FUNDING TESTAMENTARY TRUSTS: TAX AND NON-TAX ISSUES MICKEY R. DAVIS DAVIS & WILLMS, PLLC 3555 Timmons Lane, Suite 1250 Houston, Texas 77027 (281) 786-4500 [email protected] State Bar of Texas 19th ANNUAL ADVANCED ESTATE PLANNING STRATEGIES COURSE April 4-5, 2013 Santa Fe, New Mexico CHAPTER 5.2 MICKEY R. DAVIS PARTNER DAVIS & WILLMS, PLLC 3555 TIMMONS LANE, SUITE 1250 HOUSTON, TEXAS 77027 (281) 786-4500 [email protected] EDUCATION: University of Texas School of Law, J.D. with High Honors, 1982. Chancellors; Order of the Coif; Associate Editor, TEXAS LAW REVIEW; Member, Board of Advocates. University of Arizona, B.B.A. with High Distinction, 1979. Beta Alpha Psi; Beta Gamma Sigma. OTHER QUALIFICATIONS: Board Certified, Estate Planning and Probate Law, Texas Board of Legal Specialization. Admitted to Practice: State Bar of Texas; Federal District Court for the Southern District of Texas; United States Tax Court. Certified Public Accountant, Texas, Certified 1983. Adjunct Professor, University of Houston School of Law, 1988Bpresent, teaching Income Taxation of Trusts and Estates and Postmortem Estate Planning. Named the Best Lawyers' 2013 Houston Trusts and Estates "Lawyer of the Year" Named by Texas Lawyer as a 2013 "Top Notch Lawyer" for Trusts and Estates PROFESSIONAL ACTIVITIES: Fellow, The American College of Trust and Estate Counsel (Chairman: Estate & Gift Tax Committee; Member: Communications, Business Planning and Fiduciary Income Tax Committees). Former Editor, ACTEC LAW JOURNAL. Member of the Board of Directors, ACTEC Foundation Member, State Bar of Texas (Sections of Real Property, Probate and Trust Law; Taxation); Houston Bar Association (Sections of Probate, Trust and Estate; Taxation); College of State Bar of Texas; Texas Academy of Probate and Trust Lawyers; Houston Estate and Financial Forum. Member, Texas Society of Certified Public Accountants, Houston Chapter; American Institute of Certified Public Accountants. Estate Planning and Probate Law Exam Commission, Texas Board of Legal Specialization (Member 1993-2003, Chair 2000-2003) RECENT SPEECHES AND PUBLICATIONS: Co-Author: Streng & Davis, RETIREMENT PLANNINGBTAX AND FINANCIAL STRATEGIES (2nd ed., Warren, Gorham & Lamont (2001, updated annually) Co-Author/Panelist: Using the $5 Million Gift Tax Exemption: A 2012 Toolbox, State Bar of Texas 18th Annual Advanced Estate Planning Strategies Course, 2012; Attorneys in Tax and Probate, 2012. Co-Author/Speaker: Using the $5 Million Gift Tax Exemption: Advanced ANew Age@ Estate Planning Strategies, Texas Society of CPAs-Houston Chapter, 2012. Co-Author/Speaker: Administration of Estates with Revocable TrustsBDrafting to Head Off Pre- And Post-Death Problems, State Bar of Texas 22st Annual Estate Planning and Probate Drafting Course, 2011; Estate Planning Council of Central Texas, 2012. Co-Author/Speaker: Fixing Broken Trusts: How to Tell if Your Ox is in the Ditch, and How to Get it Out, Texas Society of CPAs Advanced Estate Planning Conference, 2012. Co-Author/Speaker: Recent Developments and Predictions in Tax LawBPending Legislation, Portability and Decanting, South Texas College of Law Wills & Probate Institute, 2012 Author/Speaker: Tax, Procedural And Administration Rules: Contrasting Revocable Trusts with Estates, 46th Annual Southern Federal Tax Institute, 2011. Author/Speaker: Update on Administering 2010 EstatesBWhat Have We Learned So Far?, State Bar of Texas 35th Annual Advanced Estate Planning and Probate Course, 2011; Houston Business and Estate Planning Council, 2011; Texas Society of CPAs Advanced Estate Planning Conference, 2010. Funding Testamentary Trusts: Tax and Non-Tax Issues Chapter 5.2 TABLE OF CONTENTS I. INTRODUCTION. ............................................................................................................................................ 1 A. Overview. ................................................................................................................................................... 1 B. Scope. ......................................................................................................................................................... 1 II. IDENTIFYING WHICH ASSETS ARE SUBJECT TO THE WILL. .............................................................. 1 A. Probate vs. Non-Probate Assets. ................................................................................................................ 1 1. Non-Probate Assets. ........................................................................................................................... 1 2. Probate Assets. ................................................................................................................................... 3 B. Non-Probate Assets Used in Funding. ....................................................................................................... 3 1. Payment to Estate or Trustee. ............................................................................................................. 3 2. Contingent Payment to Estate or Trustee. .......................................................................................... 3 III. CHANGES IN ASSETS DURING ADMINISTRATION. ............................................................................... 4 A. Payment of Debts and Expenses. ............................................................................................................... 4 B. Apportionment of Taxes. ........................................................................................................................... 4 C. Other Changes in Assets During Administration. ...................................................................................... 4 1. Income Earned During Administration. ............................................................................................. 4 2. Sales and Exchanges of Estate Assets. ............................................................................................... 4 3. Appreciation and Depreciation. .......................................................................................................... 4 IV. IDENTIFYING THE STAKES. ........................................................................................................................ 5 A. Outlining Objectives. ................................................................................................................................. 5 1. Appreciation and Depreciation. .......................................................................................................... 5 2. Maximizing Basis Step-Up. ............................................................................................................... 5 3. Income Production. ............................................................................................................................ 5 4. Capital Gain Avoidance. .................................................................................................................... 6 B. Income Taxation of Estate Distributions. ................................................................................................... 6 1. DNI Carry Out Rules. ......................................................................................................................... 6 2. Gains and Losses from Distributions In Kind. ................................................................................... 8 3. Non-Pro Rata Distributions. ............................................................................................................. 10 4. Income in Respect of a Decedent. .................................................................................................... 10 V. ALLOCATION OF INCOME AND EXPENSES DURING ADMINISTRATION OF A DECEDENT'S ESTATE ........................................................................................................................................................... 11 A. Allocation of Income. ............................................................................................................................... 11 1. Statutory Allocation of Income and Principal in Estates. ................................................................. 11 2. The Texas Trust Code. ..................................................................................................................... 12 B. Apportionment of Expenses. .................................................................................................................... 12 C. Deduction of Expenses for Tax Purposes. ............................................................................................... 12 1. Section 642(g) Expenses. ................................................................................................................. 13 2. Method of Election. .......................................................................................................................... 13 3. Charging Expenses to Deductible Bequests. .................................................................................... 13 4. Charging Expense to Estate Income. ................................................................................................ 14 5. Regulatory Guidance. ....................................................................................................................... 14 6. Interpreting Wills Under the Hubert Regulations. ..........................................................................