Bar News - February 15, 2017
Tax Law: Death Is No Excuse: Post-Mortem Income Tax Obligations
By: Amy K. Kanyuk
A clientís death brings with it a host of tax considerations, including the payment of income taxes after death.
Decedentís Final Tax Returns
The executor must file the decedentís final income tax return (Form 1040) for the period ending with the date of death. The final return is due April 15 of the year following the date of death. The decedent and his surviving spouse can file a joint tax return for the year of death, as long as the surviving spouse does not remarry before the end of the tax year. The final joint return will include the decedentís income through the date of death, and the surviving spouseís income for the entire year.
The executor should confirm that the decedent filed all of his prior tax income returns before the date of death. If the executor cannot locate copies of prior returns, he can request copies from the IRS. The executor should delay distributing estate assets until he is sure that all of the estateís tax obligations have been satisfied.
Estateís Income Tax Return
The decedentís estate is a separate taxpayer. Accordingly, the executor should obtain a taxpayer identification number for the estate, and file a Form 56 (Notice of Fiduciary Relationship) with the IRS.
The executor can choose a calendar or fiscal tax year for the estate. Choosing a fiscal year can significantly defer the date of the first payment of income tax by the estate. If the executor chooses a fiscal year, the initial fiscal year must end no later than the last day of the calendar month before the month of the decedentís death. For example, if the decedent dies April 20, the fiscal year must end no later than March 31.
Income in Respect of a Decedent. Income in respect of a decedent (IRD) is income that the decedent earned, but didnít receive, before death. A common example of IRD is income attributable to distributions from a decedentís IRA or 401K. IRD received by the decedentís estate or a beneficiary is taxable to the estate or beneficiary when the estate or beneficiary receives it. IRD also is an asset of the decedentís estate for estate tax purposes. If the decedentís estate was subject to federal estate tax, the estate or beneficiary can take an income tax deduction against the IRD for the estate tax attributable to the inclusion of the IRD in the decedentís gross estate.
Taxation of Distributions
Distributable net income (DNI) is, in general, the estateís or trustís taxable income, excluding capital gains. DNI provides a ceiling on the amount an estate or trust can deduct for distributions to beneficiaries; a ceiling on the amount a beneficiary must account for on his income tax return with respect to distributions from an estate or trust; and DNI identifies the character of the income distributed to the beneficiary (e.g., taxable interest, dividends, etc.).
DNI and fiduciary accounting income (FAI) usually are not the same in a given year because the rules for determining DNI and FAI are different. DNI deals with determining the appropriate amount of tax to be borne by the trust or estate and its beneficiaries. FAI deals with equitable concepts of allocating the amount of income and principal between income beneficiaries and remaindermen. An item that may be subject to federal income tax will not necessarily be ďincomeĒ for FAI purposes (e.g., capital gains), and an expense that may be deductible for income tax purposes may not be chargable in full against ďincomeĒ for FAI purposes (e.g., fiduciary fees). Although capital gains are taxable as income for income tax purposes, they usually are not included in DNI because they are considered principal for fiduciary accounting purposes.
Distributions from an estate or trust to a beneficiary are taxable to the beneficiary, and deductible by the estate or trust, only to the extent of the estateís or trustís DNI. Taxable income is not allocated to beneficiaries who do not actually receive distributions from the estate or trust.
Specific Bequests. The payment of a specific bequest (money or specific property) is not taxable to the beneficiary, as long as the bequest is: 1) paid all at once, or in no more than three installments; and 2) ascertainable under the governing instrument as of the date of the decedentís death. Interest paid on pecuniary bequests is interest income to the beneficiary.
Distribution of Property In-Kind. Distributions in kind generally donít result in the recognition of gain or loss. However, if the fiduciary distributes appreciated property to a beneficiary to satisfy a pecuniary bequest (i.e., a bequest that has a fixed dollar amount), the distribution is treated as a taxable sale or exchange, and any gains or losses must be recognized by the estate or trust.
If the will or trust leaves bequests to multiple beneficiaries, and the beneficiaries agree to take specific assets of equal value, rather than receive a fractional interest in every asset, there is a taxable exchange, unless the fiduciary is authorized (under state law or the governing instrument) to make non-pro rata distributions. Drafting attorneys therefore should ensure that their wills and trust agreements authorize the fiduciary to make non-pro rata distributions.
Basis Adjustments at Death. The basis of property acquired from a decedent generally is the propertyís fair market value on the date of death. This rule can either ďstep upĒ or ďstep downĒ the basis of property. However, the step-up rule does not apply to items of IRD; the basis of an item of IRD equals the decedentís basis at the time of death.
The 65-Day Rule. Generally, for an estate or trust to take a distribution deduction for a particular tax year, the entity actually must make the distribution to the beneficiary during that tax year. However, Section 663(b) of the Internal Revenue Code allows fiduciaries to elect to treat all or any portion of a distribution made to a beneficiary within the first 65 days of the estate or trustís subsequent tax year, as if the entity had made the distribution on the last day of the preceding tax year. This 65-day rule provides flexibility to fiduciaries with respect to timing distributions for tax purposes, and allows the fiduciary to base those distributions on the entityís actual income for a given year.
The 645 Election
During the grantorís life, the IRS ignores a revocable trustís existence for federal income tax purposes, and the grantor reports the trustís income, deductions and credits on his individual income tax return. After the grantorís death, the trustee must wind up the trustís affairs before distributing its assets to the beneficiaries. During this wind-up, the decedentís revocable trust is a separate taxpayer for income tax purposes. The trustee must obtain a taxpayer identification number for the trust and file income tax returns for it.
The Code treats the decedent grantorís revocable trust and estate differently for federal income tax purposes. In some cases, the Code affords more favorable tax treatment to the estate than to the trust (for example, an estate can elect to be a fiscal year taxpayer, but a trust cannot). Code Section 645 levels the playing field between trusts and estates by allowing the trustee to elect to treat the trust as part of the grantorís estate (rather than as a separate entity) for income tax purposes. If the 645 election is made (on IRS Form 8855), all items of income, deduction and credit are combined and reported on one income tax return (Form 1041) filed under the name and taxpayer ID number of the estate. The 645 election is effective as of the date of the decedentís death. The fiduciary should determine and calendar the ending date of the 645 election period. See Treas. Reg. Section 1.645-1(f).
Planning for Subchapter
Maintaining S Status. Estates are permitted S corporation shareholders during the period of administration. A decedentís revocable trust is an eligible S shareholder during the personís life. When the decedent dies, new rules apply with respect to the eligibility of the trust to hold the S stock. If the decedentís revocable trust owned S stock at the time of the death, the trustee should determine and calendar the time period during which the trust will be an eligible S shareholder, and plan for the disposition of the S stock at the end of that period. See Code Section 1361(c)(2)(A).
Any trust that continues in existence beyond the grace period after the decedentís death, and that will continue to hold S stock, must elect to be treated either as a ďqualified subchapter S trustĒ (QSST), or an ďelecting small business trustĒ (ESBT). QSSTs and ESBTs differ with respect to how income and principal may be distributed, and how the income from the S corporation is taxed. Although ESBTs provide more flexibility with respect to the dispositive provisions of the trust, QSSTs may be more efficient for income tax purposes.
Conclusion. Regardless of the size or complexity of an estate, fiduciaries and their advisors must address income tax obligations after a personís death, to ensure they are satisfied before distributing assets to the beneficiaries.
Amy K. Kanyuk
Amy Kanyuk is a founding member of McDonald & Kanyuk, in Concord, NH. She is licensed to practice law in New Hampshire, Massachusetts and South Dakota. She concentrates her practice on estate, gift and generation-skipping planning for individuals and families of high net worth.