Chapter Nineteen Accounting for Estates and Trusts Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objective 19-1 Understand the proper methods of accounting for and administering an estate and the corresponding legal terminology. 19-2

Estate Accounting  The term estate refers to the property (assets) owned by an individual.  More specifically defined as a separate legal entity holding title to the real and personal assets of a deceased person.  Estate accounting focuses on the recording and reporting of financial events from the time of a person’s death until the ultimate distribution of all property held by the estate. 19-3

Estate Accounting   A valid will ensures that asset disposition occurs as intended and avoids disputes when a person dies.   A will is a person’s declaration of how s/he desires the property they own to be disposed of after death.   When someone dies:   With a valid will, they die testate. A will serves as the blueprint for settling the estate.   Without a valid will, they die intestate. State laws control the administration of the estate. Real property is conveyed based on laws of descent. Personal property transfers based on laws of distribution. 19-4

 Laws governing wills and estates are called “probate laws”.  Each state establishes its own laws of descent and laws of distribution.  Almost half of the states have adopted the Uniform Probate Code. Estate Accounting Probate Laws -- Three general purposes: 1) 1)Gather and preserve all of the property. 2) 2)Carry out orderly and fair settlement debts. 3) 3)Discover and implement the decedent’s intentions for remaining property. 19-5

Probate Process The will is presented to the court. An executor (administrator) is assigned. Court appoints a representative as administrator. Terms of will are carried out. Entitled to compensation. Administration of the Estate Court rules on will’s validity. No will has been discovered. State laws control administration of estate. 19-6

Executor Responsibilities 1.Take possession of all decedent’s assets and complete an inventory of the property. 2.Discover claims against the estate and settle those claims. 3.File estate tax returns. Federal and State 4.Distribute property. 5.Make a full accounting to the probate court. 19-7

Estate Property Estate Property Includes:  Cash  Investments in stocks and bonds  Interest accrued to the date of death  Dividends declared prior to death  Investments in businesses  Unpaid wages  Accrued rents and royalties  Valuables such as jewelry, paintings and antiques 19-8

Typical order of priority:  Expenses of administering the estate.  Funeral and medical expenses (during last illness).  Debts and taxes.  All other claims. Discovery of Claims Against the Estate 19-9

Protection for Remaining Family Members  A wide variety of probate laws exist and differ according to the states:  Usually small monetary allowances are paid prior to payment of legal claims.  Homestead allowances are often provided to the surviving spouse and/or minor or dependent children.  A family allowance is often allowed for a limited time while the estate is being administered.  Limited amounts of exempt property (such as automobiles, furniture and jewelry) are often permitted to family

Learning Objective 19-2 Describe the types of estate distributions and identify the process of asset allocations and distributions from an estate

Gifts of personal property are called legacies or bequests.   Specific legacy (Gift of personal property from a directly identified source)   Demonstrative legacy (Cash gift from particular source)   General legacy (Cash gift from an unspecified source)   Residual Legacy (Gift from remaining estate property) Legacies and Devises 19-12

If funds are insufficient to satisfy all of the legacies, the reduction of these gifts is called “the process of abatement.” Estate Distributions Priority: Specific legacies Demonstrative legacies General legacies Residual legacies Debts and expenses of the administration of the estate are paid first

Learning Objective 19-3 Understand the federal estate tax and state inheritance tax systems, the corresponding exemptions, and tax planning opportunities

Estate and Inheritance Taxes The federal estate tax is an excise tax assessed on the right to convey property. The computation begins by determining the fair value of all property held at death. Real property transferred immediately to a beneficiary and not subject to probate must be included for federal estate tax purposes. An alternative evaluation date, six months after death, may be used to determine fair value if it reduces the amount of estate taxes to be paid

Federal Estate Taxes Items that reduce the gross estate: a) Funeral expenses b) Estate administration expenses c) Liabilities, and losses during the administration period d) Charitable bequests e) Marital deduction for property conveyed to spouse f) State inheritance taxes A specified amount may be deducted from the estate value in arriving at the federal estate tax. The 2010 legislation renewed increased exemptions, and the 2013 legislation indexed the exemption and raised the tax rate

Federal Estate Taxes Annual gifts of $14,000 per person (indexed to change with inflation) can be made tax-free to an unlimited number of donees. The federal gift tax has not been eliminated, but a $5.25 million (2013) lifetime tax-free exclusion (indexed at the same rate as the estate tax exemption) has been established over and above the $14,000 exclusion per person per year

State Inheritance Taxes  Some wills specify that inheritance taxes are to be paid from any residual cash amounts the estate holds.  Often, recipients of property must contribute cash to the estate to cover the taxes.  If the will makes no provisions for state inheritance taxes (or if the decedent dies intestate), the amount conveyed to each party must be reduced proportionately based on the fair value received. Other Estate Issues 19-18

Any income from estate assets is taxable to the estate.  Tax return must be filed for gross income of $600 or more.  An exemption of $600 is provided.  A reduction is allowed for taxable income donated to charity and taxable income distributed to a beneficiary.  Separate tax rates are available for estate income.  Tax return is due by the 15 th day of the 4 th month following the close of the estate’s taxable year. Estate and Trust Income Taxes 19-19

Learning Objective 19-4 Understand and account for the distinction between principal and income in the context of estate and trust accounting

 The recipient of estate income is called the “income beneficiary”.  The recipient of the estate principal (also called “corpus”) is called the “remainderman”.  How income is to be determined should be defined by the decedent in the will to avoid confusion.  Principal of the estate includes assets that existed at the date of death, which became assets of the estate. Distinction Between Income and Principal 19-21

Adjustments to principal include:   Life insurance proceeds if estate is named beneficiary.   Dividends declared and other income earned prior to death.   Liquidating dividends even if declared after death.   Debts incurred prior to death.   Gains and losses on the sale of corporate securities or rental property.   Major repairs (improvements) to rental property.   Investment commissions and other costs.   Funeral expenses.   Homestead and family allowances. Distinction Between Income and Principal 19-22

Distinction Between Income and Principal Income of the estate includes all revenues and expenses incurred after the date of death. Reductions to income include:   Recurring taxes (such as real and personal property taxes),   Ordinary repair expenses,   Water and other utility expenses,   Insurance expenses, and   Other ordinary expenses required for the management and preservation of the estate

Distinction Between Income and Principal Some costs must be apportioned between the principal and interest in some fair manner if manner of allocation has not been specified in the decedent’s last will and testament. These costs include: Executor’s fee Court costs Attorney’s fees Accountant’s fees 19-24

Recording Transactions of an Estate Estate assets are recorded at FMV. Subsequently discovered assets are disclosed separately. Debts, taxes & other obligations are recorded when paid. Distribution of legacies are not recorded until actually conveyed. Separately identify income and principal transactions.   Often, two cash accounts are maintained

Learning Objective 19-5 Describe the financial statements and journal entries utilized to account for estate and trust transactions

 Periodic Charge and Discharge statements report disclose progress in settling the estate.  Separate statements are required for income and principal.  Each statement reports:  Assets under the control of the executor.  Disbursements made to date.  Any property still remaining. Charge and Discharge Statement 19-27

Learning Objective 19-6 Describe various trusts, their proper use, and accounting for activities

Trusts A TRUST is created by conveying assets to a fiduciary (or trustee) Trusts are often established: - from the provisions of a will, specified by the decedent to guide distribution of estate property. - to reduce the size of a taxable estate and estate taxes that must be paid. - to protect assets and ensure that the eventual use of these assets is as intended. A trustee may be an individual or an organization 19-29

A testamentary trust is established by the will after the trustor’s death. Trusts The person who funds the trust is called the grantor, trustor, or settlor. An inter vivos trust is established while a person is still alive. The person who funds the trust appoints a trustee to manage the investments of the trust

Revocable Trusts  Trustor usually manages the fund and receives most (if not all) of the income until death.  Revocability means that the trustor can change beneficiaries and other terms at any time.  Avoids delay and expense of probate.  Allows for privacy (wills are public documents).  At the trustor’s death, the trust continues and makes future payments as defined in the trust agreement

Different Types of Trusts Credit Shelter Trust  Designed for couples, where each spouse agrees to transfer at death an amount up to the tax-free exclusion ($5.25 million in 2013) to the other.  Reduces the estate of surviving spouse. Qualified Terminable Interest Property Trust (QTIP Trust)  Property is conveyed to a trust; distributions are paid to the beneficiary (usually spouse).  At a specified time, the remainder is conveyed to a designated party.  Allows steady income for one beneficiary, while protecting principal for another

Different Types of Trusts Charitable Remainder Trust  Trust income is paid to a beneficiary for a period of time (or death of the beneficiary).  Then the principal is given to a stated charity.  Renders appreciated property requiring liquidation nontaxable. Charitable Lead Trust  Trust income paid to a specified charity for a period of time, then the remaining principal is transferred to a different beneficiary. Grantor Retained Annuity Trust (GRAT)  Trustor collects fixed payments from the trust.  Principal given to beneficiary after a specified time or at the death of the trustor.  Allows for reduction of gift tax

Different Types of Trusts Minor’s Section 2503(c) Trust  Eligible to receive a tax-free gift of $14,000 ($28,000 if from a couple) each year. Spendthrift Trust  Beneficiary cannot transfer or assign any payments not yet received. Irrevocable Life Insurance Trust  Money is contributed to purchase life insurance on the donor, so that proceeds can be used to pay estate and inheritance taxes. Qualified Personal Resident Trust (QPRT)  Donor’s home is given, but the donor retains the right to live there for a period rent free

Usually, the cash basis of accounting is used to record trust fund transactions. Adjustments to the Trust’s Principal:  Investing costs and commissions.  Income taxes on gains added to the principal.  Costs of preparing property for sale.  Extraordinary repairs. Record-Keeping for a Trust Fund 19-35

Adjustments to the Trust’s Income include:  Rent expense  Lease cancellation fees  Interest expense  Insurance expense  Income taxes on trust income  Property taxes Trustee fees and periodic reporting costs (accountant and legal fees) must be allocated between trust income and principal based on the value of the assets. Record-Keeping for a Trust Fund 19-36

An inter vivos trust reports on an annual basis (often more frequently) to all income and principal beneficiaries. Testamentary trusts, under the jurisdiction of the courts, issues additional reports regularly. Two accounts monitor changes that occur: Trust Principal Trust Income Accounting for the Activities of a Trust 19-37