Creditors, Testamentary Trusts, and Tax Issues - Module 5 of 5

Module 5: Creditors, Testamentary Trusts, and Tax Issues

In addition to gathering a deceased person’s assets and distributing gifts to beneficiaries of the estate, executors are responsible for a number of financially important matters, including the payment of creditors and paying taxes on behalf of the estate. In addition, executors and trustees are responsible for funding and overseeing various aspects of testamentary trusts.

Paying Creditors

Any time a person dies owing money – whether on a personal loan or car loan, credit card, mortgage, student loan or child or spousal support – the estate may be responsible for payment of the debt. There are statutes and rules in place to help an executor evaluate such debts and determine the amount to be paid to the creditor, if any.

The first step an executor takes in evaluating potential creditors is determining if creditors exist and who those creditors may be. Bills for payment of credit cards, mortgages or loans or medical bills can help an executor identify outstanding creditors. Known creditors who may be owed money from the estate, and creditors who, with due diligence, should be found, must be notified of the testator’s death and given the opportunity to file a claim for payment.[1] This includes sending notice to the Agency for Health Care Administration for a testator who was receiving Medicaid or Medicare[2] and to the state’s Department of Taxation or Revenue to determine if the decedent owed any taxes.[3]

Notice may be actual or constructive. Actual notice is sent directly to a known creditor, advising the creditor of the testator’s death and the information needed to file a claim for payment. Constructive notice may be used for unknown creditors, often by publishing the death and the notice to file claims in a newspaper in the county of the decedent’s residence.[4] To be effective, any notice must include pertinent information such as the decedent’s name, last known address, date of birth, and date of death, the name and address of the estate’s executor and the amount of time the creditor has to present a claim.[5]  

Generally, creditors’ claims are time-limited; claims not filed within the allotted time are barred.[6] For example, in Indiana, creditors must file claims within ”three months after the date of the first published notice to creditors or three months after the court revokes probate of a will… if the claimant was named as a beneficiary.” Any late-filed claim is permanently barred.[7]

The executor is responsible for reviewing all claims filed in the estate. Claims that are not filed in a timely manner are barred, although state law may require the filing of an objection or disallowance by the executor.[8] A claim may also be considered invalid if it was previously paid or paid during life, if the debt is not owed or was forgiven or if the creditors’ proof of the claim is insufficient. A probate court reviewing the claims and the executor’s allowances or objections will either file an order for payment or an order approving the objection.  

Priorities of Claims

When all claims have been evaluated, the executor will notify the court which debts are valid and what amount will be paid.[9] If the estate has sufficient resources to pay all debts and sufficient assets to also pay all beneficiaries, the creditors and beneficiaries receive the full amount of their claims and inheritances. However, where the estate is insufficient to pay all creditors and beneficiaries in full, the assets of the estate abate, usually in accordance with priorities set forth by state law.

For example, Wisconsin law gives priority to creditors and beneficiaries as follows:

1. Costs and expenses of administration;

2. Reasonable funeral and burial expenses;

3. Certain provisions for the family of the decedent;

4. Reasonable and necessary expenses of the last sickness of the decedent, including compensation of persons attending the decedent;

5. All debts, charges or taxes owing to the United States, the state or a governmental subdivision or municipality;

6. wages, including pension, welfare and vacation benefits, due to employees which have been earned within 3 months before the date of the death of the decedent, not to exceed $300 to each employee;

7. Property assigned to the surviving spouse or surviving domestic partner;

8. All other allowed claims.[10]

Most priority statutes have similar priority for expenses of estate administration, burial or funeral expenses and federal and state taxes owed.[11] No preference is generally given within any class, and all claims abate proportionately.[12]

Claims must be fully paid, objected to, or abated, and included in an official accounting before the executor may file documents to distribute the remaining assets of the estate to beneficiaries and then close the estate.[13]

Tax Issues

Taxes which are incurred during life, but not paid prior to death, become the responsibility of the deceased person’s estate. Estates and trusts are subject to taxation like individuals, although smaller estates or trusts will not pay much in the way of taxes. Executors and trustees will often employ attorneys and accounts to assist with the filing of required returns, including income tax returns.

Income Tax

Estates must file all final income tax returns of the deceased person, including federal, state and local taxes. In addition, estates and trusts are required to file annual federal and state income tax returns (Form 1041 on the federal level) reporting all amounts earned by the estate or trust on assets held between the date of the testator’s death and final distribution of assets to beneficiaries. Estate income taxes are imposed if the estate’s assets produce income of $600 or more in a year.[14]

Federal estate tax  

The estate tax is a tax on a person’s right to transfer property at death. Everything a person owns or has a certain interest in will be accounted for and subject to the tax. The tax rate is a flat 40% on all amounts above the exemption amount.[15] As a result of the Tax Cuts and Jobs Act of 2017, only the very largest estates - those in excess of $11.4 million (for 2019, adjusted annually for inflation[16]) - are required to file a federal estate tax return and potentially pay estate tax.[17]  

A return may also occasionally be required for other reasons, such as when a spouse chooses to make a portability election. Portability allows a surviving spouse to elect to apply a deceased spouse’s unused estate tax exemption to his or her own taxable estate. Estates making the election are required to file an estate tax return at the death of the deceased spouse to preserve that right.[18] Estates of married persons electing portability have an effective federal estate tax exemption of $22.8 million for 2019, combining the exemptions of both spouses.

State estate and inheritance tax

Some states also impose a state estate tax (imposed upon the assets of the estate) or inheritance tax (imposed upon the inheritance of heirs). The state tax may require the filing of a return on amounts lower than and different from the high federal exemptions. For example, Illinois imposes an estate tax of .8% to 16% on estates valued in excess of $4 million. The District of Columbia (Washington, D.C.), by contrast, imposes estate tax of 6.4% to 16% on estates in excess of the federal exemption amount. Maryland has both an estate tax and an inheritance tax.[19]  Other states have repealed their estate or inheritance tax statutes, such as New Jersey, which repealed its estate tax on January 1, 2018 (but retained its inheritance tax).

Federal gift tax

The federal gift tax is unified with the federal estate tax, so the exemption amount is $11.4 million cumulative, for both gifts made during a person’s lifetime and amounts being transferred through the estate at death. In addition, a person may make gifts of up to $15,000 per person, per year (as of 2019), without using their exemption amount. This amount, referred to as the annual exclusion amount, is adjusted annually for inflation in increments of $1,000 (so the amount will increase to $16,000 next). Gifts made during a person’s life in excess of the annual exclusion amount require the filing of a gift tax return. If not filed during life, the gift tax return may be late-filed by the estate after death.[20]

State gift tax

Very few states impose their own gift taxes. Connecticut’s gift tax, for example, comes with an exemption of $3.6 million in 2019, although that amount is slated to match the federal gift tax exemption in 2020.[21] The vast majority of states imposing a gift tax have since repealed them,[22] such as Minnesota which imposed a gift tax in 2013 and repealed it less than a year later.

Generation-skipping transfer tax

The generation-skipping transfer tax is a tax imposed upon transfers that effectively skip one or more living generations. For example, a grandparent making a gift to a grandchild or great-grandchild whose parent is living, makes a generation-skipping transfer.[23]

The amount exempted from the tax is $11.4 million, the same as the estate and gift tax exemption. Generation-skipping transfers are either gifts (i.e., made during life) or transfers (made after death). They are included on the federal estate tax return when calculating estate, gift, and generation-skipping transfer taxes.

Other taxes

The estate may also be responsible for payment of other taxes on behalf of the deceased testator. This may include sales and use taxes or property taxes for the year of death or late returns for any required tax where the return was not filed during life. In addition, where a testamentary trust is created under a will, the trustee is required to file tax returns on behalf of the trust, including trust income tax returns.

Testamentary Trusts

            Testamentary trusts are often created under wills, to hold assets for the benefit of beneficiaries of the will. Different testamentary trusts have different purposes and different provisions.

Some trusts are tax-related. Although less common now that the estate tax exemption is so high, testamentary trusts can be used to defer or reduce transfer taxes that may be imposed upon the estate at death. Some common types of transfer tax-related trusts include marital trusts, credit shelter trusts and generation skipping transfer tax trusts.

Marital Trust

The marital trust is established at death by a deceased spouse for her surviving spouse. The trust allows the surviving spouse to benefit from assets of the estate, which fund the trust. Payment of estate taxes are deferred until after the surviving spouse’s death by use of the estate tax marital deduction, which is unlimited. The marital trust may be funded with all or part of an estate’s assets, or by means of a formula designed to reduce the total federal estate tax to its lowest amount possible over both deaths.   

Spouses benefitting from a marital trust may or may not have full control over the assets of the trust, depending upon how the trust is written. A testator wishing to provide her spouse with the most assets possible may give control over the assets to the surviving spouse, including the ability to act as his own trustee. On the other hand, a testator wishing to protect assets against a surviving spouse’s remarriage, for example, may restrict how the assets can be used and choose a third-party trustee.

While marital trusts may vary in their provisions, to qualify for the marital deduction, there are certain minimum requirements. They include that the spouse must be entitled to all income generated by the trust, the spouse must have the right to insist that the assets be placed in income-generating investments and that there can be no beneficiary of the trust other than the spouse as long as the spouse is alive.[24]

Because of the increase in the federal estate tax exemption and other changes in the tax law, such as portability, marital trusts are used primarily for large estates and for estates where the testator wishes to preserve assets in the event of remarriage. Assets funded into a marital trust are included in the estate of the surviving spouse at death and taxed at their value on that date.[25]

Credit Shelter Trust

A credit shelter trust is often used in conjunction with a marital trust, although it can be used alone. The credit shelter trust is designed to “shelter,” or hold, the estate tax exemption amount that can pass to beneficiaries free of federal estate tax. Beneficiaries, such as spouse or children, benefit from the trust, while the principal of the trust grows free of estate tax until distribution to beneficiaries sometime after the surviving spouse’s death.   

Although a spouse may benefit from the trust, the maximum estate tax savings is achieved only if the spouse’s use of the trust is restricted. This preserves the assets for the benefit of children or grandchildren.  

Unlike a marital trust, a credit shelter trust can allow assets to grow free of estate tax between the death of the first spouse and the death of the surviving spouse. The federal estate tax exemption amount, not unlimited marital deduction, is applied to assets placed into a credit shelter trust. As a result, the assets of a credit shelter trust pass estate tax-free to beneficiaries, while the assets of a marital trust are included in the estate of the surviving spouse for federal estate tax purposes.

As with the marital trust, the large federal estate tax exemption has reduced the need for most estates to establish a credit shelter trust.

For more analysis of both marital and credit shelter trusts, please see our course on trust drafting.

Generation-skipping Transfer Tax Trust  

A testator who wishes to establish a trust to benefit more remote generations may wish to establish a generation-skipping transfer tax (or “GSTT”) Trust. GSTT trusts can hold assets for multiple generations without paying any intervening estate or inheritance taxes. In addition, a credit shelter trust may also do double duty as a GSTT trust, if the generation-skipping transfer tax exemption is applied to that trust. The dynasty trust is a subset of GSTT trust, designed to be held for the maximum amount of time allowed by law before distributing to beneficiaries.[26]

Disclaimer Trust

A disclaimer trust is a type of trust that can be established for any beneficiary, which allows the beneficiary to disclaim (which means to refuse) any part of an inheritance into a trust. Although the disclaimer trust may be used as part of planning for the federal estate tax, it can also be used for non-tax purposes. For example, a spouse receiving a gift from an estate can disclaim assets into a credit shelter trust if tax planning is needed. Or, a parent can disclaim an inheritance into a trust for the benefit of her child, if the parent is not in need of the assets, but the child may be.

Funding a disclaimer trust requires that a beneficiary disclaim the assets in the manner prescribed by state law, within nine months of the death of the testator. All states have disclaimer statutes, and many have adopted the Uniform Disclaimer Statute.[27]

Special Needs Trust

The special needs trust is a testamentary trust designed to hold assets for a disabled beneficiary receiving government benefits. Because receipt of government benefits is often linked to income, special needs trusts give the beneficiary no access to assets that can count as income. Most special needs trusts are designed to pay for “extras,” such as trips and luxury items, rather than basic need items like rent, clothing, or food. They enhance a beneficiary’s standard of living, rather than providing a means of living (which the government benefits provide).[28]

            Thank you for participating in LawShelf’s course on wills. We hope that this basic course has given you an overview of the topic and the base upon which to take other, more advanced, courses in the area. Best of luck and please let us know if you have any questions or feedback.