How income taxes work during estate administration

By Richard C. Wilson, Founder, Family Office Club

For a business owner’s family, an executor or a beneficiary, begin the review with three folders: the decedent’s income records, the estate’s receipts and payments, and the beneficiary distribution records. Use the sections below to prepare questions about the final return, estate reporting, sales and expenses.

Research notice: Core authorities include Internal Revenue Code §§6012, 645, 663 and 642, Treasury regulations on estate termination, IRS Publication 559 and the Instructions for Form 1041. Ask an estate attorney or CPA to confirm an election, filing decision, deadline or tax calculation before acting.

The final return and estate return cover different periods

The final return uses the decedent’s regular accounting method through death. For a cash method taxpayer, include only income actually or constructively received before death. For an accrual method taxpayer, generally include only income normally accrued before death. Review later receipts to identify the estate or other recipient entitled to payment.

For the final return review, gather the decedent’s accounting records and identify the accounting method used before death. Place receipts near death beside the payer’s records and any documents identifying the person entitled to payment. Take questions about the estate’s ending date to the termination section below.

When an estate must file

A domestic estate’s fiduciary, or one of its joint fiduciaries, must file Form 1041 if gross income for the tax year is $600 or more or any beneficiary is a nonresident alien. Filing is also required if the estate held a qualified investment in a qualified opportunity fund at any time during the year, with Form 8997 attached. A foreign estate’s fiduciary files Form 1040 NR instead.

The $600 threshold measures gross income for the tax year, not the value of estate assets. Ask the CPA to review all three filing triggers rather than assessing filing from an asset inventory alone.

Income received after death needs its own reporting review

Apply for an employer identification number, or EIN, for the estate. Give payers the estate EIN for interest payable to the estate and the surviving joint owner’s identification number for interest payable to that owner. When appointed to act in a fiduciary capacity, separately file Form 56 as soon as the necessary information, including the EIN, is available. Form 56 reports the fiduciary relationship and does not supply the estate EIN.

Keep the EIN confirmation, fiduciary notice and payer correspondence together. Before asking a payer to change a reporting number, identify the intended recipient in the account documents.

Income in respect of a decedent

Income in respect of a decedent generally means income the decedent was entitled to receive but that was not properly includible on the final return under the decedent’s accounting method. The estate reports that income when received if it acquired the right from the decedent. If the estate did not acquire the right, the person acquiring it directly because of death reports the income when received. A person acquiring the inherited right through the estate reports the income when received after the estate distributes that right. Section 1014 does not adjust the basis of a right to receive income in respect of a decedent.

For detailed estate tax deduction allocations and transfers of rights to income, continue to the income in respect of a decedent guide. For retirement distributions, use the retirement accounts and beneficiaries guide.

Choosing the estate’s tax year

The personal representative chooses a calendar or fiscal accounting year on the estate’s first Form 1041, with the first year ending on the last day of a month and lasting no more than 12 months. Changing the chosen tax year generally requires IRS approval. A fiscal year return is due on the fifteenth day of the fourth month after year end, moving to the next business day if the due date falls on a weekend or legal holiday. Request an automatic 5½ month filing extension on Form 7004 by the regular due date, but pay the tax by the regular payment deadline.

Put the selected year end, filing deadline, payment deadline and any extension request in the administration calendar. Have the CPA confirm the entries before relying on them.

Estimated tax during administration

A decedent’s estate is excepted from §6654 estimated income tax requirements for tax years ending before the date two years after death. Apply that test to the estate tax year’s ending date. The estate must still pay the income tax due in full by the regular return due date.

Ask the CPA for specialist guidance on estimated payment calculations and safe harbors for later estate tax years.

Distributions can affect beneficiary reporting

Distributable net income, or DNI, limits the estate’s deduction for income required to be distributed currently and other amounts properly paid, credited or required to be distributed. DNI also helps determine beneficiaries’ income inclusions. No distribution deduction is allowed for the portion attributable to income excluded from estate gross income. Capital gains allocated to corpus are excluded from DNI only to the extent they are neither paid, credited or required to be distributed to a beneficiary during the tax year nor paid, permanently set aside or to be used for §642(c) purposes.

Bring the governing instrument, distribution records and the estate’s income and capital gain records to the return preparation meeting. Ask the preparer to distinguish the distribution deduction from the amount of property delivered to a beneficiary.

Specific bequests

A gift or bequest is excluded from the §§661 and 662 distribution regime when the governing instrument provides a specific sum of money or specific property, properly paid or credited all at once or in no more than three installments. An amount payable only from estate or trust income does not qualify. Review the governing instrument before applying this exclusion to an inheritance or principal distribution.

Beneficiary schedules and reporting years

Provide Schedule K 1 by the required Form 1041 filing date to each beneficiary receiving a property distribution or allocation of an estate item. Estate income generally enters the beneficiary’s tax year in which the estate’s tax year ends. Section 662 amounts retain their character in the beneficiary’s hands. Consult Publication 559 about reporting when a beneficiary dies.

Ask beneficiaries to bring the schedule to their own tax preparers. Use Publication 559 and specialist advice for reporting after a beneficiary’s death.

The 65 day election

An executor may elect under §663(b) to treat qualifying amounts properly paid or credited within the first 65 days of the following estate tax year as paid or credited on the preceding year’s last day. The election is limited to the greater of that preceding year’s accounting income or DNI, reduced by amounts already paid, credited or required to be distributed for that year, excluding amounts previously treated as paid in an earlier year under §663(b). To make the election, check the Form 1041 election box and file by the due date including extensions. Make a separate election for each year, and remember that the election is irrevocable.

Bring the payment dates, crediting records and prior year distribution records to the CPA before deciding whether to elect. Request a review of both the permitted amount and the filing requirements.

An asset sale depends on who owns the property

For a sale during administration, consult local law to determine whether the estate or beneficiaries legally own the property and must report gain or loss. The representative’s authority to sell does not necessarily put title in the estate. Gain is the amount realized above adjusted basis, and loss is adjusted basis above the amount realized. Use the linked basis guide for detailed basis adjustments and recognition exceptions.

For real estate, a business interest or a private investment, gather the deed or ownership records, sale documents and basis records before the reporting review. The inherited basis values and reporting guide covers inherited basis, special use valuation, basis consistency, adjustments and recognition exceptions.

Administration expenses have distinct deduction rules

Under §642(g), amounts allowable as estate tax deductions under §§2053 or 2054 generally cannot also reduce taxable income or offset a property sale price for the estate or another person. Income tax use requires a statement that the amounts have not been allowed as estate tax deductions and a waiver of the right to claim them as estate tax deductions, filed within the prescribed time, manner and form. The restriction excludes deductions under part II relating to income in respect of decedents. Section 642(g) restricts double deductions and does not independently make an expense deductible.

Keep invoices, payment records, proposed deductions and waiver documents together for the CPA. Ask the preparer to assess whether an expense qualifies before deciding which return should claim it.

Medical expenses and property taxes follow separate rules

Qualifying decedent medical expenses paid by the estate within the one year period beginning the day after death may be elected onto the decedent’s income tax return for the year incurred, with itemized deductions and only to the extent expenses not compensated by insurance or otherwise exceed 7.5% of adjusted gross income. Attach the prescribed statement in duplicate, stating that the amount has not been claimed as an estate tax deduction and waiving the estate’s right to that deduction. Expenses incurred in an earlier year require an amended return while the refund claim period remains open. The decedent’s medical and dental expenses paid by the estate are not deductible on Form 1041.

For this review, gather the medical bills, dates incurred, estate payment dates and insurance reimbursement records. Ask the CPA which return and election documents are appropriate before filing.

For computing the taxable estate on Form 706, §2053 excludes deductions for income taxes on income received after death, property taxes not accrued before death, and estate, succession, legacy or inheritance taxes. Ask the CPA to review any proposed Form 1041 property tax deduction separately.

Three questions separate the reporting issues

Use three questions to organize the meeting with the estate’s attorney and CPA. Bring the records needed to work through each answer.

• Which accounting method did the decedent use, who was entitled to each receipt, and which taxpayer and reporting year need review?
• Who legally owned property that was sold, and where are the title, sale and basis records?
• Which return is proposed for each expense, and which qualification, payment timing or waiver requirements need confirmation?

Coordinating a revocable trust

Use the estate and revocable trust income tax guide to prepare for a coordinated review. Bring the trust instrument and any election documents.

Ending estate income tax administration

Federal income tax administration cannot be unduly prolonged. If administration is unreasonably prolonged, the estate is treated as terminated after a reasonable period for the executor to complete administration duties. Termination also occurs when all assets are distributed except a reasonable reserve held in good faith for unascertained or contingent liabilities and expenses, excluding a beneficiary’s claim as beneficiary. A valid §645 election prevents termination before its election period ends.

At termination, unused §172 net operating loss carryovers, §1212 capital loss carryovers and final year deductions exceeding gross income other than §642(b) and §642(c) deductions may pass as deductions to beneficiaries succeeding to the estate’s property, subject to the prescribed regulations.

Request specialist guidance on the character and limitations of successor deductions. Have the CPA review the final return, remaining reserve and beneficiary schedules together.

Common questions

Resources to check out

• IRS Publication 559: Survivors, Executors, and Administrators: Guidance on final returns, estate income, expenses and beneficiary reporting.
• IRS Instructions: Form 1041 and Schedule K 1: Filing instructions for estate returns, elections and beneficiary schedules.
• 26 U.S.C. §691: Income in Respect of Decedents: Statutory source for reporting income in respect of a decedent.
• 26 U.S.C. §663: Distribution Exceptions and the 65 Day Election: Statutory source for specific bequests and the distribution timing election.
• Treasury Regulations: Termination of Estates and Trusts: Federal income tax termination guidance.