Death and Taxes

EXECUTIVE SUMMARY

CPAs WHO FILE FORM 706 ON BEHALF OF DECEASED clients should be familiar with some common pitfalls. The form shows the decedent’s assets, liabilities and allowable deductions that together are used to calculate the estate’s tax liability. FOR HELP IN DETERMINING WHICH ASSETS TO LIST on form 706, CPAs should consult an attorney familiar with laws in the deceased’s state of residence. In some instances special rules cover property held as joint tenants, the valuation of securities and whether the accountant must include property the deceased previously transferred to others, such as gifts. FAMILY LIMITED PARTNERSHIPS (FLPs) PRESENT a potential minefield of estate issues. One of the greatest areas of contention with the IRS is how to value such interests. CPAs should secure an appraisal of any FLPs the client owns and attach it to form 706. CPAs SHOULD PAY CAREFUL ATTENTION TO HOW THEY handle generation-skipping transfers. These are transfers to the grandchildren or later generation and may be subject to a separate tax. ADMINISTRATIVE DEDUCTIONS GO ON SCHEDULE J. Such deductions must surmount two hurdles—state law and the federal requirement that they be reasonable and necessary. As a general rule, if an expense isn’t deductible under state law, the IRS won’t allow it.

BARBARA KEVLES is a Texas-based business writer. Her work has appeared in Salon.com, Esquire, the New York Times and The Atlantic. She was previously a lecturer in the executive MBA program at the University of Texas at Dallas.

iven rising federal budget deficits and the war on terrorism, it’s impossible to predict whether Congress will permanently retire the federal estate tax, which in 2001 produced revenues totaling a whopping $24.4 billion. The Economic Growth and Tax Relief Reconciliation Act of 2001 gradually repeals the tax; as of January 1, 2010, there is no federal estate tax at all. But these impending reforms should not cause CPAs to give up their estate tax practices. The 2001 act has a sunset provision. Unless Congress acts to make the repeal permanent, the estate tax comes back in full force in 2011 for estates of more than $1 million.

Whatever the tax’s fate, CPAs still need to know how to navigate Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, due nine months after a client’s date of death. This article may help CPAs avoid some of the pitfalls of form 706, such as which assets and deductions to include or issues related to family limited partnerships. In this way they can work smarter on behalf of their clients’ estates. If CPAs understand the thorny 706 issues relevant to recording a decedent’s assets, debts and administrative deductions, they will be able to do a better job of reducing the estate’s tax liability.

FORM 706
Form 706 reports the value of a decedent’s estate—the property the deceased left to his or her heirs. It shows the decedent’s assets, liabilities and allowable deductions that combine to produce the estate’s taxable value. CPA John Pace, senior manager with the wealth transfer group at the Fort Worth, Texas, office of Weaver and Tidwell, LLP, says the form “is like a balance sheet at the date of death.”

A CPA should consult an attorney familiar with state laws governing property rights before listing a deceased client’s assets on form 706. “State law doesn’t necessarily dictate valuation,” says an IRS estate tax attorney, “but it certainly determines what a person owns.” Here are some of the specific areas where CPAs should exercise caution.

Joint tenancy and rights of survivorship. Even if a bank account or certificate of deposit lists both the decedent and the heir as having rights of survivorship, if the deceased contributed all the moneys, the account belongs on form 706. If the joint tenant made contributions, then the CPA should deduct them from the account’s total worth to find its estate value. An IRS estate tax attorney says, “In that case, the CPA should attach an affidavit to form 706 signed by the heir as proof of his or her contribution.”

Valuing stocks and bonds. When a person dies, his or her stocks and bonds automatically receive a step-up or step-down in basis to the market value on the date of death or the alternate valuation date. A CPA calculates each stock’s worth neither on the purchase price nor on the closing price, but on the mean fair market value on the date of death. Pace explains: “A CPA would take the high and low of the security’s market value for that day, divide by two, multiply the stock’s mean value by the number of shares held and include that figure in the estate’s total assets. For a weekend death, a CPA would obtain the stock’s mean market values on Friday and Monday, and find the average of the two days.”

“For example,” Pace continues, “if a decedent died Saturday, October 19, 2002, owning Bank of America stock, a CPA would combine the October 18 (Friday) market value high of $69.95 and low of $68.05 for a mean value of $69, and the October 21 (Monday) high of $70.60 and low of $68.50 for a mean of $69.55, then add the Friday mean and the Monday mean and divide by 2. The result—$69.275—is the value of one share of Bank of America in the estate. Multiply that price by the number of shares the decedent owned for the stock’s total value.”

CPA and board-certified estate tax attorney David Adler of Adler & Adler, PC, in Dallas points out, in the case of a weekend death and no trading days on the weekend, the number of trading days from Friday to the valuation date and from that date to Monday are the same. But if there were more trading days, CPAs would be required to use a weighted average. Accountants would give the higher weight to the average price closer to the valuation date and the lower weight to the average price further away.”

Timing of valuation. The IRS allows 706 filers to use the date of death or alternately a date six months from the decedent’s death to value the estate. In cases of falling stock prices, CPAs might choose the alternate date in order to obtain a major tax reduction and put more cash in the hands of beneficiaries. The election may be made, however, only if valuing the estate on the alternate valuation date decreases the “gross estate and the estate tax” according to IRC section 2032(c). Pace cautions, however, that “if a CPA elects the alternate valuation date and the fiduciary sells stock before that date, the sale price becomes the alternate value for the sold stock.”

To value other properties, Susan Finnell, a board-certified estate tax attorney with Geary, Porter & Donovan, PC, in Addison, Texas, comments, “I typically get updated appraisals for alternate valuation if other assets have declined in value or if real estate prices have declined significantly since the date of death.”

On the other hand, during a plummeting market, some beneficiaries may prefer greater capital losses that would result from the sale of estate stock during a plummeting market based on the date-of-death asset valuation. These losses would be computed by subtracting the stock’s sale price from its fair market value at date of death and multiplying that figure by the number of shares held for the total loss. In the year of the estate’s termination and distribution, the capital losses shown on Form 1041, U.S. Income Tax Return for Estates and Trusts, are passed through on form K-1 to the heirs proportionately in accordance with the decedent’s will.

Beneficiaries may use these inherited losses to reduce capital gains on their own 1040 schedule D and then against up to $3,000 of ordinary income. Excess losses are carried to the next year, when they are subject to the same limits. One of a CPA’s most important decisions is whether to elect the date of death for securities valuation for possibly greater capital losses for the beneficiaries’ benefit or the alternate six-month valuation date for the greater hard cash benefits from reduced estate taxes. In making this decision, CPAs should be influenced by the choice that generates the greatest net benefit to individual beneficiaries.

Transfer limitations. IRC sections 2035, 2036, 2037, 2038 and 2042 mandate that a CPA bring back into the estate certain property transferred during the decedent’s lifetime that meets conditions enumerated in these sections. For example, section 2035, which previously meant all assets transferred within three years of death had to be included, has now been narrowed to include only life insurance policies and a few other specific assets. Under section 2036, if a deceased client had retained the right to income from a transferred property, the CPA should list the asset on form 706, omit it if the interest in the property’s income was also transferred, but include it if the right to the property’s income was given away three years before death, in accordance with section 2035. Because of the complexities in this area, CPAs should make sure they thoroughly familiarize themselves with the relevant code sections and consult an attorney with such expertise if necessary.

FAMILY LIMITED PARTNERSHIPS
With family limited partnerships (FLPs), CPAs face a minefield that demands very careful navigation. An FLP is an unincorporated association of family members who pool assets to share profits and losses whereby certain partners’ liability is limited to their contributions to the partnership. FLPs have become popular estate planning vehicles for a number of reasons. Senior counsel Elizabeth Howard, an estate tax attorney at Locke Liddell & Sapp LLP in Dallas, says: “A family member can bequeath a partnership interest rather than the underlying partnership assets. Often, the appraised value of the partnership interest will be less than the value of the proportionate partnership assets.”

While CPAs typically include the decedent’s FLP interest in the gross estate on form 706, the area of contention with the IRS is its value. The executor may seek to discount the value of such partnerships for various reasons, perhaps because it is a minority interest or due to its lack of marketability. Howard explains: “When the decedent held a 30% interest in a partnership holding a $1 million ranch, the estate can’t cash out the interest or sell it easily. As a result a minority interest that’s difficult to sell may be eligible for a valuation discount.” An IRS estate tax attorney says: “CPAs and attorneys sometimes say a partnership interest is worth less than the property in the partnership. We generally question the amount of the discount. That’s where the contention lies.”

Howard advises CPAs to secure a solid appraisal and attach a copy of it to form 706. “If the partnership assets don’t have an easily determined fair market value,” Howard says, “it may be necessary to get a separate appraisal by a qualified expert, even though what’s included in the estate is only the partnership interest.” Valuation questions may also require appraisals of an undivided interest in real estate, a closely held family business, furniture, automobiles, jewelry and fine art.

Besides the discount, the IRS also questions the exclusion of assets in an FLP in which, according to IRC section 2036(a), the decedent had continued “the possession or enjoyment of, or the right to the income from the property” during his or her lifetime. In the precedent-setting case of Theodore R. Thompson et al. v . Commissioner in September 2002 the Tax Court held two FLPs were includable in the decedent’s taxable estate because he had retained full enjoyment of the properties he contributed to the partnerships. Pace explains: “The partnerships were nothing more than testamentary transfers. Thompson kept control over the income from the securities and real estate in the partnerships so he could pull out money yearly to make substantial cash gifts to family members.” He summarizes: “You can’t just transfer property or money into an FLP you use indiscriminately like a bank account and expect to get a discounted valuation at death.” (See the box at the end of this article for other Tax Court cases related to FLPs.)

GIFT TAXES
On form 706 the IRS wants to know the total of the adjusted taxable gifts of cash or property the decedent had made after December 31, 1976. The combined total of these gifts plus the taxable estate will be subject to tax, but first reduced by the unified lifetime credit which in 2003 is the equivalent of the tax on a $1 million estate. The estate tax is further decreased by any gift taxes the deceased paid on adjusted taxable gifts.

Here are some tips on handling gift taxes on form 706. Line 4 of the August 2002 version of form 706 asks CPAs for the total adjusted taxable gifts other than those included in the decedent’s gross estate. Estate attorney Adler explains how to compute this figure: “If the decedent gave $11,000 in 2002, that gift wasn’t taxable because of the $11,000 annual gift exclusion. For example, the decedent could have given five people identical sums without reporting it. But if a single gift amounted to $14,000, then $11,000 of the gift could be excluded for tax purposes and the remaining $3,000 would be taxable. In preparing form 706, a CPA computes the amount of every gift above the yearly exclusion and enters that sum on line 4. On line 7, the CPA subtracts out from the estate tax any gift taxes payable on transfers above the annual exclusion.”

Gifts by a spouse. Even if the decedent’s spouse had included gifts on his or her past gift tax returns for which the decedent was the donor, the Internal Revenue Code, in some circumstances, treats the spouse’s share of adjusted taxable gifts as includable in the decedent’s gross taxable estate. An IRS estate tax attorney says, “Although the gift tax provision allows a wife to consider half of the gifts her husband made as having been made by her, in estate matters, they are brought back into the estate because it was in fact his property—even though the wife filed a gift tax return.” David Adler points out: “On the 706, however, the estate gets a credit not only for the gift taxes the decedent had paid on a split gift, but also for the share of taxes the spouse paid if the adjusted taxable gift was included in the deceased’s gross estate.”

GENERATION SKIPPING TRANSFER TAX
If recipients of a decedent’s money, securities, life insurance, pension or other property are in the grandchildren or a later generation, a separate tax called the generation skipping transfer (GST) tax may apply. Like the gift tax, the GST tax has an annual exclusion identical to the one for the gift tax ($11,000 for 2003) and a lifetime exclusion separate from the gift and estate tax ($1.12 million in 2003).

“In calculating the GST tax,” attorney Adler says, “the CPA adds up all the nonexcludable transfers made to grandchildren or later generations during the decedent’s lifetime, subtracts that figure from the decedent’s separate GST tax lifetime exemption, and allocates what’s left of the exemption to those direct skips made at death. Then the CPA subtracts the projected GST tax from any remaining gift balance. After that deduction, the final balance is subject to the GST tax which in 2003 is a flat 49%. This tax goes on line 20 of the revised form 706.” In effect, Adler says, “the government gives the estate a reduction for the GST tax it will pay based on the gift going to the grandchildren or later generation.”

In transfers to trusts, Adler says: “If the only beneficiaries are in the grandchildren or later generation, then the transfer will be vulnerable to the GST tax. Even though the property is in a trust, the entity the property is transferred to is less important for GST tax purposes than the ultimate beneficiaries.”

ALLOWABLE DEDUCTIONS
CPAs enter funeral and administrative deductions on schedule J, and the decedent’s outstanding debts, mortgages and liens on schedule K. CPAs should be sure to list every conceivable expense on these two forms to help bring the estate’s total value below the lifetime exclusion credit for the year the decedent died. However, an IRS estate tax attorney says: “Any administrative deductions on schedule J have to surmount two hurdles—state law and the federal requirement that expenses be reasonable and necessary. And deductions on schedule K have to be enforceable obligations under state law.” CPA Pace warns, “As a general rule, if the expenses aren’t deductible under state law, the IRS won’t allow them.”

Administrative expenses. In most states, funeral bills—such as those for the tombstone, flowers, obituary announcement, clergy, burial, the travel of one person with the body; probate expenses such as filings, executor, lawyers, accounting, appraisal fees; and miscellaneous fees such as those for death certificates—all are legitimate deductions. For years the IRS won estate cases in Florida not because of the nature of the deductions, but their size. Pace recalls that “the IRS said the executor, legal and accounting fees were too large.” Eventually the legislature eliminated the contention by replacing the charges based on hourly billing with a fee schedule.

Charges related to the sale of the decedent’s house for the convenience of the heirs are not deductible, but if the sale is necessary to raise money to pay estate debts, expenses and taxes, the sale charges may be valid administrative expenses. Are they valid deductions if the decedent’s will mandates the sale? CPA Page says accountants should “review the circumstances of a mandated sale to determine if the sales charges are deductible. In most cases they would not be valid deductions because the sale would be for the benefit of the beneficiaries.”

Estate tax attorney Finnell says she does deduct sales charges in other instances. “I weigh the assets, debts and what the will says and make sure I have a good case for claiming the deduction.” Moving fees for the transportation of the deceased’s furniture to an heir—unless the will mandates payment of these expenses—are invalid deductions on schedule J. An IRS source says, “Commissions on the sale of securities to preserve the estate’s capital may also be deducted on schedule J.”

Decedent’s debts, mortgages and liens. In most states the decedent’s debt obligations incurred before death but paid after the date of death—such as credit card charges, last illness expenses not covered by insurance, owed rent, the entire mortgage, utility bills and subscriptions—are all deductible charges against the estate. Finnell advises, “A CPA should obtain a list of all creditors—paid and unpaid—for schedule K.” John Pace says: “Any last illness expenses the fiduciary pays after death can be put on schedule K or on the decedent’s final 1040—wherever it’s more advantageous. Accountants have a choice about where to use them.”

MISCELLANEOUS ISSUES
Here are some of the other issues CPAs may have to deal with in preparing form 706.

Extensions. If during the nine months from the date of death a CPA wants more time to file form 706, he or she simply submits form 4768 to the IRS to obtain an automatic six-months extension. In three decades of handling form 706, Pace says: “The simple act of filing for the extension doesn’t trigger an audit. It has no bearing on how the IRS picks a case. Rather it looks at the estate’s assets, the size of the estate and how form 706 is prepared to see whether the government can get more tax dollars.” It’s also important to remember that an extension of time to file does not extend the time the estate has to pay any taxes it owes.

Filing for refunds. An estate has three years from the filing date of the return or two years from the date of the last payment, whichever is later, to file for an estate tax refund. An IRS estate tax attorney advises CPAs to “use form 843 to claim a refund and explain the reasons.” Pace adds, “A CPA also could file another form 706 with just the amended supporting schedules and write ‘Supplemental Information’ on top of the return.”

Penalties. An IRS estate tax attorney says: “There is no IRS penalty for a preparer’s bad advice. However, the IRS invokes penalties against preparers who attempt to defraud the government by manipulating form 706 to keep a client from paying more taxes. These are violations of tax law.” In addition the IRS may levy penalties against the estate. If an executor believes the estate would not have had a penalty levied against it except for the CPA’s actions, the client may sue for malpractice.

KEEP TAX BILLS LOW
CPAs should thoroughly familiarize themselves with state and federal laws governing form 706 so they may remain far out of range of any client lawsuits and IRS penalties. However, practitioners should make every effort to tabulate all legally valid administrative expenses, debts, FLP discounts, taxes paid on gifts and generation skipping transfers as well as all other state and federally allowed deductions so they can save for their clients all the taxes possible.

Copyright © 2003 by Barbara Kevles

Cases Related to Family Limited Partnerships For further reading, see www.ustaxcourt.gov for information on Estate of Theodore R. Thompson et al. v. Commissioner, TC Memo 2000-246; No. 7578-99 (26 Sep. 2002). Estate of Morton B. Harper v. Commissioner, TC Memo 2002-121. Estate of Albert Strangi v. Commissioner, 115 TC 478, 485 (2000). Estate of Charles E. Reichardt v. Commissioner, 114 TC 144 (2000). Estate of Dorothy M. Schauerhamer v. Commissioner, TC Memo 1997-242. Commissioner v. Estate of Church, 335 US 632, 645 (1949). (Supreme Court: re: IRC section 2036).