By Stephen A. Kurzman, CPA | Kurzman, Dempsey & Kowalker, LLP
Now that we have a schedule of the entities for which returns might be required, as well as a preliminary idea of what assets and income are in each of the entities, we can begin the second step. As it may be obvious, there is an interrelationship between these returns. Time will be needed to be sure of the correct amount of income for each entity particularly between the decedent’s final income tax return and the first income tax return of the estate. Therefore, I strongly recommend that the estate tax return and the decedent’s final income tax return along with any existing trust returns to all be extended for their tax year which includes the date of death.
Let’s start with the preparation of the estate tax return (Form 706). From my perspective, the most glaring and frequent error which I see in estate tax returns is that the decedent appears to have died with neither a liability for income taxes nor a refund receivable. I am amazed at all of the people who at their date of death have paid in the exact amount of federal and state income taxes which they will owe for the year of death (and in many cases, especially if the death occurs early in the calendar year, for the prior year as well). In the case of joint returns, Treasury Regulation 20.2053-6(f) details the steps that will allow you to determine the income tax of each spouse. Once the tax of each spouse has been determined, the next step is to determine the amount of withholdings and estimates which that spouse paid for the year.
After determining the amount of withholdings and estimates that spouse has paid for the year, the next step is to simply subtract what was paid against what was owed, and you will know if the deceased owed taxes or was entitled to a refund. In addition, on joint returns the personal representative of the deceased and the surviving spouse can agree to the allocation of the tax payments which have been made by each. By agreeing to an allocation, which creates a liability of the decedent to the surviving spouse, the estate tax will be reduced. A payment by the estate to the surviving spouse will be the satisfaction of a liability and therefore not taxable to the surviving spouse.
Next, address the decedent’s final 1040. As mentioned in Part 4, the first task should be determining the amount of income to report which may require verifying the correctness of third-party documents. For example, it is obvious that the 1099 for interest, which was received by the decedent from a bank, included the entire interest for the calendar year. However, only a portion of the 1099 interest is properly reported on the decedent’s final 1040.
If you report the correct amount, how do you avoid IRS correspondence that the income is under reported? The answer is to report the entire amount shown on the 1099, and then on the next line a negative amount identified as being “Post death interest reported by name and tax identification number of the taxpayer who correctly reported the income.” Usually that taxpayer is the estate of the decedent.
Typically, the most confusion arises when the decedent was a beneficiary or trustee of a trust. Therefore, it is important to determine what trusts there might be and to obtain copies of the documents. In most cases, obtaining/reviewing the third party information (1099s, K-1s, etc.), which was used in the preparation of the decedent’s income tax returns for two or three years proceeding death, is the easiest approach.
Are there K-1s from trusts, do 1099s show the name of a trust or are there real estate bills which list the owner of the property as a trust? In addition, reading the decedent’s could indicate that there either are trusts in existence or will be trusts which are to be funded after death. If there is a surviving spouse, they might be able to provide information and/or direct you to the decedent’s attorney who may have copies of trusts that exist. Regardless of how diligent you might be, there is probably no fool proof method to be sure that all trusts are discovered, and on occasion you might learn of the existence of a trust just when you thought that you were all done.
Since no trust is ”alive” for income tax purposes until such time as it is funded (property is owned by the trust), do not panic if you discover many trusts for which you never prepared a tax return. There is a high potential that no tax return was required, either because the trust was not funded or because the trust was a grantor (revocable) trust, the decedent was both trustee and beneficiary (commonly called living trusts) and/or the income was reported by the decedent on his/her income tax return. In those cases, it is important to determine what happens upon death. If a revocable trust exists, the successor trustee to the decedent and personal representative of the decedent do have the option to elect (Sec 645) to file one income tax return for the estate which will include the income of both the trust and the estate. This allows both the option of a fiscal year as well as the federal exemption from making estimated tax payments for the first two tax years applicable to the revocable trust. The election does cause the separate share rule to apply. Therefore, the estate and trust will each have to separately account for their income and expense, and it is the total of the two separate taxable incomes which will be reported on the single Form 1041.
For trusts which are created under the decedent’s will, no return is required until such trusts are funded. Therefore, it is important to coordinate with the personal representative so that the funding is done with consideration given the optimum time from an income tax perspective.
One final bit of guidance which is frequently overlooked is that there is a legal doctrine known as the fruit and the tree doctrine. This has nothing to do with either trees or fruit, but it does have everything to do with where income is reported. If a decedent’s will has a specific bequest of income producing property, such as: “I leave my common stock in XYZ Corporation to my daughter Jessica.” Then all income (fruit) which comes from that stock (tree) after decedent’s death belongs to Jessica and should be reported by her or her income tax return in the year in which it was received (by the estate) even if it is not distributed to her in that year.
Similarly, if the decedent and their spouse each have a living trust which provides that upon the death of the first spouse, all income is to be paid to the surviving spouse, then all the post death income should be reported by the surviving spouse even if not distributed to the surviving spouse.
Although I read many trusts/wills and usually understand the tax consequences of the provisions, there have been moments where I have questioned if I was properly interpreting a provision or a provision referred to a person and I had no knowledge of the relationship of that person to the deceased. I never hesitate to contact the attorney who drafted the document to learn what I need to know. If the drafts person is not available or unknown, I contact an attorney whom I have worked in the past and discuss it with them. I urge you to not be shy or embarrassed – I would rather learn the answer and be embarrassed than learn the answer during an IRS examination or litigation. Additionally, I recommend that you send an email to the person thanking them for their assistance and stating what you understood them to have told you. If you misunderstood, hopefully they will correct you and if they were wrong then you have documented that the error was theirs, not yours.
I find a great deal of satisfaction in working in this area and it is an excellent boutique type area for a practioner who is willing to make the investment of time to learn. I hope that the above will help you feel more comfortable when you are working in this area, and over the years I have certainly been contacted by other practioners with questions. No one can know everything, and I respect the practioner who when faced with something that they are not sure of, reaches out to someone who they believe can assist them. If you think that I could help, please do not hesitate to contact me.
I would be amiss if I did not mention and thank Aimee Kowalker and Kate Seekell for their substantial, outstanding assistance making sure that this series of articles were both accurate and understandable, any errors are mine, not theirs’.
I am grateful for the opportunity to have written them.