When a loved one who was financially comfortable passes away, there will be tax issues. You may be the heir responsible for dealing with them, and major bucks could be in play.
This column addresses some of the most important tax-related considerations. In two earlier columns, I covered some others. See here and here. This column covers part, but not all, of the rest of the story. Here goes.
Taxes are the executor’s responsibility
You may be the estate executor or the estate administrator appointed by the probate court. Either way, let’s call you the executor to keep things simple. As such, you’re responsible for complying with applicable federal tax rules.
Important deadlines for filing the estate’s federal income tax return (Form 1041)
As the executor, you’re on the hook for filing the federal income tax return for the estate of your deceased loved one (the decedent), if a return is required. Income from the decedent’s holdings now belongs to the estate, and that income generally does not completely escape the clutches of good old Uncle Sam.
The estate’s initial federal income tax year begins immediately after the decedent’s date of death. The tax year-end can be December 31 or the end of any other month that results in an initial tax year of 12 months or less.
File the return on IRS Form 1041, U.S. Income Tax Return for Estates and Trusts. The due date is the 15th day of the fourth month after the tax year-end (adjusted for weekends and holidays). So, for a loved one who dies in 2021, the estate tax return deadline is 4/15/22, assuming you choose to use the standard December 31 tax year-end.
You can get an automatic 5-1/2-month extension of time to file Form 1041, and you may need that extra time to get things squared away. For example, you can automatically extend a return that’s due on 4/15/22 to 9/30/22. Get an extension by filing IRS Form 7004, Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns.
Key point: There’s no need to file Form 1041 when all the decedent’s income-producing assets bypass probate and go straight to the surviving spouse or other heirs by contract or by operation of law. For example, this is what happens with real property that is owned as joint tenants with right of survivorship (JTWROS), IRAs and qualified retirement plan accounts that have designated account beneficiaries, and life insurance proceeds that are paid directly to designated policy beneficiaries.
Don’t forget about the estate’s federal estate tax return (Form 706)
Next up is the estate’s federal estate tax return. This is not the same thing as the estate’s federal income tax return, which I just covered. File the estate’s federal estate tax return on IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. Assuming the decedent did not make any significant gifts before passing away, no federal estate tax is due, and no Form 706 is required, unless the estate is valued for federal estate tax purposes at more than $11.7 million for a loved one who dies in 2021.
Significant gifts mean those in excess of $15,000 for gifts in 2018-2021 to a single human gift recipient, $14,000 for gifts in 2013-2017; $13,000 for 2009-2012; $12,000 for 2006-2008; $11,000 for 2002-2005; and $10,000 for 2001 and earlier. If such significant gifts were made, the excess over the applicable threshold for the year of the gift is added back to the estate to see if the estate tax exemption ($11.7 million for 2021) for 2019) is surpassed. If it is, there’s a 40% federal estate tax on the excess.
Key point: Form 706 is due nine months after the date of death, but you can automatically extend the deadline for six months by filing IRS Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes. Once again, you may need that extra time to get things squared away.
Unlimited marital deduction
If the decedent was married and the surviving spouse is a U.S. citizen, an unlimited amount can pass from the decedent’s estate to the surviving spouse free of any current federal estate tax. This is thanks to the so-called unlimited marital deduction privilege. The unlimited marital deduction, in conjunction with the generous federal estate tax exemption allowed for 2021, can allow even large estates to avoid any current federal estate tax liability.
Life insurance death benefits
While life-insurance death benefits are generally free of any federal income tax, they are usually included in the decedent’s estate for federal estate tax purposes, even though the money may go directly to the designated policy beneficiaries.
An exception to this general rule can apply when the policy beneficiary is the surviving spouse. Reason: assets inherited by a surviving spouse (including life insurance payouts) are not included in the decedent’s estate for federal estate tax purposes when the surviving spouse is a U.S. citizen. This is thanks to the aforementioned unlimited marital deduction privilege.
Another exception applies if the decedent set up an irrevocable life insurance trust to hold policies on his or her life.
Consider filing Form 706 solely to make the portability election
While you may think no Form 706 is necessary because no federal estate tax is owed, that could be an erroneous conclusion. Reason: filing Form 706 is necessary to make the so-called portability election that allows the estate executor to pass the decedent’s unused unified federal estate and gift tax exemption to the surviving spouse. The portability privilege can be a really big tax-saving deal for well-off married couples.
In future years, who knows what the federal estate and gift tax exemption will be or if there will even be an exemption? Who knows what the impact of making an earlier portability election will be? Only soothsayers know and they are not talking. Since making the election cannot possibly hurt, and it might pay off big time in the future, make the election for any well-off married couple. Making the election requires filing Form 706.
When you as the executor file Form 706 solely to make the portability election, an extended filing deadline applies. The deadline is on or before the second anniversary of the decedent’s date of death.
X-factor: proposed tax changes
As explained in earlier columns, the proposed Biden tax plan includes several changes that could adversely affect heirs. Another tax plan proposed by Congressional Democrats would decrease the federal estate tax exemption to about $6 million for 2022 (versus $11.7 million for 2021) but retain the existing basis-step-up-at-death break. What proposed changes will actually become law? Beats me. Stay tuned.
But wait, there’s more: other tax-related details
If you as the executor will be filing Form 1041 and/or Form 706, you must obtain a federal employer identification number (EIN) for the estate. The EIN is analogous to an individual’s Social Security number. Apply for an EIN by filing IRS Form SS-4, Application for Employer Identification Number.
Next, file IRS Form 56, Notice Concerning Fiduciary Relationship to notify the IRS that you will be acting on behalf of the estate regarding federal tax matters. Filing Form 56 ensures that you will receive any notices sent out by the IRS (fingers crossed).
Next, open a checking account in the name of the estate with some funds transferred from the decedent’s account(s). You as the executor have the legal power to do this, but make sure you have the estate’s EIN in hand, because the bank will ask for it. Use the new account to accept deposits for income earned by the estate and to pay the estate’s expenses.
Unfortunately, once you’ve taken care of all of the things I’ve covered so far in three columns, your tax-related work may still not be finished. You may also be responsible for state income tax returns and perhaps a state death tax return as well.
The bottom line
When a financially comfortable loved one departs, a bevy of federal tax issues can come into play. Dealing with them can be daunting, and there may be state tax issues too. A good tax professional with estate tax experience can provide valuable assistance.