Serving as a Trustee - Part Three: Paying Taxes and Funding Subtrusts

ESTATE TAX RETURN (Form 706)

One of the Trustee’s most important responsibilities during the first year is filing the Federal Estate Tax Return (IRS Form 706), and any applicable state estate and/or inheritance tax returns. Such returns must be filed and the tax paid within nine months of the Trustor’s date of death. The IRS will grant a six-month extension for filing the return (upon request), but an extension is not typically available for paying the estate tax. Therefore, you should attempt to get a good estimate of the value of the estate tax liability and pay all of the estate tax within the nine-month time frame, even if you do not file the estate tax return until later. If it is not possible to pay the entire tax, paying as much of the estimated estate tax as possible will help reduce the interest and penalties that may accrue.

For a death occurring in 2011 or 2012, an estate tax return is required when the Trustor’s estate exceeds $5,000,000. If taxable lifetime gifts have been made, a return may be due even if the estate is valued at less than $5,000,000 at death. In addition, if there is a surviving spouse, filing an estate tax return may be desirable in order to make an election allowing the surviving spouse to use any of the deceased spouse’s unused estate tax exemption amount. It may also be prudent to file an estate tax return for a smaller estate, as doing so limits amount of time the IRS has to assess additional tax (for which the Trustee could be personally liable) to 3 years. If no return has been filed, the IRS can assess additional tax at any time.

In some cases, the Trustee may not be in control of all of the assets. Joint tenancy, pay on death, pension and/or life insurance may pass to others. The Trustee must learn about all of these assets before making a determination as to whether an estate tax return is due.

California does not currently impose an inheritance or estate tax. However, if the decedent was a resident of another state, or had property in another state which has a separate state inheritance or estate tax, you may need to file a tax return in that state. You should seek advice from an attorney in that state to determine your filing obligations.

If a decedent died in 2010, the executor/trustee has the option of (1) filing an estate tax return, in which case an estate of up to $5,000,000 can pass free of estate tax and all assets receive a new income tax basis, or (2) filing an asset allocation return (with the final income tax return) in which case the estate can be of unlimited size and not result in any tax, but the basis increase in the assets is limited.

TRUSTOR’S INDIVIDUAL TAX RETURNS

In addition to possibly filing an estate tax return (depending on the size of the estate), you will have to file the Trustor’s final state and federal income tax returns for the period starting January 1 through his date of death. You may also have to file a final gift tax return as well as the income and gift tax returns for any years the Trustor did not file. Understandably, a Trustor who was ill during the last part of his life may not have filed his tax returns. Also, if the Trustor died before April 15, there may be an income and/or gift tax return due for the prior year. These returns may be filed jointly with the surviving spouse as well, subject to certain requirements. All individual tax returns must be filed in the state where the Trustee lives.

MAKE SURE THE IRS AND STATE TAX AGENCIES GET PAID

As Trustee, you are legally responsible for filing the tax returns and paying taxes, both income and estate, before the assets are distributed to the beneficiaries. Both the IRS and the California Franchise Tax Board (FTB) will hold a Trustee personally liable for any tax due, if that Trustee made distributions to beneficiaries and/or creditors before paying the taxes. This liability is limited to the value of the assets in your possession at the date of death. In addition, the IRS provides mechanisms for discharging this personal liability. These include requesting an “early determination” of estate tax liability. Even if you, as Trustee, are relieved of personal liability, both the estate, and the beneficiaries (to the extent of their distributions), continue to be liable for the tax due.

Certain important tax elections must also be made in a timely fashion by the Executor/ Trustee. These include: a QTIP election (for the marital deduction), a reverse QTIP election, a spousal election to use any unused estate tax exemption (portability), an election to take deductions on either the estate tax return or the Trustor’s final individual income tax return, an election for a calendar versus a fiscal year, an election under IRC 754 regarding partnerships, and an election to execute a Notice to Creditors. If you have any questions about whether or not to make one of these elections, please consult an attorney or other tax specialist.

TRUST INCOME TAX RETURNS

You will also be responsible for reporting the yearly income of the trust (and/or estate) to both the IRS and the FTB. In addition, you must supply each of the beneficiaries with Form K-1, which sets out all distributions made to that beneficiary during the trust’s taxable year. This form is necessary in order for the beneficiary to report his individual income tax properly.

FUNDING THE TRUSTS

Couples often set up a family trust that will split up into several “subtrusts” upon the death of the first spouse. It is your responsibility to make sure that each of these subtrusts is properly funded, which can be quite tricky, so getting the assistance of an attorney is highly recommended.

Funding usually occurs after the estate tax return (if any) is filed and the estate has received a closing letter from the IRS. The trust itself will dictate how assets will be divided among the several subtrusts, but not necessarily which assets are to be placed in each subtrust. It is therefore essential that you understand the trust provisions that apply at the death of the Trustor.

SMART FUNDING

There are many estate planning tools and techniques available to reduce estate and income taxes due upon the death of a person. In all likelihood, the Trustor and his attorney discussed most of these techniques before setting up the trust. Unless you were privy to these discussions, you will not know what the Trustor planned with respect to which assets should be used to fund each trust. This is where the assistance of an attorney and/or accountant will be most helpful.

For example, the marital trust (which will be taxed at the surviving spouse’s death) is typically not funded with assets that are likely to appreciate, because doing could increase the amount of estate taxes due at the surviving spouse’s death. Such assets are best placed in a Bypass or Credit Shelter trust which is not taxable at the survivor’s death. Pitfalls like these can result in increased income and/or estate tax, and get a Trustee into hot water with the beneficiaries. Other considerations in funding include the needs of the surviving spouse for income or asset protection (for example, a family could be placed in an irrevocable trust to limit the survivor’s personal liability).

SUMMARY

Preparing and filing timely tax returns for the estate and trust, and paying the taxes, is a significant responsibility of the Trustee and carries with it personal liability. Likewise, careful subtrust funding can enhance the benefits available to the trust beneficiaries.

The above information may be helpful when serving as a Trustee. It is designed merely to serve as a guide to those dealing with the administration of a Trust and is not intended to be all-inclusive or to provide legal advice of any sort.