Tax rate compression and estate income tax planning. (includes related article)by Streer, Paul J.
RRA '93 calls for taxable estate income in excess of $7,500 to be taxed at 39.6%. The author addresses this dramatic rate compression and the completely new planning necessary to minimize the cost to taxpayers.
The Revenue Reconciliation Act of 1993 ushered in a number of important income tax changes. For many taxpayers and their advisors, none may be more important than the recent compression of estate and trust income tax rates. Beginning in 1993, estates and trusts are subject to new marginal tax rates at much lower threshold amounts with rates of 36% on taxable income in excess of $5,500 and of 39.6% on taxable income in excess of $7,500. Comparable 1993 rates for single individual income taxpayers are triggered at taxable income levels of $115,000 and $250,000 respectively. As a result of this radical increase in estate and trust income tax rates, conventional estate income tax planning has been materially altered for all but the smallest estates. The discussion that follows will highlight and analyze a number of specific planning strategies that have been impacted and suggest ways that overall income tax liability can be minimized.
Different Post-Mortem Planning Required
After the death of an individual, an estate planner can assist the executor or administrator in minimizing total income and estate taxes. An estate automatically comes into existence upon the death of a decedent. The taxable income of an estate is taxed to the estate unless it is distributed to beneficiaries before the end of the estate's tax year. This result is achieved by givIng the estate a deduction for distributions actually made to beneficiaries. Under prior law, estate and trust income tax brackets were comparable to those of individuals. Therefore one effective strategy used to minimize income tax liability had always been to retain substantial income in the estate rather than distribute it to beneficiaries. The fact that throwback rules do not apply to estates made this technique viable. In addition, it was often advisable to keep the estate open as long as possible in order to continue to take advantage of these tax savings as long as possible.
Distributions to Beneficiaries
In the new tax rate environment, it will frequently be most beneficial for an estate to make annual estate distributions of most of its taxable Income to beneficiaries before year end. These distributions will reduce overall tax liability by shifting the tax Incidence to lower tax bracket recipients. Unfortunately, most state laws limit the power of the executor or administrator to make distributions before the expiration of the time within which creditors may present their claims to the estate representative for collection. Earlier distributions may require specific court authorization which can be cumbersome and costly to obtain. Fortunately, this problem can be overcome in one of several ways.
Specific Bequests. If the decedent provides for specific bequests of income producIng property under the terms of the will, these distributions can be made without restriction. To qualify, the bequests of specific items of property or money must be paid or credited all at once or in not more than three installments. In addition, they must not be payable solely from estate accounting income. Specific bequests are not taxable to the recipient beneficiary and are not deductible by the estate.
Items of income in respect of a decedent (IRD) make excellent candidates for specific bequests. These are items of income the decedent was entitled to receive at death but were not properly includible in the decedent's taxable income in the year of death or prior tax years under his or her method of accounting. These income items are also typically recognized for income tax purposes within a reasonably short time horizon after the decedent dies and the estate is created. In addition, unlike most assets included in a decedent's gross estate, they do not receive a basis step-up to their date of death fair market values. Consequently, when the income embedded in the assets is collected, it is fully taxable to the recipient. This means the income is potentially subjected to both estate and income tax. Limited relief from this possible double taxation is provided by giving the IRD recipient a deduction for any additional estate tax paid as a result of including the item in the decedent's gross estate. The beneficiary treats the deduction as a miscellaneous itemized deduction that is not subject to the two percent of adjusted gross income floor.
Typical IRD items include unpaid salary and bonuses, royalties receivable, dividends receivable if death occurred on or after the record date, and the income element contained in any installment receivables that remain uncollected at death. If the decedent was a partner in a partnership, IRD includes the pre-death portion of his distributive share of partnership income for the partnership year ending after his death. It also includes his share of any partnership unrealized receivables. While proper tax planning cabs for the minimization of items of IRD, for most decedents the complete avoidance of all IRD is both impractical and often imprudent.
Proper Selection of a Tax Year. Another way to help insure income will be distributed and taxed to beneficiaries on a timely basis is to select an initial tax year of the longest possible duration. Unlike trusts, estates are allowed to choose any fiscal year, provided the initial year does not exceed 12 months. Before tax-rate compression, this flexibility often resulted in the use of a January or February year end so that a calendar-year estate beneficiary could receive distributions but delay paying income tax on them for as long as possible. This objective will now often be of secondary importance to shifting tax liability to lower- bracket beneficiaries by getting actual distributions in their hands before the end of the initial estate tax year.
Alternatively, choosing an initial tax year of very short duration could be desirable. If it ends before significant estate taxable income is generated, after taking advantage of the estate's $600 personal exemption, what little taxable income there is will be taxed at a low marginal estate tax rate. In addition, the estate will have gained some additional time within which to make distributions that will be deductible in its second taxable year and more favorably taxed to its beneficiaries.
Property Distributions. If the estate lacks sufficient liquidity to make cash distributions or the beneficiaries simply want to receive a particular estate asset, distributions in kind may be an effective way to shift income to beneficiaries. Normally, the beneficiary will receive taxable income and the estate will receive a distribution deduction in an amount equal to the basis of the property in the hands of the estate. However, the income and deduction cannot exceed either the fair market value of the property at the date of distribution or the estate's distributable net income. In all cases, the basis of the distributed property will carry over from the estate to the beneficiary.
Alternatively, the estate can elect to recognize gain or loss upon distribution of the property in an amount equal to the difference between its basis and date of distribution fair market value. The estate's distribution deduction, limited to distributable net income, will also be the property's fair market value. The basis of the property distributed to the recipient beneficiary and the taxable income he or she recognizes will also both be equal to the property's date of distribution fair market value. The election is made annually and it applies to all distributions in kind made during the taxable year.
With the advent of the current, high marginal estate income tax rates, it is now very unlikely that it is prudent for an estate to make the gain recognition election if ordinary income property is distributed. In the case of capital gain property, a maximum rate of 28% applies whether the gain is reportable by the estate or the individual beneficiary. Therefore, a case-by-case analysis is necessary to determine whether the election is advisable in a given tax year. If the estate has sizeable capital loss carryforwards on hand, the election is more likely to be beneficial. However, any unused estate capital losses are not wasted because they pass through to the beneficiaries in the year the estate terminates.
Making use of the election to recognize a loss upon the distribution of depreciated property can be a highly desirable and effective estate income tax saving device. Capital losses that otherwise would not be currently deductible by the beneficiaries because of the annual $3,000 ordinary income offset limitation may be salvaged. In the case of ordinary losses, the tax benefit will often be maximized if the loss is deductible by the estate.
In an estate's final tax year, if the tax-deductible expenses incurred exceed its gross income, these so-called excess deductions are available as deductions on the income tax returns of the beneficiaries. However, the deductions for charitable contributions and the personal exemption are specifically excluded from the computation of excess deductions. In addition, excess deductions are treated as miscellaneous itemized deductions that are subject to the two percent of adjusted gross income floor in the beneficiary's individual income tax return computation. This treatment holds true even though the estate deductions involved are administrative expenses the estate itself can deduct free of the two percent floor.
In spite of these limitations, it was often standard practice for a knowledgeable executor or administrator to plan for the estate to generate excess deductions in the estate's final tax year with the expectation that they would be passed through to the beneficiaries succeeding to the property of the estate. This goal was readily accomplished in the context of the typical estate that used the cash method of accounting. When the activities of the estate were drawing to a close, anticipated income receipts were accelerated into the current tax year and deductible expense disbursements were delayed until the next tax year. Shortly thereafter, the estate was terminated resulting in the creation of excess deductions.
Now that estate income tax rates substantially exceed those of individuals, this strategy will rarely be beneficial. Deductions are now often more valuable to the estate than to the beneficiaries. In addition, they may not be subject to the two percent floor in the estate income tax computation. Now the proper approach should ordinarily be to coordinate income and deductions so that the estate taxable income in each year will be taxed at a low marginal tax rate.
Termination of the Estate
The issue for many estates has now shifted from how to justify keeping the estate open longer for income tax purposes to one of how to distribute its income-producing property and terminate it as rapidly as possible. A quick termination can minimize the number of tax years the estate--rather than the lower tax bracket beneficiaries--are taxed on the income produced. Additionally, terminating an estate within several months of the beginning of its previous tax year end can significantly depress the taxable income for the final year of its existence. This could produce a situation in which retaining the income within the estate results in the application of a lower marginal income tax rate. In this regard, the IRS has long taken the position that the period of administration of an estate cannot be unduly prolonged. It has held an estate is considered terminated for federal income tax purposes after a reasonable period has expired for the performance by the executor of all administrative duties. The executor should now be able to utilize this IRS position to the estate's advantage if it is called upon to justify its prompt termination of the estate. This IRS interpretation will be particularly useful to the estate if it is still legally in existence at the desired date of tax termination because of its failure or inability to obtain final discharge from the probate court on a timely basis.
The use of several other elections available to the estate will be affected by the new estate and trust income tax rate structure.
Administrative Expenses. Administrative expenses such as attorney, accounting, and executor fees and losses incurred during the period of administration are deductible on either the estate tax return (Form 706) or the estate income tax return (Form 1041) but not on both. The expenses can either all be deducted on one of the returns or split between the two returns as the executor sees fit. An income tax deduction will not be allowed unless a statement is filed in duplicate with the Form 1041 that the expenses claimed have not been allowed as estate tax deductions and the right to do so is permanently waived. The statement can be fried at any time prior to the expiration of the statute of limitations that applies to the taxable year for which the deduction is sought.
Normally, these expenses should be deducted on the return where they will provide the greatest tax benefit. In cases in which no estate tax return is required to be filed because the estate tax base does not exceed $600,000, the value of these deductions on the Form 1041 is increased as a result of the higher marginal estate income tax rates. If an estate tax return is necessary, these higher rates increase the likelihood that some or all of the administrative expenses and losses should be claimed as income tax deductions.
Executor Commissions. In many situations, the executor, along with other relatives, is the sole or principal beneficiary of the estate. In this situation, the executor will often not accept the commission that is otherwise payable under state law. Consequently, the executor avoids the reporting of taxable income and the estate receives no deduction. In the current climate of high estate income tax rates, this decision should be carefully evaluated. If the election to deduct administrative expenses on Form 1041 is made and the estate's marginal income tax rate exceeds that of the executor, overall income tax savings will result from acceptance of the fee. Of course, the impact of the executor's decision to accept or decline the fee on the actual amount of property inherited by each beneficiary should also be carefully considered before a decision is reached.
U.S. Savings Bonds. An election is also available to the estate of a cash-basis taxpayer who owned U.S. savings bonds at the time of death. Assuming that the decedent had not previously elected to include the annual increase in redemption value in gross income, the executor may elect to include the cumulative difference between the original purchase price of the bonds and their date of death redemption value in the decedent's gross income on the final individual income tax return. The alternative is for the estate to report income collected on the bonds as part of its taxable income for the year of redemption. Obviously, with the new estate tax rate structure in place, estates can realize worthwhile tax savings by making the election. In addition, the election will be particularly useful if the decedent was an unmarried taxpayer who died early in his or her tax year before realizing much gross income. In that case, the election may keep the decedent's exemptions and deductions from either going to waste or providing only a limited tax benefit.
LETTER TO CONGRESS FROM THE AICPA
The Revenue Reconciliation Act of 1993 increased the income tax rates and sharply reduced the brackets applicable to estates and trusts. While the AICPA has deliberately stayed away from the debate as to the "right" top rates for individuals and corporations, we believe the higher tax rates on estates and trusts are unfair.
Historically, estates and trusts have been taxed at the highest income tax rates applicable to individual taxpayers--those pertaining to married persons filing separate returns. However, the Tax Reform Act of 1986 (TRA '86) changed that. Under TRA '86, the first $5,000 of taxable income of trusts and estates was taxed at 15% and taxable income in excess of $5,000 was taxed at 28%. Married persons filing separate returns, however, were only subject to the 28% tax rate when their taxable income exceeded $14,875.
The Revenue Reconciliation Acts of 1990 and 1993 (1990 Act and 1993 Act) further compressed the rate brackets. For example, in 1991 the 31% marginal tax rate brackets for married persons filing separate returns began at $41,025, compared to $10,350 for estates and trusts.
The 1993 Act changed the income tax rates and brackets applicable to estates and trusts so that the 15% income tax bracket for estates and trusts will end at only $ 1,500 as compared with $18,450 for married persons filing separate returns. Furthermore, the 39.6% surtax rate on "high-income taxpayers" (so called in the 1993 Act) applies to all taxable income in excess of $7,500 in the case of estates and trusts, but is levied on married persons filing separately only on taxable income above $125,000.
Non-Tax Reasons for Accumulations in Estates and Trusts
The highly compressed rates which were part of the 1993 Act have had a harsh effect on many trusts and estates. The greatest areas of difficulty arise in instances where there is a need to accumulate income for non-tax reasons. The grantors' intentions or the best interests of the beneficiaries are frustrated by the diversion of funds either to pay the tax or make unwise distribution to avoid the tax.
There are many non-tax reasons for accumulations in estates and trusts. For example, estates may accumulate income because of the liquidity needs to pay bequests and debts (including taxes); unavoidable recognition of income (IRA and other qualified plan distributions); state law requirements that distributions cannot be made until the claims period for debts expires (personal liability of executor); litigation; and will contests, etc. Trusts may need to build a fund for the future education of minor children, for the care of surviving spouses, orphans, elderly parents, the mentally or physically disabled, children with special needs, protection of spendthrifts, and other special non-tax reasons.
Rationale for Tax Rate Bracket Compression Faulty
Although Congress gave no reason for further compression of income tax brackets for estates and trusts in the Conference Committee Report in the 1993 Act, the reason given in the Report of the Conference Committee for the 1990 Act changes is enlightening. That Committee report stated that the tax rates applicable to trusts and estates were modified, "in order to not increase the benefit of the lower brackets that might otherwise arise from the adoption of the 31% marginal tax rate bracket. The conferees believed that modification of these rates is necessary to prevent additional undesirable incentives to create multiple trusts."
Insufficient recognition was given in all three statutes (1986, 1990, and 1993) to the fact that the compression in the tax brackets enacted affected not only multiple trusts, but all trusts and all estates. There is nothing sinister or subversive about estates and trusts. For example, an estate is created when an individual dies. The executor merely steps into the shoes of the decedent and collects income and pays expenses until disposition of the assets and liabilities of the estate. Generally, estates are not planned, and the executor wants to wind them up as soon as possible but may not be able to do so for various reasons. There is no reason for a discriminatory tax in this situation.
Further, with respect to multiple trusts, Congress has already given the necessary weapons to combat the multiple trust "evil" in 1976 by the enactment of heavy penalties levied on distributions from more than two accumulation trusts to the same beneficiary for any taxable year IRC Sec. 667(c). Also, in 1984, Congress provided (under regulations still not issued) to treat as one trust, two or more trusts having substantially the same grantors and beneficiaries, when a principal purpose of such trusts was the avoidance of tax IRC Sec. 643(fl).
Revenue estimates must be based on dynamic assumptions that fiduciaries who are charged with the responsibility to act prudently and not to commit waste will distribute income downstream to lower bracket beneficiaries. Almost every taxpayer will be in a lower bracket than the trust or estate. The fact is that restoration of more appropriate rates could lead to revenue gain as trusts accumulate income they would otherwise be driven to distribute to those who are lower bracket individuals.
Even if there is a revenue loss, it would be in those circumstances where there is the greatest non-tax objective. For example, the trustee may choose to withhold current distributions of income from a drug addict beneficiary or to accumulate income for the future care and support of a child with special needs. The tax burden then falls where the non-tax reason for accumulation is the greatest. We would also expect that any revenue loss would lessen over the years as trustees and executors became more sensitive to the problems of compressed rates and provide appropriate drafting in instruments and adopt defensive practices and procedures.
Objective--Restore Tax Rata Schedule of Estates and Trusts to Those Applied to Married Persons Filing Separately
We urge you to restore the estate and trust tax rate brackets to the highest individual income tax rate brackets which are those rates applicable to married persons filing separate income tax returns.
This proposal has been endorsed by numerous professional groups and individual members or officers of the American Bar Association as evidenced by the letter written to you by Professor Joel Newman dated March 10, 1994.
Paul J. Streer, PhD, CPA, is Professor of Accounting at the J.M. Tull School of Accounting, University of Georgia.
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