Postmortem Income Planning
By Bernard Gitlitz, CPA, Glassel & Bonfiglio, LLC
The increased Federal Unified Estate and Gift Tax Credit means fewer estates are required to file federal estate tax returns. Some interrelated income and estate tax considerations remain, however. Interpreting the facts, making necessary elections, and claiming all allowable deductions on the appropriate tax return will minimize the tax burden.
Examining the Facts
Assume that the amount of a decedent’s gross estate has been determined, the estate assets have been valued, and the decedent’s final personal income tax return Form 1040, federal estate tax return Form 706 (or a determination that none is required to be filed), and federal estate income tax return Form 1041 are being prepared. The decedent and estate are usually cash-basis taxpayers. One of the first tasks is to determine the decedent’s gross income earned from January 1 to the decedent’s date of death and the income received after death, in order to allocate the income to be reported either on the decedent’s Form 1040 or the estate’s Form 1041. Some receipts should be reported on both Form 706 and Form 1041.
Some items of income have their own special tax characteristics. IRC section 691, which covers income in respect of a decedent (IRD), requires that, upon distribution, some items of income must be reported on both Form 1041 (or on the tax return of the beneficiary receiving the income) and Form 706 as a taxable asset of the estate. IRD is untaxed or tax-deferred income earned by the decedent taxed after death. Several typical items of IRD (the decedent’s pension plans, accrued vacation pay, and U.S. Savings Bond interest) are subject to both income and estate taxes. The federal estate tax attributable to the IRD is a miscellaneous itemized deduction, deductible by the recipient of the IRD but not subject to the 2% floor.
Income from partnerships and Subchapter S corporations must also be examined. The death of a partner causes the partnership year to end with respect to that partner. Therefore, the decedent’s share of the partnership income for the calendar year of death must be prorated between the decedent’s final Form 1040 and the estate’s Form 1041 (or another successor in interest). If the fair market value of the partnership at the date of death of the partner is higher than the decedent’s predeath tax basis, the fiduciary should inquire whether the partnership has made a valid IRC section 754 election. The estate may be entitled to additional income tax depreciation deduction attributable to the step-up in basis. Income from a Subchapter S corporation prorated to the date of death is reported on the decedent’s final 1040, and the income for the balance of the year is reported by the estate or other successor in interest.
The decedent’s final income tax return may reflect some tax carryovers. The decedent’s capital loss carryover terminates at death. The sources of the carryover must be traced and then split between both taxpayers on a joint return. The survivor may continue to use her own share of the joint capital loss carryover. All capital gains of both spouses (including the postdeath capital gains of the survivor) are reported on the joint income tax return in the year of death. The surviving spouse should consider selling appreciated assets to use as much of the decedent’s capital loss carryover as possible on the joint tax return and to avoid the total loss of the carryover. Investments in passive activity partnerships are stepped to date-of-death value on Form 706. Accordingly, if a passive activity interest is transferred because of the owner’s death, unused passive losses are recognized on the decedent’s Form 1040 to the extent they exceed the amount by which the transferee’s basis in the passive activity has increased on Form 706. Any unused suspended losses thereafter disappear. If the decedent’s final income tax return is a joint return, the income tax overpayment on the joint return can be applied to the surviving spouse’s return.
Rules for Expenses and Deductions
Some expenses can be deducted on both Form 706 and Form 1041. These are deductions in respect of a decedent (DRD) under IRC section 691(c), and they include items that are deductible for income tax purposes and are also debts of the decedent. They typically consist of the decedent’s personal state income and real estate taxes paid after death, as well as similar expenses. Schedule K of the estate’s Form 706 should be reviewed to determine if any of these double deductions exist.
Other deductions have their own rules. If the estate waives the estate tax deduction for medical expenses, medical expenses paid by the estate within one year after death may be deducted on the decedent’s final Form 1040 (not the estate’s Form 1041). The estate tax waiver may be appropriate when the final Form 1040 reflects a sufficient amount of income and there is no federal estate tax.
IRC section 642(g) states that the estate’s administration expenses can be deducted on an income tax return only if the fiduciary waives the right to claim them on the Form 706 by filing a statement with the IRS. Administration expenses of the estate under the laws of its jurisdiction are deductible for estate or income taxes or can be split between them, subject to the estate tax waiver. The administration expenses must also be “necessary.” Because the definition of necessary expenses is not always clear, the fiduciary should consider how long the cost of maintaining real estate is necessary and when such expenses are made on behalf of the beneficiaries. Tax preparers should inquire and determine the reasonableness of deducting administration expenses related to real estate when the administration of the estate is unduly prolonged. Estates are subject to the 2% floor on miscellaneous itemized deductions. Deductions for expenses that would not have been incurred had the property not been held in an estate, however, are not subject to the 2% floor. Tax preparers should analyze and separate those two types of deductions. Funeral expenses, including a reasonable expenditure for perpetual care, can be deducted only on Form 706 and never on Form 1040 or 1041. State death or inheritance taxes are not deductible for income or estate purposes.
Amounts paid to charities pursuant to testamentary bequests are deductible for estate or income tax purposes. Estates may also claim an income tax deduction for amounts set aside but not yet paid to a charity. The actuarially valued (at date of death) estate obligation to pay the decedent’s alimony to the ex-spouse is deductible for estate tax purposes but not for income tax purposes. Ordinarily, claims against the estate based upon a decedent’s legal obligation to support are not treated the same as alimony. Claims against the estate for the reasonable value of the decedent’s minor children’s support, however, have been allowed as deductible estate tax deductions.
In many cases, the two largest allowable income tax deductions available to fiduciaries are the deductions for professional fees and executor’s commissions. Assuming that the fiduciary has determined that the fees should be deducted on the estate’s income tax return, several important planning matters should be considered. The first relates to the executor commissions. If the executor is also the prime beneficiary residue of the estate, the effect of waiving the commissions should be considered. Executor commissions are taxable income to the executor. If there is no estate tax and the commissions are waived, the executor’s income tax on those commissions can be avoided. If the executor elects to claim the commissions, the timing of their payment is important.
If in any year the gross taxable income of the estate is less than the amount paid for administration expenses, the benefit of the excess deductions will be lost. This can be mitigated by projecting the income of the estate in the year, then limiting that year’s expenses to the amount of administration expenses. Alternatively, the fiduciary can postpone the payment of those fees to the final year of the estate. Excess deductions paid in the final year of the estate are passed on to the beneficiaries and thereby not wasted.
Other elections and considerations include the following: Fiduciaries may elect a noncalendar fiscal year for the estate. The fiscal year must end on the last day of any month, and the year cannot exceed 12 months. For example, if an individual died on November 15, 2002, the estate’s initial fiscal year begins on the day after death and may end on the last day of any month from November 30, 2002, to October 31, 2003. Careful choice of a fiscal year may allow the fiduciary to bunch income or defer payment of income taxes to subsequent years. The election is made by filing a timely return or extension within three and one-half months of the end of the first fiscal year.
Estates are allowed a Form 1041 income tax distribution deduction for distributions to beneficiaries. Professionals should therefore take special care to match income and deductions. For example, if a surviving spouse has a large personal income tax deduction for real estate taxes and mortgage interest in the year of death, the decedent died on November 15, 2002, and a large amount of income is paid into the estate between date of death and December 31, 2002, the fiduciary should consider an estate year-end of December 31. Estate distributions of 2002 income to the surviving spouse will allow the surviving spouse to get the full benefit of the 2002 income tax deductions. The fiduciary may elect to treat any distribution made to beneficiary within 65 days after the end of the estate’s tax year as having been paid in the prior year.
Other matters to consider include the IRC section 179 depreciation deduction, which is not available to estates. Estates are not required to make estimated income tax payments for their first two fiscal years. Under IRC section 643(g), fiduciaries may also elect to treat any estimated tax payments made by the estate, in its final year, as made by the beneficiaries. This election is made by filing Form 1041-T within 65 days of the end of the estate’s final year.
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