Postmortem Estate Planning
The right decisions can preserve family wealth and save estate taxes.
| EXECUTIVE SUMMARY |
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| JOSEPH R. OLIVER, CPA, PhD, is a professor of accounting at Southwest Texas State University in San Marcos. CHARLES A. GRANSTAFF, CPA, JD, is a practicing attorney in San Antonio, Texas. He is board certified in estate planning and probate law by the Texas Board of Legal Specialization. |
With federal estate tax rates reaching as high as 55%, a small business owners death and the resulting estate tax liability can create additional problems for the business, ranging from negative cash flow to insolvency. Although business owners should complete effective estate planning before their deaths, certain postmortem measures are available to reduce or eliminate federal estate taxes, even for a client who did no estate planning during his or her life or one whose planning was inadequate or in error. This article reviews the primary postmortem strategies available to a small business owners family and executor. With a working knowledge of these planning opportunities, CPAs can work with the family to help protect a clients cash, facilitate business continuity and preserve family wealth by saving estate taxes.
ALTERNATE VALUATION 
If asset values are declining, determining a gross estates fair market value on an alternate valuation date rather than on the date of death may save taxes. Typically, the alternate valuation date is six months after death under IRC section 2032. Property the estate or the heirs dispose of within six months after death is valued on the date of distribution, sale, exchange or other disposition.
An executor may elect the alternate valuation date if
- Using that date decreases the gross estate, estate taxes and any generation-skipping transfer tax.
- The estate files Form 706, U.S. Estate Tax Return , within one year of its due date, including extensions.
Thus, alternate valuation is not available to estates that increase in value after death or to estates so small they dont require filing form 706. Also, if other strategies eliminate estate taxes, alternate valuation serves only to reduce beneficiaries asset bases since they use form 706 values for this purpose. Alternate valuation is irrevocable and applies to each of the estates assets, whether its value has increased or decreased.
The date an executor selects for alternate valuation of property generally should depend on the plans for that property. An asset marked for sale should be sold (and valued) as soon as possible after death if it is declining in value. Any decline after six months would not reduce estate taxes but would lower the total estate available to beneficiaries. Property marked for funding trusts or for outright distribution to beneficiaries generally should be kept in the estate for at least six months after death if its value is falling. This permits the full decline in value to be reflected in the estate tax bill.
THE SPECIAL-USE VALUATION
Section 2032A permits U.S. real estate that a deceased U.S. citizen or resident used in a trade or business, including farming or ranching, to be valued at a discount. The propertys value is based on its use in the activity in which it is employed rather than on its so-called highest and best use, with a maximum discount of $750,000 (adjusted for inflation after 1998).
A decedent or a member of the decedents family must have owned and used the property in the trade or business for at least five of the eight years before death. The decedent or family member must have materially participated in the business. The property must pass to the decedents spouse or certain relatives, and each person who has an interest in it must agree in writing to continue using the property in that activity for 10 years and to sell to no one except another family member. Cessation of use or disposition triggers tax for which family members are responsible.
In addition, the property must meet two percentage tests:
- Equity in qualifying real estate must be at least 25% of the decedents gross estate after subtracting debts.
- Equity in real estate and personal property used in the business at the time of death must be at least 50% of the gross estate net of liabilities.
Example. Development around John Allens equipment rental business caused real estate values to skyrocket in the years before his death. Allens gross estate is appraised at $4.2 million, including $2.5 million of real estate and $600,000 of equipment used in his business. The realty is subject to a $400,000 mortgage, the estates only liability. The gross estate net of debt is $3.8 million and the estates equity in the real estate is $2.1 million. Thus, equity in real property valued at its highest and best use amounts to more than 25% of the gross estate net of debt. And $2.1 million equity in real estate added to $600,000 of equipment totals $2.7 million, over 50% of the $3.8 million net estate. If Allens estate meets all other requirements, this real estate is eligible for a valuation discount of up to $750,000 from its highest and best use to the use it serves in Allens business, saving his estate around $400,000 in federal estate taxes.
Property the deceased gave away within three years of death counts toward the 25% and 50% tests under IRC section 2035(d)(3)(B). Permissible valuation methods and certain other opportunities and requirements of discount valuation for real estate are beyond the scope of this brief overview.
The decedents estate can own the qualifying real estate indirectly through an interest in a corporation, partnership or trust. A minority ownership interest in a partnership or closely held corporation may itself be subject to discounted valuation since the interest cannot control the entity and thus is generally less marketable than a majority interest. Electing special-use valuation for real estate may preclude discounting the decedents minority interest in the same business. CPAs should help clients make the choice carefully.
FAMILY-OWNED BUSINESS EXCLUSION
In addition to the discount for business real estate, a business owner who dies after December 31, 1997, may transfer certain family-owned business interests to qualified heirs partly or completely free of federal estate taxes. IRC section 2033A, part of the Taxpayer Relief Act of 1997, exempts up to $675,000 of business interest in 1998. The exclusion declines in subsequent years because it shields the difference between $1.3 million and the unified credit exemption equivalent, which is scheduled to increase. For example, in 2000, when the unified credit equivalent is $675,000, the family-owned business exclusion will be $625,000.
A business interest is eligible for the exclusion only if the decedent and his or her family members own at least half of the enterprise in question. Alternatively, they may own only 30% if two families own at least 70% of the entity or if three families own 90%. An interest generally does not qualify if stock or debt is traded on a public securities market or if investments generate more than 35% of the enterprises adjusted gross income. The decedent must have been a U.S. citizen or resident at the time of his or her death and the entitys principal place of business must be in the United States.
Qualifying interests the business owner transfers to certain heirs must exceed half of his or her adjusted gross estate. As under section 2032A, the owner and family must materially participate in the business during specified periods before and after death. Likewise, the heirs agree to pay part or all of the tax reduction with interest if they stop participating in the business or sell their interests within 10 years, or if certain other events occur.
THE VALUE OF DISCLAIMERS AND PARTIAL QTIP ELECTIONS
Once an estate is valued, a disclaimer or partial qualified terminable interest property (QTIP) election may facilitate using the decedents unified tax credit or fine-tuning the marital deduction. Through a disclaimer, the beneficiary of an interest in property refuses in writing to accept the interest under IRC section 2518. The refusal must occur within nine months of the day the interest is transferred or of the beneficiarys 21st birthday, if later. For inherited property, the date of death generally begins the nine-month period. If the intended recipient has not accepted the interest or any benefit of the property, the disclaimed property passes to an alternate beneficiary under the decedents will or trust. Transfer of title, by itself, does not necessarily constitute acceptance of the property (such as shares of stock) without some further act such as the receipt of income (dividends) on it.
Example. Bert and Eileen Tyler, a married couple, own 60% of a corporations one class of stock as tenants in common. Their children own the other 40%. Bert dies in 1998, leaving his half of a $2.5 million estate to Eileen under a simple will in which their children are secondary beneficiaries. Berts estate owes no tax because of the unlimited marital deduction, but this wastes Berts 1998 unified tax credit equivalent of $625,000. Eileen would then owe tax on the entire estate at her death. Assuming she has not accepted dividends or other benefits of ownership, Eileen could disclaim $625,000 of the corporations stock (more in succeeding years as the unified credit increases if Bert were to live longer), allowing it to pass under Berts will to their children. Neither spouse would owe estate taxes on this stock because Berts unified tax credit (if not used during his lifetime) would shelter it. Eileens disclaimer would save $300,000 in estate taxes.
In other circumstances, a partial QTIP election provides the same tax savings but permits a surviving spouse to enjoy some ownership benefits of the property. This election is used when a decedent bequeaths property in a trust that has aspects of both a QTIP trust, paying all income at least annually to the surviving spouse for life, and a bypass trust that holds assets not included in the surviving spouses estate.
The executor divides the trust into two parts under IRC section 2056(b)(7)(B)(iv). One part is treated as a QTIP trust; the other portion qualifies as a bypass trust. QTIP trust assets avoid federal estate tax until the survivors death because of the unlimited marital deduction. The decedents unified tax credit shelters the bypass trust assets, keeping them out of the survivors estate so they escape federal estate tax entirely. The survivor still receives all income generated by both portions of the trust. If she serves as trustee, her access to the principal must be limited to an ascertainable standard, generally health, education, support or maintenance.
Suppose Berts will in the above example transferred his portion of their estate in trust for Eileen, with all income payable to her annually for life. Rather than disclaim $625,000 of the estate to use Berts unified credit, Eileen divides the trust into two parts. One portion uses Berts credit, escaping estate tax entirely; the other avoids estate tax until Eileens death because of the marital deduction. Eileen would receive dividends and other income from the entire estate during her lifetime. If she needed additional funds, Eileen could access trust principal.
WHERE TO DEDUCT EXPENSES AND LOSSES
A small business owners estate may incur casualty losses and substantial administration expenses such as court costs, property storage and compensation of executors, appraisers, accountants and attorneys. If advance estate planning has eliminated all estate taxes, these items often are best deducted on Form 1041, U.S. Income Tax Return for Estates and Trusts , although this might reduce the decedents unified tax credit and the amount transferable to a bypass trust. Otherwise, CPAs should consider deducting them on form 706; after exhausting the unified tax credit, estates pay federal estate tax at rates ranging from 37% to 55%. Losses and expenses may be divided between the two tax returns in any proportion. Similarly, a decedents medical expenses paid within a year after death are deductible on the final form 1040, subject to the 7.5% floor, or can be deducted in full on the federal estate tax return.
DELAYING PAYMENT OF ESTATE TAXES
An executor may elect to postpone paying estate taxes attributable to a closely held business that is more than 35% of the decedents adjusted gross estate. Interests in two or more businesses can be combined to meet the 35% threshold if the estate owns, together with the surviving spouse, at least 20% of each. Under IRC section 6166, payments on this portion of the tax begin five years after the normal due date and can extend to nine more annual payments. Interest is due even during the first five years, but the rate is only 2% on up to $1 million of business value, adjusted for inflation after 1998. (For decedents dying before January 1, 1998, the rate is 4%.)
A closely held business may be a sole proprietorship or at least 20% ownership of a corporations voting stock or a partnerships total capital interest. Ownership of less than 20% qualifies if the business has no more than 15 owners. The entity must actively produce business income rather than earnings from investment property. This often disqualifies limited partnership interests and other passive activities. Except for a postmortem stock redemption, any sale, distribution or other disposition of 50% or more of the value of a business interest, or withdrawal of the equivalent in cash from the business, may accelerate all remaining estate taxes.
POSTMORTEM STOCK REDEMPTIONS
If stock in one or more closely held corporations exceeds 35% of an individuals adjusted gross estate, an IRC section 303 stock redemption can help the executor raise cash for death taxes, funeral costs and administration expenses without dividend treatment. The redemption generally produces little or no income tax because the estates basis in the stock is stepped up to the fair market value at death.
Ownership in two or more corporations may be combined for purposes of the 35% test if the estate owns, together with the surviving spouse, at least 20% of the value of each companys outstanding stock. Stock given away by the deceased owner within three years of death counts toward the 35% and 20% tests under IRC section 2035(d)(3)(A).
Example. Juan and Melissa jointly own 25% of the stock in one corporation and 22% of the stock in another. Melissa dies at a time when her portion of the holdings amounts to 65% of her adjusted gross estate. Under section 6166, Melissas executor can elect to delay paying the estate taxes attributable to her interests in the corporations. To raise cash, the executor sells a portion of the stock back to each company. The estate recognizes minimal gain because the stock has a stepped-up basis and the sale does not accelerate deferred estate taxes.
A SERVICE TO SMALL BUSINESS CLIENTS
While it is essential for small business clients and their CPAs to do proper estate planning before death to minimize or eliminate estate taxes, postmortem planning can correct or enhance these lifetime efforts. Such planning can help save the heirs hundreds of thousands of dollars in federal estate taxes. By playing an active role in making these choices, a CPA can help minimize some of the problems small business clients face.
