- Written by Martin M. Shenkman
Planning for uncertain times is the key issue on the table for advisors and clients today. Instead of focusing on what you can’t assure clients about, focus on proactive steps you can take to help clients deal with estates of decedents who died in 2010.
Carryover Basis Rules
If a client died in 2010, you have to deal with the carryover basis rules of Code Section 1022 enacted with the 2001 Tax Act and guide the executor. The basis of assets from a decedent is the lower of the decedent’s adjusted basis, or the fair value of the asset on death. This is adjusted for the special basis of $1.3 million on property passing to anyone and the $3 million for property passing out-right to a spouse, or in a trust that meets the requirements of Qualified Spousal Property.
Be proactive: get appraisals of all assets to demonstrate fair market value; corroborate the decedent’s income tax basis. Prepare a worksheet allocating the basis adjustment. The worksheet will be somewhat analogous to worksheets you have prepared in the past to allocation of 754 basis adjustments.
Don’t wait for forms to be released or for detailed instructions; move now. Returns will be due April 15, 2011, and the allocation of basis adjustments will have to be reported May 15, 2011. If Congress gives 2010 estates the option of using carryover basis or 2009 rules, you’ll still need calculations to confirm the decision. The answer may not be obvious because of the complexity and myriad of factors to consider: capital gains rates may rise, some assets cannot be stepped up, the $1.3 million basis step-up might eliminate capital gains with no tax, etc.
Beneficiaries are pressuring executors for distributions. With the law so unclear, suggest executors find sources (e.g., heirs, family business, insurance trust) to loan funds to the estate so that the estate can make some distributions to beneficiaries. To raise cash, guide the executor to also consider borrowing funds on margin, mortgages, commercial loans, etc. in order to avoid selling assets and solidifying unknown tax consequences
Executors and trustees of revocable trusts still have the responsibility to invest prudently, and this must be addressed. Review with the estate’s legal counsel the provisions of the will or trust and applicable state law. Help guide fiduciary in preparing an investment plan in coordination with whoever is managing the estate/trust assets.
In the past, executors could sell concentrated positions in an estate without capital gains because of the assured step-up in tax basis at death. While many estates might qualify to step-up basis using the $1.3 million and $3 million basis adjustments, the rules are still uncertain, and for some estates these won’t suffice. This means an income tax may be incurred on the sale. Tax costs are a factor which the prudent investor act requires executors to consider in evaluating the appropriate investment options.
Many states have enacted laws that provide that formula clauses under a will should be interpreted based on 2009 estate tax rules. An example of this is a will that states: “I give, devise and bequeath the largest amount that will not create a federal estate tax, to the Credit Shelter Trust for my spouse and children ... ”
Executors have to apply and interpret state statutes enacted to deal with formula clauses. These may influence who receives property under a will and therefore, affect the circumstances that have to be considered in evaluating options for allocating the $1.3 million or $3 million basis adjustment. If a trust for a spouse and children receives assets, rather than a trust solely for spouse, the tax status of the beneficiaries (likely holding period and other factors pertinent to deciding on how to allocate basis) may all change.
Executors have to begin the process of gathering data and beginning the analysis as to how to allocate the basis adjustments to estate assets as soon as practical. A major problem is that few, if any, wills (or trusts) address these issues. Some documents provide general language about tax elections and executor decisions that may indirectly provide some guidance. Fiduciaries should consider informing beneficiaries and having beneficiaries approve any allocations and decisions.
Caution: CPAs should clarify in their engagement letters who they are representing. Be wary of the minefields of conflict that can occur between the executor and beneficiaries and especially, among the various beneficiaries on these issues. Executors should get receipts and releases (a legal document in which a beneficiary acknowledges the bequest they are receiving and agrees to release the executor from any claims or actions) from the beneficiaries before filing their allocation determinations with the IRS. Worksheets prepared by the estate CPA may be attached to those releases to corroborate the decision process involved in the allocation.
Appraisals for estates will raise new and unexpected issues. The initial issue with many clients will be explaining why an appraisal is even needed if there is no estate tax in 2010. Appraisals are necessary, even if there is no federal (or state) estate tax in order to comply with the carryover basis regime.
Practitioners will need basis data to confirm whether the fair value on death or the taxpayer/decedent’s cost basis is lower. If in fact the fair value exceeds the cost basis, the appraisal of fair value will be essential to ascertain the maximum basis adjustment which can be allocated.
Discounts on partnerships and other family entities may have surprising effects, especially on estates with less appreciation then the maximum adjustments permitted. Discounts, long sought after as the nectar of successful estate planning, will reduce the amount of basis allocation that may be allocated to assets having a negative impact for some estates.
If a will provides a distribution to trusts for grandchildren, it is unclear that those trusts can be exempt from GST in future years. In 2010, there is no GST tax, so this is not an issue. But, what happens in 2011 when the GST is expected to be reinstated?
In some instances, it might be advisable to distribute the trust assets outright to an adult grandchild (or other skip person) before the end of 2010 to possibly avoid GST implications. While even this position is subject to uncertainty, it may prove to be a preferable option if outright distributions to grandchildren (GST skip persons) in 2010 escape GST, and trusts formed in 2010 are subjected to GST in 2011 and later years.
What income tax planning should be done for estates in 2010? In past years, the general presumption was to select the estate’s fiscal tax year and plan deductions, income realization and distributions, to defer taxable income to later years. However, 2010 may be a planning anomaly for which it might be advantageous to accelerate income and postpone deductions if there will be higher income tax rates in 2011 and later years.
Most estate planners rely extensively on the use of marital qualified terminable interest property (“QTIP”) trusts in wills and estate plans. Upon the death of the first spouse, significant wealth is often transferred into a QTIP trust to benefit the surviving spouse. But, in 2010, there is no estate tax.
If a QTIP-type trust is still funded, the restrictions under the QTIP rules (which if embodied in the governing document may apply to the trust regardless of the status of the estate tax in 2010) will limit the extent to which the surviving spouse can engage in affirmative estate tax minimization following the death of the first spouse. It may prove advantageous, especially if 2011 brings a $1 million exclusion and 55% rate for surviving spouses to disclaim assets to pass to a QTIP trust from a 2010 deceased spouse so that those assets can pass free of federal estate tax to other heirs.