10 EFFECTIVE POST-MORTEM TAX PLANNING TECHNIQUES

 by Adam Cohen, Esquire 

 After an individual dies, the estate and trust administration process can and should include more than just the basic steps of marshaling assets, paying debts, and distributing the remaining funds. Along with making necessary tax filings, there are often cost-effective and highly advantageous strategies that can be employed to reduce the tax burden on the estate or trust, as well as to the ultimate beneficiaries. 

1. An estate and a grantor trust (after death of the grantor) are their own tax-filing entities. For each year these entities remain active they are required to file income tax returns. The federal return is known as Form 1041, with similar state forms as well. When the estate or trust is only opened for a short period of time- less than a year, which is typical- the fiduciary only needs to fine one income tax return. The return is both the initial and final return. Wrapping up the administration within a year, and making all distributions, enables the fiduciary to pass through all income to the beneficiaries to the K-1. The estate or trust pays no tax. No subsequent returns are needed, saving the estate or trust money. 
2. Capital gains are somewhat limited on 1041s as most assets held by the estate or trust received a stepped-up basis as of date of death. However, many brokers and investment managers fail to step up the basis on their accounts unless told to do so. If the assets are sold quickly there is limited time for them to accrue value. On the other hand, if investments are retained during the administration, those assets (typically securities) may grow significantly. If the assets are then sold, there are capital gains reportable to the estate or trust. If the bases were never stepped up the gains may also be artificially inflated. All capital assets held by the estate or grantor trust are treated as long-term capital gains. Making sure the basis of all appreciating assets is stepped-up to the date-of-death value ensures the best possible income tax outcome for the entity and its beneficiaries. 
3. While S corporation (S-corp) status can have many benefits for small business owners, there can be significant pitfalls for the unwary after a shareholder dies. If all shareholders of the S-corp are not properly qualified owners, the corporation loses the tax-advantaged status; the S-corp can be involuntarily terminated. While an Estate can be a qualified shareholder, IRS rules do not condone keeping estates open for an unlimited period of time. Similarly, certain trusts, such as testamentary trusts, may be qualified S-corp shareholders, but only for a 2-year grace period. This can leave estate administrators and trustees in a difficult situation, having to determine how to dispose of the stock during this 2-year window. One option that should not be overlooked is converting a trust into a qualifying S-corp trust, such as a Qualified Subchapter S Trust (QSST) or Electing Small Business Trust (ESBT), by modifying the dispositive terms of the trust. Similarly, fiduciaries must ensure that the proper S-corp election as to the new shareholder is timely made.
4. One step many fiduciaries fail to take is filing an IRS Form 56. Filing Form 56 creates for the IRS a legal record of the fiduciary appointment, helping to establish the fiduciary’s authority to act on behalf of the or entity. Critically, Form 56 denotes for the IRS where to send all tax notices. In many cases where a decedent has died, the mail forwarding (through USPS) is often not a seamless process. Without a Form 56 on record, the IRS will send all tax notices to the decedent’s last known address; this is unlikely to be the fiduciary’s address. Form 56 is protective of the fiduciary in that they can be assured all tax notices will make it to their attention. Absent this simple step, the fiduciary may become liable for the decedent’s tax burden. 
5. In matters where the decedent’s gross taxable estate is significant and an Estate Tax Return (Form 706) is being filed, the fiduciary should be sure to have all information. While bank statements and investment holdings may be readily available, personal representatives should be more worried about the unknown than know. If the fiduciary does not have available to them previously filed Gift Tax Returns (Form 709) or Income Tax Returns (both 1040s and 1041s), these returns should be requested from the IRS through Form 4506. If the fiduciary, for example, fails to account for prior taxable gifts, this can severely impact the Estate Tax Return. Whereas, if a fiduciary attempts to obtain records from the IRS and none are produced, the fiduciary is not responsible for that unknown information. 
6. Similar to the above, one issue that can plague an Estate Tax Return is unfiled Gift Tax Returns for previously made but unreported gifts. In reviewing estate or trust information, a fiduciary, or their attorney, may discover large prior transfers. While individuals are supposed to file Gift Tax Returns where taxable gifts are made (over $18,000 per donor, per done, in 2024), many do not. Best practice would dictate that in cases where a fiduciary is going to file a 706, that 709s for prior gifts, even if late, still be filed. There is no penalty for late filing of these returns with the IRS where no tax is due. The IRS generally has three years from the filing of a Gift Tax Return to assess additional tax. If no Form 709 is filed or if the gift is not adequately disclosed with a Gift Tax Return, then the IRS can assess tax at any time. 
7. Failing to file a 706 Estate Tax Return in spousal cases where no filing is necessary can have significant and negative impacts. When there’s a surviving spouse, estates that aren’t required to file an Estate Tax Return should consider filing one for the sole purpose of electing portability. Portability helps minimize federal Gift and Estate Taxes by allowing a surviving spouse to use a deceased spouse’s unused Gift and Estate Tax exemption amount, currently $13,610,000. Portability may be critical to many moderate to high-wealth individuals, as the Gift and Estate Tax exemption is set to sunset after 2025. In cases where filing is only for portability, the returns can be prepared on an abbreviated basis. 
8. When individuals are named beneficiaries of retirement accounts, like IRAs, they have various options on how they would like to withdraw the money. Many people do not carefully consider these options. Individual beficiaries are generally required to withdraw all inherited funds within 10 years. However, Eligible Designated Beneficiaries (EDBs) may withdraw from the retirement account over the anticipated lifetime, stretching the investment and deferring the taxation. A surviving spouse, a minor child of the decedent, a disabled or chronically ill individual, or an individual who is less than 10 years younger than the decedent can qualify as an EDB. Unintentionally failing to qualify as an EDB for this select group of beneficiaries can have disastrous tax consequences. 
9. Fiduciaries can maximize assets to beneficiaries by reducing taxes. One way to do this is by employing the “65-day rule” under Section 663(b) of the Tax Code. The 65-day election gives fiduciaries an additional 65 days after the end of the fiscal year to make beneficiary distributions and still be able to report them on their prior-year tax return. For example, if annual income caused the trust to incur a higher tax burden than the beneficiary would if he received the income, the trustee could pass out the income within 65 days of the end of the tax year. Utilizing the 65-day rule affords fiduciaries extra time to distribute just the right amount of income to minimize tax to the estate or trust. 
10. In routine matters, fiduciaries should try to conclude an estate or trust within one tax year (including the additional 65 days above) to prevent unnecessary tax filings or subsequent tax years. Where possible, the fiduciary can achieve this by ensuring that timely distributions are made to beneficiaries and that any remaining assets are do not generate more than $600 of taxable gross receipts that would trigger an additional return filing requirement. Prompt conclusion of an estate or trust typically results in lower fees for professional services, maximizing money for the beneficiaries.