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Financial Security by Design

What To Do When Your Spouse Dies

Peter James Lingane. Revised 3/5/2001.

Introduction. You are probably relieved that your loved one is no longer in pain. You may feel a little guilty that you don’t miss the care giving. You don’t fully appreciate that you have lost your partner. You don’t feel lonely, yet.

I hope that family and friends are providing support and that time will heal your loss.

You are apprehensive about the financial implications of your spouse’s death. You wonder what you must do to comply with the law and to obtain the benefits to which you are entitled. This discussion addresses these concerns for California residents. The discussion is necessarily generic. Please seek competent advice specific to your circumstances.

The process of settling your spouse’s affairs is going to take longer and will cost more than you may have expected. There has to be an inventory and valuation of your assets and liabilities. Tax returns have to be filed and debts and taxes have to be paid. The good news is that costs and delay are reduced because you and your spouse created a living trust.

Before you make any decisions, spend any money or give anything to the heirs, consult with knowlegable advisers.

It is easy to accidentally foreclose opportunities by seemingly innocuous actions. For example, your bank may encourage you to rename your spouse’s IRA as your own but this could accelerate taxes. It is natural to claim life insurance benefits but this might preclude passing these monies to your children free of estate tax.

Overview. Your living trust owns most of your assets.  The primary exceptions are your IRAs and pensions.

Now that your spouse has died, your spouse's share is to be divided into two trusts.  The first, which is typically called a by-pass or exemption trust, will provide you income and money for emergencies. On your death, the remaining assets will pass to your spouse's heirs, typically the children.

The second trust qualifies for the marital deduction.  This mean that you are entitled to the income and can use the principal in any way that you choose. If marital deduction trust is designed to meet the special provisions of "Qualified Terminal Interest Property", it is called a QTIP trust.

Your share of the assets remains in the living trust. The name of the trust may change, it may be called the "Survivor's Trust" for example, and you may have to change the Social Security number associated with the trust.

You are probably the trustee of the by-pass and QTIP trusts. Your attorney and tax adviser will help you become comfortable with your role as a fiduciary and they will share the work so that it is done as expeditiously and inexpensively as possible.

Your attorney will likely

Are there any specific bequests?

Who are the beneficiaries of the by-pass trust?

Do you receive the income from the by-pass trust? Can there be distributions to other family members during your lifetime?

What is the formula for funding the by-pass and marital trusts?

Who is responsible [End Note 4]for funeral and medical expenses?

How are taxes allocated [End Note 5] among the beneficiaries?

Do your documents limit the trustee’s statutory authorities [End Note 6] or the provisions of the Uniform Principal and Income Act [End Note 7]?

Your tax adviser will likely

Your Role As Fiduciary. You and your spouse owned most of your assets as community property. Legal title was held by the trustee of your living trust. Typically, you and your spouse served as co-trustees.

One half of these assets belong to you. You will manage the survivor’s trust exactly as before with exclusive and absolute control. You can amend the survivor’s trust, change beneficiaries, appoint new trustees and spend the money for any purpose.

The assets that belonged to your spouse will be used to pay funeral and administrative expenses and to pay any estate taxes. (There probably won’t be any estate taxes.) Up to $675,000 [End Note 8] will be used to fund the by-pass trust and to pay specific bequests. The reminder generally comes to you, the surviving spouse, in the form of a QTIP or QDOT trust.

The trustee of the by-pass, marital and QTIP trusts has broad discretion in managing these trusts but a fiduciary does not have absolute control. For example, a fiduciary can't amend the trusts and generally won't be able to change trust beneficiaries.

You will probably receive all of the interest and dividends earned by the by-pass trust. You are probably entitled to spend any additional money that you need but you can’t spend money from the by-pass trust simply because you want to since whatever you do not need belongs to the other beneficiaries, probably your children. (There are different rules for marital, QTIP and QDOT trusts.)

While your spouse intended that you should not skimp for the benefit of the other beneficiaries of the by-pass trust, you as fiduciary have an obligation to manage this trust mindful of the interests of the other beneficiaries. This means investing in a prudent manner and managing withdrawals in a way that allows the other beneficiaries to pay the least taxes at your death.

Because you do not have complete control over the by-pass trust, this money will not be included in your estate, even if the by-pass trust grows to tens of millions of dollars. A dollar in the by-pass trust is therefore more valuable to your heirs than is a dollar in an asset which is subject to estate taxes at your death.

As a practical measure, assuming that the ultimate beneficiaries of all of the trusts are the same, you should spend your personal funds and the money in the survivor’s, marital, QTIP and QDOT trusts before you take money from the by-pass trust.

If the terms of the by-pass trust require that all income be distributed to you, and if you don’t need this income, you should rejigger the trust investments so that there is less interest and dividends. Otherwise, you won’t be able to spend down your personal assets. [End Note 9]

This discussion assumes that you and your spouse have common heirs. If yours is a combined family, the generalizations described here probably don’t apply.

Estate Taxes. As the fiduciary responsible for your spouse’s assets, you are also responsible for your spouse’s estate tax returns. Estate tax returns are required if the value of the decedent’s gross estate, plus the value of taxable gifts during their life time, exceeds $675,000.

The gross estate is calculated without considering debts and mortgages and may include assets even when the decedent’s name does not appear on the title. For example, your spouse’s gross estate includes gifts of life insurance within three years of death and a home that you gave away but continued to live in. Your spouse's estate probably includes one half of your IRAs, the full value of UTMA accounts with your spouse as custodian and the full value of bank accounts owned in joint tenancy with a third person.

Estate tax returns are due nine months after death. It is good practice to request a six month extension in case extra time is needed to clear up various issues. Extra time may also allows your executor to save taxes if you should die soon after your spouse. The IRS has proposed making this extension automatic.

Even if there is estate tax at the first death, the decisions that you make when preparing your spouse’s estate tax return will affect future income taxes and the estate tax liability at your death. Therefore, it is necessary to value each and every asset and to document these valuations in the estate tax return. You will be amazed at how thick the return will become once you have attached all required documentation!

Your brokers, banks and IRA custodians will provide date of death values for many of your financial assets. It may be necessary to engage professional appraisers for real estate. The IRS requires a special Form 712 for life insurance and annuity policies.

If your home or rental property is worth a million dollars, it does not follow that a buyer would pay a half million dollars for your spouse’s half interest. A controlling interest in a business or partnership might be worth extra. You must apply valuation discounts and premiums, and document the basis for these adjustments, when you file the estate tax return.

Liabilities and debts must be determined and documented on the estate tax return. You may be surprised to learn that the decedent is entitled to a deduction for real estate tax unpaid for the current fiscal year and, if death is between January and June, for real estate tax for the next fiscal year.

In addition to the valuation information, the IRS wants to see a copy of your living trust and of any other trusts where your spouse was the trustee or a beneficiary.

All estate tax returns are reviewed by an IRS attorney. Your goal should be to provide, with the original return, all the documentation that the attorney needs to decide whether to accept the return as filed. If the IRS has to request information to complete their initial review, there will be delay and the risk of audit will be increased.

Since you cannot make a final distribution of the assets until you get an all clear signal or "closing letter" from the IRS, you may want to file a letter which requires the IRS to expedite their review. [End Note 10]

Income Taxes. The fiduciary responsible for the decedent’s assets is also responsible for the various income tax returns.

You will prepare your personal income tax return much as in prior years. You are entitled to the tax rates, standard deduction and personal exemptions of a married couple in the year of your spouse's death. Thereafter, you will file as "single" unless you remarry or have a child at home.

There usually won’t be a separate tax return for the survivor’s trust but a return must be filed for each of the other trusts [End Note 11] for any year in which gross income exceeds $600 or if there is tax due. Generally speaking, the income tax  returns due April 15th, just like your personal tax return.

There is usually an interim period after death before the decedent's share of the assets is distributed.  The living trust serves as an administrative trust during this interim period.  It reports all income which is received after your spouse’s death and allocates the income to you and to the various trusts and other heirs. The administrative trust usually does not pay any income taxes because the tax liability is distributed to you and to the various trusts and other heirs.

Once the assets are distributed, the administrative trust ceases to exist and you won’t have to file any more income tax returns on its behalf. However, you will continue to file income tax returns for by-pass and QTIP trusts.

Paying Bills. It makes the bookkeeping easier if you set-up a system to distinguish your personal income and expenses from the income and expenses of the administrative trust. Don’t be worried if you make mistakes and pay a few bills out of the wrong account. However, tracing expenses and income over an extended period can be expensive, which is why it is good practice to maintain separate accounts.

You will need a checking account set up under your Social Security number. Ideally, you would open a new account in the name of the Survivor’s Trust. Use this account to pay your personal bills and deposit your payroll, Social Security and pension checks to this account.

You or your tax adviser need to obtain tax identification numbers for the administrative trust and you should replace the Social Security number on the living trust accounts with the ID number of the administrative trust. This should be done in a way that causes financial institutions and limited partnerships to issue separate year end tax documents, Forms 1099 and K-1, for the periods before and after your spouse’s death.

Trust income should be deposited into a checking or brokerage account using the tax ID of the administrative trust. It simplifies the bookkeeping if you do not reinvest interest and dividends and capital gains for the duration of the administrative period.

Which bills are personal and which are expenses of the administrative trust?

You will have to manage rental properties, business interests and investments during the administrative period. You may want to close unneeded credit card accounts and to combine brokerage and bank accounts. Most of these actions are benign but it would be prudent to confirm specific transactions with your advisers in advance lest you unwittingly sell an asset specifically bequeathed to one of the heirs or do anything that would affect the valuation of the estate, preclude an opportunity to disclaim or decrease the amount of money that can be sheltered in the by-pass trust.

Stepped-Up Valuation. The tax on gains on homes, rental properties and stock portfolios, which you and your spouse held as community property, is forgiven upon the death of your spouse.  In contrast, only one half of the tax is forgiven on assets that you own as joint tenancy. Ownership as community property thus conveys a substantial tax benefit.

Ownership as community property also means that you can sell these assets without the chore of reconstructing what you paid for them!

Often times, unrealized gains keep us from making changes to our investment portfolios. The death of your spouse means that you can rearrange your investments without tax consequences. There can also be tax reasons to own certain assets personally and other assets in the by-pass trust. It is probably opportune, therefore, to review your investment strategy before you fund the by-pass trust.

But Is It Community Property? Determining whether an asset is separate or community property can require careful analysis. The presumption is that everything owned by California residents is community property. The legal title is not necessarily determinative and real estate can be community property even if the deed says something else.

Ask yourself the following questions.

If the answer is "No", then everything that you acquired during marriage as a result of your personal effort is probably community property. Wages are community property. The home that you buy with your wages and the IRA and pension accounts financed from your wages are community property. Assets that you acquired during marriage while living in another state are treated as pseudo community property after you move to California.

It is difficult to draft separate property agreements in a way that is legally binding. Agreements have been ruled invalid when one spouse was not represented by independent legal counsel and the ERISA rules make it impossible to enter into a pre-nuptial agreement concerning pension assets. Ask your attorney to review any existing separate property agreements to be sure that they are consistent with current case law.

Such assets are probably separate property so long as they were not commingled with money that you earned during marriage. Commingling does not necessarily convert separate to community property but the effect is the same if it becomes impossible to trace the separate portion.

It is important that you transfer property to the surviving spouse in a manner which is consistent with it being community or separate property.  For example, you undercut the argument that a home titled as joint tenancy is really community property if your transfer ownership to the surviving tenant rather than probating the property. 

Monthly Social Security and Pension Benefits. Call 1-800-772-1213 and tell the Social Security Administration of your spouse’s death. They will ask for your spouse’s Social Security number and date of birth and your marriage date. Social Security payments are paid in arrears and any benefits received death have to be returned.

A surviving spouse is usually entitled to the larger of the benefit based on their own earnings or on their spouse’s earnings.  Thus, your spouse's check will stop but your own check may increase. Unless you have a child at home, you won’t receive this benefit until you are of retirement age and apply for Social Security, even if your spouse was receiving benefits at the time of their death. You will have to produce a copy of your marriage certificate in order to claim spousal benefits.

You can claim a $255 lump-sum death payment by filing a claim with the Social Security Administration within two years of your spouse’s death. This payment is not included in your spouse’s gross estate.

See www.ssa.gov/pubs/deathbenefits.htm for additional information.

If your spouse was receiving a monthly pension or annuity payment, you are probably entitled to continued payments. Contact the payer to learn the details and the procedure for claiming benefits. The value of these continued benefits is included in your spouse's gross estate.

Disclaimers. IRAs and life insurance pass automatically to the named beneficiaries. IRAs and life insurance are usually community property.

You do not have to accept your spouse’s share of these assets. Saying "No, thank you" is one way to control the size of your spouse’s taxable estate and the by-pass trust. This control may save your heirs estate taxes.

Disclaimers are only effective if you have received no benefit from the IRA or life insurance. Therefore, consider disclaimers before applying for life insurance or pension benefits and before retitling or taking money from your spouse’s IRA account.

A misstep could cost big bucks.

Funding the By-Pass Trust. Once all of the assets are valued, all the bills paid and the estate tax return accepted by the IRS, it is time to fund the trusts and make final distributions to the other heirs.

You will usually fund the by-pass trust with assets which will appreciate in value. This strategy lets your heirs pay the least estate tax at your death.

You will also want to fund the trust in a way that presents the least hassle. For example, if you put half of your residence inside the by-pass trust, you will have to negotiate with yourself as trustee if you want to paint your home and it is conceivable that the color or expenses might not be in the best interests of the remainder beneficiaries. While the concept of negotiating with yourself may strike you as bizarre, you will have to pay the painter and real estate taxes and homeowners insurance with two checks, one from your personal account and the other drawn on the by-pass trust.

It might save estate taxes at your death if you split [End Note 12] a business or partnership interest among more than one trust. This creates fractional interests which reduce the value of the asset for estate tax purposes at your death.

There are income tax considerations. For example, if an asset which has appreciated after death goes to a trust which is funded by a pecuniary formula, there can be an income tax bill. If you fund the by-pass trust with your personal residence, you lose the $250,000 personal exemption when your home is sold and there will be no step-up in basis when you die.

If you and your spouse executed a special community property agreement under 100 of the California Probate Code, it is possible to consider IRAs and other assets not owned by the administrative trust. Disclaimers may be another way to fund the by-pass trust with assets outside the administrative trust.

There are further considerations if you and your spouse chose to leave your money to different heirs.

Further Reading. For the views of California attorneys, see

"Administering a California Living Trust After the Death of the First Spouse" by Milton Berry Scott. This is available at http://www.mbscott.com/firstdea.htm.

"A Practical Workshop on Trust Administration of the Living Trust, Exhibits 46 and 51." by David B. Gaw, 1999. This is available through the California CPA Education Foundation.

"Federal Estate Tax: Hot Issues and Battlegrounds of Form 706" by Keith Schiller. This is available through the California CPA Education Foundation.

"Make Your Own Living Trust" by Dennis Clifford, Nolo Press, 3rd Edition 1999.

"California Community Property" by Eileen Preville. This is available through the California CPA Education Foundation.

See also

Henry W. Abts III, "How to Settle Your Living Trust", Contemporary Books, 1998.

The "valuation method" or aggregate theory of community property, which Mr. Abts considers the default method in community property states, is generally NOT available to California residents since few couples have executed the required written agreement.  Cf. California Probate Code 100.

Mr. Abts states that the holding period of an inherited asset is measured from the original purchase date.  This is incorrect. The holding period of an inherited asset is always long term.  Cf. IRC 1223.

Doug H. Moy, "Living Trusts", John Wiley, 1997.

End Notes.

  1. California Probate Code 8200
  2. California Probate Code 19050 - 19104.
  3. See California Probate Code 18100.5 for required content.
  4. Absent contrary language in your documents, California Probate Code 19326 says that funeral expenses and your spouse’s medical expenses are NOT community debts but are to be charged to the decedent’s estate.
  5. California Probate Code 20110 calls for an equitable proration of taxes among all beneficiaries absent contrary instructions in your documents.
  6. California Probate Code 16220 et seq.
  7. California Probate Code 16300 et seq. until December 31, 1999; 16320 et seq. thereafter.
  8. This is the current applicable exclusion amount. It is scheduled to gradually increase to $1 million by 2006. The size of the by-pass trust is limited to what your spouse owned less funeral and other expenses, less gifts during your spouse’s lifetime and less bequests to other heirs. Absent special planning, it may not be possible to fund the by-pass trust to the full exclusion amount if a major portion of your spouse’s wealth is in the form of an IRA.
  9. Some by-pass trusts have been drafted without considering the estate tax implications of requiring that income be paid to the surviving spouse. My preference is to not require any distributions so as to not influence the Trustee’s investment decisions. Cf. www.lingane.com/tax/tx_eff.htm.
  10. Write a letter citing IRC 2204(a). As a result of this letter, the regulations require the IRS to notify you of the estate tax liability within nine months. Form 5495, "Request for Discharge from Personal Liability Under IRC 6905," is used to expedite IRS review of income and gift tax returns.
  11. You are allowed to report income and expenses of the living trust during the administrative period on the same tax return as the income and expenses of the probate estate. For further discussion see my article "Changes Affecting the Preparation of the Income Tax Return for a Decedent's Living Trust" in The California Enrolled Agent, April 2001 or  www.lingane.com/tax/seminars/645election.pdf.
  12. See Estate of Mellinger, 112 TC 4 (1999). The IRS has agreed to apply this decision to other taxpayers; AOD 1999-006 is available at http://ftp.fedworld.gov/pub/irs-aod/mellingr.pdf.
  13. These comments are meant for educational purposes only. Consult with your adviser before taking any actions.


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