Tennessee Estate Planning Law : Tennessee Estate Planning Lawyer & Attorney : Bryan Howard : Howard & Mobley Law Firm : Nashville, Chattanooga, Memphis

When someone dies, their estate becomes a separate taxpayer for income tax purposes. Estates are allowed to choose their tax year. We generally recommend that estates elect the longest fiscal year available, which is the end of the month preceding the one-year anniversary of the decedent’s death. For example, the latest fiscal year that can be elected for a decedent who dies in April of 2010 is March of 2011. The reason that we generally elect a fiscal year is to postpone the time when income taxes will be paid on income earned by the estate.

Revocable trusts are also allowed to make the same fiscal year election, though they are required to make a separate election (referred to as a Section 645 election) with the IRS.

Federal income taxes will be increasing for tax years beginning after December 31, 2010. The maximum rate for dividends will increase from 15% to 39.6%. The maximum rate for capital gains will increase from 15% to 20%. The maximum rate for rents and interest income will increase from 35% to 39.6%.

As a general rule, the estate or revocable trust pays taxes on capital gains and taxes on other income is paid by the beneficiaries to the extent the income is distributed, or paid by the estate or revocable trust if the income is retained.

If the estate retains the income, the estate will benefit from making a fiscal year election. If the estate or revocable trust intends to make distributions to the beneficiaries, and the beneficiaries are in a high income tax bracket, the estate or revocable trust may want to avoid a fiscal year election for decedents who die in 2010.  The fiscal year election would cause the beneficiaries to pay higher taxes because the income will be taxed on their 2011 federal income tax returns.

There is a corollary problem for estates that already have fiscal years. If the estate is terminated in 2011 or later, the income will flow out to the beneficiaries in 2011, when it is likely to be taxed at a higher rate. Conversely, if the estate is terminated by December 31, 2010, the income will be taxed to the beneficiaries based on the lower 2010 rates. It is not always possible to accelerate the closing of an estate. However, if there are just a few minor details, it may be possible for the beneficiaries to assume responsibility for the final details in order to allow the estate to close.

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A prior article pointed out that higher tax rates in the future would increase the chance that converting your IRA to a Roth IRA would provide a benefit to you and your family. We now know that income tax rates for high-income individuals will increase beginning in 2013, due to the 2010 Healthcare Act.

High-income taxpayers, defined as single people earning more than $200,000 and married couples earning more than $250,000, will be hit with a a tax increase on wages and a new levy on investments. Under the provisions of the new law, which take effect in 2013, high-income taxpayers will be taxed at an additional 0.9% on wages exceeding $200,000 for single people or $250,000 for married couples.

Beginning in 2013, a new 3.8% tax will be imposed on net investment income of high-income taxpayers. Net investment income includes interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from disposition of property (other than property held in a trade or business). Net investment income is reduced by properly allocable deductions to such income. However, the new tax will not apply to income in tax-deferred retirement accounts such as IRAs and 401(k) plans. Also, the new tax will apply only to income in excess of the $200,000/$250,000 thresholds.

These new taxes enhance the benefits of a Roth IRA conversion in two respects. First, if you do not make the conversion, the required distribution from your regular IRA will increase the chance that you are a high-income individual. Even though the new investment tax will not apply to the amount distributed from a regular IRA, the income from the IRA may force more of your other income to bear a 3.8% tax. If you had converted to a Roth IRA, you would not be required to take a required minimum distribution. Even if you take a distribution, it would not be considered income.

If you make a Roth IRA conversion, it is advisable to pay the income taxes from separate assets. If you do not make a conversion, the income from those separate assets would be hit with this 3.8% investment tax. Stately differently, the after-tax income that you would have received from the money used to pay the conversion tax will be decreased due to the new 3.8% investment tax.

The increased taxes for high-income taxpayers may only be getting started. The new taxes in the Healthcare Act help to pay for the benefits provided by the Act. Many have predicted that the cost of the new Act will substantially exceed the government’s estimates. If this is true, someone will have to pay for the additional costs.

Regardless of whether the new taxes fully pay for the Healthcare Act, someone needs to pay for the burgeoning federal deficit. High-income taxpayers will be a likely target. Any additional taxes imposed in the future will further enhance the benefit of having made a Roth IRA conversion in 2010.
 

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Our firm is assisting Executors and Trustees with the administration of several estates and revocable trusts of decedents who have died during 2010. Administering these estates has presented numerous challenges.

The first problem is that we do not know whether federal estate taxes will be reinstated retroactively. We are advising the Executors that there are two different sets of laws that could apply, either the law that is currently on the books, or another law that has not yet been written. We are guessing that a retroactive law, if one is enacted, will be similar to the law that existed as of December 31, 2009; however, there are no guarantees.

If there is no federal estate tax, this is great news for most of our estates. However, the price to be paid for having no federal estate taxes is carryover basis. I was not practicing law in the late 1970’s when the prior version of carryover basis was the law, but have been forewarned by various practitioners who were practicing during that time period. Carryover basis is even worse than I had imagined.

We are advising Executors to assume that carryover basis is the law. This means that the Executor needs to ascertain the cost basis of the decedent’s assets unless the total value of the assets is less than $1.3 million, or is less than $4.3 million if the decedent was married and leaves at least $3 million of assets to the spouse or a qualified marital trust. Fortunately, most publicly traded securities held in brokerage accounts now list the cost basis. Determining the cost basis of various other assets such as furniture, artwork, real estate and interests in closely held businesses is not so easy.

One revocable trust has a large holding in a single stock. The stock has performed well since the time of the decedent’s death and the Trustee would like to sell a substantial portion of this position. However, the decedent’s basis in the stock was very low and the beneficiaries do not want the Trustee to sell and incur a large capital gains tax. If carryover basis is repealed and stepped-up basis is restored, everyone will be delighted to sell the stock. By the time the law is settled, the value of the stock may have declined precipitously.

Another revocable trust makes a large charitable bequest that will only occur if federal estate taxes are reinstated retroactively. Neither the charity nor the alternate takers can make plans until the law is settled.

Another estate holds significant real estate holdings. The Executor would prefer not to sell the real estate in the current market. Sales are not necessary if there are no federal estate taxes, but sales will be necessary if federal estate taxes are reinstated retroactively. Waiting until the law is settled may be too late to raise money in time to pay taxes if that becomes necessary.

There are numerous income tax planning issues that must be addressed due to carryover basis and all of its complicated rules. There are also carryover basis strategies that should be considered prior to death when you know that death is imminent but have at least a few days to make changes. I plan to discuss these strategies in a future article.

Because of the Tennessee inheritance tax, Executors still have to obtain date of death values, and perhaps alternate valuation date values, for all assets owned by the decedent. This means that Executors for estates of 2010 decedents have more to do than ever before.

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The simplest estate plan for a married couple is for them to own everything jointly, with the result that everything will be owned by the survivor after the death of the first spouse to die. Unfortunately, the Federal estate tax and Tennessee inheritance tax laws penalize couples for taking the simple approach if their combined assets exceed $1 million in value. This is because the survivor’s estate will exceed the available exemptions from federal and Tennessee inheritance tax.

A better tax plan is for the couple to each own separate assets or to own assets as tenants-in-common. If the first spouse to die owns a tenancy-in-common interest in real estate or a brokerage account, the decedent’s Will can transfer these assets to a credit shelter trust for the primary benefit of the survivor. The credit shelter trust will not be subject to tax upon the subsequent death of the survivor.

The first spouse to die must own assets that can be transferred to the credit shelter trust. For Tennessee residents, this is not possible with assets that are owned jointly with a spouse, unless the form of ownership is specifically designated as tenancy-in-common. As in most states, there is a presumption in Tennessee that property held jointly by a husband and wife is held as tenants-by-entirety, rather than as tenants-in-common. This means that the assets will not be available to fund a credit shelter trust upon the death of the survivor.

In the Estate of Oscar Goldberg, the failure to change ownership of real estate to tenancy-in-common resulted in litigation with the IRS and unnecessary estate taxes of almost $400,000. When it comes to estate planning, simplicity may carry a high price tag for your children.
 

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Congress has learned that maintaining the uncertainty in the future of the federal estate tax system allows them to collect substantial campaign contributions from special interest groups. Federal estate tax laws have been in a state of flux since the passage of a 2001 law that gradually increased the estate tax exemption, decreased rates, and totally repealed estate taxes for the year 2010. The 2001 law was the result of an intense lobbying effort by a group of wealthy families that have spent more than $500 million in lobbying expenditures. These families want Congress to eliminate federal estate taxes. While certain Congressmen have benefited from these lobbying expenditures, other Congressmen have benefited from lobbying expenditures from various groups that wanted to retain the estate tax.

The enclosed article by the National Center for Policy Analysis titled The Politics of Estate Tax Reform predicts that Congress will reinstitute the estate tax at 2009 levels with an exemption of $3.5 million per person and a maximum rate of 45%, retroactive to January 1, 2010. Indeed, the President’s budget proposal favors this approach and the President recently signed legislation which increases the likelihood that exemptions and rates will be returned to the 2009 rates for the years 2010 and 2011 only. Under this approach, the estate tax exemption would decrease to $1 million and the maximum rate would increase to 55% beginning in 2012. Such a short-term fix would keep the issue alive so that Congressmen would be able to collect additional campaign contributions.
 

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The Congressional Research Service (“CRS”) has issued a report titled “Estate and Gift Taxes: Economic Issues.” The CRS is a “think tank” that provides reports to members of Congress on a variety of topics. Taxpayers spend over $80 million per year to fund the CRS. One controversial conclusion of the report is that

“…Only a tiny fraction of farms and small businesses face the estate and gift tax and it has been estimated that the majority of those who do have sufficient non-business assets to pay the tax. Moreover, only a small portion of the estate tax is collected from these family owned farms and small businesses, so that dramatically reducing estate tax rates or eliminating the tax for the purpose of helping these family businesses is not very target efficient.”

This report is supposedly based upon data from estate tax returns that have been filed. However, the conclusions drawn in the report are not realistic.

A lot of my clients have farms and small businesses. These clients worry a great deal about estate taxes. They purchase large life insurance policies to provide funds to be used to pay taxes. They establish and fund irrevocable trusts and various entities including limited liability companies and/or limited partnerships. They make gifts and sales to trusts for their children sooner than they would prefer if there were no estate taxes.

As mentioned in the report, some families are able to accumulate enough liquidity outside the business to pay taxes. In some cases, this means that the only asset left to pass on to children is the family business. When one or more children do not work in the business and cannot draw a salary from the business, this is not a happy result.

Perhaps my view is distorted because of the region in which I practice. Middle Tennessee probably has more valuable farmland than other areas of the country. The value is not necessarily based on the value of the land for farming. In many cases, the value of the farmland is artificially inflated by the development potential of the property.

Middle Tennessee also has a keen entrepreneurial spirit. I am constantly amazed by the ingenuity of my clients and how they have amassed a fortune from one or more business opportunities.

Nevertheless, the notion that reducing taxes on family businesses is not worthwhile clearly misses the mark. Owners of farms and successful family businesses spend a lot of time and money on planning strategies to cope with the liquidity crunch and distortions to their estate plan that are caused by estate taxes.

Members of the House of Representatives were not fooled by the Report. They understand that estate taxes create severe problems for owners of farms and family businesses. On December 3, 2009, they passed the Permanent Estate Tax Relief for Families, Farmers, and Small Businesses Act of 2009. Though this bill does not eliminate estate taxes, it seeks to ensure that married couples will be able to leave up to $7 million to their children without paying federal estate taxes. This bill has been forwarded to the Senate, where it faces an uncertain fate.
 

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Over the course of my career, I have worked with several clients who knew they had but a few months to live due to inoperable cancer. As a general rule, these clients have been mentally sharp when I have worked with them.

The knowledge that death will occur in the near future causes the client to be keenly focused on making sure their estate planning affairs are in order. It is basic to make sure that the client has incapacity documents such as a living will, health care power of attorney, and a financial power of attorney.

There are numerous financial matters to be considered. Perhaps ownership of assets can be changed to avoid probate or to provide tax benefits. Should gifts be made to children and grandchildren? Should a revocable trust be utilized in order to avoid probate? Beneficiary designations on assets such as retirement accounts and life insurance policies should be verified.

One married client changed the ownership of the house into his name and changed the beneficiary of his life insurance policy to his estate. These steps will provide his estate with enough assets to fund a credit shelter trust. The credit shelter trust will save substantial estate and inheritance taxes upon the subsequent death of his wife.

The estate planning steps outlined above would be equally effective for any client nearing the end of his or her life. Unfortunately, a lot of terminal illnesses incapacitate the client to the point that he or she is not able to accomplish them. The only “good” thing about terminal cancer is that it generally gives the client adequate time to get their affairs in order and to say their good-byes.
 

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The estates of a lot of Tennessee decedents pay Tennessee inheritance taxes but do not pay federal estate taxes. The federal estate tax exemption is currently $3.5 million. As of the date of this article, various members of Congress favor extending this exemption amount indefinitely into the future. The Tennessee inheritance tax exemption is currently $1 million. There does not appear to be much likelihood that Tennessee will increase its exemption to match the federal exemption.

The difference between the federal and Tennessee exemptions means that unmarried decedents who die with a taxable estate with a value between $1 million and $3.5 million will pay Tennessee inheritance taxes but not federal estate taxes. There are several things that can be done to reduce the value of assets for Tennessee inheritance tax purposes.

Some of these steps can be taken shortly before death. As an example, a parent might make a deathbed gift of a fractional interest in real property to a child with the goal of capturing a fractional interest discount for the remaining portion of the property when the parent dies. There are also various post-mortem decisions that can affect the value of the assets owned by the estate.

Even though the estate is not subject to federal estate taxes, the date of death value of the assets becomes the basis of the assets for federal income tax purposes. Basis will be relevant when the estate or the beneficiaries later sell the assets. Federal capital gains taxes are 15% and are scheduled to increase to 20% in the year 2011. If the beneficiaries live in a state outside of Tennessee that imposes a capital gains tax, this will make the capital gains tax rate even higher. The maximum Tennessee inheritance tax rate is 9.5%.

Since capital gains tax rates are higher than the maximum Tennessee inheritance tax rate, it is generally not advisable to take steps that reduce the value of the decedent’s assets for Tennessee inheritance tax purposes, unless it is known that the beneficiaries will continue to own the assets in the estate for several years. The reduction in the value of the estate will increase capital gains taxes by more than the Tennessee inheritance taxes that are saved.

Making tax-free annual exclusion gifts is still a good idea. It is better to give cash as opposed to an appreciated asset that will receive a free basis increase upon death. A cash gift reduces Tennessee inheritance taxes without increasing capital gains taxes.
 

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I am currently working with a client who plans to make $2 million of bequests to his favorite charities upon his death. His estate will receive an estate tax deduction for these bequests; however his estate will not receive an income tax deduction for these bequests.

I told him about a different method for making the payments that will require the cooperation of his wife. The plan works as follows:

1. His Will makes a $2 million cash bequest to his wife.
2. The Will makes a non-binding request for his wife to consider making gifts to his favorite charities.
3. After my client dies, his wife will receive $2 million and will make charitable gifts of $2 million.

The revised plan will have the following tax consequences: My client’s estate will receive a $2 million marital deduction for estate tax purposes. This replaces the $2 million charitable estate tax deduction that he would have otherwise received. His wife will get a $2 million income tax deduction. Since his wife will be in the highest income tax bracket (currently 35%), she will save $700,000 on her income taxes. Her income will not be large enough to receive the entire deduction in the first year. Rather, it will take about four years. Nevertheless, she will receive substantial income tax savings that would not have been realized if her husband had given the money directly to charity.

The risk for my client is that his wife will not make the charitable gifts. Legally, she can keep the money. My client trusts his wife to honor his wishes, especially since his wife likes most of his favorite charities.
 

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Family limited partnerships (or LLCs) are often used to obtain valuation discounts for estate and gift tax purposes. Appraisers typically conclude that the fair market value of an interest in a family limited partnership (“FLP”) is at least 35% less than the value of the assets owned by the FLP.

The IRS dislikes these discounts and has successfully challenged the discounts in several court decisions. As a general rule, the taxpayers were "sloppy" in the cases that the IRS has won. Errors were made either in funding, distributions, or record keeping.

When the FLP is properly funded and administered, taxpayers are able to substantiate the discounts. For every case in which the IRS has successfully disallowed discounts, there are many others where the court approved a discount or the IRS agreed to a discount without going to trial.

A case in point is the recent Rayford L. Keller et al v. United States decision. Mrs. Williams was in the hospital, dying from cancer. Six days before her death, she signed documents to establish an FLP to be funded with $240 million of bonds and $10 million cash.

The assets were not transferred to the FLP until one year after she died. Nevertheless, the Court ruled that her family was entitled to a 47.5% discount on the value of the bonds and cash that were transferred to the FLP.

I do not recommend waiting until death is imminent to establish an FLP. It is far better to establish the FLP when you have several years to live, and then to make gifts or sales of FLP interests when that is appropriate.

Detailed summary of Keller case by Steve Akers of Bessemer Trust Company, N.A.

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529 Accounts allow a family to set aside funds for the education of their children or grandchildren without having to pay income tax on the earnings of the plan. These accounts work well for the great majority of families. However, I often discourage my clients from establishing 529 accounts.

In order to avoid paying income tax on the earnings of the 529 account, the funds in the account must be used to pay for expenses of attending college. Tuition accounts for the largest portion of these expenses.

Federal and state gift tax laws allow individuals to pay tuition for another individual without such payment being considered a taxable gift. Tuition payments allow parents and grandparents to reduce the amount of their estate that will be subject to estate taxes upon their death.

Assume that a wealthy grandparent makes gifts to a 529 account for the benefit of a grandchild. Gifts by the grandparent to the 529 account are considered taxable gifts. Generally, the grandparent uses the $13,000 per year annual gift tax exclusion when making gifts to a 529 account.

When the grandchild attends college, the 529 account will be used to pay for the grandchild’s college expenses. The net result of the above example is that the grandparent “lost” the opportunity to make tax-free gifts of the grandchild’s tuition.

If the annual exclusion gifts to the 529 account had instead been made to a traditional brokerage account for the grandchild, the grandparent could have paid tuition without utilizing the funds in the brokerage account. The grandparent’s taxable estate would be reduced and the grandchild would have funds that could be used to make a down payment on a house or to supplement the child’s cash flow when entering the work force.

It is true that income taxes would have been paid on the earnings of the traditional brokerage account. However, this income tax cost does not offset the estate tax savings from being able to make a tax-free gift of tuition expenses. Furthermore, 529 accounts have internal fees and are restricted as to investment choices. These fees and investment limitations somewhat dilute the income tax savings associated with 529 accounts.

Affluent families should evaluate the overall tax ramifications before funding a 529 account to fund a child or grandchild’s college education.

For more information on 529 accounts, you can visit this link.
 

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UBS has agreed to provide the IRS with information regarding 4,450 United States investors with secret Swiss bank accounts (pdf).

The IRS originally found out about these accounts from a former UBS employee named Bradley Birkenfeld. Birkenfeld had been a member of a team of UBS private bankers who assisted wealthy Americans with the establishment of foreign bank accounts that were disguised through offshore corporations.

After resigning from UBS, Birkenfeld filed a claim for a whistleblower reward and then contacted the IRS, the Justice Department, the Securities and Exchange Commission, and a Senate Investigative panel. The whistleblower law provides generous rewards to persons who help the IRS catch tax cheaters.

Birkenfeld has been convicted for aiding and abetting tax evasion and will serve 40 months in prison. If he survives his prison stay, he may be a very wealthy man. An article titled, For American Who Blew Whistle, Only Reward May Be a Jail Sentence, by David Hilzenrath in the Washington Post, cites a man who helped write the whistleblower laws.  This man believes that Birkenfield is entitled to a reward totaling tens of millions of dollars.
 

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