A decedent's tax year ends on his or her date of death, although the due date of the final return (Form 1040, U.S. Individual Income Tax Return) remains the same, typically April 15 of the following year. In general, normal tax accounting rules apply regarding the recognition of income and deductions, including the doctrine of constructive receipt. The tax year of the estate's income tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts, begins with the date of death and must terminate at a month end no more than 12 months after the date of death.
Tax planning opportunities must be considered both when death is imminent and after death. Several elections can affect the income or deductions reported in a decedent's final return.
A final individual income tax return (Form 1040) must be filed for the year of a decedent's death. If a surviving spouse does not remarry during the year, the spouse may file a joint return with the decedent for the year of death but is not required to do so (Sec. 6013(a)(3)). The joint return will include income and deductions for the decedent prior to the date of death and the surviving spouse's income and deductions for the entire year (Regs. Sec. 1.6013-1(d)(1)). If the surviving spouse remarries before the close of the tax year that includes the date of death, a separate return must be prepared for the decedent (Regs. Sec. 1.6013-1(d)(2)).
The personal representative generally decides whether to file a joint return. However, the surviving spouse may initiate the joint return if a personal representative has not been appointed by the due date (including any extensions) for filing the spouse's return and no return has previously been filed for the decedent for that year (Sec. 6013(a)(3); Regs. Secs. 1.6013-1(d)(3) and (4)). If these criteria are met, a surviving spouse may file a joint return with his or her deceased spouse, even though the IRS has prepared a "substitute for return" under Sec. 6020(b) and issued a notice of deficiency (CCA 201044011).
If a personal representative is later appointed, that person may disaffirm the joint return by filing a separate return for the decedent within one year of the due date (including extensions) of the spouse's (joint) return (Regs. Sec. 1.6013-1(d)(5)). A surviving spouse may not file an amended return (indicated as "filing as surviving spouse") for a tax year for which a joint return was previously timely filed prior to the decedent spouse's death, unless the deceased spouse had given authority (such as a power of attorney) to the surviving spouse (CCA 201107020).Advantages of filing a joint return
Since the surviving spouse's tax year does not end upon the death of the decedent, it may be possible to reduce the combined income tax liability of the decedent and spouse by accelerating or postponing income or deductions to maximize use of the joint tax rates. Other benefits of filing jointly for the decedent's final income tax return include the following:
- Use of one spouse's excess deductions against the income of the other spouse (e.g., excess charitable contributions of a decedent who died before generating the income needed to offset the donations) and the flexibility it gives the surviving spouse for tax planning purposes (e.g., to generate capital gains, or other income or deductions through his or her own assets before year end).
- Increase in the individual retirement account (IRA) contribution limit (because of the spousal IRA rules). A surviving spouse can make an IRA contribution to his or her spousal IRA after the death of the decedent spouse, based upon that decedent spouse's earned income prior to death. However, an IRA contribution for the deceased taxpayer must be made prior to the death of that taxpayer (IRS Letter Ruling 8527083).
- The ability of the decedent's net operating loss (NOL), capital loss, and passive activity loss (subject to the limitation in Sec. 469(g)(2)(A)) carryovers to offset income of the surviving spouse. Any NOL or capital loss carryover of the decedent that is not used on the final return (whether it is a separate or joint return) will expire unused (Rev. Rul. 74-175).
- Capital gains distributed to the surviving spouse from the decedent's estate, if allowed by the will or state law, may be used to offset pre-death capital losses and capital loss carryovers on the joint return. (This would occur only if the estate's tax year end falls before or coincides with the year end of such joint return.)
- Many tax credits are generally larger on a joint return than on a married-filing-separately (MFS) return. Some credits are not allowed on an MFS return.
Filing a joint return with the surviving spouse is not always the best option. Disadvantages of filing a joint return for the decedent's final tax year include the following:
- The decedent's estate and the surviving spouse are jointly and severally liable for any tax, interest, and penalties due on the joint return (Sec. 6013(d)(3)). When the surviving spouse is not the sole beneficiary of the estate, the personal representative may not be willing to expose the estate to potential unknown liabilities (e.g., tax on the surviving spouse's unreported income). Potentially, this exposure may be avoided because of the Sec. 6015 innocent spouse rules.
- Filing a joint return can negatively affect the amount of the decedent's deductions that are subject to adjusted-gross-income (AGI) limits (e.g., medical and charitable) and other AGI-sensitive items, since AGI is based on joint income rather than separate income.
- The surviving spouse must cooperate with the personal representative by sharing the information necessary to prepare the return and by signing the return once it is prepared.
Often, a joint return filing is preferred, when permitted, since such a filing can utilize some or all of the decedent's various tax carryovers that would otherwise never produce a tax benefit on any return.
NOL carryovers and capital loss carryovers
NOLs and capital losses allocable to the decedent cannot be carried over and used by his or her estate, nor can they be carried over and used in future tax years by a surviving spouse (IRS Letter Ruling 8510053). However, they can be used, subject to the usual limitations, in the decedent's final return, including one filed with the surviving spouse. Carryover losses not used in the decedent's final return expire unused (Rev. Rul. 74-175).
Planning tip: If a taxpayer in failing health is holding property that would generate a capital loss if sold, gifting the property to the spouse before death would preserve the capital loss. After a taxpayer dies, the surviving spouse can continue generating capital gain income (on separately held assets that were not eligible for a step-up in basis) during the remainder of the tax year to utilize his or her decedent spouse's capital loss carryovers on the final joint return. Since wash-sale rules do not apply to securities sold at a gain, the surviving spouse may immediately repurchase any securities he or she wishes to continue holding.
Example. Decedent's loss carryforwards available in final year if joint return filed: J died during the current year. At the time of his death, J was married to C. C did not remarry before the end of the year. J and C had items of income and loss activity during the year as shown in the table "J and C's Items of Income and Loss" (below). In addition, J had a $7,000 capital loss carryforward and a $5,000 NOL carryforward coming into the year.
If the personal representative filed a separate return for J, the capital loss would be lost because J had no capital gains or taxable income for the year. Likewise, the current-year NOL and the $5,000 NOL carryforward could not be utilized. However, if a joint return is filed with C, both the $7,000 capital loss and the NOL (both the current-year and the carryforward) can be used to offset C's capital gain and salary.
Note: In Lassiter, T.C. Memo. 2002-25, the Tax Court held that NOLs attributable to a decedent's bankruptcy estate could be claimed on a joint return filed with the surviving spouse for the year of death when the bankruptcy estate terminated before year end. The fact that the decedent's bankruptcy estate did not terminate until after death did not prevent the NOLs from passing to the decedent's final joint return.
Planning tip: If it appears that a decedent's loss carryforward will be lost, the surviving spouse should consider accelerating income into the current tax year or deferring deductions to the next year. Examples include selling appreciated property prior to year end, electing out of bonus depreciation, electing the accrual method for interest on U.S. bonds, delaying property taxes or state and local tax payments (taking into account the $10,000 yearly maximum deduction), or deferring charitable contributions.
Carryovers arising from joint income tax returns must be allocated between the spouses. Carryovers properly allocated to the surviving spouse are not affected by the death of the decedent.
This case study has been adapted from PPC's Guide to Tax Planning for High Income Individuals, 21st edition (March 2020), by Anthony J. DeChellis and Patrick L. Young. Published by Thomson Reuters, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).
|Patrick L. Young, CPA, is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact firstname.lastname@example.org.