I'm occasionally asked whether heirs or naked owners are subject to tax when they receive the proceeds or investments from a usufruct account.
To explain this easily, let use an example: Husband dies while Husband and Wife own a $2 million investment account. The account is community property. Husband's Last Will leaves the lifetime usufruct of his estate to Wife. Husband's children are designated in the Last Will as the naked owners.
Husband died. Wife and naked owners get together, hire lawyers, complete the Succession, judge signs necessary court orders, financial institution's lawyers review the court orders, and the $2 million joint account gets divided into two new account: one solely in the name of Wife (her half of the community property), and another account titled, "Wife Usufruct." Years later, after interest, dividends, sales, reinvestments, market appreciation and depreciation, Wife dies and assets are distributed to the naked owners. The naked owners are wondering whether tax is due.
There really should be two questions asked: (1) Do we owe tax? and (2) Are we receiving the right assets?
Unless Husband's estate was large and exceeded the estate tax exemption when he died - requiring an estate tax marital deduction election, the usufruct assets will not be included in Wife's estate for federal estate tax purposes. So, typically no estate tax due.
Income tax not likely to be applicable under the general rule that an inheritance is free of income tax. Note that beneficiaries of traditional IRAs and certain annuity beneficiaries have income tax consequences upon distribution of those accounts, but that is beyond this scope.
The real messy one is the capital gains tax. It's messy because usufruct accounts are often not established consistently with Louisiana usufruct law.
Here'a a few rules that are helpful. Interest and dividends produced by assets subject to usufruct belong to the usufructuary. If stock in the usufruct account pays a dividend, that dividend should go into Wife's individual account. This is important because Wife's heirs may be different than Husband's naked owners. Also Wife's assets in her estate get another step-up in basis when she dies. While assets subject to usufruct typically do not.
Another important rule all usufructuaries and naked owners to know is that when investments (nonconsumables) subject to usufruct are sold, the usufruct attaches to the proceeds of the sale (money, which is a consumable), and Wife becomes the owner of the money with an obligation to pay the naked owner this amount when the usufruct terminates.
Another example: Wife, as usufructuary. sells investments in the usufruct account for $500,000. There may be capital gains tax due if these investments had appreciated since Husband died. Nonetheless, Wife reinvests these proceeds and, at her death, they are valued at $800,000. Result: Wife's heirs benefit from this appreciation. Wife's heirs enjoy the benefit of another step-up in basis when Wife dies, and Wife's estate owes Husband's naked owners $500,000.
Bottom line: If assets subject to usufruct are sold, then when the usufruct terminates and the naked owners receive the assets and sell them, they will owe capital gains tax on the appreciation that occurred since the date of death of the person who bequeathed naked ownership to them.
There are many moving parts to usufruct and naked ownership taxation, ownership, and indebtedness that affect the rights and obligations of usufructuaries and naked owners. And since sharing an inheritance is not always the most amicable of life circumstances, it would behoove you to have an understanding of these difficult-to-understand concepts.
This post is for informational purposes only and does not provide legal advice. Please do not act or refrain from acting based on anything you read on this site. Using this site or communicating with Rabalais Estate Planning, LLC, through this site does not form an attorney/client relationship.
Louisiana Estate Planning Attorney
Phone: (225) 329-2450