Real Estate, Probate and Trust Law Section Seminar (Session 2)

Income Tax Planning - What An Estate Planning Lawyer Needs to Know

Gerard T. Forget III Gross & Welch P.C., L.L.O.

William J. Lindsay, Jr. Gross & Welch P.C., L.L.O.

Thursday, October 10, 2019 Embassy Suites Hotel – La Vista Conference Center

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INCOME TAX PLANNING, THE NEW BASIS FOR ESTATE PLANNING

William J. Lindsay, Jr., Esq.

Gross & Welch PC LLO

Omaha, Nebraska

Gerard T. Forgét III JD, MBA, LL.M. (Taxation)

Gross & Welch PC LLO

Omaha, Nebraska

WILLIAM J. LINDSAY, JR.

EDUCATION: Creighton University, B.S. (Math), cum laude, 1975 Creighton University, J.D., cum laude, 1978 University of Florida, L.L.M. (Taxation), 1979 ADMITTED: Nebraska State Bar Association, 1978 U.S. District Court - Nebraska, 1978 U.S. Tax Court, 1985 MEMBER: Nebraska State Bar Association (NSBA)

--Member, Real Property & Probate Section --Member, Elder Law Section --Member, Law Practice Management Section --Member, Legislation Committee

Omaha Bar Association American College of Trust and Estate Counsel (ACTEC) (2002-present) Omaha Estate Planning Council PRESENT AFFILIATION: Gross & Welch, P.C., L.L.O. Omaha, Nebraska OTHER INFORMATION: --Member informal study group for changes in guardianship and conservatorship

laws (1996-1997) --Member Uniform Trust Code Study Committee based on 2001, 2002 and 2003 Interim Study Resolutions – Committee’s Report was posted on NSBA website --Member Nebraska Supreme Court Committee Technology Committee (1999-Present) --Member Uniform Power of Attorney Study Committee --Member Nebraska Supreme Court Commission on Guardianships & Conservatorships (2013-Present) --Member Forms Committee Revising Guardianship & Conservatorship Forms (2013-Present)

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GERARD T. FORGÉT III

EDUCATION: Creighton University, Bachelor of Science ACS – Chemistry, 1990 Creighton University, M.B.A., 1993 Creighton University, J.D., 1993 University of Missouri Kansas City, L.L.M. (Taxation), ADMITTED: Nebraska State Bar Association, 1993 U.S. District Court - Nebraska, 1993 U.S. Tax Court, 1993 MEMBER: Nebraska State Bar Association (NSBA) Omaha Bar Association Omaha Estate Planning Council PRESENT AFFILIATION: Gross & Welch, P.C., L.L.O. Omaha, Nebraska

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IN ORDER TO PLAN AN ESTATE, THERE MUST BE AN ESTATE TO PLAN.” (Can’t remember for sure either, Marcus Tullius Cicero 63 BC or Dennis W. Collins 1997.)

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Pop Quiz

The following are to be answered True or False

1. All assets passing through an estate receive a step up in basis. 2. Life insurance proceeds are always free from income tax. 3. Medical expenses of the decedent paid by the estate are deductible on the estate’s return. 4. Annuities receive a step-up in basis when paid to the beneficiary. 5. Payments received after death on an installment sale completed before death for which

the decedent elected installment sale treatment get a step-up in basis. 6. Medical expenses paid within one year of death of the decedent for services to the

decedent during lifetime are never deductible. 7. Funeral expenses are an income tax deduction. 8. The estate will include in its income interest on a bank account received by one of the

children as a POD beneficiary. 9. Income for income tax purposes and income determined under the Nebraska Uniform

Principal and Income Act are identical. 10. IRA proceeds paid directly to a qualified public charity as a beneficiary are taxable to the

estate. 11. Decedent received a check for the first half cash rent on the farm but died before

depositing the check. The estate will include this in the estate’s income. 12. Farm is owned by the decedent’s revocable trust. Decedent lived in town and was not a

farmer. Stored grain on a crop share lease received during lifetime and sold after death receives a step-up in basis.

13. No part of the life insurance policy proceeds check which is paid to the beneficiary (assume IRC 101(a)(2) does not apply in this case) is taxable to the beneficiary.

14. The personal representative (without any provision in the will authorizing it) pays $2,500 to the decedent’s favorite charity because the decedent on her deathbed asked to have it done. There is a charitable contribution deduction to the estate.

15. An estate tax return Form 706 must be filed in order to get a step up in basis.

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I. Why is Income Tax an Issue?

At a recent seminar the authors heard the projected number of Federal Estate tax returns to be filed in the United States for 2019 for which a Federal estate will be paid. That number is 1,800. The Center for Disease Control states that in 2017 registered deaths in the United States were 2,813,503. Clearly most estates will not have a Federal estate tax issue.

Income tax can be an issue in many estates. While we have heard of step-up in basis, there are many assets to which a step-up in basis does not apply. Most of these would be considered to be income in respect of a decedent (IRD). IRD remains subject to income tax and receives no step-up in basis.

Among the most common examples would be individual retirement accounts. As long as the account is not a Roth IRA and as long as there have been no non-deductible contributions made to the IRA, the income or the distributions coming out of the IRA will be taxable income.

Importance of both State Law and Federal Law

It is important to have an understanding of both Federal and State income tax laws as well as Federal and State laws relating to Trusts and Estates. The legal interests and rights are created by State law. Federal law determines what interests or rights created by State law shall be taxed.

An example of how Federal law comes into play is the decision of the U.S. Supreme Court in Drye v. United States, 529 U.S. 49 (1999). This case involved when a Federal tax lien attaches. The decedent left the property to an individual who had a Federal tax lien against that potential beneficiary in place at the time of the death of the decedent. The potential beneficiary exercised the right under State law to disclaim the interest. Under State law, the disclaimer results in a relation back, so under state law it is treated as if the person signing the disclaimer had predeceased the decedent.1

State law created the right to disclaim. That was enough under the Drye decision for Federal law to impose a lien.

Income Tax Status of Estates and Trusts

Under Nebraska state law the Trust or Estate is not an entity. Under Federal law the Trust or the Estate is an entity which is a taxpayer.

The Trust or Estate being a taxpayer may owe income taxes. This differs from partnership taxation where ordinarily the partnership itself is not a taxpayer.

The actual distribution of income or the requirement to distribute income on a mandatory basis to the beneficiaries is what can cause taxation of the beneficiaries. The beneficiary will

1 The Nebraska Disclaimer Statute is called a Renunciation under State law. §30-2352

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receive a Schedule K-1 from Form 1041 to tell the beneficiary the amount of their income is and what category that income is in. There may also be certain separately stated deductions.

For example, if the estate has $10,000 of interest income and the estate distributes $6,000 of it, the result should be that the beneficiary pays tax on the $6,000 distributed and the estate pays tax on the remaining $4,000. A common example is to use an old fashioned gravity fed grain bin. The grain is put in at the top and there is a door on the bottom where grain can be released. The grain is the equivalent to the income. If the door on the bottom remains closed, then the income is taxed to the Trust or the Estate. If the door on the bottom is open and all of the income comes out, it can be taxed to the beneficiaries.

The design of the Will or the Trust can have a major effect on the income tax consequences.

We will see concepts known as “distributable net income” and “fiduciary income”. Both of these concepts are necessary to determine the taxation.

Mandatory distributions of income will create a deduction for the Trust equal to the amount of the mandatory distribution of income.2 You can affect the distribution of income and who pays the tax depending upon the design of the Trust or the Will. For example, Mary signs a Trust. In the Trust, Mary provides that her stock in X corporation is to be distributed to Beneficiary 1. The remainder of the Trust is to be distributed to Beneficiary 2.

While the Trust is operating, X corporation pays $8,000 in dividends. The remaining assets will be distributed to Beneficiary 2. The remaining assets produced $6,000 in income.

The Trust is a mandatory income distribution Trust. At the end of the year who receives the $14,000?

Since the X corporation stock goes to Beneficiary 1, that $8,000 will be distributed to Beneficiary 1 and will be taxable to Beneficiary 1. Absent a provision providing otherwise in the Trust, the income of specifically devised property will go to the devisee of that specifically devised property. The remaining income was earned by the remainder of the Trust and will be distributable to Beneficiary 2. In both cases, the Trust receives a deduction which totals $14,000 leaving the Trust with no taxable income.

Estates and complex Trusts are taxed on a two-tier basis. Every Estate is taxed this way and complex Trusts are taxed this way.3

Tier one is that portion of the income of the Estate or Trust that is required to be distributed, and is taxable to the beneficiary whether or not it is actually distributed. Tier two is

2 I.R.C. §651 3 I.R.C. §662

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all other amounts that are promptly paid, credited or required to be distributed to the beneficiary for the tax year. Please note that both Estates and Trusts now have the 65-day rule which says that, at the election of the fiduciary, distributions made in the first 65 days of the following tax year can be treated as having been made during the tax year. For those Trusts on a calendar year or the Estates on a calendar year, always be careful of leap years. Remember, February has 29 days in 2020. This means that the last day is March 5 in 2020 where in 2021 it will be March 6.

Another item to be aware of is that a Revocable Trust during the lifetime of the Settlor is what is known as a “Grantor” Trust. This means that the income of the Trust is taxable to the Settlor setting up the Trust. It does not matter whether or not it is actually distributed to the Settlor.

Nebraska Income Taxation of Trusts

State income taxes also come into play. In Nebraska a Trust that is established in Nebraska may remain a Nebraska resident long after the decedent dies. For a Testamentary Trust, if the decedent resided in Nebraska, that Trust is a Nebraska Trust. For a Trust established during the lifetime of the decedent, the Trust is a Nebraska Trust if, at the date the Trust becomes irrevocable, or if revocable until death, the date of death, the Settlor is a Nebraska resident. While there may be some question about the constitutionality of this particular provision, it is currently the law in Nebraska.

II. Analysis of Ownership.

Who Receives the Property at Death?

At the death of a person we check through the following 4 levels to see who receives the asset. A prior level overrides any levels below it. Note that the will is at the lowest level.

Level 1: Ownership

• Joint Tenancy with Right of Survivorship. At the moment of death, the survivor or survivors own the property. Note special rule for bank accounts with husband, wife and others on them. If two people named as joint tenants and one has already died, then at the death of the second, it is property of the estate of the surviving joint tenant (unless there is a POD Beneficiary under Level 3.).

• Assets transferred to Trust during lifetime generally are owned by the trust and pass under the terms of the trust.

• A joint tenant or a trust beneficiary receives the property no matter what the will says.

Level 2: Contingent Ownership. Sometimes a contingent owner is named. If the owner dies and the contingent owner survives, the contingent owner now owns the property.

• Section 529 plans (College Savings Plans specially authorized by the IRS. See the Nebraska State Treasurer’s website for links to more information) usually have a contingent or successor owner.

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At the death of the owner of the 529 plan, the ownership passes to the contingent or successor owner.

• Life insurance policies may have a contingent or successor owner. If Tom owns a life insurance policy on Mary’s life and if Alice is the successor owner, then if Mary is still alive, on Tom’s death Alice owns the life insurance policy.

• A trust can be a contingent or successor owner. • The contingent owner receives the property no matter what the will says.

Level 3: Beneficiary Designation. A beneficiary can be named during the lifetime of the decedent who owned the property. The beneficiary who survives the decedent receives the property. Quite often successor or contingent beneficiaries are named to take the property if the first beneficiary died before the decedent. The beneficiary designation overrides the will.

• There can be beneficiaries on many different types of assets. These include annuities, life insurance policies, retirement plans, bank accounts, brokerage accounts, stocks, mutual funds.

• A contingent beneficiary is one who receives if the primary beneficiary does not survive. • A POD Beneficiary is used on Bank accounts and means “Payable on Death”. • A TOD Beneficiary is used on stocks and other securities and means “Transfer on Death”. • Nebraska will have what is called a Transfer on Death Deed. It became effective January 1, 2013

for deaths occurring on or after that date. • A trust can be a beneficiary. • The beneficiary receives the property no matter what the will says.

Level 4: Will/Estate/Probate/No Will. We have now reached level 4. The will now controls (although there can be some exceptions). If there is no will, the law provides who receives. There will usually be a probate for the will.

• A will (or a case where there is no will) requires a probate (or administration of the estate through court) to transfer property.

If there is no will the Nebraska statutes provide for the distribution of the assets. Only if there are no relatives (and the list of relatives goes quite a long way) does the property escheat or pass to the state.

III. Income Tax Effects of Determining Property Ownership

Once the ownership determination is made in the prior part, the incidence of income taxation follows.

Level Ownership Income Tax Owner

1 Joint Tenancy Surviving joint tenants generally equally. However, note §30-2723 for an account with one of the surviving joint owners being the surviving spouse of the deceased owner the income from the share of the deceased owner belongs to the surviving spouse as under that statute the surviving spouse owns the deceased spouse’s share. This applies to bank accounts.

1 Trust If the trust had been an owner as a Grantor Trust during lifetime a new EIN is needed.

The trust owns the property and will receive the income and it will be reported on the Trust’s income tax return, Form 1041.

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The trust will pay tax on the income unless it is distributed to the beneficiaries within the year (or at the option of the trustee) within the first 65 days of the next year.

2 Successor Owner College Savings Plan

While it remains in the plan no income tax is due. Upon distribution if properly used for qualified education no income tax due. If withdrawn from the plan and not properly used for qualified education expenses the earnings portion of the distribution is taxable to the distributee (whether the account owner or the beneficiary) and subject to a 10% penalty tax.

2 Successor Owner Life Insurance Policy

When taxable taxed to the owner.

2 Successor Owner Annuity When taxable taxed to the owner. To have a successor owner the annuitant can’t be the owner. This can also be subject to early withdrawal penalties.

3 POD Beneficiary Payable on Death. This is taxable starting with receipts received after death to the beneficiary, unless the decedent was the rare individual on an accrual basis method of accounting.

3 POD Beneficiary Trust is Beneficiary

Payable on Death. This is taxable to the trust subject to all of the trust income tax rules starting with receipts received after death to the beneficiary, unless the decedent was the rare individual on an accrual basis method of accounting. See 1 under trust above.

3 TOD Beneficiary Transfer on Death. This is taxable starting with receipts received after death to the beneficiary, unless the decedent was the rare individual on an accrual basis method of accounting.

3 TOD Beneficiary Trust is Beneficiary

Transfer on Death. This is taxable to the trust subject to all of the trust income tax rules starting with receipts received after death to the beneficiary, unless the decedent was the rare individual on an accrual basis method of accounting. See 1 under trust above.

3 Life Insurance Beneficiary Beneficiary receives the policy proceeds. Interest earned after death taxable to the beneficiary. If there had been a transfer for value made during lifetime under IRC §101(a)(2) excess of proceeds over basis may be taxable income. See 1 under trust above.

3 Life Insurance Beneficiary Trust is Beneficiary

Trust as Beneficiary receives the policy proceeds. Interest earned after death taxable to the trust. If there had been a transfer for value made during lifetime under IRC §101(a)(2) excess of proceeds over basis may be taxable income. See 1 under trust above.

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3 Annuity Beneficiary When taxable, taxed to the beneficiary. This remains subject to income tax with no step up in basis. Income is ordinary income even if had been invested in stocks.

3 Annuity Beneficiary is trust Taxed to the trust. This remains subject to income tax with no step up in basis. Income is ordinary income even if had been invested in stocks. See 1 under trust above.

3 Transfer on Death Deed This is taxable to the beneficiary starting with receipts received after death to the beneficiary, unless the decedent was the rare individual on an accrual basis method of accounting. Rents paid before death remain taxable to the decedent even if covering periods after death. There can be a mismatch of income and deductions.

3 Transfer on Death Deed Transfer on Death Deed

This is taxable to the beneficiary starting with receipts received after death to the beneficiary, unless the decedent was the rare individual on an accrual basis method of accounting. Rents paid before death remain taxable to the decedent even if covering periods after death. There can be a mismatch of income and deductions. See 1 under trust above.

3 Beneficiary is the Estate First don’t do this. See 4 below.

4 Estate A new EIN is needed.

The estate owns the property and will receive the income and it will be reported on the estate’s income tax return, Form 1041. The estate will pay tax on the income unless it is distributed to the beneficiaries within the year (or at the option of the personal representative) within the first 65 days of the next year.

The estate may elect its own tax year which ends at the end of any calendar month not more than 1 year after death. It may elect to report its income along with certain revocable trusts under IRC §645.

4 Estate, Trust is devisee If IRC §645election made report on return with the estate. If not must report when distributed from estate if estate has not already paid tax on it. If no §345 election made must use a calendar year.

See 1 under trust above regarding beneficiaries.

IV. Estate and Trust Tax Rates

Trusts and estates have their own income tax rates [§1(e), §1(j)(2)(e)]. The tax brackets for trusts and estates are compressed vis-a-vis individual income tax brackets, meaning that it takes less income for a trust or estate to get taxed at the highest marginal rate. The tax rate schedules for 2018 and 2019 are as follows [Rev. Proc. 2018-18, Rev. Proc. 2018-57]:

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If 2019 taxable income is: The tax is:

Not over $2,600 15% of taxable income Over $2,600 but not over $9,300 $260 plus 24% of the excess over $2,600

Over $9,300 but not over $12,750

$1,868 plus 35% of the excess over $9,300

Over $12,750 $3,075.50 plus 37% of the excess over $12,750

Net capital gains are taxed at preferential rates of 0%, 15%, or 20%, depending on the taxpayer's ordinary income tax rate [§1(h)]. For tax years 2018 through 2025, special modifications are made to the taxation of net capital gains [§1(j)(5)]. These modifications are made to account for the different rates applicable during those years.4

V. We Always Get a Step-Up in Basis, Right?

V.1. Step up is Basis is the exception not the rule

This may be overstating the situation, but in many estates it is true. A large number of estates today have a substantial portion of their assets in retirement plans or annuities. These are income in respect of a decedent (IRD) and there is no step-up in basis with regard to these assets. They remain subject to income tax. Another example that is sometimes seen is United States Savings Bonds. Some of the old Series HH savings bonds may have been converted form Series E or EE. If so, they will state on the front of the bond how much of the bond is the taxable income that was rolled over into the HH savings bond. This option is no longer available and eventually these savings bonds will be gone. Savings bonds remain subject to income tax. Series EE are bought at 50% of face value. Most people do not report the annual build-up of savings bond interest. Thus it remains taxable upon redemption, maturity or a §454 election5.

V.2. Income in Respect of a Decedent

Income in respect of a decedent (IRD) is taxable to the person or persons receiving it.

There is no specific definition of income in respect of a decedent. The taxability of income in respect of a decedent is provided in I.R.C. §691. You can think of income in respect of a

4 Bloomberg BNA 2019 Federal Tax Guide Para. 1800.A.2.A. 5 A personal representative of an estate can elect to report all the accrued interest up to the date of death on the decedent’s final income tax return. Then, when an heir redeems the bonds, the only interest to report will be the interest that has accrued from the date of the decedent’s death [Rev Rul 68-145, 1968-1 CB 203]. This also applies to a revocable trust which is a grantor trust until death. It is the personal representative who makes the election. REV. RUL. 79-409, 1979-2 C.B. 208.

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decedent as income that was not taxed to the decedent. Thus a step-up in basis (capital gain not taxed to a decedent) is actually the exception to the income in respect of a decedent rule.

There is no step up in basis for IRD. This means that IRD will be taxable to the appropriate person. Please see the discussion above for determining who will pay tax on income in respect of a decedent. Some examples of IRD include:

Wages – the decedent’s final wages remain subject to income tax. These are generally an asset of the estate. However, if there is an employment agreement, it is possible that the employment agreement may name a beneficiary. If there is a named beneficiary that will control and the asset would not be part of the estate. Fringe Benefits – to the extent they would have been taxable to the decedent will remain taxable. Non-qualified deferred compensation – remains taxable to the beneficiary. A non-qualified deferred compensation arrangement generally has a written plan. As with wages, there may be a beneficiary named. The beneficiary should be the person receiving it. Post-death bonuses or other payments payable to the decedent's estate or another person because of, and for, decedent's services and labors will be IRD items if, at decedent's death, there was a substantial certainty that such bonuses or other payments would be awarded or made, even though the decedent had no legally enforceable right to such bonuses or other payments. Insurance Renewal Commissions – many insurance agents have the ability to receive insurance renewal commissions. These commissions remain taxable as if they had been received as a result of insurance policies sold by the decedent during lifetime. Pensions Plan distributions – These remain taxable to the extent they would have been taxable to the decedent. Profit-sharing plan distributions – These remain taxable to the extent they would have been taxable to the decedent. Annuities – These remain taxable to the extent they would have been taxable to the decedent. However, one thing to note is that if an annuity stops at death and if there is any unrecovered basis, that can be a deduction on the decedent’s final income tax return. 403(b) – These remain taxable to the extent they would have been taxable to the decedent. 401(k) – These remain taxable to the extent they would have been taxable to the decedent. IRA – These remain taxable to the extent they would have been taxable to the decedent. Roth IRA (in first 5 years of existence of a Roth IRA for the taxpayer) – Remember the Roth IRA must have been established for five years in order to be non-taxable. There can be income taxes if the decedent dies within the first five years and distributions are withdrawn.

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Covenant not to Compete payments received after death – The covenant not to compete is subject to ordinary income taxation. It remains subject to ordinary income tax. As with many other contracts there may be a beneficiary named. Installment sales proceeds when installment sale elected before death. – This is because the sale actually occurs during the decedent’s lifetime. An installment sale means the disposition of property where at least one payment is to proceed after the close of the taxable year in which the disposition occurs. Note that it is possible under I.R.C. §453(d)(1) to elect out of installment sales. If the decedent sold property on installments but has not yet filed the return in which the election is made to report on an installment sale basis, it is possible to elect out of the installment sale and incur the tax on the decedent’s final return. This may be a good idea depending upon relative rates and particularly if you have a Nebraska inheritance tax rate of 13% or 18%. The income tax due on the decedent’s final return is a deduction for Nebraska inheritance tax purposes. Independent Contractor Payments – These are similar to insurance renewals. Special rules apply where the decedent's successor sells certain inherently income-type property such as previously unrecognized crop shares, stock options, or partnership interests representing receivables. In one sense, we should not be surprised that these examples of special property are subject to the IRD scheme because the property itself may be said to be an item of income not yet recognized and the decedent's death ought not to affect the application of the income tax laws on these items of income.6 Litigation claims

In the instant case any award received by the estate will be for income lost by the decedent during his lifetime from the exploitation of his patent rights. He commenced the action to recover his loss which at the date of his death was in process of litigation. It cannot be said that he did not have a “right to receive” an award of compensation for his lost income merely because his claim was still in dispute at the time of his death. Any judgment entered in favor of his estate will be in recognition of his claim that he had a “right to receive” such an award. If the decedent had lived and received the judgment it would have been taxable to him. [Citation omitted.]

In view of the foregoing, it is held that income realized by the estate of a deceased person

resulting from a claim which was in the process of litigation at the date of his death constitutes income acquired by reason of the death of the decedent and, under the provisions of section 691 of the Internal Revenue Code of 1954, is includible in its gross income in the taxable year when received.7

HSA Accounts. If the beneficiary is the spouse, it can be rolled over into the spouse’s

account. If the beneficiary is not the estate and not the spouse, it is taxable (without penalty) to the beneficiary in the year which includes the death. The account loses its HSA status. If the

6 BNA Tax Management Portfolios 862-4th Income in Respect of a Decedent, VII C.(3)(b) 7 Rev. Rul. 55-463 1955-2 C.B. 277.

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beneficiary is the estate, it is taxable in the decedent’s final return. Any of these are reduced by medical payments of the deceased paid after death within 1 year of death.8

Qualified Opportunity Zones. These have been established and can allow a delay in recognizing capital gain to 12/31/2026. If an inclusion event occurs before then, there can be earlier income taxation. Prop. Reg. §1.1400Z2(b)-1(c) reads Transfer of an investment in a QOF by reason of the taxpayer's death— (i) In general. Except as provided in paragraph (c)(4)(ii) of this section, a transfer of a qualifying investment by reason of the taxpayer's death is not an inclusion event. Transfers by reason of death include, for example: (A) A transfer by reason of death to the deceased owner's estate; (B A distribution of a qualifying investment by the deceased owner's estate; (C) A distribution of a qualifying investment by the deceased owner's trust that is made by reason of the deceased owner's death; (D) The passing of a jointly owned qualifying investment to the surviving co-owner by operation of law; and (E) Any other transfer of a qualifying investment at death by operation of law. (ii) Exceptions. The following transfers are not included as a transfer by reason of the taxpayer's death, and thus are inclusion events, and the amount recognized is includible in the gross income of the transferor as provided in section 691: (A) A sale, exchange, or other disposition by the deceased taxpayer's estate or trust, other than a distribution described in paragraph (c)(4)(i) of this section; (B) Any disposition by the legatee, heir, or beneficiary who received the qualifying investment by reason of the taxpayer's death; and (C) Any disposition by the surviving joint owner or other recipient who received the qualifying investment by operation of law on the taxpayer's death.

Alimony and alimony arrears (pre-2019 decrees). These remain taxable to the recipient. As I.R.C. §71 has been repealed, but the repeal does not apply to pre-2019 decrees. Alimony 2019 or later decree.9 These are not taxable as I.R.C. §71 has been repealed.

V.3. Taxation of Annuity Benefits During Owner’s Lifetime Internal Revenue Code Section 72 deals with taxation of annuities. However, for individual retirement accounts Section 408 deals with annuities. An annuity is a periodic payment resulting from the systematic liquidation of a principal sum.10 The annuities, if the amounts are received as an annuity, have what is known as an exclusion ratio. You take the total investments in the contract and divide by the expected return and that percentage of each payment comes in as a recovery of basis. The excess is taxed as ordinary income. Once all the principal is recovered (for annuities who’s starting date was after December 31, 1986) there is no longer any exclusion. Pre-1987 annuities continue the exclusion.

8 I.R.C. §223 9 Including one modified after 2018 and which states that the modified decree is subject to the repeal of I.R.C. §71. 10 I.R.C. §72(b).

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For amounts not received as an annuity, for example withdrawals, surrenders and non-annuity payouts, there are differing rules depending upon when the contract was entered into. For contracts entered into after August 14, 1982, non-annuity distributions are taxed by using the interest first. In other words, the full payment will be taxable income. Contracts entered into before August 14, 1982 are taxed under the cost recovery rule which is principal first. However, this applies only to investments made before August 14, 1982. For example, if an annuity had a payment made before August 14, 1982 for the investment and another investment after that date, principal recovery is only applicable to the pre-August 14, 1982 investment. Also remember there is a 10% penalty for premature distributions from an annuity contract. Premature distributions are those before the date on which the taxpayer attains the age of 59 ½. There are some exceptions such as the taxpayer becoming disabled, part of a series of substantially equal periodic payments not less frequently than annually made for the life for life expectancy of the taxpayer, allocable to investment in a contract before August 14, 1982 or under an immediate annuity contract. An annuity held by a corporation or other entity that is not a natural person is not treated as an annuity contract for tax purposes and will not enjoy tax deferral. If the nominal owner of the annuity is not a natural person, but in the case of a trust, the beneficial owner is, the annuity will be treated as held by a natural person and treated as an annuity for tax purposes.11 Net investment income does include income from annuities. Thus the income from an annuity may be subject to the 3.8% Medicare supplemental tax. It is possible to do an exchange of an annuity for an annuity under Code Section 1035 on a tax-free basis. A life insurance policy can be exchanged for an annuity, but an annuity cannot be exchanged for a life insurance policy. If there is boot (some cash or other property received) there can be tax consequences. An individual transfers an annuity contract issued after April 22, 1987 for less than full an adequate consideration, it is treated as having received an amount not received as an annuity an amount equal to the excess of the cash surrender value of the contract over the investment in the contract. The transfer of ownership of an annuity is generally speaking a taxable event for both income tax and gift tax purposes. Depending upon the trust, a transfer of the ownership of the annuity to the trust may or may not be taxable. The transfer of an annuity from the owner to the owner’s revocable trust (a Grantor Trust) is not a taxable event. The trust must be fully revocable. Transfers to an irrevocable Grantor trust are questionable while transfers to a non-Grantor irrevocable trust are taxable.

11 Need to look at private letter rulings.

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V.4. Annuities Taxation Upon Death

There are two fundamental questions that determine the nature and the timing of the tax consequences of an annuity post-death distribution. First is the determination of whether a holder dies prior to the “annuity starting date” or dies on or after that date. Second, the determination of the beneficiary either as a person (e.g. spouse, child, etc.) or a non-natural person (e.g. Trust, corporation or partnership).

If a holder dies on or after the annuity starting date and before the entire interest in the contract has been distributed, the remaining portion of such interest must be distributed “at least as rapidly as under the method of distributions being used as of the date of death” (at-least-as-rapidly)12 Under the at-least-as-rapidly rule, if any annuity holder dies on or after the annuity starting date, any remaining interest in the contract must distributed “at least as rapidly under the method of distribution being used as of the date of the annuity holder’s death.”13

Alternatively, if the holder dies before the annuity starting date, the entire interest in the contract must be distributed within five years after the death of the holder (five-year rule).14 The Code and the Regulations further define the “annuity starting date” as the latter of: (1) the date upon which the obligation under the contract becomes fixed and (2) the first date of the period which ends on the date of the first annuity payment.15

There is an overriding exception to these stated rules if the beneficiary is a “designated beneficiary” and the distributions begin no later than one year after the date of the holder’s death.16 If these two rules met, then for purposes of these stated rules, the interest in the annuity will be distributed over the life of such designated beneficiary. (or over a period not extending beyond the life expectancy of such beneficiary) For taxation purposes, that portion of the holder’s interest in the annuity will be treated as distributed on the day on which such distributions begin (the lifetime payout rule).17

The lifetime payout rule under the legislative history of §72(s) appears to be an alternative to the five-year rule under which the entire interest must be “annuitized” over some period of time within one year of the holder’s death.18 With regard to the lifetime payout rule, the rules have been very strictly interpreted by the Service. Specifically, the IRS in PLR 201532026 concluded that the lifetime payout rule did not apply where distributions did not

12 §72(s)(1)(A) 13 §72(s)(1)(A) 14 §72(s)(1)(B) 15 §72(c)(4); Treas. Reg. §1.72-4(d)(1) 16 No regulations had been promulgated under §72(s) which permit distributions under the lifetime payout rule to begin later than one year after the date of the holder’s death. 17 §72(s)(2) 18 S. Rep. No. 98-861 at 10777(1984)

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actually commence within one year after the owner’s death even though the taxpayer timely elected to receive distributions.19

This does beg the question; what constitutes a “designated beneficiary?” The term “designated beneficiary” is defined in §72(s)(4) as “any individual designated a beneficiary by the holder of a contract.” Essentially, the beneficiary is the person who becomes the new owner of the annuity contract.20 However, a trap for the unwary; depending upon the terms of the contract, a designated beneficiary may or may not be the person named as the beneficiary under the contract. As an example, for a joint annuity, the contract might provide that after the death of the first owner, the surviving joint owner is entitled to the death benefit payable under the contract. The joint owner can be the designated beneficiary be virtue of being the person who is the owner of the contract and controls the use of the contracts cash value and stream of income payments.

Special rule applies if the designated beneficiary is also the deceased annuity holder’s surviving spouse. The §72(s) distribution requirements treat the surviving spouse as the holder of the contract.21 The surviving spouse can continue the contract as his or her own annuity. The after-death distribution rules do not apply upon the death of the original owner and are triggered on the subsequent death of the surviving spouse. However, this is further complicated if the surviving spouse is one of multiple designated beneficiaries. Most importantly, the Code allows the surviving spouse to continue as the holder of his or her interest in the contract.22 The simplest application of this rule is that the spousal continuation applies only where the surviving spouse is the sole designated beneficiary.

Regarding non-natural persons, §72(u)(1) provides the general rule, that if any annuity contract is held by a non-natural person, the contract will not be treated as an annuity contract for purposes of the income tax provisions in the Code. For this purpose, an annuity held by “a Trust or other entity as an agent for a natural person shall not be taken into account.”23 The legislative history of §72(u)(1) seemingly offers a narrow exception. Specifically, in the case of an annuity contract of which the “nominal owner” is a non-natural person, but the “beneficial owner” is a natural person, “the contract is treated as held by a natural person”.24 This line of thinking as embodied in the legislative history is referred to as the Agency Exclusion.

Applying the Agency Exclusion to a Grantor Trust; that is, when an annuity is held by the Grantor Trust and the Grantor is an individual, the IRS generally has taken the position that §72(u)(1) does not prevent the annuity from being an annuity contract for Federal tax purposes.25

19 PLR 201532026 20 S. Rep. No. 98-169, vol. I at 580 (1984) 21 §72(s)(3) 22 §72(s)(3) 23 §72(u)(1)(flush language) 24 S.Rep.No. 99-313 at 567 (1986); H.R. Rep. No. 99-426 at 704 (1985) 25 PLR 9810015, PLR 9316018, PLR 9322011, PLR 9120024

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The verbiage in the cited Private Letter Rulings opine that the annuity contract is treated as held by the individual Grantor (rather than the Trust), and thus §72(u) does not apply. Most interestingly, it is important to note that if an annuity contract is held by a Grantor Trust, and if the Trust ceases to be a Grantor Trust (e.g. after the death of the Grantor), it will be necessary to apply §72(u) after the Grantor’s death to determine whether the agency exclusion or one of the other exceptions apply at that time.

There are instances where a non-natural person holding an annuity contract wherein the agency exclusion does not apply. In the event the agency exclusion does not apply, the annuity will not be treated as an annuity contract for income tax purposes. However, unless §72(u)(3) provides for five exceptions that still will allow a non-natural person to hold an annuity contract. The five exceptions are: (1) the contract is acquired by the Estate of a Decedent by reason of the death of the Decedent; (2) the contract is held under a plan described in §401(a) or §403(a), under a program described in §403(b), or under an Individual Retirement Plan; (3) the contract is a “qualified funding asset”26; (4) the contract is purchased by an employer under the termination of the plan described in §401(a) or §403(a) and is held by the employer until all amounts under such contract are distributed to the employee; or (5) the contract is an “immediate annuity”.27

In general, the “Post-Death” distribution rules for Annuities are wrought with exceptions. Consequently, a thorough understanding of the terms of the annuity, the existing “Pre-Death” distributions (if any) from the annuity, and the “status” of the beneficiary are critical.

VI. Step up in Basis

An item included on a Federal estate tax return does not always have a step-up in basis. No federal estate tax return is required to have a step-up in basis. However, you must understand the inclusion rules for Federal estate taxes as that can determine whether or not there is a step-up in basis.

For example, an old marital trust that was previously established by the decedent’s spouse who predeceased the decedent and for which a QTIP election is made is included in the estate under §2044. Even if due to the increased federal estate tax exemption no federal estate tax return is required for the estate of the surviving spouse, under §1014 this trust’s assets are included in the estate of the decedent and thus there is a step-up in basis.

Property included in the federal estate to which Step-up in basis may apply

A property must be acquired from the decedent in order to receive a step-up in basis.28 The basis adjustment occurs regardless of whether an estate tax return is filed.

26 §130(d) 27 §72(u)(3) 28 I.R.C. §1014

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§1014 provides for the definition of property that is considered acquired from the decedent.29

1. Property acquired by bequest, devise or inheritance.

2. Revocable trust property as long as it was revocable at all times before death.

3. Property transferred by the decedent during lifetime and placed in trust to pay the income for life to or on the order or direction of the decedent with the right reserved to the decedent at all times before death to change the enjoyment of income through the exercise of a power to alter, amend or terminate the trust.

4. Property subject to a general power of appointment.

5. Both halves of community property.

6. Property otherwise includable in the decedent’s gross estate.

7. Property for which a QTIP election has been made.

8. For a life estate it depends on whether or not the decedent was the transferor who created the life estate. If Harry sets up a life estate for his benefit with the life estate continuing to his wife, Elizabeth, for the remainder of her life and the remainder to the children, there will be a step-up in basis on Harry’s death but there will not be a step-up in basis upon Elizabeth’s death as she was not the transferor.

There is a special exception if there is appreciated property that was given by someone to the decedent, and if it returns to the same person, and the decedent dies within one year of the gift, there is no step-up in basis.30

Remember gifts made during lifetime, unless acquired from the decedent as described in §1014 under §1015 have a carryover basis. This means they use the donee’ s basis to determine gain. If the property has been depreciated, this includes subtracting the depreciation taking and can include recapture of depreciation.

For example, Harry bought a farm for $200.00 per acre. Harry gives his daughter, Jean, a farm. Jean later gives the farm to her daughter, Rachel. Rachel wants to sell the farm. The farm is now worth $4,500.00 per acre. Rachel uses Harry’s basis of $200.00 per acre and thus has a taxable gain of $4,500.00 minus $200.00 or $4,300.00 per acre. If instead Rachel inherited the farm from Jean when it was worth $4,000.00 per acre her basis is the date of death value of $4,000.00 leaving only a $500.00 taxable gain.

29 I.R.C. §1014(b) 30 I.R.C. §1014(e)

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If gift tax was paid, the basis of the gifted property is increased by that portion of the gift tax paid which is attributable to the net appreciation on the gifted assets. It cannot go above fair market value.31

If an asset is gifted during lifetime and it is a passive activity that has suspended passive losses, those losses that are suspended that are attributable to the gifted asset are added to the cost basis. As in other cases where there is an addition to cost basis if the new basis exceeds the fair market value, there are restrictions on its use.32

If a lifetime QTIP trust is established but to the extent that no QTIP election is made it is not a QTIP trust for purposes of obtaining a step-up in basis.

Property for which there would be a step-down in basis

Remember the discussion about transferring low basis assets to the taxpayer with a death within one year of the gift received by the decedent. This applies if it goes back to the person who donated the property.

For example, Helen is terminally ill. Alex, her husband, transfers low basis property to Helen. Helen’s Will leaves everything to Alex. Helen dies six months later. There is no step-up in basis as of the date of death.33 However, what happens if Alex does a timely disclaimer of the property that is valid under state law, and under the Will it now passes the children. The disclaimer relates back to the date of death and results in the bequest being treated as if Alex died before Helen. Thus the property is not received by the person who made the gift to the decedent and a step-up in basis is received.

Remember that tax claims have a priority over most other distributions from an estate.34 The IRS does appear to recognize exceptions for administration expenses and funeral expenses to this priority.

Remember on a step-down in basis if the value of the property has declined before the person dies you may wish to sell the asset. The capital losses would then be recognized to the decedent’s return. Assuming that there are capital gains, these losses can be offset again the capital gains. You may need to get additional income on to the return in order to use these losses.

No Step Up in Basis Situations

For the old family trust for which the predeceasing spouse’s exemption was used, there is no step-up in basis.35

31 I.R.C. §1015(d)(6) 32 I.R.C. §469(j)(6) 33 I.R.C. §1014(e). 34 31 U.S.C. §3713

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Remember basis of property gifted during lifetime is established under §1015, not under §1014. A common example that Nebraska attorneys will see is a situation where grandfather gave the property to his daughter during his lifetime. The daughter gives the property to her son during her lifetime. If neither case has there been a step-up in basis. The son’s basis will be the grandfather’s basis in the property. If the grandfather bought the property and you do not have a record of that basis, sometimes you can use the documentary stamp tax to determine approximately what was paid for the property.

If a farmer has ground that has a low basis and the center pivots involved had been depreciated out, that farmer should not make a lifetime gift. Remember there is no step-up in basis under §1015. However, if the farmer allows that to pass through a Will or a Trust to the farmer’s family, there will be a step-up in basis on both the farm ground and the center pivots. The center pivots can now be depreciated again.

There is a difference in the income taxation with regard to step-up in basis for shares in a S-corporation versus shares in a limited liability company that is taxed as a partnership for Federal income tax purposes. In order to understand this, you must understand the concepts of inside basis and outside basis.

The inside basis is the basis of the property in the hands of the entity (either the S-corporation or the LLC) in its property. The outside basis is the basis of the owner of the shares or membership units in those assets.

With an S-corporation the only step-up in basis is the outside basis. While without special treatment, the basis step-up in the limited liability company is in the outside basis, if a §754 election is made on the first return of the limited liability company for the tax year including the death of the decedent, the outside basis can be brought inside and with regard to that member’s interest a new depreciation schedule can be made. For this reason, (along with other reasons) most real estate investing in Nebraska is now done through limited liability companies rather than corporations.

One special rule to remember is the rule for step-up in basis on real estate held in joint tenancy between spouses. In this case each spouse is presumed to own 50% and only a 50% step-up is provided. This rule also applies to securities held in joint tenancy.

There is a special rule for a joint tenancy between spouses that was created before 1977. Because of the effective date provisions of ERTA of 1981 the old rules apply. Under the old rules the contribution of each spouse was determined and the inclusion in the estate and thus the basis was based upon the relative contributions.

35 You may want to consider if there was a 5-5 power included in the trust, the lapse of the 5-5 power in the year of death is included in the decedent’s estate and so there may be a step-up on 5% of the assets of the family trust.

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For example, farm ground that had been development ground was owned by one spouse. The spouses married in 1975. Shortly after marriage a deed was filed putting the property into joint tenancy.

After the death of the spouse who previously owned the real estate, there would be a full step-up in basis. If the property was sold shortly after death to a developer, it is likely that there are no income tax consequences. If the joint tenancy in real estate existed before 1977 be very cautious in trying to determine whether or not to sever it.

In or mobile society today you need to be aware of the effect of community property on basis. With community property there is a full step-up in basis. If a client moves from a community property state36 when planning for somebody who has come to Nebraska after living in a community property for some time it is essential to keep records to establish that the property was indeed community property. You may wish to work with counsel in the state from which they came to see if a community property agreement is appropriate. You also need to know whether income from community property remains community property.

Another common area of concern is life estates. If the decedent established a life estate, upon the death of the decedent is included in the decedent’s estate and there is a step-up in basis. If the life estate was established by someone else, it is not included in the decedent’s estate and thus there is no step-up in basis.

Ordinarily when an asset is distributed from an estate or a trust and there was a step-up in basis the basis of the estate or trust is transferred to the recipient of the distribution. There are certain elections that can be made that you may want to look into if there has been a further increase since death.

One that is often forgotten is if the decedent is a custodian under the Uniform Transfers to Minors Act and if the decedent created the custodianship, it is included in the decedent’s estate and thus there will be a step-up in basis even though the property actually belongs to the minor beneficiary of the custodianship. This is because the control is retained by the transferor or decedent.

The use of a college savings plan, sometimes known as a Section 529 Plan, can be a very valuable technique in making transfers to minors. The Trust document, if there may be minor beneficiaries, may want to permit the Trustee to invest in a 529 Plan.

Remember, a 529 Plan will have its income avoid tax while it is within the 529 Plan. If the expenses for which distributions are made are qualified expenses the property comes out of the 529 Plan on an income tax free basis. The owner of the Plan can be the person who is the donor. The donor has the ability to take the property back. It is excluded from the donor’s estate

36 Remember Wisconsin is now included in this. Most of the states that are community property are in the Southwest or West.

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for estate tax purposes, so there is no step-up in basis. You can name a successor owner. This should be done. A few years ago a law change was made so that in the event that there is no remaining successor owner, the account now belongs to the beneficiary.37

You must be careful in situations where there is dividend reinvestment. We have seen a number of situations where the decedent had a stock or mutual fund reinvesting the dividends. When this occurs, the step-up applies only to the stock or units held on the date of death. Any dividends reinvested after the date of death get no step-up in basis. There basis is the amount reportable for income tax purposes.

One situation to be careful of is if the estate or trust has an installment sale that is created after death. The distribution of the right to receive the installment sale proceeds will be taxable to the estate or trust selling the property. Thus you will have a situation where in the hands of the beneficiary there has been effectively a step-up because it was a taxable transaction.

With regard to installment sales created before death under §453(c)(6) if distributed from the estate or trust, no gain is incurred on the distribution but it will be taxable as received.

For unmarried couples with property held in joint tenancy, remember that §2040 requires the inclusion in the estate based upon the contribution of the owner involved. If the member of the couple who contributed less dies first, you will have a smaller percentage step-up. If you have a situation where the death is imminent, you may wish to consider severing the joint tenancy and perhaps using a Transfer on Death Deed.

You will have to assure yourself that you are not in violation of the one-year transfer before death rule. Under that rule, if a decedent received a gift within one year of death, and if it goes back to the donor upon the death of the decedent, there is no step-up in basis.

For example, an unmarried couple owns a rental house. The value is $200,000. The basis is $100,000, but it is reduced by depreciation taken of $75,000. Thus, there is $25,000 of remaining basis. Member number 1 contributed 90%. Member number 2 contributed 10%. Member number 2 is dying. The step-up in basis would only be 10%. If there is a severance of the joint tenancy, then, at least theoretically, there should be a basis step-up of 50% of the property. An analysis needs to be made if there has been a gift and if §1014(e) would apply.

Lifetime gifts of appreciated property will result in no step-up in basis upon death (absent the inclusion of the gift for example under I.R.C. §2036) and thus any capital gains will be taxable upon a sale. Also note that if the property is subject to a non-recourse loan and the non-recourse loan exceeds basis, there can be taxable income to the donor upon the transfer. In addition, note that the loans made as gifts without sufficient interest can result in imputed interest which is taxable income to the person making the loan.

37 Assets held in the Nebraska College Savings Plan are not subject to Nebraska inheritance tax.

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If the property given is a passive asset, the suspended loss is not triggered by the gift. If the property that is gifted is a passive property when there are suspended passive losses, these are added to the tax basis.38 Also remember that depreciated property carries over the basis including possible recognition of ordinary gain on recapture of depreciation.

VII. What does the Client Mean when they Ask About Taxes?

When your client comes in to you and they ask you the inevitable question, “What is my tax?” they do not think about inheritance tax or estate tax. They are used to Federal and state income tax on an annual basis. You will need to clarify which tax you are speaking about.

In most estates today the major tax will be income tax. There will be inheritance tax due to Nebraska. If you have a Class 2 or Class 3 beneficiary, that may be the big tax.

Make sure that you are answering the client’s question. Make sure you understand the tax that the client is talking about and also make sure they understand about inheritance tax and estate tax.

VIII. Planning for Children.

Kiddie Tax

There are special income tax rates on taxes on children. The following two situations may affect the tax and reporting of the unearned income of certain children.39 The following are the requirements for this special tax rate to be used.

Unearned income Is greater than $2,100.00 Parents At least one is alive at end of year Return Status The child does not file a joint return for the year Age The child were under age 18 at the end of the tax year or The child was age 18 at the end of the tax year and the child didn't

have earned income that was more than half of the child’s support or

The child was a full-time student at least age 19 and under age 24 at the end of the tax year and the child didn't have earned income that was more than half of the child’s support

Filing Requirement Under certain circumstances may be filed on a parent’s return, (Form 8814) otherwise the minor must file a return if unearned income over $2,100 or otherwise must file.

Beginning in 2018, the tax rates and brackets for the unearned income of certain children have changed and are no longer affected by the tax situation of the child's parent or the unearned

38 I.R.C. §469(j)(6) 39 IRS Tax Topic No. 553 https://www.irs.gov/taxtopics/tc553

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income of any siblings. Trust tax rates are now used. See the rates for trusts above. (There aren’t as many brackets for these children.)

If the child's only income is interest and dividend income (including capital gain distributions) and totals less than $10,500, the parent may be able to elect to include that income on the parent’s return rather than file a return for the child. See Form 8814, Parents' Election to Report Child's Interest and Dividends.

Support includes all amounts spent to provide the child with food, lodging, clothing, education, medical and dental care, recreation, transportation, and similar necessities. To figure the child’s support, count support provided by the child, the child’s parents, and others. However, a scholarship isn’t considered support if the child is a full-time student.

IX. Immediate Pre-Mortem Income Tax Planning

IX.1. Existing Marital Trust

In the event that there is an existing Marital Trust when the second spouse is in the process of dying, the existing Marital Trust will be included in the estate of the second spouse to die. If there are loss assets, you should sell those while the surviving spouse still remains alive. This allows the Marital Trust to recognize the losses. If they are not sold at death, there are step-down in basis. Under I.R.C. §§2044 and 1014 the Marital Trust is included in the estate and thus there is a step-down in basis. The loss is thus gone. It dies with the surviving spouse.

If there is a couple who are not married, you need to consider what happens with joint tenancy assets. I.R.C. §2040 requires inclusion in the estate of the first member of the couple to die based upon contribution. You may wish under the right circumstances to sever the joint tenancy.40 For example if there is a rental house with a value of $200,000, an original basis of $100,000, depreciation taken of $75,000, there is a $25,000 remaining basis. The member of the couple who is surviving contributed 90% and the other member of the couple who is dying contributed 10%. If you do not sever the joint tenancy only 10% of the property will get a step-up in basis. By severing the joint tenancy and using a Transfer on Death Deed, you accomplish essentially the same purpose but you get a step-up in basis of 50%.

If the same couple is reversed with the survivor being the one who contributed 10%, do not sever the joint tenancy as you will get a step-up in basis of 90%.41

If you have an old joint tenancy between spouses that was created before 1977 be very careful. If a couple owns a farm with a joint tenancy created before 1977 the old contribution

40 Neb. Rev. Stat. §76-118 states what is needed to sever a joint tenancy. 41 Remember that an unmarried couple is a Class 3 beneficiary for Nebraska inheritance tax purposes with a $10,000 exemption and an 18% rate.

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rules still apply.42 Severing the joint tenancy or transferring the property into a Trust could be an income tax error.

For example, husband and wife own a farm. The farm is in development range of one of the cities. The husband owned the farm before marriage. The couple married in 1976 and a joint tenancy was created immediately after marriage in 1976. The farm has been paid for before the marriage and there are no outstanding loans at death.

Husband dies. Husband contributed 100% and there is a total step-up in basis.

If you have clients that have community property, for example they resided in one of the community property states for many years before moving to Nebraska, make sure that you have recognized what the community property is and that the records are preserved. Perhaps a community property agreement between the couple would be a good approach.

John and Mary lived in California for many years. They moved to Nebraska to be with their grandchildren. They have a brokerage account with $1,000,000 in assets and basis of $100,000 that was acquired as residents of California. Before changing anything you should contact an attorney in the community property state involved as if the property remains community property there is a 100% step-up in basis. You do not want to take any action that destroys the community property status.

IX.2. Items Deductible only on the final return of the decedent

Itemized Deductions paid before death. Capital Loss Carryforward of the decedent. Charitable Loss Carryforward of the decedent. Net operating loss carryforward of the decedent.43 Disallowed investment interest carryforward of the decedent.

These items die with the decedent. Make sure the decedent has sufficient income to absorb these deductions. An example of post-death planning is to make an election to report on the decedent’s final return all accrued US Savings bond interest.44 This increases the decedent’s income for federal purposes and this interest is not taxable for state income tax.45

Pre-Mortem Planning

42 Gallenstein v. Commissioner, 975 F.2d 286 (6th Cir. 1992). 43 Note under IRC §170(a) these are now limited to 80% of taxable income calculated without the NOL deduction. 44 IRC §454. 45 https://www.treasurydirect.gov/indiv/research/indepth/ebonds/res_e_bonds_eetaxconsider.htm

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Another item of premortem planning would be if there are charitable gifts to be made at death and there is additional income, if there are itemized deductions, perhaps those gifts should be advanced during lifetime in order to create an income tax deduction which may be of value on the income tax return.

If there is suspended passive activity losses that would be lost at death, perhaps the passive activity should be sold during lifetime so that the losses can be recognized and used on the decedent’s return.

One of the most common situations if you have deductions that need to be used is that the decedent may have a retirement plan. Assuming the beneficiary of the retirement plan and the beneficiary of the estate or trust are the same it may be wiser to take out more than the required minimum distribution so that the deductions can be used on the decedent’s return (effectively a 0% tax rate on that income) and perhaps use the lower brackets to minimize the income tax.

If eligible, consider the possibility of making a Roth IRA conversion before the decedent dies. This would produce additional income and could allow (in a case where a Roth IRA has existed for the decedent for at least the five-year requirement) no income tax would be paid by the beneficiary.

Remember that if the decedent has a large amount of income or there are income tax returns that need to be filed, if the spouse signs a joint return, the spouse becomes liable for the tax. Consider using married filing separately on the return if the spouse has concerns about joint liability.

Remember most individuals are on a cash basis. If the income has not been received by the taxpayer before death, it is reportable on the trust or estate’s return. Generally, receipts on the date of death are allocable to the decedent. Timing of the receipt of income can be essential.

X. The Estate or Trust After Death

X.1. Tax Identification Numbers

The decedent’s social security number can no longer be used. The social security number dies with the decedent. Either an estate or a trust that was revocable at death needs an identification number. You apply on Form SS-4. This is to be signed by the trustee or personal representative. In addition, we recommend the use of a form that authorizes you to apply online for the identification number. Assuming the IRS computer system is properly working, you can obtain the identification number within minutes. You should advise your client that they will be receiving a letter from the IRS within the permanent assignment of the employer identification number.

If the trust was a grantor trust before death and was revocable until death, it may have had an identification number. If it already had an identification number, you will need to file a

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final return up through the date of death using the old number and you will need to obtain a new identification number.

X.2. Form 1041

The return for a trust or estate is Form 1041. The identification number used is that obtained by the trust or the estate.

X.3. The §645 Election

Under §645 of the Internal Revenue Code, a trust may elect to be part of an estate and be reported along with the estate’s return. Trusts are ordinarily required to have a calendar year. By electing to file with the estate the trust can join in the estate’s fiscal year election. After two years, the trust would need to file separate returns. This only applies to trusts that were revocable at death. An irrevocable trust can’t file Form 8855.

X.4. Tax Year Planning

If the decedent dies while having a surviving spouse, and if a joint return is to be filed with the surviving spouse, it is possible to make an election to have the fiscal year of the estate end December 31 or at the end of any prior calendar month of that calendar year. If distributions are made from the estate to the surviving spouse, the income will be reportable on the surviving spouse’s joint income tax return with the decedent.

For example, Tom dies on July12, 2019. His wife, Mary does not remarry before the end of the year and files a joint return with Tom. The joint return has a large amount of deductions and there will be no income tax due, if fact deductions will go to waste.

The estate receives income of $15,000.00 which is the amount of DNI. Although the estate can elect to file using a June 30, 2020 year end (which means that income distributions are reported on Mary’s 2020 return46) if the estate elects a December 31, 2019 year end and distributes the $15,000.00 to Mary47 then Mary reports this income on the joint return.

A non-working surviving spouse can make a post-death contribution as the spouse to their own IRA for the year of death providing that there were sufficient pre-death earnings to qualify.

X.5. Coordination with Inheritance Tax

46 IRC §652(c) and §662(c). 47 Either on or before December 31, 2019 or, if the personal representative elects within the first 65 days of 2020. Since 2020 is a leap year March 5, 2020 is the last day to distribute. IRC §663(b).

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In Nebraska we have an inheritance tax. We are one of six states that still have an inheritance tax. While it is probably not an issue for Class 1 beneficiaries, if the beneficiary is Class 2 or Class 3, income tax can be a big issue.

For example, if the retirement account has a balance of $200,000 in it and the exemption is used under other assets passing to the decedent’s niece, that $200,000 would be subject to a 13% Nebraska inheritance tax totaling $26,000. If, however, there is income tax due because the funds were taken out of the IRA during lifetime, that is now a debt of the decedent and a deduction for Nebraska inheritance tax purposes. If that income tax is $60,000 there is a deduction effectively 13% on the $60,000 which would result in a $7,800 inheritance tax savings.

Assume that the decedent had a $1,000,000 rental real estate. It was depreciated out except for the land which had a value of $50,000. Interest expense and costs incurred with depreciation results in excess deductions of $30,000. If this is held by an estate and if the decedent met the requirements in the year of death for the $25,000 deduction under the passive loss rules for rental real estate, the estate can take $25,000 of those losses against its income and only have a suspended passive loss of $5,000. If it is a trust that owns the real estate there is no deduction and there’s a $30,000 suspended passive loss.

X.6. Allocations between Final Return and Form 1041

Some allocations may need to be done on Form 1099. If there is interest received, that interest received or credited to the account while the decedent is alive is reportable on the decedent’s return. Interest received or credited to the account after the decedent’s death is reported on the return of the owner of the account, the estate, the trust or the beneficiary. However, form 1099’s almost never match the actual income taxable to the decedent and there may need to be some allocations made on the returns.

X.7. Special Tax Rules

If there is an annuity that allocated basis over lifetime and the decedent dies before reaching the life expectancy, there may be unrecovered basis available. This may be deducted on the final return of the decedent.48

If the individual was involved in certain terrorist attacks as a specified terrorist victim, please also look at §692.

A surviving spouse with children that would otherwise be eligible to be claimed as exemptions may be entitled to joint rates for the year of death and the following two years.49

48 I.R.C. §72(b)(3)(A) 49 I.R.C. §1(a)

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All gains on assets of the estate or trust that were acquired from the decedent are automatically long-term capital gains.50

X.8. Use of Pecuniary Formulas

One thing to keep in mind is if a large part of the estate or trust will consist of income in respect of a decedent, we recommend that you consider not using pecuniary formulas as this can lead to gain recognition to the estate or trust if the IRD is used to satisfy the request.

X.9. Simple and Complex Trust

In order to determine a simple trust from a complex trust, if there are mandatory income distributions with no principal invasion, the trust is a simple trust. If there is a mandatory income provision and there is a principal invasion power, but it is not exercised during the calendar year, it is a simple trust. If there is a mandatory income provision and there is some principal distribution during the year, it is a complex trust. Discretionary income is a complex trust. A discretionary income provision with all of the income being distributed is still a complex trust. Any provision that allows income to be accumulated results in a complex trust. A trust which files an election form with the estate under Form 8855 is a complex trust.

XI. Distributable Net Income

Distributable Net Income is a concept for Federal income tax purposes only. Distributable net income is used to determine the maximum amount of income that can be a distribution deduction on the Federal income tax return of the Trust or Estate.

Income is defined when it does not include words in front of it such as “taxable”, “distributable net”, “undistributed net”, or “gross” to be the amount of income of an Estate or a Trust for a taxable year determined under the terms of the governing instrument and applicable local law.51 In other words income means Fiduciary Accounting Income (FAI). Trust provisions that depart fundamentally from traditional principles of income and principal will generally not be recognized.52

The deduction is based upon income (FAI) as determined under the instrument or under State law. The maximum amount deductible is distributable net income. The other purpose of distributable net income calculation is to determine the character of the income distributed. For

50 I.R.C. §1223(11) 51 I.R.C. §643(b) 52 Treas. Reg. §1.643(b)-1

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example, if there is tax exempt interest included in the Estate there will be a portion of the distribution from the Estate that is considered a distribution of the tax exempt interest.53

Distributable net income is ordinarily equal to the following:

1. The taxable income determined without the distribution deduction or without the personal exemption54 (when it is allowed);

2. Less the net capital gains; and

3. Plus the tax exempt income reduced by expenses (add any charitable deduction) allocated to such income.55

Other modifications to taxable income are that capital losses are not taken into account exempt to the extent that they reduce the amount of capital gains actually paid or credited to the beneficiaries. The exclusion under §1202 is not taken into account. If the Trust is a simple Trust and if there are extraordinary dividends or taxable stock dividends, these are not included in DNI unless they are allocated to fiduciary accounting income (FAI).

On some occasions, there can be capital gains or losses involved in the DNI calculation.

Please note that we have discussed both simple trusts and complex trusts. Simple trusts have their distributions calculated under §§651 and 652. Complex trusts and Estates have their distributions and income calculated under §§661 and 662.

If it’s an Estate, it is automatically treated as the equivalent of complex. If it is Trust you need to determine whether it is a simple trust or a complex trust. The basic principle of a simple trust is that it must be a mandatory income distribution provision.

XII. Fiduciary Accounting Income

Fiduciary Accounting Income is determined under the Nebraska Uniform principal and Income Act, but it is a default rule. It will be the source of the rules except as overridden by the controlling document. You can control the definition of income in your drafting.

What does it mean if you draft a trust that says the income is to be distributed to the surviving spouse? Does this include all income taxable on the trust’s Form 1041?

Under I.R.C. §643(b) the word “income” when not preceded by the words “taxable”, “distributable net”, “undistributed net”, or “gross”, means the amount of income of the estate or trust for the taxable year determined under the terms of the governing instrument and applicable

53 This may be very important for state income tax purposes as municipal interest which is exempt for federal income tax purposes is not always exempt for state income tax purposes. 54 I.R.C. §642(b) 55 I.R.C. §643

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local law. Items of gross income constituting extraordinary dividends or taxable stock dividends which the fiduciary, acting in good faith, determines to be allocable to corpus under the terms of the governing instrument and applicable local law shall not be considered income.

The distribution deduction on the estate or trust income tax return is to allow the income to be taxable to the beneficiaries. To the extent it is taxable to the beneficiary there is an income tax deduction. I.R.C. §651 & 661. They are subject to the definition in 643(b). They both limit the deduction to income.

There is a concept known as Distributable Net Income (DNI). This is an income tax term. Its purpose is to limit the deduction for income tax purposes. The deduction on the estate’s or trust’s return is for income (Fiduciary Accounting Income or FAI) but it is limited to the amount of DNI. Taxable income does not always match FAI.

Thus under IRC §651 the deduction is the smaller of FAI or DNI.

Thus under IRC §661 the deduction is limited so that it can’t exceed DNI. It is the sum of the amounts required to be paid plus any other amounts properly paid or credited or required to be distributed for such taxable year.

State law thus has a place in determining the income tax deduction for an estate or a trust. FAI also determines the amount of income which can be distributed. If it is not income and if there is no authority to distribute principal, FAI determines what may be distributed. The trustee must consider the state law duty of loyalty in the determining distributions. There are adjustments between income and principal permitted under the Nebraska UPIA.

If a distribution from a retirement plan is made to a trust how much of that is income (FAI) versus taxable income?

The table below shows some of the provisions of the Nebraska UPIA involving receipts and disbursements and their allocation between income and principal.

Statute Description Income Principal 30-3127 Distribution from an

entity corporation, LLC, LP or Real estate investment trust

Cash except for items in other column

Cash in liquidation, partial liquidation, or acquisition of part or all of trust’s interest in the entity,

Mutual Fund or REIT Distribution56

Cash to extent it is ordinary income for income tax

Cash to extent it is capital

56 Comment to UPIA §401 “…cash received by a trust because of a net short-term capital gain is income under this Act.” On reinvested dividends the comment states: “If a trustee elects (or continues an election made by its predecessor) to reinvest dividends in shares of stock of a distributing corporation or fund, whether evidenced by new certificates or entries on the books of the distributing entity, the new shares would be principal. Making or continuing such an election would be equivalent to deciding under Section 104 to transfer income to principal in

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Statute Description Income Principal gain for income tax

Property from entity other than money

Principal

Money if money and property exceed 20% of gross assets

Money with maximum of 20% Property and money to extent in excess of 20%

30-312957 Sale of business operated by Trustee

Net receipts in business operated by trustee

Net receipts in excess of amount needed for working capital, acquisition or replacement of fixed assets and amounts needed for other reasonable foreseeable needs of the business

amount needed for working capital, acquisition or replacement of fixed assets and amounts needed for other reasonable foreseeable needs of the business

30-3130 Eminent domain separate award made for the loss of income with respect to an accounting period during which a current income beneficiary had a mandatory income interest is income;

All other receipts

30-3131 rents amount received as rent of real or personal property, including an amount received for cancellation or renewal of a lease

refundable deposit, including a security deposit or a deposit that is to be applied as rent for future periods

deposit that was to be applied as rent for future period, when that period occurs

30-3144 Depreciation of fixed asset having a useful life of more than one year

a reasonable amount of the net cash receipts from a principal asset that is subject to depreciation

Depreciation for of that portion of real property used or available for use by a beneficiary as a residence or of tangible personal property held or made available for the personal use or enjoyment of a beneficiary58

order to comply with Section 103(b). However, if the trustee makes or continues the election for a reason other than to comply with Section 103(b), e.g., to make an investment without incurring brokerage commissions, the trustee should transfer cash from principal to income in an amount equal to the reinvested dividends. 57 §30-3129 allows trustee to maintain separate accounting for businesses operated by the trust. 58 §30-3144 omitted UPIA §504(b)(4) 504(b)(4) permits the trustee to transfer additional cash from income to principal for this purpose to the extent that the amount transferred from income to principal for depreciation is less than the amount of the principal payments. Thus if depreciation is less than principal payment on an amortization, there may be a problem. You can deal with this in drafting as the Neb UPIA is the default rule and the document controls. However, see §30-3145 which provides for a trustee that the trustee may transfer to principal when

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Statute Description Income Principal Depreciation during the

administration of a decedent's estate

under this section 30-3144 if the trustee is accounting under section 30-3129 for the business or activity in which the asset is used

30-3132 Interest Income Prepayment penalty for

early payment of principal

Income

Amortization of Premium Principal Bonds issued at a

discount59 Proceeds over cost if the obligation matures in less than a year

All proceeds if the obligation matures in over a year

30-3133 Insurance policy proceeds proceeds of a contract that insures the trustee against loss of occupancy or other use by an income beneficiary, loss of income

proceeds of a life insurance policy or other contract in which the trust or its trustee is named as beneficiary,

dividends on an insurance policy to income if the premiums on the policy are paid from income,

Proceeds of a contract that insures the trust or its trustee against loss for damage to, destruction of, or loss of title to a trust asset.

dividends on an insurance policy to principal if the premiums are paid from principal.

30-3135 30-3135(b) applies to plans whose terms characterize payments made under the plan as dividends, interest, or payments in lieu of dividends or interest.60

To the extent that a payment is characterized as interest, a dividend, or a payment made in lieu of interest or a dividend, a trustee shall allocate the payment to income.61 See §30-3135(b)

The trustee shall allocate to principal the balance of the payment and any other payment received in the same accounting period that is not characterized as

periodic payments on an obligation secured by a principal asset to the extent that the amount transferred from income to principal for depreciation is less than the periodic payments 59 UPIA §406 comment states Subsection (b) applies to all obligations acquired at a discount, including short-term obligations such as U.S. Treasury Bills, long-term obligations such as U.S. Savings Bonds, zero-coupon bonds, and discount bonds that pay interest during part, but not all, of the period before maturity. Under subsection (b), the entire increase in value of these obligations is principal when the trustee receives the proceeds from the disposition unless the obligation, when acquired, has a maturity of less than one year.

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Statute Description Income Principal interest, a dividend, or an equivalent payment.

30-3135(c)

Annuity or retirement plan, other than to spouse62

If no part of a payment is characterized as interest, a dividend, or an equivalent payment, and all or part of the payment is required to be made a trustee shall allocate to income ten percent of the part that is required to be made during the accounting period and the balance to principal.63

The trustee shall allocate the remaining balance payment to principal.

a trust to which an election to qualify for a marital deduction under section 2056(b)(7) of the Internal Revenue Code of 1986, as amended, has been made; or a trust that qualifies for the marital deduction under section 2056(b)(5) of the Internal Revenue Code of 1986, as amended.

the internal income of each separate fund for the accounting period as if the separate fund were a trust subject to the Uniform Principal and Income Act.

The balance of the payment

If a trustee cannot determine The balance of the payment

60 Comment to UPIA §409 states that §409(b) (§30-3135(b)) applies to certain plans. For example, some deferred compensation plans that hold debt obligations or stock of the plan’s sponsor in an account for future delivery to the person rendering the services provide for the annual payment to that person of dividends received on the stock or interest received on the debt obligations. Other plans provide that the account of the person rendering the services shall be credited with “phantom” shares of stock and require an annual payment that is equivalent to the dividends that would be received on that number of shares if they were actually issued; or a plan may entitle the person rendering the services to receive a fixed dollar amount in the future and provide for the annual payment of interest on the deferred amount during the period prior to its payment. 61 Comment to UPIA §409 provides that Section 409(b) does not apply to an IRA or an arrangement with payment provisions similar to an IRA. IRAs and similar arrangements are subject to the provisions in Section 409(c). This means §30-3135(c). 62 Comment to UPIA Section 409 applies to receipts from all forms of annuities and deferred compensation arrangements, whether the payment will be received by the trust in a lump sum or in installments over a period of years. It applies to bonuses that may be received over two or three years and payments that may last for much longer periods, including payments from an individual retirement account (IRA), deferred compensation plan (whether qualified or not qualified for special federal income tax treatment), and insurance renewal commissions. It applies to a retirement plan to which the settlor has made contributions, just as it applies to an annuity policy that the settlor may have purchased individually, and it applies to variable annuities, deferred annuities, annuities issued by commercial insurance companies, and “private annuities” arising from the sale of property to another individual or entity in exchange for payments that are to be made for the life of one or more individuals. The section applies whether the payments begin when the payment right becomes subject to the trust or are deferred until a future date, and it applies whether payments are made in cash or in kind, such as employer stock (in-kind payments usually will be made in a single distribution that will be allocated to principal under the second sentence of subsection (c)). 63 §30-3135(b) provides “a payment is not required to be made to the extent that it is made because the trustee exercises a right of withdrawal.”

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Statute Description Income Principal the internal income of a separate fund but can determine the value of the separate fund, the internal income of the separate fund is deemed to equal at least three percent of the fund's value, according to the most recent statement of value preceding the beginning of the accounting period.

If the trustee can determine neither the internal income of the separate fund nor the fund's value, the internal income of the fund is deemed to equal the product of the interest rate and the present value of the expected future payments, as determined under section 7520 of the Internal Revenue Code of 1986, as amended, for the month preceding the accounting period for which the computation is made.

The balance of the payment

30-3136 Liquidating asset64 ten percent of the receipts from a liquidating asset

The balance of the payment

30-3137 Minerals and other natural resources

nominal delay rental or nominal annual rent on a lease,

a production payment, a receipt must be allocated to income if and to the extent that the agreement creating the production payment provides a factor for interest or its equivalent.

The balance of the payment

royalty, shut-in-well payment, take-or-pay payment, bonus, or delay rental is more than nominal, 10%

The balance of the payment

working interest or any other interest not provided for above ten percent of the net amount received must be allocated to

The balance of the payment

64 §30-3136 applies to a leasehold, patent, copyright, royalty right, and right to receive payments during a period of more than one year under an arrangement that does not provide for the payment of interest on the unpaid balance. Under the comment to UPIA a state lottery payment is included.

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Statute Description Income Principal income.

water that is renewable must be allocated to income.

If the water is not renewable, ten percent of the amount must be allocated income

The balance of the payment

Disbursements 30-314265 one-half of the regular

compensation of the trustee and of any person providing investment advisory or custodial services to the trustee

one-half of the regular compensation of the trustee and of any person providing investment advisory or custodial services to the trustee

one-half of all expenses for accountings, judicial proceedings, or other matters that involve both the income and remainder interests;

one-half of all expenses for accountings, judicial proceedings, or other matters that involve both the income and remainder interests;

ordinary expenses incurred in connection with the administration, management, or preservation of trust property and the distribution of income, including interest, ordinary repairs, regularly recurring taxes assessed against principal, and expenses of a proceeding or other matter that concerns primarily the income interest;

recurring premiums on insurance covering the loss of a principal asset or the loss of income from or use of the asset

30-3143 all of the trustee's compensation calculated on principal as a fee for acceptance, distribution, or termination, and disbursements made to prepare property for sale

payments on the principal

65 See §30-3122 for exceptions.

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Statute Description Income Principal of a trust debt

expenses of a proceeding that concerns primarily principal, including a proceeding to construe the trust or to protect the trust or its property; premiums paid on a policy of insurance not described in subdivision (4) of section 30-3142 of which the trust is the owner and beneficiary; estate, inheritance, and other transfer taxes, including penalties, apportioned to the trust; disbursements related to environmental matters, including reclamation, assessing environmental conditions, remedying and removing environmental contamination, monitoring remedial activities and the release of substances, preventing future releases of substances, collecting amounts from persons liable or potentially liable for the costs of those activities, penalties imposed under environmental laws or regulations and other payments made to comply with those laws or regulations, statutory or common-law claims by third parties, and defending claims based on environmental matters

premiums paid on a policy

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Statute Description Income Principal of insurance not described in subdivision (4) of section 30-3142 of which the trust is the owner and beneficiary;

estate, inheritance, and other transfer taxes, including penalties, apportioned to the trust;

disbursements related to environmental matters, including reclamation, assessing environmental conditions, remedying and removing environmental contamination, monitoring remedial activities and the release of substances, preventing future releases of substances, collecting amounts from persons liable or potentially liable for the costs of those activities, penalties imposed under environmental laws or regulations and other payments made to comply with those laws or regulations, statutory or common-law claims by third parties, and defending claims based on environmental matters

If a principal asset is encumbered with an obligation that requires income from that asset to be paid directly to the creditor, the trustee shall transfer from principal to income an amount equal to the income paid to the creditor in reduction of the principal balance of the obligation.

30-3146 Income Taxes A tax required to be paid by a trustee based on receipts

A tax required to be paid by a trustee based on

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Statute Description Income Principal allocated to income must be paid from income.

receipts allocated to principal must be paid from principal, even if the tax is called an income tax by the taxing authority.

Chart for Allocation under §30-3135 for annuities and retirement plans

Description Statute Section plans whose terms characterize payments made under the plan as dividends, interest, or payments in lieu of dividends or interest

§30-3135(b)

some deferred compensation plans that hold debt obligations or stock of the plan’s sponsor

§30-3135(b)

“phantom” shares of stock and require an annual payment that is equivalent to the dividends that would be received on that number of shares if they were actually issued

§30-3135(b)

plan may entitle the person rendering the services to receive a fixed dollar amount in the future and provide for the annual payment of interest on the deferred amount during the period prior to its payment

§30-3135(b)

IRA §30-3135(c) an arrangement with payment provisions similar to an IRA §30-3135(c) Qualified retirement plan (except for spouse needing marital deduction) §30-3135(c)

Retirement plans are allocated under §30-3135(c) not §30-3135(b). If no part of a payment is characterized as interest, a dividend, or an equivalent payment, and all or part of the payment is required to be made, a trustee shall allocate to income ten percent of the part that is required to be made during the accounting period and the balance to principal.

In the year of death when the decedent had not reached age 70&1/2 there is no required distribution under federal law.66 Under the comment cited in the footnote, if there is no distribution requirement under the plan, the entire payment is allocated to principal.

Allocation between principal and income upon death

E.g. Trust for spouse with mandatory income payment to spouse for life

66 Comment to UPIA §409(c) states: An IRA is subject to federal income tax rules that require payments to begin by a particular date and be made over a specific number of years or a period measured by the lives of one or more persons. The payment right of a trust that is named as a beneficiary of an IRA is not a right to receive particular items that are paid to the IRA, but is instead the right to receive an amount determined by dividing the value of the IRA by the remaining number of years in the payment period. This payment right is similar to the right to receive a unitrust amount, which is normally expressed as an amount equal to a percentage of the value of the unitrust assets without regard to dividends or interest that may be received by the unitrust. An amount received from an IRA or a plan with a payment provision similar to that of an IRA is allocated under Section 409(c), which differentiates between payments that are required to be made and all other payments. To the extent that a payment is required to be made (either under federal income tax rules or, in the case of a plan that is not subject to those rules, under the terms of the plan), 10% of the amount received is allocated to income and the balance is allocated to principal. All other payments are allocated to principal because they represent a change in the form of a principal asset; Section 409 follows the rule in Section 404(2), which provides that money or property received from a change in the form of a principal asset be allocated to principal. (Emphasis Added.)

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If due date of the payment is before death, allocate to principal regardless of date of payment.67 For stock dividends the due date is the date on which the owner determines who receives the dividend, i.e., the record date.68 The next payment which is due on or after death is entirely income. It is not apportioned.69

For non-periodic payments or payments that have no due date the payment is allocated between principal and income on a daily basis. That portion ending with the date before death is allocated to principal.70 An example is an income tax refund. The decedent died on August 31. Interest through August 30 is principal and the balance is income.

A payment with a due date is due on the date when payment is required to be made. From the comments to UPIA §30371

Assume that a periodic payment of rent that is due on July 20 has not been paid when an income interest ends on July 30; the successive income interest begins on July 31, and the rent payment that was due on July 20 is paid on August 3. Under Section 302(a), the July 20 payment is added to the principal of the successive income interest when received. Under Section 302(b), the entire periodic payment of rent that is due on August 20 is income when received by the successive income interest. Under Section 303, neither the income beneficiary of the terminated income interest nor the beneficiary’s -estate is entitled to any part of either the July 20 or the August 20 payments because neither one was received before the income interest ended on July 30. The same principles apply to expenses of the trust.

XIII. Differences and Similarities Between and Estate and a Trust

If §1244 stock72 is held during lifetime the ordinary loss must be received by an individual. Thus funding a trust with 1244 stock removes this benefit.73 An estate also does not have this benefit. If there is §1244 stock, use a TOD beneficiary naming the trust to preserve this benefit during the lifetime of the client.

67 §30-3125(a) 68 Comment to §302 UPIA 69 §30-3125(b) 70 §30-3125(b) 71 §30-3125 is based on this section. Note that the ULC issued a new act in 2018 and Nebraska law is based on the UPIA. 72 IRC §1244 provides for certain small business stock which is held by an individual to have a loss on the sale of the stock be an ordinary loss up to $50,000 ($100,000) on a joint return and it is subject to additional limitations. 73 IRC §1244(d)(4).

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At death, the revocable living trust (assuming it was not a joint living trust remaining revocable by the surviving Settlor) becomes a new taxpayer.74 The table below shows differences between estates and formerly revocable trusts.

Description Estate Trust Taxpayer Status Separate Taxpayer Separate Taxpayer75 Fiscal Year Available Yes, by election Must be calendar year unless

files with estate on Form 8855 and then for 2 year only.76

Estimated Tax Payments Not required for first two years77 Not required for first two years78 May allocate estimated tax payments to beneficiaries

Only in last year79 In any year80

May deduct amounts set aside for payment to charity

Yes81 Only for certain trusts created on or before 10/9/196982

Passive losses on rental real estate during first two years up to $25,000 may be deducted

Yes, with possible reduction for surviving spouse’s exemption used within tax year83

No.84

Possible unlimited deduction for charitable distributions of income

Yes.85 No.

Unrelated related business income distributed to charity

Subject to IRC §642(c) These are subject to percentage limitations applicable to individuals86

How long may S Corporation stock be held

A reasonable period of time 2 years87

May apply for release of liability of personal representative for income tax and gift tax returns

Yes.88 Section does not apply

Deductibility of medical expenses paid within 1 year of death

Yes.89 No provision

74 Rev. Rul. 57-51, 1957-1 CB 171 75 Assuming an election is not made under IRC §645 on Form 8855. If so, the estate and trust file on one tax return. 76 IRC §645 77 IRC §6654(k) 78 Id. 79 IRC § 643(g) 80 Id. 81 IRC §642(c) 82 IRC §642(C)(2) 83 IRC §469(i)(4) 84 IRC §469(i) 85 IRC §642(c) 86 IRC §681(a) 87 IRC §1361(c)(2)(A)(ii) 88 IRC §6905. §6905(b) For purposes of this section, the term “executor” means the executor or administrator of the decedent appointed, qualified, and acting within the United States. 89 IRC §213(c)

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XIV. Miscellaneous

Remember that tax claims have a priority over most other distributions from an estate.90 The IRS does appear to recognize exceptions for administration expenses and funeral expenses to this priority.

XV. S-Corporation Planning

There are restrictions on S-Corporations with regard to who may hold stock. Generally eligible shareholders are citizens or residents of the United States who are natural persons, along with certain Trusts, Estates and exempt organizations.91 With very few exceptions, S-Corporations, C-Corporations and partnerships may not be shareholders.92

A Grantor Trust that is owned by a United States citizen or resident individual may be a shareholder.93 After the death of the Grantor, a Trust that was a Grantor Trust may remain as a shareholder for two years after the owner’s death. It may continue as a shareholder if it qualifies as a Qualified Subchapter-S Trust (QSST) or an Electing Small Business Trust (ESBT). A Testamentary Trust can qualify as a shareholder for a period of up to two years. Again, either the ESBT or QSST election must be made.94 Failure to make a timely election can result in the corporation losing its status as an S Corporation.

A QSST can have only one beneficiary, all the Trust income must be distributed to that beneficiary, the beneficiary’s interest must terminate at the earlier of the beneficiary’s death or the termination of the Trust, and if termination of the Trust occurs during the beneficiary’s life, the Trust must distribute its assets to the beneficiary.95 The status must be elected by the beneficiary within two months and fifteen days of qualification. The QSST election applies to subsequent beneficiaries and is irrevocable without IRS consent. However, you can convert a QSST to an ESBT and the IRS consent to that conversion is automatic.96

The ESBT election allows more flexibility in the planning but it comes at a high tax cost. That tax cost is that the tax rate on the ESBT election is at the top rate. There may also be State law special rules.

90 31 U.S.C. §3713 91 I.R.C. §1361(b)(1) 92 There may be a qualified Subchapter-S corporation that is a shareholder. This is commonly called a Q-Sub. Nothing restricts a S-corporation from holding a limited liability company interest. 93 I.R.C. §1361(c)(2)(A)(ii) 94 I.R.C. §1361(c)(2)(A) 95 I.R.C. §1361(d)(3) 96 Treas. Reg. §1.1361-1(j)

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One special rule for an Estate in determining outside basis in the stock is that the Decedent’s share of what is income in respect of a decedent (IRD) in the Corporation must be taken into account as if the Decedent had directly held that item.97

Upon death it is considered a disposition of the S-Corporation stock which requires allocation of the income between the Decedent and the transferee which could include the Estate.

In both the partnership taxation and the S-Corp taxation we will need to understand the distinction between “inside basis” and “outside basis”. Inside basis is the basis of the corporation or partnership in its assets. Outside basis is the basis of the shareholder or partner in its stock or partnership interest.

Death causes the step-up (or perhaps step-down) in basis of the outside basis. It does not directly affect the inside basis, that is the basis of the assets in the corporation.

Unlike a partnership, which can make what is known as a “Section 754 Election”, the inside basis is unaffected by the death. This is one of the reasons why limited liability companies have become so popular. Another reason is that upon distribution from a S-Corporation of an appreciated asset, generally gain is incurred. This can make it very difficult to get out of a corporation. Timing is crucial. It can be done without severe tax consequences assuming that the assets to be distributed are capital assets which are not subject to depreciation.

For example, a farm corporation was established back in the 1960’s. This was a common practice back then to avoid social security taxes. Now in 2019 the shareholders have decided to go their own ways.

Scenario 1 – One of the shareholders wants to remain farming. That particular shareholder buys out the other two shareholders. Assuming the price paid is the same as the new basis, the remaining shareholder has a 100% interest in the entity. However, upon distribution of the assets to that shareholder, if that is desired, we have a taxable situation.

If all that is present at that time in the corporation is land, then the step-up in basis in the stock resulting from the recognition of the gain may offset part of the gain if the liquidation occurs in the same year as the distribution.

Please remember that the fact that the real estate is in a S-Corporation means that there’s often a discount taken in valuing it. This is because of the potential for the gain recognition upon a sale or distribution. Thus the step-up in basis may not be the same as the value increase.

Scenario 2 – None of the shareholders are farming the property and they decided to sell the property. The corporation sells the ground at a farm sale in 2019 but the liquidation is not completed until 2020. The corporation recognizes capital gain on the sale because its inside

97 I.R.C. §1367(b)(4)(A) This also affects the basis.

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basis has never been stepped up since the ground was transferred into the corporation in the 1960’s. This will result in an increase in basis for the amount of the capital gain. However, the liquidation occurs in 2020. Thus there is a large capital loss in 2020 which has nothing to offset as the gain was incurred in 2019. It is very important to have the liquidation occur in the same year as the sale.

Scenario 3 – Over the years equipment has been purchased. The equipment has been depreciated out. We will assume that the ground is worth $2,000,000 and has a basis of $100,000. The equipment has a value of $400,000 and a basis of $0.00. The shareholders have the equipment sold and the farm sold at auction in 2020. They also liquidate in 2020. The corporation will recognize $1,900,000 in capital gain on the land sale. The corporation will also recognize $400,000 of ordinary income on the farm equipment sale. Thus income of $2,300,000 is carried out to the shareholders.

The shareholders had a basis step-up which we will assume was to $2,000,000. The shareholders then receive $2,300,000. The sale increases their basis by $2,300,000. Thus their basis is now $4,300,000. They received $2,300,000, so there is a $2,000,000 capital loss.

They will report $1,900,000 in capital gains with a $2,000,000 capital loss carry over. Thus there will be no capital gains that are subject to tax. However, the farm equipment sale produced $400,000 in ordinary income. The most that can be offset against the ordinary income is $3,000 per shareholder. The remaining capital loss is carried forward. Thus there will be a taxable consequence on the sale because of the ordinary income disparity.

In planning we want to be certain that the farm equipment is not owned in the corporation. You may wish to consider a limited liability company owning the equipment and leasing it to the corporation.

For limited liability companies taxed as partnerships and partnerships, the situation is a little bit different. The normal rule of inside basis and outside basis discussed above does apply to these limited liability companies taxed as partnerships and to partnerships. There is an exception. The exception is known as the Section 754 election.

The Section 754 election allows the outside basis that has been stepped-up to be brought inside and become the partnership’s basis inside in its assets with respect to the Decedent’s former interest. For example, if we have 10 members in the limited liability company and one of them dies, the limited liability company now has to keep at least two sets of depreciation records. It keeps one for those members who have not died and one for each of the members who have died. If they die at different times, there can be multiple depreciation schedules involved. Clearly this is unwieldly in many larger entities.

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If the Section 754 election is not made there is the same results on a sale as with the S-Corporation as discussed above. However, if the members decide to dissolve the entity there will be generally no tax consequence on the distribution.98

In our example above, if the Section 754 election were made (assume there is a nominal partner who owns a tiny percentage in order to allow partnership tax treatment) the results are different.

The $2,000,000 basis would be brought inside to be split up based upon proportionate values so that there would be some allocated to the real estate and some allocated to the ordinary income property. We also have a situation where we have a step-up in basis. This means that we’re going to be eligible for re-depreciating the assets. §704c(1)(B)

One thing to remember is partnership taxation requires that there be an entity which can be taxed as a partnership. This means there must be at least two partners. For example, Tom and George who are brothers have been farming a farm in a partnership for the last 50 years. George dies. The partnership agreement provided for a TOD beneficiary designation of Tom. At the time of George’s death there is no longer any entity that can be taxed as a partnership. The sole ownership interest in the partnership is now in Tom’s hands. We thus have to look at the rules for disregarded entities.

98 If a person has contributed appreciated property upon the formation of the partnership and a distribution is made to that person, then under §704(c)(1)(B) there is a transfer back to that person of the appreciated property they take it over at their basis. However, if it is distributed to other people then there can be gain recognition. In addition, note that if there are liabilities in excess of basis there can be gain recognition.