After death, there are numerous administrative tasks to be taken care of – whether or not there is a probate. For example, the trustee will need to:

● File the decedent’s final income tax returns
● Pay bills as they come due
● Notify Social Security
● Cancel insurance policies
● File the Oregon estate tax return (and pay the tax) within 9 months
● Assist IRA beneficiaries in setting up “inherited IRA” accounts or selecting the most prudent distribution options
● Collect life insurance payable to the trust
● If the decedent was first spouse to die, the trustee has 9 months after death to (i) file the federal estate tax return to claim “portability” of the decedent’s $5.25M exemption, and (ii) determine whether to make disclaimers to fund the “disclaimer trust”
● Determine outstanding balances on the decedent’s loans to beneficiaries and the appropriate offset

The trustee should never make cash distributions that create risk of running out of money, even temporarily. Once funds are distributed, it is hard to get them back.

It is prudent to retain a reserve for contingencies. The amount of the reserve depends on the decedent’s circumstances. If, for example, the decedent’s only asset is a brokerage account and there are virtually no liabilities, the reserve might be modest. But if the decedent owned real property or business interests, owes taxes, or was frequently engaged in business transactions, a larger reserve is appropriate. The same is true if there are disgruntled family members who may contest the decedent’s will or trust. (The trustee will need funds for a legal defense.) Finally, there is the potential for an Oregon estate tax audit, which will usually occur more than a year after death. Without a reserve, the trustee may have to loan personal funds.

I have been involved in several cases involving trustees who acted without legal counsel and made big mistakes. In a memorable case, the trustee held the funds in the decedent’s trust for five years as a joint account to pay expenses for her and her sister (who were both going through divorces). The sister claimed she was shorted and sued. Another trustee failed to file the Oregon estate tax returns and incurred a 20% late payment penalty. I also remember a case in which the trustee failed to utilize disclaimers to reduce the survivor’s estate, which will unnecessarily result in roughly $70,000 in Oregon estate tax. Another paid himself tens of thousands of dollars for caring for his deceased parent, even though there was no contract and his siblings were kept in the dark. (He was sued.) Giving away inheritances seems easy, but there are plenty of opportunities for beneficiaries to second guess the trustee after the fact.

In conclusion, most trustees need coaching from a lawyer on an as-needed basis when administering a revocable trust after death. Especially first-time trustees for estates over $1M. Occasional legal counsel from time to time will help avoid substantial errors, and (perhaps more importantly) reduce stress to the trustee.

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An IRS audit is a lengthy, stressful and expensive experience. By the end of the process, the taxpayer-examiner relationship is inevitably heated. Equally relevant, the examiner needs to justify the time spent on the audit with a commensurate tax recovery. Needless to say, it is often nearly impossible to convince an auditor that a proposed adjustment is unreasonable or contrary to the tax laws. At that point, the taxpayer’s best course of action is to stop negotiating and simply ask the examiner to make the proposed adjustments and issue a final examination report.

The examination report will be accompanied by a letter (often known as a 30-day letter) that the taxpayer may request a conference with the IRS Appeals Office. Publication 3498 is also enclosed. The critical next step is that — within the next 30 days – the taxpayer must send Appeals a letter explaining why the adjustments are erroneous. This letter to Appeals is commonly known as a “Protest.” With a telephone call, the 30-day deadline can usually be extended. But if the deadline is blown, it may be necessary to file a formal petition with the US Tax Court to contest the proposed deficiency (without first paying it). Thus, the importance of filing a timely Protest with Appeals cannot be overstated.

Several months after receipt of the Protest, an Appeals Officer will contact the taxpayer and schedule a conference. Sometimes the Appeals Officer will ask for additional information. At the conference, the Appeals Officer will discuss each issue and propose a resolution. Provided the Protest is carefully prepared and the positions are well-supported, the proposal by the Appeals Officer is usually a significant improvement over that of the examiner. Even if Appeals makes only nominal reductions to the tax deficiency, it might agree to waive penalties, for example. There are a number of reasons. The mission of the Appeals Office is to settle cases, and each Appeals Officer has a significant caseload and backlog. Unlike the examiner, Appeals Officers are authorized to take the hazards of litigation into account when crafting compromises of unagreed issues. Finally, Appeals takes a fresh look without the baggage of audit acrimony.

Taking a case through Appeals usually reduces the tax deficiency, but is not a panacea. It is usually time-consuming for a tax lawyer to review the workpapers, research the underlying law and write a persuasive explanation of why the examiner is wrong. Thus, the bigger the examiner’s error, the more likely it is that filing a Protest will be cost effective. Second, a favorable Appeals outcome is by no means automatic. If the examiner’s position is reasonable and well-supported, taking the case to Appeals may be a waste of time and money.

In conclusion, if a reasonable settlement with an IRS examiner is unrealistic (and it often will be), the taxpayer should consider filing a Protest and having the case reviewed by the IRS Appeals Office. In my experience, the tax savings will be many times the amount of the related attorney fees.

PS – A similar procedure is allowed for protesting adjustments proposed by examiners of the Oregon Department of Revenue and Washington Department of Revenue.

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By way of background, Treasury Form TD F 90-22.1 (often referred to as the “FBAR form”) must be filed each year by US residents and citizens who have foreign bank accounts with aggregate balances in excess of $10,000. [The FBAR form for each year must be received by the US Treasury by the following June 30. Form 8938, which requires similar disclosures, must be filed by the due date (including extensions) of the taxpayer’s income tax return.]

If you have not filed your FBAR forms on time, you may be liable for staggering penalties. For example, even if the failure to file was not willful, the maximum penalty is $10,000 per unreported account per year.

As mentioned in a prior post, IR-2012-65 provides FBAR penalty relief to many US citizens and green card holders living outside the US. But it does not help US citizens or green card holders living in the US. Instead, they are relegated to either: (1) applying for relief under the 2012 Offshore Voluntary Disclosure Program (2012 OVDP), or (2) filing the delinquent FBAR forms and requesting reasonable cause waivers of FBAR penalties.

The 2012 OVDP removes the risk of the $10,000/account/year penalty and potential criminal prosecution. But the cost of the 2012 OVDI is substantial: the penalty is normally 27.5% of the highest aggregate balance of unreported foreign accounts during the last eight years. And if there is unreported income from foreign rental property, the value of the real property is also included in the penalty base. For example, suppose the highest aggregate balance of the taxpayer’s undisclosed foreign accounts is $20,000 during the 2004-2011 period, and that the taxpayer also failed to report rents earned on foreign real property worth $100,000. Instead of a $5,500 penalty on the $20,000 of accounts, there is also a $27,500 penalty on the real property.

FAQ 36 of the 2012 OVDP provides:

Question: A taxpayer owns valuable land . . . located in a foreign jurisdiction. Must the taxpayer report the land . . . and pay a 27.5 percent penalty . . . if the property produced income that the taxpayer did not report?

Answer: [I]f the assets produced income subject to U.S. tax during the voluntary disclosure period which was not reported, the assets will be included in the penalty computation . . .

The language in FAQ 36 begs the question of whether the 27.5% penalty applies to the foreign rental property if the net income (after deducting expenses for depreciation, maintenance, interest, etc.) is zero. One interpretation is that the penalty applies unless the foreign rental activity is reported on Schedule E, even if there is a net loss. Having said that, if the rental property generated losses, one could argue that the property produced no “income subject to US tax,” and that the rental property should be excluded from the penalty base.

The standard FBAR penalty is not imposed on foreign rental property, even if the rental income was not reported. Further, as covered in a different post, the Internal Revenue Manual states that the examiner can use discretion to impose either no penalty or a reduced penalty. For example, the IRM suggests a penalty of $500/account/year may be appropriate if the violation is not willful and the aggregate accounts do not exceed $50,000. See IRM Exhibit 4.26.16-2.

US residents with FBAR penalty exposure must carefully choose between the 2012 OVDP and reasonable cause penalty waiver requests.

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Here is the rule on citizenship. It all depends on how old the children are, and how long the parents lived in the US before each child was born.

A. If the child was born after 11/14/86 (i.e., turns 26 after 11/14/2012), the child is a US citizen if ALL of the following are true:
1. The person’s parents were married at time of birth
2. One of the person’s parents was a U.S. citizen when the person in question was born
3. The citizen parent lived at least five years in the United States before the child’s birth
4. A minimum of two of these five years in the United States were after the citizen parent’s 14th birthday.

B. If the child was born between 12/24/52 and 11/14/86 (i.e., is at least 26 but not more than 60 on 11/14/2012), the child is a US citizen if ALL of the following are true:
1. The person’s parents were married at the time of birth
2. One of the person’s parents was a U.S. citizen when the person was born
3. The citizen parent lived at least ten years in the United States before the child’s birth;
4. A minimum of 5 of these 10 years in the United States were after the citizen parent’s 14th birthday.

Thus, US citizens living overseas should advise their children that they may also be US citizens with rigorous US tax reporting obligations.

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In this post, “inheritance” means the share or amount to be received under a parent’s will or revocable trust at death. In lawyer language, a future inheritance is commonly referred to as an “expectancy.”

Beginning in 1929, Oregon courts have held that an expectancy under a will (of a living person) is not “property” to be divided in a divorce. See, e.g., Jerman v. Jerman, 275 P2d 915 (Or. 1929). In reaching this conclusion, the courts have noted that the potential beneficiary has no legally enforceable rights, and the person creating the will retains full ownership and can revoke the will at any time.

Until 2009, Oregon courts had not ruled on divorce ramifications of a potential inheritance under a revocable trust. By way of background, a revocable trust (sometimes also known as a “living trust”) is a will substitute that directs the disposition of the decedent’s property at death. Like a will, it can be amended or revoked at any time. A key difference is that a revocable trust also governs the administration of the decedent’s assets during life.

In the case of Githens v. Githens, 204 P3d 835 (Or. App. 2009), the husband in a divorce proceeding was a beneficiary under his mother’s revocable trust. The mother was afflicted with dementia and had questionable capacity to amend her revocable trust. The wife contended that her husband’s future inheritance was marital property to be divided between them. (The key asset to be inherited was the house they had lived in for the last 15 years.) The Oregon Court of Appeals disagreed. The court reasoned that an expectancy under a revocable trust has no practical difference than an expectancy under a will, and both should receive the same treatment. Neither is “property” to be taken into account in a divorce proceeding.

In conclusion, even if you are certain to receive an inheritance from a parent, whether under a will or revocable trust, your expectancy is only marginally relevant in a divorce proceeding unless the parent has died.

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The New Laws

Highlights of the Act include:

● The estate tax, gift tax and generation skipping tax exemptions of $5M have been retained. (Actually, the exemption is now $5.25M per spouse by reason of inflationary adjustments.)

● The rate attaching to the excess over $5.25M has been increased from 35% to 40%.

● Portability of the $5.25M exemption (which effectively confers a $10.5M exemption to the surviving spouse) has been retained.

● State death taxes (such as the Oregon estate tax and Washington estate tax) will continue to be deductible against the federal taxable estate.

Other developments include:

● The annual gift tax exclusion has increased to $14,000. Rev. Proc. 2012-41.

● The annual marital deduction for gifts to spouses who are not citizens has increased to $140,000. Rev. Proc. 2012-41.

Planning and Recommendations

For most clients, a “credit shelter” or “bypass” trust is not needed, since portability confers the surviving spouse with a $10.5M exemption if everything passes outright to him or her. Thus, an optional “disclaimer” trust will be the best strategy for most clients. Under the disclaimer trust approach, everything passes outright to the surviving spouse – except to the extent he or she disclaims, and the disclaimed assets are held in trust for the benefit of the surviving spouse. No marital deduction (via a QTIP election) will be claimed for the amount held in the disclaimer trust, so these assets will not be included in the surviving spouse’s estate.

Why would a surviving spouse disclaim? One advantage is that future appreciation in the disclaimed assets is removed from the surviving spouse’s estate. Another is that assets in the disclaimer trust will be protected from the surviving spouse’s creditors. If the surviving spouse lives in a state with an estate tax (such as Oregon or Washington), a disclaimer trust is needed to capture the benefit of the state exemption (i.e., $1M for Oregon or $2M for Washington) allowed to the estate of the first spouse to die. (Most states do not allow portability.) Finally, deflecting assets to the disclaimer trust reduces the tax risk associated with a Congressional reduction of the $5.25M estate tax exemption.

But don’t forget to file Form 706. The “price” of portability is that a Form 706 must be filed at the death of the first spouse to die, even if his or her estate is under $5.25M. Absent a timely filed 706, no portability is allowed, and the surviving spouse will have only a $5.25M (rather than $10.5M) exemption.

Although death taxes are less of a concern than in the past, they are still relevant. In particular, the generous federal legislation does not soften the Oregon or Washington estate tax. Further, it is inevitable that numerous taxpayers will fail to file Form 706 when the first spouse dies, and then discover that they have lost the benefit of the $5.25M exemption available to the first spouse’s estate. Thus, there are still plenty of traps for the unwary.

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Advantages of a SLAT:

● Assuming no estate tax clawback, the husband protects against the estate tax exemption being reduced below $5.12M in 2013.

● There should be no estate tax inclusion (in either spouse’s estate) of future appreciation in the assets funding the SLAT.

● It is permissible to give the wife all income of the SLAT, along with principal as needed for health, education, support and maintenance. This gives the wife broad access to the funds, even though they are not included in her estate at her death.

● The SLAT is immune to the wife’s creditors.

● In a second marriage situation, the husband’s children cannot be disinherited by the wife with respect to the SLAT assets.

Disadvantages:

● There is no stepped-up cost basis (for determining gain or loss) on assets transferred by the husband to the SLAT; instead, the SLAT’s assets have the husband’s cost basis.

● None of wife’s property can be used to fund the SLAT. Otherwise, there is §2036 estate tax inclusion (at the wife’s death) of her share of SLAT assets. This can be managed by splitting assets and running everything through separate accounts for each spouse.

● The husband has §2036 estate tax exposure if he receives benefits from the SLAT. This could inadvertently occur if SLAT distributions migrate into a joint account. The exposure can be managed if the trust accumulates all income and principal, or carefully makes all distributions to the wife’s separate accounts.

● Once the SLAT is established, the wife will have to set up separate accounts to hold the SLAT assets, and then separately account for all SLAT income and expenses. She will also have to file separate income tax returns for the SLAT. Conversely, for a typical credit shelter trust created at the husband’s death, these duties would not start until after the husband’s death.

● Will the estate tax “clawback” render the SLAT strategy futile? There is a mild level of uncertainty whether lifetime taxable gifts (perhaps in excess of the exemption at death) will be added back to the decedent’s estate when computing estate tax.

● If each spouse creates an identical SLAT for the other, the IRS will assert the “reciprocal trust doctrine” and contend that each spouse is deemed to have retained an interest in the SLAT for his or her benefit, and that the SLAT is included in the spouse’s estate under §2036.

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● Always Buy Assets, Not Shares of an Entity. If the business is owned by an entity, such as an LLC or a corporation, a buyer should refrain from purchasing shares or interests in the entity. Instead, the buyer should purchase the assets, such as goodwill, inventory, equipment and intangibles. This shields the buyer from liabilities, creditors, claims by disgruntled employees, etc. of the selling entity, and will generally increase future tax deductions for depreciation and amortization.

● Study the Financial Statements. The buyer should examine the seller’s financial statements (or at least the tax returns) to verify the gross sales, salaries to owners, etc. Be wary of sellers who contend that the business is worth more than its tax returns would indicate because of unreported income.

● Get a Non-Compete Covenant from the Seller. It makes no sense to buy a business only to have the value eroded by the seller starting a competing business. You can eliminate this risk by having the seller sign a non-compete agreement, which prevents the seller from competing for a reasonable period of time.

● Research the Price. The value of most businesses is a multiple of annual gross sales, or profits disbursed to the owner. You can usually search for listing prices of similar businesses on the internet. Do your homework before you make an offer.

● Search for Liens. Sometimes the seller hasn’t fully paid for the equipment it is selling. Instead, the seller has mortgaged the equipment, and the lender has the right to repossess it if the debt is not paid. The lender’s right to repossess the equipment remains intact even if the equipment is sold. The solution is to do a UCC search for liens, and either insist that the secured debts be paid off at closing or the balance due be allowed as an offset against the purchase price.

● Inspect the Equipment. Equipment is usually sold “as is,” so the buyer needs to determine if the equipment is broken or worn out. It may be necessary to hire an inspector. Along the same lines, the buyer should confirm that the seller has transferable licenses for any software used in the business. If the software has been pirated or the licenses are not transferable, the buyer may be liable if it uses the software.

● Decide on Payment Terms. If you cannot pay cash for the business (and most buyers cannot), your offer needs to specify the down payment, monthly installments and interest rate.

● Do You Have Sufficient Cash? Many businesses fail because the buyer does not have sufficient cash to get the business started. This is especially true if there are up-front costs, and sales receipts lag weeks or months behind. For example, will you spend funds on remodeling or employee training before the business opens?

● Investigate the Lease. Without the lease of the premises, the business may have little value. It will be necessary for the buyer to either assume the seller’s lease or perhaps sublease from the seller. In either event, it will be necessary to obtain the landlord’s consent, which should be done in advance. The landlord will frequently charge a fee of $500 to $1,000 to consent to an assignment or assumption of the lease. From a buyer’s perspective, this cost should be paid by the seller.

● Ensure Smooth Transition. Unless the buyer is thoroughly familiar with the business (as an employee, etc.), the sales agreement should contain a commitment from the seller that it will demonstrate use of the equipment, introduce the buyer to the customers, and answer various other questions unique to the business. Usually a minimum number of seller consulting hours are included in the price of the business, and hours in excess of this threshold are billed to buyer at an hourly rate.

● Agree on Accounts Receivable. It is unusual for a buyer to purchase the seller’s accounts receivable. A more common approach is for the buyer to collect seller’s receivables and remit them to the seller. The buyer is usually allowed a fee of perhaps 10% to cover the overhead involved in collecting the receivables and remitting them to the seller.

● Use an Entity. If you are buying assets, the buyer should be a corporation or LLC owned by you. Using an entity will help avoid personal liability for debts of the business. The seller and landlord will normally insist on personal guarantees, but the entity will provide protection from other creditors.

Conclusion
Most potential business purchasers should consult an attorney (and perhaps their accountant) before making an offer. In my experience, a buyer represented by an attorney will almost always get a better deal, with the savings far exceeding the attorney fees.

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Most trust agreements state that the trustee is entitled to a “reasonable fee” — without further explanation. The Oregon Uniform Trust Code [ORS 130.635(1)] is no better: “If the terms of a trust do not specify the trustee’s compensation, a trustee is entitled to compensation that is reasonable under the circumstances.”

What is reasonable? One benchmark is the fee charged by professional trustees. Most banks will charge about 1% per year to administer a trust. (The percentage is usually a sliding scale that decreases as the value of the trust increases.) But the bank’s 1% fee usually covers both trustee duties and investment management services, which are bundled together. This complicates comparing a bank’s 1% fee with a “trustee only” fee. In the latter case, there will be two fees; an investment management fee of roughly 1%, and a trustee fee of roughly .5% to 1%. So the aggregate fee is usually higher if trustee and investment services are purchased separately.

It gets more complicated, depending on the services the trustee actually provides.

Trust Holding Liquid Assets for Cooperative Beneficiary. On one end of the spectrum, a trustee might manage a $1M portfolio for a minor child and issue an equal payment each month. In this scenario, a 1% fee is a reasonably good deal for the trustee.

Trust Holding Liquid Assets for High Maintenance Beneficiary. Another alternative is an adult beneficiary (undoubtedly angry that his inheritance is locked up in trust) who constantly badgers the trustee about extraordinary distributions (cars, wedding rings, spending money, etc.), excessive fees, inadequate investment performance, improper asset allocation, etc. In these cases, a reasonable fee might be 1% plus an hourly rate for telephone calls in excess of perhaps two hours per month.

Post-Death Administration of Revocable Trust. Finally, there is the trustee of a revocable trust engaged in post-death administration. The assets of the decedent must be inventoried and liquidated; the house must be cleaned up and sold; scores of bills must be paid; tax returns must be filed; and there will be a steady dialog with numerous beneficiaries. The post-death administration process will usually last a year or longer. During this period, a reasonable trustee fee might be the same as the 2% fee allowed to court appointed executor, as discussed below.

Executor Fees

Under Oregon law, specifically ORS 116.173, a court appointed executor is automatically entitled to a fee of roughly 2% of the probate estate. An additional fee of 1% is allowed for non-probate assets, such as IRAs, life insurance, and joint bank or brokerage accounts. If the probate estate is a $1M brokerage account and there are only a couple of beneficiaries, a 2% fee may be a windfall to the executor. On the other hand, a 2% fee may be inadequate if the executor must maintain and sell real property, liquidate multiple assets, settle creditor claims, file multiple years of tax returns, deal with contentious beneficiaries, wind down a closely-held business, etc. In these cases, an executor can apply for fees in excess of the 2% statutory fee. A court is likely to approve an additional fee if none of the beneficiaries object.

Conclusion

It is common for lawyers to state that trustee fees and executor fees are roughly 1% and 2%, respectively. However, as described above, the services to be provided must be evaluated on a case-by-case basis, and the fee should be adjusted commensurately. About the only generalization that can be made is that the 1% and 2% thresholds are usually the “floor” when determining the reasonableness of the fee.

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Most people will pay no federal estate tax, even without tax planning. The lifetime exemption is $5.124M per spouse. Further, the unused exemption of the first spouse to die is “portable,” meaning that it automatically shifts to the surviving spouse, thereby leaving the survivor with a $10.248M exemption. It is true the laws may change, but even under Obama’s 2013 budget the exemption only rolls back to $3.5M, with full portability.

In years past, when the exemption was, say, only $1M, most wills automatically caused the first $1M of the decedent’s wealth to pass to a “credit shelter” or “bypass” trust, rather than outright to the surviving spouse. This amount was not included in the survivor’s estate (at her death), which had the effect of reducing estate taxes at that time. Since the exemption was not “portable,” the credit shelter trust was necessary to capture the benefit of the decedent’s exemption. Absent a trust, the decedent’s $1M exemption would be lost. Portability changes the landscape, and a credit shelter trust is no longer necessary to utilize the first spouse’s federal estate tax exemption. And a will calling for a mandatory credit shelter trust may force the surviving spouse to hold wealth in a trust even it serves no tax purpose.

A more flexible approach is to pass all of the wealth outright to the surviving spouse, except to the extent she disclaims. The disclaimed assets pass to a “disclaimer trust,” which is similar to a traditional credit shelter trust. Conceptually, the surviving spouse deflects assets as needed to reduce her estate below the taxable threshold. So long as (i) the estate tax exemption remains portable, or (ii) the survivor’s wealth is likely to be less than her separate exemption, there will probably be no reason to disclaim. Thus, a disclaimer will provides for a tax planning trust – but only if needed.

One final nuance. Unlike the federal system, the Oregon and Washington estate tax exemptions (of $1M and $2M, respectively) are not portable. Thus, the surviving spouse’s exemption will be only $1M or $2M, not $2M or $4M. To minimize Oregon or Washington estate taxes, the surviving spouse may wish to disclaim up to $1M or $2M, as the case may be, if her estate would otherwise exceed the applicable threshold. Some spouses intentionally forego this opportunity. For example, an Oregon surviving spouse in her 50s may conclude that the hassle of administering a disclaimer trust for the next 30 or 40 years outweighs the potential tax benefit. (Administration includes separate accounting for all trust receipts and disbursements, and separate trust income tax returns each year.) Since the Oregon marginal rate starts at 10%, a disclaimer trust funded with $1M may only produce $100,000 of tax savings at the surviving spouse’s death.

In conclusion, most married clients are well served by using a disclaimer trust to provide “wait and see” flexibility to decide whether to use tax planning trusts when the first spouse dies.

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