CHAPTER 12 Special Elections & Post Mortem Planning

CHAPTER 12 Special Elections & Post Mortem Planning DISCUSSION QUESTIONS 1. Why is it important for an estate to have cash? An estate must cover the taxes, administrative expenses, last medical costs, and funeral costs. All of these expenses must be paid for with cash, and if the estate does not have the cash necessary to make these payments, assets will have to be liquidated and possibly sold at a price lower than the asset s fair market value to generate the necessary cash. 2. How can an individual potentially reduce the medical expenses to be paid by his estate? An individual s estate is required to pay the medical expenses not otherwise paid by health insurance. If an individual keeps his medical insurance up to date until his death, the amount his estate will have to pay should be less than if he did not have health insurance. 3. How can an individual reduce the funeral expenses that his estate will have to pay? If an individual pre-arranges and pre-funds his funeral before his death, his estate will be relieved of the burden of paying for the services. 4. List three common administration costs of an estate. Executor s fees. Attorney s fees. Fees for the preparation of the estate and inheritance tax returns. Fees for appraisals of assets. 5. Why should selling an estate s assets to generate the liquidity necessary for the estate taxes generally be the last option? When the estate s assets are sold to generate the liquidity necessary for the estate, the assets are often sold in a fire-sale fashion for an amount less than the true fair market value of the assets. The executor usually has to spend a substantial amount of time selling the assets which may increase his executor s fee. Also, the estate must pay capital gains tax on the amount of the sales price above the adjusted basis at the decedent s date of death. All of these result in a loss for the heirs of the estate. DISCUSSION QUESTIONS 133

6. List three methods that an executor can use to reduce the liquidity requirements of an estate. The executor can make in-kind distributions to beneficiaries. If planned properly, the executor could sell assets to an ILIT. The executor could use the assets of a qualified plan payable to the decedent s estate. If there is an interest in a closely held business, the executor can redeem some of the stock under Section 303. The executor could take a loan for the amount necessary to meet the cash needs of the estate. 7. How can an ILIT be used to generate liquidity for an estate without requiring the value of the ILIT to be included in the decedent s gross estate? To avoid inclusion of the ILIT assets in the decedent s gross estate, the trust should not make the death benefits available to the executor or give the executor of the estate the right to demand a withdrawal from the ILIT. To use the assets of the ILIT and still prevent the inclusion of the ILIT s assets, the trust can allow the executor to make a loan, with interest, from the ILIT or the executor can sell the decedent s assets to the ILIT at the fair market value. In the latter scenario, the estate will be subject to capital gains tax on the sales price above the estate s adjusted basis, but the estate will not be required to sell the assets at a fire-sale price. 8. Even if qualified plans are payable to the decedent s estate, why should the executor seek alternative means of meeting the cash requirements of the estate before taking distributions from the qualified plans? Distributions from qualified plans are taxed as ordinary income for the heir or party taking the distribution. If the estate takes the distribution from the qualified plan to generate the cash necessary to meet the estate s cash requirements, the estate will be required to pay income tax on the distribution. Also, if the estate takes a distribution, it eliminates any opportunity of future tax-deferred growth of the assets in the qualified plan. 9. Explain the tax benefit allowed by a Section 303 stock redemption. With a stock redemption to a closely held corporation, the redemption is considered a dividend if it is not for a complete redemption of the stock. Section 303 allows the estate to redeem enough shares to pay its estate taxes and receive capital gain treatment on the sale, even if it is only a partial redemption. Section 303 is only allowed at a decedent s death. 10. What requirements must an estate meet to benefit from Section 303 stock redemption? To qualify for a Section 303 redemption, more than 35 percent of the decedent s adjusted gross estate must consist of the closely held business interest. In the event that the decedent owned interests in several closely held businesses, all of the business interests can be aggregated to meet the 35 percent test provided the decedent owned at least 20 percent of each company s outstanding stock. In addition, the shareholder redeemed must be responsible for the payment of the estate taxes, administration expenses, and funeral expenses. Also, only the stock redeemed to generate the necessary cash to cover the taxes, administration expenses, and funeral expenses receives the Section 303 capital gains treatment. 11. List two reasons why borrowing cash is an attractive option for the executor of an illiquid estate. Borrowing may prevent the fire-sale of assets. The interest incurred on the note is deductible. 12. In the year of a decedent s death, what are his surviving spouse s filing status options? The surviving spouse may file married filing jointly or married filing separately in the year of a decedent s death. 134 CHAPTER 12: SPECIAL ELECTIONS & POST MORTEM PLANNING

13. What requirements must be met for a surviving spouse to file as a qualifying widow/widower? The surviving spouse can file as a qualified widower for two years following the decedent s death if the surviving spouse has not remarried and the surviving spouse is maintaining a home for one or more dependent children. 14. Unpaid medical expenses of a decedent are deducted on which form, the estate tax return or the final income tax return? The executor of the estate may elect to deduct the decedent s unpaid medical expenses either on the estate tax return or on the decedent s final income tax return, but the same expenses may not be deducted in both places. 15. When is the tax year-end of an estate for income tax purposes? The executor can elect to have the estate s tax year end on the last day of any month during the year. 16. When would an executor choose to deduct an estate s administrative fees on the fiduciary income tax return? An executor would choose to deduct an estate s administrative fees on the fiduciary s income tax return when the decedent did not have a taxable estate (an estate under the applicable estate tax credit equivalency), and the estate received income during the year. 17. Why might an executor choose to waive his executor s fee? The executor s fee is subject to ordinary income tax and potentially self-employment tax if he is a professional executor or administrator. So, if the executor is also a beneficiary of the estate and the estate is in a lower marginal estate tax bracket than the executor s income tax bracket, the executor may choose to waive his fee and receive a distribution, as an inheritance, from the estate. The inheritance is not subject to income tax or selfemployment tax. Of course, this may only work when the executor is the only heir. 18. Why do small estates generally overvalue the fair market value of assets in the gross estate? Small estates are estates with a fair market value less than the applicable estate tax credit equivalency amount. These estates do not owe any estate tax, so they are not concerned with reducing the value of the gross estate. Instead, these estates will try to include all of the assets of the estate at the highest fair market value possible without creating an estate tax due. In such a case, the heirs of the estate will receive the property with the highest adjusted basis possible, and will pay the lowest capital gains on a subsequent sale, or receive the highest capital loss on a subsequent sale. 19. What are the two requirements for electing the alternate valuation date? The total value of the assets included in the gross estate six months after the decedent s date of death must be lower than the value of the assets on the decedent s date of death. There must be a reduction in the estate tax due as a result of the election. 20. List the three requirements necessary for an estate to elect Section 6166. The value of the business interest must be more than 35% of the value of the decedent s adjusted gross estate. The business interest must be a closely held business. The entity must have been actively engaged in the conduct of a trade or a business at the date of the decedent s death. DISCUSSION QUESTIONS 135

21. Explain why the government would allow an estate to utilize the special use valuation as a property s fair market value in the gross estate. Generally, fair market value implies the value of a property in its highest and best use. Over the years, the highest and best use of a particular piece of property may change. For example, 50 years ago the use of property outside of a city for farming purposes may have been the highest and best use of the land, but as the city expands, the highest and best use of the property may shift from farming activities to a residential subdivision or office complex. For estate tax purposes, the fair market value (i.e., the highest and best use value) of the property must be included in the gross estate; the value of the land in its current use does not matter. If an individual is using a piece of real property as a farm or in another trade or business that is not employing the property at its highest and best use, the value of the property may be higher than the value of the property in its current use. This may create an estate tax that could be much larger than an estate tax based on the value of the property utilizing its current use value. As a result, the farming operation or business enterprise may not be able to continue, since the real estate it is using must be sold to pay the estate taxes it has generated. 22. Why is the special use valuation rarely used? Special use valuation is rarely used because of the ongoing requirements that must be met in order to benefit from its use. 136 CHAPTER 12: SPECIAL ELECTIONS & POST MORTEM PLANNING

MULTIPLE-CHOICE PROBLEMS 1. Which of the following is not a typical reason an estate will have liquidity concerns? a. To meet specific bequests. b. To pay taxes. c. To pay life insurance premiums on the decedent s life. d. To pay funeral and administrative expenses and the executor s fee. The correct answer is c. Generally, an estate does not need cash to pay the premiums on a life insurance policy for the decedent since the decedent is dead. All of the other options are reasons an estate will have liquidity concerns. 2. Which of the following estates will most likely have the greatest liquidity problem? a. An estate with $4,000,000 of marketable securities. b. An estate comprised of rental real estate and marketable securities totalling $2,000,000. c. An estate consisting of a closely held business interest valued at $3,000,000, several pieces of art work valued at $400,000, and $500,000 of cash. d. An estate comprised of a closely held business interest valued at $4,000,000, and cash of $100,000. The correct answer is d. The estate in answer d will most likely have the greatest liquidity problem because of the lack of cash that will be necessary to pay the estate tax, and the fact that the closely held business interest will generally not be very liquid. Answer a is completely comprised of marketable securities, which can easily be converted to cash. Answer b owes the least amount of tax, and there are liquid assets to use to pay the tax.the estate in answer c will have a liquidity problem but not as bad of a liquidity problem as answer D. 3. The executor of an estate liquidated assets to generate the cash necessary to pay the estate taxes. Of the following assets, which is the least likely to generate income tax consequences upon its sale? a. Real estate sold within three months of the decedent s date of death. b. Publicly traded securities sold two weeks after the decedent s date of death. c. The redemption of the stock of a closely held business. The redemption qualified for Section 303 treatment. d. Publicly traded securities sold eight months after the decedent s date of death. The correct answer is a. The real estate sold within three months of the decedent s date of death would not generally create any income tax consequences because the fair market value on the estate tax return of that piece of real estate would be that sales price. So, when the estate sold the real estate it would not have any gain or loss on the transaction because its adjusted basis (the fair market value on the estate tax return) would be equal to the proceeds of the sale. Answers b and d would create income tax consequences as the adjusted basis of the securities to the estate would be the fair market value of the securities at the decedent s date of death. Since these are publicly traded securities, their value changes daily, and the estate would most likely have some gain or loss on the sales. The stock redemption in answer c would create tax consequences. Section 303 redemption takes an otherwise dividend distribution subject to ordinary income tax and subjects any gain to capital gains tax. MULTIPLE-CHOICE PROBLEMS 137

4. Which of the following statements regarding selling an estate s assets to generate cash is not correct? a. The estate may have income tax consequences. b. The assets may not be sold at full, realizable fair market value. c. Any losses on the sale of the assets are deductible as losses on the estate tax return. d. Any selling expenses are deductible on the estate tax return. The correct answer is c. Any losses on the sale of the assets are income tax losses and are deductible on the estate s income tax return, not on the estate tax return. All of the other answers are true statements. 5. In 2012, Amy created and funded an irrevocable Life Insurance Trust (ILIT) naming her children as the beneficiaries. Amy contributed cash each year to the trust to pay the life insurance policy premiums. In 2014, Amy died in a car accident, and the policy death benefit of $1,000,000 was paid to the ILIT. Which of the following statements regarding this ILIT and Amy s estate is false? a. The ILIT will be included in Amy s gross estate because Amy made a contribution to the trust within three years of her death. b. If Amy s executor can demand a distribution from the ILIT to pay Amy s estate taxes, the value of the ILIT will be included in Amy s gross estate. c. Amy s executor can sell the assets from Amy s estate to the ILIT without causing the value of the ILIT to be included in Amy s gross estate. d. If Amy had released any rights she had to revoke the ILIT in 2013, the value of the ILIT would be included in Amy s gross estate. The correct answer is a. Answer a is false statement. Since Amy was only making cash contributions to the trust, the value of the ILIT will not be included in Amy s gross estate. If Amy had to pay any gift tax on the contributions to the ILIT, the gift tax paid on the contributions would be included in her gross estate. All of the other options are true statements. Answer d is a true statement, because to the extent the grantor of an ILIT releases a right to revoke the trust within three years of death, the value of the ILIT is included in their gross estate. 6. Josh was a majority owner in a closely held business. He had an adjusted basis in his interest of $400,000, and at his death this year, the fair market value reported on his estate tax return was $6,000,000. Like most majority owner s in closely held businesses, Josh did not have much liquidity in his estate and his executor was forced to redeem some of his interest in the business. If Josh s executor redeemed 30% of Josh s interest for $2,500,000 to pay the estate tax and administration fees, how much is subject to capital gains tax? a. $0. b. $700,000. c. $2,100,000. d. $2,500,000. 138 CHAPTER 12: SPECIAL ELECTIONS & POST MORTEM PLANNING

The correct answer is b. Josh s estate would have an adjusted basis in the 30% interest equal to 30% of the fair market value at Josh s date of death, or $1,800,000. If the executor of Josh s estate sold the interest for $2,500,000, the gain of $700,000 ($2,500,000-$1,800,000) would be subject to capital gains tax under Section 303 (only available at the death of the owner). Ordinarily, unless a redemption is a complete redemption, the redemption is treated as a dividend. 7. Which of the following statements concerning an illiquid estate is true? a. If the executor of an illiquid estate takes a loan to pay estate taxes, and pledges the estate s assets as security for the loan, the interest on the loan is deductible. b. When an executor sells an estate s assets eight months after the decedent s date of death, any gain or loss is included in the fair market value of the asset in the decedent s gross estate. c. An heir who agrees to take an in-kind distribution, instead of a cash distribution, from the estate, will take the property with an adjusted basis equal to the decedent s adjusted basis immediately before his death. d. Real property valued under the Special Use Valuation rules can be sold after four years for an unrelated use without suffering recapture. The correct answer is a. The interest on a loan used to pay estate taxes is deductible by the estate. Answer b is a false statement as the property is reported on the estate tax return at the fair market value at the decedent s date of death, or the alternate valuation date. Answer c is incorrect as the heir would receive the property with an adjusted basis equal to the fair market value at the decedent s date of death. Answer d is incorrect as the recapture occurs if property valued under the special use valuation rules is sold within ten years of the decedent s date of death. 8. Which of the following is not a benefit of taking a loan to pay estate taxes and administration fees? a. The interest on the loan is deductible for income tax purposes. b. The executor of the estate will have more time to sell the estate s assets. c. The estate s assets will not be sold in a fire-sale fashion. d. The principal of the loan is a debt on the estate tax return. The correct answer is d. The principal of the loan is not a debt on the estate tax return. The estate tax return would only include those debts that existed at the date of his death. This debt would have been acquired by the executor after the decedent s date of death. All of the other answers are true benefits. 9. Mary Jane s husband died in October of 2014. Which filing status will Mary Jane probably use on her 2014 income tax return? a. Single. b. Head of household. c. Married filing jointly. d. Qualifying widow. MULTIPLE-CHOICE PROBLEMS 139

The correct answer is c. In the year of death, the surviving spouse can file either married filing separate or married filing jointly. 10. Mary Jane s husband died in October of 2014. Mary Jane has a one year old dependent child and has not remarried. Which filing status will Mary Jane use on her 2017 income tax return? a. Single. b. Head of household. c. Married filing jointly. d. Qualifying widow. The correct answer is b. Mary Jane will file as head of household in 2017. Since Mary Jane s husband died in 2014, she will file married filing jointly for the year of her husband s death. In the two years after her husband s death (2015 and 2016), Mary Jane will file as qualifying widow. For the 2017 tax year, Mary Jane will file head of household, and this will continue until she remarries or does not provide a home for her child. 11. The executor of an estate makes many elections before he files an estate tax return. Which of the following is not an available election for the executor? a. Utilizing the annual exclusion against the testamentary transfers. b. Selection of the tax year-end. c. Electing QTIP on certain property passing to the surviving spouse. d. Deducting the expenses of administering the decedent s estate on the estate s income tax return. The correct answer is a. The annual exclusion cannot be used against testamentary transfers. All of the other options are available elections for the executor. 12. Before his death in 2014, Melvin, age 66, incurred $65,000 in medical bills. Melvin s taxable estate at his death was $675,000 and his adjusted gross income for 2014 was $100,000. How much of Melvin s medical expenses will be deducted on his estate tax return? a. $0. b. $57,500. c. $65,000. d. $100,000. The correct answer is a. In this situation, Melvin s executor would not elect to deduct any of the final expenses on Melvin s estate tax return because the medical expenses will not change the estate tax due on Melvin s estate tax return - Melvin s taxable estate is less than the applicable estate tax credit equivalency. Melvin s executor will deduct the expenses, to the extent they exceed 7.5% of Melvin s AGI, on Melvin s final income tax return because he is over 65. 140 CHAPTER 12: SPECIAL ELECTIONS & POST MORTEM PLANNING

13. In which of the following cases will Robert, the executor of his father s estate, not waive his executor s fee? a. Robert is a 39.6% taxpayer and his father s estate is a 40% taxpayer. b. Robert is the only heir of his father s estate. c. Robert and his mother are the only heirs to his father s estate. Neither Robert s father or his mother are very wealthy and his mother has very expensive prescription costs. Robert is in the 39.6% marginal tax bracket. d. Robert is also one of three beneficiaries of his father s estate. The beneficiaries will share the residual of the estate equally. The correct answer is d. Based on the scenario, Robert will not waive his executor s fee in answer d. If he waived the fee he would have to share the residual with two other beneficiaries, and he would be left with less than if he would have taken the executor s fee. Robert would waive his fee in the scenarios under answers a and b as the overall tax burden would be lower. Robert would also waive his fee in answer c because he would want to help his mother. 14. Which of the following is not a requirement of using the special use valuation of property? a. The property must be used in a farming operation or a trade or business that was actively managed by the decedent or the decedent s family for 5 out of the 8 years immediately preceding the decedent s death. b. The value of the real and personal property used in a qualifying manner must equal or exceed 50 percent of the decedent s gross estate as adjusted. c. The value of the real property used in a qualifying manner must equal or exceed 75 percent of the value of the decedent s gross estate as adjusted. d. The qualifying property must pass to qualifying heirs who must actively participate in the farming activity or trade or business. The correct answer is c. Answer c simply reads the percentage incorrectly. The value of the real property used in a qualifying manner must equal or exceed 25 percent of the value of the gross estate as adjusted. 15. Joseph died this year. His will specifically bequeaths $1,000,000 to his son, Kevin and bequeaths the residual of his estate to his wife, Martha. At the time Joseph had written his will, his net worth was in excess of $4,000,000, but at his death his net worth had plummeted to $1,050,000. Because Kevin s mother would only receive $50,000 ($1,050,000-$1,000,000) of his father s assets, Kevin fully disclaimed his bequest three months after his father s death. How much will Kevin have to report as a taxable gift because of this disclaimer? a. $0. b. $38,000. c. $50,000. d. $1,000,000. MULTIPLE-CHOICE PROBLEMS 141

The correct answer is a. A qualified disclaimer is a disclaimer that is made in writing, filed within nine months of the decedent s date of death, does not allow the disclaiming party to specify to whom the property will pass, and does not allow the disclaiming party to benefit from the property before disclaiming his interest. If a disclaimer is qualified the property will pass to the residual heirs of the estate, or as directed by a disclaimer clause, with no effect to the disclaiming party. In this case, Kevin has no taxable gift related to this disclaimer. 142 CHAPTER 12: SPECIAL ELECTIONS & POST MORTEM PLANNING