Client Tax Letters

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2016 tax organizer for personal income taxes

Trust, estate and gift tax planning strategies

Dear California clients,

This letter summarizes a variety of federal trust and gift tax planning strategies, which we hope you will find useful.


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 $14,000. 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, but only if the kiddie tax rules do not apply.

If a client with a large taxable estate is looking for more than just the $14,000 per year gift per person, consider paying other individual’s medical bills or tuition payments directly. These are allowed in addition to the $14,000 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 $14,000 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 and an adequate disclosure made so that the three-year statute of limitations will begin to run.

Gifting above the $14,000 limit. Any gifts exceeding the $14,000 limit require the filing of a gift tax return and will absorb or reduce the lifetime $5 million (plus indexing) gift tax exclusion. If cumulative taxable gifts exceed the $5 million level (plus indexing) a gift tax is due along with the gift tax return. The estate tax applicable exclusion amount and the gift tax applicable exclusion amount are both currently $5 million (plus indexing).

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 $14,000 each to their own children and Jan’s children. Jan and her husband give $14,000 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 $14,000 ($28,000 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:

(1) The check was paid by the drawee bank when first presented for payment;
(2) The donor was alive when the check was paid by the drawee bank;
(3) The donor intended to make a gift;
(4) Delivery of the check was unconditional; and
(5) 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 $14,000 gift check to her son Jake on 12/25/16. Jake deposits the check in his bank on 12/31/16. The check is paid by the drawee bank on 1/4/17. The gift is considered complete in 2016.

Fiduciary income tax

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 income tax rates applicable to trusts and estates for 2017.

Taxable income Tax Rate

Not over $2,550 15%

Over $2,550--$6,000 25%

Over $6,000--$9,150 28%

Over $9,150--$12,500 33%

Over $12,500 39.6%

Compare these to individual rates, which do not reach the 39% bracket until taxable income exceeds well over $300,000 for a married joint return.

The compression of the rates means that it is less costly to distribute trust income to beneficiaries in lower income tax brackets and thereby avoid the higher trust income tax brackets. For example, if trust income is $50,000, the sum of $37,500 is taxed at 39.6%, 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.

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) 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.

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, which was added in 1997, permits revocable trusts owned by a decedent (dying after 8/5/97) 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. 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 $5 million (plus indexing). Usually, due to non-tax funding clauses, there is no tax at the first death. For example if the death was in 2017 $5 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 preparer’s 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 is funded with less than the optimal $5 million (plus indexing), 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 and limit the deduction taken to administrative phase income, but since this exception is hard to qualify for, be very careful.

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.

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.

Additional considerations

IRD deduction. 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

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 $5M exclusion (plus indexing), 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 $5M threshold for filing).

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.

The portability carryover feature was set to expire after 2012, however, on January 2, 2013 a new 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, portability has one big advantage, the DSUE assets get a full step-up at the second death.

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 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.


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 April 2017.

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