Tax reporting--sale of stepped-up assets in year of death

What is the name of your state? California

I am asking this question for a relative who lost her husband earlier this year. She will be filing a joint tax return for 2007, since he just died this year. She is considering the sale of some taxable mutual funds, which are held in the name of a revocable living trust. These mutual funds were specified as California community property in the trust, so they receive a full step-up in basis.

Her question is concerning tax reporting if she sells these mutual funds in 2007. Is it okay that she'd report the sale of the stepped-up assets on the same Form 1040 as she is filing a joint return with her deceased husband? In other words, can she inherit a fund/stock and yet file with the person she's inheriting from?

Thanks for your help!

Yes, she can.

Thanks for your kind assistance, Abezon.

It all depends on the provisions of the trust. Tell us more about what happens when the first of the Settlors passes on.

Hello, Tecate.

Sorry, but I'm not exactly sure what you're asking.

To clarify, the trust specifically put everything into community property. The widow went from co-trustee to successor "death trustee" upon her husband's death. She has complete control and use of the assets. The trust specifies that any assets remaining at the time of her eventual death will be passed on to her deceased husband's children (from a prior marriage).

I hope that addresses your question adequately. If not, please let me know. Does this change anything regarding Form 1040 tax reporting if she decides to sell taxable mutual funds this year?

Thanks for your help!

Does the living trust split into two or more trusts on the first death? Look for terms like Trust A and Trust B, Marital Trust, Survivors Trust, Bypass Trust, and Residual Trust.

It is my understanding that it was an A-B Trust, but I don't believe there is any intention to fund the Bypass Trust. The decedent's assets are worth less than the estate tax exemption of $2 million. Also, the widow's CPA has advised her that it is not necessary to file an estate tax return.

Are you saying that the trust says the surviving spouse isn't required to split the assets? Or are you saying that the surviving spouse will ignore the trust and her husband's wishes?

Hello again, Tecate.

I haven't read the trust myself, so I can't say for sure. The widow has consulted an attorney and CPA regarding these matters. I assume she's following their advice.

Can you explain why this is relevant to my original question, which was:

"Is it okay that she'd report the sale of the stepped-up assets [mutual funds] on the same Form 1040 as she is filing a joint return with her deceased husband? In other words, can she inherit a fund/stock and yet file with the person she's inheriting from?"

Abezon originally replied that she can report the sale on her 1040. Was that the correct answer? And what if Trust B (the Bypass Trust) IS funded? Would she report the sale on the joint 1040 this year if she's selling assets from Trust A?

If funding of Trust B is optional, what benefit would there be to fund it since the deceased's assets were worth less than the estate tax exemption amount? Once the widow dies, wouldn't tax on his estate, with or without Trust B, ultimately be the same in the end under these circumstances--zero?

One more question.... If funding of Trust B is mandatory, is there a deadline when that needs to be completed?

I would appreciate any further explanations, from both you and anyone else, as I'd like to understand this better. Thanks very much!

magic_man said:

What is the name of your state? California

I am asking this question for a relative who lost her husband earlier this year. She will be filing a joint tax return for 2007, since he just died this year. She is considering the sale of some taxable mutual funds, which are held in the name of a revocable living trust. These mutual funds were specified as California community property in the trust, so they receive a full step-up in basis.

Her question is concerning tax reporting if she sells these mutual funds in 2007. Is it okay that she'd report the sale of the stepped-up assets on the same Form 1040 as she is filing a joint return with her deceased husband? In other words, can she inherit a fund/stock and yet file with the person she's inheriting from?

Thanks for your help!

Click to expand...

You got the simple and accurate answer to your question from Abezon. Its a revocable living trust, therefore its income is pass through income. Yes, she can report the sale of an inherited asset on a joint return with the person from whom she inherited it.

I am not sure where Tecate was going with his questions.

Thanks for your response, LdiJ. I appreciate you clarifying that for me.

Can anyone answer the other questions in my last post:

magic_man said:

If funding of Trust B is optional, what benefit would there be to fund it since the deceased's assets were worth less than the estate tax exemption amount? Once the widow dies, wouldn't tax on his estate, with or without Trust B, ultimately be the same in the end under these circumstances--zero?

If funding of Trust B is mandatory, is there a deadline when that needs to be completed?

Click to expand...

Thanks again for your help!

Your next to last response tells me you have some experience in this area. Since you haven't read the trust, all we can do is discuss hypotheticals. AB trusts in community property states usually envision a first step in which the trustee decides which community assets satisfy the surviving spouse's 50% interest, and which community assets pass according to the wishes of the decedent.

Its relevant because if this is a typical AB trust and the surviving spouse is required to split the community property assets, the terminating living trust has a split personality for tax purposes until the trustee accomplishes the split. Half of the income is taxed on the survivor's 1040 and half is taxed to a separate taxable administrative trust. If the assets sold are allocated to the survivor's half, sold during the year her spouse died, and the surviving spouse files a joint return with her deceased spouse, then yes, the sales are reported on the same return.

So it is possible for the trustee to allocate the stocks to the survivor's side, and get the result you envision. If the trustee allocates the stocks you have in mind to the bypass trust, the sales are reported on the return for that trust. The issue is not whether it is ok, but whether that is what the trustee actually does.

If funding is optional, you have correctly summarized the surviving spouse's dilemma. Sometimes, laws change, and investments skyrocket, making a taxable estate out of one everyone thought wouldn't be. I hope the crystal ball is clear.

If funding is mandatory, there is usually no set time limit, but not doing it at all may lead to much more work down the line, especially if it means something for tax purposes.

Taxation of Bypass Trust

Thanks very much for the additional information, Tecate! I appreciate the time you and the others have devoted to my situation.

Is my understanding of taxation of the Bypass Trust (Trust B) correct, as summarized below?

Assuming it was specified in Trust B, all income generated by Trust B can be paid to the surviving spouse annually. This income would be reported on Schedule K-1, is taxable to the surviving spouse at her personal income tax rate, and is reported on her Form 1040.

Principal may be removed from Trust B if allowed by the trust, within strict guidelines. Is that reported and taxed the same way as income (via Schedule K-1 and Form 1040)? Are capital gains usually considered income, or are they retained in the trust as part of the principal?

Trust B would have its own taxpayer identification number and Form 1041 would be filed annually. What kinds of things would be taxable to Trust B (at the higher trust income tax rates), assuming all income (such as dividends) is paid out to the surviving spouse annually?

It's my understanding that the step-up in basis is not available to beneficiaries (adult children) upon the death of the surviving spouse if the assets were held in Trust B, but the step-up IS allowed for the beneficiaries if the assets were held in the surviving spouse's Trust A. Is this correct?

I know there are a lot of questions here. I am attempting to sort things out for my relative, and also trying to figure out my own estate plan. Any help is greatly appreciated!

My guess is you have more than just "some" experience in this area, since your summary is correct. A few minor points:

Usually, bypass trusts provide that trust accounting income must be distributed to the surviving spouse at least annually. Your use of the word "may" means a discretionary payout. My guess is you mean "must." These are usually simple trusts for income tax purposes.

For trust accounting purposes, capital gains are usually added to principal, but there are exceptions under the Uniform Principal and Income Act. Capital gains are also usually not part of distributable net income for income tax purposes, and hence do not pass out to the surviving spouse, although there are exceptions to this also. Instead, capital gains are usually taxed to the trustee. Distributions of principal are usually income tax free to the surviving spouse.

Thanks very much again, Tecate.

Can you provide any link(s) to a plain-language (not IRS publication!) explanation of Trust B taxation? I'd like to understand Trust B tax brackets, what is actually taxed, and how the tax is calculated.

I'm still unclear about what's taxable to the surviving spouse and what's taxable to the trust. You had said, "Instead, capital gains are usually taxed to the trustee. Distributions of principal are usually income tax free to the surviving spouse." Did you mean "taxed to the trust"? If a stock is sold from Trust B, its sale value is more than its basis, and the proceeds are paid to the surviving spouse, does Trust B pay tax on the resulting capital gain or does the surviving spouse? How is that gain reported? Or were you saying there would be no tax owed despite the fact that there is a gain?

And can you address this question directly:

magic_man said:

It's my understanding that the step-up in basis is not available to beneficiaries (adult children) upon the death of the surviving spouse if the assets were held in Trust B, but the step-up IS allowed for the beneficiaries if the assets were held in the surviving spouse's Trust A. Is this correct?

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Was my understanding correct? If Trust B assets would not enjoy a basis step-up upon death of the surviving spouse, that would seem like a major disadvantage to the beneficiaries if those assets had appreciated substantially while in Trust B.

Sorry for all the questions. I have a great curiosity about these things, and the issues are relevant to my own estate planning process, as I continue to weigh whether a Living Trust is the best solution for my own family. I am aware of the many benefits, but Trust B seems to add another layer that I'm not sure I want to burden my beneficiaries with. I'm not sure the potential tax savings (if any) to the ultimate beneficiary are worth the hassles of Trust B annual reporting, following the rules precisely, etc. Especially for an elderly surviving spouse, it seems like an unwelcome complication.

I will understand if you don't want to devote any more time to my questions, as you've already helped so much, but I do appreciate your assistance! I want to have a thorough understanding of the issues *before* I consult with an attorney about my own situation, and I also want to help my relative who is dealing with this right now.

P.S. I assume you're an attorney or a tax professional. In what part of California is your practice and what is your specialty, if you don't mind sharing that information?