Trust, Estate, AB Funding and Gift Tax Planning
For our California clients regarding gift strategies.
This letter summarizes a variety of federal estate, trust and gift tax planning strategies, which we hope you will find useful.
Gifts — Form 709
Gift appreciated property.
With the capital gains rate at 15% for most people (and zero percent for middle to low tax bracket individuals) gifting offers substantial tax savings. Recall that a gift recipient receives the donor’s basis for appreciated property and the donor has no gift tax consequences if the gift is less than $15,000. Therefore, a taxpayer could gift to a parent in a low bracket stock and the parent could sell the stock at a 0% tax bracket, a savings to the family of 15%. Could also use the same strategy with children.
If a client with a large taxable estate is looking for more than just the $15,000 per year gift per person, consider paying other individual’s medical bills or tuition payments directly. These are allowed in addition to the $15,000 per person per year limit. This is a substantial benefit particularly to large family estates.
Gift tax returns and annual exclusion gifts.
A gift tax return must be filed to take advantage of split gifts between husband and wife. A return is not required if each spouse makes his and her own $15,000 annual exclusion gifts. If the gift is made with hard-to-value assets (such as interests in a closely held business or real estate), then a gift tax return should be filed with adequate disclosure made so that the three-year statute of limitations will begin to run. Strict requirements must be met to constitute adequate disclosure (copy of discount appraisals etc.)
Gifting above the $15,000 limit.
Any gifts exceeding the $15,000 limit require the filing of a gift tax return and will absorb or reduce the lifetime gift tax exclusion. If cumulative taxable gifts exceed the lifetime gift exclusion (same as lifetime estate tax exclusion) a gift tax is due along with the gift tax return.
Annual exclusion tax trap—cross gifting.
Bill and Jan are brother and sister. They each have a spouse and three children. Bill and his wife give $15,000 each to their own children and Jan’s children. Jan and her husband give $15,000 each to their own children and Bill’s children. The IRS will limit the number of annual exclusion gifts by the couples to their own children. The other gifts will be taxable.
Gift checks at year-end.
Taking advantage of the annual $15,000 ($30,000 for split gifts) gift tax exclusion is a simple and effective method for reducing the value of an estate as well as shifting income to lower bracket taxpayers. Sometimes if clients wait until the last minute to write a check in December, the check may not clear the bank until after December 31. The gift will still qualify for the annual exclusion in the year the check is written if:
- The check was paid by the drawee bank when first presented for payment;
- The donor was alive when the check was paid by the drawee bank;
- The donor intended to make a gift;
- Delivery of the check was unconditional; and
- The check was deposited, cashed, or presented in the year for which completed gift treatment is sought and within a reasonable time after issuance.
Example: Jan delivers $15,000 gift check to her son Jake on 12/25/2019. Jake deposits the check in his bank on 12/31/2019. The check is paid by the drawee bank on 1/4/2020. The gift is considered complete in 2019.
Fiduciary Trust Income Tax — Form 1041 (541 for California)
After-death administrative trust.
Consider closing an after-death estate or trust that is winding down by year-end. Particularly when a trust has a capital loss carryover or has large administration expenses. By closing in the optimal year, the benefits of a capital loss carryover and excess deductions can pass out to the beneficiaries and reduce their personal taxable income. This benefit is only available in the final year of a trust or estate.
Compression of trust and estate income tax rates.
Income tax rates applicable to trusts and estates are more compressed than the rates for individuals. The following table shows the top income tax rates applicable to trusts and estates for 2020.
|Taxable income||Tax rate|
Compare these to individual rates, which do not reach the 37% bracket until taxable income exceeds well over $600,000 for a married joint return.
The compression of the rates means that it is less costly to distribute trust income to beneficiaries in the drastically lower income tax brackets and thereby avoid the higher trust income tax brackets. For example, if trust taxable income is $80,000, almost all of the income is taxed at 37%, using the trust’s tax rate for federal tax. If trust beneficiaries are in lower tax brackets, there is a tax savings by distributing trust income as long as the trust permits distribution of income.
Triggering capital gains upon funding an after-death trust.
This issue pertains only to appreciation from the date of death of a first to die spouse and the date assets are actually funded into the after-death A/B trusts. If assets have appreciated since the date of death then any funding of appreciated assets to a pecuniary trust will trigger capital gains tax even if the assets have not been sold. This is a trap for the unwary. Would the common living trust be a problem? Absolutely, almost every living trust has a pecuniary trust (A/B) formula and very rarely are the trusts designed to avoid this problem.
Solution: Fund the A/B trust shortly after a first death or carefully pick and choose assets going to the A and B trusts to minimize or avoid the capital gains problem. Funding means changing the title, such as with a deed, to move the asset into the designated trust.
Importance of choosing a fiscal year for estates.
Estates may select a fiscal year rather than a calendar year. This will avoid a short taxable year, thereby allowing sufficient time to distribute the taxable income to the beneficiaries to avoid the higher estate income tax. Thus, a probate estate trust return is permitted to utilize a fiscal year. Unlike a non-probate trust which may not utilize a fiscal year end. The non-probate trust may use a fiscal year end if the IRC section 645 election in the next paragraph is implemented.
Treating a revocable trust as part of the estate.
Section 645 permits revocable trusts owned by a decedent to be treated and taxed as part of the estate for income tax purposes. The Section 645 election is effective for a period of two years after death if an estate tax return is not required, or six months after the final determination of the estate tax. Electing trusts may now select a fiscal year, deduct related party trust losses, deduct amounts paid to or permanently set aside for charities, deduct up to $25,000 in real estate passive activity losses, and qualify for the $600 personal exemption. None of these benefits are available for a trust that does not make the 645 election. The 645 election is therefore a valuable tool permitting trusts to qualify for many of the benefits previously only available to probate estates. Use Form 8855 to make the Section 645 election.
Deductions after a first spouse death.
Upon the first death of a husband or wife an estate tax return is required if the deceased spouse estate exceeds the lifetime applicable exclusion. Usually, due to non-tax funding clauses, there is no tax at the first death. For example, if the death was in 2020 $11 million (plus indexing) goes to the B trust and the remaining decedent assets pass to the spouse with a typical A/B style trust. The unlimited marital deduction shields this structure from any estate tax at the first death.
Because no tax is due with these first death estate returns, many preparers assume they can take all administration expenses (e.g. appraisals, trustee fees, attorney and CPA fees, etc.) on the after-death trust tax returns (Form 1041). Taking these deductions on the trust returns instead of the estate return results in one of two disastrous consequences. If these expenses are paid out of the marital share of the trust estate, then taking the deductions on the trust return forces the estate return into a first death taxable 706. This would certainly be undesirable, as most surviving spouses would wish to avoid an estate tax. The second bad consequence occurs if the administration expenses are instead chargeable to or paid by the B trust. In this instance, the B trust will be funded with less than the optimal lifetime applicable exclusion, if the expenses are deducted on the B trust return. Please recall that the B trust is estate tax free at the second death. Therefore, care should be taken to preserve and optimize the B trust, not diminish it.
To conclude, bad things will happen if these administration expenses are deducted on the after-death trust returns rather than on the estate return (706). You can avoid these bad results if you have a particular type of funding clause in your living trust and you limit the deduction taken to administrative phase income, but since this exception is hard to qualify for, be very careful. If the 706 (first death) is being filed for portability purposes (estate is less than the lifetime applicable exclusion) then you may want the current 1041 deduction and gamble that the second death will be under the applicable exclusion when the time comes.
Planning for the trust 65-day rule.
The 65-day rule permits trustees of complex trusts (i.e. trusts that are not required to distribute all trust income) to elect to treat distributions (in whole or in part) within the first 65 days of the year as though they were made in the prior year. This gives the trustee an opportunity to look back to determine what course of action produces the best income tax result for the trust and for the beneficiaries. This election (IRC section 663) allows after the fact planning to pass high bracket trust income out to low bracket beneficiaries. Don’t use this election for distributions after a trust year end if the return is marked as a final year, this is an audit trap.
The 65-day rule only applies to ordinary income such as dividends and interest income (i.e. not to capital gains).
Discharge from personal liability.
Trustees, particularly trustees who are not beneficiaries, are very concerned about assuming liability to the IRS for all trust returns still open as to the statute of limitations.
Fortunately, the IRS permits trustees to file an IRC section 6905(a) request to discharge the trustee from personal liability. The request is filed, and then upon the passing of nine months the discharge becomes effective if the IRS does not respond. Use Form 5495 to apply for this benefit.
Consider this a valuable tool for all trustees when the trust is close to winding down.
When dealing with estates and trusts, it is important to distinguish between depreciation for tax purposes and depreciation for fiduciary accounting purposes. The tax depreciation rules applicable to individuals are also applicable to trusts and estates.
Fiduciary accounting depreciation.
This depreciation, typically referred to as “a reserve for depreciation,” is used in the computation of fiduciary accounting income. A reserve for depreciation will be charged to accounting income. A charge to income is a reduction in accounting income. This is important as distributions to beneficiaries are usually measured by accounting income. Deciding whether or not to set up a reserve for depreciation will be a major factor in determining how much beneficiaries will receive each year.
A trustee or executor must consider the governing instruments (will or trust) and local law to see if a reserve is required. In California, set up a reserve if the will or trust requires a reserve.
If the trust is silent in California (California probate code), the trustee or executor may set up a reserve for depreciation.
If rental real estate is expected to appreciate (the most common scenario) then the trustee may decide not to set up a reserve if the trustee has the discretion. This way, the income beneficiaries receive more during the lifetime of the trust. Due to appreciation, the remainder beneficiaries will also prosper.
Contrast this with real estate where appreciation is not a significant factor (eg. low income housing and leased property with options to buy), in this case, the trustee or executor might set up a reserve to provide the remainder beneficiary with a more equitable allocation of the overall estate or trust.
Depreciation for fiduciary accounting purposes is determined in a manner similar to GAAP (generally accepted accounting principles) depreciation. Factors such as economic life will be considered in the calculation of the depreciation reserve.
Where does depreciation go on the 1041 trust return? The decision on setting up a reserve will impact where the tax depreciation will be allocated (ie. between the beneficiary K-1 and the trust schedule E).
When a reserve is setup the tax depreciation will appear on the schedule E, similar to a personal return.
When no reserve is set up the tax depreciation will be allocated directly to the beneficiaries on the K-1.
Example of a trustee’s decision regarding a depreciation reserve.
The Carson C Trust (a QTIP trust) was set up to provide income for life to the surviving spouse. The trust consists of $15,000,000 in California real estate holdings with yearly tax depreciation of $200,000. The taxable income and fiduciary accounting income are both $300,000 per year without depreciation. The trust is silent as to depreciation; therefore, the trustee is deciding whether or not to set up a reserve. Assume that the $200,000 depreciation for tax purposes is approximately the same as depreciation for fiduciary accounting purposes (ie. economic life etc.).
Results with a reserve: If the trustee decides to set up a reserve then the surviving spouse will receive yearly income distributions of $100,000 ($300,000 accounting income less $200,000 reserve). The 1041 schedule E will reflect $300,000 less $200,000 depreciation on the schedule E. The K-1 will pass out the net rental income of $100,000 as one-line item on the K-1. The K-1 depreciation line will be blank.
Results without a reserve: With no reserve set up, the surviving spouse will receive yearly income distributions of $300,000 ($300,000 accounting income less zero reserve). The 1041 Schedule E will reflect only the $300,000 in rental income and nothing in the depreciation line. The K-1 will pass out the $300,000 as a rental income line item and the $200,000 as a depreciation expense line item.
Yes, the beneficiary receives $300,000 in distributions and only pays tax on $100,000 ($300,000 less depreciation $200,000). What a great deal when there is no reserve. Therefore, when the trust is silent as to a reserve a beneficiary should treat the trustee like a king. The trustee has total control of the purse strings here.
Final year of trust.
For income tax purposes, the trust or estate is considered terminated when all assets have been distributed except for a reasonable amount set aside for the payment of unascertained or contingent liabilities. The IRS requires that the administration period cannot be unduly prolonged.
All income tax flows through to the beneficiary in a termination year of an estate or trust. Income, capital gains, etc. all flow through the K-1 to the beneficiaries. The 1041 will show no tax due at the fiduciary level.
Capital gains and losses are typically principal transactions and therefore are taxed at the trust level and not to the beneficiaries. However, in the final year all capital gains and losses pass out to the beneficiaries. Capital loss carryovers also pass out to the beneficiaries, on the K-1, in a termination year.
Net operating losses, including carryovers, pass out to the beneficiaries in the final year.
Suspended passive loss carryovers increase the basis of property distributed in a final year.
Income in respect of a decedent (“IRD”) generally refers to amounts received after the date of death, which, if they had been received by the decedent, would have been included in his/her taxable income. Because IRD does not receive a step-up in basis, the person who acquires the IRD from the decedent must include it in gross income. Common items of IRD are IRA and qualified retirement plan distributions, royalties, deferred compensation, and similar items. In order to lessen the impact of double taxation, the amount of estate tax attributable to the IRD may be deducted on the recipient’s income tax return. The deduction is a miscellaneous deduction not subject to the 2%-of-AGI floor.
Action required: Any individuals who are beneficiaries of an estate or trust should inquire as to all IRD in the estate. Typically, most estates have a large amount of IRD and thus a big deduction is available on the personal tax return of the beneficiary. The big deduction is there for the asking, but you need to inquire to get the necessary information to calculate the deduction.
Estate Tax — Form 706
Estate Tax Portability Feature
Now Permanent. After 2010 the applicable exclusion has a portability feature. If the first spouse to die does not utilize the full lifetime applicable exclusion, then the surviving spouse may use the unused exclusion later on the second death 706 (estate tax return). This feature is only available by filing a timely estate tax return (including extensions) of the first to die (even if the estate is below the $11M plus indexing threshold for filing). Note that after 2025 the $11M applicable exclusion drops back to $5M.
What does all this mean for estate tax filings? A lot more 706’s will be filed to take advantage of the first to die unused portable exclusion.
It is important to note that portability relates to the DSUE (deceased spousal unused exclusion) not the utilized exclusion at the first spouse death. The utilized exclusion would be the credit shelter (B trust) share, assets going to other than the spouse at the first death and also lifetime gifts made (all of these use up the applicable exclusion at the first death).
For large estates (where decedent assets exceed the exclusion) the DSUE typically would be zero with a traditional AB or ABC style trust in play. These trusts are designed to utilize the maximum applicable exclusion. Therefore, portability would only apply to large estates when the estate was poorly planned or poorly executed (i.e. too many or all assets held in JT WROS or CP WROS). JT WROS = Joint Tenancy with rights of survivorship. CP WROS = Community Property with rights of survivorship.
For small estates (decedent assets below the exclusion) the DSUE would always apply and the advantages of the portability feature should always be considered. Some factors to consider would include the amount of the DSUE available, the size of each spouses projected estate, the cost of preparing the estate 706 return and the projected applicable exclusion for future years.
January 2, 2013 a law was passed making portability permanent.
If the surviving spouse has several pre-deceased spouses then the DSUE of the “last deceased spouse” will be the DSUE to use, even if zero. Not applicable if pre-deceased spouse died before 1/1/11.
A surviving spouse may use the DSUE in addition to her/his exclusion at the second death (or for lifetime gifts).
IRS has the authority to audit these DSUE estate returns (no statute) to insure the amount of DSUE used on the second 706 is accurate.
Filing a complete and “properly-prepared” 706 tax return by the due date is the method to elect portability of the DSUE. Simply look at the 706 and see what the taxable estate is, the DSUE is simply the applicable exclusion minus the taxable estate.
To elect portability an estate return has to be filed within 9 months of the date of death. If an extension Form 4768 is filed before the 9-month period expires you can add another six months to this deadline.
Observations Regarding Portability.
Portability does not replace the AB style trust as an estate planning tool. The AB style trust is better in several respects; B trust creditor protection, post-death appreciation is estate tax free, GST tax exemption preserved from the first death and preservation of the state estate tax exemption in states that have a state inheritance tax.
When compared to the AB trust, a trust designed just for portability has one big advantage, the DSUE assets get a full step-up at the second death. However, with an AB style trust, careful AB selection of assets for funding can avoid the loss of the second death step-up.
The AB style plan and the portability plan actually work together to benefit the client. The AB trust provides the ideal estate plan and utilization of the first death exclusion for those assets properly funded to the AB trust. Portability preserves the remainder of the exclusion not fully utilized with the AB trust.
New Form 8971 Required for Basis Reporting to Beneficiaries.
You have 30 days after filing the estate return to file form 8971 and schedule A with the IRS and with the beneficiaries. The 8971 form is used to report the basis used for estate tax purposes to the IRS and to the beneficiaries to achieve consistent reporting. Several exceptions to filing this form apply when a 706 is not required to be filed, but is anyway, such as for portability. New section 6035 contains the reporting requirements.
If assets have not been distributed then report all assets (at 100%) to all beneficiaries that may inherit those assets (i.e. all residual beneficiaries).
Generally, the 8971 form will include all assets reported on the 706 as finally determined. Four exceptions to reporting are provided for cash; IRD (income in respect of decedent), personal property for which an appraisal is not required and property which has been sold where gain or loss has been recognized (generally on the 1041).
Additional reporting is required for subsequent gifts, transfers and/or distributions to related parties (spouse and relatives, up down and sideways and controlled entities). You have 30 days from the transfer date to file a supplemental 8971 and schedule A with the IRS and also 30 days to furnish a copy of the schedule A to the transferee.
Be sure to file the 8971 properly and on time as the IRS has extensive penalties associates with this filing.
AB Trust Funding (or ABC funding)
The typical living trust will split into multiple trusts after a first death. Funding the various trusts can be a daunting task for a trustee. Non-tax reasons such as different beneficiaries for various trusts will create a nightmare if assets going to one trust appreciate more than assets going to another trust. The beneficiaries of the lower performing trust will typically have an issue. Also, property tax reassessment and lender restrictions may limit where real estate assets may be funded.
The typical B trust will be estate tax free at the second death. The trade off is not getting a step-up in asset values at the second death. A comparison of federal and California capital gains rates to the estate tax must be done when considering the AB funding. Currently California plus federal capital gains are less than the estate tax rate of 40%, therefore, avoiding the estate tax would be better than paying capital gains for large estates, as the rates stand today.
Larger estates may also have a decedent’s QTIP trust (sometimes called the C trust). This trust is generally set up to include the decedent’s (first death) assets exceeding the applicable exclusion amount. This trust is structured to permit the use of the unlimited marital deduction. The QTIP format is commonly used to protect and preserve the decedent’s share of assets for his/her heirs. As a starting point the will or trust documents should be reviewed to determine new trusts to be created upon death. State and local laws dictate trust administration matters. This summary is California specific and will only address California resident estate and trust issues.
A/B or A/B/C funding and the administrative trust.
During the period starting at the first spouse death and ending at distribution (trust funding), the estate trust will need to address the tax filing form 1041 requirements for this administrative period. The living trust, now irrevocable at death, obtains a taxpayer ID number (EIN) and a form 1041 will be filed from the date of death forward. The share of the trust relating to the survivor assets would maintain the “grantor trust” status and taxation would pass through to the survivor (stay on form 1040). The decedent’s share would be a simple trust 1041 and taxation of accounting income like interest income would pass out to the surviving spouse form 1040 if the trust requires all accounting income to be distributed to the surviving spouse during the period of trust administration. Principal, on the other hand, is almost always taxed on the 1041 and does not pass out to the individual return (capital gains for example). The administrative trust ends upon funding of the A/B trusts.
To do AB funding you must first obtain a list of client assets and determine which assets are eligible for funding to the A/B trusts. Generally, only assets titled in the name of the living trust are eligible for division. Also, look for assets brought into the trust by law (i.e. where the trust is the designated beneficiary, life insurance, IRA’s, etc.).
Once you have obtained a list of the assets in the trust you can begin the funding work. The next step is to obtain appraisals and valuations then you are ready to allocate assets to different trusts.
At this point you will need someone to review the living trust document and determine the steps necessary to execute the funding clauses in the trust instrument.
Joint tenancy property
This property passes directly to the surviving joint tenant by virtue of law, thus not available for the A/B allocation. Same treatment for community property with rights of survivorship.
Don’t be fooled by the list of trust assets in the trust document. The mere listing of the asset in the trust does not make it a trust asset, contrary to what most people think. Property must vest in the trust regardless of whether it is on the list of trust assets or not. For instance, joint tenancy property passes to the surviving joint tenant even though it may be listed as a trust asset on schedule A behind the trust. There is a court petition that can be filed, in the right circumstances to bring the assets into the trust.
For property held in the decedent’s name (not in trust). Look at the pour-over will and determine if any property comes into the trust, either with probate or without probate if under $150,000.
IRA’s and retirement accounts pass to the designated beneficiaries by law. If an individual is named as beneficiary, then that individual owns the asset not the trust. A trust can be an IRA beneficiary if the trust is carefully constructed to include California provisions required to be a receptacle of an IRA. Also, the custodian must be contacted to coordinate the proper set-up. Naming the trust as the IRA beneficiary is usually not the best option.
For life insurance if the trust is the beneficiary, then the life insurance will be available for trust funding. Once you have obtained a list of the assets in the trust you can begin the funding work. The next step is to obtain appraisals and valuations then you are ready to allocate assets to different trusts.
At this point you will need someone to review the living trust document and determine the steps necessary to execute the funding clauses in the trust instrument.
Discounting and partial interest
If an asset is given partially to the exemption trust and partially to the marital trust, then discounting must be considered. For instance, if a 50% interest in real estate or a closely held business is given to each trust, each is required to use the discounted value. In the typical ABC trust the B and C trust representing the decedent’s share are by formula are split into a residual bequest and a pecuniary bequest. The pecuniary trust (living trust will designate which trust is the pecuniary trust) which by formula will receive its full share of assets based on higher date of death values (full undiscounted value before splitting in half) and achieve full funding. The residual trust (spelled out in the living trust) however, will receive the after-discount residue which would be less than it would without any discounting. Shorting a trust is usually fine when all the trusts have the same beneficiaries. Not fine when the beneficiaries are not the same for the different trusts. Here is where you need experts, partial interest appraisers, estate trust CPA and an attorney.
The tax law is filled with both traps and opportunities. The complexity of the Internal Revenue Code and the constant changes in tax law make a regular and careful review mandatory to avoid the traps and to take advantage of tax-saving opportunities.
This summary is intended to inform you of potential tax planning opportunities. It is not intended to replace a carefully constructed tax plan, which would include tax projections and careful analysis. Always seek professional guidance before implementing any of these ideas.
We hope you find this letter helpful. Written by Robert Manton, CPA January 2020.