Income tax issues for estates.

This two-part article focuses on some distinguishing features of the taxation of estates. A decedent's death may trigger the filing of estate tax (Form 706) and/or estate income tax (Form 1041) returns. Tax advisers need to familiarize themselves as to which deductions can and should be taken on which return, to maximize tax savings.

Advisers familiar with the income tax rules for individuals can encounter problems when working with estates. Although the income taxation of estates is similar in many ways to the roles applicable to individuals, there are differences--some obvious, others subtle. Familiarity with these differences will avoid tax problems or permit tax savings.

This article focuses 6n some distinguishing features of estate taxation. Part I, below, centers on income tax issues that often arise during the probate process, with an emphasis on deciding between estate and income taxes. Part II, in the next issue, will examine maximizing tax benefits by timing deductions and distributions.

Understanding the Process

After a death, the estate administration process governs the tax adviser's efforts. Incomplete understanding of this process will increase the time spent on postmortem tax planning and return preparation and increase the likelihood of mistakes.

When an estate is created, the probate process begins in a local court.(1) An executor's first task is to determine the estate assets and liabilities, which can be time-consuming. The executor then must carry out the instructions in the decedent's will. While following these instructions, the executor has a fiduciary responsibility to preserve and maintain estate property until the estate's liabilities are settled and all property is distributed to the beneficiaries. The tax adviser's role in this is as follows:

1. Determine the estate's assets and liabilities. These will be reported on Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return, and also on any state inheritance tax return. The assets must be valued and described in detail and the form of ownership determined.

2. Estate property will usually generate income and expenses during administration, requiring the preparation of Form 1041, U.S. Income Tax Return for Estates and Trusts.

3. As administration progresses, property will be distributed to the beneficiaries. As is discussed in Part II of this article (in the February 2001 issue), the timing of such distributions can have a dramatic effect on the estate's or beneficiaries' income tax expense.

4. The income tax basis of distributed property will generally be its date-of-death (DOD) value or alternate valuation date value (six months after the DOD).(2) This basis information needs to be given to beneficiaries for use in their income tax calculations.

Logic dictates that a complete and accurate determination of all estate assets and liabilities be made before gathering income and expense information for income tax purposes. This approach can be thwarted if the tax professional responsible for completing Form 706 differs from the one preparing Form 1041. Communication and information sharing ensures the successful and efficient completion of both returns in such situations. Some deductions can be taken either as estate tax deductions on Form 706 or as income tax deductions on Form 1041. Such choices may have a significant effect on the total tax burden; thus, cooperation between tax professionals is critical:

* The Form 706 preparer should supply asset and liability information as it is being gathered to the Form 1041 preparer. If the former waits until Form 706 is complete before sharing such information, tax planning opportunities may be lost, such as the ability to choose an optimal tax year-end or minimize the estate's overall tax burden.

* The Form 1041 preparer should immediately begin an accounting based on the first draft information of the estate's assets and liabilities. At a minimum, this will require obtaining bank and securities statements from the DOD forward. By taking an accounting from the initial information, the Form 1041 preparer will likely find sources of income not traceable to known assets or estate administration expenses not originally picked up on Form 706. This new information can then be shared with the Form 706 preparer.

* Teamwork and communication are the key to benefiting a client.

What Is An Estate?

Besides working with the probate process and engaging in productive teamwork, a tax adviser needs to understand the tax consequences flowing from the form of ownership of estate property.

A fundamental ownership concept is the difference between probate and nonprobate property. A misunderstanding of this distinction will likely result in the (all-too-common) mistake of reporting taxable income (and less frequently, deductions) on the estate's Form 1041 instead of a beneficiary's Form 1040.

For estate tax purposes, an "estate" includes all of a decedent's property, according to Sec. 2031 et seq.; it may even include property to which the decedent did not hold legal title at death. For income tax purposes, an "estate" includes only those assets owned by the probate estate, not property owned by an heir immediately after the decedent's death (i.e., nonprobate property). As expressed in Regs. Sec. 20.0-2(b)(2), the gross estate for Federal estate tax purposes may be very different from the estate for local probate purposes. Any such probate property is subject to estate income taxation.

The disposition of probate property is subject to a will; the disposition of nonprobate property is controlled by some other legal document. Some examples of nonprobate property include:

* A pension plan (assets pass to a designated beneficiary (e.g., spouse) on the decedent's death).

* A bank or securities account owned jointly with the right of survivorship (passes to remaining joint tenant(s) on the decedent's death).

* A bank account payable on death or held in trust (passes to the person named by the decedent).

* A grantor trust that becomes irrevocable on the grantor's death (the trust property will be managed by the trustees for the trust beneficiaries).

* A business buyout agreement that becomes effective on death, under which the business (or the other owners) pay the surviving spouse. The spouse owns the benefits of the buyout agreement.

The common theme in these examples is that a contract or agreement, not a will, controls the disposition of the decedent's property after death. Such property never belongs to the estate; it instead goes to a person or entity specified in the legal document. That other person or entity (not the estate) reports income from the property.

It is possible for a nonprobate asset to become a probate asset. For instance, if a decedent named his estate as the beneficiary of his pension account, the pension would become probate property. Likewise, if a buyout agreement specified the estate as the payee, the estate would include the interest portion of the payments (or any other associated income) in taxable income.

Thus, the first rule for income taxation of estates is to determine who owns the decedent's property. Probate property belongs to the estate; its associated income and deductions are reported on Form 1041. If the property is nonprobate property, related income and deductions are reported on the owner's return.

Form 706

Should deductions be taken on Form 706 or 10417 Can certain deductions be taken on both forms? Before getting into the particulars of the various kinds of deductions, a general discussion of the tax treatment of deductions for each of these returns is helpful:(3)

* Deductions taken on Form 706 save taxes at rates ranging from 37% (for taxable estates of $675,000-$750,000) to 55% (for taxable estates over $3 million).

* Deductions taken on Form 1041 save taxes up to 39.6% (plus the effective state income tax rate, if any).(4)

* No matter an estate's size, if the marital deduction will "zero out" the estate tax liability, the estate is generally better off taking deductions on Form 1041.

Given these ground rules, on which return can (and should) deductions be taken?

Consider first the deductions reportable on Form 706, Schedule J, Funeral Expenses and Expenses Incurred in Administering Property Subject to Claims. The first item on this schedule is funeral expenses, which can be deducted only on Form 706. The remaining items are administration expenses; executor's fees, attorney fees and accountant fees; and so-called miscellaneous administrative expenses.

The various fees should be deducted on the return (Form 706 or 1041) that yields the greater tax benefit. In dealing with a "small" taxable estate (one less than approximately $750,000), it might appear that a 37% estate tax deduction (Form 706) versus a 39.6% income tax deduction (Form 1041) would call for taking deductions on the latter form. However, it is often wise to look beyond this simple analysis and choose Form 706, because:

* The taxable income for such an estate (after considering all deductions) may place it in a tax bracket less than 39.6%.

* An estate tax savings is fairly immediate; income tax savings from a future fee may not be recognized for one or more years after the decedent's death (i.e., a deduction today is worth more than one a year from now).

Larger estates (i.e., those with tax not "zeroed out" by the marital deduction) will generally find an advantage in taking these deductions on Form 706.

The choices available for the other Schedule J deductions (i.e., miscellaneous administrative expenses) offer some interesting opportunities, especially for larger estates that may save 55% in taxes (as opposed to 39.6%(5) on Form 1041). Given this rate difference, an estate should strive to shift allowable deductions to Form 706. The following items are suggested:

1. Costs of selling or otherwise disposing of estate assets. Such expenses will not always be deductible from the taxable estate, although they are available as income tax deductions. Kegs. Sec. 20.2053-3(d)(2) requires that such expenses must be incurred to provide funds to pay debts, expenses or taxes, or to make cash distributions. Because an income tax deduction for these items will likely be worth only 20% in tax savings (as they will probably be incorporated in a capital gain/loss computation), practitioners meeting the regulation's requirement can justify the deduction on Form 706 for taxable estates.

2. Maintenance, storage and moving costs for estate assets.

3. Investment adviser fees.

4. Court costs and filing fees.

This list is not intended to be complete. These items are sometimes inadvertently deducted on Form 1041 when they would provide a greater benefit on Form 706.

In summarizing Schedule J items, funeral expenses are deductible only on Form 706; the various professional fees can be deducted on either form. Miscellaneous administrative expenses are allowed only on Form 706 or either Form 706 or 1041, depending on the kind of expense.(6)

Other deductions that may result in a choice between Forms 706 and 1041 are reportable on Form 706, Schedule K, Debts of the Decedent, and Mortgages and Liens. An important distinction between Schedule K and Schedule J items is that the former are debts actually due at the decedent's death (as determined by rules similar to accrual-basis accounting); the latter are post-DOD expenditures (not usually determinable on the DOD, except by estimate).

Schedule K items include outstanding credit card balances, mortgages, etc. However, many of these debts have no income tax significance. Only debts with income tax significance will result in interplay between Forms 706 and 1041, such as:

1. Property taxes due.

2. Accrued mortgage interest.

3. Sole proprietorship debts.

4. Medical bills.

The first three items in the above list are deductions in respect of a decedent (DRDs) the opposite of IRD. Both DRDs and IRD are included in an estate under the estate tax laws (as either a claim against the estate or assets); when later paid or collected, they are allowed as income tax deductions or required to be included in income. Appearing on both returns is certainly a negative for IRD items; however, the deduction of DRDs on both Forms 706 and 1041 is quite a benefit. This double benefit (estate and income tax deductions) would occur only if the decedent were a cash-method taxpayer.(7)

The DRD concept for certain Schedule K items contrasts sharply with the treatment of Schedule J administrative expense deductions (discussed previously). Such administrative expenses are deductible on Form 706 or 1041, not both.

Medical expenses are likewise deductible on Form 706 or 1041.(8) The same analysis is used to elect which return to use: which yields the bigger tax savings?

IRD and the Estate Tax Deduction

Under Sec. 691, IRD is income earned during a decedent's life, but uncollected at his death. For the usual cash-basis taxpayer, income earned during life (i.e., accrued) but uncollected at death is not included in the decedent's predeath taxable income. A few examples of IRD are:

* Bond interest and stock dividends accrued (but unpaid) before death.

* An IRA or pension account.

* An installment note receivable reported on the installment method (only the gross profit portion of the total note is IRD).

* Rent past due but not yet received as of the DOD.

These IRD items do not go untaxed when finally collected. IRD items are included in the recipient's taxable income, under Sec. 691(a), whether the income is collected by the estate or some other successor-in-interest. Further, no basis step-up is allowed for an estate's IRD assets, according to Sec. 1014(c).

Although no basis step-up is allowed for an IRD item, the accrued asset must be included in the taxable estate at fair market value. To the extent the taxable estate exceeds $675,000 (in 2001), there will be an estate tax liability based on the asset's value. The end result is a double tax on IRD items (both estate and income taxes).

Sec. 691 (c) provides for an income tax deduction for the Federal estate tax paid on the IRD item, thus ameliorating this inequity. The deduction is allowed to the estate (or heir, beneficiary, etc.) as the IRD is collected and included in income. Computing the estate tax deduction for IRD items is a two-step process (see the example below):

1. Calculate the Federal estate tax on the IRD item.

2. Compute the portion of this estate tax associated with the fraction of the IRD collected and included in income in the particular tax year.

Example: X's net taxable estate is $1,665,000; the only IRD item is a $500,000 IRA account with a zero basis.

                          Form 706      Form 706     Estate Tax
                          (no IRD)        (IRD)        on IRD

Taxable estate            $1,165,000    $1,165,000
IRA (IRD)                        -0-       500,000
Adjusted taxable estate   $1,165,000    $1,665,000
Tentative tax             $  413,450    $  630,050
Less:
Unified credit             (220,550)     (220,550)
State death tax credit      (42,960)      (75,480)
Net estate tax/income
tax deduction             $  149,940    $  334,020   $184,080

The deduction computation is a "with/without" calculation--the estate tax is computed based on the actual taxable estate (per Form 706), then calculated based on the estate without the IRD item; the difference is the income tax deduction.

If there were more than one IRD item, the estate tax differential/income tax deduction would be allocated to each pro rata, based on value. For instance, if the above calculation included two IRD items of $250,000 each, the income tax deduction for each would be $92,040 ($184,080/2).

The issue is remembering to make the computation available to the party who will collect the IRD. Often, the Form 706 preparer (who would have the information needed to compute the estate tax on the IRD item) does not communicate the existence of the deduction to the beneficiary who receives the item.

Excess Deductions on Termination

If an estate has a net loss during a tax year (i.e., deductions exceed income), such loss generally is not deductible by the beneficiaries. Further, only a net operating loss (NOL) (i.e., a loss based on excess business deductions) can be carried to another estate tax year to reduce taxable income, thus allowing a refund.

An important exception is found in Sec. 642(h)(2), which describes excess deductions on termination. Although NOLs comprised of business deductions (e.g., losses from a sole proprietorship or rental real estate business) can be carried back or forward to offset profitable estate tax years, yielding a refund,(9) losses comprised of nonbusiness deductions cannot. However, nonbusiness losses can be passed through to beneficiaries if they occur in an estate's final year; such losses can then be deducted by beneficiaries on their returns. Because attorney, accountant and executor's fees likely to create an estate's loss are nonbusiness deductions, these deductions can be lost if they do not occur in an estate's final year.

Accordingly, some thought should be given to the timing of nonbusiness deductions toward the end of an estate's existence. Further, consideration of other factors (including creating a short estate final year) may increase the tax benefits available to beneficiaries.(10)

Under Sec. 642(h)(1), unused capital losses or NOLs can be passed through to beneficiaries only in an estate's final year.

Conclusion

The issues discussed above will arise for most estates. A focus on the highlights enables better understanding of tax saving opportunities and avoidance of common mistakes. Communication and teamwork result in a better outcome for clients and is appreciated by other professionals. Hopefully, the concepts discussed have offered insight into tax compliance and planning for estates, including the ability to make decisions based on an integrated knowledge of both estate and income taxes.

In the next issue, Part II of this article will discuss the basic design of estate income taxation and post-DOD planning issues. Real-life examples will be presented, so that tax advisers can quantify the alternative outcomes and develop a deeper understanding of the available options.

EXECUTIVE SUMMARY

* Although the income taxation of estates is similar in many ways to the rules applicable to individuals, there are differences.

* A complete and accurate determination of all estate assets and liabilities should be made before gathering income and expense information for income tax purposes.

* "Estate" is defined differently for estate tax and income tax purposes.

(1) For state law purposes, an estate would not be created following a death if, for example, a living trust containing dispositive provisions owned all of the decedent's property. Although such a trust would preclude a probate court from having jurisdiction over the administration of the decedent's property, the income tax rules applicable to the (then irrevocable) trust would be similar to those for an estate. Further, the trust could elect under Sec. 645 to be treated as an estate for income tax purposes. Two of the advantages of such an election are the opportunity for the trust to (1) choose a fiscal, rather than calendar, year-end and (2) avoid payment of estimated taxes for its tint two tax years.

(2) An exception applies to income in respect of a decedent (IRD) property; such property takes a carryover basis under Sec. 1014(c)

(3) The Hubert regulations (Regs. Sec. 20.2056(b)-4) are beyond the scope of this article; for a discussion, see Whitlock, "Significant Recent Developments in Estate Planning," 31 The Tax-Adviser 576 (August 2000), p. 577. These rules provide that an estate's marital or charitable deduction may be reduced by certain administration expenses if paid from the marital or charitable share. Practitioners should become familiar with these regulations and consider their potential effect on the decision to take deductions on Form 706 or 1041.

(4) Although the Federal estate income tax rate begins at 15%, the 39.6% rate is reached when income reaches $8,650 (for tax years ending in 2000). Accordingly, in all but the smallest estates (or larger estates with minimal income), the 39.6% rate will generally apply.

(5) State income taxes may increase this percentage.

(6) Lists of the various types of miscellaneous expenses and the form(s) on which to report them can be found in tax treatises.

(7) If the decedent was on the accrual basis, the income tax deduction would have been allowed before his death; thus, the deduction would not be again allowed to his estate or other successor-in-interest.

(8) See Sec. 213(c) for more information on this election.

(9) NOLs can also be carried out to estate beneficiaries in the estate's final year, if unused during estate administration.

(10) See Keene, "Maximizing Excess Deductions on Termination," 29 The Tax Adviser 472 (July 1998).

David Keene, CPA
Keene & Company, CPAs
Seattle, WA