Income Tax Planning for the Terminally Ill or Recently Deceased Person

Notes for lawyers from the Massachusetts Bar Association’s program that I chaired entitled “Estate, Tax and Health Care Planning for the Terminally Ill Client”

Some income tax planning for a person’s final income tax returns can be done not only immediately prior to the person’s death, but also after the person’s death. The following items should be considered.

(1) Pre-Death Capital Losses

The date of death of a client establishes a new basis in the client’s assets for capital gains tax purposes. Thus, pre-death sales of appreciated assets should be avoided if possible. On the other hand, capital losses are lost when someone dies (due to a step-down in basis), so a pre-death sale of such assets could end up being good income tax planning if the decedent’s final return would otherwise show significant taxable income. Whenever in doubt, capital losses should be recognized, as they will be lost upon death.

(2) Accrued Income on U.S. Savings Bonds

Accrued income on U.S. Savings Bonds, Series E, EE, H and HH can be included by the executor on the decedent’s final income tax returns. See Rev. Rul. 68-145, 1968-1 CB 203.

It may be beneficial for a surviving joint tenant on such bonds to execute a qualified disclaimer of the survivorship interest if the decedent would have been in a lower bracket. If a disclaimer may be advisable, it can be done within nine months of the decedent’s death, but note that the ability to do so could be tainted by any acceptance of its interest by the surviving joint tenant. A warning to surviving joint tenants not to take any action that would cause deemed acceptance of the interest is advisable in many circumstances.

(3) Medical Expenses Paid by Executor

Private payment of nursing home expenses in the client’s final year could result in a large itemized deduction that can offset a significant amount of income. Any medical expenses paid within one year of death by the executor can be elected either as estate tax deductions or as income tax deductions on the decedent’s final income tax returns.

(4) Qualified Plans and IRAs

Upon the death of an unmarried client who has attained the required beginning date and has opted to recalculate his/her life expectancy on IRAs or qualified plans, distribution must take place before the last day of the calendar year immediately after the year of the decedent’s death. It could be advisable to make a pre-death withdrawal from such IRAs and qualified plans in order to recognize the income on the client’s income tax returns, as well as to cause the resulting income taxes to be estate tax deductions. A conversion to a Roth IRA would have the same result, yet allow the beneficiary the option of future tax-free accumulations, and may well be advisable in such situations.

It may be advisable to include in clients’ durable powers of attorney the power to convert an IRA to a Roth IRA.

(5) Pre-1977 Spousal Joint Tenancies and Tenancies By the Entirety

The presumption that each spouse contributed 50% does not apply to joint tenancies and tenancies by the entirety created before 1977, under the holding of Gallenstein, 975 F.2d 286 (6th Cir. 1992) and its progeny. Thus, if the non-contributory spouse is terminally ill, a division of jointly-held assets into tenancy in common may be advisable to obtain a step-up in basis of 50% of the assets and for the proper funding of the estate plan.

(6) Using Discretionary Testamentary Trusts

Even if the couple has a significant amount of assets for federal tax planning purposes, for long-term care planning purposes it may be advisable to have the dying spouse execute a will containing a discretionary trust for the benefit of the surviving spouse. This technique has the benefit of shielding the assets from any possible nursing home costs of the survivor under the definition of trusts under federal law (42 U.S.C. Section 1396p(d)(2)(A)) and concomitant state regulations in Massachusetts and many other states.

It also appears that the loss in basis adjustment referenced in Internal Revenue Code Section 1014(e) would not apply if the trust were discretionary; thus, even assets transferred into the decedent’s name shortly before death would appear to attain a stepped-up basis. Under a specific prohibition in Section 1014(e), assets transferred to a person who dies within one year of receipt of the gift do not receive a step-up in basis only if there is a requirement that the assets be distributed to the prior owner; while there are no cases or regulations on point, the use of a discretionary trust appears to circumvent this prohibition.

(7) Granting General Power of Appointment to Dying Spouse

It has been suggested by at least one commentator that granting a general power of appointment to a spouse, even within one year of death, can result in a complete step-up in basis on the assets affected thereby. (See The Tax Basis Revocable Trust: New Concepts in Estate Planning, by Paul M. Fletcher, The Covercroft-Twigmore Group.) The method is to make the surviving spouse’s trust property subject to a limited, general power of appointment for debt payment during administration of the deceased spouse’s estate. Because of this general power of appointment, the surviving spouse’s appreciated trust property is included in the gross estate of the first spouse to die. While Internal Revenue Code Section 1014(e) disallows a step-up in basis on a gift made to the decedent within one year of death, the author suggests that the language of that provision does not apply to inclusion of someone else’s property in the decedent’s gross estate. To draw your own conclusion, see not only the Code section, but also PLR 9308002, where a step-up in basis was disallowed. For an article on the subject, see Melinda S. Merk, “Joint Revocable Trusts for Married Couples Domiciled in Common-Law Property States,” Real Property, Probate and Trust Journal, Vol. 22, No. 2, p. 345 (Summer 1997).