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Fixing Five Fiduciary Fumbles

Executors frequently go to work with no "on the job training." They are often well intentioned volunteers, chosen on the basis of family relationship rather than knowledge and experience. However, ignorance of income and estate tax law can be costly to the beneficiaries and the executor.

First Fumble: Don’t waste deductions for administration expenses.
Legal, accounting and probate fees often greatly exceed estate income. If these "excess expenses" are paid in the "termination year" of the estate, they can be deducted by the beneficiaries on their personal returns. This can be a very substantial benefit. This deduction is often lost by an uninformed executor who does not file an estate income tax return, thinking that it isn’t necessary because there is no taxable income. The deduction can also be wasted by paying administration expenses at the wrong time.

EXAMPLE: We settled the estate of someone I’ll call "Ajax." Ajax left his entire estate to his son, Bjax. We knew that the estate could be fully administered within one taxable year. The estate had income of $30,000 and administrative expenses of $55,000. Because we claimed the "excess" deductions on the estate’s 1041, Bjax could deduct $25,000 on his personal return, subject to the 2% floor for miscellaneous itemized deductions.

If, as in our "Ajax" example, the executor is positive that the estate can be fully administered within one fiscal year, the timing of payments probably does not matter. However, if the administration is expected to take longer, the executor should try to pay expenses in a way that "absorbs" estate income. He or she should try to match income and deductions by selecting an appropriate fiscal year and try to control the timing of income, expense payments and distributions.

Second Fumble: Insufficient Understanding of Retirement Plans.
All retirement plans have Minimum Required Distributions ("MRDs"). Navigating the complex rules governing the size and timing of these MRDs can be a "taxing" experience. Financial advisors should examine each situation carefully. Are there one or more "Designated Beneficiaries?" Can the beneficiaries "stretch" the MRDs or must the entire plan be distributed within five years? If the beneficiaries can continue to receive MRDs, are they calculated using their life expectancies or do they have to continue the decedent’s distribution schedule? If the retirement plan is payable to a trust, can we use the beneficiaries’ life expectancies to determine the MRDs? There may be opportunities for a creative executor to save substantial money.

EXAMPLE: We recently settled an estate that was distributable to more than twenty beneficiaries, including several charities. The decedent had an IRA of approximately $180,000 – less than the share of one of the charitable beneficiaries. The beneficiary of the IRA was "the Trust," without any specific allocation to any beneficiary. If the trustee received the IRA and then distributed the proceeds, the entire $180,000 would have been taxable. The trust would not have received a charitable deduction because there were no "separate shares." We found several Revenue Rulings in which a trustee assigned an IRA directly to a charity, completely eliminating the tax. Unfortunately, the custodian was a national brokerage company which refused to honor the assignment. All’s well that ends well because we found a more flexible custodian and saved our client over $60,000.

Third Fumble: Being unaware of the Full Basis Step-up for Certain Jointly Owned Property.
Chester Riley died in 2007. In the 1960s, he and his wife, Peg, bought a piece of rural land for $40,000. Although they owned the property jointly, Chester provided all of the purchase money. When Chester died in 2008, the property was zoned commercial and was worth $700,000.

On the estate’s income tax return, the executor claimed a basis of $370,000 – using a stepped-up basis for Chester’s "portion" and half of the cost for Peg’s "portion." He paid $49,500 in capital gains tax.

Chester’s executor was unaware that, under the Supreme Court’s decision in a case known as Gallenstein, there is a full (not half) step up in basis for jointly owned real estate which a married couple bought prior to 1977. Chester’s executor need not have paid any capital gain tax. The Gallenstein rule applies to all pre-1977 jointly owned real estate, except to the extent that the surviving spouse paid for the property and improvements.

Fourth Fumble: Not Taking Advantage of Valuation Discounts.
For estate tax purposes, the whole is greater than the sum of the parts. Partial interests, are "discounted" for lack of control and marketability. It does not matter who the owners of the other "parts" are. In one Revenue Ruling, Papa made gifts of 20% interests in a business to each of five children. The Service allowed minority discounts even though Papa had owned the entire business.

FIRST EXAMPLE: We settled the estates of a husband and wife who died within two weeks of each other. Each of them owned a one-half interest in a house worth $800,000. The lawyer who started settling the estate reported one-half of the value on each of their estate tax returns. We amended the returns, claiming a 20% discount and eventually settled for 10% because the house had been sold shortly after the couple died. This "small" discount paid a decent dividend, saving approximately $40,000 of estate tax.

SECOND EXAMPLE: Unavoidable delays in selling assets can also generate substantial valuation discounts. We settled the estate of a man who owned a collector car worth approximately $3.5 Million. Five years after the owner died, we were still unable to sell due to ongoing litigation. We originally claimed a 39% discount. The IRS offered 15% and we eventually settled for 35%. The tax saving was approximately $368,000.

THIRD EXAMPLE: Sometimes an asset simply can’t be sold. A number of years ago, we settled the estate of a lottery winner. The payments could not be transferred. We were essentially "stuck" with a fixed income note. We claimed a 25% discount based on sales of similar assets and settled for 20%, saving a tax of approximately $100,000.

Executors must always consider valuation discounts. They also need to find competent appraisers and to be conversant with those appraisers’ methodology and language.

Fifth Fumble: Insufficient Grasp of Estate Tax Concepts.
Estate tax returns ("706s") are what lawyers call "sui generis." They are a "thing unto themselves." Estate tax returns resemble income tax returns the way that apples resemble pears. The estate tax treatment of the same factual situation can vary from one state to another depending on local law. This is an area where a little knowledge can truly be a dangerous thing. Here are some examples of 706s that we’ve "corrected" and one "unfixable" mistake that led to a malpractice settlement.

FIRST EXAMPLE: We were asked to review an estate tax return prepared by a general lawyer. The decedent’s wife had died leaving assets in several trusts. One issue became immediately apparent. One of the trusts was called an "Exempt QTIP Trust." This is a marital deduction trust designed to use up the first spouse’s generation skipping tax exemption. Because it was described as "exempt," the executor wrongly omitted it on the husband’s return. Although we were able to have penalties waived, the estate had to pay over two years’ interest on almost $300,000.

SECOND EXAMPLE: In another "surviving spouse" situation, the husband had died ten years ago. His estate tax return indicated that he had made a substantial gift, but we were not given any gift tax returns. Because spouses commonly elect to "split" large gifts, we expected to see an "adjusted taxable gift" on the wife’s estate tax return. When we made the executor aware of this, we found out that the wife had in fact elected to split this gift, requiring half of it to be listed on her estate tax return. This avoided an issue on audit and saved the estate interest and possible penalties.

THIRD EXAMPLE: Several years ago, I served as an expert witness in a matter where failure to see the benefit of a disclaimer proved costly to a corporate executor. A husband and wife died within six months of each other. There was clear language in the document regarding disclaimers. Nevertheless, the executor, knowing that the second spouse had died before the first spouse’s estate tax return was due, allowed all of the assets to pass outright to the survivor. Not funding the estate tax "exemption" share by disclaimer cost the bank and its counsel over $400,000.

Settling estates is an interesting and challenging part of our law practice. Failing to consider tax planning, even in "simple" estates, can be costly to the beneficiaries, and possibly the executor. We welcome the opportunity to work with you in all aspects of estate administration.