Beneficiary Designations and Nontestamentary Transfers at Death

Take-Away: Clients and their advisors need to spend more time looking closely at beneficiary designations, contingent beneficiary designations that are signed by clients and used to transfer wealth on the client’s death. Arguably more wealth might be transferred on an individual’s death via beneficiary designations or nontestamentary contractual arrangements than pursuant to their will and their trust. The language used in a will and trust attracts a lot of attention from advisors; more attention needs to be devoted to the ‘simple’ beneficiary designations or other nontestamentary contractual arrangements which are usually completed without an advisor’s input.

Background: Many assets owned by a client at death are not transferred by the more traditional estate planning instruments  of a will or trust. Consider the magnitude of wealth that passes on the owner’s death under a conventional beneficiary designation: life insurance proceeds, employer sponsored qualified retirement plans (like 401(k) accounts,) IRAs, tax sheltered annuities, Payable on Death (POD) deposit accounts, and Transfer on Death (TOD) investments or investment accounts. Those are the assets that usually transferred on death by beneficiary designation with which we are most familiar. But the list of assets that fall under the classification of nonprobate transfers on death is actually much broader than those just described.

• Statutory NonprobateTransfers: The Estates and Protected Individuals Code (EPIC) describes the effect of death with respect to nonprobate transfers on death as follows:

A provision for a nonprobate transfer on death in an insurance policy, contract of employment, bond, mortgage, promissory note, certificated or uncertificated security, account agreement, custodial agreement, deposit agreement, compensation plan, pension plan, individual retirement plan, employee benefit plan, conveyance, deed of gift, marital property agreement or other written instrument of similar nature is nontestamentary. This subsection includes a written provision in the instrument that is intended to result in 1 or more of the following: (a) Money or another benefit due to, controlled by, or owned by a decedent before death is paid after the decedent’s death to a person, including a trustee of a trust created by will, who the decedent designates either in the instrument or in a separate writing, including a will executed either before, at the same time as, or after the instrument. [MCL 700.6101(1)(a).]

Property the decedent controls or owns before death that is the subject of the instrument passes to a person the decedent designates either in the instrument or in a separate writing, including a will, executed either before, at the same time of, or after the instrument. [MCL 700.6010(1)(c).]

This EPIC section thus identifies a variety of writings or instruments that call for a shift in economic benefit at death. They are nontestamentary, which means that the writing does not have to comply with the requirements for a valid will, e.g. two witnesses who sign in the presence of the testator who in turn signed in front of them. The economic benefits of a nontestamentary writing will shift without having to go through probate, and the decedent’s estate’s personal representative (or trustee) is not involved in the transfer of that wealth. A deed of gift mentioned in the statute refers to tangible personal property, not real estate. For example, this provision  permits an individual to use a written bill of sale for expensive artwork, in which on the same bill of sale, signed by the individual, he/she designate children to receive title to the artwork at the time of their parent’s death. Presumably the artwork will avoid probate (and Probate Court Inventory fees), and is removed from the control of the individual’s will and/or trust. I am not sure if a bill of sale with designated beneficiaries is a sensible way to transfer a Rembrandt at death, but arguably it is permissible under EPIC.

• TOD: The parts of EPIC that address TOD arrangements is a bit more detailed than the general nontestamentary section, but they also are more expansive.  A beneficiary form is defined as a registration of a security that indicates the owner of the security and the owner’s intention regarding the person who will become the security’s owner upon the owner’s death. [MCL 700.6301(a).] Security is then defined as a share, participation, or other interest in property, in a business, or in an obligation of an enterprise or other issuer, and included certificated security, uncertificated security, and security account, both accounts maintained in a financial institution as well as an account with a broker. [MCL 700.6301(e).] Several other sections deal with the implications of a security being registered in beneficiary form, and what is required for the beneficiary designation to be recognized as such and the effect of registering a security in beneficiary form, and the effect of ownership on the death of the owner of the security. Consequently, with a broad definition of security, many other investments, e.g. LLC units; partnership interests, can pass on the death of the owner without being subject to probate.

Nonprobate Transfers: Nonprobate transfers and beneficiary designations are popular with the public for a variety of reasons. No probate proceeding (with its expense, delays, and publicity) is involved with a beneficiary designation. Nor is a will or trust required, which might either confuse the individual, or be subject to judicial  interpretation or litigation, again delaying access to and control of the inherited asset.  Rather, the transfer (on death) is accomplished by completing, signing and submitting a pre-printed beneficiary designation form usually furnished by the bank, broker,  custodian or insurance company, and the beneficiary producing the owner’s death certificate.

Nonprobate Transfer Limitations: While efficient and cost-effective, the simplicity normally associated with the use of a beneficiary designation can often lull the owner into making incorrect assumptions, mistakes, or lead to disputes with the other party to the transfer-on-death-contract. Examples of questions or problems that can arise when dealing with a beneficiary designation or a nonprobate transfer follow:

1. Inflexible: Most wills and trusts are drafted with the attorney constantly addressing the ‘what if…?’  questions, e.g. ‘What if your named beneficiary does not survive you, who do you want to receive the asset?’ Usually with a beneficiary designation the plan sponsor or IRA custodian or insurance company includes default beneficiaries if the primary beneficiary does not survive and no contingent beneficiary is identified by the owner in the beneficiary designation form. Does the owner agree with the third-party account sponsor or insurer’s choice of default beneficiaries? What if the owner wants a ‘hold back’ provision to stop a distribution if the named beneficiary is close to filing for bankruptcy? Beneficiary designations seldom contain any ‘hold back’ provisions that are flexible to meet the needs of the beneficiary. Or consider an IRA custodian which names the IRA owner’s estate as the default beneficiary when the owner had surviving grandchildren who might have enjoyed exploiting a ‘stretch IRA.’ Naming the owner’s estate as the default beneficiary could result in depleting the IRA over a period of 5 years after the owner’s death and thus lose the opportunity to stretch the taxable IRA distributions over decades. Over the years when working with clients I regularly asked them to bring to our meetings copies of their beneficiary designations- only a handful of clients ever accommodated that request, most complaining that they could not find copies of their beneficiary designations.
2. Unknown Default Beneficiaries: Qualified plans e.g. 401(k) accounts, are not required to offer all of the options that the Internal Revenue Code permits for distributions of a deceased participant’s interest in the plan. Few plan participants are even aware of the default beneficiaries named in their employer sponsored qualified plan if their primary and contingent beneficiaries do not survive them.
3. Disclaimers Not Recognized: Part of flexible planning these days is to contemplate that the named beneficiary might disclaim part or all of the benefit to be transferred for future tax planning purposes. Will the broker, insurance company,  or IRA custodian recognize a qualified disclaimer by the primary beneficiary? If no contingent beneficiary is named, the primary beneficiary may be hesitant to execute a qualified disclaimer if the default beneficiaries under the beneficiary designation are not consistent with the disclaimant’s donative wishes, or the default beneficiary is the owner’s probate estate.
4. Governing Law: Often brokers, IRA custodians, and insurance companies require that the law where the company conducts business is the law that governs the interpretation of the beneficiary designation ‘contract.’ For example, if the IRA is maintained at Fidelity, Massachusetts law will govern the interpretation of the owner’s IRA beneficiary designation ‘contract,’ which means that if a dispute arises, some litigation may take place in Massachusetts or force Michigan courts to interpret Massachusetts law. Does the IRA owner know, or care about, what law governs his/her beneficiary designation?
5. Third Party Requirements for Information: Or, consider a financial institution that is unwilling to follow a direction in a POD beneficiary designation to distribute the owner’s deposit account balance among the owner’s ‘then living descendants per stirpes.’ The financial institution may not want to spend the time and money to ascertain the decedent’s ‘descendants’- it might insist, instead, that all descendants be identified by name, address and social security number on the beneficiary designation- information the account owner may not readily have available.
6. Identity of Trustee- Judicial Proof of Acceptance:  Sometimes a beneficiary designation will name the ‘then acting trustee of my trust dated —’. But the custodian or insurance company will balk at distributing the assets without proof that the individual or entity who files a claim for payment actually serves as the trustee of the owner’s trust, having formally accepted that appointment. In one case I had to obtain a court order to confirm that the named individual as successor trustee of the decedent’s trust had accepted that fiduciary role, and did not have to post a fidelity bond,  just so I could provide that court order to a life insurance company that had  refused to pay the life insurance death benefit to the trustee because the beneficiary designation indicated the trustee solely by fiduciary role (‘then acting trustee’) and not by name.
7. Separate Attachments to Beneficiary Designation Form: At times the owner will craft his/her own beneficiary designation to address many of the rhetorical ‘what if…?’ questions that normally accompany a will or trust, and attach that comprehensive separate beneficiary designation to the third party’s form beneficiary designation. Financial institutions or insurance companies will often balk if their own preprinted form is not used as the ‘sole’ beneficiary designation. Custom-drafted attachments to the custodian or insurer’s beneficiary form will often cause the third-party to the contract to go that much slower in processing the claim for benefits or transferring the account balance.
8. Inequitable Estate Tax Allocations: One of the larger problems (at least in the past when federal estate taxes were more of a concern than today) is the simple estate tax allocation clause used in a will or trust that directs that any ‘estate taxes be paid from the residue of my estate.’ The problem is that the assets that are transferred via beneficiary designation or nonprobate transfer contracts are not part of the residue of the deceased owner’s taxable estate yet they contribute to the estate tax liability. The result is that often ‘other’ beneficiaries named under the decedent’s will or trust may end up indirectly paying the federal estate taxes attributable to the assets that are transferred by beneficiary designation, imposing an unfair tax burden on the will and trust beneficiaries. When there are substantial nonprobate transfers as part of an estate, it is better to impose ‘an equitable allocation of estate taxes’ among both the decedent’s estate and all of the beneficiaries who receive assets in nonprobate transfers, i.e. beneficiary designations.

Conclusion: With so many individuals now holding their wealth in retirement accounts like IRAs, and the increasing popularity of POD and TOD nonprobate transfer arrangements, more time needs to be spent reviewing with clients their beneficiary designations to make sure the client’s testamentary wishes are actually carried out and not frustrated. Questions like how the named beneficiaries under these beneficiary arrangements are consistent, or coordinate, with the owner’s will and trust beneficiaries need to be asked. The default beneficiaries under a beneficiary designation or a qualified plan or insurance policy need to be documented so that the individual is fully aware of what will happen if their named beneficiaries predecease them. And finally, if we ever return to a time when estate taxes are a concern, the client needs to be fully aware of how federal estate taxes are allocated, or on whom the estate tax burden will fall. Beneficiary designations are simple and popular, but they can present their own set of problems when they are part of a decedent’s estate.