The choices are many:
Some may be doubled.

By Philip J. Michaels

In Brief

Estate or Income Tax?

There a number of elections that affect both the U.S. estate tax return and the decedent's final income tax return and/or the fiduciary tax return. The author discusses elections with respect to the following matters:

* Medical and dental expenses

* Alternate valuation date

* Administrative expenses

* Deductions in respect of the decedent

* Principal vs. income

* Disclaimers

* Appreciated assets

* U.S. Savings Bonds

While most tax practitioners are more or less aware of the calculations and deductions involved in computing a decedent's estate tax obligation (U.S. Form 706), there still appears to be confusion with respect to certain elections that affect both the U.S. estate tax return and the decedent's final income tax return and/or the fiduciary tax return (Form 1041) for the decedent's estate.

Medical and Dental Expenses

The first election deals with the decedent's medical and/or dental expenses. For those medical or dental expenses incurred by the decedent before his or her death and paid by the decedent's estate within one year after date of death, the executor has a choice. The executor can elect to either deduct these expenses on Form 706 or on the decedent's final income tax return for the year in which the expenses were actually incurred. If the decision is made to deduct these expenses on the decedent's final income tax return, a statement that no estate tax deduction has been allowed with respect to this item should be attached to the return. However, the medical and/or dental expenses will not be deductible on the decedent's final income tax return unless they exceed 7.5% of the decedent's adjusted gross income for that return. Expenses that are not deductible because of this limitation cannot be taken on the 706 as a deduction. It follows that if any of these expenses are deducted on the decedent's final income tax return and are later reimbursed, this constitutes income to the estate and must be included on Form 706. Finally, under no circumstances can the medical or dental expenses be deducted on the estate's fiduciary income tax returns (Form 1041).

Alternate Valuation Election

Advisors should be fully conversant with the rules regarding alternate valuation and the step-up in basis of assets owned by the decedent at his or her death. The general rule under IRC section 2032 is that the basis of all property in the hands of either the estate or the beneficiary of the estate is stepped-up to either (1) the fair market value of the property as of the date of death or, (2) in the case of an election under IRC section 2032, the alternate value of such property.

The alternate value is the value of the property as of six months after the date of death except if particular property has been either distributed, sold, or exchanged within that six month period following the decedent's date of death. If it has been disposed of during that period, the value is the value on the date of such distribution, sale, or exchange.

The election must be made on Form 706 filed no later than one year after the time prescribed by law including any extensions. Once made, this election
to utilize the alternate valuation is
irrevocable.

The alternate value election may not be made unless it will decrease both 1) the value of the gross estate and 2) the sum of the Federal estate and generation skipping taxes that are payable. Thus, for Federal estate tax purposes, the election cannot be made if 1) there is no tax due because of a maximum marital deduction or charitable deduction or 2) the estate is less than the value (currently $600,000) required to file a Form 706.

State Elections. The election can be made solely for New York State purposes even if a Form 706 is not filed. This is done by filing, if required, Form ET-90. In those instances where a 706 is not filed but a ET-90 is filed, a basis discrepancy exists. For Federal purposes, the basis is the date of death value. For New York State purposes, if the alternate valuation is elected, New York is bound by the alternate value. Thus, when filing fiduciary income tax returns for an estate where capital gains may have been realized, a principal adjustment must be made with respect to the New York State fiduciary income tax return to adjust for the gain and or loss.

Administrative Expenses

Generally, administration expenses of an estate are deductible either on Form 706 or on the income tax return for the estate for the year in which the expenses are actually paid. If these types of administration expenses (usually legal and accounting fees) are deducted on the estate's 1041 and the deductions are in excess of income for that particular year, these excess deductions are lost and cannot be carried forward. The only exception to this rule is in the final year of the estate or trust. If it is the final year, the excess administration deductions will be "distributed" out to the respective individual beneficiaries or trust depending upon the decedent's testamentary plan.

Allocation for Tax Exempt Income. In those estates where there is tax exempt income and administrative expenses are deducted on the 1041, an allocation must be followed. As a result, a portion of the administration expenses will be lost. For example, assume the estate in a particular year has $100,000 of income, $60,000 in taxable interest and dividends, and $40,000 in tax exempt income. In that same year, the estate pays $10,000 of legal and accounting fees. Forty percent or $4,000 of the administration expenses (based on the fact that 40% of the gross income for the year is tax exempt income) will be lost and cannot be deducted on Form 1041.

The executor does have an election and could elect to deduct the legal and accounting fees on Form 706 (rather than on Form 1041) if he or she feels it would benefit the estate based on the tax brackets involved. Thus, in those estates where there is a large amount of tax exempt income, thought should be given to as to whether these type of expenses should be taken on Form 706 where they would be fully deductible or on Form 1041 and subject to allocation.

In dealing with expenses allocated to tax exempt income, the tax practitioner may wish to consider the following aggressive approach. In New York, for accounting purposes, deductions are allocated two-thirds to principal and one-third to income. Assuming again the estate has $10,000 of deductions, two-thirds or $6,666 will be allocated to principal and will be fully deductible; $3,333 will be allocated to income and assuming 40% represented the amount of tax exempt income, only 40% of $3,333 or $1,333 would be lost.

Again, if the executor elects to deduct the administration expenses on the estate's 1041, the executor must file a statement that no estate tax deduction for the item has been allowed.

Miscellaneous Itemized Deductions. If the administration expenses of the estate are to be deducted on the Form 1041, it must be determined whether these expenses are "miscellaneous itemized deductions," subject to the two percent of adjusted gross income floor. In the past, the IRS has taken the position that only those expenses "unique" to the administration of the estate or trust are not subject to the two percent floor. The question that has been litigated is what constitutes a "unique" expense? The principal case in this area is the O'Neill case (William J. O'Neill, Jr. Irrevocable Trust, 98 TC No. 17, 1992). The trustees of the O'Neill Trust engaged the services of an investment advisor. In Tax Court, the IRS was successful in subjecting the investment advisory fees incurred by the trust to the two percent floor. The court did indicate trustee commissions and accounting fees were unique to the trust and would not be subject to the two percent floor if they were mandated under state law or the trust agreement. However, on appeal to the Sixth Circuit (O'Neill v. Commissioner, 994 F.2nd 302, 93-1 U.S.T.C.), the court held the investment advisory fees were not subject to the two percent floor. In practice, it seems tax return preparers are, for the most part, taking the position that most expenses with respect to an estate or trust are "unique" and are not subject to the two percent floor.

Deductions in Respect of Decedent

There are certain items that can be deducted on both the Form 706 and the estate's 1041. These are routinely referred to as deductions in respect of the decedent (DRD). Examples of these types of deductions are the decedent's state income tax that can be deducted on both the 706 and the 1041. In addition, accounting fees attributable to the preparation of the decedent's final 1040 can also be deducted on the 706 and Form 1041. Finally, legal fees with respect to tax work incurred by the decedent during his or her lifetime may be deducted on both returns.

Allocations of Expense Between Principal and Income

Assume a $2,000,000 estate has incurred $50,000 of administration expenses and there are no other debts, expenses, or taxes due. In addition, assume the will of the decedent provides for a credit shelter trust with the balance of the estate passing into a marital deduction trust for the surviving spouse. The question is where should the $50,000 of administration expenses be deducted? Should they be deducted on the Form 706 or the 1041, and where is the greatest benefit to the estate or the surviving spouse?

If the decedent's will has been properly drawn, and if the administration expenses of $50,000 are deducted on Form 706, the credit shelter trust will be fully funded with $600,000 and the marital deduction trust will be funded with $1,350,000 ($1,400,000 less the $50,000 of administration expenses).

If the $50,000 of administration expenses are deducted on Form 1041 for the estate, the marital deduction trust will be fully funded with $1,400,000 of property and the credit shelter trust will be reduced to $550,000 ($600,000 less the $50,000 of administration expenses).

Thus, if there is no available unified credit at the decedent's death and the residuary estate passes to or for the benefit of a surviving spouse, all administration expenses must be taken on the 706 even though there is no tax benefit. If these administration expenses are deducted on Form 1041, the IRS will deem the expenses (in the case above, $50,000) to be property that does not qualify for the marital deduction and the $50,000 will be subject to an estate tax. Because there are no other beneficiaries in our example other than the surviving spouse, an interrelated tax calculation and, in this example, a tax of almost $50,000 would occur.

In the Hubert case decided in March 1997, the decedent's will granted his executors the discretion to pay expenses from income if they so chose. By permitting the decedent's estate to allocate administration expenses totally against the income earned by the estate, the result was that (based upon the above example) the $50,000 of expenses were fully utilized on the Form 1041, and the marital deduction trust was reduced to $1,350,000 with the credit shelter trust being fully funded with $600,000. In addition, there is no interrelated calculation, and thus no estate tax payable. The question that must be dealt with in each case that relies on Hubert is whether these deductions were "material" with respect to the overall estate? In Hubert, the size of the estate was in excess of $30,000,000 and the expenses involved were approximately $2,000,000.

Possible Adjustments. With respect to New York estates, there are two adjustments that should be kept in mind when an executor is contemplating making elections that affect income and principal distributions of an estate. The first adjustment is based on the Warms case, which has now been codified in New York. The best way to illustrate this first adjustment is through an example. Assume the decedent left her entire estate in trust for her child. The trust is to last for the child's life with the remainder passing to the decedent's grandchild. It is a taxable estate and the executors have elected to take $50,000 of administration expenses on the 1041 rather than on Form 706. Obviously if the expenses are deducted on the Form 1041, the estate tax will be increased. The income beneficiary has thus benefitted to the long-term detriment of the remainderman or grandchild. The adjustment must be to decrease the benefit the income beneficiary now receives and increase the ultimate principal the remainderman will eventually inherit. This is accomplished by computing the estate tax with and without the deductions in question. The difference is then taken from the income account to reimburse the principal account.

The next adjustment is based on the Holloway case (New York). This case involved the "trapping" distribution from an estate. Whenever money or property is distributed from an estate, it takes out with it an equal amount of distributable net income (DNI). (For example, if the estate has $10 of income and $6 of cash and/or property is distributed to A in the same year, A is assumed to have received $6 of income.) Again, assume the same facts that the entire estate is left in trust for the child with the remainder passing to the grandchild. In a particular year, the executor distributes DNI to the trust. Also assume the trust does not make any current distributions to the child and thus the trust pays the income tax on the income it had received from the estate that was "trapped" in the trust. This is an obvious benefit to the income beneficiary. Again, the adjustment is to reimburse the principal from the amount due the income beneficiary in future years. It should be noted, however, that based upon the 1986 Tax Reform Act that increased the income tax rates within a trust, the usual practice is to force income out to the income beneficiaries and not have it remain in the trust.

Disclaimers

The next type of election that should be considered is the use of disclaimers. A disclaimer is a beneficiary's refusal to accept a bequest or property from an estate. If someone does execute a valid disclaimer, they are deemed to have "predeceased" the decedent and the will or testamentary instrument will be construed in that manner. Besides potentially passing property to another beneficiary or another generation through the use of a disclaimer, disclaimers can also be utilized to "fix" or correct certain bequests. For example, assume the draftsman had intended to qualify a trust for the marital deduction but had included a child as a potential income beneficiary together with the surviving spouse. Obviously, this type of a trust does not qualify for the marital deduction. However, the child, if he or she wishes, could execute a disclaimer renouncing all interest in the trust during the surviving spouse's lifetime. In this manner, the sole income beneficiary will be the surviving spouse and the trust would then qualify for the estate tax marital deduction.

The disclaimer or renunciation must be in writing and executed within nine months of the date of death or the creation of the particular interest being disclaimed. If a minor is involved, the disclaimer must be executed within nine months after the minor attains the age of 21. The person executing the disclaimer must not have accepted any interest or benefits from the property being disclaimed. In addition, the property must pass without any direction by the disclaimant. The exception to this rule is the surviving spouse who is permitted to disclaim property into a trust (typically a credit shelter trust) of which he or she is the beneficiary.

Disclaimers are also extremely helpful in those cases where the decedent and his or her surviving spouse executed proper wills but left all their property in jointly-held accounts. Usually, to properly fund the credit shelter trust, a series of disclaimers must be executed. However, only one-half of the value of the jointly-held property is permitted to pass into the estate and used to fund the credit shelter trust. For example, if the decedent and his surviving spouse had a $600,000 brokerage account and a disclaimer is properly executed by the surviving spouse, only $300,000 of the brokerage account is permitted to pass into the estate and thus into the credit shelter trust.

Appreciated Assets

When the executor of an estate sells appreciated assets, the capital gains are usually allocated to principal. These types of gains are not included in DNI and in most cases are not distributed out to the beneficiaries of the estate. The only exception to this is the final year of an estate when capital gains or net capital losses are permitted to be distributed.

There are certain rules that apply when the executor of an estate is considering distributing appreciated assets to a beneficiary. If an appreciated asset is used to satisfy the bequest of a specific dollar amount, the estate will realize a gain on such distribution. For example, assume beneficiary A is to receive a cash bequest of $1,000 under the decedent's will and the estate is holding a particular stock that at the date of death was worth $6 per share but has now appreciated to $10 dollars per share. Obviously, if 100 shares of this $10 stock are distributed to beneficiary A, the beneficiary would have received $1,000 from the estate. For tax purposes this distribution is treated as if the estate had sold the stock, realized $400 ($4 per share) of capital gain, and distributed $1,000 of cash to A. The executor can also have the estate realize a loss if depreciated property is distributed under similar circumstances.

In those situations where the will calls for the funding of a pecuniary formula bequest, such as a credit shelter bequest, the same result can occur. Thus, if the executor waits two years from the date of death to fund a $600,000 credit shelter bequest and uses appreciated stock with a date of death value of $500,000, the estate will realize a $100,000 capital gain. The best way to avoid this problem is to fund the credit shelter trust as early as possible during estate administration. However, if assets that have appreciated in value are distributed to residuary beneficiaries, the estate will not realize any capital gain.

IRC Sec. 643 Election. A special election is set forth in IRC section 643(e) that permits the executor to elect to recognize gain (or loss) on the distribution of assets to a residuary beneficiary. The gain or loss is based upon the basis in the hands of the executor and the fair market value on the date of distribution to the residuary beneficiary. If this election is made, it applies to all distributions made by the executor during that particular tax year. The result from a tax perspective is twofold. First, the distribution of the appreciated property (based on its fair market value on the date of distribution) carries out DNI to the beneficiary. Secondly, if the property has appreciated in value, and the executor makes the appropriate election, the estate will realize a taxable gain.

Under what circumstances should an executor elect to use IRC section 643(e)? If it is the final year of the estate, it may be a good idea to utilize Section 643(e) and realize a capital loss at the estate level; the capital loss will then be distributed to the beneficiary. The beneficiary could then use the capital loss on his or her own personal 1040. Another use would be to realize gains or losses at the estate level that would then be offset against other gains or losses within the estate on the estate's 1041. Finally, it might make sense to recognize a capital gain in the final year of the estate that would then be distributed to the beneficiary. If the beneficiary has capital losses, the capital gain may then be offset on the beneficiary's personal 1040.

U.S. Savings Bonds

The final area of discussion is the tax planning available regarding U.S. Savings Bonds. Series E Bonds were originally issued at 75% of face value, after January 1, 1980; Series EE Bonds were issued at a 50% discount.

The interest on these types of U.S. Savings Bonds is not taxable until either a) the bonds are redeemed, b) the bonds are held until maturity, or c) the holder of the bonds elects to have the interest taxed to him or her on an annual basis.

Before the Series EE Bonds mature, they may be converted into Series HH Bonds. HH Bonds pay interest on a semiannual basis. The income accrued while the taxpayer held the EE Bonds is deferred until the HH Bonds themselves have matured. When the HH Bonds are actually issued by the government, the Federal Reserve literally types on the face of the bond the amount of the interest that has accrued and that must some day be subject to income tax.

At death, all accrued income is subject to both estate and income tax. This is an example of an income in respect of a decedent item (IRD). The value to be used on the Form 706 is the date of death redemption value for the particular bond.

The elections the executor should consider with respect to U.S. Savings Bonds are as follows:

* Elect to accrue all income on the decedent's final 1040 and pay the necessary income tax. This income tax may then be deducted on the estate's Form 706.

* If the beneficiaries of the estate are in low income tax brackets, the estate could redeem all the bonds and distribute out the income (DNI) to the beneficiaries.

* The bonds could be distributed in-kind to the beneficiaries without realizing gain or loss. The beneficiaries would then decide whether to accrue the income on an annual basis or hold the bonds to maturity.

There is no step-up in value regarding U.S. Savings Bonds and all accrued income since the date of purchase must be accounted for when the bonds are eventually redeemed. *