n o r t h e r n t r u s t © 2015 northern trust corporation northerntrust.com james ciarlette...

N O R T H E R N T R U S T

© 2015 Northern Trust Corporation northerntrust.com

James CiarletteSenior Vice PresidentThe Northern Trust [email protected]

Income Tax Planning and Administration in Decedent’s Estates

Mairav RothsteinVice President and Tax CounselThe Northern Trust [email protected]

LEGAL, INVESTMENT, AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice, or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.

http://www.northerntrust.com/



Part 1: Techniques for Maximizing the Basis Step Up at Death



3 Income Tax Planning and Administration in Decedent’s Estates

Techniques for Maximizing the Basis Step Up at Death

Donating rapidly appreciating assets to a defective grantor trust not includible in the grantor’s estate minimizes transfer taxation. Non-taxable repurchase following appreciation brings the low basis assets back into the grantor’s estate to capture the step up in basis at death.

Grantor Buys Low Basis Stock from Defective Grantor Trust

Step 1: Fund GRAT with low basis stock. Prior to IPO, founder of a successful closely held business funds a 2 year GRAT with shares valued at $2 million.

Step 2: GRAT remainder is payable to an intentionally defective grantor trust benefitting the grantor’s descendants. At the end of the GRAT term, the remainder (valued at $10 million after the company was successfully taken public) is transferred to an intentionally defective grantor trust benefitting the grantor’s descendants.

Step 3: Grantor buys low basis post IPO shares for cash. The sale between the Grantor and the defective grantor dynasty trust is non-taxable. The low basis shares will receive a step up in basis at the Grantor’s death, and the dynasty trust enjoys appreciation without taxable gain.



Discretionary In-Kind Distributions to BeneficiaryIn kind principal distributions to a dying beneficiary will be includible in his/her estate, and thus receive a step up in basis. The success of this strategy depends on the following elements:

Value of basis step up is greater than the estate tax incurred by the estate of the recipient beneficiary as a result of the distribution.

The discretionary distribution to the beneficiary will not be deemed a breach of fiduciary duty.

The other beneficiaries of the distributing trust have no legal right to contest the discretionary distribution. If not then:

(1) the distribution may be a taxable gift made by the other beneficiaries; and

(2) the basis step up may be disallowed under Code Section 1014(e) if those beneficiaries receive the distributed assets from the deceased beneficiary’s estate.



Maximize Estate Inclusion Using Portability

Prior to 2011, a married couple owning assets in excess of the unified credit shelter amount could avoid estate taxation only by establishing a credit shelter trust at the death of the first spouse.

Assets within the credit shelter trust would be excluded from the estate of the surviving spouse, thereby avoiding estate taxation, but losing the benefit of the basis step up when the survivor died.




Portability: After 2010, the executor of a married decedent may elect to preserve his/her unused gift and estate exemption (called the “deceased spouse’s unused exemption” or “DSUE”) for use by the surviving spouse or his/her estate.

When the first spouse dies, the entire estate is placed in a QTIP marital trust and the executor files a DSUE election.

Assets of the QTIP marital trust are includible in the estate of the surviving spouse and thus receive a step up in basis. Using the DSUE, assets equal to the sum of both spouse’s unified credit shelter amounts are exempt from estate tax when the surviving spouse dies.




Unlike the unused gift and estate tax exemption, the unused GST exemption of the first spouse to die is not portable. However, a reverse QTIP election effectively preserves the GST exemption of the donor spouse by allowing the donor spouse to remain the GST transferor of the trust even after those assets are included in the estate of the surviving spouse for estate and income tax purposes.

Reverse QTIP Election

Under Internal Revenue Code Section 2652, when establishing a QTIP marital trust, the estate of the first spouse to die may “elect to treat all of the property in such trust for purposes of this chapter as if the election to be treated as qualified terminable interest property had not been made.”



Part 2: Income Tax Rules Unique to Decedent’s Estates




Income Tax Rules Unique to Decedent’s Estates

Cash Basis Taxpayer

Accrued but undistributed income, e.g., deferred compensation [including IRAs and 401(k)s]

Income in which the decedent had a contingent interest at death, e.g., proceeds of a lawsuit

Income in Respect of a Decedent or “IRD”IRD is defined as “amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent.”

Income that accrued as a result of the decedent’s death, e.g., decedent dies while employed under a contract which pays a bonus upon termination of employment

Accrual Basis Taxpayer

Code Section 691 – Taxation of Income in Respect of a Decedent


691(a)(1)The amount of all items of gross income in respect of a decedent which are not properly includible in respect of the taxable period in which falls the date of his death or a prior period . . . shall be included in the gross income, for the taxable year when received, of:(A) the estate of the decedent, if the right to receive the amount is acquired by the decedent's estate from the decedent;(B) the person who, by reason of the death of the decedent, acquires the right to receive the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent; or(C) the person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right.

Income Tax Rules Unique to Decedent’s EstatesCode Section 691 – Taxation of Income in Respect of a Decedent

IRD is included in the gross income of the person to whom the right to such income passed by reason of the decedent’s death or through distribution by the decedent’s estate (via bequest or devise), or to a remainder beneficiary upon termination of a trust.



EXAMPLE

Decedent, a cash basis taxpayer, was a lawyer who died with receivables totaling $50,000 and an IRA valued at $1 million, the designated beneficiary of which was her revocable trust. Under the terms of the revocable trust, the decedent’s retirement plan interests are payable in equal shares to her daughter and two sons, except that the younger son’s share is payable to a creditor protection trust for his benefit, which terminates only at his death. Decedent’s estate was liable for $500,000 of estate tax.

During the administration of the decedent’s estate and revocable trust, $40,000 of the receivables are collected and the decedent’s RMD was distributed to the revocable trust. In the following year, upon termination of the revocable trust, the trustee allocates one third of the IRA to each of the decedent’s daughter and older son, and the remaining third to the younger son’s trust. Following the administrative period, the remainder beneficiaries each received a third of the remaining $10,000 of receivables. The trustee of the younger son’s trust distributed the IRA to him upon receipt from the revocable trust.

Code Section 691 – Taxation of Income in Respect of a Decedent



The following are items are income in respect of a decedent:

The decedent’s income accrued during her lifetime, but, because it was not collected before she died, it was not includible in her final return.

Deferred compensation is a form of accrued but undistributed income. Although the decedent earned the money during her lifetime, she is treated as having received only those amounts paid out of the IRA before she died.

RECEIVABLES IRA



The following parties are taxed on the IRD:

Estate

Receivables totaling $40,000 received during estate administration

Revocable Trust

RMDs withdrawn during estate and trust administration

Daughter - One third share of $10,000 receivables paid after estate administration, and

distributions from inherited IRA solely for her benefit

Older Son - One third share of $10,000 receivables paid after estate administration, and

distributions from inherited IRA solely for her benefit

Trust for Younger Son - One third share of $10,000 receivables paid after estate administration; and

entire IRA distributed to younger son from the trust



Under Code Section 691(c), the recipient of IRD may deduct the amount of estate tax paid that is attributable to the income.

Section 691(c)

A person who includes an amount in gross income under subsection (a) shall be allowed, for the same taxable year, as a deduction an amount which bears the same ratio to the estate tax attributable to the net value for estate tax purposes of all the items described in subsection (a)(1) as the value for estate tax purposes of the items of gross income or portions thereof in respect of which such person included the amount in gross income (or the amount included in gross income, whichever is lower) bears to the value for estate tax purposes of all the items described in subsection (a)(1).

Value of IRD Items Includible in

Taxpayer’s Income)(691(c)

Deduction

Estate Tax Paid on All IRD Items

X=( )Value of All IRD Items( )



Code Section 645 – Election to Treat Revocable Trusts as Part of the Estate

Under Code Section 645, the trustee of one or more qualified revocable trusts may elect (in conjunction with the decedent’s executor) to treat such trust(s) as part of the decedent’s estate for income tax purposes.

Section 645(a)

For purposes of this subtitle, if both the executor (if any) of an estate and the trustee of a qualified revocable trust elect the treatment provided in this section, such trust shall be treated and taxed as part of such estate (and not as a separate trust) for all taxable years of the estate ending after the date of the decedent's death and before the applicable date.



ElementsTiming

*Deadline - election must be made by the filing deadline for the Estate’s first income tax return

*Termination date - if no estate tax return is filed then 2 years after decedent’s death, otherwise, 6 months after issuance of a closing letter for a filed estate tax return Parties*Estate’s executor or personal representative (if any)

*Trustee of one or more “qualified revocable trusts”

QUALIFIED REVOCABLE TRUST – a trust described in Code Section 676, i.e., created by the decedent and over which at the time of his/her death the decedent or a non-adverse party had the power to re-vest the property in him/herself





Take a charitable set aside deduction for undistributed ordinary income and capital gains attributable to a charitable beneficiary’s share in the trust

Election permits the revocable trust to take advantage of rules that apply only to estates.

Elect a fiscal year to defer income taxation

Avoid loss limitations for related parties under exception for loss recognition by a decedent’s estate when satisfying a pecuniary bequest by distributing appreciated property

Take advantage of state taxation exemptions applicable to only to decedent’s estates, e.g., no Illinois replacement tax imposed on decedent’s estates


Code Section 642(g) – Disallowance of double deduction

Income Tax Rules Unique to Estates

The decedent’s estate may use deductible expenses to reduce either the value of assets subject to estate tax or the income of the estate subject to income tax, but not both.

642(g) Disallowance Of Double Deductions

Amounts allowable under section 2053 or 2054 as a deduction in computing the taxable estate of a decedent shall not be allowed as a deduction (or as an offset against the sales price of property in determining gain or loss) in computing the taxable income of the estate or of any other person, unless there is filed, within the time and in the manner and form prescribed by the Secretary, a statement that the amounts have not been allowed as deductions under section 2053 or 2054 and a waiver of the right to have such amounts allowed at any time as deductions under section 2053 or 2054. Rules similar to the rules of the preceding sentence shall apply to amounts which may be taken into account under section 2621(a)(2) or 2622(b). This subsection shall not apply with respect to deductions allowed under part II (relating to income in respect of decedents).


Code Section 642(g) – Disallowance of double deduction


Whether to deduct from income or estate assets depends on which tax rate is higher under the circumstances. The following factors will determine the effective income tax vs. estate tax rate:

Tax base: the size of the estate as compared to its gross taxable income for the year

State income and estate taxation: the same estate should take an income tax deduction in a high income tax, no estate tax jurisdiction, but take an estate tax deduction in a low/no income tax jurisdiction which does impose estate tax

Character of income: whether the income is subject to ordinary vs. preferred income tax rates, the applicability of the 3.8% Medicare tax on NII, and the existence of IRD (for which the Section 691(c) deduction will later be available)


Code Section 454(a) – Election by Executor to Include Accrued Series E Bond Income in the Decedent’s Final Income Tax Return


In general, the owner of a Series E or Series EE Bond (for which accrued income is taxable in the year the bond is redeemed) may elect to treat accrued income as taxable annually.

454(a) Non-Interest-Bearing Obligations Issued At A Discount

… taxpayer may, at his election made in his return for any taxable year, treat such increase as income received in such taxable year. If any such election is made with respect to any such obligation, it shall apply also to all such obligations owned by the taxpayer at the beginning of the first taxable year to which it applies and to all such obligations thereafter acquired by him and shall be binding for all subsequent taxable years, unless on application by the taxpayer the Secretary permits him, subject to such conditions as the Secretary deems necessary, to change to a different method.


Code Section 454(a) – Election by Executor to Include Accrued Series E Bond Income in the Decedent’s Final Income Tax Return


The Treasury has issued Revenue Rulings holding that the executor of a decedent’s estate (and the trustee of a revocable trust which owned such bonds) may make the election on the decedent’s final return. The executor may (but need not) make a separate election on behalf of the estate. The following factors determine whether to make the election in the decedent’s final return:

Income tax rates: difference in marginal rates between the decedent and the recipients of the Series E bonds

Deferral: length of time before the bonds will mature, thereby requiring payment of income tax by the recipients

Estate tax and the benefit of the Sec. 691(c) deduction: whether payment of income tax in the decedent’s final return will reduce the estate tax liability and the extent to which the deduction from IRD will offset the additional estate tax.



Part 3: Trends and Timely Tips


22



Navigating State Income Taxation

Trends and Timely Tips

The majority of states tax testamentary and inter vivos irrevocable trusts based upon the existence of one of the following factors, or based upon a combination thereof (in descending order of frequency):

Domicile or residency of the decedent at death or of the grantor at the time the trust became irrevocable

State of administration

Residency of the trustee(s) during the year

Residency of beneficiary(ies)




About 14 states treat an irrevocable trust as a resident of the state if the decedent or grantor was a resident upon creation. Due to federal constitutional concerns over a lack of nexus, taxability has been modified based on other factors, such as non-residency of beneficiaries or lack of other contacts with the state, so that such modifications apply to approximately half of the states using the grantor’s residency to define residency of a trust.

Permit deduction from tax based on income attributable to non-resident beneficiaries

Treat resident trusts as exempt from state taxation where none of the trust’s fiduciaries, assets, or income are located or arise in the state

Limit taxation of inter vivos trusts to scenarios where the trust has at least one other contact with the state

Require at least one other contact with the state to be defined as a resident by statute




Less controversial, but still debatable, are issues relating to taxation based on residency of trustee(s) and location of trust administration. Note that approximately 18 states base residency on residency of the trustee or the location of administration.

Which parties are “trustees?” Trust protectors? Investment advisors? Distribution committees?

Where is the trustee resident? Fiduciary committee comprised of individuals having disparate states of residency? Corporate trustee with offices all over the world?

What is the location of administration? Majority of activities? Fiduciary significance of the types of activities?




When creating and administering trusts, consider how to reduce state income taxation by replacing trustees, modifying fiduciary roles, and moving the location of administrative activities, especially via decanting.

Transfer ownership of real and tangible property to a corporation or an LLC

Transfer fiduciary duties to non-residents while retaining resident’s ability to advise

Remove resident trustees and replace with non-residents


Foreign Grantors, Estates, Trusts, and Beneficiaries: Special Considerations


The existence of non-U.S. persons as key parties to an estate or trust may cause the entity or its beneficiaries to be subject to reporting and income taxation under Chapters 3 and 4 of the Internal Revenue Code.

Foreign Estate

3 factors determine foreign status:

Location of assetsCountry of domiciliary administrationNationality/residency of PR

Foreign Trust

2 conditions necessary for domestic status:

U.S. court has primary jurisdictionU.S. persons control all substantial decisions

Foreign Grantor or Beneficiary

Non-resident alien = non-citizen, non-green card holder, not resident for at least 183 day in the year




Foreign estates and foreign non-grantor trusts are subject to U.S. tax at a flat 30% rate (unless treaty provisions apply) on undistributed income from a trade or business effectively connected to the U.S., gains from the disposition of U.S. real estate, and U.S. source “fixed, determinable, annual or periodic” income – interest and dividends (“FDAP”). Under FATCA, a foreign trust may be deemed a foreign financial institution and, unless such trust is compliant, subject to 30% FATCA withholding, not reduced by income tax treaties.




Beneficiaries of foreign estates and foreign non-grantor trusts are taxed on distributable net income (“DNI”) in accordance with their domestic/foreign status.

NB: DNI OF A FOREIGN TRUST INCLUDES NET ORDINARY INCOME AND CAPITAL GAINS.

Undistributed DNI is accumulated and deemed distributed (or “thrown back”) to U.S. beneficiaries in future years when distributions exceed current DNI. Accumulation distributions are taxed at ordinary income tax rates (regardless of the original character of the income received and undistributed in a prior year) and the beneficiary is subject to an interest charge on the tax.




Foreign estates, trusts, and beneficiaries require alternative and/or additional reporting to the Internal Revenue Service.

Forms W-8: BEN, BEN-E, ECI, EXP, IMY

Report information establishing the foreign income and FATCA status of an estate, trust or beneficiary

Forms 1042 and 1042-S

Report tax withheld under Chapter 3 (taxation of U.S. source income) and Chapter 4 (FATCA)

Form 8966

Report FATCA compliance information for foreign financial institutions

Forms 3520 and 3520-A

Report gifts to U.S. persons from non-resident aliens, foreign entities, or foreign estates (minimum $100,000 from individuals and estates, $15,385 from other entities

Report distributions to U.S. persons from foreign trust

Report ownership under Code Sections 671-679 of foreign trusts

Report the creation of or transfer of assets to a foreign trust by a U.S. person

Report the existence of loans between related foreign trusts and U.S. persons

NB: Penalties of 35% of unreported amounts (with a minimum of $10,000) apply to unreported events


Additional Medicare Tax on Net Investment Income


NET INVESTMENT INCOME (“NII”) = gross income other than (i) compensation or self-employment income, (ii) proceeds from a trade or business (other than trading financial instruments) in which the recipient materially participates, and (iii) qualified plan distributions.

1411(a)(2) Application To Estates And Trusts

In the case of an estate or trust, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax of 3.8 percent of the lesser of—(A) the undistributed net investment income for such taxable year, or(B) the excess (if any) of—

(i) the adjusted gross income (as defined in section 67(e)) for such taxable year, over(ii) the dollar amount at which the highest tax bracket in section 1(e) begins for such taxable year.

For tax years starting after 2012, an additional 3.8% tax is imposed on some or all of the net investment income of an estate or trust.


Additional Medicare Tax on Net Investment Income


The NII of an individual is subject to the 3.8% Medicare Tax only to the extent it exceeds a “threshold amount” of $200,000 for a single taxpayer and $250,000 for taxpayers who are married, filing jointly. Because these threshold amounts are much greater than the corresponding threshold amount of an estate or trust ($12,150 for 2014 and $12,300 for 2015), NII will often be subject to the 3.8% Medicare Tax if retained by the estate or trust, but not if distributed to the beneficiaries.

For new trusts, establish a practice of including capital gains in DNI

Coordinate receipt of NII with estate’s termination

Convert/create a unitrust for which capital gains are included in DNI


The 65-Day Election


The fiduciary of an estate or trust may elect to treat certain distributions made within the first 65 days of a tax year as having been made during the prior tax year by making an irrevocable election on the entity’s income tax return for the first year. The election can be made only for distributions less than or equal to the greater of undistributed DNI or undistributed trust accounting income (not otherwise required to be distributed). The fiduciary may choose among distributions made within the first 65 days to which the election will apply.

663(b)

(1)General rule.— If within the first 65 days of any taxable year of an estate or a trust, an amount is properly paid or credited, such amount shall be considered paid or credited on the last day of the preceding taxable year.(2)Limitation.— Paragraph (1) shall apply with respect to any taxable year of an estate or a trust only if the executor of such estate or the fiduciary of such trust (as the case may be) elects, in such manner and at such time as the Secretary prescribes by regulations, to have paragraph (1) apply for such taxable year.


The 65-Day Election


Why make the election?

Prevent the accumulation of DNI for trusts subject to throwback tax

Make non-taxable distributions when trust accounting income exceeds DNI

Take time to calculate and compare the taxability of the income to the estate or trust vs. to the beneficiaries


Section 67(e) Final Regulations: Miscellaneous Itemized Deductions Not Subject to the 2% Floor


Effective for tax years beginning in 2015, unless an exception applies, miscellaneous itemized deductions of an estate or trust will be fully deductible only if they represent fees not commonly incurred by individual.

Fees (Usually) Subject to the 2% Floor

(a) ownership costs(b) tax preparation fees (other than for estate tax returns, generation-skipping transfer tax returns, fiduciary income tax returns, and decedents’ final income tax returns)(c) investment advisory fees (d) appraisal fees

Fees Not Subject to the 2% Floor

(a) probate court fees(b) fiduciary bond premiums(c) fees for publishing notices legally required in the administration of a decedent’s estate(d) costs of certified copies of a death certificate(e) costs of preparing fiduciary accountings


Section 67(e) Final Regulations: Miscellaneous Itemized Deductions Not Subject to the 2% Floor


Fiduciaries charging a bundled fee are required to reasonably allocate fees between those subject to the 2% floor and those that are not. However, if the fiduciary fees are not charged on an hourly basis, only investment advisory fees must be “unbundled” or separately stated.

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Please contact me with follow up questions.

Mairav Rothstein(212) [email protected]

Q & A

LEGAL, INVESTMENT, AND TAX NOTICE: This information is not intended to be and should not be treated as legal advice, investment advice, or tax advice. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel.


Biographies

Mairav Rothstein is a Vice President at The Northern Trust Company, Chicago. She is one of a Tax Counsel team of three tax lawyers, and a member of Wealth Planning Advisory Services, a unit within the Wealth Management Group. In that role, Mairav fields questions ranging across the Internal Revenue Code (and state tax statutes), but focuses on federal and state fiduciary income taxation, charitable tax and compliance, and tax aspects of IRAs.

Prior to joining The Northern Trust Company in 2005, Mairav was at Levin & Schreder, Inc. for three years, where she worked as an estate planning associate, focusing primarily on transfer and income tax planning for high net worth clients. Prior to that, she was an associate in the Trust and Estates department in the New York office of Kirkland & Ellis.

Mairav received a B.A. degree, cum laude, from Barnard College and a J.D. degree, with honors, from the University of Chicago.

Ph: (212) 339-7427E: [email protected]

Mairav RothsteinVice PresidentTax Counsel


Biographies

Jim is a manager in Wealth Planning Advisory Services. In his role, Jim oversees the Family Education and Governance, Philanthropy, Business Owner Consulting and Wealth Transfer disciplines. He also works closely with Tax Counsel to address tax related issues affecting IRAs, Charities, Trusts and client reporting.

Jim previously managed Global Client Tax Services. In that role Jim directly oversaw managers of multiple client tax units including fiduciary income tax, global family office tax, personal tax, charitable tax, corporate and institutional tax and related tax support functions. Jim participates in the development of processes for the unit to ensure compliance with federal and state taxing authorities and manages the compilation, analysis, and production of internal management reports. Prior to that, Jim managed the Global Family Office Tax Services team and the Fiduciary Income Tax Services team, which were responsible for reviewing and preparing annual 1099 statements, agency letters, and trust and partnership tax returns for those groups’ respective clients. Jim also managed the Tax Technology team, the group responsible for the workflow, process and tracking of all tax department functions. Jim began his management career at Northern by managing the Personal Tax Service team, which is responsible for preparing and reviewing clients’ income tax and gift tax returns.

Jim began his career at Northern Trust as a tax technician within the Personal Tax Department.

Prior to joining Northern Trust Jim worked ten years in public accounting with Clifton Gunderson LLC in Joliet.

Ph: (312) 444-5404E: [email protected]

James CiarletteSenior Vice PresidentTax Manager

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