When a loved-one dies, the trustee or executor is generally responsible for filing final tax returns, which may include a final 1040 and one or more 1041 income tax returns. For large estates a 706 estate tax return may also need to be filed.
Final personal income tax returns. A final 1040 personal tax return is often required to be filed along with state tax returns for the state in which the decedent lived or owned real estate. The final 1040 reports income and expenses up to the date of death. The 1041s report income and expenses from the date of death until the final distribution.
1041 fiduciary (estate or trust) income tax returns. The 1041 (along with the state version) reports income and expenses from the date of death until the final distribution of the estate. Income may include interest, dividends, retirement plan distributions, earnings from annuities (if estate or trust is beneficiary) and proceeds from the sale of assets. Expenses may include, costs incurred to administer the estate, trustee or executor fees, final medical, accounting, legal, appraisals, probate costs (if applicable), expenses to sell assets and other expenses. In the final year unused capital losses and net operating losses pass to the beneficiaries.
Step in basis at death. When property is inherited, the basis is generally “stepped-up” or “stepped down” to the fair market value of the asset on the date of death or the alternate valuation date (see below). The “step” in basis attaches to the property and carries to the beneficiary. This is also the value included on the 706 estate tax return and subject to estate tax (if applicable).
Inherited vs. gifted? Inherited property gets a “step” in basis, but property received as a gift does not. For gifted property, the basis to the recipient is the same as the basis from the person transferring the property.
Tax consequences to beneficiaries. The general rule (for California and states without an inheritance tax) is that most capital assets, after-tax cash and financial accounts inherited are generally not taxable unless from income sources that have never been taxed, such as IRAs, qualified retirement plans or deferred annuities.
Final distributions. All required tax returns must be filed and all taxes paid before the estate can be closed and final distributions made. Since, the IRS ordinarily has three years (California four) from the date a tax return is filed or its due date (whichever is later) to audit the returns or assess more taxes, a trustee or executor may want to request a prompt assessment of tax (IRS Form 4810) to reduce the timeline.
Estate and gift tax returns (form 706 or 709) are not income tax returns, but instead asset tax returns or transfer tax returns. Taxes are calculated on the net value of assets transferred to another (cumulative during lifetime and at death) and not on the income earned by the assets. Estate taxes are generally due on net estates that approach or exceed $5.5 million dollars (indexed to inflation). The due date for the 706 estate return is nine months from the date of death (unless an extension is filed) and any tax is due at that time (unless an extension of time to pay is approved by the IRS). Each person has a lifetime credit against the combined estate and gift tax.
Gift tax returns are filed on an annual basis for the prior year when taxable gifts made to one person exceed the annual exemption amount ($14,000 for 2015) and have the same due date as 1040 returns. There is no tax due on the filing of a gift tax return until the cumulative total of all taxable gifts approaches the $5.5 million exemption amount. Trustees or executors of larger estates must check whether any taxable lifetime gifts were made prior to death and reduce the estate tax credit appropriately.
Alternate valuation date. Instead of using date-of-death values, an election can be made to use the values of the assets six months after the date of death (if beneficial). The election must apply to all estate assets, no partial application is permitted.
Gift and estate tax credit. Each American citizen has a lifetime credit against the combined estate and gift taxes, which generally means no estate tax is due until an estate approaches or exceeds about $5.5 million. The amount of an estate larger than that begins to be taxed at 35% and goes higher.
Estate and gift taxes for those married. Gift and estate tax is imposed on each individual. For married couples each spouse has their own exemption amount that can be excluded from the tax, which means that those married can exclude double the amount of a single person if planned properly. In addition, an unlimited amount of assets may generally pass from one spouse to the other without triggering estate or gift tax. However, that may not generate the best outcome. Therefore, it’s critical for large estates to plan properly or the exemption for the first-to-die could be lost.
Generation skipping tax. When gifts are made to grandchildren in which the total gift and estate exceeds $5.5 million, the portion that “skips” a generation is taxed twice.
Estate expenses (form 706). Large estates are allowed to deduct expenses from the total value of assets before calculating the tax. Deductions fall into three categories.
- Debts of the decedent, including mortgages, loans and bills due at the time of death (utilities, income and property taxes, final medical) and other expenses.
- Expenses in administering the estate, death certificates, copies of documents, postage, reimbursement for telephone or travel, legal, accounting, costs to maintain or sell assets, trustee or executor fees and funeral expenses.
- Charitable contributions paid from the estate.