Income Tax Planning

Although the federal estate tax is the main concern of estate tax planning, you can’t afford to ignore the possible consequences of the federal income tax as well. It is likely that income tax planning at death will become as important, if not more important, for most people under the new tax law and under new laws that are likely in the future.

An estate and a trust each constitutes a separate taxpayer for income tax purposes (with exceptions for living trusts--see chapter 11), and this offers a broad range of tax-planning options. For example, the timing of paying estate expenses and making distributions have critical tax implications. Moreover, there are income tax options for series E and H savings bonds, the filing of a joint return with the surviving spouse, the deduction of medical expenses, and highly sophisticated techniques for timing of distributions to beneficiaries.

Subject to Tax

Although the standard bequests in a will pass to the beneficiaries free of income tax, some income is still subject to income tax when received by the estate or its beneficiaries, including:

• Wages, bonuses and fringe benefits

• deferred compensation

• stock options

• qualified retirement plans

• some IRAs (other than Roth IRAs)

• medical savings accounts

• insurance renewal commissions

• professional fees

• interest earned before death

• dividends declared before death

• crop shares

• royalties

• proceeds of a sale entered into before death

• alimony arrearages

• income received through distributions from an estate (distributive net income)

Good Advice Can Make a Big Difference

Expenses of estate administration may be used as either an income tax deduction on taxes owed by the estate or an estate tax deduction (but not both). In the last year of the estate, such expenses can even be handled so as to be deductible directly or indirectly from the tax return of the individual beneficiaries.

This means that your survivors may have to make some tough calls about how and when to take certain deductions or make certain tax payments after you die. It’s a good idea to plan ahead for competent financial and legal advice.

Tax savings are possible, but no adviser can help if the family member in charge (whether an executor, surviving spouse, trustee, etc.) lacks the powers and discretion to make the proper tax choices. Most states give the necessary authority by statute, unless the person making the will provides otherwise.

If you don’t specify otherwise in your will, many states that have a law that apportions the tax to each person who receives anything from your estate.

Refusing Bequests

Don’t laugh--to reduce taxes or for other reasons, sometimes your beneficiaries may not want their bequests. For example, if your son already has plenty of money to live on, he might disclaim his inheritance from you so it goes directly to his children (or to a trust that benefits them). This avoids taxing the money twice (once when he inherits it, once when his children do), and could save a huge amount of money. Or perhaps he might disclaim property that you left him that’s subject to liens and mortgages greater than its market value.

Most states permit someone to disclaim (i.e., renounce or refuse) an inheritance or benefit. The Internal Revenue Code describes how a beneficiary may disclaim an interest in an estate for estate tax purposes. State law also defines how to disclaim for purposes of state death taxes; usually the two standards are the same. The beneficiary can disclaim only a portion of the gift and must disclaim within nine months of becoming eligible for it.

Once you disclaim a gift, the law generally acts as if you died before the testator so far as the gift is concerned. If the will or trust provides that should you die before the decedent, your share will go to your children, the children will take it if you disclaim the gift. You should see a lawyer if you intend to disclaim any gift.