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Estate Tax Planning

Filing the return and paying the tax.

WHO PAYS THE ESTATE TAX?

An often-overlooked area in estate tax planning is determining who will pay the estate tax. Although the estate normally pays, the determination is actually made in the will. It is up to the deceased to decide whose share of the estate should be used to pay any estate taxes that may be due. For example, if the estate is going to be reduced by estate taxes, one or more of the heirs' shares will be reduced to pay the tax. If the will does not provide whose share of the estate will be reduced to pay the taxes, state law will control. The law in some states provides that the tax will be paid from the residue of the estate. If the deceased had planned on his spouse getting the residue, this rule will result in the spouse's share being significantly reduced while other heirs get their full share of the estate tax-free.

WARNING The executor and the attorney should carefully examine the will's tax apportionment clause to determine who should pay. If there is no answer then state law needs to be consulted.

FILING THE ESTATE TAX RETURN (FORM 706)

The law requires that the executor files the Federal Estate Tax Return (Form 706) and pays any estate tax nine months after death, when the value of the net estate exceeds $600,000 (or the amount established by Congress in the future). Even for relatively simple estates, this short time frame can be difficult to meet in practice. Inventorying and valuing property can be extremely time-consuming. In some cases there may be valuable assets that generate a lot of estate tax but little cash to actually pay the tax. Luckily the tax code allows extensions and some relief measures are also available to the executor.

Extensions

Although the Federal Estate Tax Return is due nine months after death, an extension for a "reasonable amount of time" is available if the executor files IRS Form 4769, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes.

The application for the extension must detail why it is impossible or impracticable for the executor to file a reasonably complete return on or before the due date. The extension request needs to be filed before the nine-month period has expired.

Although the time allotted for extensions will generally not be greater than six months to a year, the IRS has discretion to extend time for payment up to ten years if reasonable cause is shown. Normally the executor would have to show some extreme hardship to have the time to pay extended from one year to ten. Heirs of small business owners may be able to get a fifteen-year extension.

WARNING Failure to file the Federal Estate Tax Return on time may result in a penalty equal to 5 percent of the amount of the tax due if the filing is less than one month late, with an additional 5 percent for each additional month, not to exceed 25 percent in the aggregate. If the failure to file is due to reasonable cause and not due to willful neglect, late penalties may be waived.

WARNING To avoid the penalty for failure to file, the executor must provide a written statement to the District Director or to the Director of the appropriate Internal Revenue Service Center, detailing the circumstances that would constitute reasonable cause for the failure to file. Reliance on an accountant or attorney is generally insufficient evidence to establish reasonable cause.

COMPLETING THE ESTATE TAX RETURN

Preparation of the Federal Estate Tax Return is complex and time-consuming. Usually either the estate's attorney or a CPA will complete the form.

Contents of the Return

The return includes numerous schedules on which the executor must detail all of the deceased's property, along with proper valuations. The schedules include:

  • Schedule A, Real Estate

  • Schedule A-1, Section 2032A Valuation ("special use valuation")

  • Schedule B, Stocks and Bonds

  • Schedule C, Mortgages, Notes, and Cash

  • Schedule D, Insurance on the Decedent's Life

  • Schedule E, Jointly Owned Property

  • Schedule F, Other Miscellaneous Property

  • Schedule G, Transfers During Decedent's Life (details gifts)

  • Schedule H, Powers of Appointment

  • Schedule I, Annuities

  • Schedule J, Funeral Expenses and Expenses Incurred in Administering Property Subject to Claims

  • Schedule K, Debts of the Decedent and Mortgages and Liens

  • Schedule L, Net Losses During Administration and Expenses Incurred in Administering Property Not Subject to Claims

  • Schedule M, Bequests, to Surviving Spouse (Marital Deduction)

  • Schedule N, (no current schedule)

  • Schedule O, Charitable, Public, and Similar Gifts and Bequests

  • Schedule P, Credit for Foreign Death Taxes

  • Schedule Q, Credit for Tax on Prior Transfers

  • Schedule R, Generation-Skipping Transfer Tax (GSTT)

  • Schedule S, Increased Estate Tax on Excess Retirement Accumulations

WARNING The Federal Estate Tax Return requires a surprising amount of detail, and the amount of preparation time should not be underestimated. If information is missing or unavailable, the executor should consult with the estate's attorney to determine how to complete the return.

Valuation of Property

The executor must place a value on each item of property listed in the return. In practice it can be difficult to value many items of property. Interests in small businesses are especially troublesome. The executor will normally hire one or more appraisers to help with valuation. These appraisals must be filed along with the Federal Estate Tax Return.

Alternate Valuation Date

The executor may be able to reduce federal estate tax by electing the alternate valuation date. If the executor so elects, all property still in the estate will be valued sixth months after the date of death. Assets no longer in the estate are valued as of their date of sale or distribution. Additional Documents to Be Filed When filing the Federal Estate Tax Return with the IRS, the executor will also have to include a copy of the following documents:

  1. certified copy of the will

  2. court order admitting the will to probate

  3. Life Insurance Statement (Form 712) describing all policies

  4. evidence of alternate valuations, if elected

  5. appraisals

  6. financial statements if decedent owned a small business

  7. trust documents

  8. powers of appointment

  9. disclaimers

  10. extension requests to file or pay tax

PAYING THE ESTATE TAX

Generally, the estate tax is due when the return is filed, nine months after death. The tax must be paid by the executor. If there is no executor appointed by the time the tax is due, any person possessing the decedent's property must pay the tax.

Discharge of Liability for Estate Tax

As a rule, the executor is liable for any unpaid estate tax. However, once the tax has been paid, the executor should apply to the IRS for a discharge from personal liability for tax. The executor should request the IRS to issue Form 7990, U.S. Estate Tax Certificate of Discharge From Personal Liability, after payment of the tax and any interest due.

WARNING A discharge of the executor by the local probate court is not a release from the executor's tax liability.

WARNING An executor may be liable for estate tax even after resigning and being replaced by a new executor. If the payment of the estate tax is extended, and his successor fails to pay any of the remaining estate tax installments, the original executor remains liable for the estate tax.

Transferee Liability

If the estate tax is not paid by the executor when due, the transferees of the estate become liable. A transferee is a party who has received property from the estate not only after the decedent's death but also from inter vivos (predeath) transfers required to be included in the decedent's gross estate.

WARNING The IRS does not consider an extension to file the return to be an extension to pay the tax. The executor needs to ask for both.

INCOME TAX ISSUES

Although this article is devoted to explaining the federal estate and gift tax, sometimes estate tax and income tax issues overlap. The executor is ultimately responsible for seeing that the Federal Estate Tax Return (Form 706) and the Fiduciary Income Tax Return (Form 1041) are filed. A final income tax return (Form 1040) will have to be filed for the deceased. When there is a surviving spouse, filing a joint return is usually advantageous. However, when filing a final tax return, the advantages of filing a separate tax return need to be weighed. If a final joint return has been filed and an executor reconsiders the advantages of filing separately, he may cancel the joint return and file a separate return for the decedent within one year from the due date of the return.

Unpaid medical expenses are deductible for federal estate tax purposes on the Federal Estate Tax Return, Form 706, or the executor can deduct such medical expenses on the decedent's final Form 1040. However, the medical expenses cannot be deducted on both forms. If no estate tax is due, then the expenses should be deducted on the deceased's Form 1040.

If the estate employs both an attorney and an accountant, each might assume the other will be preparing the returns. The executor should determine which professional will be preparing which return; the executor also needs to verify that the returns are filed on time.

How to Deduct Medical Expenses

Medical expenses of a decedent are deductible from either income tax or estate tax, but not both. For income tax purposes, medical expenses are only deductible to the extent they exceed 7 percent of adjusted gross income (AGI). To maximize the benefit of the deduction, the executor should compare the decedent's personal income tax rate and the decedent's estate tax rate before making the election. Because estate tax rates generally exceed income tax rates, it is generally better to claim the expenses on the Federal Estate Tax Return.

Income in Respect of a Decedent (IRD)

Executors also need to consider "income in respect of a decedent" issues. Income in respect of a decedent (IRD) is income that is accrued by a cash basis taxpayer before death but is not includable on the decedent's last Form 1040. IRD must be included in the decedent's estate. Typical IRD items include salary and commissions, investment income, and proceeds from the installment sales of property. Additionally, income from S Corporations and partnerships can also be deemed IRD income.

POSTMORTEM PLANNING

Postmortem means "after death." Although a will becomes final at the time of death, the executor and other family members can engage in a limited amount of postmortem planning, which can often reduce estate taxes and preserve more property for the heirs.

Postmortem planning essentially entails establishing devices that will allow another party to make dispositive and tax decisions after the deceased's death. Nontax techniques are generally established in a will or trust. The tax code provides the deceased's executor with several elections that can minimize both income taxes and transfer taxes. A few techniques, for example disclaimers, can further both nontax and tax goals.

REDEMPTION TO PAY DEATH TAXES FOR BUSINESS OWNERS

The tax law provides a special relief provision for small business owners, which is found in tax code section 303. An executor may redeem (buy) stock from the estate of a decedent or from beneficiaries of an estate to pay estate tax, state death taxes, and administrative expenses, if stock of a redeemed corporation makes up 35 percent of the estate and redemption occurs in a set period after death. Stock of two or more companies may be aggregated to meet the 35 percent test.

Essentially this allows the estate of a small business owner to sell its stock back to the corporation. Normally the proceeds are used by the executor to pay estate taxes. Although section 303 redemptions were originally envisioned to help pay death taxes, they can be undertaken to meet any liquidity needs of the estate.

OBSERVATION Certain family-owned businesses are now also eligible for an estate tax exclusion of up to $1,300,000.

ELECTION FOR DEFERRAL OF TAXES

Congress enacted another relief provision for heirs of a small business owner. In the past, families were sometimes forced to sell a family business because they lacked the cash to pay the estate tax. This relief provision, found in tax code section 6166, allows the executor to defer the payment of estate taxes attributable to the value of the deceased's business. This rule allows the estate to pay the estate taxes over a ten-year period and also allows up to a five-year deferral. During the five years after death, the estate merely pays interest on the tax. The estate then makes installment payments of the tax and interest payments over the next ten years. To qualify for this tax break, the value of the closely held business interest must exceed 35 percent of the adjusted gross value of the estate.

SPECIAL USE VALUATION FOR FARMERS

Congress likes family farmers and they have passed a relief provision to help keep farms in family hands. An executor may elect to value real property used in a farm trade at its business value rather than its fair market value. The maximum reduction in value is limited to $750,000. However, with an estate tax ranging between 37 and 55 percent, this benefit can save a family $250,000-350,000 in estate taxes. To qualify, all property used in the farm must

  1. comprise at least 50 percent of the adjusted value of the gross estate and,

  2. the real property must comprise at least 25 percent of the adjusted value.

The property must pass to a "qualified heir" of the decedent. If the property is ultimately disposed of to a nonfamily member within ten years of the decedent's death, or if the qualified heir ceases to use the property for farm purposes, an additional estate tax is due.

DISCLAIMERS

Disclaimers can be used for both tax and nontax planning.

Generally, any party may refuse to receive a gift and heirs may also disclaim an inheritance under a will. Often disclaimers are used for estate tax savings when a party wishes to avoid receiving property in his own name.

A disclaimer is the right to reject a bequest made in a will or trust. The party can refuse to take the property. If an alternate beneficiary is mentioned, then the property skips the first beneficiary and passes to the second. For example, a father could disclaim property which could then pass to his child. If the will provides for no alternate beneficiary, the disclaimed property will pass to another party under the operation of local law. The estate's attorney can help determine exactly how a decedent's property will pass once it is disclaimed.

A disclaimer must generally comply with both state law and federal tax law if it is to provide any tax advantages. Starting with the basic premise that a person can refuse a gift, a potential heir can always refuse or disclaim property to be received whether under a will or through intestate distribution.

What Can Be Disclaimed

Almost any property can be disclaimed, including joint interests in bank accounts, real estate, or community property. The law also allows partial disclaimers.

EXAMPLE Andrew left the entire residue of his estate to his son Howard. Howard can disclaim all or perhaps 50 percent of the residue. Disclaiming would make sense if Howard does not need the property and wants to avoid estate tax problems himself. It would also allow Howard to move property to another person or persons - perhaps his own children if they are named as contingent beneficiaries in Andrew's will.

Similarly a disclaimer can be based on a formula. For example, a will might provide that a gift may be disclaimed under a formula in order to fund a trust to use up the unified credit.

Other situations in which a disclaimer can lead to tax savings include:

  1. disclaiming powers of appointment

  2. making sure "farm property" goes to a "qualified heir" so it qualifies for the special use valuation (discussed above)

  3. preventing an inadvertent termination of an S Corporation when S Corporation stock is left to an ineligible shareholder, such as an ineligible trust

  4. keeping property out of the hands of creditors

  5. curing a defective tax clause in a will

Disclaimer by Surviving Spouse

A common use of qualified disclaimers is to increase or reduce the size of a surviving spouse's estate to maximize the use of the unified tax credit. Assume that John and Mary are well-to-do, and their estate planner has suggested that John plan to leave property to other family members or to charity, with a view toward minimizing Mary's estate tax burden on his death. John, like many husbands, finds this objectionable and wants a will that provides that all his property go to Mary. Additionally, over the years he has purchased significant amounts of life insurance naming Mary as beneficiary. This is a quite common occurrence. John is naturally reluctant to expose Mary to financial risk late in life. Although there is no federal estate tax imposed on property left to a surviving spouse in a will, if John predeceases Mary, Mary will be left with a large potential estate comprised of her own property, the property left in John's will, and the insurance proceeds. The tax will be imposed not on John's estate but on Mary's. To the extent that she cannot gift away the property during her lifetime, the estate may be exposed to estate tax because it exceeds her unified estate tax credit (which shelters $600,000 of property) and less will be left for her heirs.

If, at John's death, Mary feels confident that her own property and the proceeds of John's life insurance will provide for her needs, she could use a qualified disclaimer to disclaim John's property in favor of other family members. The disclaimer will effectively transfer property to other family members without the need for costly trusts or a formal gifting program.

For tax purposes a disclaimer must be:

  1. in writing,

  2. made within nine months of the initial transfer, and

  3. irrevocable.

Additionally, the disclaimant must not have previously accepted the bequest or benefited from it, and cannot direct who will receive the disclaimed property. Some older couples whose children are well-off financially make gifts to the children but provide that the children may disclaim in favor of a charity.

Although disclaimers are typically used by the surviving spouse to pass property to children, the reverse strategy may also be used. For example, a child could disclaim in favor of the surviving spouse if the parent needs the funds or to maximize the use of the marital deduction if the family wants to avoid paying estate taxes immediately.

 


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