Hours: Monday - Friday 8:00 am - 5:00 pm


Estate planning and income tax: Key considerations and planning points

ARTICLE | August 12, 2022

Authored by RSM US LLP

You have mapped out your estate plan and feel confident in its estate tax efficiency. However, it is important to consider the income tax ramifications of each decision throughout the planning process to avoid unintended consequences. After all, an individual’s death, and the gifting they do during their life, affects many taxpayers, including the decedent; their surviving spouse, estate, and beneficiaries; and, potentially, their trusts.

RSM answers 10 important income tax questions and shares correlated planning ideas to consider when creating an estate plan:

1. How will your pass-through business income be taxed after transfer?

Pass-through business income is typically categorized as active, passive, or portfolio. Ideally, taxpayers want income to be classified as active because it is generally treated more favorably under the tax code compared to passive income. If you are actively participating in your business, your business income may qualify for a lower tax rate or for the deduction of losses. It may be important to preserve this treatment after lifetime transfers or at death.

Determining whether certain business income is active or passive in relation to a trust or estate is not as straightforward as it is for individuals. Your participation prior to transferring the business interest is no longer relevant. There is no authoritative IRS guidance for how activities of a trust or estate are tested for participation purposes. Instead, participation rules and guidance for an estate or trust rely heavily on two prominent court cases, the Mattie K. Carter Trust and Frank Aragona Trust cases.

Based on case law, the participation of a trust or estate is determined by whether key individuals acting as a fiduciary (or agents of the fiduciary) are participating in the activity. The IRS has indicated it is going to propose regulations around this area. If and when those are issued, they could provide different guidance on how activities are tested for income tax purposes.

Planning point: Consider the participation rules when choosing a trustee or executor. Your business income could be taxed at a higher rate, and losses may not be deductible, depending on whether the fiduciary participates in the income-producing activity. Use caution when relying on case law in your planning, because the IRS has not indicated that it agrees with the outcome of the cases.

2. Is your favorable S corporation status safe after transfer?

If you own shares of an S corporation, planning is important to ensure that the entity’s favorable tax election is not compromised after the transfer and that it does not lose its pass-through tax treatment.

Loss of the election by a small business corporation would cause tax to be paid at the entity level as a C corporation rather than as a pass-through entity taxed on the shareholder’s income tax returns. This is generally undesirable, as C corporations have less favorable income tax treatment, such as potential double taxation. Relief is available to save the pass-through tax treatment; however, it is time-consuming and costly to obtain. It is better to protect the S corporation election with proper planning.

There are many ways that estate or trust ownership can cause an S corporation to lose its S status. Estates and specific types of trusts are qualified S corporation shareholders, but there are many factors to consider and deadlines to keep in mind to keep the S election safe.

Generally, estates and trusts can hold S corporation stock for a limited period after death, so timing is important, as is ensuring the ultimate beneficiary is an eligible S corporation shareholder. When S corporation stock is transferred during life, the period to make certain elections is much shorter. In general, only certain trusts can own S corporation stock, and some of these trusts require that special elections be made timely.

Foreign trusts, nonresident aliens, individual retirement accounts, charitable remainder trusts, and other nonqualified trusts are not able to hold S corporation stock. To qualify for the favorable tax election, S corporations also have a limitation on how many shareholders can own the entity.

Planning point: Make sure you have a plan for your S corporation ownership. The rules around trusts owning S corporations can be complex. It is important to work with an estate planning advisor who is familiar with S corporations. 

3. Should you give your partnership interest away during life or hold it until death?

If you own an interest in a partnership, there are benefits and pitfalls to weigh when considering when to transfer it. Assets given away during life retain your basis, while assets transferred after death receive either a step-up or a step-down in basis.

If the asset is given away during life and appreciates in value, the growth is outside of your taxable estate, but the beneficiaries may have capital gain and ordinary income to report due to a basis lower than the fair market value.

If the asset has a negative capital account when gifted, there can be adverse tax consequences. If the asset is held until death and receives a step-up in basis, capital gain and ordinary income related to activity during life are eliminated. There is also an opportunity for beneficiaries to benefit from additional deductions, such as depreciation if the partnership makes a certain election.

Planning point: Weigh whether it is more beneficial to gift your partnership interest during life or hold it until death. Discuss it with your tax advisor to ensure there are no unintended adverse income tax consequences related to the transfer to your beneficiaries. Additional rules and complexities govern charitable contributions of partnership interests, which may result in unintended tax consequences.

4. How will your beneficiaries be taxed on your retirement accounts?

Recent changes involving retirement plan accounts within an estate plan are significant enough that you may want to review your estate plan to be sure beneficiary designations still reflect the intended income tax consequences, especially if the account is left to a trust. The income tax consequences of these accounts may vary depending on the type of account and the type of designated beneficiary.

It is crucial to understand how these assets will be taxed for the recipient, especially when the recipient is a trust. The age of the decedent and the type of beneficiary (e.g., surviving spouse, trust, charity, etc.) will affect how quickly the accounts must be liquidated, and therefore taxed, when in the hands of the beneficiary. The Setting Every Community Up for Retirement Enhancement Act of 2019, or SECURE Act, significantly affected the required minimum distributions, or RMDs, for a beneficiary that inherits a retirement plan account after Jan. 1, 2020.

The estate and income tax consequences of these retirement accounts can make them an ideal asset to leave to a charity if you are charitably inclined. This shifts the income tax burden away from both your estate and your heirs to an entity not subject to income taxes.

Deathbed Roth conversions have also become increasingly popular as the tax law has grown in complexity for these assets. A deathbed Roth conversion allows the taxpayer to convert the account from a pre-tax account to an after-tax account so that the income tax liability is generated by the taxpayer before death. This strategy avoids income tax consequences for the estate or beneficiary.

Planning point: Review your existing estate plan to ensure your wishes will still be fulfilled in light of recently enacted legislation, proposed legislation, and pending IRS regulations. Many different planning strategies are available for taxpayers who hold retirement plan assets. Due to the complexity of the rules, it is important to work with a professional familiar with the law in this area.

5. Have you planned for your principal residence or vacation home?

Does your principal residence or vacation home have significant value? These types of assets commonly have a low basis that would result in capital gains tax if sold during life. If held outright until death, the home will be included in your estate and receive a step-up in basis (or potentially a step-down) to the fair market value on the date of death. A basis equal to fair market value is often very advantageous for the ultimate heirs because it will eliminate most, if not all, of the capital gains tax owed upon future sale.

In some situations, it may make sense to transfer the principal residence or vacation home into a trust to avoid the inclusion of future appreciation in your estate. These strategies often freeze, so to speak, the value of the home for estate tax purposes at the expense of forgoing the step-up in basis. A qualified personal residence trust, or QPRT, is one of the most common tools to achieve this goal.

A QPRT allows the taxpayer to transfer the home, which must be either the principal residence or a vacation home, into a trust, with a retained right to live in the home for a certain term, or period of time. The retained right to live in the home discounts the value of the gift to the trust; and assuming the taxpayer outlives the term, the value of the house is excluded from the estate. The transferor must pay fair market value rent to continue living in the house once the term has ended. This can be a favorable planning technique; however, the law should be reviewed carefully to ensure the transaction is properly structured to achieve the desired tax result.

Your estate may also have an opportunity to deduct a loss on the sale of a principal residence or vacation home when the loss would otherwise be nondeductible. As mentioned previously, the home’s basis will be stepped up or down to fair market value on the date of death. If, for example, the value of the home further declines after the date of death, or if a loss is generated due to selling costs, case law—specifically, Miller v. Commissioner of Internal Revenue and Watkins v. Commission of Internal Revenue—supports possible deductibility of the loss since the home is a capital asset held by the estate. This loss may be deductible on the estate’s income tax return and subject to the capital loss limitation rules.

Despite case law supporting possible deduction, IRS Chief Counsel Memorandum 1998-012 explains that such a deduction is allowed only when the property has been converted to an income-producing property. The memorandum is not authoritative; however, it does provide insight into the IRS’s position on this situation and highlights an area of potential scrutiny.

Planning point: It is important to weigh the benefits of transferring a principal residence or vacation home out of your estate before death versus holding on to it to receive a potential step-up in basis. Keep in mind the available personal residence gain exclusion ($250,000 if single, $500,000 if married) if property is sold during life and certain holding periods are met. Use caution when relying on case law in your planning, because the IRS has not indicated that it agrees with the outcome of the cases related to deducting a loss on the sale of a residence after death.

6. Will your contributions qualify for the fiduciary income tax charitable deduction?

If you are charitably inclined, it is important to ensure your will and trust agreements are written in a way that allows future charitable contributions to be eligible for the fiduciary income tax charitable deduction. Charitable deduction rules for estate and trust fiduciary income taxes are generally more beneficial than the rules for individuals in what can qualify for a charitable deduction, but there are also some roadblocks.

Under section 642(c) of the tax code, fiduciary income tax charitable deductions are allowed for estates and trusts only when the governing document specifically allows for charitable contributions. The deduction is limited to the extent that the amount given to charity was paid from current income or prior year income. Unlike the individual income tax charitable deduction, there is no carryover of excess charitable contributions on fiduciary income tax returns.

Even with the additional roadblocks, it may make sense for a taxpayer to make charitable contributions from a trust rather than individually. Section 642(c) allows trusts and estates to make and deduct charitable contributions to a broader set of organizations compared to individuals.

Also, there is generally no adjusted gross income limitation applied to gifts to charity on the fiduciary income tax return. This means that a trust created for charitable purposes may be able to take a deduction of up to 100% of the gross income.

Lastly, under Code of Federal Regulations section 1.642(c)-1(b), a special election allows a trustee to treat contributions paid in the preceding tax year as a current year charitable deduction, which allows for flexible income tax planning. For example, a trust filing a 2021 tax return with $1 million of gross income can make a $1 million charitable contribution before Dec. 31, 2022, and elect to treat it as a 2021 deduction and reduce the gross income to $0.

Planning point: If you are charitably inclined, consider creating and funding a trust for charitable purposes to maximize deductions and contribute to a broader set of organizations.

7. Are you certain your beneficiaries will receive what you intend from your “simple” trust?

Simple trusts require that beneficiaries receive distributions of all the trust’s income at least annually—and the definition of income can depend on the trust agreement or state law.

If you are utilizing a simple trust as part of your estate plan, consider how the income generated by the trust will be treated for trust distribution purposes. If the trust holds a partnership interest or S corporation stock, generally the flow-through income from the entity is ignored and only actual distributions made from the entity are income for distribution purposes.

If the trust holds flow-through entities that rarely make distributions, the beneficiary may not receive as much benefit as the grantor had originally intended. This structure, however, may be perceived as a benefit in other planning scenarios in which the flow-through entity’s distributions control the trust’s ability to make distributions.

Understanding how these types of trusts operate for distribution and income tax purposes can help facilitate an effective estate plan to ensure beneficiaries receive a benefit in line with the grantor’s intentions.

Planning point: If the trust has taxable income and the beneficiaries receive distributions, the beneficiaries will have personal income tax consequences related to the distribution they receive. Make sure the beneficiaries understand the impact of the distributions to avoid surprises.

8. How might the flexibility of irrevocable grantor trusts factor into your planning?

An irrevocable grantor trust is a trust created and funded during life in which you retain an element of control over the assets that results in taxation of the trust income and calculation of related deductions and credits on your individual income tax return. The assets of the trust are not taxed as part of your estate, and the payment of income taxes on behalf of the trust further reduces your estate without gift tax consequences.

In addition, there is flexibility if the payment of income taxes on behalf of the trust becomes too burdensome. First, the trustee may have the discretion to reimburse you for the income taxes paid on the trust’s behalf. Second, the trust agreement may allow you to make a change to the powers you retained and thus turn off the grantor trust status, so to speak, if desired. This would cause the trust to pay its own income tax liability from trust funds.

You should also carefully consider state income tax elections that allow the payment of state income taxes via an entity owned by the trust instead of by the grantor, because the grantor may then be liable for a gift tax.

Planning point: Be aware that if the trustee is required to reimburse you or has a prearranged agreement to do so, the assets of the trust are likely includible in your estate.

9. Have you considered the potential impact of divorce on a trust created for the benefit of your spouse?

Trusts for the benefit of your spouse and descendants are typically structured as irrevocable grantor trusts, and you are personally taxed on the income because distributions may be made to your spouse.

In the event of a divorce, you may still be liable to pay the tax on the income earned by a trust set up for the benefit of a now ex-spouse. Possible post-divorce solutions include modifying the trust agreement, terminating the trust, distributing the assets to the spouse, or creating an agreement as part of the divorce settlement to have the ex-spouse reimburse the grantor for the taxes paid.

Planning point: Taxpayers typically do not set up trusts for the benefit of a spouse when contemplating a divorce. In the event of divorce, the trust should be carefully considered in the divorce proceedings and divorce agreement to ensure the spouses understand the income tax impact.

10. How will you plan for illiquid assets in your estate?

If your estate is made up mostly of illiquid assets, how will your executor find the cash to pay the estate tax? To prevent them from having to rely on a quick sale, the purchase of life insurance may be a simple solution. If the policy is structured properly, the death benefit will not be subject to income taxes or be includible in your estate. The life insurance could be held in trust outside of your estate, and the cash may be available to pay estate taxes or benefit heirs.

Life insurance may be an income- and estate-tax-friendly method of wealth replacement for your family. For example, a first-to-die life insurance policy can be used to generate additional wealth at the first spouse’s death to ensure enough assets remain for the surviving spouse to maintain their lifestyle. You may also choose to leave assets to charity to avoid estate taxes and fund a life insurance policy held outside of your estate that will provide wealth for heirs.

Planning point: There are many pitfalls to avoid when incorporating life insurance in an estate plan, and many different types of life insurance to consider. It is important to work with an advisor knowledgeable in this area to ensure you provide your estate and beneficiaries with the maximum benefit.


Ensuring that your estate plan considers income tax consequences can be crucial to its success. Many of the strategies described above require technical analysis and familiarity with tax laws. If you have questions about how these or other topics affect your estate plan, consult with your RSM tax professional, who can help ensure your plan is up to date for the most recent changes in income tax law.

Let's Talk!

Call us at (325) 677-6251 or fill out the form below and we'll contact you to discuss your specific situation.

  • Topic Name:
  • Should be Empty:

This article was written by Carol Warley, Amber Waldman, Tandilyn Cain and originally appeared on Aug 12, 2022.
2022 RSM US LLP. All rights reserved.

The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.

RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.

Condley and Company, LLP is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.

Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise and technical resources.

For more information on how Condley and Company can assist you, please call (325) 677-6251.

Share This