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.

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.

 

 

You should carefully consider your answer if a friend or family member asks you to serve as his or her executor.

Most first time executors underestimate the number of tasks that must be completed by an executor. There is potential liability if something bad happens. For example, the beneficiaries want you to keep a certain asset and the value of the asset suddenly declines for reasons beyond your control.

Executors have to make difficult decisions. What is best for the estate as a whole may not be the best for particular beneficiaries. Finally, beneficiaries can be challenging to deal with. Beneficiaries often view the executor as preventing them from receiving their inheritance.

Keith Keisling sent me the following poem which summarizes some of the potential headaches faced by an executor.

THE EXECUTOR

I had a friend who died and he,
On earth so loved and trusted me,
That ere he quit this earthly shore,
He made me his executor.
He tasked me through my natural life,
To guard the interests of his wife,
To see that everything was done,
Both for his daughter and his son.
I have his money to invest,
And though I try my level best,
To do what wisely, I’m advised,
My judgment oft is criticized.

His widow once so calm and meek,
Comes, hot with rage, three times a week,
And rails at me, because I must,
To keep my oath appear unjust.
His children hate the sight of me,
Although their friend I’ve tried to be,
And every relative declares,
I interfere with his affairs.
Now when I die I’ll never ask,
A friend to carry such a task,
I’ll spare him all such anguish sore,
And leave a hired executor.

—Today and Tomorrow, Edgar A. Guest
(Chicago: Reilly & Lee Company, 1942)