By Bill Bischoff
A loved one who was “financially comfortable” has passed away. What happens now tax-wise? Good question, especially if you’re the one responsible for taking care of such matters. This column addresses some of the most important tax-related considerations in this scenario. In two earlier columns, I covered other tax issues. Please read those along with this one to see the full picture. See How to avoid painful tax issues when settling a loved one’s estate and 5 key questions when you’re responsible for a loved one’s estate.
The role of the executor
When a loved one (the decedent) passes away, someone must take on the job of winding up the financial aspects of the estate. That person may be identified in the decedent’s will as the executor of the decedent’s estate. If a family trust holds the decedent’s assets, the trust document will name a trustee. If there’s no will or trust, the probate court will appoint an administrator. In any of these scenarios, we will call that person the executor to keep things simple. That person might be you.
The executor’s assignment is to identify the estate’s assets, pay off the debts, and distribute the remainder to the rightful heirs and beneficiaries. The executor is also responsible for filing any necessary tax returns and arranging to pay any taxes. Let’s discuss the tax stuff.
Filing the estate’s federal income tax return (Form 1041)
You as the executor are responsible for filing the federal income tax return for the decedent’s estate, if a return is required. After the decedent has passed away, income generated by his or her holdings now belongs to the estate, and that income generally does not completely escape the clutches of good old Uncle Sam.
The estate’s initial federal income tax year begins immediately after the decedent’s date of death. The tax yearend can be December 31 or the end of any other month that results in an initial tax year of 12 months or less.
The return is filed on Form 1041 (U.S. Income Tax Return for Estates and Trusts) and is due by the 15th day of the fourth month after the tax yearend (adjusted for weekends and holidays). So for a decedent who dies in 2019, the estate tax return deadline is 4/15/20, assuming the standard December 31 tax yearend is chosen.
An automatic 5-1/2-month extension of time to file Form 1041 can be obtained. For example, a return that’s due on 4/15 can be automatically extended to 9/30.
There’s no need to file Form 1041 when all the decedent’s income-producing assets bypass probate and go straight to the surviving spouse or other heirs by contract or by operation of law. For example, this is what happens with real property that is owned as joint tenants with right of survivorship (JTWROS), IRAs and qualified retirement plan accounts that have designated account beneficiaries, and life insurance proceeds that are paid directly to designated policy beneficiaries.
Filing the estate’s federal estate tax return (Form 706)
File the estate’s federal estate tax return on Form 706 [United States Estate (and Generation-Skipping Transfer) Tax Return]. This is not the same thing as the estate’s federal income tax return, which I just covered.
Assuming the decedent did not make any significant gifts before passing away, no federal estate tax is due, and no Form 706 is required, unless the estate is valued for federal estate tax purposes at more than $11.18 million for a person who died in 2018 or $11.4 million for someone who dies in 2019.
Significant gifts mean those in excess of $15,000 for gifts in 2018-2019 to a single human gift recipient, $14,000 for gifts in 2013-2017; $13,000 for 2009-2012; $12,000 for 2006-2008; $11,000 for 2002-2005; and $10,000 for 2001 and earlier. If such significant gifts were made, the excess over the applicable threshold for the year of the gift is added back to the estate to see if the estate tax exemption ($11.18 million for 2018; $11.4 million for 2019) is surpassed. If it is surpassed, there’s a 40% federal estate tax on the excess.
Form 706 is due nine months after the date of death, but you can extend the deadline for up to six months.
Unlimited marital deduction privilege
If the decedent was married and the surviving spouse is a U.S. citizen, an unlimited amount can pass from the decedent’s estate to the surviving spouse free of any current federal estate tax. This is thanks to the so-called unlimited marital deduction privilege. The unlimited marital deduction, in conjunction with the generous federal estate tax exemptions allowed for 2018-2026, can allow even large estates to avoid any current federal estate tax liability.
Life insurance proceeds
While life-insurance proceeds are generally free of any federal income tax, they are usually included in the decedent’s estate for federal estate tax purposes, even though the money may go directly to the designated policy beneficiaries.
An exception to this general rule can apply when the policy beneficiary is the surviving spouse. Reason: assets inherited by a surviving spouse (including life insurance payouts) are not included in the decedent’s estate for federal estate tax purposes when the surviving spouse is a U.S. citizen. This is thanks to the aforementioned unlimited marital deduction privilege.
Another exception applies if the decedent set up an irrevocable life insurance trust to hold policies on his or her life. Your tax adviser can supply details on how this works.
Filing Form 706 solely to make the portability election
While you as the executor may think no Form 706 is necessary because no federal estate tax is owed, that could be an erroneous conclusion. Reason: filing Form 706 is necessary to make the so-called portability election that allows the executor to pass the decedent’s unused unified federal estate and gift tax exemption to the surviving spouse. The portability privilege can be a really big tax-saving deal for well-off married couples.
In future years, who knows what the federal estate and gift tax exemption will be or if there will even be an exemption? Who knows what the impact of making an earlier portability election will be? Only soothsayers know and they are not talking. Since making the election cannot possibly hurt, and it might pay off big time in the future, make the election for any well-off married couple. Making the election requires filing Form 706. A tax professional can help you with that.
When you as the executor file Form 706 solely to make the portability election, an extended filing deadline applies. The deadline is on or before the second anniversary of the decedent’s date of death. Even better, you only need to complete part of Form 706, and it’s a fairly simple task. Nevertheless, you may want to delegate this task to a tax professional.
The bottom line
When a “financially comfortable” loved one departs, a bevy of tax issues can come into play. The executor is responsible for dealing with those issues, and it can be a daunting task. A good tax professional can provide valuable assistance in meeting applicable tax compliance rules and in developing appropriate tax planning strategies for the future.
Other tax-related details
If you as the executor will be filing Form 1041 and/or Form 706, you must obtain a federal employer identification number (EIN) for the estate. The EIN is analogous to an individual’s Social Security number. Apply for an EIN by filing Form SS-4 (Application for Employer Identification Number).
Next, file Form 56 (Notice Concerning Fiduciary Relationship) to notify the IRS that you will be acting on behalf of the estate regarding federal tax matters. Filing Form 56 ensures that you will receive any notices sent out by the IRS (fingers crossed).
Next, open a checking account in the name of the estate with some funds transferred from the decedent’s account(s). You as the executor have the legal power to do this, but make sure you have the estate’s EIN in hand, because the bank will ask for it. Use the new account to accept deposits for income earned by the estate and to pay the estate’s expenses.
Unfortunately, once you’ve taken care of all of the things I’ve covered in three different columns, your tax-related work may still not be finished. You may also be responsible for state income tax returns and perhaps a state death tax return as well.