A common confusion in estate administration is knowing what income taxes are due after a person’s death. Now that the Federal and Maryland Estate tax exclusions are increasing, most people will not pay an estate tax on inherited property. Under the current law, most family members receive inherited assets without paying an inheritance tax. Capital assets such as stocks, real estate and mutual funds get an adjustment to basis at the death of the owner. So upon the sale of the capital assets little or no capital gains tax will likely be paid. However, the tax returns that most executors and trustees need to focus on are the income tax filings.
Several income tax returns need to be filed when administering an estate. One of these is the final income tax return of the decedent. That is the IRS form 1040. If you are married, most likely you will file a joint income tax return for the final year of your spouse’s life. In some cases, there may be reasons to file a separate return and that is something you will want to discuss with your income tax advisor.
The executor or trustee of the estate will file the final income tax return of the decedent if the decedent was single. If there is no executor appointed, the income tax return can still be filed along with an IRS form 1310.
An IRS form 1041, called a Fiduciary Income tax return, must be filed if there is income to the estate during the administrative period. The estate or trust will pay the income tax on the income if the income remains in the estate and is not distributed. If the income is distributed to the beneficiaries, then the beneficiaries will pick up the income on their own personal income tax return. To provide the income information that they need to claim on their income tax return, a form K1 will be issued to the beneficiary. Prior to making distributions, it is important to get the social security number of the beneficiary by requesting that the beneficiary complete an IRS form W-9 which will include all the information you need to provide to the IRS to report the income of the beneficiary.
As the executor of the estate or the trustee of the trust, it is important to pay attention to the income of the estate during the administrative process. Income in trusts tends to be taxed at higher rates than individuals. Some assets like retirement accounts, IRA’s, annuities, and 401(k)s have a lot of income accumulated in them. If the income is paid into a trust or an estate, we sometimes refer to it as a “hot potato”. It is important to analyze when that income should be paid to the beneficiaries, and how much should be paid once the funds are distributed from the account into the estate. Performing this analysis will help reduce the amount of income tax paid on inherited assets.
Working with an attorney and an income tax advisor during the estate administration process will help sort through these complicated income tax issues.
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