Estate Planning – Christopher C. Jones

by Barbara Liss,
Federal and state taxes are important factors to consider when administrating a trust, going through probate court, or in any stage of the estate planning process. Taxes are so important that even the idea of an estate exists largely for taxation purposes. After all, as the name implies, only the “taxable estate” is subject to taxation after death. For your estate to survive the probate process intact, you must understand your taxable estate and how to protect it.

Value of the Taxable Estate
If you are a recently appointed successor trustee or executor, or if you have an interest as a beneficiary, or other interested party to an estate, then you must become aware that settling the estate may require filing a federal estate tax return. This filing requirement only applies to estates valued at over a certain amount of money, but that amount (and the total estate tax liability) will also depend on the laws in your particular state. Every state may have its own set of rules, regulations and procedures for settling the taxable estate.

These procedures are likely to be different from the procedures that govern the settling of the probate estate, which deals with the transfer of title to the assets. Though researching all of these rules and procedures is tedious, the parties responsible for the disposition of the estate must ensure everything proceeds in full accordance with the law of the taxing (or probate) jurisdiction. For instance, if your estate is large enough to owe federal estate taxes, these taxes must be paid before property is transferred to the inheriting parties.

Nuts and Bolts of Paying Taxes on an Estate
For federal and state tax purposes, death triggers two events: it ends the decedent’s (person who died) last tax year for purposes of filing an income tax return, and it establishes a new, separate entity for tax purposes: the “estate.”

For federal tax purposes, it may be necessary to complete and file a Final Form 1040 Federal Income Tax return, a Form 1041 Federal Fiduciary Income Tax return for the estate, Form 709 Federal Gift Tax return(s), and/or Form 706 Federal Estate Tax return. The specific requirement for any of these forms will depend on the decedent’s income, the size of the estate, and the income of the estate.

Tax Responsibilities for Executors or Administrators
For state purposes, the “personal representative” (also called the “executor” or “administrator”) must file the appropriate state income tax return (assuming the decedent was required to do so while living) and any state income tax returns for the estate (if generating income) during the probate period. The personal representative must also file all estate tax, inheritance tax (if any), and gift tax returns required by the state where the decedent lived. Note that in many states, gift, estate, and inheritance taxes have been eliminated for most small and medium-sized estates. The requirements for filing tax returns and paying taxes vary widely from state-to-state.

The personal representative needs to pay attention to other taxes in the probate process as well, such as local real estate and personal property taxes, business taxes, and any special state taxes.

The personal representative should also be alert to the possibility that there may be unresolved tax issues for the tax years prior to the decedent’s death.

Getting Help
Being aware of these and other rules is critical to ensuring that the greatest amount of assets follow the will of the decedent, rather than the will of the IRS. This is also part of why so many choose to hire estate planning lawyers to help guide them through the process. Even relatively small estates that don’t owe estate taxes or don’t have to go through probate can benefit from consulting with knowledgeable, licensed estate planning attorneys for the most important legal decisions.

The Law Office of Christopher Jones specializes in advising clients and assisting personal representatives through the administration of estates process. Tax considerations are also given foremost consideration, along with the specific personal desires of the client, when drafting estate planning documents, such as Wills and Trusts.  If you are addressing any circumstance surrounding these matters, we urge you to make an appointment with our office soon.

As an estate planning paralegal, I’ve discovered that many folks erroneously believe that the safest place to store valuable items is in a bank safe deposit box.  This is because they think that banks have the best 24 hour security and alarm systems and are least likely to be subject to destruction by fire or other catastrophes.  But what they fail to take into account is that the contents of a safe deposit box are rarely insured, while items in one’s home are more often covered by homeowner’s or renter’s insurance policies.

Cash in a safe deposit box is not covered under a bank’s FDIC insurance.  The FDIC only insures the funds on deposit in accounts held by banks, not the contents stored in rented safe deposit boxes.  Finally, and from the perspective of the work I do, most importantly, it’s not a good idea to store original copies of documents that you require immediate access to, such as passports, spare keys, Wills, Trusts, Advance Health Care Directives, Powers of Attorney, funerary directives, etc. in a safe deposit box.  Bank safe deposit boxes are only accessible during banking operating hours and the boxes are typically sealed when the bank receives a death notice.  To open a sealed safe deposit box, estate representatives are required to provide court orders to the bank, which can take significant lengths of time to obtain.  This can defeat the intended purpose of some of the documents kept there for safekeeping.

For these reasons it’s good idea to buy a fireproof safe for the home.  What should be kept in it? Here are a dozen suggestions:

1.  Property insurance policies and agent contact information.  This information will be needed right away if your home suffers damage and you need to know how to file a claim.

2.  Passports and original birth certificates. These are a hassle to replace and will come in handy to establish identity, especially when traveling with children.  If you have pets, keep information about them, too.

3. A list of family doctors, prescription medications, and contact information for all pharmacies you use.   Useful to provide at your annual medical checkups to ensure up to date information is maintained; in case of an emergency, it is available for fast reference if EMTs or paramedics require it and when traveling, always take a copy along with you.

4.  CDs or an external hard drive containing digital copies of all family photos.  It’s a good idea to scan all older family photos and keep a digital copy of them as well.  Your family memories in photographs are irreplaceable.

5.  Safe deposit box keys.  If you store valuables in a bank safe deposit box, you’ll want to make sure you keep the keys to it in a safe place.  If you have multiple safe deposit boxes, be sure to identify which key goes to what box – saving you the trouble of trying to figure that out later, when memory is fuzzier.

6. Important papers related to life insurance policies, investments, retirement plans, bank accounts, and associated contact information.  Be sure to review these at least once a year and update them as needed.

7.  Information on your outstanding debts, due dates, and contact information.  It’s important to keep tabs on your finances and protect your credit, in the event you’re displaced by a fire.

8. Original Social Security cards. These can take time to replace and may be needed to establish eligibility for benefits.

9. Copies of your important legal documents, including powers of attorney, advance health care directives, and health care proxies — both for yourself and for anyone else for whom you are designated attorney-in-fact or health care surrogate. Having access to these can help ensure the protection they were created to provide.

10. Copy of wills, trusts and all estate plan documents in which you are designated the executor or trustee.  It’s important to have access to these as safe deposit boxes are typically sealed upon notification of the box owner’s death.  Notice that I’m suggesting copies and not originals!  Because we are often tempted to notate on these documents as life circumstances change, I strongly suggest that the attorney who created them be the repository for the originals to prevent you from accidentally writing marginalia on them.  If you need to alter their terms, contact the lawyer to do so.

11. Valuables: Jewelry, coins, cash, etc.  You may want to keep some cash on hand for ready access in an emergency.

12. Spare Keys and titles to all vehicles.  It helps to know where copies are in the case that you need them.

Of course, exactly what you choose to store in your fireproof safe will depend on your personal circumstances and the size and location of the safe.

 - Barbara Liss

As a part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (124 Stat. 3302) (the “2010 Tax Act”) and corresponding changes to the Internal Revenue Code (the “Code”), surviving spouses may elect to reduce their estate tax bill if their spouse passed away after December 31, 2010, by taking an affirmative step not previously required in similar circumstances.

In accordance with the 2010 Tax Act, the estate tax basic exclusion amount was increased from $1,000,000 to $5,000,000 for the 2011 and 2012 tax years.  Under that same legislation, spouses now have a new “portability election” that makes the unused estate tax exclusion amount at the death of the first spouse “portable.”

Pursuant to section 303(a) of the 2010 Tax Act and section 2010(c) of the Code, a surviving spouse is able to make an election whereby she may take her spouse’s unused estate tax basic exclusion amount and add it to her own estate tax basic exclusion amount to be used upon her death. An example of the election’s benefit is as follows:

If a husband died in 2011 with an estate tax basic exclusion amount of $5,000,000 and an estate worth $3,000,000, his estate would have $2,000,000 of unused estate tax basic exclusion amount.  Under the 2010 Tax Act’s portability election, the surviving spouse may elect to have this $2,000,000 of unused exclusion added to her own estate tax basic exclusion amount at the time of her death.  Therefore, if the wife dies in 2012 after taking advantage of the portability election, her estate will have not only her $5,000,000 of basic exclusion, but also an additional $2,000,000 of exclusion, giving her estate a total estate tax exclusion amount of $7,000,000. Under the right circumstances, the portability election can generate substantial estate tax savings.

In fact, the IRS has now made it easier to make the portability election.  According to IRS Notice 2011-82, all an estate’s executor or personal representative has to do to make the portability election is to timely file a federal estate tax return (Form 706), regardless of whether an actual estate tax is due or payable.  No affirmative statement has to be made by the estate indicating that it wants to take the election.

However, it should be noted that many estates would not previously have ordinarily filed a federal estate tax return because they fall below the minimum limit for doing so.  As a result of the fact that the only way to make the new portability election is by timely filing the federal estate tax return, it is imperative that you seek the advice of a qualified tax professional to determine whether your personal circumstances dictate that it is appropriate to do so, and if so, what is the deadline in your case to avoid waiving the portability election. Please let me know how I can assist you.

 - Christopher C. Jones

Retroactive Reinstatement of Estate Tax for 2010 Decedents

The estate tax was reinstated retroactively for estates of decedents dying in 2010, with an estate tax applicable exclusion amount of $5 million and a rate of 35%.  However, there is an option to “opt out” of the estate tax and instead elect to have limited carryover basis rules (with certain adjustments) apply to property passing from the decedent.

In general, 2010 decedents with estates of less than $5 million or which pass to a surviving spouse would not opt out of the estate tax, as the estate would not owe federal estate tax and would receive a step-up in basis of the estate assets to their fair market value at the date of the decedent’s death.  Executors of estates of 2010 decedents with more than $5 million may want to opt out of the estate tax so that the estate does not pay estate tax, but advisers have to calculate whether paying capital gains tax on the appreciation over the decedent’s basis upon sale of property yields a better tax result than paying the estate tax.

Basis Increase Allocations

If an executor opts out of the estate tax for a 2010 decedent, assets will have a limited carryover basis (but not in excess of date of death fair market value), but that basis can be adjusted to a certain extent.  The executor can allocate several adjustments to increase the basis of assets received by recipients that are both “property acquired from the decedent” and “property owned by the decedent.”  The amount of increased basis from these allocations is referred to as the “Basis Increase.”

There is $3 million of Spousal Basis Increase that may be allocated to “qualified spousal property” acquired from the decedent by a surviving spouse.  Qualified spousal property includes outright transfers of property and qualified terminable interest property.

The General Basis Increase, which can be allocated to property going to anyone, is $1.3 million.  However, for a decedent who was neither a resident nor a citizen of the United States, the General Basis Increase is only $60,000.

The Carryover Basis Election Is Made by Filing Form 8939

The election to opt out of the federal estate tax and elect the carryover basis regime may be made up until January 17, 2012.  The election in effect on the due date is irrevocable (except as provided in Notice 2011-66).

Filing Due Dates for 2010 Decedents

For estates of decedents who died before December 17, 2010, the due date for filing a Form 706 was September 19, 2011. However, IRS Notice 2011-76 acknowledges that because of the length of time that has been required to implement the carryover basis legislative changes and to issue Form 8939 and the related instructions, 2010 estates may not have had sufficient time by September 19, 2011, to decide how to proceed.  The Notice makes clear that an automatic six-month extension of the time to file is available by filing Form 4768 (Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes).  There is no need to substantiate the reason an estate is requesting an extension.  The automatic six-month extension makes the Form 706 due on March 19, 2012.  For estates of decedents dying on or after December 17, 2011, the automatic six-month extension period will end 15 months after the decedent’s date of death.

President’s Budget Proposal for Fiscal Year 2012

The President’s budget proposal for Fiscal Year 2012 includes three transfer tax-related items that were proposed in each of the past two years and two new items dealing with estate and gift taxes.

Consistency of Basis Valuation

The proposal to require consistency in value for transfer and income tax purposes requires that the basis for income tax purposes be the same as that determined for estate and gift tax purposes.

Eliminating Certain Valuation Discounts

The budget proposal adds a new category of “disregarded restrictions” that would be ignored for transfer tax valuation purposes in valuing an interest in a family-controlled entity transferred to a member of the family.

Grantor Retained Annuity Trusts (GRATs) to Be Subject to New Rules

Three additional requirements would be imposed on Grantor Retained Annuity Trusts (GRATs): (i) they must have a 10-year minimum term; (ii) they must have a remainder interest greater than zero; and (iii) the annuity amount cannot decrease in any year during the annuity term.

Make Portability Permanent

The budget proposal seeks to make portability permanent by extending the provisions of the 2010 Act regarding the portability of unused exclusion between spouses.

Limiting the Duration of the GST Exemption

The exclusion from the imposition of GST tax would last only 90 years, regardless of whether a trust has a longer duration.

PLANNING OPPORTUNITIES TO CONSIDER IMMEDIATELY

Make Outright Gifts to Take Advantage of Reduced Gift Tax Rate and Increased Applicable Exclusion Amount

You now have a total of $5 million ($10 million for a married couple) that you can gift in the aggregate during your lifetime, subject to reduction for any gifts in excess of the Annual Gift Tax Exclusion Amount you have previously made.  Gifts in excess of that amount are subject to a federal gift tax rate of only 35%.  The $5 million applicable exclusion amount is substantially in excess of the $1 million applicable exclusion amount for gifting that was previously available.  Therefore, making gifts before the end of 2011 may provide significant transfer tax savings.  In addition to the reduced rate, it is always cheaper to make lifetime gifts rather than gifts at death.  This result occurs because you do not pay a tax on the dollars used to pay gift tax, but you do pay estate tax on the dollars used to pay estate tax.  The benefit is compounded further by the lower gift tax in 2011.  We should note that under current law, there is a possibility that if the applicable exclusion amount is reduced in the future, there may be a “clawback” if amounts gifted during life exceed the applicable exclusion amount in place at the time of death.  In that event, estate tax could be imposed on the amount gifted in excess of the applicable exclusion amount at the time of death.  We believe this unintended “glitch” will be fixed.  However, even if it is not, you will be no worse off than if you had not gifted and you will benefit by getting any appreciation on the gift out of your estate.

Grantor Retained Annuity Trusts (GRATs)

GRATs remain one of our most valuable planning tools, particularly in this time of historically low interest rates.  Because of the possibility that legislation may soon pass changing how GRATs may be structured and interest rates may rise, GRATs should be created as soon as possible.

A GRAT provides you with a fixed annual amount (the annuity) from the trust for a term of years (currently as short as two years).  The annuity you retain may be equal to 100% of the amount you use to fund the GRAT, plus the IRS-assumed rate of return applicable to GRATs (which for gifts made in December 2011 is 1.6%).  As long as the GRAT assets outperform the applicable rate, at the end of the annuity term, you will be able to achieve a transfer tax-free gift of the spread between the actual growth of the assets and the applicable rate.  Because you will retain the full value of the GRAT assets—as calculated using the IRS’s assumptions for growth—if you survive the annuity term, the value of the GRAT assets in excess of your retained annuity amount will then pass to whomever you have named with no gift or estate tax, either outright or in further trust.

Gift Residence or Vacation Home Using Qualified Personal Residence Trusts and Other Trusts

A discounted and leveraged gift of a residence is possible using a Qualified Personal Residence Trust (QPRT).  After the gift to the QPRT, you can continue to reside in the residence until the QPRT ends and, even thereafter, if the property is leased back at fair market rent from the new owners.

This planning is most effective when the value of the residence to be given is low and the IRS assumed rate of return is high.  However, even though the IRS assumed rate of return is now low, housing prices are dropping across the country, which makes use of a QPRT beneficial.  As a result, QPRT gifting is an important alternative to consider, particularly in light of the increased gifting applicable exclusion amount.  In addition, one can retain a contingent reversionary interest in case the donor dies during the QPRT term, further discounting the taxable value of the transferred interest—sometimes by a substantial amount in the case of older donors.

Another possibility, given the depressed real estate prices and the increased applicable exclusion amount, is to make a gift of real estate outright or to a trust that is not a QPRT.  You may rent the house back from the trust for its fair market rental value and thus continue to use the house. If the trust is drafted as a defective grantor trust, the rent will not be subject to income tax, as for tax purposes it will be treated as though you are renting from yourself.  The rent proceeds may be used to pay maintenance and taxes (which you will still be able to deduct).  To the extent rent payments exceed expenses, you will have made additional transfer tax-free gifts to the trust.

Alternatives to Section 1031 Exchanges: Gifts to Charitable Remainder Trusts

Many taxpayers owning certain kinds of appreciated real estate sell that property and “roll over” the gain—using Section 1031 of the Internal Revenue Code (IRC)—into another property, using this “like kind exchange” to defer income taxes.  However, the economy is such that taxpayers desiring to sell properties now are finding it harder to find properties to purchase to accomplish this rollover.

An alternate approach to consider is a gift of the property to a charitable remainder trust, retaining for life a payment equal to up to 90% of the value of the gifted property.  You would be allowed an income tax deduction equal to a portion of the gifted property.  (In the case where 90% of the value is retained by you in the form of lifetime payments, the deduction is equal to 10% of the value of the gifted property.)

When the charitable remainder trust sells the property it recognizes no gain or loss.  When you receive payments from the charitable remainder trust, part will be taxed as income, part as capital gain and (potentially) part will be treated as a distribution from principal of the trust and not taxable at all.

At your death, the charitable remainder trust can pay over to a family foundation, allowing your family to use those funds to accomplish the family’s charitable goals.

Consider Buy-Back of Appreciated Low Basis Assets from Grantor Trusts

Some clients sold or gave (through a GRAT or other grantor trust) an asset that was expected to appreciate in value.  The tax planning idea that motivated them was to pass that appreciation on to trusts for their children without gift or estate tax.  The children’s trust that ends up owning the asset typically has a very low basis, meaning that a significant capital gains tax will be due if the trust sells the appreciated asset.

Where those plans succeeded, that appreciated asset now sits in a defective grantor trust for the children.  That grantor trust has a low basis in the asset.  If you purchase the asset back from the grantor trust for fair market value, no gain or loss is recognized.  The trust would then hold cash equal to the value of the appreciated asset that was repurchased, leaving the same amount to escape estate tax.  Alternatively, many grantor trust instruments give the grantor the power to substitute the trust’s assets with other assets, which would allow the appreciated assets to be removed from the trust.

The advantage is that, on your death, the purchased or reacquired asset will be included in your taxable estate and will receive a step-up in basis equal to fair market value.  This means that the capital gains tax on sale of that asset is eliminated.  The children benefit from the grantor trust’s cash—and each dollar of cash has a dollar of basis—so truly the capital gain is eliminated forever.

Use of Intra-Family Loans

Because interest rates are so low, many techniques involving use of intra-family loans should be considered, including:

• The purchase of life insurance on the life of one family member by an irrevocable life insurance trust, with premium payments funded by loans from other family members.

• The creation of trusts by older generation members for the benefit of younger family members, to which the older generation members loan funds. The spread between the investment return earned by the trust and the interest owed will create a transfer tax-free gift.

Upcoming in 2012:

• Effective January 1, 2012, S.B. 507 will take effect, under which the deadline to file a change of ownership statement with the local assessor will be extended from 45 days to 90 days.  This bill applies to transferees of real property or manufactured homes; corporations, partnerships and other legal entitles that own real property; and legal entities that own real property for which ownership or control has been changed by more than 50%.

Additionally, this bill will increase the penalty cap for late filings from $2,500 to $5,000 for properties eligible for the homeowners’ exemption, and increase the penalty cap to $20,000 for properties that are ineligible for the homeowners’ exemption.

• Effective January 1, 2012, the value of estate assets that can be transferred without probate administration will increase due to the passage of Chapter 117, Statues of 2011 (AB 1305-Huber).

The size of estate trust assets—excluding joint tenancy assets, which pass under beneficiary designation, such as life insurance or retirement accounts—that can be collected by affidavit will increase from $100,000 to $150,000 (Probate Code Section 13100).  Additionally, the value of the decedent’s salary or other compensation that is excluded from the value of the decedent’s property in California will increase from $5,000 to $15,000 (Probate Code Section 13050).  These statutory increases will assist in the collection of small value accounts, investments or automobiles that were inadvertently not transferred to a decedent’s revocable living trust.

Year-End Checklist for 2011

In addition to the above planning ideas, consider the following before 2011 is over:

• Make year-end annual exclusion gifts of $13,000 ($26,000 for a married couple).

• Make year-end IRA contributions.

• Create 529 Plan accounts before year-end for children and grandchildren, and consider front-loading the accounts with five years’ worth of annual exclusion gifts, taking into account any gifts made during the year to children and grandchildren. Pay tuition and medical expenses directly to the school or medical provider.

• Consider making charitable gifts before year-end to use deduction on 2011 income tax return.

We Can Help

I hope that this Advisory helps you with your year-end estate and gift tax planning, and also provides you with some interesting ideas to consider for the future.  Please immediately make an appointment to meet with me if your estate plan needs require any year end changes.

Sincerely yours,

CHRISTOPHER C. JONES

Planning for the New Year.

Everyone heaved a sigh of relief when Congress quickly passed the two year extension of the Bush tax cuts through 2012. Once again, the federal estate tax exemption was changed from what it was the year before, and what it was scheduled to become in 2011. The bill increased the estate tax exemption to $5,000,000 per person, or $10,000,000 per couple. For most of us, that means that our heirs will not have to pay any federal taxes on the transfer of the estate property.

However, the changes in estate tax exemptions over the last decade have also created some problems for existing estate plans. The estate tax exemption has risen from $600,000 to $5,000,000. The exemption amount has changed each of the last five years. For couples who have created A-B trusts, the terms of which provide that the trust assets be allocated to two shares when a spouse dies, the language in the trusts can have the effect of placing all of the trust assets in the “B” trust, or decedent’s share of the trust estate. This will leave the survivor without any assets of their own, and a dependence on decedent’s share of the trust estate. While the surviving spouse usually has the right to receive income from the decedent’s share, there are restrictions on the survivor’s ability to withdraw and use the assets assigned to the decedent’s share of the estate.

In the meanwhile, real property values have declined. Assumptions about net worth five years ago are no longer valid. Yet couples made estate plans that, if anything, assumed that their net worth was going to rise, or at least maintain its current value. If your net worth has gone down in the last five years, and you have not had your estate plan reviewed, there is a likelihood of the trust requiring that more property be sheltered in a decedent’s trust than is necessary. The survivor may find that they do have access to the resources that they need.

ACTION ITEM: Have your family trust documents reviewed by competent legal counsel to make sure that your funding formulas are not so restrictive on the surviving spouse. Most estate these days don’t need to use the A-B trust structure to avoid estate taxes. Since most married couples do not want to interfere with the survivor’s enjoyment of the trust estate during their lifetimes, the traditional structures no longer as useful.

By Christopher C. Jones © Jan 2011