Estates & Trusts - An Overview

1. No State Inheritance Tax. There is no longer a state inheritance tax in California (except for the so-called "pickup tax" that is deductible from the federal estate tax), so estate or inheritance taxes are generally not a concern for estates under $600,000 in value. However, note that some states still have an inheritance tax that is imposed on smaller estates, which can be a serious concern if clients own out-of-state real property or plan to retire to another state.
2. Unified Credit.Each U.S. resident has a "unified credit" of $192,800, equal to the tax on an estate of $600,000. Generally, referring to the "unified credit" (instead of another term like "exemption equivalent" or "exemption amount") helps to keep in mind that the estate and gift tax system is unified, with a single series of tax brackets and a single credit applied to all non-exempt lifetime gifts and all transfers at death.
3. "Incidents of Ownership."Federal estate tax applies to any property in which the decedent had any "incidents of ownership" within three years before death. This is an incredible malpractice trap, as clients and their heirs will undoubtedly deny ever having been warned about this complication, particularly as applied to life insurance policies.

The cost of probate is often exaggerated. In California, statutory fees for the executor and attorney (each) are as follows: 4% of the first $15,000, 3% of the next $85,000, 2% of the next $900,000, and 1% of the next $9 million. California Probate Code 10800, 10810. However, if the executor is an heir, s/he may waive all or part of the fee, and the attorney's fee is actually negotiable and for larger estates should be substantially less than the statutory fee.

Probate always involves substantial delay: a minimum of 6 months and typically 8 to 12 months. Further delays can be caused by the executor, the attorney, the probate referee (who must appraise all non-cash estate property), and by court delays.

Two of the most cumbersome the duties of the probate executor are preparation of an inventory and appraisal, and later, preparation of an "accounting" in a format specified by the court. Warning: Do not agree to prepare your client's probate accounting until you understand the exact format required for the accounting. Each county may have different requirements, and each probate paralegal will complain about different "defects" in a probate accounting.

The most common significant example of IRD is the inheritance of a retirement account: the beneficiary is subject to both estate taxes on the value of the retirement account (if the decedent's total estate exceeds $600,000 in value), and income taxes on money as it is withdrawn.

Warning: This is another malpractice trap (and certainly a client-relations issue), because clients and heirs will often claim that their advisors told them that no income tax was due on withdrawals from inherited IRAs. In addition, heirs often procrastinate about making the required election regarding their planned withdrawal method from the inherited IRA (or they will claim that they thought it was an election they could later make on one of the various tax returns).

Always discuss with clients how much GSTT exemption should be allocated whenever filing Form 706 (estate tax return) or 709 (gift tax return).

In some cases, I have seen tax professionals attempt to "re-characterize" such transfers: for example, imagining that the transfer was actually made in two parts, $50,000 last year and $50,000 this year, and that the transfer was not to one child, but to the child, the child's spouse, and a grandchild; accordingly, each transfer was less than $20,000 from the client couple, and will be exempt. This is hard to justify if there is a paper trail reflecting a different transfer, and if the transferred assets remain in the name of the child alone.

In addition, beware of clients who transfer assets to minor beneficiaries (usually children or grandchildren) in an effort to shift income tax reporting; such transfers are not easily undone. For example, if a client transfers partial interests in a residence to minors, and later needs to sell the home and use the proceeds to buy a new home or to pay for nursing home care, it will be necessary to obtain appointment of a legal "guardian of the estate" for each child, and a judge may refuse to allow the transfer to be "undone" for the benefit of the elderly donor.

A common problem in estate administration is that each person thinks the others are taking care of certain tasks. For example, the attorney may think the tax professional is preparing a draft 706, while the tax professional thinks the attorney is preparing it. Or the client may believe that the probate administration is proceeding fine, while the attorney is waiting for the financial figures needed to prepare the inventory and appraisement or the final accounting. Another possibility: the attorney and the EA may each obtain a tax ID number for an estate or trust, so that now there are two different tax ID numbers assigned to the same trust.

Also, just as clients often think you will easily be able to prepare their income tax return based on information they deliver to you on April 13 or August 14, they often have no idea how complex the estate tax return can be. And you must be cautious and plan ahead when agreeing to prepare estate tax returns, especially if the decedent makes the mistake of dying on July 15 (so that the estate tax return will be due nine months later on April 15).

I strongly recommend that you take the extra step of communicating everything to your client both orally and in writing, and try to provide clear, organized "checklists" of tasks the client must complete before you can do your work.

In addition, try to assess the client's situation, and the client's level of skill and knowledge. You may be surprised to learn that the surviving spouse doesn't know how to balance a checkbook, or that an adult child has no idea what assets their deceased parent had. You may even discover that your client lacks essential literacy or "numeracy" skills.

When the first spouse in a married couple dies, the surviving spouse often fails to do anything at all. However, if the couple has a revocable living trust, and if the trust provides for a "bypass" or "exemption" or "credit shelter trust," it is important that the surviving spouse prepare written records showing the allocation of assets, obtain a tax identification number for the new irrevocable trust, and file annual tax returns for the exemption trust.

Of course, the surviving spouse may also be required to file a federal estate tax return, and in general, if the total value of the property owned by the married couple is more than $600,000 or may reasonably rise to that level before the survivor's death, it is advisable to file a 706 at the time of the first death.

Post-death administration is especially difficult if a client believes that they created a living trust in order to "eliminate" any probate proceedings, taxes, or filings.

Finally, it is quite common to discover, after death, that some or all of the assets have never been formally transferred to the decedent's living trust. If so, an attorney's help may be required to obtain a court order declaring that these assets are part of the trust, or if there is no evidence of trust ownership, to petition for probate administration of the non-trust property.

• Decedent's income tax returns (1040):
  • Decedent's final return (e.g. return for year of death);
  • Decedent's prior year return, if not yet filed;
  • Possible amendment of earlier filed returns
• Estate Tax return (706)
• Fiduciary Income Tax Return(s) for estate (1041) - Note that estate may elect a non-calendar tax year
• Fiduciary Income Tax Returns for trust(s) (1041) - e.g., annual return for exemption/bypass trust
• Gift tax returns (if not timely filed during decedent's lifetime) (709)

1. Planning Ahead. The Federal Estate Tax Return requires many attachments, and any attempt to prepare the 706 at the last minute is guaranteed to be completely frustrated by the absence of required information. I once worked with a CPA who sent me an excellent draft 706 before leaving on a two-week vacation; when she returned two days before the return was due, she discovered she did not have copies of real estate appraisals or the decedent's will to attach to the return. She also lacked the social security numbers for several of the heirs. We all know what happened: an extension was requested, the tax was overpaid, and a refund requested several months later.

2. Counting Money Twice. It is often extremely difficult to allocate interest and dividend income, and to adjust for situations where such information must be reported on more than one return. This arises in two related contexts: interest or dividends accrued but unpaid on the date of death, and interest or dividends accrued and paid after the date of death. Some clients use figures from investment or bank statements that arrive months after the date of death as the "date of death" values or share counts, which generally include interest and dividends (and occasionally stock splits) from after the date of death. While most stock brokers are very helpful in this area, a few are lazy or uncooperative. In one case I handled, the clients spent $40,000 on repairs and improvements to make a property ready for sale, and only then obtained an appraisal of the house; the money spent on improvements was thus counted twice: once as part of cash on hand, and again in the appraised value of the real estate.

3. Malpractice & Liability: Some attorneys take the position that preparation of an estate tax return (706) is legal work and must be prepared by the attorney. I take the position that advice regarding certain elections on the 706 is legal advice, and whenever I represent an administrator or successor trustee, I always demand that I see and approve the 706 before it is filed. However, I prefer to have the CPA or EA prepare the actual return, in order to minimize total fees.

   In my opinion, any non-attorney who assists a client in regard to the administration of a decedent's estate or post-death administration of a trust, when the client has not retained an attorney, is looking for trouble. If the client experiences any problems, the client will seek to shift responsibility, and if no attorney is not available to take the blame, it will be shifted to the CPA, EA, paralegal, or whomever else is available.

   Go back to section III(B) above. Keep in mind that although the client will forget 90% of what you tell them orally, they will vividly remember hearing you say what they wanted to hear, or what they later want you to have said. My solution to this problem is the follow-up letter that repeats the advice I gave orally, and which provides a checklist and outline of responsibility.

   (One of my clients repeatedly complained that it was unnecessary to send letters confirming our discussions. Then one day he called, furious that I had failed to warn him about a specific tax consequence of an action he'd taken. I politely responded that I had warned him, both orally and in a confirming letter which he had obviously received -- since he had called to complain that it was unnecessary.)

   It is vitally important that all professionals understand the inherent risks of giving advice regarding estate planning. Some very basic "mistakes" can result in immense adverse tax consequences. For example, the heirs of a married couple with a $1.2 million estate face $235,000 in estate taxes if no "exemption" or "credit shelter" trust is created when the first spouse dies.

   The worry is that the tax professional who assists a client by recommending the allocation of assets between the "exemption" and "bypass" trusts, or who otherwise appears to recommend or endorse a specific action or inaction, or who even undertakes as simple an action as helping a client obtain a tax ID number, may later be sued for malpractice -- perhaps even legal malpractice if a jury later decides that the tax professional engaged in activity that constituted the practice of law.

   You should take little comfort in the fact that most problems arise after the client dies -- and thus the only witness other than you is unavailable to testify. Even if a suit is unsuccessful, or even if no suit is ever filed, the unsatisfied heirs will not only turn to another professional, but will probably complain to everyone they know about their bitter experience and your responsibility for it -- whether real or imagined.