Post-death tax planning for the unprepared, Part 3: Who reports post-death income, and for how long?
The personal representative must make determinations and take action on assets before terminating the estate
Editor’s note: When a loved one dies unexpectedly, survivors face a potentially daunting task of settling the estate without a will. For the personal representative, completing the process requires several important tax-related duties. Part 1 of this series discussed how to identify the personal representative and the estate’s assets. Part 2 of this series discussed the personal representative’s ongoing responsibilities. In Part 3, we’ll discuss income reporting and tax implications for the estate and its beneficiaries.
Additional editor’s note: This article has been reviewed for changes following the passage of the 2017 Tax Cuts and Jobs Act. The information provided in this article was not affected by the 2017 TCJA
As this series has highlighted, the personal representative of an estate has a lot on his or her plate. In addition to identifying the deceased person’s assets, the personal representative must figure out:
- Which assets pass to the estate to get reported on the estate’s income tax return
- What income to report each year
- When the estate’s administration can end with the transfer of remaining assets to beneficiaries
In this article, we’ll discuss each one of these responsibilities. But first, here’s a review from Part 2 of this series about categorizing assets.
The personal representative must categorize assets
To correctly prepare potential tax returns, the personal representative must identify the decedent’s assets and figure out what, if any, arrangements the decedent made for the transfer of those assets following death. These assets usually fall into two categories: probate assets and non-probate assets.
Form 1041 reports probate assets
Form 1041 is the estate income tax return, which reports income earned on probate assets after death. If a state-level court is administering the decedent’s assets, the court will handle these items, which will pass to beneficiaries according to the terms of the decedent’s will (if any).
Probate assets include basically anything that the deceased person owned at death that doesn’t qualify as a non-probate asset.
Non-probate assets pass to a specific named beneficiary or a surviving joint owner
Common examples of non-probate assets include:
- A joint bank account
- A home owned by the decedent and someone else as joint tenants with survivor rights
- Property held in a living trust
- Retirement accounts with at least one named beneficiary
The estate income tax return won’t include income from these items. Instead, the named beneficiary/surviving joint owner will report post-death income from non-probate assets.
The personal representative must determine what income to report
Estates determine income in largely the same way as individual taxpayers. Estate income can include items such as unpaid wages, post-death interest from a bank or savings account, and dividends from stock the deceased individual held at the time of death. An estate must file a return if it receives gross income of $600 or more during the year.
Property sales can also result in gross income, but a special rule applies that will usually cause a post-death sale to generate no gross income. One common situation where this rule applies is in the sale of a deceased person’s former home. The Internal Revenue Code allows a new tax basis for the home at death equal to its fair market value.
For example, assume the decedent bought his home in 1985 for $45,000, and that the home is worth $300,000 at the time of his death in 2017. The home passes to his estate, and the personal representative sells the home soon afterward for $300,000. This rule allows the personal representative to use the $300,000 fair market value basis, so there is no gain for the estate to recognize. Without this rule, the estate would figure gain using the original $45,000 cost basis, and the $300,000 sale would result in gross income of $255,000.
The personal representative must determine duration of the estate
The personal representative can file the last Form 1041 once the estate’s administration ends.
What constitutes the “end” of the administration period will vary for different estates. In general, an estate with more assets and beneficiaries will usually take longer to administer than a smaller one.
The personal representative also must determine and pay debts the deceased person owed during the estate administration period. In all cases, the IRS presumes that the administration won’t take longer than two years, and will end once all (or substantially all) of the remaining estate assets have been distributed to beneficiaries or used to pay debts.
Usually, distributing assets from the estate to beneficiaries involves either selling the asset and distributing the proceeds, or retitling probate assets to the name of the beneficiary.
In the year the estate terminates, the personal representative needs to check a box on the Form 1041 to mark the return as final. Checking this box informs the IRS that it should not expect any more returns to be filed by the estate. Note that the personal representative doesn’t need to file a final-year Form 1041 if the estate doesn’t meet the filing requirements.
The personal representative must handle tax responsibilities related to beneficiaries
Estates are pass-through entities, so if the personal representative distributes income to beneficiaries during the year the estate earns it, the beneficiary will report the income and owe any related taxes on it. In a non-final year, if the estate doesn’t distribute income, it will report the income and pay the tax. In the final year, all the income is automatically allocated to beneficiaries, so the estate will never owe income tax at the entity level in its final year.
Each estate beneficiary will also likely receive a Schedule K-1 (Form 1041) reporting his or her allocated share of estate income, expenses, etc. They will use the Schedule K-1 information when preparing their personal Form 1040 returns.
The personal representative sends a copy of each Schedule K-1 he or she prepares to the IRS (along with the Form 1041 return), as well as to each beneficiary. To prepare this form, the personal representative needs to obtain information from each beneficiary, such as a name, address, and a tax identification number (e.g., a Social Security Number). If the personal representative fails to prepare a completed Schedule K-1 where required, he or she may owe a penalty of $50 per beneficiary.
In some cases, a beneficiary may receive in-kind property from an estate instead of cash. When this occurs, the personal representative should provide basis information to the beneficiary for that item. With most in-kind transfers from an estate to a beneficiary, the property’s basis will remain the same in the hands of the beneficiary as it was when owned by the estate immediately before the transfer. Therefore, with inherited property held by an estate, the basis often equals the date-of-death fair market value because of the Internal Revenue Code section mentioned above.
Being personal representative is an important responsibility
As this series shows, there are many planning difficulties that can arise with any death. When there is no post-death plan, these problems can seem even more onerous.
Nonetheless, a thorough and thoughtful personal representative can untangle even the most convoluted estate by knowing what information to get, how to obtain it, and what responsibilities he or she must fulfill.