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April 1989

The final year of an estate-special rules. (estate planning) (column)

by Wolosky, Gabe M.

    Abstract- The final year of an estate carries several deductions which merit considerable attention from estate planners. Administrative expenses are deductible from an estate on a pre-tax basis and can also be deductible from the estate income for income tax purposes. Unused net capital losses can be passed through to beneficiaries. An estate is also allowed to deduct passive losses upon disposal of a passive activity during its final year. Additionally, the final year can be a short year that enables acceleration or deferment of pass-through benefits.

The observation "It ain't over 'til it's over," is as true in estate planning as it is in baseball. Special rules applicable to categories of deductions in the final year of an estate offer unique planning opportunities.

Administrative Expenses

Administrative expenses, such as attorney's fees and executor's commissions, are deductible in determining the taxable estate for estate tax purposes. Alternatively, these deductions, though chargeable either partially or in whole to principal, are permitted deductions from estate income for income tax purposes. However, no deduction is allowed for income tax purposes if a deduction has been allowed for estate tax purposes. A waiver of the right to deduct administrative expenses on the estate tax return should be filed with the income tax return.

It would be desirable to take deductions against estate income where, for example, as a result of the marital deduction and the unified credit, no estate tax is due.

The 2% floor on "miscellaneous itemized deductions" does not apply to "deductions for costs which are paid or incurred in connection with the administration of the estate or trust and would not have been incurred if the property were not held in such trust or estate" IRC Sec. 67(e).

If administrative expenses are taken as an income tax deduction, a decision must be made as to whether to use these deductions to offset estate income or to pass deductions for administrative expenses through to beneficiaries on the final fiduciary return. The option of making deductions available to estate residuary beneficiaries is available only in the final year of an estate.

In each year other than the final year of an estate, administrative expenses paid during the year may be offset against estate income. In the final year, if estate income is less than the administrative expenses paid, IRC 642(h) enables the executor to pass these expenses in excess of estate income through to the estate beneficiaries, who in turn may deduct these expenses on their personal income tax returns. It appears that these expenses are subject to the 2% floor in miscellaneous itemized deductions on the residuary beneficiaries' income tax returns.

The ability to pass through expenses can result in the maximization of benefits. For example, if in Year 1 the estate had $10,000 in income and paid $12,000 in administrative expenses, the excess would be lost. If the excess of expenses over income were paid in Year 2 and it was the final year, the loss would be available to the beneficiaries. Furthermore, in a time of rising tax rates it might be advisable to defer paying the administrative expenses until Year 2. As a result the estate would report income at a lower rate and the beneficiaries would benefit from the deduction at a higher tax rate.

Capital Losses

Although the favorable treatment of capital gains treatment has been eliminated, the distinction between capital gains and ordinary income still remains extremely important in the estate area. Capital gains and losses are income or losses for tax purposes, but generally not treated as such for trust accounting purposes. Capital gains and losses are generally excluded from distributable net income, which is the measure of what the residuary beneficiary reports as his income from an estate during its administration. In case of a net capital gain, the estate would pay tax on the income. In the event of a net capital gain, the estate would $3,000 would be available on future estate returns.

In the final year of an estate, unused net capital losses can be passed through to the beneficiaries. As a result, the beneficiaries may carry forward their pro rata share of these losses during their lifetimes. The availability of the estate's loss may enable a beneficiary to sell capital gain property at a reduced or no tax cost.

Unused NOL Carryover

As a general rule, if upon termination of an estate an NOL exists which would have been available in future years of the estate, the loss is allowed to the beneficiaries of the estate as a deduction in determining AGI. The year of the estate and the beneficiaries' tax year are each considered tax years for the purpose of determining the number of years to which a loss may be carried forward. As a result, for example, a September 30, 1988 estate income tax return and a beneficiary's 1988 income tax return would use up two years of the available loss carryover.

If the final year of an estate is the last year to which a loss may be carried, the loss may be treated as an excess deduction treated in the same manner as administrative expenses paid in the last year. As such it is available as a deduction to the residuary beneficiary subject to the 2% floor.

If an estate sustains a net operating loss in the year of termination, the loss must be carried back and to the extent not absorbed by prior year income, the unused net operating loss is available to the beneficiary.

Passive Losses

When an estate disposes of a passive activity, the estate is permitted to deduct suspended or unused passive losses, i.e., those it has previously not been allowed as deductions. Generally, the distribution of passive activity property would not be a taxable event. In the case of a distribution of passive activity property on termination of an estate, absent amendment to the Code, there seems to be no ability to pass through suspended losses to the beneficiaries. Depending on the facts, this might be an asset that should be distributed or sold prior to termination of an estate.

Short Year

The final year of an estate need not be a 12-month year. If all estate assets are distributed prior to its year-end, the estate has a short year. The use of this opportunity for a short year can enable an executor to accelerate or defer the benefits of the pass-through of administrative expenses, capital losses, net and operating losses.

It is apparent that until the estate is terminated, the executor faces post-mortem choices that can have a significant tax impact both on the estate and its beneficiaries.

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