Fall 2012 Newsletter
Developing an Estate Administration Roadmap for Unstable Terrain: Three Current Issues in Advising Decedents’ Fiduciaries
By Jennifer E. Shirkey
One of the most useful client relationship tools in a trust and estate administration practice is (what my firm refers to as) the “administration letter.” Ideally provided within the first several weeks of your engagement, this document assesses the lay of the land for the particular estate or trust you’re dealing with and charts a course forward for the fiduciary. (We also share this information with beneficiaries as often as we can.) Planning a route becomes challenging, however, when the ground is shifting beneath your feet. Some variability is due to the uncertain state of the estate tax, and some is simply human nature, as explained further below. This article highlights how we’re navigating the three most common hazards we’re encountering this year—and probably next year too—in formulating administration strategies.
As a framework for this discussion, the bulk of our estate planning clients are married couples with combined net assets in the $500,000 to $3,000,000 range. Assuming (1) they don’t win the lottery before death and (2) Congress ends up roughly where most of us expect it to (a prediction some of our clients aren’t buying), their fiduciaries won’t have estate tax problems. Instead the fiduciaries’ biggest challenges will be implementing their decedents’ control wishes and making smart income tax choices. Particularly with the expectation that income tax rates are likely to be rising, and most likely more so than estate tax rates.
1. What will you do with the credit shelter trust?
Despite our best efforts in encouraging clients to refresh their documents every 5–7 years, fiduciaries are frequently working with 10 or even 20 year old estate plans—human nature at work. And with the lower estate tax thresholds that applied back then these plans usually have a credit shelter trust hard wired into them, i.e., the trust formula mandates that assets equal to the applicable federal estate tax exemption flow to the credit shelter trust (the “Family Trust”), with the spouse receiving only the excess outright or occasionally in a marital trust. For couples with even relatively modest estates of say $1.5 million divided equally between them, this means half their wealth will flow to the Family Trust at the first spouse’s death. Few of our surviving spouses are interested in the hassle factor and complexity of administering the Family Trust when it’s probably not really needed for estate tax purposes, “a” [the] primary reason most used a Family Trust to begin with.
Your first step should be to consider whether the assets can be distributed to the surviving spouse under the Family Trust’s existing distribution standards. However, the typical distribution provision is an ascertainable “health, maintenance, and support” standard that generally can’t justify a full distribution of principal in these cases. If you can’t figure out a way to otherwise distribute the assets to the spouse under the trust’s distribution standard, you may want to consider seeking an early termination of the trust. It’s best to get all the remainder beneficiaries on board (typically the couple’s children and parents of any minor descendants), and if assets exceed $100,000 we seek judicial approval under Virginia Code §§ 64.2-729 or 64.2-730. Anecdotally, we’re seeing success in the courts approving these terminations, at least for straightforward situations, e.g., the Family Trust is for survivor’s lifetime benefit then to children outright and all the children are grown and still alive.
Even if the surviving spouse receives only the life estate value of the Family Trust assets, you get a second step up in income tax basis on at least that amount of assets. On the other hand, the basis of assets staying in the Family Trust is frozen with the first spouse’s death. Setting aside control issues, you’re balancing (a) the likelihood that the Family Trust assets will appreciate beyond the first spouse’s available estate tax exemption before the survivor’s death, yielding an estate tax benefit, against (b) the likelihood that those assets will receive a second step up in basis if still held by the survivor at death, yielding an income tax benefit. Tipping the scales further in favor of termination is the increased flexibility to respond to future legal, tax, and family changes that the spouse generally gains by holding assets outright. In most cases, the income tax and flexibility factors win out with our fiduciaries. On the other hand, the estate tax factors may be more compelling if the Family Trust assets are expected to appreciate rapidly following the first spouse’s death, pushing beyond the survivor’s available estate tax exemption. Unfortunately, rapid appreciation has not been a common “problem” for many of our clients in recent years.
In the end, the upfront expense of a judicial termination may be justified compared to the expenses—primarily income tax return preparation and possibly future professional consulting fees— and general hassle factor of maintaining the Family Trust.
2. What will you do with the family LLC?
A number of our fiduciaries are dealing with family LLCs or limited partnerships. (Our firm always uses LLCs instead of limited partnerships, just a preference.) Once more, most of these were implemented in the estate tax heyday when the name of the game was discount planning. Cooperative and proactive clients proceeded with their gifting, typically claiming 35-40% discounts. Again however, with larger estate tax thresholds, clients have less need and desire for lifetime gifting and discount planning. Increasingly, our concern in administering trusts and estates holding family LLC assets is the income tax consequences of those previously claimed discounts.
Say the widowed family matriarch’s revocable trust still holds a 40% ownership interest in her family LLC at her death, which contains only marketable securities. During life, she dutifully gifted minority LLC ownership interests to her only child, George, claiming 35% discounts on those gifted interests along the way. The trust ends at mom’s death, and George plans to discontinue the LLC. What value should mom’s trustee use for the trust’s remaining LLC interest?
We have not experienced it yet, but we worry the IRS will probably take the position that the same 35% discount should apply to the trust’s 40% share of the LLC assets. If the matriarch’s estate falls below the applicable exemption threshold regardless, there are no transfer tax ramifications for mom’s estate, but there could be significant income tax consequences for George. The selected value will fix his income tax basis in the portion of the LLC, or proceeds from the dissolution thereof, passing to him from mom’s trust. If the LLC contains marketable securities worth $2.5 million at mom’s death, George would receive just a $650,000 basis in his inherited 40% interest versus a $1,000,000 basis. If markets rally and George sells the securities in two years for $1,200,000, and even if the capital gains rate remains a favorable 15% (and not factoring in possible application of the new 3.8% Medicare tax on net investment income), he could owe at least an additional $52,500 in income taxes.
Perhaps this fact pattern is ultimately more a concern for the George as the trust’s beneficiary than for mom’s trustee per se, but often those individuals are one and the same. And your fiduciary clients likely expect you to give them a heads up on the issue regardless. Moreover, it’s definitely a concern for mom’s trustee if the LLC holds depreciable property so that the accountant will likely recommend making a 754 election to step up the LLC’s basis in its assets following mom’s death. Accordingly, we recommend raising the issue with both your fiduciary and the accountant(s) involved to make sure everyone understands the risks and advantages of each position and that the accountant is comfortable with the position he or she will ultimately take on the tax returns.
3. Should you file to elect portability?
Even though the IRS has finally provided guidance for electing portability of a deceased spouse’s unused transfer tax exemption on the Form 706, your fiduciary clients may resist the expense of filing returns for estates that aren’t taxable, and we don’t necessarily blame them. Again, if the current relatively high estate tax threshold continues and the client does not expect to exceed those levels even under optimistic scenarios, there is no reason to spend the several thousand in professional fees it will likely take to file the 706. In the short run, however, we are encouraging new estates to idle on the Form 706 portability decision until early 2013 and possibly file a Form 4768 to obtain an additional six-month extension in hopes Congress will provide clarity before the end of 2013.
Although it’s tough to identify an ideal path when faced with shifting territory, we find the estate administration letter is a useful tool even beyond guiding our fiduciaries. It forces us lawyers to systematically analyze evolving issues like those discussed in this article, then plot a pragmatic course for navigating the uncertainties. This journey ultimately helps us become smarter planners on the front end.
Jennifer E. Shirkey is an attorney with Lenhart Obenshain PC in their Harrisonburg office. She concentrates her practice in trusts and estates and employee benefits. Ms. Shirkey earned her law degree summa cum laude Washington and Lee School of Law and her BA summa cum laude from James Madison University. After law school, she clerked for the Hon. H. Emory Widener, Jr. of the U.S. Court of Appeals for the Fourth Circuit. She was recently named Assistant Commissioner of Accounts for the Rockingham County Circuit Court, effective January 1, 2013.