Estate planning is a critical aspect of financial security, as it involves creating a plan for the distribution of one’s assets and properties after they pass away. Without proper estate planning, the distribution of assets can become a contentious and complicated process, which can lead to potential conflicts among family members and legal disputes. Proper estate planning helps to ensure that one’s wishes are carried out in a manner that is fair, efficient and cost-effective.
Another key aspect of estate planning is that it can minimize tax liabilities and other expenses that may arise during the probate process. To that end, Christian Koch, lecturer in finance in the Poole College of Management, recently collaborated with colleagues to publish a paper in Tax Notes, about the tax consequences of settling estate disputes. We sat down with him to discuss his findings.
Q&A with Christian Koch
What does your research focus on?
This paper is written from a finance practitioner’s standpoint and fits into the overall financial planning ecosystem. Specifically, it’s looking at the tax consequences of settlement payments and how to get the right deductions on your estate tax return.
There are a lot of legal and tax challenges that can emerge in the process of closing an estate or settling a dispute – and this paper examines the tax consequences of settling estate disputes. The main question we wanted to answer was how settlement payments impact beneficiaries and surviving spouses on estate tax returns, and how they affect what is – or is not included – in the taxable estate. We also offer practitioners some practical advice for identifying and resolving these challenges.
Why is this significant?
Compared to investing, estate planning has a lot more predictability. Investing is market-based – and so it has more ups and downs because the market is uncertain – whereas estate planning is rules-based. So planning your estate adds more value than investing. However, the tax effects of estate planning are often an afterthought.
These are important, though. Today, you can have $11.5 M of assets without paying federal estate tax, and a married couple can have $22.8 million. There’s a real opportunity for value creation there. Legally, you can minimize your estate tax which can be worth in the range of 2.5% percentage points of investment return each year for about 20 years. So understanding these tax effects has significant implications for achieving your family’s financial goals.
Tell us a little more about the tax consequences associated with administering an estate and settling disputes.
Executors are responsible for satisfying all tax obligations for the decedent and the estate, and as part of this obligation, they file an income tax return for the estate (Form 1041), as well as any necessary estate tax return (Form 706). Form 706 is a 29-page document that includes some complex calculations to navigate in order to determine the taxable estate. They also challenge any questionable claims made against the estate.
Notably, settlement payments have some important tax consequences – and these differ depending on whether you’re a creditor, beneficiary or surviving spouse. Imagine three doors. For creditors, settlement payments made to satisfy third-party debts are generally tax-deductible. For beneficiaries, such as sons or daughters, you have to look at the nature of the claim. It’s tricky here because when beneficiaries file claims against the estate, they can hold two statuses: a beneficiary and a third-party creditor. Settlement payments to valid third-party claims are tax-deductible, but settlement payments to a beneficiary are not. Surviving spouses usually get the marital deduction (under Section 2056) which passes tax-free, but there’s a lot of blurriness – there are a lot of strict requirements that must be met to meet the deductibility threshold of Section 2056.
What’s the biggest takeaway from your research? And what advice do you give to practitioners?
Settlement payments to beneficiaries typically don’t reduce the overall taxable estate of a decedents, except in certain cases – and settlement payments to surviving spouses may qualify for the marital deduction and reduce the taxable estate of a decedent.
As for advice to practitioners, one of the first things newly-appointed executors should do is identify and satisfy any legitimate third-party debts owed by the decedent. For any payments excluded to a beneficiary, an executor should practice great care to ensure they draft a proper settlement agreement with significant evidence supporting the claim that the settlement amounts are excluded from the taxable estate. For settlement payments to surviving spouses, practitioners must carefully document and support any claims that the payment was legitimate and is justified by bona fide enforceable spousal rights under state law.
Finally, I recommend using the TPA/TGE ratio. The numerator is total pre-tax assets (IRAs, 401Ks, etc) and the denominator is total gross estate. This ratio tells you how much of your assets are infested with taxes.
What are some of your future research ideas?
Based on this research paper, I am now working on the taxable investors view point. One of the main constructs of academic finance is the capital market line (CML), which describes different asset classes from treasury bonds, common stocks to private equity. The CML is upward sloping to the right based on risk and return. However, most anyone who studies finance both academically or professionally as a financial advisor treats taxes as an afterthought. I am working on a model to tax effect the capital market line which leads to a distinct competitive advantage for two specific asset classes, which are muni bonds and common stocks. The taxable investor needs to think differently from an investment as well as an estate tax perspective. Creating value at the intersection of investing, tax and estate planning is the chief cornerstone of financial planning.
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