Authored by RSM US LLP
The successful execution and administration of your plan play a pivotal role in ensuring your intentions are realized and your legacy is protected. Failing to navigate these crucial aspects can leave your estate vulnerable to potential challenges by the IRS, jeopardizing your wealth. Below, we shed light on eight pitfalls to avoid, empowering you to proactively safeguard your estate and secure a lasting legacy for your loved ones.
Generally, the primary objective of your estate plan is to ensure the fulfillment of your desires and take care of your loved ones. However, overlooking the tax implications can result in unforeseen and unfavorable consequences.
Costly examples include failing to understand the taxation of business income after your death, risking the loss of an S corporation election due to an ineligible shareholder inheriting the asset, and burdening beneficiaries with substantial tax liabilities.
While the statute of limitations for a gift tax return is generally three years from the date of filing, if a transfer goes unreported or is inadequately disclosed on a gift tax return, the statute of limitations will be extended indefinitely, leaving your gifts open to scrutiny long after they have been made.
Even if a gift tax return has been timely and accurately filed, the IRS can still challenge the value of your gift if it examines the return prior to the statute of limitations closing. Further, if the appraisal is incomplete or was not professionally prepared, the return may not achieve adequate disclosure at all.
Proper appraisals are not only important for gift tax reporting purposes, they also affect charitable planning. In a March 2023 ruling, the Tax Court disallowed a charitable deduction even though the charity had already received the donation, and one of the reasons was that appraiser was not qualified.
One of the oldest grounds for IRS action is the “substance over form” doctrine, in which the IRS will look at the true nature of a transaction instead of merely the legalities of what took place.
Further, under the “step transaction” doctrine, the IRS may treat multiple transactions as one if the sole purpose of the transactions is tax avoidance. In a November 2021 ruling, a taxpayer gave assets to their spouse. The spouse then gave those assets to a trust. The IRS argued that the gift was from the taxpayer to the trust, which caused a significant gift tax liability.
There are advantages and disadvantages associated with gifting assets during your lifetime versus holding them until death.
For instance, consider the scenario in which you gift a $1,000,000 property with a $100,000 cost basis. The recipient of the gift assumes the original $100,000 basis, which means they may be responsible for capital gains taxes if they decide to sell the property. If the property appreciates in value after the gift, there could be a significant tax bill.
On the other hand, if you kept the property until your death, when it is worth $2,000,000, it would receive a step-up in basis to the date of death value, potentially eliminating the capital gains tax burden altogether. However, holding until death could mean an estate tax liability.
You may think that setting up an “irrevocable” trust means that everything is set in stone, but it is important to draft flexibility into your estate plan.
Looking at the example above, let’s say that the property did increase to a $2,000,000 value after the gift was made to a trust for the benefit of your descendants. The trustee decides to sell the property after your death and must pay capital gains tax on the $1,900,000 gain. If you had held this asset until your death, it would have had a step-up in basis to $2,000,000, eliminating the capital gains tax.
In addition to the estate and gift exemption, you have the generation-skipping tax (GST) exemption to use during your life or at death. This exemption can be utilized to protect assets from the generation-skipping transfer tax (GSTT), allowing for the preservation of wealth across multiple generations. This exemption is automatically allocated to certain transfers, but there are elections available to affirm whether you want to protect certain assets from the GSTT.
Relying on an automatic allocation could cause a waste of your available GST exemption. For example, you set up a trust for the benefit of your child and descendants, but you expect that your child will deplete the trust before it benefits grandchildren. Absent an election, your GST exemption would most likely be allocated to any transfer to that trust. This trust does not need to be protected from the GSTT since it will never go to grandchildren and beyond.
You may transfer assets with the intention of removing them from your estate, but, despite your efforts, certain factors trigger their inclusion in your estate. Generally, this could be related to retaining too much enjoyment or control over the assets.
Another common fact pattern involves spousal trusts. For example, you set up a trust for the benefit of your spouse and descendants. You fund the trust with jointly held assets. Your spouse is able to take distributions during their life if needed. Funding this type of trust with property partly owned by the beneficiary spouse would cause estate inclusion issues.
By steering clear of common pitfalls, you can enhance the effectiveness of your estate plan and provide peace of mind for yourself and your loved ones. Avoiding these eight pitfalls will enable you to craft a comprehensive and resilient estate plan that reflects your wishes and secures your legacy for future generations.
Remember, seeking professional guidance and regularly reviewing your plan are essential to adapting to evolving circumstances and ensuring the enduring protection of your legacy.
This article was written by Carol Warley, Scott Filmore, Amber Waldman, Spencer Diamond and originally appeared on 2023-08-08.
2022 RSM US LLP. All rights reserved.
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