This is the first of two articles on this topic.
Administering an estate can be a daunting and tiring task. It’s likely something you’ve not done before and may never be called on to do again. Among the many duties you have is making sure taxes for the deceased and the estate are in good order before closing the estate. This can be overwhelming as thinking about your own taxes can be scary enough! Here we’ll discuss considerations around this aspect of your fiduciary obligation.
Income Tax Filings of the Deceased
Just as you are accustomed to filing your own income tax return, you’re now responsible for making sure the deceased’s last income tax return is filed. This may be a joint return with a surviving spouse or a return for only the deceased if he/she was not married at death. The final return could also be a jointly-filed return for both deceased spouses if they passed away in the same year. If you are the executor for an individual who was married at his/her death, you’ll need to coordinate this final tax filing with the surviving spouse or executor of the other spouse’s estate if this isn’t you. In addition to a federal income tax return filed on Form 1040, a state income tax return may also be required depending on the deceased’s state of residence/domicile and states where the deceased owned income-producing property or had business activity.
Not only must the deceased’s final tax returns be filed, you’ll also want to make sure there aren’t any other years for which the IRS or other taxing authorities are expecting tax returns or tax payments. For example, if the deceased owed the IRS several years of back taxes, these must be addressed before closing out the estate. If you are at all unsure about this, a phone call to the IRS is the best starting point. Request a compliance check to see if any returns or balances due are outstanding and also to see if any overpayments may be on file. States can also be contacted on an individual basis as appropriate. Note that you’ll need proof of your role as executor for a taxing authority to speak with you, e.g. letters testamentary. A financial power of attorney for the deceased will not be helpful in this situation as these are void after death.
What do you do if you don’t have tax-related records for the deceased? I often find executors are missing some or even all of a deceased’s tax records. This can be because the deceased’s estate plan was disorderly or absent, address changes, lack of access to electronic accounts, or the volume of documentations may be such that something is invariably misplaced. The first step is to see what income documents can be obtained from employers, financial asset custodians, and other tax form issuers. If income activity may still be missing, the next step is to contact the IRS for a wage & income transcript for any years in question. In addition, some income activity may need to be created, e.g., if the deceased owned a business or rental property. Keep in mind that tax documents and IRS transcripts typically cover only items of income. Although an IRS transcript will likely show mortgage interest as reported on Form 1098, information for other itemized deductions such as medical expenses, state taxes, and charitable contributions will have to be created from the deceased’s bank records or other documents. Additionally, IRS transcripts may not show the correct cost basis for the sale of financial assets and will likely show no cost basis for any sales of real estate, so further work will be required for these types of transactions.
Individual income tax returns are generally due April 15thof the year following the deceased’s death. This can sometimes cause the closing of the estate to be delayed even if all else is resolved. For example, if the deceased died in February 2019, the 2019 Form 1040 can’t be filed until nearly a year later. On the other hand, you may have an estate that will take some time to close. If you need additional time to gather information for a complete and accurate tax return, an extension of time can be requested which gives you until October 15thof the year following the deceased’s death to file his or her final Form 1040. Keep in mind extensions do not extend the time to pay any taxes owed, so late payment penalties and interest may accrue if balances are owed with the returns when filed.
Income Tax Filings of the Estate
The estate is the entity that exists from the deceased’s date of death until the deceased’s property is completely distributed to beneficiaries and the estate is closed out with the appropriate court. While in existence, the estate’s assets may generate income, e.g., financial account earnings or sale of real estate. If $600 or more of income is generated by the estate, it will likely have a federal income tax filing requirement. Just as individuals file Form 1040 to report their taxable income, estates file Form 1041. As you are working with the attorney helping you administer the estate, it’s likely he or she will obtain for a federal tax ID (also called EIN for Employer Identification Number) from the IRS which is the identification number under which you will file Form 1041. Note that the estate may choose a fiscal year and that the accounting period for an initial filing is allowed to be less than 12 months. This allows for potential tax planning, as well as a prompt filing for an estate that can quickly be closed.
Who pays taxes on the earnings of an estate? In some situations, it’s the estate itself. In other situations, it’s one or more beneficiaries. It’s also possible that both the estate and the beneficiaries have taxable activity for the same period. If an estate distributes property to beneficiaries in the same tax year it generates taxable income, it’s possibly the beneficiaries may be required to include their share of the estate’s income in their own personal tax returns. Included in Form 1041 is a Schedule K-1 that reflects a beneficiary’s share of an estate’s activity to be incorporated into the beneficiary’s personal tax situation. You’ll want to understand as soon as possible in the estate administration process what tax impact there may be to beneficiaries so that you can communicate this information to them. Beneficiaries may have no idea that receiving money from an estate could have an income tax consequence to them. As a best practice for properly completing Schedules K-1, obtain beneficiary Social Security numbers in advance of issuing distributions as these may be difficult to obtain after beneficiaries have received their share of estate assets.
The deceased’s will may include a provision for what’s known as a testamentary trust, i.e., a trust that comes into being upon death. If so, consider that this newly-created trust may also contain assets that generate income and, as such, may also need a tax return of its own. You as the executor may or may not also be the trustee of a testamentary trust. In a very specific set of circumstances, the estate and such a trust may even file one Form 1041 to report their combined activity. This may or may not be feasible or desirable depending on the trust’s trustee, beneficiaries of the trust and estates, etc.
Other Tax Filings
In addition to Form 1040 and 1041 considerations, two other federal tax returns should be considered for the deceased. The first is Form 709 which reports taxable gifts made during the year. In general, a gift to an individual of $15,000 or more is reported to the IRS. Such a gift may or may not have an associated tax with it depending on several factors including the deceased’s lifetime gifting history. The second tax return is Form 706 which reports assets of the deceased for, not income tax, but estate tax purposes. Only estates over a certain threshold are subject to the federal estate tax. At the time of this writing, this amount is over $11,000,000 in combined estate assets and lifetime gifts. As such, most estates will not require a Form 706 filing to report and pay estate tax. However, executors handling estates under this threshold should still give Form 706 consideration for purposes of what’s known as portability. Portability allows a deceased spouse to shift his or her unused lifetime estate exemption to the surviving spouse and is accomplished only by filing a Form 706 to elect such treatment. If the deceased has a surviving spouse or if the deceased had a spouse whose executor had previously made a portability election, care should be taken in deciding the applicability of Form 706 to the situation.
Also be aware of state-level taxes. States may tax the income of an estate via a state Form 1041 equivalent, although this is generally handled without much fuss as part of the federal tax filing. What may not be as obvious is that some states impose an estate tax on the estate and/or inheritance taxes on beneficiaries. The state estate taxes may be on much lower thresholds meaning that just because an estate isn’t subject to federal estate tax doesn’t mean it isn’t subject to an estate tax to one or more states. Inheritance taxes are charged to the beneficiary rather than the estate and can be an unpleasant surprise for an uninformed recipient of estate assets. The good news is that few states impose such taxes, so it’s quite possible these are of no concern to you.
While this is a primer on the tax implications for those administering an estate there is so much more that can be said. This article should, however, give executors an idea of what they’re in for, but isn’t a substitute for discussions with legal and tax advisors. If I can help in any way or answer additional questions, feel free to contact me at firstname.lastname@example.org.
In the second article, I will talk about working with a CPA and other tax considerations. To download the full article as a PDF, click here.