to challenge this transaction?” If a client of questionable capacity executes a will giving her estate to her husband, and then to her children if her husband does not survive her, it’s unlikely to be challenged. If, on the other hand, she executes a will giving her estate entirely to one daughter with nothing passing to her other children, the attorney must be more certain of being able to prove the client’s capacity.

While the standards may seem clear, applying them to particular clients may be difficult. The fact that a client does not know the year or the name of the President may mean she does not have capacity to enter into a contract, but not necessarily that she can’t execute a will or durable power of attorney. The determination mixes medical, psychological and legal judgments. It must be made by the attorney (or a judge, in the case of guardianship and conservatorship determinations) based on information gleaned by the attorney in interactions with the client, from other sources such as family members and social workers, and, if necessary, from medical personnel. Doctors and psychiatrists cannot themselves make a determination as to whether an individual has capacity to undertake a legal commitment. But they can provide a professional evaluation of the person that will help an attorney make this decision.

Because you need a third party to assess capacity and because you need to be certain that the formal legal requirements are followed, it can be risky to prepare and execute legal documents on your own without representation by an attorney.

Estate Taxation

Under the tax law enacted in 2001, whatever you own is subject to the federal estate tax upon your death, until 2010. For the year 2010, estates will be entirely free from federal taxation. However, the law that includes this provision expires at the end of 2010. Thus, unless Congress acts in the interim, the estate tax rules will then revert to those prevailing in 2001.

For 2005, the tax rate on estates begins at 45 percent and rises to a maximum of 47 percent, depending on how much is being passed to your heirs. Between 2005 and 2009, the top tax rate will gradually be lowered to 45 percent .

That said, not all estates will be taxed while the estate tax is in effect. First, spouses can leave any amount of property to their spouses, if the spouses are U.S. citizens, free of federal estate tax. Second, the estate tax applies only to estates valued at more than $1.5 million in 2005 and this threshold will increase incrementally until it reaches $3.5 million in 2009 (see box). The federal government allows you this tax credit for gifts made during your life or for your estate upon your death. Third, gifts to charities are not taxed.

Most states also have an estate or inheritance tax. But more and more have moved to a so-called “sponge” tax, which ultimately doesn’t cost your estate. The way this works is that the states take advantage of a provision in the federal estate tax permitting a deduction for taxes paid to the state up to certain limits. The states simply take the full amount of what you are allowed to deduct off the federal taxes. However, under the 2001 tax law the allowable state deduction is being phased out and will disappear in 2005. This means that many states are changing their estate tax laws to make up the difference. These changes may call for a restructuring of your estate plan; check with your attorney.

Making Gifts: The $10,000 Rule

One rule that most people think they know is that you can give away $10,000 each year without paying gift tax. Actually, most people have it wrong. It’s not just $10,000 anymore; currently the annual gift tax exclusion is $13,000, and is indexed for inflation.

Using this annual exclusion is one simple way you can reduce estate taxes or shelter assets in order to achieve Medicaid eligibility is to give some or all of your estate to your children (or anyone else) during their lives in the form of gifts. Certain rules apply, however. There is no actual limit on how much you may give during your lifetime. But if you give any individual more than $13,000, you must file a gift tax return reporting the gift to the IRS. Also, the amount above $13,000 will be counted against your lifetime gift limit, which is currently $5 million lifetime tax exclusion for gifts. Each dollar of gift above $5 million reduces the amount that can be transferred tax-free in your estate.

The $13,000 figure is an exclusion from the gift tax reporting requirement. You may give $13,000 to each of your children, their spouses, and your grandchildren (or to anyone else you choose) each year without reporting these gifts to the IRS. In addition, if you’re married, your spouse can duplicate these gifts. For example, a married couple with four children can give away up to $104,000 in 2012 with no gift tax implications. In addition, the gifts will not count as taxable income to your children (although the earnings on the gifts if they are invested will be taxed). For more on gifting, see Gifts to Grandchildren.

However, many people misunderstand that this is strictly a tax exemption for the gift tax. It has no bearing on Medicaid’s ability to count such gifts as uncompensated transfers, which will result in a Medicaid eligibility penalty if the gifts are made within five years of applying for Medicaid.

Charitable Gift Annuities

Another way to remove assets from an estate is to make a contribution to a charitable gift annuity, or CGA. A CGA enables you to transfer cash or marketable securities to a charitable organization or foundation in exchange for an income tax deduction and the organization’s promise to make fixed annual payments to you (and to a second beneficiary, if you choose) for life. A portion of the income will be tax-free.

Estate Administration

Probate is the process by which a deceased person’s property, known as the “estate,” is passed to his or her heirs and legatees (people named in the will). The entire process, supervised by the probate court, usually takes about a year. However, substantial distributions from the estate can be made in the interim.

The emotional trauma brought on by the death of a close family member often is accompanied by bewilderment about the financial and legal steps the survivors must take. The spouse who passed away may have handled all of the couple’s finances. Or perhaps a child must begin taking care of probating an estate about which he or she knows little. And this task may come on top of commitments to family and work that can’t be set aside. Finally, the estate itself may be in disarray or scattered among many accounts, which is not unusual with a generation that saw banks collapse during the Depression.

Here are the steps surviving family members should take:

These responsibilities ultimately fall on whoever was appointed executor or personal representative in the deceased family member’s will. Matters can be a bit more complicated in the absence of a will, because it may not be clear who has the responsibility of carrying out these steps.

First, secure the tangible property. This means anything you can touch, such as silverware, dishes, furniture, or artwork. You will need to determine accurate values of each piece of property, which may require appraisals, and then distribute the property as the deceased directed. If property is passed around to family members before you have the opportunity to take an inventory, this will become a difficult, if not impossible, task. Of course, this does not apply to gifts the deceased may have made during life, which will not be part of his or her estate.

Second, take your time. You do not need to take any other steps immediately. While bills do need to be paid, they can wait a month or two without adverse repercussions. It’s more important that you and your family have time to grieve. Financial matters can wait. (One exception: Social Security should be notified within a month of death. If checks are issued following death, you could be in for a battle. For more on Social Security’s death procedures, click on http://www.ssa.gov/pubs/deathbenefits.htm)

Third, when you’re ready, but not a day sooner, meet with an attorney to review the steps necessary to administer the deceased’s estate. Bring as much information as possible about finances, taxes and debts. Don’t worry about putting the papers in order first; the lawyer will have experience in organizing and understanding confusing financial statements.

The exact rules of estate administration differ from state to state. In general, they include the following steps:

  1. Filing the will and petition at the probate court in order to be appointed executor or personal representative. In the absence of a will, heirs must petition the court to be appointed “administrator” of the estate.
  2. Marshaling, or collecting, the assets. This means that you have to find out everything the deceased owned. You need to file a list, known as an “inventory,” with the probate court. It’s generally best to consolidate all the estate funds to the extent possible. Bills and bequests should be paid from a single checking account, either one you establish or one set up by your attorney, so that you can keep track of all expenditures.
  3. Paying bills and taxes. If an estate tax return is needed — generally if the estate exceeds $1 million in value — it must be filed within nine months of the date of death. If you miss this deadline and the estate is taxable, severe penalties and interest may apply. If you do not have all the information available in time, you can file for an extension and pay your best estimate of the tax due.
  4. Filing tax returns. You must also file a final income tax return for the decedent and, if the estate holds any assets and earns interest or dividends, an income tax return for the estate. If the estate does earn income during the administration process, it will have to obtain its own tax identification number in order to keep track of such earnings.
  5. Distributing property to the heirs and legatees. Generally, executors do not pay out all of the estate assets until the period runs out for creditors to make claims, which can be as long as a year after the date of death. But once the executor understands the estate and the likely claims, he or she can distribute most of the assets, retaining a reserve for unanticipated claims and the costs of closing out the estate.
  6. Filing a final account. The executor must file an account with the probate court listing any income to the estate since the date of death and all expenses and estate distributions. Once the court approves this final account, the executor can distribute whatever is left in the closing reserve, and finish his or her work.
    Some of these steps can be eliminated by avoiding probate through joint ownership or trusts. But whoever is left in charge still has to pay all debts, file tax returns, and distribute the property to the rightful heirs. You can make it easier for your heirs by keeping good records of your assets and liabilities. This will shorten the process and reduce the legal bill.

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