Probate and Estate Planning Income Tax

By Elliott Stapleton Esq. 

Final Tax Returns Timeline, Forms and Filing Procedure

A final tax return is required for a deceased individual if the decedent met the income requirements for filing a tax return in the year of death. A surviving spouse, executor, administrator or legal representative must file on behalf of the decedent as a personal representative. The personal representative files a return for the decedent’s year of death and any prior years in which the decedent did not complete a return. The final return covers the period from the beginning of the decedent’s tax year to the date of death. All returns are due in the year after death by the decedent’s normal filing date.

The personal representative uses the Form 1040 series to file the decedent’s final return. The word “Deceased,” the decedent’s name, and the date of death should appear on the top of the form. The personal representative must pay any tax liability from the decedent’s assets.

Payments should include the representative’s name, address, and phone number, the decedent’s social security number, the tax year, and form number. Refund claims must be filed within three years. The document appointing the personal representative is required to receive a refund.[1]

Requesting Deadline Extensions

An automatic five-month extension to file Form 1041 is available with the filing of Form 7004. This extension must be filed no later than the regular due date for Form 1041. Any estimated tax liability still must be fully paid by the original due date. No signature or reason is necessary.

Failure to file an extension or pay taxes when due will result in penalties absent a showing of reasonable cause. Interest is charged on unpaid taxes even with an extension or showing of reasonable cause.

Income Tax Considerations in Ohio Probate

Selecting a Tax Year: Calendar or Fiscal?

The personal representative may select either a calendar or fiscal year to report estate income. An estate’s tax year must end on the last day of a selected month and cannot exceed twelve months. Once selected, changes in an estate’s tax year require IRS approval. A fiscal year is often beneficial for an estate as it allows greater income deferral especially if the decedent dies late in the calendar year.

It also allows more flexibility in matching income, expenses, and distributions of the estate and may be beneficial with fluctuating tax rates.[2] However, a calendar year may be more practical especially for poorly organized estates.

Decedent’s Final Income Tax Return

A decedent’s final income tax return is generally completed in the same manner as if the decedent was living. Whether certain income is reported on the decedent’s final return or the estate’s return depends on whether the taxpayer uses the accrual or cash reporting methods.

For accrual method taxpayers, income earned or accrued while living but received after death should be included in the individual’s final return rather than the estate’s return. For cash method taxpayers, only income received before death is included in the final return. Accrual method taxpayers will include deductions incurred before death in the final return, while cash method taxpayers will include only deductions actually paid before death.[3]

Estate Income Tax Return

Subchapter J of the Internal Revenue Code governs the income tax liability of estates, trusts and beneficiaries. The personal representative must file an estate income tax return if estate income exceeds $600 or a beneficiary of the estate is a nonresident alien.

The representative must immediately obtain a Taxpayer Identification Number (TIN) for the estate. The TIN is requested online or with Form SS4. All taxes on income retained in the estate and not distributed are payable by the estate.

The personal representative is liable for any tax deficiencies if he or she had notice of the deficiency or failed to exercise due diligence in discovering such deficiency.[4] To qualify as notice, the representative must have knowledge or should have knowledge of the liability before distribution of the assets and discharge of his or her duties.[5] Whether the liability was formally assessed is irrelevant. The representative is personally liable to the extent he or she actually paid debts or made distributions before paying the estate’s tax liability.[6] A beneficiary may become liable for unpaid estate income taxes to the extent such income is later distributed.

Estate income taxes are reported on Form 1041. A copy of the will is only necessary if requested. If the IRS does request the will, the representative should include a signed statement attesting its authenticity and highlighting the relevant provisions for tax purposes. If the estate receives income from property for which it is not the owner of record and does not file a 1041, then the personal representative may have to file Form 1099.[7]

Form 1041 is due on April 15th for calendar year estates or on the 15th day of the 4th month after the end of an estate’s fiscal tax year. Like the decedent’s final return, a five-month extension is available for filing only. Estimated payments are required for estates with an expected tax liability of at least $1,000 and tax years ending two or more years after the decedent’s death.

Estimated payments are not necessary if withholding and credits are expected to equal 90% of the current year tax liability or 100% of the prior year tax if the prior year covered a full 12 months. Estimated taxes are due in four equal installments on the 15th day of the 4th, 6th and 9th months of the tax year and the 1st month of the following tax year.[8]

Tax on Income Earned by Estate after Decedent’s Death

Income

An estate is taxed on income received after the decedent’s death during the administration of the estate. If the right to income is passed directly to a beneficiary, then only the beneficiary is taxed on the income. The taxable income of an estate is determined in largely the same manner as that of an individual. An estate’s gross income includes all income received or accrued during the tax year.[9]

An estate recognizes gain or loss on the sale or disposition of estate property if title is vested in the estate rather than the beneficiary at the time of disposition. This determination is based on local law and not simply on whether the personal representative had legal authority to dispose of the property.

Whether income from the sale of an asset is capital or ordinary is determined based on the character of the asset in the hands of the estate. Depending on its use by the estate, capital assets of the decedent generally remain capital assets for the estate. Property used in the decedent’s business will retain its character if the estate continues to operate the business. Gain from the sale of depreciable property to a beneficiary is ordinary income to the estate unless sold to satisfy a specific cash bequest.

All property acquired by the estate from a decedent has a holding period of more than one year. The basis of property received from the decedent is its fair market value at the date of death. Property purchased by the estate after decedent’s death has a cost basis. The estate will take the decedent’s adjusted basis for property that was gifted to the decedent within one year of death, has a fair market value greater than the original donor’s adjusted basis, and the proceeds of the sale of the property were distributed to the donor.

The decedent’s personal residence is a capital asset with capital gain or loss treatment if held for a business or investment purpose. Otherwise, capital gain treatment is allowed but no loss is deductible. Allowing a beneficiary to live in the house rent-free is a common non-business purpose.[10]

An estate recognizes gain or loss on a distribution in kind to a beneficiary only if the distribution satisfies the beneficiary’s right to receive a specific dollar amount or property and the estate elects to recognize the gain or loss on its income tax return. This election will apply to all noncash distributions except for charitable distributions and specific bequests.

Loss recognition is only permitted if the distributed property satisfies a specific cash bequest. The gain or loss generally will equal the difference between the FMV of the property and the estate’s basis.

Income in Respect of a Decedent is any income the decedent would have received absent his or her death and not properly included on the decedent’s final return.[11] For accrual method taxpayers, accrued income received after death should be included in the individual’s final return rather than the estate’s return.

Prior to death, any individual taxpayer can elect to use the accrual method of accounting for reporting income and expenses on the taxpayer’s return as long as this method clearly reflects the taxpayer’s income and expenses.[12] A change in accounting method after a taxpayer files an initial return requires IRS approval.[13]

For cash method taxpayers, any income received after death by the estate is taxable to the estate. Income in respect of a decedent retains the same character it would have had if the decedent was alive.

Deductions and Credits

An estate is granted a $600 exemption deduction. This exemption applies for tax years of less than twelve months, but if the estate changed its accounting period, it may only take an exemption of $50 per month.

A deduction for charitable contributions is allowed without limit only if the gift is specifically provided for in an instrument governing the disposition of the decedent’s assets such as a will or trust.[14] The estate may also claim casualty and theft losses if incurred during the administration of the estate and not claimed on the federal estate tax return. For purposes of the 10% limit on casualty loss deductions, an estate’s adjusted gross income is reduced by administrative expenses.

An estate may claim a net operating loss deduction. This is calculated in the same manner as for individuals, except an estate cannot use the income distribution deduction or charitable deduction in calculating its loss or loss carryover.[15]

An estate may also deduct losses from the sale of property. No loss is allowed for sales to beneficiaries as the estate and beneficiaries are treated as related persons. This loss disallowance does not apply to sales made to satisfy a cash bequest.

No deduction is permitted for dependents of the decedent or any carryover losses incurred by the decedent before death. An estate may claim a deduction for income in respect of a decedent included in both the estate’s gross income and a federal estate tax return.[16]

This deduction is only available in the same year in which the income is received by the estate. Income in respect of a decedent received by the estate is reduced by any distributions to beneficiaries. The beneficiary rather than the estate is then entitled to any estate tax deduction. The estate is also allowed all other ordinary deductions not properly included on the individuals final return.

Expenses of administering an estate are deductable either for federal estate tax purposes or income tax purposes. If such a deduction is taken in calculating the estate’s income, the representative must file a statement waiving it for federal estate tax purposes.[17] Taxes, interest, business expenses and other items accrued at death may be deducted for both estate tax purposes and income tax purposes as deductions in respect of a decedent.[18]

Such items not accrued at the date of death qualify as administrative expenses and only a single deduction is permitted. Administrative expenses allocable to an estate’s tax-exempt income are only deductible on the federal estate tax return. If estate taxes are paid in installments, the estate may not deduct associated interest.

A deduction is available to the estate for any income distributed to beneficiaries.[19] The income distribution deduction includes any income that must be currently distributed even if it is not actually distributed in the current year. For amounts not required to be paid under the terms of the will or local law, only amounts actually distributed may be deducted.

A representative may elect to treat distributions paid or credited within 65 days of the end of the estate’s tax year as having been paid or credited on the final day of that tax year. If title to real estate passes directly to beneficiaries, then its value is excluded from any amount distributed. Property distributed in kind is deducted based on the lesser of the estate’s basis or fair market value.

The income distribution deduction is limited to the estate’s distributable net income.[20] Distributable net income equals the estate’s taxable income, excluding the income distribution deduction, with several modifications. Tax-exempt interest is included but is reduced by related expenses used to make charitable contributions. All other items of tax-exempt income not included in the estate’s gross income are excluded. The $600 exemption deduction is also not included.[21]

Capital gains may be included in distributable net income only under any one of the following conditions:

  • If capital gain is allocated to income of the estate by the will or local law;
  • The gain is allocated to the principal of the estate and actually distributed to beneficiaries during the tax year;
  • The gain is used to determine the amount actually distributed or must be distributed; or
  • Capital gains are used to make charitable contributions.[22]

Capital losses are excluded unless used to calculate capital gain that is distributed or must be distributed. If the estate has multiple beneficiaries, then the separate share of each beneficiary is treated as a separate estate solely for determining distributable net income allocated to each share.[23] Distributable net income is allocated based on each share’s portion of gross income and deductions.

A representative must use a reasonable and equitable method in making allocations. Gross income is allocated based on the income each share is entitled to under the will or local law, including non-cash items.

Income in respect of a decedent is allocated based on the amount of a beneficiary’s share that could potentially be funded with this income. A separate share exists if the economic interests of one beneficiary are unaffected by the economic interests of another beneficiary. A bequest of a specific sum of money or property is not a separate share. [24]

A distribution is not deductible by the estate and is excluded from a beneficiary’s net income if the distribution is required by the terms of the will, a gift or bequest of a specific sum of money or property, and is paid in three or fewer installments under the terms of the will.[25]

The amount of money or identity of the property must be determinable under the decedent’s will on the date of death. An annuity, residuary estate, or amounts that can only be paid from income of the estate do not qualify as bequests. Conditional bequests are permitted for this exclusion.

Estates may take some tax credits on its income tax return. Permitted credits include the foreign tax credit and general business credit, but not credits for the elderly or disabled, the child tax credit, or the earned income credit. Any credits taken may be allocated between the estate and beneficiaries.

Ohio Estate Beneficiary Income Tax Considerations

A beneficiary must include income distributions from an estate in his or her gross income. Beneficiaries report their share of distributable net income required to be distributed currently under the decedent’s will or local law regardless of whether it is actually received. All other income is reported when distributed.[26]

A beneficiary only reports distributions to the extent his or her share of the estate’s distributable net income exceed mandatory current distributions. A distribution retains the same character for the beneficiary as it had for the estate.

An estate may transfer any unused deductions or loss carryovers in its final tax year to beneficiaries. Deductions and loss carryovers are allocated among beneficiaries according to each beneficiary’s share in the burden of the loss or deduction. For transfers to beneficiaries, deductions must exceed gross income in the final tax year of the estate and are only available to a beneficiary in the estate’s final tax year.[27]

Transferred deductions for individual beneficiaries are subject to the 2% limit on miscellaneous itemized deductions. The $600 exemption deduction and charitable contribution deduction are non-transferable. The representative may also elect to transfer to the beneficiaries credits for the estate’s estimated tax payments.

The personal representative must provide each beneficiary with a Schedule K-1 and file a copy with the IRS by the filing date. The representative may have to file Form 1040NR and pay any tax liability for any nonresident alien beneficiary if that beneficiary lacks an agent in the United States. For income actually distributed to foreign beneficiaries, the personal representative must file both Forms 1042 and 1042-S to report and transmit withheld tax on distributable net income.

Proper Use of Disclaimers and Valuation Discounts

Disclaimers

A disclaimer is a refusal by a beneficiary or donee to accept a gratuitous transfer. A disclaimer treats a gift or bequest as if it was never transferred to the disclaimant and is governed by I.R.C. § 2518. A disclaimer causes the disclaimed property to be retroactively transferred to an alternative beneficiary as of the date of the original transfer.[28]

A beneficiary may wish to disclaim in order to benefit a family member not provided for by the decedent.  Disclaimers can also eliminate a trust or minimize taxes when deaths occur in quick succession due to a common accident. Children may disclaim, leaving the remainder to a surviving spouse and increasing the marital deduction for the estate. However, depending on state law, disclaimers by minor children or grandchildren may be prohibited if a guardian fails to first obtain court approval. [29]

A disclaimant must make a qualified disclaimer to avoid a transfer. A qualified disclaimer is an “irrevocable and unqualified refusal” to accept a property interest.[30]

This means that the disclaimant cannot alter or terminate the disclaimer, and it cannot be contingent on another event. A qualified disclaimer must be written, signed, and delivered to the transferor within nine months of the transfer date or the disclaimant’s 21st birthday.

The nine-month time limit begins on the date of the transfer creating the interest. No provision addresses the effect of a disclaimant’s lack of knowledge of the gift. A minor may still accept a gift and disclaim within nine months of his or her 21st birthday. No extension is allowed for filing a disclaimer.

After a disclaimer, the disclaimant is barred from accepting any interest or benefit from the property and cannot direct how the interest passes. Acceptance of benefits must be manifested by an affirmative act consistent with ownership such as using property or accepting income.

It does not include merely taking delivery of an instrument of title or paying real estate taxes. The immediate vesting of real property upon death does not constitute acceptance. Language expressing the disclaimant’s wishes for the property with no legal effect is permitted but must be carefully drafted.

Any express or implied agreement with the final recipient regarding the disposition of the property or consideration for the disclaimant is prohibited. If the recipient makes a later gift to the disclaimant or a related party, the IRS will apply the substance over form doctrine.

A decedent’s surviving spouse may continue to benefit from disclaimed property under the spousal exception rule even when the spouse makes the disclaimer.[31] A common estate planning tool involves a disclaimer by a surviving spouse into a trust in which the spouse is a beneficiary.

This is permitted as long as the spouse does not direct the beneficial enjoyment of the property. In a transfer not subject to federal estate and gift taxes, the spouse may serve as trustee and will not be deemed to violate this provision as long as the spouse’s power as trustee is limited by an ascertainable standard.[32]

A joint tenant can generally disclaim a survivorship interest but cannot disclaim any portion of the consideration for a joint bank or investment account furnished by the survivor.

Partial disclaimers are allowed if the interests are severable. Under Treasury regulations, property must be divisible into separate parts, after which each part has a complete and independent existence. For this provision, income and remainder interests in a trust, funds in a bank account, and individual stock shares are all separate, but a trust beneficiary cannot disclaim income from specific assets.

Disclaimers must also comply with varying state standards. These standards generally do not differ significantly from the standards for a qualified disclaimer under the Code.

Some states, such as Ohio, require filings with the county probate court or county recorder’s office under certain circumstances. For gifts to minors, states may mandate that a disclaimer be completed by the donee’s 18th birthday rather than 21st. States are split on whether a disclaimer can circumvent creditors. Ohio has held a disclaimer constitutes an act to defraud creditors.[33]

Since that case, ORC 5815.36 as part of the Ohio Trust Code, provides for the disclaimer of succession to property. The amendment legislatively overturns the decision in Stein v. Brown, which found that disclaimers can be deemed fraudulent against the disclaimant’s creditors if made with actual intent to defraud. The amendment in subsection (N) of R.C. 5815.36 means that disclaimers are no longer subject to the Ohio Uniform Fraudulent Transfer Act.

Disclaimed assets are included in the assets of an individual or spouse seeking to qualify for Medicaid to determine income and resources. A refusal to take an elective share is not a transfer for these purposes.

Valuation Discounts

Interests in closely held businesses are valued as part of a decedent’s gross estate. Transferring assets to a limited partnership or limited liability company, where ownership is limited to a single family, can provide a lower valuation for estate or gift tax purposes than direct ownership of the same assets.[34] Partial interests in a family entity are discounted from the full liquidation value of the entity.

Several factors require discounted valuation. A partial interest in a family entity lacks marketability because the interest is not registered or readily tradable. It also lacks transferability because even if a market existed, owners often cannot transfer their interest because new members must be approved by the other current owners. Lack of control also requires discounted valuation.

An individual owner holds a minority interest and cannot compel liquidation of the business. Even a majority equity owner may seek a control discount if control is granted to a general partner in a LP or a manager named in a LLC operating agreement. Because of these restrictions the value of a fractional ownership interest in a family entity is less than the value of the entity’s net assets.[35]

Discounting allows for the accelerated transfer of interests and better utilization of the annual and lifetime gift exclusions. By transferring fractional interests in a family entity, it becomes easier to take advantage of gift tax exclusions without dividing property.

The entity’s ownership by only related parties does not impede the use of this planning strategy. Assets held in a trust may also receive a valuation discount depending on the beneficiaries’ degree of control.

Valuation of an interest without an established market involves a high degree of uncertainty. Three different valuation methods have become generally accepted. The Market Method compares the closely held company to similar companies with known values.

The Discounted Cash Flow Method discounts future income to its present value. Net Asset Value simply takes the value of the company’s assets less liabilities. This method is more common for investment companies. Empirical evidence supports a wide range of discount rates.

Marketability studies comparing prices of unregistered or pre-IPO shares to later publicly traded shares of the same company suggest discounts ranging anywhere from 13%-59%. However, factors other than lack of marketability could distort these figures.[36]

A higher discount is afforded less liquid assets. Real estate interests are commonly held in family entities, and discounts range from 30-35%. Investment companies holding cash or marketable securities receive lower discounts than entities holding nonmarketable equities or private equity investments.

Other factors affecting the discount rate include the size of the ownership block, likelihood of distributions, ease of borrowing for owners, and the amount of built-in capital gain.

The IRS generally allows a 25-30% total discount for investment holding companies and a 25-35% total discount for business or real estate holding companies.[37] In valuation contests, courts rely on the expert opinion of a qualified appraiser and the specific circumstances of each case.

The court will consider the experience and qualifications of the appraiser as well as the uncertainty or inconsistency to his or her approach. In conducting a professional appraisal of business interests, the qualified appraiser ideally should be certified by an appraisal organization and free of conflicts. The appraiser should draft a formal appraisal report with clear, enumerated standards.[38]

While courts are usually willing to respect family-owned entities, they often dispute the taxpayer’s valuation discount absent a compelling justification from the taxpayer. In a recent case, the 8th Circuit reduced a valuation discount, holding that stringent transfer restrictions in the limited partnership’s agreement would have little practical effect in restricting transfer of the entity’s highly liquid assets.

The tax court’s reduction of the appraiser’s marketability and control discounts was upheld because of the appraiser’s vague, non-quantitative justifications for departing from the discount’s found in available studies.

Other cases have stressed the importance of relating valuation studies to the taxpayer’s specific circumstances and using more current studies.[39] However, experts argue that older studies more accurately reflect the marketability discounts required for family entities because they account for longer holding periods.[40]

There is also a growing trend of tax courts disregarding family entities if the form is not respected by the owners. The IRS is more likely to challenge such arrangements with an estate audit than with gift audits. This uptick in disputes is likely due to more aggressive revenue collection.

The IRS ultimately wants to eliminate discounts for family entities. The Treasury Department has proposed legislation to this effect on several instances, but Congress has not supported these efforts.[41]

If you have questions on this legal topic, feel free to contact Elliott Stapleton, a Cincinnati Estate Planning and Probate Attorney.

References:

[1] Internal Revenue Service, U.S. Dep’t. of Treasury, Pub. 559: Survivors, Executors, and Administrators, 3-4, 8 (2014).

[2] Karyn Scott, Fiscal Year Elections for an Estate Make Fiscal Sense, Nichols Proactive Tax and Growth Planning (June 20, 2013), http://www.nicholsaccounting.com/fiscal-years-make-fiscal-sense/.

[3] Treas. Reg. § 1.451-1(b); Pub. 559, 4-6.

[4] Treas. Reg. § 1.641(b)-2.

[5] Pub. 559, 3.

[6] 31 U.S.C. § 3713(b).

[7] Pub. 559, 15-16.

[8] Id. at 20.

[9] Treas. Reg. § 1.641(b)-1.

[10] Pub. 559, 16.

[11] Internal Revenue Code § 691(a).

[12] I.R.C. § 446; Treas. Reg. § 1.446.

[13] Treas. Reg. § 1.446-1(e); Internal Revenue Service, U.S. Dep’t. of Treasury, Pub. 538 Accounting Periods and Methods, 21.

[14] I.R.C. § 642(c).

[15] Treas. Reg. § 1.642(d)-1.

[16] I.R.C. § 691(c).

[17] I.R.C. § 642 (g).

[18] I.R.C. § 691(b)

[19] I.R.C. § 661.

[20] I.RC. § 661(a)(2)

[21] I.R.C. § 643(a).

[22] Treas. Reg. § 1.643(a)-3(b).

[23] I.R.C. § 663(c).

[24] Treas. Reg. § 1.663(c)-1, 2, 4.

[25] I.R.C. § 663(a)(1).

[26] I.R.C. § 662.

[27] I.R.C. § 642(h).

[28] Rev. Rul. 83-27.

[29] A. Stephen McDaniel, Using Disclaimers in an Uncertain Estate Planning Environment, National Association of Estate Planners and Councils Annual Conference (Nov. 2006); I.R.S. Tech. Adv. Mem. 87-01-001 (Aug. 29, 1986); James J. Costello Jr., A Guide to Disclaimers, New Jersey Law Journal Estate Planning Supplement, (May 1999).

[30] I.R.C. § 2518(b).

[31] I.R.C. § 2518(b)(4)(A).

[32] Treas. Reg. §25.2518-2(e)(2); McDaniel, supra note 27 at 20.

[33] Stein v. Brown, 18 Ohio St. 3d 305 (1985).

[34] Richard L. Zinn, Advantages of Utilizing Valuation Discounts, Barber Emerson, L.C. (March 2012), http://www.barberemerson.com/publications.html.

[35] Larry D. Marsh, Esq., Using Entities in Estate Planning for Valuation Discounting, National Juris University, last visited Feb. 3, 2015,.

[36] Justin P. Ransome & Vinu Satchit, Valuation Discounts for Estate and Gift Taxes, Journal of Accountancy (Jul. 1, 2009).

[37] Scott Nammacher & Jonathan Blattmachr, The Name of the Game in Estate Planning is Valuation, Empire Valuation Consultants, Interactive Legal Services Webinar, 18 (Jun. 15, 2011), http://www.empireval.com/downloads/library/valuationinestateplanning.pdf.

[38] Id. at 10-12.

[39] Temple v. United States, 123 F.Supp.2d 605 (2006); Litchfield v. IRS, T.C. Memo. 2009-21 (2009).

[40] John H. Hardwick, Jr., Esq., Recent Valuation Case Summaries, Management Planning, Inc.

[41] Marsh, supra note 27.

By Elliott Stapleton

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