Because they don’t encounter them often, many tax practitioners are hesitant to prepare a decedent’s final Form 1040, U.S. Individual Income Tax Return. Often, the most that tax practitioners do differently from a return for a living client is to determine who can sign the return on the decedent’s behalf.
But it is better to take control of the situation and make the final Form 1040 a powerful and effective part of the post-mortem planning process. Practitioners should aim to stride confidently into the final Form 1040 preparation and come out of it with tax savings for the decedent’s family.
Here are some things I have learned about tax planning and preparation during a quarter century of helping clients after the loss of a loved one.
Stop making estimated tax payments
Once a taxpayer dies, he or she is no longer required to make estimated tax payments. Many well-meaning family members continue to submit the decedent’s quarterly estimated tax vouchers, which is not necessary and may require taking funds out of an investment portfolio, where they could otherwise be growing and earning income for as long as a year.
Not only does Regs. Sec. 1.6654-2(e)(7) indicate no joint estimated tax payments can be made after death and the estate has no liability to make further payments, it makes practical sense that no payments are needed, too. The decedent’s tax year ends on the date of death, so only income received through that date is reportable on the final Form 1040. If the deceased taxpayer was paying an amount each quarter to cover the expected tax liability for that quarter, he or she would no longer need to make those payments after the tax year ends. (Note, however, that the surviving spouse may need to make estimated payments for his or her own tax liability.)
Even if the deceased taxpayer was taking advantage of the prior-year-tax safe harbor in making estimated tax payments and the Form 1040 ends up with a balance due later on, the tax preparer can eliminate filing the Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts.
Who will sign the return? What if there is a refund?
A surviving spouse filing a joint return need not do anything special. He or she will just sign as the surviving spouse. If someone other than a surviving spouse has been appointed by a court to administer the decedent’s affairs, that executor or personal representative should sign the return and attach a copy of the certificate that shows the official appointment.
If the return shows an overpayment of tax, and it is not a joint return with the surviving spouse, or there is no court-appointed executor or personal representative, Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, will need to be filed with the return to obtain a refund.
Can a spouse file a joint return with a decedent?
Yes, a surviving spouse can file a joint return with the decedent for the year of death. Depending on the relative earnings of each spouse, the joint tax rate tables may yield the greatest benefit.
However, if the decedent incurred significant medical expenses during his or her last illness and passed away early enough in the year to be reporting substantially less income, consider filing separately if it would save tax by allowing medical expenses to exceed the adjusted gross income threshold for deduction and create a better overall result for the surviving spouse and family.
Savings bond interest is normally taxable to the beneficiary of the bond
This is one of my favorite post-mortem planning strategies. Savings bonds were particularly popular among what is now the older generation among us. Many decedents have bonds that have accrued interest rolled into them when earlier issues of bonds were converted to later issues, and many types of bonds accrue interest until maturity. That accrued interest, which usually has never been taxed, will be taxed when the beneficiary of the bond cashes it.
But there is an important exception that allows accrued bond interest to be reported on the decedent’s final Form 1040, using a Sec. 454(a) election, which often saves tax over what the child beneficiaries’ marginal tax rate would be if they reported all the interest when cashing the bonds.
This takes some coordination of reporting. First, all the interest accrued through the decedent’s date of death is reported on the decedent’s final Form 1040. After that, the beneficiaries should cash the bonds. The beneficiaries will receive Forms 1099-INT, Interest Income, for the interest they receive, which may be more than the interest already reported by the decedent if interest continues to accrue on the bonds.
The beneficiaries should report the interest on their personal returns, to avoid a matching notice from the IRS. On the next line of their Schedule B, Interest and Ordinary Dividends, the beneficiaries should deduct it as a negative income item with an explanation that the interest has already been reported by the decedent (and including the decedent’s Social Security number) under a Sec. 454(a) election. The bonds should be cashed as soon as possible because, if they are cashed five or 10 years after the decedent’s death, it will be easy to lose track of the fact that the accrued interest through the date of death has already been reported and taxed.
If the decedent is the beneficiary of the bond, all the better. When preparing the Form 1041, U.S. Income Tax Return for Estates and Trusts, the tax practitioner can control the process of reporting the bond interest. The estate reaches the highest federal tax rate, 39.6%, plus 3.8% net investment income tax, when taxable income exceeds $12,400 in 2016. But the decedent’s final Form 1040 may be at a very low tax rate, depending on how much bond interest there is, so the family can often save a lot of tax by reporting the bond interest on the final Form 1040.
Allocation of income between pre- and post-death reporting
On a loved one’s date of death, most family members do not obtain a federal identification number for the estate, call all the brokers to open new accounts that are titled in the estate’s name, and transfer his or her assets into those new accounts. And, of course, these things usually cannot be done immediately because the legal processes to appoint the executor or personal representative take some time. So the Forms 1099 for investment earnings for the year of death are often messy. They usually include activity that occurred after the date of death and may include sales of securities whose basis has not been adjusted to date-of-death values.
Thought should be given to allocating only the income earned prior to death to the decedent’s Form 1040. Any post-death earnings should be reported either on a Form 1041 for the estate or on the beneficiary’s return, if it is an asset that is titled to transfer immediately on death. Consider whether the post-death earnings will be reportable by a surviving spouse who is filing jointly with the decedent anyway. Think about whether moving this post-death income to Form 1041 will allow expenses incurred after death, or administrative expenses incurred by reason of the death, to offset this post-death income; and consider whether the cost to prepare the Form 1041 to use expenses to offset the income is justified.
Medical expenses can be deducted on the final Form 1040 or as a debt on the federal estate return, Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, wherever the greatest benefit is derived. When they are deducted on Form 1040, any expense paid that year can be deducted, whether it was paid before or after death.
The medical expenses that are eligible for deduction on Form 706 are the ones paid only after the date of death. Medical expenses cannot be deducted on Form 1041.
Federal estate tax is generally not deductible, but state estate tax is deductible on the federal estate tax return
Neither federal nor state estate tax can be deducted on a federal income tax return. However, beneficiaries may be entitled to take an itemized deduction for the estate and generation-skipping transfer tax attributable to income in respect of a decedent (IRD) on their individual income tax returns for the year they include the IRD in income. Funeral expenses are also not deductible on an income tax return.
Is federal income tax deductible?
Yes. Amounts owed on a final income tax return are deductible as a debt on the estate return, Form 706. (On the other hand, income tax refunds are taxable to the estate as accounts receivable.)
This is one reason to think about a deathbed conversion to a Roth IRA. If the tax on converting the IRA reduces the size of a federally taxable estate and results in less income tax to the beneficiaries when they take withdrawals, that is truly a winning combination. Just cashing the IRA completely before the end of life can be worthwhile, but the beneficiaries would lose the tax-free growth of the account balance that could occur over their single life expectancies.
Think about taking big IRA withdrawals if someone is near death early enough in the year that his or her income will be very low and much of the IRA withdrawal would fall into lower tax brackets. Or take that large IRA withdrawal just to get the amount of the resultant federal income tax either to reduce the assets in the estate at the date of death or to be a deductible debt of the estate, which results in the same lower figure.
Extend the final Form 1040 to facilitate post-mortem planning
The federal estate tax return, Form 706, is due nine months after the date of death.
The estate income tax return, Form 1041, can use a fiscal year end that can be as late as the last day of the month that falls in the following year before the month of death. (For example, a date of death of Aug. 25, 2015, can have a fiscal year that runs to as late July 31, 2016.) Form 1041 is due the 15th day of the fourth month after the end of the tax year.
It is often preferable to extend the final Form 1040 to coordinate the preparation of these returns in such a way that every angle can be considered. The Form 1040 is still due April 15th, even when the taxpayer passes away during the year, and an automatic six-month extension can be obtained by filing Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return. Taking the extension provides more flexibility to determine where things will be reported to obtain the lowest overall tax for the family.
Use those capital losses
The decedent’s capital loss carryover evaporates if it is not used as part of the final Form 1040. It does not pass over to the surviving spouse or other beneficiaries. This is an opportunity for the surviving spouse to dispose of enough of his or her own appreciated stock to fully use the other spouse’s remaining capital loss carryover, but the last chance to do that is the year of death. The surviving spouse can then immediately repurchase the same stocks, as the wash-sale rules do not apply to gains.
Any stocks a surviving spouse inherits are not likely to be much help in recognizing capital gains, as they will have received a step-up in basis to their value at the date of death.
What about suspended passive losses?
If the decedent had any suspended passive losses, either generated in or carried forward to the year of death, those losses may be able to be deducted on the final Form 1040. Passive losses in excess of the amount of basis step-up received on the asset that generated the passive losses can be deducted on the final Form 1040.
Having a dear client pass away is difficult. But knowing the tools to enable the client’s family to receive excellent professional care in winding up the deceased client’s tax affairs is very gratifying. Being there for clients when they need you most is why I continue to practice as a CPA.
Karen Cohen, CPA, MBA, is a principal with Packer Thomas CPAs in Canfield, Ohio, specializing in personal income tax planning and trust, estate, and gift tax planning and compliance.