Tax Considerations of Serving as an Executor or Trustee

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When serving as an Executor or a Trustee there are 3 primary areas of concern: the estate tax, income tax for the estate, and income tax for the beneficiaries.

1. Estate Tax

At the death of the decedent, there may be federal or state estate taxes due. For 2012-2013, the federal estate tax only applies to assets greater than $5.25 million ($10.5 million for a couple), which by most estimates is only the top half of one percent of all estates. You’ll definitely need expert help in preparing the federal estate tax return, which is due nine months after the death.

2. Income Tax — Estate

As executor, you may need to file a final income tax return for the deceased. You may also file an income tax return for the estate if the probate assets have generated income after the date of death. In that case, beneficiaries will be given a Schedule K-1 to report any income or losses generated from the estate on their individual income tax returns. It’s the executor’s job to file the deceased person’s state and federal final income tax returns for the year of death. If a joint return is filed, the surviving spouse shares this responsibility.
One of the important concepts of estate income tax is the step-up in basis, which allows assets to be transferred to heirs or sold using the date-of-death value as the cost basis instead of the decedent’s original purchase price. This can be a tremendous benefit when the decedent has stock or real estate that has appreciated greatly in value during his or her lifetime. The step-up applies whether the assets are sold while registered in the name of the estate or after they have been distributed to heirs.

Some special rules apply to surviving spouses.

Filing a joint return:
A surviving spouse may file a joint tax return for the year of the deceased spouse’s death. If the spouse remarries during that year, however, file a “married filing separately” return for the deceased taxpayer.
A surviving spouse who has a dependent child may get an income tax break for two tax years after the death. A surviving spouse who qualifies for a special filing status, called “qualifying widow(er),” can pay the tax rate that applies to married couples. The result may be a smaller tax bill. To be eligible, you must have:

  1. been entitled to file a joint return with your spouse for the year of death (whether or not you actually did)
  2. not remarried before the end of the current tax year
  3. had a child, stepchild, or foster child who qualified as your dependent for the tax year, and
  4. provided more than half the cost of maintaining your home, which is the child’s principal residence.

Claiming a Refund

If you’re the surviving spouse filing a joint return, there’s no extra paperwork involved in claiming a refund. Anyone else filing a return on behalf of a deceased person must file additional documents.

  • If you’re the court-appointed executor, attach a copy of the court document that authorizes you to act. This may be called your “Letters Testamentary,” or something similar, depending on the state.
  • If a court hasn’t appointed you to represent the estate, file IRS Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, with the return.

Other important tax issues that arise are A) Tax Basis, B) Capital Gains Tax, and C) Jointly Owned Property.

A. Tax Basis:

To understand capital gains tax, you must understand the concept of tax basis. The “tax basis” of an asset is the value that’s used to calculate the taxable gain—or loss—when the asset is sold. Usually, the tax basis is the price the owner paid for the asset. For example, if you bought a house for $100,000, your tax basis would be $100,000. If you sold it a month later for $120,000, your taxable gain would be $20,000. But what is your tax basis when you don’t buy something, but inherit it? The tax laws say that your tax basis is the value as of the previous owner’s date of death. For example, if a son inherits a house from his mother that’s worth $200,000 as of her death, his tax basis is $200,000. It doesn’t matter that her tax basis was only $75,000, the amount she paid for the house 30 years ago.
The inheritor’s tax basis is called a “stepped-up” basis, because the basis is stepped up from the previous owner’s purchase price to the date-of-death value. And if property is held for a long time, its value generally does go up. But the basis could be stepped down, too, if the property was worth less when the person died than it was when it was bought. What matters is simply the date-of-death market value. Note for very large estates: If you’re working with an estate that’s may owe estate tax—currently, that means there must be more than $5.25 million in taxable assets—then the basis may be figured differently. Instead of the date of death value, the estate can choose an alternative valuation date of six months after the death. See an estate tax expert if this is an option for you.

B. Capital Gains Tax:

A high tax basis is good. That’s because when someone sells an inherited asset, long-term capital gains tax will be due on the difference between the sales price and the tax basis. The higher the basis, the smaller the difference between it and the sales price.

For example, take that house, inherited by a son from his mother, with a date-of-death value of $200,000. If the son promptly sells it for $200,000, no tax will be owed, because he gets a stepped-up basis of $200,000. But if his tax basis had been the same as his mother’s, $75,000, then he would have owed capital gains tax on his gain of $125,000 on the same transaction. Currently, the tax rate for long term capital gains is 15%.

C. Jointly Owned Property:

Tax basis gets a little more complicated when property is co-owned and one of the owners dies. It’s a common situation, of course, because many couples own valuable property together and leave their shares to each other.

Joint tenancy property. When property is held by two owners in joint tenancy, only half of it gets a stepped-up tax basis when the first owner dies. For example, say a couple owns a house worth $200,000; they paid $150,000 for it. If one of the owners dies, the survivor gets a stepped-up tax basis in the half she inherits. She already owned the other half-interest, so her basis stays the same. That means that her new basis is $175,000. (The basis in her original half-interest is still $75,000, and the basis of the half-interest she inherits is $100,000.)

Community property. In community property states, married couples get a tax advantage. Both halves of community property (owned by the couple together) get a stepped-up basis when one spouse dies and the other becomes sole owner. So in the example above, the surviving spouse would have a new stepped-up basis of $200,000 after her husband’s death.

3. Income Tax — Beneficiaries

Distributions received by inheritance are generally not taxed as income. It doesn’t matter how the property passes to the inheritor. Whether the property passes under the terms of a will or trust, or the inheritor was a designated beneficiary (for example, a payable-on-death bank account), it’s not taxable income.

Exceptions can include IRAs, annuities, savings bond interest, or any asset carrying tax-deferred income. Special rules apply as to how distributions can be made from tax-deferred assets: often with IRAs and annuities, distributions can be stretched over a number of years, which may ease the tax burden for a beneficiary. Each beneficiary of a tax-deferred asset is responsible for the taxable income on their portion of the asset.

Tax-deferred retirement plans.

The money contributed to conventional IRAs and 401(k) plans is generally not taxed before it is put in. Either contributions are made with pre-tax dollars, or the contributor gets a tax deduction for the contribution. Income tax on the funds is deferred until money is withdrawn from the account, either by the original contributor or by the person who inherits the account. A beneficiary who withdraws money from an inherited account must report that money as ordinary income. The tax will be due with the person’s regular annual income tax returns (state and federal). If some contributions were nondeductible, then the beneficiary doesn’t have to pay tax on them. Figuring out just what portion of the funds isn’t taxable, however, can be complicated. The beneficiary will probably need some expert help. Surviving spouses who inherit a retirement account can defer the tax by rolling over the account into a retirement account of their own. Other beneficiaries can change the account into an “inherited IRA” and withdraw the money over several years, spreading out the income tax as well.

Roth retirement plans.

Money that a beneficiary withdraws from a Roth IRA or 401(k) plan, however, is generally not taxable income. Roth accounts are funded with money that has already been taxed, so the accounts are treated like other inherited property. People don’t have to pay income tax on amounts they take from a Roth account they inherited if: a) the money was contributed by the person who created the Roth account (that is, it isn’t a return on the investment of contributed funds), or b) the account was opened and contributed to at least five years earlier.
For more about Roth IRAs, see IRS Publication 590.
The executor is generally responsible for filing an inheritance tax return, and the executor may not be able to close the probate case without showing that all inheritance taxes have been paid. There is only one return per deceased person, even if there are multiple inheritors who owe tax. If there’s no personal representative for the estate, it is the legal responsibility of the beneficiaries to file the return and pay the inheritance tax.

Helpful Resources:

For more information, see IRS Publication 559.

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Robert.L.Shepard offers estate planning legal services designed to avoid probate, reduce estate taxes, protect assets and creating irrevocable trusts.
To learn more about him, visit his website.

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