Ben Franklin said that nothing is certain, except death and taxes — and in this day and age, death and important tax decisions come together, whether or not estate tax is owed.
Tax filings must be made and important tax decisions taken soon after an individual’s death. At an emotional time, planning may be difficult, so here’s what to know in advance.
FINAL INCOME TAX RETURN
When an individual dies, a final income tax return must be filed for him/her reporting all income he/she received during the year until the date of death. The return follows normal rules and is due on April 15 of the year following death (in 2009 for an individual who dies in 2008). The return can be prepared by…
A surviving spouse filing a joint return.
A court-authorized representative of the deceased, such as the executor or administrator of the deceased’s estate.
A person placed in charge of the decedent’s property who signs the return as the deceased’s “personal representative,” if there is no surviving spouse or court-authorized representative. This often happens when an estate is very small and simple and doesn’t require probate.
Important: If you prepare a final return for a decedent who is not your spouse, file IRS Form 56, Notice Concerning Fiduciary Relationship, so that the IRS will send correspondence relating to the return to you.
The final return should have the word “Deceased” the decedent’s name, and the date of death written across the top of it.
Planning opportunities…
A surviving spouse’s ability to file a joint return with a deceased spouse for the year of the latter’s death (providing the surviving spouse has not remarried) is an exception to the normal rule that year-end marital status determines filing status for the year.
The joint return will cover only a part year for the deceased spouse, but a full year for the surviving spouse, so a special opportunity may exist for the surviving spouse to make tax-saving moves during the latter part of the year.
Example: If the deceased spouse had sold assets in the year of his death, the surviving spouse can realize offsetting losses (or gains) during the rest of the year in the most tax-beneficial manner.
Medical expenses incurred by the decedent and paid off up until a year after death can be deducted on the final return as “paid when incurred,” if an election to do so is made on the return. See Code Section 213(c).
Series EE and I savings bonds owned by the decedent under the cash accounting method (with interest on them not realized until they are redeemed) may either have their accumulated interest reported and taxed on the deceased’s final return, or be distributed to heirs with all accumulated interest to be taxed to these heirs in the future when they redeem or sell the bonds.
Best: Pick the option that produces the lower tax rate on bond interest.
“Passive losses” accumulated in past years from real estate investments may be deductible against ordinary income on a final tax return — providing a potentially large deduction to the extent that it’s not reduced by basis step-up at death.
Rules are complicated, so consult a real estate tax expert.
The final tax return of an individual can be more complicated than those filed while he lived — especially if such items as realized passive losses and other complex investment tax matters will affect the tax planning of a surviving spouse. So, consider these issues with an expert.
ESTATE INCOME TAX RETURN
An estate must file an income tax return, IRS Form 1041, US Income Tax Return for Estates and Trusts, and pay estate income taxes, even if it doesn’t owe federal estate tax because its assets don’t exceed $2 million in 2009 — even if the surviving spouse is going to file a joint return for the death year. The estate’s income tax return generally reports income paid to the deceased after his date of death and before the estate is distributed to heirs, if any.
Examples: An accrued bonus from an employer, income from investment accounts, business receivables.
Corresponding deductions are also allowed.
If an estate’s income does not exceed $600, no income tax return is due. But if an estate is large or complex, it may incur income tax for a significant time as income continues to come in. Executors are personally liable for any estate tax owed by an estate that goes unpaid, so they often are slow to distribute an estate to heirs until the IRS “signs off” on its tax status.
Deferral strategy: The estate may select a fiscal year rather than a calendar year to postpone the payment of income tax as long as possible. Example: If the decedent died on November 30, 2008, the estate’s income for December would be required to be reported on April 15, 2009, if a calendar year were selected. If, instead, a fiscal year with a November year-end were selected, the December 2008 income wouldn’t be reported until March 15, 2010.
BASIS DETERMINATIONS
It’s vital that the executor of an estate determine the market value of all assets in the estate at the date of the deceased’s death, and report these values in writing to the heirs who inherit the assets.
Why: Heirs receive assets bequeathed to them with a tax basis that is “stepped up” to this market value. If, at a later time — perhaps years later — they sell the assets, but don’t know this value, they may not be able to reliably calculate their gain or loss (as gain equals sale price minus basis). In the worst case, the IRS may then deem the entire sale price to be gain. This can be a special problem with collectibles, heirlooms, and other items that don’t have a published market value.
Problem: Valuing all the items in an estate is what an executor does when preparing an estate tax return — so even if no estate tax is due, he may have to do most of the work of preparing an estate tax return (and charge corresponding fees).
Note: When estate tax is due, the lowest reasonable valuation of the estate’s assets is desired to minimize tax. But when no estate tax is due, the highest reasonable valuations will be desired to maximize “stepped-up basis” and reduce future income tax on the gain.
DISCLAIMING A BEQUEST
A relative who dies may leave you a bequest you don’t want.
Example: A parent may leave you assets you don’t need that generate income that will be taxed at a high rate to you. You may prefer that the bequest go to your children if the will so provides.
By electing to “disclaim” a bequest, you can have it pass as though you weren’t alive to receive it — avoiding gift taxes otherwise due if you were to accept the bequest and then give it to your children.
Important: The IRS says that you must execute a disclaimer within nine months of the date of death and cannot make any beneficial use of the disclaimed property in the meantime.
INCOME IN RESPECT OF A DECEDENT
Wages, retirement distributions, and other items that include income that had never been subject to income tax may be included in the estate. These items are called income in respect of a decedent (IRD).
The estate may pay estate tax on the value of these IRD assets. The beneficiary of such items (a child, the estate, etc.) may qualify to claim an income tax deduction for the amount of estate tax paid on this IRD component. This deduction provides tax relief since this item is getting taxed both on the estate tax return and an income tax return.
Example: $100,000 of estate tax was allocated to an inherited traditional IRA worth $300,000. As the IRA is distributed to the heir (the IRA’s owner), up to $100,000 of IRD deductions can be taken to shelter the otherwise fully taxable IRA distributions from tax.
Important: All the information needed to support future IRD deductions must be generated by the executor and provided to heirs, or the deduction will be lost. But this is often overlooked. Rules are complex, but the deduction can be very valuable, so consult an expert.
