Tax Responsibilities After Someone Dies

The death of a loved one is always difficult but it can be even more challenging if you are the one who must handle all the resulting tax responsibilities.

There are a couple different ways you can assume the required duties:

  • You may be named as the executor of the decedent’s estate under his or her will.
  • In the absence of a will, you could be appointed as the administrator by the probate court.

Who can be an executor?

In most states, any U.S. citizen over the age of majority, who has not been convicted of a felony, can be named an executor. However, some states also require an executor to be a resident of the state.
Some people choose an accountant, lawyer or financial consultant because of the person’s expertise and the complexity of the job. Others appoint a spouse, adult child, relative or friend, especially if the estate is small.

Either way, the duties are essentially the same, so for purposes of this article, we’ll call the person with the responsibility the executor.

What must be done? The executor is charged with the task of finding the estate’s assets, paying off its debts, and distributing whatever is left to the rightful heirs and beneficiaries. The executor is also required to file the necessary tax returns and pay any taxes due. If you are the executor and fail to do this, the IRS can come after you personally for tax underpayments, plus penalties and interest. So you need to understand what is involved and get the proper assistance from your attorney.

One of the duties is to make sure the decedent’s final 1040 form is filed. The decedent’s final 1040 tax return covers the period from January 1st through the date of death. The return is due on the normal date (generally April 15 of the following year). If the decedent was unmarried, the final 1040 is prepared in the usual fashion. When there is a surviving spouse, the final 1040 can be a joint return filed as if the decedent were still alive as of year end. The final joint return includes the decedent’s income and deductions up to the time of death, plus the surviving spouse’s income and deductions for the entire year.

The Handling of Medical Expenses

If large uninsured medical expenses were accrued but not paid before death, the executor must make an important choice about how they are treated for tax purposes. Along with any medical expenses paid before death, these accrued expenses can be deducted on the decedent’s final 1040 to the extent they exceed 7.5 percent of adjusted gross income (AGI). This is an exception to the general rule that expenses must be paid in cash before they can be deducted. (Final medical expenses can easily exceed 7.5 percent of AGI, especially when death occurs early in the year before much income is earned.)

Alternatively, an executor can choose to deduct the accrued medical expenses on the decedent’s federal estate tax return. Of course, this is the wrong choice if no federal estate tax is owed. However, when estate tax is due, deducting accrued medical expenses on the estate tax return is usually the tax-smart option. Why? Because the minimum estate tax rate is a whopping 45 percent for 2005 while the decedent’s final income tax rate could be as low as 10 percent. Plus, the full amount of the accrued medical expenses can be deducted on the estate tax return (not just the excess over 7.5 percent of AGI).

In addition to the final tax return and the medical expenses, here are the rest of the tax-related duties:

File the Estate’s Income Tax Returns. Immediately after death, the decedent’s estate may take over ownership of some or all of the decedent’s assets. If so, the estate will be taxed on its income under complicated IRS guidelines applicable to trusts.

Important distinctions: We are talking about income taxes for the estate, not the final income taxes of the decedent. And the federal estate tax is an entirely different subject.

Small estates (with gross income under $600) aren’t required to file income tax returns. If you are in charge of an estate that must file, get professional help to assist you with this onerous chore because the tax law is very complex.

File the Estate’s Estate Tax Return. The federal estate tax return is filed on Form 706. Assuming the decedent did not make any sizable gifts before dying, no estate tax is due, and no Form 706 is required, unless the estate is worth over $3.5 million. By sizable gifts, we mean in excess of $13,000 to a single recipient (unchanged from 2009). If sizable gifts were made, the excess over the $13,000 threshold is added back to the estate to see if the $3.5 million threshold is surpassed.

Form 706 is due nine months after death, but the deadline can be extended up to six months. Remember: While life insurance proceeds are generally free of any income tax, they are usually included in the decedent’s estate for estate tax purposes – even if the money goes directly to policy beneficiaries. In fact, life insurance proceeds are the most common cause of unexpected estate tax bills. One other very important point: assets inherited by a surviving spouse are not included in the decedent’s estate, as long as the surviving spouse is a U.S. citizen. This is called the unlimited marital deduction privilege and it’s the most common reason why many large estates don’t owe any federal estate tax.

If you are the executor of a substantial estate, consult with an attorney even if you think no estate tax is actually due. If you are correct, the cost to confirm your conclusion will be minimal. If you are wrong, filing Form 706 is generally a complicated matter and you may need professional assistance. Also, an experienced estate attorney may be able to find perfectly legal ways to substantially reduce the tax bite or even make it disappear.

Source: Daskal Bolton LLP June 2010 Newsletter