Death and Taxes: When the Two Coincide

Date December 12, 2022
Article Authors
Tejal Shah

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.

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IRS Issues Final Regulations on Trust and Estate Deductions

Date October 1, 2020
Article Authors

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.

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.

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Secure Act: Retirement Tax Law Changes & More, Part I

Date June 27, 2019
Article Authors

Congress is great at titling laws with acronyms. The SECURE Act is yet another one of that category of bills with cutesy names with greater emphasis on creating a word than making sense, in this case, “Setting Every Community Up for Retirement Enhancement Act of 2019,” which, contrary to its title, has nothing to do with communities per se. This bill has passed the House with overwhelming bipartisan support and is paired with a similar bill in the Senate. The Senate effort to pass this legislation is currently stalled.

We expect many of the following proposals to become law:

• Eliminate the age 70-1/2 cutoff at which workers are no longer allowed to contribute to IRAs;

• Increase the age at which required minimum distributions must be made from an IRA or employer sponsored qualified retirement plans, like 401(k) plans, from age 70-1/2 to age 72;

• Limit the period of time that distributions from inherited IRAs and inherited employer sponsored qualified retirement plans would be required to be paid out to 10 years rather than the life expectancy of their beneficiaries. Exceptions to this limit are likely to include spousal rollovers and inherited retirement accounts where the beneficiary is a minor or disabled;

• Permit employers to automatically escalate their employees’ contributions up to 15% of pay, which is an increase from the prior limitation of 10%;

• Increase the tax credits provided to small businesses who start up retirement savings plans and/or include automatic enrollment from $500 to $5,000;

• Allow graduate students and postdoctoral to save for retirement based on their stipends/fellowships, and allow home healthcare workers to save based on “difficulty of care” payments, which are otherwise not counted as compensation;

• Create a safe harbor that employers can use when they are choosing group annuity issuers to support 401(k) plan lifetime income stream options;

• Require plan sponsors to tell the participants about how much monthly retirement income their assets might produce; and

• Expand Section 529 education savings accounts to include such categories as apprenticeships and homeschooling expenses.

The proposed changes to the required distribution period from IRAs and other employer sponsored qualified retirement plans will significantly accelerate distributions. Let’s look at this example:

An individual age 25 inherits a $1,000,000 IRA. The required distributions under current law would be paid out over the life expectancy of the 25-year old, which would be 58.2 years. The SECURE Act would require the beneficiary to withdraw everything from the inherited IRA over 10 years. Under current law, the initial required distribution for the 25-year-old beneficiary would be $17,182 ($1,000,000 divided by 58.2). In the second year, the minimum amount required to be distributed would be the balance at the beginning of the second year divided by 57.2. In each successive year the divisor would be reduced by 1. Ultimately, the full amount would be distributed within the 58.2-year period. If the required minimum amount is not distributed, the beneficiary would be subject to a 50% penalty on the amount not distributed.

The SECURE Act would not require a distribution in the first year. The total amount in the IRA would be required to be fully distributed within the 10-year period in any manner the IRA beneficiary decides. The entire IRA could be distributed on the last day of the 10-year period. The SECURE Act will require a beneficiary to plan distributions over the 10-year period more carefully.

We will address planning issues associated with these proposed changes to the required minimum distribution rules in future articles.

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The Pennsylvania Inheritance Tax: Plan for It

Date October 10, 2016
Article Authors

Common misconception: The federal estate and gift tax exemption is $5.45 million for an individual, $10.9 million for a married couple. So those of us under that threshold need not be concerned about anything we pass along to our heirs being taxed.

Correction: If you are Pennsylvania resident, your estate will be subject to an inheritance tax of up to 15 percent – regardless of its value.

Consider these scenarios:

  • A couple with no children plans to distribute their estate, comprised of a home and a portfolio of stock and bonds, among their siblings. They have a will, which provides for the sale of the home and sets out details on how the assets should be divided. At the death of the last of the two, there is but one surviving sibling, the woman’s brother. Pennsylvania requires the man first to secure a supportable appraisal on the home and any other non-cash assets, then exacts a tax of 12 percent on the total value of the estate.
  • A year prior to her death, a widow with a terminal illness adds her daughter’s name to her checking account to provide access to needed funds while she’s alive and avoid probate and taxes after her death. At her mother’s death, the daughter learns that she must file an inheritance tax return and the entire amount in the account is subject to Pennsylvania inheritance tax.

State inheritance taxes might be the most overlooked aspect of estate planning. Yet their impact can be draconian, up to 15 percent of the estate’s value in Pennsylvania. They apply to all estate assets: real estate, personal tangible property, cash, even retirement accounts if the deceased was more than 59½ years old and qualified to make withdrawals. The sole inheritance tax deduction is for “final” expenses, such as the costs for the funeral, executor of the will, and probate administration.

The applicable tax rates:
On an estate passed to a surviving spouse: No tax
On assets distributed to direct descendants (children, grandchildren, etc.): 4.5%
For siblings: 12%
For anyone else: 15%
On assets left to a charity: No tax

There are nuances to these divisions, for example, for assets divided among a spouse and someone outside the family, only the portion distributed outside the family is subject to the Pennsylvania Inheritance Tax. And nuances to the law, such as the requirement that heirs file an inheritance tax return with the applicable county’s Office of the Register of Wills within nine months of the death, and a discount of 5 percent of the tax if it is paid within three months after the death.

Every inheritance tax return is audited, so such things as appraisals must be reasonable and all assets must be reported. The state has covered the landscape to the point that anyone opening a safe deposit box with the estate owner’s name tied to it is required to report on the contents within 21 days of turning the key.

The point is there is little to do to avoid the tax after death, so it should be addressed as part of your estate planning process – and for inheritance tax purposes, planning must be completed at least five years prior to the estate owner’s death. The strategies are similar to other estate planning tactics, including various gifting and trust options.

So now that you know about the Pennsylvania Inheritance Tax, talk to your accountant and attorney about it, so you understand how it will affect your estate and what you can do to protect your assets against it.

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