The death of a loved one is always difficult but it can be even more challenging if you are the one who must handle all the resulting tax responsibilities.
There are a couple different ways you can assume the required duties:
- You may be named as the executor of the decedent’s estate under his or her will.
- In the absence of a will, you could be appointed as the administrator by the probate court.
Either way, the duties are essentially the same, so for purposes of this article, we’ll call the person with the responsibility the executor.
What must be done? The executor is charged with the task of finding the estate’s assets, paying off its debts, and distributing whatever is left to the rightful heirs and beneficiaries. The executor is also required to file the necessary tax returns and pay any taxes due. If you are the executor and fail to do this, the IRS can come after you personally for tax underpayments, plus penalties and interest. So you need to understand what is involved and get the proper assistance from your attorney.
The duties may include:
Make Sure the Decedent’s Final 1040 Form is Filed
The decedent’s final tax return covers the period from January 1st through the date of death. The return is due on the normal date (generally April 15 of the following year). If the decedent was unmarried, the final 1040 is prepared in the usual fashion. When there is a surviving spouse, the final 1040 can be a joint return filed as if the decedent were still alive as of year end. The final joint return includes the decedent’s income and deductions up to the time of death, plus the surviving spouse’s income and deductions for the entire year.
The Handling of Medical Expenses
If large uninsured medical expenses were accrued but not paid before death, the executor must make an important choice about how they are treated for tax purposes. Along with any medical expenses paid before death, these accrued expenses can generally be deducted on the decedent’s final 1040 to the extent they exceed 7.5% or 10% of adjusted gross income (AGI). This is an exception to the general rule that expenses must be paid in cash before they can be deducted. Final medical expenses can easily exceed 7.5% or 10% of AGI, especially if death occurs early in the year before much income is earned.
Important Note: If the decedent was age 65 or older in 2016, the 7.5% figure applies for his or her 2016 tax return. As of 2017, the 10% applies regardless of age.
Alternatively, an executor can choose to deduct the accrued medical expenses on the decedent’s federal estate tax return. Of course, this is the wrong choice if no federal estate tax is owed. However, when estate tax is due, deducting accrued medical expenses on the estate tax return is usually the tax-smart option. Why? Because the estate tax rate is 40% while the decedent’s final income tax rate could be as low as 10%. Plus, the full amount of the accrued medical expenses can be deducted on the estate tax return (not just the excess over 10% or 7.5% of AGI).
In addition to the final tax return and the medical expenses, here are the rest of the tax-related duties:
File the Estate’s Income Tax Returns
Immediately after death, the decedent’s estate may take over ownership of some or all of the decedent’s assets. If so, the estate will be taxed on its income under complicated IRS guidelines applicable to trusts.
Important distinctions: We are talking about income taxes for the estate, not the final income taxes of the decedent. And the federal estate tax is an entirely different subject.
Small estates (with gross income under $600) aren’t required to file income tax returns. If you are in charge of an estate that must file, get professional help to assist you with this onerous chore because the tax law is very complex.
File the Estate’s Estate Tax Return
The federal estate tax return is filed on Form 706. Assuming the decedent did not make any sizable gifts before dying, no estate tax is due, and no Form 706 is required, unless the estate is worth over $5.49 million (up from $5.45 million in 2016). By sizable gifts, we mean in excess of $14,000 to a single recipient for 2017 (and 2016). If sizable gifts were made, the excess over the $14,000 threshold is added back to the estate to see if the annual limit in effect for that year is surpassed.
Form 706 is due nine months after death, but the deadline can be extended up to six months. Remember: While life insurance proceeds are generally free of any income tax, they are usually included in the decedent’s estate for estate tax purposes — even if the money goes directly to policy beneficiaries. In fact, life insurance proceeds are the most common cause of unexpected estate tax bills.
One other very important point: Assets inherited by a surviving spouse are not included in the decedent’s estate, as long as the surviving spouse is a U.S. citizen. This is called the unlimited marital deduction privilege and it’s the most common reason why many large estates don’t owe any federal estate tax.
If you are the executor of a substantial estate, consult with your tax adviser even if you think no estate tax is actually due. If you’re correct, the cost to confirm your conclusion will be minimal. If you’re wrong, filing Form 706 is generally a complicated matter and you may need professional assistance. Also, an experienced estate advisor may be able to find perfectly legal ways to substantially reduce the tax bite or even make it disappear.
More Miscellaneous Details
- If an estate must file income tax or estate tax returns, a federal employer identification number (EIN) must be obtained from the IRS.
- You should open a checking account in the name of the estate with some funds transferred from the decedent’s accounts.
The bank will ask for the estate’s EIN. Use the new account to accept deposits from income earned by the estate and to pay expenses – such as outstanding bills, funeral and medical expenses, and, of course, taxes. - State income tax returns and perhaps a state estate tax return will have to be filed.
An important planning step you can take right now, is to check the beneficiary designations for your bank accounts, brokerage firm accounts, tax-favored retirement accounts, company benefit plans, life insurance policies, annuities and 529 college accounts. Many people fail to take these simple steps, and the consequences can be dire. For more information, see: An Important Estate Planning Step to Take Now.