- August 20, 2024
- Posted by: Gavtax
- Category: estate planning
When it comes to estate planning, understanding the roles and functions of estates and trusts is important. These entities are defined by the assets they hold and operate as separate legal entities from the individuals who create or benefit from them. This blog will explore the basics of creating and terminating estates and trusts, and the implications for beneficiaries.
The Creation of an Estate or Trust
An estate comes into existence when a taxpayer dies. The estate manages and distributes the deceased’s assets according to the will or state laws if there is no will. On the other hand, a trust can be created during a taxpayer’s lifetime (a living trust) or established upon their death (a testamentary trust). Trusts are designed to distribute income and assets to beneficiaries, either during the taxpayer’s lifetime or after death.
To legally function, an estate or trust must obtain an Employer Identification Number (EIN) from the IRS, similar to any other legal entity. This number is necessary for managing tax obligations and financial transactions.
For those studying for exams like the Enrolled Agent (EA) exam, it’s essential to understand the specific reporting requirements, filing deadlines, and exemption thresholds associated with estates and trusts. Knowledge of how distributions affect individual tax returns is also important.
The Termination of Estates and Trusts
Estates and trusts generally terminate when all assets and income have been distributed, and all liabilities have been settled. However, if a trust or estate’s existence is unnecessarily prolonged, the IRS can intervene to terminate it after a reasonable period has passed, particularly after the final administration is completed.
An estate or trust that incurs a loss in its final year can pass that loss to the beneficiaries, who can then deduct it on their individual tax returns. However, losses cannot be passed to beneficiaries in a non-termination year.
A compelling example involves Johan, who passed away five years ago, leaving an estate worth $10 million to his two children, Teresa and Socorro. Disputes between the siblings over the division of assets led to delays in the distribution. Meanwhile, Johan’s estate continued to generate revenue from various sources, including stocks and rentals. In such a scenario, Johan’s estate would not terminate until an agreement is reached and the assets are distributed.
Tax Implications for Beneficiaries
Beneficiaries must report the estate’s income on their individual tax returns in the same manner as their personal income. Under the Surface Transportation Act, the executor of an estate must file an estate tax return and provide beneficiaries with a statement that includes:
(a) The value of each interest in property as reported on the estate tax return.
(b) Any other pertinent information required by the IRS.
This information must be furnished within 30 days following the date of the estate tax return’s filing or within 30 days after the actual filing of the return, whichever is earlier.
Building on our previous discussion about the creation and termination of estates and trusts, it’s important to delve into the tax obligations and reporting requirements that accompany these processes. Understanding these obligations ensures compliance with federal tax laws and prevents potential issues for both the estate and its beneficiaries.
Estate Taxation and Reporting: Key Considerations
When a taxpayer passes away, their estate becomes a separate legal entity. This estate is subject to U.S. estate taxation, which includes all the decedent’s assets at the time of death in the gross estate for tax purposes. However, beneficiaries who inherit property directly from an estate are typically not taxed on the transfer. Instead, it is the estate itself that is responsible for paying any applicable taxes before distributing assets to the beneficiaries.
Important Note: A new reporting requirement, Form 8971, “Information Regarding Beneficiaries Acquiring Property from a Decedent,” has been introduced to address inconsistencies in the reporting of inherited property. Executors must complete this form, which includes Schedule A, and provide it to the IRS. Schedule A is then provided to each beneficiary, ensuring that the value of the property reported on an estate tax return aligns with the value used for income tax purposes when the beneficiary sells the property.
The Estate’s Tax Liability
For federal tax purposes, estates have certain thresholds that determine whether an estate tax return (Form 706) must be filed. For example, in 2018, the estate tax exemption amount was $11.18 million. If the combined value of the decedent’s assets exceeds this threshold, an estate tax return is required. If the estate’s value is below this amount, filing may not be necessary unless the decedent made significant taxable gifts during their lifetime.
Let’s consider the case of Stefan, a U.S. citizen who lived primarily in Spain and owned properties both in Spain and the United States. Upon Stefan’s death in 2018, his assets, including U.S. investments and properties in both countries, were valued at approximately $14 million. Since the combined value exceeded $11.18 million, Stefan’s estate was required to file an estate tax return, reporting all his assets to the IRS. Additionally, the estate had to consider any foreign assets that might be subject to U.S. estate taxes.
The Role of the Personal Representative
After an individual’s death, a personal representative—often an executor named in the will, or an administrator appointed by a court—takes responsibility for managing the estate. This role includes settling debts, distributing assets, and ensuring that all tax obligations are met. The personal representative must provide documentation proving their authority, such as a certified copy of the will or a court order, before they can act on behalf of the estate.
Moreover, the personal representative is also tasked with determining the estate’s tax liability and filing the necessary returns. This includes filing the estate tax return (Form 706) if required and ensuring that taxes are paid before any distribution to beneficiaries. Failing to meet these obligations can result in the personal representative being held liable for any unpaid taxes.
Continuing from our previous discussions on estate planning and tax obligations, a critical aspect of managing an estate involves the filing of various tax returns after the death of an individual. These responsibilities typically fall on the personal representative, often an executor or administrator. This blog will explore the key tax forms that must be filed, the reporting of income earned during estate administration, and how executor fees are treated for tax purposes.
Essential Tax Filings for an Estate
When an individual passes away, there are several tax filings that the personal representative must manage:
1. Final Income Tax Return (Form 1040): This return covers the income earned by the decedent from the beginning of the tax year until the date of death. For example, if someone earned wages before their death in 2018, these earnings would be reported on their final Form 1040.
2. Fiduciary Income Tax Return (Form 1041): This return is used to report the income earned by the estate during its administration. This includes income generated from the decedent’s assets after their death, such as interest, dividends, or rental income.
3. Estate Tax Return (Form 706): Filed only if the decedent’s estate exceeds the estate tax exemption threshold (which was $11.18 million in 2018), this return reports the total value of the estate and determines the amount of estate tax due.
Reporting Executor Fees and Income
The personal representative is often compensated for their work managing the estate. The tax treatment of these fees depends on whether the executor is engaged in the trade or business of being an executor or if they are simply a friend or family member of the deceased.
(a) If the executor is not in the trade or business of being an executor (i.e., they are a family member or friend doing this as a one-time duty), the fees they receive are reported as “other income” on Line 21 of Schedule 1 of their personal Form 1040.
(b) If the executor is in the trade or business of being an executor (such as a professional estate attorney), the fees are reported as self-employment income on Schedule C and are subject to self-employment tax.
Let’s look at some examples to illustrate these scenarios:
Example 1: Marcia, the Sole Heir and Executor
Prescott died in April 2018, leaving his daughter Marcia as the sole heir and executor of his estate. Prescott had earned $83,000 in wages before his death, which Marcia needs to report on his final Form 1040. Additionally, Prescott’s estate, valued at approximately $12 million, exceeds the exemption threshold, so Marcia must also file Form 706. As the executor, Marcia is responsible for managing these filings and ensuring all taxes are paid.
Example 2: Janice, the Executor as a Favor
Jane, an enrolled agent, was named as executor in the will of her best friend Lori, who passed away in 2018. Although Jane is not in the business of being an executor, she agrees to manage Lori’s estate. Lori’s will stipulates that Jane will receive 2% of the income generated by the estate as compensation for her work. Jane must report this executor fee as “other income” on her individual Form 1040, but it is not subject to self-employment tax since this is a one-time role performed as a favor.
Example 3: Eli, the Professional Estate Attorney
Eli, a professional estate attorney, is named executor in the will of Carol, one of his long-time clients who died in 2018. As per the will, Eli is entitled to 5% of the income generated by Carol’s estate. Since Eli is in the business of managing estates, he must report this income on Schedule C of his tax return and pay self-employment tax.