Income tax issues for estates.

EXECUTIVE SUMMARY

* Generally, the deductions and credits allowed to individuals are also allowed to estates and trusts.

* Two important planning objectives are tax deferral and using tax rate differentials.

* Tax savings depend on coordination and cooperation among the executor, attorney and CPA.

This two-part article focuses on some distinguishing features of the taxation of estates. Part I, in the last issue, examined income tax issues that arise during the probate process. This part illustrates, through comprehensive examples, how advance planning can minimize an estate's income tax and maximize distributions to beneficiaries.

The first part of this two-part article, in the last issue, explored the decision-making process that occurs at the beginning of probate. Part I emphasized the importance of an integrated approach to income and estate tax issues and engaging in teamwork among professionals.

Part II, below, examines the design of estate income taxation. After deciding which return (Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return, or 1041, U.S. Income Tax Return for Estates and Trusts) will maximize the tax benefit from deductions, a tax adviser should examine how to optimize tax advantages by timing deductions and distributions to beneficiaries. Included in this analysis is the selection of the estate's optimal tax year-end.

Design of Estate Income Taxation

Subchapter J of the Code contains the rules governing the income taxation of estates:

* Under Sec. 641(b), taxable income is determined in the same way as for individuals.

* Under Sec. 661, an estate takes a deduction for distributions to beneficiaries (the distribution deduction).(11) (Taxable income before the distribution deduction is sometimes referred to as tentative taxable income (TTI).)

* Generally, estate taxable income equals TTI less the distribution deduction and $600 personal exemption.

* Under Sec. 662, the beneficiaries include their distributions in taxable income, but only to the extent the estate is allowed a deduction for the distributions.

Who reports the income? If there is an estate distribution deduction, a beneficiary will get the income (which will be reported via Form 1041, Schedule K-1). The character of the income (ordinary vs. capital, passive vs. active, etc.) is determined at the estate level; the income retains its character in the beneficiary's hands. However, capital gains are generally not passed through to beneficiaries, except in an estate's final tax year.

Estate income taxation does not follow the strict conduit theory applied to partnerships and S corporations. Only estate net income is passed through to beneficiaries (i.e., an estate's net loss is not passed through to beneficiaries). An exception is made for an estate's final tax year, as was discussed in Part I of this article.

Determining TTI

Sec. 641(b) provides that estate TTI (i.e., taxable income before the distribution deduction) is computed the same as for an individual, "except as otherwise provided 'in this part." Those looking through subchapter J for a description of these promised exceptions will be disappointed. Regs. Sec. 1.641(b)-1 provides that "generally, the deductions and credits allowed to individuals are also allowed to estates and trusts" but provides no examples or exceptions. These promised exceptions are found elsewhere:

* According to Sec. 67(e), the 2% disallowed itemized deductions rule does not apply to estate and trust deductions that would not have been incurred had the property not been held in a trust or estate. There have been few cases on the application of this rule.(12) However, most estate administration expenses should be deductible without regard to the 2% limit.

* Under Sec. 68(e), the disallowance of 3%/80% of itemized deductions when adjusted gross income (AGI) exceeds certain levels does not apply to estates or trusts.

* Under Sec. 469(i)(1) and (2), the $25,000 of allowed passive activity losses from rental real property does not apply to trusts. However, estates are allowed this deduction if the decedent could have claimed a loss as an active participant in the activity. This exception applies only to an estate's first two tax years, under Sec. 469(i)(4)(A). After this two-year period, no passive loss deduction is allowed.

* Under Sec. 179(d)(4), the election to expense depreciable property does not apply to estates.

* An estate cannot take a standard deduction, under Sec. 63(c) (6) (D).

A major difference between the taxation of individuals and estates is deductions for administration expenses. For an estate, such expenses are deducted from AGI; if incurred by an individual, however, such expenses might (1) be deemed nondeductible personal expenditures, (2) not meet the 2% threshold or (3) not exceed the standard deduction.

Form 1041 implies (and the IRS instructions explicitly state) that administration expenses are to be subtracted firm gross income in arriving at AGI, as opposed to being allowed as itemized deductions. Oddly, this deductibility theory is found in Sec. 67(e), which addresses the 2% disallowance rule for itemized deductions.(13) In any case, deductibility hinges on qualifying as an "administration expense."

Investment Expense

Investment expenses are also deductible. In part, Sec. 212 lists as deductible expenses for the (1) production or collection of income or (2) management, conservation or maintenance of property held for the production of income.

"Income" for this purpose includes prospective capital gain. Accordingly, if real property is held for sale (although not rented during the holding period), expenses for management, conservation or maintenance will be deductible. If property generates income during estate administration (e.g., interest, dividends, rents, etc.), related expenses would be deductible. Also, if estate property is sold during the administration period, expenses related to holding the property are deductible.

Example 1: W, a widow, died, leaving her condominium and other property to her children. The executor listed the property for sale, because W's children wanted the cash proceeds. During the period the residence was on the market, the executor continued paying utilities, association dues and real estate taxes. Because the objective of the estate (as carried out by the executor) was to sell the residence, the utilities and association dues would be deductible investment expenses under Sec. 212. The real estate taxes would be deductible as a tax expense on Form 1041.

If, instead, an estate does not intend to sell the property and it generates no income during administration, would management, conservation or maintenance expenses be deductible under Sec. 2127 Or as administration expenses? This is for the IRS and the courts to decide.

Fiscal Year-End/Distributions Planning

Given the design of estate income taxation, two important objectives of tax year-end/distributions planning are tax deferral and using tax rate differentials (between the estate and its beneficiaries and between tax years). This endeavor requires knowledge of the tax laws and depends on the facts and circumstances. Also required are information on the estate's assets and debts (i.e., a Form 706 or inventory, even if in draft stage) and a current accounting of activity since the date of death (DOD). Further, as was discussed in Part I of this article, a list of probate vs. nonprobate assets is needed. This distinction will not necessarily be evident from Form 706, although a complete inventory should indicate it. The example below demonstrates how tax savings can be achieved by engaging in advance planning

Example 2: Z, a widow, died in July 2000. Her will provided for her two children, S and D, to share her estate equally. Z's assets are an IRA account, a certificate of deposit (CD), publicly traded common stock, a house, cash in a combined savings/checking account and some personal effects. Z did not complete a beneficiary designation form for her IRA account. As a result (based on the terms of the IRA agreement), Z's estate is the default beneficiary.

The CD, common stock and house were titled in Z's name alone and are probate property. The savings/checking account was held by Z and S as joint tenants with right of survivorship. (The funds were contributed exclusively by Z.) The projected executor, attorney and accountant fees for administering the estate will be $30,000. This information, along with debts at the DOD and the funeral expenses, are shown in Exhibit 1 below. Z's estate owes $409,500 in estate tax -- $334,020 to the IRS and $75,480 to the state of Z's residence (the amount due the state equals the Federal state death tax credit).

Exhibit 1: Z's estate--assets, liabilities and projected administration expenses at DOD (no planning)

Item                                            Amount

Cash, checking, savings (joint with S)         $40,000
Common stock portfolio                         700,000
IRA                                            500,000
House                                          500,000
Mortgage                                      (50,000)
Personal effects                                20,000
Funeral expenses                               (5,000)
Administrative fees                           (30,000)
Credit card and other consumer debt           (10,000)
Net taxable estate                          $1,665,000

Total (Federal and state) estate taxes        $409,500

Neither the estate nor the beneficiaries is subject to state income tax and the beneficiaries have no capital gains or losses during estate administration. Further, the beneficiaries decline to receive the house or common stocks, thus obliging the executor to sell them and distribute cash. There are no carrying costs on the house (utilities, etc.) and the mortgage wan not be paid off until the property is sold.

The IRA distribution is taxed to the estate at up to 39.6%, but S and D (each married filing jointly) are taxed on estate income at a predictably lower rate, as their taxable incomes are normally about $40,000 each.

Variation 1 (no planning)--In September 2000, S took possession of the cash he had owned jointly with Z. The $300 of interest earned on these funds from the DOD until September 2000 will be reported on S's return. (Interest earned before the DOD will be included on Z's final return.) Three months after the DOD, in October 2000, the IRA funds were distributed to the estate. The portfolio of common stock was sold for $755,000, less $5,000 commission. Z's credit card and other consumer debts were paid. S paid the funeral expenses and was reimbursed by the estate. The remaining funds of $1,235,000 ($500,000 + $750,000 - $10,000 - $5,000) were invested in a money market account.

In April 2001, the $409,500 in Federal and state estate taxes were paid. In June 2001, executor, accountant and legal fees of $15,000 were paid.(14) From October 2000-June 2001 (the last month the estate could choose as its tax year-end), the house remained unsold, no distributions were made to S or D and the money market account for Z's estate earned $35,000.

In July 2001, the accountant completed Form 1041. The tax of $147,748 (mostly at the 39.6% rate) was due on Oct. 15, 2001. After the June 2001 year-end, the house was sold for $500,000 less $40,000 commission and other costs of sale; the mortgage ($50,000) was paid on closing. The final executor, legal and accounting fees of $15,000 were paid, as was the Federal income tax. Also, Z's estate earned $40,000 in money market dividends. The remaining estate assets, totaling $1,152,752, were distributed to the beneficiaries in October 2001. The final income tax return, for the year ending October 2001, reflected TTI of $37,000 ($40,000 of money market dividends -- $3,000 allowed capital loss from the residence sale). Exhibits 2 and 3 summarize these facts for the estate and the beneficiaries.

Exhibit 2: Z's estate--taxable income, distributions and tax (no planning)

Item                           Year 1        Year 2
                            (7/00-6/01)   (7/01-10/01)       Total

IRA distribution               $500,000             --      $500,000
Stock sale proceeds             755,000             --       755,000
Less: Costs and basis         (705,000)             --     (705,000)
Money market dividends           35,000     $   40,000        75,000
House sale proceeds                  --        500,000       500,000
Less: Casts and basis                --      (540,000)     (540,000)
TTI                            $585,000       $37,000(*)    $622,000
Distributions to $ and D             --      1,152,752     1,152,752
Tax deduction for income
  in respect of a
  decedent (IRD)                184,080             --       184,080
Income before exemption        $400,920     $        0      $400,920
Income tax                     $147,748     $        0      $147,748

(*) Ordinary income of $40,000 less $3,000 allowed capital lass

Exhibit 3: Effect on either beneficiary (no planning)

Item                                Year 1      Year 2
                                    (2000)      (2001)       Total

Taxable income (excluding           $40,000     $39,800     $79,800
  estate and estate-related
  items)
Ordinary income per K-1                  --      20,000      20,000
Capital gain/(loss) per K-1              --    (20,000)    (20,000)
Estate tax deduction for IRA             --          --
income (IRD passthrough)
Disallowed itemized deductions           --          --          --
Disallowed capital loss                  --      17,000      17,000
Taxable income after estate         $40,000     $56,800     $96,800
  items
Income tax without estate items     $ 6,004     $ 5,974     $11,978
Income tax with estate items        $ 6,004     $ 9,983     $15,987
Incremental tax from estate         $     0     $ 4,009     $ 4,009
  items (for either S or D)
Incremental tax from estate         $     0     $ 8,018     $ 8,018
  items (for S and D)

Variation 2 (with planning) -- The strategies employed for reducing the estate's and beneficiaries' tax liabilities include taking advantage of the higher marginal estate tax rate (45%) by deducting the costs of sale for the stock and house on the estate tax return, instead of on the estate income tax return (the latter saves only 20% for these capital transactions(15)). Given that these properties need to be converted by the executor to cash to fulfill the beneficiaries' requests, Regs. Sec. 20.2053-3(d)(2)'s conditions have been met.(16) Accordingly, this deduction can be taken against the taxable estate.

Based on the size of this estate and its assets, it is presumed that estate administration will be concluded before the end of 2001. Accordingly, the estate's activity can affect S and D for only two tax years. The estate itself can have as many as three fiscal years (e.g., by choosing a first fiscal year-end of Aug. 31,2000).

Which year-end should the estate choose? This analysis requires careful attention, as the potential estate income tax savings (by using the lower income tax rates three times instead of two(17)) could easily be exceeded by greater legal and accounting fees for the extra effort involved. After considering this and other factors, a November 2000 fiscal year-end is chosen. In addition, income will be distributed to the beneficiaries in the first year to take advantage of their lower tax rates. This strategy can be implemented as follows:

During October 2000, $250,000 (of the total $500,000) of the IRA funds is distributed to the estate. The portfolio of common stock is sold in October for $755,000, less $5,000 commission,(18) yielding $750,000. The decedent's credit card and other consumer debts are paid and the funeral expenses reimbursed to S. Distributions to the beneficiaries of $240,000 are made in November (resulting in much of the estate's income being taxed at the beneficiaries' lower tax rates).

Estate income tax for the Nov. 30, 2000 fiscal year is $12,430, mostly computed at the capital gain rate (for the stock sale gain). Only $6,347 ($10,000 undistributed IRA income less the corresponding $3,653 estate tax deduction) will be taxed as ordinary income. This tax will be due in March 2001. In April 2001, the Federal and state estate taxes of $389,250 are paid.

In June 2001, the house was sold for $500,000, less $40,000 commissions and other costs of sale (previously deducted on Form 706); the mortgage ($50,000) was paid on dosing. The $30,000 of executor, legal and accounting fees were paid.

During the December 2000-October 2001 final year, money market dividends of $35,000 are earned by Z's estate. It is also presumed the beneficiaries earned money market dividends of $40,000 from their investment of estate funds previously distributed to them. (Thus, the total dividends are the same as in Variation 1.) The remaining $750,000 IRA account balance is distributed to the estate.

The remaining estate assets, totaling $1,028,320, are distributed to the beneficiaries in October 2001. The income tax return for the year ending October 2000 reflects TTI of $285,000. Exhibits 4-6 illustrate the effects on the estate and beneficiaries.

Exhibit 4: Z's estate--assets, liabilities and projected administration expenses at DOD (with planning)

Item                                          Amount

Net taxable estate (see Exhibit 1)          $1,665,000
House, costs of sale                          (40,000)
Stock, costs of sale                           (5,000)
Net taxable estate                          $1,620,000
Total (Federal and state) estate taxes        $389,250

Exhibit 5: Z's estate--taxable income, distributions and tax (with planning)

Item                           Year 1           Year 2
                           (7/00-11/00)   (12/00-10/01)      Total

IRA distribution               $250,000        $250,000     $500,000
Stock sale proceeds             755,000              --      755,000
Less: Basis(*)                (700,000)              --    (700,000)
Money market dividends               --          35,000       35,000
House sale proceeds                  --         500,000      500,000
Less: Basis(*)                       --       (500,000)    (500,000)
TTI                             305,000         285,000      590,000
Distributions to S and D        240,000       1,028,320    1,028,320
Tax deduction for IRD             3,653              --        3,653
Income before exemption          61,347               0       61,347
Income tax                     $ 12,430       $       0    $  12,430

(*) Costs were deducted on Form 706

Exhibit 6: Effect an either beneficiary (with planning)

Item                             Year 1        Year 2         Total
                                 (2000)        (2001)

Taxable income (excluding        $40,000       $39,800       $79,800
  estate and
  estate-related items)
Ordinary income per K-1          120,000       142,500       262,500
Capital gain/(loss)                   --            --            --
  per K-1
Money market dividends                --        20,000        20,000
  attributable to estate
  distributions
Estate tax deduction for        (43,834)      (45,660)      (89,494)
  IRA income (IRD
  passthrough)
Disallowed itemized                1,385         3,317         4,702
  deductions and
  exemptions
Disallowed capital loss               --            --            --
Taxable income after             117,551       159,957       277,508
  estate items
Income tax without                 6,004         5,974        11,978
  estate items
Income tax with estate            27,208        40,354        67,562
  items
Incremental tax from              21,204        34,380        55,584
  estate items (for
  either S or D)
Incremental tax from            $ 42,408      $ 68,760      $111,168
  estate items (for
  S and D)

Planning reduced the combined tax bills of the estate and beneficiaries by $42,898 (see Exhibit 7), by taking advantage of tax rate differentials. By deducting selling costs (for the house and stock), 45%-rate tax savings were realized on Form 706, as opposed to the lower capital gain rate on Form 1041. If the costs are not deducted on Form 706, some of the income tax savings may be at a higher rate than the 20% capital gain rate, because a capital loss (at $3,000 per year) may be used against ordinary income. No matter the income tax consequence, the deduction is more beneficial as an estate tax deduction. (In Variation 1, the tax effect of the unused capital loss from the house sale was computed based on the beneficiaries' normal 28% rate. This deferred tax benefit computation minimizes the calculated benefit of Variation 2, as compared to using a 20% rate.)

Exhibit 7: Estate and beneficiaries--no planning vs. planning

Item                         No planning     Planning    Difference

Estate tax                      $409,500     $389,250     $(20,250)
Estate income tax                147,748       12,430     (135,318)
Beneficiaries' income tax          8,018      111,168       103,150
Beneficiaries' deferred          (9,520)                      9,520
  tax benefit(*)
Total taxes                     $555,746     $512,848     $(42,898)

(*) Capital loss carryover = ($40,000 - $6,000) x 28%

By spreading the IRA income over two years and making distributions from the estate in the first year, use of the beneficiaries' lower income tax rates was maximized. In essence, this significant income was "stepped through" their lower rates twice (never attaining the level that triggers the beneficiaries' highest income tax rate). This strategy offered a significant improvement over distributing the entire IRA account to be taxed within the estate--mostly at a 39.6% rate.

Current and complete accounting information is required to produce the results of Variation 2. Without it, opportunities to change the structure and timing of transactions and choose an optimal year-end will be eclipsed. Executors or attorneys who hoard information will frustrate this process. Some operate under the notion that waiting until the estate's year-end to give the CPA information saves fees. This is seldom true, and is likely to cost the estate and beneficiaries additional income tax. (The simple planning techniques used in Variation 2 resulted in significant tax savings for this relatively modest estate.)

Conclusion

Careful attention to the consequences of choosing a tax year-end and the timing of transactions (including distributions to beneficiaries) can result in significant tax savings for most estates. These savings depend on coordination and cooperation among the executor, attorney and CPA.

If the financial activity throughout probate is tracked and accounting information made available to the professionals involved, everyone involved can achieve rewards.