General Practice, Solo & Small Firm DivisionMagazine
American Bar Association
General Practice, Solo, and Small Firm Division The Compleat Lawyer
Spring 1997 copyright American Bar Association. All rights reserved.
Post-Mortem Estate Planning
BY JOHN J. WEILER
John J. Weiler is a partner in the New Orleans tax specialty firm of Guarisco, Weiler & Cordes. He is board certified in Louisiana as a tax attorney and an estate planning specialist.
The person chosen to oversee an estate after someone passes away faces a challenging task: To sift through the tax elections and options and select the ones that will minimize federal estate, gift, and income taxes.
There may or may not have been pre-death tax planning, and there may be some flexibility in the estate plan. But ultimately, the representative must consider all of the opportunities to reduce an estate's tax burden.
Deducting Administrative Costs
Expenses of administering a decedent's estate are deductible in determining the taxable estate for estate tax purposes. Certain administrative expenses, though chargeable to the principal of the estate, are alternatively deductible in computing the taxable income of the estate for income tax purposes. (This planning option is available only to those payments that are deductible for either estate or income tax purposes.)
If the estate's value does not exceed the $600,000 unified transfer tax exemption equivalent amount, the decedent's representative should elect to deduct the administrative expenses for income tax purposes. Certain technical requirements must be complied with in order to deduct the expenses on the estate's income tax return. A statement must be filed with the income tax return indicating that the administrative expenses have not been claimed as deductible expenses on the estate tax return. Remember, once filed, this choice becomes irrevocable. It may be preferable to file the statement later so the choice can be preserved until the audit.
If the administrative expenses are to be deducted for income tax purposes, an additional choice is available: whether to claim the expenses as deductions for the estate's income tax return in the taxable year they are paid, or to pay them in the year of termination of the estate and if the deductions exceed the estate's income for that year, pass the excess deductions to the residuary legatee. The deduction for income tax purposes is available only for the year in which the expenses are paid (assuming the estate is on a cash basis of reporting income).
Certain expenses may only be claimed as estate tax deductions or as income tax deductions. For example, funeral expenses, personal expenses of the decedent, and federal gift and income taxes owed by the decedent are only deductible for estate tax purposes. However, deductions for state and city income taxes on income of the estate, interest accruing after death on obligations incurred by the estate, or interest accruing after death on those obligations incurred in states that do not recognize such interest as administrative expenses are only deductible for income tax purposes.
Setting the Value of Assets
The decedent's representative may elect to have the assets valued as of the date of death or as of a date six months after the decedent's death. Assets sold or distributed during the six month period need to be valued as of the date of sale or distribution. The election in choosing the alternate valuation date is made by marking an appropriate box on the federal estate tax return; once the choice is made, it is irrevocable. Selective elections of specific assets is not permissible. If the election is made, it applies to all property included in the decedent's gross estate. The election must be made on a return filed not later than one year after the due date (including extensions). The due date is nine months after the decedent's date of death. Further, the election may only be made if the election reduces both the value of the gross estate and the estate taxes due.
Whether to choose a higher or lower value for the assets through the exercise of this election depends on the particulars of the estate. Will the lower values result in a lower tax basis for the assets, which will increase the capital gain on a subsequent sale? Will the values affect any bequest formulas set out in the will that are used to fund such bequest?
Protecting the Representative
The decedent's representative can make a written request to the IRS for an expedited determination of the decedent's estate tax liability and the discharge from personal liability. If this request is filed, the IRS has nine months from the date of the request to audit the estate tax return and assert any deficiency. If this is not done within the nine-month period, the succession representative is discharged from personal liability for any tax deficiency. This will allow the decedent's representative to distribute assets to the heirs without concern that a subsequent audit by the IRS and the assertion of a deficiency may expose the representative to personal liability. This is also good mechanism to accelerate the audit of the estate tax return if that is a desirable goal. - J.W. The Handy Marital Deduction
Our federal estate tax law and federal gift tax law incorporates the concept of the unlimited marital deduction. The concept is that spouses may transfer property between themselves free of any estate or gift taxes. There are no restrictions as to either the value of the property transferred or the number of times that such transfers can take place. If the transfer is of a property interest in full and complete ownership by a spouse to a surviving spouse, no marital deduction election is necessary nor is it possible to elect out of the marital deduction. The bequest or gift will automatically result in an unlimited estate or gift tax marital deduction.
The unlimited marital deduction is commonly used to defer all federal estate taxes until the surviving spouse's death. Most estate plans are written to defer estate taxes until the second death; the idea is that taxes deferred for a substantial period of time are the same as taxes not paid. However, the estate tax is a progressive tax and the tax on the combined estates of a husband and wife taxed as one estate is often greater than if the estates were taxed separately. Thus, an estate planner must always consider whether it is tax wise to equalize the estates and pay estate taxes in both estates or whether to defer estate taxes until the second death. If each estate would be under the $600,000 amount, a marital deduction may cause estate tax where none would otherwise be due.
The Spouse Has Options
If the decedent's will is not written to take advantage of the unlimited marital deduction through a bequest to a surviving spouse, it might be possible to achieve this result by having the surviving spouse assert dower or curtesy rights against the will. Most states, other than community property states, give a surviving spouse the right to elect to take either a bequest under the will or a specified percentage of the probate estate. State law varies widely, both as to the amount available and as to the procedure.
The advantage of electing against the will and claiming the dower or curtesy interest is that the interest may qualify for the unlimited estate tax marital deduction, reduce the taxable estate, and defer estate taxes. State laws must be complied with and care exercised so that the claiming of the dower or curtesy rights results in the availability of the estate tax marital deduction.
Perhaps the most important election that the decedent's representative can make is the Qualified Terminable Interest Property (QTIP) election. Property that passes in full ownership as an outright bequest to the surviving spouse automatically qualifies for the estate tax marital deduction. No election needs to be made. Congress felt that a full ownership bequest to the surviving spouse in order to qualify for the marital deduction was too harsh a price to pay since it gave the surviving spouse full control over the property.
So Congress enacted a new property interest that can qualify for the marital deductionÑQTIP. This property interest can provide income to the surviving spouse for life; and on the surviving spouse's death, the property can pass to children of the decedent. This is ideally suited to multiple marriages, where the children are from a prior marriage. The property interest must comply with a number of technical statutory requirements. The property interest over which the election is made is includable in the gross estate of the surviving spouse if the property is not consumed during the surviving spouse's lifetime.
The price of the estate tax deferral is that the property interest is included in the taxable estate of the surviving spouse, even though its ownership passes to someone other than the surviving spouse. The surviving spouse does have the right of reimbursement from the heirs of the property for a share of the estate taxes attributable to the included property interest, if that right is not waived.
The QTIP election is made by the decedent's representative on the decedent's federal estate tax return. Once the election is made, it is irrevocable. It is possible to make a partial election, but the partial election must be expressed as a fraction or a percentage of the assets that are subject to the QTIP interest. The fraction or percentage can be calculated by means of a formula. A typical estate plan divides an estate into two trusts or two portions. One trust or portion is funded with assets equaling the unified transfer tax credit exemption equivalent amount, generally $600,000, and over this bequest no QTIP election is made.
The rest of the estate is bequeathed in such a manner that a QTIP election can be made. This typical estate plan pattern will result in no estate taxes due on the first death. The bequest up to the $600,000 unified transfer tax credit exemption equivalent amount is not subject to estate tax, while the bequest in excess of this amount is sheltered by the QTIP election. Through the QTIP election, the estate tax is deferred until the death of the surviving spouse.
Asking for More Time to Pay
A number of provisions allow a decedent's representative to defer the payment of part or all of the estate tax that is otherwise due nine months after the decedent's death. The deferral provisions should be considered as an alternative to selling assets, converting them to cash, and paying the estate tax.
An extension to pay the estate tax may be granted by the IRS for a 12-month period for "reasonable cause." Applicable Treasury regulations give guidance on what constitutes reasonable cause. A denial may be appealed. An extension of up to ten years may also be granted. Obviously, the IRS will be less inclined to grant such a lengthy extension and good cause will have to be established. Also, it appears that such an extension may be granted a year at a time. The decedent's representative can elect to pay the estate tax attributable to a closely held business interest in up to ten equal installments. The first payment is due five years after the normal due date, nine months after death. Thus, in effect the extension is 15 years. Additionally, a favorable interest rate is imposed on the deferred payments. Public policy is to encourage the retention of closely held business interests in family ownership and not force their sale to pay federal estate taxes, and this is the basis for the provision.
In order to qualify under this favorable 15-year extended payout provision, a number of tests must be met. The closely held business interests must comprise 35 percent of the value of the adjusted gross estate. If the closely held business interests are but part of decedent's estate, as is typically the case, then only a portion of the federal estate tax can be extended. The amount that can be extended is the portion of the tax that reflects the ratio of the value of the closely held business interests to the value of all assets.
Also, a number of definitional rules must be met as to what constitutes closely held business interests. Sole proprietorships qualify. Partnerships and corporate interests meeting certain ownership requirements also qualify. Passive assets, such as rental real estate, generally do not fall within the definition of closely held business interests. Rental real estate can be considered an active business interest under certain circumstances.
The decedent's representative must make an election to have this 15-year installment payout provision apply. The applicable Treasury regulations set forth in some detail what information the election notice must contain. The extended payout provision also provides a 4 percent interest rate on the tax on the first $1 million in value of the closely held business interests. The IRS may require the posting of a bond to provide security for the extended payout opportunity. If the IRS insists on a bond and the decedent's estate can not furnish one, the 15-year installment election is not available.
Then There's the Family Farm
The decedent's representative is allowed to elect to value certain farm and ranch property at the value of its actual use as opposed to its fair market value. The definition of fair market value requires property to be valued at its highest and best use. Allowing farm and ranch property to be valued at its actual use allows farmers and ranchers to continue to use the property for farming and ranching purposes without having to sell all or part of the property to pay the federal estate tax attributable to it. Obviously, the highest and best use of farm or ranch property located near large metropolitan areas may not be as a farm or ranch but rather as property for commercial or residential development.
In order to use this favorable valuation formula, family members must have operated the farm or ranch and continue to operate the property. Family members must have farmed or ranched the property in question and not simply leased the land to a tenant farmer or rancher. The election for special valuation is made with the filing of the estate tax return. Each heir who has interest in the farm or ranch must consent to personal liability for the additional estate tax that would be due if the heir, within ten years after the decedent's death, ceases to use the property for farming or ranching or disposes of the interest in the property to a non-family member. There are, of course, a whole set of rules and requirements that must be complied with in order to qualify for this election.
What If the Beneficiary Says "No"?
A "federal disclaimer" allows a beneficiary to disclaim a bequest under a will without incurring any federal gift taxes. A disclaimer is a multipurpose mechanism. Often, estate plans are written from the point of view that a post-mortem disclaimer will provide flexibility in adjusting the estate plan of the decedent after death. Also, a disclaimer can be used to fix a marital deduction bequest that was too large or a charitable bequest that does not qualify for an estate tax charitable deduction.
The making of a qualified disclaimer does not result in a taxable gift. Instead, it's as if the disclaimed interest had never been received by the individual making the disclaimer.
A number of elections are available to the decedent's estate involving federal income taxes. One election concerns keeping the estate open as a separate taxpayer. The decedent's representative should analyze the income tax bracket of the estate and the income tax brackets of the heirs. An attempt should be made to equalize these brackets by distributing a portion of the estate's income to the heirs, which would generate a deduction in the estate for the amount of the distribution and correspondingly taxable income to the heirs.
With the compression of income tax rates for estates, income tax planning for an estate is not as simple as keeping the estate open as a separate taxpayer as long as possible. The topic of the timing of distributions and the type of income to be distributed deserves its own lengthy article. The representative needs to choose a taxable year for the estate. He or she may choose a calendar year or a 12-month fiscal period. This choice involves a number of considerations, such as the desire to defer the payment of income taxes as long as possible or to choose a fiscal year that ends after the close of the heir's taxable year.
Choosing when to close the estate and terminate its status as a separate taxable entity is also an important decision. The representative does not have unlimited discretion in this area. The IRS may conclude that the administration of the estate has been kept open too long and that the estate has closed for tax purposes even though all assets have not been distributed.
If an heir of the estate is a trust, consideration needs to be given as to whether it is desirable to use the trust as a separate taxpayer. A number of considerations come into play, such as when a trust should be funded and whether distributions of income should be made to the trust. The surviving spouse may file a joint tax return with the decedent's estate for the year in which the decedent died. This has the advantage of joint return rates. The disadvantage is that the estate is jointly and severally liable for the entire income tax plus any interest and penalties.