Wednesday May 19, 2010

THE TRUSTEE ADVISORY

Special Tax Alert

“Living the DREAM of No Estate Tax Creates the NIGHTMARE
of Capital Gains Tax”

Effective Trust Planning to Avoid it

A daunting attempt to simplify the New Law (as discussed in The Estate Planning and Probate Reporter) for clients and non-lawyer professionals.

We have a new IRC §1022 respecting capital gains tax for individuals dying after December 31, 2009—property received by heirs obtain a basis of the lesser of the adjusted basis or fair market value of the property on date of death limited to a $1.3 Million increase. There is also provisions for increasing basis subject to date-of-death value limitations of $3 Million for spouses.

But to insure these increases, certain requirements have to be met in the estate plan which may require amendments as described hereafter. Even if IRC §1022 only lasts for the year 2010, the negative tax impact for heirs of decedents dying in 2010 could be substantial. As a result, such heirs may inquire as to why the professional advisors of the decedents dying this year failed to notify them about the need for corrective action.

A. The $1.3 Million Increase in Basis:
Under IRC §1022 (b), the decedent’s estate assets will obtain an increase in basis of $1.3 Million subject to a fair market value limitation. What does this mean to our clients? It may or may not be significant. For real properties which have received years of depreciation (rental, trade or business property), such property basis may be very low. A new increase in basis can allow for continued future depreciation deductions creating immediate tax consequences. The huge problems will be the responsibility of establishing the former basis because of lack of records and allocating new basis increases to inherited property by the estate Executor.

B. How to Become the Most Unpopular Member of the Family:
If you have been designated the Executor of a Will, which is also normally the Successor Trustee, you have the awesome responsibility of establishing and allocating the basis for estates of decedents dying in 2010 under IRC§1022 (d)(3)(A). If this doesn’t make you take a look at your Trust and Will to confirm who you’ve designated, nothing will. This is an awesome responsibility which is fraught with liability. The allocation is to be made by the Executor or “any person in actual or constructive possession of any property of the decedent.” This would obviously be a Successor Trustee who holds title to the property in Trust. Thus, we could have two individuals allocating basis on estate assets if these fiduciary positions are occupied by two different individuals or entities-perfect for creating conflict.

The executor has the responsibility of filing an informational tax return to allocate basis an advise the IRS and heirs how basis is assigned to inherited properties and assets. IRC §6018. The Executor must file a return for any estates in which the value of all property acquired from a decedent exceeds $1.3 Million or if the decedent acquired property by gift within 3 years of death. (There is no basis increase for any asset received by the decedent or decedent’s spouse within 3 years of the decedent’s death no matter who inherits such asset.)

Hypothet: An unmarried decedent dies leaving an estate to 3 children having a total value of $5 Million in 2010. As indicated previously, there is no estate tax. The estate consists of a residence with a fair market value of $1.4 Million and a basis of $800,000; a rental property with a fair market value of $1.6 Million and an adjusted basis of $700,000; and an office condo with a fair market value of $2 Million and a $400,000 basis.

Who should the owner/parent designate as his Executor/ Successor Trustee? If he designates one of his 3 children, will such child be considered in a conflict of interest as a fiduciary and beneficiary in allocating basis. Isn’t this a huge burden and issue? This should be discussed in detail with all clients and, in my opinion, such allocation should be specifically stated in the Trust or Will.

A detailed provision in the Trust or Will might be as follows:
The Trustee shall distribute Trustor’s residence to my son Christopher and his wife Katy. Based on the value of the property and the fact that they will reside in the residence and make it their home, they will be entitled to a $500,000 exclusion from gain under IRC § 121 should they desire to sell it. As a result, the Trustee/Executor shall allocate $100,000 of my $1.3 Million basis increase to the home which will increase it to $900,000 in basis.

To my daughter, Natalie, the Trustee shall distribute Trustor’s rental property with a present adjusted basis of $700,000 and a fair market value of $1.6 Million. The Trustee executor shall allocate $900,000 to the basis for a total of $1.6 million.

To my son, Joe who is designated Successor Trustee/ Executor, the Trustee shall distribute Trustor’s business condo with a present fair market value of $2 Million and a basis of $400,000. The Trustee/ Executor shall allocate $300,000 of my basis increase to such asset for a total increase to $700,000 in basis.

Basically, the Trustor made the allocation in his Trust in an attempt to equalize distributions among his children with capital gains tax a consideration. The Trustor could then allocate the remainder of his estate to his children in an effort to further equalize distributions. The key is that the parent/Trustor specifically made the allocation in his Trust for Joe to follow and file the informational basis returns with the IRS without Joe incurring potential liability, family hostility or a conflict of interest. A codicil to the Will should be executed requiring that the Executor follow the instructions in the Trust regarding basis allocation.

If assets are to be sold and divided into equal shares to the children, allocation of basis is not as crucial, but obtaining the $1.3 Million basis increase may be dicey. Check out the next section as our nightmare continues.

C. Ownership at Death Requirement:
To obtain an increase in basis, the asset must be owned by the decedent at date of death. IRC§1022 (d)(1)(A). This, at first blush, shouldn’t be a problem, right? Well, leave it to Congress to make it a problem because there is no “taxable estate” in 2010. Thus, we must look at the rules defining ownership.

Property transferred to a Qualified Revocable Trust (QRT) by the decedent during his/her lifetime is treated as owned by the decedent. IRC§1022 (d)(1)(B)(ii). This leads us to the potentially incredible issue raised by the new legislation for 2010. For California practitioners and clients, a surviving spouse’s one-half of community property is considered owned by the decedent spouse. IRC §1022 (d) (I) (B)(iv). As a result, property transferred to a typical Survivor’s Trust at the death of the first spouse will not necessarily be treated as property owned by the Surviving Spouse on his/her death because he/she did not personally transfer the assets to such Trust as required under the QRT provisions. (This will be addressed in more detail below). It is transferred by a formula dividing the community property between the decedent’s and surviving spouse’s Trusts.

Additionally, property subject to a General Power of Appointment, as normally found in the Survivor’s Trust provisions, will not be treated as owned by the power holder by reason of the power to obtain a basis increase. IRC §1022 (d)(1)(B)(iii). Finally, property in a 2056 (b)(5) Power of Appointment Marital Deduction Trust, with assets passing from a decedent spouse, will not be treated as owned by the surviving spouse for purposes of a basis increase on the death of the surviving spouse. Again, this is because the surviving spouse didn’t make the transfer personally during his/her lifetime. IRC §1022 (d)(1)(B)(ii).

D. The $3 Million Basis Increase in Basis for Spouses
An additional basis increase is available for qualified spousal property subject to fair market value limitations. In order for the property to obtain a basis increase, such property must pass outright to the surviving spouse or to a QTIP Trust. IRC §1022 (c)(3). If the Trust includes a survival period contingency by the surviving spouse and the surviving spouse does not survive the survival period, the $3 Million basis increase will be lost.

QTIP Trust:
A transfer to a QTIP Trust qualifies for the $3 Million basis increase on the death of the first spouse but such property is not eligible for another basis increase on the death of the surviving spouse because there is no provision for treating such property as being owned by the survivor. As indicated in the CEB article, this might not be a bad result for estates after 2010 because the QTIP property will not be included in the surviving spouse’s estate for federal estate purposes as only property subject to a marital deduction under §2044 would be included.

E. The Survivor’s Trust Conundrum for the Basis Increase
A potential major loss of basis increase could develop as a result of IRC §1022 (c)(3) which defines “qualified spousal property.” In order to be entitled to the $1.3 Million or $3 Million spousal basis increase the property must be considered owned by the decedent at date of death and pass outright to the surviving spouse. The $3 Million basis increase is only available to property passing in an “outright transfer” to a surviving spouse or via a QTIP Trust. It is questionable whether a transfer to a Survivor’s Trust is an “outright transfer” to a surviving spouse especially if such Trust allows distributions to third persons during the surviving spouse’s lifetime. This is not unusual should the surviving spouse become incapacitated.

Transfers from the Survivor’s Trust to beneficiaries after the death of the surviving spouse may not qualify for the $1.3 Million basis increase. As previously indicated, IRC §1022 (d)(1)(B)(ii) provides that property transferred to a Qualified Revocable Trust by the decedent during life is considered owned by the decedent. There is no comparable provision treating property transferred to a Survivor’s Trust by the first deceased spouse as being owned by the surviving spouse. The Estate Planning and Probate Reporter authors recommend that for first spousal deaths in 2010 such property should pass outright to the surviving spouse who would then assign his/her interests to the Survivor’s Trust immediately after the first spouse’s death. This would insure qualification under IRC §1022 (d) (1) (B) (ii) so that the basis increase would be allowed. It is also prudent to include authority for this action in the Financial Durable Power of Attorney in case the surviving spouse lacks capacity.

What about assets inherited in 2010 but sold in later years? Which basis is utilized, the basis increases for 2010 or the step-up to fair market value basis we have enjoyed under IRC §1014? It appears that the new basis laws of IRC §1022 would be observed for inherited property in 2010 but the sunset provisions of EGTRRA-2001 §901(a) states: “The Internal Revenue Code of 1986...shall be applied and administered to years, estates, gifts and transfers described in subsection (a) as if the provisions and amendments described in sub-section (a) had never been enacted.” If EGTRRA-2001 had never been enacted, heirs would receive a step-up in basis to date of death fair market value under IRC §1014. So what basis will be utilized? Only time will tell.

If you don’t feel that these are serious Trust issues of which your clients should be aware, Wake Up! You are definitely, “California Dreaming”.

Recommendations:

1. Inform your clients of the status of the law. Feel free to send them this article or they may obtain a copy of this article from my website.

2. A-B Trust formulas for the year 2010 should be adjusted by Trust amendment subject to any retroactive legislation this year by Congress. In addition, basis should be allocated among beneficiaries by an appropriate Trust instruction if property is specifically designated to children or heirs. (This amendment may effect other provisions in the typical AB Trust which should be reviewed by a knowledgeable estate planning attorney.)

3. Pray for simpler legislation.

Sincerely,

Jack E. Stephens, Esq.
Law Offices of Jack E. Stephens, J.D., LL.M.
12526 High Bluff Drive, Ste. 200
San Diego, CA 92130
(858) 792-0909 phone
(858) 792-0806 fax

www.jackstephens.com
Jack Stephens Newsletter Sign Up Click Here

TAX ADVICE DISCLOSURE: To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.