The Legal Duties of California Trustees, the Investment of Trust Assets, and the Importance of Choosing a Successor Trustee Wisely

If you are serving as a trustee, executor or administrator, conservator, or guardian, you are termed a “fiduciary” under California law.  The procedure for the investment and handling of assets in the trust, estate, conservatorship, or guardianship is established by California law.  If you, as a fiduciary, fail to correctly carry out your duties, you may be liable for any losses that occur in the investments and for your failure to produce sufficient income and growth in the investments, depending upon market conditions.

How many fiduciaries are aware of their legal responsibilities and obligations?  Probably, very few.

The responsibilities of an executor or administrator, conservator, or guardian are set forth in detail in the California Probate Code.  While assets can be sold, sometimes only with a court order, they generally cannot be purchased without a court order.  This article does not address these responsibilities, only those of a trustee of a living or testamentary trust.

Trusts, generally last for longer periods of time than other fiduciary accounts, and the trustee or trustees who manage the trust are generally given broad authority under the trust document and California law to handle investments and other matters, but are held to a strict standard for their actions.

In undertaking the administration of a trust, a trustee does not have to accept the appointment unless he or she wishes to.  If Uncle Fred dies and you are notified that you are the sole trustee of his living trust, you can decline to serve without having to give any reason.  No one, no matter what he or she has said or written in the past, is obligated to initially take on the job of a trustee.  However, once you agree to serve, or start acting as a trustee, then you become obligated to carry out all of the legal duties of a trustee.  You can, of course, resign at any time, but you are liable for actions taken while serving as trustee, and you must continue in your capacity as trustee until a successor trustee agrees to serve and takes over the duties of the trustee.

References below to “PC” are to the pertinent code sections of the California Probate Code.

If there are two or more trustees acting, then they must act only by “unanimous action” (PC 15620).  All are then jointly liable for the action taken.

Trustee’s areas of responsibility

The responsibilities of a trustee cover a wide range of obligations.  They include:

  1. A number of general duties of all trustees (PC16000-16015).
  2. A standard of care in the administration of the trust (PC 16040-16041).
  3. Investing funds and assets under the California Uniform Prudent Investor Act (PC 16045-16054).
  4. Reporting information and accounting to all trust beneficiaries, usually annually (PC 16060-16064).
  5. Exercising any discretionary powers reasonably (PC 16080-16082).
  6. Keeping detailed records and allocation of all receipts and disbursements under California Uniform Principal and Income Act (PC 16320-16375).

A Trustee who is initially undertaking the administration of a trust should carefully read the trust document (trust agreement or trust declaration), no matter how long, and make notes about the powers and duties of the trustee and payments to be made from the trust.  These should also be discussed with the attorney advising the trustee (the trustee should have an attorney to advise him or her).

General duties of a trustee

The general duties of all trustees are set forth in California Probate Code sections 16000-16015).  These include:

  1. Following provisions in the trust document–particularly if the trust has special provisions for handling certain assets such as a parcel of real property or a private business (PC 16000).
  2. Treating all trust beneficiaries with loyalty and impartiality–not favoring one party over the other and not discussing communications from one beneficiary with another (PC 16002-16003).
  3. Avoiding any conflict of interest with the trust and avoiding any adverse interests–such as buying or selling assets from or to the trust or benefiting personally in any way from trust transactions (PC 16004-16005).
  4. Controlling and preserving trust assets and making the assets productive (PC 16006-16007).
  5. Keeping trust assets segregated and identifiable (PC 16009).
  6. Enforcing any legitimate claims against third parties (PC 16010).
  7. Defending any actions against the trust (PC 16011).
  8. Avoiding improper delegation of the trustee’s responsibilities and duties and supervising performance of any proper agent appointed by the trustee-primarily in the investment area (PC 16012).
  9. If a co-trustee, participating in the administration of a trust and preventing other co-trustees from committing a breach of the trust, or seeking reimbursement if a co-trustee has breached the trust (PC 16013).
  10. To apply any skills the trustee has to the administration of the trust (PC 16014).

Trustee’s standard of care

California Probate Code section 16040 provides that “The trustee shall administer the trust with reasonable care, skill, and caution under the circumstances then prevailing that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character and with like aims to accomplish the purposes of the trust as determined from the trust instrument.”   The standard of care is not affected by the trustee’s fee or lack of fee if the trustee does not choose to take a fee.

This “prudent man rule” means that the courts may later review a trustee’s action upon complaint from a beneficiary and analyze in detail what the trustee did and whether the trustee’s actions were correct.  It is the trustee’s responsibility to prove what he or she did and also to prove that his or her actions were “prudent” under the circumstances.  If the trustee fails to prove this, then the trustee may be liable for damages and forced to financially reimburse the trust for what the court determines is the “loss” involved.

Trustee’s duties regarding investments

California has enacted the Uniform Prudent Investor Act (PC 16045-16054) which sets forth the duties and standards for investing in connection with a trust.  These provisions contain the “standard of care” regarding investments and also the many factors to be considered by the trustee in investing trust assets (PC 16047).

Trustees can legally delegate investment functions to an agent such as a financial planner or stock broker and, if the trustee delegates this responsibility, the trustee is not liable to any trust beneficiary for decisions or actions of the agent (PC  16052).

Trustee’s duties to inform and account to trust beneficiaries

Under California law, the trustee has a duty to keep the beneficiaries of the trust informed as to what is happening in the trust and to account to all beneficiaries annually (PC 16060-16064).

The term “beneficiary” is defined in the Probate Code section 24(c) and refers to “a person who has a present or future interest, vested or contingent.”  Thus, anyone named in a trust document who may inherit in the future must receive legal notification.  If assets are in an irrevocable trust and the trust terminates in the future and goes to children, or if they are deceased to their children, or others, then all of the children, grandchildren, great-grandchildren and any other parties who could possibly inherit must be given notice (but not an accounting–see below).

When a trust becomes irrevocable or there is a change of the trustee of  this trust a specially worded notice must be sent to all trust beneficiaries within 60 days of the date the trust becoming irrevocable (usually the death of the trustor) or 60 days from the date the new trustee takes over the administration of the trust.  In the case of a trust becoming irrevocable, beneficiaries then have a 120 day period from receipt of the notice to contest the trust.  If not contested within 120 days, it cannot later be contested.

The trustee is also obligated to account at least annually, but also upon the termination of a trust and upon the change of trustee, to all trust beneficiaries who are entitled to receive principal and income payments from the trust (PC  16062).  This accounting must contain the following (PC 16063):

  1. A statement of all receipts and disbursements during the past year or since the last accounting.
  2. A statement of assets and liabilities at the end of the accounting period.
  3. A statement of the trustee’s compensation for the last year or since the last accounting.
  4. A statement of any agents hired by the trustee, their relationship to the trustee, and any compensation paid to them.
  5. Statements as to the following:
  6. The recipients may petition the court to obtain a review of the accounting.
  7. Claims for breach of trust may not be brought more than three years after receipt of the accounting.
  8. Any accounting which must be approved by the court must follow a special format.

Trustee’s duties regarding discretionary powers

The trustee must exercise any “discretionary” power with regard to trust decisions in a “reasonable” manner.  Many trust documents state that the trustee has “absolute discretion” with regard to certain matters.  Under California law this discretion is not “absolute” even though the trust wording says so; it still must be exercised in a reasonable manner (PC 16080-16081).

Allocating receipts and disbursements under the Uniform Principal and Income Act

Most trusts contain language that talk about payments from the trust or “income” and “principal.”  Income is defined as what the trust produces such as income, dividends, and net rental income (after deducting rental expenses).  Principal consist of the trust assets and also includes any gains or losses from the sale of these assets.  The Uniform Principal and Income Act (PC  16320-16347) also covers funds receive from other unusual assets such as mineral interests, patent royalties, partnership income, and other receipts.

The trustee is therefore obligated to allocate each item of income and each disbursement to income or principal and basically keep two sets of books covering these accounts.  While these two types of accounts do not have to be physically segregated (they can be kept in one bank account), the trust records must reflect the amount of income and the amount of principal held at any time.

The various code sections go into elaborate detail to list what are income and principal and the treatment of disbursements.  As an example, the payment of trustee’s fees is charged one-half to income and one-half to principal.  The trustee then becomes a bookkeeper to allocate each item received or paid to income or principal, or partially to each.  If not allocated correctly, the trust beneficiary or beneficiaries receive an overpayment or underpayment of their income from the trust.

The trustee can, under certain circumstances, make an adjustment between income and principal if the income received is not, in the trustee’s discretion, sufficient for the investments of the trust.  If the trust is receiving 2% per year for dividends and should be receiving 4% the trustee can make an adjustment.  This adjustment is limited and, in most cases, requires notice to all trust beneficiaries (PC 16336).

In addition to the power to make an adjustment, as stated above, the trustee can convert the trust from an “income” trust to a “unitrust,” where income and principal are legally merged together and the trustee does not have to keep separate records for these two accounts.  The procedure for doing this is extremely involved (PC 16336.4-16336.7) and needs to be discussed with the trustee’s attorney.

Liability of trustee

If the trustee fails to carry out all of the duties listed above the trustee is in breach of the trust.  The trustee can then be removed as trustee or have to pay for all financial losses which have been incurred, or both (PC 16420).

In some cases a co-trustee can be liable for the breach of a trust by another co-trustee and a successor trustee may be liable for a trust breach by the previous trustee (PC 16402-16403).

Financial losses which beneficiaries may claim include: any loss or depreciation in value of trust assets, profit the trustee personally made, any profit that would have accrued to the trust, plus interest, and possibly the legal costs and fees of the beneficiary’s attorneys (PC  16440-16442).

Summary

The above is a somewhat simple explanation of many of the duties and responsibilities which a trustee has in California in the administration of a trust.  While not all inclusive, it covers most of the major areas of concern.  Any trustee of an irrevocable trust should discuss in detail the above with his or her attorney in order to meet the various legal requirements under California law.

Failure to fully comply with the above can make a trustee financially liable even if the trustee acted in good faith and without receiving any compensation for acting as trustee.

©Milton Berry Scott, 2008-2016.

The Problems, Difficulties, and Family Fights that May Arise When a New Trustee Takes Over and Does Not Do His or Her job Correctly or Promptly

Who is the Successor Trustee of your Living Trust?

When husband and wife set up a living trust or where a widow or widower establishes a trust, the question is who becomes the trustee to administer the trust upon the death or incapacity of all of the trust creators.  Frequently, the party or parties will name one or more children or other relatives.  They may name their daughter, who is an attorney, or nephew, who is a CPA, feeling that their background will make them competent to act as a trustee.

A trustee of a trust needs to spend the time and energy to determine what he or she legally has to do, and then, usually subject to guidance from an attorney, carry out these duties.  Too often, the person named as trustee has a job which requires 40-60 hours per week of work, sometimes with extensive travel, and a family, and the trustee’s job does finally get done, but it may take three years to complete what should have been done in six months.

In one trust, husband and wife both die within a few months and name the wife’s nephew, who is the senior litigation attorney for a major law firm, to handle the trust, which continues for the couple’s only child.  He is 3,000 miles away and is constantly traveling and handling court cases.  The attorney for the trust and the nephew’s paralegal together handle all of the trust matters.  However, it takes two years, instead of what should have been a nine month period.

A son is named as trustee when his mother dies and the trust ends and assets go to the three children.  The son constantly travels so his mother’s home sits vacant and ignored for two years before it is put on the market for sale.  The other two children constantly complain and finally hire an attorney and threaten to sue their brother if he does not sell the home and distribute the assets.  After the trust is finally closed, the siblings never speak to their brother again

Selecting the right trustee or trustees is very important.  The most important factor is someone who has the time to determine what has to be done and carry out the work.  The learning experience can be a steep curve, but if someone is willing to spend 10-20 hours a week for several weeks, they can quickly accomplish most of the required tasks.

Second, the trustee needs an attorney for advice.  Many people believe a trust is simple to handle so they avoid an attorney.  Others do not wish to pay the costs involved.  If the trustee makes any mistakes and is challenged by a trust beneficiary, the trustee may have to pay costs and expenses out of his or her pocket.  Even where family members are involved, the emotions can run very high after a parent’s death and siblings can be challenged to justify what they are doing.

The trustee’s job, when it arises, is to tale charge of all of the trust assets, handle the investments for these assets including possible sale of securities and real estate, keep detailed accounting records, make any required or discretionary payments from the trust, see that annual tax returns are filed for the trust, and prepare and mail annual accountings to the trust beneficiaries.  Sometimes the trusts end when both the parents die, and sometimes the trust continues for the benefit of a family member.

Trustee’s Duties

A trustee of an irrevocable trust in California acts as a “fiduciary” and has the responsibility to carry out the duties of a trustee as set forth in the law. If the trustee fails to carry out these duties properly, the trustee is liable for any loss involved, may be liable for punitive damages, and may have to pay all legal fees and costs for the person bringing the legal action as well as the legal fees in defending the trustee. A trustee, if challenged, must prove what he or she did, that it was proper, and that it was done for the good of the trust and the trust beneficiary or beneficiaries.

A trustee is not exempt under the law because he or she is the spouse or child of the trust creator. Although a husband may establish an irrevocable trust at death for his wife and the wife may be the trustee and beneficiary, the children, who receive the trust assets at their mother’s death, still have legal rights. They may demand an accounting, inquire as to investments, question payments of principal for their mother’s health and support, and even bring a legal action against their mother for the claimed mismanagement of the trust. It is not unusual for a child or children to sue a parent or for a brother or sister to sue a sibling.

Irrevocable Trusts

In California, a trust is revocable unless the trust document provides otherwise. Trusts are created by a written agreement frequently referred to as a “living trust” or are created in a will of someone who dies, which is called a “testamentary trust.” The duties of a trustee of either type of trust are the same.

Irrevocable trusts include the following:

  1. A “B” trust or “B” and “C” trusts created by husband and wife and established after the death of the first spouse.
  2. An “A” and “B” trust or “A,” “B,” and “C” trusts, established upon the death of the surviving spouse.
  3. A trust created by a single person and established after that person dies.
  4. An irrevocable trust which was created initially as an irrevocable trust, such as one for the benefit of children and grandchildren.
  5. A charitable remainder trust which provides payments to someone during his or her lifetime and then terminates with the assets going to a charity or charities upon the person’s death.

Frequently, a husband and wife will establish a living trust to save estate taxes and avoid probate. On the first spouse’s death, the trust is divided into sub-trusts, frequently referred to as trusts “A” and “B” or trusts “A,” “B,” and “C.” Usually trust “A” continues as a revocable trust for the benefit of the surviving spouse with trust “B” or trusts “B” and “C” being irrevocable trusts. Many trust documents use different terms for these trusts, referring to them as “survivor’s trust,” “marital trust,” “family trust,” “exemption trust,” or “qualified terminable interest trust” (QTIP). Although the terms used are different, the types of trust are the same.

After both husband and wife die, all of their trusts become irrevocable, even though the trusts may terminate and go to the couple’s children. It takes from six months to several years to conclude the administration of these trusts.

Husband and wife may also direct that after they both die, one or more trusts will continue for the benefit of a child, children, or grandchildren, either for the lifetime of someone or for a period of years. These trusts are also irrevocable.

A single person may set up a revocable trust to avoid probate. After the person’s death, the trust becomes irrevocable until the assets are finally distributed. Or, a portion or all of the trust may continue for a period of time and the trust or trusts will be irrevocable.

An individual or a couple may set up an irrevocable trust to make gifts to their children or grandchildren, an irrevocable charitable remainder trust to benefit a charity and save taxes, or an irrevocable trust to hold life insurance to pay taxes at death and to escape estate taxes on the life insurance. To accomplish this, any such trust must be irrevocable from its inception.

Initial Duties of the Trustee

No trustee is required to serve as trustee. A trustee may legally decline to act and the next named trustee will then serve. If no successor trustee is named, the local Superior Court can be petitioned to have a bank or individual appointed as the trustee.

Once someone agrees to act as trustee, that person may later resign, but the person cannot be relieved of his or her duty as the trustee until the next named or court appointed trustee takes over.

If several people are named as co-trustees they must act unanimously, not by majority vote, and all are jointly liable for their actions.

The new trustee must carefully read the trust document, such as the will or trust agreement, as to what has to be done by the trustee. The new trustee should immediately inquire what assets are in the trust or what assets will later be coming into the trust such as through a probate, or by beneficiary designation of a life insurance policy or retirement plan.

In addition, the trustee or trustees must give notification to certain people.

  1. If the trust becomes irrevocable due to the death of someone, the trustee must give a specific notice to anyone who has or may have a future interest in the trust and to all of the decedent’s heirs at law. This specially worded notice must advise the parties that they have 120 days to contest the trust by a court action and that they may request a copy of the trust and any amendments made to it. If the notification is not made, the trustee may have personal liability for future legal action and costs.
  2. If the trust was already irrevocable but there is only a change of trustee, then a notice as to the change of trustee and trustee’s address must be mailed to all trust beneficiaries and anyone who may have a future interest in the trust.

If any California real estate is owned, a special notice must be sent to the county assessor for each parcel of real estate owned by the trust. This notice must advise the assessor of the change of trust ownership and whether the property is subject to reassessment or not for California real estate taxes.

The trustee must also quickly take charge of all trust assets and re-register the assets in his or her name as trustee. Assets might be registered in the name of “John Doe, Trustee of the Mary L. Doe living Trust, dated 9-7-98.” If a tax identification number has not been previously obtained by the trust, the trustee must complete an Internal Revenue Service form, form SS-4, and forward it to the local Internal Revenue Service Center to obtain this number or obtain the number from the IRS website. This tax identification number will then be used in lieu of a social security number for all trust assets and for all future trust income tax returns.

Legal Duties of a Trustee

California Probate code section 16000-16042 sets forth the general legal duties of a trustee. These include

  1. Administering a trust in accordance with the trust provisions.
  2. Administering the trust solely for the benefit of the interest of the trust beneficiary or beneficiaries.
  3. Where there are two or more trust beneficiaries, dealing impartially with each beneficiary.
  4. Not using trust property for the trustee’s own profit.
  5. Not having any adverse interests to the current trust.
  6. Taking reasonable steps to control and preserve trust property.
  7. Keeping trust assets registered in the trust name and keeping them separate from the trustee’s personal assets.
  8. Not delegating to others the duties of the trustee.
  9. Where there is a co-trustee or trustees, participating jointly and not turning over trust administration to the other trustee or trustees.
  10. Using the trustee’s skill in running the trust.

Valuing and Handling Trust Assets

Where the trust has become irrevocable due to the death of the trust creator and the assets are subject to federal estate tax, the trustee must value all of the trust assets as of the date of death, and also determine if a federal estate tax return is due. If one is due, it must be filed within nine months of the date of death, although this may be extended for up to an additional six month period.

If the trust was previously irrevocable and there is merely a change in trustee, then the new trustee must obtain income tax information on the cost basis of the assets and their current value.

If a trust terminates and goes to several people, the trustee is allowed under California law (unless the trust document prohibits it) to distribute different assets to different people, based on the current fair market value of these assets. If assets go to three children, it is not necessary to divide each asset and to give each child one-third of each asset. Instead the trustee may give all of one stock to one child, all of another stock to second child, etc. As long as the current value for assets received by each child is equal, there is no problem.

If the trust is divided into sub-trusts, such as a separate trust for each of the trustor’s three children, then the trustee must divide the assets and register them separately. Assets would be registered in the name of “John Doe, Trustee of the Mary L. Doe living Trust, dated 9-7-98 f/b/o Helen Doe.” Here, “f/b/o” stands “for the benefit of” followed by the beneficiary’s name. Separate individual records need to be kept for each separate, individual trust and a separate tax identification number must be obtained for each sub-trust.

 Payments from Trust

If a trust continues after the trustor’s death, payments are normally made to the trust beneficiary or beneficiaries. These payments can be discretionary, such as payments for “health, support, and education” to the beneficiary at the trustee’s discretion. Or, the beneficiary may get all of the trust income, and the principal can be used in the trustee’s discretion for the beneficiary’s “health, support, maintenance, and education.”

“Income” from a trust refers to interest, dividends, and net rental income. It does not include capital gains. Principal includes trust assets together with any gain or loss from the sale of an asset. An irrevocable trust normally keeps any capital gain on the sale of a trust asset and pays tax on this gain. There are special provisions under California’s Principal and Income Act as to what is “income” and what is “principal.” In addition, the law provides how to treat unusual assets, such as oil royalties, and unproductive assets, such as non-income producing real estate held for several years and then sold.

A change in California law, effective January 1, 2000, allows a trustee, under certain circumstances, to make an adjustment in income by increasing or decreasing the amount paid to the trust beneficiary or beneficiaries. If the trustee wishes to make such an adjustment a notice of proposed action must be mailed to all parties who would be affected at least 30 days before the adjustment is made. If anyone objects, an adjustment cannot be made without court approval.

A trustee can also, under certain circumstances, convert a trust which pays “net income” to a beneficiary to a “unitrust,” which pays a percentage of the trust value determined annually to the trust beneficiary.

Investments

California law applies as to how the trustee invests the trust assets. This is referred to as “The California Uniform Prudent Investor Act.” This act provides that a trustee “shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust.” It then sets forth a number of guidelines.

A trustee needs to diversify the assets and to invest, balancing the income which comes in with the future growth of the assets. Assets cannot be invested totally for income or totally for growth, unless the trust document directs this. There may be a 60-40 split between growth and income assets, or a 40-60 division, depending on circumstances.

A trustee may hire an investment advisor to manage the investments and, provided certain requirements are met, the trustee is not liable to the trust beneficiaries for the investment decisions made or action taken.

Record Keeping and Accounting

One of the trustee’s duties is to keep detailed records and to render an accounting to the trust beneficiary, usually annually. An accounting is not usually required if the trust is revocable, if the trust beneficiary has waived the accounting in writing, or where the trustee and sole trust beneficiary are the same.

An annual accounting is not required for a living trust created by a trust agreement or trust declaration executed before July 1, 1987, or a testamentary trust created by a will where the will was signed before July 1, 1987.

Other than the exceptions listed above, the trustee must account at least annually and at the termination of the trust to each trust beneficiary to whom income or principal is required to be paid or may be paid. This annual account must include:

  1. A statement of receipts and disbursements.
  2. A statement of assets and liabilities.
  3. The trustee’s compensation for the last year.
  4. Any agents hired by the trustee, their relationship to the trustee, and their compensation.
  5. A statement that any recipient of the accounting may petition the court for a review of this accounting and the acts of the trustee.
  6. A statement that any claims based on this accounting may not be made more than three years after the beneficiary receives the accounting.

In addition to the accounting, the trustee must keep detailed records of trust income (in terms of each dividend, interest payment, and item of income received), of sale and purchase of trust assets, of payments made from the trust, of taxes paid, and of trustee’s compensation. Statements for payments should also be retained in case they are ever questioned.

California’s Uniform Principal and Income Act requires  a two column register of items that are income and that are principal.  This is rather complex and involved.  For instance, trustee’s fees are charged one-half to income and one-half to principal.  If the trustee does not do this correctly, then the trust beneficiary, who receives payments from the trust, is either over paid or under paid.

Trust Taxation

The trustee needs to employ an accountant, enrolled agent, or tax preparer to prepare annual income tax returns for the trust.

As has been mentioned, there may be an estate tax return due when the trustor dies. This is due within nine months of the date of death, although an extension may be obtained.

An annual federal and a California trust income tax return must be filed. Forms 1041 (federal) and 541 (California) need to be filed by April 15th for the prior calendar year ending December 31st. These returns report all of the taxable income in terms of interest, dividends, rents, capital gains and losses on sale of assets, and any other taxable income. Deductions include any allowable interest paid, real estate taxes, California income taxes (on the federal return), trustee’s fees, accountant’s fees, and other deductible expenses.

If the income is paid to a trust beneficiary, a deduction is taken on the trust income tax return for the payments made and the beneficiary is then taxed on these payments. A form K-1 is attached to the return for each trust beneficiary, listing the beneficiary’s name, address, and social security number, and showing the taxable income. A copy of the form is given to the trust beneficiary so he or she will know what to report on the beneficiary’s personal income tax return.

If the trust owes tax, estimated taxes may have to be paid during the year.

If there are several trusts with separate identification numbers, a separate set of returns is required for each trust.

Summary

Being the trustee of an irrevocable trust or trusts involves a great deal of work and skill. The trustee must carefully observe all of the legal, accounting, and tax rules regarding the trust and if the trustee violates these rules, even innocently, the trustee may be personally liable for any monetary loss.

Anyone acting as a trustee should carefully select an experienced attorney and an accountant or tax preparer who is familiar with trust taxation to advise the trustee to avoid potential problems.

When someone is naming a successor trustee to take over when they die, that person should consider the above and name a person or persons who both have the time and will carry out within a reasonable time the various duties of a California trustee.

© Milton Berry Scott, 2000-2016

 

Converting a California Trust to a Unitrust

California passed legislation, effective January 1, 2006, which allows a trustee of an irrevocable trust (either a living trust or testamentary trust), to convert the trust from a “net payment of income” to a unitrust, without a court order, under certain conditions.  This can stabilize and increase the income paid to the trust beneficiary and make the administration of the trust easier for the trustee.

Trustees of California trusts should carefully examine their trusts to see if they meet these new requirements and if conversion should be considered.

Payments of income from a trust, whether coupled with discretionary payments of principal or not, frequently lead to problems.  For example, the trust beneficiary receives the “net income” from the trust and desires the highest amount of income possible.  The “income” consists of dividends on stock, interest and net rental income.  Capital gains from the sale of trust assets are “principal” and not part of the income paid to the trust beneficiary.

The trust remainder persons, who receive the principal on the beneficiary’s death, may desire the greatest appreciation of assets, with little or no concern regarding income.  With the dividends paid by stock companies, as a percentage of the price of a stock,  falling over the years,  and with interest rates declining in the last five years, the “net income” available to a trust beneficiary has fallen.

To compensate for this, the California legislature, in 1999, amended the Probate Code dealing with what is “income” and “principal” under provisions of the California Uniform Principal and Income Act (Probate Code sections 16320-16375).  This Act, which dates from 1962, defines in great detail what is income and principal and what expenses are charged to each.  Trustees are obligated to keep detailed records reflecting income and principal accounts for each trust.

The 1999 changes to this Act allowed a trustee, under certain conditions, to make adjustments in the income paid to a trust beneficiary by allocating some capital gains (normally principal) to income or increasing the income in other ways.  While the changes were useful, this adjustment provision could not be used if a trust beneficiary, such as the spouse, was the trustee.  Unless there was a co-trustee who was not a beneficiary of the trust or a bank acting as the sole trustee, this provision could not be used.

In 2003 the Internal Revenue Service issued trust income tax regulations (IRS Reg.1.643(b)-1) which provided that if a state statute provided that net income is a unitrust amount of no less than 3% or more than 5% of the fair market value of the trust assets, determined annually, or averaged over a multiple year basis, this would be taxed as “net income.”  These regulations allowed capital gains to be taxed to a trust beneficiary instead of to the trust, when the gain was distributed to the beneficiary.

Although California had an adjustment provision in the Probate Code, as mentioned above, it did not have any provisions for a “unitrust.”  The California Uniform Principal and Income Act was therefore amended, by amending Probate Code sections 16328-16338 and adding Probate Code sections 16336.4-16336.7,  to allow a method of conversion of a trust to a unitrust.

A unitrust is a trust where the assets are valued, usually annually, and the trust beneficiary then receives a predetermined percentage of this value for the following year.

If a trust had $1,000,000 in value on December 31st, the annual valuation date, and the trust paid a unitrust amount of 4% per year, the beneficiary would receive $40,000 the following year, or $3,333 per month.  The next December 31st the trust would again be valued and, based on the value, the trust beneficiary would receive 4% of that value for the next year, usually paid on a monthly basis.

Factors to Consider When Converting

Under a number of conditions, California law now allows a trustee to convert a trust to a unitrust, whether it is a testamentary trust under a will or a living trust.  California Probate Code sections 16336.4-16336.7 were added, effective January 1, 2006, and define the conversion process and steps which must be undertaken to legally convert a trust.

California Probate Code section 16336(g) sets forth a non-exclusive list of factors that the trustee may consider when deciding whether to convert an existing trust to a unitrust. These factors are as follows:

  1. The nature, purpose, and expected duration of the trust.
  2. The intent of the trustor.
  3. The identity and circumstances of the beneficiaries.
  4. The needs for liquidity, regularity of income, and preser­vation and appreciation of capital.
  5. The assets held in the trust; the extent to which they consist of financial assets, interests in closely held enterprises, tangible and intangible personal property, or real property; the extent to which an asset is used by a beneficiary; and whether an asset was purchased by the trustee or received from the trustor.
  6. The net amount allocated to income under other statutes and the increase or decrease in the value of the principal assets (which the trustee may estimate for assets which do not have readily available market values).
  7. Whether and to what extent the trust gives the trustee the power to invade principal or accumulate income or prohibits the trustee from invading principal or accumulating income, and the extent to which the trustee has exercised a power from time to time to invade principal or accumulate income.
  8. The actual and anticipated effect of economic conditions on principal and income and effects of inflation and deflation.
  9. The anticipated tax consequences of an adjustment.

Converting a trust

Unless prohibited by the governing instrument, a trustee or trustees of a trust may convert a trust, under Probate Code section 16336.4(b), to a unitrust if all of the following provisions apply:

  1. The three conditions set for in Probate Code section 16336(a) apply;
  2. None of the express prohibitions in Probate Code section 16336.4(h) applies;
  3. The unitrust is administered, under conditions as set forth in Probate Code section 16336.4(e); and
  4. The prescribed notice to trust beneficiaries is given and no beneficiary makes timely written objections.

Three preconditions

All of the three conditions in set forth in Probate Code section 16336(a) must be met.  They include the following:

  1. The trustee invests and manages the trust assets under the Prudent Investor Rule (California Uniform Prudent Investor Act -Probate Code sections 16045-16054). Most trusts operate under this rule;
  2. The trust describes the amount that shall or may be distributed to a beneficiary by referring to the trust’s income; and
  3. The trustee determines, after applying the rules for allocation of receipts and disbursements that are mandated by Probate Code section 16335(a), and considering any power the trustee may have under the trust to invade principal or accumulate income, that the trustee is unable to treat all classes of beneficiaries impartially, under Probate Code section 16335(b).

Conditions 1 and 3, above, are generally easy to satisfy.  Condition 2, above, is only a problem if the beneficiary or beneficiaries do not receive the net income but receive a fixed amount or some other described amount.  Personal residence trusts, charitable remainder trusts, and some other trusts will not qualify for the conversion.

Prohibitions regarding the conversion of a trust

A trustee may not convert a trust to a unitrust under Probate Code section 16336.4(h) in any of the following circumstances:

  1. If payment of the unitrust amount would change the amount payable to a beneficiary as a fixed annuity or a fixed fraction of the value of the trust assets.
  2. If the unitrust distribution would be made from any amount that is permanently set aside for charitable purposes under the governing instrument and for which a federal estate or gift tax deduction has been taken, unless both income and principal are set aside.
  3. If possessing or exercising the power to convert would cause an individual to be treated as the owner of all or part of the trust for federal income tax purposes, and the individual would not be treated as the owner if the trustee did not possess the power to convert.
  4. If possessing or exercising the power to convert would cause all or part of the trust assets to be subject to federal estate or gift tax with respect to an individual, and the assets would not be subject to federal estate or gift tax with respect to the individual if the trustee did not possess the power to convert.
  5. If the conversion would result in the disallowance of a federal estate tax or gift tax marital deduction that would be allowed if the trustee did not have the power to convert.

The above prohibitions will generally not apply to most regular net income trusts.  Unlike the inability of a trustee/beneficiary to use the adjustment powers mentioned earlier, a trustee who is also a beneficiary of the trust can legally convert a trust to a unitrust.

Notice requirements

Once the trustee decides to convert, without obtaining a court order, the trustee must give a notice of proposed action under Probate Code sections 16500-16504 to all trust beneficiaries, including minors and incapacitated adults.  Then, at least 45 days must elapse before making the conversion provided no beneficiary files a written objection to the proposed conversion.

In mailing notice, under Probate Code section 16336.4(c), the trustee must include with the notice all of the following:

        1. A statement that the trust shall be administered in accordance with the provisions of section 16336.4(e) (the unitrust amount and accounting year of the trust) and the effective date of the conversion.
        2. A description of the method to be used for determining the fair market value of trust assets.
        3. The amount actually distributed to the income beneficiary during the previous accounting year of the trust.
        4. The amount that would have been distributed to the income beneficiary during the previous accounting year of the trust had the trustee’s proposed changes been in effect during that entire year.
        5. The discretionary decisions the trustee proposes to make as of the conversion date, pursuant to section 16336.4(f), which covers the following:

(a) The effective date of a conversion to a unitrust.
(b) The frequency of payments in satisfaction of the unitrust amount.
(c) Whether to value the trust’s assets annually or more frequently.
(d) What valuation dates to use.
(e) How to value nonliquid assets.
(f) The characterization of the unitrust payout for income tax reporting purposes. The trustee’s characterization shall be consistent.
(g) Any other matters that the trustee deems appropriate for the proper functioning of the unitrust.

        • A copy of Probate Code sections 16336.4-16336.
        • Notice must be provided to all income beneficiaries and to “a beneficiary who would receive a distribution of principal of a trust if the trust were terminated at the time notice is given.”

Required terms of the unitrust

After a trust is converted to a unitrust all of the following rules must apply unless a court orders otherwise or all of the trust beneficiaries agree in writing to other terms, as provided in Probate Code section 16336.4(e):

1. The trustee shall make regular distributions in accordance with the governing instrument construed in accordance with the provisions of this section.
2. The term “income” in the governing instrument shall mean an annual distribution, the unitrust amount, equal to 4 percent, which is the payout percentage, of the net fair market value of the trust’s assets, whether those assets would be considered income or principal under other provisions of this chapter, averaged over the lesser of:

A. The three preceding years, or
B. The period during which the trust has been in existence.

3. During each accounting year of the trust following its conversion into a unitrust, the trustee shall, as early in the year as is practicable, furnish each income beneficiary with a statement describing the computation of the unitrust amount for that accounting year.
4. The trustee shall determine the net fair market value of each asset held in the trust no less often than annually. However, the following property shall not be included in determining the unitrust amount:

A. Any residential property or any tangible personal property that, as of the first business day of the current accounting year, one or more current beneficiaries of the trust have or have had the right to occupy, or have or have had the right to possess or control, other than in his or her capacity as trustee of the trust, which property shall be administered according to other provisions of this chapter as though no conversion to a unitrust had occurred.
B. Any asset specifically devised to a beneficiary to the extent necessary, in the trustee’s reasonable judgment, to avoid a material risk of exhausting other trust assets prior to termination of the trust. All net income generated by a specifically devised asset excluded from the unitrust computation pursuant to this subdivision shall be accumulated or distributed by the trustee according to the rules otherwise applicable to that net income pursuant to other provisions of this chapter.
C. Any asset while held in a testator’s estate or a terminating trust.

5. The unitrust amount, as otherwise computed pursuant to this subdivision, shall be reduced proportionately for any material distribution made to accomplish a partial termination of the trust required by the governing instrument or made as a result of the exercise of a power of appointment or withdrawal, other than distributions of the unitrust amount, and shall be increased proportionately for the receipt of any material addition to the trust, other than a receipt that represents a return on investment, during the period considered in paragraph (2) in computing the unitrust amount. For the purpose of this paragraph, a distribution or an addition shall be “material” if the net value of the distribution or addition, when combined with all prior distributions made or additions received during the same accounting year, exceeds 10 percent of the value of the assets used to compute the unitrust amount as of the most recent prior valuation date. The trustee may, in the reasonable exercise of his or her discretion, adjust the unitrust amount pursuant to this subdivision even if the distributions or additions are not sufficient to meet the definition of materiality set forth in the preceding sentence.
6. In the case of a short year in which a beneficiary’s right to payments commences or ceases, the trustee shall prorate the unitrust amount on a daily basis.
7. Unless otherwise provided by the governing instrument or determined by the trustee, the unitrust amount shall be considered paid in the following order from the following sources:

A. From the net taxable income, determined as if the trust were other than a unitrust.
B. From net realized short-term capital gains.
C. From net realized long-term capital gains.
D. From tax-exempt and other income.
E. From principal of the trust.

8. Expenses that would be deducted from income if the trust were not a unitrust may not be deducted from the unitrust amount.

The trustee can deviate from the above required terms under Probate Code section 16336.5(a).  The default rule for payment is 4%, but can be any percentage from 3-5%.  The trustee can also list assets to be excluded from the unitrust computation (other than listed in section 16336.4(e)(4)), and decide that certain assets be valued less frequently than annually, and that certain expenses be paid out of the unitrust amount.  If any deviation occurs the trustee must obtain the written consent of all trust beneficiaries or a court order. 

Administrative matters determined by the trustee

The trustee is required, under Probate Code section 16336.4(f), to determine all of the following matters as they relate to the administration of a unitrust.

1. The effective date of a conversion to a unitrust.
2. The frequency of payments in satisfaction of the unitrust amount.
3. Whether to value the trust’s assets annually or more frequently.
4. What valuation dates to use.
5. How to value nonliquid assets.
6. The characterization of the unitrust payout for income tax reporting purposes. However, the trustee’s characterization shall be consistent.
7. Any other matters that the trustee deems appropriate for the proper functioning of the unitrust.

Court order for conversion

In lieu of notice, or upon the timely written objections of a beneficiary when he or she receives notice, a trustee may petition the court to convert a trust to a unitrust.  Any trust beneficiary may also petition the court for such conversion.  The court shall approve the conversion to a unitrust if all the provisions of section 16336(a) are satisfied and the court determines that the conversion will enable the trustee to comply with section 16335(b), which provides the trustee shall administer the trust impartially. The court may not change the percentage payout below 3% or for more than 5%.

Reconversion or change in percentage payout

Once converted to a unitrust, a trust can be converted back to a “net income” trust or the percentage payout can be changed pursuant to Probate Code section 16336.6(a) provided the following conditions apply:

1. At least three years have elapsed from the conversion of the trust;
2. The trustee determines that the reconversion of change in percentage would enable the trustee to better comply with section 16335(b) (administering the trust impartially for all classes of beneficiaries); and
3. Written notice to all trust beneficiaries has been made with no timely objections.

While a trustee may not reconvert a trust or change the percentage payout for three years, a trustee can petition the court at any time, even within the three year period, to make these changes.

Discretionary principal payments from trust

If the trust document provides for discretionary payments from a trust (health, support, maintenance and education), the trustee is still free to make such payments even though the trust has been converted to a unitrust.

 Exculpatory provisions regarding trustee converting or not converting a trust

The trustee has no legal obligation to adjust or convert a trust and is not liable for not considering any adjustment or conversion. In any legal proceedings regarding an adjustment or conversion to a unitrust, the sole remedy is to obtain a court order directing the trustee to covert the trust to a unitrust, to reconvert from a unitrust, to change the distribution percentage, or to order an administrative procedure which the court considers appropriate.  The court can make adjustments but can not award a party damages because adjustments were not made.

Conclusion

Every trustee of a California trust that may legally be converted to a unitrust should review the trust document and determine if the trust can legally be converted to a unitrust.  If so, the trustee should determine the current annual income payments to the beneficiary or beneficiaries as well as what amount 4% of the trust value would produce.

The trustee should then carefully review whether the trust should be converted to a unitrust or not.

If a trustee decides to make a conversion, it is important to very carefully follow the Probate Code provisions on the conversion to avoid problems at a later date.

 

 

© Milton Berry Scott, 2006-2016.

 

 

 

 

Probate in California

          Most people are aware of “probate” but do not know what it means. Especially in view of what is written in the popular media, most people want to avoid the hassle, time, and costs of this process.

Purpose of Probate

Probate is not designed to be an employment bill for attorneys. The probate process can be avoided, but most people do not take the time or effort to understand what this process is and how it can be avoided.

Probate is a legal process whereby a court validates the deceased person’s will or determines that he or she died without a will. The court also appoints someone to handle the decedent’s assets and pay the bills owed at death. That someone is referred to as an executor, administrator, or administrator with the will annexed, depending on the circumstances.

An additional purpose of probate is to see if anyone was owed money at the time of death so that creditor can come forward and make a claim to receive payment. There is a fixed period of time for creditors to come forward and demand payment.

Along with the payment of debts, the probate process is designed to see that taxes are paid. Income taxes for the personal income tax return up to the date of death must be paid. Income collected during probate requires the filing of a separate estate income tax return and the payment of tax. If the decedent owned over $5,250,000 of assets at the date of death, depending on the year of death, a federal estate tax return is required and the tax due must be paid within nine months of the date of death.

Lastly, after all assets of the decedent are collected, assets are sold and taxes and debts are paid, then the executor or administrator must distribute the remaining assets in accordance with the decedent’s will or the rules of intestate succession if the decedent died without a will.

 Assets Subject to Probate Process

While not all assets that the decedent owned are subject to probate, the following assets are subject to the probate process:

  1. Assets in the deceased person’s name alone.
  2. An asset in the decedent’s name with his or her spouse, which is registered as community property, as to one-half of each community property asset.
  3. The deceased person’s portion or share of an asset where the asset is registered as tenants in common with other people.
  4. Assets which are owned but are not registered, such as furniture, jewelry, etc.

California law provides that a probate is not necessary if the total value at the time of death of the assets which are subject to probate does not exceed the sum of $100,000.  There is a simplified procedure for the transfer of these assets. The $100,000 figure does not include vehicles and certain other assets.

Assets not subject to Probate

As mentioned, not everything is subject to probate. Even though there may be a probate for a portion of assets owned, the following assets are not subject to the probate process:

  1. Assets titled in joint tenancy with another person or persons.
  2. Assets held in a living trust.
  3. Assets such as life insurance and IRA benefits, where a beneficiary is named.
  4. Assets in a bank or savings and loan account in the deceased person’s name as “trustee” for someone else.
  5. Assets which can be registered in a person’s name and which are “payable on death” to someone.
  6. Assets passing to the surviving spouse. If the deceased person owned assets in his or her name alone but these assets are left by will or pass by intestate succession to the surviving spouse, no probate is necessary.
  7. Assets held by husband and wife and titled as “Community Property with Right of Survivorship.”

California has a simplified legal process referred to as a “spousal confirmation proceeding.” Here, a petition is filed with the court, notice is given to certain parties, and if no one objects, the court approves the assets as going to the spouse. This procedure can only be used for husband and wife.

John Doe has $200,000 of separate property stock in his name alone. He has a will which leaves everything to his wife. His wife can go through this spousal confirmation proceeding. The advantage is there is no fixed fee as there is for probate, and the process takes approximately 30-60 days instead of 9-12 months.

STEPS INVOLVED IN THE PROBATE PROCESS

When someone dies, the first question is whether there will be a probate proceeding. If all of the assets are in a living trust or joint tenancy, then the answer will be no. If the deceased person has more than $150,000 of assets in his or her name alone and there is no surviving spouse or the assets were not left to the spouse, the answer will be yes.

If it is necessary to have a probate, the second question is who will act? If the decedent left a will, he or she named someone in the will as executor. That person or persons does not have to be a California or United States citizen or resident. A friend may serve, his or her  three children may serve jointly, or a California bank or trust company may serve. No one has to serve if named. Will the person or persons agree to serve?

If there is no will then the nearest relative or relatives have the first right to serve as administrator or to nominate someone if they do not wish to serve. If there is no will, the person appointed by the court is called an administrator.

Occasionally, someone will die with a will, but the will does not name an executor or the person named is deceased or will not serve. Or possibly a bank is named and the bank declines because the estate is not large enough for the bank. The court then appoints the nearest relative who inherits under the will. That person is referred to as an administrator with the will annexed.

All of the above do the same duty once they get appointed even though their title varies depending upon the circumstances.

Appointment by Court

To start the probate process it is necessary to file a petition with the superior court in the county where the deceased person lived at the time of death. This petition is set for hearing approximately 45-60 days after it is filed with the court.

If there is an emergency and it is necessary for someone to act within the 30 day period, it is possible to get someone appointed within 24 hours as a “special administrator.” This person handles estate assets until the executor or administrator gets appointed. If the decedent was the only signer on a business bank account and salary and other bills have to be paid immediately, a special administrator can be appointed.

After the petition is filed, a notice of the court hearing must be published three times in a local newspaper. In addition, a notice of the court hearing must be mailed at least 15 days prior to the hearing to everyone named in the will and all of the deceased person’s heirs at law (those people who would inherit if he or she died without a will).

If the will had special wording at the end of it where the witnesses sign, then it may be “self-proving” and no additional statements are necessary. If the will is not self-proving then a statement must be obtained from one of the witnesses to the will.

If a witness cannot be located, then there are several alternative ways of proving the will. If the will is handwritten anyone who is familiar with the decedent’s handwriting can sign a statement proving the will.

If the will does not waive a surety bond, then the executor or administrator must post a surety bond. The surety bond is nothing more than an insurance policy which insures the estate if the executor or administrator does something improper or steals from the estate. Unfortunately, the premium of approximately $200-800 is paid out of the estate assets.

At the court hearing if everything has been done and there are no objections, the court will admit the will to probate and appoint the executor or administrator.

After the appointment the executor or administrator must file a special form with the court titled “letters testamentary” or “letters of administration.” This is signed by the person and he or she agrees to act as executor or administrator. Later, when taking legal action or transferring assets, other parties will want a certified copy of these “letters” showing that the person has the legal authority to act.

Collecting Assets

After the appointment the executor or administrator must take possession of all of the decedent’s assets subject to the probate process. Assets in joint tenancy, assets in a living trust or assets subject to a beneficiary designation are not part of the probate and are not collected.

The executor or administrator needs to change title to the assets and to put these assets in his or her name as executor or administrator. Mutual funds, stocks and bonds, brokerage accounts, bank accounts, real property, vehicles and other assets should be changed over.

After collecting all of the assets, it is necessary to prepare an inventory listing these assets. At the time that the executor or administrator was appointed the court also appointed a “California Probate Referee.” This individual has the responsibility of valuing all of the non-cash items with the fair market value as of the date of death. The referee receives a fee of $1 per $1000 for the value of the assets appraised. The value is the gross value excluding any loans or liens on the assets. If the home is valued at $300,000, even though there is an $180,000 mortgage on this home, the referee values it at $300,000 and receives a $300 fee for this.

There are legal procedures for contesting the referee’s value if someone does not believe it to be accurate.

The appraisal of all of the assets is supposed to be filed with the court within four months of the executor’s or administrator’s appointment.

Payment of Bills and Debts

As soon as the executor or administrator is appointed by the court and obtains money, bills can be paid. Funeral, utility, credit card and other bills can be paid without any special legal formality.

Anyone can be required to submit a creditor’s claim in the estate. This is a special court form which must be completed by the creditor and approved by the executor or administrator. If the executor or administrator wants this form submitted by a creditor, then a notice must be sent to the creditor.

Claims normally must be submitted within four months of the executor’s or administrator’s appointment. There is an exception if the creditor was not aware of the death. If that occurs, the creditor can petition the court after the four-month period for submitting a claim. The petition can not be filed later than one year after the executor’s or administrator’s appointment.

If a creditor’s claim is rejected by the executor or administrator, the creditor must file a lawsuit within three months of the rejection or lose all right to later sue. Before a lawsuit can be filed, the creditor must file a claim.

If John Doe is in an automobile accident and dies and other parties wish to sue his estate, they must file a creditor’s claim within the required period before they can file a lawsuit.

Most estates do not involve any creditor’s claims. The executor or administrator pays the outstanding bills and no one objects.

Sale of Estate Assets

It may be necessary or practical to sell some or all of the estate assets. Assets may have to be sold to pay taxes, fees and debts. Or the home may be vacant and the children do not wish to inherit it, so it is sold during probate.

There are two methods of selling assets in a probate proceeding, which the executor or administrator may choose.

First, court approval may be obtained before any asset is sold. If the stocks or bonds are sold, a court order is necessary before selling them. If real estate is sold, a court hearing must be held and anyone may offer a higher price for the property in court and take it away from the original buyer.

Second, the executor or administrator may sell assets under a provision of California law referred to as the “Independent Administration of Estates Act.” Under this act the executor or administrator may sell any asset. The only requirement is to give written notice to any beneficiary who is affected by the sale at least 15 days before the proposed date of sale. If no one objects, then the sale may proceed. If someone objects, then the court must be petitioned for approval the same as alternative number one, above.

After appointment, the executor or administrator usually prepares a budget with an estimate of the federal estate tax, fees for the executor and attorney, administrative costs, cash bequests under the will, and debts or claims. If there is insufficient cash available, then a decision must be made as to what assets to sell. If there is sufficient cash available, then a decision must be made as to whether any assets such as the home should be sold.

Once the decision is made to sell assets, the executor or administrator should proceed with the sale. It makes little sense to allow the home to remain vacant for nine months and then put it on the market for sale. If the home is going to be sold, there seems little reason why it should not be marketed within 30 days of the appointment.

PAYMENT OF TAXES

The executor or administrator is liable to see all of the taxes due the federal government and the State of California are paid. While he is not normally personally liable, his liability does extend to the assets which are in probate. If the executor or administrator distributes assets and the Internal Revenue Service or California Franchise Tax Board assesses a deficiency, he is liable to the value of the assets distributed.

One immediate concern is who will handle all of the tax work involved? It can be the executor or administrator if the person is skilled enough to do so. Or, it may be the attorney. More likely it will be the tax preparer, enrolled agent or certified public accountant who handled the decedent’s tax matters prior to death. Whoever it is must be skilled enough to prepare and file all of the required tax returns.

Federal Estate Tax

If a person dies with over $5,250,000 (2013), in assets, an estate tax return must be filed within nine months of the decedent’s death. An extension to file this return may be obtained for up to an additional six months.

Any amounts left to qualified charities and any amounts left to the decedent’s spouse (if a United States citizen) are exempt. All debts that the decedent owed at the time of death such as funeral costs, legal fees, debts, etc. are also deducted. If the net estate is over $5,450,000, after deducting the debts, a tax of 40% of the amount over  $5,450,000 is payable. If the return is not filed within the required time limit or if the tax due is not paid there may be substantial penalties and interest. Because the value of the assets is the value as of the date of death, the person who is preparing the tax needs to immediately start gathering information as soon as possible after the decedent’s death.

Prior to Death Income Tax Returns

Even when someone dies, an income tax return has to be filed for the year of death. Mary Doe dies on July 21st. An income tax return will be required from the first of the year until the date of death-January 1st-July 21st. The return is due by April 15th of the following year. Only the income received and any deductions paid through the date of death will be reported on the return. Income such as dividends and interest received after the date of death will not be reported on the return but will be picked up on the estate income tax return or by the surviving joint tenant if the asset was in joint tenancy.

Any medical deductions on the decedent’s part paid within one year of the date of death may be deducted on the final return. All other deductions must have been paid before death to be allowable.

Estimated income taxes paid for the year of death should be reviewed. Depending upon the date of death, it may not be necessary to continue to make estimated payments after death.

The decedent’s income tax returns for the four years prior to death should be retained and the return for the year prior to death should be carefully reviewed to be sure all items of income and deductions are picked up.

If the decedent died after January 1st but before April 15th or even later, a return may still be due for the prior year. With extensions, it is possible to file the income tax return as late as October 15th for the prior year. If the return has not yet been filed, an extension can be requested and will usually be granted.

Fiduciary Income Tax Returns

Income which comes in after the date of death is not reported on the decedent’s personal income tax return. If the interest, dividends or other income are paid to the estate, they must be reported on the fiduciary or estate income tax return. A separate tax identification number is obtained for the estate and used in lieu of the decedent’s social security number.

A separate income tax return, called a fiduciary tax return, is filed annually for the estate. This form lists the taxable income such as dividends, interest, capital gains and net rents. The fiduciary return also takes off the allowable deductions such as mortgage interest, legal and executor’s fees, taxes, and a few other deductions.

The tax return does not have to filed on a calendar year basis, as of December 31st. It can be filed on a fiscal year basis at the end of any calendar month. Once a fiscal year is picked, the return must be filed within 3-1/2 months of the end of the tax year.

At the end of the tax year if the estate has not been closed and distributed, the tax is then paid on the net income. That income is later distributed to the beneficiaries of the estate without additional tax. If the estate has been distributed during the tax year, the tax is not paid on the net income, but instead each beneficiary must list his or her proportionate share of the taxable income on his or her personal tax return.

Fiduciary tax returns are required until the estate is closed and distributed. If the estate is open for more than two tax years, estimated fiduciary taxes must be paid each year.

Other Taxes

Other taxes may also be due. Real estate taxes are due in California by December 10th and April 10th. Sales tax may be due if there is a business selling some product.

If the decedent made a gift of over $14,000 to someone during the year of death, a gift tax return may be due. If there is real property in another state or country, it may be necessary to file a separate income tax return for the income in that state or country.

Liability for Taxes

As previously mentioned, the executor is liable for taxes if assets are distributed and additional taxes are later discovered to be due. Because of this, the executor or administrator will frequently request to be allowed to hold back some estate funds for a period of time as a reserve if additional taxes are due. This reserve may be kept for two to three years and then distributed without additional court order to the estate beneficiaries.

The period of liability for taxes is normally three years for the federal government. This period is from the due date of the return or the filing date if it is later. The period of liability for the State of California is four years. The liability for a 1998 return filed on or before April 15, 1999, will expire on April 15, 2002 for the Internal Revenue Service and on April 15, 2003 for the California Franchise Tax Board. There are longer periods of liability if the taxes are underpaid by 25% or more. The period of liability never runs out if a tax return is not filed or if there is fraud involved.

CONCLUDING THE ESTATE

After the estate assets have been inventoried, the period for filing creditor’s claims has expired and all claims paid or resolved, the necessary assets sold, and all required tax returns filed and taxes due paid, then the estate can be distributed.

To conclude the estate it is necessary to petition the court and to obtain a court order to make the distribution. The executor must either file an elaborate accounting listing all receipts and disbursements or obtain a waiver of the accounting from all of the estate beneficiaries.

After the accounting is prepared or waived, a petition is drafted which is a summary of the estate and the actions taken. This petition lists the assets currently on hand and the proposed distribution of these assets. The fee that the executor or administrator and the attorney receive is computed and shown.

If everything is in order and there are no objections, the court will issue an order concluding the estate, ordering the fees paid, and the assets distributed.

Once the court order is obtained, checks may be written and assets re-registered in the names of the estate beneficiaries. After the assets are distributed a receipt for these assets is obtained from each estate beneficiary and filed with the court.

As previously stated, if the estate is relatively simple and no federal estate tax is due, it can be concluded in 6-9 months. If there is an estate tax due, the period will likely increase to 12-15 months. The estate should not be in probate for more than 18 months unless there is litigation or significant problems that prevent distribution.

© Milton Berry Scott, 1998-2016

Revised 1-2-2016