With all the hoopla given to the 2010 Tax Act increase in the exemption amount of $5 million many practitioners have written off estate tax planning as something that only applies to a very wealthy few that is not pertinent to their practices. But, there remains a host of post-death tax elections and decisions that practitioners should continue to address in serving client’s estates. There are many income tax elections that may affect even smaller estates. A $5 million exemption doesn’t obviate all planning by any stretch. Consider the following:
Meeting a Pecuniary Bequest
When an estate satisfies a pecuniary (dollar) bequest with property in kind, the transaction is deemed the equivalent of a sale or exchange of the property by the estate, and the use of the proceeds to satisfy the pecuniary bequest. For example, if a will provides for a $100,000 payment to a cousin, and the estate uses stock with a tax basis of $60,000 after death (since there is a step up on death) that has appreciated to $100,000, $40,000 gain will be triggered. Practitioners need to guide clients on selecting which assets to use to satisfy which bequests. This income tax hit can apply regardless of the size of the estate. An estate may be entitled to a deduction for a loss on funding a pecuniary bequest in spite of the rules limiting loss deductions on related party transactions. IRC Sec. 267(b)(13).
Tax Losses Flow Through on Estate Termination
In the final year of an estate unused capital losses and net operating losses pass out to the beneficiaries. IRC Sec. 642(h); Treas. Reg. Sec. 1.642(h). This may present a planning opportunity to plan the year end of the estate with the year in which the beneficiaries receiving the residuary estate can benefit from the estate’s losses. Practitioners should endeavor to coordinate the tax status of all involved.
Where to Deduct Certain Expenses
The executor can elect to deduct the expenses of estate administration on the estate tax return or the estate’s income tax return, Form 1041. The administrative expenses involved may include: expenses deductible under IRC Sec. 2053 and 2054 such as executor commissions, accounting and legal fees, appraisal fees, probate costs, expenses incurred in selling estate assets to pay debts and expenses, etc. Note that funeral expenses can only be deducted on the estate tax return, not on the estate income tax return. Medical expenses can be deducted on either the estate tax return or income tax return. IRC Sec. 213(c). For some decedents this figure can be substantial. With so few estates subject to federal estate tax in light of the $5 million exemption, the election to deduct estate expenses on Form 1041 that can be deducted will be common. Practitioners may have to weigh the income tax benefits against state estate tax benefits in some instances in order to reach the optimal decision.
Estimated Tax Payments Can be Credited to Beneficiary
A trustee can elect to have a portion or all of the trust’s estimated tax payments treated as if paid by (credited to) a beneficiary. IRC Sec. 643(g). An executor can elect to have a portion or all of the estate’s estimated tax payments (note that none are required during the first two years post-death) treated as if paid by (credited to) a beneficiary for the final tax year of the estate only. Any amount of estimated taxes allocated to a particular beneficiary are treated as a distribution to that beneficiary on the last date of the tax year. The election is made on Form 1041-T, “Allocation of Estimated Tax Payments to Beneficiaries.” If the estate (or trust) has made tax payments and the beneficiary has not, this can provide a valuable method to avoid underpayment of estimated tax penalties for a beneficiary.
Election for Estate or Trust to Recognize Gain
An election can be made by an estate (or trust) to recognize gain for income tax purposes. IRC Sec. 643(e)(3). Gain or loss shall be recognized by the estate or trust in the same manner as if the property had been sold to the distributee at its fair market value IRC Sections 661(a)(2) and 662(a)(2). An election under this provision applies to all distributions made by the estate (or trust) during a taxable year, and shall be made on the return of such estate (or trust) for such taxable year.
Election to Treat Trust as Estate
- The executor and the trustee of a qualified revocable living trust may elect to treat the trust as part of the estate for income tax purposes. This election may prove advantageous, because it may permit the trust to benefit from several income tax benefits that but for making this election the estate could choose, but the trust could not do so:
- Choosing a non-calendar fiscal year for income tax purposes.
- Avoiding estimated income tax requirements for two years after the date of death.
- Obtaining a deduction for funds set aside for charity that are not yet paid to charity under IRC Sec. 642(c)(2).
- Automatic eligibility, without making any election, as an S corporation shareholder for the duration of the period of estate administration. IRC Sec. 13651(c)(2)(A).
- Utilizing the $25,000 active real estate exception to the passive loss limitation rules for two years post-death. IRC Sec. 469(i)(4).
- Recognition of a loss on satisfaction of a pecuniary bequest. IRC Sec. 267(b)(13).
Treat Amounts Paid After Year End as Paid in Prior Year
An amount paid or credited to a beneficiary within the first 65 days of a tax year can be treated, if the election is made, as if paid or credited during the prior fiscal year. IRC Sec. 663(b).
Bypass, Portability, Disclaimer
Many wills, especially those for mid-wealth clients, use a disclaimer approach to funding a bypass trust. All assets are bequeathed outright to the surviving spouse who is given the option to disclaim in which event those assets are then bequeathed into a bypass trust. Practitioners must guide clients as to whether to fund a bypass trust by disclaimer or to instead have portability apply. If portability is to apply, then the appropriate estate tax filing must be made (not yet issued as of this writing). If the bypass trust is to be funded, which may save on state estate tax, provide asset protection, etc., then the necessary legal documents have to be filed with the local surrogate or probate court within the requisite time period. So, even for smaller estates, decisions and actions are necessary.
Extension of Time to Pay
Estate tax payment can be delayed for reasonable cause for a reasonable period of time, not to exceed 12 months, if approved by the IRS. To qualify the executor must make a request for the extension and demonstrate that the request is based upon reasonable cause. Treas. Reg. Sec. 1.6161-1(a)
Estate Tax Deferral
In certain cases, estate taxes may be paid in from two to ten installments, and can be deferred for up to four years after the date the tax is due, providing up to a 14 year deferral. In order to qualify for the deferral numerous requirements have to be met, including that the value of interests in closely held businesses included in determining the gross estate exceeds 35 percent of the adjusted gross estate, and the executor must file an election. IRC §6166. As part of the election, the executor must file an agreement as described in Section 6324A(c).
Actions Effecting Valuations
While not a formal tax election, an executor making a decision to sell an asset should be mindful of the fact that post-death sales may establish the value of an asset for estate tax purposes. One court held that a post-death sale of a closely held stock position was determinative of the value of the stock on the decedent’s estate tax return. Estate of Helen H. Noble. 89 TCM 649.
Alternate Valuation Date (“AVD”)
Estates may value estate assets, in very simplistic terms, six months from the date of death. The election must apply to all estate assets, no partial application is permitted. Treas. Reg. Sec. 20.2032-1(b)(2). So, practitioners need to help executors determine the impact on all beneficiaries in order to make an optimal decision.
Graegin Loan
A Graegin loan technique may provide a mechanism to fund some portion or all of the estate tax cost for an illiquid estate while simultaneously reducing the value of the taxable estate. For example, if an insurance trust holds liquid proceeds of an insurance policy, it can loan money to the estate and thereby enhance the estate tax deduction for future interest payments. The tax law has permitted a deduction on the estate tax return of all future interest payments required to be paid under a non-cancellable note. If there is no estate tax due, estate needs might better be met by the insurance trust buying assets from the estate. Estate of Cecil Graegin, 56 TCM 387 (1988).
754 Basis Adjustment
The basis of partnership property (or property of a limited liability company taxed as a partnership) may be adjusted as the result of a transfer of an interest in the partnership by sale or exchange or on the death of a partner if the election provided by IRC §754 is in effect with respect to such partnership.
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