Planning for Future Probate Matters to Improve Results

Death of a loved one poses challenges to our clients, which become exacerbated by the complex array of federal and state income tax reporting, estate tax concerns, tax elections, financial decisions, legal steps, family dynamics and other issues that have to be dealt with in the typical estate administration. The estate-planning practitioner can help the family navigate the host of tax decisions to be made.

Annual Tax Reviews

Encouraging clients to have annual tax reviews mitigates later issues. Ideally, clients should review the steps that will be taken post-death with those who will be involved and affected, for example, fiduciaries and beneficiaries. Unfortunately, clients may be unwilling to undertake this morbid, albeit valuable, exercise. To get around this reticence, practitioners might deflect post-death conversations to less emotionally challenging conversations about taxes. For example, a practitioner could say:

We should meet annually to review the tax status of your planning, for example, the possible benefits of swapping appreciated assets from grantor trusts back into your estate to garner a basis step-up now that the Internal Revenue Service has clarified its position that such assets wouldn’t achieve a basis step-up inside a grantor trust that’s outside your estate.¹

At such a meeting, address important probate administrative matters, such as:

• Organizing information to reduce post-death costs.
• Identifying bank, investment and other account numbers and passwords.
• Confirming where important original documents are stored.
• Documenting the client’s wishes on death.
• Obtaining permission for the planning team to meet fiduciaries and beneficiaries.
• Considering other planning opportunities.

State Inheritance Taxes

Six states impose an inheritance tax on transfers made by a decedent: Iowa,² Kentucky,³ Maryland,⁴ Nebraska,⁵ New Jersey⁶ and Pennsylvania.⁷ Impacted clients may wish to make lifetime gifts to mitigate state inheritance taxes. Prior to taking such an approach, consider:

1. Local counsel should advise on whether gifts prior to death might nevertheless be subject to inheritance tax. Maryland claws back gifts made within a 2-year look-back period. New Jersey has a rebuttable presumption that gifts made during the 3-year period prior to death were made “in contemplation of death.”
2. Confirm that making gifts won’t interfere with the client’s lifestyle by preparing an appropriate cash flow analysis.
3. Use a gift trust permitting the trustee to divert distributions in the event that the client’s relationship with an intended beneficiary sours between the date of the gift and the date of the client’s death.
4. Evaluate whether estate inclusion is more advantageous than avoiding inheritance tax. Inherited assets are typically eligible for a basis step-up on death whereas the basis of gifted property is generally the same as the basis in the hands of the donor.⁸ Prior to advising a client to make gifts, practitioners should project the potential capital gains tax on sale of a gifted asset and determine whether it would exceed the inheritance tax.

Qualified Revocable Trusts

Making an appropriate election to treat a revocable trust as a qualified revocable trust (QRT) may provide valuable tax benefits.⁹ A trustee of a QRT may elect to treat the trust as part of the estate for income tax purposes.¹⁰ In such cases, the estate and electing QRTs file a single Form 1041. The tax due on the combined Form 1041 must be allocated reasonably as between the estate and QRTs.¹¹ Rules are provided for the taxation of the electing trusts at the termination of the election period, which must end by 12 months after the issuance of a closing letter.¹²

Estates and electing QRTs may enjoy several income tax advantages:

• Choosing a non-calendar fiscal year to achieve a deferral of income.¹³
• Avoiding estimated income tax requirements for the first two taxable years.¹⁴
• Obtaining a current deduction for funds set aside but not yet paid to charity.¹⁵
• Becoming automatically eligible as a qualified
• S corporation shareholder for a reasonable period of estate administration (generally, two years).¹⁶
• Using the active real estate exception to the passive loss limitation rules for two years post-death based on the participation of the decedent prior to death.¹⁷

Income Tax Opportunities

Practitioners should identify relevant tax planning options and advise the estate representative about income tax elections that may be advantageous if timely exercised. Documenting planning options in writing may protect the practitioner should the executor either opt not to pursue those opportunities or fail to do so. Practitioners shouldn’t assume that lay executors understand tax concepts and should be aware that they could miss important opportunities. In a recent case, a trustee was unable to collect a tax refund because it filed the claim on the wrong tax form.¹⁸

Internal Revenue Code Section 454 elections. For decedents who owned U.S. Savings Bonds (in general, Series EE, E, and/or I Savings Bonds), an IRC Section 454 election allows accrued interest to be included in current income on the decedent’s final income tax return.¹⁹

Note that when a Section 454 election is made, no part of the accrued interest will be treated as income when collected on redemption of the bonds. The tax preparer for the decedent and the estate should evaluate whether including the accrued interest will increase the overall tax liability of the estate and the beneficiaries before filing the final Form 1040 for the decedent and the first Form 1041 for the estate.

Practitioners should advise estate representatives of the applicability of a deduction for income in respect of a decedent (IRD). Amounts of gross income that a decedent was entitled to receive are considered IRD. When IRD is both taxable for estate tax purposes as an asset of the decedent’s estate and subject to income taxes as it’s paid out, beneficiaries are eligible for an income tax deduction.²⁰ The concept of an IRD deduction is only relevant for estates that are taxable for federal estate tax purposes. There’s no IRD deduction for state estate or inheritance taxes paid; only for federal estate taxes paid.

Common examples of IRD include wages, retirement plan distributions, interest, dividends, gain on sales of property, installment notes collected, sales of farm crops and livestock and royalties. A competent tax preparer should calculate the IRD deduction available to the beneficiaries so that this information may be communicated to the estate representative.

Adjust the basis of underlying partnership assets.²¹ It’s often advantageous for the owner of an entity to be able to adjust the tax basis of underlying assets, particularly if such assets are sold by the entity or required to be depreciated for income tax purposes. An election to adjust a partnership’s tax basis is made by filing a written statement with the partnership’s timely filed tax return (Form 1065) for the year in which the partner dies, including extensions.²²

Deferral of Estate Taxes

Estate tax attributable to interest in closely held businesses may be deferred for up to 15 years with a preferred interest rate and no tax penalty, when:²³

1. The decedent’s interest in closely held businesses comprises at least 35% percent of the value of the gross estate.   
2. The entity is considered a “small business” either by:

• Having 45 or fewer owners, taking into account the attribution rules,²⁴ or
• Including 20% or more in value of the voting interests of the entity in determining the gross estate.

To qualify, the estate representative must apply for an extension, file an agreement with the IRS and consent to a tax lien against the property.²⁵ Practitioners should help clients explore all opportunities to secure funding to pay estate taxes and document their advice.   

Portability

An estate may wish to transfer the deceased spouse’s unused exclusion to a surviving spouse by filing a federal estate tax return.²⁶ By electing portability, spouses may share their lifetime exemption without having to retitle assets prior to death. Underlying instruments such as the client’s will, revocable trust or pre- or post-nuptial agreement might require portability and clarify who’s responsible for the costs of such filing.

The IRS has recently issued simplified procedures²⁷ to elect portability when the deceased spouse’s estate is under the threshold ($12.92 million  in 2023):

1. The estate has five years from date of death to file the estate tax return.
2. No user fee is required.
3. The estate can estimate values of assets devised to surviving spouse.

Alternate Valuation Date

Once the estate representative confirms that the net value of the estate exceeds the basic exclusion amount available to the decedent as of the date of their death, the estate representative should consider whether the estate tax liability could be lower by electing to use the alternate valuation date (AVD).²⁸ This election allows the estate representative to calculate the estate tax liability based on the values of the estate assets as of the date that’s six months after the date of death.

An estate representative can be held personally liable if the alternate valuation could lower taxes and it’s not elected.²⁹ Conversely, the estate representative isn’t permitted to use the AVD values unless the estate tax liability is lowered by doing so. Practitioners should explain to the estate representatives the consequences of transactions between the date of death and the AVD that may fix the valuation, for example, a sale.

Collaborate Early and Often

Professionals should collaborate early and often to make appropriate recommendations. In most circumstances, advisors should consider memorializing recommendations to estate representatives in writing. While there may be valuable planning opportunities available, administration of an estate and testamentary trusts, if any, can be complex, so caution is in order.

Endnotes

1. Revenue Ruling 2023-2.

2. Iowa is phasing out its inheritance tax until full repeal by 2025. No inheritance tax is due for estates $25,000 or less. Iowa Code Ann. Section 450.4.

3. See Kentucky inheritance tax guide, https://revenue.ky.gov/Individual/Inheritance-Estate-Tax/PublishingImages/Pages/default/Inheritance%20Tax%20Guide%2092F101%20%281-21%29.pdf.

4. Maryland collects both an estate and an inheritance tax. Md. Code. Ann. Section 7-201.

5. See Neb. Rev. Stat. Ann. Sect. 77-2004.

6. See N.J. Rev. Stat. Section 54-34-1.

7. See Pennsylvania Form REV-1500, www.revenue.pa.gov/FormsandPublications/FormsforIndividuals/InheritanceTax/Documents/rev-1500.pdf.

8. Internal Revenue Code Section 1014.

9. IRC Section 676.

10. IRC Section 645. The election must be filed by the extended due date of Form 1041 for the estate. IRC Section 6072; Treasury Regulations Section 1.645-1(c). The election, once made, is irrevocable.

11. Treas. Regs. Section 1.645-1(c)(1)(ii) and (2)(ii).

12. Treas. Regs. Section 1.645-1(f)(2)(ii).

13. IRC Section 441(e); Treas. Regs. Section 1.441-1T(b). See also Treas. Regs. Sec. 1.645-1(e)(3)(i) for applicability to electing qualifying revocable trusts.

14. Treas Regs. Section 1.645-1(e)(4).

15. IRC Section 642(c)(2).

16. IRC Section 1361(c)(2)(A). See Private Letter Ruling 200529006 (July 22, 2005).

17. IRC Section 469(i)(4).

18. Palermo v. United States, 2023 PTC 215 (S.D. Fla. 2023).

19. IRC Section 454.

20. IRC Section 691(c).

21. IRC Section 754, available for partnerships and limited liability companies that elect to be taxed as partnerships.

22. IRC Section 743(b); Treas. Regs. Section 1.754-1(b)(1).

23. IRC Section 6166 and related regulations.

24. Section 6166(b). See IRC Section 267 and related regulations.

25. IRC Section 6324A(c).

26. IRC Section 2010(c)(5)(A).

27. Revenue Procedure 2022-32.

28. IRC Section 2032.

29. See Re Lohm Estate, 269 A.2d 451 (Pa. 1970).