When a loved one passes away owning securities, there are steps that the personal representative and/or the trustee of the decedent’s trust should immediately take to minimize investment risk during the estate administration. In today’s column I’m going to review these basic concepts.
Most folks own securities in some form or another. They may own stock in individual companies, such as Disney, Exxon or Proctor & Gamble. They may own mutual funds that own shares of stock in different companies. They may own some combination of individually held positions and mutual funds.
When a person dies owning shares of stock or stock mutual funds, it is often a good idea to sell the securities or some portion of them at the onset of the administration. This is due to several factors. First, the capital gains consequence that the decedent would have faced at he sold the securities during his lifetime usually is no longer a factor as of his passing. Second, he may have too many eggs in one proverbial basket. Finally, the administration of the estate, generally speaking, is a short time horizon and in those situations it is usually wise to play it conservative, and stocks are by nature risky, especially in the short term.
Allow me to elaborate on those three points.
First, the reason many of us don’t sell stocks that we would otherwise sell and reinvest is because of the capital gains tax disincentive. If I bought shares in Eli Lilly Company, for example, and reinvested the dividends, over time the value of those shares has likely grown. If I sell the shares during my lifetime I must pay a tax on the gain that I recognized when I sold the shares. The gain recognized is the difference between the sales price and my “tax cost basis” in the shares. The tax cost basis in my shares is generally the price that I paid for the shares plus the reinvested dividends on which I’ve paid income tax.
When I die, however, my estate receives a step up in tax cost basis equal to the date of death value. It no longer matters what I paid for my shares. That is irrelevant. The new basis for determining capital gain is the value of the shares as of the date of my death. My personal representative and trustee should request the date of death values from my broker or financial institution. If they sell the stocks or mutual funds at the new value, the capital gains are zero, and no tax is paid.
Second, it is not uncommon for decedent’s estates to be heavily weighted in one or two holdings. Ask anyone who owned Enron stock during its collapse if they would have otherwise chosen to pay capital gains tax had they only known before the collapse what was about to happen. Too often individuals hold on to positions that they shouldn’t because they are fearful of the tax consequences of selling. This is allowing the “tax tail to wag the dog” as I like to say. You should avoid making decisions based solely on tax reasons.
I have found that there are other reasons that families tend to hold onto positions that they otherwise shouldn’t – and that is the emotional reasons. “Dad worked for that company for thirty five years and those are the shares that he broke his back for” is a refrain I’ve heard on more than one occasion.
Just as one shouldn’t base decisions on tax consequences alone, one should not base investment decisions on emotion either. The goal of any investment strategy is to maximize the return on that investment. I’m sure that any parent would favor that goal over an emotional goal of holding onto shares of a certain company solely because that parent happened to work at that company for a number of years, or chose to buy the stock and hold it for a prolonged period.
Getting back to my point, many investors for one reason or another find their portfolios over weighted with just a few particular holdings. As we learned above, when those investors die their estates are no longer burdened with the capital gains tax consequences of the sale. The personal representative or trustee would be well advised to sit down with a competent investment advisor to determine which holdings would be best to sell to limit the investment risk during the course of the administration.
And that brings me to my final point. When you are serving as the personal representative of an estate or as the trustee of a trust, you are held to a fiduciary standard to invest and protect the money in a prudent and reasonable manner. While holding stocks for the long term is not outside the scope of reasonableness, it can be argued that holding a large share of equities during an estate administration is unreasonable.
This is due to the fact that an estate or trust administration is usually a short term affair, meaning that it can take anywhere from six months to two years. In that short of a time horizon, a portfolio might have a hard time recovering from a severe dip in the stock market. Imagine if you were the trustee of a trust that consisted largely of securities just prior to the 2008 stock market collapse.
Imagine further that if the estate were to pay estate tax on the value of the date of death values and the estate were to drop suddenly in value. The estate would be paying taxes on an amount much higher than that the beneficiaries would receive. There is, by the way, a six month alternate valuation date that might take care of this problem, but it isn’t prudent to rely solely on that escape hatch.
If you should find yourself in the role as personal representative or trustee, it would be wise to bring up these issues with the estate attorney and with the investment advisor before too much time transpires.