Basic Estate Administration and Taxes: Elections & Timing
This post is written to remind non-tax advisors who administer estates of a few basic tax issues that must be considered in administering estates. From a tax perspective, estate administration is all about making elections and timing distributions, income and expenses.
The first group of elections involves selecting tax years. IRC § 441 defines a taxpayers “taxable year” as the taxpayer’s annual accounting period that may be a calendar year or a fiscal year. IRC § 441(e) defines a “fiscal year” as any period of 12 months ending other than in the month of December. IRC § 441(d) defines a “calendar year” as a tax year as ending in December. The second election that the estate attorney must consider is whether to elect a “short period.” With some exceptions, IRC §§ 443 and 7701(a)(1),(14) provides that a “short period” is a period of less than 12 months. These elections essentially allow the estate attorney to terminate the tax year when it will result in the least amount of tax.
The second group of elections involves timing the receipt of income and flow through and allocation of tax attributes. Most states have adopted some version of the Uniform Principal and Income Act, which allows the fiduciary to elect to elect to allocate capital gains to principal. Similarly, Treas. Reg. § 1.643(a)-3(b)(1) permits the fiduciary to treat certain capital gain receipts as income for trust accounting purposes, IRC § 663(b)(2) permits the fiduciary to elect to treat certain distributions as having been made during the prior year, IRC § 645 permits the fiduciary to treat a revocable trust as part of the estate, IRC § 642(g) permits the fiduciary to elect to deduct administrative expenses, and IRC § 643(g) permits the fiduciary to treat estimated tax payers as made by beneficiaries.
There are a number of other decisions that fiduciaries must make that are not elections per say, but are in essence elections. For example, fiduciaries are often able to time distributions, to make distributions under residuary clauses versus specific distribution clauses in wills, to make in-kind distributions in lieu of specific distributions, and to allocate deductions and expenses to certain beneficiaries or property.
This combination of elections presents fiduciaries administering estates with a number of planning opportunities. For example, the fiduciary may elect a short fiscal year for the first tax year and then have the estate terminate and deductions or other tax attributes flow through to the heirs’ tax returns in the second tax year. This is possible because IRC § 642(h) specifically provides that certain carryovers and excess deductions pass through to the beneficiaries if they arise in the year that the estate is terminated. This can be particularly useful where the estate is entitled to significant depreciation or depletion deductions, which would otherwise be lost because the estate had deductions in excess of income. Similarly, in other cases these flexible election rules may permit the fiduciary to time distributions so that the heirs receive distributions and expenses in years where the heirs have other offsetting tax attributes or income.
Of course, tax minimization is often not the main consideration in administering an estate. However, the rules sufficiently flexible and present the fiduciary with a number of tax minimization opportunities. Fiduciaries administering estates should not inadvertently pass up these tax minimization opportunities.