Last November, Attorney John Mugan wrote a blog titled “Income Tax Basis Adjustment of Trust Assets at Death of Trustor”. I would suggest one reads this blog to gain an understanding as to how income tax can largely be avoided at the time of death applying the long standing Internal Revenue Code rule more commonly referred to as the “step-up” basis rule.
It is rumored that President Obama would like Congress to reexamine this rule. In a New York Times article (“Obama Will Seek to Raise Taxes on Wealthy to Finance Cuts for Middle Class”) dated January 17, 2015, Julie Hirschfeld Davis wrote:
“The centerpiece of the plan, described by administration officials on the condition of anonymity ahead of the president’s speech, would eliminate what Mr. Obama’s advisers call the “trust-fund loophole,” a provision governing inherited assets that shields hundreds of billions of dollars from taxation each year.”
The proposed elimination of “step-up” basis rule has already proven to be a highly contested issue among political pundits. Although it is difficult to know for certain as to whether or not President Obama will be successful in his efforts to push through legislation that would cause the elimination of this rule, many believe that a GOP led Congress will impede his efforts.
If you find this topic of interest, I would recommend that you take a look at the article “Obama Plan to Lower Middle Class Tax at Expense of Rich is Non-Starter for GOP” for another writer’s perspective.
-Attorney Collins Hunsaker
When a person (“Trustor”) establishes a revocable living trust during his or her lifetime for the Trustor’s benefit and transfers assets of the Trustor into the Trust, the income tax basis of the Trust asset remains the same as when the assets were owned by the Trustor individually. For example, if the Trustor transfers real estate with an income tax basis of $350,000.00 and Apple stock with an income tax basis of $100.00 per share into the Trust, the income tax basis of these Trust assets remains the same during the Trustor’s lifetime. In the event the Trust sells the real estate for $375,000.00 and the Apple stock at $115.00 per share during the Trustor’s lifetime, there would be capital gain of approximately $25,000.00 on the real estate sale ($375,000.00 sale price minus $350,000.00 income tax basis and sale expenses) and $15.00 per share capital gain on the Apple stock sale ($115.00 sale price minus $100.00 income tax basis and sale expenses).
However, what if the Trust sold the assets after the Trustor’s death? Upon the death of the Trustor, these Trust assets acquire a new income tax basis equal to the fair market value of the asset on the date of Trustor’s death. This is commonly referred to as the “stepped up basis”. The reason for the adjustment is that federal estate tax is based on the value of the assets as of the date of death. If we take the above example and assume the value of the real estate was $375,000.00 and the value of the Apple stock was $115.00 per share on the date of Trustor’s death and the Trust sold the assets after the Trustor’s death for $375,000.00 and $115.00 per share, there would be no capital gain. Accordingly, it is very important that the fair market value of the Trust assets are determined as of the date of death, particularly when Trust assets are not sold for a number of years after the date of death of the Trustor.
So how does one establish the date of death values? The best proof of the value of the Trust assets as of the date of death is a federal estate tax return (Form 706) filed with the IRS. If the return is accepted by the IRS, the income tax basis is the value of the asset as reported on the return. However, many trusts and estates are not required to file federal estate tax returns. In that case, written real estate appraisals as of the date of death should be obtained, a written record of the average of the high and low bid price for the stock on the date of death obtained, et cetera. The Jeffrey Burr law office has over thirty (30) years of experience in administering trusts when a Trustor dies, and the attorneys and support staff of the Trust Administration Department can assist in establishing and documenting the stepped up basis of the Trust assets for future use.
As the New Year is upon us, unveiling the dawn of a new tax season, the time is ripe to discuss the “disregarded entity.” Although a variety of different entities can be considered “disregarded entities,” such as grantor trusts and qualified Subchapter S corporations, this discussion will refer mainly to the entity that our office most frequently incorporates into estate plans and that is the limited liability company (“LLC”).
A “disregarded entity” is one that is disregarded for income tax purposes. As a result, in the case of an LLC, the activity of the LLC will be reported on the federal income tax return of the LLC’s owner. In contrast, if the LLC is determined to be a partnership or corporation for income tax purposes, then such LLC would be required to file a separate income tax return in order to report its activity. The fact that an LLC is considered separate from its owner and not “disregarded,” can result in an unfavorable outcome from an administrative and tax planning point-of-view in some instances. Thus, in certain situations (not discussed herein) it will be important to ensure that an LLC is a “disregarded” one.
The Internal Revenue Service (“IRS”) will treat an LLC as either a corporation, partnership, or a “disregarded entity” depending on the elections that the LLC makes. According to the Treasury regulations, also known as the “check-the-box” regulations, an LLC with two (2) or more members can elect to be treated as either a corporation or a partnership. And an LLC with a single owner can elect to be a corporation or to be a “disregarded entity.” By default, however, these regulations provide that if an LLC has two (2) or more owners, it will be considered a partnership, and if it has a single owner, then it will be considered “disregarded.” To change this default classification, the LLC would have to elect otherwise.
This may seem straight forwarded. For if the LLC has two (2) or more members it is a partnership, and if it only has one (1) member, then it is a “disregarded entity.” Of course, tax law could never be that simple. In fact, there are situations where an LLC has two (2) or more members and is still “disregarded.” For instance, according to a Revenue Procedure issued by the IRS, an LLC owned by husband and wife as community property may be treated as a “disregarded entity” notwithstanding the fact that there are actually two owners: the husband and the wife. Importantly, the LLC owned by the husband and wife must be owned as community property.
Further, according to a Revenue Ruling issued by the IRS, it is possible for an LLC (“A”) to have two members or owners, which include another LLC (“B”) and a corporation (“C”), yet still be “disregarded.” In this situation, as long as B is considered “disregarded” by having its sole member be C, then A will also be “disregarded.” In other words, even though A has two (2) members, it will be considered a “disregarded entity” because according to the IRS there is only one owner for income tax purposes and that owner is C.
When a person (“Trustor”) establishes a revocable living trust during his or her lifetime for the Trustor’s benefit and the Trustor is the trustee of the trust, most of the time the trust is not required to file a separate income tax report, Form 1041. When the person creating the trust is also the beneficiary of the trust, the trust is “self-settled.” All income and deductions of the trust are reported on the Trustor-beneficiary’s individual income tax return, Form 1040. This saves the cost of the preparation and filing of an additional income tax return for the trust.
However, what happens when the Trustor-beneficiary dies? In addition to the decedent’s final income tax return, Form 1040, having to be filed, the trust now becomes a potential taxpayer and the trust may be required to file its own income tax return, Form 1041. The current trust filing requirements are if the trust has any taxable income or if the trust has gross income of $600 or more or if a nonresident alien is a trust beneficiary. The timely filing of the trust tax return is the legal responsibility of the successor trustee or trustees. A federal employer identification number must be obtained for the trust, and the number is used as the trust’s taxpayer identification number for the trust assets and on the tax return.
What if the trust was established by a husband and wife and there is a surviving spouse? If the surviving spouse has the right to all of the trust income and principal without limitation, is the sole successor trustee of the trust, and has the right to amend or revoke or terminate the trust, the trust may avoid filing a separate income tax report, Form 1041. Again, in this situation all of the trust income and deductions may be reported on the surviving spouse’s income tax return, Form 1040.
Another common income tax question is can the surviving spouse file a joint income tax return, Form 1040, for the year in which the death occurred even though his or her spouse did not live the entire tax year? The answer is yes, a joint income tax return can be filed for the year in which the death occurred. This is helpful from an income tax point of view since the personal exemption amount for the 2013 tax year is $3,900.
There are numerous other income tax issues when a trustor-beneficiary dies. For example, does a beneficiary of the trust have to report part or all of their inheritance on their income tax returns? The Jeffrey Burr law office has over 30 years of experience in administering trusts when a trustor dies, and the attorneys and support staff of the Trust Administration Department can answer this and other income tax questions a successor trustee and/or beneficiary may have.
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