Posted by Mike Kelly, CPA
As Benjamin Franklin once said, “Nothing is certain but death and taxes” so it makes sense to discuss how these two issues are intertwined with each other. There are many different types of federal taxes in the United States but the most common types related to death are estate and income taxes.
Estate taxes are based on an individual’s taxable estate at the time of his death. It is a one-time tax reported on Form 706 (An estate tax return) and is generally due nine months after the date of death. Most people escape this tax as it is only imposed on wealthy individuals whose gross estate exceeds $5,450,000, which is indexed annually for inflation. There are a few exceptions but the gross estate includes everything from real estate, stock and bond portfolio, retirement plans, property owned in certain types of trusts and other miscellaneous property. Even if property is not legally titled in the decedent’s name at death, it may get pulled back into the decedent’s gross estate for various reasons (i.e., if the decedent can still control where the property goes, maintains some beneficial interest in the property, or gives the property away within three years of death). Therefore, proper planning may be necessary to avoid this.
As with most tax returns, deductions can be claimed to reduce the tax due. Some common deductible items reported on Form 706 are funeral and administration expenses, state inheritance taxes and other debts of the decedent. The two typical largest deductions associated with Form 706 are the unlimited marital deduction and the charitable deduction. The marital deduction can be claimed for assets left to the surviving spouse while the charitable deduction can be claimed for assets left to a qualifying charity. Potentially, tax would become due on the assets left to the surviving spouse when he passes away. Therefore, planning with the use of trusts or the utilization of portability may be necessary to ensure both spouses maximize the use of their lifetime exemption to avoid any unnecessary tax. (See our tax blog Sharing is Caring – Elect Portability for a brief description of portability and the lifetime exemption)
Certain types of assets will get taxed at death and then get taxed again for income tax purposes when received by the beneficiary. This is called income in respect of a decedent and the most common example are retirement accounts. Depending on applicable tax rates, this double taxation could result in 70% – 80% of total tax on the value of the asset. However, the beneficiary can receive a special deduction on his personal return for estate taxes already paid on the asset, which will help reduce this burden.
The date of death controls what is taxable for estate tax purposes but what happens afterwards? Administrating an estate is usually a time consuming process. As long as the estate holds assets, it is responsible for reporting the income from them on Form 1041 (An income tax return) A return is generally required if gross income exceeds $600. Some common deductions that are available to offset income are interest expense, state taxes and administrative expenses. It is important to note that if a 706 and 1041 are required to be filed, identical expenses cannot be deducted on both returns.
Distributions to beneficiaries from estates also may be deductible on Form 1041 for the amount that is included in the beneficiary’s taxable income. Timely distributions can be used to effectively shift certain types of income from the estate’s tax return and move it to a beneficiary’s 1040. Since estates’ tax brackets are more compressed than an individual, distributions to beneficiaries can result in large tax savings.
The main avenues which a decedent’s assets may pass to its beneficiaries are through will, trust, and joint ownership or through beneficiary designation by a contract (i.e., IRAs) This is important because how the property passes will help determine who is responsible for reporting the income associated with it. Property owned jointly or inherited by contract usually passes to the beneficiaries at the time of death. Therefore, beneficiaries who receive assets in this manner are responsible for reporting income of these assets right after the date of death. It’s important for the executor to update all of the records as soon as possible so that income is properly reported under the correct social security or other identification number.
This brief summary of some of the federal taxes that result from death barely scratches the surface of the entire picture. Please reach out to our Estate and Trust team if you need additional information.