Any estate tax attorney will tell you that taxes are one of the most complicated aspects of probate and estate planning. One of your most important duties as executor or administrator (which we will refer to here simply as an “executor”) of a deceased person’s estate is to look after the tax affairs of the decedent. This involves filing the decedent’s final income tax return, fiduciary income tax returns on behalf of the estate, federal gift and estate tax returns, and any tax returns that may be required at the state level. Basis issues must also be considered to be sure that the overall net tax cost to the beneficiaries is minimized.
The opportunities for tax planning often outlive the decedent. Postmortem tax and estate planning is critical to ensure that the decedent’s last wishes are carried out at a minimum tax cost. This planning is usually aimed at either minimizing the estate’s or the beneficiaries’ overall tax liability or helping to facilitate the payment of taxes. This requires knowledge of the many elections and planning alternatives that are available. Are there income or estate tax elections that could be beneficial in the circumstances? If so, how can they be claimed? When and how should you fund bequests? Should disclaimers be used? Should you elect to have qualified terminable interest property qualify for the marital deduction? Should any elections be made to maximize the decedent’s generation-skipping transfer tax exemption? How to pending changes in existing law affect the tax picture? Unless you can answer these questions, you will need counsel on these issues.
An estate tax attorney or other tax advisor (such as a knowledgeable accountant or CPA) can review the estate plan (or lack thereof!) to determine if there are opportunities for adjustment to take into account circumstances that were not considered during the decedent’s life, or to adjust for changes in facts. Your tax advisor will need to consider the following tax returns and other considerations:
- The Decedent’s Final Income Tax Return
- Fiduciary Income Tax Returns
- Stepped-Up Basis for Inherited Property
- Federal Gift & Estate Tax Returns
- State Tax Returns
Decedent’s Final Income Tax Return
The executor is responsible for filing the deceased person’s final income tax return. If an executor has not been appointed when the decedent’s final income tax return is due (including any extensions) and there is a surviving spouse, the surviving spouse may file the final income tax return, which may be a joint return.
These returns are filed for the period beginning January 1 of the year of death and ending on the date of death. The executor should also be sure that income tax returns have been filed for recent prior taxable years. This is especially important if the deceased person suffered from a prolonged illness or was otherwise likely to neglect to file final income tax returns.
A person’s death terminates his or her taxable year. This means that if a person passes away on June 1, 2009, that person’s final income tax return will cover only the period from January 1, 2009, until June 1, 2009. A final income tax return will be required if the decedent’s income exceeds the filing thresholds established under the Internal Revenue Code.
The due date of the final income tax return is the same as the date on which the decedent would have had if the decedent had survived through the end of the year. This will usually be April 15 of the year succeeding the year in which the person dies. The executor may use IRS Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, to apply for an automatic four-month extension. If an executor has not been appointed by the due date of the decedent’s return, anyone with a close personal or business relationship may file the Form 4868 on behalf of the decedent. The Form 4868 must be filed on or before the due date of the return. Filing of the Form 4868 will also extend the due date of any gift tax return of the decedent which would otherwise have been due on April 15.
If additional time is needed beyond the automatic four-month extension, the executor may file IRS Form 2688, Application for Extension to File U.S. Individual Income Tax Return, to apply for an additional two-month extension. Unlike the four-month extension, however, the two-month extension is at the discretion of the Internal Revenue Service. This usually requires a showing that the executor is unable to file the return by the due date because of circumstances beyond his or her control.
If there is a refund due on the decedent’s final income tax return, the executor may attach court document (certified Letters Testamentary) evidencing his or her appointment to serve as executor to an IRS Form 1310 to claim the refund.
After the final income tax return is filed, an executor may ay request that the IRS make a prompt assessment of tax. This request must be sent separately from any other document and sent to the office in which the return was filed. The request must be made within three years of the date on which the return is filed.
Fiduciary Income Tax Returns
The estate is considered a separate taxable entity that begins on the date of the decedent’s death and lasts until the estate is closed. Income must be reported on an annual basis. Fiduciary income tax returns cover the period beginning on the date of the decedent’s death and ending on the date the estate is closed. During this period, the estate is taxed in generally the same manner as individuals, with certain exceptions related to the computation of deductions and credits. If the estate lasts for two or more years after the date of the decedent’s death, it must pay an estimated tax in the same manner as individuals.
Income earned during the estate administration is reported on IRS Form 1041, Fiduciary Income Tax Return. This return must be filed if gross income of the estate is $600 or more. The due date for filing fiduciary income tax returns can be extended only if the executor clearly describes the reasons causing the delay. The extension is requested using IRS Form 2758, Applications for Extension of Time to File U.S. Partnership, Fiduciary, and Certain Other Returns.
An executor may request a prompt assessment of the tax due. This shortens the three-year period during which the IRS normally has to assess additional tax to 18 months from the date the request for prompt assessment is filed.
The estate will generally pay income tax on income that it does not distribute to beneficiaries and on any capital gains incurred during a taxable year. In the final year of the estate, the estate will pay no tax since all of the income and capital gains are distributed (or deemed to be distributed) to the beneficiaries. Payments of income to the beneficiary are taxable to the beneficiary (Note that we are not dealing here with distributions of estate assets, but distributions of income from estate assets), and the estate is entitled to a deduction for such payments. This distribution deduction effectively prevents double-taxation of income earned during the estate administration.
If necessary, the executor is also responsible for obtaining a tax identification number (also referred to as an employer identification number) from the IRS. This is done by filing an IRS Form SS4, Application for Employer Identification Number, with the IRS.
An executor may be personally liable for the payment of the tax on the taxable income of an estate or trust if, prior to distribution of assets and discharge of the executor, the executor had notice of the tax obligation or failed to exercise diligence in ascertaining whether there was a tax obligation. Liability for the tax will also follow the assets into the hands of the beneficiaries to the full extent of the assets distributed to them. To avoid this potential liability, it is critical that all tax returns be filed and all income tax paid prior to discharge of the executor and distribution of the assets of the estate.
Stepped-Up Basis for Inherited Property
The term “basis” refers to the starting point for determining taxable gain or loss in a transaction. Under current law, a beneficiary that inherits property from a decedent takes a basis in the property equal to fair market value at the time of the decedent’s death. This is a departure from the general rule that the basis of property is its cost. In other words, the basis in the property is “stepped up” from its cost to the fair market value at the time of the decedent’s death.
This rule is best illustrated by an example. Assume that the decedent purchased land for $10 and sold it ten years later for $100. Because the property was sold during the decedent’s life, his basis for determining his tax on the sale would be his cost. In this case, the decedent would be taxed on the difference between his $10 cost (basis) and his sale price of $100, resulting in $90 gain.
Now suppose that, instead of selling the property, the decedent kept it until death and left it to his sole heir. Because of the stepped-up basis rule, the heir will take a basis in the property of $100, even though the decedent’s basis in the property was only $10. If the heir sells the property immediately before it appreciates, no tax will be due on the sale! This means that the $90 of appreciation in the property between the time the decedent purchased it and the time it was sold is forever exempted from federal income tax. This provides an incentive for individuals to retain property until death instead of selling it during their lifetime.
Because the beneficiaries take a basis in the inherited property equal to the fair market value at the time of the decedent’s death, it is important to be able to determine fair market value at the time of the decedent’s death. An appraisal is often advisable for this purpose.
Federal Gift & Estate Tax Returns
Estate Tax Returns. If a decedent has sufficient assets that are not offset by deductions, his or her estate will be subject to the federal estate tax. The federal estate tax is generally due on estates that exceed a certain threshold known as the applicable exclusion. The applicable exclusion is $2,000,000 for 2006, 2009, and 2008. It increases to $3,500,000 in 2009 and is set to be repealed for 2010. On January 1, 2011, the estate tax is scheduled to be revived with an applicable exclusion of $1,000,000. Sound confusing? It is. Most practitioners believe that Congress will act sometime before 2010 to freeze the applicable exemption amount at a certain level, but at the time of this writing such action has not been taken. In any event, it is likely that the estate tax will remain a part of our tax system for the foreseeable future.
The estate tax is reported on IRS Form 706, U. S. Estate Tax Return. It is due nine months from the date of the decedent’s death unless extended. If circumstances make it impractical to file a reasonably complete federal estate tax return within the nine-month period, an application for extension must be filed with the District Director for the IRS district in which the decedent resided. The request for an extension is made on IRS Form 4768, Application for Extension of Time to File U.S. Estate Tax Return and/or Estate Tax. Because the extension for time to file the return does not extend the time due for payment of the tax, an estimated tax payment must be made at the time the return is filed.
Special relief from the payment of estate tax may be given if the estate includes a farm or closely held business that represents more than 35 percent of the value of the gross estate. In these situations, an executor may elect to defer payment on part of the federal estate tax for up to five years. The deferred portion may then be paid in equal installments of up to ten years. The intent of this relief is to avoid the forced sale of farms or family businesses to pay estate tax liabilities.
If the estate tax return is due and tax is owed, the executor can be personally liable for failure to file the return and pay the tax. Since estate tax rates are high (currently over 40%), this liability can be substantial. To mitigate this risk, an executor may make a written request to the IRS for a prompt determination of the estate tax and a discharge of personal liability. The service must, within nine months of such a request, notify the executor of any tax due. If there is tax due, the executor may pay it from estate assets and be discharged of any personal liability.
Gift Tax Returns. If a decedent dies before filing any required Federal gift tax returns, the executor is required to file the return. This means that if the decedent made any taxable gifts in any calendar quarter, the executor must file gift tax returns and pay any tax due. The return must be filed on or before the 15th day of April following the close of the taxable year. Reasonable extensions may be granted at the discretion of the IRS. Gift tax returns are filed on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return.
State Tax Returns
Not surprisingly, states also impose specific filing requirements on executors. In many situations, the state-level tax filing and payment requirements piggy-back on the federal requirements, but there are some differences. Because each state has its own system of taxation, the executor’s duties can vary greatly depending on the state involved.
Income Taxes. For states that charge income taxes, filing requirements often mirror the federal requirements. A final income tax return and fiduciary income tax return are usually required. Even in these states, however, substantial variation exists. For example, some states may disallow a deduction that is available in another state, resulting in a significant change in tax liability. You should consult with your tax adviser regarding your responsibilities for filing state income taxes on behalf of the estate.
Estate Taxes. Like income taxes, state estate taxes vary from state to state. These taxes can usually be grouped into at least one of two categories. An “inheritance tax” is levied on the right to receive property by inheritance. This is different from an estate tax, which taxes the right to pass property by inheritance. Under an inheritance tax system, beneficiaries are grouped into classes depending on their relation to the decedent. Different exemptions and exclusions apply to each class.
A “pick-up tax” (also called a “sop tax”) is a state estate tax that is equal to the amount allowed as a credit for federal income tax purposes. Because pick-up taxes would otherwise be paid to the federal government, the effect of a pick-up tax is to transfer money from the federal coffers to the state treasury. Because the 2001 changes to the federal tax laws phase out the federal deduction for state estate taxes, states that relied on the pick-up tax system found themselves watching their estate tax phase out as well. For example, Alabama and Mississippi no longer have an estate tax because of the phase-out of the federal state tax credit. Many other states that formerly relied on pick-up taxes have enacted additional estate taxes to minimize this loss of review. For example, some states (such as New York) have frozen their estate tax system to its pre-2001 Act levels.