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Lesson 6 Tax 526

1. Given the taxable estate, explain how the tentative tax base is obtained.

Adjusted taxable gifts, which are lifetime gifts made after 1976, that are not includable in the decedent’s gross estate are added back to the taxable estate. This is so that the same tax rate schedule is applied to the estate and to lifetime gift transfers to reflect the unified estate and gift tax system. By adding back the previously transferred assets, it treats these gifts the same as transfers that occurred at the time of death. The tentative tax is based on this cumulative total. Once calculated, gift taxes in excess from the basic credit amount are deducted from the tentative tax and subsequently, along with other credits, a credit is given for any tax paid on prior transfers.

1. What amount may be deducted from the tentative tax before credits are determined, what credits may be deducted, and what is the effect of a tax credit?

Gift taxes payable on post-1976 gifts in excess from the basic credit amount are deducted from the tentative tax. This results in the estate tax payable before credits are applied. The allowable credits on a 706 estate return are the:

• Basic credit amount – In 2017 this was $2,141,8001

• Credit for foreign death taxes – this is only available to U.S. citizens or to residents of the U.S. and is the lesser of the amount of foreign tax paid or the estate tax attributable to the foreign property

• Credit for gift taxes paid on pre-1977 gifts

• Credit for taxes paid on prior transfers – this applies only to gift tax paid attributable to payment by the decedent (not spouse in the case of split gifts)

1. What is the purpose of the applicable credit amount, and how does its use during lifetime affect its availability at death?

The purpose of the applicable credit amount is to eliminate taxable transfers allocated to the lower brackets that are below the basic exclusion amount. The credit is equivalent to the exemption amount. As the credit is used first on lifetime transfers, the remaining credit can be used on the estate. If an estate is large enough that it exceeds the exemption amount, estate tax will be due. The credit amount and exemption amount have increased almost annually to reflect inflation. The credit amount for 2017 is $2,141,800 which represents tax on the 2017 exclusion amount of $5,490,000.

1. What is the purpose of the credit for foreign death taxes paid, and to whom does it apply?

The purpose of the credit for foreign tax credits paid is relieve double taxation of property owned by U.S. citizens in foreign countries where it was subject to taxation by the foreign entity. Foreign property included in the gross estate is also subject to U.S. tax but the amount attributable to the foreign property can be reduced by the credit. This is only available to U.S. citizens or to residents of the U.S. and is the lesser of the amount of foreign tax paid or the estate tax attributable to the foreign property.

5. For what reasons might an extension of time to pay the federal estate tax usually be

allowed?

The IRS will allow an extension of time to pay the estate tax due beyond the nine-month due date to an additional twelve months to ten years if reasonable cause exists2. Factors to determine reasonable cause are given through examples given in regulations but are determined on a case by case basis. Some of the factors considered are:

• The estate’s access to liquid assets sufficient to pay the tax and the ability and efforts of the executor to convert existing assets to cash if insufficient liquidity exists at the tax due date

• Whether converting assets to cash would cause harm or significant losses upon the estate when available assets are those that provide future benefit such as annuities, royalty payments, receivables, etc.

• The estate has a major asset that cannot be liquidated quickly due to litigation

• Whether the estate would be required to borrow funds at a higher than typical interest rate in order to pay the tax

• Whether the estate’s insufficient access to funds to pay tax timely effect the estate’s ability to provide for the surviving spouse and dependent children while the estate is in administrative process and whether there are sufficient funds available to pay claims currently due against the estate

• The efforts of the executor to liquidate, obtain, and secure funds in order to pay down taxes payable.

6. Describe the circumstances that must exist before the estate tax may be paid in

installments.

If certain conditions are met, an executor can elect to defer the payment of estate tax when a farm or closely held business is included in the valuation of the estate. This is only allowable when the farm or business makes up more than 35% of the adjusted gross estate. Tax is then deferred for five years; however, interest accrues and is due annually beginning in year 1. At the fifth year, interest continues to be due along with tax payments included in payment. The tax and interest annual payment installments must be completed at the end of ten years or the entire amount becomes due and payable3. In TAM 9241002, the IRS ruled that an estate that pays its estate taxes in installments under the hardship provisions of IRC § 6161 can take annual deductions for the accrued interest, allowing it to recompute and reduce both the total liability and the annual installments.4

7. Describe what circumstances will trigger an acceleration of the estate tax payable when

installment payments are being made.

If payments are late or there is a default on installment payments, estate tax becomes due and payable immediately5. Other circumstances that would trigger the immediate balance due are:

• A withdrawal of more than 50% of assets from the farm or business

• A sales, distribution, exchange, or disposition of more than 50% or 5% value interest in the business to a third party or anyone other than a beneficiary entitled to receive the interest

8. Explain a Sec. 303 stock redemption and when it can be used.

Section 303 stock redemptions are used to reduce the impact of tax on estates where decedents owned closely held incorporated businesses. Section 303 allows redemption of closely held stock owned by the party responsible for paying the debts of the estate including funeral expenses, taxes, and administrative expenses without the stock or business interest being sold to non-partners or those outside the closely-held business group6. The redemption is treated as a sale and the proceeds are capital gains, so long as the decedent’s stock represents more than 35% of the adjusted gross estate. The estate would receive a step up in basis at the redemption so, in reality, there would be no capital gain. If the redemption doesn’t qualify for section 303, any gain is treated as ordinary income.

9. What is the function of basis with respect to an asset?

The primary function of basis is to measure the amount of gain or loss when property is ultimately sold. Without knowing the original cost, the true gain or loss can be difficult to determine. For example, in stock sales, it’s possible that only proceeds are reported on a tax form issued by the brokerage house reporting the sale. If no cost basis is reported, the entire proceeds would be taxed at a gain. Additionally, by knowing the date of the acquisition the type of gain can be determined such as long-term or short-term. The basis of property transferred at death follows different rules. The basis is fair market value on the date of the decedent’s death, or the alternative valuation date of 6 months after the date of death (if elected by the executor). The transferee receives this ‘step-up’ in basis and regardless of the actual holding period in the hands of the decedent, the transferee’s holding period is considered long term. When the transferee sells the property, he or she will use this new basis to determine the amount of gain or loss.

When property is gifted prior to death, the transferee gets a carryover basis identical to the basis held by the donor, plus any gift tax paid at the time of the transfer that is attributable to the appreciation of value of the gift. If the donor gifted property that has depreciated in value, the donee’s basis is the lessor of the fair market value of the gift or the donee’s basis.

10. Nine months before his death, Mr. Jones purchased gold coins for which he paid $120,000. At the time of his death the price of gold had dropped, and the coins were worth $75,000. His executor sold the coins at auction for $90,000.

a. What was the basis to the estate?

The basis to the estate is the fair market value of the coins on Mr. Jones’ date of death which is $75,000.

b. How much, if any, capital gain was realized?

Even though Mr. Jones originally purchased the coins for $120,000, that basis is lost and has been replaced by the estate’s basis in the coins. The $15,000 gain is realized to the estate on the sale made by the executor.

11. Define income in respect of a decedent and explain the tax treatment for a beneficiary in receipt of such income.

Income in respect of the decedent is income that was payable or becomes payable to the decedent after the date of death. If the decedent received the income before dying, it would be reported on his or her final income tax return. Income in respect of the decedent is reported on the estate income tax return and may also be included on the estate tax return if applicable. The income is taxed to either the estate or to the beneficiary who received the distribution, but not both. If it is reported on the estate tax return, a deduction is allowed for income that was distributed to a beneficiary.

12. What are the similarities between estates and trusts?

Estates and trusts are both managed by someone operating in a fiduciary role that must manage the assets entrusted to him or her. The fiduciary acts in the best interest of the beneficiaries, while the executor must make an effort to manage and dispose of assets in the estate in a manner that reflects the decedent’s last wishes. Although property transferred to an estate can be dictated by function of the law, property is transferred from a grantor to a trust similarly to how property is transferred from a decedent to an estate. Both trusts and estates have beneficiaries that enjoy the income or assets derived from the estate or trust.

13. How are specific bequests distributed by an estate in more than three installments treated for income tax purposes?

Specific bequests distributed by an estate taxable to the receiving beneficiary if they are received in three installments or less7. A specific bequest should include an exact dollar amount to be considered specific. If a bequest is distributed in more than three installments, but was a specific bequest, the beneficiary will only be taxed if the distribution was made out of income to the estate. If was required to be paid out of income, the beneficiary would be taxed on the amount received. All other bequests, are considered to be paid out of income first, even if they were paid out of corpus. This happens when the estate receives income and makes a distribution to a beneficiary. It is assumed that the distribution came from the income received.