ASSET INVENTORY AND ADMINISTRATION IN FORMAL PROBATE

Within a few months of appointment, the personal representative must prepare a list of the estate’s property called an “inventory.” The inventory lists each item of property in the probate estate and its corresponding value. Personal items and household effects are often listed as a single entry with a single aggregate value.

An “inventory fee,” based on the aggregate value of the property listed on the inventory, is charged by the probate court. All beneficiaries and heirs are entitled to see the inventory, which must be filed with the probate court.

Each year the estate remains open, the personal representative must prepare, sign, and file federal and state income tax returns (see “Tax Reporting” in Chapter Eight). Annual accountings of estate income and expense must also be filed with the court, and made available to beneficiaries and heirs.

Most formal estates run their course in nine to eighteen months, requiring only one or two income tax filings. If an estate can be completed in less than twelve months, it should elect a twelve-month non-calendar fiscal year. In doing so, the estate will only be required to make a single income tax filing (see Chapter Eight).

ASSET INVENTORY AND ADMINISTRATION IN INFORMAL PROBATE

Informal estates are subject to the same inventory and income tax return requirements that apply to formal estates, except that the inventory need not be filed with the court.

ASSET INVENTORY AND TRUST ADMINISTRATION

There is no specific inventory requirement for trusts. However, depending on the terms of your spouse’s trust and the law of your state, you may be required to furnish beneficiaries with trust asset information, as well as annual accountings. To avoid having to account to your children, your spouse’s trust may exempt you from such disclosures. On the other hand, if it was a second marriage, your late spouse’s trust may require asset and accounting disclosure to keep current beneficiaries (you) and contingent beneficiaries (his children) apprised of trust activity.

While probate estates continue only so long as necessary to appoint a fiduciary, pay creditors, and distribute assets to beneficiaries and heirs, trusts may last for years. Trusts avoid probate, minimize estate tax, and allow the grantor to provide structure and security for his surviving spouse and children. You could say that probate administration is accidental while trusts administration is by design. That is why the cost and delay of probate should be avoided.

Trust administration, on the other hand, is a necessary byproduct of the grantor’s wish to keep a guiding hand on his loved ones after death. Trusts that provide for immediate distribution require little or no ongoing administration. Trusts that operate for surviving spouse’s lifetime, or until the grantor’s children reach a particular age, must be administered according to their terms for their duration.

As the surviving spouse, trust assets will likely be held for the balance of your life to allow you to maintain the lifestyle you enjoyed while your spouse was alive. Even if your late spouse’s trust makes liberal provision for you, you nonetheless have a duty to contingent beneficiaries even if they are your natural children.

You must prudently invest trust assets, file Federal and state income tax returns, and preserve trust assets for contingent beneficiaries. Your duties as trustee end at your death, or when the trust’s last dollar is distributed, if earlier.

FAMILY/MARITAL TRUST DIVISION

If your spouse’s trust holds assets in excess of the Applicable Exclusion Amount ($675,000 in 2001) it will divide into two separate trusts: a “family trust” (sometimes called a “bypass” or “credit shelter” trust) and a “marital trust.” Trust assets equal to the Applicable Exclusion Amount are first allocated to the family trust. Assets in excess of $675,000 (if any) are allocated to the marital trust. The division of trust assets between the family and marital trust allows for the full utilization of your spouse’s unified credit, and avoids estate tax at his death (unless you are not a U.S. citizen).

The family trust is not subject to estate tax since it is within the Applicable Exclusion Amount. No estate tax is imposed on the marital trust since transfers to the marital trust qualify for the unlimited marital deduction.

Some marital trusts permit you to designate the beneficiary of the balance of the trust at the time of your death (a “general power of appointment” or “POA”), and some do not (a “qualified terminal interest property” or “QTIP” Trust). In either case, the balance of the assets remaining in the marital trust at your death will be included in your taxable estate. With a QTIP marital trust, amounts remaining in the marital trust at the time of your death are paid to the family trust to be held or distributed for the benefit of the contingent beneficiaries named by your late spouse.

QTIP trusts are especially useful in second marriages. Trust assets are used for the support of the second spouse for the balance of her life with the balance distributed to the grantor’s natural children at the second spouse’s death. If the marital trust is the POA variety, amounts remaining in the marital trust at the time of your death are paid to the family trust only if you fail to designate different contingent beneficiaries at the time of your death.

By definition, you may not designate contingent beneficiaries of your spouse’s family trust, since such a power would cause the family trust to be included in your taxable estate, defeating the purpose of creating the family trust; that is, to bypass your estate and fully utilize the Applicable Exclusion Amount of your late spouse.

Income and principal from both the family and marital trusts are available to you to allow you to enjoy the lifestyle you became accustomed while your spouse was alive. How and when you take income and principal is important to minimize income and estate tax. Obtaining the best income and estate tax result is no simple task. Often, the best estate tax result comes at a high income tax cost, and vise versa. However, minimizing both taxes can be done with a little planning.

Best Income Tax Result

The family and marital trusts are separate taxable entities, subject to the highest marginal income tax rate. Fortunately, trusts are entitled to a deduction (to the extent of trust income) for distributions made to beneficiaries. The effect of the “distribution deduction” is to shift income tax liability from the trust to its beneficiaries. Since trust beneficiaries are likely to be in a much lower tax bracket than the trust, shifting the tax burden to beneficiaries is good for all of the parties involved. Unfortunately, making distributions from the family trust may not make good estate tax sense.

Best Estate Tax Result

Assets of the family trust have already passed under your spouse’s Applicable Exclusion Amount, and are not includible in your taxable estate at your death. Thus, assets of the family trust will never be (estate) taxed again, no matter how much they appreciate after your spouse’s death. So, “let it grow, let it grow, let it grow.” To achieve the greatest growth, the family trust should be invested for long-term growth, and you should take distributions from the family trust only to the extent needed to maintain your lifestyle. If you need income, you should take it from the marital trust. You should spend down the marital trust since it is included in your taxable estate. In short: spend marital, don’t spend family. This advice is tempered by the fact that income left in the family trust will be taxed at the highest marginal income tax rate.

The Problem

The problem, simply stated, is that for income tax purposes, family trust income should be distributed annually. For estate tax purposes, little or no distributions should ever be made from the family trust.

Solution

To avoid unfavorable income tax results, the family trust should be invested in growth, low-income, or non-income producing investments. By investing for growth and not for income there is no income tax reason for making distributions from the family trust. With the income tax problem solved, family trust assets can be allowed to grow estate tax free.

The following diagram illustrates the division of a single trust into a family and marital trust as described above: