Basic Estate Planning and Administration 2014

Basic Estate Planning and Administration 2014 Cosponsored by the Estate Planning and Administration Section Friday, November 21, 2014 8:30 a.m. 4:45 p.m. DoubleTree Hotel Portland Portland, Oregon 5.75 General CLE or Practical Skills credits, 1 Ethics credit, and.5 Access to Justice credit

BASIC ESTATE PLANNING AND ADMINISTRATION 2014 SECTION PLANNERS Philip Jones, Duffy Kekel LLP, Portland Jack Rounsefell, Attorney at Law, Gresham Robin Smith, Attorney at Law, Portland Katharine West, Wyse Kadish LLP, Portland Eric Wieland, Samuels Yoelin Kantor LLP, Portland OREGON STATE BAR ESTATE PLANNING AND ADMINISTRATION SECTION EXECUTIVE COMMITTEE Jeffrey M. Cheyne, Chair Matthew Whitman, Chair-Elect Marsha Murray-Lusby, Past Chair Erik S. Schimmelbusch, Treasurer Melanie E. Marmion, Secretary Stuart B. Allen Amy E. Bilyeu Eric R. Foster Janice E. Hatton Amelia E. Heath Philip N. Jones Holly N. Mitchell Jeffrey G. Moore Hilary A. Newcomb Timothy O Rourke Ian T. Richardson Margaret Vining The materials and forms in this manual are published by the Oregon State Bar exclusively for the use of attorneys. Neither the Oregon State Bar nor the contributors make either express or implied warranties in regard to the use of the materials and/or forms. Each attorney must depend on his or her own knowledge of the law and expertise in the use or modification of these materials. Copyright 2014 OREGON STATE BAR 16037 SW Upper Boones Ferry Road P.O. Box 231935 Tigard, OR 97281-1935 Basic Estate Planning and Administration 2014 ii

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TABLE OF CONTENTS 1. A Fiduciary Income Tax Primer................................... 1 i Philip Jones, Duffy Kekel LLP, Portland, Oregon 2. Watch the Oregon Border: Differences in Washington Estate Planning............ 2 i Katherine VanZanten, Cable Huston LLP, Portland, Oregon 3. Passing the Family Residence or Vacation Property to the Next Generation......... 3 i Robin Smith, Attorney at Law, Portland, Oregon 4. Recognizing and Responding to Elder Abuse.......................... 4 i Erin Olson, Law Office of Erin Olson PC, Portland, Oregon 5. More than a Will: The Intersection of Estate Planning and Elder Law............ 5 i Penny Davis, Davis Pagnano McNeil & Vigna LLP, Portland, Oregon 6. Ethics in Estate Planning and Administration Presentation Slides............. 6 i Helen Hierschbiel, Oregon State Bar, Tigard, Oregon Basic Estate Planning and Administration 2014 v

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SCHEDULE 7:30 Registration 8:30 An Introduction to Fiduciary Income Tax F Basic federal and Oregon fiduciary income tax rules F Managing trust and estates to minimize income tax F Using administrative expenses to the best advantage F Timing distributions to reduce income tax consequences Philip Jones, Duffy Kekel LLP, Portland 9:30 Watch the Oregon Border: Differences in Washington Estate Planning F Community property F Probate opportunities F Basic differences between estate planning documents Katherine VanZanten, Cable Huston LLP, Portland 10:30 Break 10:45 Passing the Family or Vacation Home to the Next Generation Issues to Consider F Family concerns F Financial details F Planning methods Robin Smith, Attorney at Law, Portland 11:45 Recognizing and Responding to Elder Abuse F Suspicious circumstances F What you can (and can t) do about it Erin Olson, Law Office of Erin Olson PC, Portland 12:15 Estate Planning and Administration Section Annual Meeting 12:20 Lunch 1:15 A View from the Bench During this session judges from probate court will offer practical tips and insight, as well as an opportunity to ask questions about the process. Honorable Andrew Erwin, Washington County Circuit Court, Hillsboro Honorable Barbara Johnson, Clark County Superior Court, Vancouver, WA Honorable Katherine Tennyson, Multnomah County Circuit Court, Portland 2:30 Break 2:45 More Than a Will: The Intersection of Elder Law and Estate Planning F Planning ahead for disability F Long-term care considerations F Beneficiaries with government benefits F Consequences of common planning techniques Penny Davis, Davis Pagnano McNeil & Vigna LLP, Portland Basic Estate Planning and Administration 2014 vii

SCHEDULE (Continued) 3:45 Ethics in Estate Planning F Duties of competent and diligent representation F Joint representation: when it s okay and when it s not F Future conflict waivers: what are they and do they really work? F Duties to deceased clients Helen Hierschbiel, Oregon State Bar, Tigard 4:45 Adjourn Basic Estate Planning and Administration 2014 viii

FACULTY Penny Davis, Davis Pagnano McNeil & Vigna LLP, Portland. Ms. Davis focuses her practice on Medicaid and long-term care issues, creating and administering special needs trusts, guardianships and conservatorships, estate planning, and probate. She has practiced elder law in Oregon for more than 30 years. She began representing clients on issues involving Medicaid and other public benefits as the staff attorney for the Senior Law Project at Multnomah County Legal Aid Service, which is now part of Legal Aid Services of Oregon. In 1998, she was one of the founding partners of the Elder Law Firm. She is a past chair of the Oregon State Bar Elder Law Section and has published a number of articles on elder law topics. Honorable Andrew Erwin, Washington County Circuit Court, Hillsboro. Helen Hierschbiel, Oregon State Bar, Tigard. Ms. Hierschbiel is General Counsel of the Oregon State Bar, where, among other things, she gives ethics guidance to lawyers. She joined the Oregon State Bar in December 2003 in the Client Assistance Office, reviewing and investigating complaints against lawyers. While at the bar, she has written numerous article and given dozens of presentations regarding lawyers ethical obligations. Prior to joining the Oregon State Bar, she worked in private practice in Portland and for DNA People s Legal Services on the Navajo and Hopi reservations in Arizona. Honorable Barbara Johnson, Clark County Superior Court, Vancouver, WA. Judge Johnson is the Presiding Judge of the Clark County Superior Court. She was sworn in as the first female judge for Clark County in January 1987. Philip Jones, Duffy Kekel LLP, Portland. Mr. Jones practices primarily in the areas of estate planning, estate and trust administration, and estate and trust litigation. He is a member of the American College of Trust and Estate Counsel and the Estate Planning Council of Portland. He served for 20 years as an Adjunct Professor of Law at Lewis and Clark Law School, where he taught Estate & Gift Taxation and Federal Tax Procedure. He is also the author of numerous articles in the Journal of Taxation and other publications. Erin Olson, Law Office of Erin Olson PC, Portland. Ms. Olson specializes in the representation of crime victims in civil and criminal cases. Her cases typically arise out of the physical, sexual, or financial abuse of children or vulnerable adults, and she has litigated dozens of child and elder abuse civil cases against individuals, religious and secular organizations, and governmental entities in state and federal trial and appellate courts. She is a cofounder and board member of the Oregon Crime Victims Law Center and a board member of the National Crime Victim Bar Association. Robin Smith, Attorney at Law, Portland. Ms. Smith focuses her practice in the areas of estate planning, trust administration, nonprofit organizations, tax, and real estate. She has taught Charitable Giving and Tax Exempt Organizations in the University of Washington Graduate Program in Taxation. She is a member of the Estate Planning Council of Portland, the Oregon State Bar Estate Planning and Administration, Elder Law, and Nonprofit Organizations Law sections, the Multnomah Bar Association, and the Washington State Bar Association Real Property and Probate Section. She is admitted to practice in Oregon and Washington (inactive). Ms. Smith is a regular author and speaker on estate planning topics. Basic Estate Planning and Administration 2014 ix

FACULTY (Continued) Honorable Katherine Tennyson, Multnomah County Circuit Court, Portland. Judge Tennyson is a member of the Family Law Department, which is a unified family court. Since July 2002, she has heard cases involving probate and protective proceedings, dissolution, custody, parenting time, support enforcement, domestic violence, juvenile delinquency, dependency, and termination of parental rights. Judge Tennyson became the Chief Probate Judge for the county in January 2007. Judge Tennyson is the Secretary of the National Council of Juvenile and Family Court Judges (NCJFCJ). Judge Tennyson has served as faculty for national judicial training, including the Child Abuse and Neglect Institute and Enhancing Judicial Skills in Elder Abuse Cases for NCJFCJ. She is admitted to practice law in both Oregon and Washington. Katherine VanZanten, Cable Huston LLP, Portland. Ms. VanZanten is an estate planning and tax attorney who has significant experience in business planning, including developing wealth transfer strategies that encompass multi-tiered family businesses, charitable remainder trusts, and establishing charitable organizations. She also regularly advises fiduciaries on their duties with respect to trust and probate administration. She is a member of the Oregon State Bar Taxation Section, the Estate Planning Council of Vancouver, and the Estate Planning Council of Portland. Ms. VanZanten is admitted to practice in Oregon and Washington. Basic Estate Planning and Administration 2014 x

Chapter 1 A Fiduciary Income Tax Primer 1 Philip Jones Duffy Kekel LLP Portland, Oregon Contents 1. Introduction.............................................. 1 1 2. Entities Not Taxed as Trusts..................................... 1 3 3. Tax Rates................................................ 1 3 4. Simple vs. Complex Trusts; Credit Shelter Trusts......................... 1 4 5. Filing Thresholds............................................1 7 6. Estimated Taxes............................................ 1 7 7. The Decedent s Final Tax Year and the First Tax Year of an Estate or Trust........... 1 9 8. Formerly Revocable Trust Election to Use a Fiscal Year..................... 1 14 9. The Final Tax Year.......................................... 1 15 10. Fiduciary Accounting Income................................... 1 17 11. Partnerships and S Corporations.................................. 1 19 12. Distributable Net Income (DNI).................................. 1 21 13. Capital Gains and Losses...................................... 1 22 14. Exemptions.............................................. 1 25 15. Calculating Taxable Income; Deductions............................. 1 25 16. The Net Investment Income Tax.................................. 1 29 17. The Election to Take Deductions on the Fiduciary Income Tax Return............ 1 31 18. The Distribution Deduction..................................... 1 33 19. Tax-Exempt Income......................................... 1 35 20. Specific Bequests........................................... 1 36 21. In-Kind Distributions........................................ 1 37 22. Charitable Deduction........................................ 1 40 23. The Sixty-Five Day Rule....................................... 1 41 24. Tiers of Distributions and Beneficiaries.............................. 1 43 25. Income in Respect of a Decedent (IRD); Deductions in Respect of a Decedent (DRD).... 1 45 26. Retirement Accounts......................................... 1 48 27. Separate Share Rule......................................... 1 51 28. Basis Step-Up............................................. 1 52 29. State Fiduciary Income Taxes.................................... 1 53 30. Revocable Trusts and Grantor Trusts............................... 1 55 Selected Additional Research Materials.................................. 1 58 Appendixes A. Miscellaneous Itemized Deductions of Trusts and Estates............... 1 59 B. Retirement Plan Distributions After Death........................ 1 61 1 This paper is not intended to provide legal advice applicable to a particular situation. If the reader seeks legal advice, the services of a professional advisor should be obtained.

Chapter 1 A Fiduciary Income Tax Primer Basic Estate Planning and Administration 2014 1 ii

1. Introduction Chapter 1 A Fiduciary Income Tax Primer The purpose of this paper is to summarize the basic elements of the fiduciary income tax for the benefit of professionals (particularly attorneys and trust officers) who administer trusts and estates or who advise fiduciaries. Those professionals and their clients will regularly make administrative decisions that will impact the fiduciary income taxation of trusts and estates, and those decisions will also impact the individual income taxation of beneficiaries (including the taxation of trusts that are beneficiaries of estates, or are beneficiaries of other trusts). Because administrative decisions have a significant impact on income tax consequences, attorneys and trust officers who administer trusts and estates should familiarize themselves with the basics of fiduciary income taxation. Even if an accountant experienced with the fiduciary income tax is part of the professional team advising an estate or trust, attorneys and trust officers should be conversant on the subject of fiduciary income taxation, if only to spot issues that need to be discussed with the accountant. This paper is devoted primarily to the federal fiduciary income tax, but discussion of Oregon law and the Oregon fiduciary income tax is also included. The fiduciary income tax is imposed on the income of all trusts and estates, to be reported by each trust or estate on a Form 1041 federal fiduciary income tax return (and on a Form 41 Oregon fiduciary income tax return). In some cases, the income tax will actually be paid by the trust or estate, but in many cases the income will be taxed to the beneficiaries (or even to the grantor), and the trust or estate will escape tax on that same income. The income allocable to the beneficiaries appears on one or more Schedules K-1 (one for each beneficiary) attached to the Form 1041. In general, the income of a trust or estate will be taxed only once, either to the trust or estate, or to the beneficiaries, or to the grantor. But beneath that general rule lie a myriad of other rules and exceptions to those rules. Nearly every estate and trust presents fiduciary income tax issues that must be dealt with by the attorneys, accountants, and trust officers administering those estates and trusts. Even an uncomplicated estate involving only a residence, an investment account, and a retirement account will present many fiduciary income tax issues. The fiduciary income tax is governed by Subchapter J of Subtitle A of the Internal Revenue Code (Internal Revenue Code 641-692) and the regulations promulgated thereunder. The number of Code sections that govern fiduciary income taxes are relatively few, but they provide an elegant framework that efficiently allocates trust and estate income among the trust, the estate, the beneficiaries, and/or the grantor. In addition, much of the rest of the Internal Basic Estate Planning and Administration 2014 1 1

Chapter 1 A Fiduciary Income Tax Primer Revenue Code applies to trusts and estates, because trusts and estates are defined as persons under 7701(a)(1), because taxpayers are defined as persons subject to tax under 7701(a)(14), and because trusts and estates are taxed in the same manner as individuals, with certain exceptions. 641(b). The general statutes of Subchapter J appear in 641-646. The statutes applicable to simple trusts appear in 651-652. The statutes applicable to estates and complex trusts appear in 661-664. (The distinction between simple trusts and complex trusts is discussed below.) The statutes applicable to grantor trusts appear in 671-679. A caution to the reader: Although the general rules governing the fiduciary income tax are relatively simple, the many nuances and exceptions can be very complex; many of the general rules stated in this short paper are subject to exceptions that are not discussed in this paper. In addition, changes to the law may have occurred after this paper was published. References to Internal Revenue Code sections, along with regulations and cases, are included in this paper; please review those Code sections, the applicable regulations, and the case law when applying the general rules to your particular situation, in order to make certain that you are correctly applying the many exceptions and the current law. Other Code sections, regulations, and cases may be applicable that are not cited in this brief summary. Selected additional research materials are listed at the end of this paper. The author would appreciate hearing from readers who have corrections, suggestions, or updates to offer. A fiduciary must take care to ensure that all of the tax obligations of the estate or trust are satisfied. If a fiduciary were to distribute assets of a trust or estate without completely satisfying those obligations, then two forms of liability are created. First, the fiduciary will become personally liable for those tax obligations, to the extent assets were distributed by the fiduciary. Second, the beneficiaries will be liable for those tax obligations to the extent the beneficiaries received assets. 6901(a). The former is known as fiduciary liability, while the latter is known as transferee liability. In general, these two types of liability are created by state law, but enforced by federal procedural law; 6901(a) is merely a federal procedural statute. Sawyer v. Commissioner, T.C. Memo 2011-298; Julia R. Swords Trust v. Commissioner; 142 T.C. No. 19 (2014). In some situations, state law might even govern the calculation of interest on the transferee tax liability. Schussel v. Commissioner, F.3d, 114 AFTR2d 2014-5038 (2 nd Cir. 2014). An additional year is tacked on to the normal statute of limitations if the IRS finds it necessary to enforce fiduciary liability or transferee liability. 6901(c); see also Reg. 1.641(b)-2; 31 U.S.C. 3713(b); United States v. Coppola, 85 F.3d 1015, 1020 (2d Cir. 1996). The obligation for an estate or trust to pay taxes includes the obligation to pay the tax liabilities of the decedent. United States v. Shriner,113 AFTR 2d 2014-616 (DC Md. 2014). Basic Estate Planning and Administration 2014 1 2

Chapter 1 A Fiduciary Income Tax Primer Many of the words and phrases used in this paper are terms of art, defined in the Internal Revenue Code, the regulations, or elsewhere. Whenever possible, those exact terms will be employed. For purposes of clarity, practitioners should become accustomed to using that same terminology. 2. Entities not Taxed as Trusts The fiduciary income tax does not apply to grantor trusts, which include revocable living trusts (while the grantor is alive) and certain other trusts that are specifically designed to be taxed to the grantor. (A brief summary of grantor trusts appears at the end of this paper.) Similarly, assets held in custodianships for minors are not taxed as trusts; income generated by a custodianship is taxed directly to the minor. Anastasio v. Commissioner, 67 T.C. 814 (1977), affirmed without opinion, 573 F.2d 1287 (2 nd Cir. 1977). For the same reason, conservatorships are not taxed as trusts. 7701(a)(6); 6012(b)(2). 3. Tax Rates Practitioners dealing with trusts, estates, and beneficiaries must keep in mind one fundamental principle: trusts and estates are usually taxed at much higher income tax rates than are most individuals. In 2014, individuals reach the highest tax bracket (39.6%) at $406,750 of taxable income ($457,600 for married couples filing jointly). 1(a), (c). But trusts and estates reach the highest tax bracket at only $12,150 of taxable income. 1(e). Those figures will be adjusted for inflation in future years. See Rev. Proc. 2013-35, 2013 I.R.B. 537. That amount is expected to increase to $12,300 in 2015. (The purpose of those compressed brackets is to prevent taxpayers from using trusts as income tax reduction devices.) For that reason, fiduciaries have a strong incentive to make certain that their trust or estate has very little taxable income, or possibly no taxable income. The most common techniques for minimizing the income of a trust or estate can be summarized as follows, and are discussed in detail in other parts of this paper: a. Maximizing the use and timing of deductions for administration expenses. This is usually done by paying such expenses before the end of the fiscal year, and by electing to take those deductions on the fiduciary income tax return, and not on the estate tax return. (In some cases, the reverse is better, as is discussed below.) If done properly, the taxable income of the trust or estate can be reduced to a small amount, or possibly to zero. (In an estate, some administration expenses, such as attorney fees and personal representative s fees, require prior court approval; plan ahead.) Basic Estate Planning and Administration 2014 1 3

Chapter 1 A Fiduciary Income Tax Primer These various deductions are discussed below, as is the election whether to take the deductions for income tax purposes or estate tax purposes. b. Maximizing the use and timing of the distribution deduction by making distributions to beneficiaries. 651; 661. If done properly, the taxable income of the trust or estate can be reduced to a small amount, or possibly to zero, and the income will then be taxed to the beneficiaries at their lower tax rates. 652; 662. (In an estate, distributions require prior court approval; plan ahead.) The distribution deduction is discussed in greater detail below. c. Closing an estate on or before the end of the fiscal year, or terminating a trust on or before the end of its fiscal year. If this is accomplished, then all of the income, gains, deductions, and other tax attributes of the trust or estate for that tax year will flow out to the beneficiaries to be taxed at the beneficiaries rates, not at the higher rates of the trust or estate. 662; 643(a)(3); Reg. 1.643(a)- 3(d). In many cases, the estate or trust can be commenced and closed within the same tax year, so that year becomes both the first tax year and the final tax year. In many cases, that will often be the simplest solution. (In an estate, final distributions require prior court approval; plan ahead.) The final year is discussed in greater detail below. Many years ago, trusts were taxed in lower brackets than individuals. Because some taxpayers were able to minimize taxation by accumulating income in trusts and distributing that income in subsequent years, Congress enacted what are known as the throwback rules to increase the taxation of such distributions. 665-667. Although those statutes are still on the books, they have little impact due to subsequent changes in the tax rates applicable to trusts and estates. In addition, 1997 amendments to the throwback rules now make them primarily applicable to foreign trusts. 4. Simple vs. Complex Trusts; Credit Shelter Trusts Trusts are generally divided into two types for purposes of the fiduciary income tax: a. A simple trust is one that is required to distribute all of its income on a current basis, and it may not pay or permanently set aside funds for charitable purposes. 651(a). If during any particular tax year a simple trust distributes principal, it will be treated as a Basic Estate Planning and Administration 2014 1 4

Chapter 1 A Fiduciary Income Tax Primer complex trust for that tax year. 651(a)(2); Reg. 1.651(a)-3(b). If it does not distribute any principal in the following year, it will regain its status as a simple trust. Reg. 1.651(a)-3(b). Similarly, an in-kind distribution causes a simple trust to be reclassified as a complex trust. Rev. Rul. 67-74, 1967-1 C.B. 194. See the discussion of inkind distributions, below. Because distributions of principal cause a trust to be taxed as a complex trust, all trusts are complex trusts in their final year. b. A complex trust is any trust that is not a simple trust. 661. Thus a complex trust may accumulate income, may distribute corpus, and may make charitable contributions. If a trust qualifies as a simple trust under 651 and 652, then it will be governed by those sections and not by 661. For example, if a trust is permitted to distribute principal, but in a particular year it distributes only income, it will be taxed as a simple trust. Reg. 1.661(a)-1. Thus the Code establishes a priority that trusts be classified as simple trusts if possible. The Code does not use the terms simple and complex, but the regulations adopt that terminology. Reg. 1.651(a)-1. An estate is neither a simple trust nor a complex trust, but it is taxed in the same manner as a complex trust. 661; 662; Reg. 1.661(a)-1. Where does a credit shelter trust fit into this scheme? Is it a simple trust or a complex trust? Or is it a grantor trust? (See the discussion of grantor trusts, below.) A typical credit shelter trust has the following characteristics: 1. It was created by the will or revocable trust of the first spouse to die. 2. The surviving spouse is the trustee. 3. The surviving spouse is entitled to receive all of the net income of the trust for the rest of her life. 4. The surviving spouse may receive discretionary distributions of principal under an ascertainable standard that permits distributions of principal for her health, education, maintenance, and support in order to maintain her standard of living. This is known as a HEMS standard. 5. After the death of the surviving spouse, the remainder of the trust passes to the children of the couple. Basic Estate Planning and Administration 2014 1 5

Chapter 1 A Fiduciary Income Tax Primer Such a trust is a simple trust, except for those years in which principal is distributed, in which event it would be a complex trust for that year. 651(a)(2); Reg. 1.651(a)-3(b). As a simple trust, it is required to file a separate income tax return (Form 1041), which would report the ordinary income as passing out to the surviving spouse and taxable to the surviving spouse, regardless of whether that ordinary income is actually distributed or not. 652(a). The result would be the same if it were classified as a complex trust; if it is required to distribute ordinary income, that required amount will be taxed to the surviving spouse regardless of whether it is actually distributed. 662(a)(1). But could it be classified as a grantor trust, thus eliminating the need for the surviving spouse to file a separate income tax return for the credit shelter trust created by her late husband? Couldn t the surviving spouse simply report the income (and capital gains) on her individual income tax return (Form 1040)? The grantor trust statutes include within the definition of a grantor trust any trust subject to the power of a person to vest the income or the principal in that person. 678(a)(1). Thus a typical credit shelter trust might appear to be a grantor trust. Is it a regular (simple or complex) trust, or is it a grantor trust? The question is much debated. Clearly, the surviving spouse is taxed on the ordinary income, and 678(a)(1) states that such a trust is a grantor trust. But who is taxed on the capital gains? Some practitioners believe that a trust can be a grantor trust as to income, while not being a grantor trust as to principal, and 678(a) itself does state that a person shall be treated as the grantor if that person holds a power over any portion of a trust with respect to which the person holds a power to withdraw income or principal. (Emphasis added.) The Ninth Circuit, sitting en banc, has held that a credit shelter trust is not a grantor trust. In United States v. DeBonchamps, 278 F.2d 127 (9 th Cir. 1960), the Ninth Circuit held that a surviving spouse who had the right to withdraw income, but whose right to withdraw principal was limited by a standard, would be taxable on the income, but not on the capital gains, even though the standard was a rather loose one. In DeBonchamps, the rights were created by a deed that granted to the surviving spouse an income interest, along with the right to withdraw principal under a standard, with the remainder passing to a remainderman. Although a trust was not expressly created, the court held that the situation would be taxed as if it were a trust, the grantor trust statutes would not apply, and the capital gains would be taxed to the trust, not to the surviving spouse. See also, Blattmachr, Gans, and Lo, A Beneficiary as Trust Owner: Decoding Section 678, ACTEC Journal, Vol. 35, No. 2, Fall 2009, which reached the conclusion that the right to withdraw income, combined with the right to withdraw principal under an ascertainable standard, did not trigger grantor trust status under 678(a)(1). Basic Estate Planning and Administration 2014 1 6

Chapter 1 A Fiduciary Income Tax Primer Thus the safest answer seems to be that a typical credit shelter trust is not a grantor trust, and it should obtain its own EIN (employer identification number) and file a separate return, in which case the surviving spouse will be taxed on the ordinary income through the issuance of a K-1, and the trust will be taxed on the capital gains. This also means that a personal residence held in a credit shelter trust is not eligible for the capital gains exclusion on personal residences provided by 121. PLR 200104005; PLR 199912026; Reg. 1.121-1(c)(3). See the discussion of capital gains and losses, below. (On a related note, 1014(e) denies a stepped-up basis for property acquired from a decedent who had acquired the property from the beneficiary within the one-year period prior to the decedent s death. It is an open question whether the denial of the basis step-up applies not only to the beneficiary, but also to a trust for the benefit of the beneficiary. Thus if Wife conveys appreciated property to Husband, and Husband dies within one year and then bequeaths the property to a credit shelter trust for the benefit of Wife (or to a QTIP trust for the benefit of Wife), whether the trust receives a stepped-up basis is uncertain. Siegel, I.R.C. Section 1014(e) and Gifted Property Reconveyed in Trust, 27 Akron Tax J. 33 (2012). Regulations under 1014(e) have not yet been promulgated.) 5. Filing Thresholds An estate must file a Form 1041 if it has gross income of $600 or more, or has a nonresident alien beneficiary. Reg. 1.6012-3(a)(1)(i). A trust must file a Form 1041 if it has any taxable income for the year, gross income of $600 or more, or a beneficiary who is a nonresident alien. Reg. 1.6012-3(a)(1)(ii). For purposes of determining whether a trust or estate has gross income in excess of $600, gross income does not necessarily include gross proceeds from the sale of a capital asset. Instead, gross income includes an amount equal to gross proceeds minus basis. Reg. 1.61-6(a). 6. Estimated Taxes Estates and trusts are required to pay quarterly estimated federal fiduciary income taxes in a manner similar to individuals. 6654(l)(1). (The state of Oregon does not require estimated fiduciary income taxes.) The quarterly installments for calendar year trusts and estates are due on April 15, June 15, September 15, and January 15. Basic Estate Planning and Administration 2014 1 7

Chapter 1 A Fiduciary Income Tax Primer Estates need not pay estimated taxes for tax years ending before the second anniversary of the date of death. 6654(l)(2). Trusts are obligated to pay such estimated taxes, but not if the trust has made a 645 election to use a fiscal year as part of the decedent s estate. Reg. 1.645-1(e)(4). See the discussion of a trust s election to use a fiscal year, below. Nor are estimated taxes due if the preceding tax year was a twelve-month year and had no tax liability. 6654(e)(2). Form 1041 specifically asks whether the estate has been open for more than two years, and if so, an explanation is requested. Estimated taxes are not required unless the estate or trust is expected to owe at least $1,000 in tax, 6654(e)(1), or the withholdings and credits are expected to be the lesser of ninety percent of the current year s tax or 100% of the prior year s tax, assuming the prior year was a twelve-month year. 6654(d)(1). If the adjusted gross income is more than $150,000, then the 100% requirement becomes 110%. 6654(d)(1)(C)(i). A trust (or an estate in its final year) is permitted to elect to treat its estimated tax payments as if the payments had been made by the beneficiaries. 643(g)(1)(A). The election must be made within sixty-five days following the end of the taxable year, and a late election is not valid. 643(g)(2). The election is made by filing a Form 1041-T. As a result of this election, the estimated tax payments of the estate or trust are allocated to the beneficiaries to reduce the tax liability of the beneficiaries. The estimated tax payments are allocated to the beneficiaries as of the last day of the tax year of the trust, and are treated as if the beneficiaries had paid those estimated taxes on January 15 of the following year. 643(g)(1)(C)(ii). Because the estimated payments are deemed to have been paid on January 15 of the following year, the 643(g) election is of little assistance to beneficiaries who should have made estimated payments in earlier quarters. (The trustee might consider advising the beneficiaries that such an election does not retroactively cure any problems of beneficiaries who are under-estimated for prior quarters.) The allocation is treated as a second tier distribution to the beneficiaries, and thus it is shown on Form 1041 Schedule B as an other amount paid. (See the discussion of tiers below.) The Schedule K-1 provided to each beneficiary will reflect the allocation. The allocations of estimated tax to multiple beneficiaries need not be equal; the Form 1041-T allows unequal allocations. The election applies to estimated taxes only; it does not apply to tax withholdings. 643(g)(1)(A). Basic Estate Planning and Administration 2014 1 8

Chapter 1 A Fiduciary Income Tax Primer 7. The Decedent s Final Tax Year and the First Tax Year of an Estate or Trust Like all taxpayers, trusts and estates are required to adopt a taxable year. With some exceptions (see the following section), trusts are required to use a calendar year, 644(a), while estates are permitted to use either a fiscal year or a calendar year. 441(e). The taxable year of a decedent ends on the date of death, and his executor or trustee is obligated to file a final personal income tax return (Form 1040) for the short year beginning on January 1 and ending on the date of death. Reg. 1.443-1(a)(2). That return is not due until April 15 of the following year, regardless of when during the year the decedent died. Reg. 1.6072-1(b). Subject to some exceptions, the surviving spouse is permitted to file a joint return for that tax year. That joint return will report the surviving spouse s income for the entire year, and the decedent s income for the short year during which he was alive. 6013(a)(3); Reg. 1.6013-1(d). The allocation of the income tax liability between the decedent and the surviving spouse is determined under Reg. 20.2053-6(f). A final return for the decedent is not required to be filed if the decedent s income was under the filing threshold for the year of death. The filing threshold varies from year to year, and is based on the decedent s age, the standard deduction, the personal exemption, and the filing status of the decedent. 6012(a). See also Reg. 1.443-1. The decedent s final individual income tax return is usually signed by either the personal representative (or trustee) or, in the case of a joint return, by the surviving spouse (who signs as surviving spouse if a fiduciary has not been appointed). Section 6012(b)(1) authorizes the decedent s final return to be signed by his executor, administrator, or other person charged with the property of such decedent. See also the instructions to Form 1040, 7701(a)(6), and CCA 201334040. The fiduciary income tax return is signed by the personal representative or trustee. If two fiduciaries are serving as cofiduciaries, then only one needs to sign the fiduciary income tax return. See the instructions to Form 1041. (In contrast, if two or more fiduciaries are serving, all need to sign the Form 706 estate tax return, Reg. 20.6018-2, although the instructions to the Form 706 state that only one needs to sign. See also 2203 regarding the signing of estate tax returns.) If the decedent s final individual income tax return shows a refund due, the filing of a joint return by the surviving spouse is sufficient to claim the refund. If the surviving spouse is a court-appointed fiduciary, a copy of the Basic Estate Planning and Administration 2014 1 9

Chapter 1 A Fiduciary Income Tax Primer court appointment should be attached to the Form 1040. Other filers need to attach a Form 1310 to the return. See the instructions to Form 1040. A decedent s estate (or trust) is not required to make estimated payments on the decedent s individual (Form 1040) tax liability after the date of death. PLR 9102010 (10/10/90). However, a surviving spouse may need to continue to make estimated payments. The personal representative of an estate (or the trustee of a formerlyrevocable trust) should file a Form 56 (Notice Concerning Fiduciary Relationship) with the IRS to ensure that the fiduciary will receive any notices concerning the decedent s tax liability. If an income tax refund is owing to the decedent, a federal Form 1310 should be filed with the return, and/or an Oregon Form 243 should be filed. Under some circumstances, a fiduciary can ask to be released for certain income tax liabilities, or can request a prompt assessment of such liabilities. For a discussion of releases and requests for prompt assessment, see Mitchell, Tax Procedure Issues for Estates and Trusts, Oregon State Bar Estate Planning and Administration Section Newsletter, Vol. XXVII, No. 3, July 2010. If the decedent s assets were held in a revocable trust, the successor trustee will usually obtain an EIN (employer identification number) for the nowirrevocable trust and then proceed to administer the trust and eventually distribute the assets to the beneficiaries. However, in some cases distributing trust assets immediately following a terminating event (such as the death of the decedent) is a simple and advantageous alternative. Thus, when a revocable trust calls for termination of the trust upon the death of the trustor, the successor trustee has two choices. First, the successor trustee may continue the trust as a new trust with its own EIN, which will then carry out the various administrative tasks and file fiduciary income tax returns for the period of administration. Such a trust is often described as an administrative trust, even though it might continue in existence for a year or two or more. Second, in the alternative, the successor trustee might decide to forgo the administrative trust and simply distribute the assets of the trust to the beneficiaries in a prompt fashion, without obtaining an EIN or filing fiduciary income tax returns. If that second alternative is chosen, then the successor trustee will supply appropriate income tax information to the beneficiaries, and the beneficiaries will each report their share of the income earned after the date of death, along with their share of the deductions. Reg. 1.641(b)-3(d). This second alternative might be appropriate if the post-mortem administration of the trust is very straightforward, such as is the case with a small trust that has no need to file federal or Oregon estate tax returns. Basic Estate Planning and Administration 2014 1 10

Chapter 1 A Fiduciary Income Tax Primer The first tax year of a decedent s estate (or formerly-revocable trust) begins on the day after the death of the decedent, regardless of the time of day that death took place, and regardless of when the personal representative is appointed. However, transactions carried out after the moment of death are likely to be viewed as transactions of the estate, not the decedent. This point is not entirely clear. Some practitioners believe that transactions that take place on the date of death, but after the moment of death, are still included in the decedent s final tax year, and are not included in the first tax year of the estate. They base that opinion on the following language of 691(a)(1): (a) Inclusion in Gross Income. (1) General rule. -- The amount of all items of gross income in respect of a decedent which are not properly includable in respect of the taxable period in which falls the date of his death or a prior period... shall be included in the gross income for the taxable year when received, of [the estate]. (Emphasis added.) The tax year of the estate ends on the last day of a month selected by the executor, as long as the first tax year does not exceed twelve months. 441(e). As a result, the first tax year of an estate is almost always a short year, unless the decedent died on the last day of a month. If the decedent died in the middle of a month, then the first tax year could be as short as two weeks, or as long as eleven and a half months. For example, if a decedent died on May 10, 2013, the first tax year of the estate could end as early as May 31, 2013, or as late as April 30, 2014, but the first tax year could not possibly extend beyond April 30, 2014. The selection of an ending month for the fiscal year is made by filing an initial fiduciary income tax return for the period ending on the last day of that month. Reg. 1.441-1(c)(1). The election may be made on a late-filed return. Reg. 1.441-1(c)(1). The filing of an extension request, or the filing of a Form SS-4 (application for EIN), or the payment of estimated taxes, does not constitute the making of an election to use a fiscal year, nor does it constitute the selection of an ending month, even though the Form SS-4 asks for the ending month of the fiscal year. The selection of a fiscal year has important tax implications for the beneficiaries of a trust or estate, in addition to the tax implications for the trust or estate itself. If a trust or estate makes a distribution of distributable net income (DNI) to a beneficiary (or income is deemed to be taxable to the beneficiary under 652(a) or 662(a)(1)), then the beneficiary will be taxed on that distribution in the tax year of the beneficiary in which the tax year of the estate or trust ends. 662(c); Reg. 1.662(c)-1. In some cases, it may be desirable to select a first fiscal year that is as long as possible, in order to defer taxation. Selecting a long fiscal year also increases the possibility of completing Basic Estate Planning and Administration 2014 1 11

Chapter 1 A Fiduciary Income Tax Primer the administration of the estate or trust within one year, so that the first fiscal year is also the final year, thus allowing all of the income (or the excess deductions) to be carried out to the beneficiaries, with no chance that any of the income will be taxed at the higher income tax rates of the trust or estate. 662; 643(a)(3); Reg. 1.643(a)-3(d). See the discussion of the final tax year, below. The selection of a fiscal year can be used to prevent a trust from earning sufficient income in the first tax year to put the trust or estate in the highest income tax bracket. If need be, the trustee or personal representative can monitor the income as it is received, and then terminate the tax year before the amount is reached that would place the estate or trust in the highest bracket. The selection of a fiscal year can also help solve the following related problem. Assume that an estate has experienced a significant taxable event, such as the withdrawal of significant funds from an IRA. If the estate has also experienced significant expenses and needs to make certain that those expenses are incurred in the same tax year as the taxable event, the selection of a fiscal year can help achieve that goal. Or perhaps the estate has experienced a significant taxable event that occurred within the first twelve months of the estate administration, but that first twelve-month period has now ended, and the estate failed to distribute that income to the beneficiaries. These problems can often be addressed by selecting a year-end that causes the estate to have a very short first year (say, a first fiscal year of only three or four months), followed by a full twelve-month second year. That decision can be made at any time prior to the filing of the first fiduciary income tax return, and it can be made even though it causes the return for the short first year to be overdue, since the election of a fiscal year can be made on a late-filed return. This technique cannot be used if the tax issues occur in a formerly-revocable trust that has elected under 645 to use the fiscal year of the estate (discussed in the following section), since the 645 election cannot be made on a late-filed return. 645(c). For example, assume that a decedent died in February, 2013. The longest possible first fiscal year of the estate would end on January 31, 2014, and the personal representative made a tentative decision to use that year end for the fiscal year. The estate withdrew all of the funds in a large IRA account in October 2013, but no significant expenses were incurred in 2013, nor were any distributions made. In April 2014, the personal representative realized that using a fiscal year end of January 31, 2014, would result in a significant tax due at the highest rates, because of the lack of deductible expenses and the lack of deductible distributions. What can the personal representative do in April 2014 to remedy this situation? Rather than use a year end of January 31, the personal representative could decide to use a year end of September 30. Although the income tax return for a year ending September 30 was due on January 15, the personal representative could nevertheless file a late return and make the Basic Estate Planning and Administration 2014 1 12

Chapter 1 A Fiduciary Income Tax Primer election to use September 30 as the year end (paying particularly close attention to any applicable interest and penalties.) The personal representative would then have until September 30, 2014, to mitigate the large taxable event that occurred in October 2013. That mitigation could take the form of (a) paying deductible expenses, (b) making distributions that carry out income to the beneficiaries, or (c) closing the estate in order to carry the income out to the beneficiaries in the final tax year. If the beneficiary has the same year-end as the trust or estate, distributions to the beneficiary will cause the beneficiary to be taxed on the trust or estate income in the same year that the trust or estate received the income. 652(c). If the beneficiary is on a different tax year, the beneficiary will be taxed in his or her tax year in which the trust or estate tax year ends. 652(c). This is a deferral opportunity: If the trust or estate tax year ends on January 31, 2013, the income earned during most of 2012 will not be taxable to the beneficiary until 2013, and the tax will not be payable by the beneficiary until April 15, 2014 (subject, of course, to the need for the beneficiary to make estimated tax payments of his individual tax liability). If a decedent s will creates a testamentary trust, the first tax year of the testamentary trust does not begin on the date of death, because the trust typically acquires no assets on that date. Instead, the first tax year of a testamentary trust begins when the trust first acquires assets, which is usually on the date that the probate estate distributes its assets to the testamentary trust. United States v. Britten, 161 F.2d 921 (3 rd Cir. 1947); Maresca Trust v. Commissioner, T.C. Memo 1983-501. If a partial distribution is made to the trust from the estate prior to the termination of the estate, then the trust will have been created on that earlier date of the partial distribution. An annual fiduciary income tax return is due within three and a half months following the end of each taxable year. 6072(a). The federal form is 1041; the Oregon form is 41. Thus an estate or trust with a tax year ending on December 31 will file its annual fiduciary income tax return on or before April 15, while an estate with a tax year ending June 30 will file its annual fiduciary income tax return by October 15. An automatic extension of the time within which to file a return for a trust or for an estate can be obtained by filing a Form 7004 on or before the due date of the return. See 6081; Reg. 1.6081-6(a). (Form 8736 is no longer used.) Unlike extensions for individual returns that are for six months, the automatic extension for a fiduciary return is for only five months. Extensions of time to pay the tax are not authorized. Reg. 1.6081-6(c). Further extensions to file beyond the original five-month extension are not authorized. Reg. 1.6081-6(a). The extension of the time to file a return for a trust or estate does not extend Basic Estate Planning and Administration 2014 1 13

Chapter 1 A Fiduciary Income Tax Primer the time for the beneficiaries to file their returns or to pay their tax. Reg. 1.6081-6(d). As a result, a fiduciary who extends the time for filing a fiduciary income tax return should advise the beneficiaries to obtain their own extensions of time to file their individual returns, and should advise them to pay an estimated tax at the time that the beneficiaries extend their own returns. 8. Formerly-Revocable Trust Election to Use a Fiscal Year Although trusts are generally required to use a calendar tax year, 644(a), a formerly-revocable living trust may elect to use a fiscal year following the death of the grantor. 645. This election is made by filing a Form 8855, in which the revocable living trust (which is now neither revocable nor living) elects to be taxed as if it were part of the decedent s estate. The form is normally filed with the first fiduciary income tax return filed for the estate. It is due by the due date of the return, or the extended due date; the election cannot be made on a late return. 645(c). The 645 election is irrevocable. 645(c). The election is available regardless of whether a probate estate is actually being administered for the decedent, but an EIN (employer identification number) must nevertheless be obtained for the estate, and the estate will file the Form 1041 under that EIN. The trust will also obtain an EIN, but the trust will not file a return; the EIN of the trust will be listed on Part III of the Form 8855, and the trust will be treated as a separate share of the estate for purposes of the separate share rule. Reg. 1.663(c)-4(a). (The trust itself might consist of two or more separate shares; see below for a discussion of the separate share rule.) If a probate estate is being administered, then both the estate and the trust will report their income on the same Form 1041, which will be the income tax return of the estate. The election to be treated as part of the decedent s estate may not be continued indefinitely. If a federal estate tax return is not filed, the election may remain in place for up to two years following the date of death. 645(b)(2)(A). If a federal estate tax return is filed, the election may remain in place until six months after the estate tax liability is finally determined. 645(b)(2)(B). The filing of a state estate tax return is not relevant for the purpose of this rule. After the period during which a fiscal year is permitted has expired, the trust will then be required to file a short-year return ending December 31, and subsequent returns will be full-year returns ending December 31. Reg. 1.645-1(h)(4)(ii). At the end of the 645 election period, the trust is deemed to have distributed its assets and all of its tax attributes to a new trust in a distribution to which 661 and 662 apply. Reg. 1.645-1(h)(2). The trustee may need to obtain a new EIN for the trust, depending on whether an estate exists. See Reg. 1.645-1(h)(3); Reg. 301.6109-1(a)(4). Basic Estate Planning and Administration 2014 1 14

Chapter 1 A Fiduciary Income Tax Primer The election to be treated as part of the decedent s estate, and to use the fiscal year of the estate, also triggers several other fiduciary income tax benefits that estates are allowed, compared to trusts. Those benefits include fewer obligations to pay estimated taxes, use of the charitable set-aside deduction, use of the exemption applicable to estates, and fewer restrictions on holding S corporation stock, among others. Those benefits are discussed separately under those topics. 9. The Final Tax Year Special rules apply to the final tax year of all trusts and estates. The primary purpose of most of these special rules is to shift all of the tax liability for the final year to the beneficiaries. As a result, all trusts and all estates pay no income taxes for income received (or gains realized) in their final year, but they nevertheless must file a final return. The reason why no tax is due: the Code is designed to permit trusts and estates to distribute all of their assets to their beneficiaries at the end of their final year, without any need to hold back a reserve to pay income taxes. All of the income, capital gains, and deductions are reported on the final return, but then a distribution deduction is allowed for all of the income and capital gains (unlike a non-final year), and then all of the income, deductions, and gains are carried out to the beneficiaries. 662; 643(a)(3); Reg. 1.643(a)-3(d). This is a very important rule, and so it bears repeating: trusts and estates pay no taxes in their final year; all of their income, gains, deductions and other tax attributes flow out to the beneficiaries in the final year; and the beneficiaries pay the resulting tax or obtain the benefit of any excess deductions. 662(b). Although the Code does not expressly state that the final year involves no tax liability for an estate or trust, that is the net effect of 662 and 643. For that reason, simple trusts are no longer classified as simple trusts in their final year; they are classified as complex trusts. The mechanism that forces that classification is 661(a)(2) and the last sentence of 651(a). Reg. 1.651(a)- 3(a). Any excess deductions in the final year flow out to the beneficiaries to be used by the beneficiaries on their individual tax returns, subject to two restrictions. 642(h). Excess deductions are defined as the amount by which deductions exceed gross income in the final year. 642(h); Reg. 1.642(h)-2(a). For purposes of calculating the excess deductions, the personal exemption and the charitable deduction are disregarded. 642(h)(2). In effect, the charitable deduction in the final year is wasted. O Bryan v. Commissioner, 75 T.C. 304 (1980). The distribution deduction is also disregarded. 643(a)(1). Basic Estate Planning and Administration 2014 1 15

Chapter 1 A Fiduciary Income Tax Primer Although 642(h) provides that excess deductions in the final year flow out to the beneficiaries to be used by the beneficiaries on their individual tax returns, two restrictions apply. Because of those two restrictions, some beneficiaries will not be able to use the excess deductions. Those restrictions stem from the fact that excess deductions are considered to be miscellaneous itemized deductions on the individual income tax returns of the beneficiaries. 67(b). Miscellaneous itemized deductions can be used by a beneficiary (1) only if the beneficiary itemizes his deductions, and (2) even then the deductions can be utilized by the beneficiary only to the extent that his miscellaneous itemized deductions exceed two percent of the beneficiary s adjusted gross income. 67(a); 642(h); Reg. 1.642(h)-2(a); Rev. Rul. 59-392, 1959-2 C.B. 163. Those excess deductions cannot be carried forward or backward by a beneficiary to a subsequent year or a prior year; they may be used, if at all, in the beneficiary s year in which the trust s final year or the estate s final year ended. Reg. 1.642(h)-2(a). If the trust or estate passes out a net operating loss carryover or a net capital loss, the beneficiaries may continue to carry over the losses. Reg. 1.642(h)(1). A trust does not end its existence simply because the governing document states that the trust terminates upon the happening of a particular event. Instead, the trust continues in existence until it has distributed all (or almost all) of its assets. Reg. 1.641(b)-3(b); Reg. 1.641(b)-3(c)(1); Dominion Trust Co. of Tenn. v. United States, 786 F.Supp. 1321 (M.D. Tenn. 1991) affirmed 7 F.3d 233 (6 th Cir. 1993; unpublished opinion); Herbert v. Commissioner, 25 T.C. 807 (1956), acq. 1956-2 C.B. 6; Rev. Rul. 55-287, 1955-1 C.B. 130. For example, if a trust document states that the trust terminates upon the death of the life income beneficiary, and the document then requires that the trust distribute all of its assets to a remainderman, the trust does not actually terminate on that date of death. Similarly, a revocable living trust might provide that it terminates on the death of the trustor, but the trust usually continues in existence for the purposes of paying debts, resolving claims, filing the decedent s final income tax return, filing an estate tax return, filing income tax returns for the trust, resolving an estate tax audit, liquidating assets, formulating a plan of distribution, obtaining releases, etc. Not all of those tasks are required of every trust, but nearly all trusts have tasks to complete before the assets can be distributed to the ultimate beneficiaries. In Dominion Trust, the completion of those tasks took more than three years. In Lowery v. Evonuk, 95 Or. App. 98 (1989), the court held that a trustee had not administered a trust within a reasonable period of time when the post-mortem administration of the trust took more than twenty-one months. Of course, what constitutes a reasonable time depends of the facts and circumstances of each case; twenty-one months might be too short for a large, complex trust. Even if a court orders a trust to be terminated, the trust does not terminate until it has accomplished the tasks necessary to effectuate a full distribution of its assets. Richards v. Campbell, 21 AFTR2d 1122, 68-1 USTC Basic Estate Planning and Administration 2014 1 16

Chapter 1 A Fiduciary Income Tax Primer 9288 (N.D. Tex. 1968). However, ORS 130.730 requires that a trustee proceed expeditiously to distribute trust property following a terminating event, and thus a trustee has an obligation to complete those tasks with reasonable promptness. See also Reg. 1.641(b)-3(a). Although a trust terminates for tax purposes when it has disposed of all of its assets, the trust may retain a reserve for contingencies and still be treated as having been terminated. Reg. 1.641(b)-3(a), (b). If the final tax year concludes in the middle of a calendar year, some accountants are reluctant to file a final return until the following tax season, when new tax forms become available, and new tax return preparation software becomes available. For example, if an estate fully distributes its assets and closes in March of 2014, the final Form 1041 is due July 15, 2014, and the return is supposed to be filed using 2014 tax forms, but 2014 forms (and 2014 tax return preparation software) won t become available until January of 2015. Filing that return during the subsequent tax season in early 2015 usually causes no harm (even though it is technically late), but some fiduciaries prefer to file the final return sooner, in order to fully and finally satisfy their all of their duties. The solution: the IRS usually will accept that final 2014 return filed on 2013 forms if the 2013 in the upper-right corner of the forms is crossed out and 2014 is written in bold digits above the struck-out 2013. For tax return preparers who are required to file all of their returns electronically, a special opt-out Form 8948 can be attached to the return and will permit the preparer to file such a return in paper form. 10. Fiduciary Accounting Income Fiduciary accounting income is essentially the income of a trust or estate defined by the will or trust, and by local law. 643(b). In general, the IRS will not honor definitions of income contained in a trust document that fundamentally vary from state law. Reg. 1.643(b)-1. In most states, the principal source of that law is the Uniform Principal and Income Act, which has been enacted in Oregon as chapter 129 of the Oregon Revised Statutes. Because fiduciary accounting income is based on state law, it is usually expressed as a dollar amount net of expenses. The Uniform Principal and Income Act refers to it as net income. ORS 129.205(8). The fiduciary income tax provisions of the Internal Revenue Code refer to fiduciary accounting income whenever the word income is not preceded by the words gross, taxable, distributable net, or undistributed net. 643(b). Basic Estate Planning and Administration 2014 1 17

Chapter 1 A Fiduciary Income Tax Primer A trust or estate is permitted to compute its taxable income under the cash method, the accrual method, or other permissible methods. 446(c); see also 641(b); 7701(a)(1), (14). Once a method has been adopted, however, the method cannot be changed without the permission of the IRS. 446(e). The primary purpose for the term fiduciary accounting income is to distinguish between principal (including capital gains) and income, particularly since many trusts call for the distribution of income to one beneficiary, followed by a distribution of principal (including capital gains) to a different beneficiary, such as a remainderman. But fiduciary accounting income also has important uses in determining DNI and the distribution deduction, as noted below. However, fiduciary accounting income will usually not trump the definition of taxable income contained in the Internal Revenue Code. For example, assume that a trust received the proceeds of an annuity that had been owned by a decedent. Under the Uniform Principal and Income act, much of the proceeds of an annuity is considered to be principal. (In Oregon, see ORS 129.355.) Despite that state law definition, the federal tax laws might reach a different result: a significant portion of the annuity proceeds is often considered to be taxable income under 72 of the Code. (Note that some of that amount is probably also income in respect of a decedent under 691.) Because a portion is taxable income, that portion is included in the distributable net income (DNI) of the trust, for the simple reason that taxable income is the starting point in the definition of DNI. 643(a). If that amount is distributed to the beneficiary of the trust, that amount would be treated as a deductible 661(a)(2) distribution of DNI, because that subsection includes any other amounts, not just income. And then it would be included in the taxable income of the beneficiary under 662(a)(2), because that subsection includes all other amounts properly paid, not just income. That treatment of a portion of the proceeds as taxable income would take place even though the amount distributed might be considered to be principal under the state law definition of fiduciary accounting income. As a result, the tax laws would determine that the distribution was income, even though the fiduciary accounting laws would treat it as principal. (However, in that situation the trustee of the trust will need to carefully review the distributive provisions of the trust to make certain that principal, as defined by the state law, may be distributed under the terms of the trust.) In that situation, DNI exceeded fiduciary accounting income. In other situations, DNI might be less than fiduciary accounting income. For example, a trust might deduct for income tax purposes an amount that the Uniform Principal and Income act requires be allocated to principal. If so, the distribution deduction will nevertheless be limited to the amount of DNI. 651(b); 661(a). The amount taxable to the beneficiaries will similarly be Basic Estate Planning and Administration 2014 1 18

Chapter 1 A Fiduciary Income Tax Primer limited to the amount of DNI. 652(a); 662(a). See the discussions of distributable net income and the distribution deduction, both below. The definition of fiduciary accounting income also causes special problems when a trust or estate holds an interest in an S corporation or a partnership. The income of such entities is generally taxed to the shareholders/partners, regardless of whether the income is actually distributed to them. If the entity earns income, but does not distribute it, then the K-1s issued to the shareholders/partners will show income taxable to the shareholders/partners, but the shareholder/partners will have received no cash with which to pay the tax on that taxable income. Such income unaccompanied by cash is known as phantom income. But the problem is even more complicated if the shareholder/partner is a trust or estate. Under the Uniform Principal and Income Act enacted in most states, income is generally limited to amounts received in cash. See, e.g., ORS 129.300(2). Items that do not qualify as income are deemed to be principal. ORS 129.300(3)(a). Amounts actually distributed by the entity will be treated as income, and will be included in DNI. But amounts not actually distributed by the entity are not included in fiduciary accounting income, nor are they included in DNI. Yet they are taxable to the trust or estate. And the trust or estate is not able to distribute such income to the beneficiaries and cause it to be taxed to the beneficiaries, because 651(a) and 661(a) allow distribution deductions only for income actually distributed or required to be distributed, and it is not possible for the fiduciary to distribute income which the fiduciary has not actually received. Yet for income tax purposes, the fiduciary is deemed to be taxed on that income, and the beneficiary will not be taxed on that income. See the next section for a further discussion of partnership and S corporation interests held in an estate or trust. 11. Partnerships and S Corporations S corporations pose special problems in estate and trust administration after an S corporation shareholder has died. Only certain kinds of trusts are eligible to be shareholders in S corporations, and some of those trusts are eligible only for brief periods following the death of a shareholder. The types of trusts eligible to hold S corporation stock include grantor trusts, revocable trusts within two years following the death of the shareholder, testamentary trusts within two years of the receipt of S corporation stock, estates during a reasonable period of administration, Qualified Subchapter S Trusts (QSSTs), and Electing Small Business Trusts (ESBTs). See 1361. For more detail on this subject, see Heath and Schnell, Estate Planning with S Corporation Stock, Oregon State Bar Estate Planning and Administration Section Newsletter, Vol. XXVII, No. 3, July 2010. A trust may be treated as an estate for purposes of these rules if the trust has made a 645 election to use a fiscal year as part of the Basic Estate Planning and Administration 2014 1 19

Chapter 1 A Fiduciary Income Tax Primer decedent s estate. Reg. 1.645-1(e)(3)(i). See the discussion of a trust s election to use a fiscal year, above. If a decedent owned an interest in a partnership or an LLC, the partnership or LLC may make an election under 754 to adjust the basis of partnership assets with respect to the transferee partner only (the person taking the interest as a result of the death of the partner). This adjustment is made pursuant to 743(b). The amount of the 743(b) adjustment is equal to the difference between the transferee s initial basis in his partnership interest (fair market value as of the date of death) and his proportionate share of the adjusted basis of partnership property. The adjustment can be a positive or a negative adjustment. Once the election is made, the 743(b) adjustment applies to all transfers of partnership interests by sale or exchange or upon the death of a partner until the election is formally revoked. The election must be filed with a timely partnership return for the taxable year during which the transfer occurs. Reg. 1.754-1(b). In the case of death, this would be the return for the year of death. Section 743(b) basis adjustments are mandatory if the partnership has a substantial built-in loss immediately after the transfer of a partnership interest. A substantial built-in loss exists where the adjusted basis of all partnership property exceeds its fair market value by at least $250,000. Reg. 1.754-1(d)(1). Assuming the adjustment is positive, the benefit of the election is that the transferee is allowed an increase in his or her basis in the partnership assets. This in turn reduces the transferee s share of capital gain realized on the sale of any of the assets. A 743(b) basis adjustment has no effect on the partnership's computation of any item under 703, nor does it impact the transferee's capital account. The disadvantages of the election to adjust the basis of partnership assets include: a. The election is essentially irrevocable (except with IRS consent). b. If the transferee s basis in partnership assets exceeds his or her basis in his or her partnership interest, the 743(b) adjustment would decrease his or her basis in partnership assets. c. It applies to both transfers of partnership interests and distributions of partnership assets. This could result in future decreases in basis depending upon subsequent events. d. The election adds accounting and record keeping complexity for the partnership. e. If a 743(b) election is not made, the gain that could have been avoided by the basis increase will be recognized. However, since this gain increases the partner s basis in his partnership interest, upon a sale Basic Estate Planning and Administration 2014 1 20

Chapter 1 A Fiduciary Income Tax Primer of his partnership interest the partner would have an offsetting recovery of the amount earlier recognized. 12. Distributable Net Income (DNI) The concept of distributable net income is central to understanding the fiduciary income tax. DNI is essentially the taxable income of the estate or trust, including both taxable income and tax-exempt income. 643(a). Since it is based on taxable income, DNI is calculated after reducing the income by deductible administration expenses, such as attorney fees, executor fees, and other expenses, but DNI is not reduced by distributions to beneficiaries, or by the personal exemption of the trust or estate. When including tax-exempt income in DNI, the income is reduced by expenses that are non-deductible by reason of having been allocated to the tax-exempt income. 643(a)(5). See taxexempt income, below. The primary function of the DNI calculation is to serve as a limit on how much of a distribution to beneficiaries may be deducted under the distribution deduction. 651(b); 661(a). That fact explains why DNI is calculated without taking into account the distribution deduction. See the discussion of the distribution deduction, below. DNI does not include most capital gains, except in the final year. 643(a)(3); Reg. 1.643(a)-3(d). See the discussion of the final year, above. The exclusion of capital gains from DNI explains why capital gains are subtracted from adjusted total income on Schedule B of Form 1041 in order to calculate DNI. The fact that DNI does not include capital gains (except in the final year) explains why most capital gains are taxed to the trust or estate, and not to the beneficiaries, except in the final year. 643(a)(3). Because DNI is based on taxable income, charitable deductions have already been removed from DNI, and no further adjustment to DNI is needed with respect to charitable deductions. This rule prevents non-charitable beneficiaries from being taxed on income distributed to charity or set aside for charitable purposes, with one exception: tier 1 beneficiaries receive no benefit from a charitable distribution of income. 662(a)(1). In effect, tier 1 beneficiaries have priority to be taxed on the income of a trust or estate, and charitable distributions of income are treated as a lower priority, but a higher priority than tier 2 distributions. See the discussions of the charitable deduction and the tier system, both below. Basic Estate Planning and Administration 2014 1 21

Chapter 1 A Fiduciary Income Tax Primer The calculation of DNI is made without subtracting the 691(c) deduction for estate taxes paid on income in respect of a decedent. Reg. 1.691(c)-2(a)(2). See income in respect of a decedent, below. As noted below, the fiduciary may elect to deduct some expenses on an estate tax return under 642(g), in which case those particular expenses may not be deducted on the fiduciary income tax return, and in that event such expenses will not reduce DNI. Nor may expenses deducted on the estate tax return also be used to reduce capital gains on a fiduciary income tax return. 642(g). 13. Capital Gains and Losses In general, capital gains and losses are taxed to trusts and estates in much the same fashion as they are taxed to individuals. The general rule, subject to many exceptions, is that in each year long-term gains are netted against longterm losses, and short-term gains are netted against short-term losses. Then the long-term net gain/loss is netted against the short-term net gain/loss. If the result is a gain, it is taxed to the trust or estate at 20%, or 15% if taxable income is less than $12,150. 1(h). If the result is a loss, it can be deducted up to the amount of $3,000 in that year, and the excess can be carried over into future years indefinitely until it has been consumed in those future years. 1212(b). See also 1.643(a)-3(d). Trusts and estates reach the highest capital gain rates at a much lower threshold than do individuals. An individual single person does not reach the maximum 20% rate unless taxable income is above $400,000 in 2013, and jointfiling married taxpayers do not reach the maximum 20% rate unless taxable income is above $450,000 in 2013. 1(h). In 2014, those numbers increase to $406,750 and $457,600, and in future years those numbers will continue to be adjusted for inflation. See Rev. Proc. 2013-35. In 2015, those numbers are expected to increase to $413,200 and $464,850. Assets acquired from a decedent and disposed of within one year after the death are automatically deemed to have been held by the recipient for more than one year, even if the recipient disposes of the asset shortly after the death of the decedent. 1223(9). As a result, any gain realized is deemed to be long-term. This rule applies not only to estates, but also to revocable trusts that became irrevocable upon the death of the decedent. 1014(b). In fact, this rule applies to any asset where the basis is determined by 1014 (basis of property acquired from a decedent). 1223(9). See the discussion of basis step-up, below. In general, capital gains and losses do not pass out to the beneficiaries; the trust or estate pays the income tax on the net gains, and the net losses are Basic Estate Planning and Administration 2014 1 22

Chapter 1 A Fiduciary Income Tax Primer deductible by the trust or estate subject to the limitations described above. That result is brought about by the fact that such gains and losses are not included in DNI. 643(a)(3). That result is based in part on state law, which typically allocates capital gains to principal. ORS 129.310. However, in the final year of a trust or estate, all of the tax attributes of that tax year pass out to the beneficiaries as part of DNI, so that any capital gains realized in that final year will be reported by the trust or estate on the fiduciary income tax return, but then the gains will be carried out to the beneficiaries on their K-1s, as will the losses. 662; 643(a)(3); Reg. 1.643(a)-3(d). See the discussion of the final year, above. Under some circumstances, capital gains are included in DNI in a nonfinal year of a trust or estate, and thus those exceptions allow capital gains to be passed out to the beneficiaries. Those exceptions are described in 643(a)(3) and Reg. 1.643(a)-3: a. Gains that are allocated to fiduciary accounting income, under state law and the governing instrument, or pursuant to the exercise of the fiduciary s discretion if authorized by state law, or authorized by the governing instrument if not prohibited by state law. b. Gains that are allocated to principal, but are actually paid, credited, or required to be distributed to any beneficiary during the taxable year. c. Gains that are paid or permanently set aside for charitable purposes under 642(c). The regulations under 643 clarify that capital gains can be included in DNI if the gains are allocated to income by state law and under the governing instrument; or are consistently treated by the fiduciary on the books, records, and tax returns of the trust or estate as part of a distribution to a beneficiary; or are allocated to principal but actually distributed to a beneficiary, or treated by the fiduciary as required to be distributed to a beneficiary. Reg. 1.643(a)-3. Capital gains are also included in DNI if paid or permanently set aside for charitable purposes. Reg. 1.643(a)-3(c). The regulations under 643 provide fourteen examples to illustrate how 643(a)(3) operates to allow capital gains to be passed out to beneficiaries. Those examples demonstrate that the second exception described above can be used only if the governing instrument or state law permits such distributions. Reg. 1.643(a)-3(e). In many modest estates, capital gains are relatively few and small, particularly since the assets will have received a stepped-up basis for income tax Basic Estate Planning and Administration 2014 1 23

Chapter 1 A Fiduciary Income Tax Primer purposes. In a relatively small estate, often the only significant capital transaction is the sale of the decedent s personal residence. Let s assume that the house is sold on the open market a few months after the date of death, through the services of a professional real estate broker. That sale usually determines the fair market value of the residence, and it is not unreasonable to use that sale price as the fair market value on the estate tax return and as the post-mortem income tax basis of the residence. But how are the broker s commission, the title insurance premium, and related closing costs handled for tax purposes? As noted below in the discussion of deductions, the expenses of sale are not usually deductible against ordinary income for fiduciary income tax purposes. Instead, those expenses are offsets against the selling price to reduce gain or to increase loss. 642(g). But because the sale price is also the basis, offsetting those closing costs will produce a capital loss. That loss can be offset against capital gains, and if the losses exceed the gains (as noted above), the excess can be deducted up to $3,000 per year against ordinary income. If the sale takes place in the final year of the estate (and modest estates often have only one tax year, which is both the first tax year and also the final tax year), then the loss flows out to the beneficiaries, who can use the loss to offset their own capital gains, and any net loss of each beneficiary can be deducted against ordinary income by each beneficiary up to $3,000 per year under 1211(b). 1.642(h)-1(c). (The IRS once took the position that a loss on the postmortem sale of a personal residence could not be deducted unless the estate had rented out the residence, SCA 1998-012, but apparently the IRS no longer takes that position. See IRS Publication 559.) Unless it is a grantor trust, a trust is not eligible for the capital gain exclusion on the sale of a personal residence provided by 121. PLR 200104005; PLR 199912026; Reg. 1.121-1(c)(3). If the trust is deemed to be partially a grantor trust, then the grantor may exclude that portion of the gain. PLR 200104005. Occasionally an undivided half interest in a personal residence is placed in a credit shelter trust, while the other half interest continues to be owned by the surviving spouse. Under the prior version of 121, the owner of a partial interest could exclude that owner s portion of the gain. Rev. Rul. 67-234, 1967-2 C.B. 78; Rev. Rul. 67-235, 1967-2 C.B. 79. Presumably that result is still available under the current version of 121. (The amount of gain that can be excluded under 121 is $250,000 for an individual and $500,000 for a married couple.) For purposes of determining whether a trust or estate has gross income in excess of the $600 filing threshold, gross income does not necessarily include gross proceeds from the sale of a capital asset. Instead, gross income includes an amount equal to gross proceeds minus basis. Reg. 1.61-6(a). Basic Estate Planning and Administration 2014 1 24

14. Exemptions Chapter 1 A Fiduciary Income Tax Primer Under 642(b), an estate is allowed a personal exemption of $600, a simple trust is allowed a personal exemption of $300, and a complex trust is allowed a personal exemption of $100. These exemptions are not available in the final year of a trust or estate because the trust or estate pays no taxes in the final year and the exemption may not be passed out to the beneficiaries as an excess deduction. 642(h)(2). A trust is allowed to use the larger $600 exemption of an estate if the trust has made a 645 election to use a fiscal year as part of the decedent s estate. Reg. 1.645-1(e)(2)(ii)(A). See the discussion of a trust s election to use a fiscal year, above. 15. Calculating Taxable Income; Deductions Estates and trusts are generally taxed in the same manner as individuals, with several exceptions. 641(b). Calculating the taxable income of an estate or trust involves several steps. The most important steps are: 1. Determine gross income. Gross income generally does not include the proceeds of life insurance received due to the death of the decedent. 101(a)(1). Also, gross income does not include tax-exempt income. 103. In the following discussion of deductions, deductions relating to tax-exempt income must be allocated in full or in part to the exempt income, and the portion so allocated may not be deducted. 265. For example, a trustee s fee for investment management must be allocated between taxable investments and tax-exempt investments. 2. Deduct the above-the-line deductions. These are deductions defined by 62 as deductions from gross income to determine adjusted gross income (AGI). They are known as above-the-line deductions because they are deducted from gross income, not from adjusted gross income. These are primarily deductions incurred in carrying on a trade or business, including ordinary and necessary business expenses under 162, business interest under 163, business taxes under 164, business losses under 165, and depreciation of business assets under 167, 168, and 642(e). If the business generates a net operating loss, the NOL may be carried back two years and then may be carried forward up to twenty years. 642(d); 172(b). 3. The result would normally be adjusted gross income (AGI) as it is defined by 62 if it were calculated for an individual taxpayer, but Basic Estate Planning and Administration 2014 1 25

Chapter 1 A Fiduciary Income Tax Primer 67(e) makes several significant changes to the calculation of adjusted gross income if it is being calculated for a trust or estate. Section 67(e), which establishes a test known as the 2% floor, requires that four deductions that would normally be below-the-line deductions from adjusted gross income must, in the case of trusts and estates, be subtracted in order to calculate adjusted gross income. Those four deductions are (1) administration expenses that would not have been incurred if the property were not held in such trust or estate, (2) the personal exemption under 642(b), (3) the distribution deduction for simple trusts under 651, and (4) the distribution deduction for complex trusts under 661. Note that 67(e) does not actually permit those four deductions to be taken above-the-line; it merely provides that they should be subtracted when calculating adjusted gross income [f]or purposes of this section. In other words, those four deductions will be subtracted for purposes of determining AGI, but only for purposes of determining the 2% floor, which is applied later in the tax calculation (see below). Those deductions that are subtracted from gross income for purposes of this calculation of adjusted gross income will be deducted below for purposes of calculating adjusted total income and eventually taxable income, but in this step the calculation simply takes a minor detour to calculate the special definition of adjusted gross income for purposes of estates and trusts. Because adjusted gross income is later used to determine the 2% floor on some of those deductions, and because those deductions are used to calculate adjusted gross income and taxable income, a simultaneous (circular) calculation is often required. 4. The result is adjusted gross income, as it is specially defined by 67(e) for trusts and estates for purposes of calculating the 2% floor (discussed below). However, because of the circular nature of the calculation, the term adjusted gross income is not actually used in the calculation of the tax; it is used only to calculate the 2% floor. For example, the Form 1041 does not actually use the term adjusted gross income on the form itself, although the term is used in the instructions to calculate the 2% floor. The instructions give an example of how to manually perform the circular calculation. Most practitioners, however, use commercial tax return software, which eliminates the need for the manual calculation. The circular calculation is not required in every case; for example, some trusts have no miscellaneous itemized deductions that are subject to the 2% floor. In another example, some trusts distribute less than DNI, and their distribution deduction is therefore less than DNI, and thus the distribution is not limited by DNI. In that situation, the impact that AGI has on DNI does not affect the distribution deduction. Basic Estate Planning and Administration 2014 1 26

Chapter 1 A Fiduciary Income Tax Primer 5. Deduct the below-the-line deductions. These are defined by 63(d)(1) as deductions other than the above-the-line deductions. They are referred to as below-the-line deductions because they are deductions that are normally (in the case of individuals) deducted from adjusted gross income, not deductions taken to determine adjusted gross income. In the case of an estate or trust, however, adjusted gross income is given a special definition (see above) that in some cases results in a circular calculation. For that reason, these below-the-line deductions are not actually deducted from adjusted gross income. Instead, they are merely deducted as the next step after deducting the above-the-line deductions. These below-the-line deductions include itemized deductions and a subset of itemized deductions known as miscellaneous itemized deductions. 63(d)(1). The itemized deductions include expenses relating to property or investments held for the production of income, including ordinary and necessary expenses under 212 for the production of income, including administration expenses. Reg. 1.212-1(i). Administration expenses generally include personal representative s fees, trustee s fees, attorney s fees, and accountant s fees under 212; interest under 163; state and local taxes under 164; losses under 165; bad debts under 166; depreciation under 167, 168 and 642(e); and tax advice and tax preparation costs under 212(3). Miscellaneous itemized deductions are defined by 67(b) as not including interest under 163, state and local taxes under 164, the charitable deduction under 642(c), and estate taxes under 691(c). Thus miscellaneous itemized deductions are defined by 67(b) to include most itemized deductions, and those miscellaneous itemized deductions are subject to a restriction known as the 2% floor. Thus the only below-the-line itemized deductions that are not subject to the 2% floor are interest under 163, state and local taxes under 164, the charitable deduction under 642(c), and estate taxes under 691(c). The deduction of miscellaneous itemized deductions, and the restrictions on those deductions, are described in the following step. In this particular step, however, we are merely deducting the itemized deductions that are not considered to be miscellaneous itemized deductions, which are deducted below. Expenses incurred in selling property are generally not deductible as administrative expenses, but are offsets against the selling price to reduce gain or to increase loss. 642(g). However, if an asset must be sold in order to pay taxes, to pay claims, or to satisfy pecuniary bequests, then the expenses of sale become deductible. Estate of Jenner v. Commissioner, 577 F.2d 1100 (7 th Cir. 1978); Estate of Joslyn v. Commissioner, 566 F.2d 677 (9 th Cir. 1977). A sale for the convenience of the beneficiaries so that they will not end up owning the asset as tenants in common would not fall into that exception. Basic Estate Planning and Administration 2014 1 27

Chapter 1 A Fiduciary Income Tax Primer 6. Deduct miscellaneous itemized deductions. Pursuant to 67(e), estates and trusts are permitted to deduct miscellaneous itemized deductions, but only to the extent that the miscellaneous itemized deductions would not have been incurred if the property were not held in a trust or estate. 67(e)(1). If a deduction fails that test, then that deduction may be deducted only to the extent that the total miscellaneous itemized deductions exceed 2% of the adjusted gross income of the trust or estate (as AGI is specially defined for purposes of estates and trusts). 67(a). The Supreme Court has interpreted that statute as exempting from the 2% floor such miscellaneous itemized deductions that an individual would have been unlikely to incur. Knight v. Commissioner, 552 U.S. 181, 128 S.Ct. 782, 101 AFTR2d 2008-544 (2008); Jones, Supreme Court Rules - Negatively - on Deductibility of Trust Investment Advisor Fees, Journal of Taxation, February 2008, Vol. 108 No. 2; Jones, Final Regulations on Trust Administration Expenses No Surprises, Journal of Taxation, July 2014, Vol. 121 No. 1. Attached to this paper as Appendix A is a table describing how miscellaneous itemized deductions are affected by the Knight opinion and the final regulations that were published following the Knight opinion. In general, those regulations allow full deductibility (not subject to the 2% floor) of administration expenses that would not have been incurred if the property were not held in [an] estate or trust. Reg. 1.67-4(a). Those regulations are effective for tax years beginning after December 31, 2014. After the miscellaneous itemized deductions are divided into the ones that are 100% deductible and those that are deductible only to the extent they exceed 2% of adjusted gross income, those deductions (after the application of the 2% floor) are referred to in the Form 1041 instructions as adjusted miscellaneous itemized deductions (AMID). 7. After the above deductions are taken, the result is referred to by Form 1041 as adjusted total income, although the Code itself does not use that term. Occasionally this amount is called the tentative taxable income, but the precise definition of that term is elusive. 8. Deduct the distribution deduction under 651 or 661, the estate tax deduction under 691(c), and the personal exemption under 642(b). Note that two of these deductions were taken into account above in calculating adjusted gross income for purposes of the 2% floor of 67(a), but they were not actually deducted at that stage, which is another reason why the calculation of the tax of an estate or trust is often circular. 9. The result is taxable income. 63. If the taxable income is a negative, the excess deductions will flow out to the beneficiaries, but only the Basic Estate Planning and Administration 2014 1 28

Chapter 1 A Fiduciary Income Tax Primer deductions incurred in the final year of the trust or estate. 642(h). In non-final years, the only negatives that may be carried over to the next tax year are capital loss carryovers and business net operating losses. 642(h). 10. Apply the tax rate table to the taxable income. 641(a); 1(e). The result is the tax due, but some trusts might be subject to two additional taxes. First, some trusts might be subject to the alternative minimum tax (AMT) under 455. See Schedule I of Form 1041. The 2014 AMT exemption amount for estates and trusts is only $23,500, much lower than the exemption amount for married couples ($82,100) or single individuals ($52,800). 55(d)(1). Those amounts are expected to increase to $23,800, $83,400, and $53,600 in 2015. And the AMT exemption for estates and trusts phases out at much lower levels as well. 55(d)(3). See Rev. Proc. 2013-35. In addition, miscellaneous itemized deductions are not deductible for purposes of calculating the alternative minimum tax, even if they exceed the 2% floor; taxes are also not deductible. 56(b)(1)(A). Second, some trusts and estates will also be required to pay an additional tax on net investment income; see the following section. 16. The Net Investment Income Tax The net investment income tax became effective on January 1, 2013. 1411. It imposes a 3.8% tax on the net investment income of individuals, trusts, and estates. The tax is reported on Form 8960 attached to the Form 1041. As in the case of the maximum income tax rate, the threshold for applying this tax is much lower for trusts and estates than for individuals. While individuals are subject to this tax if their adjusted gross income exceeds $200,000 ($250,000 for married couples filing jointly), the 2014 threshold level for trusts and estates is $12,150 of undistributed net investment income. 1411(a), (b). The threshold for estates and trusts is inflation-adjusted annually, but the threshold for couples and individuals is not adjusted. 1411(a), (b); see Rev. Proc. 2013-35. In 2015, the threshold for estates and trusts is expected to increase to $12,300. The tax is imposed on three types of income described in 1411(c): a. Interest, dividends, annuities, rents, royalties, and certain other passive income. b. Trade or business income ( covered business income ) derived from trading in financial instruments or commodities, passive activity Basic Estate Planning and Administration 2014 1 29

Chapter 1 A Fiduciary Income Tax Primer income under 469, and income generated by investing working capital. c. Net gain from the disposition of property, with some exclusions. This includes most capital gains, with some exceptions. The U.S. Tax Court has held that a trust will be deemed to have materially participated in real estate business activities under 469(c)(7), and thus the real estate business will not be deemed to be a passive activity under 469, if the trustees personally performed sufficient services to meet the exception described in 469(c)(7). Aragona v. Commissioner, 142 T.C. No. 9 (3/27/14). That exception permits a real estate business to not be a passive activity if more than half of the personal services performed by the taxpayer in trades or businesses were performed in real estate activities in which the taxpayer materially participated, and the taxpayer performed more than 750 hours in its material participation in real estate businesses. In Aragona, the trustees were individuals who actively worked in the real estate business of the trust as trustees, and some of the trustees were also employees of a real estate LLC that was wholly-owned by the trust. The court held that their activities as trustees and as employees could be aggregated to determine whether the trust materially participated in the real estate business, because under local trust law trustees who operate a trust business through a corporation controlled by the trust continue to have the same fiduciary responsibilities that trustees have. (Oregon law is similar. ORS 130.655(7).) That decision has important implications for the application of the net investment income tax to trusts, because 1411(c) exempts taxpayers who materially participate in a trade or business under the standards of 469. However, the Tax Court in Aragona limited its holding to the facts and arguments of that case (the arguments advanced by the IRS in that case were somewhat narrow), and the court specifically declined to express an opinion whether a trust could materially participate through employees who were not trustees. Although the imposition of the maximum income tax rates on the taxable income of trusts and estates in excess of $12,150 has in recent years given fiduciaries a strong incentive to distribute income to beneficiaries (who will often be in lower income tax brackets), the imposition of this new investment income tax will give fiduciaries an even stronger incentive to distribute income, because trusts and estates do not pay this new tax on income that is distributed to the beneficiaries, and the beneficiaries might not be subject to the tax if their adjusted gross income is below the threshold level for individuals, which is much higher than the threshold level for trusts, as discussed above. In the alternative, the fiduciary could minimize investments that produce investment income, and maximize investments that produce tax-exempt income or produce little dividend income but offer greater future growth potential. Of course, the Basic Estate Planning and Administration 2014 1 30

Chapter 1 A Fiduciary Income Tax Primer fiduciary would need to consider the investment objectives of the trust and of the individual beneficiaries. 17. The Election to Take Deductions on the Fiduciary Income Tax Return Decedents estates are permitted to make an election to deduct their administration expenses either on the fiduciary income tax return (Form 1041) for the year in which the expense is incurred, or on the estate tax return (Form 706) for the decedent. 642(g); 2053(a)(2). The choice is often made by comparing the marginal estate tax rate (combined federal and state) with the marginal income tax rate (combined federal and state). If the estate tax rate is higher than the income tax rate, then claiming the deductions on the estate tax returns is usually most beneficial. If the income tax marginal rate is higher than the estate tax marginal rate, then claiming the deductions on the fiduciary income tax returns is usually most beneficial. If no estate tax returns (federal or state) are being filed because the estate is below the estate tax filing thresholds (or no tax is due because of the marital deduction), then taking the deductions on the estate tax returns might appear to be pointless, but deducting those expenses on the estate tax return might nevertheless have the beneficial effect of increasing the size of the credit shelter trust, and that benefit should be weighed against the possible benefit of deducting those expenses on the fiduciary income tax return, as is discussed below. The estate tax filing thresholds (federal and state) are based on the size of the gross estate, not the size of the taxable estate, so the deductions do not affect whether estate tax returns are required to be filed, but the taking of deductions on the estate tax returns might either reduce the estate tax due or eliminate the estate tax due. When calculating bequests under formula clauses that calculate the amounts to be used to fund a credit shelter (bypass) trust, or to fund a marital trust, or to fund an outright marital bequest, the 642(g) election can alter the amounts to be placed in those parts of the estate. In general, electing to take the administration expense deductions on the income tax returns causes a portion of the estate (equal to the administration expenses) to be exposed to the estate tax, because those deductions are not being deducted on the estate tax returns. Formula clauses in tax-planning wills and trusts are usually designed to reduce the estate tax to zero through the use of two tools: the unified credit and the marital deduction. Since the administration expense deduction will not be available on the estate tax returns if the election is made to take those deductions on the income tax returns, then one of those two tools must be used to shelter that amount from tax, or a tax will result. Obviously, those expenses do not qualify for the marital deduction. As a result, a portion of the unified credit must then be used to shelter from estate tax the portion of the estate that Basic Estate Planning and Administration 2014 1 31

Chapter 1 A Fiduciary Income Tax Primer was used to pay those expenses. The credit shelter trust will then be reduced by that amount; the formula clauses used in most wills and trusts will require that result. For a fuller discussion of this subject, see Jones, Calculating Bequests Under Formula Clauses, Oregon State Bar Estate Planning and Administration Section Newsletter, Vol. XXVI, No. 4, October 2009. It should also be noted that IRS regulations divide administration expenses into two types. These are the infamous Hubert regulations that were developed after the Supreme Court decided Commissioner v. Estate of Hubert, 520 U.S. 93 (1997). The holding in Hubert is now of merely academic interest, because the regulations take an entirely different approach than the Supreme Court opinion. The regulations divide administration expenses into management expenses and transmission expenses. Management expenses are incurred to maintain estate assets; they include investment advisory fees. Transmission expenses include the costs of marshaling estate assets, paying debts and taxes, and distributing the assets; they include fiduciary fees and attorney fees. Reg. 20.2056(b)-4(d)(1). Management expenses paid from the marital share will reduce the marital deduction only if those expenses are deducted on the estate tax return. Transmission expenses paid from the marital share will always reduce the marital deduction. Reg. 20.2056(b)-4(d)(2) (3). Another factor to consider is whether taking the administration expense deductions on the income tax return will actually cause a reduction in tax. If the estate does not have sufficient income to absorb the deductions, then excess deductions will result, and those excess deductions will often be wasted (and will always be wasted in a non-final year). If those excess deductions are incurred in the final year of the estate or trust, the excess deductions can be passed out to the beneficiaries, 642(h), but in some cases the beneficiaries will not be able to use those excess deductions, because excess deductions are classified as miscellaneous itemized deductions in the hands of the beneficiaries, even though not all of those deductions were classified as miscellaneous itemized deductions on the income tax return of the estate or trust. Reg. 1.642(h)-2(a). Those excess deductions can be used by the beneficiaries only if the beneficiaries itemize their deductions, and even then the deductions can be utilized by the beneficiaries only to the extent that the deductions exceed two percent of the beneficiary s adjusted gross income. 67(a); Reg. 1.642(h)-2(a). The 642(g) election is made by filing a statement, in duplicate, with the fiduciary income tax return to the effect that the deductions have not been allowed as deductions on the estate tax return, and the right to claim them on the estate tax return is being waived. Reg. 1.642(g)-1. If the election is not made, and the deductions are claimed on the estate tax return, no statement is needed. Estate of Keitel v. Commissioner, T.C. Memo 1990-416 (1990). Basic Estate Planning and Administration 2014 1 32

Chapter 1 A Fiduciary Income Tax Primer This election need not be made on a blanket basis. It can be made for some deductions and not others, or it can be made for parts of some deductions and not other parts. Reg. 1.642(g)-2. Funeral expenses are not subject to this election. They may be deducted only on the estate tax return, and not on the fiduciary income tax return. 2053(a)(1). The fiduciary income tax statutes contain no provision for deducting funeral expenses. Estate of Yetter v. Commissioner, 35 T.C. 737 (1961). Similarly, claims against the estate can be deducted only on the estate tax return, not on the fiduciary income tax return. 2053(a)(3). The same rule applies to income taxes and gift taxes owing as of the date of death, even if those taxes have not yet been calculated as of the date of death. Reg. 20.2053-6. Similarly, the medical expenses of the decedent paid by the estate are not deductible on a fiduciary income tax return. Reg. 1.642(g)-2. They may be deducted either on the final individual income tax return of the decedent (even if paid after his death, but they must be paid within one year of his death) or on the decedent s estate tax return. 213(c); Reg. 1.642(g)-2; 2053. A 7.5% of adjusted gross income floor applies to medical expenses deducted on the decedent s final income tax return, but that limitation does not apply to the estate tax return. 213. The 642(g) election does not apply to deductions in respect of a decedent, which should be deducted on both the fiduciary income tax return and on the estate tax return. Reg. 1.642(g)-2. See income in respect of a decedent, below. The same 642(g) election is available for purposes of the Oregon fiduciary income tax. OAR 150-316.272; 150-118.010. 18. The Distribution Deduction As a general rule, a trust or estate that has DNI will pay income tax on that DNI if the trust or estate retains that income, but distributions to beneficiaries in the same tax year will usually cause that DNI to be carried out to the beneficiaries receiving those distributions. 662(a). The DNI of a simple trust will be taxed to the beneficiaries regardless of whether it is distributed. 652(a). Similarly, if a complex trust is required to distribute income, that required amount will be taxed to the beneficiaries regardless of whether it is distributed. 662(a)(1). Basic Estate Planning and Administration 2014 1 33

Chapter 1 A Fiduciary Income Tax Primer If the DNI is carried out to the beneficiaries, then the beneficiaries will be taxed on that DNI, and the trust or estate will not be taxed. Thus the income will be taxed only once. The exact mechanism used by the Code to carry out that single taxation is the distribution deduction: amounts distributed to beneficiaries are deductible by the trust or estate, up to the amount of DNI. 651(b); 661(b). (One exception: A distribution of a specific bequest does not carry out DNI to the recipient beneficiary. 663(a)(1). As a result, the trust or estate will not be entitled to a distribution deduction under 661, nor will the beneficiary be taxed under 662. See the discussion of specific bequests below.) For example, if a complex trust has $40,000 of DNI for the tax year 2014, but the trust distributes $25,000 to its beneficiaries, then the trust will be taxed on the $15,000 of DNI retained by the trust, and the beneficiaries will be taxed on the $25,000 of DNI distributed to them. If that same trust were to distribute $60,000 to the beneficiaries in that tax year, then the trust would be able to deduct only $40,000 of the amount distributed, and the beneficiaries would be taxed on only $40,000 of the amount distributed. The other $20,000 of distributions to the beneficiaries would not be deductible by the trust (since it exceeds DNI), nor would the beneficiaries be taxed on that other $20,000. Instead, that $20,000 would be treated as a distribution of principal, which is not taxable to the beneficiaries nor deductible by the trust. 661(a); 662(a)(2). DNI includes tax-exempt income, but the distribution deduction is limited to the taxable portion of DNI. 651(b); 661(c). See the discussion of tax-exempt income, below. Simple trusts deduct the income they are required by the terms of the trust to distribute, regardless of whether that income is actually distributed. 652(a). Estates and complex trusts deduct both the income that is required to be distributed and other amounts that are properly paid or credited or required to be distributed. 661(a)(2). Both deductions, however, are limited to the amount of DNI. 651(b); 661(a). And both deductions cause income to be taxed to the beneficiary. 652(a); 662(a). Charitable distributions are not included in the distribution deduction. 661(b); 663(a)(2); Reg. 1.663(a)-2. Instead, they are deductible under 642(c), and they may not be deducted through the distribution deduction. Reg. 1.663- (a)-2. However, charitable distributions out of income, which are deductible under 642(c), reduce DNI, so that the non-charitable beneficiaries will not be taxed on the income distributed to charity. 661(b); 663(a)(2). However, that rule does not apply to tier 1 beneficiaries, who will still be taxed on the income required to be distributed each year, regardless of any charitable distribution. 662(a)(1). See the discussion of the charitable deduction, below, and the discussion of the tier system, also below. Basic Estate Planning and Administration 2014 1 34

Chapter 1 A Fiduciary Income Tax Primer If a trust is required by the terms of the trust to maintain a residence for the use of a beneficiary, the amounts spent by the trust to maintain the residence are not considered to have been distributed to the beneficiary, are not deductible as a distribution, and are not taxed to the beneficiary. Instead, the income used to pay those expenses is taxed to the trust. Commissioner v. Plant, 76 F.2d 8 (2 nd Cir. 1935); PLR 8341005. When drafting such a trust, the better practice (for tax purposes) might be to require distributions to the beneficiary, and then the trust should require the beneficiary to pay the maintenance expenses, in order to avoid the high income tax rates of trusts. 19. Tax-Exempt Income The income carried out to the beneficiaries takes with it the income tax attributes that the income had in the trust or estate. 652(b); 662(b). For example, tax-exempt municipal bond interest earned by an estate or trust and carried out to the beneficiaries is reported by the beneficiaries as tax-exempt income. Similarly, interest distributed to the beneficiaries retains its character as interest, dividends retain their character as dividends, etc. The beneficiaries are deemed to have received each of those items in the same percentage as each of those items bears to the total DNI, unless the trust instrument allocates the different types of income in a different manner. 652(b); 662(b). DNI includes tax-exempt income, but gross income does not. 103; 643(a)(5). However, the distribution deduction does not include tax-exempt income distributed to the beneficiaries. 651(b); 661(c). And as noted above, 652(b) and 662(b) require that the income allocable to the beneficiaries will be deemed to include the same proportion of the tax attributes as was received by the estate or trust. The net effect of these rules can be illustrated by the following examples. Assume a trust has $50,000 of ordinary taxable income and $20,000 of tax-exempt income, for a fiduciary accounting income of $70,000, a gross income of $50,000 and a DNI of $70,000. If that trust distributes $100,000 to its beneficiaries, the trust will have $50,000 of gross income, which is then reduced by a $50,000 distribution deduction. The beneficiaries will then be taxed on $50,000 of ordinary income, but they will not be taxed on the $20,000 of tax-exempt income they received. The same result would have taken place if the trust had distributed only $70,000. If the trust distributes only $60,000, DNI will still be $70,000, but the distribution deduction will be reduced to $42,857, or 85.7% of its level in the previous example (60,000/70,000 =.857). In that event, the beneficiaries will be deemed to have received $42,857 of taxable income and $17,143 of tax-exempt income, for a total taxable and exempt income of $60,000. The trust will then be taxed on the other $7,143 of ordinary income, and will be deemed to have retained $2,857 of tax-exempt income. The net effect of these rules is that if the trustee of this particular trust Basic Estate Planning and Administration 2014 1 35

Chapter 1 A Fiduciary Income Tax Primer wishes to distribute all of the taxable income to the beneficiaries and obtain the benefit of a distribution deduction for all of that distributed taxable income, then the trustee must distribute all of the taxable income and all of the exempt income. 652(b); 662(b). Keep in mind that deductions relating to tax-exempt income must be allocated in whole or in part to the exempt income, and the portion so allocated may not be deducted. 265. For example, a trustee s fee for investment management must be allocated between the taxable investments and the taxexempt investments. 20. Specific Bequests Specific bequests include two types of bequests: a pecuniary bequest of a specific amount of money, and a specific bequest of a particular item of property. A bequest of $1,000 is a specific bequest because it is a pecuniary bequest. A bequest of 100 shares of General Motors stock is also a specific bequest, but it is not a pecuniary bequest. Distributions of specific bequests do not carry out DNI to the recipient beneficiary. 663(a)(1). As a result, the trust or estate will not be entitled to a distribution deduction under 661, nor will the beneficiary be taxed under 662. The logic behind this rule is that such distributions are in the nature of principal, not income. 102. A specific bequest is defined as a gift or bequest of a specific sum of money or of specific property. 663(a)(1). So a bequest of $1,000 or of 100 shares of General Motors stock is clearly a specific bequest. The amount of money or the identity of the specific property must be ascertainable under the will as of the date of death, or ascertainable under the terms of an intervivos trust as of the date of inception of the trust. Reg. 1.663(a)-1(b). A bequest of an amount of money to be calculated by the fiduciary (or of property to be selected by the fiduciary) equal to a stated fraction or percentage of the estate is not considered to be a specific bequest. Reg. 1.663(a)-1(b); Rev. Rul. 60-87, 1960-1 C.B. 286; see PLR 200210002. There is some debate over whether a pecuniary formula (as opposed to a fractional share formula or a percentage share formula) is a specific bequest, but the consensus seems to be that a pecuniary formula bequest is not a specific bequest, and thus it does carry out DNI. Several exceptions apply to this general rule that specific bequests do not carry out income. The following distributions will carry out DNI: Basic Estate Planning and Administration 2014 1 36

Chapter 1 A Fiduciary Income Tax Primer a. If the governing document requires the amount to be paid from income. 663(a)(1). b. If the bequest is a residuary bequest. Reg. 1.663(a)-1(b)(2)(iii). c. If the bequest is required by the governing document to be paid in three or more installments. 663(a)(1). After a distribution is made pursuant to a specific bequest, the basis of the distributed property in the hands of the beneficiary will be determined under either 1014 (property acquired from a decedent, if the bequest was in a will, in a formerly-revocable trust, or in a testamentary trust) or 1015 (property acquired by gift, if the asset was acquired by the trust through an intervivos gift), and the beneficiary will receive the same basis as the trust or estate had in the property immediately before the distribution. 21. In-Kind Distributions An in-kind distribution (a distribution of assets other than cash) raises several questions: a. Does the in-kind distribution carry out DNI to the recipient? If the distribution is made pursuant to a specific bequest (a bequest of a particular item of property, such as 100 shares of stock in General Motors), then the distribution does not carry out DNI. 663(a)(1). Similarly, if a trust distributes securities in satisfaction of a pecuniary bequest (such as a bequest of $1,000), then the distribution does not carry out DNI to the recipient beneficiary. 663(a)(1). In both situations, the trust or estate will not be entitled to a distribution deduction. 663(a)(1). But in other situations, such as a distribution of property in-kind to satisfy a residuary bequest, the distribution will carry out DNI to the beneficiary. 662. b. Will the estate or trust recognize gain or loss as a result of the inkind distribution? The general rule is that the estate or trust does not recognize gain or loss on an in-kind distribution, unless the distribution is being made in satisfaction of an obligation to pay money or an obligation to distribute property other than the property distributed in kind. Reg. 1.661(a)-2; Kenan v. Commissioner, 114 F.2d 217 (2 nd Cir. 1940). Thus gain or loss will be recognized if assets are distributed in-kind to satisfy a pecuniary bequest. Rev. Rul. 66-207, 1966-2 C.B. 243. (That rule applies even if the estate is insufficient to fully fund the pecuniary bequest and the bequest in Basic Estate Planning and Administration 2014 1 37

Chapter 1 A Fiduciary Income Tax Primer effect becomes a residuary bequest. Rev. Rul. 66-207.) Gain or loss is also recognized when an asset is distributed in-kind to a creditor in satisfaction of a debt in the form of a specific dollar amount. First Trust & Deposit Co. v. United States, 58 F.Supp. 162 (N.D.N.Y. 1944); Reg. 1.661(a)-2(f). Gain or loss is also recognized if the trust or estate was obligated or permitted to make an income distribution to the beneficiary (or the trust or estate was obligated to distribute a pecuniary amount, or was obligated to distribute specific property other than that distributed), but the trust or estate chose instead to distribute in-kind assets equal in value to the required distribution. Reg. 1.661(a)-2(f); Rev. Rul. 67-74, 1967-1 C.B. 194; Suisman v. Eaton, 15 F.Supp. 113, 36-2 USTC 9443 (D.Conn. 1935), aff d 83 F.2d 1019 (2 nd Cir. 1936), cert. denied 299 U.S. 573 (1936). For example, if a will requires a $100,000 cash bequest to a beneficiary, and rather than distributing cash to the beneficiary the estate distributes marketable securities with a current value of $100,000 and a basis of $60,000, the estate will recognize a gain of $40,000. Thus the result is the same as if the estate had sold the securities and then distributed the cash to the beneficiary. The same gain would be recognized if the trust distributed appreciated securities to a beneficiary in lieu of distributing income. The same gain would be recognized if the trust distributed appreciated securities to a creditor in satisfaction of a claim. If the trust distributed securities that had decreased in value, then a loss will be recognized. In most cases, however, any resulting loss will be disallowed under the related-party rules of 267, which applies to both trusts and estates. c. If no gain or loss is required to be recognized on an in-kind distribution, may the fiduciary nevertheless elect to recognize gain or loss? Yes, the fiduciary may elect under 643(e)(3) to recognize gain or loss on an in-kind distribution. If the election is made, then the trust or estate will be deemed to have sold the asset at its then fair market value, and the beneficiary will receive the asset with a basis equal to that fair market value. If the election is not made, the beneficiary s basis will be the basis of the asset in the hands of the fiduciary, and that basis will be used to calculate both the distribution deduction and the amount includable in the income of the beneficiary. 643(e). This election does not apply to in-kind distributions made in satisfaction of pecuniary bequests or in-kind distributions made in satisfaction of specific bequests that are made in less than three installments. 643(e)(4); 663(a)(1). The election applies to all eligible in-kind distributions made during the year, not just selected in-kind distributions; the fiduciary cannot pick and Basic Estate Planning and Administration 2014 1 38

Chapter 1 A Fiduciary Income Tax Primer choose. 643(e)(3)(B). This is a complex subject that warrants careful consideration by the fiduciary. The fiduciary will need to weigh the possible recognition of gain by the estate or trust, the availability of a distribution deduction, the income tax consequences to the beneficiary, and the resulting basis in the hands of the beneficiary. For example, the trust or estate might have losses or deductions that can be used to offset the gain resulting from the election. If the estate or trust does not have such losses or deductions, then oftentimes it is best to not make the election, and the beneficiary will receive the asset with a lower carry-over basis. If the beneficiary subsequently dies with the asset in his possession, the gain will be forgiven due to the stepped-up basis rule of 1014(a). d. If the in-kind distribution carries out DNI, what is the value of the in-kind distribution for purposes of calculating the distribution deduction? If gain or loss is recognized on the distribution (due to a 643 election or for the other reasons described above), then the distribution deduction will include the fair market value of the asset. If no gain or loss is recognized, then the distribution deduction will include only the adjusted basis of the asset, the amount taxable to the beneficiary will be that same amount, and the basis of the asset in the hands of the beneficiary will be the same. 643(e). e. What is the income tax basis of the asset in the hands of a beneficiary? The general rule is that the beneficiary will receive the same basis that the asset had in the hands of the estate or trust, except that the basis will be increased by any gain recognized by the estate or trust and decreased by any loss recognized by the estate or trust. In other words, if gain or loss was recognized by the estate or trust on the distribution of the asset, then the basis of the asset in the hands of the beneficiary will be the fair market value of the asset on the date of distribution. Rev. Rul. 67-74, 1967-1 C.B. 194; 1012. If no gain or loss was recognized by the estate or trust on the distribution of the asset, then the basis of the asset in the hands of the beneficiary will be the income tax basis of the asset in the hands of the fiduciary immediately before the distribution. 1014 and 1015. f. Can a simple trust make an in-kind distribution? No, an in-kind distribution causes a simple trust to be reclassified as a complex trust. Rev. Rul. 67-74, 1967-1 C.B. 194. Basic Estate Planning and Administration 2014 1 39

Chapter 1 A Fiduciary Income Tax Primer For a discussion of the income tax consequences of funding the various shares of a tax-planning will or trust, including the funding of pecuniary marital bequests and fractional-share marital bequests, see chapter 17 of Administering Trusts in Oregon (Oregon State Bar, 2007), particularly 17.100 through 17.117. 22. Charitable Deduction Estates and complex trusts (but not simple trusts) may deduct charitable contributions of gross income that are paid or permanently set aside. 642(c). This deduction does not apply to simple trusts, because a simple trust will be reclassified as a complex trust in any year in which it makes charitable contributions, regardless of whether those contributions are from income or principal. 651(a); Reg. 1.651(a)-3(a). The charitable contribution deduction for estates and trusts is more generous than the charitable deduction available for individuals, in four respects: a. Trusts and estates may deduct charitable contributions in any amount of income up to the total amount of gross income (including capital gains), and are not limited to a ceiling of 50% of adjusted gross income. 642(c)(1); Rev. Rul. 78-24, 1978-1 C.B. 196. b. An estate or trust may elect to deduct a charitable contribution made in one year as if it had been paid in the prior year. 642(c)(1). c. A trust or estate may deduct a contribution to a foreign charity. 642(c)(1). d. Estates (but not most trusts) may also deduct those portions of net income that are permanently set aside for charitable purposes, even though that income has not yet been distributed to charity. 642(c)(2). However, a trust may take advantage of this set-aside deduction if the trust has made a 645 election to use a fiscal year as part of the decedent s estate. Reg. 1.645-1(e)(2)(iv), (e)(3)(i). See the discussion of a trust s election to use a fiscal year, above. The ability to elect to treat charitable contributions as if made in the prior year can have significant advantages in the final year of a trust or estate, when the trust or estate is prohibited from passing out charitable deductions as excess deductions. 642(h)(2). In that situation, the fiduciary may elect to treat the charitable contributions made in the final year as if made in the prior year, thus allowing a deduction in the prior year. Basic Estate Planning and Administration 2014 1 40

Chapter 1 A Fiduciary Income Tax Primer To be deductible, the contribution must be made pursuant to the terms of the governing instrument (the will or trust). The governing instrument need not require the contribution; it need only permit it. 642(c). Special substantiation requirements apply to charitable deductions in excess of $250. In general, the estate or trust must obtain (prior to the filing date of the return) a written acknowledgment from the charitable donee, confirming the donation received, the amount of the donation, a description of any property received, whether any goods or services were provided by the donee, and a description of any such goods or services. Property (other than cash or publicly-traded securities) with a value of $5,000 or more requires an appraisal. 170(f)(8); Reg. 1.170A-13(f). The amount deducted must be a portion of gross income (including capital gains and income in respect of a decedent, but not including tax-exempt income), not principal. 642(c); Reg. 1.642(c)(3); Crestar Bank v. Commissioner, 47 F.Supp.2d. 670 (E.D.Va. 1999); Rev. Rul. 2003-123, 2003-50 I.R.B. 1200. Distributions of principal, such as a simple charitable bequest, will usually qualify for an estate tax charitable deduction, but not a fiduciary income tax deduction. 2055; 642(c). For those reasons, charitable contributions need to be traced to their source as either distributions of income or distributions of principal. Mott v. United States, 462 F.2d 512 (Ct. Cl. 1972); Riggs National Bank v. United States, 352 F.2d 812 (Ct. Cl. 1965). (This is one of the few examples of a distribution from a trust or an estate that needs to be traced to the source of the distribution.) As noted above, a charitable deduction is not eligible to be passed out to the beneficiaries as an excess deduction in the final year of the trust or estate. 642(h)(2); O Bryan v. Commissioner, 75 T.C. 304 (1980). See the discussion of the distribution deduction, above, regarding the interplay between the distribution deduction and the charitable deduction. 23. The Sixty-Five Day Rule As a general rule, income retained by an estate or a complex trust is taxed to the estate or trust, and income distributed to the beneficiaries during the taxable year is taxed to the beneficiaries. 662(a). Thus a distribution of current income carries that income out to the beneficiaries, to be taxed to the beneficiaries, and not taxed to the trust or estate. If income is retained by an estate or a complex trust, but distributed in a later year, that later distribution has no income tax significance; it is treated as if it were a distribution of income that was already taxed to the trust or estate in the prior year. (See below for a Basic Estate Planning and Administration 2014 1 41

Chapter 1 A Fiduciary Income Tax Primer different rule for simple trusts.) In effect, it is treated as if it were a distribution of principal. 663(a)(3). (However, if in that later year the trust or estate has undistributed DNI, then a distribution of principal will carry out that undistributed DNI, since the distribution rules do not require any tracing of a distribution to determine whether it came from income or principal. See the tier rules, discussed below.) However, 663(b) permits a significant exception to that rule: If an amount is distributed within sixty-five days following the end of the tax year, and if a 663(b) election is made by checking a box on the Form 1041, then the distribution will be treated as if made on the last day of that preceding tax year. For example, if a calendar year trust earns income in 2013, and a distribution of that amount is made within the first sixty-five days of 2014, and the 663(b) election is made, then the distribution can be deducted on the trust s 2013 return, and that amount will then be taxed to the beneficiaries on their 2013 returns. The purpose of this election is to permit a trust or estate to calculate its taxable income in the first sixty-five days of the following tax year, after the trust or estate has received its Forms 1099 and other tax information for the year. The trust or estate can then distribute the exact amount necessary to carry that income out to the beneficiaries. Without this election, many fiduciaries would need to make an estimate of the trust or estate income, and then distribute that estimated amount to the beneficiaries prior to December 31 in order to carry the income out to the beneficiaries. Although 663(b) distributions must be made within the sixty-five day period, the election is not made until the Form 1041 is filed, either on time or under an extension. The election cannot be made on a late return. Reg. 1.663(b)-2(a). Once made, it is irrevocable after the last day prescribed for making it, but it may be revoked up until that date. Reg. 1.663(b)-2(a). The election is made by checking a box on the Form 1041. The election applies only to that particular tax year; it does not affect subsequent or previous tax years. Reg. 1.663(b)-1(a)(2). Thus, if desired, the election needs to be made each and every year. For calendar-year trusts, the deadline for making the 663(b) distributions is March 6. In leap years, it is March 5. The sixty-five day rule applies only to estates and complex trusts. Simple trusts, which are required to distribute all of their income in the year in which it is earned, are always treated as if that income were distributed currently, regardless of whether the income is actually distributed. 652(a). As a result, making a 663(b) election for a simple trust would have no effect. Basic Estate Planning and Administration 2014 1 42

Chapter 1 A Fiduciary Income Tax Primer The sixty-five day rule applies only to distribution deductions. It does not apply to other deductions, such as administration expenses. 663(b). If a deduction for administration expenses is needed for a particular year, those expenses must actually be paid before the end of the year, and not within the first sixty-five days of the following year. The 663(b) election need not apply to all distributions made within the first sixty-five days of the following year; some distributions may be designated for the election, while other distributions not so designated will not be affected by the election. Reg. 1.663(b)-1(a), (2)(a). Query: Can a 663(b) election be used to terminate a trust or estate? In other words, may a fiduciary distribute all of the assets of a trust or an estate within the first 65 days of a tax year and then treat the trust or estate as having terminated in the previous year, such that the previous year is deemed to be the final year of the trust or estate? The answer is no. Section 663(b)(1) states that the distribution must be made within the first 65 days of any taxable year, and if the effect is to terminate the trust or estate, then the distribution will not have been made within a taxable year. In addition, Reg. 1.663(b)-1(a)(2) limits the election to distributions of income, not principal. 24. Tiers of Distributions and Beneficiaries When the income of a trust or estate is taxed to the beneficiaries, it is taxed on a tier system. Neither the Code nor the regulations utilize the word tier, but that is the common parlance. The first tier consists of the income that is required to be distributed on a current basis, regardless of whether it is actually distributed. 662(a)(1). The second tier consists of other amounts that may be distributed, but are not required to be distributed as part of the first tier. 662(a)(2). For example, the second tier includes discretionary distributions of income, distributions of principal, and distributions of income accumulated from prior years. Broadhead Trust v. Commissioner, T.C. Memo 1972-196. In the case of both the first and second tiers, the amount that is taxable to the beneficiaries is limited to the amount of DNI for the year, and in particular is limited to the taxable portion of DNI. 651(b); 661(c). If the amount of first tier income is less than DNI, and no second tier distribution is made, then the distribution deduction will be limited to the amount of the first tier income. If the amount of first tier income exceeds DNI, the deduction will be limited to the amount of DNI. In that latter case, each beneficiary will be deemed to have Basic Estate Planning and Administration 2014 1 43

Chapter 1 A Fiduciary Income Tax Primer received (and will be taxed on) a portion of the DNI based on that beneficiary s right to receive tier 1 income. For example, if income is required to be distributed 75% to Beneficiary A and 25% to Beneficiary B, then 75% of the DNI will be allocated to Beneficiary A and 25% will be allocated to Beneficiary B. 662(a)(1). Beneficiaries will be deemed to have received second tier income only if DNI exceeds the first tier distributions. 662(a)(2). The purpose of this rule is to give priority to the taxation of first tier income, and to give priority to the taxation of first tier beneficiaries. One of the benefits of this rule is to eliminate the need to trace a particular distribution to its source in order to determine whether the distribution consisted of income or principal. For example, assume Beneficiary A is entitled to receive $10,000 of current income annually, and Beneficiary B may receive discretionary distributions of income or principal. If DNI is $12,000, and each beneficiary receives $10,000, then Beneficiary A will be taxed on $10,000 of tier 1 income and Beneficiary B will be taxed on $2,000 of tier 2 income. The other $8,000 received by Beneficiary B is deemed to be a distribution of principal, which is not taxable to Beneficiary B. The tier system applies not only to types of income, but also to types of beneficiaries. Tier 1 beneficiaries are the recipients of mandatory current income distributions, while tier 2 beneficiaries may receive other distributions. The beneficiaries are taxed on a priority system: DNI is allocated to tier 1 beneficiaries first, and DNI is allocated to tier 2 beneficiaries only to the extent that the DNI is not allocated to tier 1 beneficiaries. Reg. 1.662(a)-3(c). After all of the DNI has been allocated, any distributions in excess of DNI are treated as distributions of principal. In some cases, a beneficiary might be both a tier 1 beneficiary and a tier 2 beneficiary. If the total amount distributed is less than DNI, then the tier system becomes irrelevant; every amount received by a beneficiary carries out DNI and is taxable to the beneficiary, and the portion of DNI not distributed is taxed to the estate or trust, because the distribution deduction will be limited to the amount distributed. 661(a). Simple trusts have only one tier of distributions; all distributions are deemed to be tier 1 distributions, and all beneficiaries are deemed to be tier 1 beneficiaries. Basic Estate Planning and Administration 2014 1 44

Chapter 1 A Fiduciary Income Tax Primer 25. Income in Respect of a Decedent (IRD); Deductions in Respect of a Decedent (DRD) Income in respect of a decedent (also known as IRD) is income that was earned by the decedent, or accrued to the benefit of the decedent, during his lifetime, but it was not actually received by the decedent during his lifetime. 691. IRD is not well-defined in the Code or in the regulations, because the definition is intended to be broad enough to encompass a wide variety of situations. Examples usually include: a. Wages earned during life, but not paid until after death. b. Other forms of deferred compensation not paid until after death. c. Interest accrued during life, but not received until after death. d. Assets held in an Individual Retirement Account (but not a Roth IRA) as of the date of death. e. Assets held in other qualified retirement accounts as of the date of death. f. Gains or losses from assets sold during life, but not received until after death. If the decedent held an annuity, the general rule is that the portion of the proceeds in excess of basis is taxable as ordinary income. 72(a) and (b). If proceeds of an annuity are received after the decedent s death, the taxation of those postmortem proceeds is governed partly by the annuity taxation rules of 72 and partly by the IRD rules of 691(a)(5). See also 691(d)(2)(D) and (E) and the discussion of annuities in the section pertaining to fiduciary accounting income, above. The gross income of a trust or an estate includes any IRD received by the trust or estate, to be reported as taxable income in the tax year in which it is received. 691(a)(1). IRD does not receive a stepped-up basis on the date of death. 1014(c). As a result, one of the duties of a fiduciary is to carefully manage (or postpone) the receipt of IRD. If an estate receives a paycheck resulting from pre-death work performed by the decedent, the estate has no choice but to include that IRD in gross income. But if the estate is the beneficiary of a retirement account (which is usually 100% IRD), the estate has some flexibility Basic Estate Planning and Administration 2014 1 45

Chapter 1 A Fiduciary Income Tax Primer regarding when to withdraw that IRD, and thus the estate has some flexibility to decide when that IRD will be taxed. Section 691 also permits an estate or trust to take certain deductions that accrued during the decedent s lifetime, but could not be claimed on the decedent s individual income tax returns. 691(b). These deductions are known as deductions in respect of a decedent (DRD). For example, business expenses, interest, or taxes that were incurred or accrued during the life of the decedent, but were not paid during his lifetime, would be considered to be deductions in respect of a decedent, if paid by the estate. Not only is IRD included in gross income for income tax purposes, it is also included in the gross estate for estate tax purposes. If an estate is required to include IRD in its gross income for a particular year, then it is entitled in that year to deduct the federal estate tax attributable to that IRD. 691(c). This deduction applies only to that part of the IRD that was not distributed or was not required to be distributed to the beneficiaries during that year. 691(c)(1)(B). If that restriction applies, then the beneficiaries are taxed on the IRD that they received, and they may take the 691(c) deduction. Reg. 1.691(c)-1. But the 691(c) deduction is available to the beneficiary only if the beneficiary itemizes his or her deductions, since the deduction is not listed in 62. Rev. Rul. 78-203, 1978-1 C.B. 199. However, the deduction is not considered to be a miscellaneous itemized deduction. 67(b)(7). The deduction is limited to the federal estate tax paid on items of IRD; no deduction is allowed for state estate taxes or state inheritance taxes. 691(c)(2)(a). If the item of IRD is not taxable in Oregon for purposes of the Oregon income tax, then ORS 316.680(2)(c) denies an Oregon income tax deduction under 691(c) for the federal estate tax paid with respect to that item. See the following section for a discussion of the IRD aspects of retirement accounts. Installment sale proceeds are another common example of IRD. When a taxpayer receives a payment on an installment sale of an asset, the payment is normally reported by the recipient as the receipt of three elements: (1) interest, which is taxable as ordinary income, (2) the portion of principal that represents gain, which is often taxable as capital gain, and (3) the portion of principal that represents a return of basis, which is not taxable. 453; 453A; 453B. The relative portions of principal that represent gain and return of basis are usually calculated by applying the same ratio that the purchase price bears to the gain and the basis. Basic Estate Planning and Administration 2014 1 46

Chapter 1 A Fiduciary Income Tax Primer When an installment obligation is acquired from a decedent seller (as opposed to an installment obligation created by an estate when the estate sells an asset), the portion of each payment that represents gain is treated as IRD. 691(a)(4); Reg. 1.691(a)-5. As with other items of IRD, no step-up in basis takes place on the death of the decedent. 1014(c). Thus payments received by the estate or beneficiary on an installment obligation will continue to be reported by the estate or beneficiary in the same manner that the payments were being reported by the decedent. Reg. 1.691(a)- 5. Thus the gain is not accelerated on the death of the decedent or on the transfer of the obligation to a beneficiary who is entitled to receive it under the will or trust. Instead, the estate or beneficiary will continue to report the gain over time, as the payments are received. Reg. 1.691(a)-5. See below for a different rule if the beneficiary is also the obligor. If the estate or the beneficiary sells the installment obligation or transfers the obligation to a non-beneficiary, the seller must recognize gain as IRD, using the fair market value of the obligation and the decedent s basis in the sold asset, adjusted to reflect the portions of basis that were previously received by the decedent or by his estate. 691(a)(2). The receipt of basis is not considered to be an item of IRD. 691(a)(4). If a decedent bequeaths an installment obligation to the person who is obligated to pay the installment payments, then the estate realizes a gain equal to the amount of gain that had not yet been reported by the decedent. 691(a)(5). The gain is measured by the difference between the fair market value of the obligation and the decedent s remaining basis in the obligation. 691(a)(5). That same result takes place if the decedent discharges the debt at the death of the decedent. 691(a)(5). If the decedent discharges the debt at death, and the decedent and the obligor are related, then the value of the obligation will not be less than its face value. 691(a)(5)(B). In the case of such a discharge or bequest of the debt to the obligor, the estate must recognize the gain no later than the conclusion of the estate administration, unless some act of cancellation occurs prior to that time. PLR 8806048; S. Rep. No. 96-1000, 27 (1980-2 C.B. 494, 508; 1980 WL 356610). However, a residuary bequest that includes the installment obligation does not automatically transfer the obligation to the obligor; instead, the transfer takes place in the tax year during which the obligation is actually transferred to the obligor. PLR 8806048. That result is correct even if state law provides that the assets of the estate vest immediately in the beneficiaries, subject only to the administration of the estate. PLR 8806048. (Oregon law so provides. ORS 114.215(1)(a).) If the cancellation takes place at death, the cancellation is to be treated as if the transfer had been made by the estate of the decedent. S. Rep. No. 96-1000, 27 (1980-2 C.B. 494, 508; 1980 WL 356610). Presumably, that transfer will be deemed to have taken place in the Basic Estate Planning and Administration 2014 1 47

Chapter 1 A Fiduciary Income Tax Primer first tax year of the estate. The Senate Report goes on to state, However, if the obligation were held by a person other than the decedent, such as a trust, the cancellation will be treated as a transfer immediately after the decedent s death by that person. 26. Retirement Accounts The largest and most commonly-encountered forms of income in respect of a decedent (IRD) are retirement accounts. Retirement accounts (except Roth IRAs) are almost always made up of IRD, which is taxable income to an estate, trust, or beneficiary who withdraws assets from a retirement account. In other words, neither a retirement account nor the assets in a retirement account receive a stepped-up basis on the death of the owner of the retirement account. 1014(c). Funds withdrawn from the retirement account are considered to be ordinary income (with some exceptions), to be reported on an income tax return of the recipient in the year of withdrawal. That fact makes retirement accounts very dangerous to deal with, since an inadvertent withdrawal (or an inadvertent closing of the account) can trigger a very large income tax liability. Proceed with caution. Because of the IRD nature of retirement accounts, such assets make ideal candidates for charitable dispositions. If a person holds both regular (after-tax) investments and pre-tax retirement accounts, and that person desires to leave some of his assets to his family and other assets to a charity, the charity should be designated as the beneficiary of the retirement accounts, because the charity is tax-exempt and will not be required to pay income tax when the retirement assets are withdrawn from the retirement account. In contrast, if the retirement account were left to family members, the family members would be required to pay income tax on their withdrawals from the retirement account. The taxation of retirement accounts depends primarily on who the beneficiary is: a. In most cases, the designated beneficiaries of the retirement account will be family members (such as children of the decedent) or the surviving spouse. In those situations, the attorney representing the personal representative or representing the trustee will often be called on by family members to give advice on how to handle the retirement account. If the fiduciary is not also the beneficiary, maintain an awareness of who your client is, and watch for conflicts of interest. Basic Estate Planning and Administration 2014 1 48

Chapter 1 A Fiduciary Income Tax Primer b. In some cases, the beneficiary of the retirement account is the estate or trust, and not an individual family member. If so, the attorney will need to carefully advise the fiduciary about how the actions of the fiduciary will affect the timing of the taxation of the account. c. In some instances, the decedent may have neglected to name a beneficiary for a retirement account. In those instances, the retirement plan document must be reviewed in order to determine the identity of the default beneficiary. Often, the default beneficiary will be the estate of the decedent. Typically, the surviving spouse is the designated beneficiary of most retirement accounts, including IRAs. If the spouse is the beneficiary, the spouse can usually roll the account over into her own name without triggering income tax. 408(d)(3)(C). The income tax will then be postponed until the spouse makes withdrawals. If the estate is the beneficiary of an IRA, the fiduciary must exercise extreme care. If the estate is the beneficiary, the fiduciary should carefully consider methods that might be used to postpone the taxation of that account, keeping in mind that a withdrawal from the account is a taxable event, but the assignment of the account intact is typically not a taxable event. If the account is a small one, then perhaps the simplest answer would be to withdraw all of the assets and pay the tax. But if the account is a large one, the fiduciary should consider assigning the account to the beneficiaries in the form of one or more inherited IRA accounts, without making any actual withdrawals from the IRA. If the decedent had three children, for example, the account can typically be divided into three separate inherited IRAs, one for each of the three children. The three children could then each decide when each of them would like to withdraw funds from their respective separate accounts, and thus each of them can control when they will each be taxed on the withdrawals. This is particularly helpful if the beneficiaries are in different circumstances: One beneficiary might not need the income, and might wish to postpone withdrawals and taxation for as long as possible, while another beneficiary might be in need of income and might be willing to make a withdrawal and pay tax immediately. Before taking action with respect to a retirement account, consider every possible alternative in order to minimize (i.e., postpone) the exposure to income taxation. Typically, the alternatives include the following (in this discussion, a reference to a beneficiary means the beneficiary of the retirement account, not the beneficiary of an estate or trust): 1. Have the beneficiary withdraw all of the assets from the retirement account, which is a taxable event for the beneficiary. This is usually Basic Estate Planning and Administration 2014 1 49

Chapter 1 A Fiduciary Income Tax Primer not the best choice, unless the account is small and the tax consequences minor. 2. If the beneficiary is the surviving spouse, she can roll the account into an IRA in her own name. Note that this does not involve a withdrawal; the assets stay within an IRA. Taxation will not take place until the spouse, as the beneficiary of the rollover IRA, makes a withdrawal from the rollover account. This rollover option is often the best choice for a spouse beneficiary. 3. If the spouse is not the beneficiary (the beneficiaries are the children of the decedent or are non-relatives), the beneficiaries cannot do a rollover, but they can do something similar: they can convert the account into one or more inherited IRAs. Note that this does not involve a withdrawal; the assets stay within the inherited IRAs and are not taxed until withdrawn from one of the inherited IRAs. 4. If the beneficiary is the estate or a trust, the estate or trust may wish to continue to maintain the account as an inherited IRA for the benefit of the estate or trust, but that would require keeping the estate or trust open. In most cases, the estate or trust will prefer to convert the account into one or more inherited IRAs for the benefit of the beneficiaries of the estate or trust. Keep in mind that some retirement plans, or some plan custodians, will not permit a retirement account to be divided into separate inherited accounts for each beneficiary; contact the plan custodian/administrator and review the plan document to determine what is permitted. The primary purpose of the techniques described above is to permit the beneficiary to postpone withdrawals for the longest period of time permitted by the tax laws, although the beneficiary is also free to make withdrawals on a more accelerated basis, if that is what the beneficiary desires. The length of that possible deferral period depends on several factors. Attached to this paper as Appendix B is a summary of the general rules governing those time periods, entitled Retirement Plan Distributions After Death. Exceptions may apply to those general rules. See also, Duffy, Beneficiary Designation: More Prominent Considerations in Today s Estate Tax World, Oregon State Bar Estate Planning and Administration Section Newsletter, Vol. XXX, No. 3, July 2013. Basic Estate Planning and Administration 2014 1 50

27. Separate Share Rule Chapter 1 A Fiduciary Income Tax Primer If multiple trusts are established for the respective benefit of multiple beneficiaries, then each of those trusts will be treated for tax purposes as a separate and different trust, each calculating its own income and deductions and each filing its own income tax return. But if a single trust (or an estate) is designed to benefit multiple beneficiaries and the terms of the trust or will prevent distributions to one beneficiary from affecting the interests of the other beneficiaries, then 663(c) requires the application of the separate share rule. Reg. 1.663(c)-3. The separate share rule is stated very simply in 663(c), with nearly all of the detail provided in regulations. Reg. 1.663(c)-1. If the separate share rule applies, then the result is that each separate share of the trust or estate will calculate its own DNI, separate and apart from the other shares of the trust or estate. 663(c). The rule does not apply for any other purpose. This rule is mandatory; it is not elective. Reg. 1.663(c)-1(d). It does not require or permit the creation of separate trusts, nor does it require or permit the filing of separate tax returns. Reg. 1.663(c)-1(b). Instead, the separate share rule operates within a single trust to ensure that the tax attributes of one separate share held for the benefit of one beneficiary do not affect the taxation of any other share held for the benefit of any other beneficiary. As a result of the separate share rule, if it is applicable, a beneficiary will not be taxed on income distributed to, or accumulated for the benefit of, another beneficiary. Reg. 1.663(c)-1. A separate share is defined as that portion of a trust that is administered as if it were a separate trust. Reg. 1.663(c)-3. For example, if a trust created for the benefit of three beneficiaries requires that distributions to each beneficiary may be made only from the respective share of that particular beneficiary, then the separate share rule will apply. It does not apply if the trust document actually requires the creation and administration of a separate trust for each beneficiary. And it does not apply to trusts where the trustee has the power to sprinkle distributions of income or principal from the entire trust among the various beneficiaries, because distributions to one beneficiary will affect the interests of the other beneficiaries. Reg. 1.663(c)-3(b). A specific bequest that is paid in three or fewer installments is not considered to be a separate share, because it does not carry out DNI. 663(a)(1); Reg. 1.663(c)-4. The separate share rule never applies to a simple trust, because its application is unnecessary; the DNI of any separate shares contained within a simple trust will be allocated to each separate share in any event. Basic Estate Planning and Administration 2014 1 51

Chapter 1 A Fiduciary Income Tax Primer The mechanism used to achieve the goal of the separate share rule is the calculation of separate DNI and a separate distribution deduction for each separate share. Reg. 1.663(c)-2(b). Once those separate distribution deductions are calculated per share, they are then added together to create one distribution deduction for the entire trust. That one combined distribution deduction is then subtracted from the adjusted total income of the trust to determine taxable income, and then the trust files a single income tax return for all of the shares. The separate share rule does not result in separate trusts that file separate returns. The separate share rule can apply to both estates and trusts. 663(c). In 2013, the Oregon legislature enacted a new trust statute, providing that if a trust calls for the creation of separate shares for the benefit of separate beneficiaries, then each of those separate shares will be deemed to be a separate trust for the sole benefit of its beneficiaries, and the trust (or portion of the trust) from which those new trusts were created will be deemed to have terminated to the extent of the new trusts. ORS 130.232 (SB 592, Oregon Laws 2013 ch. 529, 24). Query: As a result of this new legislation, will the separate share rule of 663(c) rarely apply in Oregon? This new statute appears to require separate trusts under the same conditions that the separate share rule would treat the original trust as one trust with separate shares that calculate their own DNI and distribution deduction. If so, then in Oregon such trusts will be treated as separate trusts, and not separate shares, and the separate share rule will not apply. Under this new statute, it is difficult to imagine the terms of an Oregon trust that would become subject to the separate share rule. (ORS 130.232 is under consideration for revision at the 2015 session of the legislature; check the current status of that statute.) 28. Basis Step-up The income tax basis of property acquired by an estate from a decedent is its fair market value on the date of death, 1014(a), or its alternate value on the alternate valuation date if elected under 2032, or its special use value if elected under 2032A. This is known as the basis step-up, although in times of declining values it becomes a basis step-down. 1014(a). The basis step-up generally applies to all assets included in the gross estate by reason of any Code section, not just assets held in the individual name of the decedent. Reg. 1.1014-1(a). One exception: Income in respect of a decedent (IRD) does not receive a basis step-up. See the discussion of IRD, above. Basic Estate Planning and Administration 2014 1 52

Chapter 1 A Fiduciary Income Tax Primer In contrast, the basis of property acquired by gift or by an intervivos transfer into an irrevocable trust remains the same basis that the property had in the hands of the donor or transferor. 1015. This is known as carry-over basis. As a result, the basis of assets held by an estate, a testamentary trust, or a post-mortem revocable trust is the date of death value, or the alternate valuation date value if elected under 2032, or the special use value if elected under 2032A. The same rule applies to other forms of transfers at death. But intervivos transfers do not receive a new basis, unless for some reason the transfer became included in the gross estate of the decedent for estate tax purposes. 1014(b). This is a very important point because in most situations a trust, estate, or beneficiary receiving a decedent s property that appreciated significantly during the decedent s lifetime can sell that asset after death with little or no capital gain realization or recognition. (See the discussion of capital gains and losses, above.) And depreciable assets transferred at death receive a new income tax basis that the estate, trust, or beneficiary may begin depreciating all over again. However, the new income tax basis of depreciable assets transferred at death must be reduced by any depreciation taken by the taxpayer (not the decedent) during the life of the decedent. 1014(b)(9); Reg. 1.1014-6(a)(1); Rev. Rul. 58-130, 1958-1 C.B. 121. 29. State Fiduciary Income Taxes Some states impose their own fiduciary income taxes, in addition to the federal fiduciary income tax, but the rules vary widely from state to state regarding when a state considers a particular trust to be subject to its state fiduciary income tax. The rules applicable to California, Oregon, and Washington are: California - The California fiduciary income tax applies to trusts that have a California resident trustee or a California resident non-contingent beneficiary. (If only one of several trustees is a California resident, then only a proportionate fraction of the income is taxed. The same rule applies if only one of several beneficiaries is a California resident.) The tax also applies to estates if the decedent was a resident of California. Income distributed to the beneficiaries is generally not taxed to the estate or trust; it is taxed to the beneficiaries, as in the federal system. If the beneficiary is a nonresident of California, the beneficiary will not be taxed by the state of California unless the income is California-source income. The initial (lowest) income tax rate is 1% on the first $7,582 of taxable income; the maximum rate is 13.3% on income in excess of $1 million. Cal. Rev. and Tax. Code 17041, 17043, 17742. For a fuller discussion of the Basic Estate Planning and Administration 2014 1 53

Chapter 1 A Fiduciary Income Tax Primer California fiduciary income tax, see Kinyon, Marois, and Johnson, California Income Taxation of Trusts and Estates, ACTEC Law Journal, Vol. 39, No. 1 & 2, 69 (Spring/Fall 2013). See also California Form 541 and its instructions. Oregon - The Oregon fiduciary income tax (reportable on Form 41) applies to both resident Oregon trusts and nonresident trusts, but in different ways. A trust is deemed to be a resident trust if the trust has one Oregon trustee or cotrustee, or the administration of the trust is carried on in Oregon. ORS 316.282(1)(d); OAR 150-316.282(3), (5) ex. 3. Administration is defined as fiduciary decision-making, not incidental execution of decisions made by others. ORS 316.282(3); OAR 150-316.282(5). A resident trust is a trust with a resident fiduciary or if the administration is being carried on in Oregon, even if the trustee is a corporate trustee with headquarters elsewhere. ORS 316.282(1)(d); OAR 150-316.282(5). Nonresident trusts are defined as trusts other than resident trusts. ORS 316.302. The Oregon fiduciary income tax also applies to an estate if the fiduciary was appointed by an Oregon court or the administration of the estate is carried on in Oregon. ORS 316.282(1)(b); OAR 150-316.282(2). A principal probate and an ancillary probate in two different states are considered to be one estate, but if the principal administration takes place in Oregon, all of the income of both estates will be taxed in Oregon. If the principal administration takes place in another state, then the estate will be taxed as a non-resident estate. OAR 150-316.282(2). The calculation of the Oregon fiduciary income tax on resident trusts and estates is made in much the same manner as the Oregon individual income tax, with some exceptions. ORS 316.272; OAR 150-316.282(6). Similarly, Oregon taxes the Oregon-source income of nonresident trusts and nonresident estates as if the trust or estate were a nonresident individual. ORS 316.307(3); ORS 316.312; OAR 150-316.307. The taxable income of an estate or trust is based on federal taxable income, but an Oregon fiduciary adjustment is made. ORS 316.282; ORS 316.287. The initial (lowest) rate of the Oregon fiduciary income tax is 5% on the first $3,250 of taxable income; the maximum rate is 9.9% on income in excess of $125,000. ORS 316.037; ORS 316.282; OAR 150-316.282(3), (4). Under some circumstances, Oregon grants a credit for fiduciary income taxes paid to other states. ORS 316.082 (residents); ORS 316.131 and 316.292 (nonresidents). A nonresident beneficiary of a trust or estate (resident or nonresident) is taxed in the same manner as if the beneficiary had received the income directly, and not through a trust or an estate. OAR 150-316.282(7). As a result, a nonresident beneficiary of a resident Oregon trust will be taxed in Oregon if the income resulted from the ownership or disposition of tangible property (real or personal) in Oregon, or from the operation of a trade or business in Oregon. ORS 316.127; OAR 150-316.127-(D). Basic Estate Planning and Administration 2014 1 54

Chapter 1 A Fiduciary Income Tax Primer Washington Washington has not enacted a fiduciary income tax. In other western states, fiduciary income taxes have been adopted in Idaho (maximum rate 7.4%) Arizona (maximum rate 4.54%) and Hawaii (maximum rate 8.25%). Fiduciary income taxes have not been adopted in Alaska or Nevada. 30. Revocable Trusts and Grantor Trusts A detailed discussion of grantor trusts (including revocable trusts) is beyond the scope of this paper, but here is a brief summary of the basic elements of revocable trusts and grantor trusts. A grantor trust is essentially a trust that a person (usually the grantor or trustor, but not always) has sufficient control over, such that some aspects of the trust are taxed to that person. The most common example is a trust that is treated as a grantor trust for income tax purposes because the grantor has retained certain powers that make the income of the trust taxable to that person for income tax purposes. Other trusts grant the trustor such powers that the trust becomes part of the trustor s gross estate for estate tax purposes, but the term grantor trust is usually used primarily in the income tax context. (See the above discussion of credit shelter trusts for a discussion of whether a typical credit shelter trust is a grantor trust.) Grantor trusts typically fall into two primary categories: First, a revocable living trust is a grantor trust for purposes of both the income tax (during the grantor s life) and the estate tax (at the grantor s death). It is primarily a probate-avoidance tool, and the trustor of a revocable living trust is not intending to achieve any particular income tax advantages or estate tax advantages, although revocable living trusts often create post-mortem trusts that have estate tax advantages for the surviving spouse of the trustor. Several alternative methods are available for reporting the income of a revocable living trust. The most commonly-used method is for the grantor to file an individual income tax return, using the grantor s social security number; that return will report all of the income and capital gains received by the trust or by the grantor. Reg. 1.671-4(b)(2)(i)(A). The same is true for a husband and wife who have a joint revocable trust and file a joint return. Reg. 1.671-4(b)(8). In both cases, no further reporting is needed, but if the grantor is not the trustee then certain specified information must be supplied to the grantor by the trustee. Reg. 1.671-4(b)(2)(ii). See Reg. 1.671-4 for alternative reporting methods. Basic Estate Planning and Administration 2014 1 55

Chapter 1 A Fiduciary Income Tax Primer Second, other grantor trusts are often created that are designed to be grantor trusts for income tax purposes, but not for estate tax purposes. (These trusts are sometimes referred to as intentionally defective grantor trusts, or IDGTs.) These trusts are designed to offer certain income tax advantages during the life of the trustor, but the assets also avoid estate tax on the death of the trustor. For example, a trustor might create a grantor trust during his lifetime, and then sell an appreciated asset to that trust. The income generated by the trust might be payable to the trustor s children, and on the grantor s death the principal of the trust would be distributed to his children or be held in further trust for the benefit of his children. But because the trust is a grantor trust for income tax purposes, the sale of the appreciated asset is not a taxable event, because the trustor has in effect sold the asset to himself. In some cases, the asset is not sold to the trust, but instead is gifted to the trust, and a completed taxable gift will have taken place, because the children received a vested interest in the trust. Following the sale or gift, any income earned by the asset in the hands of the trust is taxed to the trustor, because the trust contains certain provisions that trigger the grantor trust provisions of the Code, such as 673 through 677. However, the income earned by the trust is not payable to the trustor, even though the trustor is taxed on that income for income tax purposes. Such a trust typically contains no provisions that would trigger estate tax on the death of the trustor. In particular, the trust contains no provisions that would trigger the string sections of the estate tax statutes. (Sections 2036 through 2038 are colloquially known as the string sections, because they will result in inclusion in the gross estate of the donor or grantor if the lifetime transfers were made with certain strings attached, such as retention of an income interest, retention of a right to revoke, etc.) Thus a trustor can reduce his taxable estate by transferring assets to a grantor trust, and then further reduce his estate by paying the income tax on the income generated by the grantor trust, all the while excluding the transferred assets (and the income generated by those transferred assets) from his gross estate for estate tax purposes. The payment of the income taxes by the grantor is not considered to be a gift to the trust or to its beneficiaries. To invoke grantor trust status without triggering estate tax on the death of the trustor, the grantor trust must be carefully designed to trigger the income tax grantor trust statutes without triggering the estate tax statutes. To avoid the latter, the trust must not give the trustor the right to receive the income of the trust, or the right to amend, alter, or revoke the trust. 2036 through 2038. To trigger the grantor income tax provisions, the trustor is typically given the power to borrow trust assets without adequate security or adequate interest, or the trustor is given the power to reacquire trust assets and replace them with property of equivalent value. 675(2); 675(4)(C). Or the grantor could give a nonadverse party the power to add a charitable beneficiary. Madorin v. Commissioner, 84 T.C. 667 (1985). Basic Estate Planning and Administration 2014 1 56

Chapter 1 A Fiduciary Income Tax Primer The income, including capital gains, earned by an irrevocable life insurance trust is taxable to the grantor because 677(a)(3) provides that if trust assets may be applied to the payment of premiums on the life of the trustor, or his spouse, then the trust will be treated as a grantor trust for income tax purposes. Basic Estate Planning and Administration 2014 1 57

Chapter 1 A Fiduciary Income Tax Primer Selected Additional Research Materials Acker, Income Taxation of Trusts and Estates, Portfolio 852-3d, Bloomberg Bureau of National Affairs: Tax Management Estates, Gifts and Trusts Portfolios (2010). Acker, Income in Respect of a Decedent, Portfolio 862-3d, Bloomberg Bureau of National Affairs: Tax Management Estates, Gifts and Trusts Portfolios (2010). Zaritsky and Lane, Federal Income Taxation of Estates and Trusts, Warren Gorham, and Lamont (3d ed. 2003). Federal Income Taxes of Decedents, Estates and Trusts, CCH Tax Spotlight Series (23d ed. 2007). Choate, Life and Death Planning for Retirement Benefits, Ataxplan Publications (7 th ed. 2011). Kantor and Miller, eds., Administering Trusts in Oregon, Oregon State Bar, 2007. Appendices Appendix A: Miscellaneous Itemized Deductions of Trusts and Estates Appendix B: Retirement Plan Distributions After Death Basic Estate Planning and Administration 2014 1 58

Chapter 1 A Fiduciary Income Tax Primer Appendix A Miscellaneous Itemized Deductions of Trusts and Estates on Form 1041 under 67(e), Knight v. Commissioner, and Reg. 1.67-4 (TD 9664; 5/8/14) Type of Deduction Fully Deductible Deductible Subject to 2% Floor Trustee Fees and Investment Management Fees Attorney Fees Will and Trust Contests Court fees Fiduciary Accountings and Bond Premiums Appraisal Fees State and Local Taxes Real Estate Management Estate and GST Tax Return Preparation Gift Tax Return Preparation Income Tax Return Preparation Fees attributable to estate or trust administration, including specialized balancing of trust beneficiary interests, allocation of income and principal among beneficiaries, distribution of assets to beneficiaries, pursuit of unusual fiduciary investment objectives, and specialized fees applicable only to trusts and estates. Most attorney fees are fully deductible, because most are not commonly incurred by individuals. All. Most court fees, including most probate court fees and legal publication costs. All, including certified copies of the death certificate. Fully deductible if obtained to determine estate taxes, GST taxes, gift taxes, or to determine distributions. All (not a Miscellaneous Itemized Deduction). 67(b)(2). None, unless the trust or estate is engaged in real estate business. 62. Business expenses are not itemized deductions. 62(a)(1). All. None. Fiduciary income tax returns. Decedent s final income tax return. Fees attributable to investment management or balancing investments between current beneficiaries and remaindermen. Unitary trustee fees that compensate for both trust administration and investment management must be unbundled or allocated between trust administration and investment management, beginning with tax years starting after 5/9/14. Fees not unique to trusts and estates, such as attorney fees expended in defense of claims. None. Fees incurred defending against claims. None. Appraisals obtained for insurance purposes. None. Real estate management fees, insurance, property repairs and maintenance, condo association fees, utilities. None. All. All other income tax returns. Returns for sole proprietorships and retirement plans may be deducted under 162. This summary was prepared by Philip N. Jones of Duffy Kekel LLP. Review the statutes, court opinion, and regulations for application to particular situations. The regulations became final on 5/9/14. Basic Estate Planning and Administration 2014 1 59

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Chapter 1 A Fiduciary Income Tax Primer Appendix B Retirement Plan Distributions After Death Status of Account Death Before Age 70.5 Death After Age 70.5 Individual Designated Beneficiary named No Designated Beneficiary named Surviving Spouse named as beneficiary Beneficiary may withdraw over the beneficiary s single life expectancy table. Beneficiary must complete withdrawals within five years (by the end of the year containing the fifth anniversary of the death). Surviving spouse may roll the account over into an IRA in the surviving spouse s name. Spouse may then defer withdrawals until age 70.5, and may then use her own life expectancy table. Estate is named as beneficiary Estate cannot qualify as a Designated Beneficiary. See No Designated Beneficiary named, above. Trust is named as beneficiary and qualifies as a Designated Beneficiary Marital Trust named as beneficiary, and does not qualify as a Designated Beneficiary Account (but not withdrawals from the account) is used to fund a pecuniary bequest from an estate or trust Decedent had not yet taken an RMD for the year of death Withdrawals may be made over the life expectancy of the oldest beneficiary. Surviving spouse must complete withdrawals within five years (by the end of the year containing the fifth anniversary of the death). IRS contends that IRD income is realized immediately by the estate or trust under 691(a)(2). See CCA 2006-44020. This conclusion is probably incorrect. Not applicable. No RMDs required. Beneficiary may withdraw over the beneficiary s single life expectancy table. Beneficiary must begin withdrawals by the end of the year following death, and may thereafter follow the decedent s remaining life expectancy. Surviving spouse may roll the account over into an IRA in the surviving spouse s name. Spouse may then defer withdrawals until age 70.5, and may then use her own life expectancy table. Estate cannot qualify as a Designated Beneficiary. See No Designated Beneficiary named, above. Withdrawals may be made over the life expectancy of the oldest beneficiary. Surviving spouse must begin withdrawals by the end of the year following death, and may thereafter follow the decedent s remaining life expectancy. IRS contends that IRD income is realized immediately by the estate or trust under 691(a)(2). See CCA 2006-44020. This conclusion is probably incorrect. Beneficiary must timely withdraw the RMD. Compiled by Philip N. Jones and Peter J. Duffy, of Duffy Kekel LLP. Some exceptions apply. See also OSB Estate Planning and Administration Section Newsletter, July 2013. Basic Estate Planning and Administration 2014 1 61

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Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning Katherine VanZanten Cable Huston LLP Portland, Oregon Contents 1. Determining Residency........................................2 1 2. Character of Property......................................... 2 1 3. Small Estate Filings.......................................... 2 2 4. Nonintervention Powers....................................... 2 3 5. Health Directives............................................2 3 6. Dispute Resolution Procedures....................................2 3 7. Washington Real Estate Excise Taxes................................ 2 4 8. Estate Tax Issues............................................ 2 4 9. Estate Tax Rates............................................ 2 4 10. State QTIP Election.......................................... 2 5 11. Farming and Natural Resource Assets................................2 6 12. Statutory Provisions.......................................... 2 7 13. Rule Against Perpetuities.......................................2 7 14. Taxation of Trust Income....................................... 2 7 Sample Health Care Directive........................................ 2 9 Sample Durable Power of Attorney for Health Care........................... 2 13

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Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning 1. Determining Residency a. 458-57-005(3)(o) defines a resident as an individual who is domiciled in Washington at the time of death. There is no specific definition of domicile, but it is generally viewed the same as Oregon s definition. b. ORS 118.010(b) defines a resident decedent as an individual who is domiciled in Oregon at the time of death. Generally domicile is the place where the decedent had his fixed, permanent, principal home. It is generally the place an individual intends to return to after an absence. See OAR 150-316.027(1). 2. Character of Property a. Washington is a community property state. i. All property received by gift or inheritance will remain the individual s separate property if maintained as separate property. If one spouse contributes to the property during marriage, either in cash or in services, the property can become tainted such that a portion may be considered community property. ii. Generally, all compensation earned during marriage is community property and belongs ½ to each spouse. iii. At death, each spouse can devise their separate property and ½ of community property. iv. Spouses can sign a separate property agreement to confirm treatment of property. v. Washington s elective share statute is RCW 11.54.020. b. Oregon is a common law state. i. Oregon courts generally view assets as family assets unless there is a separate property agreement. ii. Under ORS 114.600, effective January 1, 2011, a spouse can elect a share of the augmented estate. The election begins at 5% for marriages of less than 2 years duration and increases by 2% for each additional year of marriage. For a marriage lasting 15 years or longer, it reaches the 33% maximum. iii. The augmented estate is defined in ORS 114.630(1) as the decedent s probate estate, the decedent s nonprobate estate, the surviving spouse s estate, and the decedent s probate and nonprobate transfers to the surviving spouse. Basic Estate Planning and Administration 2014 2 1

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning iv. Spouses can relinquish their elective share rights by an agreement or waiver, entered into before or after the marriage and signed by at least the surviving spouse. Ideally, the waiver will reference the statute. c. Deeds held as husband and wife: 3. Small Estate Filings i. In Washington, the property does not pass automatically to the surviving spouse unless specifically designate. If held only by husband and wife then it is community property and will pass 50% to each spouse s estate. ii. In Oregon, will pass automatically by law. a. Available in Washington if the total value of the decedent's estate does not exceed $100,000, wherever located, less liens and encumbrances. i. Not including the surviving spouse's or surviving domestic partner's community property interest in any assets which are subject to probate ii. An affidavit under this section may not be filed until 40 days after the death of the decedent. iii. Affidavit is available at http://dor.wa.gov/docs/forms/ucp/affidavitofsuccessor_e.pdf b. Available in Oregon if the fair market value of the estate is less than $275,000. i. Not more than $75,000 of the fair market value of the estate can be attributable to personal property; and ii. Not more than $200,000 of the fair market value of the estate can be attributable to real property. iii. An affidavit under this section may not be filed until 30 days after the death of the decedent. c. Transferring vehicles. i. Oregon affidavit of heirs: http://www.odot.state.or.us/forms/dmv/516.pdf ii. Washington affidavit of heirs: http://www.dol.wa.gov/forms/420041.pdf Basic Estate Planning and Administration 2014 2 2

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning 4. Nonintervention Powers a. Allows personal representative to administer the estate without interaction or supervision by the court. b. Estate must be solvent c. Keep in mind notifying beneficiaries. 5. Health Directives a. Washington allows a power of attorney to be appointed for healthcare pursuant to RCW 11.94, but does not require a specific format. b. In Oregon, ORS 127.531 requires statutory form to appoint healthcare representative and mark desires for life support. c. Polst forms are available in both states, and must be completed by the individual and their doctor. 6. Dispute Resolution Procedures a. Washington Trust & Estate Dispute Resolution Act (TEDRA) i. RCW 11.96A.080-.200 ii. Effective for resolving most trust or estate disputes, making clarifying amendments, appointing successor trustees, etc. iii. Can be invoked at any time by fiduciaries, beneficiaries or other interested parties. iv. Binding if signed by all interested parties. v. May be filed in court at election of parties. vi. Virtual representation. b. Oregon Trust Amendments under ORS 130.200 and 130.205 i. With court approval. ii. Effective for amendments for unforeseen circumstances as well as to address issues in an irrevocable trust. iii. Must be consistent with the purpose of the trust. iv. All interested parties my sign. Basic Estate Planning and Administration 2014 2 3

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning v. Not as flexible as Washington. 7. Washington Real Estate Excise Taxes a. Tax affidavit must be filed with every deed that is filed in the state. 8. Estate Tax Issues i. Exemptions available for transfers into a revocable trust. ii. Exemptions also available for transfers to a beneficiary from a trust. iii. If property that has been in farm or special use deferral is removed from such classification, back taxes are required for 7 years, plus a 20% penalty is generally imposed. However, RCW 83.34.108(6)(k) provides an exemption for the sale or transfer of land within 2 years after the death of the owner of at least a 50% interest in the land, if the land has been assessed and valued as classified forest land or agricultural land continuously since 1993. a. Washington b. Oregon i. Currently has a $2 million estate tax exemption. ii. Tied to the definitions of the Internal Revenue Code as of January 1, 2005 iii. Required to file Washington State Estate & Transfer Tax Return for a decedent domiciled in Washington or with property located in Washington if the gross estate exceeds $2 million, or if a federal estate tax return is required. i. Currently has a $1 million estate tax exemption. ii. Tied to the definitions of the Internal Revenue Code as of December 31, 2010. iii. Required to file Form OR706 if the gross estate exceeds $1 million, or if a federal estate tax return is required. c. Gifts are not subject to gift tax in either state. 9. Estate Tax Rates a. Note that Washington is computed after exemptions, and Oregon is computed before exemption and credits. i. 10%-20% Washington Tax Rate Basic Estate Planning and Administration 2014 2 4

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning 10. State QTIP Election ii. 10-16% Oregon Tax Rate a. If the estate of an individual exceeds the amount that can pass tax free under either Oregon or Washington state law, then the personal representative may want to make a separate state QTIP election to defer taxes on the excess until the death of the second spouse. The election is available only if the will or trust creates a trust for the benefit of the surviving spouse. b. Washington special QTIP election is provided under RCW 83.100.047. i. Washington allows only if the trust created for the surviving spouse meets all the requirements for a federal QTIP election. It must provide that all income is distributed at least annually to the surviving spouse, and provide that any accrued but undistributed income must be distributed to the estate of the surviving spouse at his or her death. ii. The election is made on the front page of the Washington State Estate Tax Return if a 706 is required. Otherwise, the Washington QTIP is shown on Schedule M. c. Oregon special marital property election under ORS 118.013. i. Oregon allows a special marital election to be made even if the trust or will established for the surviving spouse does not qualify for a federal QTIP election. 1. If the trust qualifies for a federal QTIP election, then it also will qualify for Oregon. 2. If the trust is not required to distribute income annually to the spouse, or allows distributions to heirs other than the spouse, then the personal representative and family of the decedent may consent to establishing the Oregon Special Marital Property by signing and filing Schedule OSMP. a. Spouse and beneficiaries must all agree to the change b. Election is irrevocable c. Court appointed guardian or custodial parent may sign for underage or unborn beneficiaries ii. The Oregon election is made by filing an Oregon Only Schedule M on which a special QTIP election is made. Basic Estate Planning and Administration 2014 2 5

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning 11. Farming and Natural Resource Assets a. RCW 83.100.046 Farming Deduction: i. Allows a deduction for the value of qualified real property and qualified tangible personal property used primarily for farming purposes. Washington Administrative Code (WAC) 458-57-155. The definition of "farming" is quite broad and includes the raising or harvesting of agricultural or horticultural commodities; the raising, shearing, feeding, caring for, training, and management of animals on a farm; and the planting, cultivating, caring for, or cutting of trees. ii. Available only if a citizen or resident of the United States; iii. 50% or more of the estate's adjusted value must be in agricultural real and personal property; iv. On the date of the decedent's death the real and personal property must have been used for a qualified farming use by the decedent or a member of the decedent's family; v. The real and personal property must pass from the decedent to a qualified heir; and vi. 25% or more of the estate consists of agricultural real property that was actively managed by the decedent or the decedent's family. b. Oregon Natural Resource Credit ORS 118.140. i. Types of property: real and personal property used if farming, timber, fishing businesses or crops. ii. Threshold: 1. Gross estate less than $15 million 2. Natural resource property is at least 50% 3. Property passes to a family member 4. For 5/8 years before death, property used for farm or forest use by decedent and/or decedent s family iii. Can elect to take all or part of the credit Basic Estate Planning and Administration 2014 2 6

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning 12. Statutory Provisions a. RCW Chapter 83.100 i. Kari Kenall is head of the Washington Estate Tax Section. Phone: (360) 570-3265 option 2; or estates@dor.wa.gov b. ORS Chapter 118. i. estate.help.dor@state.or.us Phone: 503-378-4988 Phone: 800-356-4222 13. Rule Against Perpetuities a. Washington allows trusts to last 150 years following the effective date of the instrument creating the trust. b. Oregon trusts must vest or terminate no later than 21 years after the death of an individual living at the time the trust is created, or if later, 90 years after its creation. 14. Taxation of Trust Income a. Washington does not impose a tax on a trust that is administered in the state of Washington. b. Oregon imposes income taxes on income of a trust which is not distributed to a beneficiary. Capital gains are also usually subject to Oregon income tax. c. Oregon taxes any trust which is administered in Oregon or which has an Oregon Trustee. (ORS 316.307). OAR 150-316.282 provides that a trust is a nonresident only if there is no Oregon resident trustee and the administration is not carried on in Oregon. Basic Estate Planning and Administration 2014 2 7

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Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning HEALTH CARE DIRECTIVE This Directive is made on this day of,. I,, having the capacity to make health care decisions, willfully and voluntarily make known my desire that my dying shall not be artificially prolonged under the circumstances set forth below, and do hereby declare that: A. If at any time I should be diagnosed in writing to be in a terminal condition, or in a permanent unconscious condition by two (2) qualified physicians regularly attending me, or two (2) licensed physicians under whose care I am at the time of the determination, or one (1) qualified physician regularly attending me and one (1) licensed physician under whose care I am at the time of the determination, and where the application of life-sustaining treatment would serve only to artificially prolong the process of my dying, I direct that such treatment be withheld or withdrawn, and that I be permitted to die naturally. I understand by using this form that a terminal condition means an incurable and irreversible condition caused by injury, disease, or illness, that would within reasonable medical judgment cause death within a reasonable period of time in accordance with accepted medical standards, and where the application of lifesustaining treatment would serve only to prolong the process of dying. I further understand in using this form that a permanent unconscious condition means an incurable and irreversible condition of which I am medically assessed within reasonable medical judgment as having no reasonable probability of recovery from an irreversible coma or a persistent vegetative state. B. In the absence of my ability to give directions regarding the use of such lifesustaining treatment, it is my intention that this directive shall be honored by my family and physician(s) as the final expression of my legal right to refuse medical or surgical treatment; and I accept the consequences of such refusal. If any person is appointed to make these decisions for me, whether through a durable power of attorney or otherwise, I request that the person be guided by this directive and any other clear expressions of my desires. C. If I am diagnosed to be in a terminal condition or in a permanent unconscious condition (check and initial one): I DO want to have artificially provided nutrition and hydration. I DO NOT want to have artificially provided nutrition and hydration. I DO want to have artificially provided hydration, but I DO NOT want to have artificially provided nutrition. 1 HEALTH CARE DIRECTIVE Basic Estate Planning and Administration 2014 2 9

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning D. I understand the full import of this directive and I am emotionally capable to make the health care decisions contained in this directive. E. I understand that before I sign this directive, I can add to or delete from or otherwise change the wording of this directive and that I may add to or delete from this directive at any time and that any changes shall be consistent with Washington state law or federal constitutional law to be legally valid. F. It is my wish that every part of this directive be fully implemented. If for any reason any part is held invalid, it is my wish that the remainder of my directive be implemented., Declarer Residing at: ATTESTATION OF WITNESSES STATE OF ) ) ss. COUNTY OF ) of Each of the undersigned, being first duly sworn on oath, states that on the, : day 1. ("Declarer"), has been and is personally known to me, and I believe her to be capable of making health care decisions: 2. I am not (a) related to Declarer by blood, marriage or adoption; (b) entitled to any portion of Declarer's estate upon Declarer's death under any Will or Codicil of Declarer or by operation of law; (c) Declarer's attending physician; (d) an employee of the attending physician or a health facility in which Declarer is a patient; or (e) any person who has a claim against any portion of the estate of Declarer upon Declarer's death; and 2 HEALTH CARE DIRECTIVE Basic Estate Planning and Administration 2014 2 10

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning 3. I believe Declarer to be of sound mind and that Declarer signed the foregoing Health Care Directive willfully and voluntarily. Printed Name: Printed Name: SUBSCRIBED to and SWORN before me on this,. day of NOTARY PUBLIC in and for the State of Oregon My Commission Expires: 3 HEALTH CARE DIRECTIVE Basic Estate Planning and Administration 2014 2 11

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Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning DURABLE POWER OF ATTORNEY FOR HEALTH CARE 1. Designation of Health Care Agent. I,, hereby appoint my, as my Attorney- In-Fact (or "Agent") to make health and personal care decisions for me as authorized in this document. 2. Effective Date and Durability. By signing this document I intend to create a durable power of attorney for health care under chapter 11.94.010 (3) of the Revised Code of Washington. It shall take effect upon my incapacity to make my own health care decisions, shall survive such incapacity or disability and shall continue during that incapacity to the extent permitted by law or until I revoke it. Incapacity, or partial incapacity shall be evidenced by the written statements of two (2) qualified physicians regularly attending me, or two (2) licensed physicians under whose care I am at the time of the determination, or one (1) qualified physician regularly attending me and one (1) licensed physician under whose care I am at the time of the determination. 3. Purpose. I am signing this document in recognition of my fundamental right to control the decisions relating to my medical care; in recognition of my rights to make such decisions subject only to countervailing, compelling state interests; in recognition that those rights belong equally to the competent as well as the incompetent; in recognition that modern medical technology has made possible the prolonging of life and/or postponement of death; and in recognition that such prolonging of life and/or postponement of death may cause loss of dignity and unnecessary pain and suffering while providing nothing medically necessary or beneficial. 4. Powers Regarding Health Care Decisions and Over the Person of the Principal. I grant to my Agent full authority to make decisions for me regarding my health care. In exercising this authority, my Agent shall follow my desires as stated in this document, any Health Care Directive in force, or otherwise known to my Agent. In making any decision, my Agent shall attempt to discuss the proposed decision with me to determine my desires if I am able to communicate in any way. If I am unconscious, comatose, senile, or otherwise unreachable by such communication, my Agent should make the decision guided primarily by my preferences as expressed in this document, any preferences which I may have previously expressed and as expressed in any Health Care Directive, Directive to Physicians, or "Living Will" that I have executed. Accordingly, unless specifically limited below, my Agent shall have the authority to make all the health care decisions to the same extent I could make for myself if I had the capacity to do so, including, without limitation, the following: 4.1 Health Care Decisions; Consent. Consent to giving, withholding or stopping any treatment, service, or procedure to diagnose, maintain, or treat my physical or mental condition; consent to my medical and surgical care and nontreatment, including experimental form of treatment or procedures; consent to the 1 DURABLE GENERAL POWER OF ATTORNEY FOR HEALTH CARE Basic Estate Planning and Administration 2014 2 13

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning withholding or withdrawal of life-sustaining treatment and to make any and all health care decisions on my behalf and to sign forms necessary to carry out health care decisions. 4.2 Employ and Discharge Others. To employ and discharge physicians, psychiatrists, dentists, nurses, therapists, and other professionals as my Agent may deem necessary for my physical, mental and emotional well-being or to advise or assist my Agent in the performance of his or her duties. 4.3 Fees and Costs. To pay reasonable and necessary fees and costs incurred in carrying out the powers and duties under this document, including reasonable reimbursement for the costs advanced by my Agent, from my assets. care. 4.4 Agreement Regarding Care. To enter into any agreement for my 4.5 Arrange For My Care. Arrange for my hospitalization, convalescent care, or home care. I ask my Agent be guided in making such decisions by what I have told my Agent about my personal preferences regarding such care, and by any Health Care Directive that I have executed. 4.6 Right to Refuse Treatment. Summon paramedics or other emergency medical personnel and seek emergency treatment for me, or choose not to do so, as my Agent deems appropriate given my wishes, any Health Care Directive that I may have executed and my medical status at the time of the decision; to sign documents titled or purporting to be a "Refusal to Permit Treatment" and "Leaving Hospital Against Medical Advice," as well as any necessary waivers of or releases from liability required by the hospitals or physicians to implement my wishes regarding medical treatment or nontreatment; request and concur with the writing of a "no-code" (DO NOT RESUSCITATE) order by my attending or treating physician. 4.7 Consent or Refuse Consent to My Psychiatric Care. Upon the execution of a certificate by two (2) independent psychiatrists who have examined me, who are licensed to practice in the state of my residence or a state adjacent to the state of my residence, and in whose opinions I am in immediate need of hospitalization because of mental disorders, alcoholism, or drug abuse, to arrange for my voluntary admission to an appropriate hospital or institution for treatment of the diagnosed problem or disorder; to arrange for private psychiatric and psychological treatment for me; to refuse consent for any such hospitalization, institutionalization and private psychiatric and psychological care, and to revoke, modify, withdraw or change consent to such hospitalization, institutionalization and private treatment which my Agent or I may have given at an earlier time. 4.8 Health Care Records; Medical Information. To have access to all my medical and health care records, and to consent to the disclosure of such records pursuant to the Uniform Health Care Information Act with the same power and authority 2 DURABLE GENERAL POWER OF ATTORNEY FOR HEALTH CARE Basic Estate Planning and Administration 2014 2 14

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning that I would have to authorize such disclosure; to obtain any information whatsoever regarding my personal affairs or physical or mental health from any person, including any physician, hospital, nurse, medical attendant, technician or health care or nursing facility or personnel, and I waive any privilege to such information in favor of my Agent. 4.9 Withdrawal of Consent to Treatment. To revoke or change any consent previously given or implied by law to any medical care or treatment. 4.10 Execute Documents. To sign, execute, deliver and acknowledge such documents in writing of whatever kind and nature as may be necessary or proper in accordance with the powers granted herein, including (but not limited to) granting any waiver or release liability required by any hospital, physician, or other health care provider. 4.11 Provide Me Relief From Pain. To consent to and arrange for the administration of pain-relieving drugs of any type or other surgical or medical procedures calculated to relieve my pain, even though their use might lead to permanent physical damage, addiction, or even hasten the moment of my death. 4.12 Anatomical Gifts. To make anatomical gifts of part or all of my body for medical purposes to living recipients, authorize an autopsy, and direct the disposition of my remains, to the extent permitted by law. In no event shall such gifts or disposition be for research or educational purposes. 4.13 Legal Action. To pursue any legal action in my name, and at the expense of my estate to force compliance with my wishes as determined by my Agent, or to seek damages for the failure to comply. 4.14 Remain in Home. Authorize my Agent to express, on my behalf, my desire to reside in my home whenever possible and if I should be placed in a nursing home, my desire and intent to return to my home from such nursing home, if possible. 5. Constitutional Rights. I intend that the decisions of any health care agent that I have duly appointed be constitutionally protected as if I had made such decision(s) while competent, and hereby grant such powers and constitutionally or otherwise protected rights as I would have if competent. 6. Health Care Directive. My Agent shall take into account and honor my wishes as reflected in any Health Care Directive, Directive to Physicians, or similar "Living Will" executed by me, and shall have the power to interpret my intent as to the meaning of said Directive or "Living Will." 7. Substituted Judgment/Best Interest. In exercising the powers granted in this document, my Agent shall make a substituted judgment for me to do what I would do--if I was competent to make a decision and understood all the circumstances, including my present and future competency--regarding any matter relating to the 3 DURABLE GENERAL POWER OF ATTORNEY FOR HEALTH CARE Basic Estate Planning and Administration 2014 2 15

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning rendering of my medical, health and/or nursing care. But if my Agent is unable to make such a substituted judgment for me on those matters, my Agent shall act according to a good faith determination as to my best interests regarding decisions for my medical, health and/or nursing care. 8. Restriction on Consent. No procedure referred to in RCW 11.92.043(5) which requires court approval before a guardian may consent to it may be performed without court approval. Also, life sustaining treatment may not be withdrawn or withheld from me if I object, notwithstanding any provision to the contrary contained in this document. 9. Reliance; Protection of Third Parties Relying on My Agent. No person who relies in good faith upon any representations by my Agent or any successor Agent shall be liable to me, my estate, my heirs or assigns, for recognizing the Agent's authority. All persons dealing with my acting Agent hereunder shall rely on the apparent authority of the Agent, unless they have actual knowledge of invalidity in the execution or revocation of this document. 10. Nomination of Guardian. It is my intent to avoid the necessity of Guardianship proceedings and the power given to my Agent herein should be broadly construed to accomplish such purpose. If the appointment of a Guardian or Limited Guardian of my person is sought, I nominate my Agent (or his/her successor) named above to serve as Guardian or Limited Guardian of my person. If the designation of guardian hereunder shall conflict with the designation of guardian under any other Power of Attorney executed by me, then the guardian under this Power of Attorney shall control as to guardian of my person. 11. Addition to Medical Record. This document shall be made a part of my permanent medical records upon my admission to a health care facility. 12. Administrative Provisions. 12.1 I revoke any prior Power of Attorney for health care and designations of guardian over my person that I have previously executed. 12.2 This Power of Attorney is intended to be valid in any jurisdiction in which it is presented. The laws of the State of Washington shall govern this Power of Attorney. 12.3 My agent shall not be entitled to compensation for services performed under this Power of Attorney, but he/she shall be entitled to reimbursement, without Court order, for all reasonable expenses incurred as a result of carrying out any provisions of this Power of Attorney. 12.4 In the event any of the provisions herein are deemed to be invalid or unenforceable, such invalid or unenforceable provision(s) are severable and shall not 4 DURABLE GENERAL POWER OF ATTORNEY FOR HEALTH CARE Basic Estate Planning and Administration 2014 2 16

Chapter 2 Watch the Oregon Border: Differences in Washington Estate Planning affect the validity of any other power granted herein or provision of this Power of Attorney. 12.5 Photocopies of this document are as valid as the original. BY SIGNING HERE I INDICATE THAT I UNDERSTAND THE CONTENTS OF THIS DOCUMENT AND THE EFFECT OF THIS GRANT OF POWERS TO MY AGENT. I sign my name to this Durable Power of Attorney for Health Care on this day of,, Principal Residing at: STATE OF ) ) ss: County of ) BE IT REMEMBERED, that on this, the day of,, before me, a Notary Public in and for said county and state, personally appeared known to me to be the identical person described in and who executed the foregoing Durable Power of Attorney for Health Care and acknowledged to me that she executed the same freely and voluntarily and for the uses and purposes therein mentioned. IN TESTIMONY WHEREOF, I have hereunto set my hand and affixed my official seal on this, the day and year last herein-above written. NOTARY PUBLIC FOR My commission expires: 5 DURABLE GENERAL POWER OF ATTORNEY FOR HEALTH CARE Basic Estate Planning and Administration 2014 2 17

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Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation 1 Robin Smith Attorney at Law Portland, Oregon Contents I. Overview................................................ 3 1 II. Primary Tax Issues...........................................3 1 A. Federal Estate Tax....................................... 3 1 B. Oregon Estate Tax....................................... 3 1 C. Federal Gift Tax........................................ 3 2 D. Oregon Gift Tax........................................ 3 2 E. The Annual Gift Tax Exclusion................................3 2 F. Federal GST Tax........................................ 3 2 G. Income Taxes.......................................... 3 2 III. Transfer of Property to One Child.................................. 3 3 A. Will the Residence Be an Asset of the Estate?........................3 4 B. Family Concerns........................................ 3 4 C. Transfer on Death Deed....................................3 5 D. Specifically Bequeath Property to the Interested Child.................. 3 7 E. Right to Purchase the Property from the Estate...................... 3 8 IV. Preliminary Considerations When Planning for Vacation Property.............. 3 11 A. Confirm Vacation Use Is Allowed............................. 3 11 B. Financial Feasibility Study................................. 3 11 C. Determining the Potential Family Dynamics of the Plan................ 3 14 V. Factors to Consider in Selecting a Vacation Property Plan................... 3 15 A. Clients Degree of Use.................................... 3 15 B. Potential Tax Consequences................................ 3 16 VI. Tenancy in Common as a Method for Transferring Vacation Property............ 3 17 A. Key Tenancy in Common Rights and Obligations.................... 3 17 B. Tenancy in Common Illustrations............................. 3 18 C. Practical Issues to Consider in Drafting a Tenancy in Common Agreement..... 3 23 VII. Additional Planning Options for Vacation Property....................... 3 30 A. An Irrevocable Trust..................................... 3 31 B. Family Limited Liability Company............................ 3 31 C. Qualified Personal Residence Trust............................ 3 31 Presentation Slides.............................................. 3 33 1 The author would like to thank Eric Wieland, Samuels Yoelin Kantor LLP, for his assistance in preparing this presentation. She also credits the following authors whose articles provided useful background for this presentation: Patrick J. Green, Keeping the Vacation Property in the Family, presented at the Oregon State Bar seminar entitled Hot Topics in Estate Planning, Portland, Oregon, June 9, 2006, and Nancy G. Henderson, Estate and Income Tax Planning for the Passage of Family Homes Using QPRTs Split Interest Purchases, Family LLCs, Dynasty Trusts and Other Strategies, presented at the American Law Institute conference entitled Estate Planning in Depth, Madison, Wisconsin, June 23 28, 2013.

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Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation I. OVERVIEW Most clients own real property primarily a personal residence, but also vacation homes. This real property is often one of the largest assets in the estate. Typically, the clients will want and expect to have the personal residence or vacation home sold after the death of the second spouse with the proceeds divided among the next generation. But there are two particular situations when the typical plan of selling the property and dividing the proceeds will not achieve the client s objectives: 1) When the clients have one child (among multiple children) who would like to inherit the family residence; and 2) When the clients have a vacation home that they would like to pass on to future generations who will share the property. Both of these situations require the estate planner to think outside the box to design a plan that will fit the client s objectives. This outline addresses some of the basic issues to be evaluated in planning for the above situations. Part II provides an overview of the primary tax issues to consider when transferring property to the next generation. Part III covers some planning options for when one child is to receive the property. Part IV discusses the preliminary considerations when the clients begin to consider keeping the vacation home in the family for multiple generations. Part V reviews factors for determining whether the clients should consider a plan that involves lifetime gifts of interests in the property. Part VI discusses the use of tenancy in common arrangements in planning for the vacation home, including issues to consider when drafting a tenancy in common agreement. Part VII of the outline concludes with a summary of a few more advanced options for vacation property planning that can be considered in larger estates. II. PRIMARY TAX ISSUES. A. Federal Estate Tax. The 2014 federal estate exclusion amount is $5,340,000 per individual. 1 This amount is indexed for inflation. With portability, a married couple with an estate of less than $10,680,000 in assets will not be subject to federal estate taxes upon the death of the surviving spouse. The federal estate tax rate is 40%. B. Oregon Estate Tax. The Oregon estate tax exclusion amount remains at $1,000,000 per individual. Oregon does not have portability. If a married couple utilizes both of their exemption amounts, then they can pass a total of $2,000,000 to the next generation (or 1 I.R.C. 2010(c). Basic Estate Planning and Administration 2014 3 1

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation beyond) without incurring an Oregon estate tax. The Oregon Estate Tax rate ranges from 10% to 16%. C. Federal Gift Tax. The 2014 federal gift tax exclusion amount is $5,340,000 per individual. 2 This amount is indexed for inflation. Together a couple can gift a total of $10,680,000 in assets during their lifetimes and not be subject to federal gift taxes. The federal gift tax rate is rate is 40%. Gift taxes paid by the decedent within three years of death are included in the decedent s gross estate. 3 Lifetime gifts will reduce the donor s available federal estate tax value dollar for dollar. In this outline, to capture the relationship between the federal gift and estate tax exemption amounts I refer to them jointly as the combined federal gift and estate tax exclusion amount. D. Oregon Gift Tax. There is no Oregon gift tax. E. The Annual Gift Tax Exclusion. The 2014 annual exclusion amount is $14,000 per individual. This amount is indexed for inflation. Together a couple can gift a total of $28,000 per year to any one individual. The annual gift tax exclusion amount applies only to gifts of present interests in property. 4 F. Federal GST Tax. The federal generation-skipping transfer tax ( GST tax ) is a tax that is imposed on the transfer of assets made to skip persons (defined as individuals who are, or are deemed to be, two or more generations younger than the transferor). Taxable transfers include: 1) a direct transfer to a skip person; 2) a transfer of assets to a trust in which only skip persons are permissible beneficiaries; and 3) certain trust distributions to skip persons ( taxable distributions ). The tax is also imposed upon the full value of a non-gst exempt trust at such time as there are no longer any non-skip persons who are permissible beneficiaries ( taxable terminations ). In 2014 the GST tax exemption amount is $5,340,000 per individual. 5 This amount is indexed for inflation. The federal GST tax rate is 40%. G. Income Taxes. Transfers of real property may have income tax implications. While an indepth treatment of these income tax issues is outside of the scope of this outline, there are certain income tax issues that deserve particular mention. 1. Capital Asset. Real property is a capital asset. When it has been owned by the transferor for several years, it is likely that the owner s basis in the property will be low and thus the potential for future capital gains will be an important factor to consider. 2 I.R.C. 2505(a). 3 I.R.C. 2035(b). 4 I.R.C. 2503(b). 5 I.R.C. 2631(c). Basic Estate Planning and Administration 2014 3 2

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation 2. Basis for Property Transferred by Gift. The basis of a gift in the hands of the donee will equal the donor s basis in the property. This is commonly referred to as transferred basis. It is worth noting, however, for calculating loss on the transfer of property, the donee s basis will be equal to the lesser of the property s fair market value or the donor s basis in the property. 6 3. Basis for Property Transferred by Death. The basis of property received from a decedent will be equal to its fair market value as of the date of death (or the alternate valuation date). This is commonly referred to a stepped-up basis. 7 4. Principal Residence Gain Exemption. This exemption is $250,000 for individuals and $500,000 for couples. 8 The estate planner should consider the possible impact that any transfer of real property has on the ability for the donor to take this exemption. 5. Federal Capital Gains Tax Rate. The rate varies depending on the transferor s taxable income for the year. For transferors whose taxable income places them in the 10% or 15% tax bracket the capital gains tax rate is 0%. For transferors whose taxable income places them in the 25% to 35% bracket the rate is 15%. For transfers whose income places them in the 39.6% the rate is 20%. 9 6. Medicare Surtax Rate. A surtax of 3.8% is imposed on the net investment income of individuals, trusts and estates. 10 Net investment income includes, but is not limited to, capital gain and rents derived from a trade or business in which the recipient does not materially participate. 11 7. Federal Income Tax Rate. The rate ranges from 10% to 39.6% depending on the individual s taxable income. 8. Oregon Income Tax Rate. The rate ranges from 5%-9.9%, depending on the individual s taxable income. III. TRANSFER OF PROPERTY TO ONE CHILD. As noted above, there are times when a child has an interest in inheriting the parents personal residence. In this case, the estate planner should begin with a discussion of the financial 6 I.R.C. 1015(a). 7 I.R.C. 1014(a). 8 I.R.C. 121(b). 9 See www.irs.gov/taxtopics/tc409.html for a good summary of basic capital gains issues. 10 I.R.C. 1411. 11 I.R.C. 1411(c)(1)(A). Basic Estate Planning and Administration 2014 3 3

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation likelihood that the personal residence will still be an asset of the survivor s estate that can be distributed in kind. Then the estate planner should discuss the potential repercussions on an estate plan when the parents treat one child differently as well as well as some possible options for achieving the clients goal with the least amount of family friction. A. Will The Residence Be An Asset Of The Estate? Many clients assume that their home will be an asset of their estate. However, this is not always a safe assumption to make. The estate planner should discuss the following issues with his or her clients before beginning to plan for real property. 1. Cost of Care. The cost of long term and other medical care can be significant. Healthy clients often do not take the time to consider whether they (or their estate) may need to sell their home to cover these costs. 2. Potential Estate Taxes. Given that a residence is often the largest asset in the estate, if taxes are due will there be enough other assets in the estate to cover the taxes? 3. Cost to Own Property. When a child is interested in inheriting a property the interest is typically directly tied to a particular residence. It is not uncommon for clients to need to move from the home they presently occupy before their deaths. Examples include, when the clients decide to move to a one level home or need to move to a retirement facility. If they do so, will they be able to afford or even want to pay the costs associated with keeping their present home? B. Family Concerns. 1. Mitigating Damage to Relationships. Family dynamics are important to consider in estate planning. Parents often consider this type of plan when one child has provided them with a significant amount of help and support or when a child still lives at home. While the clients may feel that this family member deserves to receive the residence at issue, other family members may not agree with the parents reasoning. This can create friction between the children that continues on for years after the parents are deceased. Fortunately, the potential damage caused by one child receiving the residence can be mitigated in the following ways: a. Offsetting Gifts. If the parents' estate is large enough they can give the children who won t be receiving the property other assets of the estate that are approximately equal to the value of the house. In helping the clients evaluate the benefits of making offsetting gifts the planner should alert the clients to the following issues: Basic Estate Planning and Administration 2014 3 4

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation i. Emotional Inequities. If the other children are also emotionally attached to the residence, then they may not feel that the other assets they are receiving are really equal to the residence. ii. iii. Financial Inequities. In determining whether or not the other assets are approximately equal to the residence, the estate planner should point out the potential income and capital gains taxes that could be owed by the children who receive the other assets. Likewise, some consideration should be given to the amount of capital gains that may be due when the recipient later sells the residence. Life Insurance Policy. If the parents are able to qualify and afford to purchase a life insurance policy this could create additional funds to be used to make offsetting bequests to the other children. b. Potential of Litigation. When one child receives the residence and the others do not receive an offsetting distribution it is more likely for the children who are not receiving the residence to challenge the validity of the document affecting the transfer. C. Transfer on Death Deed. A Transfer on Death Deed ( TODD ) is a type of deed that transfers real property at death of the transferor(s) 12 without probate. Because of the significant disadvantages of using a TODD, they are only likely to be a viable option in limited circumstances. Nevertheless, the practitioner should be familiar with its requirements and limitations. 1. Detailed Statutory Requirements. These are found in Oregon s Uniform Real Property Transfer on Death Act (ORS Chapter 93). a. Capacity. The transferor must satisfy the requirements for executing a valid TODD. These requirements are identical to those required to execute a valid will. 13 b. Statement of Intent. The deed must clearly state that the transfer is to occur at the transferor s death. 14 12 Statute refers to the person creating the TODD as a Transferor. 13 ORS 93.959. 14 ORS 93.961(1)(b). Basic Estate Planning and Administration 2014 3 5

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation c. Named Beneficiary. The deed must name the beneficiary or beneficiaries. 15 It may not designate the beneficiary or beneficiaries as a class. 16 But a person who can be a beneficiary includes a trustee. 17 d. Deed Formalities. The deed must contain the formalities of a regular inter vivos deed 18 except: i. Consideration. A statement of the consideration provided by the beneficiary is not required. 19 ii. Land Use Warning. The land use warnings contained in ORS 93.040 are not required. 20 e. Recorded. The deed must be recorded in the county in which the property is located before the transferor s death. 2. Advantages. a. Low Cost. When appropriate, a TODD can transfer title to the property without the costs of a will or probate. b. No Gift Tax. Because the transfer doesn t take place until the transferor s death, there is no completed gift for federal gift tax purposes. c. Basis Step Up. Because the property will be received from a decedent the beneficiary s basis in the property will stepped up to the date of death value. d. Control. Because the transfer does not take place until the transferor s death, the transferor retains full control over the property. He or she may sell, encumber, or revoke the deed without the consent of the beneficiary. e. Public Assistance. A TODD does not affect the transferor s eligibility for public assistance. 21 15 ORS 93.961(1)(c). 16 ORS 93.961(2). 17 ORS 93.948(4). 18 ORS 93.961(1)(a). 19 ORS 93.030(6). 20 ORS 93.040(6). 21 ORS 93.967(1), (4). Basic Estate Planning and Administration 2014 3 6

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation 3. Disadvantages. a. Revocation by Recorded Deed. Unlike a gift in a will, which can be revoked by a codicil or new will, and a gift in a trust, which can be revoked by an amendment or restatement, a TODD may only be revoked by the transferor (or agent given such authority in the TODD) recording a new deed or instrument that clearly states the TODD has been revoked. 22 b. Named Beneficiaries Only. The beneficiary or beneficiaries must be specifically named in the deed. Gifts to a class such as my children are void. If the desired beneficiary or beneficiaries change the TODD will need to be updated. c. Capacity Challenges. Because a transferor must have capacity to execute a valid TODD, a TODD can be challenged by other family members for fraud, duress, or undue influence for up to 18 months after the transferor s death. 23 d. Extended Claims Period. Creditors of the decedent s estate have up to 18 months from the transferor s death to bring a claim against the TODD property. Therefore, title insurance companies may not be willing to insure a sale by the beneficiary during this 18 month period. D. Specifically Bequeath Property to the Interested Child. Another option to transfer property to one child is for the parents to specifically bequeath the property in their wills or trusts to the interested child and give the residue to the remaining children. 1. Advantages Over TODD. a. Easier to Revoke. Wills and trusts can be more easily amended to cancel the proposed bequest. b. Claims Period. If proper notice procedures are followed, the claims period for both trusts and wills is 4 months as opposed to 18 months. 24 2. Disadvantage Compared to TODD. A specific bequest may cost more in time and money than a TODD. Wills and trusts typically cost more to draft than a TODD, and will also require administration by a personal representative or trustee who will need 22 ORS 93.965. 23 ORS 93.959(3). 24 ORS 115.005, ORS 130.360 (1) Basic Estate Planning and Administration 2014 3 7

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation to record a personal representative s deed or a trustee s deed to transfer the property. E. Right to Purchase the Property from the Estate. Another option that can be much more palatable for the children as a group is to provide terms that allow an interested child to purchase the property from the parents' estate. This can be a particularly good option when there are not enough other assets in the estate to give the other children offsetting gifts. But even when there are enough assets in the estate to make offsetting gifts, this approach can also reduce the appearance of favoritism that could be caused by making a specific bequest of the property to one child. Some factors to discuss with the clients in crafting such a plan include: 1. Purchase Price. How the purchase price is to be determined is probably the most important factor to consider and detail in the wills or trusts. If the parents decide this in advance, it will assist the Personal Representative or Trustee immensely in carrying out the plan. Options include: a. Assessed Value. The plan can provide that the purchase price should be equal to the tax assessed value of the property.. While this may save the cost of an appraisal, the assessed value for tax purposes may not reflect the fair market value. b. Appraisal. The plan could provide that the purchase price will be determined by a certified appraiser. i. Selection of appraiser. There are several options including: A. Parties Mutually Agree. The Personal Representative or Trustee (as long as they are independent from the buyer) and buyer can agree on the selection of an appraiser. If this approach is used and one side of the transaction disagrees, can they hire a second appraiser and an average of the two appraisals used? B. Two Appraisers. Each side of the transaction is entitled to hire an appraiser and then an average of the two appraisals is used. C. Three Appraisers. Each side of the transaction is entitled to hire an appraiser and then a third neutral appraiser is selected by the appraisers. The purchase price is then the average of the three appraisals. Basic Estate Planning and Administration 2014 3 8

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation ii. Appraisal Fees. Who will pay for the appraisal? A. One Appraiser. If agreed upon by both parties the costs can be split between the estate or trust on the one hand, and the buyer on the other. Or either side can cover the costs. B. Two Appraisers. If two appraisers are used, then each side can pay the cost of its appraisal. C. Three Appraisers. If three appraisers are used, then each side can pay the cost of its appraisal and split the costs of the third. 2. Discounts. Should any discounts be applied to the appraisal to come up with the purchase price? a. Advantages. i. More Affordable to Purchaser. The lower the price the more likely that the buyer will be able to afford the purchase. If the parents' primary goal is to make it possible for the child to purchase the property, discounts are preferable. ii. Fairness. There are costs involved when selling real estate. These costs are typically greater when the sale is to a third party. A discount can be designed to take into account costs the estate would otherwise have had if it sold the property to a third party. These can range from 10% to 20% depending on the particular attributes, condition and location of the property and include: A. Realtor commissions. B. Repairs/improvements. To get the best price for a home, a seller may choose to pay for certain repairs and improvements to be done to the property before placing it on the market. For example, these can include: removing and cleaning up a leaking oil tank, roof cleaning, repairing obvious leaks in the plumbing or roof, painting, carpet replacement, and replacing very old or broken appliances. C. Buyer-Requested Repairs. Depending on the market and repair issue, buyers may request repairs. The big ones that nearly every seller addresses in Portland (a hot market right now) are replacing a faulty sewer line and removing a leaking oil tank. Basic Estate Planning and Administration 2014 3 9

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation D. Carrying Costs. The carrying costs are those costs that have to be paid until the house is sold. These include mortgage payments, utilities, taxes, insurance, and maintenance. Sometimes insurance premiums are increased when a home is vacant. It is not unusual to pay a landscaper to keep the yard mowed. b. Disadvantages. If the discount is viewed as excessive by the other family members, it can create significant friction. If the discount is significantly higher than the costs associated with selling the home to a third party, then it can create inequity for those children receiving the remainder of the proceeds after the purchase. 3. Mechanism of Exercising the Right. How does the buyer exercise his or her right? Does it need to be in writing or can it be oral? 4. Time Limits. The time for exercising the right should not be indefinite. The estate will have expenses it must pay, and, if taxes are due, they must be paid within the statutory time limits. Options include: a. Based on Date of Death. For example, notification must be within sixty days from the decedent s date of death and closing must occur within three months from the date of death. b. Based on Appraisal. For example, notification must be within fifteen days of the appraisal and closing within two months of the appraisal. 5. Use of Other Estate Assets. Should the buyer be allowed to credit other assets he or she would be entitled to from the estate against the purchase price? 6. Financing Terms. Will the buyer be allowed to purchase the property in installments? If so, what should the terms of the agreement be? Issues to consider include, interest rate, term, how much of a down payment will be required, and whether payments can be of interest only with a balloon payment at the end of the term. Tip: make certain that the interest charged will comply with the minimum rate that a family member must be charged to prevent the loan from being treated as a gift. 25 25 I.R.C. 7872(e) and (f). Basic Estate Planning and Administration 2014 3 10

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation IV. PRELIMINARY CONSIDERATIONS WHEN PLANNING FOR VACATION PROPERTY. Vacation homes are unique. There is often great sentimental attachment that can cause families to want to plan to keep them in the family, even if not practical. But to be practical, the recipients need to be able to afford to pay the expenses necessary to maintain the home and they need to be committed to working together to preserve the home for the group and not just themselves. Consequently, the estate planner should first help the clients look beyond their emotions and assess whether the recipients have both the financial resources and family dynamics to succeed in keeping the property in the family. A. Confirm Vacation Use Is Allowed. A title search should be done to check to see if there are any restrictions on the property that would prevent its use by multiple parties. Such restrictions can be found in HOA rules as well as covenants on the deed. B. Financial Feasibility Study. Vacation homes are expensive to maintain. If the recipients can t afford to keep the property they will end up having to sell it thereby defeating the plan altogether. To help the client s assess whether keeping the home in the family is financially possible, the planner needs to work with the clients to gather information about the costs associated with keeping the property as well as the finances of the individual recipients. 1. Cost of Keeping the property. While it is difficult to determine the exact costs of retaining a vacation property, the estate planner can work with the clients to estimate what the future costs could be. To estimate, the planner and clients can start with the existing expenses of the property and then build a schedule that adjusts for inflation on an annual basis. Expenses that should be factored into the equation when applicable to the property include: a. Property Taxes. b. Insurance. Insurance may go up if part of the plan allows for rental of the property to help cover expenses. c. Mortgage payments. Mortgages typically include a due-on-sale clause, which provides that the lender is to be paid upon the transfer of the property to a new owner. However, the Garn-St. Germain Act 26 contains several exceptions that allow a recipient to receive the property and continue paying on the existing loan. Before designing any plan for transferring the property estate planner should review the Garn-St. Germain Act to determine whether one of the exceptions applies and confirm with the lender. 26 Garn-St. Germain Depository Institutions Act of 1982, Pub L. No. 97-320, 95 Stat. 151 (codified at 12 U.S.C.A. 1701j-3). Basic Estate Planning and Administration 2014 3 11

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation d. Maintenance. The type of maintenance expenses will depend on the condition, type of property, and the ability and willingness of the recipients to perform some of the maintenance activities themselves. But rather than assume that the recipients will perform the work themselves, it is better to include these expenses in the budget to consider the worst-case scenario. Typical maintenance costs include: i. Yard care. ii. iii. iv. Cleaning. Gutter and roof cleaning. Repairs. Normal wear and tear results in the need for repairs. It may be possible to purchase a home warranty policy that will cover repair and replacement of basic household appliances and systems. 27 Again, it is better to include these expenses rather than be surprised later. e. Capital improvements. To maintain a property, occasionally large capital improvements must be undertaken. Often owners are not aware of how many years the roof should last or if the sewer is in need of replacing until the problem becomes obvious. A home inspector can be hired to evaluate the condition of the property and project what major improvements are likely to be needed immediately and in the long term. 28 Typical capital expenses that should be considered: i. Painting. ii. iii. iv. Roof Replacement. Deck or Dock Replacement. Replacing Worn Out Heating and Cooling Systems. v. Replacing Broken Appliances. 27 These policies are available for both new and older homes. 28 Home inspections vary in price depending on the size of the home and location of the property. In Portland, the typical price for a home inspection is between $300 and $500. This is money well spent in the long run. As with any service provider, not all inspectors are equally qualified. Tip: qualifications to consider are whether an inspector was formerly a general contractor; membership in an organization such as the National Association of Home Inspectors or the American Society of Home Inspectors; and how many years he or she has been in the business. Basic Estate Planning and Administration 2014 3 12

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation vi. Replacement of worn carpet. f. Replacement of Furniture. This is likely to be relevant only if the property will be shared for multiple generations or the property is occasionally rented. g. Property Manager. If the property is a vacation home there may be times when the house sits empty or could be rented to third parties to help cover the expenses of the property. The property manager can also be in charge of setting the schedule for who gets to use the property when and making sure cleaning and maintenance items are performed. If there is a family member who lives close to the property they may be able to assume this role. However, to determine the worst case scenario carrying costs of the property, it may be worth speaking one or more management companies about what their rates are. Also, if one family member will be assuming this responsibility thought should be given to paying them the fee that would normally be charged by a local property manager. h. HOA Dues. If the property is located in a community with a home owner s association, there may be dues that the future owners will need to pay. i. Other? Every property is unique. Consequently, the above list should not be considered exhaustive. 2. Affordability. Once the budget is determined the planner and clients should discuss whether the recipient or recipients will be able to afford to keep the property. a. Can an Endowment be Created? If there are enough assets in the estate, the clients can consider creating an endowment to cover some if not all of the costs associated with keeping the property. A traditional endowment is an amount of money that is invested to generate income and then the income is used to maintain the property. If there are not enough assets in the estate, the clients may be able to purchase a life insurance policy that can be used to fund an endowment for the property. b. Individual Finances. If a sufficient endowment cannot be created, careful planning may include an open discussion with each of the potential recipients as to whether they can afford to pay their share of the expenses associated with the property. The importance of this cannot be underestimated. If one recipient is significantly better off than the others, he or she may end up paying more than their fair share of the expenses. Such a situation is likely to build resentment and may lead a family squabble of significant proportions. Basic Estate Planning and Administration 2014 3 13

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation C. Determining the Potential Family Dynamics of the Plan. Even if it is financially possible to pass the family or vacation home to the next generation, the plan will not ultimately work if its impact on the family will be divisive. The following factors should be discussed: 1. Do the children get along now? Sometimes parents think that if they leave the vacation property to their children that they will be forced to work out their differences or that the fond memories associated with the house will bring them closer together. However, the practicalities of maintaining the family vacation home will require the children to cooperate and communicate. If the children are frequently in conflict, then even the best designed plan is unlikely to succeed. 2. Do the children want the property? Have the clients asked all of the children whether they are interested in keeping the property? The clients may assume that they do, but not every child may be interested. a. Memories. Sometimes when one child doesn t fit in well with the others or never actually enjoyed the vacation activities associated with the house, they will not have fond memories and have no interest in keeping an interest in the property. b. Distance. A child who lives far from the property may feel it is too much trouble to take full advantage of their share of the home. c. Spouse s Feelings. A child may have a spouse who doesn t like all of the family members or is not interested in using their limited vacation time to use the family home. 3. How do the children view the property? Do some of the children view the vacation property as an investment and will wish to sell the property in the near future while others wish to keep it property for generations to come? If these differing viewpoints are unknown, they can come as a very unpleasant surprise and if the other children cannot afford to purchase the share of the child who wishes to cash out, the property may need to be sold. Fortunately, it is possible to design a plan that will allow a child to sell his or her interest to the others. 4. Family Meeting? To find out the answers to these questions it may be necessary for the clients to call a family meeting to discuss their plan to leave the property to the children. It may even be necessary to interview the potential recipients in private to determine the true family dynamics and if all the parties are genuinely interested in receiving a share in the property. Talking to the potential recipients in private is more likely to result in an accurate picture of the situation since a child may not wish to Basic Estate Planning and Administration 2014 3 14

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation offend the parent or a sibling by admitting his or true feelings about keeping the property or cooperating with their siblings. V. FACTORS TO CONSIDER IN SELECTING A VACATION PROPERTY PLAN. If, after conducting a feasibility study, the clients still wish to proceed with creating a plan to pass the vacation property to the next generation, the next step will be to assess when and how to create that transfer. The property could be transferred in whole or in part while the clients are still living, or the transfer could occur after the death of the surviving spouse. Key factors to consider are the clients intended future use of the property and the potential estate and gift tax implications. A. Clients Degree of Use. 1. Do the clients want to keep using the property on a full-time basis? If so, gifting interests in the property may not be practical because they will have to share use of the property with their children as tenants in common. (As discussed below, all tenants in common have the right to use the property.) Also, if the clients retain a right of possession or enjoyment (including the right to income or the right to designate the persons who would possess or enjoy such property or income) that is in excess of their fractional share of the property, the IRS could attempt to include the entire fair market value of the vacation property in their estate at date of death. 29 2. Do the clients only wish to use the property occasionally? In such a situation, gifting a portion of the property to their children is a practical option. Not only will the children be able to use the property without impinging on their parents enjoyment of the property, they will also be in a position to share in the costs of maintaining the property. 3. Are the clients happy to stop using the property completely? If so, gifting all of the interests in the property to their children will alleviate them of the responsibility of paying to maintain the property. 29 I.R.C. 2036(a). However, if it can be shown that such use only was disproportionate to their ownership interest, then only a proportionate share of the gift will be brought back into the estate. See Estate of Margot Stewart v. Comm r, 106 AFTR 2d 2010-5710 (2 nd Cir. 2010). Court held that a portion of the 49% tenancy in common interest that a decedent had gifted her son was includable in her estate under 2036 because she retained the right to keep all of the rents received from the property as well as continuously occupy the non-rented portion of the property. Basic Estate Planning and Administration 2014 3 15

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation B. Potential Tax Consequences. 1. Do the clients have a nontaxable estate? If the clients do not have a taxable estate, the estate planner should advise them that gifts do not receive a step-up in basis while bequests do. As a result, if the property has appreciated significantly since the clients acquired the property, and they gift the property to their children, the later sale of the property by their children could result in significant capital gains to the recipients. 2. Do the clients have a taxable estate? If the clients have a taxable estate, then lifetime gifting can be a method of reducing or eliminating the estate taxes that will be due on the parents combined estate. Gifting can: a. Reduce Size of Estate. Once the real property is gifted it will no longer be an asset of the estate. b. Appreciation. Gifting real property will also remove any future appreciation related to the gifted property from the estate. c. Leverage Gifts. There are opportunities to leverage the amount of the gift tax exemption by: i. Annual Exclusion. Using the annual exclusion amount to remove property from the estate without reducing the combined gift and estate tax exclusion amount. ii. Gifting Fractional Interests. Gifts are valued at the time the transfer is made. If only a portion of the property is transferred the value of the gift may be reduced to consider such factors as lack of marketability. 3. Real Tax Savings? While gifting can be valuable in a taxable estate for all of the reasons listed above, the estate planner should evaluate the potential estate tax savings versus the potential income tax consequences to the recipients to determine whether the gift will actually end up costing the recipients more in income taxes than the parents save in estate taxes. Example: An elderly individual has an estate worth approximately $2,000,000. He owns a vacation property worth $1,100,000 that he purchased for $100,000. If he does not gift the property and his assets do not dramatically increase, his estate will not owe any federal estate taxes. However, the estate will owe Oregon estate taxes of approximately $101,250. If he were to gift the property he would owe no federal gift taxes because the gift would be within the $5,340,000 federal gift tax exemption Basic Estate Planning and Administration 2014 3 16

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation amount. He would also reduce the value of his estate to $900,000 and the estate would owe no Oregon or federal estate taxes. However, the recipient s basis in the gift would be $100,000. Later, if the recipient were to sell the property for $1,000,000 there would be $900,000 of taxable income. Assuming a combined federal income tax rate of 24.5% there would be income taxes of $220,500 due by the recipient. Thus, for tax purposes the gift will have actually ended up costing the family $119,250. 30 VI. TENANCY IN COMMON AS A METHOD FOR TRANSFERRING VACATION PROPERTY. A tenancy in common is a common law form of concurrent ownership in real property where each party owns a fractional interest in the entire property. It is typically created by deed (but can also result from intestate succession). 31 ORS 93.180 creates a presumption that a deed conveying property to more than one person is intended to create a tenancy in common. 32 Ownership percentages can be equal or unequal. For example, A could own 60% and B could own 40%. A. Key Tenancy in Common Rights and Obligations. 1. Undivided Interest. While each party only owns a fraction of the property, they all have the simultaneous right to use all of the property at all times. The percentage ownership is irrelevant in terms of how much a party gets to use the property so long as no tenant prevents the other tenants from using the property. 33 2. Right to Transfer. A tenant in common owns a fee interest in the property and unless there is an agreement to the contrary, can sell, mortgage, or devise his or her interest without the consent of the other tenants and without impacting their rights. 34 3. No Right of Survivorship. 4. Partition. Tenants in common have a right of partition. A right of partition gives each owner the right to have the property divided into separate shares. First, the court will attempt to physically divide the property into the required shares. If this cannot be accomplished without great prejudice to a party, then the court can sell the property 30 This example is based on the example provided in ADMINISTERING OREGON ESTATES Chapter 14 14.2-2 (OSB Legal Pubs 2012). 31 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.3. 32 Absent language clearly indicating that a survivorship right is intended, ORS 93.180 creates a presumption that a deed conveying property to more than one person is intended to create a tenancy in common rather than a joint tenancy with right of survival. However, when the property is conveyed to a husband and wife, ORS 93.180 creates a presumption that the parties intend to hold the property as tenants by the entirety. 33 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.6. 34 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.5. Basic Estate Planning and Administration 2014 3 17

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation and then divide the proceeds among the owners according to their percentage interests. 35 5. Right to Reimbursement. A tenant has the right to be reimbursed for property taxes, insurance, and repairs that are necessary to the property. 36 6. Equal Division of Rents. Tenants in common are required to share rents received from third parties with the other owners in proportion to their ownership interests. 37 7. Liable for Waste. Tenants in common are liable to one another for waste of the property. Thus, tenants in common are financially responsible for any action that significantly damages the value of the other owners interests in the property. 38 B. Tenancy in Common Illustrations. Scenario 1. Robert and Elizabeth Anderson are in their late 60s. They own a vacation property in Bandon that they use for the month of July and periodic weekends and holidays throughout the year. The Andersons plan to keep using the home as long as they are physically able. They have two children, Bob and Bonnie, who both enjoy using the property and wish to share in the responsibilities of maintaining the cabin. The Andersons combined estate is worth approximately $5,000,000. The property is worth $1,000,000 and the Andersons basis in the property is $800,000. They like the idea of sharing ownership of the property with their children. Robert and Elizabeth have figured out how much it costs to keep the property and Bob and Bonnie have agreed that they can afford to keep the home after their parents pass. 1. Lifetime Gift of Tenancy in Common Interests. a. Option 1. Taxable Gift. The Andersons could elect to make a one-time transfer of half of the property in equal shares to their children as tenants in common. After the gift, the property would be owned 50% by Mr. and Mrs. Anderson, 25% by Bob, and 25% Bonnie. They could also provide in their estate planning documents that Bob and Bonnie would receive their parents remaining interest in the property at the death of their survivor. 35 ORS 105.205. 36 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.7 (citing Palmer v. Protrka, 257 Or. 23, 31, 478 P.2d 185 (1970)). 37 ORS 105.820 and PRINCIPLES OF OREGON REAL ESTATE (Oregon CLE 1995 & Supp 2003) Chapter 2 2.9 38 PRINCIPLES OF OREGON REAL ESTATE (Oregon CLE 1995 & Supp 2003) Chapter 1 1.6 Basic Estate Planning and Administration 2014 3 18

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation i. Advantages. Some advantages to this approach include: A. No Gift Tax. Because the gifts to Bob and Bonnie exceed the Andersons annual gift tax exemption amount they will be taxable gifts. However, the Andersons will not owe any federal gift tax because the value of the gift is well within their combined federal gift and estate tax exemption amount. B. Reduction of Estate. The gift will reduce the value of their Oregon estate and remove any future appreciation on the property from the estate. Assuming: 1) the total value of their assets remains the same, 2) the Oregon estate tax exemption amount and rates remain the same, and 3) the Andersons estate plan is designed to use other assets in utilizing the Oregon exemption amount at the death of the first spouse, the survivor s estate should be worth $3,500,000. They will have saved $55,000 in Oregon estate taxes. C. Partial Step Up In Basis. The portion of the property that is included in the survivor s estate will receive a step up in basis. Again, assuming no appreciation between the time of the gift and the surviving spouse s death, each child s basis in his or her share will be approximately $450,000 ($200,000 for the lifetime portion and $250,000 for the portion received from the survivor s estate). If Bob and Bonnie each agree to sell their 50% share in the property for $500,000, they will have only $50,000 in taxable income from the transfer. Assuming a 24.5% combined federal and Oregon income tax rate they should each owe $12,250 in income taxes. D. One Deed For Gift Portion. E. One Appraisal. If the clients wanted to fix the value of the gifts for federal gift and estate tax purposes, they should consider filing a gift tax return with an appraisal to start the running of the three year statute of limitations on challenges of gift tax returns. 39 However, since Oregon has no gift tax and the parents combined estate will be well within the federal estate tax exclusion amount, the appraisal will not be necessary unless the clients are concerned that the federal estate tax exemption amount will be reduced by future legislation. 39 Treas. Reg. 301.6501(c)-1(f)(2). Basic Estate Planning and Administration 2014 3 19

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation F. Cost. Compared to the other options summarized in Part VII below, creating a tenancy in common and accompanying tenancy in common agreement is generally less costly. G. Test Drive. By creating the tenancy in common during the parents lives the parents can see whether their tenancy in common agreement adequately covers the issues that arise with the property. If not, they can work with their children to amend the document accordingly. When children have an opportunity to have some input into the tenancy in common agreement, it is more likely that the agreement will be effective after the parents deaths. ii. Disadvantages. A. Basis. The portion of the property that Bob and Bonnie received as a gift will not receive a step up in basis at the survivor s death. B. Tenancy in Common Rights. As noted above, the rights of tenants in common are not what one might expect for shared property, for example: 1. Partition. Tenants in common have a right of partition. 2. Undivided Interest. All parties have the simultaneous right to use the property at all times. The percentage ownership is irrelevant in terms of how much a party gets to use the property. Thus, one owner could move into the property and live there full time so long as his or her use did not prevent the other owners from using the property too. 3. Right to Reimbursement. Because a tenant s right to be reimbursed for expenses that he or she covered is limited to property taxes, insurance, and necessary repairs, 40 one owner could end up making improvements without automatically having a right to be reimbursed by the other parties in accordance with their respective ownership shares. 41 40 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.7 (citing Palmer v. Protrka, 257 Or. 23, 31, 478 P.2d 185 (1970)). 41 Id. Basic Estate Planning and Administration 2014 3 20

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation 4. Right to Transfer Ownership. A tenant can convey, devise, or mortgage his or her share of the property without the permission of the other owners. 42 The party who receives such an interest becomes a tenant in common with all of the same rights and obligations. 43 Consequently, tenants in common may find themselves in a situation where one of the other owners is a non family member. 5. Creditors. A fractional ownership interest in a family vacation home may be subject to the claims of the tenant s creditors. 44 6. Divorce. A fractional ownership interest in a family vacation home may be subject to the claims of a tenant s spouse in a divorce. 45 C. Tenancy in Common Agreement Needed. Fortunately, a carefully drafted tenancy in common agreement can waive the right to partition, place limitations on a party s ability to sell or mortgage his interest, and create terms for equitable use and contribution to expenses. The agreement may also require that the tenant give the other tenants in common a right of first refusal to purchase the property. Details of issues to cover in a Tenancy in Common Agreement are discussed in detail later in the outline. b. Option 2. Annual Gift Tax Exemption Amount Gifts. Scenario 1a: The fact pattern in Scenario 1 above remains the same, with the exception that the Andersons combined estate exceeds the federal estate tax exemption amount. In this instance, the clients could take advantage of the annual gift tax exclusion amount by gifting fractional interests to their children as tenants in common that are worth less than the annual exclusion amount to multiple family members. Together, at today s rates, the Anderson s can give a share worth up to $28,000 to each of their children per year, while preserving their combined federal gift and estate tax exemption. 42 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.6 (citing Le Vee v. Le Vee, 93 Or. 370, 382, 181 P. 351 (1919)). 43 PRINCIPLES OF OREGON REAL ESTATE LAW (Oregon CLE 1995 & Supp 2003) Chapter 2 2.10 44 Id. 45 See id. Basic Estate Planning and Administration 2014 3 21

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation iii. Advantages. A. Estate Tax Savings. This plan preserves the combined federal gift and estate tax exclusion amount while decreasing the size of their combined estates. B. Leverage Gifts. The Andersons may be able to leverage the value of their gifts by having fractional discounts applied to the value of each year s share. 46 iv. Disadvantages. Are the same as with a one time gift of interests in the property to create a tenancy in common with the following additional disadvantages: A. Multiple Deeds. One deed will be needed for each year s transfer. B. Multiple Appraisals. If the Andersons wish to make sure that the value of their gifts is respected for federal gift and estate tax purposes, they will need to report the gifts on a gift tax return and submit the required appraisal. For an appraisal to be a qualified appraisal for gift tax purposes, it must be done no earlier than 6 months before the date and no later than the due date for the tax return for the year of the gift, including extensions. 47 2. Creation of Tenancy in Common at Death. Scenario 2: Same facts as Scenario 1 above, however the Andersons don t want to give over any portion of their control over the property at this time. The Andersons decide to leave the vacation property to the children in equal shares at the survivor s death. a. Advantages. i. Basis. The property will be included in the survivor s estate so the children s basis will be stepped-up to fair market value. 46 Traditionally, the IRS has limited discounts to the costs associated with partition. But in some cases, discounts may not be limited to the cost of partition. See Estate of Baird v. Commissioner, T.C. Memo 2001-258, where the court allowed a fractional interest discount of 60% after considering appraisals, which took into account that fractional shares of similar real property sold at like discounts. 47 Treas. Reg. Sec. 1.170A-13(c)(3)(i)(A). Basic Estate Planning and Administration 2014 3 22

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation ii. Control. The Andersons will retain complete control over the property and could change their minds at any time. b. Disadvantages. i. Estate Taxes. There will be no reduction in the surviving spouse s taxable estate. ii. iii. Appreciation. If the property dramatically increases in value the appreciation will be included in the survivor s estate. No Testing the Water. The children do not have a chance to get used to managing the property as a group while their parents are still alive. C. Practical Issues to Consider in Drafting a Tenancy in Common Agreement. 48 No two families or properties are identical. The complexity of the plan will depend on the type of property, how well the family members get along and how long the property is expected to remain in the family. Topics the estate planner should discuss with the clients include: 1. Restrictions. a. Partition. This right can and should be waived in the agreement. b. Mortgages and Assignments. i. Permission. The agreement can provide that the parties cannot assign, mortgage, or otherwise encumber their share of the property without the consent of the other parties. ii. Trigger Sale Clause. The agreement can provide that if a party attempts to transfer such an interest without the other parties consent that it will trigger a required sale to the other parties. 48 See Patrick J. Green, Keeping the Vacation Property in the Family, presented at Oregon State Bar Association conference entitled Hot Topics in Estate Planning, Portland, Oregon, June 9, 2006 for a sample Tenancy in Common Agreement. Basic Estate Planning and Administration 2014 3 23

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation 2. Management. a. Responsibilities. i. Maintenance and Operations. A. Utilities. Who will be the named party for the utilities and make certain that they are paid? B. Maintenance. Who will be in charge of hiring and overseeing contractors to perform regular maintenance and repair? C. Capital Improvements. Who will keep track of the condition of the property and make recommendations as to what capital improvements need to be done and when? ii. Financial. A. Bank Account. Who will maintain and balance the central bank account? B. Billing and Collection of Assessments. Who will keep track of who has paid and who has not? C. Annual Budget. Who prepares a draft of the annual budget? D. Periodic Accountings. Who prepares accountings to show who has paid, how much they have paid, and how the money in the deadicated property bank account is being spent? iii. Scheduling and Record Keeping. A. Scheduling. Who keeps track of who gets to use the vacation property and when? B. Records. When decisions are made by the larger group, who tracks the results of these decisions? b. Decision-Making. In addition to the responsibilities set out above, there are times when decisions will need to be made. How will these decisions be made? Basic Estate Planning and Administration 2014 3 24

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation i. Centralized Management? When there are a number of parties who will be involved, it can make sense to use some form of centralized management structure where one person is (or a small group of people are) responsible for making routine decisions associated with the responsibilities set out above and then major decisions are referred to the group. Options: A. Property Manager. The benefit of this approach is that property managers are experienced with keeping track of the above responsibilities. They are also neutral parties, but this will add to the costs that the parties must pay to maintain the property. B. Single Manager. One party could be in charge of the above responsibilities. However this can end up being quite a bit of work for one person to manage in addition to their regular job. C. Group Management. The responsibilities set out above could be split between several parties. ii. Group Decisions. If centralized management is used, what decisions must be referred to a group vote? Decisions that could be appropriate to refer to the larger group include: A. Hiring/Electing and Firing/Removing Managers. B. Modifications to the Tenancy in Common Agreement. C. Approving the Annual Budget. D. Approving Expenditures over a Certain Dollar Amount. E. Approving a Property Use Fee and Increases to the Fee. F. Mortgaging the Property. G. Selling the Property to a Third Party. iii. Degree of Consensus. How many votes are required to approve a decision? A majority, super majority or unanimous approval? This can vary depending on the decision to be made. It is probably wise to limit the number of decisions that must be unanimous to as small a list as possible. Basic Estate Planning and Administration 2014 3 25

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation 3. Finances. How are the expenses of the property to be paid? a. Feasibility Study. The feasibility study that was prepared to determine if passing the property to the next generation was economically feasible will help to identify the types of expenses that must be considered. b. Endowment? Can an adequate endowment be established? An endowment is typically an account (often held in trust form) that is invested to generate income. Only the income is to be used and the principal is to be maintained. If an endowment is to be created, will it be an investment account or held in trust? Who will be in charge of investing the assets? c. User Fees? If there is no endowment or it is insufficient to cover all of the expenses of the property the agreement can establish a contribution system to cover the expenses. If a contribution system is needed, then how are the amounts to be contributed decided and when are they due? i. Basic Fees. Are there basic fees which are to be shared by all, regardless of how much a party uses the property? For example, basic fees could include property taxes, insurance, mortgage payments and HOA type fees. ii. iii. iv. Capital Contributions. Should a regular amount be contributed towards a reserve or should capital contributions be due when there is an agreed upon capital expenditure to be made? Personal Use Fees. Are there some fees that should be allocated to the parties based on their actual use of the property? For example, utilities, house cleaning service, firewood, or other expenses that will be directly related to a party s use of the property could be charged to that party. Emergency Expenses. Can any party authorize repairs in an emergency? d. Enforcement. What happens when a party doesn t pay his or her fair share of the expenses? i. Suspension of Right to Use. After expenses are outstanding for an X amount of time, the noncomplying party could lose their rights to use the property until the expenses are paid. ii. Interest Charged. The agreement can provide that if a party fails to pay his or her share and another party, advances the funds on their behalf, Basic Estate Planning and Administration 2014 3 26

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation then that advancement will be treated as a loan and the nonpaying party will owe interest, with an interest rate stipulated in the agreement. iii. Require Sale of Share. If after suspension the party still refuses to pay the amount due within X amount of time the sale provisions could be triggered. The portion of unpaid expenses and interests can be calculated into the equation to reduce the price that the purchasing members have to pay. 4. Terms of Use. a. Who Is Entitled to Use the Property? i. Guest Policy. Is use of the property limited to owners and their family members, or are guests permitted? ii. iii. Former Spouses. Can former spouses use the property if they are with their children? Guest Limit. Is there a limit on the number of guests that are allowed at any one time? b. What Condition Must the Property be Left in by the Users? i. Cleaning. Must a professional housekeeper be used at the expense of the user? ii. Belongings. Can personal belongings be stored at the house? If so, can all parties and guests use them? c. Are Pets Allowed? Should pets be restricted to certain areas in case a party (or one of their family members) develops allergies? d. Kitchen? Is the kitchen required to be kosher or vegetarian? 5. Scheduling? Depending on the size of the property, it may not be possible for all parties to use the property at the same time. Even if the property is large enough, the parties may rather not have to share the property. Basic Estate Planning and Administration 2014 3 27

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation a. How Will the Time Be Divided? i. Prime Season. If there is a prime season the system should be designed to equitably divide the time. A. Alternating. If there are only two parties, the prime season can be divided in half and then swapped on a yearly basis. B. Selection. If there are three or more owners, slots can be created and parties can select in order established by: 1. Lottery. Selected each year by lottery. 2. Rotated. Selected once by lottery then order rotated so the first place position one year selects last the next year and the other positions move up. C. Off Season? If there is an off season it may be possible for families to use it on a 1 st come basis by signing up on the family calendar. D. Holidays? 1. Shared. Should all family members be welcome, provided the property is large enough and all family members get along? 2. Rotated. Should they simply be rotated? E. Exchange Program? Should the system selected allow for swapping slots upon mutual agreement? 6. Can the property be rented? Vacation properties can be expensive to keep. Even if there is no mortgage on the property, taxes, and maintenance expenses can add up to thousands of dollars each year. If a party is having trouble paying his or her share of these expenses, then allowing the property to be rented can help the party retain his or her share. But before rental will be permitted under the agreement the following should be considered: a. Insurance. Insurance premiums can increase when a property is rented. Basic Estate Planning and Administration 2014 3 28

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation b. Third-Party Management. Should a property management company be required? c. Legal Fees. There may be legal fees associated with preparing a lease or evicting the tenants if necessary. d. Liability. How can the parties protect themselves from liability should someone be injured while using the premises? If the property is held as tenants in common, the parties will have no liability protection other than that afforded by a comprehensive insurance policy. e. Taxes. If personal use vacation property is used as a rental for more than fifteen days per year, then the rents received will be taxable income and income tax deductions may be available for certain expenses for maintaining the property. 49 7. Buy/Sell Provisions. Eventually a party may want to sell his or her share of the property. To reduce conflicts, the Tenancy in Common Agreement should address how the sales price will be determined and how the right to sell is to be exercised. a. Right to Purchase. Should the parties first have to offer to sell their interest to the remaining family members? b. Sale Price for Family Members. i. Factors. Should the sales price be only based on the value of the property or should consideration be given to funds that the departing party has contributed to an endowment or capital account? ii. iii. Value. How is the value of the property to be determined? See discussion above in Section III E (1) of this outline. Discounts. Should any discount be applied to the value of the property to come up with the final sales price? Discounts can be used to make it easier for the remaining parties to purchase the departing party s interest and thus keep the vacation home in the family. See discussion See discussion above in Section III E (2) of this outline. 49 See I.R.C. 280A. Basic Estate Planning and Administration 2014 3 29

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation c. Right of First Refusal. If the other parties do not elect to purchase the property at the price set under the agreement and the selling party gets an offer from an outside party to purchase his or her interest, should the selling party have to give the remaining parties the right to purchase the property at the price offered by the outside party before selling the interest? i. Time Limits. How long must the selling party give the remaining parties to exercise their right of first refusal before he or she can sell to the outside party? d. Arbitration or Mediation. Should some form of alternative dispute resolution be required in the case of a disagreement between the parties? If so, thought should be given to: i. Type of Dispute Resolution. A. Process. Should the parties be required to start with mediation and then proceed to arbitration? B. Appeal. Under what circumstances can the decision of an arbitrator be appealed? ii. Selection. How is the Arbitrator or Mediator to Be Selected? A. Agreement. Should the parties have to unanimously agree on an arbitrator or mediator? B. Selection. Should the arbitrator or mediator be selected by vote of the parties who are not involved in the dispute? If so, must the vote be unanimous, supermajority or simple majority? iii. Qualifications. Should the mediator or arbitrator be a lawyer or member of a particular association such as the American Arbitration Association? VII. ADDITIONAL PLANNING OPTIONS FOR VACATION PROPERTY. Below are a few other vehicles for transferring vacation property to multiple generations. Because these vehicles tend to be more complicated and more costly to prepare than a tenancy in common agreement, they are typically used in larger estates. Because this presentation is intended to be basic in nature, this outline will only mention them briefly. Basic Estate Planning and Administration 2014 3 30

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation A. An Irrevocable Trust. An irrevocable trust can be created and then the property deeded to the trust. The trust can be created while the clients as still living or as part of a larger estate plan. Like a tenancy in common agreement, a trust can include provisions regarding the maintenance, use, and management of the property. Irrevocable trusts can be particularly well suited for clients who own a vacation property that has already been in the family for multiple generations because in such situations it is highly likely that the beneficiaries will be committed to keeping the property for the use of future generations and will not be frustrated by not being able to cash out their share of the property. They work best when the clients can afford to create an endowment to cover the trust s costs to maintain the property. The terms of the trust need to be carefully considered as it is difficult to modify the terms of an irrevocable trust after the death of the trustor(s). B. Family Limited Liability Company. A Limited Liability Company ( LLC ) is a business entity that is an unincorporated association having one or more members that is organized under the Oregon Limited Liability Company Act ( LLC Act ), ORS chapter 63. 50 LLCs are useful because, like a corporation, they can provide a significant amount of liability protection for its owners (who are called members). However, unlike a corporation, they are not subject to an entity level tax because they are taxed as a partnership. The Operating Agreement can include the terms necessary to govern use, management, and finances. Under this type of plan the clients can form the LLC and contribute the vacation property to the LLC in exchange for 100% of the membership units in the LLC. The clients can then gift interests in the LLC to their children. LLCs are particularly useful in taxable estates because they can be used to leverage gift taxes through the use of minority discounts. They also work well when the clients wish to create a plan that is easily modified and allows the recipients the ability to sell their interests in the vacation property. C. Qualified Personal Residence Trust. 51 A Qualified Personal Residence Trusts ( QPRT ) is a type of irrevocable intervivos trust funded with real property that is a personal residence of the grantor (or grantors). Under the terms of the trust, the grantor retains the exclusive right to use the residence transferred to the trust for a stated term of years. 52 At the end of the QPRT term the property passes to the remainder beneficiaries. 53 It could pass to them in trust or outright to be held as tenants in common or in a business entity such as an LLC. 50 ORS 63.001(17). 51 For an indepth discussion of QPRTs See Nancy G. Henderson, Estate and Income Tax Planning for the Passage of Family Homes Using QPRTs Split Interest Purchases, Family LLCs, Dynasty Trusts and other Strategies, Presented at American Law Institute conference entitled Estate Planning in Depth, Madison, Wisconsin, June 23-28, 2013. 52 I.R.C. 2702(a)(3)(A)(ii). 53 This can be outright or in a continuing trust for the beneficiaries benefit. Basic Estate Planning and Administration 2014 3 31

Chapter 3 Passing the Family Residence or Vacation Property to the Next Generation Because the gift tax value is the actuarial value of the remainder of a beneficiary s interest in the value of the grantor s estate. QPRTs work well when the donor s estate will be subject to estate taxes and when the donor is willing to give up control of the property at the end of the QPRT term. Basic Estate Planning and Administration 2014 3 32

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Chapter 4 Recognizing and Responding to Elder Abuse Erin Olson Law Office of Erin Olson PC Portland, Oregon Contents I. Recognizing Elder Abuse: Suspicious Circumstances....................... 4 1 II. Responding to Elder Abuse: What Can (and Can t) You Do?...................4 3

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Chapter 4 Recognizing and Responding to Elder Abuse I. RECOGNIZING ELDER ABUSE: SUSPICIOUS CIRCUMSTANCES The type of elder abuse an estate planning lawyer is most likely to encounter is undue influence. Perpetrators of undue influence may even seek to retain an estate planning attorney to facilitate their efforts to financially exploit an elderly relative or friend. There is a presumption of undue influence when suspicious circumstances exist in the transfer of property to a person in a confidential relationship with the transferor. Smith v. Ellison, 171 Or App at 294; Knutsen v. Krippendorf, 124 Or. App. 299, 308, 862 P.2d 509 (1993), rev den, 318 Or. 381 (1994). In such circumstances, [t]hat inference alone may be sufficient to establish undue influence. Rea v. Paulson, 131 Or App 743, 747, 887 P.2d 355 (1994); Smith v. Ellison, 171 Or App at 294. "A confidential relationship exists between two persons when one has gained the confidence of the other and purports to act or advise with the other's interests in mind." Smith v. Ellison, 171 Or App at 294 (quoting Knight v. Woolley Logging Co., 278 Or 691, 696, 565 P.2d 748 (1977)). Confidential relationships are not limited to legal fiduciary relationships, but may be a moral, social, domestic or merely a personal relationship. In Re Estate of Manillus Day, 198 Or 518, 530, 257 P.2d 609 (1953) (quoted in Williams v. Overton, 76 Or App 424, 432, 709 P.2d 1115, rev den, 300 Or 563 (1985)). The Oregon Supreme Court has identified several suspicious circumstances that are probative of the existence of undue influence: (1) whether the recipient of the gift participated in arranging or executing the deeds, (2) whether the alleged victim of the influence received independent advice, (3) whether the conveyances were conducted in secrecy and with haste, (4) whether there was a change in the donor's attitude toward Basic Estate Planning and Administration 2014 4 1

Chapter 4 Recognizing and Responding to Elder Abuse others, (5) whether the conveyance deviated from the donor's previous plans for disposing of the property, (6) whether the gift is unnatural and unjust, and finally (7) whether the donor is susceptible to influence. Smith v. Ellison, 171 Or App at 294 (summarizing the factors set forth in Penn v. Barrett, 273 Or 471, 476-480, 541 P.2d 1282 (1975)). The list is not exclusive, and the Oregon Supreme Court has considered the adequacy of consideration exchanged for property transferred in evaluating whether the property was procured by undue influence. Gilliam v. Schoen, 176 Or 356, 363, 157 P.2d 682 (1945). If a confidential relationship exists and suspicious circumstances are shown, then the beneficiary must go forward with the proof and present evidence sufficient to overcome the adverse inference. Ramsey v. Taylor, 166 Or App 241, 262, 999 P.2d 1178 (2000) (internal citations and quotations omitted); McNeely v. Hiatt, 138 Or App 434, 440-41, 909 P.2d 191, adhered to on recon, 142 Or App 522, 920 P.2d 1150 (1996) (once an inference of undue influence is established, the donee bears the burden of producing evidence negating that inference); Gilliam v. Schoen, 176 Or 356, 363, 157 P.2d 682 (1945) (once evidence is presented of a confidential relationship and the existence of suspicious circumstances, it becomes the beneficiary's burden to establish that the donor's transfer or execution was her free and voluntary act, and that the transaction was fair and equitable). Whether a beneficiary or transferee has met his burden of overcoming the presumption of adverse influence created by the combination of a confidential relationship and suspicious circumstances is seemingly determined using the same standard as that suggested by Justice Stewart in explaining how he identified obscenity in Basic Estate Planning and Administration 2014 4 2

Chapter 4 Recognizing and Responding to Elder Abuse film content: "I know it when I see it[.]" 1 Compare McKee v. Stoddard, 98 Or App 514, rev den, 308 Or 660 (1989), Ryan v. Colombo, 77 Or App 71 (1985), and Harris v. Jourdan, 218 Or App 470 (2008), with Briggs v. Lamvik, 242 Or App 132 (2011), Spears v. Dizick, 235 Or App 594 (2010), and Slusarenko v. Slusarenko, 209 Or App 307 (2006). II. RESPONDING TO ELDER ABUSE: WHAT CAN (AND CAN'T) YOU DO? Despite amendments to ORS 124.060 2 that add attorneys to the list of mandatory reporters of elder abuse, an attorney who suspects an estate planning client is being unduly influenced and/or financially exploited by another is constrained by the Oregon Rules of Professional Conduct from disclosing his or her suspicions to others, including Adult Protective Services or law enforcement. The relevant amendments to ORS 124.060 recognize these constraints by excepting mandatory attorney reports if the information for the report was obtained in a privileged communication, and also excepts disclosures prohibited by RPC 1.8(b) 3. Or. Laws 2013 ch. 352 (HB 2205), 6 ("An attorney is not required to make a report under this section by reason of information communicated to the attorney in the course of representing a client if disclosure of the information would be detrimental to the client."). Therefore, generally speaking, an 1 Jacobellis v. Ohio, 378 U.S. 184, 197 (1964) (Stewart, J., concurring). 2 The mandatory reporting obligation created by the amendments goes into effect January 1, 2015. 3 See also RPC 1.6, which prohibits a lawyer from revealing information relating to the representation of a client unless one of three exceptions applies: (1) the client gives informed consent; (2) the disclosure is impliedly authorized in order to carry out the representation; or (3) the disclosure is authorized by one of seven specific exceptions listed in RPC 1.6(b). Within the seven exceptions is a disclosure the lawyer reasonably believes necessary "to comply with other law * * *[.]" RPC 1.6(b)(5). Basic Estate Planning and Administration 2014 4 3

Chapter 4 Recognizing and Responding to Elder Abuse attorney may not report elder financial abuse if they learn of in their representation of a client unless the client authorizes the report. Neither the Oregon Rules of Professional Conduct nor the exceptions to the mandatory reporting law prohibit attorneys from encouraging their clients to report financial exploitation to the authorities themselves, or from assisting clients to make the report themselves. Even if a client does not want to report what amounts to clear financial exploitation to authorities, an estate planning attorney may encourage other actions to contain the financial harm, such as revoking powers of attorney being used as a license to steal by greedy relatives or friends, encouraging the client to consult with honest family members who might step in to assist the elder in taking control of the situation, and creating an estate plan in which the elder's finances are controlled by a capable and honest friend or relative, or even a professional fiduciary. Seeking recovery of the stolen assets through equitable or legal remedies, such as rescission or statutory elder abuse claims, are also possible, although the latter must be reported to the Attorney General within 30 days after the action is commenced. ORS 124.100(6). When notification of officials is permissible and appropriate, the Oregon Department of Human Services has created a single, statewide number for reporting the abuse or neglect of both children and adults: 1-855-503-7233. However, if the situation is exigent, police should be called. Basic Estate Planning and Administration 2014 4 4

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Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law Penny Davis Davis Pagnano McNeil & Vigna LLP Portland, Oregon Contents I. Introduction.............................................. 5 1 A. The Aging Population.....................................5 1 B. Estate Planning Statistics................................... 5 1 II. Planning Ahead for Disability.................................... 5 2 A. Advance Directive for Health Care, ORS 127.505 et seq.................. 5 2 B. Declaration for Mental Health Treatment, ORS 127.700 et seq............... 5 4 C. Physician Orders for Life-Sustaining Treatment (POLST), ORS 127.663 et seq......5 4 D. Financial Power of Attorney, ORS 127.002 et seq...................... 5 5 E. Revocable Living Trusts, ORS 130.001 et seq.........................5 7 III. Long Term Care Considerations................................... 5 9 A. Long Term Care Basics.................................... 5 9 B. Long Term Care and Disability Planning Documents.................. 5 11 IV. Beneficiaries with Government Benefits.............................. 5 11 A. Financially Incapable Beneficiary............................. 5 11 B. Beneficiary Who Receives Government Benefits..................... 5 12 V. Consequences of Common Planning Techniques........................ 5 13 A. Inability to Protect Spouse If Medicaid Assistance Needed............... 5 13 B. Inability to Protect Disabled Son or Daughter If Medicaid Assistance Needed.... 5 14 C. Inheritance Makes Beneficiary Ineligible for Government Benefits Based on Financial Need........................................ 5 14

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Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law I. INTRODUCTION A. The Aging Population 1. The Age Wave. The percentage of older Americans is increasing. 13.7% of the U.S. population is age 65 or older according to the federal Administration on Aging. The first baby boomers turned 65 in 2011. By 2030, when the last baby boomers turn 65, 20% of the population (approximately 72 million people) will be 65 or older. The fastest growing age group is people age 85 and older. As part of the age wave, the 65 population is becoming more racially and ethnically diverse. The LGBT 1 portion of the population is more visible, with same sex couples having won the freedom to marry in 32 states and the District of Columbia as of the date when these materials were prepared. Many of the same sex couples in the first groups to marry are older and been together for years. 2. Chronic Medical Conditions. Figures from the federal Centers for Disease Control and Prevention show that 2/3 of the people over 65 have multiple chronic medical conditions such as heart disease, arthritis, high blood pressure, diabetes, asthma, depression, stroke, and Alzheimer s Disease. Treatment for people over 65 accounts for 66% of the country s health care budget. a. The prevalence of Alzheimer s Disease and other forms of dementia increases as people age. According to projections by the Chicago Health and Aging Project (CHAP) in 2013, 11% of those over 65 and 32% of those over 85 have Alzheimer s Disease. The hallmarks of dementia are a decline in memory plus at least one other cognitive ability. 3. Disability. In 2012, 36% of people over 65 reported having some level of difficulty in hearing, vision, cognition, mobility, self-care, or independent living in the U.S. Census Bureau s American Community Survey. In 2010, 28% reported difficulty performing one or more activities of daily living (ADLs) such as bathing, dressing, eating, and getting around the house. An additional 12% reported difficulty managing money, managing medications, preparing meals, shopping, doing housework, or using a telephone, tasks which are categorized as instrumental activities of daily living (IADLs). B. Estate Planning Statistics 1. 2014 Rocket Lawyer Survey. Surveys done by Harris Poll in 2013 and 2014 for Rocket Lawyer, an online legal document company, found that 64% of American adults did not have a will, including 34% of those over 55. 2. 2009 Lawyers.com Survey. A 2009 Lawyers.com survey found that 51% of American adults had at least one estate planning document, with 35% having wills, 18% having trusts, and 29% having powers of attorney for finances and/or health care. The survey respondents reported that older relatives were more likely to have estate planning documents, with 65% having wills, 38% having trusts, and 58% having powers of attorney for finances and/or health care. 1 Lesbian, gay, bisexual, and transgender Basic Estate Planning and Administration 2014 5 1

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law II. PLANNING AHEAD FOR DISABILITY A. Advance Directive for Health Care, ORS 127.505 et seq 1. Naming a Surrogate Health Care Decision Maker. Authorizing a trusted family member or friend to make health care decisions when the principal is not capable of making and communicating those decisions himself or herself is a key part of estate and disability planning. Counseling the client about choosing a health care representative who will respect and carry out the client s wishes is an important part of the process of preparing an advance directive for health care. a. In the absence of an advance directive for health care, Oregon law does not give the spouse, adult children, or other relatives the power to make health care decisions for an incapable adult with the exception of certain end-of-life decisions described in ORS 127.635(2). b. If an incapacitated adult has not executed an advance directive for health care, a family member or friend or professional fiduciary may need to petition the court pursuant to ORS 125.005 et seq to appoint a guardian who will have the legal authority to make health care decisions. A guardianship may be necessary in some situations in which the principal has executed an advance directive for health care. 2. Requirements for a Valid Advance Directive for Health Care, ORS 127.515 a. The advance directive for health care was created by statute. The form is set out in ORS 127.531 and the requirement for executing it are in ORS 127.515. Oregon recognizes an advance directive (also known as a power of attorney for health care) executed by a resident of another state that complies with that state s laws. ORS 127.515(5). Practice Tip: The US Dept. of Veterans Affairs (VA) does not use the Oregon advance directive form or other state forms. Instead, it has created VA Form 10-0137, the VA Advance Directive Durable Power of Attorney for Health Care and Living Will, available online at http://www.va.gov/vaforms/medical/pdf/vha-10-0137-fill.pdf. A client who gets his or her medical care from VA facilities should be advised to complete the VA form. b. A person over the age of 18 who is not incapable can sign an advance directive for health care to name a health care representative and alternate(s) to make health care decisions in the event that the principal becomes incapable. The health care representative or alternate must accept the appointment in order for it to be effective. The principal may use the advance directive to disqualify one or more people from those decisions. ORS 127.520(3). Example of a Disqualification Provision for Part B, in 1. Limits : I disqualify [insert name of person(s) to be disqualified] from acting as my health care representative. I ask that the court not appoint [insert name of person(s) to be disqualified] as my guardian. If a court determines that I need a guardian, I nominate [insert person named as health care representative] to act as my guardian. c. The principal can use the advance directive form to give health care instructions for the health care representative and providers to follow. The instruction choices in the form relate to end-of-life care. The principal may add instructions in Part C or create an addendum and refer to it in Part C. Some principals add instructions related to treatment that they should or should not receive based on past medical history or on religious beliefs. For example, a Jehovah s Witness might include instructions refusing blood transfusions; a Catholic might Basic Estate Planning and Administration 2014 5 2

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law insert directions that follow the teachings of the Catholic Church related to end-of-life care; an Orthodox Jew might attach a Halactic Living Will based on Jewish law and custom; and a Muslim might add instructions consistent with Shariah law. Example of an Instruction for Part C, in 6. Additional Conditions or Instructions : I have a POLST and I direct my health care representative and health care providers to follow it. Practice Tip: Hard copies and online versions of the advance directive form are available from many sources. The Patient Self-Determination Act, 42 USC 1395cc(f) and 1396a(w), and ORS 127.649 require hospitals, nursing facilities, HMOs, and certain other medical providers to inquire whether a patient has an advance directive and to provide information about advance directives. As a result, many hospitals distribute informational packets and advance directive forms to patients at admission. Some health care providers, including Asante, KaiserPermanente, and Providence, make the forms available online. Oregon Health Decisions, www.oregonhealthdecisions.org, sells information packets in English, Spanish, Russian, and Vietnamese that include the advance directive form. d. Completing an advance directive is voluntary. A health care provider or facility cannot require a patient to have an advance directive as a condition of admission or treatment. 3. Authority of Health Care Representative. a. The health care representative named in the advance directive has the authority to make health care decisions during any period when the attending physician determines that the principal lacks the ability to make and communicate health care decisions. The health care representative has a duty to act consistently with the principal s wishes, if known, and in the principal s best interests if his or her wishes are not known. ORS 127.535. b. The health care representative cannot make decisions about convulsive treatment, psychosurgery, sterilization, or abortion. The legislature amended ORS 127.540 in 2011 to remove admission to or retention in a health care facility for care or treatment of mental illness from the list of decisions that the health care representative is not authorized to make. c. The health care representative does not have the power to make decisions about withholding or withdrawing life-sustaining treatment unless the power is given in Part B of the advance directive and the principal is in one of the four end-of-life situations described in Part C of the advance directive. d. The authority of a health care representative named in a valid advance directive supercedes the authority of a court-appointed guardian. ORS 127.545(6). e. The health care representative for an incapable principal is the principal s personal representative under the Health Insurance Portability and Accountability Act (HIPAA) of 1996, Public Law 104-191, and is entitled to receive the principal s protected health information and review the principal s medical records. 45 CFR 164.502(g); ORS 125.535(7) and 192.556(10)(b). 4. Revocation and Termination. a. A capable principal may revoke an advance directive or a health care decision made by his or her health care representative at any time and in any manner. ORS 127.545. Executing a valid advance directive revokes any prior advance directive. The revocation is effective when the principal communicates it to his or her attending physician, health care provider, or health care representative. Basic Estate Planning and Administration 2014 5 3

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law b. The advance directive is terminated when the principal dies or when it expires by its terms, but it will continue in effect if the principal is incapable at the expiration of the term. ORS 127.510(3). c. The advance directive is suspended if the document names the spouse as the health care representative, a petition for dissolution or annulment is filed, and the principal has not reaffirmed the appointment in writing after the petition was filed. d The court may determine the validity of an advance directive, remove a health care representative, or revoke or suspend an advance directive in response to a petition filed under ORS 127.550 or in a guardianship proceeding filed under ORS chapter 125. B. Declaration for Mental Health Treatment, ORS 127.700 et seq. A person who may need mental health treatment in the future can sign the declaration form set out in ORS 127.736 to name a representative and alternate(s) to make mental health treatment decisions for him or her if the principal becomes incapable of making those decisions. The declaration also can be used to state the principal s wishes regarding mental health treatment. Mental health treatment includes psychoactive medication, convulsive treatment, and admission to and retention in an inpatient facility for mental health treatment not to exceed 17 days. C. Physician Orders for Life-Sustaining Treatment (POLST), ORS 127.663 et seq. Oregon has been a leader in creating a uniform system for recording and communicating physician orders for life-sustaining treatment, including orders regarding resuscitation ( attempt resuscitation/cpr or do not attempt resuscitation/dnr ). The physician, nurse practitioner, or physician s assistant signs the bright pink POLST form after discussing the patient s preferences with the patient or, if the patient is incapable, his or her health care representative, guardian, or other recognized surrogate decision maker. Completing a POLST form is voluntary. There is more information about the POLST form in English and Spanish at www.or.polst.org. 1. POLST Registry. The legislature created a statewide POLST registry under the Oregon Health Authority (OHA) in 2009. The administrative rules for the POLST registry are at OAR 333-270-0010 et seq. a. A physician, nurse practitioner, or physician s assistant who signs or revises a POLST on or after December 3, 2009, has to submit it to the POLST registry unless the patient chooses to opt out. A patients also may submit his or her POLST to the POLST registry. Copies of completed POLST forms are entered into a secure electronic database. The patient retains the original POLST and will receive a packet from the POLST registry with a confirmation letter, a registry ID refrigerator magnet and stickers with the registry ID number. b. First responders, hospital emergency departments, and ICUs who are treating a patient can contact the POLST registry 24 hours a day, seven days a week, to find out whether the patient has a POLST and the POLST orders. Other treating providers can contact the POLST registry as well. c. A more recent POLST revokes a prior POLST. A patient who revokes a POLST in writing can submit the revocation to the POLST registry in order to have the revoked POLST removed from the active records. 2. Limited Role of POLST. The role of the POLST is to document the preferences of a person who has a serious illness or who is frail and to incorporate those preferences in the form of a physician order that can be followed by first responders and other health care Basic Estate Planning and Administration 2014 5 4

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law providers. The POLST does not take the place of an advance directive. It does not address most types of medical treatment and cannot be used to appoint a surrogate decision maker. D. Financial Power of Attorney, ORS 127.002 et seq 1. Naming a Surrogate Financial Decision Maker. Authorizing a trusted family member or friend to assist the principal with paying bills and managing finances and property is a common component of estate and disability planning. Counseling the client about choosing an agent who will manage the client s finances responsibly for the client s benefit is an important part of the process of preparing a financial power of attorney. a. In the absence of a financial power of attorney, Oregon law does not give the spouse, adult children, or other relatives power to manage the finances of a financially incapable adult. b. The financial power of attorney is based on the common law of agency. It is an agreement between the principal and the agent that authorizes the agent to do certain acts, requires the consent of both parties, and creates a fiduciary relationship. See ORS 127.045. The principal can delegate almost any act to the agent, except for acts that public policy dictates can be done only by the principal, like making a will or casting a ballot, and acts that are limited by another agreement to which the principal is a party (for example, if the principal signed a revocable living trust agreement that states that the power to amend the trust agreement is personal and cannot be exercised by an agent acting under a power of attorney). c. If a financially incapable adult has not executed a financial power of attorney or made other arrangements for his or her finances, a family member or friend or professional fiduciary may need to petition the court pursuant to ORS 125.005 et seq to appoint a conservator who will have the legal authority to make financial decisions. The conservator is required to furnish a surety bond to cover the value of the assets and income being managed by the conservator. A conservatorship may be necessary in some situations in which the principal has executed a financial power of attorney. 2. Requirements for a Valid Financial Power of Attorney a. A person over the age of 18 who is not financially incapable can sign a financial power of attorney naming one or more agents. b. Under common law, the agent s authority ends when the principal no longer has the ability to perform the act. ORS 127.005(1)(c) changes the common law by making financial powers of attorney durable, which means that the agent can act after the principal becomes financially incapable unless the document limits the period when the agent can act. c. Third parties (such as financial institutions) are not required to recognize or accept a financial power of attorney. Practice Tip: The principal s signature on a financial power of attorney is often notarized, although that is not required in order for the document to be valid in Oregon. Notarization is required in order for the financial power of attorney to be recorded, and recording is necessary if the financial power of attorney will be used to buy, sell, mortgage, or take similar actions with regard to real property. ORS 93.670. A title company may not recognize the authority of the agent to sell or convey real property if the document does not identify the real property by address and/or legal description. Basic Estate Planning and Administration 2014 5 5

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law 3. Authority of Agent under Financial Power of Attorney a. An agent named in a financial power of attorney does not have a duty to act unless that is stated in the document. b. Unless the document provides otherwise, the power of attorney is effective when it is signed and remains in effect until it is revoked. c. ORS 127.005(2) gives the principal the option of signing a springing power of attorney which does not become effective until the principal becomes financially incapable. Practitioners differ on whether and when to recommend using a springing power of attorney and on whether a lawyer should agree to hold a financial power of attorney pursuant to a letter of directions from the client who is the principal. d. A general power of attorney gives the agent the authority and the discretion to take a wide range of actions on behalf of the principal. A special power of attorney gives the agent the limited authority to act with regard to a specific asset or to take specific actions. e. If the principal wants the agent to have the power to pay himself or herself compensation, to create or amend a trust, to make gifts (including gifts to the agent), or take actions that would otherwise be a breach of the agent s fiduciary duties, the principal must specify those powers in the power of attorney. Examples of Provisions Granting Extraordinary Powers: - Payment to My Agent. Pay my Agent for the reasonable value of financial services provided by my Agent while acting under this power of attorney. The reasonable value is [insert a standard, if desired, such as, the current fair market rate for bookkeeping services. ]. - Trusts. Transfer my interests in real or personal property to the trustee of the [insert name of trust] dated [insert date of trust], establish a revocable or irrevocable trust, amend or terminate an existing trust, and transfer my interests in real or personal property to a trust, provided that the income and principal are payable solely to me and/or to my spouse during my lifetime and that the trust is consistent with my existing estate plan to the extent reasonably possible. - Government Benefits. Perform any act necessary or desirable in order for me to qualify for and receive all types of government benefits, including Medicaid assistance for long-term care. This includes the power to transfer my interest in our residence and other individual and jointly-held property to or for the sole benefit of my spouse in order to protect my spouse from impoverishment and to change beneficiaries under insurance policies, pay-on-death arrangements, retirement plans and accounts, and any other assets, provided that any designation shall be consistent with my existing estate plan to the extent reasonably possible. e. Some states, including California, have adopted a version of the Uniform Power of Attorney Act, which includes an optional form for a general financial power of attorney. Oregon has not. Many people use general or special power of attorney forms that are available online and in office supply stores. IRS Form 2848, Oregon DMV Form 735-500, and the signature cards that some banks and credit unions use to add an authorized signer to an account are examples of forms used to grant special powers of attorney. Basic Estate Planning and Administration 2014 5 6

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law 4. Revocation and Termination a. A principal who is financially capable may revoke a financial power of attorney at any time, subject to any provisions in the document regarding revocation and termination. b. A financial power of attorney is terminated by the death of the principal. To borrow a phrase used by a title company, [D]ead people cannot sign documents. c. A conservator appointed for the principal may revoke, suspend, or terminate a financial power of attorney. ORS 127.005(5). d. The agent s authority is revoked or terminated when the agent has actual knowledge of the death of the principal or other occurrence revoking or terminating the agent s authority under the financial power of attorney.. 5. Financial Powers of Attorney and Elder Financial Abuse. a. A national study on elder abuse found that the overwhelming majority of abusers were family members: adult children, spouses, partners, and others. Those with substance abuse issues, mental illness, or financial pressures are more likely to become abusers. A recent study by the Oregon Department of Human Services (DHS) dated September 10, 2014, found that 19% of the perpetrators in substantiated cases of elder financial abuse in 2013 investigated by Adult Protective Services were people named as agents in the elders financial powers of attorney. Overall, 33% of the perpetrators held a fiduciary position in relation to the elder, such as trustee, representative payee, or conservator. b. Banks, title companies, and other third parties commonly view financial powers of attorney as increasing their risk of liability, both because of the potential that the power of attorney being presented is fraudulent and because of concerns about whether a legitimate power of attorney has been revoked and whether the agent has the authority to make a particular transaction. ORS 127.035 limits the liability of third parties who reasonably and in good faith rely upon the authority of an agent under a power of attorney. c. Provisions requiring the agent to provide periodic accountings to the principal or others, placing limits on gifts and self-dealing, including standards for compensation to be paid to the agent, and revoking prior financial powers of attorney offer some protection against elder financial abuse. E. Revocable Living Trusts, ORS 130.001 et seq 1. Role of a Revocable Living Trust in Disability Planning a. Revocable living trusts are popular estate planning tools. Authorizing a trusted family member or friend or professional to administer the trust during the settlor s lifetime in the event that the settlor becomes financially incapable is central to making the revocable living trust part of the settlor s disability planning. The client s choice of a trustee or successor trustee who will manage the trust assets responsibly and follow the client s wishes as expressed in the trust agreement is one of the keys to making the plan work. b. A revocable living trust can include a wide variety of instructions to the trustee or successor trustee about how the trust assets should be managed and used. Examples of Disability Planning Provisions for a Revocable Living Trust: - Trust Purpose. The primary purpose of this trust is to provide me with the highest possible quality of life. My trustee shall give priority to my needs and preferences and is authorized to make liberal distributions of income or principal to accomplish this Basic Estate Planning and Administration 2014 5 7

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law purpose. The rights of the remainder beneficiaries of the trust are secondary to my rights as a trust beneficiary. - Preference to Remain in My Home. In the event that I need long term care services, I direct my trustee to use income and principal of the trust to allow me to remain in my home as long as possible rather than placing me in a nursing home or other care facility, even though the cost of keeping me in my home may be more than the cost of similar care provided in a care facility. My trustee may arrange for housekeeping, laundry, meal preparation, personal care, health care, and other services and for any structural modifications which may be necessary to allow me to remain in my home. In addition, my trustee may retain a geriatric care manager to establish and supervise home care for me and to develop a home care plan. - Delivery and Disposition of Tangible Personal Property. My trustee shall deliver to me at my request any item of my clothing, jewelry, artwork, electronics, household goods and furnishings, personal effects, and similar tangible personal property. My trustee shall not be responsible for protecting any items delivered to me at my request. My trustee shall not dispose of any such tangible personal property unless my trustee has obtained my written permission or has reasonably determined that I will not request or require particular items in the future. I authorize my trustee to pay for storage, packaging, or other protection of such tangible personal property. - Visitors and Companions. My trustee may pay the reasonable expenses of relatives to enable them to travel to the place where I reside in order to visit me. In addition, my trustee shall arrange for volunteer companions or pay for companion services to provide me with social interaction if I am living in my home or in a facility where social interaction to meet my needs is not adequately available to me. My trustee shall consider my personal preferences when selecting companions. 2. Transition to Successor Trustee a. The initial trustee may choose to resign and have the successor trustee take over the management responsibilities for the trust. See ORS 130.620. If the initial trustee (often the settlor) becomes unable to manage the trust and has not resigned, the revocable living trust provisions related to the transition to the successor trustee can be critical. b. One option is to require a determination by a court that a trustee is financially incapable or incapable of managing the affairs of the trust. ORS 130.615(1)(f) states that a vacancy in the trusteeship occurs if a guardian or conservator is appointed for the trustee. This option is public and expensive and may result in a significant delay in making the transition. c. Other options include giving the successor trustee the power to make the determination after consulting with the trustee s physician and/or close family members; having the adult children make the determination; and having the trustee s physician and a second physician make the determination. Practice Tip: The successor trustee will need access to the trustee s protected health information if the successor trustee has to consult with the trustee s physician or obtain a physician s opinion on whether the trustee is financially incapable. The trustee can sign a HIPAA compliant release in advance that authorizes physicians and other health care providers to disclose the necessary information to the successor trustee. Basic Estate Planning and Administration 2014 5 8

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law III. LONG TERM CARE CONSIDERATIONS A. Long Term Care Basics 1. Long Term Care Settings a. According to the federal government publication, 2014 Medicare and You, 70% of those age 65 and older will use long term care services at some point. b. The need for long term care increases with age. More than half of the residents of nursing homes are age 85 and older. c. In Oregon, long term care services can be provided in the person s home, in an adult day care center, in an adult foster care home (AFH or ACH), in an assisted living facility (ALF), in a residential care facility (RCF), in a Memory Care Unit (MUC), or in a nursing home (sometimes called a rehabilitation center or a convalescent home). A Memory Care Unit (MCU) for people who have Alzheimer s Disease or another type of dementia may be an RCF or another type of facility. Most long-term care is provided informally by spouses, domestic partners, adult children, other relatives, friends, and neighbors who are not paid for their services. Social networks and community services like the Meals on Wheels program provide support that makes it possible for people to remain at home longer. 2. Payment Options for Long Term Care. Long term care is expensive. The Oregon Medicaid program uses $7,663.00 as the average monthly cost of care for a person who is paying privately when calculating the period of ineligibility for disqualifying gifts and transfers for less than fair market value. OAR 461-140-0296(2)(h). The Genworth Financial Costs of Care Survey found that the national average median cost for a private room in a nursing home for one year was $83,950.00 in 2013. Most people pay for long term care privately for some period of time. About 18% of long-term care costs are paid out-of-pocket a. Medicare is the federal health insurance program that covers almost all people age 65 and older. In addition, Medicare covers those who have received Social Security disability (SSDI) benefits for at least two years. People who get for SSDI benefits due to ALS or endstage renal disease are entitled to Medicare without the two year waiting period. Medicare Part A covers in-patient hospital stays and a maximum of 100 days of skilled nursing facility (SNF) care following an inpatient hospital stay of at least three days. The person must meet the Medicare requirements for skilled care, and there is a co-payment ($152.00 per day in 2014) for days 21-100. Medicare Parts A and B can cover certain in-home services when they are provided by a Medicare-certified home health agency for a person who is homebound and needs some skilled care. Medicare pays about 20% of long-term care costs. Medicare, Medicare supplement insurance, and Medicare Advantage Plans do not pay for most nursing home care or most in-home care. They do not pay for adult day care, for adult foster care, or for care in a residential care facility or assisted living facility or memory care unit. b. Aid and Attendance is a non-service connected disability pension paid by the US Dept. of Veterans Affairs (VA). It provides cash benefits (up to $1,644 per month in 2010) to eligible veterans and widow(er)s of veterans who are homebound and need long-term care or who live in care facilities. The eligibility criteria include service during wartime, degree of physical and mental impairment, and financial need. Since this is a federal program, registered domestic partners are treated as unmarried individuals. VA benefits and public benefits other than Medicare and Medicaid pay for about 5% of long term care costs. c. Long term care insurance policies sold in Oregon must cover all levels of long term care, not just nursing home care. The policies must cover Alzheimer s Disease and related dementias diagnosed after the policy is issued. Insurance companies do have health Basic Estate Planning and Administration 2014 5 9

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law requirements, which are often stricter for individual policies than for group policies. Long-term care insurance pays for about 7% of long-term care costs. d. Medicaid is a complex program based on federal and state law, with ties to other public benefit programs such as Supplemental Security Income (SSI). Oregon s Medicaid program is called the Oregon Health Plan (OHP). Medicaid can covers the full range of long term care services. About half of the people who are getting long term care services in Oregon receive Medicaid assistance. Not all care facilities accept Medicaid reimbursement, and some care facilities with Medicaid contracts ask people to pay privately for a period of time before applying for Medicaid assistance. e. The Medicaid program has strict limits on income and on resources for people who are age 65 or older or disabled under the criteria used by the Social Security Administration and who need long term care services. I. The income limit in Oregon is $2,163.00 per month (gross, before any deductions) in 2014. If the person s income is over the Medicaid limit, a lawyer can help the person qualify for benefits by setting up a Medicaid income cap trust. The Medicaid rules require that most of the income go towards room and board and long term care services. II. The countable resource limit for a single (not married) person is $2,000.00. Certain assets, including the home (within certain limits), household goods, one car or truck, and a funeral plan (within set limits) are generally exempt and are not counted. Most assets, such as bank accounts, IRAs, other vehicles and real property, are counted and have to be spent before the person will qualify for Medicaid assistance. III. There are harsh penalties for gifts and transfers for less than fair market value that were made within five years before applying for Medicaid. The period of ineligibility does not begin until the person applying for Medicaid meets the rest of the eligibility requirements. There are some gifts and transfers for less than fair market value which do not result in a period of ineligibility. For example, there is no penalty if the person transfers assets to his or her spouse or to trust established for the sole benefit of a son or daughter who is disabled under the criteria used by the Social Security Administration for SSDI and SSI benefits. IV. The Medicaid program provides some protections against spousal impoverishment for married couples that are not available to registered domestic partners. For example, the spouse who is not applying for Medicaid benefits can keep countable resources of between $23,448.00 and $117,240.00 as a community spouse resource allowance, regardless of which spouse owned the resources. The spouse who is not applying for Medicaid may be able to get an allowance from the ill spouse s income. For Medicaid purposes in Oregon, legally married means a marriage valid under the statutes or the common law of the state or country where the marriage occurred. The definition now covers same sex couples as well as opposite sex couples. The definition does not include registered domestic partners. OAR 461-001- 0000(37). V. The state has a claim against the estate of the Medicaid recipient for the amount of Medicaid assistance paid after age 55. OAR 461-135-0835(4)(f)(D) was amended effective July 1, 2014, to provide that, for payments made on or after October 1, 2013, the state will limit its Medicaid estate recovery claim for a person age 55 or older to the amount of payments made or benefits paid while the Medicaid program was paying for nursing facility care, care in a community-based care facility, or in-home services. For estate recovery purposes, Oregon defines the estate as including joint accounts, property in a revocable living trust, and other assets which do not have to go through probate. The state cannot collect its claim while there is a surviving spouse or a minor or disabled child. The state can make a claim later against the estate of the surviving spouse. There is a procedure for requesting a hardship waiver to limit, delay, or prevent estate recovery. Basic Estate Planning and Administration 2014 5 10

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law VI. In Oregon, the state Medicaid agency does not have the authority to file liens against real or personal property to recover Medicaid assistance. The state does have a statutory lien on personal injury judgments and settlements for repayment of Medicaid and other assistance received following the injury. B. Long Term Care and Disability Planning Documents 1. Preferences for Care and Placement a. A client who currently needs long term care or who expects to need long term care because he or she has been diagnosed with a progressive illness (for example, Alzheimer s Disease, Parkinson s Disease, or ALS) may want to include specific instructions in his or her planning documents about future care for that condition and the setting in which the care should be provided. b. A client who does not have a diagnosis may want to include more general information about his or her preferences to provide guidance for future decisions by a surrogate decision maker. 2. Providing Flexibility for Finances a. A client who has concerns about paying for long term care, qualifying for government benefits to help pay for long term care, or protecting a spouse or a disabled son or daughter may want to include specific powers in his or her financial power of attorney, such as the power to sell the client s interest in the home or other real property; to establish an income cap trust that may be needed for Medicaid eligibility; to pay for the support and expenses of the spouse; to make gifts or transfers to the spouse; to pay for certain expenses for a disabled son or daughter; to establish and fund a trust for the sole benefit of a disabled son or daughter; and to withdraw assets from a revocable living trust for the purpose of making the gifts and transfers authorized in the power of attorney. b. A client who is married to someone who may need government benefits to help pay for long term care may want to include specific powers in his or her financial power of attorney authorizing the agent to make changes to beneficiary designations; to purchase an annuity; or to pay for certain expenses for a disabled son or daughter. IV. BENEFICIARIES WITH GOVERNMENT BENEFITS A. Financially Incapable Beneficiary 1. Disability Does Not Mean Financial Incapability. Many disabilities do not affect a person s ability to manage money and property that he or she may inherit. However, a beneficiary who has a disability that affects cognition or judgment (for example, an intellectual disability, a traumatic brain injury, memory loss, a mental illness, or drug or alcohol addiction) may not be capable of managing the assets that he or she is expected to inherit. Asking about a beneficiary s ability to manage finances can be as important as asking whether a beneficiary is a minor or an adult. 2. Planning for Financially Incapable Beneficiary a. If the attorney is aware that a beneficiary may be financially incapable, the attorney can propose that the client consider including a trust for the financially incapable beneficiary as part of the estate plan. Choosing the trustee(s) for the beneficiary s trust is an important part of this plan. Basic Estate Planning and Administration 2014 5 11

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law b. The attorney also can counsel the client not to name a financially incapable beneficiary as a beneficiary of a life insurance policy, annuity contract, IRA or other retirement plan, POD/TOD account, and similar assets. c. If a financially incapable beneficiary receives an inheritance directly, a family member or friend or professional fiduciary may need to petition the court to appoint a conservator to manage the inheritance. B. Beneficiary Who Receives Government Benefits 1. Government Benefits Not Based on Financial Need. Many government benefits are not based on financial need and would not be affected by an inheritance. Some examples of government benefits that are not based on financial need: a. Social Security retirement benefits and Railroad Retirement benefits; b. Social Security disability (SSDI) benefits; c. Social Security survivor benefits; d. Social Security disabled adult child (DAC) benefits; Practice Tip: If a beneficiary who is receiving DAC benefits received SSI benefits prior to getting the DAC benefits, he or she may still be receiving Medicaid assistance through the OSIPM program, which is based on financial need. The beneficiary may need to keep that Medicaid assistance to have access to brokerage services or other long term care services. e. Medicare federal health insurance; f. Federal and state civil service pensions; g. Military pensions; h. Tri-Care health insurance; and i. VA pensions, except for Aid and Attendance. 2. Government Benefits Based on Financial Need. Government benefits based on financial need have limits on income or resources or both income and resources. The limits vary according to the program and the size of the family or household group. Some benefits, such as Medicaid, include multiple programs that have different financial eligibility requirements. Some examples of government benefits that are based on financial need: a. Supplemental Security Income (SSI) benefits paid by the Social Security Administration; b. Medicaid, including Qualified Medicare Beneficiaries (QMB) benefits; c. Medicare Extra Help (assistance paying for Part D prescription drug plans); d. Supplemental Nutrition Assistance Program (SNAP), formerly known as food stamps; e. Subsidized housing programs, one of which is the Section 8 program; f. VA Aid and Attendance; and g. Temporary Assistance for Needy Families (TANF). 3. Current Government Benefits. The client may know which government benefits a beneficiary is receiving now, especially if the client is acting as the representative payee for the benefits or is the guardian or conservator for the beneficiary. If the client does not have that information, the beneficiary may be able to provide copies of award letters, statements about cost of living adjustments (COLAs), or other paperwork showing the government benefits programs. Basic Estate Planning and Administration 2014 5 12

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law 4. Future Government Benefits. It is difficult, perhaps impossible, to predict what government benefits a beneficiary will be receiving after the client dies and the probate or trust assets are being distributed. The beneficiary s situation may change, the eligibility requirements for the government benefits may change, and there may be different government benefit programs. a. One approach to planning for a beneficiary who is likely to continue to receive government benefits based on disability and financial need is to provide for that beneficiary s share of the estate or trust assets to be placed in a special needs trust and be managed by a trustee who is not the beneficiary. Practice Tip: You can find information about testamentary special needs trusts, including distribution standards, drafting tips, and examples, in the materials from the Oregon State Bar CLE Program, Special Needs Trusts, June 10, 2011. b. Another approach is to include both a support trust and a special needs trust for the beneficiary in the will or revocable living trust agreement and to give the personal representative or trustee the discretion to use the beneficiary s share to fund one or both of the trusts depending on the beneficiary s situation when the share is being distributed. V. CONSEQUENCES OF COMMON PLANNING TECHNIQUES A. Inability to Protect Spouse if Medicaid Assistance Needed 1. No Authority to Make Gifts or Transfers to Spouse a. If a person who needs Medicaid assistance to help pay for long term care is financially incapable and has not executed a financial power of attorney that authorizes the agent to make gifts and transfers to the principal s spouse, the spouse may not be able to protect his or her home or get access to money or property that the Medicaid rules would allow the spouse to keep as part of his or her community spouse resource allowance (CSRA). The same problem exists if the person has transferred his or her assets to a revocable living trust that does not authorize gifts or transfers to the person s spouse. b. The alternatives available to the spouse who does not need long term care would be to seek to file a petition for the appointment of a conservator with authority to make gifts and transfers to the spouse (if there is no trust); to take the steps needed to amend the trust (if there is a trust); or to file a domestic relations proceeding asking for the money and property for the CSRA to be awarded to the spouse. 2. Assets Trapped in Joint Trust a. Some joint trusts prepared for married couples include a provision making the joint trust irrevocable when one spouse becomes financially incapable. That provision traps the couple s assets in the trust where they will continue to be available to pay for the support of either spouse. Since the terms of the joint trust do not allow trust assets to be withdrawn or set aside as a CSRA for the spouse who does not need long term care, the spouse who does need long term care will not qualify for Medicaid assistance until the countable resources that are in the joint trust have been almost entirely used up. b. The alternative available to the spouse who does not need long term care is likely to be a court proceeding to amend or terminate the trust. Basic Estate Planning and Administration 2014 5 13

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law B. Inability to Protect Disabled Son or Daughter if Medicaid Assistance Needed 1. No Authority to Make Gifts or Transfers for the Benefit of a Disabled Son or Daughter. This situation is similar to the situation for a spouse, described above. 2. Assets Trapped in Trust. A revocable living trust, individual or joint, that does not allow trust assets to be withdrawn for the benefit of a disabled son or daughter means that countable resources that are in the trust will have to be almost entirely used up before the settlor will qualify for Medicaid assistance even though the Medicaid rules permit some of those resources to be placed in a trust for the sole benefit of the disabled son or daughter. C. Inheritance Makes Beneficiary Ineligible for Government Benefits Based on Financial Need 1. Beneficiary s Benefits May Be Terminated. If there is an income limit for the government benefit, most programs make the beneficiary ineligible in the month in which he or she receives the inheritance. If there is a resource limit for the government benefit, most programs continue to make the beneficiary ineligible if his or her resources are above the resource limit in the months that follow. Depending on the government benefit and the beneficiary s situation, he or she may face obstacles and lengthy delays in re-qualifying for government benefit after spending the inheritance down to the resource limit. 2. Payback Special Needs Trust. If the beneficiary wants to continue to receive SSI benefits and/or Medicaid benefits and is under age 65, it may be possible to create a payback special needs trust for him or her and transfer the inheritance to the special needs trust. 42 USC 1296p(d)(4)(A) and OAR 461-145-0540(9) set the following requirements: a. The beneficiary must be disabled according to the criteria that the Social Security Administration uses for SSDI and SSI benefits; b. The beneficiary must be under the age of 65; c. The trust must contain the beneficiary s own assets; d. The trust must be established by the beneficiary s parent, grandparent, legal guardian (usually interpreted as meaning a conservator under Oregon law), or a court; and e. The trust must provide that the amounts remaining in the special needs trust at the beneficiary s death go first to repay any state that provided Medicaid assistance to the beneficiary, up to the total amount of Medicaid assistance provided. 3. Pooled Special Needs Trust. Another option for a disabled beneficiary is to transfer the inheritance to a pooled special needs trust that meets the following requirements found in 42 USC 1296p(d)(4)(C) and OAR 461-145-0540(10): a. The beneficiary must be disabled according to the criteria that the Social Security Administration uses for SSDI and SSI benefits; b. In Oregon, the beneficiary must be under the age of 65; c. The trust must be established and managed by a non-profit association; d. A separate account is maintained for each beneficiary, but the trust pools the accounts for the purposes of investing and managing the funds; e. The separate account must be established by the beneficiary, the beneficiary s parent, grandparent, legal guardian (usually interpreted as meaning a conservator under Oregon law), or a court; and Basic Estate Planning and Administration 2014 5 14

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law f. In Oregon, the trust must provide that the amounts remaining in the beneficiary s separate account at the beneficiary s death go first to repay the state for the Medicaid assistance provided to the beneficiary. Basic Estate Planning and Administration 2014 5 15

Chapter 5 More than a Will: The Intersection of Estate Planning and Elder Law Basic Estate Planning and Administration 2014 5 16

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Helen Hierschbiel Oregon State Bar Tigard, Oregon

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Basic Estate Planning and Administration 2014 6 ii

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Ethics in Estate Planning and Administration Helen M. Hierschbiel OSB General Counsel The Three C s Competence Conflicts Confidentiality Basic Estate Planning and Administration 2014 6 1

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Competence A lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation. Oregon RPC 1.1 Example You are contacted by Fannie Foster to draft a will and power of attorney for Dottie, a 93 year old woman suffering from congestive heart failure and dementia who lives two hours away from your office. Fannie tells you that t she has been taking care of Dottie, and Dottie wants to leave Fannie all of her possessions in recognition of Fannie s care for her. Fannie is concerned that Dottie does not have long to live. Basic Estate Planning and Administration 2014 6 2

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides What do you do? Identify your client Tell Fannie and Dottie who your client is Communicate directly with your client Meet with client alone and more than once Determine whether client has capacity Question whether undue influence Find out more about Fannie and her relationship with Dottie Dangers Will/Trust Contest Undue influence Elder financial abuse Criminal conduct Malpractice Professional misconduct Basic Estate Planning and Administration 2014 6 3

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Identify your client If a lawyer acts in a way that leads a person to reasonably believe that a lawyerclient relationship exists between them, and the person relies on this conduct, then the lawyer will likely have created a lawyer- client relationship, even though h there is no express agreement or mutual consent. In re Weidner, 310 Or 757, 770 (1990) Example You meet with adult son to discuss his parents estate and Medicaid planning. Mother resides in a long term care facility. Father is spending a significant amount of their income paying for her care. Son signs a retainer agreement with you, and you send him a letter, confirming advice you gave him regarding his parents property and trust. As you discussed with Son, you file a petition on Father s behalf asking for support payments and a transfer of assets from the Mother pursuant to ORS 108.110. A settlement is reached with DHS, and Son signs the agreement as Mother s GAL. Basic Estate Planning and Administration 2014 6 4

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Who is your client? Father? Petition filed on his behalf Advice and assistance benefitted Father Son? Retainer agreement with son Advice given to son Communications with son Mother? Son GAL for mother CONFLICTS Basic Estate Planning and Administration 2014 6 5

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Current Client Conflicts A current conflict of interest exists if: (1) the representation of one client will be directly adverse to another client; (2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer s responsibilities to another client, a former client or a third person or by a personal interest of the lawyer RPC 1.7(a) Joint Representation of Spouses George and Jane Jetson consult with you about estate planning for themselves. This is their first marriage and they have two minor children together. They have no children outside of their marriage and no significant ifi property outside of their marital property. They both appear competent to make independent decisions and have the same objectives for their estate plans. Basic Estate Planning and Administration 2014 6 6

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides May you represent them both? A. Yes, because their interests are aligned. B. Yes, as long as they provide for their kids equally. C. No, unless you get their informed consent, confirmed in writing. D. No, you may not represent George and Jane under any conditions. Joint Representation of Spouses Mike and Carol Brady have been married for 15 years. They each have three kids from previous relationships. Although Mike and Carol own their house as tenants by the entirety, they have separate assets of substantially different values. They come to you for help with their estate plan. They say they would like their assets to pass first to the surviving i spouse, and upon the death of both of them, to their children equally. Carol expresses concern, however, that Mike may change the estate plan if she dies first because Mike has complained on more than one occasion about the possibility that his hard-earned money will be going to Carol s kids, rather than his own. Basic Estate Planning and Administration 2014 6 7

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides May you represent them both? A. Yes, because their interests are aligned. B. Yes, as long as you do not tell them about the possibility of doing an irrevocable trust. C. No, unless you get their informed consent, confirmed in writing. D. No, you may not represent Mike and Carol under any conditions. Representing the family Mom and Dad own an organic farm that t provides fresh organic produce and meat to various restaurants in Portland. You have provided them with business advice and assistance over the years. They have two kids, John and Jane, whom you have also represented on various matters over the years. John works the farm, and you have spoken to him on numerous occasions regarding the business; Jane is the CEO of Acme Pollutants, Inc, and you are currently representing her in negotiating an increase in her compensation package with Acme. Mom and Dad seek your help with their estate plan. They want to leave the farm business to John and nothing to Jane. Basic Estate Planning and Administration 2014 6 8

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides May you represent Mom & Dad? A. Yes, but only with the informed consent of John, Jane, Mom and Dad. B. Yes, as long as you don t have a problem with keeping their estate plan a secret. C. No, unless Mom and Dad agree to give Jane and John equal interests in their estate. D. No you can t represent them under any circumstances. Former Client Conflicts A lawyer who has formerly represented a client in a matter shall not thereafter represent another person in the same or a substantially related matter in which that person s interests are materially adverse to the interests t of the former client unless each affected client gives informed consent, confirmed in writing RPC 1.9(a) Basic Estate Planning and Administration 2014 6 9

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Substantially Related If: (1) the lawyer s representation of the current client will injure or damage the former client in connection with the same transaction or legal dispute in which the lawyer previously represented the former client; or (2) there is a substantial risk that confidential factual information as would normally have been obtained in the prior representation of the former client would materially advance the current client s position in the subsequent matter. RPC 1.9(d) Example You represented Husband and Wife with their estate planning five years ago. Wife comes to you now, asking for assistance with a divorce. May you represent Wife? Basic Estate Planning and Administration 2014 6 10

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Former client conflict? Are wife s interests materially adverse to husband s interests? Is the current matter the same as the former matter? Is the current matter substantially related to the former matter? Matter-specific (See EOP 2005-11) Information-specific (See EOP 2005-17) OSB Formal Op No 2005-148 If, however, Wife and Husband had legally bound themselves not to change their wills or if Lawyer s representation of Wife would require Lawyer to try to wrest control away from Husband of business or estate planning entities that Lawyer had formed while representing Wife and Husband, a matter- specific former client conflict would exist. Lawyer could not represent Wife adversely to Husband in the marital dissolution without first obtaining informed consent from both Wife and Husband that is confirmed in writing. Basic Estate Planning and Administration 2014 6 11

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Example Five years ago, you prepared estate planning documents for husband and wife, including reciprocal wills with an irrevocable trust created upon the death of the first spouse. The trust provided income for wife during her lifetime and gave the principal to husband s s kids upon wife s death. The husband recently died, and the wife has come to you asking for your assistance in accessing the principal assets contained in the irrevocable trust. Former Client Conflict? Are wife s interests materially adverse to husband s interests? Is the current matter the same as the former matter? Is the current matter substantially related to the former matter? Matter-specific Information-specific Is it relevant that husband is dead? In re Hostetter, 348 Or 574 (2010) Basic Estate Planning and Administration 2014 6 12

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides What is Informed Consent? Agreement by a person to a proposed course of conduct after the lawyer has communicated adequate information and explanation about the material risks of and reasonably available alternatives ti to the proposed course of conduct. RPC 1.0(g) Waiver of Future Client Conflicts Not prohibited Must adequately explain material risks and available alternatives Beware of situations not contemplated by original disclosure Non-waivable conflicts still cannot be waived OSB Formal Ethics Op No 2005-122 ABA Formal Ethics Op No 05-436 Basic Estate Planning and Administration 2014 6 13

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Estate Administration Who is Your Client? Lawyer who represents a personal representative or trustee typically has only one client the trustee or personal representative and does not represent the beneficiaries i i or the trust t or estate t of the decedent. OSB Formal Ethics Op No 2005-119 OSB Formal Ethics Op No 2005-62 Example You drafted a will for Paul, which gave his estate equally two of his kids Peter and Mary and disinherited his daughter, Karen. Paul has passed, and you now represent Peter, the personal representative in the administration i ti of Paul s estate. t You discover that Peter has been taking estate assets without permission from the court and using them for his own purposes. What do you do? Basic Estate Planning and Administration 2014 6 14

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides To Tell or Not to Tell Duty of Candor Lawyers may not lie to court or third parties Lawyers may not fail to disclose information when duty to disclose Lawyers may not assist client with illegal or fraudulent conduct Duty of Confidentiality Lawyers may not disclose information relating to representation UNLESS Necessary to comply with other law or court order or as allowed by rules RPCs 3.3(a)(4), 4.1. 8.4(a)(1) RPCs 1.6(a), 1.6(b)(5) Basic Estate Planning and Administration 2014 6 15

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides How to Decide? Determine if there is duty to disclose whether because law affirmatively requires it or because nondisclosure would materially mislead. If there is duty to disclose, ask your client permission i to disclose. If your client gives permission, disclose. If your client refuses to give permission, then withdraw from representation. Representing Successor Fiduciaries Contrary to your advice, Peter refuses to disclose his actions to the court, so you withdraw from representation. Thereafter, Mary discovers Peter s transgressions, informs the court, and asks to remove Peter and appoint Mary as the new personal representative. The court does so. Mary asks you to represent her in the administration of the estate, including recovering monies from Peter. Basic Estate Planning and Administration 2014 6 16

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides May you represent Mary? A. Yes, because your client is the same that is, Paul s estate. B. Yes, because Peter s transgressions are now out in the open. C. No, unless you get the informed consent, confirmed in writing from Mary and Peter. D. No, you cannot represent Mary under any circumstances. Protecting Confidences You tell Mary that you cannot represent her. Mary says that s just fine, because she plans to call you as a witness in the case both to help recover against Peter, and to respond to Karen s will contest. She asks you to provide a copy of your file for: 1) Peter s administration of the estate, and 2) Paul s estate planning Basic Estate Planning and Administration 2014 6 17

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides What do you do? Is the information protected? t Privileged information Information relating to the representation that would be detrimental if disclosed Does an exception apply? Authorized by client expressly expressly or impliedly To comply with other law, court order, or as permitted by these Rules Is it relevant that Paul is dead? When in doubt, get a court order Questions? Helen M. Hierschbiel Oregon State Bar 503-431-6361 1-800-452-8260, ext. 361 hhierschbiel@osbar.org Basic Estate Planning and Administration 2014 6 18

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Basic Estate Planning and Administration 2014 6 19

Chapter 6 Ethics in Estate Planning and Administration Presentation Slides Basic Estate Planning and Administration 2014 6 20