Being named the executor of someone's will is tricky tax business. Here's what you need to know.
When a loved one dies, somebody must step up to the plate to handle all the resulting tax issues. This person may be identified in the decedent's will as executor of the estate. If there isn't a will, however, the probate court will appoint someone to be the administrator. In either case, it's often the surviving spouse or another family member who takes on this responsibility.
Regardless of which route you take to get there, your duties as executor are essentially the same. The executor's job is to identify the estate's assets, pay off its debts and then distribute whatever is left to the rightful heirs and beneficiaries. He or she is also required to file any necessary tax returns and pay any taxes. Should this not be handled properly, the IRS can come after the executor personally for tax underpayments (plus penalties and interest) — even if he or she has hired a professional to deal with the paperwork. So if you find yourself in this role, you need to take the responsibility seriously.
Here's an overview of four major steps you need to consider:
1. Filing the Final 1040
Step No. 1 is to file the decedent's taxes for the year of his or her death. This final 1040 covers the period from Jan. 1 though through the date of death. The return is due on the standard date, meaning April 17, 2006, for someone who dies in 2005. If the decedent was unmarried, the final 1040 is prepared in the usual fashion. When there's a surviving spouse, the final 1040 can be a joint return filed as if the decedent were still alive as of year's end. The final joint return includes the decedent's income and deductions up to the time of death plus the surviving spouse's income and deductions for the entire year.
Be sure to keep a careful eye on medical expenses. If large uninsured medical expenses were accrued but not paid before death, you — as the executor — must make an important choice about how they're treated for tax purposes. Along with any medical expenses paid before death, you can choose to deduct the as-yet-unpaid expenses on the decedent's final 1040 to the extent they exceed 7.5% of adjusted gross income. (Final medical expenses can easily exceed 7.5% of AGI, especially when death occurs early in the year before much income has been earned.) This is an exception to the general rule that expenses must be paid in cash before they can be deducted.
Alternatively, if the estate is subject to the federal estate tax (which is only the case if it's worth more than $1.5 million, or $2 million for someone who dies in 2006) you can choose to deduct the accrued medical expenses on the decedent's federal estate-tax return (more on that below), rather than the decedent's income-tax return. Obviously, if no federal estate tax is owed, this isn't an option. But when estate tax is due, deducting accrued medical expenses on the estate-tax return is usually the tax-smart option. Why? Because the minimum estate-tax rate is a whopping 45% for a person who dies in 2004 or 2005, while the decedent's final federal income-tax rate could be as low as 10%. Plus the full amount of the accrued medical expenses can be deducted on the estate-tax return (not just the excess over 7.5% of AGI).
2. Filing the Estate's Income-Tax Return
In addition to filing the decedent's final income taxes, you may have to file the estate's income tax as well. (Understand: This is entirely different from the federal estate tax, addressed below.) Essentially, what happens here is that once the individual has died, any income generated by his or her holdings after death is now part of the estate. And that income doesn't escape the reach of Uncle Sam.
The estate's first income-tax year begins immediately after death. The year-end can be Dec. 31 or the end of any other month that results in an initial tax period of 12 months or less. You must file Form 1041 (U.S. Income Tax Return for Estates and Trusts) by the 15th day of the fourth month after the year-end. So for a person who dies in 2005, the deadline will be April 17, 2006, when the "standard" Dec. 31 year-end is chosen.
If you're dealing with an estate with annual gross income below $600, you don't need to worry about Form 1041. So tiny estates are off the hook, as are those that can be wrapped up very quickly, before $600 worth of income accumulates. There's also no need to file Form 1041 when all the decedent's income-producing assets bypass probate and go straight to the surviving spouse or other heirs by contract or operation of law. This is what happens, for example, with real estate owned jointly with right of survivorship, with retirement accounts and IRAs that have designated account beneficiaries and with life-insurance proceeds paid directly to designated policy beneficiaries.
If the estate you're in charge of is required to file Form 1041, I recommend hiring a tax professional with plenty of experience in this arcane area of the tax law.
3. Filing the Estate's Estate-Tax Return
The federal estate-tax return is filed on Form 706 (United States Estate Tax Return). Assuming the decedent didn't make any sizable gifts before dying, no estate tax is due, and no Form 706 is required, unless the estate is worth over $1.5 million, or $2 million for a person who dies in 2006. Sizable gifts are those in excess of $11,000 to a single gift recipient in a single year ($10,000 for gifts during 2001 and earlier). If sizable gifts were made, the excess over the $11,000 (or $10,000) threshold is added back to the estate to see if the $1.5 million (or $2 million) threshold is surpassed.
Form 706 is due nine months after death, but the deadline can be extended up to six months. Remember: While life-insurance proceeds are generally free of any income tax, they are usually included in the decedent's estate for estate-tax purposes — even though the money may go directly to policy beneficiaries. In fact, life-insurance proceeds are the most common cause of unexpected estate-tax bills. An exception to this rule though is if the beneficiary is the surviving spouse: Assets inherited by a surviving spouse (including life-insurance payouts) aren't included in the decedent's estate, as long as the surviving spouse is a U.S. citizen. This is the so-called unlimited marital-deduction privilege, and it's the most common reason why many large estates don't owe any federal estate tax.
If you're the executor of a substantial estate, you probably should hire a tax pro even if you're fairly certain no estate tax is actually due. If you're correct, the cost to confirm your conclusion will be minimal. If you're wrong, filing Form 706 isn't for amateurs. Also, a good estate-tax pro may be able to find some perfectly legal ways to substantially reduce the tax bite or even make it disappear completely.
4. The Miscellaneous Details
If you'll be filing Form 1041 and/or Form 706, you need to get the estate a federal employer identification number (EIN). This is analogous to an individual's Social Security number. Apply for the EIN by filling out Form SS-4 (Application for Employer Identification Number). It can be downloaded from the IRS Web site.
Next, you should file Form 56 (Notice Concerning Fiduciary Relationship), which notifies the IRS that you'll be acting on behalf of the estate regarding tax matters. This form can also be downloaded from the Web (but wait until you have the EIN in hand). It ensures you'll receive any notices shipped out by the IRS (lucky you).
Then it's time to open a checking account in the name of the estate with some funds transferred from the decedent's accounts. As the executor, you have the legal power to do this. But make sure you have the estate's EIN, because the bank will ask for it. Use the new account to accept deposits from income earned by the estate and to pay expenses — such as outstanding bills, funeral and medical expenses and of course those darned taxes.
Unfortunately, once you've done all this, your work might not be finished. You may also have to file state income-tax returns and perhaps a state estate-tax return as well. Sorry. However, I suspect that being nice enough to take care of all this stuff will greatly improve your standing in the hereafter. At least, I hope so.