CPAs are involved in all aspects of their clients' personal and financial lives—and when a client dies, they can be one of the most valuable advisers to the family. Although the increased estate tax exemption in recent years has minimized the number of taxable estates, numerous tax issues still must be addressed when a taxpayer dies. One of those issues is dealing with carryovers that the taxpayer or spouse may have had at the time of his or her death.
What happens to those carryovers—whether they are net operating losses (NOLs), passive losses, charitable contributions, or myriad other deductions or credits that have not been used in prior years? How can the CPA make sure that the correct amounts are used on the decedent's final tax return? How does the CPA ensure that he or she is capturing the necessary information each year to avoid any problems at death? And are there any planning opportunities that could benefit a surviving spouse's tax position?
Generally, carryovers can be used on the decedent's final income tax return but are lost thereafter. For a single taxpayer, this is fairly straightforward. It is more complicated when the decedent is married and files jointly. When the surviving spouse files a joint return with the decedent for the year of his or her death, the full amount of carryovers can still be used in the year of death, even if they are used to offset income of the surviving spouse that was generated after death. However, after the year of death, the carryovers must be examined carefully to determine which carryover amounts, if any, belonged to the decedent, because any amounts attributable to the decedent are lost and cannot be transferred to the surviving spouse.
For a couple who have filed a joint return for many years, there could be several types of carryovers coming into the year that one spouse dies. Each carryover must be allocated to each spouse. The following is a brief summary of how each carryover should be attributed to the decedent and the surviving spouse.
NOL carryovers: NOL carryovers are deductible only by the taxpayer who sustained the losses, and they cannot be transferred to or used by another taxpayer, including the surviving spouse. NOLs generally can be traced to specific business interests, so unless both spouses have losses, the CPA should be able to attribute the carryover to the spouse who generated the loss. For a sole proprietorship, the NOL is attributed to the spouse who is the sole owner of the business. For family-owned businesses operated as disregarded entities, or as S corporations or partnerships where losses are passed through to the business owners, any NOL on the couple's joint tax return can be attributed to each spouse based on his or her ownership in the business. Whatever amount of a decedent's NOL is not used in the year of death is lost. Rev. Rul. 74-175 specifically addressed NOL carryovers, providing that only the taxpayer who sustained the loss can use these carryovers.
Capital loss carryovers: Capital loss carryovers are also deductible only by the taxpayer who sustained the loss—again according to Rev. Rul. 74-175. Therefore, each year, any sales of capital assets should be tracked to determine which spouse generated the capital loss. If a couple sell securities, property, or other capital assets held jointly at a loss, and the loss is not fully used in years before one spouse dies, half of the loss is allocated to the surviving spouse and can be carried over. If just one of the spouses owned the asset that generated the capital loss carryover, any carryover is solely attributable to the spouse who owned the property and incurred the loss, and that carryover is lost if not absorbed in the joint return filed for the year of death.
Passive activity loss carryovers: Suspended passive activity losses (PALs) must be traced to the owner of the activity. Under Sec. 469(g)(2)(b), any of the decedent's PAL carryovers are allowed on the final joint return for the year of death, as the activity is considered disposed of. However, the amount of carryover that can be deducted must be reduced by the excess of the basis of the property in the hands of the transferee (the heir) over the decedent's adjusted basis in the property just before death. In other words, the amount of loss equal to the step-up in basis at death is not allowed to the decedent or to anyone else because the heirs receive that tax benefit from the step-up in basis. If the decedent's PAL carryover is less than the step-up in basis, none of the carryover is allowed on the final return.
Charitable contribution carryovers: Charitable contribution carryovers also expire if not used by a taxpayer before his or her death. In Stussy, T.C. Memo, 1997-293, the Tax Court ruled that any portion of a carryover attributable to a decedent cannot be used by the surviving spouse. Furthermore, Regs. Sec. 1.170A-10(d)(4)(i) provides that if the carryover is not used in the final joint return, the remaining carryover must be allocated between the spouses, and it provides the manner in which to allocate the carryover. To determine the amount of carryover attributable to the surviving spouse, the couple's original contributions must be recomputed as if separate returns had been filed for the contribution year. The portion of the carryover allocated to the surviving spouse is the amount that bears the same ratio to the total carryover as the spouse's carryover on a separate basis bears to the total contribution carryovers of both spouses on a separate basis. Any carryover allocated to the deceased spouse is lost if not used in the year of death.
Other carryovers: Other carryovers, such as investment interest expense, foreign tax credits, and alternative minimum tax (AMT) credit carryovers, all must also be allocated between the decedent and the surviving spouse, based on which spouse generated the tax credit. Any carryovers attributable to the decedent are permanently lost after the decedent's year of death. In Vichich, 146 T.C. No. 12 (2016), the Tax Court ruled that a widow could not use an AMT credit carryover on her separate return in a year after her husband's death, as he had incurred the AMT in a prior year, which gave rise to the AMT credit.
After considering the tax treatment of carryovers as described above, what can a practitioner do not only to ensure that the carryovers are properly allocated at death, but also to help surviving spouses best use tax carryovers that would otherwise expire? Some possible suggestions include:
- When preparing tax returns for married couples, always trace items of deduction, loss, and credit to each spouse. Be careful to note which spouse owns which capital assets and passive activities.
- If a couple are new clients, and there are carryovers from prior years, consult with the clients and determine the amount of carryovers attributable to each spouse. In addition to asking for a copy of the immediate prior-year tax return for new clients, consider asking for several years of returns to be able to track the carryovers to the years generated. It is always much easier to get those return copies when the couple first become clients, as opposed to years later when there is a death.
- Advise the surviving spouse to consider ways he or she could use the deceased spouse's carryovers on the joint return for the year of death. The surviving spouse could sell his or her own properties at a gain to use the deceased spouse's capital loss carryovers that would otherwise expire, or the surviving spouse could take an IRA distribution and offset that income with the deceased spouse's NOL carryovers. Work with the surviving spouse to achieve the best tax results before the end of the calendar year in which the decedent died, since the final joint return will include all income for both spouses for the entire year, and the decedent's carryovers are available on that return.
- Use this opportunity to discuss estate planning for the surviving spouse. While the widow or widower may not need to make major financial decisions immediately upon the death of a spouse, if income tax issues need to be addressed, the CPA is typically in a good position to cover these with the surviving spouse.
Whether the death of a spouse is sudden or follows a long illness, it can be a heartbreaking time. Being aware of the rules for carryovers, knowing how they affect taxpayers, and being prepared to discuss potential tax saving opportunities may allow the CPA to make this difficult time a little bit easier for the surviving spouse and other family members.
Valrie Chambers is an associate professor of accounting at Stetson University in Deland, Fla. Jan Lewis is a tax partner with Haddox Reid Eubank Betts PLLC in Jackson, Miss., and is also the immediate past chair of the AICPA Tax Practice & Procedures Committee. For more information about this column, contact firstname.lastname@example.org.