Postmortem Tax Planning Raymond T. Rowe, J.D., C.P.A. Troy, Michigan (248) 643-8640 Rowelawfirm.com

Your Client Died – Your Tax Planning Did Not There are a number of choices to be made Final Personal Income Tax Return Income Tax Returns for Estate and/or Trust Estate tax return issues Dealing with pass-through entities I.R.S. Audits

AICPA 360 Degrees of Financial Literacy Available at both AICPA and MICPA website What is a post-mortem election? Estate planning technique that can help minimize federal transfer tax or income tax liabilities Usually made by personal representative Must be timely made in the required fashion QTIP election allows treatment of all of part of qualifying assets to pass to spouse free to tax under marital deduction Selection of tax year allows personal representative to divide income into as many taxable years as possible to prevent bunching of income

Income Tax Returns in General Executor or administrator estate or other person in control of property must file an income tax return for the tax year that ends on date of death. Reg. Sec 1.6012-3(b)(1) Executor or administrator must file tax return for estate from date of death until estate is liquidated for each tax year in which gross income is $600.00 or more or beneficiary is nonresident alien. Secs. 6012(a)(3),(5). Trustee of trust must file tax return for each nonexempt trust where gross income is $600.00 or more, there is any taxable income or beneficiary is nonresident alien. Secs. 6012(a)(4),(5).

Opportunities on Final Income Tax Return Accrued interest on U.S. Savings Bonds Most taxpayers are on a cash basis for reporting this income Taxpayer at any time can elect to change to accrual basis for this interest For year of switch all accrued and untaxed interest is taxable in year of change. There is no step up in basis for Savings Bond interest. If no change in method beneficiaries are taxable on interest when bonds are cashed in Elderly clients may be in lower tax bracket than beneficiaries Taxpayer may have high itemized deductions Medical expenses Carryover of excess charitable contributions Foreign tax credits carryovers (need foreign income to use) Investment interest carryover

Opportunities on Final Income Tax Return Decedent’s net operating loss deduction Rev Rul.74-175,1974-1 C.B. 52 Decedent’s capital and net operating loss sustained in final tax year are deductible only on the final tax return and are available to estate or heirs. See Secs. 165 and 172 Can carryback losses

Opportunities on Final Income Tax Return Capital loss carryovers No benefit to sell unrecognized capital gain assets in final year since these assets will receive step up in basis upon death Capital assets with unrecognized loss Step up in basis rule also affects unrecognized loss assets. The basis in these assets is stepped down to current FMV If final year has taxable income taxpayer could sell loss assets before death to lower tax (use $3,000 of loss)

Opportunities on Final Income Tax Return Installment sales during year of death The election to treat a sale as an installment sale is an election to be made on a sale by sale basis Installment sale income is income in respect of a decedent and there is no step up in basis. 100% of gain would be reported by the recipient Compare tax rates of decedent and beneficiaries and taxable income of decedent to determine whether or not to elect installment sale income recognition

Opportunities on Final Income Tax Return Income from partnership and S corporation returns Income from pass through entities are allocated For partnerships to whoever was partner at year end For S corporations to owners on either pro rata basis based on dates of ownership or by interim closing of books Election to close tax year is made at entity level Personal representative should work with entities to plan income allocation to final decedent's return Sec. 754 Election in Partnership Upon death partner’s outside basis is increased Partnership can make 754 Election to increase inside basis of partnership assets attributable to deceased partner is increased as to the inherited partnership interest Other partners do not benefit from basis increase

Opportunities on Final Income Tax Return Sec. 754 Election continued Election is made on partnership return for year partner died Return must be filed by extended due date or within 12 months thereafter Can be revoked only with IRS approval 754 election can also be made if there is a sale of the partnership interest Election to file joint return Personal Representative and spouse have the right but not the obligation to file a joint return for the year of death Include only income through date of death on Form1040 If no Personal Representative is appointed spouse has sole right to decide to file a joint return

Estate or Trust - Form 1041 Estate and Trust are two separate entities Estate Decedent's Probate Estate Exemption $600.00 Can choose any fiscal year ending on end of month not more than 12 months after decedent’s death Trust Exemption of $300.00 for simple trust and $600.00 for complex trust Must use calendar year unless it qualifies for natural business year Can elect to treat trust income on tax return for estate Make election on Form 8855 Effective for two years beyond date of decedent’s death

Estate or Trust - Form 1041 Taxation of Estate Administration expenses can be significant Expenses can be deducted in year paid Unless Estate elects to report income on accrual basis Often expenses are paid just before closing of estate thus it may make sense to choose accrual basis No loss carry forward for excess expenses Income can carryout to beneficiaries if there are distributions Excess expenses do not carry out to beneficiaries

Estate or Trust - Form 1041 Taxation of Trust Expenses can reduce taxable income Consider using accrual method For simple trusts all income is taxed to beneficiaries For complex trusts distributions carry out taxable income Can elect to treat distributions made within 65 days of year end as if they were distributed during prior tax year Excess expenses Do not carry forward In year of trust termination excess expenses carryout to beneficiaries as itemized deduction

Estimated Tax In Final Year On final year for a Form 1041 all income including capital gains is passed out to and taxed to beneficiaries By filing Form 1041-T Allocation of Estimated Tax Payments to Beneficiaries any estimated tax can be allocated to the beneficiaries Must file this form within 65 days of end of tax year Does not apply to withheld taxes such as taxes withheld on retirement plan distributions

Estate or Trust - Form 1041 Distributions in kind Generally estate or trust does not recognize tax on a distribution Exception is a distribution of capital asset in satisfaction of a pecuniary (money) bequest. Beneficiary has carryover basis from estate or trust when estate or trust does not recognize income on distribution 643€(3) election estate or trust treats distribution as a sale at fair market value Beneficiary’s basis is increased by gain recognized Election is annual election and applies to all property distributed Benefits of election: Income recognized by estate or trust could offset excess deductions or capital losses Detriment: If beneficiary is in a lower tax bracket

Expenses – Form 706 or Form1041 Form 706 no longer as much of an issue since exemption is $5,450,000.00 Deductions that are allowable on Form 706 as administration expenses under Sec. 2053(a)(2) or losses under Sec. 2054 are not deductible on Form 1041 unless Election is made waiving right to deduct these items on Form 706 Copy of election is attached to Form 1041

Expenses – Form 706 or Form1041 Double deductions for Deductions in Respect of a Decedent Sec. 691(b) Claims against decedent’s estate accruing prior to date of death that are paid after date of death Deductible as expenses on Form 1041 Deductible on Form 706 as debts Examples are interest and property taxes accrued but unpaid at date of death

Expenses on Form 706 If there is an estate tax liability a number of expenses are deductible on 706 and as noted above there is generally no double deductions Requirements for expenses Must be enforceable Related party claims & expenses must be bona fide Underlying transaction must be in ordinary course of business, negotiated at arms length and free from donative intent Nature of claim or expense must be unrelated to expectation or claim of inheritance Must originate under agreement between decedent & family, related party or beneficiary & substantiated with contemporaneous evidence (for example family member who provided care prior to death is deemed to have done so for love and affection if there was no written agreement)

Expenses on Form 706 Related party expense requirements Performance by claimant is under terms of agreement and performance can be substantiated All amounts paid are reported by each party and properly taxed to claimant If claimant is a beneficiary weigh taxability of payment to tax savings to decedent Not all payments must be made by due date of Form 706 Reasonably ascertainable claims and expenses Executor commissions, attorney & CPA fees Claim or counterclaim that existed as of date of death Claims not exceeding $500,000 existing at date of death even if contested if there is a qualified appraisal of claim Recurring payments that are enforceable & non-contingent Similar claims

Other Form 706 Elections Alternate valuation – elect to use value of property 6 months after date of death rather than date of death Must lower tax due If asset sold prior to 6 months use sale date value Special use valuation Sec. 2032A For certain real estate used in farm or trade or business Decedent must have been U. S. citizen or resident Property transfers to a qualified heir Used by decedent or family member in qualified use Percentage tests Adjusted value must be 50% of gross estate 25% of Adjusted value must have material participation in 5 of last 8 years prior to retirement, death or disability

Other Form 706 Elections Q-Tip Election Property must pass to surviving spouse who must have a qualifying interest for life in the property All trust accounting income must be payable spouse and no one else annually during spouse’s lifetime No one, including spouse may have power to distribute or appoint assets during spouse’s life Spouse must have right to require property be productive Executor must make election on 706 by extended due date to treat property as a marital deduction Q-Dot election spouse is not a U.S. citizen Can elect to treat trust as qualifying for marital deduction if certain requirements are met

Other Form 706 Elections Generation Skipping Trust Exemption Can elect how to allocate exemption among GST transfers Without election there is an automatic allocation on pro rata basis Deferral of estate tax payment Sec. 6166 Tax must relate to closely held business Value must exceed 35% of adjusted gross estate 14 year deferral with 5 years interest only Interest at 2% for first $1,000,000 in FMV and 45% of Sec. 6621 interest rate for excess

Other Form 706 Elections Portability of unused estate tax exemption Estate tax exemption is currently $5,450,000.00 Use portability to double in survivor’s estate Cannot transfer unused GST exemption Surviving spouse entitled to use the unused portion of the estate tax exemption for first spouse to die Must elect portability on timely filed 706 for surviving spouse to use balance of estate tax exclusion. See Reg. 20.2010-2T(a) Can be elected by Personal Representative if appointed or if none by person actually or constructively in possession of property If 706 being filed for this reason Personal Representative not required to value Marital deduction or charitable deduction assets

Other Form 706 Elections Disclaimers Filed by beneficiary receiving assets Requirements In writing Made within 9 months of transfer Cannot direct who is to receive assets Person making cannot have beneficial interest in assets

Election related to S Corporations A non-Grantor trust is not a qualified S corporation shareholder An estate can hold S Corp stock for as long as necessary for reasonable administration If no 706 is filed estate can only qualify for 2 years. Distribution can be made to qualifying individual beneficiary, a Qualified Subchapter S Trust or and Electing Small Business Trust Either trust must make an affirmative election under Sec. 645

IRS Audits Just because the client died doesn’t mean the audit is over Things you must do File Form 56 – Notice Concerning Fiduciary Relationship Filed by the fiduciary, Personal representative, Trustee, guardian, conservator Terminating entity such as trust or estate can only file when it is still in existence Needed to be able to represent the fiduciary estate Often these are not filed

IRS Audits Things to Do New Form 2848 CPA previously represented taxpayer who is now dead CPA now needs to represent the fiduciary

References Post-Mortem Tax and Estate Planning Elections; David L. Johnson, Montana Law Review, September 1981, Article 2 The Power of Post-Mortem Estate Planning (selected issues for 2010 and 2011); Carol A. Cantrell, University of Miami, 45th Annual Heckerling Institute on Estate Planning, January 2011 The 10 most powerful postmortem planning pointers for trusts and estates; Karen S. Cohen, CPA, Journal of Accountancy, May 2012

Powers of Attorney Issues Presenter at Small Practioners’ Conference said powers of attorney should include reaffirmation provision since some banks or IRA sponsors are not accepting powers of attorney over 3 years old ICLE site in topic on medical powers of attorney mentions reaffirmation Reaffirmation is signing an existing power of attorney an additional time

Signing Requirements for Durable Financial Power of Attorney Must be signed, dated and must be witnessed by two witnesses Helpful if witnesses print names below signatures Signature must be notarized Notary can be a witness Notary cannot be family member Agent must sign an acknowledgement agreeing to follow statutory rules Signer must be competent when signing

Signing Requirements for Durable Medical Power of Attorney Must be signed, dated and must be witnessed by two witnesses Helpful if witnesses print names below signatures Witnesses cannot be Specified family members Medical, nursing home, assisted living employees Employee of company selling medical insurance Signature does not need to be notarized Agent must sign an acknowledgement agreeing to follow statutory rules Signer must be competent when signing

Medical Powers of Attorney Not valid if individual can still make own medical decisions Without HIPPA release agent may not have information to show person cannot make own decisions Should obtain a separate HIPPA release

Problems with Reaffirmation Individual must be competent when signing reaffirmation What if they are not? How can you then sign? At time of reaffirmation you must fulfill witness requirements since witnesses are stating that person is competent If document contains reaffirmation provisions and individual is no longer competent or fails to reaffirm that could be evidence that document is no longer valid