Estate Settlement and Income Tax Considerations

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Estate Settlement and Income Tax Considerations

Jan 11, 2018

by Gregory S. Dowell

January 11, 2018

If you are so fortunate as to receive an inheritance from a relative or friend who has passed away, it is important to understand the income tax implications. Most individuals have this experience at best once or twice in their lives, and this is understandably a unique issue to them. As a practical matter, we also find that many tax practitioners (particularly those tax preparers who are not CPAs or enrolled agents) rarely see these issues and, unfortunately, do not always handle the transactions correctly. The area of estate and trust taxation is very complicated and the intent of this article if only to provide a very brief and conceptual overview.

First, let’s consider a few important concepts. When an individual passes away, a new entity for income tax purposes is created. This new entity may be either an estate, or perhaps an irrevocable trust. There are potentially two different types of tax that could come into play for the estate or trust, and those are the estate tax and the income tax. The key distinction is that the estate tax is a tax that is assessed on the value of the estate at the date of death (or at an alternate valuation date), if the value of the estate exceeds a minimum threshold ($5.49 million per individual). The estate tax is effectively a one-time tax. On the other hand, the income tax is assessed on the earnings (net of allowable deductions) of the estate or trust. Income and deductions up to the date of death are reported in the deceased person’s (“decedent”) final individual income tax return. Any income or deductions that occur after the date of death are reportable under the estate or trust (the new entity that was created). The estate or trust will have to declare a taxable year end and file an income tax return to report the income and deductions that occurred post-death, if the gross income exceeds a minimal threshold. A couple of other important concepts:

When an estate or trust is created at death, an “executor” or “trustee” is appointed pursuant to the will or the trust document. The executor or trustee is the individual or entity (perhaps a bank) that is appointed to discharge the affairs of the estate or trust, including filing and paying any estate taxes or income taxes.
A “beneficiary” is someone who is named in the will or trust document, and who has an interest in the income and the value of the estate.

From a beneficiary’s viewpoint, the question is almost always “what is the effect of the inheritance on my individual income taxes?”. The answer is that the beneficiary does not pay tax on the value of the estate received, but only on the income that is subsequently earned post-death and distributed to the beneficiary. If the income is not distributed, the estate actually is responsible for paying the income tax on the taxable income earned post-death. The basic principal is that the body (also referred to as “corpus”, from the Latin word for body) of the estate that is received by the individual does not represent income and is thus not an income-taxable event, and it has already been subject to estate taxation (if the total value of the estate exceeded the $5.49 million minimum threshold).

The bottom line is that there is no tax effect to the beneficiary until the beneficiary receives a distribution (a distribution, by the way, can be in the form of cash or assets, such as stocks and bonds). If a beneficiary receives a distribution from the estate, that distribution will likely include some portion of the income earned post-death. The distribution is a triggering event that warns the beneficiary that they may need to report their share of the estate’s income on their individual income tax return. If any income is distributed, the executor will be required to prepare a form that identifies the income (and possible deductions) that are to be reported on the beneficiary’s individual income tax return. The form is known as a “Schedule K-1”. Because a K-1 is not necessarily prepared and distributed until after the tax year is over, it is good practice for the executor to estimate and advise the beneficiaries as soon as possible as to how much income the estate or trust might pass through to the beneficiary. This allows the beneficiary to estimate the income taxes that might be due and to plan for the payment of those taxes. Depending on the amount of income taxes that might be due, the beneficiary may be able to adjust their income tax withholdings from their wages (if they are employed) or the beneficiary may need to consider paying estimated income taxes.

In subsequent tax years (following the distribution and closing of the estate), there is no longer any estate the beneficiary will want to estimate the amount of earnings (interest, dividends, and capital gains) that might be earned on the estate proceeds that were added to the beneficiary’s investment portfolio. Again, this could require the beneficiary to pay quarterly estimated income taxes in future years.

Again, this is intended as a brief overview. There is always a danger in trying to simplify complicated subjects, but we certainly hope that this article is helpful.

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by Gregory S. Dowell Updated May 16, 2023 Spring is the traditional kick-off to wedding season, and thoughts quickly turn to the wedding venue, gifts, the happy couple, and, of course, the guest list. Lurking somewhere in the shadows, behind even that strange uncle you barely know, is another guest that needs to be considered: The tax impact on the newlyweds. To start, newlyweds will have two options for filing their income taxes in the year of marriage: Filing status can either be married filing jointly, or married filing separately. In the vast majority of cases, a couple will benefit with a lower overall tax burden to the couple by choosing to file married filing jointly. One of the classic cases where a couple may consider filing separately is when one spouse has significant amounts of medical expenses for the year. 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As a result, the TCJA eliminated any tax-bracket-generated marriage penalty effect for joint filers where each spouse has roughly the same amount of taxable income-through the 32% bracket. For example, if two individuals who each have $215,950 of taxable income file as single taxpayers for 2022, each would have a tax bill of $49,335.50, for a combined total of $98,671. If they were married, their tax bill as marrieds filing jointly would be $98,671, exactly the same amount as the combined total tax they’d pay as single taxpayers. Because the 35% bracket for marrieds filing jointly isn’t twice the amount of the singles 35% bracket, the marriage penalty effect will still apply to joint filers whose income falls in the 35% bracket. Using 2022 tax tables, two single taxpayers may each have $500,000 in taxable income, for a combined total of $1,000,000, without having any of it taxed higher than 35%. 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The bonus is the result of two factors: 1) the tax brackets for marrieds filing jointly cover wider spans of income than the tax brackets for taxpayers as singles; and 2) the taxable income of the lower-earning individual may not push the couple’s combined income into a higher tax bracket. In such a case, it will probably be better from the tax standpoint to accelerate the marriage into this year if feasible. There are a number of other factors that should also be taken into account when determining the effect of a marriage on income taxes of the couple. As mentioned early in this post, the first decision is to verify that filing a joint return is preferred to filing separate returns. In addition, many provisions of the tax code phase out completely (or decrease partially) as adjusted gross income increases. In a perfect world, there would only be good surprises for a newlywed couple following their wedding. To avoid any unpleasant income tax surprises, we always recommend that a newlywed couple take the time to make a projection of what their income will look like when combined as a couple, and determine what the tax bill will look like, at the Federal and State levels. After all, planning ahead, communicating with each other, discussing finances, and avoiding unpleasant surprises are some of the keys to a long marriage.