You know the saying: Only two things in life are certain, death and taxes. Sometimes the two certainties coincide, and sometimes in very complicated ways. Inheritance taxes are complicated and as tax advisors we are frequently questioned on the subject.

As difficult emotionally as a family member’s death can be, it can also lead to forced reconnections with family members who were content with being at a distance. The inheritance laws can even force people into joint ownership of property with people they have never met or might not get along with, not to mention that the government will come for its pound of flesh. You need to be prepared.

Among the types of taxes an executor may be responsible for:

Income Tax- Form 1040

When someone dies, the decedent will have lived for some part of that year and possibly have earned income during that part of the year. The executor or personal representative will be responsible for filing the decedent’s final income tax return.

The process can be complicated by a lack of information. The executor will need to locate the 1099s, W2s, and other tax documents necessary to complete the tax return. If the decedent failed to file prior year returns, the executor must find the information necessary to back-file any of those. The IRS has established a process for the executor to obtain the tax transcripts and file a return based on that information.

The tax documents received generally over-report the income that needs to be filed on the decedent’s final return. The income earned by the decedent through the date of death should be reported on their individual tax return; income earned after the date of death generally is reported on the decedent’s estate income tax return. If there is a named beneficiary on assets, such as an individual retirement account or a brokerage account, then the beneficiary reports that income on their individual tax return. Filing can be complex and should generally be handled by a tax advisor familiar with the process.

Estate Income Tax – Form 1041

The deceased’s estate may be liable for tax on any income it continues to earn after the date of death. For example, if an inherited IRA is owned by an estate and a distribution is taken, that gets reported on an estate income tax return. Rental real estate owned by an estate earns rental income that also gets reported on the estate income tax return, though that income could be offset by expenses and depreciation.

Income tax applies to an estate that generates more than $600 a year. If distributions are made during the year, taxable income may pass to the beneficiaries and be taxed on their individual returns instead of the estate return. In general, if an estate earns more than $600, the executor, trustee, or personal representative of the estate will have to obtain a Tax ID for the estate and file Form 1041. Each situation is unique and there may be instances where an estate should file a return even if the $600 threshold is not met.

Estate income is generally taxed at high rate due to compressed tax brackets. Under the 2022 tax rate schedule, to reach the highest tax bracket of 37 percent the estate’s income must be more than $13,450. Since taxable income can be passed on to the beneficiaries through distributions, it makes sense to do so if they are in a lower marginal tax bracket than the estate. To mitigate and minimize the burden of estate income tax, it pays to be proactive.

Beneficiary taxes

In general, beneficiaries do not have to pay taxes on anything they inherit, with few notable exceptions. If the beneficiary inherits a bank account, they do not pay tax on what is in the account but will be taxed on interest earned, such as on a savings account. Similarly, if the decedent’s qualified retirement account, like a 401(k) or an IRA, has a noted beneficiary, the beneficiary will be taxed on the withdrawals.

Life insurance policies present a similar but potentially confusing tax situation. If the beneficiary is paid one lump sum policy amount, it is not taxable income. However, if the beneficiary is paid in installments over several years, any interest accrued on the policy amount is considered taxable income.

When a decedent leaves an asset, such as a house or a car, and the beneficiary sells it for more than it was worth at the time of decedent’s death, the beneficiary will have to pay capital gains taxes on the difference. Only the “date of death value” is relevant, not the value when it was purchased.

Estate Tax– Federal Form 706

The estate or “death” tax, calculated on a Form 706, is the tax your deceased loved one’s estate must pay within nine months of the death. In the past, many more estates were subject to the estate tax because the exemption, the amount that can pass estate-tax free, was so low. Since the early 2000s the exemption has slowly crept higher, sometimes in large leaps, and currently sits at $12.06 million for 2022.

Estate refers to an individual’s assets, which includes their home(s), bank accounts, investment accounts, cars, jewelry, and so on. Estate taxes apply to assets that the decedent owned or retained an interest in at death. Gifts made during life of the decedent decrease the exemption available at death.

Portability & Federal Estate Tax Exemption:

Even when the estate is not taxable, the executor will elect to file estate tax due to “portability,” a provision in federal estate tax law that allows a surviving spouse to use any unused estate and gift tax exemptions after the deceased spouse’s death. Portability can be used to protect the surviving spouse from having to pay steep gift or estate taxes upon a spouse’s death.

State estate and inheritance taxes

Twelve states and the District of Columbia also apply state estate taxes, the threshold for which ranges from $1 million to $5.74 million. Some states also have an inheritance tax. Currently there are six states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—that tax an estate based on who inherits the assets located in that state. State inheritance taxes typically apply only when the estate passes to a beneficiary who is not a spouse or member of the immediate family, though there are some exceptions.

Tax laws can appear complex, tedious, and intimidating. HBK professionals who specialize in estate planning and consulting services are accessible and responsive, helping to lift the burden off those responsible for administering estates. If you are administering a loved one’s estate, reach out to an HBK tax advisor. We’re here to help.

On Monday, September 21st, the IRS issued final regulations addressing the ability of trusts and estates to deduct administrative expenses, despite the 2017 Tax Cuts and Jobs Act’s suspension of miscellaneous itemized deductions through 2025. The final regulations largely mirror the proposed regulations issued in May (read our article on the proposed regulations, IRS Issues Proposed Regulations on Trust and Estate Deductions).

Most importantly, the final rules provide guidance on the treatment of expenses which result in excess deductions – deductions exceeding a trust or estate’s income in the final year that are passed on to beneficiaries when the trust or estate terminates. Consistent with the proposed rules, the final rules provide that the excess deductions retain the character of the specific underlying expense, and require fiduciaries to categorize the excess deductions into one of three categories – an administrative expense that is deductible when computing adjusted gross income (i.e., an above-the-line deduction), a non-miscellaneous itemized deduction that is not subject to the 2% limitation (e.g., state and local income taxes), or a miscellaneous itemized deduction that is subject to the 2% limitation and disallowed through 2025 under TCJA (e.g., investment management fees).

The final rules also confirm that the character and amount of the excess deductions is determined by allocating the deductions among the trust or estate’s income as provided under IRC §652. Those regulations provide that all deductible expenses directly attributed to a certain class of income are allocated to that class of income, and that deductions which are not directly attributable to one class of income may be allocated to any item of income at the trustee’s discretion provided that a proportionate amount of the deduction is allocated to tax-exempt income, as applicable. This discretion presents an opportunity to maximize the tax benefit of the excess deductions.

As an illustration, consider the following updated example from the final regulations. Assume an estate’s income and deductions in its final year are as follows: total income of $6,500, consisting of taxable interest of $500, dividends of $3,000, rental income of $2,000, and capital gain of $1,000, and total deductions of $17,500, consisting of probate fees of $1,500, estate tax preparation fees of $8,000, and legal fees of $2,500 (collectively, IRC §67(e) deductions), personal property taxes of $3,500 (itemized deductions), and rental real estate expenses of $2,000. There are two beneficiaries – A (75%) and B (25%).

Pursuant to the regulations under IRC §652, the $2,000 of rental real estate expenses are allocated to the $2,000 of rental income. The executor may, in his discretion allowed under the regulations, allocate the $3,500 of personal property taxes and $1,000 of the IRC §67(e) deductions to the remaining $4,500 of income (thus maximizing the amount of the excess deductions which are considered above-the-line deductions). Therefore, the excess deductions on the termination of the estate are $11,000, consisting entirely of IRC §67(e) deductions which are deductible when computing gross income. Beneficiary A will be allocated $8,250 of above-the-line deductions, and beneficiary B will be allocated $2,750 of above-the-line deductions.

Conclusion
The final regulations provide clarity on determining the character and amount of, as well as the method for allocating, excess deductions that beneficiaries of a terminated estate or non-grantor trust may claim on their individual income tax returns. Under the rules, fiduciaries have discretion which allows them to maximize the tax benefit of these deductions. Please contact your HBK advisor to discuss how these final regulations may impact your tax situation.

Maybe Tony Soprano was living dangerously but no one expected James Gandolfini to die at age 51, including Gandolfini. The popular actor who played the lead role on the long-running TV cable series “The Sopranos” left behind an estate valued at more than $70 million. But his will was so poorly planned that nearly half of it is likely to go to the IRS.

When the flame went out for the flamboyant Prince, the international pop star was 57 and clearly not past his prime, recording and touring and still acclaimed for his energy and intensity on stage. Ironically, he was an artist meticulous about the business of his music yet he left no will, and it will likely take a decade or longer to sort out the distribution of his enormous wealth.

Only a few of us have to be concerned about how to plan for reducing estate taxes. For 2016, the estate and gift tax exemption is $5.45 million per individual, up from $5.43 million in 2015. That means an individual can leave $5.45 million to heirs and pay no federal estate or gift tax. A married couple can shield $10.9 million from federal estate and gift taxes. More than half of U.S. states do not have an estate tax. So for most of us, the issue is how we want our assets distributed, how they will be managed and making certain we leave a meaningful legacy for our family.

No one wants to confront his or her own mortality. We don’t want to think about it, and that often translates into ignoring planning for it. But what will happen to a business where ownership is shared if one owner dies without a buy-sell agreement in place? Many times successful businesses fail without adequate succession planning. What about considerations for certain family members, like a child with long-term healthcare needs? Would it be appropriate to leave a lump sum of money or control of a business to a child who won’t handle it responsibly? And what if you became physically or mentally unable to make important decisions about your assets? So for the majority of us, estate planning is more about how our assets pass on to our beneficiaries and making certain our intensions are met rather than payment of taxes. Planning often boils down to identifying your goals and objectives and executing key documents such as a will, a durable power of attorney and advance medical directives, and occasionally, in particular for individuals with more substantial assets, one or several types of trusts.

HBK CPAs & Consultants and HBKS Wealth Advisors have collaborated on an Estate Planning Series that addresses key issues of the complete process, including details on the legalities of transferring wealth and assets to heirs, beneficiaries and successors for individuals and businesses.