FISCHER | TAYLOR | CHENG Estates and Trusts: Their Nature and the Accountant’s Role

Learning Objectives 1.Describe the goals of estate planning. 2.Account for the various factors that affect estate principal and income. 3.Describe various forms in which an estate may be distributed. 4.Explain how one’s estate is taxed and how such taxes may be minimized. 5.Explain what a trust is and what the basic accounting issues are. COPYRIGHT © 2012 South-Western/Cengage Learning 2

Key Terms Regarding Estates and Trusts DecedentThe deceased individual WillA legal declaration containing directions as to the disposition of property Died testateDecedent has left a will Probate courtDetermines validity of will Probate processIdentifies the decedent’s assets and liabilities, determines asset values, disburses assets to pay debts and taxes, and distributes the net assets of the estate per the instructions in the will ExecutorThe fiduciary responsible for the administration of a will, named or nominated in the will (also: personal representative) COPYRIGHT © 2012 South-Western/Cengage Learning 3 …continued…

Key Terms Regarding Estates and Trusts AdministratorIf necessary, a court appointed individual responsible for the administration of a will Died intestateDecedent has no will Inter vivos trustA trust formed during one’s lifetime which passes property to one’s heirs without a will and therefore avoids the probate process (also: living trust) Probate estateThe decedent’s assets which pass to others by means of a will COPYRIGHT © 2012 South-Western/Cengage Learning 4 …continued…

Key Terms Regarding Estates and Trusts Gross estateThe assets of an estate which are considered for federal and/or state estate tax purposes Corpus The assets of an estate (also principal) Joint tenancyProperty passes in its entirety to the surviving tenant and is excluded from the decedent’s estate Community propertyOnly the decedent’s interest in such property is included in the estate Homestead or family allowance Certain assets of the decedent which are exempt from the probate process and are intended to support the family homestead and its members COPYRIGHT © 2012 South-Western/Cengage Learning 5

Identifying the Probate Principal (Corpus) of an Estate Assets are measured at fair value Identify those assets that were the legal property of the decedent at the time of death Include additional assets that are subsequently discovered No reduction for liabilities of the decedent COPYRIGHT © 2012 South-Western/Cengage Learning 6

Exempt Property and Allowances Assets titled as joint tenants pass outside the probate process –Interest held by decedent is included in estate for tax purposes Assets held as tenants in common are excluded from estate –Decedent’s interest is included in the estate Assets held as marital property are not included in the estate –Decedent’s interest is included in the estate Homestead allowance or family allowance assets are removed from the estate; certain personal property also COPYRIGHT © 2012 South-Western/Cengage Learning 7

Accounting for the Inventory of a Probate Estate Determine exemptions and allowances Fiduciary files a report with probate court identifying the estate principal Accounting –Debit various assets –Credit Estate Principal Subsequent sale and liquidation of estate assets –Debit Cash; Credit appropriate asset –Recognize gain or loss on sale COPYRIGHT © 2012 South-Western/Cengage Learning 8

Identifying Claims Against the Probate Estate 1.Claims having a special lien against property, but not to exceed the value of the property 2.Funeral and administrative expenses 3.Taxes: income, estate, and inheritance 4.Debts due the United States and various states COPYRIGHT © 2012 South-Western/Cengage Learning 9 Claims are identified, validated, and generally placed in the following order of priority:...continued...

Identifying Claims Against the Probate Estate 5.Judgments of any court of competent jurisdiction 6.Wages due domestic servants for a period of not more than one year prior to date of death and medical claims for the same period 7.All other claims COPYRIGHT © 2012 South-Western/Cengage Learning 10

Measurement of Estate Income Distinguish estate corpus from estate income –Estate income is derived from estate assets Identified parties –Income beneficiary: Recipient of estate income –Remainderman: Party ultimately receiving the principal COPYRIGHT © 2012 South-Western/Cengage Learning 11

Components of Estate Income Income: –Rents collected or accrued on principal assets –Interest on monies lent –Interest and dividends received on principal assets which were not accrued or declared as of date of death –Business profits including farming and extractive endeavors Charges against income: –Ordinary expenses incurred in connection with the principal assets after the date of death such as ordinary repairs, taxes, and utilities –Professional fees associated with income issues and the management of income –Taxes imposed on income –A reasonable allowance for depreciation/depletion COPYRIGHT © 2012 South-Western/Cengage Learning 12

Distributions of the Property In an intestate distribution, generally only a spouse or blood relative may receive property In a testate distribution: –A distribution of real property is a devise to a devisee –A distribution of personal property is a legacy to a legatee COPYRIGHT © 2012 South-Western/Cengage Learning 13

Distributions of Property DeviseDistribution of specific testate real property DeviseeRecipient of the testate property LegaciesDistributions of personal property (also bequest) LegateeRecipient of personal property COPYRIGHT © 2012 South-Western/Cengage Learning 14

Distributions of Property Legacies –Specific –Demonstrative –General –Residuary If assets are not adequate to satisfy legacies, abatement occurs –Legacies are satisfied to the extent possible in the order above –Available amount is abated proportionately among the recipients if insufficient to fully cover all COPYRIGHT © 2012 South-Western/Cengage Learning 15

The Charge and Discharge Statement The statement is prepared by the fiduciary –Summarizes the results during the period of stewardship Two sections –Principal –Income Fiduciary responsibilities complete –Close estate principal –Close estate income COPYRIGHT © 2012 South-Western/Cengage Learning 16

Tax Implications of an Estate Unified transfer tax rate equal to –Federal gift tax rate –Federal estate tax rate –Unified credit may reduce tax on gifts and estates Most estates are not subject to estate tax Estates subject to tax have a claim against assets from –Federal estate tax –State estate tax –State inheritance tax COPYRIGHT © 2012 South-Western/Cengage Learning 17

Tax Implications of an Estate Recipient of gift or estate assets –Do not pay gift tax –Do not pay estate tax –Do not pay income taxes on amounts received Gift tax –Paid by party making the gift; unified transfer tax rate Estate tax –Paid by the estate; unified transfer tax rate COPYRIGHT © 2012 South-Western/Cengage Learning 18

Estate Reduction with Gifts Reduce taxable estate –Annual nontaxable gifts First $13,000 ($26,000 with spousal consent) To any one person During any calendar year –Gift from one spouse to the other No limit –Other nontaxable gifts COPYRIGHT © 2012 South-Western/Cengage Learning 19

The Unified Credit Lifetime credit Applied against gross tax on taxable gifts Renders (currently) the first $1,000,000 of other- wise taxable gifts tax-free Unified credit that is applied against assessed gift tax is not available as a credit against estate taxes COPYRIGHT © 2012 South-Western/Cengage Learning 20

Federal Estate Taxation Taxable gifts and taxable estates are taxed at the same (unified) tax rate Tax associated with gifts and estate are determined separately COPYRIGHT © 2012 South-Western/Cengage Learning 21

Computation of the Federal Estate Tax COPYRIGHT © 2012 South-Western/Cengage Learning 22 Gross estateXX Less deductions allowed– XX Taxable estateXX Add post-1976 taxable gifts+ XX Unified tax base XX Tentative tax on total transfersXX Less tax credits– XX Estate tax due XX

Computation of the Federal Estate Tax COPYRIGHT © 2012 South-Western/Cengage Learning 23 The fair value of all property in which the decedent has an interest at date of death… Gross estateXX Less deductions allowed– XX Taxable estateXX Add post-1976 taxable gifts+ XX Unified tax base XX Tentative tax on total transfers XX Less tax credits– XX Estate tax due XX

Computation of the Federal Estate Tax COPYRIGHT © 2012 South-Western/Cengage Learning 24 Allowable expenses Indebtedness against property included in the gross estate Unpaid property and income taxes of the decedent to date of death Uninsured losses Transfers to charity Marital deduction Gross estateXX Less deductions allowed– XX Taxable estateXX Add post-1976 taxable gifts+ XX Unified tax base XX Tentative tax on total transfers XX Less tax credits– XX Estate tax due XX

Marital Deduction Allowed for the value of qualifying property passing to the surviving spouse Amount of the deduction is unlimited Full transfer tax-free to surviving spouse On death of surviving spouse, remaining estate is subject to net-of-unified-credit tax Effect: Defers estate taxes until the death of the surviving spouse Possible strategy: Credit shelter trust COPYRIGHT © 2012 South-Western/Cengage Learning 25

Credit Shelter Trusts Also referred to as marital deduction trusts, family trusts, bypass trusts, “A-B” trusts Such trusts shelter a portion of the estate from estate tax To maximize their benefit, the amount of such trusts should equal the exclusion amount which corresponds with the unified credit COPYRIGHT © 2012 South-Western/Cengage Learning 26

Valuation of Assets Included in the Gross Estate Assets are valued at fair market value at the date of death An alternative valuation date may be employed –If employed, all estate assets must be valued as of six months after the decedent’s death Exception: property sold, distributed, or otherwise disposed of during the six-month period Value as of the date of disposition –The alternative valuation date may be used only if it would reduce the total gross estate and decrease the estate tax liability COPYRIGHT © 2012 South-Western/Cengage Learning 27

Valuation of Assets Included in the Gross Estate Recipient’s basis of property acquired from a decedent –Fair market value on the date of death or alternative valuation date –May result in a stepped-up basis If decedent does not have estate tax –No tax on appreciation at either estate or recipient Tax planning strategy –Hold appreciated assets as part of estate COPYRIGHT © 2012 South-Western/Cengage Learning 28

Other Taxes Affecting an Estate Most states assess an inheritance tax on the value of estate assets conveyed to heirs State inheritance tax is deductable against the gross estate An estate is viewed as a separate entity –Estate income that is distributed to a beneficiary generally is excluded from the taxable income of an estate –Estate income retains its character in the hands of recipient –Estate is taxed on income it accumulates COPYRIGHT © 2012 South-Western/Cengage Learning 29

Trust Accounting Issues Trust: A separate entity that receives assets for purposes of managing them and distributing them over time A trust is recognized as a taxable entity Reasons for creation –Manage assets for heir(s) –Exempt assets from the probate process and probate taxes –Convey assets to special organizations or causes COPYRIGHT © 2012 South-Western/Cengage Learning 30

Trust Accounting Issues Forms of trusts –Charitable remainder: income from assets distributed to beneficiaries for life; assets transferred to remainderman –Credit shelter (bypass): split assets between surviving spouse and trust to maximize the marital deduction and unified credit –QTIP (qualified terminable interest property): similar to bypass –Testamentary: operative while the grantor is alive –Inter vivos: created through a will COPYRIGHT © 2012 South-Western/Cengage Learning 31

Financial Accounting For Trusts Accounting for a trust is similar to accounting for an estate –The distinction between principal and income must be maintained through the use of trust principal and trust income accounts –The trust agreement should provide direction regarding how income is to be determined –A charge and discharge statement is required periodically for both trust principal and income COPYRIGHT © 2012 South-Western/Cengage Learning 32