There is no accounting for how many heirs an account might need to be divided among in an estate plan. There might be 3 beneficiaries or there might be 7, 11 or 13. Here are the best practices for how to divide the estate.
Dividing the estate should not trigger a taxable event. Beneficiaries will have different tax circumstances and as much as possible the sale of appreciated assets in taxable accounts should be avoided. Similarly the realization of losses should be left to each beneficiary to determine the appropriateness and the timing of such an event. This means that the best practice will not try to be the financial advisor of each beneficiary when you are dividing the estate. That way, after division each beneficiary can make the decision based on their own life circumstances. You could take short cuts and try to buy and sell in taxable accounts on behalf of all the heirs, but as we will see, this is not necessary.
Here are the steps to divide an estate. For our example we will use three musketeers, Athos, Porthos and Aramis, named as heirs of a taxable account of stocks, bonds and mutual funds. Here are the account holdings:
- 351.362 shares of XYZ mutual fund @ $36.34/shares worth about $12,768.49
- 2,000 shares of ABC stock @ $100/share worth about $200,000. (the holding is comprised of two trade lots of 1,000 shares each and each trade lot has a different cost basis)
- $85,000 face value of CorpCorp bond @$97.00 par value worth about $82,450 (and traded in $5,000 face value units)
- $100,000 face value of MuniMuni bond @$102.00 par value worth about $102,000 (and traded in $5,000 face value units)
- A little bit of cash, $5,236.45
The total account value is $402,454.94 making each musketeer’s share at $134,151.64 with two pennies left over.
Here is how to divide the account:
The 351.362 shares of XYZ mutual fund can be divided into three equal portions of 117.12 shares for each musketeer. This leaves 0.002 shares left over.
Athos and Porhos will receive 117.121 shares and Aramis will receive 117.120 shares plus 0.001 times the closing valuation of XYZ mutual fund on the day of transfer. This will probably result in Aramis receiving about 4 cents in lieu of missing out on 0.001 share. The shares can be transferred and then after the fact look at the mutual fund’s valuation at the close of business that day.
2,000 shares of ABC stock are comprised of two different trade lots:
- 1,000 shares purchased 1 year ago @$80/share
- 1,000 shares purchased 6 months ago @$105/share
Both positions can be divided into 333 share equal portions. That leaves just two shares to be divided, each with a face value of $100.
Obviously if one of the musketeers is in the zero percent capital gains tax bracket it would be better for them to have the appreciated share. And if one of the musketeers is in the highest 33.8% capital gains tax bracket it would be better for them to have the share with a loss. Assuming all else is equal and they are all in the 15% capital gains tax bracket, the value of each share is the closing valuation on the day of transfer adjusted for 15% capital gains taxes:
- 1 share of the $80 cost basis = $100 – $3 (15% of $20 gain) = $97.00
- 1 share of the $105 cost basis = $100 + $0.75 (15% of $5 gain) = $100.75
So in dividing it equally use these portions:
- 1 shares of the $80 cost basis + $3.75
- 1 shares of the $105 cost basis
- $100.75 in cash
Some advisors will *not* try to adjust for capital gains and losses due to tax considerations. In large estates with many things which can be distributed the left over shares can be divided up as evenly as possible to minimize the difference between the capital gains received by recipients. This is perfectly acceptable. At other times one beneficiary will volunteer to take all the capital gains with the intention of selling them in the zero percent tax bracket. The point is simply to make the methodology as fair as possible before the transfers, and then after the transfers use that day’s valuation to make everyone equal.
These portion are as equal as you can get.
The $85,000 face value of CorpCorp can only be divided into seventeen $5,000 face value units.
That means that each musketeer receives 5 $5,000 face value units with two $5,000 units left over. These units are worth $4,850 each. Whoever doesn’t receive a unit will receive the equivalent in cash.
The $100,000 face value of MuniMuni bond can only be divided into twenty $5,000 face value units.
Each musketeer will receive six $5,000 with two units left over again. These units are worth $5,100 each. Whoever doesn’t receive a unit will receive the equivalent in cash again.
I’m assuming on both bonds there are no tax considerations to adjust. And I would vary who receives the cash so that one musketeer doesn’t receive all the cash divisions.
Why don’t you just sell everything and split the money?
There are lots of reasons not to sell something. There might be tax consequences. It might be illiquid. The fund might be closed. The expenses to sell might be greater in the account where it is. A new custodian might waive the transaction costs.
What if two of the musketeers want to sell something before dividing the money equally?
If Athos and Porthos both want to sell the CorpCorp bonds this doesn’t need to effect Aramis. Since there are 17 units of CorpCorp bonds, you can sell 12 units and agree to split the proceeds accordingly:
Athos and Porthos would each receive 5 and 2/3rds divided by 12 of the proceeds (47.222%) and Aramis receives 2/3rds divided by 12 of the proceeds (5.556%) plus the five unsold units.
Again the principle is to not have to make decisions on what to sell, how to sell, what transaction costs to incur, what taxes will be owed on behalf of all of the beneficiaries whenever possible.
Photo by Tax Credits used here under Flickr Creative Commons.
David John Marotta
I received this question about the column:
Yes, normally inherited assets receive a step-up in cost basis to the date of death. And normally this makes the capital gains issues non-existent.
But it is quite common when one spouse dies for half of the assets to be put into a marital trust. The surviving spouse has access to the account if they need the money, but the account is out of their estate and can grow free of the estate planning limits. When the second spouse passes away the entire estate is settled. The assets belonging to the second spouse to die has a recent step up in cost basis making the capital gains zero. But the assets in the marital trust might have received their step up in cost basis decades earlier when the first spouse died.
It was this second case, of a marital trust finally being distributed to the children that I had in mind when I was talking about potential differences in capital gains.