TAX PLANNING AND CONSEQUENCES OF PROBATE

by
Fred Hepner

(Document originally published on December 4, 2009)

This document is provided for educational purposes on and should not to be construed as the rendering of legal
advice. Readers of this document should consult a qualified attorney to discuss the application of any personal
legal issues and how they pertain to their own facts and circumstances. Tax and financial matters should be
discussed with a qualified financial and tax advisor.
INTRODUCTION

An estate may become subject to tax deadlines in various ways. The estate may be subject to tax
filing deadlines based on:

1) income generated during the administration of the estate

2) income generated by trusts
3) the gross value of the estate
4) tax obligations of decedent

Personal representatives must consider all of these aspects. Very small transactions may trigger
new concerns. For example, if the estate earns gross income of $600, the personal representative
must file an estate income tax return. Great care must be taken to avoid liability to the personal
representative, beneficiaries, heirs, estate and any entities created.

CRUCIAL DUE DATES TIMELINE

ASAP after death of Decedent:

1. Determine whether decedent’s prior year tax return was filed. (Form 1040)
2. Determine whether any gift tax returns need to be filed. (Form 709)
3. Determine whether an income tax return must be filed on behalf of the decedent. In the year
of death, a personal return may be due for income earned to the date of death.
4. Advise the personal representative to seek competent tax counsel familiar with estate tax
matters, or alternatively, begin gathering information to prepare the estate tax return, if
applicable (Form 706)
5. Consider the need to obtain a federal identification number for the estate (Form SS-4)
6. Consider filing Notice Concerning Fiduciary Relationship (Form 56)

Within First 30 Days After Letters Issued:

1. Advise the personal representative to contact banks, credit unions, brokers, mutual fund
companies and other payment sources to provide cutoff statements to show income earned before
and after death for any estate that does not have a federal identification number.
2. Provide all payers of income, the federal identification number of the estate to allow proper
allocation of income between the decedent and estate.
3. If decedents died leaving a taxable estate, then request an extension from court to file the
probate inventory after the default statutory 90 days.

Anniversaries of Six Months after Decedent’s Death:

1. Consider the use of the alternate valuation date for the estate.
Within 9 months of Decedent’s death:

1. File Form 706, if required, or file Form 4768 to request an automatic extension to file within
six months.
2. Consider whether any disclaimers are necessary (e.g., spouse must disclaim to bypass trust)

OBTAINING TAX IDENTIFICATION NUMBERS

The IRS takes the position that all estates should obtain a federal identification number. The IRS
reminds taxpayers that if they do not include the federal identification number for an entity or
social security number of a person, where required on a return, statement, or other document,
then the estate is liable for penalties for each failure. The penalty is overcome by making a
showing of reasonable cause.

The rule seems to indicate that every estate and trust must obtain a federal identification number.
However, logic would seem to indicate that filing for a federal tax identification number for
every estate just creates additional paperwork. Filing for a federal identification number may
result in notices from the IRS about missing income tax returns that need not be filed. Small
estates often do not generate much income and property is distributed in a relatively short period
of time, if few debts are involved.

A federal identification number is definitely necessary, when the estate expects to file an income
tax return, estate tax return, or otherwise intends to interact with the IRS. Any estate that will
generate $600 or more in income must file an income tax return for each year the estate remains
open.

Obtaining a federal tax identification number is relatively simple. Complete a form SS-4, which
may be download from the IRS website.1 The rules require a third-party to obtain the signature
of the personal representative and hold a signed copy of the Form SS-4, before obtaining the
federal identification number. The identification number should be obtained after the order is
obtained from the court to open the probate of the estate. The fiduciary is the person authorized
to sign the SS-4.

Practice Tip: Clients often get the federal identification number before they come to see
the attorney for the initial appointment. The online application process does not seem to
catch the premature filing of the SS-4 application, or the fact that the person ordering the
number is not authorized to obtain the number.

There is a special rule applicable to completing the SS-4 that is unique to estates. An estate is
not limited to a calendar year-end. The estate may elect an alternative year-end that falls on day
other than December 31st. By electing a day other than December 31st, the personal
representative extends the time for filing the first income tax return for the estate, as well as all
subsequent annual tax returns. This benefit also allows the estate beneficiaries or heirs to extend

1
The link for Internal Revenue forms and publication is http://www.irs.gov/formspubs/
the reporting of their share of estate income into the next tax year.

For example, if the decedent died on April 12, 2009, the personal representative may elect a
year-end date ending on March 31, 2010 for the first year. The election is easy to make, just
choose the third month of the year as the year-end, when completing the Form SS-4. Always
choose the last day of a month for the closing period.

The beneficiaries will also appreciate the election for two reasons. First, the timing for
completion of any estate income tax return will be less of an administrative issue. Tax returns
may be completed during less busy times of the year and the personal representative is less likely
to be pressured to obtain the tax information. Second, estate tax returns often pass-through
income to the beneficiaries and this process generates a Form 1041 K-1 for each beneficiary.
The K-1's provide the income tax information necessary for the beneficiaries to file their
personal returns. A calendar year-end invariably causes the information to arrive in the hands of
the beneficiaries, after they file their personal income tax returns. The beneficiaries or heirs
must amend their tax returns to include the K-1 income, which significantly increases the
likelihood of audits.

MATCHING ESTATE INVENTORY AND TAX RETURN IN PROBATE

The idea of a gross estate is primarily a federal tax concept. The idea of the probate estate is a
concept of state law. Federal tax law includes all property interests of the decedent in his or her
gross estate. The probate court is only concerned with the probate assets, not the nonprobate
assets transferred outside of probate. Preparation of the inventory filed with the court includes
only the probate part of the gross estate.

The inventory filed with the court is attached to a Form 706 estate tax return filed with the IRS.
Care needs to be taken to file an accurate inventory with the court, as the document is a sworn
document. The probate court may not be as demanding on the issues of value, but the IRS is
known to dispute estate valuations.

FILING THE FINAL TAX RETURNS

Certain Aspects of the Final Estate Return

Estate Return - An estate tax return is filed on Form 706 and due nine months after the
decedent’s death. The maximum extension available for filing the return is six months. Interest
and penalties will apply to any unpaid taxes remitted after the due date. No return is necessary if
the value of the gross estate exceeds the exemption amount ($3.5 million for 2009).

The following documents are included with the return:

1. A death certificate
2. Certified copy of the will - testate decedent
3. Certified copy of the court’s order
4. Certified copy of the inventory filed with the court
5. Copies of appraisals for real estate
6. List of qualified terminable interest property (QTIP) elected property
7. Copies of gift tax returns filed by the decedent
8. Copies of inter vivos trust instruments and documents related to gifts made during the lifetime
of the decedent.
9. Form 712 (obtain from insurance company) to show the life insurance on the decedent’s life
10. A certificate obtained from any state to prove the amount and date state death taxes were
paid

Calculating the taxable value of an estate is based on a complex formula. There are valuation
issues, discounts, exemptions and the inclusion of assets in the taxable estate may not necessarily
be limited to property the decedent held title to at his or her death. The gross estate includes
certain property the decedent held a beneficial interest in at death. For example, gifts made
within three years prior to decedent’s death triggers inclusion of the value of the gifts into the
decedent’s gross taxable estate.2

Certain Aspects of Finalizing the Decedent’s Personal Tax Obligations

Tax Obligations of Decedent Prior to Death - A decedent may die before fulfilling tax
obligations for the year before death (consider that personal income returns are now
automatically extended to October 15th). A personal return may need to be filed by the personal
representative for the decedent. A second tax return may also be required in the year the
decedent dies.

Many Americans are delinquent in fulfilling their tax obligations for past tax years. Consider the
fact that the statute of limitations for collections does not run, until a taxpayer actually files their
tax return. Failure to file the proper returns subjects the estate and the personal representative to
personal liability. Beneficiaries receiving property against the interest of the IRS or state may
incur liability. Income tax issues may be only part of the total tax liabilities of the decedent. The
decedent may also die leaving gift, payroll, business and state tax issues.

Refund Claims - Decedents do not always die owing money to the IRS. A decedent’s final
personal income tax returns may result in refund claims for the estate. The personal
representative is authorized to claim the refund, but must follow special steps to collect the
claim. A surviving spouse, filing a joint return with the decedent, may also make the refund
claim by attaching a Form 1310 to the joint return. Form 1310 is not needed when a personal
representative makes the claim. However, the personal representative must attach a copy of the
court certificate to the tax return to show that he or she is the appointed personal representative.
This assumes the personal representative is filing an original return. If the personal
representative is filing a claim for refund using Form 1040X or Form 843, and the court
certificate has already been filed with the IRS, then a Form 1310 must also be attached. The
personal representative should write “Certificate Previously Filed” at the bottom of the form. It
is important to remember that all returns are signed under penalty of perjury.

2
IRC §2035(a).
Request for Prompt Assessment - The IRS is permitted three years to assess a tax return from the
latter of the date the return is filed, or the due date of the return. For an estate, this can be
problematic, because the personal representative needs to hold sufficient estate assets to cover
any potential additional tax assessments. The personal representative may request a prompt
assessment for any tax return, other than the estate tax return. A request for an early assessment
may be made in writing, or by using Form 4810 (Request for Prompt Assessment Under Internal
Revenue Code Section 6501(d)). The request must be filed separately from any other document
and the effect is to shorten the three year time for assessment from three years to 18 months.

TAX ISSUES CONNECTED WITH INSOLVENCY

The IRS’ position on an insolvent estate is as follows:

Generally, if a decedent's estate is insufficient to pay all the decedent's debts, the debts
due the United States must be paid first. Both the decedent's federal income tax liabilities
at the time of death and the estate's income tax liability are debts due the United States.
The personal representative of an insolvent estate is personally responsible for any tax
liability of the decedent or of the estate if he or she had notice of such tax obligations or
had failed to exercise due care in determining if such obligations existed before
distribution of the estate's assets and before being discharged from duties. The extent of
such personal responsibility is the amount of any other payments made before paying the
debts due the United States, except where such other debt paid has priority over the debts
due the United States. The income tax liabilities need not be formally assessed for the
personal representative to be liable if he or she was aware or should have been aware of
their existence.3

Exposure to Beneficiary Liability - The IRS may hold beneficiaries receiving property
distributions responsible for unpaid tax liabilities.

Limiting Personal Representative Liability - A personal representative may make a request for
discharge from personal liability for a decedent's income, gift, and estate taxes. The request must
be made after the returns for the taxes are filed. To make the request, file Form 5495 (Request
for Discharge From Personal Liability Under Internal Revenue Code Section 2204 or 6905). For
this purpose, the personal representative must be an executor or administrator appointed,
qualified, and acting within the United States. Within nine months after receipt of the request, the
IRS notifies the personal representative about the amount of taxes due. If this amount is paid, the
personal representative will be discharged from personal liability for any future deficiencies. If
the IRS has not notified the personal representative within nine months, he or she will be
discharged from personal liability at the end of the 9-month period. However, even if the
personal representative is discharged from personal liability, the IRS takes the position that it is
still be able to assess tax deficiencies against the personal representative to the extent that he or
she still holds any property of the decedent.

3
IRS Pub 559.
SIMPLE TIPS FOR MINIMIZING TAX BURDEN

Use of Alternate Valuation Date - If a taxable estate exists, the personal representative may
choose an alternate valuation date for determining the value of the gross estate. The alternate
date of valuation is six months after the decedent’s date of death. All assets must be valued in
total on the same date. Any assets sold or distributed during the date of death and the alternate
date are valued on the date of sale or distribution. Any decrease in value due to the passage of
time must be ignored.4 The alternate valuation date is irrevocable and may be elected, only when
the value of the gross estate reduces the estate tax liability, after considering the reduction for
any credits.5

Benefit of Stepped-Up Basis - Clients are often confused about the special tax rules allowing
recipients of estate property to step-up the cost basis of estate assets they receive. The step-up in
basis is a tax concept that corresponds to the valuation of estate property. Essentially, the
decedent’s property basis is wiped clean and the beneficiary gets the current market value taken
on the decedent valuation date. Highly appreciated property receives a good benefit. Devalued
property receives a negative result, because the basis is lowered.

A higher cost basis is matched against the proceeds of a subsequent sale and used to reduce the
profit recognized on the sale. The higher cost basis is important to beneficiaries, the estate and
any trust selling the property. The benefit cuts their tax liability. (Note: current estate tax law is
scheduled for automatic repeal at the end of 2009. Technically, the estate tax law is repealed in
2010. A congressional bill was introduced at the beginning of 2009 to prevent the expiration of
an estate tax system, but at this writing, minimal action has been taken on the bill. If the estate
tax system is repealed for 2010, then the repeal will also eliminate this step-up basis concept.
Any decedent dying during the repeal period may not receive the step-up benefit.)

Evaluate Use of Marital Deduction - Spouses receive an unlimited marital deduction for estate
and gift tax purposes and any transfers between spouses are exempt from taxation. Careful
consideration should be used in determining how much property to transfer to the surviving
spouse. While estate taxes may be eliminated or reduced by transferring all property to the
surviving spouse, upon the death of the surviving spouse, there may be significant taxation
burden place on the surviving spouse’s estate.

Postmortem Planning With Disclaimers - Postmortem estate tax planning often involves the use
of full or partial disclaimers. Both state law and federal tax law recognize the use of disclaimers
and the Texas statute empowers an heir or beneficiary to avoid both tax consequences and
creditor claims. Trusts may disclaim property, but the practitioner must recognize the
requirements of the Texas Property Code, which requires court approval under certain
conditions.6

4
Reg. Sec. 20.2032-1(f).
5
Sec. 2032(c).
6
See Tex. Ppty. Code §112.010.
Important Note: Disclaimers may cause serious harm to Medicaid recipients. A Medicaid
recipient may lose benefits, because the recipient is considered to have received the disclaimed
property. The disclaimed property becomes a countable resource.

Income With Respect to Decedent - Income distributed from tax-sheltered investment, e.g.,
decedent’s IRA, is income with respect to a decedent and any income passing through a trust is
taxable income to the trust. If the trust subsequently makes a charitable contribution to a charity,
then a tax planning opportunity is lost. Check for postmortem planning opportunities allowing
the trust to avoid receipt of the income by the trust. If possible, allow the income with respect to
a decedent to transfer directly to the charity. The charity receives a larger contribution and will
receive the distribution tax-free. The trust pays less income tax.

Practitioner Caveat - Probate practitioners need to be aware of a potential practice pitfall

involving tax matters. In 2007, the IRS made major revisions to Circular 230. Circular 230
provides the general rules that all “tax preparers” must follow to avoid fines, penalties and
disbarment from practice before the IRS. Disbarment precludes the preparer from
communicating or representing any client for any matter before the IRS, including preparation of
forms and letters communicated to the IRS. Many probate practitioners take the position that
they do not prepare tax returns, so the rules do not apply. Unfortunately, the 2007 Circular 230
revisions expand the meaning of tax preparer to include many practitioners outside the traditional
meaning of the term. The rules now include anyone, who prepares a form, writes a letter, or
conducts certain other forms of communication with the IRS. Thus, a probate practitioner who
prepares a Form SS-4 or Form 56 (see below) for a client is technically a tax preparer and subject
to the Circular 230 rules. Here is an interesting fact, the first two professionals disciplined and
suspended from practice before the IRS were attorneys.

Consider Filing IRS Form 56 - This material has discussed many personal liability issues
involving personal representatives of an estate. The personal representatives must actually
receive notice of tax issues or show reasonable cause for not responding to tax issues. An often
overlooked document that provides an administrative advantage is IRS Form 56 (Notice
Concerning Fiduciary Relationship). Immediately after receiving an order appointing the
personal representative, the personal representative may file separate Form 56 notices for both
the estate and decedent. You cannot file Form 56 until a federal identification number is
obtained. This form notifies the IRS of the decedent’s death and also informs the Service to send
all future notices regarding the decedent personal taxes, based on the personal Form 56 filed for
the decedent. The Form 56 notice filed for the estate gives notice regarding the decedent’s
estate. Both notices also inform the IRS to send the notice to the personal representative address.

Communicating With the IRS - Federal law requires the IRS to disclose information only directly
to the taxpayer. A decedent’s personal information is protected and may only be disclosed to the
decedent, a spouse who filed a joint tax return with the decedent, or an estate personal
representative appointed by the court. In the latter instance, the IRS will require information to
prove the validity of the appointment. The personal representative may only authorize an
attorney, CPA or enrolled agent to represent the decedent and/or the estate. Your legal assistant
is not permitted to communicate on a client’s behalf, without one the credentials noted. Plan
ahead, if you anticipate any tax issues with the estate, a trust, or the decedent’s personal taxes. A
separate Form 2848 is required for each type of entity. The form takes about seven to 10 days
for entry into the IRS CAF system via a fax, so plan ahead. If you plan to use alternate tax
counsel, involve counsel early in the administration process to allow duplicate notice to be
received by that counsel.

State Inheritance Tax Liability - If an estate is subject to federal estate tax filing requirements,
then the practitioner must also consider the Texas inheritance tax. Texas law relies on the
federal estate tax structure to impose collection of state inheritance taxes. The essence of the
Texas inheritance tax is that if an estate is taxable for federal purposes, then the estate is taxable
for state purposes. Use caution and consider that any property located in another estate may be
subject to estate tax of the state where the property is located. Mineral interests, business
interests, real and similar property with a situs in another state may trigger additional estate and
income tax burdens. Any state tax paid by the estate is a deduction on the federal estate tax
return. Remember to obtain a certificate for the amount and date of payment, signed by a state
authority authorized to sign the certificate.

Qualifying Closely-Held Business Benefit - Estates holding a closely-held business may qualify
for an installment payment of taxes under IRC §6166. The estate is essentially borrowing from
the government at very low rates of interest and extending the time for payment of estate taxes.
Special rules apply for qualification, but anytime a closely-held business is involved with an
estate, which is subject to estate tax liability, consider this election. Structuring the estate for
qualification is essentially an estate planning issue and not a postmortem planning issue.

Allocation of Estate Administration Expenses - There are opportunities to deduct estate

administration expenses on the estate tax return or an estate income tax return. All
administrative expenses may be deducted on one return, or allocated between both returns. The
personal representative may seek the best overall tax benefit.

Married Filing Joint Income Tax Return - If a personal representative is appointed, then the
personal representative may file a joint income tax return with the surviving spouse on behalf of
the decedent. If no personal representative is appointed, then the surviving spouse may file the
joint return. If the spouse remarries in the year of decedent’s death, then no joint tax return may
be filed. The practitioner may wish to use caution in filing a joint tax return with the surviving
spouse. Any party who signs a joint tax return is jointly and severally liable for the total amount
of taxes due on the return.

TAX TREATMENT OF TRUSTS

Trusts and estates must file an income tax return when their annual gross income is $600 or
more. Many deductions available to individuals are also available to trusts and estates. For
example, trusts may deduct capital losses, subject to the same $3,000 deduction limit as
individuals.
While there are similarities, there are many differences too. Both estates and trusts receive a
greatly reduced personal exemption of $600, whereas individuals generally receive a personal
exemption of a few thousand dollars. Trusts, as well as estates, possess the potential to pass
income through to beneficiaries, which reduces the taxable income of the trust or estate entity.

Complex and Simple Trusts - Trust instruments often contain unique formulas that determine the
way distributions are made to beneficiaries. Some trusts contain language that requires all
income earned to be fully distributed to beneficiaries in the tax year received. Other trust
instruments require income to be added to the trust corpus. Still other trusts give discretion to
the trustee to decide whether the beneficiary is receives varying levels of income or trust
property distributions.

The tax effect of these formulas decides whether the trust or the beneficiaries pay the income tax.
Trusts that pass all income through to the beneficiaries are called “simple trusts.” Another way to
look at the definition of a simple trust is to remember that a simple trust never makes a
distribution of trust property to the beneficiaries. Trusts allowing the trustee to retain income of
the trust or that require retention of trust income are called “complex trusts.” A simple trust in
its last year of existence becomes a complex trust, because the simple trust transfer the remaining
trust property to the beneficiaries. The distinction between simple and complex trusts determines
who pays income tax and whether applicable elections may be made with respect to deducting
charitable contributions and creditor protections.

Estate Tax Rates - A Texas trust is obviously subject to federal income tax requirements. The
type of return filed is a Form 1041. Currently, there is no income tax on trusts under Texas law,
but the investment activities of the trustee may impose income tax requirements involving other
states. For example, interest earned through an Ohio bank account may require the trust to file
an Ohio income tax return and apportion income and expenses between Ohio and Texas.

Estates and trusts pay tax based on graduated tax rates. The tax rates climb rapidly, relative to
individual taxpayer rates. For example in 2009, the trust and estate income tax rates impose a
15% marginal tax rate on taxable income between zero and $2,300. Additionally, trusts pay the
top marginal rate of 35% on all taxable income exceeding $11,150. A complex calculation is
used to determine the difference between accounting income and the concept of a distributable
net income (DNI). DNI essentially becomes a deduction for the trust or estate used to reduce
taxable income for the trust and pass income through to beneficiaries.

Tax Planning Balance - Tax planning opportunities center on balancing the overall tax effect
between the estate, trusts, beneficiaries, heirs, and charitable organizations. Overall tax
reduction planning requires consideration of the interests of the various parties to discover the
optimum level of tax savings. Additionally, the best tax strategies involve considering whether
income generating property is better held for an extended period of time in the estate, a trust, or a
beneficiary. While the estate tax return must be filed within nine months, and any extension,
some estates remain open for several years. The IRS pressures closure within four years.

With respect to trusts, the personal representative appointed by the court is empowered to
administer the estate. However, a trust is generally created to avoid involvement of the court.
Therefore, the personal representative may not necessarily be the same person named to serve as
a trustee of the testamentary trusts created under the Will. The personal representative’s only
relationship to the trust may be to transfer title to property from the estate to the trust. The
trustee is responsible for filing and signing any income tax returns required by the trust.

Capital Gain Election on Final Estate Income Tax Return - All estates and trusts are permitted to
offset capital gains with capital losses. Estate and trusts are also subject to the $3,000 capital
loss carryover rules applicable to individual taxpayers. The capital loss carryover rules are
problematic for simple trusts, because the trust distributes all income to the beneficiaries and
unless there are capital gains available to offset against, the losses are carryovers. Estates and
complex trusts are also permitted to offset capital gains of the trust, before distributing taxable
income to the beneficiaries, the trustee may use his or her discretion to offset losses against other
trust income. Therefore, any trust or estate should elect to passthrough any unused capital losses
of any trust directly to beneficiaries in the final year of existence. The election must be attached
to the final estate tax return.

Conclusion - Taxation of decedents is based on complex interpretations of tax. This article has
only touched on the surface of the issues and serves as a basic presentation of this subject.
Probate often crosses into the realm of taxation, so the key is to be ready to recognize major
issues and advise a client to seek competent tax counsel. The decedent’s CPA may not be
completely familiar with estate and trust taxation, but he or she may be of assistance in resolving
the personal tax issues related to the decedent.