By Stephen A. Kurzman, CPA | Kurzman, Dempsey & Kowalker, LLP
It was my original intent to conclude this series of articles with the third installment which appeared in the March 2019 issue of SumNews. However, I was speaking with a CPA who told me that his greatest problem was trying to figure out what went where when preparing the income tax returns of the decedent, the estate and any trust income tax returns which might exist, leading to the fourth and fifth installments being born.
The first step is to determine which returns are required.
Estate Tax Return
Will a federal estate tax return (Form 706) need to be filed? Will a state estate tax return for the decedent’s home state need to be filed? If there are assets which are not located in the decedent’s home state but are in another state or country, will they require an estate tax or estate tax type return to be filed?
Income Tax Return
Will an income tax return for the year of death need to be filed? The date of death is the last day of the decedent’s tax year (the day after death is the first day of the estate’s tax year). For a decedent who passes on January 1st, they will have only one day’s worth of income to report on their final individual income tax return. If the decedent had a surviving spouse, will a joint return be filed? If so, then the decedent’s one day of income will be reported on that joint return along with the surviving spouse’s income for the entire year (or through the surviving spouse’s date of death). In the preparation of the deceased individual’s income tax return, the inclusion (or non-inclusion) of items of income or deduction will be determined in the same manner as they are determined on December 31st for a taxpayer who lived through the end of the year. The preparation of the final federal and state income tax returns should generally be no more difficult than preparing any income tax return. That said, there is one situation which arises only in the case of a decedent.
It is highly unlikely that third party payors of income items are notified of the death immediately and therefore the preparer will need to determine if wages, interest, dividends, income from pass-through entities, etc. are correctly reported for the deceased’s tax year. Often times the amount of income reported will include post death income. If the decedent was working, it is likely that the final W-2 is correct. However, I consider it worth the time to verify if it is and if not, then to request the employer to issue a corrected W-2.
Payments of wages and other compensation after death and in the year of death are not subject to income tax withholding but are subject to both Social Security and Medicaid as well as FUTA and the net amount should be paid to the estate or possibly the surviving spouse. The deceased’s W-2 should include the amounts of withheld Social Security and Medicaid and the amount of Social Security and Medicaid wages, but box 1 wages should only be what was paid to the deceased. For the amounts paid to the estate or surviving spouse the gross wages are reported on a 1099 MISC issued to the payee. However, payments that are paid in the year after death are exempt from income tax withholding as well as Social Security, Medicaid and FUTA and are reported on a 1099 MISC issued to the payee (see Instructions for Forms W-2 and W-3).
I have frequently been asked “Is it really wrong to report it on the decedent’s return, it was only …dollars?.” What they mean is: I know it is wrong, but it is easier. My suggestion is to consider the following: materiality and will the income go to the correct person. Also, consider how you would respond if you were on the stand or being deposed and were asked the simple question: “In other words, you knowingly prepared the return incorrectly?”
Fiduciary Income Tax Return(s)
The estate may well need to file a fiduciary income tax return (Form 1041). Nothing is more confusing than the fact that there is more than one type of estate. The type which is most familiar to CPAs is the 706 A/K/A the taxable estate. This particular estate is defined by the Internal Revenue Code. It includes property which was owned by the deceased at death but also includes property which might not be owned by them at death. These “non-owned” assets are included because while the deceased does not own them, the deceased has or had an interest in them during life.They may include property which was transferred to someone else for less than full consideration, directly as in a gift or indirectly via a trust. It will include assets over which the decedent has retained a degree of control, although, not ownership.
Fortunately, the estate tax return (Form 706) is both well organized and is accompanied by instructions which are extremely well done, even if not always obvious to a non-attorney. However, the income of the estate is the income from those assets which are includable in the probate estate, i.e., those are the assets which do not pass at death via law or contract. The decedent may have owned and been the insured of a life insurance contract, but upon the decedent’s death the proceeds go to the beneficiaries in accordance with the contract and any income which relates to the proceeds are not income to the estate unless the estate was a beneficiary. Property owned by the deceased and spouse with the right of survivorship pass to the survivor by operation of law and post death income is reported by the survivor even before the title might be changed.
Are there any trusts which were created by the decedent during life which are either funded or not funded? A trust only becomes a “taxpayer” when it is funded. If you have already been preparing returns for a trust, you should be sure to review the instrument to determine if the death of the settlor will cause the trust to terminate. Read the decedent’s will to learn if existing unfunded trusts will be funded from the estate and if new trusts are created under the will. I frequently find that a flow chart can be helpful both for me to understand what existed the moment before death and what will now be. If the assets are to be distributed, to whom are they distributed? You will also need to understand where the post death/post termination income is to be taxed.
At that point you should be able to make a schedule of potential returns which might be needed. In our firm, we will complete new client forms and enter the entities into our system. I think that one of the most embarrassing situations is to realize a few years after a death that there was another entity for which a tax return should have been prepared, but we forgot about it. It is better to send engagement letters for returns which are not needed than to explain to your client that you will cover any penalties or interest for late filed returns. You should then look at the last filed income tax return and create a list of the source of income and expense, using the schedule of “potential” returns add to it the assets which will be owned by each potential taxpayer.
One simple example are assets in the name of the deceased and the deceased’s spouse which probably pass to the surviving spouse. Do you have a 1099 or K-1, etc. with the name of the account holder as husband and wife with the right of survivorship? If so, by operation of law, the property passes to the surviving spouse upon death. The pre-death income will most likely be reported on a joint return for the year of death and attributed 50/50 to each spouse with the post death income also being reported on the joint return but being attributable to the surviving spouse. This is information which you will need in order to determine the amount of the decedent’s tax for the year of death. Therefore, whatever tax was attributable to the post death income is not a tax liability of the decedent at death.
If you use software to control return due dates, guarantee that you have both the date for filing the estate tax return (Form 706) as well as the due date of the income tax return (Form 1041) in the system.
Having now established a basic understanding of the work ahead and a schedule of the tax returns which you might need to prepare listing the assets and income, it is time for a deep breath and to wait for the fifth and concluding article which will discuss the second step.