Editor: Mo Bell-Jacobs, J.D.
It is important to consider the income tax ramifications of each decision throughout the estate planning process to avoid unintended consequences. After all, an individual’s death and the gifting they do during their life affect the taxes of the decedent, a surviving spouse, the estate, the beneficiaries, and, potentially, their trusts.
Below are 10 important income tax questions to consider when creating an estate plan:
1. How will passthrough business income be taxed after transfer?
If the client owns a passthrough business, one question to focus on is how that income will be taxed after transfer. Passthrough business income is typically categorized as active, passive, or portfolio. Ideally, taxpayers want income to be classified as active because it is generally treated more favorably under the Code, compared with passive income. If a taxpayer actively participates in a business, the income may qualify for a lower tax rate or allow for a loss deduction. It may be important to preserve this treatment after lifetime transfers or at death.
Determining whether certain business income is active or passive in relation to a trust or estate is not as straightforward as it is for individuals. Participation prior to transferring the business interest is no longer relevant, and there is no authoritative IRS guidance for how activities of a trust or estate are tested for participation purposes. Instead, participation rules and guidance for an estate or trust rely heavily on two prominent court cases, Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003), and Frank Aragona Trust, 142 T.C. 165 (2014).
Based on case law, the participation of a trust or estate is determined by whether key individuals acting as a fiduciary (or agents of the fiduciary) are participating in the income-producing activity. The IRS has indicated it will propose regulations around this area. If regulations are issued, they could provide different guidance on how activities are tested for income tax purposes.
Planning point: Consider the participation rules when choosing a trustee or executor. Business income could be taxed at a higher rate, and losses may not be deductible, depending on whether the fiduciary participates in the income-producing activity. Use caution when relying on case law in planning, because the IRS has not indicated that it agrees with the outcome of the cases.
2. Is favorable S corporation status safe after transfer?
If the client for whom estate planning is being done is a shareholder of an S corporation, it is important to ensure that the S corporation’s favorable tax election is not compromised after the transfer and that it does not lose its passthrough tax treatment. Loss of the election would cause tax to be paid at the entity level as a C corporation rather than as a passthrough entity taxed on the shareholder’s income tax returns. This is generally undesirable, as C corporations have potential double taxation. Relief may be available to save the passthrough tax treatment (see Rev. Proc. 2022-19); however, it is better to protect the S corporation election with proper planning.
Generally, estates and trusts can hold S corporation stock for a limited period after death, so timing is important, as is ensuring the ultimate beneficiary is an eligible S corporation shareholder. When S corporation stock is transferred during life, the period to make certain elections is much shorter. In general, only certain trusts can own S corporation stock, and some of these trusts require that special elections be made timely.
Foreign trusts, nonresident aliens, individual retirement accounts, charitable remainder trusts, and other nonqualified trusts are not eligible to hold S corporation stock. To qualify for the favorable tax election, S corporations also limit the total number of shareholders.
Planning point: Make sure there is a plan for S corporation ownership. The rules on trusts owning S corporations can be complex. It is important to work with an estate planning adviser who is familiar with S corporations.
3. Should a partnership interest be transferred during life or at death?
Another estate planning issue that arises involves transferring a partnership interest. Assets given away during life generally retain the transferor’s basis, while assets transferred after death receive either a step-up or a step-down in basis. If a partnership interest is given away during life and it appreciates in value, the growth is outside the transferor’s taxable estate, but the beneficiaries may have capital gain and ordinary income to report due to a lower basis.
If the partnership interest has a negative capital account when gifted, there can be adverse tax consequences. If the asset is held until death and receives a step-up in basis, capital gain and ordinary income related to the activity during life are eliminated. There is also an opportunity for beneficiaries to benefit from additional deductions, such as depreciation, if the partnership makes a certain election.
Planning point: Weigh whether it is more beneficial to transfer a partnership interest during life or at death. Ensure there are no unintended adverse income tax consequences related to the transfer to ultimate beneficiaries. Additional rules and complexities govern charitable contributions of partnership interests, which may result in unintended tax consequences.
4. How will beneficiaries be taxed on inherited retirement accounts?
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, P.L. 116-94, introduced significant changes that affect estate planning for retirement accounts. Beneficiary designations should be reviewed to be sure they reflect the intended income tax consequences, especially if the account is left to a trust. The income tax consequences and period over which minimum distributions must be taken may vary depending on the type of account, the age of the decedent, and the type of designated beneficiary (e.g., surviving spouse, trust, or charity).
The estate and income tax consequences of these retirement accounts can make them an ideal asset to leave to a charity if charitable planning is part of the overall estate plan. This shifts the income tax burden from both the estate and heirs to an entity not subject to income taxes.
Roth conversions have also become increasingly popular, as they allow the taxpayer to convert the account from a pretax account to an after-tax account, with the income tax liability for the conversion being borne by the taxpayer. This strategy avoids income tax consequences for the estate or beneficiary.
Planning point: Review existing estate plans to ensure wishes will still be fulfilled in light of recently enacted legislation, proposed legislation, and pending IRS regulations. Many planning strategies are available for taxpayers who hold retirement plan assets. Due to the rules’ complexity, it is important to work with a professional familiar with the law in this area.
5. Does the estate contain a principal residence or vacation home with significant value?
These types of assets commonly have a low basis that would result in capital gains tax if sold during life. If held outright until death, the home will be included in the estate and receive a basis adjustment to the fair market value (FMV) on the date of death that will eliminate most of the capital gains tax owed upon a future sale. If sold during life, there is a potential personal residence gain exclusion ($250,000 if single, $500,000 if married).
It may make sense to transfer the home into a qualified personal residence trust (QPRT) to avoid the inclusion of future appreciation in the estate. This strategy freezes the home’s value for estate tax purposes at the expense of forgoing a potential step-up in basis. A QPRT allows the taxpayer to transfer the home into a trust with a retained right to live in the home for a certain term. The retained right to live in the home discounts the value of the gift to the trust, and, assuming the taxpayer outlives the term, the value of the house is excluded from the estate. The transferor must pay FMV rent to continue living in the house once the term has ended.
An estate may also have an opportunity to deduct a loss on the sale of a home when the loss would otherwise be nondeductible by an individual. If the value of the home declines after the date of death, or if a loss is generated due to selling costs, case law (Miller, T.C. Memo. 1967-44, and Watkins, T.C. Memo. 1973-167) supports possible deductibility of the loss since the home is a capital asset held by the estate. This loss may be deductible on the estate’s income tax return and be subject to the capital loss limitation rules.
Despite case law supporting possible deductions, IRS Chief Counsel Memorandum 1998-012 explains that such a deduction is allowed only when the property has been converted to an income-producing property. The memorandum is not authoritative; however, it does provide insight into the IRS’s position and highlights an area of potential scrutiny.
Planning point: It is important to weigh the benefits of transferring a home out of the estate before death versus holding on to it to receive a potential step-up in basis. Use caution when relying on case law in planning, as the IRS has not indicated that it agrees with the outcome of the cases related to deducting a loss on the sale of a residence after death.
6. Will contributions qualify for the fiduciary income tax charitable deduction?
If transfers to charitable organizations are part of the estate plan, it is important to ensure the will and trust agreements are written in a way that allows future charitable contributions to be eligible for the fiduciary income tax charitable deduction. Charitable deduction rules for fiduciary income tax are generally more beneficial than the rules for individuals.
Under Sec. 642(c), fiduciary income tax charitable deductions are allowed only when the governing document specifically allows for charitable contributions. The deduction is limited to the amount given to charity that was paid from current income or prior-year income. There is generally no adjusted-gross-income (AGI) limitation for gifts to charity, and there are broader and more flexible charitable contribution deduction rules compared to those for individuals. However, fiduciary income tax returns do not allow a carryover of excess charitable contributions.
If a trust has trade or business income, the deduction under Sec. 642(c) is not allowed with respect to business income under Sec. 681. Sec. 681 provides for a charitable income tax deduction based on the same rules that apply to individuals.
A special election under Regs. Sec. 1.642(c)-1(b) allows a trustee to treat contributions made in the subsequent year as a current-year charitable deduction, allowing for additional flexibility in income tax planning. For example, a trust filing a 2022 tax return with $1 million of gross income can make a $1 million charitable contribution before Dec. 31, 2023, and elect to treat it as a 2022 deduction to reduce its gross income to $0.
Planning point: Creating and funding a trust for charitable purposes can help to maximize deductions and contribute to a broader set of organizations. Generally, no AGI limitation is applied to gifts to charity on the fiduciary income tax return. This means that a trust created for charitable purposes may be able to take a deduction of up to 100% of its gross income.
7. Will beneficiaries receive what is intended from a ‘simple’ trust?
Simple trusts require that beneficiaries receive distributions of all the trust’s income at least annually; the definition of income can depend on the trust agreement or state law.
Consider how the income generated by a simple trust will be treated for trust distribution purposes. For example, if the trust holds an interest in a flowthrough entity, the income from the entity is generally ignored, and only actual distributions made from the entity are “income” for fiduciary accounting distribution purposes. If the trust holds flowthrough entities that rarely make distributions, the beneficiary may not receive as much benefit as the grantor had originally intended. This structure, however, may be perceived as a benefit in other planning scenarios in which the flow-through entity’s distributions control the trust’s ability to make distributions.
Understanding how these types of trusts operate for distribution and income tax purposes can help facilitate an effective estate plan to ensure beneficiaries receive a benefit consistent with the grantor’s intentions.
Planning point: If the simple trust has taxable income and the beneficiaries receive distributions, the beneficiaries will have personal income tax consequences related to the distributions they receive. Make sure the beneficiaries understand the impact of the distributions to avoid surprises.
8. How might the flexibility of irrevocable grantor trusts factor into planning?
An irrevocable grantor trust is a trust created and funded during life in which the grantor retains an element of control over the assets, which results in taxation of the trust income and calculation of related deductions and credits on the grantor’s individual income tax return. The assets of the trust are not taxed as part of the grantor’s estate, and the payment of income taxes on behalf of the trust further reduces the grantor’s estate without gift tax consequences.
In addition, there is flexibility if the payment of income taxes on behalf of the trust becomes too burdensome. First, if the trustee has the discretion to reimburse the grantor for income taxes paid, the trustee can reimburse the grantor without the assets of the trust being included in the grantor’s estate. However, if the trustee is required to reimburse the grantor or has a prearranged agreement to do so, the assets of the trust are likely includible in the grantor’s estate. Second, the trust agreement may allow the grantor to make a change to the powers the grantor retained and effectively “turn off ” the grantor trust status. This would cause the trust to pay its own income tax liability from trust funds.
Carefully consider state income tax elections that allow the payment of state income taxes via an entity owned by the trust instead of by the grantor, as the grantor may then be treated as making a gift if they reimburse the trust.
Planning point: Be aware that if the trustee is required to reimburse the grantor or has a prearranged agreement to do so, the assets of the trust are likely includible in the grantor’s estate.
9. What is the potential impact of divorce on a trust created for the benefit of a spouse?
Trusts for the benefit of a spouse and descendants are typically structured as irrevocable grantor trusts, and the grantor is personally taxed on the income because distributions may be made to the grantor’s spouse. In the event of a divorce, the grantor may still be liable to pay the tax on the income earned by a trust set up for the benefit of a now ex-spouse. Possible post-divorce solutions include modifying the trust agreement, terminating the trust, distributing the assets to the spouse, or creating an agreement as part of the divorce settlement to have the ex-spouse reimburse the grantor for the taxes paid.
Planning point: Taxpayers typically do not set up trusts for the benefit of a spouse when contemplating a divorce. In the event of divorce, the trust should be carefully considered in the divorce proceedings and the divorce agreement to ensure the spouses understand the trust’s income tax impact.
10. What type of planning should there be for an illiquid estate?
If an estate is made up mostly of illiquid assets, how will the executor find the cash to pay the income and estate tax? To prevent the executor from having to rely on a quick sale, the purchase of life insurance may be a simple solution. Generally, if the policy is structured properly, the death benefit will not be subject to income taxes or be includible in the individual’s estate, and the cash may be available to pay taxes or to benefit heirs. Life insurance may be an income and estate tax–friendly method of wealth replacement for a family. For example, a first-to-die life insurance policy can be used to generate additional wealth at the first spouse’s death to ensure enough assets remain for the surviving spouse to maintain their lifestyle. Individuals may also choose to leave assets to charity to avoid estate taxes and fund a life insurance policy held outside of their estate that will provide wealth for heirs.
Planning point: There are many pitfalls to avoid when incorporating life insurance in an estate plan and many types of life insurance to consider. It is important to work with an adviser knowledgeable in this area to ensure the plan provides the estate and beneficiaries with the maximum benefit.
Planning for estate success
Ensuring that an estate plan considers income tax consequences can be crucial to its success. Many of the strategies described above require technical analysis and familiarity with tax laws. Tax professionals can help ensure estate plans are successful by making sure they are up to date regarding the most recent changes in income tax law.
Mo Bell-Jacobs, J.D., is a senior manager with RSM US LLP. Contributors are members of or associated with RSM US LLP. For additional information about this item, contact Carol Warley, CPA/PFS, J.D. (incoming vice chair of the AICPA Trust, Estate, and Gift Tax Technical Resource Panel) (Carol.Warley@rsmus.com); Amber Waldman, CPA, M.Acc. (Amber. Waldman@rsmus.com); Abbie Everist, J.D., LL.M., MBA, MA (Abbie.Everist@rsmus.com); Tandilyn Cain, CPA, MST, CFP (Tandilyn.Cain@rsmus.com); and Rachel Ruffalo, J.D., LL.M. (Rachel.Ruffalo@rsmus.com), Washington, D.C.